EXAMPLE TEST QUESTIONS

Chapter 15

Multiple Choice

1. For a compensatory stock option plan for which the date of grant and measurement date are the same, compensation cost should be recognized in the income statementa. At the date of retirementb. Of each period in which services are renderedc. At the exercise dated. At the adoption date of the plan

Answer d

2. Payment of a dividend in stocka. Increases the current ratiob. Decreases the amount of working capitalc. Increases total stockholders’ equityd. Decreases book value per share of stock outstanding

Answer d

3. The directors of Corel Corporation, whose $40 par value common stock is currently selling at $50 per share, have decided to issue a stock dividend. The corporation has an authorization for 200,000 shares of common, has issued 110,000 shares of which 10,000 shares are now held as treasury stock, and desires to capitalize $400,000 of the retained earnings balance. To accomplish this, the percentage of stock dividend that the directors should declare isa. 10b. 8c. 5d. 2

Answer a

4. When a stock dividend is small, for example a 10% stock dividend,a. Retained earnings is not reduced because the dividend is immaterial .b. Retained earnings is reduced by the fair value of the stock.c. Retained earnings is reduced to the par value of the stock.d. Paid-in capital in excess of par value is unaffected.

Answer b

5. The par value method of reporting a treasury stock transactiona. Will be reported in the balance sheet as a reduction of total stockholders’ equity.b. Results in no change to total stockholders’ equity.c. Results in a reduction in the number of shares that are available to be sold to prospective

investors.d. Assumes constructive retirement of the treasury shares.

Answer d

6. On December 31, 2010, when the Conn Company’s stock was selling at $36 per share, its capital accounts were as follows

Capital stock (par value $20, 100,000 shares issued) $2,000,000 Premium on capital stock 800,000 Retained Earnings 4,550,000 If a 100 percent stock dividend were declared and the par value per share remained at $20

a. No entry would need to be made to record the dividendb. Capital stock would increase to $5,600,000c. Capital stock would increase to $4,000,000d. Total capital would decrease

Answer c

7. A company has not paid dividends on its cumulative nonvoting preferred stock for 20 years. Healthy earnings have been reported each year, but they have been retained to support the growth

of the company. The board of directors appropriately authorized management to offer the preferred shareholders an exchange of bonds and common stock for all the preferred stock. The exchange is about to be consummated. Which of the following best describes the effect of the exchange on the company?a. The statute of limitations applies; hence, cumulative dividends of only seven years need to be

paid on the preferred stock exchanged.b. The company should record an extraordinary gain for income determination purposes to the

extent that dividends in arrears do not have to be paid in the exchange transaction.c. Gain or loss should be recognized on the exchange by the company, and the exchange would

have to be approved by the Securities and Exchange Commission. d. Regardless of the market value of the bonds and common stock, no gain or loss should be

recognized by the company on the exchange, and no dividends need to be paid on the preferred stock exchanged.

Answer d

8. A restriction of retained earnings is most likely to be required by the a. Exhaustion of potential benefits of the investment credit b. Purchase of treasury stock c. Payment of last maturing series of a serial bond issue d. Amortization of past service costs related to a pension plan

Answer b

9. A feature common to both stock splits and stock dividends is a. A reduction in total capital of a corporationb. A transfer from earned capital to paid-in capitalc. A reduction in book value per shared. Inclusion in conventional statement of source and application of funds

Answer c

10. Assuming the issuing company has only one class of stock, a transfer from retained earnings to capital stock equal to the market value of the shares issued is ordinarily a characteristic of a. Either a stock dividend or a stock splitb. Neither a stock dividend nor a stock splitc. A stock split but not a stock dividendd. A stock dividend but not a stock split

Answer d

11. When a stock option plan for employees is compensatory, the measurement date for determining compensation cost is the a. Date the option plan is adopted, provided it precedes the date on which the options may first

be exercised by less than one operating cycleb. Date on which the options may first be exercised (if the first actual exercise is within the

same operating period) or the date on which a recipient first exercises any of his optionsc. First date on which are known both the number of shares than an individual employee is

entitled to receive and the option or purchase price, if anyd. Date each option is granted

Answer c

12. As a minimum, how large in relation to total outstanding shares may a stock distribution be before it should be accounted for as a stock split instead of a stock dividend?a. No less than 2 to 5 percentb. No less than 10 to 15 percentc. No less than 20 to 25 percentd. No less than 45 to 50 percent

Answer b

13. The dollar amount of total stockholders’ equity remains the same when there is a (an)a. Issuance of preferred stock in exchange for convertible debenturesb. Issuance of nonconvertible bonds with detachable stock purchase warrantsc. Declaration of a stock dividendd. Declaration of a cash dividend

Answer c

14. A company with a substantial deficit undertakes a quasi-reorganization. Certain assets will be written down to their present fair market value. Liabilities will remain the same. How would the entries to record the quasi-reorganization affect each of the following?

Contributed Capital Retained Earningsa. Increase Decreaseb. Decrease No effectc. Decrease Increased. No effect Increase

Answer c

15. What is the most likely effect of a stock split on the par value per share and the number of shares outstanding?

Par Value Number of shares Per share outstanding

a. Decrease Increaseb. Decrease No effectc. Increase Increased. No effect No effect

Answer a

16. Gilbert Corporation issued a 40percent stock split-up of its common stock that had a par value of $10 before and after the split-up. At what amount should retained earnings be capitalized for the additional shares issued?a. There should be no capitalization of retained earningsb. Par valuec. Market value on the declaration dated. Market value on the payment date

Answer c

17. How would the declaration and subsequent issuance of a 10 percent stock dividend by the issuer affect each of the following when the market value of the shares exceeds the par value of the stock?

Common Stock Additional Paid-in Capitala. No effect No effectb. No effect Increasec. Increase No effectd. Increase Increase

Answer d

18. A company with a $2,000,000 deficit undertakes a quasi-reorganization on November 1, 2010. Certain assets will be written down by $400, 000 to their present fair market value. Liabilities will remain the same. Capital stock was $3,000,000 and additional paid-in capital was $1,000,000 before the quasi-reorganization. How would the entries to accomplish these changes on November 1, 2010, affect each of the following?

Capital Stock Total Stockholders’ Equity

a. No effect No effect b. No effect Decreasec. Decrease Decreased. Decrease No effect

Answer d

19. How would a stock split affect each of the following? Total Stockholders’ Additional Assets Equity Paid-in Capital

a. Increase Increase No effect b. No effect No effect No effectc. No effect No effect Increased. Decrease Decrease Decrease

Answer b

20. The purchase of treasury stocka. Decreases common stock authorizedb. Decreases common stock issuedc. Decreases common stock outstandingd. Has no effect on common stock outstanding

Answer d

21. The equation, assets = equities, expresses which of the following theories of equity?a. Proprietary theory.b. Commander theory.c. Entity theory.d. Enterprise theory.

Answer c

22. Under the residual equity theorya. A business is viewed as a social institution.b. Management is responsible for maximizing the wealth of common stockholders.c. A manager’s goals are considered as important as those of the common stockholders.d. Equities are viewed as restrictions on assets..

Answer b

23. Under which of the theories of equity is a manager’s goals considered as important as those of the common stockholder. a. Proprietary theory.b. Commander theory.c. Entity theory.d. Enterprise theory.

Answer b

24. Which of the theories of equity is consistent with the definition of equity that is found in Statement of Financial Accounting Concepts No. 6?a. Proprietary theory.b. Commander theory.c. Entity theory.d. Enterprise theory.

Answer a

25. Which of the following securities must be reported as a liability because they have the characteristics of both liabilities and equity, but the liability characteristic is dominant?a. Redeemable preferred stock.b. Stock options issued with a debt security .c. Detachable stock options.d. Mandatorily redeemable preferred stock.

Answer d

26. When a dividend paid to stockholders who own mandatorily redeemable preferred stock, the company must report the dividenda. As an adjustment to retained earnings in its statement of owners’ equity .b. As an expense in the income statement.c. As a reduction to other comprehensive income.d. In the financing activities section of the statement of cash flows.

Answer b

27. When preferred stock is converted to common stocka. The debt-to-equity ratio decreases.b. The debt-to-equity ratio increases.c. The debt-to-equity ratio is unchanged.d. A gain or loss is reported in earnings for the difference between the fair value of the common

stock and the book value of the preferred stock that was converted .

Answer c

28. When employees are granted options as part of a compensatory stock option plan, a. Total compensation is measured using a fair value method.b. Total compensation is measured using the intrinsic method.c. Total compensation is measured when the options are in the money.d. Total compensation is measured using the difference between the strike price and the fair

value of the options on the grant date.

Answer c

Essay

1. Discuss the following theories of equity:a. Proprietary

According to the proprietary theory, the firm is owned by some specified person or group. The ownership interest may be represented by a sole proprietor, a partnership, or a number of stockholders. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners’ liabilities. Revenues received by the firm immediately increase the owner’s net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. This theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they are distributed. Therefore, the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as

assets – liabilities = proprietorship

Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company’s financial statements. The proprietary theory is particularly applicable to sole proprietorships where the owner is the decision maker. When the form of the enterprise grows more complex, and the ownership and management separate, this theory becomes less acceptable.

b. Entity

The rise of the corporate form of organization, (1) was accompanied by the separation of ownership and management, (2) conveyed limited liability to the owners, and (3) resulted in the legal definition of a corporation as though it were a person, encouraged the evolution of new theories of ownership. Among the first of these theories was the entity theory. From an accounting standpoint, the entity theory can be expressed as

assets = equities

The entity theory, like the proprietary theory, is a point of view toward the firm and the people concerned with its operation. This viewpoint places the firm, and not the owners, at the center of interest for accounting and financial reporting purposes. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups. The assets and liabilities belong to the firm, not to its owners. As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity. Any profits belong to the entity and accrue to the stockholders only when a dividend is declared. Under this theory, all the items on the right-hand side of the balance sheet, except retained earnings (it belongs to the firm), are viewed as claims against the assets of the firm, and individual items are distinguished by the nature of their claims. Some items are identified as creditor claims and others are identified as owner claims; nevertheless, they are all claims against the firm as a separate entity.

c. Fund

The use of the fund theory would abandon the personal relationship advocated by the proprietary theory and the personalization of the firm advocated by the entity theory. Under the fund approach, the measurement of net income plays a role secondary to satisfying the special interests of management, social control agencies (e.g., government agencies), and the overall process of credit extension and investment. The fund theory is expressed by the following equation:

assets = restrictions on assets

This theory explains the financial reporting of an organization in terms of three features, as follows:

1.Fund. —an area of attention defined by the activities and operations surrounding any one set of accounting records and for which a self-balancing set of accounts is created.

2. Assets. —economic services and potentials.

3. Restrictions. —limitations on the use of assets.

These features are applied to each homogeneous set of activities and functions within the organization, thereby providing a separate accounting for each area of economic concern.

The fund theory has not gained general acceptance in financial accounting; it is more suitable to governmental accounting.

d. Commander

The commander approach is offered as a replacement for the proprietary and entity theories because it is argued that the goals of the manager (commander) are at least equally important to those of the proprietor or entity. The proprietary, entity, and fund approaches emphasize persons, personalization, and funds, respectively, but the commander theory emphasizes control. Everyone who has resources to deploy is viewed as a commander.

The commander theory, unlike the proprietary, entity, and fund approaches, has applicability to all organizational forms (sole proprietorships, partnerships, and corporations). The form of organization does not negate the applicability of the commander view because the commander can take on more than one identity in any organization. In sole proprietorships or partnerships, the proprietors or partners are both owners and commanders. Under the corporate form, both the managers and the stockholders are commanders in that each maintains some control over resources. (Managers control the enterprise resources, and stockholders control returns on investment emerging from the enterprise.)

A commander theorist would argue that the notion of control is broad enough to encompass all relevant parties to the exclusion of none. The function of accounting, then, takes on an element of stewardship, and the question of where resource increments flow is not relevant. Rather, the relevant factor is how the commander allocates resources to the benefit of all parties. Responsibility accounting is consistent with the commander theory. Responsibility accounting identifies the revenues and costs that are under the control of various “commanders” within the organization, and the organization’s financial statements are constructed to highlight the contributions of each level of control to enterprise profits. The commander theory is not on the surface a radical move from current accounting practices, and it has generated little reaction in accounting circles.

e. Enterprise

Under the enterprise theory, business units, most notably those listed on national or regional stock exchanges, are viewed as social institutions, composed of capital contributors having “a common purpose or purposes and, to a certain extent, roles of common action.” Management within this framework essentially maintains an arm’s-length relationship with owners and has as its primary responsibilities (1) the distribution of adequate dividends and (2) the maintenance of friendly terms with employees, consumers, and government units. Because this theory applies only to large nationally or regionally traded issues, it is generally considered to have only a minor impact on accounting theory, or the development of accounting principles and practices.

f. Residual equity

Residual equity is defined as “the equitable interest in organization’s assets which will absorb the effect upon those assets of any economic event that no interested party has specifically agreed to.” Here, the common shareholders hold the residual equity in the enterprise by virtue of having the final claim on income, yet they are the first to be charged for losses. The residual equity holders are vital to the firm’s existence in that they are the highest risk takers and provide a substantial volume of capital during the firm’s developmental stage.

The residual equity theory is formulated as

assets –specific equities = residual equities

Under this approach, the residual of assets, net of the claim of specific equity holders (creditors and preferred stockholders), accrue to residual owners. In this framework, the role of financial reporting is to provide prospective and current residual owners with information regarding enterprise resource flows so that they can assess the value of their residual claim. Management is in effect a trustee responsible for maximizing the wealth of residual equity holders. Income accrues to the residual owners after the claims of specific equity holders are met. Thus, the income to specific equity holders, including interest on debt and dividends to preferred stockholders, would be deducted in arriving at residual net income. This theory is consistent with models that are formulated in the finance literature, with current financial statement presentation of earnings per share, and with the Conceptual Framework’s emphasis on the relevance of projecting cash flows. Again, as with the fund, commander, and enterprise theories, the residual equity approach has gained little attention in financial accounting.

2. What is mandatorily redeemable preferred stock and how is it accounted for under the provisions of SFAS No. 150 (FASB ASC 480-10)?

Redemption provisions on preferred stock are common features of agreements entered into among the owners of closely held businesses. These agreements, which are often referred to as

shareholders’ or buy–sell agreements, provide for the orderly disposition of the owners’ investment in the company upon their separation from the company, usually at retirement, disability, or death. Because there is no market for the equity securities of a closely held company, departing owners or their heirs must rely on the company or the remaining owners to provide them with liquidity. Redemption by the company is usually favored over requiring the remaining owners to fund a buyout because the remaining owners may not have the necessary financial resources. Prior to the guidance contained at FASB ASC 480 owners’ equity that was redeemable pursuant to a buy–sell agreement was accounted for as equity, not debt, and the existence and significant terms of the buy–sell agreement are required to be described in the notes to financial statements.

In 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity,” (See FASB ASC 480). This guidance requires companies to record and report mandatorily redeemable preferred stock (MRPS) as a liability on their balance sheets, and the dividends on these securities as interest expense. Most companies previously disclosed MRPS between the liability and stockholders’ equity sections (i.e., the mezzanine section) of the balance sheet.

3. List and discuss four advantages of the corporate form of organization..

Several advantages accrue to the corporate form and help explain its emergence. Among these are:

1. Limited liability. —A stockholder’s loss on his or her investment is limited to the amount of the amount invested (unless on the date of acquisition, the purchase price of the shares acquired was less than their par value). Creditors may not look to the assets of individual owners for debt repayments in the event of a liquidation, as is possible in the case of sole proprietorships and partnerships.

2. Continuity. —The corporation’s life is not affected by the death or resignation of owners.3. Investment liquidity. —Corporate shares may be freely exchanged on the open market.

Many shares are listed on national security exchanges, thereby improving their marketability.

4. Variety of ownership interest. —Shares of corporate stock usually contain four basic rights: the right to vote for members of the board of directors of the corporation and thereby participate in management, the right to receive dividends, the right to receive assets on the liquidation of the corporation, and the preemptive right to purchase additional shares in the same proportion to current ownership interest if new issues of stock are marketed. Shareholders may sacrifice any or all of these rights in return for special privileges. This results in an additional class of stock termed preferred stock, which may have either or both of the following features: a. Preference as to dividends.b. Preference as to assets in liquidation.

4. Discuss the components of a corporation’s balance sheet capital section.

The components of a corporation’s capital section are classified by source in the following manner:

I. Paid-in capital (contributed capital)

A. Legal capital-par, stated value, or entire proceeds if no par or stated value accompanies the stock issue

B. Additional paid-in capital—amounts received in excess of par or stated value

II. Earned capital

A. Appropriated

B. Unappropriated

III. Other comprehensive income

5. Discuss the following special features of preferred stock:a. Convertible

A conversion feature allows preferred shareholders to exchange their shares for common shares. It is included on a preferred stock issue to make it more attractive to potential investors. Usually, a conversion feature is attached to allow the corporation to sell its preferred shares at a relatively lower dividend rate than is found on other securities with the same degree of risk. The conversion rate is normally set above the current relationship of the market value of the common share to the market value of the preferred convertible shares.

b. Call

Call provisions allow the corporation to reacquire preferred stock at some predetermined amount. Corporations include call provisions on securities because of uncertain future conditions. Current conditions dictate the return on investment that will be attractive to potential investors, but conditions may change so that the corporation may offer a lower return on investment in the future. In addition, market conditions may make it necessary to promise a certain debt–equity relationship at the time of issue. Call provisions allow the corporation to take advantage of future favorable conditions and indicate how the securities may be retired. The existence of a call price tends to set an upper limit on the market price of nonconvertible securities, since investors will not normally be inclined to purchase shares that could be recalled momentarily at a lower price.

c. Cumulative

Preferred shareholders normally have a preference as to dividends. That is, no common dividends may be paid in any one year until all required preferred dividends for that year are paid. Usually, corporations also include added protection for preferred shareholders in the form of a cumulative provision. This provision states that if all or any part of the stated preferred dividend is not paid in any one year, the unpaid portion accumulates and must

be paid in subsequent years before any dividend can be paid on common stock. Any unpaid dividend on cumulative preferred stock constitutes a dividend in arrears and should be disclosed in the notes to the financial statements, even though it is not a liability until the board of directors of the corporation actually declares it. Dividends in arrears are important in predicting future cash flows and as an indicator of financial flexibility and liquidity.

d. Participating

Participating provisions allow preferred stockholders to share dividends in excess of normal returns with common stockholders. For example, a participating provision might indicate that preferred shares are to participate in dividends on a 1:1 basis with common stock on all dividends in excess of $5 per share. This provision requires that any payments of more than $5 per share to the common stockholder also be made on a dollar-for-dollar basis to each share of preferred.

e. Redemption

A redemption provision indicates that the shareholder may exchange preferred stock for cash in the future. The redemption provision may include a mandatory maturity date or may specify a redemption price. If so, the financial instrument embodies an obligation to transfer assets, and would meet the definition of a liability, rather than equity. The SEC requires separate disclosure of manditorily redeemable preferred shares because of their separate nature. FASB ASC 480-10-50-4 requires that a manditorily redeemable financial instrument be classified as a liability unless redemption is required to occur only upon the liquidation or termination of the issuing company.

6. How did SFAS No. 123R change accounting for stock options?

SFAS 123R ( FASB ASC 718), requires companies issuing stock options to estimate the compensation expense arising from the granting of stock options by using a fair value method and to disclose this estimated compensation expense on their income statements. This treatment differs from the previous requirement to estimate compensation expense on the date of the grant as the difference between the option price and the market price.

7. Define and discuss accounting for stock warrants.

Stock warrants are certificates that allow holders to acquire shares of stock at certain prices within stated periods. These certificates are generally issued under one of two conditions:

1. As evidence of the preemptive right of current shareholders to purchase additional shares of common stock from new stock issues in proportion to their current ownership percentage.

2. As an inducement originally attached to debt or preferred shares to increase the marketability of these securities.

Under current practice, the accounting for the preemptive right of existing shareholders creates no particular problem. These warrants are recorded only as memoranda in the formal accounting records. In the event warrants of this type are exercised, the value of the shares of stock issued is measured at the amount of cash exchanged.

Detachable warrants attached to other securities require a separate valuation because they may be traded on the open market. The amount to be attributed to these types of warrants depends on their value in the securities market. Their value is measured by determining the percentage relationship of the price of the warrant to the total market price of the security and warrant, and applying this percentage to the proceeds of the security issue. This procedure should be followed whether the warrants are associated with bonds or with preferred stock.

8. Discuss the difference between a stock dividend and a stock split. Include in your discussion, the reasons a company might issue either a stock dividend or a stock split.

Corporations may have accumulated earnings but not have the funds available to distribute these earnings as cash dividends to stockholders. In such cases, the company may elect to distribute some of its own shares of stock as dividends to current stockholders. Distributions of this type are termed stock dividends. When stock dividends are minor, relative to the total number of shares outstanding, retained earnings is reduced by the market value of the shares distributed. Capital stock and additional paid-in capital are increased by the par value of the shares and any excess, respectively. In theory, a relatively small stock dividend will not adversely affect the previously established market value of the stock. The rationale behind stock dividend distributions is that the stockholders will receive additional shares with the same value per share as those previously held. Nevertheless, stock dividends are not income to the recipients. They represent no distribution of corporate assets to the owners and are simply a reclassification of ownership interests.

A procedure somewhat similar to stock dividends, but with a different purpose, is a stock split. The most economical method of purchasing and selling stock in the stock market is in blocks of 100 shares, and this practice affects the marketability of the stock. The higher the price of an individual share of stock, the fewer are the number of people able to purchase the stock in blocks of 100. For this reason, many corporations seek to maintain the price of their stock within certain ranges. When the price climbs above that range, the firm may decide to issue additional shares to all existing stockholders (or split the stock). In a stock split, each stockholder receives a stated multiple of the number of shares currently held (usually two or three for one), which lowers the market price per share. In theory, this lower price should be equivalent to dividing

the current price by the multiple of shares in the split, but intervening variables in the marketplace frequently affect prices simultaneously. A stock split does not cause any change in the stockholder’s equity section except to increase the number of actual shares outstanding and reduce the par or stated value per share. No additional values are assigned to the shares of stock issued in a stock split because no distribution of assets or reclassification of ownership interests occurs.

9. Define and discuss the two methods of accounting for treasury stock.

Two methods of accounting for treasury stock are found in current practice: the cost method and the par value method. Under the cost method, the presumption is that the shares acquired will be resold, and two events are assumed: (1) the purchase of the shares by the corporation and (2) the reissuance to a new stockholder. The reacquired shares are recorded at cost, and this amount is disclosed as negative stockholders’ equity by deducting it from total capital until the shares are resold. Because treasury stock transactions are transactions with owners, any difference between the acquisition price and the sales price is generally treated as an adjustment to paid-in capital (unless sufficient additional paid-in capital is not available to offset any “loss”; in such cases retained earnings is charged).

Under the par value method, it is assumed that the corporation’s relationship with the original stockholder is ended. The transaction is in substance a retirement; hence, the shares are considered constructively retired. Therefore, legal capital and additional paid-in capital are reduced for the original issue price of the reacquired shares. Any difference between the original issue price and the reacquisition price is treated as an adjustment to additional paid-in capital (unless a sufficient balance is not available to offset a “loss” and retained earnings is charged). The par value of the reacquired shares is disclosed as a deduction from capital stock until the treasury shares are reissued.

10. Obtain the financial statements of a company and ask the students to compute the:a. Return on common stockholders’ equity.b. Financial structure ratio

The answer to this question is dependent on the company selected.