Profit and Changes in Retained Earnings

McGraw-Hill/Irwin Copyright © 2010 by The McGraw-Hill Companies, Inc. All rights reserved.

Profit and Changes inProfit and Changes inRetained EarningsRetained EarningsChapter 12

12-2

Information about profit can be divided into two major categories

Profit from continuing operations.

Reporting the Results of Reporting the Results of OperationsOperations

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This tax expense does not include

effects of unusual, nonrecurring items.

These unusual, nonrecurring items are

each reported net of taxes.

12-4

When management enters into a formal plan to sell or discontinue a component of a company,

the related gains and losses must be disclosed on the income statement.

Discontinued OperationsDiscontinued Operations

Discontinued Operations

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A component is operations and cash flows that can be clearly

distinguished, operationally and for financial reporting purposes,

from the rest of the entity.


When management enters into a formal plan to sell or discontinue a component of a company, the related gains and losses must be disclosed

on the income statement.

12-6

During 2009, Matrix Limited sold an unprofitable component of the company. The component had

a loss from operations during the period of $150,000 and a loss on the sale of its assets of

$100,000. Matrix reported profit from continuing operations of $1,750,000. All items are taxed at

30%.

How will this appear on the income statement?


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Loss on segment operations (150,000)$ Less: Tax benefits ($150,000 × 30%) 45,000 Loss (105,000)$

Loss on disposal of assets (100,000)$ Less: Tax benefits ($100,000 × 30%) 30,000 Loss (70,000)$

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Income Statement Presentation:


Profit from continuing operations 1,750,000$ Discontinued operations: Loss on operations (net of tax benefit of $45,000) (105,000) Loss on disposal of assets (net of tax benefits of $30,000) (70,000) Profit for the year 1,575,000$

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Extraordinary ItemsExtraordinary Items•Material in amount.•Gains or losses that are both unusual

in nature and not expected to recur in the foreseeable future.

•As many companies abused it, the IASB has prohibited presentation or disclosure of extraordinary items.

•Some countries or places, e.g. US, still allow such presentation

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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.

Earnings Per Share (EPS)Earnings Per Share (EPS)

Earnings Per Share = Profit ÷

Weighted Average Number of Shares

Outstanding

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Remember that Matrix Limited has profit from continuing operations of $1,750,000.

The after-tax loss from discontinued operations was $175,000. Assume that

Matrix has 156,250 weighted average shares outstanding.

Let’s prepare a partial income statement using all this information.


12-12* Rounded.


$1,750,000 ÷ 156,250

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If preference share is present, subtract preference dividends from profit prior to computing EPS.

EPS is required to be reported in the income

statement.


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Issuance of new shares.

Profit orLoss

Payment of Dividends

IFRS excludessome unrealized items from profit, such as the

change in market value of available-for-sale debt and equity investments.

Other Comprehensive Other Comprehensive IncomeIncome

Normally, there are 3 ways that financial position can change.

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IFRS requires that certain unrealized items that are recognized in equity in the balance sheet be added back to compute “Other Comprehensive Income.”


The statement can then be termed as

Statement of Comprehensive

Income

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Declared by Board of Directors.

Not legally required.

Creates liability at declaration.

Requires sufficient Retained Earnings

and Cash.

Cash DividendsCash Dividends

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Dividend DatesDividend DatesDate of Declaration

•Board of Directors declares the dividend.•Record a liability.

On 1 March 2009, the Board of Directors of Matrix Limited declares a $1.00 per share cash dividend on

its 500,000 ordinary shares outstanding. The dividend is payable to shareholders of record on

1 April, and paid on 1 May.

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Dividend DatesDividend DatesEx-Dividend Date

•The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.

NO ENTRY

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Date of Record•Shareholders holding shares on

this date will receive the dividend. (No entry)

Dividend DatesDividend Dates

XApril 2009

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Date of Payment•Record the payment of the

dividend to shareholders.


12-22

On 1 June 2009, a corporation’s board of directors declared a dividend for the 2,500 shares of its $100 par value, 8% preference share. The dividend will be paid on 15 July. Which of the following will be included in the 15 July entry?a. Debit Retained Earnings $20,000.b. Debit Dividends Payable $20,000.c. Credit Dividends Payable $20,000.d. Credit Preference share $20,000.

$100 × 8% = $8 dividend per share$8 × 2,500 = $20,000 total dividend


12-23

All shareholders retain same percentage

ownership.

No change in total shareholders’ equity.

No change in par values.

Stock DividendsStock DividendsDistribution of additional shares to

shareholders.

12-24

Entries to RecordEntries to RecordStock DividendsStock DividendsIn accounting for a relatively small stock

dividend (say, less than 20%), the market value of the new shares is transferred from Retained Earning account to the

share premium accounts. This process is sometimes called “capitalizing” retained

earnings.On 1 June, Aspen Corporation has outstanding 1,000,000 shares of $1 par value ordinary share with a market value

of $25 per share. The company declares a 5% stock dividend on this date. The dividend is distributable on 15 July to shareholders of record on 20 June. Let’s look at

the journal entries.

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Entries to RecordEntries to RecordStock DividendsStock Dividends

Ordinary shares outstanding 1,000,000 Stock dividend percent 5%Additional shares issuable 50,000 Market value per share 25$ Amount assigned to dividend 1,250,000$

Additional shares issuable 50,000 Par value per share 1$ Change in ordinary share account 50,000

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Dividend DatesDividend DatesDate of Declaration

•Board of Directors declares the dividend.•Do not record a liability.

Date Description Debit CreditJun. 1 Retained Earnings 1,250,000

Stock Dividend to be Distributed 50,000 Share Premium: Stock Dividend 1,200,000

500,000 shares × $1 par value

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Dividend DatesDividend DatesEx-Dividend Date

•The day which serves as the ownership cut-off point for the receipt of the most recently declared dividend.

NO ENTRY

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Date of Record•Shareholders holding shares on

this date will receive the dividend. (No entry)


X

June 2009

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Date of Payment•Record the payment of the

dividend to shareholders.


Date Description Debit CreditJul. 15 Stock Dividend to be Distributed 50,000

Ordinary Share 50,000

12-30

Reasons for Stock Reasons for Stock DividendsDividendsManagement often finds stock

dividends appealing because they allow management to distribute something of perceived value to

shareholders while conserving cash which may be needed for other

purposes.Shareholders like stock dividends

because they receive more shares, often the share price does not fall

proportionately, and the dividend is not subject to income taxes (until the

shares received are sold).

12-31

Distinction between Share Distinction between Share Splits and Stock DividendsSplits and Stock Dividends

The difference between a stock dividend and a share split lies in the intent of management and the related issue of the size of the distribution. A stock dividend usually is intended to substitute for a cash dividend and is small enough that the market price of the share is relatively unaffected.

Stock dividends do not result in a change in the par value of the share. On the other hand, share splits result in a pro rata reduction in the par value of the share.

12-32

Small Stock Dividend

Large Stock Dividend Share Splits

Total Shareholders'

EquityNo Effect No Effect No Effect

Ordinary Share Increases Increases No EffectShare Premium 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 Summary of Effects of Stock Dividends and Share Stock Dividends and Share SplitsSplits

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• Change in accounting policy retrospective application (unless specified by IFRS)

• Correction of error (prior period error) retrospective restatement

Retrospective Application and Retrospective Application and Retrospective RestatementRetrospective Restatement

Adjust retained earnings

retroactively.

The adjustment should be

disclosed net of any taxes.

12-34

Restrictions of Retained Restrictions of Retained EarningsEarnings

If I loan your company $1,000,000, I will want you to restrict your

retained earnings in order to limit dividend payments.

Loan agreements can include restrictions on paying dividends below a

certain amount of retained earnings.

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Statement of Changes in Statement of Changes in EquityEquity

12-36

Shareholders’ Equity Shareholders’ Equity Section of the Balance Section of the Balance SheetSheet

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End of Chapter 12End of Chapter 12

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Profit and Changes in Retained Earnings