Problem 23 - Accounting

Question

The net income reported on the income statement of Goth Co. was $$\$ 2,500,000$$. There were 100,000 shares of $$\$ 10$$ par common stock and 40,000 shares of $$\$ 4$$ preferred stock outstanding throughout the current year. The income statement included two extraordinary items: a $$\$ 500,000$$ gain from condemnation of land and a $$\$ 200,000$$ 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) $22 per share, (b) $25 per share.

Step 1: Calculate the Total Extraordinary Items

The extraordinary items include a gain of \(500,000 and a loss of \)200,000. First, calculate the net effect of these items:\[\text{Net Extraordinary Items} = \\(500,000 - \\)200,000 = \$300,000\]

Step 2: Determine Income Before Extraordinary Items

Start with the reported net income of \(2,500,000 and remove the net extraordinary items calculated in the previous step.\[\text{Income Before Extraordinary Items} = \\)2,500,000 - \\(300,000 = \\)2,200,000\]

Step 3: Calculate Per-Share Income Before Extraordinary Items

To find the per-share income before extraordinary items for common stock, divide the income before extraordinary items by the number of common shares.\[\text{Per-Share Income Before Extraordinary Items} = \frac{\\(2,200,000}{100,000} = \\)22\]

Step 4: Calculate Per-Share Net Income

To calculate the per-share net income for common stock, divide the total net income by the total number of common shares.\[\text{Per-Share Net Income} = \frac{\\(2,500,000}{100,000} = \\)25\]

Key Concepts

Extraordinary Items

Extraordinary items are significant financial events that are both unusual and infrequent. They can have a substantial impact on a company’s income statement. In the context of Goth Co., two extraordinary events were noted: a gain of $500,000 from the condemnation of land and a loss of $200,000 due to flood damage. It is crucial to understand how these items affect financial reporting:

• Unusual nature: These events are not expected to recur regularly as part of the company’s operations.
• Infrequency of occurrence: They happen rarely and are distinct from normal business activities.

Extraordinary items are reported separately (usually below the line) on the income statement to aid in better understanding of a company’s regular operational performance, without the effects of these unusual events.

Common Stock

Common stock represents ownership in a company and a claim on a portion of its profits. People who own common stock are known as shareholders and they typically have the ability to vote on corporate matters, like selecting the board of directors. For Goth Co., there were 100,000 shares of $10 par common stock.

• Dividends: Common shareholders may receive dividends, which are usually paid out after the obligations to preferred stockholders are met.
• Capital Appreciation: Shareholders have the potential to benefit from the increase in stock price over time.

In the exercise, we calculated per-share income for common stock, a crucial metric that indicates profitability available to each share owned, by dividing specific income measures by the total number of common stock shares.

Income Statement

The income statement is a financial document that summarizes a company's financial performance over a specific period. It includes revenues, expenses, and profits or losses. For Goth Co., the income statement shows a net income of $2,500,000 for the year.

• Net income: It represents the total profit after all expenses and taxes have been deducted from total revenue.
• Separate line items: Extraordinary items are distinguished on the income statement, revealing the company’s typical operational performance separately from these unique events.

Understanding an income statement allows stakeholders to evaluate a company's financial health and efficiency in generating profits in its normal business operations.

Preferred Stock

Preferred stock is a class of ownership in a corporation that has a higher claim on its assets and earnings than common stock. Preferred shareholders generally receive dividends before common shareholders and have a fixed dividend rate. In the case of Goth Co., there were 40,000 shares of $4 preferred stock.

• Priority in dividends: Preferred stockholders must be paid their dividends before any dividends can be paid to common stockholders.
• Less control: Typically, preferred stock does not carry voting rights, limiting shareholders from influencing corporate policies.

Preferred stock is often a pragmatic choice for investors seeking a more stable dividend income, given its preferential treatment in dividend payments.