Accounting: The Language of Business (Part 87)

No one would suggest completely ignoring news about your investments. Enron investors, for example, would have been well served to sell once early reports of accounting irregularities surfaced. But the key is to keep news in context and act only if further reflection or study indicates that the core thesis for an investment has changed.

Whitney Tilson

Income Taxes, Unusual Income Items, and Investments in Stocks (Part C)

by

Charles Lamson

Earnings per Common Share

The amount of net income is often used by investors and creditors in evaluating a company's profitability. However, net income by itself is difficult to use in companies of different sizes. Also, trends in net income may be difficult to evaluate, using only net income, if there have been significant changes in a company's stockholders' equity. Thus, the profitability of companies is often expressed as earnings per share. Earnings per common share (EPS), sometimes called basic earnings per share, is the net income per share of common stock outstanding during a period.

Because of its importance, earnings per share is reported in the financial press and by various investors services, such as Moody's and Standard & Poor's. Changes in earnings per share can lead to significant changes in the price of a corporation's stock in the marketplace. For example, the stock of Texas Instruments Inc. surged by over 12% to $16 per share after the company announced earnings per share of 6 cents as opposed to Wall Street analysts' estimate of 3 cents per share (Warren, Reeve, & Fess, 2005).

Corporations whose stock is traded in a public market must report earnings per common share on their income statements. If no preferred stock is outstanding, the earnings per common share is calculated as follows:

Earnings per Common Share = Net Income / Number of Common Shares Outstanding

When the number of common shares outstanding has changed during the period, a weighted average number of shares outstanding is used. If a company has preferred stock outstanding, the net income must be reduced by the amount of any preferred dividends, as shown below.

Earnings per Common Share = Net Income - Preferred Stock Dividends / Number of Common Shares Outstanding

Comparing the earnings per share of two or more years, based on only the net incomes of those years, could be misleading. For example, assume that Jones Corporation, whose partial income statement was presented in Exhibit 2 (from part 86 and reintroduced below), reported $700,000 net income for 2022. Also assume that no extraordinary or other unusual items were reported in 2022. Jones has no preferred stock and has 200,000 common shares outstanding for 2022 and 2023. The earnings per common share is $3.50 ($700,000 / 200,000 shares) for 2022 and $4.16 ($832,000 / 200,000 shares) for 2023. Comparing the two earnings per share amounts suggests that operations have improved. However, the 2023 earnings per share comparable to the $3.50 is $3.45, which is the income from continuing operations of $690,000 / 200,000 shares. The latter amount indicates a slight downturn in normal earnings.

EXHIBIT 2 Unusual Items in Income Statement

When unusual below-the-line items [An item is listed on the financial statement as below the line when it is excluded from the gross profit, and, therefore, does not affect the profit or loss from normal operations for that accounting period (corporatefinanceinstitute.com)] exist, earnings per common share could be reported for those items. To illustrate, a partial income statement for Jones Corporation, showing earnings per common share, is shown in Exhibit 3. In this income statement, Jones reports all the earnings per common share amounts on the face of the income statement. However, only earnings per share amounts for income from continuing operations and net income are required to be presented on the face of the statement. The other per share amounts may be presented in the notes to the financial statements.

EXHIBIT 3 Income Statement with Earnings per Share

In the preceding paragraphs, we have assumed a simple capital structure with only common stock or common stock and preferred stock outstanding. Often, however, corporations have complex capital structures with various types of securities outstanding, such as convertible preferred stock, options, warrants, and contingently issuable shares. In such cases, the possible effects of converting such securities to common stock must be calculated and reported as earnings per common share assuming dilution or diluted earnings per share.

Comprehensive Income

Comprehensive income is defined as all changes in stockholders' equity during a period, except those resulting from dividends and stockholders' investments. Companies must report traditional net income plus or minus other comprehensive income items to arrive at comprehensive income.

Other comprehensive income items include foreign currency items, pension liability adjustments, and unrealized gains [An unrealized gain is an increase in the value of an asset, such as a stock position or a commodity like gold, that has yet to be sold for cash. A gain becomes realized once the position is sold for a profit (investopedia.com).] and losses on investments. These "other" comprehensive income transactions are reported in a middle ground that requires disclosure of these items but does not include them as part of reported earnings on the income statement. The Financial Accounting Standards Board (FASB) wanted these items disclosed separately from earnings in order to avoid potential confusion in interpreting the income statement. To the extent that other comprehensive income items give rise to tax effects, the taxes should be allocated to these items, which was illustrated for unusual below-the-line items. The cumulative effects of other comprehensive income items must be reported separately from retained earnings and paid-in capital, on the balance sheet, as accumulated other comprehensive income. When other comprehensive income items are not present, the income statement and balance sheet formats are similar to those that have been illustrated in this and preceding posts.

Companies may report comprehensive income on the income statement, in a separate statement of comprehensive income, or in the statement of stockholders' equity. In addition, companies may use terms other than comprehensive income; such as "total non-owner changes in equity."

To illustrate reporting for comprehensive income, assume that Triple-A Enterprises, Inc., reported comprehensive income on a separate statement, called the statement of comprehensive income, as follows:

The stockholders' equity section of the balance sheet for Triple-A Enterprises is as follows:

Accumulated other comprehensive income is the cumulative effect of other comprehensive income items. Thus, the additional other comprehensive income of $90 for 2023 is added to the accumulated other comprehensive income beginning balance of $1,200 to yield the December 31, 2023 balance of $1,290.

You should note that comprehensive income does not affect net income or retained earnings, as we have discussed and illustrated. In the next post, the determination of other comprehensive income will be illustrated, using unrealized gains and losses on investments. 

*WARREN, REEVE, & FESS, 2005, ACCOUNTING, 21ST ED., PP. 568-571*

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