Problem 23 - Accounting

Question

Crystal Arts, Inc., had earnings of \(\$ 160,000\) for 2010 . The company had 20,000 shares of common stock outstanding during the year. In addition, the company issued 2,000 shares of \(\$ 100\) par value preferred stock on January 3,2010 . The preferred stock has a dividend of \(\$ 7\) per share. There were no transactions in either common or preferred stock during \(2010 .\) Determine the basic earnings per share for Crystal Arts.

Step-by-Step Solution

Answer

The basic earnings per share for Crystal Arts is \( \$7.30 \).

Step 1: Calculate Total Preferred Dividends

First, we need to calculate the total preferred dividends for the year. Since the preferred stock has a dividend of \( \\(7 \) per share and there are 2,000 shares, we calculate: \( 2,000 \times 7 = \\)14,000 \).

Step 2: Determine Earnings Available to Common Shareholders

Next, subtract the total preferred dividends from the total earnings to find the earnings available to common shareholders. We calculate: \( \\(160,000 - \\)14,000 = \$146,000 \).

Step 3: Calculate Basic Earnings Per Share (EPS)

Now, we calculate the basic earnings per share (EPS) by dividing the earnings available to common shareholders by the number of common shares outstanding: \( \frac{\\(146,000}{20,000} = \\)7.30 \).

Key Concepts

Preferred Dividends

Preferred dividends are payouts that companies promise to preferred shareholders before common shareholders receive any dividends. This is because preferred shares typically have a set dividend rate that must be honored.
In the example of Crystal Arts, Inc., the preferred stock carries a dividend rate of $7 per share.

• With 2,000 preferred shares outstanding, the company is obligated to pay a total of \(2,000 \times 7 = 14,000\) in dividends to preferred shareholders each year.
• This prioritized obligation impacts the earnings that are available for common shareholders, which is crucial when calculating Basic Earnings Per Share (EPS).

Understanding preferred dividends is vital because those amounts are deducted from total earnings before distributing any profit to common shareholders.

Common Shareholders

Common shareholders are the owners of common stock in a company, like Crystal Arts. They are essentially the true owners of the company, as they hold the rights to vote on corporate matters and receive a portion of the company's profits. However, their dividends are paid after preferred shareholders receive their guaranteed payouts.
This hierarchy is significant because:

• For Crystal Arts, the earnings available to common shareholders are calculated after satisfying the preferred dividend requirement.
• In the scenario given, there were 20,000 shares of common stock outstanding throughout 2010, so earnings per share directly affect these shareholders.

Ultimately, understanding the role of common shareholders is critical because their dividends will vary based on the company’s remaining earnings, unlike fixed-rate preferred dividends.

Earnings Calculation

The calculation of earnings available for each type of shareholder is an important component in understanding a company's financial health. First, we derive the total earnings available for common shareholders after paying off preferred dividends.

• Crystal Arts starts with total earnings of \(160,000\).
• Next, the obligation to pay preferred dividends means \(14,000\) must be deducted from these earnings, leaving \(146,000\) available for common shareholders.

This amount is then divided by the number of common stock shares to find the Basic Earnings Per Share (EPS), a key metric of financial performance.

• In this example, dividing \(146,000\) by 20,000 gives the EPS of \(7.30\), indicating the profit earned per share of common stock.

This calculation highlights the impact of preferential payouts on the earnings per share for common shareholders, making it a vital exercise for investors and accountants alike.