Chapter 12 – Income and Changes in Retained Earnings
Financial and Managerial Accounting, 17e 12-1
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 reflect unusual and
nonrecurring events. We begin by explaining how to define 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 briefly review basic and
diluted earnings per share. The emphasis here is on interpretation of the EPS figures, since the
detailed mechanics of calculating these measures is beyond the scope of the first 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 significant 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 effects of these
transactions on a company’s financial statements.
5. Describe and prepare a statement of retained earnings.
6. Define prior period adjustments, and explain how they are presented in financial
statements.
7. Define comprehensive income, and explain how it differs from net income.
8. Describe and prepare a statement of stockholders’ equity and the stockholders’ equity
section of the balance sheet.
Chapter 12 – Income and Changes in Retained Earnings
9. Illustrate steps management might take to improve the appearance of the company’s net
income.
Brief topical outline
A Reporting the results of operations
1 Developing predictive information
2 Reporting irregular items: an illustration
3 Continuing operations
a Income from continuing operations
4 Discontinued operations
5 Extraordinary items
a Other unusual gains and losses
b Restructuring charges
c Distinguishing between the unusual and the extraordinary – see Your Turn
(page 526)
6 Earnings per share (EPS)
a Preferred dividends and earnings per share
b Presentation of earnings per share in the income statement
B Financial analysis and decision making – see Case in Point (page 529) and Your
Turn (page 529)
1 Basic and diluted earnings per share
C Other transactions affecting retained earnings
1 Cash dividends
2 Dividend dates
3 Liquidating dividends
4 Stock dividends
a Entries to record a stock dividend
b Reasons for stock dividends – see Case in Point (page 531)
c Distinctions between stock splits and stock dividends
5 Statement of retained earnings
6 Prior period adjustments
a Restrictions of retained earnings
7 Comprehensive income
8 Statement of stockholders’ equity
9 Stockholders’ equity section of the balance sheet – see Ethics, Fraud &
Corporate Governance (page 538)
D Concluding remarks
Chapter 12 – Income and Changes in Retained Earnings
Financial and Managerial Accounting, 17e 12-3
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
1
A
1, 2, 3, 5
1, 3, 4, 5
1, 3
3, 6
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:
1 Explain the purpose of reporting irregular events separately from normal and recurring
business activities.
2 Carefully define discontinued operations and extraordinary items. Review and discuss
the financial statement presentation of each category of event.
3 Illustrate the computation of earnings per share, and briefly discuss the distinction
between basic and diluted earnings.
4 Discuss 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.
5 Explain the nature of prior period adjustments. Discuss probability of occurrence in
publicly owned and closely held corporations.
6 Review and discuss the statement of retained earnings.
7 Explain the nature of comprehensive income.
8 Review the statement of stockholders’ equity portrayed as an “expanded” statement of
retained earnings.
Chapter 12 – Income and Changes in 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.)
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.
Chapter 12 – Income and Changes in Retained Earnings
Financial and Managerial Accounting, 17e 12-5
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 – Income and Changes in Retained Earnings
CHAPTER 12 NAME #
10-MINUTE QUIZ A SECTION
Indicate the best answer for each question in the space provided.
1 Beck Corporation declared a 2-for-1 common stock split, but this transaction was
erroneously recorded as a 100% common stock dividend. As a result:
a The common stock account is overstated.
b The total dollar amount of stockholders’ equity is overstated.
c The corporate records do not show the correct number of shares of common stock
outstanding.
d The par value per share is understated.
2 Fuller Mfg.’s financial 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 benefit) …………………………..……………………….. 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.
3 The 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.
4 At 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
5 Donnell 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.