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CHAPTER 12
The Corporate Income Statement and the
Statement of Stockholders’ Equity
REVIEWING THE CHAPTER
Objective 1: Define quality of earnings, and identify the components of a corporate income
statement.
1.
The most commonly used predictors of a company’s performance are expected changes in
earnings per share and expected return on equity. Net income is a key component of both
measures.
2.
Because net income is so important in measuring a company’s prospects, it is equally important to
evaluate the quality of the net income figure, or the quality of earnings. The quality of earnings
refers to the substance of earnings and their sustainability into future accounting periods. It is
affected by the accounting methods and estimates that management chooses and by the gains and
losses, write-downs and restructurings, and nature of the nonoperating items reported on the
income statement. Management also has choices about the content and positioning of these
income-statement categories.
3.
Net income or loss for a period includes all revenues, expenses, gains, and losses. A corporate
income statement may therefore contain many line items and subtotals. On the income statement
of a corporation that has both continuing and discontinued operations, the operating income
section is called income from continuing operations. This section, which includes revenues,
costs and expenses, gains and losses on the sale of assets, write-downs of assets, and
restructurings, is followed by a section on income taxes. Appearing below that are nonoperating
items, such as discontinued operations, extraordinary gains and losses, and the write-off of
goodwill that has been impaired. Earnings per share data appear at the bottom of the statement.
4.
The different estimates and methods that management can choose for dealing with such matters as
uncollectible accounts, inventory, and depreciation produce different net income figures. In
general, an accounting method or estimate that produces a lower, or more conservative, figure
produces a more reliable quality of earnings. Management’s choices about how nonoperating and
nonrecurring items are reported on the income statement also affect the “bottom line.” Financial
analysts should therefore look beyond the net income figure to the notes to the financial
statements, where generally accepted accounting principles require full disclosure of the
significant accounting methods used in preparing the statements and any changes in those
methods.
5.
Although gains or losses on the sale of assets appear in the operating section of the income
statement, they usually represent one-time events. They are not sustainable, ongoing operations,
and management often has some choice as to their timing. Analysts should therefore ignore them
when considering operating income.
6.
A write-down (also known as a write-off) is recorded when the value of an asset drops below its
carrying value. (Write-downs are reflected on both the balance sheet and the income statement.) A
restructuring is the estimated cost of altering a company’s operations, often involving plant
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Chapter 12: The Corporate Income Statement and the Statement of Stockholders’ Equity
closures and layoffs. Write-downs and restructurings are frequently an indication of bad
management decisions in the past. Both reduce current operating income; however, because they
shift future costs to the current period, they make it more likely that future earnings will show
improvement. They are therefore often taken when a company is having a bad year anyway or
when there is a change in management.
7.
Generally speaking, gains and losses, asset write-downs, restructurings, and nonoperating items
have no effect on cash flows; the cash expenditures for these items were made in previous periods.
However, sustainable earnings generally do have a relationship to future cash flows.
Objective 2: Show the relationships among income taxes expense, deferred income taxes, and net
of taxes.
8.
A corporation’s taxable income is determined by subtracting allowable business deductions from
includable gross income. Tax rates currently range from a 15 percent to a 39 percent marginal
rate.
9.
Income taxes expense is the expense recognized in the accounting records on an accrual basis that
applies to income from continuing operations. It may or may not equal the amount of taxes
actually paid and recorded as income taxes payable in the current period. The difference arises
because generally accepted accounting principles govern how income taxes are computed for
financial reporting purposes, whereas the Internal Revenue Code dictates methods of computing
income taxes owed to the federal government.
10. When income computed for financial reporting purposes differs from taxable income, the income
tax allocation method should be used. Under this method, the difference between the income
taxes expense and income taxes payable is debited or credited to an account called Deferred
Income Taxes. This account is evaluated yearly to determine whether changes in income tax laws
and regulations have made adjustments necessary.
11. Deferred income taxes are the result of temporary differences in the treatment of certain items
(such as depreciation) for tax and financial reporting purposes. They are classified as current or
noncurrent, depending on the classification of the asset or liability that created the difference.
12. To avoid distorting net operating income on the income statement, certain items must be reported
net of taxes—that is, after considering applicable tax effects. These items are discontinued
operations and extraordinary gains and losses.
Objective 3: Describe the disclosure on the income statement of discontinued operations and
extraordinary items.
13. Segments are distinct parts of a company, such as a separate major line of business or class of
customer. Any gain or loss on the discontinued operations of a segment must be disclosed on the
income statement separately from continuing operations and net of taxes.
14. Extraordinary items are events that are both unusual in nature and infrequent. Gains and losses
arise from such extraordinary events as natural disasters, theft, the passage of a new law, and a
foreign government’s takeover of property. Extraordinary gains and losses that are material in
amount should be disclosed separately on the income statement (net of taxes) after discontinued
operations.
Objective 4: Compute earnings per share.
15. Readers of financial statements use earnings per share of common stock to judge a company’s
performance and to compare it with the performance of other companies. Appearing on the
income statement just below net income, the earnings per share section always shows (a) income
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Chapter 12: The Corporate Income Statement and the Statement of Stockholders’ Equity
3
from continuing operations, (b) income before extraordinary items and the cumulative effect of
accounting changes, (c) the cumulative effect of accounting changes, and (d) net income.
16. A company that has issued no securities that are convertible to common stock has a simple
capital structure. In this case, the income statement presents only basic earnings per share,
which is calculated as follows:
Net Income − Nonconvertible Preferred Dividends
Weighted-Average Common Shares Outstanding
17. A company that has issued securities that can be converted to common stock has a complex
capital structure. Potentially dilutive securities, such as stock options and convertible preferred
stocks or bonds, are so called because they have the potential to decrease earnings per share.
When a company has a complex capital structure, its income statement must present both basic
and diluted earnings per share. Diluted earnings per share shows the maximum potential effect
of dilution on the ownership position of common stockholders.
Objective 5: Define comprehensive income, and describe the statement of stockholders’ equity.
18. Corporate financial statements should report comprehensive income—that is, the change in a
company’s equity from sources other than stockholders during an accounting period.
Comprehensive income includes net income, changes in unrealized investment gains and losses,
and other items affecting equity. Although sometimes reported in a separate statement or in the
income statement, comprehensive income is most often reported in the statement of stockholders’
equity.
19. The statement of stockholders’ equity (also called the statement of changes in stockholders’
equity) is often used in place of the statement of retained earnings. It is a labeled computation of
the changes in stockholders’ equity accounts during an accounting period. It contains all the
components of the statement of retained earnings, a summary of the period’s stock transactions,
and accumulated other comprehensive income, such as adjustments for foreign currency
translations.
20. Retained earnings are the profits a corporation has earned since its beginning, minus any losses,
dividends declared, or transfers to contributed capital. Ordinarily, Retained Earnings has a credit
balance. When a debit balance exists, the corporation is said to have a deficit. Retained earnings
are not the same as cash or any other asset; they are simply an intangible representation of
earnings “plowed back into the business.”
Objective 6: Account for stock dividends and stock splits.
21. A stock dividend is a proportional distribution of shares among stockholders. A board of
directors may declare a stock dividend to (a) give evidence of the company’s success without
paying a cash dividend, (b) reduce the stock’s market price by increasing the number of shares
outstanding, (c) make a nontaxable distribution to stockholders, or (d) increase the company’s
permanent capital. A stock dividend results in the transfer of a part of retained earnings to
contributed capital. For a small stock dividend (less than 20 to 25 percent of outstanding common
stock), the market value of the shares distributed is transferred from retained earnings; for a large
stock dividend (greater than 20 to 25 percent), the par or stated value is transferred. A stock
dividend does not change total stockholders’ equity or any individual’s proportionate equity in the
company.
22. A stock split is an increase in the number of shares of stock outstanding, with a corresponding
decrease in the par or stated value of the stock. For example, a 3-for-1 split on 40,000 shares of
$30 par value would result in the distribution of 80,000 additional shares (i.e., someone who
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Chapter 12: The Corporate Income Statement and the Statement of Stockholders’ Equity
owned one share would now own three shares). The par value would be reduced to $10. A stock
split does not change the number of shares authorized or the balances in stockholders’ equity. Its
main purpose is to improve a stock’s marketability by pushing its market price down. In our
example, if the stock was selling for $180 per share, a 3-for-1 split would probably cause its
market price to fall to about $60 per share. Although a stock split does not have to be journalized,
it is appropriate to document it with a memorandum entry in the general journal.
Objective 7: Calculate book value per share.
23. The book value of a company’s stock represents the company’s total assets less its liabilities. It is
simply the stockholders’ equity or, to put it another way, the company’s net assets. If a company
has common stock only, the book value per share is computed by dividing total stockholders’
equity by the number of outstanding and distributable shares. If the company also has preferred
stock, the call or par value of the preferred stock, plus any dividends in arrears, is deducted from
stockholders’ equity in computing the book value per share of common stock.
Summary of Journal Entries Introduced in Chapter 12
A.
(LO 2)
Income Taxes Expense
Income Taxes Payable
Deferred Income Taxes
To record estimated current and deferred income
taxes
XX (amount per GAAP)
XX (currently payable)
XX (eventually payable)
B.
(LO 6)
Stock Dividends
Common Stock Distributable
Additional Paid-in Capital
Declared a stock dividend on common stock
XX (amount transferred)
XX (par value amount)
XX (excess of par)
C.
(LO 6)
Common Stock Distributable
Common Stock
Distributed a stock dividend
XX (par value amount)
XX (par value amount)
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