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					Chapter 14: Corporate Income Statement & Retained Earnings Transactions

ASSUMPTION:             publicly-held corp., reporting to outside S/H's who are not involved in
                        business, but may be L-T owners...

EMPHASIS: Give reader info needed to best guess future prospects of the corp.

         *      separate out effect of revs/exps that won't likely be there after this year...

         *      Allow S/H to see how income/loss from “continuing” revs/exps

3 main sections

         * EXAMPLES – Handout & page 555: K-Mart, then Allied Electronics

A.       Top Section - Income from Continuing Operations

             Continuing Operations:

             Other Gains/Losses Section:

                Income that didn’t come directly from selling our “widgets”…

                        But are a normal part of continuing operations…

                Items included in Other Gains/Losses

                o Restructuring Costs – costs from a major “shakeup” in company structure


             Income from Cont. Ops After Tax


         -      does not include any “non-continuing” revs/exps

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              NOTE: Why 2 “income” figures?

         1) Income from Cont Ops before tax

                 - and –

         2) Income from Cont Ops (after tax)

                 WHY Different for a Corp?

B.       "Special Items” or “Non-continuing operations” section:

         **      Are pulled out of continuing operations and shown separately

         **      Why "break out" from continuing operations revs/exps??

                 -         Are not part of “normal” operations every year...



C.       Bottom: Earnings Per Share section

         -       Bottom of Statement

         -       NI (and all "other" components) broken down to per- share basis

         -       Example: NI/Share =                     Net Income     .
                                                 # of outstanding shares

         -       S/H can see effect each had on their EPS

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Tax Disclosure on a Corporate Income Statement

A. Income Tax Expense – Continuing Operations

*        Income Tax Expense is now line item on Statement


         -      Non-continuous Income/Losses below are taxed, but...

B. Non-Continuous-Ops Items - Taxes

*        All shown "Net of Taxes" (or after taxes)

*        "Net of Taxes" concept

         -      ...the tax effects (+ or -) of these "other" items are pulled out of Income Tax
                Expense (continuing operations section.)…

                …and disclosed below with each non-continuous ops item

*        WHY:

         1)     Pull tax effect of non-continuous items out of continuing operations


                       -       Want S/H's to see how well continuing operations doing w/o
                               Extraordinary items -


*        Non-continuous items tax effects:

         1.     Non-continuous Income/Gain item


                *      Tax effect shown in parentheses (Net of Taxes, $2,000)

                EXAMPLES – Allied, Lucent and K-Mart

                (K-Mart shows calculation of tax effect in note to financial statements)

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          2.      Non-Continuous Expense/Loss


                        EXAMPLE from overhead

          QUIZ:         Solve for the missing item

                                        Case 1        Case 2        Case 3        Case 4
Extraordinary Gain (Loss) Before Tax    100,000       (10,000)
Income Tax @ 40% tax rate                                           8000 tax      16000 tax
Extraordinary Gain/Loss After Tax                                   12000         (24000)


      S14-8           NOTE: must calculate Income Tax Expense on both continuing operations
                      and on the 2 special items

      E14-8           NOTE: taxes on continuing operations included in Operating Expenses
                      NOTE: Income tax on 3 special items listed out – no need to calculate

      TURN-IN ASSIGNMENT: “Beaulac Excursions” (Handout)

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Explanation of “Non-continuous Operations” or “Below the Line” Items

A.       Discontinued Operations:

         -      corp. may be diversified – may be into several lines of business

         -      Each “division” in a different line of business is considered a separate “segment”

             GAAP says if one segment sold off/closed…



         *      Discontinued Operations usually reported in two parts



                       *       When discontinued operation sold, asset accounts credited,
                               Accumulated Depreciation accounts closed, etc.

                               -      G/L will occur

                               -      REALITY CHECK: Will it usually be a gain or loss?

B.       Extraordinary Gains/Losses


         -      G/L not reasonably expected to reoccur in foreseeable future

         -      Possible causes of extraordinary G/L:

                Extraordinary G/L Examples: Flood losses for Grand Forks company in 1997

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                NOTE: Why report these separate from continued operations?

                Unusual example: Treatment of 9-11 losses (see transparency)

C.       Accounting Procedure/FASB Rule Changes (See Lucent example)

*        Involuntary Change from FASB ruling

                                 (FASB 106 example)

*        Voluntary change

         a) Inventory -

         b) Depreciation -

         *      Consistency & Comparability needed, but...

                          Review: Can change if new method better reflects operations of company

         *      Must show "Cumulative Effect" of change:

                must "go back" reasonable number of years...

                ...calc effect new method would have had on previous period income (more revs,
                more exps?)



                *         5-year old building, changing from S-L to DDB depreciation

                          Go back five years to see effect of DDB on years 1-4 also

                                 (more expense would have occurred under DDB)

                *         Cumulative effect on old years is taken this year

                                 - Brings records "up- to- date"

                * NOTE: must also put footnotes to statements to explain change to S/H's

II. Earnings Per Share
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       GAAP & SEC require corporations to show much income/loss info on a “per-share” basis
       on the bottom of Income Statement

       -       major income items each divided by # of outstanding shares

       -       shows S/H the effect of each income/loss item on the value of one share

*      Basic EPS =

       EXAMPLE: See p 555 Income statement

               NOTE: 20,000 Shares C/S Outstanding

    o Net Income per Share:

       a. EPS Breakdown: EPS always broken down to show effect of :

               Review Calculations – each item

       b. EPS when # of shares outstanding changed during the year

           o Must calculate a weighted average # of Shares for the year to use as the

       Miscellaneous EPS Notes:

       b. "Diluted" EPS

               *      If preferred stocks (or bonds) are convertible to C/S, this could increase
                      number of outstanding common shares

                      would lower EPS since denominator (# of outs shares) would increase

               •      Fully Diluted EPS


Page 7               ONLINE ASSIGNMENT                            Updated 11/22/06
      E14-10         EPS calculations – no change in # of shares
      S14-9          Calculate EPS, Income from Continuing Operations/share & Net
                     Income/share on S14-8 income statement.
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III. Retained Earnings

                (Review Stockholder’s Equity Concept)

A.       Retained Earnings Definition: (expanded)

B.       Retained Earnings Deficit:    (SEE EXAMPLE – K-MART HANDOUT)

         -      Debit balance in Retained Earnings account

         -      WHY Does it happen?



                                       (this may be allowed)

                - Balance Sheet Treatment: (of R.E. deficit)

                    *     subtracted from contributed capital ( instead of adding)
Other Balance sheet Stockholders Equity Issues:

1. Stock Splits
2. Stock Dividends
3. Treasury Stock transactions

             All have to do with corp. trying to “manage” their stock price in the marketplace

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IV. Stock Splits

A.    What is it?

      Literal split of current shares into more “smaller” shares


B.    What is the result?




C.    Why split stock?


      EXAMPLE:       BIOMED firm stock selling at $630/share ($10 par - 10,000 shares

      -      Can you buy $1000 worth?

             NO - must buy one share or two whole shares
             Decides to split 4 to 1
             Market price fell to $160/share - (easier to buy and sell)

D.    Splits - Accounting Treatment

      1)     Find New number of shares + New par value



             CHECK FIGURES – OVER…

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              CHECK FIGURES:

      2)      Journal Entry

              *       Are any dr's/cr's needed?

              *       Do memorandum entry

                              - tells what happens on that date w/o Dr/Cr
                              - for significant transactions where no balances changed


                              The 10,000 shares of $10 par common stock were split 4 for 1,
                              resulting in 40,000 shares of $2.50 par value stock

 ASSIGNMENTS           S14-3           Stockholders Equity section of Bal. Sheet after split
                       E14-3           Same…

V. Stock Dividends

           Similar transaction to splits – with at “twist”

A.    Concept:

      What does it do?

              #1 -

              #2 -

      What doesn't it do?




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QUESTION: What happens to market price of stock after stock dividend?

             - No more assets in corporation, just more shares to claim them

B.    Mechanics of Stock Dividend – 3 dividend dates

      1) Declaration date:

                     Just distributing shares, not assets

      2) Date of Record

      3) “Distribution” Date        (Not “Payment Date” – WHY?)


             - now part of contributed capital

C.    Small Stock Dividends vs. Large Stock Dividends

          Small Stock Dividend: Increases # of outstanding shares by less than 25%


          Large Stock Dividend: Increases # of outs shares by > 25%


          Logic: Small Stock dividend will not greatly decrease market price…

             …so stock given can be valued at market


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D.     Example: Small Stock Dividend

       Jeff’s Planes has 100,000 shares of $1 par common stock outstanding. Declares 15%
       stock dividend on January 31st, to be distributed on February 28 to shareholders of
       record on February 14th. Market price per share on 1/31 was $10 per share.

       January 31 – Declaration date -

       February 14 – Date of Record -

       February 28 – Distribution date

                # of shares to be distributed =

                $$ to be transferred from RE =

       Feb 28

Discussion Question: will one S/H with 300 shares at beginning of problem own a different
percent of corporation after stock dividend?

       Why do corporations give Stock Dividends?

                * To reduce per share price of a high-priced stock?


          S14-1          Small Stock Dividends
          E14-1          Small Stock Dividends

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VI. Treasury Stock

      * Definition:

             - Is not an Investment (Asset)

      EXAMPLE: buying another corp.’s stock vs. buying your own

a.    Is Treasury Stock part of...

             - Authorized shares?

             - Issued shares?

             - Outstanding shares?

b.    Treasury Stock has no "rights"

c.    Buying Treasury Stock

          Corporation must make offer to buy on-the-market


          EXAMPLE 8:      Jeff's Planes, Inc. buys back 1000 shares of $2 par C/S for

                               SHARES and price per share we paid
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d.    Balance Sheet Treatment

             EXAMPLES: SEE page 548 + McKesson Article and Balance Sheet handouts

             -       C/S still shown at par of all issued shares


e.    Selling Treasury Stock

             (NOTE: Corp. may sell to EE's through stock option plan)

      Rule: Gains/Losses from Selling T-Stock are not shown on income statement


      * Two Possibilities

      1.     Sold for higher price (than we paid)

             Treatment: Credit out Treasury Stock, credit excess to a "special" Paid-
                               In-Capital account

             EXAMPLE 9:            Jeff's Planes, Inc. sells 400 shares of above
                                           Treasury stock @ $12 per share


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      2.     Sold for lower price (than we paid)

                      If PIC T-Stock account is depleted, take from Retained Earnings

      *       EXAMPLE 10:          Jeff's Planes, Inc., sells 400 shares treasury stock for


Discussion: Which financial statement is affected by selling T-stock at a gain or loss?

      Where does that affect show up? “Gain” or "Loss" on selling shares never shows
                                      up as an expense...just reduces S/H Equity
                                      (capital) directly.

f.    Retiring Treasury Stock

      Board can "retire" the treasury stock

      Stock retired is removed from T-Stock, C/S and Paid-in Capital in Excess

 ASSIGNMENTS:          S14-4        Straight T-Stock Transactions
                       E14-4        ONLINE ASSIGNMENT - analysis of effect of
                                    transactions on Stockholders’ Equity
                       E14-5        Straight T-Stock transactions
                       E14-6        T-stock and Stockholders Equity section

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g.   Why would corporation buy Treasury Stock?

               Need stock to sell to EE’s (under stock for stock option plan – later)

               Hostile takeover defense

                  If a “raider” is seeking to buy up corp. shares, management may try to
                  pulls shares off market that "raider" might try to buy...

               Common Reason:

               If there are fewer shares…then what happens to

                  o Book Value/Share?
                  o Dividends/Share?

                      How would an increase in these affect the stock market value?

     VII. Retained Earnings Restrictions

           * What normally is limit on how much dividends can be declared & paid?


           * Board may further limit dividends by “restricting” some retained earnings

                  - Meaning:

                  - WHY: Someone may not want too much corp cash distributed to S/H's

                  - WHO?

           * Disclosure:

                           "Board has restricted $ x of Retained Earnings for.../because"

     Page 17                                                         Updated 11/22/06
VII. Prior period adjustments to Retained Earnings


      -      Cannot “go back” and change previous income statements


      -      Financial Statement Treatment:

             Prior Period Adjustment done to R.E. on balance sheet only...

                        Unrecorded Profits –

                        Unrecorded Losses –

               not shown on income statement (WHY??)


      **     ENRON

             o Kept large 1997-2000 losses off corporation books by keeping some activities
               in “off the books” partnerships

             o In 2001 were forced to put back on their books

             o Did Prior Period Adjustment - reduction in retained earnings of $600,000,000


IV. Statement of Stockholders Equity

A.    Review: Stmt of Owners Equity (Sole Prop)

      *      Shows changes in owners capital account

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B.    Stmt of Stockholders Equity

      *      Shows same info for corp.

      *      But...more complex

      *      shows changes in each account in S/H Equity

                    ...and explains how each change occurred


ASSIGNMENT: NONE - But be prepared to
     1)  Describe what stmt shows
     2)  Interpret a given statement

V. Stock Option Plan

      * Plan that allows corp. EE's to buy their C/S directly from corp.

      * Shares likely will come from treasury stock

      * Why have stock option plan?

             - For EE - saves brokerage fees - buying direct from corp.

      2 Types of plans:

             1. Shares sold at current market value – 2 Possibilities

                    a)     New issue -

                    b)     Sold from Treasury Stock

                                  - Dr.

                                  - Cr.

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                2. Discount-type option plan

                        *       Plan where EE can often buy stock at a preset discount
                                price, so...

                                -       If market price goes up, manager can still buy at lower
                                        pre-set price.

                                Why Give this type of stock option?

EXAMPLE: 2005 CEO Compensation.

 “Financial CEOs Making Big Money” (From Dustin Woodard,)

“We can all name athletes, actors or high-tech company founders that make big money. Heck, we’d even
recognize them on the street. But what about the guys working Wall Street? Have you even heard of
Richard Fuld Jr.? Considering he made more than Brad Pitt, Heidi Klum, Saquille O’Neal, and Regis
Philbin combined in 2005, it is amazing that someone of his financial status could probably sit in the
middle of a football stadium without attracting a second glance.”

“1st Place: Richard Fuld Jr of Lehman Brothers
He might as well had a salary of zero dollars, because his $750,000 salary was a tiny component of his
over $104.4 million total realized compensation. I have to give him credit, his 51% shareholder return
helped him gain almost $75 million in stock options gains, plus he was granted another $10 million in
stock options and was given a cash bonus of almost $28.7 million.”

“Richard Fairbank of Capital One didn't earn a penny in salary, bonus, or incentives. However, his
realized stock option gains amount to $249 million.”

Source: The Wall Street Journal and Mercer Human Resource Consulting 2005 CEO
Compensation Survey.
Accounting for Stock Options:

Old Approach: Corporations did not have to show stock options as an expense – Just a stock sale:

        Allowed compensation to EE’s w/o showing as expense on financial statements

        Problem for S/H’s – Creates more shares w/o bringing in as much cash into the corporation
        (Shares sold at a discount)

2006:   Corporations now required to expense stock options on the income statement

        What effect might this have?

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