CHAPTER 14
Retained Earnings, Treasury Stock, and the Income Statement
Chapter Overview
This chapter continues the presentation of stockholders’ equity by examining the Retained Earnings account and transactions affecting Retained Earnings. Stock dividends are discussed; calculations and journal entries are presented. Stock splits are described and compared with stock dividends. The authors introduce treasury stock by first explaining why companies buy their own stock to hold “in the treasury.” Entries illustrate the purchase and subsequent sale of treasury stock, which may be at cost, above cost, or below cost. Retirement of stock is discussed briefly, followed by Decision Guidelines covering the accounting for retained earnings, dividends, and treasury stock.
Next, the chapter covers restrictions on and appropriations of retained earnings; their presentation in the financial statements is described. The general teaching format of the stockholders’ equity section of the balance sheet is compared to the real-world format. A mid-chapter summary problem allows students to test their understanding of accounts that make up the stockholders’ equity section of the balance sheet and journalize entries related to stock dividends and treasury stock transactions.
The chapter then focuses on the corporate income statement and the statement of retained earnings. Continuing operations, discontinued operations, extraordinary gains and losses, and the cumulative effect of a change in accounting principle are discussed. Earnings per share is introduced; calculations are first presented for a corporation that has only common stock and then for a corporation that has both common and preferred stock. Diluted EPS is mentioned briefly. A combined statement of income and retained earnings is illustrated. Reporting comprehensive income is discussed. Decision Guidelines help students understand how to analyze a corporate income statement. Prior-period adjustments are explained. A statement of stockholders’ equity is illustrated. A final summary problem allows students to prepare both an income statement and a statement of retained earnings, including the calculation of EPS. An Excel Application problem reviews topics covered in this chapter.
Learning Objectives
After studying Chapter 14, your students should be able to:
1.Account for stock dividends
2. Distinguish stock splits from stock dividends
3. Account for treasury stock
4. Report restrictions on retained earnings
5. Analyze a complex income statement
6. Prepare a statement of stockholders’ equity
Chapter Outline
A.Retained Earnings is the account that accumulates the income that has been retained in the business, that is, not paid out in dividends to stockholders, over the life of the business.
Retained earnings = All net income minus net losses minus dividends
1.A negative balance in Retained Earnings is called a deficit.
2.Credits to Retained Earnings result only from net income.
B.Retained Earnings is not a fund of cash; it is a stockholders’ equity account. Cash and Retained Earnings are two separate accounts and have no particular relationship.
Objective 1: Account for stock dividends
A. A stock dividend is a proportional distribution by a corporation of its own stock to its stockholders.
B.Stock dividends do not transfer assets to stockholders and therefore affect only stockholders’ equity accounts; the paid-in (contributed) capital accounts increase and Retained Earnings decreases by the same amount. This effect is illustrated in Exhibit 14-1.
C.The reasons that corporation might choose to distribute a stock dividend are:
1.To continue dividends but conserve cash.
2.To reduce the market price per share of the company’s stock.
D.Large stock dividends, dividends that are greater than 25% of the outstanding stock, are rare.
E.Small stock dividends are dividends that are less than 25% of the outstanding stock. Small stock dividends (as illustrated in Exhibit 14-2) are recorded at the market value, with this entry:
Retained EarningsXX
Common Stock XX
Paid-in Cap.in Excess of Par—CommonXX
F.A stock dividend does not affect assets, liabilities, or total stockholders’ equity.
Objective 2: Distinguish stock splits from stock dividends
- A stock split is an increase in the number of shares authorized, issued, and outstanding, coupled with a proportionate reduction in the par value of the stock.
B.Stock splits are recorded with a memorandum entry because no account balances are affected.
C.A stock split reduces the market price of the stock.
D.A comparison of stock dividends and stock splits reveals the following similarities and differences:
1.Both increase the number of shares owned per stockholder.
2. Both increase the number of shares outstanding.
3.Both are tax-free to the investor.
4.Only a stock dividend shifts some retained earnings to paid-in capital, leaving the par value per share unchanged.
5.Only a stock split affects the par value.
6.Neither a stock dividend nor a stock split affects total stockholders’ equity.
E.Exhibit 14-3 shows the effect of both cash and stock dividends and stock splits on total stockholders’ equity.
Objective 3: Account for treasury stock
A.Treasury stock is issued stock that has been later reacquired by the issuing corporation.
B.Reasons for acquiring treasury stock include:
1.Increase net assets by purchasing treasury stock at a lower price and reselling it at a higher price.
2.Help support the stock’s current market price by decreasing the supply of stock available.
3.Try to avoid a takeover.
C.The purchase of treasury stock is recorded with a debit to Treasury Stock, a contra equity account. The entry reduces both assets and stockholders’ equity.
1.The entry to record the purchase is:
Treasury StockXX
CashXX
2.The debit to Treasury Stock is based on the purchase price (“cost”), not its par value. Par value is irrelevant in treasury stock transactions.
3.The purchase of treasury stock does not reduce the number of shares issued, only the number of shares outstanding.
4.Since treasury stock is not outstanding, it does not vote or receive cash dividends.
5.Treasury Stock is reported on the balance sheet just below Retained Earnings; it is deducted from total stockholder’s equity.
D.The sale of treasury stock increases both assets and stockholders’ equity. Exhibit 14-4 illustrates the effects on stockholders’ equity when there is a purchase and resale of treasury stock.
1.The sale of treasury stock at cost is recorded as:
CashXX
Treasury StockXX
2.The sale of treasury stock at a price above cost is recorded as:
CashXX
Treasury StockXX
Paid-in Capital from
Treas. Stk. TransactionsXX
3.The sale of treasury stock at a price below cost is recorded as:
CashXX
Paid-in Capital from
Treas. Stk. Transactions
(or Retained Earnings)XX
Treasury StockXX
E.The purchase and sale of treasury stock do not affect net income. No “gain” or “loss” is recorded on the sale of treasury stock.
F.Retirement of stock requires the cancellation of stock certificates.
1.Canceled stock may not be reissued.
2.The stock accounts must be reduced for the original issue price, including both par and excess over par.
3.Retiring stock does not affect net income; no “gain” or “loss” is recorded.
G.Decision Guidelines discuss accounting for retained earnings, dividends, and treasury stock.
Objective 4: Report restrictions on retained earnings
A.Restrictions and appropriations of retained earnings are actions that classify a portion of retained earnings as being unavailable for dividends.
- Both dividends and treasury stock purchases may cause restrictions of retained earnings.
- Restrictions are usually reported in the notes to the financial statements. State laws restrict the amount of treasury stock a corporation may purchase. A bank may require the borrower to restrict dividend payments.
3.Appropriations require a formal journal entry. This entry segregates a portion of retained earnings for some specific use (such as future expansion).
4.Retained earnings appropriations are rare; it is more likely that a restriction will be footnoted.
B.Variations in reporting stockholders’ equity are common. See Exhibit 14-5 for a comparison of the general teaching format and a real-world format for stockholders’ equity.
1.In the real world, similar accounts are often combined for simplification.
2.Different terminology is often used.
3.On the statement of stockholders’ equity, “Total stockholders’ equity” may not be specifically labeled.
Objective 5: Analyze a complex income statement
A.The corporate income statement can be used to help analyze earnings. The various sections of the income statement are illustrated in Exhibit 14-6.
1.The income statement is the most important of the financial statements.
2.In order to evaluate the company’s net income, it is important to examine the various types of income that make up the total.
B.Income (loss) from continuing operations measures the profitability of the ongoing operations and is useful for making projections about future earnings.
C.Special items on the income statement might include:
1.Discontinued operations – segmentsof a business that have been sold. This gain or loss is reported net of (after) taxes, in a separate section of the income statement entitled “Discontinued Operations”.
2.Extraordinary gains and losses (extraordinary items) – gains and losses that are bothinfrequentandunusual. They are also reported after (net of) tax. Note that ordinary gains and losses are reported in the “Other gains and losses” section of the income statement.
3.Cumulative effect of a change in accounting principle – gains or losses from changing from one accounting method to another (for example, straight-line depreciation to double-declining depreciation).
D.Earnings per share (EPS) is the amount of a company’s net income per share of common stock outstanding; it is a key measure of success in business.
1.It is presented on the income statement after net income.
2.EPS figures are provided for continuing operations, discontinued operations, extraordinary items, cumulative effect of a change in accounting method, and net income.
3.EPS is based on the average number of common shares outstanding at year-end.
4.The basic formula for EPS is:
Net income - Preferred dividends
Average number of common shares outstanding
5.Two sets of EPS figures, basic and diluted, are presented for companies that have potentially dilutive securities (such as convertible preferred stock).
a.Basic EPS is based on outstanding common shares.
b.Diluted EPS is based on outstanding common shares plus any additional shares that would be issued upon conversion of preferred stock into common stock. Diluted EPS will always be less than basic EPS.
E.Exhibit 14-7 illustrates how a company may report a combined statement of income and retained earnings.
F.Comprehensiveincome, the company’s change in total stockholders’ equity from all sources other than from the owners of the business, includes net income plus some specific gains and losses. (Refer to Exhibit 14-8.)
1.Unrealized gains and losses on certain investments and foreign currency translation adjustments should be included as a part of comprehensive income even though they are not a part of net income.
2.EPS is reported only for net income (and its components) but not for comprehensive income.
G.Decision Guidelines aid in analyzing a corporate income statement.
H.Prior-period adjustments are corrections of errors in calculating income from previous periods.
1.These errors are reported as adjustments to the beginning retained earnings balance, as well as to the related asset or liability account.
2.The correction appears on the statement of retained earnings.
Objective 6: Prepare a statement of stockholders’ equity
A.A statement of stockholders’ equity reports changes in all categories of stockholders’ equity. See Exhibit 14-9 for an illustration of this format, which is more comprehensive than a statement of retained earnings.
B.For full disclosure, the statement includes information about all stock transactions, treasury stock, dividends, and so on.