Income and Changes in Retained Earnings
About Managerial Accounting
Managerial Accounting is very different from Financial Accounting. There you learned about the overall framework of accounting, and how to prepare financial statements for investors and other people outside the company. Managerial Accounting will focus on preparing financial information for Managers who are inside the company. Their needs are different than the general public's, and Managers are entitled to access information that is confidential.
In this course, and in the legal and business world in general, Managers (or Management) are viewed as a special group of people. We will view them both as a "whole" and as individuals. They are employees of the company, and they are the ones in charge of running a company and making daily, mission-critical decisions that effect the very life of the company.
Because of their position in a company, Management can either act to benefit the company and it's owners or they can undermine the company. We expect the former, and cringe at the latter. The financial collapse of Enron is a recent example of a group of Managers who put their own personal gain above their obligation to the stockholders and public alike. It was the 7th largest company in the US at the time. Thousands of employees people lost their entire retirement fund, and thousands of other investors lost their entire investment.
Each week we will learn to use new managerial tools. Each one is a little different, but when you are done you will have many useful tools for business decision-making. After all, a carpenter would use a hammer to drive a nail, and a screwdriver to install a screw. OK, I know a few that would use a hammer to drive a screw but you get the idea! ;-)
Let's put it this way: you can do more with a full box of useful tools. Fair enough? So each week we will learn to use some new ones, or find new and different uses for one's we've learned about earlier.
In week 1 we will study the Income Statement in more detail. In week 2 you will learn how to analyze and interpret financial information. After that, the remaining 6 weeks will deal with the business of management. You will learn some important tools managers use to make their business run better, be more efficient and more profitable.
Chapter 12 expands on the Income Statement, and adds some new sections to include three special situations that are presented separately in the Income Statement. It also introduces Earnings Per Share, which is a required disclosure under GAAP.
You learned about the Income Statement in Accounting I. What you learned was OK at that level of learning. But it does not entirely comply with GAAP. This chapter will show you how to prepare an Income Statement that is fully in compliance with GAAP. This is very important for managers; a company's financial statements are Management's responsibility!
In this course we will assume that all companies we study are publicly traded (sell their stock on a public stock exchange) and must file their annual audited financial statements with the SEC. The SEC requires companies to comply with GAAP. These companies are all corporations, so the owners' equity section will actually be referred to as Stockholders' Equity, in the financial statements. From now on owners' equity and stockholders' equity will be used to mean the same thing.
The Retained Earnings (RE) account has a special purpose. It is used to accumulate the company's earnings, and to pay out dividends to the company's stockholders. Let's look at the first part of that for a moment.
At the end of the fiscal year, all Revenue and Expense accounts are closed to Income Summary, and that account is closed to Retained Earnings. Profits increase RE; losses will decrease RE. So the RE account might go up or down from year to year, depending on whether the company had a profit or loss that year.
The changes in the RE account are called "Changes in Retained Earnings" and are presented in the financial statements. This information can be included in the Income Statement, in the Balance Sheet, or in a separate statement called the Statement of Changes in Retained Earnings. Each company can decide how to present the information, but it must be presented in one of those three places.
Most financial statements today include a Statement of Retained Earnings. Some companies prepare a Statement of Stockholders' Equity to give a more comprehensive picture of their financial events. This statement includes information about how many shares of stock were outstanding over the year, and provides other valuable information for large companies with a complex capital structure. The changes in RE are included in the Stockholders' Equity statement.
Dividends are payments companies make to their stockholders. These must be made from earnings. Since we record accumulated earnings in the RE account, all dividends must come out of that account. There are several types of dividends, but they all must come from Retained Earnings. In order to pay dividends, the RE account MUST have a positive, or Credit, balance.
If the RE account has a Debit balance, we would call that a Deficit, and the company would not be able to pay dividends to its stockholders. Deficits arise from successive years of posting losses in excess of profits.
Let's assume a company makes $10,000 profit each year for each of 5 years in a row. Their RE account would have a Credit balance of $50,000. If in the 6th year the company lost $60,000, the RE account would have a negative, or Debit, balance of $10,000, and no dividends could be paid to the stockholders, despite the profits in prior years.
What could have been done to salvage the situation? Dividends could have been paid each year, in the prior 5 years, when RE had a positive (Credit) balance, right?
Maybe yes, maybe no. Having a positive balance in RE is not the only consideration in paying dividends. Cash Dividends also require the company to have sufficient Cash to pay the dividend. They might need their cash for other things, such as the purchase of new equipment, inventory expansion, etc. Rapidly growing companies often have cash needs well beyond what they are able to generate on their own. Every dollar is important, and dividends get deferred to the future.
Why do people invest in the stock market?
All investors hope to get a return on their money, that is greater than the amount they put down initially to buy the stock. A return can come in one of two ways:
1) dividends received from company earnings, or
2) capital gains from selling the stock at a higher price than what was paid.
Blue Chip company's generally pay regular dividends. But their stock prices are high, and the prices tend to move slowly. If you buy a blue chip stock hoping for capital gains, you might have to wait many years for the price to increase to the desired level.
On the other hand, new, fast growing companies may never pay a dividend, but their stock price can be increasing steadily because the company is growing. In these companies, because of their growth, a share of stock can quickly increase in value. We saw that in the late 1990s with tech stocks. Unfortunately, the tech sector suffered a serious setback by the start of the 21st century.
The moral of this story is... investing in growth stocks is risky business. BUT people do it because the gains can be very impressive. Capital gains can easily be many times what would have been earned in dividends. This provides a tremendous incentive for investors to put their money on risky investments. Each investor has to decide how much or how little risk they are willing to accept in their portfolio.
Gambling casinos are also risky. But that risk is a calculated risk. For any game, we can statistically calculate your chances of winning or losing a particular turn of play. That is never the case in the stock market. You must always be prepared to lose your entire investment in the stock market. The odds are always against you.
Why do companies care about their stock market price?
A company sells its stock to the public ONCE and only once, in what is commonly known as an IPO (Initial Public Offering). After that, all trading in the stock is done between individual stockholders, and the company is essentially out of the picture.
So once a company has money in it's hand for the stock, why should it care about the stock market price?
Managers are very sensitive to stock market prices, and the information in their financial statements directly influences stock prices.
Many managers are also stockholders in their company, so they have a personal interest in the stock price. They want their own portfolio to be strong, and the company's stock price will have an impact on them personally.
Other companies have to decide whether to do business with yours, and that's also very important. Right now how many other companies are anxious to do business with Enron, Global Crossing or K-Mart? Not very many, and the number is dwindling.
These companies have all recently filed for bankruptcy, and their stock prices are extremely low. Investors have little trust in the management of these companies and they are voting with their investment dollars. Other companies who sell merchandise to them are cautious, because they're not sure if these companies will be around long enough to pay their bills.
So, stock price sends a message to everyone - investors, suppliers, creditors and bankers, employees - everyone. And the message is "this company is in financial trouble, and the management of this company is not doing a good job."
This is a course in Managerial Accounting, and in Chapters 12 & 14 we will study the Income Statement, learn to analyze information in the financial statements, and gain a better perspective on financial reporting, that can benefit you as both an investor and a manager. It is important to understand why we study this material, it's importance in the investing community, and that this information is the responsibility of a company's management! So it's a good topic for a course in managerial accounting.
The Income Statement - Reporting Continuing Operations
Continuing Operations - are the "regular" business activities a company is engaged in. It is called "continuing" or "ongoing" operations, because this is the part of the business that will continue into the future.
Investors evaluate Income from Continuing Operations separately from other, irregular items. It is so important that it is listed as a separate item on the Income Statement. This is a required disclosure under GAAP.
Stock market prices are greatly influenced by income from continuing operations. It is part of the calculation referred to as the Price Earnings Ratio, or PE Ratio. It is so important to investors, you will find the PE in the Wall Street Journal, listed next to the stock price for each company. PE ratio is SP/EPS which means:
Current Common Stock Price Per Share
In this chapter, you will learn more about both of these items. You will be preparing an Income Statement and calculating Earnings Per Share as part of your homework assignment in this chapter. EPS is just as it sounds:
EPS = Current Earnings / Number of Shares of Common Stock
We will cover EPS in more detail a little later. The PE
ratio is actually a multiple of a company's earnings. In essence, investors
are trading stock at a multiple of the expected future earnings of the
company. So if a company has a PE of 5, the stock price is 5 times the
most recent earnings per share (i.e., the most recent audited financial
statements released to the public). A PE of 20 would indicate 20 times
EPS. Investors are buying a piece of a company's expected future earnings
they trade based on PE ratio.
Income Statement - Reporting Irregular Items
Irregular items are those that are not expected to influence, or be part of, future continuing operations. We report 3 items separately in the Income Statement. These items appear below Operations from Continuing Operations. We also calculate EPS for each of these items, as illustrated in your text in the Tanner Corporation example.
These three items are always presented in the following
Multiple irregular items should be listed separately. They may be subtotaled as a group. You could have two or three extraordinary items, each listed separately, but the group netted as a single dollar amount.
Irregular items are reported separately for several
Second, they represent major events or decisions by management, and deserve special attention. Investors like to evaluate these decisions separately as well.
Net of income taxes....
All items in this group are presented net of income taxes, whether they produce a gain or loss. If the item is a gain, the tax expense is deducted from the gain. If the item is a loss, the tax effect will decrease the loss. So, in either case, the tax effect will decrease the item. Gains will be smaller gains, and losses will be smaller losses.
In problems and homework assignments the tax effect will be expressed as either a dollar amount for each item, or as a percentage that can be applied to each item. Either way, you will reduce each item by the amount if its tax effect, and list the dollar amount of the tax effect in parentheses. This is called parenthetical disclosure - which means it is enclosed in parentheses. Example:
Total Gain .....105,000
We don't need to show the total gain, because the reader only has to add the two numbers to get the total:
A discontinued operation is one that will not continue into the future. The company may just disband part of the business entirely and scrap or sell off the facilities and related equipment and assets. Or it might try to sell that part of the business to another company. Sometimes they might "spin off" part of the business to create a separate segment, which is later sold.
Sometimes one business buys another business, and gets rid of those parts of the new acquisition that don't fit it's overall strategy or profile. For instance, a food producer might buy another company that owns food production facilities and a hotel chain. They might choose to sell off the hotel chain, because it is not within their normal line of business. Since they have expertise in food production, but not in hotel management, this might be a wise decision.
Discontinued operations are reported in two parts:
These are listed separately because they represent two different types of income. The first type of income arises from the continuing the business and earnings process until the assets can be sold off. The second is Capital Gain or Loss which arise from selling business assets.
In many cases a company will continue running the discontinued segment until a new owner can take over. A running business has more value than one that has been shut down, and must be started up again. Keeping a stream of customers coming in the doors, and making a little more money from the operations, will certainly help minimize any loss that might result from the decision, and will increase value to both the stockholders and potential buyers.
Some events don't happen very often, and are considered so uncommon that they fall in a special category called Extraordinary Items. This list includes earthquakes, tornadoes, acts of war, and the moon crashing into the earth. OK, the last one's not on the list, I just made that up. But you get the idea.
Extraordinary items must meet two criteria:
An item which does not meet both these criteria is considered Unusual, and is listed as part of Continuing Operations. It must meet both to be Extraordinary.
Changes in Law - Changes in law meet both requirements. If a company suffers a loss due to a change in law, that would be extraordinary.
Example: assume Congress outlaws the sale of cigarettes and tobacco products. All companies manufacturing or carrying these products would have an extraordinary loss on the disposal of inventory. .
Condemnations - a city, county or state government may condem property, perhaps for a new roadway, or other public use. Losses resulting for condemnations are extraordinary. However, these losses are usually mitigated because the government will pay for the property. As a result either an extraordinary loss or gain may result from a condemnation (see discussion below).
Acts of War, Civil War, etc. - Acts of war, civil war, and similar events often mean that companies lose property and investments in the countries affected. Local currencies and property values may be devalued or changed as well.
Deciding if an event is Extraordinary is a matter of professional judgement. We do try to keep the list small, and look at each event individually to see if it clearly meets the conditions and criteria for an extraordinary event. Geography may also play a role in making this determination.
Some events are specifically NOT considered extraordinary:
Fires are never considered extraordinary. Fires are a common occurrence, and businesses are expected to carry insurance to protect them against fire loss.
Floods that occur in a flood plain are not considered extraordinary. Floods are expected in a flood plain, and should be insured against. However, if you had a flood on top of a mountain, that WOULD BE extraordinary!!
Strikes are considered a normal business risk. They're also part of having employees, which relates to continuing operations, and are therefore not extraordinary.
Hurricanes in Florida are not considered extraordinary, because they are bound to happen in the foreseeable future. However, a hurricane in Missouri would be an extraordinary event, and a good reason to move to higher ground.
Volcanos in Hawaii erupt on a frequent basis, and are not extraordinary events. People building homes near an active volcano are taking a calculated risk.
From our discussion above you might get the idea that extraordinary items are generally losses. And you would generally be right. But sometimes, in rare circumstances, a company may get an insurance or government settlement that exceeds their actual loss. In these cases, they would have an extraordinary gain.
Indemnification against loss
Changes in Accounting Principle
There are a few accounting principles that deal with the value of certain items, such as inventory or long-term contracts. On rare occasion a company will change the way it records these items, and start using a different accounting principle. For instance, it might change from using FIFO to LIFO for inventory valuation.
The old method was used in previous years, and there may be some lingering effect left on the books. In order to change to a new method of accounting you must recalculate the impact on prior years, as if the new method had been used in the past. The net cumulative effect of the change from old to new method is shown in the Income Statement. It is the last item listed before Net Income.
Changes in accounting principle don't happen very often. It is more likely that a company will change from a method that is not approved by GAAP, to a method that is approved by GAAP. In these cases, no adjust needs to be made. One would only report a change from one approved application of GAAP to another.
Let's look at an example of an income statement prepared according to GAAP, with significant subtotals, irregular items and EPS.
These are the account balances for Amalgamated Widget's
Income Statement, in alphabetic order. The company has an average tax rate
First we separate the Operating Income and Non-operating items, and calculate the tax effect of each. In this example the lawsuit will be a significant item listed in the Operating section. Lawsuits are commonplace in business, so it is not considered extraordinary. However, because of the large dollar amount, such losses should be shown on their own line. This helps the user to better evaluate future results of operations.
In the example below I have calculated operating income
before taxes, then I apply the 30% tax rate.
This chart shows one approach to calculating the needed
amounts. In all cases the tax effect reduces the amount shown. Gains
are made smaller because taxes have to be paid on them. Losses are reduced,
because they reduce the total tax espouse; this is called a tax benefit.
Having calculated all the needed amounts I just need to put them in the right order for an income statement. I have shown some significant subtotals in blue because we will use them later when calculating Earnings Per Share. The company had 1,000,000 shares of common stock outstanding all year.
Amalgamated Widget, Inc.
Of course, the Income Statement will be modified to show only the items that actually happened in any given year. There is no need to put a line on the statement for something that didn't happen. IF the company has any of these three items, they would be disclosed as shown above. These are called irregular items, because they don't happen very often.
Earnings Per Share
All Income Statements must show Earnings Per Share for each significant subtotal item, starting with Income from continuing operations. The significant ones are the amounts in the far right column in the statement.
EPS = Earnings available to common stock / Outstanding shares of common stock
An outstanding share is one in the hands of an investor. If a company has Treasury Stock, those share are not outstanding, no dividend is paid on them, and they don't figure in to EPS.
In most cases, the company will have the same number of shares of common stock outstanding all year. In these cases, calculating EPS is an easy job. But in some cases the number of shares outstanding may change during the year. If that happens we use the weighted average method.
Weighted average might be a complex calculation if the company issued new shares during the year, on many different days. The company may also have Treasury stock transactions, which changes the number of outstanding shares. Since dividends are not paid on Treasury stock, these shares are also not included in calculating EPS. Generally this is not the case, but let's look at a simple example of a weighted average.
A company has 100,000 shares of stock outstanding for the entire year. On July 1 it issues an additional 50,000 shares.
Weighted Average Shares of Common Stock
This is a simple example, and you could use a decimal instead of a fraction. You could also have more than two parts, if there was a change in outstanding shares on more than one occasion. If there is no change in outstanding shares, you don't need to do this calculation.
Once you have the number of shares figured out, all you need to do is divide to calculate the EPS for each item in the list above. Your text has a couple of examples of the calculations worked out for you.
Calculating Preferred Dividends
Preferred dividends are paid on preferred stock (Pfd) . This type of stock carries special privileges and features. Preferred stockholders are in line for dividends before common stockholders. If all the retained earnings and cash are used up to pay preferred dividends, then there is nothing available for the common stockholders. So we deduct Pfd dividends when calculating EPS on common stock.
It is fairly easy to calculate the preferred dividends.
You need to know the number of shares of Pfd stock, and the amount of the
dividend, which will always be stated. If the Pfd stock has a dollar amount,
that is the dividend to be paid each year, per share. If the Pfd stock
has a percentage, multiply the par value per share times the percentage
to get the dividend. Here are two examples. Assume the company has 5,000
shares of preferred stock.
Types of dividends
Dividends must first be declared by the Board of Directors. Dividends are recorded (entry dated) in the books on the day they are declared. The Board of Directors must examine the Retained Earnings account and determine how much dividends could be paid. In this example, the RE account has a Credit balance of $20,000 so this will the maximum amount of dividends they would be able to declare.
It is unlikely a company would declare all the retained earnings as dividends. As discussed above, they would also have to consider cash needs of the company for the coming months ahead and see if they are able to pay a dividend at all.
Let's assume the Board of Directors declared a $10,000
cash dividend on December 31. It can take a month or more to prepare dividend
payments to all stockholders in a large corporation. When dividends are
declared, we write a journal entry, as follows:
In this example I debited Cash Dividends, to differentiate
this type of dividend from other types. Companies often simply debit a
Dividends account for all dividend transactions. Either way is acceptable.
When the dividend checks are prepared and mailed to the stockholders we
record the following entry, to eliminate the payable.
The Dividend accounts are closed to Retained Earnings
at the end of the year. Companies also have the option to directly deduct
the dividend from Retained Earnings on the day the dividend is declared.
Some company's follow this procedure. In that case the first entry would
look like this:
Different textbooks will show these two methods. The company's accounting managers will generally decide which method the company will use. You must always remember that an accounting system is tailored to the needs of the company using it. GAAP deals with disclosure of information in financial statements, not with bookkeeping procedures. Different bookkeeping procedures may be equally acceptable, as long as the financial statements are prepared according to GAAP.
Stock dividends are paid for various reasons. Sometimes they are paid because the company has adequate Retained Earnings, but not the cash to make a dividend payment. Stockholders are often very happy to have more shares of stock, rather than money. Stock dividends are not taxed until the stock is sold; tax on cash dividends must be paid in the year the dividend was received. So taxes on a stock dividend become deferred to a future year, which many investors see as an advantage.
Stock dividends are declared in the same way as cash dividends. However, the company is issuing stock, so we will credit the common Stock account, and perhaps the Additional Paid-In Capital (APIC) account. If you're not up to speed on journal entries for stock issues you should review Chapter 11. There is also a good example of these journal entries in Chapter 12, in the discussion of stock dividends.
Stock dividends are directly linked to the market price
of the stock. The market value of a stock dividend is transferred from
the RE account to the Common Stock and APIC accounts, to record the issuance
of the shares. Let's assume that stock is trading for $25 per share, and
has a par value of $1. The journal entry for one share would be:
Of course, you would determine the total number of shares to be distributed, and write a journal entry to match. If 1000 shares were to be distributed, you would multiply each of the numbers above by 1000.
[Note: the book illustrates how to do a stock dividend, where the stock is issued at a future date. In that case a Stock Dividend to be Distributed account is used, similar to the use of Dividends Payable in a cash dividend situation. This would be normal, and my illustration above is meant to show you how the RE and stock accounts are linked, and how the dollars are split in the transaction.]
Prior Period Adjustments
A prior period adjustment is one that relates to a previous fiscal year that has already been closed - closing entries have been posted, and financial statements have been prepared and released. Sometimes after the year end we discover a material error that would have effected net income of the prior period. When this happens, we make an adjusting journal entry to Retained Earnings to correct the problem.
We have to report the situation in the financial statements
and this is done by showing an adjustment to the beginning balance of Retained
Earnings. After RE has been restated, the current year's activity is reported
on. Your textbook has a good example of how this is shown in a Statement
of Retained Earnings.