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Chapter 16 Retained Earnings and Earnings per Share Objectives After reading this chapter, you will be able to: 1. 2. 3. 4. Explain the accounting and reporting for different types of dividends. Discuss the accounting for prior period adjustments. Prepare a statement of changes in shareholders’ equity. Compute basic earnings per share (EPS) including the computation of weighted average common shares. 5. Compute diluted earnings per share including the identification of potential common shares. Lecture Outline I. Content of Retained Earnings A. Used to summarize the earned capital component of shareholders’ equity, which primarily comprises the cumulative amount of net income over the life of the corporation minus the cumulative amount of dividends paid out to shareholders 1. A deficit, or a negative retained earnings balance, is the result of a corporation’s accumulated prior net losses or dividends in excess of its earnings B. Items affecting retained earnings 1. Net income (or net loss) 2. Dividends 3. Retrospective and prior period adjustments 4. Appropriations II. Dividends A. Requirements to distribute dividends 1. Legal requirements a. Board of directors is responsible for establishing a dividend policy and determining the amount, timing, and type of dividends to be declared b. Most states require a corporation to have a positive (credit) retained earnings balance before it may declare dividends c. Amount of dividends generally cannot exceed the retained earnings balance d. Contractual agreements may restrict a corporation from declaring dividends 2. Financial status – management considers the following factors before declaring a dividend a. Impact of a dividend on its current assets and working capital b. Ability to finance capital expansion projects c. Effect on stock market price per share d. Ability to maintain a liquidity “cushion” against possible future deteriorating economic conditions III. Types of Dividends © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 2 A. Cash dividends – distribution of cash by the corporation to its common (and any preferred) shareholders 1. Declaration date – board of directors formally declares that a dividend will be paid to shareholders of record on a specific future date a. The corporation becomes legally obligated to pay the dividend and reduces retained earnings and records the current liability 2. The ex-dividend date is the date the stock stops selling with dividends attached a. No accounting entry is required 3. The date of record is the date that investors listed in the shareholders’ ledger can receive the dividend a. The corporation makes a memorandum entry 4. On the date of payment, the corporation distributes the dividend checks a. The corporation makes a journal entry to eliminate the liability and reduce cash B. Property dividends – payable in assets other than cash 1. Classified as a nonreciprocal, nonmonetary transfer to owners a. Record at the fair value of the asset transferred (on the declaration date) b. Recognize a gain (or loss) in income if the asset fair value is greater than (less than) book value C. Scrip dividends – issue promissory notes (called “scrip”) requiring it to pay dividends at some future date 1. Make usual journal entries on the declaration date and date of payment a. Some companies may credit Notes Payable instead of Dividends Payable b. When the notes carry an interest rate, the corporation should make any necessary entries to record interest expense D. Stock dividends – a proportional (pro rata) distribution of additional shares of a corporation’s own stock to its shareholders 1. No corporate assets are distributed 2. Shareholders often view stock dividends favorably 3. Economic substance of a stock dividend is that it is not really a “dividend” but instead is similar to a stock split a. From an accounting standpoint a corporation records it like other dividends i. Retained earnings is decreased ii. Contributed capital is increased b. Small stock dividend recorded at fair value of additional shares issued i. Less than 20% to 25% of the previously outstanding shares c. Large stock dividend recorded at par value of additional shares issued 4. Fractional shares not normally issued and shareholders are normally offered two alternatives a. Shareholders receive cash equal to the market price of the fractional share b. Shareholders pay in sufficient cash to receive a full share E. Stock splits 1. Results in a change in the par value amount and a proportional increase (or decrease) in the number of shares issued and outstanding a. No journal entry is made b. A memorandum entry is normally made to document the stock split F. Liquidating dividends © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share IV. V. VI. Instructor’s Manual, p. 3 1. A return of contributed capital rather than a distribution of retained earnings a. A corporation usually declares these dividends when it is ceasing or reducing operations Prior Period Adjustments (Restatements) A. Errors in the financial statements of one accounting period not discovered until a later period 1. These errors might be due to oversights, incorrect use of existing facts, mathematical mistakes, or errors in applying accounting principles a. Usually affect an asset or liability and a revenue or expense of a prior year b. The asset or liability account is corrected and the offsetting entry is made directly to the Retained Earnings account Restrictions (Appropriations) of Retained Earnings A. A restriction (appropriation) of retained earnings means that the board of directors make a commitment that a portion of retained earnings is unavailable for dividends 1. To meet legal requirements – acquisition of treasury stock 2. To meet contractual restrictions – debt covenants B. Corporations disclose restrictions of retained earnings in a note (or sometimes by parenthetical notations) to the financial statements Reporting Changes in Shareholders’ Equity A. A corporation must disclose the changes in 1. The different classes of common stock 2. Additional paid-in capital 3. Retained earnings 4. Accumulated other comprehensive income 5. Treasury stock B. Accumulated other comprehensive income 1. Other comprehensive income (loss) might include the following four items a. Unrealized increases (gains) or decreases (losses) in the fair value of investments in available-for-sale securities b. Translation adjustments from converting the financial statements of a company’s foreign operations into U.S. dollars c. Gains and losses on certain types of derivative financial instruments that are designated as cash flow hedges d. Certain types of pension plan gains, losses, and prior service cost adjustments 2. A corporation may report its comprehensive income (net of taxes) a. On the face of its income statement b. In a separate statement of comprehensive income c. In its statement of changes in shareholders’ equity C. Statement of retained earnings 1. Disclose earnings, dividends, prior period and retroactive adjustments, and other reductions 2. A corporation may include the retained earnings statement a. As a separate statement within the financial statements b. As a supporting schedule directly beneath the income statement c. In the statement of changes in shareholders’ equity 3. Any restrictions of retained earnings are disclosed in a note to the financial statements D. Miscellaneous changes in shareholders’ equity 1. It is possible for a corporation to receive donated assets from a governmental unit to induce it to locate in a particular community © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share VII. VIII. Instructor’s Manual, p. 4 a. This nonreciprocal, nonmonetary transfer records the asset at its fair value b. The resulting credit is recorded in a Donated Capital account that is listed separately in its shareholders’ equity E. International dimension 1. Under IFRS, a corporation’s shareholders’ equity (sometimes called shareholders’ interests) consists of two sections a. Share capital b. Other equity 2. IFRS permits the reporting of a Revaluation Reserve for the revaluation of some a. Intangible assets b. Property, plant, and equipment c. Inventories 3. IFRS requires the statement of shareholders’ equity be presented as a primary financial statement 4. Many of the disclosures required are similar to those required for U.S. GAAP a. Number of shares authorized, issued, and outstanding; par value; reacquired shares and rights; preferences; and restrictions regarding dividends b. Changes in the above items from the previous period c. Any externally imposed capital requirements that result in restrictions Earnings per Share A. The primary components of a corporation’s net income are 1. Income (loss) from continuing operations which includes operating revenues and operating expenses 2. Results from discontinued operations which includes the income (loss) from the operations of a discontinued component as well as the gain (loss) from the disposal of the discontinued segment 3. Extraordinary gains or losses which are the results of unusual and infrequent events B. Corporations are also required by GAAP to report earnings per share information on its income statement 1. Earnings per share represent the amount of income associated with each share of common stock C. Price/earnings ratio 1. Market Price per Share (of the Common Stock) ÷ Earnings per Share a. Used to evaluate return and risk Computing Basic Earnings per Share A. Simple capital structure 1. Consists of common stock outstanding and possibly nonconvertible preferred stock 2. Basic earnings per share a. (Net Income – Preferred Dividends) ÷ Weighted Average Number of Common Shares Outstanding 3. Numerator calculations a. Includes earnings available to common shareholders b. Excludes dividends declared on noncumulative preferred stock c. Excludes dividends whether declared or not on cumulative preferred stock 4. Denominator calculations a. Weighted average number of common shares © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share IX. Instructor’s Manual, p. 5 i. Actual Shares Outstanding x Fraction of Year Outstanding b. Stock dividends or splits can change the shares outstanding i. Retroactive recognition for all comparative income statements presented 5. Why it matters a. Price/earnings ratio measures the market’s assessment of the future earnings potential of the company i. Higher ratios are generally interpreted as a positive signal regarding a company’s future prospects b. Dividend yield provides investors with information pertaining to the rate of return that was received in cash dividends i. The dividend yield, together with the percentage change in the market price of the stock held during the period, is the total return on the shareholders’ investment 6. Components of earnings per share a. Report separate earnings per share amounts for i. Income from continuing operations ii. Discontinued operations iii. Extraordinary items iv. Net income Diluted Earnings per Share A. Complex capital structure 1. One that has both common stock outstanding and potentially dilutive securities a. Potential common shares 2. Diluted earnings per share shows the earnings per share after including all potential common shares that would reduce earnings per share 3. Potential common shares are included in the calculation of diluted earnings per share only if they have a dilutive effect on earnings per share B. Computing diluted earnings per share (DEPS) 1. Step 1. Compute basic earnings per share for the company 2. Step 2. Include all dilutive share options and warrants and compute a tentative DEPS 3. Step 3. Develop a ranking of the impact of each convertible preferred stock and convertible bond on DEPS, from the most dilutive to the least dilutive 4. Step 4. Beginning with the most dilutive security first, include each dilutive convertible security in DEPS in a sequential order based on the ranking in Step 3 and compute a new tentative DEPS 5. Step 5. Report as the diluted earnings per share the lowest computed DEPS C. Share options and warrants 1. Considered first in diluted earnings per share calculations 2. Only included in diluted earnings per share if they are dilutive a. Will not be dilutive if they are out of the money (the exercise price of the option or warrant is higher than the market price) 3. The treasury stock method is used to determine the change in the number of shares a. Step 1. Determine the average market price of common shares during the period (if less than option or warrant exercise price, stop, the assumed exercise of the options would be antidilutive) b. Step 2. Compute the shares that would be issued from the assumed exercise of all options and warrants © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 6 c. Step 3. Compute the proceeds received from the assumed exercise by multiplying the shares issued by the exercise price d. Step 4. Compute the assumed shares that would be reacquired by dividing the proceeds (Step 3) by the average market price (Step 1) e. Step 5. Compute the incremental common shares that would need to be issued (shares assumed issued minus shares assumed reacquired; the results of Step 2 minus Step 4) D. Convertible securities 1. If-converted method a. Each convertible stock or bond is assumed to have been converted into common stock at the beginning of the earliest period reported b. The assumed conversion causes two changes in the earnings per share calculation i. The denominator increases by the number of common shares issued in the assumed conversion ii. If bonds are assumed to be converted into common stock the numerator increases because the corporation would not have to pay interest expense, increasing net income iii. If preferred stock is assumed to be converted into common stock, the numerator increases because the corporation would not have to pay preferred dividends on the converted preferred shares c. Impact of each convertible security on DEPS i. Increase in Earnings per Share Numerator ÷ Increase in Earnings per Share Denominator ii. The convertible security with the most dilutive impact on DEPS causes the smallest increase iii. The convertible security having the most dilutive impact on dilutive earnings per share is listed at the top of the ranking, and other convertible securities are ranked in sequential order so that the security with the least dilutive impact is listed at the bottom of the ranking iv. The ranking enables the corporation to sequentially include dilutive securities in its diluted earnings per share in the descending order of their individual effect on earnings per share E. Computation of tentative and final diluted earnings per share 1. Step 1. Calculate basic earnings per share 2. Step 2. Compute the incremental shares from the assumed exercise of share options and warrants and calculate an initial tentative diluted earnings per share 3. Step 3. Include the dilutive convertible securities in diluted earnings per share in sequential order according to their dilutive effect on earnings per share a. Start with the most dilutive convertible security, include it in diluted earnings per share if its impact is less than the initial tentative diluted earnings per share 4. Step 4. Repeat with each dilutive security in the ranking until the impact of the convertible security is antidilutive (or until all dilutive securities are used) a. Any remaining securities in the ranking are antidilutive and are excluded from diluted earnings per share 5. Step 5. Final diluted earnings per share is the last tentative figure © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 7 a. It contains all the dilutive convertible securities included in the tentative diluted earnings per share computations F. Special issues related to dilutive earnings per share 1. If a corporation reports a loss from continuing operations, then it does not include potential common shares in calculating diluted earnings per share 2. If the corporation reports income from continuing operations and extraordinary items or discontinued operations in its net income, it tests for dilution based on income from continuing operations and not overall net income G. Additional considerations 1. Typically, the “conversion ratio” for convertible securities and stock options is proportionally adjusted for the stock dividend or stock split a. The corporation uses the current conversion ratio for convertible securities and share options in its diluted earnings per share computations 2. A corporation may be obligated to issue common shares in the future if certain conditions are met a. If the conditions have been met before issuance, the corporation considers these shares to be outstanding for both basic and diluted earnings per share b. If the conditions have not been met, if dilutive, the corporation includes these shares in diluted earnings per share 3. When a corporation reports its basic and diluted earnings per share on its income statement, it is also required to make additional disclosures in the notes to its financial statements a. A schedule or note identifying and reconciling the numerators and denominators on which it calculated both basic and diluted earnings per share b. The amount of preferred dividends deducted to determine the income available to common shareholders c. The potential common shares that were not included in the diluted earnings per share computation because they were antidilutive d. Any material impact on the common shares outstanding of transactions after the close of the accounting period but before the issuance of the financial report H. International dimension 1. Main differences between U.S. GAAP and IFRS a. When applying the treasury stock method for potentially dilutive share options, IFRS do not require a company to include any unrecognized compensation cost in the assumed proceeds resulting in lower earnings per share amounts compared to U.S. GAAP b. U.S. GAAP requires that any contingently convertible debt securities that convert when the stock price reaches a certain level are always included in dilutive earnings per share i. IFRS only includes if the targeted stock price has been reached ii. Inclusion of these contingent shares by GAAP would result in lower basic earnings per share amounts under GAAP c. For contracts that may be settled by issuance of shares or payments of cash, IFRS requires the if-converted method to be used which assumes that the contract will be settled in shares i. Under U.S. GAAP if a cash settlement is presumed companies are allowed to ignore the dilutive effects of the contract © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 8 d. Because IFRS do not have the concept of extraordinary items, there is no EPS disclosure related to extraordinary items e. U.S. GAAP does not allow the presentation of non-GAAP EPS amounts, whereas IFRS do allow such presentation in the notes to the financial statements Synopsis Content of Retained Earnings Earned capital arises as the corporation generates earnings for the shareholders and reinvests the earnings in the company, minus any dividends the company may pay to common shareholders. Retained earnings is an account used by a corporation to summarize the earned capital component of its shareholders’ equity, which primarily comprises the cumulative amount of net income over the life of the corporation, minus the cumulative amount of dividends paid out to shareholders. Most corporations prefer the account title Retained Earnings, with the remaining corporations using titles with very similar meanings (such as Reinvested Income or other variations). A number of corporations have negative retained earnings and use the term Retained Earnings (Deficit) or Accumulated Deficit. A deficit is a negative retained earnings balance resulting from a corporation’s accumulated prior net losses or dividends in excess of its earnings. Dividends The distribution of cash or property dividends decreases the assets (and capital) and reduces the retained earnings component of common equity. To pay cash (or property) dividends, a corporation must meet legal requirements and have assets available for distribution. The board of directors is responsible for establishing a dividend policy and determining the amount, timing, and type of dividends to be declared. It must consider the articles of incorporation, applicable state regulations for dividends, the impact on legal capital (established to protect corporate creditors), and compliance with contractual agreements as well as the financial well-being of the corporation. Legal requirements for dividends vary from state to state, but most states require a corporation to have a positive (credit) retained earnings balance before it may declare dividends. Also, the amount of dividends generally cannot exceed the retained earnings balance. Usually, a corporation must restrict the amount of retained earnings available for dividends by the cost of the treasury shares held. Also contractual agreements (such as long-term bond covenants) may restrict a corporation from declaring dividends. Besides meeting legal requirements, the board of directors must evaluate the financial desirability of a particular dividend. In this case, the board may consult with the corporate accountants and financial executives. Consideration should be given to the corporation’s financial flexibility and operating capability. Factors that management may evaluate when considering a dividend would be: impact of a dividend on its current assets and working capital; ability to finance capital expansion projects; effect on the stock market price per share; and ability to maintain a liquidity “cushion” against possible future deteriorating economic conditions. The declaration of a dividend must be in the financial long- and short-term interests of the shareholders. Types of Dividends © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 9 The most common type of dividend is the cash dividend – the distribution of cash by the corporation to its common (and any preferred) shareholders. Unless described otherwise, the simple term dividends refers to cash dividends. Four dates are important for a cash dividend (or any type of dividend): declaration date; exdividend date; date of record; and date of payment. The declaration date is the date the board of directors formally declares that a dividend will be distributed to shareholders of record on a specific future date, typically four to six weeks later. On this declaration date, the corporation becomes legally liable to pay the dividend. Because the corporation increases a liability on the declaration date, it records a journal entry which: Reduces retained earnings. Most corporations reduce (debit) Retained Earnings directly. However, some corporations use a contra-retained earnings account titled Dividends Declared for the dividends related to each class of stock. Records the current liability. The corporation either increases (credits) a current liability, Dividends Payable, or increases separate liability accounts for the amounts owed to each class of shareholder. After the declaration date, the outstanding stock of the corporation trading in the market normally sells “with dividends attached” (that is, at a higher market price that includes the amount of the future dividend payment). The ex-dividend date occurs several days before the date of record to enable the corporation to update its shareholders’ ledger by the date of record. The ex-dividend date is the date the stock stops selling with dividends attached. Any purchase of the stock on or after this date will not receive the current dividend. No accounting entry is required on the ex-dividend date. Normally, it takes a corporation some time to process the dividend checks. Thus, a “cut-off” date is needed – the date of record. The date of record is the date which determines which shareholders will receive the dividend for the next payment date. These investors are listed in the shareholders’ ledger on the date of record. The date of record usually occurs several weeks after the declaration date and several weeks before the payment date, as specified in the dividend provisions. On the date of record, the corporation makes a memorandum entry indicating that the date of record has been reached and showing the future dividend payment date. On the date of payment the corporation distributes the dividend checks and makes a journal entry to eliminate the liability and reduce cash. For a stock dividend it is the date on which the additional shares are distributed and the company increases the capital stock accounts and reduces the capital stock to be distributed account. After the date of payment, the corporation has completed the dividend process. It reports the payment of dividends as a cash outflow in the financing section of its statement of cash flows. Usually, the amounts of dividends payable to each class of stock can be easily determined. In certain cases, however, preferred stock may be either fully or partially participating. In these cases, a corporation must compute the dividends payable to preferred and common shareholders. Fully participating preferred stock shares equally with the common stock in any extra dividends. These extra dividends are distributed proportionally, based on the respective total par values of each class of stock. Partially participating preferred stock is limited in its participation to a fixed rate (based on the respective par value) or amount per share. Occasionally, a corporation will declare a property dividend which is a dividend that is payable in assets other than cash (such as inventory or investments) and often referred to as dividends in kind. For example, a corporation paying a property dividend might distribute marketable © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 10 securities of other companies that it owns for the property dividend because they can be distributed easily to the shareholders, and as liquid assets the shareholders can easily sell the securities for cash if they wish. A property dividend is classified as a nonreciprocal, nonmonetary transfer to owners. That is, the corporation enters into an exchange in which it gives up something of value (the asset) but for which it receives no asset or service in return. Also, because no cash is involved, the exchange is a nonmonetary transfer. GAAP requires a corporation to record a property dividend at the fair value of the asset transferred. Therefore, the corporation would remove the asset distributed by crediting the asset account for the book value of the asset, it would debit Retained Earnings by the amount of the fair value of the asset distributed, and it would recognize gain (or loss) in income if the asset fair value is greater than (less than) book value. The logic behind using fair value for the property dividend is that the corporation could have sold the assets distributed in the dividend for cash and used the cash proceeds (fair value) to pay a cash dividend. The fair value is determined on the declaration date (because this is the date the dividend becomes a legal liability) by referring to existing stock or bond market prices, recent cash exchanges of similar assets, or objective independent appraisals. In the case where a corporation distributes “available-for-sale” debt or equity securities as a property dividend and there is a previously recorded unrealized increase or decrease in value, the computation of the gain or loss is more complex. The corporation is carrying the investment in available-for-sale securities at the fair value of the securities on the last balance sheet date. It is also reporting an “unrealized increase (or decrease) in value” amount in the accumulated other comprehensive income section of its shareholders’ equity. However, the realized gain or loss on this type of property dividend is computed as the difference between the fair value of the securities on the declaration date and the original cost of the securities. The corporation must record a journal entry on the declaration date to revalue the investment, to record the realized gain or loss, and to eliminate the unrealized increase (decrease) in value for these securities. A corporation may have adequate retained earnings to meet the legal dividend requirements but insufficient cash to justify a current cash dividend. In this case, it may declare a scrip dividend which is an issuance of promissory notes (called “scrip”) requiring the corporation to pay dividends at some future date. It makes the usual entries on the declaration date (although some companies may credit Noes Payable instead of Dividends Payable) and date of payment. When the notes carry an interest rate, the corporation should make any necessary entries to record interest expense. Additionally, the dividend liability will be classified as short-term or longterm depending on the maturity date of the scrip. Scrip dividends are rare, because corporations with liquidity problems do not commit to future cash out flows. A corporation may also declare and distribute a stock dividend. A stock dividend is a proportional (pro rata) distribution of additional shares of a corporation’s own stock to its shareholders. A stock dividend usually consists of the same class of shares; that is, a common stock dividend is declared on common stock outstanding. This type of distribution is called an ordinary stock dividend. The distribution of a different class of stock (common on preferred or preferred on common) sometimes is called a special stock dividend. A corporation usually issues a stock dividend out of authorized but unissued shares, although it may use shares of treasury stock. Unlike other dividends, a corporation may legally rescind the declaration of a stock dividend before distribution. A stock dividend also differs from other dividends in that no corporate assets © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 11 are distributed. Each shareholder maintains the same percentage ownership in the corporation before and after the distribution. The economic substance of a stock dividend is that it is not really a “dividend” but instead is similar to a stock split. In both cases, even though the number of shares increases, a corporation does not distribute any assets to the shareholders, and each shareholder’s percentage ownership stays the same. So, the corporation’s total assets and shareholders’ equity remains unchanged. From an accounting standpoint, however, a corporation does not account for a stock dividend like a stock split, but instead records it like other dividends. When a stock dividend is recorded, total shareholders’ equity is not changed. Retained earnings are decreased by the amount of the “dividend,” and contributed capital is increased by the same amount because of the additional shares issued. This treatment is based on an “opportunity cost” argument. That is, the corporation should record the “dividend” at the fair value of the stock because this is the value that it foregoes to issue the stock dividend. A small stock dividend is viewed as a simultaneous sale of stock and payment of a dividend. Therefore, a corporation accounts for a small stock dividend by transferring from retained earnings to contributed capital an amount equal to the fair value of the additional shares issued. In distinguishing between a small and a large stock dividend, GAAP states that fair value is ordinarily the appropriate value to use whenever the stock dividend (that is, small dividend) is less than 20% or 25% of the previously outstanding shares. State legal requirements govern the minimum amount that a corporation must capitalize (transfer from retained earnings to contributed capital as part of legal capital) for a stock dividend. Generally, this is the par or stated value of the additional shares distributed. The accounting for a large stock dividend relates to this legal capital. Therefore, a corporation accounts for a large stock dividend by transferring from retained earnings to contributed capital an amount equal to the par value of the additional shares issued. In this case, GAAP suggests that the use of the term dividend be avoided or, when this is not possible because of legal restrictions, the transaction should be described in terminology such as a stock split affected in the form of a dividend. In the case of a stock dividend, the number of shares that many shareholders own will not entitle them to receive additional whole shares from the dividend. Some corporations have a policy of not issuing fractional shares. These corporations usually offer shareholders the following two alternatives: Shareholders receive cash equal to the market price of the fractional share, in which case the corporation accounts for the cash it pays as a cash dividend and issues fewer shares. Shareholders pay in sufficient cash to receive a full share, in which case the corporation records the stock dividend in the usual manner and adjusts contributed capital for the cash it receives. A stock split results in a corporation issuing additional shares, or in the case of a reverse stock split, reducing the number of shares outstanding. However, a stock split does not affect retained earnings. Rather it results in a change in the par value amount and a proportional increase (or decrease) in the number of shares issued and outstanding. No journal entry is made for a stock split; however, a memorandum entry is normally made to document the stock split. Liquidating dividends are dividends representing a return of contributed capital rather than a distribution of retained earnings. A corporation usually declares these dividends when it is © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 12 ceasing or reducing operations. A liquidating dividend also may arise when a corporation with natural resources pays a dividend based on earnings before depletion. That portion of the dividends equal to the amount of depletion is considered the liquidating dividend. When a corporation pays a dividend that is in part (or in total) a liquidating dividend, it must adhere to state legal requirements in recording the dividend. It records the normal portion of the dividend as a reduction of retained earnings and the liquidating portion as a reduction of contributed capital. The latter may be recorded as a debit either to an additional paid-in capital account or to a special contra-contributed capital account entitled, for instance, Contributed Capital Distributed as a Liquidating Dividend. The corporation should disclose the liquidating dividend in a note to its financial statements to notify shareholders that a portion of contributed capital is being returned. Relevant Examples and Exhibits Example 16.1 Dividend Accounting Dates Example: Declaration and Payment of Dividends Example: Participating Preferred Stock Dividends Example 16.1 Dividend Distribution Example: Investment Securities (Bonds) Distributed as Property Dividend Example: Available-for-Sale Security Distributed as Property Dividend Exhibit 16.2 Accounting for Stock Dividends Example: Stock Dividends Example: Small Stock Dividend Example: Large Stock Dividend Prior Period Adjustments (Restatements) Prior period adjustments (restatements) are retrospective adjustments of retained earnings that can arise from changes in accounting principles, change in accounting entity, and corrections of errors of prior periods. A corporation may make an error in the financial statements of one accounting period that it does not discover until a later period. These errors may be due to oversights, incorrect use of existing facts, mathematical mistakes, or errors in applying accounting principles. Usually these errors affect an asset or liability and a revenue or expense of a prior year. A corporation is required to treat corrections of all material errors as prior period adjustments (restatements) of retained earnings. That is, when the error is corrected, the asset or liability account balance is corrected (debited or credited) and the offsetting credit or debit (which involves revenue or expense previously closed to retained earnings) is made directly to the Retained Earnings account. Any related impact on income taxes is similarly recorded. Relevant Examples and Exhibits Example: Prior Period Adjustment Restrictions (Appropriations) of Retained Earnings To indicate that a certain portion of retained earnings is not available for dividends, a corporation may restrict (appropriate) retained earnings. A restriction (appropriation) is a policy where the board of directors makes a commitment that a portion of retained earnings is unavailable for dividends. It is important to understand that such a policy does not directly restrict the use of any assets. It merely requires that the corporation not distribute any assets that would reduce restricted retained earnings. A board of directors may restrict retained earnings to meet legal requirements or to meet contractual restrictions. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 13 Certain states require restrictions of retained earnings when a corporation reacquires its own stock as treasury stock. Usually retained earnings are reduced by an amount equal to the cost of the treasury shares. The argument for this is that acquiring treasury stock reduces the amount of retained earnings that can be paid in dividends. A corporation also may restrict retained earnings because of a contractual agreement. This type of agreement may be made when a corporation issues long-term bonds. To provide some assurance that sufficient assets will be kept in the corporation to satisfy bondholders’ claims (and not paid out to shareholders in dividends), the bond provision (sometimes called “debt covenants”) may require the restriction of a certain amount of retained earnings. Corporations disclose restrictions of retained earnings in a note (or sometimes by parenthetical notations) to the financial statements. In the notes, a clear description of the legal or contractual provisions and the amount of the restriction is required. When a corporation cancels a restriction (for instance, because it no longer has treasury stock), it does not include the note in its financial statements. Reporting on Changes in Shareholders’ Equity A corporation must disclose the changes in the different classes of common stock, additional paid-in capital, retained earnings, accumulated other comprehensive income, and treasury stock in its annual report. The intent is to help report on changes in the corporation’s financial structure to help users assess its financial flexibility, profitability, and risk. Most corporations prepare a statement of changes in shareholders’ equity that includes an analysis of the changes in these items. The ending amounts of this statement then tie to the shareholders’ equity section of the year-end balance sheet. A corporation is required to report its total comprehensive income for the accounting period. Comprehensive income includes both net income and “other comprehensive income.” Other comprehensive income (loss) might include the following four items: Unrealized increases (gains) or decreases (losses) in the fair value of investments in available-for-sale securities. Translation adjustments from converting the financial statements of a company’s foreign operations into U.S. dollars. Gains and losses in certain types of derivative financial instruments that are designated as cash flow hedges. Certain types of pension plan gains, losses, and prior service cost adjustments. 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. Although not a required separate financial statement, many small corporations include a statement of retained earnings in their financial statements. A corporation may include the retained earnings statement within the financial statements, as a supporting schedule directly beneath the income statement, or as is common, in the statement of changes in shareholders’ equity. A retained earnings statement usually includes only adjustments to retained earnings for net income and dividends. Any restrictions on retained earnings are disclosed in a note to the financial statements. In rare instances, a corporation may increase shareholders’ equity for events not related to the issuance of stock or to retained earnings. For example, it is possible for a corporation to received donated assets from a governmental unit to induce it to locate in a particular community. As this is a nonreciprocal, nonmonetary transfer, the corporation records the asset © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 14 at the fair value. It records the related credit in a Donated Capital account. A corporation lists these items separately in its shareholders’ equity. Under IFRS, a corporation’s shareholders’ equity (sometimes called shareholders’ interests) consists of two sections: share capital and other equity. Within the equity section, one major difference with regard to the components of shareholders’ equity is that IFRS permit the reporting of a Revaluation Reserve. The Revaluation Reserve is the result of IFRS allowing, but not requiring, the revaluation to fair value of some intangible assets; property, plant, and equipment; and some inventories. In addition, GAAP and IFRS differ in how changes in shareholders’ equity are reported. IFRS require that the statement of changes in equity be presented as a primary financial statement. GAAP, however, permits the statement of changes in shareholders’ equity to be presented as a primary financial statement or within the financial footnotes. However, the SEC requires that publicly registered companies must present a statement of changes in shareholders’ equity. Many of the disclosures required for shareholders’ capital are similar to those required under U.S. GAAP. Companies are required to disclose information about Number of shares authorized, issued, and outstanding; par value; reacquired shares and rights; preferences; and restrictions regarding dividends. Changes in the above items from the previous period. Any externally imposed capital requirements that result in restrictions. Relevant Examples and Exhibits Example 16.2 Bardwell Corporation, Statement of Changes in Shareholders’ Equity for 2013 Example 16.3 Bardwell Corporation, Shareholders’ Equity on December 31, 2013 Exhibit 16.3 Statement of Retained Earnings for 2013 Real Report 16.1 Shareholders’ Equity and Related Changes Earnings per Share Net income (loss) is the amount of earnings from a corporation’s income-producing activities during its accounting period. A corporation summarizes the components of its net income on its income statement and the primary components are: Income (loss) from continuing operations, which includes operating revenues and operating expenses. Results from discontinued operations, which includes the income (loss) from the operations of a discontinued component as well as the gain (loss) from the disposal of the discontinued component. Extraordinary gains or losses, the results of unusual and infrequent events. Corporations are also required by GAAP to report earnings per share information on its income statement. Earnings per share is one of the pieces of financial information most closely examined by financial analysts and investors. At its most basic, earnings per share is an element of financial information that represents the amount of net income associated with each share of common stock. The amount of earnings per share, the change in earnings per share from the previous period, and the trend in earnings per share are all important indicators of a corporation’s profitability for investors. The price/earnings ratio is a ratio used to evaluate return and risk and investors often use in intercompany comparisons of share price relative to profitability; computed as market price per © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 15 share of the common stock divided by earnings per share. When using earnings per share information (e.g., price/earnings ratios) for intercompany comparisons, a user must be sure that calculations are comparable. For example, two companies may have identical earnings, but different earnings per share because of differences in the number of shares outstanding. In addition, earnings per share does not take into account the amount of capital that a company utilizes when generating earnings. Computing Basic Earnings per Share Due to the importance of earnings per share (EPS) as a summary measure of company performance, the accounting rules for its calculation are detailed and specific. When computing earnings per share, the company’s capital structure will determine what type of information will need to be reported. There are two types of corporate capital structure – simple and complex: A simple capital structure is a type of corporate capital structure that consists of common stock outstanding and possibly nonconvertible preferred stock. A complex capital structure is a type of corporate capital structure that has both common stock outstanding and potentially dilutive securities, such as share options, convertible debt, or preferred shares. A corporation with a simple capital structure is required to report basic earnings per share. Basic earnings per share (sometimes called earnings per common share) is calculated as net income minus preferred dividends divided by weighted average number of common shares outstanding. Several complexities affect the numerator and denominator of the earnings per share equation. Although we discuss these issues for basic earnings per share, they also apply to corporations that report diluted earnings per share. Only the amount of earnings available to common shareholders is used in the numerator of the earnings per share computation. If a corporation has outstanding noncumulative preferred stock, it deducts the dividends declared during the current period from net income to determine the income available to common shareholders. If the corporation has cumulative preferred stock outstanding, it deducts the dividends for the current period, whether declared or not. It discloses the amount of the dividends deducted in the notes to its financial statements. In determining the weighted average number of shares a company should use in the denominator of its earnings per share calculation, it must consider when the shares were issued and if the shares were issued in a stock split or dividend. Because a corporation generates net income over the entire year, the earnings relate to the common shares outstanding during the year. If a corporation has not issued or reacquired any shares and the number of shares outstanding has remained constant during the year, it uses the number of common shares outstanding at the end of the accounting period as the denominator. If a company has issued or reacquired common shares during the period, the denominator is the weighted average number of common shares outstanding during the period, calculated as follows: Actual Shares Outstanding x Fraction of Year Outstanding = Weighted Average Number of Common Shares Outstanding When the company issues more shares or repurchases shares, the revised number of common shares outstanding are multiplied by the fraction of the year they are outstanding. This process © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 16 continues for the entire period and the amounts are totaled to determine the weighted average number of common shares. A company’s shares outstanding can change as a result of a stock dividend or stock split, which are non cash events. These events do not affect shareholders’ total investment in the corporation, instead only changing the number of shares outstanding. Because these events do not affect the company’s net assets, the company gives retroactive recognition to these events for all comparative income statements that it presents. This retroactive adjustment results in comparable earnings per share amounts for all periods presented in the financial statements, based on the most recent capital structure. The simplest way of giving retroactive recognition is to first assume that the stock dividend or split occurred at the beginning of the earliest comparative period. Then assume that all stock transactions between the beginning date and the actual date of the stock dividend or split included the additional shares resulting from the assumed dividend or split. Investors, creditors, and others use various measures to assess how effective a company has been at meeting its profit objective. The price/earnings ratio and dividend yield are two measures used for this purpose. The price/earnings ratio measures the market’s assessment of the future earnings potential of the company. The price/earnings ratio is computed as follows: Price/Earnings Ratio = Market Price per Common Share Earnings per share While price/earnings ratios should be evaluated in the context of the industry in which the company operates, higher price/earnings ratios relative to other similar companies are generally interpreted as a positive signal regarding a company’s future prospects. Another useful measure of shareholder profitability is dividend yield. This ratio provides investors with information pertaining to the rate of return received in cash dividends. The dividend yield is computed as: Dividend Yield = Dividends per Common Share Market Price per Common Share The dividend yield, together with the percentage change in the market price of the stock held during the period, is the total return on the shareholders’ investment. Net income is the bottom line earnings amount on a corporation’s income statement. If the net income includes any results from discontinued operations or extraordinary items, the corporation must report separate earnings per share amounts for both income from continuing operations and net income on its income statement. It is also required to disclose the earnings per share related to the results from discontinued operations and extraordinary items. The corporation may report these component amounts on its income statement or in the notes to its financial statements. When a corporation has deducted preferred dividends in the computation of total earnings per share, it also deducts these dividends from the income related to continuing operations to reconcile the earnings per share amounts. Each of these earnings per share component amounts is based on the same weighted average number of shares. When reported on the income statement, the components are summed to © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 17 report the total earnings per share. The intent is to show the contribution of each income statement component to the total earnings per share. Relevant Examples and Exhibits Example: Basic Earnings per Share Example: Weighted Average Shares Example 16.4 Weighted Average Shares Example: Stock Dividend and Split Example 16.5 Comparative Weighted Average Shares Example: Basic Earnings per Share Example 16.6 Computation and Reporting of Basic Earnings per Share Diluted Earnings per Share Many corporations have complex capital structures. Their capital structures include securities such as share options and warrants, convertible preferred stock, convertible bonds, participating securities, differing classes of common stock, and contingent shares. These securities are referred to as potential common shares if they are securities that can be used by the holder to acquire common stock. Because conversion of these securities would change the number of common shares outstanding, they are considered in computing a corporation’s earnings per share. A corporation with a complex capital structure is required to report both basic and diluted earnings per share amounts on the face of its income statement. Basic earnings per share is computed under the assumptions of a simple capital structure. Diluted earnings per share (DEPS) are the earnings per share after including all potential common shares that would reduce earnings per share. It considers those potential common shares in addition to the weighted average common share calculations. Potential common shares are included in the calculation of diluted earnings per share only if they have a dilutive effect on (that is, decrease) earnings per share. Depending on stock prices and other factors, some potential common shares may be dilutive and others may not be, and given how stock prices change over time, some potential common shares may be dilutive in one period but not another. To evaluate the dilutive effect of each security, a corporation must include potential common shares in the diluted earnings per share (DEPS) calculations in a certain order. Therefore, the steps for computing DEPS are as follows: Step 1. Compute basic earnings per share for the company. Step 2. Include all dilutive share 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, from the most dilutive to the least dilutive. Step 4. Beginning with the most dilutive security first, include each dilutive convertible security in DEPS in a sequential order based on the ranking in Step 3 and compute a new tentative DEPS. Step 5. Report as the diluted earnings per share the lowest computed DEPS. A corporation always first considers share options and share warrants in its diluted earnings per share calculations. However, they are only included in diluted earnings per share if they are dilutive. Share options and warrants will not be dilutive if they are out of the money (that is, the exercise price of the option or warrant is higher than the market price). Because the exercise price of share options or warrants does not affect the corporation’s net income, the focus is on © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 18 the earnings per share denominator. The treasury stock method is used to calculate additional dilutive shares resulting from stock options and stock warrants. Under this method, the number of shares added to the earnings per share denominator is the difference between the assumed shares issued and the assumed shares reacquired. Whenever the shares issued exceed the shares reacquired, the effect is a dilution of earnings per share. Dilution occurs whenever the average market price is greater than the option (exercise) price. The steps for the treasury stock method are as follows: Step 1. Determine the average market price of common shares during the period (if less than the option or warrant exercise price, stop; the assumed exercise of the options or warrants would be antidilutive). Step 2. Compute the shares that would be 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 exercise price [plus any unrecognized compensation cost (net of tax) per share]. Step 4. Compute the assumed shares that would be reacquired by dividing the proceeds (Step 3) by the average market price (Step 1). Step 5. Compute the incremental common shares that would need to be issued (shares assumed issued minus shares assumed reacquired; the result of Step 2 minus Step 4). Convertible bonds and convertible preferred stock are considered for inclusion in diluted earnings per share after options and warrants. A corporation includes convertible securities in its diluted earnings per share only if they are dilutive. It must be careful to include the individual securities, one at a time, in the proper sequence. To determine the sequence in which to include convertible securities in diluted earnings per share, the securities are ranked by their potential impact on diluted earnings per share resulting from the assumed conversion of each convertible security into common shares. The ifconverted method is used to calculate additional dilutive shares resulting from convertible bonds and convertible preferred stock. Under this method, each convertible stock or bond is assumed (for computing diluted earnings per share) to have been converted into common stock at the earliest period reported (or on the issuance of the security, if later). This assumed conversion causes two changes in the earnings per share calculation: The denominator increases by the number of common shares issued in the assumed conversion. If bonds are assumed to be converted into common stock, the numerator increases because the corporation would not have to pay interest expense (net of income taxes) for the converted bonds, increasing net income. If preferred stock is assumed to be converted into common stock, the numerator increases because the corporation would not have to pay preferred dividends on the convertible preferred shares. The impact of each convertible security on the corporation’s diluted earnings per share is computed as follows: Impact on DEPS = Increase in Earnings per Share Numerator Increase in Earnings per Share Denominator © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 19 After the corporation has computed the impact on DEPS for each convertible security, it ranks the securities. The convertible security having the most dilutive impact on diluted earnings per share is listed at the top of the ranking, and the other convertible securities are ranked in sequential order so that the security with the least dilutive impact is listed at the bottom of the ranking. Beginning with the convertible security listed at the top of the ranking, the corporation sequentially enters the dilutive securities into its diluted earnings per share computations. It is important to understand that the convertible security with the most dilutive impact on DEPS causes the smallest increase in the numerator relative to the increase in the denominator from the assumed conversion. Consequently, that security, which causes the greatest decrease in diluted earnings per share, is the most dilutive convertible security and is the first (after options and warrants) to be included in diluted earnings per share. A corporation computes its diluted earnings per share in the following sequence: Step 1. Calculate basic earnings per share. Step 2. Compute the incremental shares from the assumed exercise of share options and warrants. Add the incremental shares to the denominator from basic earnings per share, and calculate an initial tentative diluted earnings per share. Step 3. Include the dilutive convertible securities in diluted earnings per share in sequential order according to their dilutive effect on tentative earnings per share. Starting with the most dilutive convertible security, include it in diluted earnings per share if its impact is less than the initial tentative diluted earnings per share. This involves computing a new numerator and denominator by adding the increase in the numerator and the increase in the denominator resulting from the assumed conversion to the amounts used to compute the initial tentative diluted earnings per share. Step 4. Repeat with each dilutive security in the ranking until the impact of the next convertible security is antidilutive (or until all dilutive securities are used). Any remaining securities in the ranking are antidilutive and are excluded from diluted earnings per share. Step 5. Final diluted earnings per share is the last tentative figure. It contains all the dilutive convertible securities included in the tentative diluted earnings per share computations. If a corporation reports a loss from continuing operations, then it does not include potential common shares in calculating diluted earnings per share. This is true even if it reports a positive overall net income due to having gains from extraordinary items or discontinued operations. If the corporation reports income from continuing operations and extraordinary items or results of discontinued operations in its net income, it tests for dilution based on income from continuing operations, not overall net income. After issuing convertible securities or share options, a corporation may declare a stock dividend or stock split. Typically, the “conversion ratio” for convertible securities and stock options is proportionally adjusted for the stock dividend or stock split. The corporation uses the current conversion rate for convertible securities and share options in its diluted earnings per share computation. A corporation may be obligated to issue common shares in the future if certain conditions are met. This stock is referred to as contingently issuable common stock. If the conditions have been met before issuance, the corporation considers these shares to be outstanding for both basic and diluted earnings per share purposes. If the conditions have not been met, if dilutive, the corporation includes the shares in diluted earnings per share. They are included based on © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 20 the number of shares that would be issuable if the end of the accounting period were the end of the contingency period of the shares. When a corporation reports its basic and diluted earnings per share on its income statement, it is also required to make additional disclosures in the notes to its financial statements. These include a schedule or note identifying and reconciling the numerators and denominators on which it calculated both basic and diluted earnings per share. The schedule or note also includes information that: Identifies the amount of preferred dividends deducted to determine the income available to common shareholders. Describes the potential common shares that were not included in the diluted earnings per share computation because they were antidilutive. Describes any material impact on the common shares outstanding of transactions after the close of the accounting period but before issuance of the financial report. Due to convergence efforts, IFRS and U.S. GAAP are similar in regard to computing and reporting basic and diluted earnings per share. In addition, the FASB and the IASB have both issued Exposure Drafts that, if adopted, would even more closely align the calculations of earnings per share for U.S. GAAP and IFRS. The main differences that need to be resolved are as follows: When applying the treasury stock method for potentially dilutive share options, IFRS do not require a company to include any unrecognized compensation cost in the assumed proceeds for issuing the stock. The exclusion of unrecognized compensation cost would result in lower earnings per share amounts under IFRS as compared to U.S. GAAP. U.S. GAAP requires that any contingently convertible debt securities that convert when a company’s stock price reaches a certain level are always included in diluted earnings per share, even if the target stock price has not been reached. Under IFRS, the additional shares would only be included in diluted earnings per share if the target price has been reached at the financial statement date. The inclusion of these contingent shares by GAAP would result in lower basic earnings per share amounts. For contracts that may be settled in issuance of shares or payments of cash, IFRS require the if-converted method to be used which assumes that the contract will be settled in shares. However, under U.S. GAAP if a cash settlement is presumed, companies are allowed to ignore the dilutive effects of the contract and treat the settlement as an adjustment to earnings. IFRS and U.S. GAAP differ on presentation and disclosure requirements. Because IFRS do not have the concept of extraordinary items, there is no EPS disclosure related to extraordinary items. Finally, U.S. GAAP does not allow the presentation of non-GAAP EPS amounts, whereas IFRS do allow such presentations in the notes to the financial statements. Relevant Examples and Exhibits Exhibit 16.4 Flowchart of EPS Computations Exhibit 16.5 Change in Shares – Treasury Stock Method Example: Share Options Example 16.7 Computation of Impact of Convertible Securities on Diluted Earnings per Share Exhibit 16.6 Calculations of Tentative EPS Example 16.8 Computation and Reporting of Diluted Earnings per Share Real Report 16.2 Starbucks’s Earnings per Share Disclosures © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Chapter 16: Retained Earnings and Earnings per Share Instructor’s Manual, p. 21 Ethical Dilemma Answer Note: This was cut and pasted from the Chapter 16 answer on the ftp site, but is exactly the same as Chapter 15. This ethical dilemma is an example of misaligned incentives. The CEO is well within her authority to select the method of financing to be used to finance the modernization of the facilities. However, the CEO appears to be primarily concerned with the short-term goal of reaching the company’s desired return on equity and earning a bonus. Given the fact that the CEO plans to retire in two years, her short-term thinking is understandable; however her decisions do not appear to be in the best long-term interest of the company. Because the CEO is clearly motivated by personal issues, you may feel that the Board of Directors should be informed. However, debt and equity financing both have advantages and disadvantages, and if you present your concerns to the Board, the CEO may be able to easily defend her position. Also, if you go to the Board with this concern, your future with the company may be in doubt. Clearly, both action and inaction may have undesirable consequences that must be considered. In addition to the ethical implications of this situation, the instructor may wish to discuss with the student the advantages and disadvantages of equity and debt financing as well as the way that financial leverage may be used to increase return on equity (see the ratio application later in the chapter). Instructional Notes Participating preferred stock occasionally create difficulties. It is important to emphasize that in the allocation common shares are first paid at the same rate (not amount) as preferred shareholders. Common shareholders do not participate in dividends in arrears. Extra dividends are distributed proportionally based on the relative par values. When explaining property dividends, sometimes it is helpful for students to understand the effects by artificially treating the dividend as two transactions. First, the property (asset) is sold for cash (recognizing a gain or loss). Second, the cash is used to pay a dividend (and retained earnings is reduced by the fair value). It is helpful to also include a discussion of how the unrealized increase/decrease account and allowance account are affected in this situation. In regard to a stock dividend, for theoretical purposes, it is useful to reinforce that a stock dividend is very similar to a stock split. No assets are distributed. For the weighted average number of common shares outstanding in EPS calculations, students often have difficulty when both stock splits and stock dividends have occurred. It is important to emphasize that the percentages must be multiplied, not added together. For instance, if a 2 for 1 stock split and a 20% stock dividend occur, the outstanding shares must be multiplied times 2.4 (2.00 x 1.20) and not 2.2 (2.00 + 0.20). When using the treasury stock method for share options and warrants in computing diluted earnings per share, it is often helpful to develop a numerical example to reinforce the concept. When discussing the ranking of securities in EPS it is useful to show a simple numeric example which calculates how a convertible security with a smaller impact on EPS will decrease EPS more than a convertible security with a larger impact on EPS. Use of Example 16.7 will be useful. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.