Problem 22 - Accounting

Question

The net income reported on the income statement of Cincinnati Soap Co. was \(\$ 890,000\). There were 500,000 shares of \(\$ 20\) par common stock and 40,000 shares of \(\$ 8\) cumulative preferred stock outstanding throughout the current year. The income statement included two extraordinary items: a \(\$ 256,000\) gain from condemnation of land and a \(\$ 166,000\) loss arising from flood damage, both after applicable income tax. Determine the per share figures for common stock for (a) income before extraordinary items and (b) net income.

Step-by-Step Solution

Answer

(a) Per share income before extraordinary items is \(\$0.96\). (b) Per share net income is \(\$1.14\).

Step 1: Calculate Adjusted Net Income

First, we need to adjust the net income by removing the effects of the extraordinary items. The net income before extraordinary items is calculated by subtracting extraordinary gains and adding extraordinary losses from the reported net income. Given: Net income = \( \\(890,000 \) Extraordinary gain = \( \\)256,000 \) Extraordinary loss = \( \\(166,000 \) So, adjusted net income is given by:\[ 890,000 - 256,000 + 166,000 = 800,000 \] Thus, income before extraordinary items is \( \\)800,000 \).

Step 2: Analyze Preferred Dividends Impact

Since preferred stock dividends rank above common stock dividends, we need to account for them. The preferred dividend is calculated using the par value, number of shares, and if they are cumulative. Given:- Preferred stock par value = \(\\(8\)- Number of preferred shares = 40,000- Dividend rate is assumed to be based on par value unless stated otherwise. Calculate preferred dividends:\[ \text{Preferred Dividends} = 8 \times 40,000 = \\)320,000 \]

Step 3: Calculate Income Allocable to Common Shareholders

Subtract the preferred dividends from the adjusted net income to find income available to common shareholders.This gives us:\[ 800,000 - 320,000 = \$480,000 \]

Step 4: Calculate Per Share Income Before Extraordinary Items

We now calculate per share income before extraordinary items by dividing income available to common shareholders by the number of common shares.Given:- Number of common shares = 500,000Per share income:\[ \text{Per Share Income} = \frac{480,000}{500,000} = \$0.96\]

Step 5: Calculate Net Income Available to Common Shareholders

We will now calculate the net income available to common shareholders by subtracting preferred dividends from the total net income.Calculate: \[ 890,000 - 320,000 = \$570,000 \]

Step 6: Calculate Per Share Net Income

Finally, calculate the net income per share for common stock by dividing the net income available to common shareholders by the number of common shares.Per share net income:\[ \text{Net Income per Share} = \frac{570,000}{500,000} = \$1.14 \]

Key Concepts

Income Statement

The income statement is a financial document that showcases the revenue and expenses of a company over a specific period, usually a year. It is commonly referred to as the profit and loss statement or statement of operations.
Understanding the income statement is crucial for evaluating a company’s performance. It helps investors, analysts, and management determine profitability and operational efficiency. An income statement broadly consists of the following components:

• Revenue: The total sales or income generated by the company.
• Expenses: Costs incurred by the company to generate revenue. These include costs of goods sold, operating expenses, and non-operating expenses.
• Net Income: Also called the bottom line, it reflects the total profit after subtracting all expenses from the revenue. It indicates the company's financial health.
• Extraordinary Items: Special items that are unusual and infrequent, affecting the net income calculation, such as significant gains or losses, which we will discuss next.

Understanding these components is vital for accurately analyzing Cincinnati Soap Co.'s income statement and its implications for investors.

Extraordinary Items

Extraordinary items are events or transactions that significantly affect a company's financial results and do not regularly occur. They are distinct from regular operating items because of their unusual nature.
Such items often include natural disasters, sales of certain business segments, or other major, one-time events. In the income statement of Cincinnati Soap Co., there were two defined extraordinary items which played a significant role:

• Gain from Condemnation of Land: This was an unexpected gain amounting to $256,000.
• Loss from Flood Damage: This resulted in a loss of $166,000.

These extraordinary items are subtracted or added back when calculating income before extraordinary items, as shown in Cincinnati Soap Co.’s case.
For example, starting with a net income of $890,000, subtracting the gain and adding back the loss resulted in an adjusted net income of $800,000.

Per Share Income

Per share income offers insights into the profitability of a company on a per-share basis. It is an important metric for potential and current investors, indicating how much profit can be attributed to each share.
To compute the per share income before extraordinary items, take the income allocable to common shareholders (after accounting for preferred dividends), then divide by the number of common shares. For Cincinnati Soap Co., we had:

• Income available for common shareholders: \(480,000
• Number of common shares: 500,000
• Per Share Income before Extraordinary Items: \[\text{Per Share Income} = \frac{480,000}{500,000} = \\)0.96\]

To find the net income per share, include all income, even from extraordinary items, still after preferred dividends. In this case:

• Net Income available for common shareholders: \(570,000
• Net Income per Share: \[\text{Net Income per Share} = \frac{570,000}{500,000} = \\)1.14\]

These figures help investors understand the earnings and profitability of the company on a per-share basis.

Preferred Dividends

Preferred dividends are payments made to preferred shareholders before any dividends are paid to common shareholders. They have priority over common stock dividends which is crucial when determining the income allocation among shareholders.
Preferred stock often has a fixed dividend based on par value. For Cincinnati Soap Co., the calculation was straightforward:

• Preferred par value: \(8
• Number of shares: 40,000
• Annual preferred dividends: \[8 \times 40,000 = \\)320,000\]

These dividends reduce the income available to common shareholders, influencing the per share income figures. Preferred dividends ensure income stability for preferred stockholders, reflecting their less risky nature compared to common stock investments.
Understanding the impact of preferred dividends allows better comprehension of per share income for common shareholders, as the remaining earnings determine common dividends.