The Corporate Income Statement and The Statement of Stockholders' Equity

Chapter 12
The Corporate Income Statement

and the Statement
of Stockholders’ Equity
12–1
Motorola, Inc.
 Motorola had good
earnings in 2005 and
2006 but had a
decrease in revenue
of 15% in 2007
 Additionally
Motorola
experienced a large
operating loss of
$553 million in 2007 © Royalty Free/ Corbis
What important questions should investors ask about

Motorola’s future? Can the improvements be made and can
Motorola come back to prominence?
Click here for the Motorola financial reports archive.

Copyright © Cengage Learning. All rights reserved. 12–2
LO1 Quality of Earnings
The substance of a company’s earnings and their
sustainability into future accounting periods
What methods or estimates might
affect the quality of earnings?
Gains and losses on transactions

Write-downs and restructurings
Nonoperating items
Investors should understand which items included in

earnings are recurring and which are one-time items.
Income from continuing operations (before nonoperating
items) gives a clear signal about future results.

The Impact of Estimates and Methods
Different accounting methods have different
effects on net income
LIFO and Double-
FIFO and Declining-
Straight-Line Balance LIFO produces a
Net sales $462,500 $462,500 higher cost of goods
Goods available for sale $200,000 $200,000 sold. An accelerated
Less ending inventory 30,000 25,000
Cost of goods sold $170,000 $175,000 depreciation method
Gross margin $292,500 $287,500 yields a higher
Less depreciation expense $20,000 $40,000 depreciation expense.
Less other expenses 85,000 85,000
Total operating expenses $105,000 $125,000
Income from continuing
operations before income taxes $187,500 $162,500 Produces a lower
operating income

Ordinary Gains and Losses
 appear in the other

revenue and expense
section of the income
statement,
 one-time events should
not go here but often are
© Royalty Free PhotoDisc Collection/ Getty Images

Write-Downs and Restructurings
Imagine that a company decides to “write-

down” the value of a large asset below its
carrying value on the balance sheet
How does this affect income?
Reduces current operating

income and boosts future Often called “big
income by shifting future baths” or taking all
costs to the current possible losses
accounting period

Nonrecurring Items
Reported on the income statement:

Discontinued operations
Extraordinary gains and losses
The effects of changes

in accounting
principles are no
longer reported on the
income statement.
© Royalty Free PhotoDisc Collection/ Getty Images

Discussion: Ethics on the Job
Charles Brink, the new CEO of RDR Industries, instructs the

CFO to take all possible losses in the current year. He says
he wants to wipe the slate clean of costs associated with the
previous management.
Q. Do you think the CEO’s instructions are ethical? How will

this action affect future years’ performance?
While the CEO’s actions are legal, taking a ‘big bath’
on losses makes it possible for him to claim large
improvements in future years. The decision may be more
about his personal gain than the best interest of
stockholders, and is not an ethical action.

Stop & Review
Q. If an analyst believes that a company has a

poor quality of earnings, what does this
mean?
A. In general, the analyst believes that the
substance of a company’s earnings is not
sustainable into the future.

Stop & Review
Q. Does a company’s choice of inventory

costing method have an impact on its quality
of earnings? Why or why not?
A. Yes. Certain methods will produce a higher
cost of goods sold, thus yielding a lower
operating income. If a company makes
choices that continually manipulate its
earnings, it will not be seen as able to
sustain these earnings if they are created
through accounting methods alone.
LO2 Taxable Versus GAAP
Taxable Income Accounting Income
 Determined by  Determined in
deducting allowable accordance with
expenses from GAAP
income  Income taxes expense
 Federal tax laws is recognized on an
dictate which accrual basis
expenses
corporations may
deduct The difference between
accounting income and
taxable income, especially in
large businesses, can be
material
Deferred Income Taxes
Represents the amount by which income taxes

expense differs from income taxes payable
Income tax allocation

A technique used to account for the difference
between income taxes expense based on
accounting income and the actual income taxes
payable based on taxable income

Deferred Income Taxes Illustrated
Vistula Corporation has

income taxes expense of
$289,000 on its income
statement, but has actual
income taxes payable of
$184,000.
Record the estimated income taxes expense applicable to income from

continuing operations using the income tax allocation procedure:
Dec. 31 Income Taxes Expense 289,0000
Income Taxes Payable 184,000
Deferred Income Taxes 105,000
To record estimated current and
deferred income taxes

Deferred Income Taxes
 Deferred income taxes are recognized for

Rules for recording, the estimated future tax effects resulting
measuring, and from temporary differences in the
classifying deferred valuation of assets, liabilities, equity,
income taxes revenues, expenses, gains, and losses for
tax and financial reporting purposes.
What are temporary differences?

Revenues and expenses or gains and losses that
are included in taxable income before or after
they are included in accounting income

Example of Temporary Difference
Treatment of advance payment for goods

Accounting income
(Revenue is not recognized until goods are shipped)
Taxable income
(Revenue is recognized when cash is received)
Result
Taxes paid > Taxes expense
Creates a deferred income taxes asset (prepaid
taxes)

Net of Taxes
 taxes have been taken
into account in
reporting an item on
the income statement
 Used for one time
items
 keeps from distorting
income taxes
associated with © Royalty Free/ Corbis
ongoing operations

Stop & Review
Q. Why are taxable income and accounting

income usually different?
A. They are calculated using different rules.
Taxable income is calculated using tax rules
and allowable expenses. Accounting income
is calculated using GAAP. Thus, the two
amounts are usually different.

Stop & Review
Q. What is the income tax allocation procedure?

A. A procedure used to account for the
difference between income taxes expense
based on accounting income and the actual
income taxes payable based on taxable
income. The difference goes to the Deferred
Income Taxes account.

LO3 Earnings Per Share (EPS)
Used to evaluate a company’s performance and

compare it with other companies
 Should be presented on the
face of the income statement
 Usually disclosed just below
net income
 Show earnings per share for
income from continuing
operations and other major
components of net income
© Royalty Free C Squared Studios/ Getty Images

Basic EPS
Net Income
Basic EPS 
Weighted - Average Common Shares Outstandin g
Vistula Corporation had net income of $669,000 and

200,000 shares of common stock outstanding.
$669,000
Basic EPS   $3.35 per share
200,000 shares

Calculating Weighted-Average
Suppose that from Jan. 1 to March 31, Vistula had 200,000

shares outstanding; from April 1 to Sept. 30, it had 240,000
shares outstanding; and from Oct. 1 to Dec. 31, 260,000
shares were outstanding. Vistula had net income of $669,000.
200,000 shares × 3/12 year 50,000
240,000 shares × 6/12 year 120,000
260,000 shares × 3/12 year 65,000
Weighted-average common shares outstanding = 12/12 235,000
$669,000
Basic EPS   $2.85 per share
235,000 shares
Dividends for nonconvertible preferred stock outstanding
should be subtracted from net income before earnings per
share for common stock are computed.
Diluted EPS
Simple No preferred stocks,

Capital bonds, or stock options
Structure that can be converted
Has the
into common stock
potential to
Complex Issued securities or dilute EPS of
Capital stock options that can common stock
Structure be converted to
common stock
Diluted earnings per share are calculated by adding all

potentially dilutive securities to the denominator of the basic
earnings per share calculation.
Dilution of Ownership
S. Green owns 10,000 shares of a company’s common stock,

which equals 2 percent of the outstanding shares of 500,000.
Suppose holders of convertible bonds convert the bonds into
100,000 shares of stock.
Now, S. Green’s 10,000 shares would equal only 1.67
percent (10,000 ÷ 600,000) of the outstanding shares.
Reporting Companies with a complex capital

structure must report basic and
requirements diluted earnings per share.

Stop & Apply
Q. Kraffton Corporation had net income of $495,300

and 200,000 shares of common stock outstanding.
Compute earnings per share.
$495,300
A. Basic EPS   $2.48 per share *
200,000 shares
* Rounded

Stop & Apply
Q. Possible Corporation had net income of $759,500

and 500,000 shares of common stock outstanding. It
also issued preferred stock that could be converted
into 100,000 shares of common stock. Compute
diluted earnings per share.
A. $759,500 *
Diluted EPS   $1.27 per share
600,000 shares
* Rounded

LO4 Comprehensive Income
Transactions that affect stockholders’ equity, but are

not stock transactions
Includes items like:
Net income
Changes in unrealized investment gains and losses
Foreign currency translation adjustments
Comprehensive income
can be shown as part of
the statement of
stockholders’ equity or
in a separate statement

Statement of Stockholders’ Equity
Summarizes changes in the components of the stockholders’

equity section of the balance sheet
Preferred
Stock$100 Par Accumulated
Value 8% Common Stock Additional Paid- Retained Other Compre-
Convertible $10 Par Value in Capital Earnings Treasury Stock hensive Income Total
Balance, December 31, 2009 $800,000 $600,000 $600,000 $1,200,000 $3,200,000

Net income 540,000 540,000
Foreign currency
translation adjustment ($20,000) (20,000)
Issuance of 10,000 shares of
common stock 100,000 400,000 500,000
Conversion of 2,000 shares
of preferred stock to 6,000
shares of common stock (200,000) 60,000 140,000 —
10 percent stock dividend
on common stock, 7,600
shares 76,000 304,000 (380,000) —
Purchase of 1,000 shares of
treasury stock ($48,000) (48,000)
Cash dividends
Preferred stock (48,000) (48,000)
Common stock (95,200) (95,200)
Balance, December 31, 2010 $600,000 $836,000 $1,444,000 $1,216,800 ($48,000) ($20,000) $4,028,800

Retained Earnings
• Represent • Assets kept in the
stockholders’ claims to company to help it grow
assets arising from the • Retained Earnings may
earnings of the have a debit or credit
business balance
• A debit balance means
that past dividends and
losses have been greater
than its previous profits

Stop & Review
Q. If you were interested in the changes that

occurred in each of the stockholders’ equity
accounts, which financial statement would
be most useful?
A. Statement of Stockholders’ Equity

Stop & Review
Q. Where are foreign currency translations

reported?
A. As part of comprehensive income on the
statement of stockholders’ equity or in a
separate comprehensive income statement.

LO5 Stock Dividend
Proportional distribution of shares of a
corporation’s stock to its shareholders
changes the content of

stockholders’ equity
Involves no distribution
of assets
Moves $ from RE to
Contributed Capital
© Royalty Free/ Corbis

Why Issue a Stock Dividend?
 Gives stockholders some evidence of the company’s

success without using cash unlike a cash dividend
 Nontaxable distribution to stockholders
 Increases the company’s permanent capital by

transferring an amount from retained earnings to
contributed capital
 May reduce the stock’s market price since the

number of shares outstanding increases
Stock Dividends Illustrated
Rivera Corporation has the following stockholders’

equity structure before stock dividends are declared:
Contributed Capital
Common stock, $5 par value, 50,000 shares
authorized, 15,000 shares issued and outstanding $ 75,000
Additional paid-in capital 15,000
Total contributed capital $ 90,000
Retained earnings 450,000
Total stockholders’ equity $540,000

Stock Dividends Illustrated (cont’d)
Rivera Corporation declares a 10 percent stock dividend on February 24,

distributable on March 31 to stockholders of record on March 15. The
market price of the stock on February 24 is $20 per share.
Date of Declaration:
Feb. 24 Stock Dividend Declared 30,000

Common Stock Distributable 7,500
Additional Paid-in Capital 22,500
Declared a 10 percent stock dividend on
common stock, distributable March 31
to stockholders of record on March 15
15,000 shares x .10 = 1,500 shares
1,500 shares x $20/share = $30,000
1,500 shares x $5/share = $7,500

Stock Dividends Illustrated (cont’d)
Rivera Corporation declares a 10 percent stock dividend on February 24,

distributable on March 31 to stockholders of record on March 15. The
market price of the stock on February 24 is $20 per share.
Date of Record:
• No entry is required
• Recall that this date is used to determine the owners of stock who will
receive dividends
Date of Distribution:
Mar. 31 Common Stock Distributable 7,500
Common Stock 7,500
Distributed a stock dividend of 1,500 shares

Effects of Stock Dividends on
Contributed Capital
Before After
Stockholders’ Equity Dividend Dividend
Common stock $ 75,000 $ 82,500
Additional paid-in capital 15,000 37,500
Total contributed capital $ 90,000 $ 120,000
Retained earnings 450,000 420,000
Total stockholders’ equity $540,000 540,000
Shares outstanding 15,000 16,500
Stockholders’ equity per share $ 36.00 $ 32.73
One Stockholder’s Investment
Shares owned 500 550

Shares outstanding 15,000 16,500
Percentage of ownership 3 1/3 % 3 1/3%
Proportionate investment ($540,000 x .0333) $18,000* $18,000*
* Rounded
Total stockholders’ equity is the same before and after a stock dividend
The assets of a corporation are not reduced as they would have been if a
cash dividend had been declared and paid
The proportionate ownership in the corporation of any individual is the
same before and after a stock dividend 12–36
Stock Split
• A corporation increases the number of shares

of stock issued and outstanding and reduces
the par or stated value proportionally
• Has the effect of lowering a stock’s market
value per share and increasing the demand
for the stock at this lower price
• Stock splits and stock dividends reduce
earnings per share because they increase the
number of shares issued and outstanding.

Stock Split Illustrated
July 15: MUI Corporation’s 15,000 shares of $5 par value common stock
issued and outstanding were split 2 for 1.
Common Stock Before Stock Split After Stock Split

Shares issued and outstanding 15,000 30,000
Par value per share $5.00 $2.50
Amount of common stock equity $75,000 $75,000
Each stockholder’s proportionate A stock split does not increase the

interest in the company remains the number of shares authorized, nor
same because each share of $5 par does it change the balances in the
value stock was converted to 2 accounts in the stockholders’
shares of $2.50 par value stock. equity section of the balance sheet.
No journal entry required, memorandum entry is appropriate.

Stop & Review
Q. What is the difference between a stock split

and a stock dividend?
A. A stock dividend changes the makeup of
stockholders’ equity in that it transfers
capital from retained earnings to permanent
capital accounts. A stock split does not
change the makeup of stockholders’ equity.

LO6 Book Value per Share
When a company has only common shares outstanding,

calculate book value per share as follows:
Total Stockholde rs' Equity

Book Value per Share 
Total Common Shares Outstandin g
Shares outstanding
• Includes common stock distributable
• Does not include treasury stock
When a company has both common and preferred stock,

subtract the call value of the preferred stock plus any
dividends in arrears from total stockholders’ equity. (Use par
value if call value is not specified.)

Book Value per Share Illustrated
Crisanti Corporation has total stockholders’ equity of $4,028,800 that

includes:
6,000 shares of $100 par 8 percent convertible preferred stock outstanding;
83,600 shares issued and 82,600 shares outstanding of $10 par value
common stock; and 1,000 shares of treasury stock. No dividends are in
arrears and the preferred stock is callable at $105. What is the book value
per share for both preferred and common stock?
Total stockholders’ equity $4,028,800
Less equity allocated to preferred shareholders
(6,000 shares x $105) 630,000
Equity pertaining to common shareholders $3,398,800
Preferred Stock : $630,000  6,000 shares  $105.00 per share

Common Stock : $3,398,800  82,600 shares  $41.15 *per share
* Rounded
Book Value per Share Illustrated
(Dividends in Arrears)
Crisanti Corporation has total stockholders’ equity of $4,028,800 that
includes:
6,000 shares of $100 par 8 percent cumulative preferred stock outstanding;
83,600 shares issued and 82,600 shares outstanding of $10 par value common
stock; and 1,000 shares of treasury stock.
One year of dividends are in arrears and the preferred stock is callable at
$105. What is the book value per share for both preferred and common stock?
Less: Call value of outstanding preferred shares $630,000
Dividends in arrears ($300,000 x .08) 48,000
Equity allocated to preferred shareholders 678,000

*
Common Stock : $3,350,800  82,600 shares  $40.57 per share
Copyright © Cengage Learning. All rights reserved. * Rounded 12–42

Stop & Review
Q. What is the meaning of book value per share

of stock?
A. It represents the equity of the owner of one
share of stock in the net assets of a
company.

Stop & Apply
Q. Grapple Corporation has 2,000 shares of 6 percent $100 par

value cumulative preferred stock and 50,000 shares issued and
48,400 outstanding of $10 par value common stock. Total
stockholders’ equity is $1,945,000. One year of dividends are
in arrears and the preferred stock is callable at $110. What is
the book value per share for both classes of stock?
A. Total stockholders’ equity $1,945,000

Less: Call value of outstanding preferred shares $220,000
Dividends in arrears ($200,000 x .06) 12,000
Equity allocated to preferred shareholders 232,000

Common Stock : $1,713,000  48,400 shares  $35.39 * per share
* Rounded
Chapter Review Problem
The stockholders’ equity of Latte Company on July 31, 20x7, was as follows:
Contributed capital
Common stock, no par value, $6 stated value,
500,000 shares authorized, 300,000 shares
issued and outstanding $1,800,000
Additional paid-in capital 800,000
Total contributed capital $2,600,000
Retained earnings 670,000
The board declares a 10 percent stock dividend on August 15, 20x7,

distributable on September 9 to stockholders of record on September 1. The
market price on Aug. 15 is $20 per share.
Required: Record the stock dividend in the general journal on the date of
declaration. Determine the book value per share after the dividend.

Chapter Review Problem (Solution)
Aug. 15 Stock Dividend Declared 600,000

Common Stock Distributable 150,000
Additional Paid-in Capital 450,000
Declared a 10 percent stock dividend on
common stock, distributable on September 9
to stockholders of record on September 1
300,000 shares x .10 = 30,000 shares
30,000 shares x $20/share = $600,000
30,000 shares x $5/share = $150,000
$3,270,000
Book Value per Share   $9.91 per share
*
330,000 shares
* Rounded

The Corporate Income Statement and The Statement of Stockholders' Equity

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Chapter 12

The Corporate Income Statement

What important questions should investors ask about

Click here for the Motorola financial reports archive.

Gains and losses on transactions

Investors should understand which items included in

Copyright © Cengage Learning. All rights reserved. 12–3

Copyright © Cengage Learning. All rights reserved. 12–4

 appear in the other

© Royalty Free PhotoDisc Collection/ Getty Images

Copyright © Cengage Learning. All rights reserved. 12–5

Imagine that a company decides to “write-

Reduces current operating

Copyright © Cengage Learning. All rights reserved. 12–6

Reported on the income statement:

The effects of changes

© Royalty Free PhotoDisc Collection/ Getty Images

Copyright © Cengage Learning. All rights reserved. 12–7

Charles Brink, the new CEO of RDR Industries, instructs the

Q. Do you think the CEO’s instructions are ethical? How will

Copyright © Cengage Learning. All rights reserved. 12–8

Q. If an analyst believes that a company has a

Copyright © Cengage Learning. All rights reserved. 12–9

Q. Does a company’s choice of inventory

Represents the amount by which income taxes

Income tax allocation

Copyright © Cengage Learning. All rights reserved. 12–12

Vistula Corporation has

Record the estimated income taxes expense applicable to income from

Copyright © Cengage Learning. All rights reserved. 12–13

 Deferred income taxes are recognized for

What are temporary differences?

Copyright © Cengage Learning. All rights reserved. 12–14

Treatment of advance payment for goods

Copyright © Cengage Learning. All rights reserved. 12–15

Copyright © Cengage Learning. All rights reserved. 12–16

Q. Why are taxable income and accounting

Copyright © Cengage Learning. All rights reserved. 12–17

Q. What is the income tax allocation procedure?

Copyright © Cengage Learning. All rights reserved. 12–18

Used to evaluate a company’s performance and

Copyright © Cengage Learning. All rights reserved. 12–19

Vistula Corporation had net income of $669,000 and

Copyright © Cengage Learning. All rights reserved. 12–20

Suppose that from Jan. 1 to March 31, Vistula had 200,000

240,000 shares × 6/12 year 120,000

260,000 shares × 3/12 year 65,000

Weighted-average common shares outstanding = 12/12 235,000

Simple No preferred stocks,

Diluted earnings per share are calculated by adding all

S. Green owns 10,000 shares of a company’s common stock,

Reporting Companies with a complex capital

Copyright © Cengage Learning. All rights reserved. 12–23

Q. Kraffton Corporation had net income of $495,300

Copyright © Cengage Learning. All rights reserved. 12–24

Q. Possible Corporation had net income of $759,500

Copyright © Cengage Learning. All rights reserved. 12–25

Transactions that affect stockholders’ equity, but are

Copyright © Cengage Learning. All rights reserved. 12–26

Summarizes changes in the components of the stockholders’

Balance, December 31, 2009 $800,000 $600,000 $600,000 $1,200,000 $3,200,000

Copyright © Cengage Learning. All rights reserved. 12–27

© Royalty Free C Squared Studios/ Getty Images