Chapter 12 – Income and Changes in Retained Earnings
12 INCOME AND CHANGES IN
RETAINED EARNINGS
Chapter Summary
Chapter 12 continues the coverage of stockholders’ equity but shifts
the focus from paid-in capital to retained earnings. The student is already
aware that net income drives the changes in retained earnings. However, in
any given period net income may re”ect unusual and nonrecurring events.
We begin by explaining how to de%ne such items and how to present them
so that the income statement may still serve as the basis for reasonable
estimates of future earnings. The two categories of events, which require
special treatment, are (1) discontinued operations, and (2) extraordinary
items.
Before turning to the impact of various dividend transactions, we
brie”y review basic and diluted earnings per share. The emphasis here is on
interpretation of the EPS %gures, since the detailed mechanics of calculating
these measures is beyond the scope of the %rst course.
The second major section of the chapter explains a number of
stockholder equity transactions that affect retained earnings. The most
obvious example of such transactions is the declaration of a cash dividend.
The requirements for distributing a cash dividend are outlined as are the
signi%cant dates involved in the distribution of the dividend. Stock
dividends are discussed since they too result in a reduction in retained
earnings. This portion of the chapter closes with a brief explanation of prior
period adjustments to retained earnings.
Additional topics covered in Chapter 12 include an introduction to
comprehensive income and a review of the statement of stockholders’
equity.
Learning Objectives
1. Describe how irregular income items, such as discontinued operations
and extraordinary items, are presented in the income statement.
2. Compute earnings per share.
3. Distinguish between basic and diluted earnings per share.
4. Account for cash dividends and stock dividends, and explain the
effect of these transactions on a company’s %nancial statements.
5. Describe and prepare a statement of retained earnings.
Financial Accounting, 16e 12- 1
6. De%ne prior period adjustments, and explain how they are
presented in %nancial statements.
7. De%ne comprehensive income, and explain how it di-ers from net
income.
8. Describe and prepare a statement of stockholders’ equity and the
stockholders’ equity section of the balance sheet.
9. Illustrate steps management might take to improve the appearance of
the company’s net income.
Brief topical outline
AReporting the results of operations
1Developing predictive information
2Reporting irregular items: an illustration
3Continuing operations
aIncome from continuing operations
4Discontinued operations
5Extraordinary items
aOther unusual gains and losses
bRestructuring charges
cDistinguishing between the unusual and the extraordinary – see Your Turn
(page 526)
6Earnings per share (EPS)
aPreferred dividends and earnings per share
bPresentation of earnings per share in the income statement
BFinancial analysis and decision making – see Case in Point (page 529) and Your
Turn (page 529)
1Basic and diluted earnings per share
COther transactions affecting retained earnings
1Cash dividends
2Dividend dates
3Liquidating dividends
4Stock dividends
aEntries to record a stock dividend
bReasons for stock dividends – see Case in Point (page 531)
cDistinctions between stock splits and stock dividends
5Statement of retained earnings
6Prior period adjustments
aRestrictions of retained earnings
7Comprehensive income
8Statement of stockholders’ equity
9Stockholders’ equity section of the balance sheet – see Ethics, Fraud &
Corporate Governance (page 538)
DConcluding remarks
Chapter 12 – Income and Changes in Retained Earnings
Topical coverage and suggested assignments
Homework Assignment
(To Be Completed Prior to Class)
Class
Meetings
on Chapter
Topical
Outline
Coverage
Discussion
Questions
Brief
Exercises Exercises Problems
Critical
Thinking
Cases
1 A 1, 2, 3, 5 1, 3, 4, 5 1, 3 3, 6 1
2 B – D 7, 8, 10, 12, 13 7, 8, 10 4, 6, 7 4
Comments and observations
Teaching objectives for Chapter 12
In this chapter, we discuss a variety of events and transactions that affect retained earnings. In the
classroom, our objectives are to:
1Explain the purpose of reporting irregular events separately from normal and recurring
business activities.
2Carefully define discontinued operations and extraordinary items. Review and discuss the
financial statement presentation of each category of event.
3Illustrate the computation of earnings per share, and briefly discuss the distinction between
basic and diluted earnings.
4Discuss the nature and purpose of cash dividends and stock dividends, emphasizing the
effects upon total stockholders’ equity and the probable effects upon stock price. Illustrate
the journal entries for each of the events.
5Explain the nature of prior period adjustments. Discuss probability of occurrence in
publicly owned and closely held corporations.
6Review and discuss the statement of retained earnings.
7Explain the nature of comprehensive income.
8Review the statement of stockholders’ equity portrayed as an “expanded” statement of
retained earnings. General comments
Many accounting faculty ask us why we cover discontinued operations in the introductory
course. Our answer is that in this era of “corporate restructuring,” discontinued operations are
commonplace in the financial statements of publicly owned corporations. Discontinued operations
are far more commonplace (and more material in dollar amount) than are extraordinary items.
(Prior period adjustments, by comparison, are virtually nonexistent in the financial statements of
large corporations.)
Financial Accounting, 16e 12- 3
Chapter 12 – Income and Changes in Retained Earnings
We make these points in the text but feel that we owe a separate explanation to
instructors. While extraordinary items and prior period adjustments are “traditional“ accounting
topics, discontinued operations is a relative newcomer. We also know that some introductory
accounting textbooks still do not address this emerging topic.
In discussing irregular events, we focus upon the appropriate financial statement
presentation rather than upon the recording of transactions. Most of these transactions are
recorded in the same manner as ordinary transactions. Allocations of revenue, expenses, and gains
and losses to such special categories as “continuing operations,” “discontinued operations,” and
“extraordinary items” are made on a working paper at the end of the period. The tax effects
relating to these items also are determined and allocated on a working paper rather than through
journal entries.
We consider these working paper procedures beyond the scope of the introductory course.
Entries to record accounting changes and prior period adjustments also are beyond the scope of
the introductory accounting course. Anyone with responsibility for recording such transactions
needs more of an accounting background than an introductory course can provide. Any user of
financial statements, however, needs to understand the nature of these unusual items in order to
interpret properly the operating results of the current period.
Several of our problems are intended to illustrate the presentation of irregular events in
financial statements, including Problems 1, 2, and 3. These problems are successively
comprehensive and challenging. We also recommend class discussion of Case 1 involving several
well-known corporations.
In discussing earnings-per-share, we consider a conceptual understanding important, but
regard most of the mechanics of per-share computations as beyond the scope of the course. For
instance, we discuss the concept of diluted earnings-per–share, but do not get into any
computations. We do, however, review Exercise 5. This exercise helps clarify the idea that
earnings-per–share is based only upon the income applicable to common stock.
The “stockholders’ equity” portion of this chapter includes a variety of short topics. We
find an in-class review of Exercise 9 is an efficient way to cover many of these topics. As an
overview, we use Problem 5, which also acquaints students with the unofficial “statement” of
stockholders’ equity. Supplemental Exercises
Group Exercise
The text points out that restructuring charges have been very common during the 1990’s.
Visit websites for several large corporations, find the latest annual reports and study the notes to
the financial statements for information on restructuring charges incurred by the corporations.
Internet Exercise
Visit websites for several large corporations, find the latest annual reports and review the
income statements. Report on discontinued operations and extraordinary items. CHAPTER 12
NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1Beck Corporation declared a 2-for-1 common stock split, but this
transaction was erroneously recorded as a 100% common stock
dividend. As a result:
Chapter 12 – Income and Changes in Retained Earnings
aThe common stock account is overstated.
bThe total dollar amount of stockholders’ equity is overstated.
cThe corporate records do not show the correct number of shares of
common stock outstanding.
dThe par value per share is understated.
2Fuller Mfg.’s %nancial statements for the current year include the
following:
Income from continuing operations…………………………..…… $663,200
Prior period adjustment (increase in prior-year net income,
net of taxes)……………………………………………………….……. 180,000
Cash dividends paid to preferred stockholders…………..……. 196,800
Gain from discontinued operations (net of taxes)…..……..…. 433,600
Extraordinary loss (net of tax bene%t)…………….……………... 174,400
On the basis of this information, net income for the current year is:
a$488,800. b$922,400. c$725,600. d $1,102,400.
3The following two items are disclosed in the stockholders’ equity
section of Cort Corporation’s December 31, 2010, balance sheet:
Treasury stock (500 shares, at cost)………………….……..……. $50,000
Additional paid-in capital: treasury stock transactions…….... 22,500
If the company had reacquired 3,000 shares of treasury stock in
February of 2010 then some of the treasury stock must have been sold
during 2010 for:
a$9 per share above its par value.
b$9 per share.
c$109 per share.
d$109 per share above its cost.
4At the beginning of the current year, Bard Corporation had 400,000
shares of $1 par common stock outstanding and had retained earnings
of $11,000,000. During the year, the company earned $5,000,000,
declared a 5% stock dividend when the price of stock was $25 per
share, and paid a year-end cash dividend of $2 per share. (The cash
dividend was paid after the stock dividend had been distributed.) Bard
Corporation’s retained earnings at the end of the year amount to:
a$16,000,000.b$14,660,000.c$14,320,000.d $14,700,000
5Donnell Corp. had 100,000 shares of 8% preferred stock, $100 par, and
500,000 shares of $1 par common stock outstanding throughout the
year. Net income for the year was $4,800,000, and Donnell declared
and distributed a cash dividend of $4 per share on its common stock.
Earnings per share amounted to:
a$8.80. b$4.00. c$8.00. d$2.00.
CHAPTER 12 NAME _________ #
____________
10-MINUTE QUIZ B SECTION
Financial Accounting, 16e 12- 5
Chapter 12 – Income and Changes in Retained Earnings
The stockholders’ equity section of the balance sheet of Global Publishing at
December 31, 2009, appears as follows:
Stockholders’ equity:
5% preferred stock, $100 par,
50,000 shares authorized, ?? shares issued……………..…. $1,200,000
Common stock, $2 par, 500,000 shares authorized,
140,000 shares issued, of which ?? are held in treasury. . 280,000
Additional paid-in capital:
From issuance of preferred stock………………….…………… 288,000
From issuance of common stock…………………………..…… 840,000
From treasury stock transactions………………………..…..… 16,000
From common stock dividends……………..…..…………..…. 400,000
Total paid-in capital…………………………………..………….. $3,024,000
Retained earnings ($112,000 equal to cost of treasury
stock is not available for dividends)……………………………. 880,000
$3,904,000
Less: Treasury stock (at cost: 14,000 common shares)...... (112,000)
Total stockholders’ equity……………………………..………..…. $3,792,000
Answer the following questions based on the stockholders’ equity section
given above. The company had no treasury stock purchases before 2009.
1Refer to the above data. What was the average issue price per
share of preferred stock?
a$80. b$100. c$124. d$148.
2Refer to the above data. How many shares of common stock are
outstanding?
a140,000. b126,000. c500,000. d120,000.
3Refer to the above data. A small stock dividend of 5,000 shares was
declared and distributed during 2009. What was the market price per
share on the date of declaration?
a $82 per share. b $80 per share. c $2 per share. d $78 per
share
4Refer to the above data. If Global Publishing had reacquired 16,000
shares of treasury stock early in 2009, then some treasury stock must
have been sold during 2009 for:
a$5 per share. b$8 per share. c$6 per share.d $16 per share.
5Refer to the above data. Assume that all remaining treasury stock
is reissued at a price of $18 per share in January of 2010. What
amount should be credited to the account Additional Paid-in Capital:
Treasury Stock Transactions in the journal entry to record this
transaction?
a$96,000. b$140,000. c$112,000. d$288,000.
CHAPTER 12 NAME #
10-MINUTE QUIZ C SECTION
Chapter 12 – Income and Changes in Retained Earnings
The stockholders’ equity section of the balance sheet of Xanadu Fashions,
Inc., at December 31, 2010 appears as follows:
Stockholders’ equity:
7% preferred stock, $100 par, callable at $105,
50,000 shares authorized, 40,000 shares issued............. $4,000,000
Common stock, $2 par, 600,000 shares authorized,
450,000 shares issued, of which 30,000 are held in treasury
900,000
Additional paid-in capital:
From issuance of preferred stock………………….…………… 640,000
From issuance of common stock…………………………..…… 1,890,000
From treasury stock transactions………………………..…..… 60,000
From common stock dividends……………..…..…………..…. 450,000
Total paid-in capital…………………………………..………….. $7,940,000
Retained earnings ($240,000 equal to cost of treasury
stock is not available for dividends)……………………………. 3,600,000
$11,540,000
Less: Treasury stock (at cost: 30,000 common shares)...... (240,000)
Total stockholders’ equity……………………………..………..….$11,300,000
Answer the following questions based on the stockholders’ equity section
given above. The company purchased no treasury stock before 2010.
1Refer to the above data. What was the average issue price per share of
preferred stock?
2Refer to the above data. How many shares of common stock are
outstanding?
3Refer to the above data. A small stock dividend of 20,000 shares was
declared and distributed during 2010. What was the market price per share
on the date of declaration?
4Refer to the above data. If Xanadu Fashions had reacquired 35,000
shares of treasury stock early in 2010, compute the price per share for
which the reissued treasury stock was sold.
5Refer to the above data. Assume all remaining treasury stock is
reissued at a price of $24 per share in January of 2011. Prepare the
journal entry to record this transaction:
6 CHAPTER 12 NAME
_________________________________________________ # __________
10-MINUTE QUIZ D SECTION
Shown below is information relating to operations of R. Brook, Inc for the current
year:
Continuing operations:
Financial Accounting, 16e 12- 7
Chapter 12 – Income and Changes in Retained Earnings
Net sales…………………………………………………………….…..…….. $2,750,000
Costs and expenses (including income taxes)….………..………… 2,125,000
Other data:
Current-year loss generated by segment of the business
discontinued in July (net of income tax bene%t)..…….............. 207,500
Gain on disposal of discontinued segment (net of
income tax)…………………………………………………………….……. 137,500
Prior period adjustment (decrease in prior year’s depreciation
expense, net of income taxes)……………………………..…………. 45,000
Extraordinary loss (net of income tax bene%t)………………….….. 17,500
Cash dividends declared ($1.50 per share).…………..………….... 150,000
In the space provided, complete the income statement for R. Brook, Inc.,
including earnings per share %gures. R. Brook, Inc. has 100,000 shares of a
single class of common stock outstanding throughout the year.
R. BROOK, INC.
Condensed Income Statement
For the Year Ended December 31, 2009
SOLUTIONS TO CHAPTER 12 10-MINUTE QUIZZES
QUIZ A QUIZ B
QUIZ C
1
$2 par value + $22.50 excess over par (above) = $24.50 per share
4
5,000 shares treasury stock reissued (35,000 – 30,000 remaining)
5
Additional Paid-In Capital: Treasury
Stock Transactions………………………………..……. 480,000QUIZ D
R. BROOK, INC.
Condensed Income Statement
For the Year Ended December 31, 2009
Net sales…………………………………………………..…….. $2,750,000
Cost and expenses (including applicable
income taxes)………………………..………..…………….. (2,125,000)
Income from continuing operations………………...…… $ 625,000
Discontinued operations:
Operating loss (net of income tax bene%ts)……..….. $(207,500)
Gain on disposal (net of income taxes)…................ 137,500 (70,000)
Income before extraordinary items and cumulative
Financial Accounting, 16e 12- 9
Assignment Guide to Chapter 12
Brief
Exercise
s
Exercise
s
Problems Cases Ne
t
1-10 1-15
1
234 5 67 8 912345 6 7
Time estimate (in minutes) <15 <15 4
0
4
0
2
5
3
0
30 3
0
3
0
30 5
0
2
0
2
0
3
0
3
5
6
0
30 30
difficulty rating E E M M S M M M M M S E M S S S M E
Learning Objectives:
1, 2, 3
2, 3, 4,
11, 15
1. Describe how irregular
income items, such as
discontinued operations
and extraordinary items,
are presented in the
income statement.
2. Compute earnings per
share.
2, 3, 4,
5, 6, 10
3. Distinguish between basic
and diluted earnings per
share.
2, 14
4. Account for cash
dividends and stock
dividends, and explain the
eCects of these
transactions on a
company’s Enancial
statements.
4, 7, 8, 9
1, 2, 6,
7, 8, 10,
13
√ √
5. Describe and prepare a
statement of retained
earnings.
5, 6 11, 14 √
6. DeEne prior period
adjustments, and explain
how they are presented in
Enancial statements.
6 2 √
7. DeEne comprehensive
income, and explain how
it diCers from net income. 10 2, 12
8. Describe and prepare a
statement of
stockholders’ equity and
the stockholders’ equity
section of the balance
sheet.
9 9, 11, 15 √
9. Illustrate steps
management might take