Recording Net Income in the Balance Sheet

Chapter 12 Exhibit on page 62 highlights the connection from net income in the income statement to retained earnings in the balance sheet. This chapter explains that earning profit increases the retained earnings account. Also, earnings per share (EPS) is explained.

Suppose a business has $10 million total assets and $3 million total liabilities (both non-interest operating liabilities and interest-bearing notes payable), and that its owners have invested $2 million capital in the business. Assets don't just drop down like "manna from heaven." (My old accounting professor was the first person I heard use this phrase, and I've never forgotten it.) The other $5 million of assets must have come from profit it earned but did not distribute—from retained earnings, in other words.

Two separate owners' equity accounts are needed—one for capital invested by the owners, and one for retained earnings. When a business distributes money to its owners it must distinguish between returning their capital (which is not taxable to them) versus dividing profit among them (which is taxable). In fact, a business corporation is legally required to keep separate accounts for capital stock and retained earnings.

The income statement reveals that the business earned $718,200 profit, or net income for the year. This amount is entered as an increase in retained earnings, which is an owners' equity account. The retained earnings account is so named because annual profit is entered as an increase in the account, and distributions to owners from profit are entered as decreases in the account.

During the year the business paid $200,000 cash dividends from profit to its stockholders. Therefore, its retained earnings increased only $518,200 during the year. At the end of the year its retained earnings stands at $2,544,700, which is the cumulative result from all years the company has been in business.

In this example the company obviously has been profitable over the years, given its relatively large retained earnings. Nevertheless, we can't tell from the balance sheet whether the company suffered a loss one or more years in the past, or whether the business regularly pays cash distributions from its annual profits. If a company's losses over the years are larger than its profits, then its retained earnings account would have a negative balance, which generally is called accumulated deficit or some similar title.

Retained earnings probably is the most misunderstood account in financial statements. Many people, even some experienced business managers, think this account is an asset or, more specifically, cash. Retained earnings is not an asset and it certainly is not cash. The amount of cash is reported in the cash account in a company's balance sheet ($565,807 in this example).

The retained earnings balance, frankly, has little practical significance. Hypothetically, a business could sell all its assets for their book values, pay all its liabilities, return all capital invested in the business to its stockholders, and distribute a "going out of business" cash dividend equal to its retained earnings balance. To stay in business a company can't do this, of course.

Earnings Per Share (EPS)

Net income, the bottom line in the income statement, is the profit measure for the business as a whole. Earnings per share (EPS) is the profit measure for each ownership unit, or share in the business.

Suppose in our example you own 10,000 shares of the company's capital stock. Many years ago you invested $25,000 capital in the business when it was just starting up; you're one of the original stockholders. Later the business issued additional stock shares to new investors. Your cost per share is $2.50 ($25,000 capital invested ^ 10,000 shares = $2.50 per share). Later investors paid more per share. We can tell this from the balance sheet in Chapter 12 Exhibit. The $775,000 balance in the capital stock account divided by the 200,000 shares outstanding works out to about $4.00 per share. Some of the later investors must have invested $5.00 or $6.00 per share, perhaps more.

Since you own only 5% of the stock (10,000 shares out of 200,000 total shares) you are a passive, outside investor. You do not participate actively in managing the company. Of course you're entitled to 5% of any cash dividends paid from profit, and you control 5% of the votes on matters that have to be put to a vote of stockholders.

As a stockholder you are provided a copy of the company's annual financial report. Needless to say, you're quite interested in the company's profit performance. You could take the view that 5% of the company's $718,200 annual net income "belongs" to you, which is $35,910. This is your cut of the net income pie. Or you could look at earnings per share (EPS), which is net income divided by the number of stock shares. In this example, EPS for the year just ended is:

Generally accepted accounting principles (GAAP) distinguish between nonpublic companies, whose capital stock shares are not traded in any established marketplace, and public companies whose shares are traded on the New York Stock Exchange or through another national stock market such as NASDAQ (National Association of Securities Dealers Automated Quotations System). Only public companies have to report EPS at the bottom of their income statements. Nonpublic companies can report EPS if they want to, though I don't think many do.

EPS is compared with the market price of the stock shares. The ratio of current market value to EPS (called the price/earnings ratio) is discussed in Chapter 22. There are no active markets for stock shares of nonpublic, or privately owned business corporations. Nevertheless, the stockholders in nonpublic businesses can use EPS to make an estimate of the value of their stock shares.

For example, suppose I offered to buy 1000 of your shares. You might offer to sell them at 15 times the $3.59 EPS, or about $54 per share. Of course, I might not be willing to pay this price, but you could ask. Another example would be the need to put a current value on stock shares for estate tax purposes when someone dies. EPS is one basis for putting an estimated value on capital stock shares.

CHAPTER 13 EXHIBIT—CASH FLOW FROM PROFIT (OPERATING ACTIVITIES)

balance sheet

Assets

End oí Year

start at Year

Cliafijís

Cash

S SfiS.SP?

i 750,003

(iiBä.tsgj

Accounts Receivable

i.wo.otio

oai.coa

íi ra.tioo

Inventory

1,690,300

i .nso.ct'O

$440,000

Prepaid Expenses

1150,QUI]

¡íss.aoot

Tctal G'jrran: Assels

S3,415,607

M.CHO.COO

Propely, F'antfi Equiprr-ant

3,000.000

£.353,M0

Í750.000

Accumulated Depreciation

iEocLoam

¡540,W0)

ÍÍ260.D0C)

Tolal Assets

SE.ei5.6Q7

S4.72D,C30

Liabilities and Owners' Equity

End oí Year

S tu ri ol YcaT

Account^ Payable—liwwiloiji

$ SEO.OCtO

5 450,000

Accounts Payable Ope'tiling

Expenses

íac-.oúo

es,MO

Tolal Accounts Payable

S 640.000

S 535.000

Accrued Operating Expense:

24O.0CO

1BE.OOO

Accrued Interest Payable

17,167

12,500

To till Accused Expenses

î 257.167

ï 197.500

Income Till Payable

33,340

36.D00

SHorl ■ Turin Koios Payable

635, CM

ino.ono

Total Cu rrent Liabilities

S 1.546,107

£1.368.500

Long-Term Ncles Payable

750,000

SOO.OOO

Total Liabilities

Î2.2ÇS.1Û7

S1.il68.500

Caeitm Stoeti

7 75, MO

725.000

Paaxec Ear 13:

a.sAtjTOÓ

2.Û2Ê.S0Û

Total Owners' Equiiy

S3,315,700

52.751.500

Total Liahi: lias and

Owners' Equiiy

S5.&15.S07

Changos

(105,008

From Income stafentent

CASH FLOW STATEMENT FOR YEAR

Cash Hows fmm QperG(ing Activities

- Accosts n^eyaTsie increiise (Si'/^.oOi1}

- Inventory Increase (4JC.OOO}

- PrepitS Expenses peerage Ei.POO

■ Depreciation Expense iio.oOO

- Account Payable Increase lCS.QtX1

- An:rued Expenses Increase

- Income Tax Payatve Decrease _i;l2.ijL-0j

Net income (177,393)

Cash Flowtrem Operalm;]

Activities i£40.a07

Cssh Flows Jiem Investing Activities

Purchases 01 property Plant t Eí^jipmen"

Cash Flews frora Financing Activities

Sticrl Term CI L-bl Boi rowing Long'Term Debt Berrcwing Capital SI.>:K Issue

Dividends Paid StUC'BliiktCrs

Increase (Decrease} in Cash during Yea*

S 25.000

Notice Ihattfte cash acceurti iiecteaseti flïaaly this amount.

Cash Flow from Profit

0 0

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