The Corporate Income Statement and the Statement of Stockholders’ Equity

The Corporate Income Statement and the Statement of Stockholders’ Equity Chapter 13

Importance of Net Income • Expected changes in earning per share • Expected return on equity

Quality of Earnings • Substance of earnings • Sustainability into future accounting period • Affected by • The accounting methods and estimates the company’s management chooses • The nature of nonoperating items on the income statement

Choice of Accounting Methods and estimates • Examples • Depreciation methods and estimates of long term assets • Criteria for deciding revenue versus capital expenditures • Methods for bond amortization • Estimate of uncollectible A/R • Estimate of expected environment cleanup costs

Choices • Aging vs. Percentage of Net Sales • LIFO, FIFO, Weighted Average, Specific identification • Accelerated, production or straight-line depreciation method

Effects • See spreadsheet demonstration on 595 • In general, an accounting method or estimate that results in lower current earnings is considered to produce a better quality of operating income

Full Disclosure • Requires that management explain the significant accounting policies used in preparing the financial statements in a note to the statements

Nonoperating items • Discontinued operations • Extraordinary gains and losses • Effects of accounting changes • Examples • Loss through restructuring charges • Gain through one time gain (medical companies through bio-terrorism)

Comprehensive income • The change in a company’s equity during a period from sources other than owners and includes net income, change in unrealized investment gains and losses and other items affecting equity

Deferred income taxes • Accounting income vs. taxable income • Can be a material difference • A simple example: magazine subscriptions are not recognized in financial income until the product is shipped, but for tax purposes they are usually recognized as revenue when cash is received. • The result is that taxes paid exceed tax expense, which creates a deferred income tax asset (or prepaid taxes)

Net of taxes • Means that the effect of applicable taxes has been considered in determining the overall effect of an item on the financial statements

Extraordinary items • “events or transactions that are distinguished by their unusual nature and by the infrequency of their occurrence” • Examples: • A gain or loss resulting from the passage of a new law • The expropriation of property by a foreign government

Accounting changes • Need adequate justification • The cumulative effect of an accounting change should be shown on the income statement immediately after extraordinary items. • Relevant information about the change is shown in the notes to the financial statements

EPS • Earning Per Share • Basic earning per share is net income applicable to common stock divided by weighted-average number of common shares outstanding • See demo on page. 603

Capital structure • Simple • No bonds, stocks, or stock options that could be converted into common stock • Complex • Convertible securities have the potential of diluting the earning per share of common stock. • Diluted earning per share

The statement of stockholders’ equity • Also called the statement of changes in stockholders’ equity • Summarizes the changes in the components of the stockholders’ equity section of the balance sheet • See page 605 Exhibit 2 and Exhibit 3

Retained earnings • The part of stockholders’ equity that represents stockholders’ claims to assets arising from the earnings of the business • Are not the assets themselves • Means that assets as a whole have been increased since the date of its inception

Stock Dividends • A proportional distribution of shares of a corporation’s stock to its shareholders. • It does not change the firm’s assets and liabilities b/c there is no distribution of assets. • The effect is to transfer a dollar amount from R/E to the CC section on the date of declaration • The amount is the fair market value of the additional shares to be issued

Stock dividend • See demo on 609 • That is, a comparison of the stockholders’ equity before dividend and after dividend

Stock split • Occurs when a corporation increases the number of issued shares of stock and reduces the par of stated value proportionally. • On page 610, see that before split and after split have the exact number on the right hand side but the par value has reduced to the same proportion.

Book Value • The book value of a company’s stock represents the total assets of the company less its liabilities. • It is simply the stockholders’ equity of company, or • The company’s net assets

The calculation of book value • The general rule is that the call value of the P/S plus any dividends in arrears is substracted from total stockholders’ equity to determine the equity pertaining to common stock. • See demo on page 611

The Corporate Income Statement and the Statement of Stockholders’ Equity