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1
Chapter 16
Earnings Per Share
and Retained
Earnings
An electronic presentation
by Douglas Cloud
Pepperdine University
2
Objectives
1. Know the equation for computing basic
earnings per share (EPS).
2. Understand how to compute the weighted
average common shares for EPS.
3. Identify the potential common shares
included in diluted EPS.
4. Apply the treasury stock method for
including stock options and warrants in
diluted EPS.
Continued
3
Objectives
5. Calculate the impact of a convertible
security on EPS.
6. Compute diluted EPS.
7. Record the declaration and payment of cash
dividends.
8. Account for property dividends.
9. Explain the difference in accounting for
small and large dividends.
Continued
4
Objectives
10. Understand how to report accumulated
other comprehensive income.
11. Prepare a statement of changes in
stockholders’ equity.
12. Account for a quasi-reorganization
(Appendix).
5
Basic Earnings Per Share
Net Income – Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
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Weighted Average Shares
Since a corporation earns its net
income over the entire year, the
earnings are related to the common
shares outstanding during the year.
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Weighted Average Shares
A corporation had 12,000 shares of common stock outstanding
at the beginning of the year. On March 2, it issued 2,700
shares; on July 3, it issued another
3,300 shares, and on
The nearest
December 1, it reacquiredwhole
480 shares
as treasury
stock.
month
is
usedof Year
Months Shares
Shares
Fraction
Equivalent
= Whole Units
Are Outstanding Outstanding x Outstanding
January-February
12,000 x
2/12
=
2,000
March-June
14,700 x
4/12
=
4,900
July-November
18,000 x
5/12
=
7,500
December
17,520 x
1/12
=
1,460
Total weighted average common shares 15,860
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Weighted Average Shares
A corporation begins operations in January 2004, and issues
5,000 shares of common stock that are outstanding all during
2004. On December 31, 2004, it issues a 2-for-1 stock split.
Months Shares
Shares
Fraction of Year
Equivalent
= Whole Units
Are Outstanding Outstanding x Outstanding
January-December
5,000 x
12/12
The two-for-one split is retroactive to January 1
Total weighted average common shares
Continued
=
5,000
+ 5,000
10,000
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Weighted Average Shares
On May 28, 2005, the corporation issues 5,000 shares of
common stock; on August 3, it issues a 20% stock dividend;
and on October 5, it issues 2,005 shares of stock.
2004 Data on 2004 Statement
Months Shares
Shares
Fraction of Year
Equivalent
= Whole Units
Are Outstanding Outstanding x Outstanding
January-December
5,000
x
12/12
=
5,000
5,000 x 200% x 120% = 12,000 equivalent whole units
Continued
10
Weighted Average Shares
2005 Data on 2001 Statement
Months Shares
Shares
Fraction of Year
Equivalent
= Whole Units
Are Outstanding Outstanding x Outstanding
January-May
June-July
August-September
10,000
15,000
18,000
Issued 5,000 shares
Issued 20% stock dividend
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Weighted Average Shares
2005 Data on 2005 Statement
Months Shares
Shares
Fraction of Year
Equivalent
= Whole Units
Are Outstanding Outstanding x Outstanding
January-May
June-July
August-September
October-December
12,000
10,000
15,000
18,000
18,000
20,000
Increases 20%
Increases 20%
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Weighted Average Shares
2005 Data on 2001 Statement
Assumed Shares
Outstanding
January-May
June-July
August-September
October-December
Shares
Fraction of Year
Equivalent
= Whole Units
Outstanding x
Outstanding
12,000
10,000
15,000
18,000
18,000
20,000
x
x
x
x
5/12
2/12
2/12
3/12
=
=
=
=
5,000
3,000
3,000
5,000
16,000
13
Diluted Earnings Per Share
A corporation with a complex
capital structure is required to
report two amounts
theearnings
face of
Yes… on
basic
its income
per statement.
share and diluted
earnings per share.
14
Diluted Earnings Per Share
Diluted earnings per share shows the
earnings per share after including all
potential common shares that would
reduce earnings per share.
15
Diluted Earnings Per Share
To be included in the diluted earnings
per share calculation, any potential
common share must have a dilutive
effect on earnings per share.
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Diluted Earnings Per Share
Step 1: Compute the basic earnings per share.
Step 2: Include dilutive stock options and warrants
and compute a tentative DEPS.
Step 3: Develop a ranking of the impact of each
convertible preferred stock and convertible
bond on DEPS.
Step 4: Include each dilutive convertible security in
DEPS in a sequential order based on the
ranking and compute a new tentative DEPS.
Step 5: Select as the diluted earnings per share the
lowest computed DEPS.
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Flowchart of EPS Computations
Capital Structures
Any options, warrants, or
convertible securities
outstanding?
No
Yes
Simple Capital Structure
Complex Capital Structure
Basic EPS
Go to next slide
Net Income - Preferred Dividends
Weighted Average Common Shares
18
Complex Capital Structure
Diluted EPS
Basic = Net Income - Preferred Dividends
EPS
Weighted Average Common Shares
Stock Options
and Warrants
Convertible
Securities
Average Market Price > Option Price ?
Yes, go to next slide
No
Continued
next slide
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Convertible Securities
Outstanding?
Stock Options
and Warrants
Average Market Price > Option Price ?
No
Yes
No
Yes
Apply Treasury
Stock Method
No
Diluted EPS Computations
* Options and Warrants
Adjustments
* Convertible Securities
Adjustments
Develop Ranking of All
Convertible Securities
Individually
Dilutive?
Yes
No
Stop
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Stock Options and Warrants
Assumed Shares Issued
+
Change (Increment)
in Shares
Proceeds ($)
Assumed Shares
Reacquired (at average
market price)
-
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Treasury Stock Method
Step 1. Determine the average market price of common
shares during the period.
Step 2. Compute the shares issued from the assumed
exercise of all options and warrants.
Step 3. Compute the proceeds received from the assumed
exercise by multiplying the shares issued by the
option price [plus any unrecognized compensation
cost (net of tax) per share].
Step 4. Compute the assumed shares reacquired by
dividing the proceeds by the average market price.
Step 5. Compute the incremental common shares.
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Treasury Stock Method
The per share
To illustrate Step
3
further,
assume
a
corporation
has
unrecognized
compensatory
stock options
compensation
cost to purchase 1,000
common(net
shares
at $18
per share
of tax)
related
to outstanding the
entire year, and
that
the
average
market
price
for
the
the stock option.
common stock was $25 per share.
Shares assumed issued from assumed exercise:
1,000Proceeds
x ($18 + $2)
$20,000
=
Average Market
Price
Per
Share
$25
$25
Assumed increment in common shares for
computing diluted earnings per share
1,000
= (800)
200
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Convertible Securities
Convertible bonds and
convertible preferred stock are
considered in DEPS after stock
options and warrants.
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Convertible Securities
Numerical Value Impact on
Diluted Earnings Per Share
Increase in Earnings
Per Share Numerator
$5,400
Security A:
= $1.80
Increase in Earnings 3,000
Per Share Denominator
9% convertible preferred stock dividends
of $5,400 were declared during the year.
The preferred shares are convertible into
3,000 shares of common stock.
Continued
25
Convertible Securities
Numerical Value Impact on
Diluted Earnings Per Share
Security B:
$4,800
= $2.50
1,920
10% convertible bonds. Interest expense (net
of income taxes) of $4,800 were recorded
during the year. The bonds are convertible into
1,920 shares of common stock.
Continued
26
Convertible Securities
Numerical Value Impact on
Diluted Earnings Per Share
Security C:
$8,000
= $1.60
5,000
8% convertible preferred stock. Dividends of
$8,000 were declared during the year. The
preferred shares are convertible into 5,000
shares of common stock.
Continued
27
Convertible Securities
Numerical Value Impact on
Diluted Earnings Per Share
Security D:
$6,300
= $2.00
3,150
7% convertible bonds. Interest expense (net of
income taxes) of $6,300 was recorded during
the year. The bonds are convertible into 3,150
shares of common stock.
Continued
28
Convertible Securities
Security
Impact Order in Ranking
A
$1.80
2
B
$2.50
4
C
$1.60
1
D
$2.00
3
Security C has the lowest impact on DEPS and
is the most dilutive. It is the first convertible
security (after options and warrants) to be
included in DEPS (if dilutive).
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If Convertible Security Is Dilutive
Add Increase to Numerator
Revised Numerator
Revised Denominator
Add Increase to Denominator
Revised
= Tentative
Diluted EPS
30
Additional Disclosures
1. Identifies the amount of preferred dividends
deducted to determine the income available to
When
a corporation
reports its basic and
common
stockholders.
diluted
earnings
per
share
on
its
income
2. Describes the potential common shares that were
statement,
it also
required
to make
not included
in theisdiluted
earnings
per share
additional
disclosures
in the
notes
to its
computation
because they
were
antidilutive.
financial
statements.
3. Describe
any material
impact on the common
shares outstanding of subsequent transactions
after the close of the accounting period but before
the issuance of the financial report.
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Cash Dividend
There are four
significant dates for
a cash dividend.
 The date of
declaration
 The ex-dividend
date
 The date of
record
 The date of
payment
32
Cash Dividend
Date
Accounting Procedures
Reduce Retained Earnings
Date of Declaration
Increase Liabilities
Date of Record
Memorandum Entry
Reduce Assets
Date of Payment
Reduce Liabilities
33
Cash Dividend
On November 3, 2004, the board of directors of a
corporation declares preferred dividends totaling
$10,000 and common dividends totaling $20,000.
These dividends are payable on December 15, 2004 to
stockholders of record on November 24, 2004.
November 3, 2004
Retained Earnings
30,000
Dividends Payable: Preferred Stock
Dividends Payable: Common Stock
10,000
20,000
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Cash Dividend
On November 3, 2004, the board of directors of a
corporation declares preferred dividends totaling
$10,000 and common dividends totaling $20,000.
These dividends are payable on December 15, 2004 to
stockholders of record on November 24, 2004.
November 24, 2004
Memorandum entry: The company will pay dividends
on December 15, 2004, to preferred and common
stockholders of record as of today, the date of record.
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Cash Dividend
On November 3, 2001, the board of directors of a
corporation declares preferred dividends totaling
$10,000 and common dividends totaling $20,000.
These dividends are payable on December 15, 2001 to
stockholders of record on November 24, 2001.
December 15, 2004
Dividends Payable: Preferred Stock
Dividends Payable: Common Stock
Cash
10,000
20,000
30,000
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Fully Participating
Preferred Stock
A corporation has issued
10%, participating,
cumulative preferred stock
with a total par value of
$20,000 and common stock
with a total par value of
$30,000. The preferred stock
is two years in arrears. The
Corporation declares a
$13,000 dividend.
37
Fully Participating
Preferred Stock
Preferred Common
Dividends in arrears:
2 x (10% of $20,000)
Current dividend (10% x $20,000)
Common dividend (10% x $30,000)
Total to allocate
$13,000
Allocated
( 9,000)
Remainder
$ 4,000
$20,000/$50,000 to preferred and
$30,000/$50,000 to common
Dividend to each class of stock
$4,000
2,000
$3,000
1,600
$7,600
2,400
$5,400
38
Partially Participating
Preferred Stock (up to 12%)
Preferred Common
Dividends in arrears:
2 x (10% of $20,000)
$4,000
Current dividend (10% x $20,000)
2,000
Common dividend (10% x $30,000)
2% dividend on par
400
Remainder to common
($13,000 – $10,000)
Dividend to each class of stock
$6,400
$3,000
600
3,000
$6,600
39
Property Dividend
Occasionally, a corporation will
declare a property dividend that is
payable in assets other than cash.
40
Property Dividend
The corporation typically uses
marketable securities of other
companies that it owns for the
property dividend.
41
Property Dividend
Corporation C declares a property dividend on
March 16, 2005, payable in Company D stock
on June 1, 2005. The Company D stock was
purchased early in 2004 for $24,000 and was
reported at its fair market value of $29,000 on
December 31, 2004 (along with an unrealized
increase in value of $5,000). The market value
on the declaration date is $31,000.
Continued
42
Property Dividend
March 16, 2005
Allowance for Change in Value of
Investment in Available-for-Sale
Securities
Unrealized Increase in Value of
Available-for-Sale Securities
Gain on Disposal of Investments
Retained Earnings
Property Dividends Payable
2,000
5,000
7,000
31,000
31000
43
Property Dividend
June 1, 2005
Property Dividends Payable
31,000
Investment in Available-for-Sale
Securities
Allowance for Change in Value of
Investment in Available-for-Sale
Securities
24,000
7,000
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Stock Dividends
 They receive no corporate assets.
Stockholders
often view
stock
dividends
favorably
even though--
 Their percentage ownership does
not change.
 Theoretically the total market
value of their investment will
remain the same.
 Future cash dividends may be
limited because retained earnings
is decreased by the amount of the
stock dividend.
45
Stock Dividends
What factors might
enhance the perceived
attractiveness of stock
dividends?
46
Stock Dividends



The stockholders may see the stock
dividend as evidence of corporate growth.
The stockholders may see the stock
dividend as evidence of sound financial
policy.
Other investors may see the stock dividend
in a similar light, and increased trading in
the stock may cause the market price not to
decrease proportionally.
47
Stock Dividends


The corporation may state that it will pay
the same fixed cash dividend per share.
The stockholders may see the market price
decreasing to a lower trading range,
making the stock more attractive to
additional investors so that the market price
may eventually rise.
48
Stock Dividends
Retained
Earnings
Small
(<20 or 25%)
Large
Fair Value
Par Value
Capital
Stock
Additional
Paid-In
Capital
Retained
Earnings
Capital
Stock
49
Stock Dividends
Stockholders’ Equity Prior to Stock Dividend
Common stock, $10 par (20,000 shares
issued and outstanding
$200,000
Additional paid-in capital
180,000
Retained earnings
320,000
Total stockholders’ equity
$700,000
50
Small Stock Dividend
M Corporation declares and issues a 10%
stock dividend. On the date of declaration,
the stock sells for $23 per share.
Date of Declaration
Retained Earnings
46,000
Common Stock To Be Distributed
20,000
Additional Paid-in Capital From
20,000 shares x 0.10 x $23
Par
Stock Dividend
26,000
Continued
51
Small Stock Dividend
M Corporation declares and issues a 10%
stock dividend. On the date of declaration,
the stock sells for $23 per share.
Date of Issuance
Common Stock To Be Distributed
Common Stock, $10 par
20,000
20,000
Par
52
Small Stock Dividend
Stockholders’ Equity After Stock Dividend
Common stock, $10 par (22,000 shares
issued and outstanding
$220,000
Additional paid-in capital
206,000
Retained earnings
274,000
Total stockholders’ equity
$700,000
Note: Total
remained the same
53
Large Stock Dividends
M Corporation declares and issues a 40%
stock dividend. On the date of declaration,
the stock sells for $23 per share.
Date of Declaration
Retained Earnings
80,000
Common Stock To Be Distributed
80,000
Date of Issuance
20,000 shares x 0.40 x $10
Common Stock To Be Distributed
80,000
Common Stock, $10 par
80,000
Continued
54
Large Stock Dividends
Stockholders’ Equity After Stock Dividend
Common stock, $10 par (28,000 shares
issued and outstanding)
$280,000
Additional paid-in capital
180,000
Retained earnings
240,000
Total stockholders’ equity
$700,000
Note: Same total as
small stock dividend
55
Statement of Retained Earnings
Although not a required separate
financial statement, some
corporations include a statement
of retained earnings in their
financial statements.
56
Retained earnings, as previously reported, Jan. 1, 2004
Plus (minus) Prior period adjustments (net of
income tax effect)
Adjusted retained earnings, January 1, 2004
Plus (minus): Net income (loss)
Minus: Dividends (specifically identified, including
Statement
of
Retained
Earnings
per share amounts)
Reductions due to retirement or
reacquisition of capital stock
Reductions due to conversion of bonds or
preferred stock
Retained earnings, December 31, 2004
57
Accumulated Other
Comprehensive Income
Other comprehensive income might include- Unrealized increases (gains) or decreases (losses)
in the market value of investments in availablefor-sale securities.
 Translation adjustments from converting the
financial statements of a company’s foreign
operation into U.S. dollars.
 Certain gains and losses on “derivative” financial
instruments.
 Certain pension liability adjustments.
58
Accumulated Other
Comprehensive Income
A corporation may report its comprehensive
income (net of income taxes)- On the face of its income statement.
 In a separate statement of comprehensive
income.
 In its statement of changes in stockholders’
equity.
59
Statement of Changes in
Stockholders’ Equity
APB Opinion No. 12 states: “…disclosures of
changes in the separate accounts comprising
stockholders’ equity (in addition to retained
earnings) and of the changes in the number of
shares of equity securities during at least the most
recent annual fiscal period…is required to make
the financial statements sufficiently informative.
60
Appendix: Quasi-Reorganization
Click the button next
to me to skip the
Appendix material.
61
Appendix: Quasi-Reorganization
A corporation that incurs net losses over an extended
period of time may find itself in serious financial
difficulty. Rather than enter into a formal bankruptcy
or other legal proceedings, the corporation engage in
a quasi-reorganization.
62
Appendix: Quasi-Reorganization
The suggested readjustment procedures include the
following steps:
1. The corporation reports to the stockholders about
the restatements proposed and obtains the
stockholders’ formal consent.
2. Any amounts written off are first charged against
retained earnings and then against additional paid-in
capital.
3. The corporation begins its “fresh start” with a zero
retained earnings balance.
Continued
63
Appendix: Quasi-Reorganization
The suggested readjustment procedures include the
following steps:
4. The corporation presents a balance sheet as of the
date of readjustment in which the assets and
liabilities are reported at their fair values.
After the quasi-reorganization, several additional
accounting procedures are suggested:
Continued
64
Appendix: Quasi-Reorganization
5. If losses or readjustments are identified that are
determined to have occurred before the
readjustment date, they are recorded as a reduction
of additional paid-in capital and not current income
or retained earnings.
6. Additional paid-in capital is not reduced for losses
occurring after the readjustment.
7. Retained earnings is dated as of the readjustment
date, and this dating is disclosed in a note to the
financial statements until such dating loses it
significance.
65
Chapter 16
The End
66