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KOWALSKI, INC.: REVIEW PROBLEM

KOWALSKI, INC.: REVIEW PROBLEM

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638

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

Answers to
Review Problem

1. Entries in T accounts:
a. No entry (memorandum in journal)
b. No entry (memorandum in journal)

2. Stockholders’ equity section of the balance sheet:

Kowalski, Inc.: Review Problem

639

3. Book values:
June 30, 2010
Common Stock: $1,645,000 Ϭ 125,000 shares ϭ $13.16 per share
June 30, 2011
Preferred Stock: Call price of $104 per share equals book value per share
Common Stock:
($2,737,600 Ϫ $1,040,000) Ϭ (254,500 shares ϩ 25,450 shares)
$1,697,600 Ϭ 279,950 shares ϭ $6.06 per share*
*Rounded.

When there is no ready market for a company’s common or preferred stock, book value
per share is often used as a guide for determining the stock’s value.

640

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

STOP

& REVIEW

LO1 Define quality of earnings, and identify the
components of a corporate income statement.

The quality of earnings refers to the substance of earnings and their sustainability into future accounting periods. The quality of a company’s earnings may be
affected by the accounting methods and estimates it uses and by the gains and
losses, write-downs and restructurings, and nonoperating items that it reports on
its income statement.
When a company has both continuing and discontinued operations, the operating income section of its income statement is called income from continuing operations. Income from continuing operations before income taxes is affected by choices
of accounting methods and estimates and may contain gains and losses on the sale
of assets, write-downs, and restructurings. The income taxes expense section of the
statement is subject to special accounting rules. The lower part of the statement may
contain such nonoperating items as discontinued operations and extraordinary gains
and losses. Earnings per share information appears at the bottom of the statement.

LO2 Show the relationships among income
taxes expense, deferred
income taxes, and net of
taxes.

Income taxes expense is the tax applicable to income from operations on an
accrual basis. Income tax allocation is necessary when there is a material difference
between accrual-based accounting income and taxable income—that is, between
the income taxes expense reported on the income statement and actual income
tax liability. The difference between income taxes expense and income taxes payable is debited or credited to an account called Deferred Income Taxes. The
phrase net of taxes indicates that taxes have been taken into account in reporting
an item in the financial statements.

LO3 Compute earnings
per share.

Readers of financial statements use earnings per share to evaluate a company’s performance and to compare it with the performance of other companies.
Earnings per share of common stock are presented on the face of the income
statement. The amounts are computed by dividing the income applicable to common stock by the number of common shares outstanding for the year. If the
number of shares outstanding varied during the year, the weighted-average number of common shares outstanding is used in the computation. A company that
has a complex capital structure must disclose both basic and diluted earnings per
share on the face of its income statement.

LO4 Define comprehensive
income, and describe the
statement of stockholders’ equity.

Comprehensive income includes all items from sources other than stockholders
that account for changes in stockholders’ equity during an accounting period.
The statement of stockholders’ equity summarizes changes over the period in
each component of the stockholders’ equity section of the balance sheet. This
statement reveals much more than the statement of retained earnings does about
the transactions that affect stockholders’ equity.

LO5 Account for stock dividends and stock splits.

A stock dividend is a proportional distribution of shares among a corporation’s
stockholders. The following is a summary of the key dates and accounting treatments of stock dividends:
Key Date

Declaration date

Stock Dividend

Debit Stock Dividends for the market value
of the stock to be distributed (if the stock
dividend is small), and credit Common Stock
Distributable for the stock’s par value and
Additional Paid-in Capital for the excess of
the market value over the stock’s par value.

641

Stop & Review
Key Date

Stock Dividend

Record date
Date of distribution

No entry is needed.
Debit Common Stock Distributable and credit
Common Stock for the par value of the stock.

A company usually declares a stock split to reduce the market value of its
stock and thereby improve the demand for the stock. Because the par value of the
stock normally decreases in proportion to the number of additional shares issued,
a stock split has no effect on the dollar amount in stockholders’ equity. A stock
split does not require an entry, but a memorandum entry in the general journal
is appropriate.

LO6 Calculate book value
per share.

Book value per share is stockholders’ equity per share. It is calculated by dividing stockholders’ equity by the number of common shares outstanding. When a
company has both preferred and common stock, the call or par value of the preferred stock and any dividends in arrears are deducted from stockholders’ equity
before dividing by the common shares outstanding.

REVIEW of Concepts and Terminology
The following concepts and terms
were introduced in this chapter:

Income from continuing
operations 616 (LO1)

Book value 635

Income tax allocation 622

Complex capital
structure 626

(LO6)

Net of taxes 623
(LO3)
(LO4)

Deferred Income Taxes 622

(LO2)

Deficit 630

(LO4)

(LO1)

(LO1)

(LO5)

Write-down 619

(LO1)

Restructuring 619

Key Ratios

(LO1)

Basic earnings per share 626

(LO1)

Retained earnings 629

Book value per share 635

(LO4)

Simple capital structure 626

Discontinued operations 620
Extraordinary items 620

Stock split 633
(LO2)

(LO5)

(LO2)

Quality of earnings 616

Comprehensive income 627

Stock dividend 630

Statement of stockholders’
equity 629 (LO4)

(LO3)

Diluted earnings per
share 627 (LO3)

(LO3)

(LO6)

642

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1

Quality of Earnings
SE 1. Each of the items listed below is a quality of earnings issue. Indicate whether
the item is (a) an accounting method, (b) an accounting estimate, or (c) a nonoperating item. For any item for which the answer is (a) or (b), indicate which
alternative is usually the more conservative choice.
1. LIFO versus FIFO
2. Extraordinary loss
3. 10-year useful life versus 15-year useful life
4. Straight-line versus accelerated method
5. Discontinued operations
6. Immediate write-off versus amortization
7. Increase versus decrease in percentage of uncollectible accounts

LO1

Corporate Income Statement
SE 2. Assume that Jefferson Corporation’s chief financial officer gave you the following information: net sales, $360,000; cost of goods sold, $175,000; loss from
discontinued operations (net of income tax benefit of $35,000), $100,000; loss
on disposal of discontinued operations (net of income tax benefit of $8,000),
$25,000; operating expenses, $65,000; income taxes expense on continuing operations, $50,000. From this information, prepare the company’s income statement
for the year ended June 30, 2011. (Ignore earnings per share information.)

LO2

Corporate Income Tax Rate Schedule
SE 3. Using the corporate tax rate schedule in Table 14-1, compute the income
tax liability for taxable income of (1) $800,000 and (2) $40,000,000.

LO3

Earnings per Share
SE 4. During 2010, Wells Corporation reported a net income of $1,338,400. On
January 1, Wells had 720,000 shares of common stock outstanding. The company
issued an additional 480,000 shares of common stock on August 1. In 2010, the
company had a simple capital structure. During 2011, there were no transactions
involving common stock, and the company reported net income of $1,740,000.
Determine the weighted-average number of common shares outstanding for
2010 and 2011. Also compute earnings per share for 2010 and 2011.

LO4

Statement of Stockholders’ Equity
SE 5. Refer to the statement of stockholders’ equity for Crisanti Corporation in
Exhibit 14-4 to answer the following questions: (1) At what price per share were the
10,000 shares of common stock sold? (2) What was the conversion price per share of
the common stock? (3) At what price was the common stock selling on the date of
the stock dividend? (4) At what price per share was the treasury stock purchased?

LO4 LO5

Effects of Stockholders’ Equity Actions
SE 6. Tell whether each of the following actions will increase, decrease, or have
no effect on total assets, total liabilities, and total stockholders’ equity:
1. Declaration of a stock dividend
3. Stock split
2. Declaration of a cash dividend
4. Purchase of treasury stock

Chapter Assignments

643

LO5

Stock Dividends
SE 7. On February 15, Asher Corporation’s board of directors declared a 2 percent stock dividend applicable to the outstanding shares of its $10 par value
common stock, of which 400,000 shares are authorized, 260,000 are issued, and
40,000 are held in the treasury. The stock dividend was distributed on March 15
to stockholders of record on March 1. On February 15, the market value of the
common stock was $15 per share. On March 30, the board of directors declared
a $0.50 per share cash dividend. No other stock transactions have occurred.
Record, as necessary, the transactions of February 15, March 1, March 15, and
March 30.

LO5

Stock Split
SE 8. On August 10, 2010, the board of directors of Karton, Inc. declared a
3-for-1 stock split of its $9 par value common stock, of which 200,000 shares
were authorized and 62,500 were issued and outstanding. The market value on
that date was $60 per share. On the same date, the balance of additional paid-in
capital was $1,500,000, and the balance of retained earnings was $1,625,000.
Prepare the stockholders’ equity section of the company’s balance sheet after
the stock split. What entry, if any, is needed to record the stock split?

LO6

Book Value for Preferred and Common Stock
SE 9. Using data from the stockholders’ equity section of Soong Corporation’s
balance sheet shown below, compute the book value per share for both the preferred and the common stock.
Contributed capital
Preferred stock, $100 par value, 8 percent cumulative,
20,000 shares authorized, 1,000 shares issued and
outstanding*
Common stock, $10 par value, 200,000 shares
authorized, 80,000 shares issued and outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity

$ 100,000
800,000
1,032,000
$1,932,000
550,000
$2,482,000

*The preferred stock is callable at $108 per share, and one-year’s dividends are in arrears.

Exercises
LO1 LO2

LO3
LO5

LO4
LO6

Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. In what way is selling an investment for a gain potentially a negative in evaluating quality of earnings?
2. Is it unethical for new management to take an extra large write-off (a “big
bath”) in order to reduce future costs? Why or why not?
3. What is an argument against the recording of deferred income taxes?
4. Why is it useful to disclose discontinued operations separately on the income
statement?
Discussion Questions
E 2. Develop brief answers to each of the following questions:

1. What is one way a company can improve its earnings per share without
improving its earnings or net income?

644

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

2. Why is comprehensive income a part of stockholders’ equity?
3. Upon receiving shares of stock from a stock dividend, why should the stockholder not consider the value of the stock as income?
4. What is the effect of a stock dividend or a stock split on book value per share?

LO1

Effect of Alternative Accounting Methods
E 3. At the end of its first year of operations, a company calculated its ending
merchandise inventory according to three different accounting methods, as follows: FIFO, $95,000; average-cost, $90,000; LIFO, $86,000. If the company
used the average-cost method, its net income for the year would be $34,000.
1. Determine net income if the company used the FIFO method.
2. Determine net income if the company used the LIFO method.
3. Which method is more conservative?
4. Will the consistency convention be violated if the company chooses to use
the LIFO method? Why or why not?
5. Does the full-disclosure convention require disclosure of the inventory
method used in the financial statements?

LO1

Corporate Income Statement
E 4. Assume that the Cetnar Corporation’s chief financial officer gave you the following information: net sales, $1,900,000; cost of goods sold, $1,050,000; extraordinary
gain (net of income taxes of $3,500), $12,500; loss from discontinued operations (net
of income tax benefit of $30,000), $50,000; loss on disposal of discontinued operations (net of income tax benefit of $13,000), $35,000; selling expenses, $50,000;
administrative expenses, $40,000; income taxes expense on continuing operations,
$300,000. From this information, prepare the company’s income statement for the
year ended June 30, 2011. (Ignore earnings per share information.)

LO1

Corporate Income Statement
E 5. The items below are components of Patel Corporation’s income statement
for the year ended December 31, 2011. Recast the income statement in proper
multistep form, including allocating income taxes to appropriate items (assume
a 30 percent income tax rate) and showing earnings per share figures (100,000
shares outstanding).

LO2

Sales
Cost of goods sold
Operating expenses
Restructuring
Total income taxes expense for period
Income from discontinued operations
Gain on disposal of discontinued operations
Extraordinary gain
Net income

$ 555,000
(275,000)
(112,500)
(55,000)
(89,550)
80,000
70,000
36,000
$ 208,950

Earnings per share

$

2.09

Corporate Income Tax Rate Schedule
E 6. Using the corporate tax rate schedule in Table 14-1, compute the income tax
liability for the following situations:
Situation

A
B
C

Taxable Income

$ 70,000
85,000
320,000

Chapter Assignments

LO2

645

Income Tax Allocation
E 7. The Danner Corporation reported the following accounting income before
income taxes, income taxes expense, and net income for 2011 and 2012:
Income before income taxes
Income taxes expense
Net income

2011
$280,000
88,300
$191,700

2012
$280,000
88,300
$191,700

On the balance sheet, deferred income taxes liability increased by $38,400 in
2011 and decreased by $18,800 in 2012.
1. How much did Danner actually pay in income taxes for 2011 and 2012?
2. Prepare entries in journal form to record income taxes expense for 2011 and
2012.

LO3

Earnings per Share
E 8. During 2011, Arthur Corporation reported a net income of $3,059,000.
On January 1, Arthur had 2,800,000 shares of common stock outstanding. The
company issued an additional 1,680,000 shares of common stock on October 1.
In 2011, the company had a simple capital structure. During 2012, there were
no transactions involving common stock, and the company reported net income
of $4,032,000.
1. Determine the weighted-average number of common shares outstanding
each year.
2. Compute earnings per share for each year.

LO4

Statement of Stockholders’ Equity
E 9. The stockholders’ equity section of Erich Corporation’s balance sheet on
December 31, 2010, follows.
Contributed capital
Common stock, $2 par value, 500,000 shares
authorized, 400,000 shares issued
and outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity

$

800,000
1,200,000
$ 2,000,000
4,200,000
$ 6,200,000

Prepare a statement of stockholders’ equity for the year ended December 31,
2011, assuming these transactions occurred in sequence in 2011:
a. Issued 10,000 shares of $100 par value, 9 percent cumulative preferred
stock at par after obtaining authorization from the state.
b. Issued 40,000 shares of common stock in connection with the conversion of
bonds having a carrying value of $600,000.
c. Declared and issued a 2 percent common stock dividend. The market value
on the date of declaration was $14 per share.
d. Purchased 10,000 shares of common stock for the treasury at a cost of
$16 per share.
e. Earned net income of $460,000.
f. Declared and paid the full-year’s dividend on preferred stock and a dividend
of $0.40 per share on common stock outstanding at the end of the year.
g. Had foreign currency translation adjustment of negative $100,000.

646

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

LO5

Journal Entries: Stock Dividends
E 10. Snols Corporation has 30,000 shares of its $1 par value common stock outstanding. Record in journal form the following transactions as they relate to the
company’s common stock:
July

17

31
Aug. 10
Sept. 1

Declared a 10 percent stock dividend on common stock to be
distributed on August 10 to stockholders of record on July 31.
Market value of the stock was $5 per share on this date.
Date of record.
Distributed the stock dividend declared on July 17.
Declared a $0.50 per share cash dividend on common stock to
be paid on September 16 to stockholders of record on
September 10.

LO5

Stock Split
E 11. Fernandez Corporation currently has 500,000 shares of $1 par value common stock authorized with 200,000 shares outstanding. The board of directors
declared a 2-for-1 split on May 15, 2010, when the market value of the common stock was $2.50 per share. The retained earnings balance on May 15 was
$700,000. Additional paid-in capital on this date was $20,000. Prepare the
stockholders’ equity section of the company’s balance sheet before and after the
stock split. What entry, if any, would be necessary to record the stock split?

LO5

Stock Split
E 12. On January 15, 2010, the board of directors of Tower International
declared a 3-for-1 stock split of its $12 per value common stock, of which
3,200,000 shares were authorized and 800,000 were issued and outstanding. The market value on that date was $45 per share. On the same date,
the balance of additional paid-in capital was $16,000,000, and the balance
of retained earnings was $32,000,000. Prepare the stockholders’ equity section of the company’s balance sheet before and after the stock split. What
entry, if any, is needed to record the stock split?

LO6

Book Value for Preferred and Common Stock
E 13. Below is the stockholders’ equity section of Hegel Corporation’s balance sheet.
Determine the book value per share for both the preferred and the common stock.
Contributed capital
Preferred stock, $100 per share,
6 percent cumulative, 10,000 shares
authorized, 200 shares issued and outstanding*
Common stock, $5 par value, 100,000 shares authorized,
10,000 shares issued, 9,000 shares outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total contributed capital and retained earnings
Less treasury stock, common (1,000 shares at cost)
Total stockholders’ equity

$ 20,000
50,000
28,000
$ 98,000
95,000
$193,000
15,000
$178,000

*The preferred stock is callable at $105 per share, and one-year’s dividends are in arrears.

Chapter Assignments

647

Problems
LO1

Effect of Alternative Accounting Methods
P 1. Matka Corporation began operations in 2011. At the beginning of the year,
the company purchased plant assets of $450,000, with an estimated useful life
of 10 years and no residual value. During the year, the company had net sales of
$650,000, salaries expense of $100,000, and other expenses of $40,000, excluding depreciation. In addition, Matka Corporation purchased inventory as follows:
Jan. 15
Mar. 20
June 15
Sept. 18
Dec. 9
Total

200
100
400
300
150
1,150

units at $400
units at $408
units at $416
units at $412
units at $420
units

$ 80,000
40,800
166,400
123,600
63,000
$473,800

At the end of the year, a physical inventory disclosed 250 units still on hand. The
managers of Matka Corporation know they have a choice of accounting methods,
but they are unsure how those methods will affect net income. They have heard
of the FIFO and LIFO inventory methods and the straight-line and doubledeclining-balance depreciation methods.

User insight Ǡ
User insight Ǡ

LO1

LO2
LO3

User insight Ǡ

Required
1. Prepare two income statements for Matka Corporation, one using the
FIFO and straight-line methods and the other using the LIFO and doubledeclining-balance methods. Ignore income taxes.
2. Prepare a schedule accounting for the difference in the two net income figures
obtained in requirement 1.
3. What effect does the choice of accounting method have on Matka’s inventory turnover? What conclusions can you draw? Use the year-end balance to
compute the ratio.
4. How does the choice of accounting methods affect Matka’s return on assets?
Assume the company’s only assets are cash of $40,000, inventory, and plant
assets. Use year-end balances to compute the ratios. Is your evaluation of
Matka’s profitability affected by the choice of accounting methods?
Corporate Income Statement
P 2. Information concerning operations of Camping Gear Corporation during
2011 is as follows:
a. Administrative expenses, $90,000
b. Cost of goods sold, $420,000
c. Extraordinary loss from an earthquake (net of taxes, $36,000), $60,000
d. Sales (net), $900,000
e. Selling expenses, $80,000
f. Income taxes expense applicable to continuing operations, $105,000
Required
1. Prepare the corporation’s income statement for the year ended December 31,
2011, including earnings per share information. Assume a weighted average
of 50,000 common shares outstanding during the year.
2. Which item in Camping Gear Corporation’s income statement affects
the company’s quality of earnings? Why does it have an effect on quality of
earnings?

648

CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity

LO1

LO2
LO3

Corporate Income Statement and Evaluation of Business Operations
P 3. During 2012, Vitos Corporation engaged in two complex transactions to
improve the business—selling off a division and retiring bonds. The company
has always issued a simple, single-step income statement, and the accountant has
accordingly prepared the December 31 year-end income statements for 2011 and
2012, as shown below.

Vitos Corporation
Income Statements
For the Years Ended December 31, 2012 and 2011
2012

2011

Net sales
$ 2,000,000 $ 2,400,000
Cost of goods sold
(1,100,000) (1,200,000)
Operating expenses
(450,000)
(300,000)
Income taxes expense
(358,200)
(270,000)
Income from discontinued operations
320,000
Gain on disposal of discontinued operations
280,000
Extraordinary gain on retirement of bonds
144,000
Net income
$ 835,800 $ 630,000
Earnings per share
$
2.09 $
1.58

Robert Vitos, the president of Vitos Corporation, is pleased to see that both
net income and earnings per share increased by almost 33 percent from 2011 to
2012, and he intends to announce to the company’s stockholders that the plan to
improve the business has been successful.

User insight Ǡ

LO4

LO5

Required
1. Recast the 2012 and 2011 income statements in proper multistep form,
including allocating income taxes to appropriate items (assume a 30 percent
income tax rate) and showing earnings per share figures (400,000 shares
outstanding).
2. What is your assessment of Vitos Corporation’s plan and business operations
in 2012?
Dividends, Stock Splits, and Stockholders’ Equity
P 4. The stockholders’ equity section of the balance sheet of Lim Mills, Inc., as of
December 31, 2010, was as follows:
Contributed capital
Common stock, $3 par value, 1,000,000 shares
authorized, 80,000 shares issued and outstanding
Additional paid-in capital
Total contributed capital
Retained earnings
Total stockholders’ equity

$240,000
75,000
$315,000
240,000
$555,000

A review of the stockholders’ equity records of Lim Mills, Inc., disclosed the
following transactions during 2011:
Mar.

25

The board of directors declared a 5 percent stock dividend to
stockholders of record on April 20 to be distributed on May 1.
The market value of the common stock was $21 per share.