Horngren's Accounting: Volume Two, Eleventh Canadian Edition

Horngren’s Accounting
Volume Two, Eleventh Canadian Edition
Chapter 14
Corporations: Retained
Earnings and the Income
Statement
Copyright © 2020 Pearson Canada Inc. 14 - 1

Recall from Chapter 13 ….
Owners’ equity of a corporation is called
shareholders’ equity.
Shareholders’ Equity is divided into two
components:
• Contributed Capital
• Retained Earnings

Expanding on Chapter 13 ….
• Owners’ equity of a corporation is called
shareholders’ equity
• In chapter 14, we take corporate equity a few
steps further:

Retained Earnings (1 of 2)
• Retained Earnings carries the balance of the
business’s accumulated lifetime net income (less
all net losses from operations) less all dividends
– Retained means “held onto” or “kept”
• A debit balance in Retained Earnings is called a
deficit

Retained Earnings (2 of 2)
• Important facts about Retained Earnings include:
– Credits to Retained Earnings arise only from net
income (*)
– Retained Earnings is not equivalent to cash
– Ending Retained Earnings balance = Beginning
balance + Net income ( – Net loss) – Dividends for the
year
(*) Exceptions to this are covered later in the chapter

Retained Earnings and Cash Dividends
• To declare dividends, there must be a credit
balance in retained earnings before and after
declaring dividends
• To pay the dividend, the corporation must have
the cash

Calculation of Retained Earnings
- Example -

Learning Objective 1
Account for stock dividends and stock splits
• How do we account for stock dividends and stock
splits?

Stock (Share) Dividends
• Stock dividends (or share dividend) is a
distribution of a corporation’s own shares to its
shareholders.
Stock dividends:
• Stock dividend increases Common Shares and
decreases Retained Earnings.
• Affects only the accounts within shareholders’
equity, so total shareholders’ equity is unchanged.

Stock Dividends, an example (1 of 2)
• Assume Sugar Bay Parts Inc. declares a 10
percent stock dividend on the 75,000 outstanding
shares.
• Assuming the market value is $1.50 per share, the
stock dividend is valued at $11,250 ($1.50 * 7,500
shares)
• The affect on shareholders’ equity is:


Reasons for Stock Dividends
• To continue dividends but conserve cash
• To reduce the market price per share of its stock
– Stock dividends increase the number of shares
outstanding and are likely to reduce the price per share
making the shares more affordable and attractive to
investors.

Recording Stock Dividends
• As with cash dividends, there are three key dates
for stock dividends:
1. Declaration date – date announced by Board of
Directors
2. Date of record
3. Distribution date – payment date
• Valuation of the stock dividend is usually based on
the market value (trading price) on the declaration
date as suggested by the Canada Business
Corporations Act.
Stock Dividends
• Common Stock Dividend Distributable is a
shareholders’ equity account (it is not a liability
account).
• If the company prepares financial statements after
the declaration of the stock dividend but before
issuing it, the Common Stock Dividend
Distributable is reported in the shareholders’
equity section of the balance sheet.

• Assume Tweeter Corpoartion declares a 10%
common stock dividend on November 17 when
the market value of shares was $16.00. The
company will distribute 4,000 shares (40,000
shares outstanding * 10%) on December 12.
• The following entry is made on the declaration
date:

Stock Dividends, an example
• Date of record: no journal entry. A list of
shareholders is created at this time and they are
the ones who will receive the dividend.
• Distribution date: the company records issuance
of the dividend shares:

Stock Dividends: Comparison of
Shareholders’ Equity
• Note: there is no affect on assets, liabilities, or total

shareholder’s equity. It rearranges the information within
the shareholder’s equity accounts.
Stock Splits
• Stock split defined: increases the number of authorized
and outstanding shares with a proportionate reduction in
the book value per share
• Stock splits usually result in the reduction in the market
price per share
• Stock splits will leave all account balances and total
shareholders’ equity unchanged
• Because the stock split affects no account balances, no
formal journal entry is required
• The split is recorded in a memorandum entry
Stock Split, An Example
• Assume the market price of one common share of
Marcato Corp. is $100, with 400,000 shares
issued
• The company wants to decrease the market price
to $50 per share, and decides to split the common
shares 2-for-1
• This increases the number of issued shares to
800,000

Stock Split, An Example (1 of 2)
• After the split, there are 800,000 common shares
issued that now have a market price of $50

Stock Splits (2 of 2)
• A consolidation, or reverse split, will decrease
the number of authorized and outstanding shares
with a proportionate increase in the book value
per share.
• The reverse split usually results in an increase in
the market price per share.

Similarities between Stock Dividends
and Stock Splits
• Both increase the number of shares owned per
shareholder
• Neither changes the investor’s total cost of the
shares owned
• Both increase the number of shares issued by the
Corporation
• Both cause an increase in the number of shares,
which will likely cause a decrease in the per share
value
Differences between Stock Dividends
and Stock Splits (1 of 2)
• Taxation:
– Stock splits do not create taxable income to the
investor
– Stock dividends are taxed at the market value of the
shares on the date the dividend is declared
• Shareholders’ Equity:
– Stock dividends shift an amount from retained earnings
to contributed capital
 total book value remains unchanged
 book value per share will decrease

Differences between Stock Dividends
and Stock Splits (2 of 2)
• Stock splits do not affect account balances
– book value of each share will change

Account for repurchased shares
• Why are shares repurchased, and how do we
account for them?

Repurchase of Its Shares by a
Corporation
• Several reasons for a repurchase:
– May have issued all its authorized shares and need to
recover shares for distributions to officers and
employees under bonus plans or share purchase plans
– To help support the share’s current market price by
decreasing the supply of shares available to the public
– To avoid a takeover by an outside party
– To meet share-ownership requirements or limits

Repurchased Shares (1 of 2)
• CBCA requires that all repurchased shares be
cancelled
– The shares become authorized, but unissued
• Generally a repurchase is only allowed if a
corporation has sufficient cash
• Repurchased shares decrease both the
corporation’s assets and its shareholders’ equity
• Some provinces require repurchased shares to be
cancelled, while others allow them to be held as
Treasury Shares, available for resale later
Repurchased Shares, Example (2 of 2)
Dawson Resources Ltd. had the following
shareholders’ equity at February 28, 2020:
The average issue price = $180,000 / 1,000

shares = $20.00 per share
Repurchased Shares, Example (Purchase
Price = Average Issue Price) (1 of 8)
• On March 20, Dawson repurchases 1,000 shares
at $20 per share; the entry is:

Price = Average Issue Price) (2 of 8)
Before repurchase:
After repurchase:

Price < Average Issue Price) (3 of 8)
• Average issue price per share is $20
• On April 30, Dawson repurchases 1,000 shares at
$15 per share, below average issue price
• The entry is:

• Contributed Surplus is reported as part of
contributed capital (in shareholders’ equity) along
with share capital

Before repurchase:
After repurchase:

Price > Average Issue Price) (6 of 8)
• Average issue price per share is $20
• On May 10, Dawson repurchases 1,000 shares at
$15 per share, above average issue price
• The entry is:

When shares are repurchased at a price above the
average issue price, any existing contributed
surplus related to a previous repurchase of this
class of shares must first be reduced, followed by a
reduction to retained earnings if, and when, the
contributed surplus reaches nil.

Before repurchase:
After repurchase:

Summary of Journal Entries for Share
Repurchases (1 of 2)

Summary of Journal Entries for Share
Repurchases (2 of 2)

Repurchased Shares
• A later sale of repurchased shares is no different
than an original sale of authorized shares
• The repurchase and/ or sale of shares does NOT
affect Net Income
• Full disclosure throughout the process is important
to avoid any ethical concerns
• “Insider trading” is not allowed!

Prepare a detailed corporate income statement
• How do we prepare a corporate income
statement?

The Corporate Income Statement –
Analyzing Earnings
Net Income:
• Is probably the most important piece of
information about the company
• Measures success of operations
• Builds up assets and shareholder equity
• Attracts capital from new investors

The Corporate Income Statement
– Example (1 of 2)

The Corporate Income Statement
– Example (2 of 2)

Continuing Operations
• Income from continuing operations helps users
make predictions about the business’s future
earnings
• Includes:
– Results from the normal operating activities – for
example, a $20,000 loss on restructuring operations
– Other gains and losses – for example, a $42,000 gain
on the sale of machinery (machinery is used in day to
day operations);
– Income tax – for example, a $63,000 tax expense.

Discontinued Operations
• This section of the income statement is divided

into two components:
– Operating income (or loss) from the segment that is
disposed of or discontinued
– Gain (or loss) on the disposal of assets in the segment
• They are shown net of the related tax effect
Earnings Per Share (EPS)
• EPS is the amount of a company’s net income per
outstanding common share
• Note: calculation of the weighted average number

of common shares outstanding is included in
following slides.
Earnings Per Share Weighted Average
Example (1 of 2)
• Assume IMC Communications Corporation had
the following common shares outstanding on the
respective dates:
– January to May: 240,000 shares
– June to August: 200,000 shares
– September to December: 210,000 shares

Earnings Per Share Weighted Average
Example (2 of 2)
• The weighted average number of common shares (C/S)
is:
• EPS = Net income ÷ 220,000 shares

Earnings Per Share Stock Dividend
Example (1 of 2)
• Using the same information from IMC
Communications, assume a 10 percent stock
dividend was effective September 1
• The weighted average number of common shares
outstanding during the year is:

Earnings Per Share Stock Dividend
Example (2 of 2)

Earnings Per Share Stock Split Example
(1 of 2)
• Using the same information from IMC

Communications, assume a 2-for-1 stock split
effective September 1 (instead of the stock
dividend)
• The weighted average number of common shares
outstanding during the year is:

Earnings Per Share Stock Split Example
(2 of 2)

Earnings Per Share (1 of 3)
• Preferred dividends must be deducted from net
income in the computation of EPS
– Where cumulative, the annual dividend is deducted
even if not declared

• EPS is presented as both basic and diluted
– Basic: EPS based on outstanding common shares
– Diluted: EPS based on outstanding common shares
plus the number of additional common shares that
would arise from conversion of the preferred shares or
bonds
– Fully diluted EPS is always lower than basic EPS
– Dilution will be covered in intermediate accounting

• Price-earnings ratio is the market value of the
shares divided by EPS; it is a very powerful and
widely used ratio

Prepare a statement of retained earnings and a
statement of shareholders’ equity
• How do we prepare a statement of retained
earnings and a statement of shareholders’ equity?

Statement of Retained Earnings
• Retained earnings may be a significant portion of
a corporation’s shareholders’ equity
• Some corporations prepare a statement of
retained earnings; others report income and
retained earnings on a single combined statement

Statement of Retained Earnings
- Example -
• Some corporations prepare a statement of
retained earnings; others report income and
retained earnings on a single combined statement

Statement of Shareholders’ Equity
• Presents a chart detailing the change in all
components of shareholders’ equity

Restrictions on Retained Earnings
• Restrictions may be applied
– Legally, through incorporating acts, or
– Voluntarily, to put funds aside for a specific purpose.
 Voluntary restrictions are called appropriations.
 Although rare, appropriations are handled through a journal
entry, and separately reported in the statement of retained
earnings

Account for errors and changes in accounting
policy and circumstances
• How do we record or report errors or changes?

Accounting for Errors and Changes in
Accounting Policy
• Retained Earnings is retrospectively adjusted
for:
– Errors from a previous period that have not been
corrected during that period
– Change in accounting policy
• Changes in estimates are NOT reflected
retrospectively in retained earnings
– Prospective treatment is done to make accounting
information more useful

Accounting for Errors - Example
• Assume Paquette Corporation recorded the
closing inventory balance for 2019 as $30,000; the
correct amount was $40,000. The error resulted in
overstating 2019 expenses and understating net
income by $10,000
• The entry to record this error correction in 2020 is:

Accounting for Errors Statement of
Retained Earnings

Identify the impact of IFRS on the income
statement and the statement of shareholders’
equity
• What is the impact of IFRS on the income
statement and the statement of shareholders’
equity?

The Impact of IFRS on the Income Statement
and the Statement of Shareholders’ Equity (1 of 2)




Example of Consolidated Statement of
Earnings and Comprehensive Income (1 of 3)



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Horngren’s Accounting

Volume Two, Eleventh Canadian Edition

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• Note: there is no affect on assets, liabilities, or total

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The average issue price = $180,000 / 1,000

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• This section of the income statement is divided

• Note: calculation of the weighted average number

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• EPS = Net income ÷ 220,000 shares

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• Using the same information from IMC

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