CHAPTER 12

INCOME AND CHANGES IN RETAINED EARNINGS

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1. The purpose of presenting subtotals such as Income from Continuing Operations and Income before
Extraordinary Items is to assist users of the income statement in making forecasts of future earnings.
By excluding the operating results of discontinued operations and the effects of unusual and
nonrecurring transactions, these subtotals indicate the amount of income derived from the company’s
ongoing, normal operations.
2. The discontinued operations classification is used in the income statement only when a business
discontinues an entire segment of its activities. Frank’s has two business segments—pizza parlors and
the baseball team. Only if one of these segments is discontinued in its entirety will the company report
discontinued operations. The sale or closure of a few parlors does not represent the disposal of the
pizza parlor segment of the company’s business activities.
3. Extraordinary items are gains and losses that are unusual in nature and not expected to recur in the
foreseeable future.
Examples of extraordinary items are (a) losses from unusual casualties, such as earthquakes, tornadoes,
or acts of war, (b) losses as a result of the expropriation of assets by a foreign government, and (c)
losses as a result of a prohibition under a newly enacted law.
Gains and losses that do not qualify as extraordinary items include (a) losses or gains on the sale
of plant assets or marketable securities, (b) losses incurred as a result of strikes or lawsuits, and
(c) losses or gains relating to a segment of the business discontinued during the year.
4. The restructuring charges should be combined and presented as a line item in the company’s income
statement in determining operating income.
In predicting future earnings for the company, the charges generally should not be considered to be
costs that will be incurred in the future. In fact, if the program of downsizing is successful, operating
results in the future could be expected to improve as a result of having incurred the restructuring
charges.
5. In determining the cumulative effect of a change in accounting principle, the income of prior periods is
recomputed under the assumption that the new accounting principle has always been in use. The
difference between this recomputed past income and the income actually reported represents the
cumulative effect of the change on the income of prior periods and is reported as a separate item in the
income statement.
A prior period adjustment represents a correction of an error in the amount of income reported in a
prior period. Prior period adjustments are shown in the statement of retained earnings (or statement of
stockholders’ equity) as an adjustment to the balance of retained earnings at the beginning of the
period in which the error is identified.
6. The cumulative effect of an accounting change is the difference between the income reported in past
years and the income that would have been reported had the new accounting method always been in
use. Stegall Products had been using an accelerated depreciation method, and, therefore, reported more
depreciation expense and lower net income than would have resulted from use of the straight-line
method. The company will report this retroactive increase in the income of prior years as the
cumulative effect of the accounting change. Thus, the change will increase the net income reported in
the current year.
7. a. The current-year preferred dividend is deducted from net income to determine the earnings

© The McGraw-Hill Companies, Inc., 2003 1

 allocable to the common stockholders. (If the preferred stock is noncumulative, the preferred
dividend is deducted only if declared; the preferred dividend on cumulative preferred stock is
always deducted.)
b. The call price of all preferred stock outstanding and the amount of all dividends in arrears on
preferred stock are deducted from total stockholders’ equity to determine the aggregate book value
allocable to the common stockholders.
8. No, the number of common shares used in computing earnings per share is not always the same as
that used to determine book value per share. In computing earnings per share, earnings allocable to
the common stockholders is divided by the weighted-average number of common shares outstanding
throughout the period. In computing book value per share at a specified date, stockholders’ equity
allocable to the common stockholders is divided by the number of common shares actually outstanding
on that date. If the number of common shares outstanding has not changed during the period, the
weighted-average number of common shares outstanding during the period will be equal to the number
of common shares outstanding on a particular date.
9. a. The price-earnings ratio is computed by dividing the market price of a share of common stock by
the annual earnings per share.
b. The amount of basic earnings per share is computed by dividing the net income available for
common stock by the weighted-average number of common shares outstanding during the year.
c. The amount of diluted earnings per share is computed by dividing net income by the maximum
potential number of shares outstanding after convertible securities are assumed to have been
converted.
10. a. Shares used in computing basic earnings per share:
Common shares outstanding throughout the year............................................................. 2,000,000
b. Shares used in computing diluted earnings per share:
Common shares outstanding throughout the year............................................................. 2,000,000
Additional common shares that would exist if preferred stock had
been converted at the beginning of the year (150,000 × 3) ............................................ 450,000
Total shares used in diluted earnings computation ........................................................... 2,450,000
11. The analyst should recognize the risk that the outstanding convertible securities may be converted into
additional shares of common stock, thereby diluting (reducing) basic earnings per share in future years.
If any of the convertible securities are converted, basic earnings per share probably will increase at a
slower rate than net income. In fact, if enough dilution occurs, basic earnings per share could actually
decline while net income continues to increase.
12. Date of declaration is the day the obligation to pay a dividend comes into existence by action of the
board of directors. Date of record is the day on which the particular stockholders who are entitled to
receive a dividend is determined. Persons listed in the corporate records as owning stock on this day
will receive the dividend. Date of payment is the day the dividend is distributed by the corporation. Ex-
dividend date (usually three business days prior to the date of record) is the day on which the right to
receive a recently declared dividend no longer attaches to shares of stock. As a result, the market price
of the shares usually falls by the amount of the dividend.
13. The purpose of a stock dividend is to make a distribution of value to stockholders as a representation
of the profitability of the company while, at the same time, conserving cash.
14. A stock split occurs when there is a relatively large increase in the number of shares issued without any
change in the total amount of stated capital (because the par value per share is reduced proportionately
to the increase in the number of shares).
A stock dividend occurs when there is a relatively small increase in the number of shares issued, with

© The McGraw-Hill Companies, Inc., 2003 2

 no change in the net assets of the company but a transfer from retained earnings to the paid-in capital
section of the balance sheet. The par value of stock remains the same.
The distinction in the accounting treatment of a stock dividend and a stock split stems directly from the
difference in the effect on stated (legal) capital and retained earnings. There is no difference in the
probable effect on per-share market price of a stock dividend and a stock split of equal size, although
stock splits are usually much larger than stock dividends.
15. Prior period adjustments are entries made in the accounting records to correct material errors in the net
income reported in prior years.
In the year in which a prior period adjustment is recorded, it should appear in the statement of retained
earnings (or statement of stockholders’ equity) as an adjustment to the balance of retained earnings at
the beginning of the year.
16. Three items that may be shown in a statement of retained earnings as causing changes in the balance of
retained earnings are:
(1) Net income or net loss for the period
(2) Dividends declared (both cash dividends and stock dividends)
(3) Prior period adjustments
17. If the price of the stock declines in proportion to the distribution of shares in a stock dividend, at the
time of that distribution the stockholder does not benefit. He/she holds exactly the same percentage of
the outstanding shares, and the value per share has declined in proportion to the increased number of
shares. Often, however, the value does not drop in proportion to the increased number of shares,
meaning that the recipient of the shares has an immediate benefit. For example, if an investor who held
2,000 shares of stock that had a market value of $10 each received a 10% stock dividend, and the
market price only declined 5%, the following would result:
Market value before stock dividend:
2,000 shares @ $10 ............................................................................................................. $20,000
Market value after stock dividend:
(2,000 shares × 110%) × ($10 × 95%) ................................................................................ $20,900
The investor has benefited by $900. He/she could sell about 95 shares [$900/($10 × 95%)] at $9.50 and
still have a stock investment equal to the value before the stock dividend, although the investor would
own a smaller percentage of the company after the sale.
18. A liquidating dividend is a return of the investment made in the company to the investor, in contrast to
a non-liquidating dividend which is a return on the investment in the company. A liquidating dividend
occurs when dividends are distributed in excess of a company’s retained earnings.
19. The student is right in one sense—both stock splits and stock dividends are distributions of a
company’s shares to existing stockholders with the company receiving no payment in return. The
student is incorrect, however, in stating that the two are exactly the same. The primary difference is
one of magnitude. A stock dividend is usually relatively small—5% to 20% of the outstanding shares.
A stock split, on the other hand, is usually some multiple of the number of outstanding shares, like a
2:1 split (100% increase) or a 3:1 split (200% increase). The market price reacts strongly to a
distribution as large as a stock split while stock dividends are often unnoticed in the stock price.
20. The statement of retained earnings shows for the Retained Earnings account the beginning balance,
changes in the account balance during the period, and the ending balance. A statement of stockholders’
equity provides the same information, but includes every category of stockholders’ equity account
(including retained earnings). Therefore, a statement of stockholders’ equity may appropriately be
described as an expanded statement of retained earnings.

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Ex. 12–2 a. Extraordinary item
b. None (Treasury stock is not an asset; it represents shares that have been reacquired by the
company, not shares that have not yet been issued.)
c. Stock dividend
d. Stock subscription
e. Prior period adjustment
f. P/e ratio (Market price divided by earnings per share.)
g. Discontinued operations (Showing the discontinued operations in a separate section of the
income statement permits presentation of the subtotal, Income from Continuing Operations.)
h. Diluted earnings per share
i. Comprehensive income

Ex. 12–5 a. 1. Net income (all applicable to common stock) ............................................... $1,850,000
Shares of common stock outstanding throughout the year............................ 400,000
Earnings per share ($1,850,000 ÷ 400,000 shares) ....................................... $4.63

2. Net income .................................................................................................... $1,850,000

Less: Preferred stock dividend (100,000 × 8% × $100)................................ 800,000
Earnings available for common stock ........................................................... $1,050,000
Shares of common stock outstanding throughout the year............................ 300,000
Earnings per share ($1,050,000 ÷ 300,000 shares) ....................................... $3.50

b. The earnings per share figure computed in part a (2) is a basic EPS figure. Although the
company has outstanding both common and preferred stock, the preferred stock must be
convertible into common stock in order to result in a diluted computation of earnings per
share. The potential conversion of preferred stock into common stock is what necessitates
disclosure of diluted EPS. Because the preferred stock in this exercise is not convertible, the
EPS computation is basic.

Ex. 12–7 a. Apr. 30 Memorandum: Issued an additional 1,000,000 shares of capital stock in a 2-for-1
stock split. Par value reduced from $1 per share to $0.50 per share.
June 1 Dividends.......................................................................... 1,200,000
Dividends Payable ................................................ 1,200,000
To record the declaration of a dividend of 60 cents per
share on 2 million shares of stock outstanding.
July 1 Dividends Payable............................................................ 1,200,000
Cash ...................................................................... 1,200,000
To record payment of the dividend declared on June 1.
Aug. 1 Retained Earnings............................................................. 1,900,000
Stock Dividend to Be Distributed......................... 50,000
Additional Paid-in Capital: Stock Dividends ....... 1,850,000
To record declaration of a 5% stock dividend consisting
of 100,000 shares (2,000,000 shares x 5%) of $0.50 par
value common stock. Amount of retained earnings
transferred to paid-in capital is based on market price of
$19 a share.
Sept. 10 Stock Dividend to Be Distributed..................................... 50,000

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 Common Stock ..................................................... 50,000
To record distribution of a stock dividend of 100,000
shares.
Dec. 15 Retained Earnings............................................................. 525,000
Stock Dividend to Be Distributed......................... 525,000
To record declaration of a 50% stock dividend
consisting of 1,050,000 shares of $0.50 par value
common stock.

b. 2,100,000 shares
1,000,000 + 1,000,000 + 100,000
(Note: The Dec. 15 stock dividend has not been distributed at the end of year.)

c. $0.50 par value per share ($1 par reduced to $0.50 par due to 2-for-1 stock split on April
30.)

d. Stock split—No effect

Declaration/payment of cash dividend—Decrease retained earnings
Declaration/distribution of small stock dividend—No effect
Declaration/distribution of large stock dividend—No effect

Ex. 12–8 The market value of the total DXY, Inc.’s shares outstanding is $5,280,000 (80,000 × $66)
before the stock dividend. Because the issuance of new shares has no effect on the net assets of
the company, there is no basis of predicting any change in total market value of the company’s
stock as a result of the stock dividend. The logical conclusion is, therefore, that the market price
per share should fall to $60 ($5,280,000 ÷ 88,000 shares). The fact that this exact result does not
always follow in practice must be attributed to a lack of understanding on the part of the
investing public and to other factors affecting per-share market price at the time of a stock
dividend.

Ex. 12–9 Net Cash Flow

Current Stockholders’ Net (from Any
Event Assets Equity Income Source)
a D D NE D
b NE NE NE NE
c NE NE NE NE
d D D NE D
e I I NE I

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Ex. 12–10 a. After a stock split, earnings per share are expressed in terms of the new shares. Therefore, a
4-for-1 stock split will cause earnings per share figures to be restated at one-fourth of their
former amounts.

d. Dividends declared or paid do not enter into the determination of net income. Therefore, the
declaration and/or payment of a cash dividend on common stock has no effect upon earnings
per share.

e. Earnings per share are restated to reflect the increased number of shares resulting from a
stock dividend. Therefore, a stock dividend causes a proportionate reduction in the earnings
per share reported in past periods, as well as in the current period. (This effect parallels that
of a stock split, only smaller.)

f. Acquisition of treasury shares reduces the weighted average number of shares currently
outstanding and, therefore, increases earnings per share.

Ex. 12–13 a. There are no nonrecurring items, such as extraordinary items, discontinued operations, and
effects of accounting changes, included in the determination of net earnings that would
affect an evaluation of Tootsie Roll’s financial statements. Tootsie Roll actually has two
income statements–one that reports net earnings and the other comprehensive income. For
an analysis that is intended to predict future performance of the company, net earnings is
probably the amount that should be used.
b. (1) The primary differences between the two classes of stock are as follows:
• The Class B common has ten votes per share compared to only one vote per share
for the common stock.
• The Class B common is not traded on any stock exchange as is the common stock
and is restricted as to transfer.
• The Class B common is convertible into shares of common stock.
(2) The company issued a 3% stock dividend in 1998 as well as a 2:1 stock split. It issued
additional 3% stock dividends in both 1999 and 2000. The impact of these distributions
is to significantly increase the number of outstanding shares. For example, if you held
100 shares at the beginning of 1998, you would have 218 shares at the end of 2000,
determined as follows:
1998: 100 x 103% = 103
103 x 2 = 206
1999: 206 x 103% = 212
2000: 212 x 103% = 218
c. (1) The amounts of paid-in capital for 2000 and 1999 are as follows:

(IN THOUSANDS) 2000 1999

Common stock $22,907 $22,815

Class B common stock 11,150 10,908
Capital in excess of par value 256,698 249,236
$290,755 $282,959

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 (2) The par value of $22,815 thousand is a relatively small part of total stockholders’
equity. In fact, it is only a little over 5% of total stockholders’ equity. Total paid-in
capital, on the other hand, makes up a much larger percentage of stockholders’ equity
($282,959/$430,646 = 66%). In other words, the par value of common stock is only a
small part of total stockholders’ equity. In addition to the Class B common and the
capital in excess of par value, the company has a significant amount of retained
earnings which also contributes to the total amount of stockholders’ equity.

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40 Minutes, Strong PROBLEM 12–6
QUICK DELIVERY SERVICE
a.
General Journal

2002
Jan 3 Dividends 3 8 2 0 0 0
Dividends Payable 3 8 2 0 0 0
To record declaration of $1 per share cash dividend payable
on Feb. 15 to stockholders of record on Jan. 31.

Feb 15 Dividends Payable 3 8 2 0 0 0

Cash 3 8 2 0 0 0
To record payment of dividend declared Jan. 3.

Apr 12 Treasury Stock 2 4 0 0 0 0

Cash 2 4 0 0 0 0
Purchased 6,000 shares of treasury stock at $40 per share.

May 9 Cash 1 7 6 0 0 0
Treasury Stock 1 6 0 0 0 0
Additional Paid-in Capital: Treasury Stock Transactions 1 6 0 0 0
Sold 4,000 shares of treasury stock, which cost $160,000, at
a price of $44 per share.

June 1 Retained Earnings 7 9 8 0 0 0

Stock Dividend to Be Distributed 1 9 0 0 0
Additional Paid-in Capital: Stock Dividends 7 7 9 0 0 0
Declared a 5% stock dividend (19,000 shares) on 380,000
outstanding shares. Market price $42, par value $1. To be
distributed on June 30 to stockholders of record at June 15.

30 Stock Dividend to Be Distributed 1 9 0 0 0

Capital Stock 1 9 0 0 0
Issued 19,000 shares of capital stock as 5% stock dividend
declared June 1.

Aug 4 Cash 2 2 2 0 0
Additional Paid-in Capital: Treasury Stock Transactions 1 8 0 0
Treasury Stock 2 4 0 0 0
Sold 600 shares of treasury stock, which cost $24,000, at a
price of $37 per share.

Dec 31 Income Summary 1 9 2 8 0 0 0

Retained Earnings 1 9 2 8 0 0 0
To close Income Summary account for the year.

Dec 31 Retained Earnings 3 8 2 0 0 0

Dividends 3 8 2 0 0 0
To close Dividends account.

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 PROBLEM 12–6
QUICK DELIVERY SERVICE (concluded)
b. QUICK DELIVERY SERVICE
Partial Balance Sheet
December 31, 2002
Stockholders’ equity:
Capital stock, $1 par value, 500,000 shares authorized, 401,000 shares
issued, of which 1,400 are held in the treasury $ 4 0 1 0 0 0
Additional paid-in capital:
From issuance of capital stock $4 2 0 2 0 0 0
From stock dividends 7 7 9 0 0 0
From treasury stock transactions 1 4 2 0 0 4 9
9 5 2 0 0
Total paid-in capital $5 3
9 6 2 0 0
Retained earnings* 3 4
5 2 6 0 0
$8 8
4 8 8 0 0
Less: Treasury stock, 1,400 shares at cost 5 6 0 0 0
Total stockholders’ equity $8 7 9 2 8 0 0

*Computation of retained earnings at Dec. 31, 2002:

Retained earnings at beginning of year $2 7 0 4 6 0 0
Add: Net income for year 19 2 8 0 0 0
Subtotal $4 6 3 2 6 0 0
Less: Cash dividend declared Jan. 3 $ 3 8 2 0 0 0
Stock dividend declared June 1 7 9 8 0 0 0 11 8 0 0 0 0
Retained earnings, Dec. 31, 2002 $3 4 5 2 6 0 0

c. Computation of maximum legal cash dividend per share at

Dec. 31, 2002:
Retained earnings at Dec. 31, 2002 $3 4 5 2 6 0 0
Less: Restriction of retained earnings for treasury stock owned 5 6 0 0 0
Unrestricted retained earnings $3 3 9 6 6 0 0
Number of shares of capital stock outstanding (401,000 shares
issued, minus 1,400 shares held in treasury) 3 9 9 6 0 0
Maximum legal cash dividend per share ($3,396,600 divided by
399,600 shares) $ 8 50

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30 Minutes, Strong PROBLEM 12–7
TECH PROCESS, INC.

a. Net Cash
Current Stockholders’ Net (from Any
Event Assets Equity Income Source)
1 NE D NE NE
2 D NE NE D
3 D D NE D
4 I I NE I
5 NE NE NE NE
I = Increase
D = Decrease
NE = No effect

b. 1. Declaration of a cash dividend has no immediate effect upon net income or cash flows. It increases
current liabilities (dividends payable), but has no effect on current assets. Also, retained earnings is
decreased, resulting in a decrease in stockholders’ equity.
2. Payment of a cash dividend has no effect on revenue or expenses, but it reduces cash. Since it
reduces cash, it also reduces current assets. The transaction has no effect on stockholders’ equity,
which has already been decreased when the dividend was declared.
3. The purchase of treasury stock has no effect on either revenue or expenses and, therefore, does not
affect net income. But cash is used to purchase the treasury stock, and this decreases cash and
current assets. Because treasury stock is deducted from stockholders’ equity in the balance sheet, its
purchase decreases stockholders’ equity.
4. Reissuance of treasury stock at a price less than its original cost results in a loss, but these losses are
not recorded in the income statement. Instead additional paid-in capital is decreased for the amount
of the loss. Therefore, this transaction does not affect net income. Since the treasury stock account is
deducted from stockholders’ equity, reissuance of the stock increases the total amount of
stockholders’ equity. Also, both cash and current assets are increased as a result of the cash received
from sale of the stock.
5. Declaration of a stock dividend results in a reclassification of amounts from Retained Earnings to
the Capital Stock and Additional Paid-in Capital accounts. It has no effect on cash, current assets,
stockholders’ equity, or net income.

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