Case 6-5 Earnings per Share Progresso Corporation, one of your new audit clients, has not reported EPS data in its annual reports to stockholders in the past. The president requested that you furnish information about the reporting of EPS data in the current year’s annual report in accordance with GAAP. a. Define the term earnings per share as it applies to a corporation with a capitalization structure composed of only one class of common stock. Then explain how EPS should be computed and how the information should be disclosed in the corporation’s financial statements. ● Earnings per share as it applies to a corporation that has a capitalization structure is made up of a single class of common stock, is the amount of earnings that are applicable to each share of the common stock outstanding during the period earnings are reported. EPS is computed based on a weighted average of the number of shares outstanding in the period. If stocks split they are recognized retrospectively, except for the small nonrecurring stock dividends which can be ignored. b. Explain the meanings of the terms senior securities and residual securities (terms often used in discussing EPS), and give examples of the types of items that each term includes. ● Senior securities are securities that rank above other securities in a company’s hierarchy of capital providers. Preferred securities are considered senior to common shares because of its greater degree of safety. A senior security will most of the time offer lower returns than the securities below it in the hierarchy. Common stock offers the investors with the highest potential returns because of its bigger risk. Common stock is normally the least senior of the securities. ● Residual securities are securities that can be changed into another form such as a convertible bond that can be converted into common stock. Corporations often offer residual securities to attract investment capital when there is a lot of tough competition in the market. Residual securities are converted and that increases the number of current outstanding common stocks. c. Discuss the treatment, if any, that should be given to each of the following items in computing EPS for financial statement reporting: i. The declaration of current dividends on cumulative preferred stock ● Dividends on preferred stock should be deducted from net income before computing earnings per share applied to common stock and other residual securities. ii. The acquisition of some of the corporation’s outstanding common stock during the current fiscal year (the stock was classified as treasury stock) ● The acquisition of the company’s stock will increase the EPS, but it will decrease the outstanding common stock. All computations should be based on the weighted average number of shares outstanding during the period. iii. A two-for-one stock split of common stock during the current fiscal year ● The stock split will increase the number of outstanding common shares. The computation should be based on shares outstanding at the end of the year. These changes should reduce the EPS, because the amount of stock will increase. iv. A provision created out of retained earnings for a contingent liability from a possible lawsuit ● This doesn’t have an effect on the EPS; the amount of retained earnings does not affect net income or the number of shares outstanding. v. Outstanding preferred stock issued at a premium with a par value liquidation right ● Issued preferred stock at a premium with a par value liquidation will affect the calculation of book value but does not affect the computation of EPS unless a dividend is paid on it. vi. The exercise at a price below market value but above book value of a common stock option issued during the current year to officers of the corporation ● This has no effect because the common stock option isn’t considered real stock and would only result in a minor increase in the number of outstanding shares. vii. The replacement of a machine immediately before the close of the current year at a cost 20 percent above the original cost of the replaced machine (the new machine will perform the same function as the old machine, which was sold for its book value) ● This has no effect on the EPS. The number of shares remains unchanged since the old machine was sold for its book value and earnings are unaffected. Case 6-3 Income Statement Format Accountants have advocated two types of income statements based of differing views of the concept of income: the current operating performance and all-inclusive concepts of income. Required: a. Discuss the general nature of these two concepts of income. b. How would the following items be handled under each concept? i. ii. iii. iv. Cost of goods sold Selling expenses Extraordinary items Prior period adjustments a. Current operating performance concept and the all-inclusive concept of income are defined in the below table: This concept implies that normal and recurring items, termed sustainable income, Current operating should constitute the principal measure of enterprise performance. That is, net income performance should reflect the day-to-day profit-directed activities of the enterprise, and the concept inclusion of other items of profit or loss distorts the meaning of the term net income. This concept holds that net income should reflect all items that affected the net All-inclusive increase or decrease in stockholders’ equity during the period, with the exception of concept of income capital transactions. This group believes that the total net income for the life of an enterprise should be determinable by summing the periodic net income figures. (Schroeder, Clark, and Cathey, 2014) b. The following items are handled similarly and divergently in some cases under both concepts. This is expressed in greater detail in the following summary. i. ii. iii. iv. Cost of goods sold are handled similarly under both the current operating performance concept and the all-inclusive concept of income. These costs would all be expensed. Selling expenses are also handled the same as they would be expensed under both concepts. In the case of extraordinary items these would be recorded as revenues and expenses under the allinclusive concept of income. Conversely, these extraordinary items would be considered gains or losses under the current operating performance concept. Prior period adjustments would also be considered revenues or expenses under the all-inclusive concept. With respect to the current operating performance concept and prior period adjustments theses would be considered gains or losses.
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