Accounting Principles II

Some companies report additional items after income tax expense on their income statements. These items represent special items outside of normal business operations. They are shown separately to ensure users can identify what income from continuing business results will be. If any special items are included on the income statement, the income tax expense or savings related to each item is net against the special item to report it after taxes. These additional special items may be one of three types: discontinued operations, extraordinary items, and changes in accounting principles.

Discontinued operations occur when a significant segment of a business has been identified for disposal. Once so identified, any gain or loss from operations of the segment while it is being disposed of and any gain or loss on the sale of the assets of the segment, are reported separately from the remaining, continuing operations.

Extraordinary items are events that occur infrequently and are unusual. They can include acts of God as long as they rarely occur in the area where the business operates. Events that would not be extraordinary as they occur regularly, although not yearly, are a severe freeze effecting crops in Florida or an earthquake in southern California.

A change in accounting principle occurs when a company changes from one acceptable principle to another. The new principle is used to calculate the current year's amounts in the financial statements. The effect of the change on any prior years' amounts is shown separately in the income statement, net of taxes. A partial income statement for a corporation with these items follows:

Earnings per share

Corporations are also required to report earnings per share on the income statement. Earnings per share represents the amount of earnings related to one share of common stock. There are two types of earnings per share, basic earnings per share and diluted earnings per share. If applicable, both types of earnings per share must be reported. In addition, if the corporation has any of the special items just described, earnings per share must be reported for income from continuing operations, each special item, and net income.

If no preferred stock is outstanding, basic earnings per share is calculated by dividing net income by weighted average number of common shares outstanding for the period.

If preferred stock is outstanding, the current year's dividend declared on preferred stock is deducted from net income prior to dividing by weighted average number of common shares outstanding.

If the number of common shares outstanding changes during the period, the weighted average number of shares is used to calculate earnings per share. The weighting is based on how long shares are outstanding during the period. For example, if Tom & Margaret, Inc. began the year with 20,000 shares outstanding and issued an additional 5,400 shares on August 20, the weighted average shares would be calculated as:

Alternatively, the weighted average shares may be calculated using the total common shares outstanding at a given time.

Diluted earnings per share

Diluted earnings per share uses the same formula. However, it requires that additional common shares, which could become outstanding as a result of the corporation's compensation plans or having issued convertible debt or convertible preferred stock, to also be included as outstanding common stock. As the formula includes additional shares outstanding, the diluted earnings per share is usually less than basic earnings per share.

Think of earnings per share as a continuum with basic earnings per share on one end and diluted earnings per share on the other.