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12 REPORTING UNUSUAL EVENTS

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12 REPORTING UNUSUAL EVENTS

    12 INCOME AND CHANGES IN

    RETAINED EARNINGS

Chapter Summary

     Chapter 12 continues the coverage of stockholders’ equity but shifts the focus from paid-in capital to retained earnings. The student is already aware that net income drives the changes in retained earnings. However, in any given period net income may reflect unusual and nonrecurring events. We begin by explaining how to define such items and how to present them so that the income statement may still serve as the basis for reasonable estimates of future earnings. The three categories of events, which require special treatment, are (1) discontinued operations, (2) extraordinary items, and (3) changes in accounting principle. Each item is explained and illustrated with a Case in Point capsule based on the experience of an actual company.

     Before turning to the impact of various dividend transactions, we briefly review basic and diluted earnings per share. The emphasis here is on interpretation of the EPS figures, since the detailed mechanics of calculating these measures is beyond the scope of the first course.

     The second major section of the chapter explains a number of stockholder equity transactions that affect retained earnings. The most obvious example of such transactions is the declaration of a cash dividend. The requirements for distributing a cash dividend are outlined as are the significant dates involved in the distribution of the dividend. Stock dividends are discussed since they too result in a reduction in retained earnings. This portion of the chapter closes with a brief explanation of prior period adjustments to retained earnings.

     Additional topics covered in Chapter 12 include an introduction to comprehensive income and a review of the statement of stockholders’ equity.

Learning Objectives

    1. Describe how discontinued operations, extraordinary items, and accounting changes

    are presented in the income statement.

2. Compute earnings per share.

3. Distinguish between basic and diluted earnings per share.

    4. Account for cash dividends and stock dividends, and explain the effects of these

    transactions on a company’s financial statements.

5. Describe and prepare a statement of retained earnings.

6. Define prior period adjustments, and explain how they are presented in financial

    statements.

    McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005 136 Instructor’s Resource Manual

    7. Define comprehensive income, and explain how it differs from net income.

8. Describe and prepare a statement of stockholders’ equity.

     Brief topical outline

     A Reporting the results of operations

     1 Developing predictive information see Management Strategy (page 505)

    2 Reporting irregular items: an illustration

    3 Continuing operations

    a Income from continuing operations

    4 Discontinued operations

    a Discontinued operations are not really unusual see Case in Point

    (page 506)

     5 Extraordinary items see Case in Point (page 507)

     a Other unusual gains and losses

     b Distinguishing between the unusual and the extraordinary

     c Restructuring charges see Case in Point (page 508)

     6 Changes in accounting principle

     a The cumulative effect of an accounting change

     b Changes in principle versus changes in estimate see Your Turn (page

    509)

     7 Earnings per share (EPS)

     a Computing earnings per share

     b What happens if more shares are issued?

     c Preferred dividends and earnings per share

     d Presentation of earnings per share in the income statement

     e Interpreting the different per-share amounts

     B Financial analysis see Case in Point (page 512)

     1 Basic and diluted earnings per share see Management Strategy (page 512)

     C Other transactions affecting retained earnings

     1 Cash dividends see Your Turn (page 513)

     2 Dividend dates

     3 Liquidating dividends

     4 Stock dividends

     a Entries to record a stock dividend

     b Reasons for stock dividends see Case in Point (page 516)

     c Distinctions between stock splits and stock dividends

     5 Statement of retained earnings

     6 Prior period adjustments

     a Restrictions of retained earnings

     McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005

    Financial and Managerial Accounting: The Basis for Business Decisions, 13e 137

    7 Comprehensive income see Cash Effects (page 520)

    8 Statement of stockholders’ equity

    9 Stockholders’ equity section of the balance sheet

     D Concluding remarks see A Second Look (page 522)

Topical coverage and suggested assignment

    Homework Assignment

    (To Be Completed Prior to Class)

    Class Topical

    Meetings Outline Discussion

    on Chapter Coverage Questions Exercises Problems Cases Internet

    1 A 1, 2, 3, 5 1, 3, 4, 5 1, 3 3, 6 1

    2 B D 9, 10, 14, 16, 18 7, 8, 10, 11 4, 6, 7 4

Comments and observations

Teaching objectives for Chapter 12

In this chapter, we discuss a variety of events and transactions that affect retained earnings. In

    the classroom, our objectives are to:

1 Explain the purpose of reporting irregular events separately from normal and recurring

    business activities.

2 Carefully define discontinued operations, extraordinary items, and accounting

    changes. Review and discuss the financial statement presentation of each category of

    event.

    3 Illustrate the computation of earnings per share, and briefly discuss the distinction

    between basic and diluted earnings.

4 Discuss the nature and purpose of cash dividends and stock dividends, emphasizing the

    effects upon total stockholders' equity and the probable effects upon stock price.

    Illustrate the journal entries for each of the events.

    5 Explain the nature of prior period adjustments. Discuss probability of occurrence in

     publicly owned and closely held corporations.

6 Review and discuss the statement of retained earnings.

7 Explain the nature of comprehensive income.

    8 Review the statement of stockholders' equity portrayed as an "expanded" statement of

    retained earnings.

McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005 138 Instructor’s Resource Manual

New features in Chapter 12

    The changes to this chapter reflect the new organization of the material on stockholders’ equity. We have moved the prior treatments of stock splits and treasury stock transactions to Chapter 11 so that we might concentrate on retained earnings. In most other respects, the coverage of topics in this chapter parallels that in our previous edition. A section discussing the concept of comprehensive income has been added. The Case in Point capsules have all

    been updated. The assignment material has been expanded to include an exercise on comprehensive income.

General comments

    Many accounting faculty ask us why we cover discontinued operations in the introductory course. Our answer is that in this era of "corporate restructuring," discontinued operations are commonplace in the financial statements of publicly owned corporations. Discontinued operations are far more commonplace (and more material in dollar amount) than are extraordinary items. (Prior period adjustments, by comparison, are virtually nonexistent in the financial statements of large corporations.)

     We make these points in the text but feel that we owe a separate explanation to instructors. While extraordinary items and prior period adjustments are "traditional" accounting topics, discontinued operations is a relative newcomer. We also know that some introductory accounting textbooks still do not address this emerging topic.

     In discussing irregular events, we focus upon the appropriate financial statement presentation rather than upon the recording of transactions. Most of these transactions are recorded in the same manner as ordinary transactions. Allocations of revenue, expenses, and gains and losses to such special categories as "continuing operations," "discontinued operations," and "extraordinary items" are made on a working paper at the end of the period. The tax effects relating to these items also are determined and allocated on a working paper rather than through journal entries.

     We consider these working paper procedures beyond the scope of the introductory course. Entries to record accounting changes and prior period adjustments also are beyond the scope of the introductory accounting course. Anyone with responsibility for recording such transactions needs more of an accounting background than an introductory course can provide. Any user of financial statements, however, needs to understand the nature of these unusual items in order to interpret properly the operating results of the current period.

     Several of our problems are intended to illustrate the presentation of irregular events in financial statements, including Problems 1, 2, and 3. These problems are successively

    comprehensive and challenging. We also recommend class discussion of Case 1 involving

    several well-known corporations.

     In discussing earnings-per-share, we consider a conceptual understanding important, but regard most of the mechanics of per-share computations as beyond the scope of the course. For instance, we discuss the concept of diluted earnings-per-share, but do not get into

     McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005

    Financial and Managerial Accounting: The Basis for Business Decisions, 13e 139

any computations. We do, however, review Exercise 5. This exercise helps clarify the idea

    that earnings-per-share is based only upon the income applicable to common stock.

     The "stockholders' equity" portion of this chapter includes a variety of short topics. We find an in-class review of Exercise 9 is an efficient way to cover many of these topics. As an overview, we use Problem 5, which also acquaints students with the unofficial "statement" of stockholders' equity.

Supplemental Exercises

Business Week Exercise

     The article “A Closer Look at All Those Write-offs”, Business Week, October 13,

    2003, states that corporate earnings write-offs has helped create “the worst quality of earnings in more than a decade”. How do corporate write-offs affect analysis of a company’s financial

    statements, particularly the income statement?

Group Exercise

     The text points out that restructuring charges have been very common during the 1990’s. Visit websites for several large corporations, find the 2002 annual reports and study the notes to the financial statements for information on restructuring charges incurred by the corporations.

Internet Exercise

     Visit websites for several large corporations, find the 2002 annual reports and review the income statements. Report on discontinued operations and extraordinary items. McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005 140 Instructor’s Resource Manual

CHAPTER 12 NAME #

    10-MINUTE QUIZ A SECTION

     Indicate the best answer for each question in the space provided.

     1 Midas Corporation declared a 2-for-1 common stock split, but this transaction was

    erroneously recorded as a 100% common stock dividend. As a result:

     a The common stock account is overstated.

     b The total dollar amount of stockholders’ equity is overstated.

     c The corporate records do not show the correct number of shares of common stock

    outstanding.

     d The par value per share is understated.

     2 Garrett Mfg.’s financial statements for the current year include the following:

     Income from continuing operations ........................................................... $729,000

     Prior period adjustment (increase in prior-year net income,

     net of taxes) ........................................................................................... 125,000

     Cash dividends paid to preferred stockholders ........................................... 146,000

     Gain from discontinued operations (net of taxes) ....................................... 443,000

     Cumulative effect of accounting change (reduction in

     net income, net of tax benefit) ................................................................. 307,000

     Extraordinary loss (net of tax benefit) ....................................................... 118,000

     On the basis of this information, net income for the current year is:

     a $429,000. b $747,000. c $726,000. d $853,200.

     3 The following two items are disclosed in the stockholders’ equity section of Kent

    Corporation’s December 31, 2006, balance sheet:

     Treasury stock (500 shares, at cost) .......................................................... $30,000

     Additional paid-in capital: treasury stock transactions ............................... 10,000

     If the company had reacquired 3,000 shares of treasury stock in February of 2006, then some

    of the treasury stock must have been sold during 2006 for:

     a $4 per share above its par value.

     b $4 per share.

     c $64 per share.

     d $64 per share above its cost.

     4 At the beginning of the current year, Sutton Corporation had 400,000 shares of $1 par

    common stock outstanding and had retained earnings of $8,000,000. During the year, the

    company earned $6,000,000, declared a 5% stock dividend when the price of stock was $25

    per share, and paid a year-end cash dividend of $3 per share. (The cash dividend was paid

    after the stock dividend had been distributed.) Sutton Corporation’s retained earnings at the

    end of the year amount to:

     a $14,000,000. b $12,240,000. c $12,720,000. d $12,740,000.

     5 Gerstan Corp. had 25,000 shares of 8% preferred stock, $100 par, and 500,000 shares of $1

    par common stock outstanding throughout the year. Net income for the year was $2,200,000,

    and Gerstan declared and distributed a cash dividend of $3 per share on its common stock.

    Earnings per share amounted to:

     McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005

    Financial and Managerial Accounting: The Basis for Business Decisions, 13e 141

a $4.40. b $2.00. c $4.00. d $1.60.

McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005 142 Instructor’s Resource Manual

CHAPTER 12 NAME #

10-MINUTE QUIZ B SECTION

     The stockholders’ equity section of the balance sheet of United Publishing at December 31,

    2006, appears as follows:

     Stockholders’ equity:

     5% preferred stock, $100 par,

     50,000 shares authorized, ?? shares issued .......................................... $1,600,000

     Common stock, $2 par, 500,000 shares authorized,

     120,000 shares issued, of which ?? are held in treasury ........................ 240,000

     Additional paid-in capital:

     From issuance of preferred stock ......................................................... 280,000

     From issuance of common stock .......................................................... 800,000

     From treasury stock transactions ......................................................... 12,000

     From common stock dividends ............................................................ 200,000

     Total paid-in capital .......................................................................... $3,132,000

     Retained earnings ($96,000 equal to cost of treasury

     stock is not available for dividends) ...................................................... 780,000

     $3,912,000

     Less: Treasury stock (at cost: 12,000 common shares)……………… (96,000)

     Total stockholders’ equity ..................................................................... $3,816,000

     Answer the following questions based on the stockholders’ equity section given above. The

    company had no treasury stock purchases before 2006.

     1 Refer to the above data. What was the average issue price per share of preferred stock?

     a $88. b $100. c $117.50. d $108.

     2 Refer to the above data. How many shares of common stock are outstanding?

     a 120,000. b 108,000. c 500,000. d 96,000.

     3 Refer to the above data. A small stock dividend of 5,000 shares was declared and

    distributed during 2006. What was the market price per share on the date of declaration?

     a $42 per share. b $40 per share. c $2 per share. d $38 per share.

     4 Refer to the above data. If United Publishing had reacquired 14,000 shares of treasury

    stock early in 2006, then some treasury stock must have been sold during 2006 for:

     a $5 per share. b $8 per share. c $6 per share. d $14 per share.

     5 Refer to the above data. Assume that all remaining treasury stock is reissued at a price

    of $13 per share in January of 2007. What amount should be credited to the account

    Additional Paid-in Capital: Treasury Stock Transactions in the journal entry to record this

    transaction?

     a $96,000. b $60,000. c $156,000. d $66,000.

     McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005

    Financial and Managerial Accounting: The Basis for Business Decisions, 13e 143

CHAPTER 12 NAME #

10-MINUTE QUIZ C SECTION

     The stockholders’ equity section of the balance sheet of Butterfly Fashions, Inc., at December

    31, 2006, appears as follows:

     Stockholders’ equity:

     7% preferred stock, $100 par, callable at $105,

     50,000 shares authorized, 50,000 shares issued ................................... $5,000,000

     Common stock, $2 par, 500,000 shares authorized,

     300,000 shares issued, of which 30,000 are held in treasury ................ 600,000

     Additional paid-in capital:

     From issuance of preferred stock ......................................................... 580,000

     From issuance of common stock .......................................................... 1,620,000

     From treasury stock transactions ......................................................... 50,000

     From common stock dividends ............................................................ 300,000

     Total paid-in capital .......................................................................... $8,150,000

     Retained earnings ($240,000 equal to cost of treasury

     stock is not available for dividends) ...................................................... 2,400,000

     $10,550,000

     Less: Treasury stock (at cost: 30,000 common shares)……………… (240,000)

     Total stockholders’ equity ..................................................................... $10,310,000

     Answer the following questions based on the stockholders’ equity section given above. The

    company purchased no treasury stock before 2006.

     1 Refer to the above data. What was the average issue price per share of preferred stock?

    $__________ per share

     2 Refer to the above data. How many shares of common stock are outstanding? _________

    shares

     3 Refer to the above data. A small stock dividend of 20,000 shares was declared and distributed

    during 2006. What was the market price per share on the date of declaration? $__________

    per share

     4 Refer to the above data. If Butterfly Fashions had reacquired 35,000 shares of treasury stock

    early in 2006, compute the price per share for which the reissued treasury stock was sold.

    $__________ per share

     5 Refer to the above data. Assume all remaining treasury stock is reissued at a price of $16 per

    share in January of 2007. Give the journal entry to record this transaction: McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005 144 Instructor’s Resource Manual

CHAPTER 12 NAME #

10-MINUTE QUIZ D SECTION

     Shown below is information relating to operations of Barbara Blank for the current year:

     Continuing operations:

     Net sales ........................................................................................................ $ 5,500,000

     Costs and expenses (including income taxes)................................................... 4,250,000

     Other data:

     Current-year loss generated by segment of the business

     discontinued in July (net of income tax benefit) ............................................. 415,000

     Gain on disposal of discontinued segment (net of

     income tax) .................................................................................................. 275,000

     Prior period adjustment (decrease in prior year’s depreciation

     expense, net of income taxes)........................................................................ 90,000

     Cumulative effect of change in accounting principle

     (increase in net income, net of related income tax) ......................................... 305,000

     Extraordinary loss (net of income tax benefit) ................................................. 35,000

     Cash dividends declared ($3 per share) ........................................................... 300,000

     In the space provided, complete the income statement for Barbara Blank, including earnings per share

    figures. Barbara Blank has 100,000 shares of a single class of common stock outstanding throughout

    the year.

     BARBARA BLANK

     Condensed Income Statement

    For the Year Ended December 31, 2006

     Net sales ........................................................................................ $

     Earnings per share:

     McGraw-Hill/Irwin ? The McGraw-Hill Companies, Inc., 2005

    Financial and Managerial Accounting: The Basis for Business Decisions, 13e 145

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