This document discusses accounting for income, irregular income items, and changes in retained earnings. It covers: 1. How net income is divided into income from continuing operations and results from discontinued operations, extraordinary items, and changes in accounting principles. 2. How discontinued operations and extraordinary items are presented on the income statement separately and net of tax. 3. How to compute and present earnings per share, distinguishing between basic and diluted EPS. 4. How to account for cash and stock dividends, including their effects on financial statements. Cash dividends create a liability and require sufficient retained earnings, while stock dividends do not change stockholders' equity or par values.

1. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
INCOME AND CHANGES IN
RETAINED EARNINGS
Chapter
12

2. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO1
To describe how irregular
income items, such as
discontinued operations and
extraordinary items, are
presented in the income
statement.

3. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Information about net income can be dividedInformation about net income can be divided
into two major categoriesinto two major categories
Information about net income can be dividedInformation about net income can be divided
into two major categoriesinto two major categories
Income from
continuing
operations.
Income from
continuing
operations.
1. Results of
discontinued
operations.
1. Results of
discontinued
operations.
2. Impact of
extraordinary
items.
2. Impact of
extraordinary
items.
3. Effects of
changes in
accounting
principles.
3. Effects of
changes in
accounting
principles.
Normal, recurring revenue and
expense transactions.
Normal, recurring revenue and
expense transactions.
Unusual, nonrecurring events
that affect net income.
Unusual, nonrecurring events
that affect net income.
Reporting the Results of OperationsReporting the Results of Operations

4. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
This tax expense
does not include
effects of unusual,
nonrecurring items.
This tax expense
does not include
effects of unusual,
nonrecurring items.
These unusual,
nonrecurring items
are each reported
net of taxes.
These unusual,
nonrecurring items
are each reported
net of taxes.

5. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Income/Loss from
operating the segment
prior to disposal.
Income/Loss from
operating the segment
prior to disposal.
Income/Loss on disposal
of the segment.
Income/Loss on disposal
of the segment.
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.
Discontinued OperationsDiscontinued Operations
Discontinued
Operations
Discontinued
Operations

6. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
A segment must be a separate line
of business activity or an
operation that services a distinct
category of customers.
A segment must be a separate line
of business activity or an
operation that services a distinct
category of customers.
Discontinued OperationsDiscontinued Operations
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.
When management enters into a formal plan to sell or
discontinue a segment of the business, the related gains
and losses must be disclosed on the income statement.

7. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
During 2007, Matrix, Inc. sold an unprofitableDuring 2007, Matrix, Inc. sold an unprofitable
segment of the company. The segment had asegment of the company. The segment had a
net loss from operations during the period ofnet loss from operations during the period of
$150,000 and a loss on the sale of its assets$150,000 and a loss on the sale of its assets
of $100,000. Matrix reported income fromof $100,000. Matrix reported income from
continuing operations of $1,750,000. Allcontinuing operations of $1,750,000. All
items are taxed at 30%.items are taxed at 30%.
How will this appear on the incomeHow will this appear on the income
statement?statement?
During 2007, Matrix, Inc. sold an unprofitableDuring 2007, Matrix, Inc. sold an unprofitable
segment of the company. The segment had asegment of the company. The segment had a
net loss from operations during the period ofnet loss from operations during the period of
$150,000 and a loss on the sale of its assets$150,000 and a loss on the sale of its assets
of $100,000. Matrix reported income fromof $100,000. Matrix reported income from
continuing operations of $1,750,000. Allcontinuing operations of $1,750,000. All
items are taxed at 30%.items are taxed at 30%.
How will this appear on the incomeHow will this appear on the income
statement?statement?
Discontinued OperationsDiscontinued Operations

8. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Discontinued OperationsDiscontinued Operations

9. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Income Statement Presentation:
Discontinued OperationsDiscontinued Operations

10. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Extraordinary ItemsExtraordinary Items
• Material in amount.Material in amount.
• Gains or losses thatGains or losses that
are both unusual inare both unusual in
nature and notnature and not
expected to recur inexpected to recur in
the foreseeable future.the foreseeable future.
• Reported net ofReported net of
related taxes.related taxes.
• Material in amount.Material in amount.
• Gains or losses thatGains or losses that
are both unusual inare both unusual in
nature and notnature and not
expected to recur inexpected to recur in
the foreseeable future.the foreseeable future.
• Reported net ofReported net of
related taxes.related taxes.

11. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
During 2007, Matrix, Inc. experienced a loss ofDuring 2007, Matrix, Inc. experienced a loss of
$75,000 due to an earthquake at one of its$75,000 due to an earthquake at one of its
manufacturing plants in Nashville. This wasmanufacturing plants in Nashville. This was
considered an extraordinary item. Theconsidered an extraordinary item. The
company reported income before extraordinarycompany reported income before extraordinary
item of $1,575,000. All gains and losses areitem of $1,575,000. All gains and losses are
subject to a 30% tax rate.subject to a 30% tax rate.
How would this item appear on the 2007How would this item appear on the 2007
income statement?income statement?
During 2007, Matrix, Inc. experienced a loss ofDuring 2007, Matrix, Inc. experienced a loss of
$75,000 due to an earthquake at one of its$75,000 due to an earthquake at one of its
manufacturing plants in Nashville. This wasmanufacturing plants in Nashville. This was
considered an extraordinary item. Theconsidered an extraordinary item. The
company reported income before extraordinarycompany reported income before extraordinary
item of $1,575,000. All gains and losses areitem of $1,575,000. All gains and losses are
subject to a 30% tax rate.subject to a 30% tax rate.
How would this item appear on the 2007How would this item appear on the 2007
income statement?income statement?
Extraordinary ItemsExtraordinary Items

12. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Income Statement Presentation:
Extraordinary Items - ExampleExtraordinary Items - Example

13. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Let’s moveLet’s move
on to a fewon to a few
final topics.final topics.

14. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO2
To compute
earnings per
share.

15. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
A measure of the company’s profitability and
earning power for the period.
A measure of the company’s profitability and
earning power for the period.
Based on the number of shares
issued and the length of time
that number remained
unchanged.
Based on the number of shares
issued and the length of time
that number remained
unchanged.
Earnings Per Share (EPS)Earnings Per Share (EPS)

16. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Remember that Matrix, Inc. has income fromRemember that Matrix, Inc. has income from
continuing operations of $1,750,000. The after-continuing operations of $1,750,000. The after-
tax loss from discontinued operations wastax loss from discontinued operations was
$175,000 and the extraordinary loss was$175,000 and the extraordinary loss was
$52,500. Assume that Matrix has 156,250$52,500. Assume that Matrix has 156,250
weighted average shares outstanding.weighted average shares outstanding.
Prepare a partial income statement showing thePrepare a partial income statement showing the
EPS for income from continuing operations andEPS for income from continuing operations and
for the other special items.for the other special items.
Remember that Matrix, Inc. has income fromRemember that Matrix, Inc. has income from
continuing operations of $1,750,000. The after-continuing operations of $1,750,000. The after-
tax loss from discontinued operations wastax loss from discontinued operations was
$175,000 and the extraordinary loss was$175,000 and the extraordinary loss was
$52,500. Assume that Matrix has 156,250$52,500. Assume that Matrix has 156,250
weighted average shares outstanding.weighted average shares outstanding.
Prepare a partial income statement showing thePrepare a partial income statement showing the
EPS for income from continuing operations andEPS for income from continuing operations and
for the other special items.for the other special items.
Earnings Per Share (EPS)Earnings Per Share (EPS)

17. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
* Rounded.
Earnings Per Share (EPS)Earnings Per Share (EPS)

18. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
If preferred stock is present, subtract preferred
dividends from net income prior to computing EPS.
If preferred stock is present, subtract preferred
dividends from net income prior to computing EPS.
EPS is required to be reported
in the income statement.
EPS is required to be reported
in the income statement.
Earnings Per Share (EPS)Earnings Per Share (EPS)
Net Income - Preferred Dividends
Weighted Average Number of
Common Shares Outstanding
Earnings
Per Share
=

19. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO3
To distinguish
between basic and
diluted earnings per
share.

20. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Basic and Diluted Earnings per ShareBasic and Diluted Earnings per Share
If a company has convertible securities,If a company has convertible securities,
like convertible preferred stocklike convertible preferred stock
outstanding, the conversion of theseoutstanding, the conversion of these
securities to common stock may dilutesecurities to common stock may dilute
(reduce) earnings per share.(reduce) earnings per share.
If a company has convertible securities,If a company has convertible securities,
like convertible preferred stocklike convertible preferred stock
outstanding, the conversion of theseoutstanding, the conversion of these
securities to common stock may dilutesecurities to common stock may dilute
(reduce) earnings per share.(reduce) earnings per share.
Diluted earnings per share reflect theDiluted earnings per share reflect the
impact of the assumed conversion ofimpact of the assumed conversion of
the securities on earnings.the securities on earnings.

21. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Often, the Price-Earnings Ratio is used to evaluate
the reasonableness of a company’s stock price.
Often, the Price-Earnings Ratio is used to evaluate
the reasonableness of a company’s stock price.
Price-earnings Ratio (P/E)Price-earnings Ratio (P/E)
Let’s examine this
further.
Let’s examine this
further.

22. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO4
To account for cash
dividends and stock
dividends, and explain the
effects of these transactions
on a company’s financial
statements.

23. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Declared by Board
of Directors.
Declared by Board
of Directors.
Not legally
required.
Not legally
required.
Creates liability
at declaration.
Creates liability
at declaration.
Requires sufficient
Retained Earnings
and Cash.
Requires sufficient
Retained Earnings
and Cash.
Accounting for Cash DividendsAccounting for Cash Dividends

24. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Date of Declaration
• Board of Directors declares the dividend.
• Record a liability.
Date of Declaration
• Board of Directors declares the dividend.
• Record a liability.
Dividend DatesDividend Dates
On March 1, 2007, the Board of Directors of Matrix, Inc.
declares a $1.00 per share cash dividend on its 500,000
common shares outstanding. The dividend is payable to
stockholders of record on April 1, and paid on May 1.
On March 1, 2007, the Board of Directors of Matrix, Inc.
declares a $1.00 per share cash dividend on its 500,000
common shares outstanding. The dividend is payable to
stockholders of record on April 1, and paid on May 1.

25. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Ex-Dividend Date
• The day which serves as the ownership
cut-off point for the receipt of the most
recently declared dividend.
Ex-Dividend Date
• The day which serves as the ownership
cut-off point for the receipt of the most
recently declared dividend.
NO ENTRY
Dividend DatesDividend Dates

26. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Date of Record
• Stockholders holding shares on this date will
receive the dividend. (No entry)
Date of Record
• Stockholders holding shares on this date will
receive the dividend. (No entry)
Dividend DatesDividend Dates
X
April 2007

27. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Date of Payment
• Record the payment of the dividend to
stockholders.
Date of Payment
• Record the payment of the dividend to
stockholders.
Dividend DatesDividend Dates

28. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
On June 1, 2007, a corporation’s board of
directors declared a dividend for the 2,500 shares
of its $100 par value, 8% preferred stock. The
dividend will be paid on July 15. Which of the
following will be included in the July 15 entry?
a. Debit Retained Earnings $20,000.
b. Debit Dividends Payable $20,000.
c. Credit Dividends Payable $20,000.
d. Credit Preferred Stock $20,000.
On June 1, 2007, a corporation’s board of
directors declared a dividend for the 2,500 shares
of its $100 par value, 8% preferred stock. The
dividend will be paid on July 15. Which of the
following will be included in the July 15 entry?
a. Debit Retained Earnings $20,000.
b. Debit Dividends Payable $20,000.
c. Credit Dividends Payable $20,000.
d. Credit Preferred Stock $20,000.
$100 × 8% = $8 dividend per share
$8 × 2,500 = $20,000 total dividend
$100 × 8% = $8 dividend per share
$8 × 2,500 = $20,000 total dividend
Dividend DatesDividend Dates

29. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
All stockholders
retain same
percentage
ownership.
All stockholders
retain same
percentage
ownership.
No change in total
stockholders’ equity.
No change in total
stockholders’ equity.
No change in par
values.
No change in par
values.
Accounting for Stock DividendsAccounting for Stock Dividends
Distribution of additional shares of stock to
stockholders.
Distribution of additional shares of stock to
stockholders.

30. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Small Stock
Dividend
Large Stock
Dividend
Stock Splits
Total
Stockholders'
Equity
No Effect No Effect No Effect
Common Stock Increases Increases No Effect
Paid-in Capital Increases No Effect No Effect
Retained Earnings Decreases Decreases No Effect
Number of Shares
Outstanding
Increases Increases Increases
Par Value per
Share
No Effect No Effect Decreases
Summary of Effects of Stock
Dividends and Stock Splits
Summary of Effects of Stock
Dividends and Stock Splits

31. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO5
To describe and
prepare a statement
of retained earnings.

32. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Statement of Retained Earnings with
Prior Period Adjustment
Statement of Retained Earnings with
Prior Period Adjustment
Retained earning, 12/31/06 as reported 1,250,000$
Prior period adjustment for
accounting error (65,000)
Retained earnings, 12/31/06 as restated 1,185,000
Net income for 2007 327,500
Subtotal 1,512,500
Less: dividends:
Cash dividends (100,000)
Stock dividend (200,000)
Retained earnings, 12/31/07 1,212,500
Rockford Company
Statement of Retained Earnings
For the Year Ended December 31, 2007

33. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Restrictions of Retained EarningsRestrictions of Retained Earnings
If I loan your companyIf I loan your company
$1,000,000, I will want you to$1,000,000, I will want you to
restrict your retained earnings inrestrict your retained earnings in
order to limit dividend payments.order to limit dividend payments.
Loan agreements can include restrictions
on paying dividends below a certain
amount of retained earnings.
Loan agreements can include restrictions
on paying dividends below a certain
amount of retained earnings.

34. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO6
To define prior period
adjustments, and explain
how they are presented
in financial statements.

35. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Adjust retained
earnings retroactively.
Adjust retained
earnings retroactively.
The adjustment
should be disclosed
net of any taxes.
The adjustment
should be disclosed
net of any taxes.
The correction of an error identified as
affecting net income in a prior period.
The correction of an error identified as
affecting net income in a prior period.
Prior Period AdjustmentsPrior Period Adjustments

36. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO7
To define
comprehensive income,
and explain how it differs
from net income.

37. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Issuance of new
shares of stock.
Issuance of new
shares of stock.
Net Income or
Net Loss
Net Income or
Net Loss
Payment of
Dividends
Payment of
Dividends
GAAP excludes some unrealized items from
income, such as the change in market value of
available-for-sale debt and equity investments.
GAAP excludes some unrealized items from
income, such as the change in market value of
available-for-sale debt and equity investments.
Comprehensive IncomeComprehensive Income
Normally, there are 3 ways that financial
position can change.
Normally, there are 3 ways that financial
position can change.

38. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
As a second
Income Statement.
As a second
Income Statement.
Combined with
Net Income on the
Income Statement.
Combined with
Net Income on the
Income Statement.
As an element of
Stockholders’
Equity.
As an element of
Stockholders’
Equity.
Comprehensive IncomeComprehensive Income
GAAP requires that unrealized items that are normally reported
on the balance sheet be added back to compute
“Comprehensive Income.”
GAAP requires that unrealized items that are normally reported
on the balance sheet be added back to compute
“Comprehensive Income.”
The accumulated amount of
changes affecting
Comprehensive Income is
reported in equity.
The accumulated amount of
changes affecting
Comprehensive Income is
reported in equity.
There are 3 options for
reporting Comprehensive
Income.
There are 3 options for
reporting Comprehensive
Income.

39. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO8
To describe and prepare a
statement of stockholders’
equity and the
stockholders’ equity
section of the balance
sheet.

40. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
(In millions) Retained
Shares Amount Earnings Total
Balance at January 1, 2007 821 2,500$ 9,500$ 12,000$
Stock sales 17 500 500
Stock repurchases and retirement (17) (260) (925) (1,185)
Cash dividends declared (500) (500)
Other, net 70 70
Net income 1,523 1,523
Balance at December 31, 2007 821 2,740$ 9,668$ 12,408$
Common stock and
capital in excess of par
Matrix, Inc.
Statement of Stockholders' Equity
For the Year Ended December 31, 2007
Statement of Stockholders’ EquityStatement of Stockholders’ Equity
This is a more inclusive statement than
the statement of retained earnings.

41. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Stockholders’ Equity Section of the
Balance Sheet
Stockholders’ Equity Section of the
Balance Sheet

42. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Learning ObjectiveLearning Objective
LO9
To illustrate steps
management might take
to improve the
appearance of the
company’s net income.

43. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
Improving the Appearance of IncomeImproving the Appearance of Income
Companies may take certain steps that areCompanies may take certain steps that are
intended to improve the appearance of itsintended to improve the appearance of its
financial performance in the financialfinancial performance in the financial
statements. The Securities and Exchangestatements. The Securities and Exchange
Commission brought a series ofCommission brought a series of
enforcement actions against certainenforcement actions against certain
companies for taking these steps.companies for taking these steps.
Companies may take certain steps that areCompanies may take certain steps that are
intended to improve the appearance of itsintended to improve the appearance of its
financial performance in the financialfinancial performance in the financial
statements. The Securities and Exchangestatements. The Securities and Exchange
Commission brought a series ofCommission brought a series of
enforcement actions against certainenforcement actions against certain
companies for taking these steps.companies for taking these steps.

44. © The McGraw-Hill Companies, Inc., 2008McGraw-Hill/Irwin
End of Chapter 12End of Chapter 12