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INCOME AND CHANGES IN RETAINED EARNINGS

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INCOME AND CHANGES IN RETAINED EARNINGS

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    1. Chapter 12: Income and changes in retained earnings.Chapter 12: Income and changes in retained earnings.

    2. Learning Objective Learning objective number 1 is to describe how irregular income items, such as discontinued operations and extraordinary items, are presented in the income statement. Learning objective number 1 is to describe how irregular income items, such as discontinued operations and extraordinary items, are presented in the income statement.

    3. Reporting the Results of Operations When a company’s income-related activities include events not part of its normal continuing operations, it must disclose this information. Reporting this information separately provides users with more information about what to expect in the future. Unusual items are reported in the order of discontinued operations, extraordinary items, and then the cumulative effect of a change in accounting principle. Let’s look at an income statement with continuing operations, discontinued operations, extraordinary items, and changes in accounting principles. When a company’s income-related activities include events not part of its normal continuing operations, it must disclose this information. Reporting this information separately provides users with more information about what to expect in the future. Unusual items are reported in the order of discontinued operations, extraordinary items, and then the cumulative effect of a change in accounting principle. Let’s look at an income statement with continuing operations, discontinued operations, extraordinary items, and changes in accounting principles.

    4. Part I Income from continuing operations is the net effect of revenues earned and expenses incurred from recurring items in the normal course of business. Part II The income tax expense subtracted from revenues is only the tax expense for the recurring items. The unusual items, such as discontinued operations and extraordinary items, are reported net of taxes. Let’s look in more detail at discontinued operations and extraordinary items. Part I Income from continuing operations is the net effect of revenues earned and expenses incurred from recurring items in the normal course of business. Part II The income tax expense subtracted from revenues is only the tax expense for the recurring items. The unusual items, such as discontinued operations and extraordinary items, are reported net of taxes. Let’s look in more detail at discontinued operations and extraordinary items.

    5. Discontinued Operations When a company has a discontinued operation, it must report two items: the income or loss from operating a segment that has been discontinued, and the gain or loss on the sale of the segment. Let’s look at what qualifies as a segment. When a company has a discontinued operation, it must report two items: the income or loss from operating a segment that has been discontinued, and the gain or loss on the sale of the segment. Let’s look at what qualifies as a segment.

    6. Discontinued Operations A business segment is a separate line of a business activity or a separate and distinct category of customers. Let’s take a closer look.A business segment is a separate line of a business activity or a separate and distinct category of customers. Let’s take a closer look.

    7. Discontinued Operations During 2007, Matrix Incorporated sold a segment of their company. The segment had a net loss from operations of $150,000 and a loss on the sale of assets of $100,000. Matrix reported income from continuing operations of $1,750,000, and all items are taxed at 30%. How will Matrix report the discontinued operation on their financial statements? During 2007, Matrix Incorporated sold a segment of their company. The segment had a net loss from operations of $150,000 and a loss on the sale of assets of $100,000. Matrix reported income from continuing operations of $1,750,000, and all items are taxed at 30%. How will Matrix report the discontinued operation on their financial statements?

    8. Discontinued Operations First, determine the net loss on operations and the net loss on the sale of assets for Matrix. Remember that discontinued operations are reported net of taxes, so reduce the original losses by the amount of the tax benefits Matrix will receive because of the losses. Let’s see how Matrix will report this on their income statement.First, determine the net loss on operations and the net loss on the sale of assets for Matrix. Remember that discontinued operations are reported net of taxes, so reduce the original losses by the amount of the tax benefits Matrix will receive because of the losses. Let’s see how Matrix will report this on their income statement.

    9. Discontinued Operations Matrix reports a loss on operations of $105,000 and a loss on disposal of assets of $70,000. Both are reported net of their tax benefits.Matrix reports a loss on operations of $105,000 and a loss on disposal of assets of $70,000. Both are reported net of their tax benefits.

    10. Extraordinary Items Material in amount. Gains or losses that are both unusual in nature and not expected to recur in the foreseeable future. Reported net of related taxes. Extraordinary items are gains and losses that are both unusual and infrequent in occurrence. Some examples include losses from natural disasters and expropriation of property by a foreign government. Extraordinary items are also reported net of taxes. Let’s look at an example of an extraordinary item. Extraordinary items are gains and losses that are both unusual and infrequent in occurrence. Some examples include losses from natural disasters and expropriation of property by a foreign government. Extraordinary items are also reported net of taxes. Let’s look at an example of an extraordinary item.

    11. Extraordinary Items In 2007, Matrix Incorporated had an extraordinary loss of $75,000. Matrix reported income before extraordinary items of $1,575,000, and all items are taxed at 30%. How will Matrix report this on their income statement?In 2007, Matrix Incorporated had an extraordinary loss of $75,000. Matrix reported income before extraordinary items of $1,575,000, and all items are taxed at 30%. How will Matrix report this on their income statement?

    12. Extraordinary Items - Example Part I First, Matrix has to determine the net loss associated with the extraordinary item. Extraordinary items are reported net of taxes, so they have to reduce the original loss by the amount of the tax benefit they’ll receive because of the loss. Part II The net loss Matrix reports on their income statement is $52,500. Part I First, Matrix has to determine the net loss associated with the extraordinary item. Extraordinary items are reported net of taxes, so they have to reduce the original loss by the amount of the tax benefit they’ll receive because of the loss. Part II The net loss Matrix reports on their income statement is $52,500.

    13. Now let’s change topics.Now let’s change topics.

    14. Learning Objective Learning objective number 2 is to compute earnings per share. Learning objective number 2 is to compute earnings per share.

    15. Earnings Per Share (EPS) Earnings per share is equal to net income divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders. Earnings per share is one of the most widely quoted financial ratios calculated. It is a measure of the company’s ability to produce income for each common share outstanding. Investors track this ratio carefully. Let’s calculate earnings per share for Matrix. Earnings per share is equal to net income divided by the average number of common shares outstanding. The numerator of the equation is sometimes referred to as income available to common shareholders.

    16. Earnings Per Share (EPS) Review the information for Matrix Incorporated. It is based on the work done with discontinued operations and extraordinary items on the previous slides. Assume that Matrix has weighted average shares outstanding of 156,250. Let’s look at how earnings per share is reported on the income statement.Review the information for Matrix Incorporated. It is based on the work done with discontinued operations and extraordinary items on the previous slides. Assume that Matrix has weighted average shares outstanding of 156,250. Let’s look at how earnings per share is reported on the income statement.

    17. Earnings Per Share (EPS) Matrix reports earnings per share for several items: income from continuing operations, discontinued operations, income before extraordinary items, extraordinary loss, and net income. Matrix reports earnings per share for several items: income from continuing operations, discontinued operations, income before extraordinary items, extraordinary loss, and net income.

    18. Earnings Per Share (EPS) If a company has preferred stock, the earnings per share ratio is slightly modified as net income less preferred stock dividends divided by the average number of common shares outstanding. If a company has preferred stock, the earnings per share ratio is slightly modified as net income less preferred stock dividends divided by the average number of common shares outstanding.

    19. Learning Objective Learning objective number 3 is to distinguish between basic and diluted earnings per share.Learning objective number 3 is to distinguish between basic and diluted earnings per share.

    20. Basic and Diluted Earnings per Share Convertible preferred stock is considered a potentially dilutive security because if the preferred shares are converted into common shares, earnings per share may go down. Dilutive earning per share reflects the impact of assuming the convertible preferred stock is converted into common shares.Convertible preferred stock is considered a potentially dilutive security because if the preferred shares are converted into common shares, earnings per share may go down. Dilutive earning per share reflects the impact of assuming the convertible preferred stock is converted into common shares.

    21. Price-earnings Ratio (P/E) The Price-Earnings Ratio is used to evaluate the reasonableness of a company’s stock price. It is calculated as current stock price divided by earnings per share. Let’s examine earnings per share a little further.The Price-Earnings Ratio is used to evaluate the reasonableness of a company’s stock price. It is calculated as current stock price divided by earnings per share. Let’s examine earnings per share a little further.

    22. Learning Objective Learning objective number 4 is to account for cash dividends and stock dividends, and explain the effects of these transactions on a company’s financial statements.Learning objective number 4 is to account for cash dividends and stock dividends, and explain the effects of these transactions on a company’s financial statements.

    23. Accounting for Cash Dividends Stockholders receive a return on their investment in two ways: increases in the market value of the stock, and cash dividends. To pay a cash dividend, a corporation must have two things: (1) Sufficient retained earnings to absorb the dividend without creating a deficit, and (2) Enough cash to pay the dividend Dividends are not legally required but rather are declared at the discretion of the Board of Directors. When the dividends are declared, a liability is created. There are four important dates to remember when discussing dividends: (1) The date of declaration (2) The date of record (3) The ex-dividend date, and (4) The date of payment Let’s look at an example.Stockholders receive a return on their investment in two ways: increases in the market value of the stock, and cash dividends. To pay a cash dividend, a corporation must have two things: (1) Sufficient retained earnings to absorb the dividend without creating a deficit, and(2) Enough cash to pay the dividend Dividends are not legally required but rather are declared at the discretion of the Board of Directors. When the dividends are declared, a liability is created. There are four important dates to remember when discussing dividends: (1) The date of declaration (2) The date of record (3) The ex-dividend date, and (4) The date of payment Let’s look at an example.

    24. Date of Declaration Board of Directors declares the dividend. Record a liability. Dividend Dates Part I On March 1st, Matrix declared a $1 per share dividend on its 500,000 common shares outstanding. The dividend is payable on May 1st to stockholders of record on April 1st. Let’s look at the entry for March 1st. Part II The entry on March 1st includes a debit to Retained Earnings and a credit to Common Dividends Payable of $500,000. Part I On March 1st, Matrix declared a $1 per share dividend on its 500,000 common shares outstanding. The dividend is payable on May 1st to stockholders of record on April 1st. Let’s look at the entry for March 1st. Part II The entry on March 1st includes a debit to Retained Earnings and a credit to Common Dividends Payable of $500,000.

    25. Ex-Dividend Date The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend. Dividend Dates The ex-dividend date is an important date for purchasers and buyers of stock. This is the date which serves as the ownership cut-off point for the receipt of the most recent declared dividend. If you buy stock after this date but before the payment date, you will not receive the dividend. The ex-dividend date is an important date for purchasers and buyers of stock. This is the date which serves as the ownership cut-off point for the receipt of the most recent declared dividend. If you buy stock after this date but before the payment date, you will not receive the dividend.

    26. Dividend Dates Who owns the stock must be known on the April 1st record date, but an accounting entry is not needed.Who owns the stock must be known on the April 1st record date, but an accounting entry is not needed.

    27. Dividend Dates Part I Let’s look at the entry for May 1st to record the payment of the dividend. Part II On May 1st, the payment date, Matrix would debit Dividends Payable and credit Cash for the $500,000 dividend. Part I Let’s look at the entry for May 1st to record the payment of the dividend. Part II On May 1st, the payment date, Matrix would debit Dividends Payable and credit Cash for the $500,000 dividend.

    28. Dividend Dates Part I Review the information provided about dividends. What will be included in the July 15th entry? Part II July 15th is the payment date. This entry includes a debit to Dividends Payable and a credit to Cash for $20,000. Part I Review the information provided about dividends. What will be included in the July 15th entry? Part II July 15th is the payment date. This entry includes a debit to Dividends Payable and a credit to Cash for $20,000.

    29. Accounting for Stock Dividends Sometimes corporations will distribute additional shares of stock as a dividend. Reasons for doing this include: keeping the market price affordable by increasing the number of shares outstanding, and providing evidence of management’s confidence in the company. Sometimes corporations will distribute additional shares of stock as a dividend. Reasons for doing this include: keeping the market price affordable by increasing the number of shares outstanding, and providing evidence of management’s confidence in the company.

    30. Summary of Effects of Stock Dividends and Stock Splits A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than or equal to 25% of the outstanding shares. A large stock dividend is a distribution of stock that is greater than 25% of the outstanding shares. Stock splits are the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value of the stock changes. Take a moment to review the impact of a small stock dividend, a large stock dividend, and a stock split on the financial statements. A stock dividend can be classified as small or large. A small stock dividend is a distribution of stock that is less than or equal to 25% of the outstanding shares. A large stock dividend is a distribution of stock that is greater than 25% of the outstanding shares. Stock splits are the distribution of additional shares of stock to stockholders according to their percent ownership. When a stock split occurs, the corporation calls in the outstanding shares and issues new shares of stock. In the process of a stock split, the par value of the stock changes. Take a moment to review the impact of a small stock dividend, a large stock dividend, and a stock split on the financial statements.

    31. Learning Objective Learning objective number 5 is to describe and prepare a statement of retained earnings.Learning objective number 5 is to describe and prepare a statement of retained earnings.

    32. Statement of Retained Earnings with Prior Period Adjustment Rockford Company found an error that overstated income in a prior period’s financial statements. Net of taxes, the error is reported as a $65,000 reduction on the Statement of Retained Earnings. Rockford Company found an error that overstated income in a prior period’s financial statements. Net of taxes, the error is reported as a $65,000 reduction on the Statement of Retained Earnings.

    33. Restrictions of Retained Earnings Retained earnings can have legal or contractual restrictions. Some loan agreements place restrictions on dividend amounts, based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements. Retained earnings can have legal or contractual restrictions. Some loan agreements place restrictions on dividend amounts, based on the balance in retained earnings. Restrictions on retained earnings are generally disclosed in the notes to the financial statements.

    34. Learning Objective Learning objective number 6 is to define prior period adjustments, and explain how they are presented in financial statements.Learning objective number 6 is to define prior period adjustments, and explain how they are presented in financial statements.

    35. Prior Period Adjustments Prior period adjustments are the corrections of errors in a prior period’s financial statements. Prior period adjustments require an adjustment to Retained Earnings and are reported net of tax. Prior period adjustments are the corrections of errors in a prior period’s financial statements. Prior period adjustments require an adjustment to Retained Earnings and are reported net of tax.

    36. Learning Objective Learning objective number 7 is to define comprehensive income, and explain how it differs from net income. Learning objective number 7 is to define comprehensive income, and explain how it differs from net income.

    37. Comprehensive Income There are three ways that a company’s financial position can change: issuing new stock, reporting net income or net loss, and paying dividends. Generally accepted accounting principles, or GAAP, excludes some unrealized gains and losses from income. An example of an unrealized gain or loss is the gain or loss that results from reporting available for sale securities at market value. Comprehensive income is a way to determine the whole impact of items not included on the income statement. Let’s look at this in more detail on the next slide. There are three ways that a company’s financial position can change: issuing new stock, reporting net income or net loss, and paying dividends. Generally accepted accounting principles, or GAAP, excludes some unrealized gains and losses from income. An example of an unrealized gain or loss is the gain or loss that results from reporting available for sale securities at market value. Comprehensive income is a way to determine the whole impact of items not included on the income statement. Let’s look at this in more detail on the next slide.

    38. Comprehensive Income Comprehensive income starts with net income and adds or subtracts certain unrealized gains and losses that are not reported on the income statement. Comprehensive income can be reported as a second income statement, reported below net income on the income statement, or reported as an element of stockholders’ equity.Comprehensive income starts with net income and adds or subtracts certain unrealized gains and losses that are not reported on the income statement. Comprehensive income can be reported as a second income statement, reported below net income on the income statement, or reported as an element of stockholders’ equity.

    39. Learning Objective Learning objective number 8 is to describe and prepare a statement of stockholders’ equity and the stockholders’ equity section of the balance sheet.Learning objective number 8 is to describe and prepare a statement of stockholders’ equity and the stockholders’ equity section of the balance sheet.

    40. Statement of Stockholders’ Equity Many companies issue a Statement of Stockholders’ Equity rather than a simple Statement of Retained Earnings. The Statement of Stockholders’ Equity is more inclusive and discloses changes in all equity accounts, not just Retained Earnings. Many companies issue a Statement of Stockholders’ Equity rather than a simple Statement of Retained Earnings. The Statement of Stockholders’ Equity is more inclusive and discloses changes in all equity accounts, not just Retained Earnings.

    41. Stockholders’ Equity Section of the Balance Sheet Here is an example of the stockholders’ equity section of a balance sheet. Notice that it reports both common and preferred stock at par value, additional paid-in capital for common and preferred stock, and retained earnings. Here is an example of the stockholders’ equity section of a balance sheet. Notice that it reports both common and preferred stock at par value, additional paid-in capital for common and preferred stock, and retained earnings.

    42. Learning Objective Learning objective number 9 is to illustrate steps management might take to improve the appearance of the company’s net income. Learning objective number 9 is to illustrate steps management might take to improve the appearance of the company’s net income.

    43. Improving the Appearance of Income The Securities and Exchange Commission often takes enforcement actions against companies whose management attempts to artificially enhance the appearance of net income in the financial statements.The Securities and Exchange Commission often takes enforcement actions against companies whose management attempts to artificially enhance the appearance of net income in the financial statements.

    44. End of Chapter 12 End of chapter 12.End of chapter 12.

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