Solution of ch12 sm

CHAPTER 12INCOME AND CHANGES IN RETAINED EARNINGS

overview of exercises, problems, cases,and internet assignment

Exercises TopicLearning

ObjectivesCharacter ofAssignment

12–1 Stock dividends and stock splits 4 Personal, conceptual12–2 Terminology 1, 2, 3, 4, 6, 7 Conceptual12–3 Discontinued operations 1, 2 Conceptual, mechanical12–4 Extraordinary items 1, 2 Conceptual, mechanical12–5 Earnings per share: effect of

preferred stock2 Conceptual, mechanical

12–6 Restating earnings per share for stock dividends

2, 4 Conceptual, mechanical, real—Microsoft

12–7 Stock dividends and splits 4 Mechanical12–8 Effect of stock dividends on stock

price4 Conceptual, communication

12–9 Effects of transactions upon financial measurements

8 Analytical, conceptual

12–10 Effects of transactions upon earnings per share

2, 4 Conceptual, communication

12–11 Identifying source of desired financial information

1, 5, 8 Conceptual

12–12 Comprehensive income 7 Analytical12–13 Analysis of stock information 2, 8 Conceptual, mechanical, real—

Tootsie Roll

Problems

12–1 Reporting unusual events 1, 2 Conceptual, mechanical12–2 Format of statements of income

and retained earnings1, 2, 5, 6 Conceptual, mechanical

12–3 Reporting unusual events: a comprehensive problem

1, 2, 5, 6 Conceptual, mechanical

12–4 Stock splits, stock dividends, treasury stock, and book value

4 Mechanical, conceptual

12–5 Statement of stockholders’ equity 4 Mechanical12–6 Dividends and treasury stock

transactions4 Conceptual, mechanical

12–7 Effects of transactions upon financial measurements

8 Analytical, conceptual, group, communication

12–8 Stockholders’ equity: comprehensive

4 Conceptual, mechanical

12–9 Format of an income statement 1, 2 Conceptual, mechanical, real—Bally Manufacturing

© The McGraw-Hill Companies, Inc., 2002 383

Cases TopicLearning

ObjectivesCharacter ofAssignment

12–1 Reporting special events 1 Conceptual, real—various companies

12–2 Forecasting continuing operations

1 Analytical, communication, group

12–3 Interpreting earnings per share 1, 2, 3 Analytical, communication12–4 Analyzing statement of

stockholders’ equity8 Analytical, mechanical, group, real

—The Quaker Oats Company and Subsidiaries

12–5 Classifying unusual items 1, 2, 8 Ethics, group, analytical, communication

Business WeekAssignment

12–6 Business Week assignment 1, 3 Analysis of earnings

InternetAssignment

12–1 Comparing price/earnings ratios 2 Internet, research, analytical

384 © The McGraw-Hill Companies, Inc., 2002

DESCRIPTIONS OF PROBLEMS, CASES,AND INTERNET ASSIGNMENT

Below are brief descriptions of each problem, case, and the Internet assignment. These descriptions are accompanied by the estimated time (in minutes) required for completion and by a difficulty rating. The time estimates assume use of the partially filled-in working papers.

Problems

12–1 Atlantic AirlinesPreparation of a condensed income statement and earnings per share figures for a company with a discontinued segment and an extraordinary loss. Emphasizes format of the income statement rather than computation of amounts. Students also are asked to forecast future operating results.

30 Easy

12–2 Ashton Software, Inc.A comprehensive problem on reporting the results of operations. Stresses the format of an income statement and statement of retained earnings, with disclosure of “unusual items.” EPS computation involves common and preferred stock outstanding.

30 Medium

12–3 Aspen, Inc.Given an incorrectly prepared income statement, student is asked to draft a revised income statement and a statement of retained earnings. Includes discontinued operations, an extraordinary item, an accounting change, and a prior period adjustment.

35 Strong

12–4 Foreign Adventures, Inc.Demonstrates the effect of various transactions upon total stockholders’ equity, number of shares outstanding, and book value per share. Includes stock splits, stock dividends, and treasury stock transactions.

20 Easy

12–5 Marble Oasis CorporationPreparation of a statement of stockholders’ equity. Stresses an understanding of the effects of various transactions upon the elements of stockholders’ equity.

20 Medium

12–6 OverNight LetterA comprehensive problem on cash dividends, stock dividends, and treasury stock transactions. Requires journal entries and preparation of stockholders’ equity section of the balance sheet. Student is asked to compute maximum amount available for dividends.

40 Strong

12–7 Rapid Process, Inc.Explanation of the effects of equity transactions on various financial measures.

30 Strong


12–8 Mandella CorporationPreparation of the stockholders’ equity section of a balance sheet in two successive years. Transactions affecting stockholders’ equity include issuance of common stock, a stock dividend, purchase and sale of treasury stock, cash dividends, and a stock split.

50 Strong

12–9 Falcon Manufacturing CorporationPreparation of a partial income statement for Falcon Manufacturing Corp., including discontinued operations, an extraordinary loss, and an accounting change. Emphasizes format of the income statement rather than computation of amounts. Students also are asked to compute earnings per share.

25 Strong

Cases

12–1 Unusual Events in Published Financial StatementsFive “unusual events” taken from the published financial statements of well-known corporations. Students are asked to indicate whether each event qualifies as an extraordinary item, a discontinued operation, or an accounting change.

20 Easy

12–2 Life Without BaseballStudent is presented with an income statement containing discontinued operations and an extraordinary item and is asked to forecast future earnings. Requires an understanding of recurring versus nonrecurring events. Good practice for interpreting annual reports.

20 Medium

12–3 Pick a NumberStudent is given six earnings per share figures, including earnings from continuing operations, earnings before extraordinary items, and net earnings, computed on both a basic and diluted basis. From this information, student is asked to determine the amount of the extraordinary loss, to use a p/e ratio to estimate stock price, and to forecast future performance.

30 Strong

12–4 . . . But What Does It All Mean?Based upon the statement of common stockholders’ equity for The Quaker Oats Company and Subsidiaries. Student is asked to answer specific questions requiring analysis and understanding of items reported in this financial statement.

35 Strong

12–5 Extraordinary?Students discuss the classification of unusual items from several perspectives—accounting principles, pressures on management, cash flows, and probable effects on stock price. Adapted from an actual case; illustrates the “real world” aspects of financial reporting. Good group assignment.

60 Strong


Business Week Assignment

12–6 Business Week AssignmentStudents are asked how they would deal with management’s tendency to take stops to improve the company’s earnings in difficult financial times.

30 Medium

Internet Assignment

12–1 Price-Earnings RatiosStudents are to obtain information on the Internet about a Fortune 500 company and an emerging company. They are to compare p/e ratios and speculate on the reasons for the differences.

30 Easy


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. Pappa Joe’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. Maddox 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 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 year 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.......................................................... 2,000,000Additional common shares that would exist if preferred stock had

been converted at the beginning of the year (150,000 4)......................................... 600,000 Total shares used in diluted earnings computation........................................................ 2,600,000

11. The analyst should recognize the risk that some of 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 an 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 an increase in the number of shares issued, with 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.

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 types of information, but covers 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.


SOLUTIONS TO EXERCISES

Ex. 12–1 a. 1,440 shares = [(200 2) 120%] 3$14,400 = 1,440 $10.

b. Since Willis is a small and growing corporation, the board of directors probably decided that cash from operations was needed to finance the company’s expanding operations.

c. You are probably better off because of the board’s decision not to declare cash dividends. Willis was obviously able to invest the funds to earn a high rate of return, as evidenced by the value of your investment, which has grown from $1,000 to $14,400.

Ex. 12–2 a. Extraordinary itemb. 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 dividendd. Stock subscriptione. Prior period adjustmentf. 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 sharei. Comprehensive income

Ex. 12–3 a. SUNSPORTS, INC.Income Statement

For the Year Ended December 31, 20__

Net sales.........................................................................................................$10,800,000Costs and expenses (including applicable income taxes).............................. 8,600,000 Income from continuing operations..............................................................$ 2,200,000Discontinued operations:

Operating loss from tennis shops (net of income taxbenefit)...................................................................................$192,000

Loss on sale of tennis shops (net of income tax benefit)......... 348,000 (540,000 )Net income..................................................................................................... $1, 660,000

Earnings per share:Earnings from continuing operations ($2,200,000 175,000 shares)...... $12.57Loss from discontinued operations ($540,000 175,000)........................ (3.09 )Net earnings ($1,660,000 175,000 shares).............................................. $ 9.48


b. The $12.57 earnings per share figure from continuing operations (part a) is probably the most useful one for predicting future operating results for SunSports, Inc. Earnings per share from continuing operations represents the results of continuing and ordinary business activity, which is expected to continue in the future. Discontinued operations and extraordinary items are not likely to recur in the future.

Ex. 12–4 a. GLOBAL EXPORTSIncome Statement


Net sales......................................................................................................... $9,000,000Less: Costs and expenses (including income taxes)...................................... 6,200,000 Income before extraordinary items............................................................... 2,800,000Extraordinary gain, net of income taxes....................................................... 685,000 Net income..................................................................................................... $ 3,485,000

Earnings per share of common stock:Earnings before extraordinary items ($2,800,000 900,000 shares)....... $3.11Extraordinary gain ($685,000 900,000 shares)..................................... .76Net earnings ($3,485,000 900,000 shares).............................................. $3.87

b. The $3.11 earnings per share before extraordinary items is the figure used to compute the price-earnings ratio for Global Exports. If a company reports an extraordinary gain or loss, the price-earnings ratio is computed using the per-share earnings before the extraordinary item.

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

2. Net income............................................................................................... $1,850,000Less: Preferred stock dividend (100,000 8% $100)........................ 800,000 Earnings available for common stock..................................................... $1,050,000Shares of common stock outstanding throughout the year.................... 300,000Earnings 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. 12–6 a. 2003 2002 2001

Earnings per share............................................... $1.88 $1.575 (1) $1.205 (2)(1) $3.15 originally reported, divided by 2 (twice as many shares)(2) $2.41 originally reported, divided by 2

b. Following the stock dividend, the earnings per share of earlier periods should be retroactively restated to reflect the increased number of shares. In this situation, each “new” share (after the 100% stock dividend) is equal to only one-half of a 2002 or 2001 share. If the earnings of each 2002 or 2001 share are allocated between the two “new” shares, each new share is viewed as having earned one-half of the original amount ($3.15 2 = $1.575; $2.41 2 = $1.205).

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...................................................................... 1,200,000Dividends 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........................................................ 1,200,000Cash................................................................... 1,200,000

To record payment of the dividend declared on June 1.

Aug. 1 Retained Earnings........................................................ 1,900,000Stock Dividend to Be Distributed..................... 50,000Additional 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................................ 50,000Common Stock.................................................. 50,000

To record distribution of a stock dividend of 100,000 shares.

Dec. 15 Retained Earnings........................................................ 525,000Stock 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 shares1,000,000 + 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 effectDeclaration/payment of cash dividend—Decrease retained earningsDeclaration/distribution of small stock dividend—No effectDeclaration/distribution of large stock dividend—No effect

Ex. 12–8 The market value of the total Wansley’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

EventCurrent Assets

Stockholders’ Equity

NetIncome

Net Cash Flow(from AnySource)

ABCDE

DNENEDI

DNENEDI

NENENENENE

DNENEDI

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.

b. Realization of a gain from most sources, including discontinued operations, increases net earnings per share. (As this gain relates to discontinued operations, however, it would not increase the per-share earnings from continuing operations.)

c. A change in depreciation methods is defined as a change in accounting principle. A change from an accelerated depreciation method to the straight-line method normally would involve a reduction in the Accumulated Depreciation account, as stated in the exercise. The income statement, however, would contain a gain representing the cumulative effect of the change. (This gain is actually a recovery of—or reduction in—the cumulative depreciation expense recorded in past years.) Because the cumulative effect of the change is included in net income and is a credit, it would increase net earnings per share. (It would have no effect, however, upon per-share earnings before extraordinary items and the cumulative effect of an accounting change.)

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. 12–11 a. Balance sheet (also statement of stockholders’ equity).

b. Statement of retained earnings (or statement of stockholders’ equity).

c. This information is not included in any formal financial statement—it is quoted daily in publications such as The Wall Street Journal.

d. Statement of retained earnings (or statement of stockholders’ equity).

e. Income statement.

f. Statement of stockholders’ equity.

g. Income statement.

h. This information may be reported in the annual report, but it is not a required disclosure in any formal financial statement. It is also reported by investors’ services.

i. This information may be included in the annual report, but it is not a required disclosure in financial statements. It is reported by investors’ services and in the financial pages of most newspapers.

j. Statement of stockholders’ equity, and statement of cash flows.

Ex. 12–12 a. Revenues.......................................................................................................... $450,000Expenses........................................................................................................... 250,000Income before income tax................................................................................ $200,000Income tax*...................................................................................................... 70,000Net income....................................................................................................... $130,000

*$200,000 35%

b. Net income....................................................................................................... $130,000Other comprehensive income:

Change in value of available-for-sale investments*.................................... 1,105Comprehensive income.................................................................................... $131,105

*$19,200 $17,500 = $1,700 gain$1,700 ($1,700 35% income tax) = $1,105


c. Net income is unchanged.

Net income....................................................................................................... $130,000Other comprehensive income:

Change in value of available-for-sale investments*.................................... (2,145 )Comprehensive income.................................................................................... $127,855

*$17,500 $14,200 = $3,300 loss$3,300 ($3,300 35% income tax) = $2,145

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 1997, another 3% stock dividend in

1998 as well as a 2:1 stock split and a third 3% stock dividend in 1999. 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 1997, you would have 218 shares at the end of 1999, determined as follows:

1997: 100 x 103% = 1031998: 103 x 103% = 106

106 x 2 = 2121999: 212 x 103% = 218

c. (1) The amounts of paid-in capital for 1999 and 1998 are as follows:

(IN THOUSANDS) 1999 1998

Common stock $22,815 $22,527Class B common stock 10,908 10,710Capital in excess of par value 249,236 210,064

$282,959 $243,301


(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 also has a significant amount of retained earnings which also contributes to the total amount of stockholders’ equity.


SOLUTIONS TO PROBLEMS

30 Minutes, Easy PROBLEM 12–1ATLANTIC AIRLINES


30 Minutes, Medium PROBLEM 12–2ASHTON SOFTWARE, INC.


PROBLEM 12–2ASHTON SOFTWARE, INC. (concluded)

d. The single 2003 $8.00 figure for EPS is unfavorable in comparison with 2002 performance. Since 2003 has only one EPS figure, it should be compared to the earnings per share from continuing operations in 2002, which amounted to $12.25 per share. Ashton Software, Inc.’s earnings per share from continuing operations fell $4.25 per share (approximately 35%) from 2002 to 2003.


35 Minutes, Strong PROBLEM 12–3ASPEN, INC.


PROBLEM 12–3ASPEN, INC. (concluded)

c. The “gain on sale of treasury stock” represents the excess of reissue price received over the cost Aspen paid to acquire some of its own shares of stock. Although a corporation may reissue treasury stock at prices above or below its cost of acquiring its own stock, the difference between amounts received and the cost of treasury shares does not result in gains or losses recognized in the income statement. Rather, the amount described as “gain on sale of treasury stock” is included as part of additional paid-in capital in the stockholders’ equity section of the balance sheet.


20 Minutes, Easy PROBLEM 12–4FOREIGN ADVENTURES, INC.

Note to instructor: Net income actually increases book value throughout the year, not merely on the date upon which net income is closed into retained earnings.


20 Minutes, Medium PROBLEM 12–5MARBLE OASIS CORPORATION

MARBLE OASIS CORPORATIONStatement of Stockholders’ Equity


© The McGraw-Hill Companies, Inc., 2002

PROBLEM 12–5MARBLE OASIS CORPORATION (concluded)

b. Declaration/distribution of a 5% stock dividend has no effect on total stockholders’ equity. Declaration of a cash dividend reduces total stockholders’ equity by the amount of the dividend.

The two types of dividends do not have the same impact upon stockholders’ equity. A cash dividend is a distribution of a corporation’s assets (cash) to stockholders and, as such, causes a decrease in stockholders’ equity. A stock dividend is simply issuing more stock certificates to the existing group of shareholders with no accompanying increase or outflow of assets; a corporation’s own stock is not an asset of the corporation. With both small and large stock dividends, stockholders’ equity is adjusted to reflect the increased number of shares outstanding, but there is no additional equity created and no decrease in equity.


40 Minutes, Strong PROBLEM 12–6OVERNIGHT LETTER


PROBLEM 12–6OVERNIGHT LETTER (concluded)


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

a.

EventCurrent Assets

Stockholders’ Equity

NetIncome

Net Cash(from AnySource)

12345

NEDDI

NE

DNEDI

NE

NENENENENE

NEDDI

NE

I = IncreaseD = DecreaseNE = 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.


50 Minutes, Strong PROBLEM 12–8MANDELLA CORPORATION


25 Minutes, Strong PROBLEM 12–9FALCON MANUFACTURING CORP.


SOLUTIONS TO CASES

20 Minutes, Easy CASE 12–1UNUSUAL EVENTS IN PUBLISHED

FINANCIAL STATEMENTS

a. Both the operating loss from the noncoal minerals activities and the loss on disposal should be classified in ARCO’s income statement as discontinued operations and should be shown separately from the results of ARCO’s ongoing business operations. These losses qualify for this separate treatment because the discontinued activities represented an entire identifiable segment of ARCO’s business operations.

b. A change in the estimated useful life of depreciable assets is a change in estimate, not a change in accounting principle. Changes in estimate affect only the current year and future years; the cumulative effect of such changes upon prior years is not computed. On the other hand, had American Airlines changed the method used in computing depreciation expense, the cumulative effect of such a change in accounting principle would be shown in the income statement in the year of the change.

c. The explosion of a chemical plant appears to meet the criteria for classification as an extraordinary loss. These criteria are (1) material in amount, (2) unusual in nature, and (3) not expected to recur in the foreseeable future.

d. A change in the method used to depreciate assets is a change in accounting principle. Therefore, the cumulative effect of this change upon the net income of prior periods (a $175 million reduction) would appear as a separate item in AT&T’s income statement in the year of the change.

e. The criteria for classification as an extraordinary item are (1) unusual in nature and (2) not expected to recur in the foreseeable future. Condemnations of assets by governmental authorities generally are viewed as meeting these criteria. Therefore, the $10 million gain would be classified as an extraordinary item in Georgia Pacific’s income statement.


20 Minutes, Medium CASE 12–2LIFE WITHOUT BASEBALL

a. If MPI had not sold the baseball team at the end of 2002, it still would have incurred the team’s $1,300,000 operating loss for the year. However, the company would not have realized the $4,700,000 gain on the sale. Other items in the income statement would not have been affected. Thus, MPI’s income for 2002 would have been $4,700,000 less than was actually reported, or $2,600,000 ($7,300,000 $4,700,000 = $2,600,000).

b. In 2002, Midwestern’s newspaper business earned $4,500,000, as shown by the subtotal, Income from Continuing Operations. If the profitability of these operations increases by 7% in 2003, they will earn approximately $4,815,000 ($4,500,000 1.07 = $4,815,000). If the baseball team were still owned and lost $2,000,000 in 2003, MPI could be expected to earn a net income of about $2,815,000 in that year.

c. Given that the baseball team was sold in 2002, MPI should earn a net income of approximately $4,815,000 in 2003, assuming that the profitability of the continuing newspaper operations increases by 7% ($4,500,000 1.07 = $4,815,000).

d. The operating loss incurred by the baseball team in 2002 indicates that the team’s expenses (net of tax effects) exceeded its net revenue by $1,300,000. If the expenses were $32,200,000, the net revenue must have amounted to $1,300,000 less, or $30,900,000.


30 Minutes, Strong CASE 12–3PICK A NUMBER

a. The company reports earnings per share computed on both a basic and a diluted basis because it has outstanding convertible preferred stock. The conversion of these securities into common stock would increase the number of common shares outstanding and thereby dilute (reduce) earnings per share of common stock. The primary purpose of a company’s disclosing diluted earnings per share is to warn investors of the dilution in earnings that could occur if the convertible securities actually were converted.

It is important to recognize that diluted earnings represent a hypothetical case. The convertible securities have not actually been converted into common shares as of the close of the current year.

b. The total dollar amount of the company’s extraordinary loss can be computed from the earnings per share information as follows:

Extraordinary loss per share ($6.90 $3.60)................................................................... $3.30Total extraordinary loss ($3.30 per share 3 million shares)........................................ $9,900,000

c. The approximate market price of the company’s common stock is $69 per share. When a company’s income statement includes an extraordinary item, the price-earnings ratio shown in newspapers is based upon basic earnings before extraordinary items ($6.90 10 = $69).

d. (1) $9.02 ($8.20 110%)Only the continuing operations will be earning revenue and incurring expenses next year, and the extraordinary item is not expected to recur. Therefore, the starting point for projecting future net earnings should be earnings from continuing operations. Since both revenue and expenses are expected to increase by 10%, earnings per share also should increase 10%.

(2) $7.48 ($6.80 110%)The diluted earnings per share figures show the effect that conversion of all of the convertible preferred stock into common shares would have had upon this year’s earnings. Earnings per share from continuing operations would have been only $6.80, rather than $8.20. Thus, $6.80 per share becomes the logical starting point for forecasting next year’s net earnings. As in part (1), next year’s earnings are expected to rise by 10% over those of the current year.


35 Minutes, Strong CASE 12–4. . . BUT WHAT DOES IT ALL MEAN?

a. Beginning of year: 79,395,732 shares outstanding (83,989,396 issued 4,593,664 held in treasury)End of year: 78,767,415 shares outstanding (83,989,396 issued 5,221,981 treasury shares)

b. $95,200,000 total dividend declared on common stock79,333,333 approximate number of shares entitled to $1.20 per share dividend ($95,200,000 $1.20 per share)

This answer appears reasonable, since the number of common shares outstanding ranged from 79,395,732 at the beginning of the year to 78,767,415 at year-end. We cannot determine precisely the number of shares receiving each quarterly dividend of 30 cents per share, but the 79,333,333 approximate figure for the overall $1.20 annual dividend appears compatible with the beginning and ending actual figures because it falls between these numbers.

c. The stock issued during the year for the stock option plans consisted of treasury shares, not newly issued shares. The Treasury Stock account is used to account for repurchases of a corporation’s stock, as well as the reissuance of treasury shares. When stock is repurchased and subsequently reissued, the Common Stock account is not affected; these transactions do, however, affect the Treasury Stock account, a contra-stockholders’ equity account.

d. $28.93 average cost per share of treasury stock at the beginning of the year($132,900,000 total cost 4,593,664 treasury shares)

e. The aggregate reissue price for the treasury shares must have been lower than the cost to acquire those treasury shares, because the Additional Paid-in Capital account was reduced by the reissuance of the treasury stock. The cost of the treasury shares reissued was $16,700,000; the reissue price for the treasury shares must have been $15,300,000 to cause a $1,400,000 reduction in Additional Paid-in Capital.

f. $55.79 average cost per share for treasury stock acquired during the current year($68,600,000 aggregate cost 1,229,700 shares repurchased)

g. Earnings per share: Divide by the weighted-average number of shares outstanding throughout the yearBook value per share: Divide by the actual number of shares outstanding as of the specific date (usually a balance sheet date)


60 Minutes, Strong CASE 12–5EXTRAORDINARY?

a. An asset represents something with future economic benefit. But if the amount at which the asset is presented in the balance sheet (i.e., its book value) cannot be recovered through future use or sale, any future economic benefit appears to be less than the asset’s current book value. In such cases, the asset should be written down to the recoverable amount.

b. Although materiality in terms of size is important, size alone does not qualify a loss as an extraordinary item. Nor does the fact that the item is not routine.

To qualify as extraordinary, an event should be unusual in nature, and not be expected to recur in the foreseeable future. Given that Elliot-Cole has operations in more than 90 countries, losses of this nature could recur. The fact that in a single year, such losses were incurred in several different countries suggests that this may be more than a one-time event. Thus, in light of Elliot-Cole’s business environment, it appears that we would not classify these losses as extraordinary.

Note to instructor: We do not consider this answer cut and dried. If these assets had been expropriated, the losses would be classified as extraordinary. These assets have not been expropriated—nor is there any indication that they will be. Nonetheless, there are some parallels between this situation and an expropriation of assets by a foreign government. These similarities may be set forth as an argument for classifying the losses as extraordinary.

c. 1. Net income will be reduced by the same amount regardless of whether these losses are classified as ordinary or extraordinary. In either case, they are deducted in the computation of net income.

2. Income before extraordinary items will be reduced only if the losses are classified as ordinary. If they are classified as extraordinary, they will be deducted after the computation of the subtotal, Income before Extraordinary Items.

3. Extraordinary items are deducted after the determination of Income from Continuing Operations. Therefore, this subtotal will be reduced only if the losses are classified as ordinary.

4. Given that these losses do not affect income taxes, they have no cash effects. Therefore, net cash flow from operating activities will be unaffected.

d. The p/e ratio is based upon income before extraordinary items (stated on a per-share basis). As stated in c (2), above, income before extraordinary items will be unaffected if the losses are classified as extraordinary. Therefore, the p/e ratio will be unaffected. But if the losses are classified as ordinary, income before extraordinary items will be reduced, and the p/e ratio, therefore, will be higher.

e. Yes. Members of management have a self-interest in seeing stock prices increase, which would favorably affect the value of their stock options as well as stock they already own. In addition, a rising stock price makes it easier for the company to raise capital, benefits stockholders, and makes management look good.


CASE 12–5EXTRAORDINARY? (concluded)

The classification of these losses may well affect Elliot-Cole’s stock price. Investors consider income from continuing operations a predictive subtotal. If the losses are classified as ordinary, this key subtotal will decline, probably below last year’s level. (The losses amount to 18% of pre-loss earnings, which exceeds the company’s normal earnings growth of 15%. Thus, these losses may be sufficient to cause a decline in earnings relative to the preceding year.) This could have an adverse effect on stock price.

On the other hand, if the losses are considered extraordinary, this subtotal will be unaffected and, presumably, continue to reflect the company’s 15% annual growth rate.

Similarly, classifying the losses as ordinary will reduce income before extraordinary items, which is the income figure used in computing p/e ratios. Thus, the p/e ratio reported in the financial press will rise significantly above its normal level. This, too, may have a depressing effect upon stock price. But if the losses are classified as extraordinary, the per-share earnings used in the computation of the company’s p/e ratio will not be affected.

In summary, the adverse effects of these losses on the company’s stock price are likely to be greater if the losses are classified as ordinary, rather than extraordinary. Therefore, management has a self-interest in seeing these losses classified as an extraordinary item.

f. These write-offs are likely to increase the earnings reported in future periods, especially if the company continues to do business in any of the related countries. With the assets having no book value, future earnings from these operations will not be reduced by charges for depreciation (or, in some cases, for a cost of goods sold).

g. The ethical dilemma is the classification of these losses. Because of the probable effects upon stock price, classifying them as extraordinary may be to management’s advantage. The case is arguable—though we think it’s a bit of a reach. Bear in mind that a higher stock price also benefits the company’s current stockholders. So who, if anybody, stands to lose?

In management’s shoes, how would you classify these losses? (We find this question easier to ask than to answer.)

Note to instructor: This case is adapted from an incident involving an international pharmaceutical company. The details of the situation have been altered for the purpose of creating an introductory level textbook assignment, and the so-called quotations from corporate officers are entirely fictitious. Nonetheless, we believe that the outcome of the actual event provides insight into the financial reporting process and also to the importance that investors attach to the various computations of earnings per share.

Management originally classified the losses as extraordinary, and the auditors concurred. The SEC, however, did not agree. It insisted that the corporation revise and reissue its financial statement—with the controversial items classified as ordinary operating losses. When the company announced the reclassification of these losses, its stock price fell substantially—despite the fact that the reported amount of net income remained unchanged.

Who were the losers? Anyone who bought the stock between the release of the original earnings figures and the announcement that substantial losses would be reclassified.30 Minutes, Medium CASE 12–6


BUSINESS WEEK ASSIGNMENT

Responses are likely to vary among students, but following are some of the things that should be included in a well-thought-out answer:

I would read the audit report to determine that the company has received an unqualified opinion. (This assumes one is looking at an annual, rather than a quarterly, report.)

I would look to see if there are non-recurring items in the income statement—extraordinary items, disposals of segments, accounting changes, etc. In addition, I would look at line-item disclosures of items such as investment gains and losses that, while technically not extraordinary items, may signal nonoperating items that are not as likely to occur as normal operations and may indicate management’s attempts to “window dress” its income statement.

I would look at earnings per share—both basic and diluted—in an attempt to get a sense of the potential impact conversions of securities into common stock may have on future earnings per share.

I would look at the trend in earnings and earnings per share over the multiple time periods for which information is provided, to identify the direction these items are going over time.

I would read carefully management’s analysis and interpretation for bits of information that may be useful in identifying steps that may have taken by management to make the company look better in these difficult times.


SOLUTION TO INTERNET ASSIGNMENT

30 Minutes, Easy INTERNET 12–1PRICE-EARNINGS RATIOS

Note: We cannot supply quantitative answers to this assignment as they will vary depending upon which companies the student selects. In general, it would be expected that the NASDAQ company will have a higher price-earnings ratio than the Fortune 500 company.
