Income and Changes in Retained Earnings
About Managerial Accounting
Managerial Accounting is very different from Financial Accounting. There you learned about the overall framework of accounting, and how to prepare financial statements for investors and other people outside the company. Managerial Accounting will focus on preparing financial information for Managers who are inside the company. Their needs are different than the general public's, and Managers are entitled to access information that is confidential.
In this course, and in the legal and business world in general, Managers (or Management) are viewed as a special group of people. We will view them both as a "whole" and as individuals. They are employees of the company, and they are the ones in charge of running a company and making daily, mission-critical decisions that effect the very life of the company.
Because of their position in a company, Management can either act to benefit the company and it's owners or they can undermine the company. We expect the former, and cringe at the latter. The financial collapse of Enron is a recent example of a group of Managers who put their own personal gain above their obligation to the stockholders and public alike. It was the 7th largest company in the US at the time. Thousands of employees people lost their entire retirement fund, and thousands of other investors lost their entire investment.
This lesson expands on the Income Statement, and adds some new information to include three special situations that are presented separately in the Income Statement. It also introduces Earnings Per Share, which is a required disclosure under GAAP.
You learned about the Income Statement in a previous lesson. What you learned was sufficient at that level of learning. But it does not entirely comply with GAAP. This chapter will show you how to prepare an Income Statement that is fully in compliance with GAAP. This is very important for managers; a company's financial statements are Management's responsibility!
In this lesson we will assume that all companies we study are publicly traded (sell their stock on a public stock exchange) and must file their annual audited financial statements with the SEC. The SEC requires companies to comply with GAAP. These companies are all corporations, so the owners' equity section will actually be referred to as Stockholders' Equity, in the financial statements. From now on owners' equity and stockholders' equity will be used to mean the same thing.
The Retained Earnings (RE) account has a special purpose. It is used to accumulate the company's earnings, and to pay out dividends to the company's stockholders. Let's look at the first part of that for a moment.
At the end of the fiscal year, all Revenue and Expense accounts are closed to Income Summary, and that account is closed to Retained Earnings. Profits increase RE; losses will decrease RE. So the RE account might go up or down from year to year, depending on whether the company had a profit or loss that year.
The changes in the RE account are called "Changes in Retained Earnings" and are presented in the financial statements. This information can be included in the Income Statement, in the Balance Sheet, or in a separate statement called the Statement of Changes in Retained Earnings. Each company can decide how to present the information, but it must be presented in one of those three places.
Most financial statements today include a Statement of Retained Earnings. Some companies prepare a Statement of Stockholders' Equity to give a more comprehensive picture of their financial events. This statement includes information about how many shares of stock were outstanding over the year, and provides other valuable information for large companies with a complex capital structure. The changes in RE are included in the Stockholders' Equity statement.
Dividends are payments companies make to their stockholders. These must be made from earnings. Since we record accumulated earnings in the RE account, all dividends must come out of that account. There are several types of dividends, but they all must come from Retained Earnings. In order to pay dividends, the RE account MUST have a positive, or Credit, balance.
If the RE account has a Debit balance, we would call that a Deficit, and the company would not be able to pay dividends to its stockholders. Deficits arise from successive years of posting losses in excess of profits.
Let's assume a company makes $10,000 profit each year for each of 5 years in a row. Their RE account would have a Credit balance of $50,000. If in the 6th year the company lost $60,000, the RE account would have a negative, or Debit, balance of $10,000, and no dividends could be paid to the stockholders, despite the profits in prior years.
What could have been done to salvage the situation? Dividends could have been paid each year, in the prior 5 years, when RE had a positive (Credit) balance, right?
Maybe yes, maybe no. Having a positive balance in RE is not the only consideration in paying dividends. Cash Dividends also require the company to have sufficient Cash to pay the dividend. They might need their cash for other things, such as the purchase of new equipment, inventory expansion, etc. Rapidly growing companies often have cash needs well beyond what they are able to generate on their own. Every dollar is important, and dividends get deferred to the future.
Why do people invest in the stock market?
All investors hope to get a return on their money, that is greater than the amount they put down initially to buy the stock. A return can come in one of two ways:
- dividends received from company earnings, or
- capital gains from selling the stock at a higher price than what was paid.
Blue Chip company's generally pay regular dividends. But their stock prices are high, and the prices tend to move slowly. If you buy a blue chip stock hoping for capital gains, you might have to wait many years for the price to increase to the desired level.
On the other hand, new, fast growing companies may never pay a dividend, but their stock price can be increasing steadily because the company is growing. In these companies, because of their growth, a share of stock can quickly increase in value. We saw that in the late 1990s with tech stocks. Unfortunately, the tech sector suffered a serious setback by the start of the 21st century.
The moral of this story is...investing in growth stocks is risky business. BUT people do it because the gains can be very impressive. Capital gains can easily be many times what would have been earned in dividends. This provides a tremendous incentive for investors to put their money on risky investments. Each investor has to decide how much or how little risk they are willing to accept in their portfolio.
Gambling casinos are also risky. But that risk is a calculated risk. For any game, we can statistically calculate your chances of winning or losing a particular turn of play. That is never the case in the stock market. You must always be prepared to lose your entire investment in the stock market. The odds are always against you.
Why do companies care about their stock market price?
A company sells its stock to the public ONCE and only once, in what is commonly known as an IPO (Initial Public Offering). After that, all trading in the stock is done between individual stockholders, and the company is essentially out of the picture.
So once a company has money in it's hand for the stock, why should it care about the stock market price?
Managers are very sensitive to stock market prices, and the information in their financial statements directly influences stock prices.
Many managers are also stockholders in their company, so they have a personal interest in the stock price. They want their own portfolio to be strong, and the company's stock price will have an impact on them personally.
Other companies have to decide whether to do business with yours, and that's also very important. Right now how many other companies are anxious to do business with Enron, Global Crossing or K-Mart? Not very many, and the number is dwindling.
These companies have all recently filed for bankruptcy, and their stock prices are extremely low. Investors have little trust in the management of these companies and they are voting with their investment dollars. Other companies who sell merchandise to them are cautious, because they're not sure if these companies will be around long enough to pay their bills.
So, stock price sends a message to everyone - investors, suppliers, creditors and bankers, employees - everyone. And the message is "this company is in financial trouble, and the management of this company is not doing a good job."
This is a lesson in Managerial Accounting, and in this lesson and the lesson on financial analysis we will study the Income Statement, learn to analyze information in the financial statements, and gain a better perspective on financial reporting, that can benefit you as both an investor and a manager. It is important to understand why we study this material, it's importance in the investing community, and that this information is the responsibility of a company's management!
The Income Statement - Reporting Continuing Operations
Continuing Operations - are the "regular" business activities a company is engaged in. It is called "continuing" or "ongoing" operations, because this is the part of the business that will continue into the future.
Investors evaluate Income from Continuing Operations separately from other, irregular items. It is so important that it is listed as a separate item on the Income Statement. This is a required disclosure under GAAP.
Stock market prices are greatly influenced by income from continuing operations. It is part of the calculation referred to as the Price Earnings Ratio, or PE Ratio. It is so important to investors, you will find the PE in the Wall Street Journal, listed next to the stock price for each company. PE ratio is SP/EPS which means:
Current Common Stock Price Per Share
Most Current Earnings Per Share
In this lesson, you will learn more about both of these items. You will be preparing an Income Statement and calculating Earnings Per Share. EPS is just as it sounds:
EPS = Current Earnings / Number of Shares of Common Stock
We will cover EPS in more detail a little later. The PE ratio is actually a multiple of a company's earnings. In essence, investors are trading stock at a multiple of the expected future earnings of the company. So if a company has a PE of 5, the stock price is 5 times the most recent earnings per share (i.e., the most recent audited financial statements released to the public). A PE of 20 would indicate 20 times EPS. Investors are buying a piece of a company's expected future earnings when they trade based on PE ratio.
Income Statement - Reporting Irregular Items
Irregular items are those that are not expected to influence, or be part of, future continuing operations. We report 3 items separately in the Income Statement. These items appear below Operations from Continuing Operations. We also calculate EPS for each of these items.
These three items are always presented in the following order.
- Gain or loss from discontinued operations.
- Gain or loss from extraordinary items.
- Cumulative effect of a change in an accounting principle.
Multiple irregular items should be listed separately. They may be subtotaled as a group. You could have two or three extraordinary items, each listed separately, but the group netted as a single dollar amount.
Irregular items are reported separately for several reasons:
First, they are not expected to affect future earnings. Investors prefer to evaluate expected future earnings separately, as was discussed above.
Second, they represent major events or decisions by management, and deserve special attention. Investors like to evaluate these decisions separately as well.
Third, this information is considered necessary for the adequate disclosure of important information in the financial statements.
Net of income taxes....
All items in this group are presented net of income taxes, whether they produce a gain or loss. If the item is a gain, the tax expense is deducted from the gain. If the item is a loss, the tax effect will decrease the loss. So, in either case, the tax effect will decrease the item. Gains will be smaller gains, and losses will be smaller losses.
In problems and homework assignments the tax effect will be expressed as either a dollar amount for each item, or as a percentage that can be applied to each item. Either way, you will reduce each item by the amount if its tax effect, and list the dollar amount of the tax effect in parentheses. This is called parenthetical disclosure - which means it is enclosed in parentheses. Example:
|Gain on condemnation of land (net of $31,500 income tax)||$73,500|
We don't need to show the total gain, because the reader only has to add the two numbers to get the total: $73,500 + $31,500 = $105,000.
A discontinued operation is one that will not continue into the future. The company may just disband part of the business entirely and scrap or sell off the facilities and related equipment and assets. Or it might try to sell that part of the business to another company. Sometimes they might "spin off" part of the business to create a separate segment, which is later sold.
Sometimes one business buys another business, and gets rid of those parts of the new acquisition that don't fit it's overall strategy or profile. For instance, a food producer might buy another company that owns food production facilities and a hotel chain. They might choose to sell off the hotel chain, because it is not within their normal line of business. Since they have expertise in food production, but not in hotel management, this might be a wise decision.
Discontinued operations are reported in two parts:
- Gain or loss from wrapping up business operations, and
- Gain or loss from selling off assets.
These are listed separately because they represent two different types of income. The first type of income arises from the continuing the business and earnings process until the assets can be sold off. The second is Capital Gain or Loss which arise from selling business assets.
In many cases a company will continue running the discontinued segment until a new owner can take over. A running business has more value than one that has been shut down, and must be started up again. Keeping a stream of customers coming in the doors, and making a little more money from the operations, will certainly help minimize any loss that might result from the decision, and will increase value to both the stockholders and potential buyers.
Some events don't happen very often, and are considered so uncommon that they fall in a special category called Extraordinary Items. This list includes earthquakes, tornadoes, acts of war, and the moon crashing into the earth. (OK, the last one's not on the list, But you get the idea!)
Extraordinary items must meet two criteria:
- It must be unusual in nature, and
- not expected to recur in the foreseeable future.
An item which does not meet both these criteria is considered Unusual, and is listed as part of Continuing Operations. It must meet both to be Extraordinary.
Changes in Law: Changes in law meet both requirements. If a company suffers a loss due to a change in law, that would be extraordinary.
Example: assume Congress outlaws the sale of cigarettes and tobacco products. All companies manufacturing or carrying these products would have an extraordinary loss on the disposal of inventory.
Condemnations: a city, county or state government may condemn property, perhaps for a new roadway, or other public use. Losses resulting for condemnations are extraordinary. However, these losses are usually mitigated because the government will pay for the property. As a result either an extraordinary loss or gain may result from a condemnation (see discussion below).
Acts of War, Civil War, etc.: Acts of war, civil war, and similar events often mean that companies lose property and investments in the countries affected. Local currencies and property values may be devalued or changed as well.
Deciding if an event is Extraordinary is a matter of professional judgement. We do try to keep the list small, and look at each event individually to see if it clearly meets the conditions and criteria for an extraordinary event. Geography may also play a role in making this determination.
Some events are specifically NOT considered extraordinary:
Fires are never considered extraordinary. Fires are a common occurrence, and businesses are expected to carry insurance to protect them against fire loss.
Floods that occur in a flood plain are not considered extraordinary. Floods are expected in a flood plain, and should be insured against. (However, if you had a flood on top of a mountain, that WOULD BE extraordinary!)
Strikes are considered a normal business risk. They're also part of having employees, which relates to continuing operations, and are therefore not extraordinary.
Hurricanes in Florida are not considered extraordinary, because they are bound to happen in the foreseeable future. However, a hurricane in Missouri would be an extraordinary event, and a good reason to move to higher ground.
Volcanos in Hawaii erupt on a frequent basis, and are not extraordinary events. People building homes near an active volcano are taking a calculated risk.
That sounds like an oxymoron, like "definite maybe" or "legally drunk." From our discussion above you might get the idea that extraordinary items are generally losses. And you would generally be right. But sometimes, in rare circumstances, a company may get an insurance or government settlement that exceeds their actual loss. In these cases, they would have an extraordinary gain.
Indemnification Against Loss
The discussion above covers losses from several circumstances. In general accountants (especially outside auditors) expect companies to recognize potential losses, and indemnify themselves against loss by taking out insurance policies.
Changes in Accounting Principle
There are a few accounting principles that deal with the value of certain items, such as inventory or long-term contracts. On rare occasion a company will change the way it records these items, and start using a different accounting principle. For instance, it might change from using FIFO to LIFO for inventory valuation.
The old method was used in previous years, and there may be some lingering effect left on the books. In order to change to a new method of accounting you must recalculate the impact on prior years, as if the new method had been used in the past. The net cumulative effect of the change from old to new method is shown in the Income Statement. It is the last item listed before Net Income.
Changes in accounting principle don't happen very often. It is more likely that a company will change from a method that is not approved by GAAP, to a method that is approved by GAAP. In these cases, no adjust needs to be made. One would only report a change from one approved application of GAAP to another.
The next lesson provides detailed examples of income statements.