13

Equity Financing

Overview

After discussing debt financing in Chapter 12, we now turn to the other kind of financing available to businesses—equity financing. Like debt financing, equity financing, once you delve below the surface of what you probably covered in your introductory accounting course, can be quite complex. It isn’t as simple as selling shares of stock for which you debit Cash and credit Common Stock. One of the complexities involves various kinds of stock. There is not only the common, voting stock. There are also a wide variety of preferred stock possibilities. Preferred stock doesn’t mean that it is “better” stock. For instance, as far as voting goes, preferred shares are usually inferior to common shares. When a company performs really well, or the prospects for performance are favorable, common shares tend to appreciate in value (sometimes substantially). Preferred shares, on the other hand, tend to produce only minor fluctuations in price. Preferred share pricing is tied much more to changes in interest rates and company credit ratings than to company performance. This example shows how preferred shares usually act more like debt than equity. The bonds discussed in the prior chapter also change in value based on changes in interest rates and company credit ratings. Some preferred shares (mandatorily redeemable preferred shares) are so similar to debt that they are actually classified as liabilities on the balance sheet. Some of the other complexities discussed in this chapter include stock that isn’t quite stock yet like rights, warrants, and options. Options, in particular, are common in U.S. corporations and, hence, the new accounting treatment for them is important to understand well. Finally, financing cuts both ways. The chapter discusses not only the obtaining of cash and issuing of stock and other equity instruments, but also the repurchase of stock (treasury stock) and the payment of dividends. The payment of dividends (usually) is one of several means by which the Retained Earnings account is adjusted.

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Learning Objectives

Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered. If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with. The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.

Tips, Hints, and Things to Remember

LO1 – Identify the rights associated with ownership of common and preferred stock. Why? Why would a business have two kinds of stock? Why not stick to one? Companies generally don’t issue preferred stock initially. It is when the business has grown to a sufficient size, yet more cash is needed, that the issuance of preferred shares is sometimes considered. Preferred shares, rather than more common shares, are sometimes issued because the common shareholders don’t want their stake in the business to be diminished. At the same time, the existing common stockholders don’t want, or don’t have the resources, to put more money into the business. By issuing a different kind of stock, the company is able to raise additional funds without taking on more debt (which their current creditors may not allow), while at the same time not reducing the stake current owners have in the business. How? Preferred stock and common stock have little in common outside the word “stock.” Preferred shareholders get paid first when it comes to dividends and in a liquidation. As mentioned on page 13-1, with the reduced risk can also come a reduced reward for the preferred shareholders. When the company performs well, or is expected to perform well, preferred shareholders don’t receive the kinds of returns that common stockholders do. They also don’t have any voting rights, which can be a primary motivator for some shareholders (like those taking over the company who need not buy up the preferred shares).

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LO2 – Record the issuance of stock for cash, on a subscription basis, and in exchange for noncash assets or for services. How? When stock is issued for cash, there are usually two accounts that receive a credit. The first is the Common Stock account, which gets a credit equal to the par value of the stock issued. For example, if the par value is $1 and 20,000 shares are issued, then Common Stock will be credited $20,000. The difference between the actual amount of cash received and the credit to Common Stock receives the remaining credit to an account called Paid-In Capital in Excess of Par Value or Additional Paid-In Capital. If someone (or some business) is going to provide other assets or services in exchange for stock, the corporation is essentially giving the person (or business) stock instead of cash. This is frequently the case with new, small corporations that don’t have cash. Another way of looking at it is to pretend the corporation is giving cash for the services or assets and then the cash is going right back into the corporation for stock. If that was the case, the corporation would be giving cash to the extent of the fair market value of the items received. Therefore, these transactions should be booked based on the fair market value of the assets or services. If the stock trades on an exchange, then the fair market value of the stock is known and can be used as a firmer number than an appraisal of assets or estimate of the value of the services.

LO3 – Use both the cost and par value methods to account for stock repurchases. How? The cost method is the simpler of the two. When shares are repurchased, the contra-equity account of Treasury Stock is the only account debited under the cost method. Under the par value method, as the name implies, the Treasury Stock account is only debited to the extent of the par value of the stock reacquired. Other accounts (Additional Paid-In Capital and maybe Retained Earnings) make up the difference.

LO4 – Account for the issuance of stock rights and stock warrants. How? There is nothing difficult about accounting for warrants. When cash comes in for stock that has a warrant attached to it, Cash, of course, receives a debit. The credit is allocated between the value of the warrant and the stock it is attached to. If the stock has a par value, then an additional paid-in capital account will also be credited for a total of three credits (Paid-In Capital in Excess of Par Value, Additional Paid-In Capital, and Stock Warrant).

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LO5 – Compute the compensation expense associated with the granting of employee stock options. How? Stock options are now accounted for using a fair-value approach. Compensation expense is recognized based on the fair value of the options at the grant date evenly over the period the options vest. This wasn’t usually the case until recently. Hence, it is probably an area that is likely to be tested on the CPA Exam. Even if the options aren’t exercised, the expense associated with the granting of them is never reversed or taken off of the books.

LO6 – Determine which equity-related items should be reported in the balance sheet as liabilities. Why? There are several items that sound like equity but for which FASB has ruled should be listed as a liability since the substance of these instruments looks more like a liability than their names imply. The major ones listed in this chapter include mandatorily redeemable preferred shares, written put options, and obligations to issue shares at a certain dollar value (rather than a certain number of shares). The written put options issued by companies to which the put option applies should be distinguished from other put options traded on the open market. Written put options, in the sense discussed in this chapter, deal with only those written by the company (not those that can be purchased and sold on something like the Chicago Board Options Exchange which are written by the exchange instead of by the companies being traded).

LO7 – Distinguish between stock conversions that require a reduction in retained earnings and those that do not. How? It is rare that a reduction in retained earnings is necessary when preferred stock is converted into common stock. Usually, you simply need to take the preferred stock off the books and put the common stock on the books at the same amount (with the plug going as a credit to Additional Paid-In Capital). However, in the rare circumstance in which you are missing a debit in this entry (because the common stock has a high par value), Retained Earnings will receive that debit.

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LO8 – List the factors that impact the Retained Earnings balance. How? You have hopefully already mastered the most common changes in the Retained Earnings balance: income increases the credit balance and dividends reduce the balance. Outside of those entries there are a couple that can affect it in either direction: error corrections and some changes in accounting principle. Finally, there are two that can only decrease the balance: some treasury stock transactions and some stock conversions (as mentioned in the rare circumstance for LO7).

LO9 – Properly record cash dividends, property dividends, small and large stock dividends, and stock splits. How? Generally, the recording of a dividend, regardless of the type of dividend, is a two-step process with similar components. On the date of declaration, Retained Earnings (or Dividends, which gets closed out to Retained Earnings) receives a debit, and Dividends Payable receives a credit. Sometimes (in the case of noncash dividends), another account receives a debit or a credit as well. Then, on the date of payment, Dividends Payable receives a debit, and the item dividended to shareholders receives a credit.

LO10 – Explain the background of unrealized gains and losses recorded as part of accumulated other comprehensive income, and list the major types of equity reserves found in foreign balance sheets.

LO11 – Prepare a statement of changes in stockholders’ equity.

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The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format. The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.

Multiple Choice

MC13-1 (LO1) Which of the following shareholder rights is most commonly enhanced in an issue of preferred stock? a. the right to vote for the board of directors b. the right to maintain one’s proportional interest in the corporation c. the right to receive a full cash dividend before dividends are paid to other

classes of stock d. the right to vote on major corporate issues MC13-2 (LO2) The par value of common stock represents the a. liquidation value of the stock. b. book value of the stock. c. amount received by the corporation when the stock was originally issued. d. legal nominal value assigned to the stock. MC13-3 (LO3) Gains and losses on the purchase and resale of treasury stock may be reflected only in a. Paid-In Capital accounts. b. Paid-In Capital and Retained Earnings accounts. c. income, Paid-In Capital, and Retained Earnings accounts. d. income and Paid-In Capital accounts.

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MC13-4 (LO4) A company issued rights to its existing shareholders to acquire, at $18 per share, 10,000 unissued shares of common stock with a par value of $1 per share. Common Stock will be credited for a. $18 per share when the rights are exercised. b. $18 per share when the rights are issued. c. $1 per share when the rights are exercised. d. $1 per share when the rights are issued. MC13-5 (LO5) On January 1, 2011, Watson Corporation granted stock options to key employees for the purchase of 60,000 shares of the company's common stock at $25 per share. The options are intended to compensate employees for the next two years. The options are exercisable within a four-year period beginning January 1, 2013, by grantees still employed by the company. The fair value of the options based on the market price of Watson's common stock at the date of grant is $7 per share. Watson plans to distribute up to 60,000 shares of treasury stock when options are exercised. The treasury stock was acquired by Watson at a cost of $28 per share and was recorded under the cost method. How much should Watson charge to Compensation Expense for the year ended December 31, 2011? a. $420,000 b. $210,000 c. $180,000 d. $90,000 MC13-6 (LO6) Which of the following items should NOT be reported as a liability on the balance sheet? a. written put options b. mandatorily redeemable preferred shares c. obligation to issue shares of a certain dollar value d. obligation to issue a certain number of shares MC13-7 (LO7) An adjustment to Retained Earnings as a result of a conversion of preferred stock to common stock most likely would occur when par value of the a. preferred stock is high relative to fair value of the common stock. b. common stock is less than the book value of the preferred stock. c. common stock exceeds the book value of the preferred stock. d. preferred stock is low relative to fair value of the common stock. MC13-8 (LO8) Which of the following actions or events does NOT result in an addition to Retained Earnings? a. a change from the double-declining-balance method to the straight-line

method of depreciation b. net income earned for the period c. the correction of an error in which ending inventory was understated in a

previous year d. the issuance of a 2-for-1 stock split

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MC13-9 (LO9) Kearney Company declared a cash dividend on its common stock in December 2010, payable in January 2011. Retained Earnings would a. increase on the date of declaration. b. not be affected on the date of declaration. c. not be affected on the date of payment. d. decrease on the date of payment. MC13-10 (LO10) Slattery Company reported the following for the year ended December 31, 2011 (all items are net of income taxes): Income from continuing operations $1,300 Income (loss) from discontinued operations (200) Unrealized gain (loss) on available-for-sale securities 30 (Increase) Decrease in minimum pension liability (72) Unrealized gain (loss) on derivative instruments (12) Foreign currency translation adjustment, increase

(decrease) in stockholders' equity 180

Comprehensive income (loss) for the year ended December 31, 2011 is a. ($74). b. $1,226. c. $1,426. d. $126. MC13-11 (LO11) Which of the following is NOT found on a statement of changes in stockholders’ equity? a. Revenue b. Treasury Stock c. Retained Earnings d. Accumulated Gains (Losses) Not Affecting Retained Earnings

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Matching

Matching 13-1 (LO1) Listed below are the terms and associated definitions from the chapter for LO1. Match the correct definition letter with each term number. ___ 1. board of

directors ___ 2. par value ___ 3. stated value ___ 4. cumulative

preferred stock ___ 5. dividends in

arrears ___ 6. noncumulative

preferred stock ___ 7. participating

preferred stock ___ 8. convertible ___ 9. callable ___ 10. redeemable

preferred stock

a. preferred stock that provides for additional dividends to be paid to preferred stockholders after dividends of a specified amount are paid to common stockholders

b. a security, such as a bond or a preferred stock, that can be redeemed and canceled at the option of the issuing company

c. has a right to receive current dividends as well as any dividends in arrears before common stockholders receive any dividends

d. group elected by the shareholders to oversee the strategic and long-run planning for the corporation

e. preferred stock that has no claim on any prior year dividends that may have been “passed”

f. preferred stock that may be turned into cash at the option of the holder, at a fixed price on a specific date, or upon other conditions not solely within the control of the issuer

g. securities, such as bonds and preferred stock, whose terms permit the holder to convert the investment into common stock of the issuing company

h. a nominal value that is assigned to stock by the terms of a corporation’s charter

i. dividend on cumulative preferred stock that are passed or not paid

j. a nominal value that may be assigned to no-par stock by the board of directors of a corporation

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Matching 13-2 (LO2, LO3) Listed below are the terms and associated definitions from the chapter for LO2 and LO3. Match the correct definition letter with each term number. ___ 1. additional paid-

in capital ___ 2. subscription ___ 3. business

combination ___ 4. purchase

method ___ 5. treasury stock ___ 6. cost method ___ 7. par (or stated)

value method

a. a method of accounting for treasury stock purchases in which the entire amount of the treasury stock is shown as a subtraction from equity

b. the investment by stockholders in excess of the amounts assignable to capital stock as par or stated value, as well as invested capital from other sources, such as sale of treasury stock

c. stock issued but subsequently bought back by the same company and held for possible future reissuance or retirement

d. accounting for a business combination whereby the asset and liability values of the purchased company are recorded at their market values; goodwill is recognized

e. the combining of two businesses accomplished through the exchange of cash or an exchange of stock

f. method of accounting for treasury stock purchases in which the repurchased shares are accounted for as if they were being retired

g. a contract between the purchaser of stock and the issuer in which the purchaser promises to buy shares of the issuing company’s stock

Matching 13-3 (LO4, LO5) Listed below are the terms and associated definitions from the chapter for LO4 and LO5. Match the correct definition letter with each term number. ___ 1. stock rights ___ 2. stock warrants ___ 3. stock options ___ 4. detachable

warrants ___ 5. nondetachable

warrants ___ 6. performance-

based stock option plan

___ 7. stock appreciation rights (SARs)

a. awards an employee a cash amount equal to the market value of the issuing firm’s shares above a specified threshold price

b. cannot be traded separately from the security with which they were originally issued

c. dependent on how well the individual or company performs after the date the options are granted

d. generally issued in conjunction with the issuance of another security

e. can be traded separately from the security with which they were originally issued

f. granted to officers or employees as part of a compensation plan; allow for the purchase of shares at a specified exercise price

g. issued to existing shareholders to buy shares of stock in order to maintain their proportionate ownership interests

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Matching 13-4 (LO8, LO9) Listed below are the terms and associated definitions from the chapter for LO8 and LO9. Match the correct definition letter with each term number. ___ 1. appropriated

retained earnings

___ 2. cash dividend ___ 3. property

dividend ___ 4. nonreciprocal

transfer to owners

___ 5. small stock dividend

___ 6. large stock dividend

___ 7. stock split ___ 8. liquidating

dividend

a. a stock dividend of 25% or more of the shares outstanding

b. a dividend paid in the form of some asset other than cashc. amount of retained earnings restricted (i.e., made

unavailable for dividend payments) at the discretion of the board of directors

d. a stock dividend of less than 25% of the shares outstanding

e. a distribution to stockholders representing a return of a portion of their contributed capital

f. a reduction in the par or stated value of stock accompanied by a proportionate increase in the number of shares outstanding

g. the payment of cash to shareholders in proportion to the number of shares owned

h. transfer of cash or property to shareholders in which nothing is received by the company in return

Matching 13-5 (LO10, LO11) Listed below are the terms and associated definitions from the chapter for LO10 and LO11. Match the correct definition letter with each term number. ___ 1. foreign

currency translation adjustment

___ 2. minimum pension liability adjustment

___ 3. available-for-sale securities

___ 4. derivative ___ 5. equity reserve ___ 6. statement of

changes in stockholders’ equity

a. negative equity item resulting from the adjustment to pension liability to ensure that at least a minimum pension liability is reported

b. a financial instrument, such as an option or a future, that derives its value from the movement of a price, an exchange rate, or an interest rate associated with some other item

c. a partition of total equity common in the financial statements of foreign companies; each has specific legal restrictions dictating whether it can be distributed to shareholders

d. equity item arising from the change in the equity of foreign subsidiaries resulting from changes in foreign currency exchange rates

e. a report that summarizes the reasons for the changes in all equity accounts during a period of time

f. investment securities not intended for immediate trading but, in the case of debt securities, not intended to be held until maturity

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Problems

Problem 13-1 (LO2) The following transactions relate to the stockholders' equity transactions of Kati Corporation for its initial year of existence. a. Jan. 7 Articles of incorporation are filed with the state. The state authorized

the issuance of 10,000 shares of $50 par value preferred stock and 200,000 shares of $10 par value common stock.

b. Jan. 28 Issued 40,000 shares of common stock for $14 per share. c. Feb. 3 Issued 80,000 shares of common stock in exchange for land and

buildings that have an appraised value of $250,000 and $1,000,000, respectively. The stock traded at $15 per share on that date on the over-the-counter market.

d. Feb. 24 Issued 2,000 shares of common stock to Salisbury and Associates, Attorneys-at-Law, in payment for legal services rendered in connection with incorporation. The company charged the amount to organization costs. The market value of the stock was $16 per share.

e. Sept. 12 Received subscriptions for 10,000 shares of preferred stock at $53 per share. A 40 percent down payment accompanied the subscriptions. The balance is due on October 1.

f. Oct. 1 Received the final payment for 10,000 shares. Prepare journal entries to record the foregoing transactions. Identify the entries by letter (a–f). Problem 13-2 (LO3) On July 1, Renne Corporation reacquired 10,000 shares of its $1 par value common stock at $34. The stock was originally issued at $18. All 10,000 shares were resold on November 1 at $45. Provide the journal entries required to record the reacquisition and the subsequent resale of the stock using the (1) par-value method and the (2) cost method of accounting for treasury stock.

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Problem 13-3 (LO1, LO9) Lux Company paid cash dividends totaling $150,000 in 2009 and $75,000 in 2010. In 2011, Bennett intends to pay cash dividends of $800,000. Compute the amount of cash dividends per share to be received by common stockholders in 2011 under each of the following assumptions. Treat each case independently. There were no dividends in arrears as of January 1, 2009. 1. 25,000 shares of common stock; 100,000 shares of 6 percent, $50 par cumulative

preferred stock 2. 25,000 shares of common stock; 50,000 shares of 6 percent, $50 par noncumulative

preferred stock 3. 25,000 shares of common stock; 70,000 shares of 6 percent, $100 par cumulative

preferred stock

Solutions, Approaches, and Explanations

MC13-1 Answer: c Approach and explanation: Choices a and d pertain to common stock—not preferred stock. Choice b relates only to stock rights (which generally only apply to some shares of common stock—not preferred stock). When additional shares of preferred stock are issued, they are usually a new kind of preferred shares (with a different dividend rate than prior issues based on the current market). Again, shares of preferred stock aren’t necessarily better; they merely pay dividends (which are limited and stated) before shares of common stock. Preferred shareholders also tend to get paid before common shareholders, but after creditors, in a liquidation of a corporation. MC13-2 Answer: d Approach and explanation: Don’t confuse the word “par” when used in conjunction with stock with the word “par” when used in conjunction with bonds. Bonds are usually sold at a price very near the par value. Common stock is seldom sold at a price near the par value. Preferred stock, on the other hand, is frequently sold at a price near the par value. The liquidation value of common stock is whatever is left over in a corporation after all the creditors and preferred stockholders are taken care of. Par value has nothing to do with this.

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The book value of common stock is the price the shares were sold at initially (less fees). This amount is usually much more than the par value. Choices b and c are the same thing. If you knew that you could safely rule out those choices since they both couldn’t be correct, then there is only one correct choice. MC13-3 Answer: b Approach and explanation: Whether the cost or par-value method is used for the recording of treasury stock doesn’t matter. Neither will result in income being reported when treasury stock is resold, reissued, or retired. Therefore, you can safely rule out choices c and d. So then the question is, “When, if ever, is Retained Earnings affected by the resale of treasury stock?” Under the cost method (the method most widely used), Retained Earnings receives a debit if treasury stock is sold for less than it was purchased for if the Paid-In Capital from Treasury Stock account is at, or reduced to, zero. Retained Earnings can also be debited if shares are retired, under the cost method, after being purchased back for more than the original issue price. Under the par-value method, treasury stock that is purchased for more than the original issue price is always recorded, in part, as a debit to Retained Earnings. This is why the par-value method is not usually used in practice since companies usually have more reductions in retained earnings under this method. MC13-4 Answer: c Approach and explanation: Rule number one of this chapter is that Common Stock does not receive credits for amounts beyond the par value. With that in mind, you can rule out choices a and b. The next rule is that you should not account for something prematurely. Similar to taking out a line of credit, until cash is actually drawn down on that line of credit, a credit to a liability does not take place. Similarly, when rights have been issued, nothing, from an accounting standpoint, has really taken place yet—no cash has come in and no shares have been issued. There is no entry to make at this point which should, or will, affect the face of the financial statements. It is when the rights are exercised, cash is received, and shares are actually issued that the following entry (assuming all of the rights are exercised at the same time) should be made: Cash 180,000

Common Stock 10,000 Additional Paid-In Capital 170,000

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MC13-5 Answer: b Approach and explanation: The total compensation expense is calculated on the date of grant and then expensed evenly over the vesting period. How much a company pays to acquire treasury stock is irrelevant to the compensation expense calculation. Another item to note is that it doesn’t matter how many of the employees are expected to stay with the company or how many actually do stay. Compensation expense is still recognized even if they leave the company in 2012 or, given past turnover rates, it is expected that some may leave in 2012. The calculation is as follows: $7 × 60,000 = $420,000 of compensation expense Vesting period (not exercisable period) = 2 years $420,000/2 = $210,000 of compensation expense in each year (2011 and 2012) MC13-6 Answer: d Approach and explanation: The first thing to note is the “not” in the question. Underline it, highlight it, or circle it—do something so that you don’t miss it. With that in mind, you should be looking for three choices that are liabilities and one that is not (and likely to be equity since that is what this chapter is about). The first three choices are the ones discussed in the chapter that sound like equity, but, in substance, are actually more like liabilities and, hence, required to be classified as such. The reason why a certain number of shares is equity, whereas a dollar value of shares is not, is that if a number of shares is required to be issued, the person to whom the shares will be issued essentially becomes an owner at that point. They will begin to share in the risks and rewards that other equity interests will share in. On the other hand, a person receiving a dollar value of shares will have their number of shares change between now and the time they are actually issued and, hence, will not share the risk and reward of other equity owners in the meantime. Once they actually receive the shares, the liability is turned into equity as they will begin to be an equity investor at that point. MC13-7 Answer: c Approach and explanation: The only time Retained Earnings is adjusted in a conversion is in the rare situation in which the common stock par value is high. Here are examples of the other choices:

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Choices a and b: Preferred Stock 1,000,000

Common Stock 1,000 Additional Paid-In Capital—Common Stock 999,000

Or if the par value of the common stock was also high, but not as high as the preferred stock: Preferred Stock 1,000,000

Common Stock 100,000 Additional Paid-In Capital—Common Stock 900,000

Choice d: Preferred Stock 100,000 Additional Paid-In Capital—Preferred Stock 50,000

Common Stock 1,000 Additional Paid-In Capital—Common Stock 900,000

Remember that preferred stock usually sells at or very near its par value, unlike common stock. Therefore, the par value and the fair value of preferred stock are frequently numbers that are close in value. Common stock, on the other hand, usually sells for much more than its par value. If the company has been around for a long time the fair value of shares of common stock can be dozens, or even hundreds, of times greater than the par value. MC13-8 Answer: d Approach and explanation: The first item to note is, of course, the “not” in the question. After you have circled, underlined, or highlighted it, realize that three of the choices will add to Retained Earnings and one will do nothing, or will result in a subtraction, to Retained Earnings. With that in mind, analyze each choice independently, and write a +, –, or 0 for the effect each action or event will have on Retained Earnings next to each choice. A change from an accelerated depreciation method to the straight-line method is a change in accounting principle that will require prior financial statements to be restated. Restating those income statements with less depreciation under the newly adopted method will increase net income in prior years, thereby increasing Retained Earnings. Put a + next to choice a and move on. Net income that is earned during the period is probably the easiest of the four choices. Net income will, of course, increase Retained Earnings. Put a + next to choice b and move on.

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For choice c, you’ll need to recall information from a few chapters back. Remember this formula? Beginning inventory + Purchases = Cost of goods available for sale – Ending inventory = Cost of goods sold If ending inventory was too low, then that means that cost of goods sold was too high and income was understated in the previous year. If income was understated and that understatement is now being corrected, the effect is to increase Retained Earnings now. Put a + next to choice c and move on. Do not just assume that choice d is correct, based on your other three + marks, without thinking it through first. What happens in a 2-for-1 stock split? No journal entry is made. Rather, the number of shares outstanding doubles and the par value gets cut in half. Therefore, choice d earns a 0 mark next to it and you can circle it as being the correct answer. MC13-9 Answer: c Approach and explanation: On the date of declaration, what has happened? A liability has been created called Dividends Payable. That account receives a credit for the amount of the declaration. The “missing” debit must, therefore, be to Retained Earnings. So Retained Earnings is affected, but not with an increase. Choices a and b can be crossed off. On the date of payment, what has happened? Cash has been paid, so Cash receives a credit. The liability created on the date of declaration is no longer owed, so Dividends Payable will receive a debit to bring it to a zero balance. That means Retained Earnings isn’t affected on the date of payment. MC13-10 Answer: b Approach and explanation: The solution to this question is as simple as adding up all the numbers given. MC13-11 Answer: a Approach and explanation: The only piece of the income statement that you will find on the statement of changes in stockholders’ equity is net income. Therefore, Revenue (choice a) is the correct answer as it is not found on this statement too. Even though Treasury Stock (choice b) decreases stockholders’ equity, any company that had repurchased its own shares would show Treasury Stock both on this statement and on the balance sheet (as negative numbers).

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Retained Earnings (choice c) is a part of stockholders’ equity even though it doesn’t represent contributed capital. Perhaps the trickiest one is “Accumulated Gains (Losses) Not Affecting Retained Earnings” (choice d) as it sounds like the opposite of Retained Earnings and, hence, something that possibly could be correct if Retained Earnings (choice c) is not. However, this item is actually very similar to Retained Earnings in that it isn’t contributed capital. What is it exactly? This category of items are those that go into comprehensive income but not net income. Net income is closed out to Retained Earnings but other, comprehensive income items, are not. Hence, this separate account tracks comprehensive income adjustment items over the years. The textbook uses the above term as an example in the case of IBM’s statement of changes in stockholders’ equity. Other companies sometimes use a phrase that more closely describes where these items are coming from like “Accumulated Other Comprehensive Income (Loss).” Matching 13-1 1. d 2. h 3. j 4. c 5. i 6. e 7. a 8. g 9. b 10. f Complete these terminology matching exercises without looking back at the textbook or on to the glossary. After all, you probably won’t have those as a reference at test time. Learning through trial and error causes the item to be learned better and to stick in your memory longer than if you just look at the textbook, glossary, or a dictionary and “cook book” the answers. Sure you may get the answer correct on your first attempt, but missing something is sometimes best for retention. Don’t be afraid of failure while studying and practicing.

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Matching 13-2 1. b 2. g 3. e 4. d 5. c 6. a 7. f Matching 13-3 1. g 2. d 3. f 4. e 5. b 6. c 7. a Matching 13-4 1. c 2. g 3. b 4. h 5. d 6. a 7. f 8. e Matching 13-5 1. d 2. a 3. f 4. b 5. c 6. e Problem 13-1 a. No entry is required for the authorization of shares. b. Cash 560,000a

Common Stock 400,000b

Paid-In Capital in Excess of Par—Common Stock 160,000

a40,000 × $14 = $560,000 b40,000 × $10 = $400,000

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c. Land 240,000

Buildings 960,000 Common Stock 800,000a

Paid-In Capital in Excess of Par—Common Stock 400,000

a80,000 × $10 = $800,000

Note: The fair market value of the stock is more readily determinable than the value of the real property because it was traded on the over-the-counter market on the transaction date. The value of the stock should be assigned to the land and buildings in proportion to their appraised values:

Cost of Land = $250,000/($250,000 + $1,000,000) × $1,200,000 = $240,000 Cost of Building = $1,000,000/($250,000 + $1,000,000) × $1,200,000 = $960,000

d. Organization Costs 32,000a

Common Stock 20,000b

Paid-In Capital in Excess of Par—Common Stock 12,000

a2,000 × $16 = $32,000 b2,000 × $10 = $20,000

e. Cash 212,000a

Subscriptions Receivable 318,000 Preferred Stock Prescribed 500,000b

Paid-In Capital in Excess of Par—Preferred Stock 30,000

a(10,000 × $53) × 0.40 = $212,000 b10,000 × $50 = $500,000

f. Cash 318,000a

Subscriptions Receivable 318,000 Preferred Stock Subscribed 500,000 Preferred Stock 500,000

a(10,000 × $53) × 0.60 = $318,000

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Problem 13-2 Fill in the pieces you know first and the missing pieces will likely come to you easier. For instance, the cash portion of each entry is the easiest part to figure out. Since it is the only credit (when it is a credit), or the only debit (when it is a debit), you know you have to come up with the other side of the entry to equal cash. Retained Earnings will never increase from dealings in treasury stock. Finally, the name of the method gives away whether the par value of the treasury stock needs to be considered or not. (1) July 1 Treasury Stock 10,000a Additional Paid-In Capital—

Treasury Stock 170,000b

Retained Earnings 160,000 Cash 340,000c

Nov. 1 Cash 450,000d

Treasury Stock 10,000 Additional Paid-In Capital—

Treasury Stock 440,000

a10,000 × $1 = $10,000 b10,000 × $17 = $170,000 c10,000 × $34 = $340,000 d10,000 × $45 = $450,000

(2) July 1 Treasury Stock 340,000 Cash 340,000 Nov. 1 Cash 450,000

Treasury Stock 340,000 Additional Paid-In Capital—

Treasury Stock 110,000

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Problem 13-3 1. Preferred dividends per year: 100 shares × $3 (0.06 × $50) = $300,000

Preferred dividends in 2009:

Paid In Arrears Preferred dividends in 2009 $150,000 $150,000 Preferred dividends in 2010:

Paid In Arrears Arrearage from 2009 $75,000 $ 75,000 Arrearage from 2010 300,000 Total in arrears at 12/31/10 $375,000

Preferred dividends in 2011: Arrearage from 2009 and 2010 $375,000 Current year preferred dividend 300,000 Total preferred dividends paid in 2011 $675,000

Remainder to common: $800,000 – $675,000 = $125,000

Common dividends per share: $125,000/25,000 shares = $5 per share

2. Preferred dividends per year: 50,000 shares × $3 = $150,000

Dividends in arrears for 2009: $0 Dividends in arrears for 2010: $0 Dividends paid on preferred shares for 2011: $150,000 Remainder to common: $800,000 – $150,000 = $650,000 Common dividends per share: $650,000/25,000 shares = $26 per share

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3. Preferred dividends per year: 70,000 shares × $6 (0.06 × $100) = $420,000 Preferred dividends in 2009:

Paid In Arrears Preferred dividends in 2009 $150,000 $270,000 Preferred dividends in 2010:

Paid In Arrears Arrearage from 2009 $75,000 $195,000 Arrearage from 2010 420,000 Total in arrears at 12/31/10 $615,000

Preferred dividends in 2011: Total dividends paid in 2011 $800,000 Total in arrears at 12/31/10 615,000 Amount available for preferred dividend in 2011 $185,000

Total preferred dividends in 2011: $800,000 [with $135,000 ($420,000 – $185,000)

still in arrears] Remainder to common: $0

Common dividends per share: $0

Glossary

Note that Appendix C in the rear portion of the textbook contains a comprehensive glossary for all of the terms used in the textbook. That is the place to turn to if you need to look up a word but don’t know which chapter(s) it appeared in. The glossary below is identical with one major exception: It contains only those terms used in Chapter 13. This abbreviated glossary can prove quite useful when reviewing a chapter, when studying for a quiz for a particular chapter, or when studying for an exam which covers only a few chapters including this one. Use it in those instances instead of wading through the 19 pages of comprehensive glossary in the textbook trying to pick out just those words that were used in this chapter.

additional paid-in capital The investment by stockholders in excess of the amounts assignable to capital stock as par or stated value, as well as invested capital from other sources, such as sale of treasury stock.

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appropriated retained earnings Amount of retained earnings restricted (i.e., made unavailable for dividend payments) at the discretion of the board of directors.

available-for-sale securities Investment securities not intended for immediate trading but, in the case of debt securities, not intended to be held until maturity.

board of directors Group elected by the shareholders to oversee the strategic and long-run planning for the corporation.

business combination The combining of two businesses accomplished through the exchange of cash or an exchange of stock.

callable A security, such as a bond or a preferred stock, that can be redeemed and canceled at the option of the issuing company.

cash dividend The payment of cash to shareholders in proportion to the number of shares owned.

convertible Securities, such as bonds and preferred stock, whose terms permit the holder to convert the investment into common stock of the issuing company.

cost method Method of accounting for treasury stock purchases in which the entire cost of the treasury stock is shown as a subtraction from equity.

cumulative preferred stock Preferred stock that has a right to receive current dividends as well as any dividends in arrears before common stockholders receive any dividends.

derivative A financial instrument, such as an option or a future, that derives its value from the movement of a price, an exchange rate, or an interest rate associated with some other item.

detachable warrants Stock warrants that can be traded separately from the security with which they were originally issued.

dividends in arrears Dividends on cumulative preferred stock that are passed or not paid. Dividends in arrears must be paid before any dividends can be paid to common stockholders.

equity reserve A partition of total equity common in the financial statements of foreign companies. Each equity reserve has specific legal restrictions dictating whether it can be distributed to shareholders.

foreign currency translation adjustment Equity item arising from the change in the equity of foreign subsidiaries resulting from changes in foreign currency exchange rates.

large stock dividend A stock dividend of 25% or more of the shares outstanding.

liquidating dividend  A distribution to stockholders representing a return of a portion of their contributed capital.

minority interest  The amount of equity investment made by outside shareholders to consolidated subsidiaries that are not 100% owned by the parent.

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minimum pension liability adjustment Negative equity item resulting from the adjustment to pension liability to ensure that at least a minimum pension liability is reported.

noncontrolling interest The term used by the FASB to replace “minority interest” and directs that this item be classified in the consolidated balance sheet as part of equity.

noncumulative preferred stock Preferred stock that has no claim on any prior year dividends that may have been “passed.”

nondetachable warrants Stock warrants that cannot be traded separately from the security with which they were originally issued.

nonreciprocal transfer to owners Transfer of cash or property to shareholders in which nothing is received by the company in return.

par (or stated) value method Method of accounting for treasury stock purchases in which the repurchased shares are accounted for as if they were being retired.

par value A nominal value that is assigned to stock by the terms of a corporation’s charter.

participating preferred stock Preferred stock that provides for additional dividends to be paid to preferred stockholders after dividends of a specified amount are paid to common stockholders.

performance-based stock option plan Option plan in which the terms are dependent on how well the individual or company performs after the date the options are granted.

pooling-of-interest method A way to account for a business combination that assumes a merger of two equals; neither of the merging companies is thought of as purchasing the other.

property dividend A dividend paid in the form of some asset other than cash.

purchase method A method of accounting for a business combination whereby the asset and liability values of the purchased company are recorded at their market values; goodwill is recognized.

redeemable preferred stock Preferred stock that may be redeemed at the option of the holder, at a fixed price on a specific date, or upon other conditions not solely within the control of the issuer.

small stock dividend A stock dividend of less than 25% of the shares outstanding.

stated value A nominal value that may be assigned to no-par stock by the board of directors of a corporation; similar in concept to par value.

statement of changes in stockholders’ equity A report that summarizes the reasons for the changes in all equity accounts during a period of time.

stock appreciation rights (SARs) Awards an employee a cash amount equal to the market value of the issuing firm’s shares above a specified threshold price.

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stock options Rights granted to officers or employees as part of a compensation plan; the options allow for the purchase of shares at a specified exercise price.

stock rights Rights issued to existing shareholders to buy shares of stock in order to maintain their proportionate ownership interests.

stock split A reduction in the par or stated value of stock accompanied by a proportionate increase in the number of shares outstanding.

stock warrants Rights to purchase shares of stock; warrants are generally issued in conjunction with the issuance of another security.

subscription A contract between the purchaser of stock and the issuer in which the purchaser promises to buy shares of the issuing company’s stock.

treasury stock Stock issued but subsequently bought back by the same company and held for possible future reissuance or retirement.