INTERMEDIATE ACCOUNTING

Transcription

1 Chapter 16 Retained Earnings and Earnings Per Share INTERMEDIATE ACCOUNTING whole or in part.

2 Objectives 1. Explain the accounting and reporting for different types of dividends. 2. Discuss the accounting for prior period adjustments and restrictions of retained earnings. 3. Prepare a statement of shareholders equity. 4. Compute basic earnings per share (EPS) including the computation of weighted average common shares. 5. Compute diluted earnings per share including the identification of potential common shares.

3 Requirements to Distribute Dividends Retained Earnings is an account used by a corporation to summarize the earned capital component of its shareholders equity, which primarily comprises the cumulative amount of net income over the life of the corporation, minus the cumulative amount of dividends paid out to shareholders. A deficit is a negative retained earnings balance resulting from a corporation s accumulated prior net losses or dividends in excess of earnings. To pay cash dividends, a corporation must meet legal requirements and have assets available for distribution. Usually, a corporation must restrict the amount of retained earnings available for dividends by the cost

4 Cash Dividends (Slide 1 of 4) The most common type of dividend is the cash dividend. Four dates are important for any type of dividend: Declaration date Ex-dividend date Date of record The Date declaration of payment date is the date the board of directors formally declares that a dividend will be distributed to shareholders of record on a specific future date, typically four to six weeks. The ex-dividend date occurs several days before the date of record to enable the corporation to update its shareholders ledger by the date of record.

5 Cash Dividends (Slide 2 of 4) The ex-dividend date is important to investors because on the ex-dividend date the stock stops selling with dividends attached. The date of record is the date which determines which shareholders will receive the dividend for the next payment date. These investors are listed in the shareholders ledger on the date of record. The date of payment is the date the corporation distributes the dividend checks and makes a journal entry to eliminate the

6 Cash Dividend Accounting Dates

7 Cash Dividends (Slide 3 of 4) Example On November 2, 2013, Bengal Corporation s board of directors declares preferred dividends totaling $25,000 and common dividends totaling $40,000. These dividends are payable on December Date of Declaration 14, 2013, to shareholders of record on November 23, November 2, 2013 Date Retained of Payment Earnings 65,000 Date of Record Dividends Payable: Preferred Stock 25,000 Dividends Payable: Common Stock 40,000 November 23, 2013 Memorandum entry: The company will pay dividends on December 14, 2013, to preferred and common stockholders of record as of today, the date of record. December 14, 2013 Dividends Payable: Preferred Stock 25,000 Dividends Payable: Common Stock 40,000 Cash 65,000

8 Cash Dividends (Slide 4 of 4) Usually, the amounts of dividends payable to each class of stock can be easily determined. Preferred stock may be either fully or partially participating. In these cases, a corporation must compute the dividends payable to each class of stock. Example Edgecombe Corporation has issued 10%, participating, cumulative preferred stock with a total par value of $20,000 and common stock with a total par value of $30,000. Edgecombe distributes cash dividends of $9,000, and there are no dividends in arrears.

9 Dividend Distribution $5,400 Total $3,600 Total Par Par of $30,000 of $20,000 = 18% = 18%

10 Property Dividends (Slide 1 of 2) A property dividend is a dividend that is payable in assets other than cash (such as inventory or investments) and often referred to as a dividend in kind. A property dividend occurs when a corporation enters an exchange in which it gives up something of value but for which it receives no asset or service in return. Example Freestone Corporation s board of directors declares a property dividend, payable in investment securities, which are bonds issued by Bandera Company. The bonds are recorded as an investment by Freestone and classified as available for sale. The bonds are carried

11 Property Dividends (Slide 2 of 2) Freestone makes the following journal entries to record the property dividend: Declaration Date Investment in Bandera Company Bonds ($43,000 $40,000) 3,000 Gain on Disposal of Investments 3,000 Retained Earnings 43,000 Property Dividend Payable 43,000 Date of Payment Property Dividends Payable 43,000 Investment in Bandera Company Bonds 43,000 On the date of payment, Freestone does not adjust the gain or loss, even though the fair value may have changed since the declaration date.

12 Script Dividends A corporation may have adequate retained earnings to meet the legal dividend requirements but insufficient cash to justify a current cash dividend. In this case, it may declare a script dividend and issue promissory notes (called script ) requiring the corporation to pay dividends at some future date. The dividend liability will be classified as short-term or long-term depending on the maturity date of the script. Script dividends are rare.

13 Stock Dividends (Slide 1 of 6) A stock dividend is a proportional (pro rata) distribution of additional shares of a corporation s own stock to its shareholders. Types of stock dividends: A stock dividend usually consists of the same class of shares. This type of distribution is called an ordinary stock dividend. The distribution of a different class of stock (i.e, common on preferred) sometimes is called a special stock dividend. A stock dividend differs from other dividends in that no corporate assets are distributed.

14 Stock Dividends (Slide 2 of 6) The following factors may enhance the perceived attractiveness of a stock dividend: The shareholders may see the stock dividend as evidence of corporate growth. The shareholders may see the stock dividend as evidence of sound financial policy. Other investors may see the stock dividend in a similar light, and increased trading in the stock may cause the market price not to decrease proportionally to the increased number of shares. The corporation may state that it will pay the same fixed cash dividend per share.

15 Stock Dividends (Slide 3 of 6) A stock dividend is not the same as a stock split. Small stock dividends: Fair value is ordinarily the appropriate value to use when the stock dividend is less than 20% or 25% of the previously outstanding shares. Large stock dividends: Valued at par value of the additional shares issued The total par value is transferred from retained earnings GAAP suggests that the use of the term dividend be avoided or, when this is not possible, use

16 Accounting for Stock Dividends

17 Stock Dividends (Slide 4 of 6) Example Querry Corporation has the following shareholders equity prior to the stock dividend: Common stock, $10 par (20,000 shares issued and outstanding) $200,000 Additional paid-in capital 180,000 Retained earnings 320,000 Total shareholders equity $700,000 Querry Corporation declares and issues a 10% stock dividend (a small stock dividend). On the declaration date, the stock is selling for $23 per share. Declaration Date Retained Earnings 46,000 Common Stock to be Distributed 20,000 Additional Paid-in Capital from Stock Dividend 26,000

18 Stock Dividends (Slide 5 of 6) Date of Issuance Common Stock to be Distributed 20,000 Common Stock, $10 par 20,000 Querry s resulting shareholders equity follows: Common stock, $10 par (22,000 shares issued and outstanding) $220,000 Note that the total Additional paid-in capital shareholders equity is 206,000 Retained earnings the same as before 274,000 Total shareholders equity the stock dividend $700,000 Assume, instead, that Querry declares a 40% stock dividend (a large stock dividend), when the stock is selling for $23 per share. Querry uses the par value of $80,000 for the 8,000 shares to record the dividend as shown on the next slide.

19 Stock Dividends (Slide 6 of 6) Querry uses the par value of $80,000 for the 8,000 shares to record the dividend. Declaration Date Retained Earnings 80,000 Common Stock to be Distributed 80,000 Date of Issuance Common Stock to be Distributed 80,000 Common Stock, $10 par 80,000 The resulting shareholders equity is as follows: Common stock, $10 par (28,000 shares issued and outstanding) $280,000 Additional paid-in capital 180,000 Retained earnings 240,000 Total shareholders equity $700,000

20 Stock Splits and Liquidating Dividends A stock split results in a corporation issuing additional shares. A reverse stock split reduces the number of shares outstanding. A stock split does not affect retained earnings. Liquidating dividends represent a return of contributed capital than a distribution of retained earnings. A corporation usually declares these dividends when it is ceasing or reducing operations. A liquidating dividend also may arise when a corporation with natural resources pays a dividend based on earnings before depletion.

21 How Do We Account for Prior Period Adjustments (Restatements)? (Slide 1 of 2) Prior period adjustments (restatements) are retrospective adjustments of retained earnings that can arise from changes in principles, change in accounting entity, and corrections of errors of prior periods. Example In 2014, Rycker Corporation discovers that it inadvertently did not accrue $10,000 of interest expense for Assuming a related income tax effect of $3,000, Rycker makes Retained the Earnings following correcting entries in 2014: 10,000 Interest Payable 10,000 Income Tax Refund Receivable (or Payable) 3,000 Retained Earnings 3,000

22 How Do We Account for Prior Period Adjustments (Restatements)? (Slide 2 of 2) If Rycker s January 1, 2014, retained earnings balance was $102,400, it reports the correction on its December 31,2014, statement as an adjustment to the beginning retained earnings balance. Retained earnings, as previously reported January 1, 2014 $102,400 Less: Correction of overstatement in 2013 net income due to interest expense understatement (net of $3,000 income taxes) (7,000) Adjusted retained earnings, January 1, 2014 $ 95,400 Rycker discloses the effect of the error on the prior year s net income and earnings per share in the period in which the correction is made. If comparative statements are presented, Rycker makes corresponding adjustments to it net income, retained earnings, assets, or liability account balances for all the periods reported.

23 Restrictions (Appropriations) of Retained Earnings A restriction (appropriation) is a policy where the board of directors makes a commitment that a portion of retained earnings is unavailable for dividends. A board of directors may restrict retained earnings to meet legal requirements, such as meeting a state s requirements concerning treasury stock. The board may restrict retained earnings to meet contractual restrictions related to issuing long-term bonds.

24 Bardwell Corporation: Statement of Shareholders Equity (Slide 1 of 2)

25 Bardwell Corporation: Statement of Shareholders Equity (Slide 2 of 2)

26 Accumulated Other Comprehensive Income Comprehensive income includes both net income and other comprehensive income. Other comprehensive income (loss) might include the following items: Unrealized increases (gains) or deceases (losses) in the fair value of investments in available-for-sale securities Translation adjustments from converting the financial statements of a company s foreign operations into U.S. dollars Gains and losses on certain types of derivative financial instruments that are designated as cash flow hedges Certain types of pension plan gains, losses, and

27 Statement of Retained Earnings for 2013

28 Real Report: Shareholders Equity and Related Changes (Slide 1 of 5)

29 Real Report: Shareholders Equity and Related Changes (Slide 2 of 5)

30 Real Report: Shareholders Equity and Related Changes (Slide 3 of 5)

31 Real Report: Shareholders Equity and Related Changes (Slide 4 of 5) Questions: 1. How many shares of treasury stock were acquired in 2010? At what average price were they acquired? During 2010, Starbucks acquired 11.2 million shares of treasury stock at an average price of $25.50 per share ($285.6 million 11.2 million shares). 2. What was Starbucks s other comprehensive income for 2010 and what was Starbucks s ending 2010 balance in Accumulated Other Comprehensive income? Starbucks reported another comprehensive loss of $8.2 million for fiscal year 2009; this consists of a translation adjustment gain of $8.8 million and an unrealized holding loss of $17.8 million. The balance in accumulated other comprehensive income at October 3, 2010, is $57.2 million. This amount can be found in the shareholders equity section of the partial balance sheet as well as the consolidated statement of shareholders equity by adding together the components of accumulated other comprehensive income (loss).

32 Real Report: Shareholders Equity and Related Changes (Slide 5 of 5) 3. What were the total dividends declared during 2010? How much did dividends change in 2010 from Total 2009? dividends declared were $267.6 million. This was an increase of $267.6 million dollars from 2009 when no dividends were declared. 4. How many shares of common stock were issued for stock option compensation in 2009? At what average price were the common shares issued? During 2010, Starbucks issued 10.1 million shares of common stock for stock options at an average price per share of $13.61 [increase in shareholders equity due to stock option transactions of $137.5 million ($137.5 million 10.1 million shares)].

33 Earnings Per Share (Slide 1 of 2) The primary components of net income (loss) are: Income (loss) from continuing operations, which includes operating revenues and operating expenses Results from discontinued operations, which includes the income (loss) from the operations of a discontinued component as well as the gain (loss) from the disposal of the discontinued component Extraordinary gains or losses, which are the results of unusual and infrequent events Corporations are also required by GAAP to report earnings per share information on its income statement. Earnings per share is calculated as net income minus preferred dividends divided by weighted average number of common shares outstanding.

34 Earnings Per Share (Slide 2 of 2) One ratio often used by investors to evaluate return and risk is the price/earning ratio, which investors often use in intercompany comparisons of share price relative to profitability. The price/earnings ratio is computed as follows: Price Market Price per Share (of the Common Stock) Earnings Ratio = Earnings per Share When using earnings per share information for intercompany comparisons, a user must be sure that calculations are comparable.

35 How are Basic Earnings per Share (EPS) Computed? There are two types of corporate capital structure: A simple capital structure is a type of corporate capital structure that consists of common stock outstanding and possibly nonconvertible preferred stock. A complex capital structure is a type of corporate structure that has both common stock outstanding and potentially dilutive securities, such as share options, convertible debt, or preferred shares. A corporation with a simple capital structure is required to report basic earnings per share. Basic earnings per share (sometimes called earnings per common share) is computed as follows: Basic Earnings per Share = Net Income Preferred Dividends Weighted Average Number of Common Shares Outstanding

36 Denominator Calculations If a corporation has issued or reacquired common shares during the period, the denominator is the weighted average number of common shares during the period, calculated as follows: Actual Shares Outstanding Fraction of Year = Outstanding Weighted Average Number of Common Shares Outstanding Example Alamance Corporation had 15,000 shares of common stock outstanding at the beginning of the year. On March 2, it issued 2,700 shares; on July 3, it issued another 3,300 shares; and on December 1, it reacquired 600 shares of treasury stock. The weighted average number of shares is 18,850 shares.

37 Weighted Average Shares Note that for simplicity, the nearest whole month is used to determine the fraction of the year. In practice, corporations will base their weighted average calculations on the actual number of days outstanding.

38 Stock Dividends and Splits The simplest way of giving retroactive recognition to stock dividends or stock splits is to assume (for EPS calculations) that the stock dividend or split occurred at the beginning of its earliest comparative period. Example Vance Corporation begins operation in January 2013 and issues 5,000 shares of common stock that are outstanding during all of On December 10, 2013, it issues a 2-for-1 split. At the end of 2013, the weighted average number of shares is 10,000. During 2014, Vance enters into the following transactions: On June 1, 2014, it issues 5,000 shares of common stock.

39 Comparative Weighted Average Shares Note that the 2-for-1 stock split actually issued on December 10, 2013, and the 20% stock dividend issued on August 9, 2014, are both assumed to have been issued on January 1, 2013.

40 Computation and Reporting of Basic Earnings per Share (Slide 1 of 3)

41 Computation and Reporting of Basic Earnings per Share (Slide 2 of 3)

42 Computation and Reporting of Basic Earnings per Share (Slide 3 of 3)

43 When Do Companies Report Diluted Earnings per Share? Share options and warrants, convertible preferred stock, convertible bonds, participating securities, differing classes of common stock, and contingent share are referred to as potential common shares if they are securities that can be used by the holder to acquire common stock. A corporation with a complex capital structure is required to report both basic and diluted earnings per share amounts on the face of its income statement. Diluted earnings per share (DEPS) is the earnings per share after including all potential common shares that would reduce earnings per share. Potential common shares are only included in the whole or in part.

44 Computing Diluted Earnings per Share The steps for computing DEPS are as follows: Step 1. Compute the basic earnings per share for the company. Step 2. Include all dilutive share options and warrants and compute a tentative DEPS. Step 3. Develop a ranking of the impact of each convertible preferred stock and convertible bond on DEPS, from the most dilutive to the least dilutive. Step 4. Beginning with the most dilutive security first, include each dilutive convertible security in DEPS in a sequential order based on the ranking in Step 3 and compute a new tentative DEPS. Step 5. Report as the diluted EPS the lowest computed DEPS.

45 Flowchart of EPS Computations

46 Share Options and Warrants (Slide 1 of 3) A corporation always considers share options and share warrants in its diluted earnings per share calculation if these items are dilutive. Dilution occurs whenever the average market price is greater than the option (exercise) price. The treasury stock method is used to calculate additional dilutive shares resulting from stock options and stock warrants. Under this method, the number of shares added to the earnings per share denominator is the difference between the assumed shares issued and the assumed shares reacquired.

47 Change in Shares Treasury Stock Method

48 Share Options and Warrants (Slide 2 of 3) The steps for the treasury stock method are as follows: Step 1. Determine the average market price of common shares during the period. Step 2. Compute the shares that would be issued from the assumed exercise of all options and warrants. Step 3. Compute the proceeds received from the assumed exercise by multiplying the shares issued by the exercise price [plus any unrecognized compensation cost (net of tax) per share]. Step 4. Compute the assumed shares that would be reacquired by dividing the proceeds (Step 3) by the average market price (Step 1). Step 5. Compute the incremental common shares that would need to be issued.

49 Share Options and Warrants (Slide 3 of 3) Example Plummer Corporation has compensatory share options for employees to purchase 1,000 common shares at an exercise price of $18 per share throughout the year, and the average market price for the common stock during the year was $25 per share. The unrecognized compensation cost (net of tax) related to the share options is $2 per share. Shares issued from assumed exercise 1,000 Shares assumed required: Proceeds (800) Average Market Price = 1,000 ($18 + $2) $25 = $20,000 $25 = per Share Assumed increment in common shares for computing DEPS 200

50 Convertible Securities The if-converted method is used to calculate additional dilutive shares resulting from convertible bonds and convertible preferred stock. Each convertible stock or bond is assumed (for computing DEPS) to have been converted into common stock at the beginning of the earliest period reported. The impact of each convertible security on the corporation s Increase DEPS in is EPS computed Numerator as Impact on DEPS = follows: Increase in EPS Denominator

51 Computation of Impact of Convertible Securities on DEPS (Slide 1 of 2)

52 Computation of Impact of Convertible Securities on DEPS (Slide 2 of 2)

53 Computation of Tentative and Final Diluted Earnings per Share (Slide 1 of 2) A corporation computes its diluted earnings per share in the following sequence: Step 1. Calculate basic earnings per share. Step 2. Compute the incremental shares from the assumed exercise of share options and warrants. Step 3. Include the dilutive convertible securities in diluted earnings per share in sequential order according to their dilutive effect on tentative earnings per share.

54 Computation of Tentative and Final Diluted Earnings per Share (Slide 2 of 2) Step 4. Repeat with each dilutive security in the ranking until the impact of the next convertible security is antidilutive (or until all dilutive securities are used). Any remaining securities in the ranking are antidilutive and are excluded from diluted earnings per share. Step 5. Final diluted earnings per share is the last tentative figure. It contains all the dilutive convertible securities included in the tentative diluted earnings per share computations.

55 Calculation of Tentative EPS

56 Special Issues Related to Diluted Earnings per Share (Slide 1 of 5) If a corporation reports a loss from continuing operations, then it does not include potential common shares in calculating diluted earnings per share. A positive overall net income due to having gains from extraordinary items or discontinued operations does not change this requirement. Example Davis Corporation reports a loss from continuing operations of $75,000 and income from discontinued operations (net of tax) of $97,000. Davis has 50,000 weighted average common shares outstanding. In addition, Davis has a convertible bond that is convertible into 12,000 common shares.

57 Special Issues Related to Diluted Earnings per Share (Slide 2 of 5) When calculating earnings per share, the potentially dilutive shares would be ignored because they are antidilutive to the loss from continuing operations. Davis would report earnings per share as follows: Loss from continuing operations $(75,000) Income from discontinued operations (net of tax) 97,000 Net income 22,000 Basic Earnings Diluted Earnings per Share per Share Loss from continuing operations $(1.50) ($1.50) Income from discontinued operations (net of tax) Net income $0.44 $0.44

58 Special Issues Related to Diluted Earnings per Share (Slide 3 of 5) Example Ryan Corporation reports income from continuing operations of $30,000 and a loss from discontinued operations of $63,000 (net of tax). Ryan has 40,000 weighted average common shares outstanding and has a convertible bond that is convertible into 15,000 common shares. Income from continuing operations $30,000 Loss from discontinued operations (net of tax) (63,000) Net loss $33,000 Ryan would report earnings per share as follows:

59 Special Issues Related to Diluted Earnings per Share (Slide 4 of 5) Basic Earnings Diluted Earnings per Share per Share Loss from continuing operations $ 0.75 $ 0.55 Income from discontinued operations (net of tax) (1.58) (1.15) Net income $(0.83) $(0.60) The dilutive shares are used to calculate dilutive earnings per share because they dilute earnings per share from continuing operations.

60 Special Issues Related to Diluted Earnings per Share (Slide 5 of 5) The display on the next two slides shows the computation of diluted earnings per share for Randolph Corporation, assuming the following: Share options are outstanding. Both convertible bonds and convertible preferred stock are outstanding. The convertible bonds are dilutive but the convertible preferred stock is antidilutive. The computation results in diluted earnings per share of $1.94. Note that Randolph reports both basic and diluted earnings per share on its income statement.

61 Computation and Reporting of Diluted Earnings per Share (Slide 1 of 2)

62 Computation and Reporting of Diluted Earnings per Share (Slide 2 of 2)

63 Additional Considerations Conversion Ratios After issuing convertible securities or share options, a corporation may declare a stock dividend or stock split. Typically, the conversion ratio for convertible securities and stock options is proportionally adjusted for the stock dividend or split. Contingent Issuances A corporation may be obligated to issue common shares in the future if certain conditions are met. This stock is referred to as contingently issuable common stock.

64 Real Report: Earnings per Share Disclosure (Slide 1 of 4)

65 Real Report: Earnings per Share Disclosure (Slide 2 of 4)

66 Real Report: Earnings per Share Disclosure (Slide 3 of 4) Questions: 1. Why was the average number of common shares used in the diluted earnings per share computation more than the weighted average number of common shares used in the basic earnings per share computation? Starbucks issues stock options and RSUs to its employees. Because the average market price was greater than the exercise price, these securities are dilutive.

67 Real Report: Earnings per Share Disclosure (Slide 4 of 4) 2. Examine footnote 14. At October 3, 2010, how many stock options were exercisable, and how many were vested and expected to vest? How does this amount compare to the number of dilutive shares used by Starbucks to compare to the number of shares used by Starbucks to compute dilutive earnings per share? Footnote 14 discloses that at October 3, 2010, Starbucks had 60.7 million stock options outstanding. Of this amount, 27.3 million options were exercisable. Employees had 55.8 million shares that were vested and expected to vest. Using the information in footnote 16, the stock options and RSUs result in 19.8 million incremental common shares for computing diluted EPS.