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4. Distinguish between the following values relative to value of $20,000. Pierre applies the fair value option to
bonds payable: this note. Given an increase in market interest rates, the
(a) Maturity value. (c) Market (fair) value. fair value of the note is $22,600. Prepare the entry to
(b) Face value. (d) Par value. record the fair value option for this note.
5. Under what conditions of bond issuance does a discount 21. What disclosures are required relative to long-term debt
on bonds payable arise? Under what conditions of bond and sinking fund requirements?
issuance does a premium on bonds payable arise? 22. What is off-balance-sheet financing? Why might a com-
6. How should discount on bonds payable be reported on pany be interested in using off-balance-sheet financing?
the financial statements? Premium on bonds payable? 23. What are some forms of off-balance-sheet financing?
7. What are the two methods of amortizing discount and 24. Explain how a non-consolidated subsidiary can be a form
premium on bonds payable? Explain each. of off-balance-sheet financing.
8. Zopf Company sells its bonds at a premium and applies *2 5. What are the types of situations that result in troubled
the effective-interest method in amortizing the premium. debt?
Will the annual interest expense increase or decrease over *2 6. What are the general rules for measuring gain or loss by
the life of the bonds? Explain.
both creditor and debtor in a troubled-debt restructuring
9. Briggs and Stratton reported unamortized debt issue involving a settlement?
costs of $5.1 million. How should the costs of issuing *2 7. (a) In a troubled-debt situation, why might the creditor
these bonds be accounted for and classified in the finan-
grant concessions to the debtor?
cial statements?
(b) What type of concessions might a creditor grant the
10. Will the amortization of Discount on Bonds Payable debtor in a troubled-debt situation?
increase or decrease Bond Interest Expense? Explain.
*2 8. What are the general rules for measuring and recognizing
11. What is the “call” feature of a bond issue? How does the gain or loss by both the debtor and the creditor in a troubled-
call feature affect the amortization of bond premium or debt restructuring involving a modification of terms?
discount?
*2 9. What is meant by “accounting symmetry” between the
12. Why would a company wish to reduce its bond indebted- entries recorded by the debtor and creditor in a troubled-
ness before its bonds reach maturity? Indicate how this debt restructuring involving a modification of terms? In
can be done and the correct accounting treatment for such what ways is the accounting for troubled-debt restructur-
a transaction. ings non-symmetrical?
13. How are gains and losses from extinguishment of a debt *3 0. Under what circumstances would a transaction be re-
classified in the income statement? What disclosures are corded as a troubled-debt restructuring by only one of the
required of such transactions? two parties to the transaction?
800 Chapter 14 Long-Term Liabilities
BRIEF EXERCISES
3 BE14-1 Whiteside Corporation issues $500,000 of 9% bonds, due in 10 years, with interest payable semian-
nually. At the time of issue, the market rate for such bonds is 10%. Compute the issue price of the bonds.
3 4 BE14-2 The Colson Company issued $300,000 of 10% bonds on January 1, 2014. The bonds are due January 1,
2020, with interest payable each July 1 and January 1. The bonds are issued at face value. Prepare Colson’s jour-
nal entries for (a) the January issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.
3 4 BE14-3 Assume the bonds in BE14-2 were issued at 98. Prepare the journal entries for (a) January 1, (b) July
1, and (c) December 31. Assume The Colson Company records straight-line amortization semiannually.
3 4 BE14-4 Assume the bonds in BE14-2 were issued at 103. Prepare the journal entries for (a) January 1, (b) July 1,
and (c) December 31. Assume The Colson Company records straight-line amortization semiannually. |
3 4 BE14-5 Devers Corporation issued $400,000 of 6% bonds on May 1, 2014. The bonds were dated January 1,
2014, and mature January 1, 2017, with interest payable July 1 and January 1. The bonds were issued at face
value plus accrued interest. Prepare Devers’s journal entries for (a) the May 1 issuance, (b) the July 1 interest
payment, and (c) the December 31 adjusting entry.
3 4 BE14-6 On January 1, 2014, JWS Corporation issued $600,000 of 7% bonds, due in 10 years. The bonds were
issued for $559,224, and pay interest each July 1 and January 1. JWS uses the effective-interest method.
Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and
(c) the December 31 adjusting entry. Assume an effective-interest rate of 8%.
3 4 BE14-7 Assume the bonds in BE14-6 were issued for $644,636 and the effective-interest rate is 6%. Prepare
the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the
December 31 adjusting entry.
3 4 BE14-8 Teton Corporation issued $600,000 of 7% bonds on November 1, 2014, for $644,636. The bonds
were dated November 1, 2014, and mature in 10 years, with interest payable each May 1 and November 1.
Teton uses the effective-interest method with an effective rate of 6%. Prepare Teton’s December 31, 2014,
adjusting entry.
9 BE14-9 At December 31, 2014, Hyasaki Corporation has the following account balances:
Bonds payable, due January 1, 2023 $2,000,000
Discount on bonds payable 88,000
Interest payable 80,000
Show how the above accounts should be presented on the December 31, 2014, balance sheet, including the
proper classifications.
4 BE14-10 Wasserman Corporation issued 10-year bonds on January 1, 2014. Costs associated with the bond
issuance were $160,000. Wasserman uses the straight-line method to amortize bond issue costs. Prepare the
December 31, 2014, entry to record 2014 bond issue cost amortization.
5 BE14-11 On January 1, 2014, Henderson Corporation redeemed $500,000 of bonds at 99. At the time of
redemption, the unamortized premium was $15,000 and unamortized bond issue costs were $5,250. Prepare
the corporation’s journal entry to record the reacquisition of the bonds.
6 BE14-12 Coldwell, Inc. issued a $100,000, 4-year, 10% note at face value to Flint Hills Bank on January 1,
2014, and received $100,000 cash. The note requires annual interest payments each December 31. Prepare
Coldwell’s journal entries to record (a) the issuance of the note and (b) the December 31 interest payment.
6 BE14-13 Samson Corporation issued a 4-year, $75,000, zero-interest-bearing note to Brown Company on
January 1, 2014, and received cash of $47,664. The implicit interest rate is 12%. Prepare Samson’s journal
entries for (a) the January 1 issuance and (b) the December 31 recognition of interest.
6 BE14-14 McCormick Corporation issued a 4-year, $40,000, 5% note to Greenbush Company on January 1,
2014, and received a computer that normally sells for $31,495. The note requires annual interest payments
each December 31. The market rate of interest for a note of similar risk is 12%. Prepare McCormick’s journal
entries for (a) the January 1 issuance and (b) the December 31 interest.
6 BE14-15 Shlee Corporation issued a 4-year, $60,000, zero-interest-bearing note to Garcia Company on
January 1, 2014, and received cash of $60,000. In addition, Shlee agreed to sell merchandise to Garcia at an
amount less than regular selling price over the 4-year period. The market rate of interest for similar notes
is 12%. Prepare Shlee Corporation’s January 1 journal entry.
Exercises 801
7 BE14-16 Shonen Knife Corporation has elected to use the fair value option for one of its notes payable. The
note was issued at an effective rate of 11% and has a carrying value of $16,000. At year-end, Shonen Knife’s
borrowing rate has declined; the fair value of the note payable is now $17,500. (a) Determine the unrealized
holding gain or loss on the note. (b) Prepare the entry to record any unrealized holding gain or loss.
EXERCISES |
2 E14-1 (Classification of Liabilities) Presented below are various account balances of K.D. Lang Inc.
(a) Unamortized premium on bonds payable, of which $3,000 will be amortized during the next year.
(b) Bank loans payable of a winery, due March 10, 2018. (The product requires aging for 5 years before
sale.)
(c) Serial bonds payable, $1,000,000, of which $200,000 are due each July 31.
(d) Amounts withheld from employees’ wages for income taxes.
(e) Notes payable due January 15, 2017.
(f) Credit balances in customers’ accounts arising from returns and allowances after collection in full of
account.
(g) Bonds payable of $2,000,000 maturing June 30, 2016.
(h) Overdraft of $1,000 in a bank account. (No other balances are carried at this bank.)
(i) Deposits made by customers who have ordered goods.
Instructions
Indicate whether each of the items above should be classified on December 31, 2014, as a current liability, a
long-term liability, or under some other classification. Consider each one independently from all others;
that is, do not assume that all of them relate to one particular business. If the classification of some of the
items is doubtful, explain why in each case.
2 E14-2 (Classification) The following items are found in the financial statements.
(a) Discount on bonds payable.
(b) Interest expense (credit balance).
(c) Unamortized bond issue costs.
(d) Gain on repurchase of debt.
(e) Mortgage payable (payable in equal amounts over next 3 years).
(f) Debenture bonds payable (maturing in 5 years).
(g) Notes payable (due in 4 years).
(h) Premium on bonds payable.
(i) Treasury bonds.
(j) Bonds payable (due in 3 years).
Instructions
Indicate how each of these items should be classified in the financial statements.
3 4 E14-3 (Entries for Bond Transactions) Presented below are two independent situations.
1. On January 1, 2014, Simon Company issued $200,000 of 9%, 10-year bonds at par. Interest is payable
quarterly on April 1, July 1, October 1, and January 1.
2. On June 1, 2014, Garfunkel Company issued $100,000 of 12%, 10-year bonds dated January 1 at par
plus accrued interest. Interest is payable semiannually on July 1 and January 1.
Instructions
For each of these two independent situations, prepare journal entries to record the following.
(a) The issuance of the bonds.
(b) The payment of interest on July 1.
(c) The accrual of interest on December 31.
3 4 E14-4 (Entries for Bond Transactions—Straight-Line) Celine Dion Company issued $600,000 of 10%,
20-year bonds on January 1, 2014, at 102. Interest is payable semiannually on July 1 and January 1. Dion
Company uses the straight-line method of amortization for bond premium or discount.
Instructions
Prepare the journal entries to record the following.
(a) The issuance of the bonds.
802 Chapter 14 Long-Term Liabilities
(b) The payment of interest and the related amortization on July 1, 2014.
(c) The accrual of interest and the related amortization on December 31, 2014.
3 4 E14-5 (Entries for Bond Transactions—Effective-Interest) Assume the same information as in E14-4, except
that Celine Dion Company uses the effective-interest method of amortization for bond premium or
discount. Assume an effective yield of 9.7705%.
Instructions
Prepare the journal entries to record the following. (Round to the nearest dollar.)
(a) The issuance of the bonds.
(b) The payment of interest and related amortization on July 1, 2014.
(c) The accrual of interest and the related amortization on December 31, 2014.
3 4 E14-6 (Amortization Schedule—Straight-Line) Devon Harris Company sells 10% bonds having a matu-
rity value of $2,000,000 for $1,855,816. The bonds are dated January 1, 2014, and mature January 1, 2019.
Interest is payable annually on January 1.
Instructions
Set up a schedule of interest expense and discount amortization under the straight-line method. (Round
answers to the nearest cent.)
3 4 E14-7 (Amortization Schedule—Effective-Interest) Assume the same information as E14-6.
Instructions
Set up a schedule of interest expense and discount amortization under the effective-interest method. |
(Hint: The effective-interest rate must be computed.)
3 4 E14-8 (Determine Proper Amounts in Account Balances) Presented below are three independent
situations.
(a) CeCe Winans Corporation incurred the following costs in connection with the issuance of bonds:
(1) printing and engraving costs, $12,000; (2) legal fees, $49,000; and (3) commissions paid to under-
writer, $60,000. What amount should be reported as Unamortized Bond Issue Costs, and where
should this amount be reported on the balance sheet?
(b) George Gershwin Co. sold $2,000,000 of 10%, 10-year bonds at 104 on January 1, 2014. The bonds
were dated January 1, 2014, and pay interest on July 1 and January 1. If Gershwin uses the straight-
line method to amortize bond premium or discount, determine the amount of interest expense to be
reported on July 1, 2014, and December 31, 2014.
(c) Ron Kenoly Inc. issued $600,000 of 9%, 10-year bonds on June 30, 2014, for $562,500. This price
provided a yield of 10% on the bonds. Interest is payable semiannually on December 31 and
June 30. If Kenoly uses the effective-interest method, determine the amount of interest expense
to record if financial statements are issued on October 31, 2014.
3 4 E14-9 (Entries and Questions for Bond Transactions) On June 30, 2014, Mischa Auer Company issued
$4,000,000 face value of 13%, 20-year bonds at $4,300,920, a yield of 12%. Auer uses the effective-interest
method to amortize bond premium or discount. The bonds pay semiannual interest on June 30 and
December 31.
Instructions
(Round answers to the nearest cent.)
(a) Prepare the journal entries to record the following transactions.
(1) The issuance of the bonds on June 30, 2014.
(2) The payment of interest and the amortization of the premium on December 31, 2014.
(3) The payment of interest and the amortization of the premium on June 30, 2015.
(4) The payment of interest and the amortization of the premium on December 31, 2015.
(b) Show the proper balance sheet presentation for the liability for bonds payable on the December
31, 2015, balance sheet.
(c) Provide the answers to the following questions.
(1) What amount of interest expense is reported for 2015?
(2) Will the bond interest expense reported in 2015 be the same as, greater than, or less than the
amount that would be reported if the straight-line method of amortization were used?
(3) Determine the total cost of borrowing over the life of the bond.
(4) Will the total bond interest expense for the life of the bond be greater than, the same as, or less
than the total interest expense if the straight-line method of amortization were used?
3 4 E14-10 (Entries for Bond Transactions) On January 1, 2014, Aumont Company sold 12% bonds having a
maturity value of $500,000 for $537,907.37, which provides the bondholders with a 10% yield. The bonds
Exercises 803
are dated January 1, 2014, and mature January 1, 2019, with interest payable December 31 of each year.
Aumont Company allocates interest and unamortized discount or premium on the effective-interest
basis.
Instructions
(Round answers to the nearest cent.)
(a) Prepare the journal entry at the date of the bond issuance.
(b) Prepare a schedule of interest expense and bond amortization for 2014–2016.
(c) Prepare the journal entry to record the interest payment and the amortization for 2014.
(d) Prepare the journal entry to record the interest payment and the amortization for 2016.
3 E14-11 (Information Related to Various Bond Issues) Karen Austin Inc. has issued three types of debt on
January 1, 2014, the start of the company’s fiscal year.
(a) $10 million, 10-year, 15% unsecured bonds, interest payable quarterly. Bonds were priced to yield 12%.
(b) $25 million par of 10-year, zero-coupon bonds at a price to yield 12% per year.
(c) $20 million, 10-year, 10% mortgage bonds, interest payable annually to yield 12%.
Instructions
Prepare a schedule that identifies the following items for each bond: (1) maturity value, (2) number of inter-
est periods over life of bond, (3) stated rate per each interest period, (4) effective-interest rate per each inter- |
est period, (5) payment amount per period, and (6) present value of bonds at date of issue.
3 4 E14-12 (Entry for Redemption of Bond; Bond Issue Costs) On January 2, 2009, Banno Corporation issued
5 $1,500,000 of 10% bonds at 97 due December 31, 2018. Legal and other costs of $24,000 were incurred in
connection with the issue. Interest on the bonds is payable annually each December 31. The $24,000 issue
costs are being deferred and amortized on a straight-line basis over the 10-year term of the bonds. The
discount on the bonds is also being amortized on a straight-line basis over the 10 years. (Straight-line is not
materially different in effect from the preferable “interest method.”)
The bonds are callable at 101 (i.e., at 101% of face amount), and on January 2, 2014, Banno called
$900,000 face amount of the bonds and redeemed them.
Instructions
Ignoring income taxes, compute the amount of loss, if any, to be recognized by Banno as a result of retiring
the $900,000 of bonds in 2014 and prepare the journal entry to record the redemption.
(AICPA adapted)
3 4 E14-13 (Entries for Redemption and Issuance of Bonds) Matt Perry, Inc. had outstanding $6,000,000 of
5 11% bonds (interest payable July 31 and January 31) due in 10 years. On July 1, it issued $9,000,000 of 10%,
15-year bonds (interest payable July 1 and January 1) at 98. A portion of the proceeds was used to call the
11% bonds at 102 on August 1. Unamortized bond discount and issue cost applicable to the 11% bonds
were $120,000 and $30,000, respectively.
Instructions
Prepare the journal entries necessary to record issue of the new bonds and the refunding of the bonds.
3 4 E14-14 (Entries for Redemption and Issuance of Bonds) On June 30, 2006, County Company issued 12%
5 bonds with a par value of $800,000 due in 20 years. They were issued at 98 and were callable at 104 at any
date after June 30, 2014. Because of lower interest rates and a significant change in the company’s credit
rating, it was decided to call the entire issue on June 30, 2015, and to issue new bonds. New 10% bonds
were sold in the amount of $1,000,000 at 102; they mature in 20 years. County Company uses straight-line
amortization. Interest payment dates are December 31 and June 30.
Instructions
(a) Prepare journal entries to record the redemption of the old issue and the sale of the new issue on June 30, 2015.
(b) Prepare the entry required on December 31, 2015, to record the payment of the first 6 months’ interest
and the amortization of premium on the bonds.
3 4 E14-15 (Entries for Redemption and Issuance of Bonds) Linda Day George Company had bonds out-
5 standing with a maturity value of $300,000. On April 30, 2014, when these bonds had an unamortized
discount of $10,000, they were called in at 104. To pay for these bonds, George had issued other bonds a
month earlier bearing a lower interest rate. The newly issued bonds had a life of 10 years. The new bonds
were issued at 103 (face value $300,000). Issue costs related to the new bonds were $3,000.
Instructions
Ignoring interest, compute the gain or loss and record this refunding transaction.
(AICPA adapted)
804 Chapter 14 Long-Term Liabilities
6 E14-16 (Entries for Zero-Interest-Bearing Notes) On January 1, 2014, Ellen Greene Company makes the
two following acquisitions.
1. Purchases land having a fair value of $200,000 by issuing a 5-year, zero-interest-bearing promissory
note in the face amount of $337,012.
2. Purchases equipment by issuing a 6%, 8-year promissory note having a maturity value of $250,000
(interest payable annually).
The company has to pay 11% interest for funds from its bank.
Instructions
(Round answers to the nearest cent.)
(a) Record the two journal entries that should be recorded by Ellen Greene Company for the two pur-
chases on January 1, 2014.
(b) Record the interest at the end of the first year on both notes using the effective-interest method.
6 E14-17 (Imputation of Interest) Presented below are two independent situations.
(a) On January 1, 2014, Robin Wright Inc. purchased land that had an assessed value of $350,000 at the |
time of purchase. A $550,000, zero-interest-bearing note due January 1, 2017, was given in exchange.
There was no established exchange price for the land, nor a ready fair value for the note. The interest
rate charged on a note of this type is 12%. Determine at what amount the land should be recorded
at January 1, 2014, and the interest expense to be reported in 2014 related to this transaction.
(b) On January 1, 2014, Field Furniture Co. borrowed $5,000,000 (face value) from Gary Sinise Co., a
major customer, through a zero-interest-bearing note due in 4 years. Because the note was zero-
interest-bearing, Field Furniture agreed to sell furniture to this customer at lower than market price.
A 10% rate of interest is normally charged on this type of loan. Prepare the journal entry to record
this transaction and determine the amount of interest expense to report for 2014.
6 E14-18 (Imputation of Interest with Right) On January 1, 2014, Margaret Avery Co. borrowed and re-
ceived $400,000 from a major customer evidenced by a zero-interest-bearing note due in 3 years. As consid-
eration for the zero-interest-bearing feature, Avery agrees to supply the customer’s inventory needs for the
loan period at lower than the market price. The appropriate rate at which to impute interest is 8%.
Instructions
(a) Prepare the journal entry to record the initial transaction on January 1, 2014. (Round all computa-
tions to the nearest dollar.)
(b) Prepare the journal entry to record any adjusting entries needed at December 31, 2014. Assume that
the sales of Avery’s product to this customer occur evenly over the 3-year period.
7 E14-19 (Fair Value Option) Fallen Company commonly issues long-term notes payable to its various
lenders. Fallen has had a pretty good credit rating such that its effective borrowing rate is quite low (less
than 8% on an annual basis). Fallen has elected to use the fair value option for the long-term notes issued
to Barclay’s Bank and has the following data related to the carrying and fair value for these notes.
Carrying Value Fair Value
December 31, 2014 $54,000 $54,000
December 31, 2015 44,000 42,500
December 31, 2016 36,000 38,000
Instructions
(a) Prepare the journal entry at December 31 (Fallen’s year-end) for 2014, 2015, and 2016, to record the
fair value option for these notes.
(b) At what amount will the note be reported on Fallen’s 2015 balance sheet?
(c) What is the effect of recording the fair value option on these notes on Fallen’s 2016 income?
(d) Assuming that general market interest rates have been stable over the period, does the fair value
data for the notes indicate that Fallen’s creditworthiness has improved or declined in 2016? Explain.
9 E14-20 (Long-Term Debt Disclosure) At December 31, 2014, Redmond Company has outstanding three
long-term debt issues. The first is a $2,000,000 note payable which matures June 30, 2017. The second is a
$6,000,000 bond issue which matures September 30, 2018. The third is a $12,500,000 sinking fund debenture
with annual sinking fund payments of $2,500,000 in each of the years 2016 through 2020.
Instructions
Prepare the required note disclosure for the long-term debt at December 31, 2014.
Exercises 805
10 * E14-21 (Settlement of Debt) Strickland Company owes $200,000 plus $18,000 of accrued interest to
Moran State Bank. The debt is a 10-year, 10% note. During 2014, Strickland’s business deteriorated due to
a faltering regional economy. On December 31, 2014, Moran State Bank agrees to accept an old machine and
cancel the entire debt. The machine has a cost of $390,000, accumulated depreciation of $221,000, and a fair
value of $180,000.
Instructions
(a) Prepare journal entries for Strickland Company and Moran State Bank to record this debt settlement.
(b) How should Strickland report the gain or loss on the disposition of machine and on restructuring of
debt in its 2014 income statement?
(c) Assume that, instead of transferring the machine, Strickland decides to grant 15,000 shares of its
common stock ($10 par) which has a fair value of $180,000 in full settlement of the loan obligation. |
If Moran State Bank treats Strickland’s stock as a trading investment, prepare the entries to record
the transaction for both parties.
10 *E 14-22 (Term Modification without Gain—Debtor’s Entries) On December 31, 2014, the American Bank
enters into a debt restructuring agreement with Barkley Company, which is now experiencing financial
trouble. The bank agrees to restructure a 12%, issued at par, $3,000,000 note receivable by the following
modifications:
1. Reducing the principal obligation from $3,000,000 to $2,400,000.
2. Extending the maturity date from December 31, 2014, to January 1, 2018.
3. Reducing the interest rate from 12% to 10%.
Barkley pays interest at the end of each year. On January 1, 2018, Barkley Company pays $2,400,000 in cash
to Firstar Bank.
Instructions
(a) Will the gain recorded by Barkley be equal to the loss recorded by American Bank under the debt
restructuring?
(b) Can Barkley Company record a gain under the term modification mentioned above? Explain.
(c) Assuming that the interest rate Barkley should use to compute interest expense in future periods
is 1.4276%, prepare the interest payment schedule of the note for Barkley Company after the debt
restructuring.
(d) Prepare the interest payment entry for Barkley Company on December 31, 2016.
(e) What entry should Barkley make on January 1, 2018?
10 * E14-23 (Term Modification without Gain—Creditor’s Entries) Using the same information as in E14-22,
answer the following questions related to American Bank (creditor).
Instructions
(a) What interest rate should American Bank use to calculate the loss on the debt restructuring?
(b) Compute the loss that American Bank will suffer from the debt restructuring. Prepare the journal
entry to record the loss.
(c) Prepare the interest receipt schedule for American Bank after the debt restructuring.
(d) Prepare the interest receipt entry for American Bank on December 31, 2016.
(e) What entry should American Bank make on January 1, 2018?
10 *E 14-24 (Term Modification with Gain—Debtor’s Entries) Use the same information as in E14-22 above
except that American Bank reduced the principal to $1,900,000 rather than $2,400,000. On January 1, 2018,
Barkley pays $1,900,000 in cash to American Bank for the principal.
Instructions
(a) Can Barkley Company record a gain under this term modification? If yes, compute the gain for
Barkley Company.
(b) Prepare the journal entries to record the gain on Barkley’s books.
(c) What interest rate should Barkley use to compute its interest expense in future periods? Will your
answer be the same as in E14-22 above? Why or why not?
(d) Prepare the interest payment schedule of the note for Barkley Company after the debt restructuring.
(e) Prepare the interest payment entries for Barkley Company on December 31, of 2015, 2016, and 2017.
(f) What entry should Barkley make on January 1, 2018?
10 *E 14-25 (Term Modification with Gain—Creditor’s Entries) Using the same information as in E14-22 and
E14-24, answer the following questions related to American Bank (creditor).
806 Chapter 14 Long-Term Liabilities
Instructions
(a) Compute the loss American Bank will suffer under this new term modification. Prepare the journal
entry to record the loss on American’s books.
(b) Prepare the interest receipt schedule for American Bank after the debt restructuring.
(c) Prepare the interest receipt entry for American Bank on December 31, 2015, 2016, and 2017.
(d) What entry should American Bank make on January 1, 2018?
10 *E 14-26 (Debtor/Creditor Entries for Settlement of Troubled Debt) Gottlieb Co. owes $199,800 to Ceballos
Inc. The debt is a 10-year, 11% note. Because Gottlieb Co. is in financial trouble, Ceballos Inc. agrees to
accept some property and cancel the entire debt. The property has a book value of $90,000 and a fair value
of $140,000.
Instructions
(a) Prepare the journal entry on Gottlieb’s books for debt restructure.
(b) Prepare the journal entry on Ceballos’s books for debt restructure.
10 *E 14-27 (Debtor/Creditor Entries for Modification of Troubled Debt) Vargo Corp. owes $270,000 to First |
Trust. The debt is a 10-year, 12% note due December 31, 2014. Because Vargo Corp. is in financial trouble,
First Trust agrees to extend the maturity date to December 31, 2016, reduce the principal to $220,000, and
reduce the interest rate to 5%, payable annually on December 31.
Instructions
(a) Prepare the journal entries on Vargo’s books on December 31, 2014, 2015, 2016.
(b) Prepare the journal entries on First Trust’s books on December 31, 2014, 2015, 2016.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
PROBLEMS
3 4 P14-1 (Analysis of Amortization Schedule and Interest Entries) The following amortization and interest
schedule reflects the issuance of 10-year bonds by Capulet Corporation on January 1, 2008, and the subse-
quent interest payments and charges. The company’s year-end is December 31, and financial statements
are prepared once yearly.
Amortization Schedule
Amount Carrying
Year Cash Interest Unamortized Value
1/1/2008 $5,651 $ 94,349
2008 $11,000 $11,322 5,329 94,671
2009 11,000 11,361 4,968 95,032
2010 11,000 11,404 4,564 95,436
2011 11,000 11,452 4,112 95,888
2012 11,000 11,507 3,605 96,395
2013 11,000 11,567 3,038 96,962
2014 11,000 11,635 2,403 97,597
2015 11,000 11,712 1,691 98,309
2016 11,000 11,797 894 99,106
2017 11,000 11,894 100,000
Instructions
(a) Indicate whether the bonds were issued at a premium or a discount and how you can determine this
fact from the schedule.
(b) Indicate whether the amortization schedule is based on the straight-line method or the effective-
interest method, and how you can determine which method is used.
(c) Determine the stated interest rate and the effective-interest rate.
Problems 807
(d) On the basis of the schedule above, prepare the journal entry to record the issuance of the bonds on
January 1, 2008.
(e) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transac-
tions and accruals for 2008. (Interest is paid January 1.)
(f) On the basis of the schedule above, prepare the journal entry or entries to reflect the bond transac-
tions and accruals for 2015. Capulet Corporation does not use reversing entries.
3 4 P14-2 (Issuance and Redemption of Bonds) Venezuela Co. is building a new hockey arena at a cost of
5 $2,500,000. It received a downpayment of $500,000 from local businesses to support the project, and now
needs to borrow $2,000,000 to complete the project. It therefore decides to issue $2,000,000 of 10.5%, 10-year
bonds. These bonds were issued on January 1, 2013, and pay interest annually on each January 1. The
bonds yield 10%. Venezuela paid $50,000 in bond issue costs related to the bond sale.
Instructions
(a) Prepare the journal entry to record the issuance of the bonds and the related bond issue costs
incurred on January 1, 2013.
(b) Prepare a bond amortization schedule up to and including January 1, 2017, using the effective-
interest method.
(c) Assume that on July 1, 2016, Venezuela Co. redeems half of the bonds at a cost of $1,065,000 plus
accrued interest. Prepare the journal entry to record this redemption.
3 4 P14-3 (Negative Amortization) Good-Deal Inc. developed a new sales gimmick to help sell its inventory
6 of new automobiles. Because many new car buyers need financing, Good-Deal offered a low downpay-
ment and low car payments for the first year after purchase. It believes that this promotion will bring in
some new buyers.
On January 1, 2014, a customer purchased a new $33,000 automobile, making a downpayment of
$1,000. The customer signed a note indicating that the annual rate of interest would be 8% and that quar-
terly payments would be made over 3 years. For the first year, Good-Deal required a $400 quarterly pay-
ment to be made on April 1, July 1, October 1, and January 1, 2015. After this one-year period, the customer
was required to make regular quarterly payments that would pay off the loan as of January 1, 2017.
Instructions
(a) Prepare a note amortization schedule for the first year.
(b) Indicate the amount the customer owes on the contract at the end of the first year. |
(c) Compute the amount of the new quarterly payments.
(d) Prepare a note amortization schedule for these new payments for the next 2 years.
(e) What do you think of the new sales promotion used by Good-Deal?
3 4 P14-4 (Issuance and Redemption of Bonds; Income Statement Presentation) Holiday Company issued
5 9 its 9%, 25-year mortgage bonds in the principal amount of $3,000,000 on January 2, 2000, at a discount of
$150,000, which it proceeded to amortize by charges to expense over the life of the issue on a straight-line
basis. The indenture securing the issue provided that the bonds could be called for redemption in total
but not in part at any time before maturity at 104% of the principal amount, but it did not provide for any
sinking fund.
On December 18, 2014, the company issued its 11%, 20-year debenture bonds in the principal amount
of $4,000,000 at 102, and the proceeds were used to redeem the 9%, 25-year mortgage bonds on January 2,
2015. The indenture securing the new issue did not provide for any sinking fund or for redemption before
maturity.
Instructions
(a) Prepare journal entries to record the issuance of the 11% bonds and the redemption of the 9% bonds.
(b) Indicate the income statement treatment of the gain or loss from redemption and the note disclosure
required.
3 4 P14-5 (Comprehensive Bond Problem) In each of the following independent cases the company closes its
5 books on December 31.
1. Sanford Co. sells $500,000 of 10% bonds on March 1, 2014. The bonds pay interest on September 1
and March 1. The due date of the bonds is September 1, 2017. The bonds yield 12%. Give entries
through December 31, 2015.
2. Titania Co. sells $400,000 of 12% bonds on June 1, 2014. The bonds pay interest on December 1 and
June 1. The due date of the bonds is June 1, 2018. The bonds yield 10%. On October 1, 2015, Titania
buys back $120,000 worth of bonds for $126,000 (includes accrued interest). Give entries through
December 1, 2016.
808 Chapter 14 Long-Term Liabilities
Instructions
For the two cases prepare all of the relevant journal entries from the time of sale until the date indicated.
Use the effective-interest method for discount and premium amortization (construct amortization tables
where applicable). Amortize premium or discount on interest dates and at year-end. (Assume that no
reversing entries were made.)
3 4 P14-6 (Issuance of Bonds between Interest Dates, Straight-Line, Redemption) Presented below are
5 selected transactions on the books of Simonson Corporation.
May 1, 2014 Bonds payable with a par value of $900,000, which are dated January 1, 2014, are sold at
106 plus accrued interest. They are coupon bonds, bear interest at 12% (payable annually at
January 1), and mature January 1, 2024. (Use interest expense account for accrued interest.)
Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the amortiza-
tion of the proper amount of premium. (Use straight-line amortization.)
Jan. 1, 2015 Interest on the bonds is paid.
April 1 Bonds with par value of $360,000 are called at 102 plus accrued interest, and redeemed.
(Bond premium is to be amortized only at the end of each year.)
Dec. 31 Adjusting entries are made to record the accrued interest on the bonds, and the proper
amount of premium amortized.
Instructions
(Round to two decimal places.)
Prepare journal entries for the transactions above.
3 4 P14-7 (Entries for Life Cycle of Bonds) On April 1, 2014, Seminole Company sold 15,000 of its 11%,
5 15-year, $1,000 face value bonds at 97. Interest payment dates are April 1 and October 1, and the company
uses the straight-line method of bond discount amortization. On March 1, 2015, Seminole took advantage
of favorable prices of its stock to extinguish 6,000 of the bonds by issuing 200,000 shares of its $10 par value
common stock. At this time, the accrued interest was paid in cash. The company’s stock was selling for
$31 per share on March 1, 2015.
Instructions
Prepare the journal entries needed on the books of Seminole Company to record the following. |
(a) April 1, 2014: issuance of the bonds.
(b) October 1, 2014: payment of semiannual interest.
(c) December 31, 2014: accrual of interest expense.
(d) March 1, 2015: extinguishment of 6,000 bonds. (No reversing entries made.)
6 P14-8 (Entries for Zero-Interest-Bearing Note) On December 31, 2014, Faital Company acquired a com-
puter from Plato Corporation by issuing a $600,000 zero-interest-bearing note, payable in full on December
31, 2018. Faital Company’s credit rating permits it to borrow funds from its several lines of credit at 10%.
The computer is expected to have a 5-year life and a $70,000 salvage value.
Instructions
(Round answers to the nearest cent.)
(a) Prepare the journal entry for the purchase on December 31, 2014.
(b) Prepare any necessary adjusting entries relative to depreciation (use straight-line) and amortization
(use effective-interest method) on December 31, 2015.
(c) Prepare any necessary adjusting entries relative to depreciation and amortization on December 31,
2016.
6 P14-9 (Entries for Zero-Interest-Bearing Note; Payable in Installments) Sabonis Cosmetics Co. purchased
machinery on December 31, 2013, paying $50,000 down and agreeing to pay the balance in four equal install-
ments of $40,000 payable each December 31. An assumed interest of 8% is implicit in the purchase price.
Instructions
Prepare the journal entries that would be recorded for the purchase and for the payments and interest on
the following dates. (Round answers to the nearest cent.)
(a) December 31, 2013. (d) December 31, 2016.
(b) December 31, 2014. (e) December 31, 2017.
(c) December 31, 2015.
3 4 P14-10 (Comprehensive Problem: Issuance, Classification, Reporting) Presented on the next page are
5 9 four independent situations.
Problems 809
(a) On March 1, 2015, Wilke Co. issued at 103 plus accrued interest $4,000,000, 9% bonds. The bonds are
dated January 1, 2015, and pay interest semiannually on July 1 and January 1. In addition, Wilke Co.
incurred $27,000 of bond issuance costs. Compute the net amount of cash received by Wilke Co.
as a result of the issuance of these bonds.
(b) On January 1, 2014, Langley Co. issued 9% bonds with a face value of $700,000 for $656,992 to yield
10%. The bonds are dated January 1, 2014, and pay interest annually. What amount is reported for
interest expense in 2014 related to these bonds, assuming that Langley used the effective-interest
method for amortizing bond premium and discount?
(c) Tweedie Building Co. has a number of long-term bonds outstanding at December 31, 2014. These
long-term bonds have the following sinking fund requirements and maturities for the next 6 years.
Sinking Fund Maturities
2015 $300,000 $100,000
2016 100,000 250,000
2017 100,000 100,000
2018 200,000 —
2019 200,000 150,000
2020 200,000 100,000
Indicate how this information should be reported in the financial statements at December 31, 2014.
(d) In the long-term debt structure of Beckford Inc., the following three bonds were reported: mortgage
bonds payable $10,000,000; collateral trust bonds $5,000,000; bonds maturing in installments, secured
by plant equipment $4,000,000. Determine the total amount, if any, of debenture bonds outstanding.
4 P14-11 (Effective-Interest Method) Samantha Cordelia, an intermediate accounting student, is having
difficulty amortizing bond premiums and discounts using the effective-interest method. Furthermore, she
cannot understand why GAAP requires that this method be used instead of the straight-line method. She
has come to you with the following problem, looking for help.
On June 30, 2014, Hobart Company issued $2,000,000 face value of 11%, 20-year bonds at $2,171,600, a
yield of 10%. Hobart Company uses the effective-interest method to amortize bond premiums or discounts.
The bonds pay semiannual interest on June 30 and December 31. Prepare an amortization schedule for four
periods.
Instructions
Using the data above for illustrative purposes, write a short memo (1–1.5 pages double-spaced) to Saman-
tha, explaining what the effective-interest method is, why it is preferable, and how it is computed. (Do not |
forget to include an amortization schedule, referring to it whenever necessary.)
10 * P14-12 (Debtor/Creditor Entries for Continuation of Troubled Debt) Daniel Perkins is the sole share-
holder of Perkins Inc., which is currently under protection of the U.S. bankruptcy court. As a “debtor in
possession,” he has negotiated the following revised loan agreement with United Bank. Perkins Inc.’s
$600,000, 12%, 10-year note was refinanced with a $600,000, 5%, 10-year note.
Instructions
(a) What is the accounting nature of this transaction?
(b) Prepare the journal entry to record this refinancing:
(1) On the books of Perkins Inc.
(2) On the books of United Bank.
(c) Discuss whether generally accepted accounting principles provide the proper information useful to
managers and investors in this situation.
10 *P 14-13 (Restructure of Note under Different Circumstances) Halvor Corporation is having financial dif-
ficulty and therefore has asked Frontenac National Bank to restructure its $5 million note outstanding. The
present note has 3 years remaining and pays a current rate of interest of 10%. The present market rate for a
loan of this nature is 12%. The note was issued at its face value.
Instructions
Presented below and on the next page are four independent situations. Prepare the journal entry that
Halvor and Frontenac National Bank would make for each of these restructurings.
(a) Frontenac National Bank agrees to take an equity interest in Halvor by accepting common stock
valued at $3,700,000 in exchange for relinquishing its claim on this note. The common stock has a
par value of $1,700,000.
(b) Frontenac National Bank agrees to accept land in exchange for relinquishing its claim on this note.
The land has a book value of $3,250,000 and a fair value of $4,000,000.
(c) Frontenac National Bank agrees to modify the terms of the note, indicating that Halvor does not
have to pay any interest on the note over the 3-year period.
810 Chapter 14 Long-Term Liabilities
(d) Frontenac National Bank agrees to reduce the principal balance due to $4,166,667 and require inter-
est only in the second and third year at a rate of 10%.
10 *P 14-14 (Debtor/Creditor Entries for Continuation of Troubled Debt with New Effective Interest)
Crocker Corp. owes D. Yaeger Corp. a 10-year, 10% note in the amount of $330,000 plus $33,000 of accrued
interest. The note is due today, December 31, 2014. Because Crocker Corp. is in financial trouble, D. Yaeger
Corp. agrees to forgive the accrued interest, $30,000 of the principal, and to extend the maturity date to
December 31, 2017. Interest at 10% of revised principal will continue to be due on 12/31 each year.
Assume the following present value factors for 3 periods.
21/ 4% 23/ 8% 21/ 2% 25/ 8% 23/ 4% 3%
Single sum .93543 .93201 .92859 .92521 .92184 .91514
Ordinary annuity of 1 2.86989 2.86295 2.85602 2.84913 2.84226 2.82861
Instructions
(a) Compute the new effective-interest rate for Crocker Corp. following restructure. (Hint: Find the interest
rate that establishes approximately $363,000 as the present value of the total future cash flows.)
(b) Prepare a schedule of debt reduction and interest expense for the years 2014 through 2017.
(c) Compute the gain or loss for D. Yaeger Corp. and prepare a schedule of receivable reduction and
interest revenue for the years 2014 through 2017.
(d) Prepare all the necessary journal entries on the books of Crocker Corp. for the years 2014, 2015, and
2016.
(e) Prepare all the necessary journal entries on the books of D. Yaeger Corp. for the years 2014, 2015,
and 2016.
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
CONCEPTS FOR ANALYSIS
CA14-1 (Bond Theory: Balance Sheet Presentations, Interest Rate, Premium) On January 1, 2014, Nichols
Company issued for $1,085,800 its 20-year, 11% bonds that have a maturity value of $1,000,000 and pay
interest semiannually on January 1 and July 1. Bond issue costs were not material in amount. Below are
three presentations of the long-term liability section of the balance sheet that might be used for these bonds |
at the issue date.
1. Bonds payable (maturing January 1, 2034) $1,000,000
Unamortized premium on bonds payable 85,800
Total bond liability $1,085,800
2. Bonds payable—principal (face value $1,000,000 maturing
January 1, 2034) $ 142,050a
Bonds payable—interest (semiannual payment $55,000) 943,750b
Total bond liability $1,085,800
3. Bonds payable—principal (maturing January 1, 2034) $1,000,000
Bonds payable—interest ($55,000 per period for 40 periods) 2,200,000
Total bond liability $3,200,000
aThe present value of $1,000,000 due at the end of 40 (6-month) periods at the yield rate of 5% per period.
bThe present value of $55,000 per period for 40 (6-month) periods at the yield rate of 5% per period.
Instructions
(a) Discuss the conceptual merit(s) of each of the date-of-issue balance sheet presentations shown
above for these bonds.
(b) Explain why investors would pay $1,085,800 for bonds that have a maturity value of only $1,000,000.
Concepts for Analysis 811
(c) Assuming that a discount rate is needed to compute the carrying value of the obligations arising
from a bond issue at any date during the life of the bonds, discuss the conceptual merit(s) of using
for this purpose:
(1) The coupon or nominal rate.
(2) The effective or yield rate at date of issue.
(d) If the obligations arising from these bonds are to be carried at their present value computed by
means of the current market rate of interest, how would the bond valuation at dates subsequent to
the date of issue be affected by an increase or a decrease in the market rate of interest?
(AICPA adapted)
CA14-2 (Bond Theory: Price, Presentation, and Redemption) On March 1, 2014, Sealy Company sold its
5-year, $1,000 face value, 9% bonds dated March 1, 2014, at an effective annual interest rate (yield) of 11%.
Interest is payable semiannually, and the first interest payment date is September 1, 2014. Sealy uses the
effective-interest method of amortization. Bond issue costs were incurred in preparing and selling the bond
issue. The bonds can be called by Sealy at 101 at any time on or after March 1, 2015.
Instructions
(a) (1) How would the selling price of the bond be determined?
(2) Specify how all items related to the bonds would be presented in a balance sheet prepared
immediately after the bond issue was sold.
(b) What items related to the bond issue would be included in Sealy’s 2014 income statement, and how
would each be determined?
(c) Would the amount of bond discount amortization using the effective-interest method of amortiza-
tion be lower in the second or third year of the life of the bond issue? Why?
(d) Assuming that the bonds were called in and redeemed on March 1, 2015, how should Sealy report
the redemption of the bonds on the 2015 income statement?
(AICPA adapted)
CA14-3 (Bond Theory: Amortization and Gain or Loss Recognition)
Part I: The appropriate method of amortizing a premium or discount on issuance of bonds is the effective-
interest method.
Instructions
(a) What is the effective-interest method of amortization and how is it different from and similar to the
straight-line method of amortization?
(b) How is amortization computed using the effective-interest method, and why and how do amounts
obtained using the effective-interest method differ from amounts computed under the straight-line
method?
Part II: Gains or losses from the early extinguishment of debt that is refunded can theoretically be
accounted for in three ways:
1. Amortized over remaining life of old debt.
2. Amortized over the life of the new debt issue.
3. Recognized in the period of extinguishment.
Instructions
(a) Develop supporting arguments for each of the three theoretical methods of accounting for gains and
losses from the early extinguishment of debt.
(b) Which of the methods above is generally accepted and how should the appropriate amount of gain
or loss be shown in a company’s financial statements?
(AICPA adapted)
CA14-4 (Off-Balance-Sheet Financing) Matt Ryan Corporation is interested in building its own soda can
manufacturing plant adjacent to its existing plant in Partyville, Kansas. The objective would be to ensure a |
steady supply of cans at a stable price and to minimize transportation costs. However, the company has
been experiencing some financial problems and has been reluctant to borrow any additional cash to fund
the project. The company is not concerned with the cash flow problems of making payments, but rather
with the impact of adding additional long-term debt to its balance sheet.
The president of Ryan, Andy Newlin, approached the president of the Aluminum Can Company
(ACC), its major supplier, to see if some agreement could be reached. ACC was anxious to work out an
arrangement, since it seemed inevitable that Ryan would begin its own can production. The Aluminum
Can Company could not afford to lose the account.
After some discussion, a two-part plan was worked out. First, ACC was to construct the plant on
Ryan’s land adjacent to the existing plant. Second, Ryan would sign a 20-year purchase agreement. Under
812 Chapter 14 Long-Term Liabilities
the purchase agreement, Ryan would express its intention to buy all of its cans from ACC, paying a unit
price which at normal capacity would cover labor and material, an operating management fee, and the
debt service requirements on the plant. The expected unit price, if transportation costs are taken into con-
sideration, is lower than current market. If Ryan did not take enough production in any one year and if the
excess cans could not be sold at a high enough price on the open market, Ryan agrees to make up any cash
shortfall so that ACC could make the payments on its debt. The bank will be willing to make a 20-year loan
for the plant, taking the plant and the purchase agreement as collateral. At the end of 20 years, the plant is
to become the property of Ryan.
Instructions
(a) What are project financing arrangements using special-purpose entities?
(b) What are take-or-pay contracts?
(c) Should Ryan record the plant as an asset together with the related obligation?
(d) If not, should Ryan record an asset relating to the future commitment?
(e) What is meant by off-balance-sheet financing?
CA14-5 (Bond Issue) Donald Lennon is the president, founder, and majority owner of Wichita Medical
Corporation, an emerging medical technology products company. Wichita is in dire need of additional
capital to keep operating and to bring several promising products to final development, testing, and pro-
duction. Donald, as owner of 51% of the outstanding stock, manages the company’s operations. He places
heavy emphasis on research and development and long-term growth. The other principal stockholder is
Nina Friendly who, as a nonemployee investor, owns 40% of the stock. Nina would like to deemphasize
the R & D functions and emphasize the marketing function to maximize short-run sales and profits from
existing products. She believes this strategy would raise the market price of Wichita’s stock.
All of Donald’s personal capital and borrowing power is tied up in his 51% stock ownership. He
knows that any offering of additional shares of stock will dilute his controlling interest because he won’t
be able to participate in such an issuance. But, Nina has money and would likely buy enough shares to
gain control of Wichita. She then would dictate the company’s future direction, even if it meant replacing
Donald as president and CEO.
The company already has considerable debt. Raising additional debt will be costly, will adversely affect
Wichita’s credit rating, and will increase the company’s reported losses due to the growth in interest
expense. Nina and the other minority stockholders express opposition to the assumption of additional debt,
fearing the company will be pushed to the brink of bankruptcy. Wanting to maintain his control and to pre-
serve the direction of “his” company, Donald is doing everything to avoid a stock issuance and is contem-
plating a large issuance of bonds, even if it means the bonds are issued with a high effective-interest rate.
Instructions
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues in this case? |
(c) What would you do if you were Donald?
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report,
including the notes to the financial statements, can be accessed at the book’s companion website, www.
wiley.com/college/kieso.
Instructions
Refer to P&G’s 2011 financial statements and the accompanying notes to answer the following questions.
(a) What cash outflow obligations related to the repayment of long-term debt does P&G have over the
next 5 years?
(b) P&G indicates that it believes that it has the ability to meet business requirements in the foreseeable
future. Prepare an assessment of its liquidity, solvency, and financial flexibility using ratio analysis.
Using Your Judgment 813
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book’s companion website and use information found there to answer the following questions
related to The Coca-Cola Company and PepsiCo, Inc.
(a) Compute the debt to assets and the times interest earned ratios for these two companies. Comment on
the quality of these two ratios for both Coca-Cola and PepsiCo.
(b) What is the difference between the fair value and the historical cost (carrying amount) of each com-
pany’s debt at year-end 2011? Why might a difference exist in these two amounts?
(c) Both companies have debt issued in foreign countries. Speculate as to why these companies may use
foreign debt to finance their operations. What risks are involved in this strategy, and how might they
adjust for this risk?
Financial Statement Analysis Case
Commonwealth Edison Co.
The following article appeared in the Wall Street Journal.
Bond Markets
Giant Commonwealth Edison Issue Hits Resale Market With $70 Million Left Over
new york—Commonwealth Edison Co.’s slow-selling new 9¼% bonds were tossed onto the resale
market at a reduced price with about $70 million still available from the $200 million offered Thursday,
dealers said.
The Chicago utility’s bonds, rated double-A by Moody’s and double-A-minus by Standard &
Poor’s, originally had been priced at 99.803, to yield 9.3% in 5 years. They were marked down yester-
day the equivalent of about $5.50 for each $1,000 face amount, to about 99.25, where their yield jumped
to 9.45%.
Instructions
(a) How will the development above affect the accounting for Commonwealth Edison’s bond issue?
(b) Provide several possible explanations for the markdown and the slow sale of Commonwealth
Edison’s bonds.
Accounting, Analysis, and Principles
The following information is taken from the 2014 annual report of Bugant, Inc. Bugant’s fiscal year ends
December 31 of each year. Bugant’s December 31, 2014, balance sheet is as follows.
Bugant, Inc.
Balance Sheet
December 31, 2014
Assets
Cash $ 450
Inventory 1,800
Total current assets 2,250
Plant and equipment 2,000
Accumulated depreciation (160)
Total assets $4,090
Liabilities
Bonds payable (net of discount) $1,426
Stockholders’ equity
Common stock 1,500
Retained earnings 1,164
Total liabilities and stockholders’ equity $4,090
Note X: Long Term Debt:
On January 1, 2015, Bugant issued bonds with face value of $1,500 and a coupon rate
equal to 10%. The bonds were issued to yield 12% and mature on January 1, 2020.
814 Chapter 14 Long-Term Liabilities
Additional information concerning 2015 is as follows.
1. Sales were $3,500, all for cash.
2. Purchases were $2,000, all paid in cash.
3. Salaries were $700, all paid in cash.
4. Property, plant, and equipment was originally purchased for $2,000 and is depreciated straight-line
over a 25-year life with no salvage value.
5. Ending inventory was $1,900.
6. Cash dividends of $100 were declared and paid by Bugant.
7. Ignore taxes.
8. The market rate of interest on bonds of similar risk was 12% during all of 2015.
9. Interest on the bonds is paid semiannually each June 30 and December 31.
Accounting
Prepare a balance sheet for Bugant, Inc. at December 31, 2015, and an income statement for the year ending |
December 31, 2015. Assume semiannual compounding of the bond interest.
Analysis
Use common ratios for analysis of long-term debt to assess Bugant’s long-run solvency. Has Bugant’s
solvency changed much from 2014 to 2015? Bugant’s net income in 2014 was $550 and interest expense
was $169.
Principles
Recently, the FASB and the IASB allowed companies the option of recognizing in their financial statements
the fair values of their long-term debt. That is, companies have the option to change the balance sheet value
of their long-term debt to the debt’s fair value and report the change in balance sheet value as a gain or loss
in income. In terms of the qualitative characteristics of accounting information (Chapter 2), briefly describe
the potential trade-off(s) involved in reporting long-term debt at its fair value.
BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation
Wie Company has been operating for just 2 years, producing specialty golf equipment for women golfers.
To date, the company has been able to finance its successful operations with investments from its principal
owner, Michelle Wie, and cash flows from operations. However, current expansion plans will require some
borrowing to expand the company’s production line.
As part of the expansion plan, Wie will acquire some used equipment by signing a zero-interest-
bearing note. The note has a maturity value of $50,000 and matures in 5 years. A reliable fair value measure
for the equipment is not available, given the age and specialty nature of the equipment. As a result, Wie’s
accounting staff is unable to determine an established exchange price for recording the equipment (nor the
interest rate to be used to record interest expense on the long-term note). They have asked you to conduct
some accounting research on this topic.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and
prepare responses to the following. Provide Codification references for your responses.
(a) Identify the authoritative literature that provides guidance on the zero-interest-bearing note. Use
some of the examples to explain how the standard applies in this setting.
(b) How is present value determined when an established exchange price is not determinable and a note
has no ready market? What is the resulting interest rate often called?
(c) Where should a discount or premium appear in the financial statements? What about issue costs?
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources.
IFRS Insights 815
IFRS INSIGHTS
As indicated in Chapter 13, IFRS and GAAP have similar definitions of liabilities.
11 LEARNING OBJECTIVE
Compare the accounting procedures
RELEVANT FACTS
for long-term liabilities under GAAP
and IFRS.
Following are the key similarities and differences between GAAP and IFRS related
to long-term liabilities.
Similarities
• As indicated in our earlier discussions, GAAP and IFRS have similar liability defi ni-
tions, and liabilities are classifi ed as current and non-current.
• Much of the accounting for bonds and long-term notes is the same for GAAP and
IFRS.
Differences
• Under GAAP, companies are permitted to use the straight-line method of amortiza-
tion for bond discount or premium, provided that the amount recorded is not materi-
ally different than that resulting from effective-interest amortization. However, the
effective-interest method is preferred and is generally used. Under IFRS, companies
must use the effective-interest method.
• Under IFRS, companies do not use premium or discount accounts but instead show
the bond at its net amount. For example, if a $100,000 bond was issued at 97, under
IFRS a company would record:
Cash 97,000
Bonds Payable 97,000
• Under GAAP, bond issue costs are recorded as an asset. Under IFRS, bond issue costs
are netted against the carrying amount of the bonds.
• GAAP uses the term troubled-debt restructurings and has developed specifi c guidelines |
related to that category of loans. IFRS generally assumes that all restructurings will be
accounted for as extinguishments of debt.
• IFRS requires a liability and related expense or cost be recognized when a contract is
onerous. Under GAAP, losses on onerous contracts are generally not recognized
under GAAP unless addressed by industry or transaction-specifi c requirements.
ABOUT THE NUMBERS
Effective-Interest Method
As discussed earlier, by paying more or less at issuance, investors earn a rate different
than the coupon rate on the bond. Recall that the issuing company pays the contractual
interest rate over the term of the bonds but also must pay the face value at maturity. If
the bond is issued at a discount, the amount paid at maturity is more than the issue
amount. If issued at a premium, the company pays less at maturity relative to the issue
price.
The company records this adjustment to the cost as bond interest expense over the
life of the bonds through a process called amortization. Amortization of a discount
increases bond interest expense. Amortization of a premium decreases bond interest
expense.
816 Chapter 14 Long-Term Liabilities
Under IFRS, the required procedure for amortization of a discount or premium is
the effective-interest method (also called present value amortization). Under the
effective-interest method, companies:
1. Compute bond interest expense fi rst by multiplying the carrying value (book value)
of the bonds at the beginning of the period by the effective-interest rate.
2. Determine the bond discount or premium amortization next by comparing the bond
interest expense with the interest (cash) to be paid.
Illustration IFRS14-1 depicts graphically the computation of the amortization.
ILLUSTRATION
IFRS14-1 Bond Interest Expense Bond Interest Paid
Bond Discount and
Carrying Value Effective- Face Amount Stated Amortization
Premium Amortization –– ==
of Bonds at × Interest of × Interest Amount
Computation
Beginning of Period Rate Bonds Rate
The effective-interest method produces a periodic interest expense equal to a constant
percentage of the carrying value of the bonds. The issuance of bonds involves engrav-
ing and printing costs, legal and accounting fees, commissions, promotion costs, and
other similar charges. These costs should be recorded as a reduction to the issue amount
of the bond payable and then amortized into expense over the life of the bond, through
an adjustment to the effective-interest rate. For example, if the face value of the bond is
$100,000 and issue costs are $1,000, then the bond payable (net of the bond issue costs)
is recorded at $99,000. Thus, the effective-interest rate will be higher, based on the
reduced carrying value.
Bonds Issued at a Discount
To illustrate amortization of a discount under the effective-interest method, Evermaster
Corporation issued $100,000 of 8 percent term bonds on January 1, 2014, due on January 1,
2019, with interest payable each July 1 and January 1. Because the investors required an
effective-interest rate of 10 percent, they paid $92,278 for the $100,000 of bonds, creating
a $7,722 discount. Evermaster computes the $7,722 discount as follows.
ILLUSTRATION
Maturity value of bonds payable $100,000
IFRS14-2
Present value of $100,000 due in 5 years at 10%, interest payable
Computation of Discount semiannually (Table 6-2); FV(PVF ); ($100,000 3 .61391) $61,391
10,5%
on Bonds Payable Present value of $4,000 interest payable semiannually for 5 years at
10% annually (Table 6-4); R(PVF-OA ); ($4,000 3 7.72173) 30,887
10,5%
Proceeds from sale of bonds (92,278)
Discount on bonds payable $ 7,722
The five-year amortization schedule appears in Illustration IFRS14-3.
Evermaster records the issuance of its bonds at a discount on January 1, 2014, as follows.
Cash 92,278
Bonds Payable 92,278
It records the first interest payment on July 1, 2014, and amortization of the discount
as follows.
Interest Expense 4,614
Bonds Payable 614
Cash 4,000
IFRS Insights 817
ILLUSTRATION
SCHEDULE OF BOND DISCOUNT AMORTIZATION
IFRS14-3
EFFECTIVE-INTEREST METHOD—SEMIANNUAL INTEREST PAYMENTS |
5-YEAR, 8% BONDS SOLD TO YIELD 10% Bond Discount
Amortization Schedule
Discount Carrying Amount
Date Cash Paid Interest Expense Amortized of Bonds
1/1/14 $ 92,278
7/1/14 $ 4,000a $ 4,614b $ 614c 92,892d
1/1/15 4,000 4,645 645 93,537
7/1/15 4,000 4,677 677 94,214
1/1/16 4,000 4,711 711 94,925
7/1/16 4,000 4,746 746 95,671
1/1/17 4,000 4,783 783 96,454
7/1/17 4,000 4,823 823 97,277
1/1/18 4,000 4,864 864 98,141
7/1/18 4,000 4,907 907 99,048
1/1/19 4,000 4,952 952 100,000
$40,000 $47,722 $7,722
a$4,000 5 $100,000 3 .08 3 6/12 c$614 5 $4,614 2 $4,000
b$4,614 5 $92,278 3 .10 3 6/12 d$92,892 5 $92,278 1 $614
Evermaster records the interest expense accrued at December 31, 2014 (year-end),
and amortization of the discount as follows.
Interest Expense 4,645
Interest Payable 4,000
Bonds Payable 645
Extinguishment with Modifi cation of Terms
Practically every day, the Wall Street Journal or the Financial Times runs a story about
some company in financial difficulty. Notable recent examples are Nakheel, Parmalat,
and General Motors. In many of these situations, the creditor may grant a borrower
concessions with respect to settlement. The creditor offers these concessions to ensure
the highest possible collection on the loan. For example, a creditor may offer one or a
combination of the following modifications:
1. Reduction of the stated interest rate.
2. Extension of the maturity date of the face amount of the debt.
3. Reduction of the face amount of the debt.
4. Reduction or deferral of any accrued interest.
As with other extinguishments, when a creditor grants favorable concessions on the
terms of a loan, the debtor has an economic gain. Thus, the accounting for debt modifi-
cations is similar to that for other extinguishments. That is, the original obligation is
extinguished, the new payable is recorded at fair value, and a gain is recognized for the
difference in the fair value of the new obligation and the carrying value of the old obli-
gation. Thus, under IFRS, debt modifications are similar to troubled-debt restructurings
in GAAP. In general, IFRS treats debt modifications as debt extinguishments.
An exception to the general rule is when the modification of terms is not substantial.
A substantial modification is defined as one in which the discounted cash flows under
the terms of the new debt (using the historical effective-interest rate) differ by at least
10 percent of the carrying value of the original debt. If a modification is not substantial,
the difference (gain) is deferred and amortized over the remaining life of the debt at the
historical effective-interest rate. In the case of a non-substantial modification, in essence,
the new loan is a continuation of the old loan. Therefore, the debtor should record inter-
est at the historical effective-interest rate.
818 Chapter 14 Long-Term Liabilities
ON THE HORIZON
The FASB and IASB are currently involved in two projects, each of which has implica-
tions for the accounting for liabilities. One project is investigating approaches to differ-
entiate between debt and equity instruments. The other project, the elements phase of
the conceptual framework project, will evaluate the definitions of the fundamental
building blocks of accounting. The results of these projects could change the classifica-
tion of many debt and equity securities.
IFRS SELF-TEST QUESTIONS
1. Under IFRS, bond issuance costs, including the printing costs and legal fees associated with the
issuance, should be:
(a) expensed in the period when the debt is issued.
(b) recorded as a reduction in the carrying value of bonds payable.
(c) accumulated in a deferred charge account and amortized over the life of the bonds.
(d) reported as an expense in the period the bonds mature or are redeemed.
2. Which of the following is stated correctly?
(a) Current liabilities follow non-current liabilities on the statement of financial position under
GAAP but non-current liabilities follow current liabilities under IFRS.
(b) IFRS does not treat debt modifications as extinguishments of debt.
(c) Bond issuance costs are recorded as a reduction of the carrying value of the debt under GAAP |
but are recorded as an asset and amortized to expense over the term of the debt under IFRS.
(d) Under GAAP, bonds payable is recorded at the face amount and any premium or discount is
recorded in a separate account. Under IFRS, bonds payable is recorded at the carrying value so
no separate premium or discount accounts are used.
3. All of the following are differences between IFRS and GAAP in accounting for liabilities except:
(a) When a bond is issued at a discount, GAAP records the discount in a separate contra liability
account. IFRS records the bond net of the discount.
(b) Under IFRS, bond issuance costs reduce the carrying value of the debt. Under GAAP, these costs
are recorded as an asset and amortized to expense over the terms of the bond.
(c) GAAP, but not IFRS, uses the term “troubled-debt restructurings.”
(d) GAAP, but not IFRS, uses the term “provisions” for contingent liabilities which are accrued.
4. On January 1, Patterson Inc. issued $5,000,000, 9% bonds for $4,695,000. The market rate of interest
for these bonds is 10%. Interest is payable annually on December 31. Patterson uses the effective-
interest method of amortizing bond discount. At the end of the first year, Patterson should report
bonds payable of:
(a) $4,725,500. (c) $258,050.
(b) $4,714,500. (d) $4,745,000.
5. On January 1, Martinez Inc. issued $3,000,000, 11% bonds for $3,195,000. The market rate of interest
for these bonds is 10%. Interest is payable annually on December 31. Martinez uses the effective-
interest method of amortizing bond premium. At the end of the first year, Martinez should report
bonds payable of:
(a) $3,185,130. (c) $3,173,550.
(b) $3,184,500. (d) $3,165,000.
IFRS CONCEPTS AND APPLICATION
IFRS14-1 What is the required method of amortizing discount and premium on bonds payable? Explain
the procedures.
IFRS14-2 What are the general rules for measuring and recognizing gain or loss by a debt extinguishment
with modification?
IFRS14-3 On January 1, 2014, JWS Corporation issued $600,000 of 7% bonds, due in 10 years. The bonds
were issued for $559,224, and pay interest each July 1 and January 1. Prepare the company’s journal entries
for (a) the January 1 issuance, (b) the July 1 interest payment, and (c) the December 31 adjusting entry.
Assume an effective-interest rate of 8%.
IFRS Insights 819
IFRS14-4 Assume the bonds in IFRS14-3 were issued for $644,636 and the effective-interest rate is 6%.
Prepare the company’s journal entries for (a) the January 1 issuance, (b) the July 1 interest payment, and
(c) the December 31 adjusting entry. (Round to the nearest dollar.)
IFRS14-5 Foreman Company issued $800,000 of 10%, 20-year bonds on January 1, 2014, at 119.792 to yield
8%. Interest is payable semiannually on July 1 and January 1. Prepare the journal entries to record (a) the
issuance of the bonds, (b) the payment of interest and the related amortization on July 1, 2014, and (c) the
accrual of interest and the related amortization on December 31, 2014. (Round to the nearest dollar.)
IFRS14-6 Assume the same information as in IFRS14-5, except that the bonds were issued at 84.95 to
yield 12%. Prepare the journal entries to record (a) the issuance of the bonds, (b) the payment of interest
and related amortization on July 1, 2014, and (c) the accrual of interest and the related amortization on
December 31, 2014. (Round to the nearest dollar.)
Professional Research
IFRS14-7 Wie Company has been operating for just 2 years, producing specialty golf equipment for
women golfers. To date, the company has been able to finance its successful operations with investments
from its principal owner, Michelle Wie, and cash flows from operations. However, current expansion plans
will require some borrowing to expand the company’s production line.
As part of the expansion plan, Wie is contemplating a borrowing on a note payable or issuance of
bonds. In the past, the company has had little need for external borrowing so the management team has a
number of questions concerning the accounting for these new non-current liabilities. They have asked you |
to conduct some research on this topic.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and
then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the
search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) With respect to a decision of issuing notes or bonds, management is aware of certain costs
(e.g., printing, marketing, selling) associated with a bond issue. How will these costs affect Wie’s
reported earnings in the year of issue and while the bonds are outstanding?
(b) If all goes well with the plant expansion, the financial performance of Wie Company could dra-
matically improve. As a result, Wie’s market rate of interest (which is currently around 12%) could
decline. This raises the possibility of retiring or exchanging the debt, in order to get a lower borrow-
ing rate. How would such a debt extinguishment be accounted for?
International Financial Reporting Problem
Marks and Spencer plc
IFRS14-8 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com-
panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-
and-Spencer-Annual-report-and-financial-statements-2012.pdf.
Instructions
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
(a) What cash outflow obligations related to the repayment of long-term debt does M&S have over
the next 5 years?
(b) M&S indicates that it believes that it has the ability to meet business requirements in the foreseeable
future. Prepare an assessment of its liquidity, solvency, and financial flexibility using ratio analysis.
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. b 2. d 3. d 4. b 5. b
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
Stockholders’ Equity
1 Discuss the characteristics of the corporate form 6 Describe the policies used in distributing dividends.
of organization.
7 Identify the various forms of dividend distributions.
2 Identify the key components of stockholders’ equity.
8 Explain the accounting for small and large stock
3 Explain the accounting procedures for issuing dividends, and for stock splits.
shares of stock.
9 Indicate how to present and analyze
4 Describe the accounting for treasury stock. stockholders’ equity.
5 Explain the accounting for and reporting of
preferred stock.
It’s a Global Market
As mentioned in prior chapters, we are moving rapidly toward one set of global financial reporting standards and one “com-
mon language” for financial information. This change will probably lead to more consolidation of our capital markets. To
understand how quickly the global financial world is changing, let’s examine a few trends occurring on stock exchanges
around the world.
In 2007, the New York Stock Exchange (NYSE) merged with Paris-based Euronext, creating the world’s first transatlantic
stock exchange. NYSE Euronext is the world’s largest exchange group, now with 8,000 listed issuers representing over
40 percent of global equity trading in 2010. Similarly, NASDAQ, the world’s largest electronic stock market, merged with OMX,
the Nordic stock market operator. This electronic exchange operates in 29 countries, on six continents, and has over 4,000
listed issuers, with a market value of approximately $5.5 trillion. (Further exchange consolidation may be in the offing, with
IntercontinentalExchange and international exchanges in Asia exploring mergers with NYSE Euronext.)
Another reason behind the movement to international financial reporting standards can be found in recent initial public
offerings (IPOs). The emerging markets are driving the global IPO market. As shown in the following table, Greater China is at
the top in IPO volume, with Poland, Korea, and India also in the top 10.
RETPAHC 15
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
2011 Global IPOs by Domicile Country—Top 10 by Number of Deals |
Country Number of Deals % of Global Total
Greater China* 388 31.70%
Poland 137 11.20
United States 108 8.80
Australia 98 8.00
South Korea 69 5.60
Canada 64 5.20
India 40 3.30
Japan 37 3.00
United Kingdom 28 2.30
Indonesia 26 2.10
Rest of world** (52 countries) 230 18.80
Total 1,225 100.00%
Source: Based on the listed company domicile.
*Includes Mainland China, Hong Kong, and Taiwan.
**Includes countries with 1% or less of IPO activity by number of deals or capital raised.
CONCEPTUAL FOCUS
> See the Underlying Concepts on
Finally, globalization has also been an enormous boon for
pages 830 and 842.
some of the biggest names in corporate America, along with
investors who own the stocks in those companies. As shown INTERNATIONAL FOCUS
in the following table, these 10 large U.S. companies —often
called “multinationals” for good reason—have increasingly > See the International Perspectives
followed globalization of markets. on pages 823 and 824.
> Read the IFRS Insights on
Total % of Revenues pages 874–880 for a discussion of:
Company Revenues Overseas —Equity
Intel $ 44 85 —Accounting for preference shares
Dow 54 67
—Presentation of equity
McDonald’s 24 66
IBM 100 64
General Electric 149 54
Ford 129 51 As indicated, Intel has 85 percent of its sales
Nike 21 50
overseas, McDonald’s in a recent year sold more
Wal-Mart 420 45
ExxonMobil 342 45 hamburgers overseas than in the United States, and
Amazon.com 34 45 Ford Motor Company’s sales would be much less
except for success in the European market. Overall,
about 40 percent of profit for firms listed in the S&P 500
stock index are now coming in from overseas sales. Foreign exposure allows U.S.-based companies to capitalize on rapid
growth in emerging markets like China, India, and Latin America, and earn much stronger profits than if they were totally
dependent on the struggling U.S. economy. As one analyst noted, “[Returns for companies] . . . in the S&P 500 continue
to outgrow the U.S. economy. Earnings power is decoupled from U.S. GDP.”
Sources: Ernst and Young, Growth During Economic Uncertainty: Global IPO Trends Report (2012); www. euronext.com; and R. Newman,
“Why U.S. Companies Aren’t So American Anymore,” http://money.usnews.com (June 30, 2011).
As our opening story indicates, the growth of global equity capital
PREVIEW OF CHAPTER 15
markets indicates that investors around the world need useful
information. In this chapter, we explain the accounting issues related
to the stockholders’ equity of a corporation. The content and organization of the chapter are as follows.
Stockholders’ Equity
Presentation and
The Corporate Form Corporate Capital Preferred Stock Dividend Policy
Analysis
• State corporate law • Issuance of stock • Features • Financial condition • Presentation
• Capital stock or • Reacquisition of • Accounting for and and dividend • Analysis
share system shares reporting preferred distributions
• Variety of ownership stock • Types of dividends
interests • Stock dividends
and stock splits
• Disclosure of
restrictions
821
822 Chapter 15 Stockholders’ Equity
THE CORPORATE FORM OF ORGANIZATION
Of the three primary forms of business organization—the proprietorship, the
LEARNING OBJECTIVE 1
partnership, and the corporation—the corporate form dominates. The corpora-
Discuss the characteristics of the
tion is by far the leader in terms of the aggregate amount of resources controlled,
corporate form of organization.
goods and services produced, and people employed. All of the “Fortune 500”
largest industrial firms are corporations. Although the corporate form has a number of
advantages (as well as disadvantages) over the other two forms, its principal advan-
tage is its facility for attracting and accumulating large amounts of capital.
The special characteristics of the corporate form that affect accounting include:
1. Infl uence of state corporate law.
2. Use of the capital stock or share system.
3. Development of a variety of ownership interests.
State Corporate Law
Anyone who wishes to establish a corporation must submit articles of incorporation to
the state in which incorporation is desired. After fulfilling requirements, the state issues |
a corporation charter, thereby recognizing the company as a legal entity subject to state
law. Regardless of the number of states in which a corporation has operating divisions,
it is incorporated in only one state.
It is to the company’s advantage to incorporate in a state whose laws favor the cor-
porate form of business organization. For example, consider that nearly half of all public
corporations in the United States are incorporated in Delaware. Why Delaware? The
state has a favorable tax and regulatory environment, resulting in Delaware being home
to more corporations—public and private—than people.1
Each state has its own business incorporation act. The accounting for stockholders’
equity follows the provisions of these acts. In many cases, states have adopted the principles
contained in the Model Business Corporate Act prepared by the American Bar Association.
State laws are complex and vary both in their provisions and in their definitions of certain
terms. Some laws fail to define technical terms. As a result, terms often mean one thing in
one state and another thing in a different state. These problems may be further compounded
because legal authorities often interpret the effects and restrictions of the laws differently.
What do the numbers mean? 1209 NORTH ORANGE STREET
Nothing about 1209 North Orange Street hints at the secrets What brings these marquee names to 1209 North Orange,
inside. It’s a humdrum offi ce building, a low-slung affair with and to other Delaware addresses, also attracts less-upstanding
a faded awning and a view of a parking garage. Hardly corporate citizens. For instance, 1209 North Orange was,
worth a second glance, if even a fi rst one. But behind its until recently, a business address of Timothy S. Durham,
doors is one of the most remarkable corporate collections in known as “the Midwest Madoff.” On June 20, Durham was
the world: 1209 North Orange, you see, is the legal address of found guilty of bilking 5,000 mostly middle-class and elderly
no fewer than 285,000 separate businesses. investors out of $207 million. It was also an address of Stanko
Its occupants, on paper, include giants like American Subotic, a Serbian businessman and convicted smuggler—
Airlines, Apple, Bank of America, Berkshire Hathaway, just one of many Eastern Europeans drawn to the state.
Cargill, Coca-Cola, Ford, General Electric, Google, JPMorgan Big corporations, small-time businesses, rogues, scoun-
Chase, and Wal-Mart. These companies do business across drels, and worse—all have turned up at Delaware addresses
the nation and around the world. Here at 1209 North Orange, in hopes of minimizing taxes, skirting regulations, plying
they simply have a dropbox. friendly courts, or, when needed, covering their tracks.
1L. Wayne, “How Delaware Thrives as a Corporate Tax Haven,” The New York Times (June 30, 2012).
The Corporate Form of Organization 823
Federal authorities worry that, in addition to the legitimate elsewhere. Today, Delaware regularly tops lists of domestic
businesses fl ocking here, drug-traffi ckers, embezzlers, and and foreign tax havens because it allows companies to lower
money-launderers are increasingly heading to Delaware, their taxes in another state—for instance, the state in which
too. It’s easy to set up shell companies here, no questions they actually do business or have their headquarters—by
asked. shifting royalties and similar revenues to holding compa-
Of course, business—the legal kind—has been the main- nies in Delaware, where they are not taxed. In tax circles, the
stay of Delaware since 1792, when the state established its arrangement is known as “the Delaware loophole.” Over the
Court of Chancery to handle business affairs. By the early last decade, the Delaware loophole has enabled corpora-
20th century, the state was writing friendly corporate and tions to reduce the taxes paid to other states by an estimated
tax laws to lure companies from New York, New Jersey, and $9.5 billion.
Source: L. Wayne, “How Delaware Thrives as a Corporate Tax Haven,” The New York Times (June 30, 2012). |
Capital Stock or Share System
Stockholders’ equity in a corporation generally consists of a large number of International
units or shares. Within a given class of stock, each share exactly equals every Perspective
other share. The number of shares possessed determines each owner’s interest.
In the United States, stockholders
If a company has one class of stock divided into 1,000 shares, a person who
are treated equally as far as
owns 500 shares controls one-half of the ownership interest. One holding 10
access to fi nancial information.
shares has a one-hundredth interest. That is not always the case in
Each share of stock has certain rights and privileges. Only by special con- other countries. For example,
tract can a company restrict these rights and privileges at the time it issues the in Mexico, foreign investors
shares. Owners must examine the articles of incorporation, stock certificates, as well as minority investors
and the provisions of the state law to ascertain such restrictions on or variations often have diffi culty obtaining
from the standard rights and privileges. In the absence of restrictive provisions, fi nancial data. These restrictions
are rooted in the habits of
each share carries the following rights:
companies that, for many years,
1. To share proportionately in profi ts and losses. were tightly controlled by a few
stockholders and managers.
2. To share proportionately in management (the right to vote for directors).
3. To share proportionately in corporate assets upon liquidation.
4. To share proportionately in any new issues of stock of the same class—called the
preemptive right.2
The first three rights are self-explanatory. The last right is used to protect each
stockholder’s proportional interest in the company. The preemptive right protects an
existing stockholder from involuntary dilution of ownership interest. Without this
right, stockholders might find their interest reduced by the issuance of additional stock
without their knowledge and at prices unfavorable to them. However, many corpora-
tions have eliminated the preemptive right. Why? Because this right makes it inconve-
nient for corporations to issue large amounts of additional stock, as they frequently do
in acquiring other companies.
The share system easily allows one individual to transfer an interest in a company
to another investor. For example, individuals owning shares in Google may sell them
to others at any time and at any price without obtaining the consent of the company
or other stockholders. Each share is personal property of the owner, who may dispose
of it at will. Google simply maintains a list or subsidiary ledger of stockholders as a
guide to dividend payments, issuance of stock rights, voting proxies, and the like. Be-
cause owners freely and frequently transfer shares, Google must revise the subsidiary
2This privilege is referred to as a stock right or warrant. The warrants issued in these situations
are of short duration, unlike the warrants issued with other securities.
824 Chapter 15 Stockholders’ Equity
ledger of stockholders periodically, generally in advance of every dividend payment or
stockholders’ meeting.
In addition, the major stock exchanges require ownership controls that the typical
corporation finds uneconomic to provide. Thus, corporations often use registrars and
transfer agents who specialize in providing services for recording and transferring
stock. The Uniform Stock Transfer Act and the Uniform Commercial Code govern the
negotiability of stock certificates.
Variety of Ownership Interests
In every corporation, one class of stock must represent the basic ownership interest. That
class is called common stock. Common stock is the residual corporate interest that bears
the ultimate risks of loss and receives the benefits of success. Common stockholders are
not guaranteed dividends or assets upon dissolution. But common stockholders gener-
ally control the management of the corporation and tend to profit most if the company is
successful. In the event that a corporation has only one authorized issue of capital stock, |
that issue is by definition common stock, whether so designated in the charter or not.
International In an effort to broaden investor appeal, corporations may offer two or
Perspective more classes of stock, each with different rights or privileges. As indicated in
the preceding section, each share of stock of a given issue has the same four
The U.S. and British systems
of corporate governance and inherent rights as other shares of the same issue. By special stock con-
fi nance depend to a large extent tracts between the corporation and its stockholders, however, the stockholder
on equity fi nancing and the may sacrifice certain of these rights in return for other special rights or
widely dispersed ownership of privileges. Thus, special classes of stock, usually called preferred stock, are
shares traded in highly liquid created. In return for any special preference, the preferred stockholder always
markets. The German and sacrifices some of the inherent rights of common stock ownership.
Japanese systems have relied
A common type of preference is to give the preferred stockholders a prior
more on debt fi nancing, inter-
claim on earnings. The corporation thus assures them a dividend, usually at a
locking stock ownership, and
stated rate, before it distributes any amount to the common stockholders. In
banker/director and worker/
return for this preference, the preferred stockholders may sacrifice their right
shareholder rights.
to a voice in management or their right to share in profits beyond the stated rate.
CORPORATE CAPITAL
Owners’ equity in a corporation is defined as stockholders’ equity, shareholders’
LEARNING OBJECTIVE 2
equity, or corporate capital. The following three categories normally appear as
Identify the key components of
part of stockholders’ equity:
stockholders’ equity.
1. Capital stock.
2. Additional paid-in capital.
3. Retained earnings.
The first two categories, capital stock and additional paid-in capital, constitute con-
tributed (paid-in) capital. Retained earnings represents the earned capital of the com-
pany. Contributed (paid-in) capital is the total amount paid in on capital stock—the
amount provided by stockholders to the corporation for use in the business. Contrib-
uted capital includes items such as the par value of all outstanding stock and premiums
less discounts on issuance. Earned capital is the capital that develops from profitable
operations. It consists of all undistributed income that remains invested in the company.
Stockholders’ equity is the difference between the assets and the liabilities of the company.
That is, the owners’ or stockholders’ interest in a company like The Walt Disney Company
Corporate Capital 825
is a residual interest.3 Stockholders’ (owners’) equity represents the cumulative net
contributions by stockholders plus retained earnings. As a residual interest, stockholders’
equity has no existence apart from the assets and liabilities of Disney—stockholders’
equity equals net assets. Stockholders’ equity is not a claim to specific assets but a claim
against a portion of the total assets. Its amount is not specified or fixed; it depends on
Disney’s profitability. Stockholders’ equity grows if the company is profitable. It shrinks,
or may disappear entirely, if Disney loses money.
Issuance of Stock
In issuing stock, companies follow these procedures. First, the state must authorize
3 LEARNING OBJECTIVE
the stock, generally in a certificate of incorporation or charter. Next, the corporation
Explain the accounting procedures
offers shares for sale, entering into contracts to sell stock. Then, after receiving
for issuing shares of stock.
amounts for the stock, the corporation issues shares. The corporation generally
makes no entry in the general ledger accounts when it receives its stock authorization
from the state of incorporation.
We discuss the accounting problems involved in the issuance of stock under the
following topics.
1. Accounting for par value stock.
2. Accounting for no-par stock.
3. Accounting for stock issued in combination with other securities (lump-sum sales). |
4. Accounting for stock issued in noncash transactions.
5. Accounting for costs of issuing stock.
Par Value Stock
The par value of a stock has no relationship to its fair value. At present, the par value
associated with most capital stock issuances is very low. For example, PepsiCo’s par
value is 12/¢, Kellogg’s is $0.25, and Hershey’s is $1. Such values contrast dramatically
3
with the situation in the early 1900s, when practically all stock issued had a par value of
$100. Low par values help companies avoid the contingent liability associated with
stock sold below par.4
To show the required information for issuance of par value stock, corporations
maintain accounts for each class of stock as follows.
1. Preferred Stock or Common Stock. Together, these two stock accounts refl ect the par
value of the corporation’s issued shares. The company credits these accounts when
it originally issues the shares. It makes no additional entries in these accounts unless
it issues additional shares or retires them.
2. Paid-in Capital in Excess of Par (also called Additional Paid-in Capital). The
Paid-in Capital in Excess of Par account indicates any excess over par value paid in
by stockholders in return for the shares issued to them. Once paid in, the excess over
par becomes a part of the corporation’s additional paid-in capital. The individual
stockholder has no greater claim on the excess paid in than all other holders of the
same class of shares.
3“Elements of Financial Statements,” Statement of Financial Accounting Concepts No. 6 (Stamford,
Conn.: FASB, 1985), par. 60.
4Companies rarely, if ever, issue stock at a value below par value. If issuing stock below par, the
company records the discount as a debit to Additional Paid-in Capital. In addition, the corpora-
tion may call on the original purchaser or the current holder of the shares issued below par to
pay in the amount of the discount to prevent creditors from sustaining a loss upon liquidation
of the corporation.
826 Chapter 15 Stockholders’ Equity
No-Par Stock
Many states permit the issuance of capital stock without par value, called no-par stock.
The reasons for issuance of no-par stock are twofold. First, issuance of no-par stock
avoids the contingent liability (see footnote 4) that might occur if the corporation
issued par value stock at a discount. Second, some confusion exists over the relationship
(or rather the absence of a relationship) between the par value and fair value. If shares
have no-par value, the questionable treatment of using par value as a basis for fair
value never arises. This is particularly advantageous whenever issuing stock for property
items such as intangible or tangible fixed assets.
A major disadvantage of no-par stock is that some states levy a high tax on these
issues. In addition, in some states the total issue price for no-par stock may be considered
legal capital, which could reduce the flexibility in paying dividends.
Corporations sell no-par shares, like par value shares, for whatever price they will
bring. However, unlike par value shares, corporations issue them without a premium or
a discount. The exact amount received represents the credit to common or preferred
stock. For example, Video Electronics Corporation is organized with authorized
common stock of 10,000 shares without par value. Video Electronics makes only a
memorandum entry for the authorization, inasmuch as no amount is involved. If Video
Electronics then issues 500 shares for cash at $10 per share, it makes the following entry.
Cash 5,000
Common Stock (no-par value) 5,000
If it issues another 500 shares for $11 per share, Video Electronics makes this entry:
Cash 5,500
Common Stock (no-par value) 5,500
True no-par stock should be carried in the accounts at issue price without any
additional paid-in capital or discount reported. But some states require that no-par
stock have a stated value. The stated value is a minimum value below which a company
cannot issue it. Thus, instead of being no-par stock, such stated-value stock becomes, in |
effect, stock with a very low par value. It thus is open to all the criticism and abuses that
first encouraged the development of no-par stock.5
If no-par stock has a stated value of $5 per share but sells for $11, all such amounts
in excess of $5 are recorded as additional paid-in capital, which in many states is fully
or partially available for dividends. Thus, no-par value stock with a low stated value
permits a new corporation to commence its operations with additional paid-in capital
that may exceed its stated capital. For example, if a company issued 1,000 of the shares
with a $5 stated value at $15 per share for cash, it makes the following entry.
Cash 15,000
Common Stock 5,000
Paid-in Capital in Excess of Stated Value—Common Stock 10,000
Most corporations account for no-par stock with a stated value as if it were par
value stock with par equal to the stated value.
Stock Issued with Other Securities (Lump-Sum Sales)
Generally, corporations sell classes of stock separately from one another. The reason to
do so is to track the proceeds relative to each class, as well as relative to each lot.
Occasionally, a corporation issues two or more classes of securities for a single payment
5Accounting Trends and Techniques—2012 indicates that its 500 surveyed companies reported 461
issues of outstanding common stock, 453 par value issues, and 40 no-par issues; 3 of the no-par
issues were shown at their stated (assigned) values.
Corporate Capital 827
or lump sum (e.g., in the acquisition of another company). The accounting problem in
such lump-sum sales is how to allocate the proceeds among the several classes of secu-
rities. Companies use one of two methods of allocation: (1) the proportional method and
(2) the incremental method.
Proportional Method. If the fair value or other sound basis for determining relative
value is available for each class of security, the company allocates the lump sum re-
ceived among the classes of securities on a proportional basis. For instance, assume a
company issues 1,000 shares of $10 stated value common stock having a market price of
$20 a share, and 1,000 shares of $10 par value preferred stock having a market price of
$12 a share, for a lump sum of $30,000. Illustration 15-1 shows how the company allo-
cates the $30,000 to the two classes of stock.
ILLUSTRATION 15-1
Fair value of common (1,000 3 $20) 5 $20,000
Allocation in Lump-Sum
Fair value of preferred (1,000 3 $12) 5 12,000
Securities Issuance—
Aggregate fair value $32,000
Proportional Method
$20,000
Allocated to common: 3 $30,000 5 $18,750
$32,000
$12,000
Allocated to preferred: 3 $30,000 5 $11,250
$32,000
Total allocation $30,000
Incremental Method. In instances where a company cannot determine the fair value of
all classes of securities, it may use the incremental method. It uses the fair value of the
securities as a basis for those classes that it knows, and allocates the remainder of the
lump sum to the class for which it does not know the fair value. For instance, if a com-
pany issues 1,000 shares of $10 stated value common stock having a fair value of $20, and
1,000 shares of $10 par value preferred stock having no established fair value, for a lump
sum of $30,000, it allocates the $30,000 to the two classes as shown in Illustration 15-2.
ILLUSTRATION 15-2
Lump-sum receipt $30,000
Allocation in Lump-Sum
Allocated to common (1,000 3 $20) (20,000)
Securities Issuance—
Balance allocated to preferred $10,000
Incremental Method
If a company cannot determine fair value for any of the classes of stock involved
in a lump-sum exchange, it may need to use other approaches. It may rely on an expert’s
appraisal. Or, if the company knows that one or more of the classes of securities issued
will have a determinable fair value in the near future, it may use a best estimate basis
with the intent to adjust later, upon establishment of the future fair value.
Stock Issued in Noncash Transactions
Accounting for the issuance of shares of stock for property or services involves an issue
of valuation. The general rule is: Companies should record stock issued for services |
or property other than cash at either the fair value of the stock issued or the fair value
of the noncash consideration received, whichever is more clearly determinable.
If a company can readily determine both, and the transaction results from an arm’s-
length exchange, there will probably be little difference in their fair values. In such cases,
the basis for valuing the exchange should not matter.
If a company cannot readily determine either the fair value of the stock it issues or
the property or services it receives, it should employ an appropriate valuation technique.
828 Chapter 15 Stockholders’ Equity
Depending on available data, the valuation may be based on market transactions
involving comparable assets or the use of discounted expected future cash flows. Com-
panies should avoid the use of the book, par, or stated values as a basis of valuation for
these transactions.
A company may exchange unissued stock or treasury stock (issued shares that it has
reacquired but not retired) for property or services. If it uses treasury shares, the cost of
the treasury shares should not be considered the decisive factor in establishing the fair
value of the property or services. Instead, it should use the fair value of the treasury
stock, if known, to value the property or services. Otherwise, if it does not know the fair
value of the treasury stock, it should use the fair value of the property or services re-
ceived, if determinable.
The following series of transactions illustrates the procedure for recording the issu-
ance of 10,000 shares of $10 par value common stock for a patent for Marlowe Company,
in various circumstances.
1. Marlowe cannot readily determine the fair value of the patent, but it knows the fair
value of the stock is $140,000.
Patents 140,000
Common Stock (10,000 shares 3 $10 per share) 100,000
Paid-in Capital in Excess of Par—Common Stock 40,000
2. Marlowe cannot readily determine the fair value of the stock, but it determines the
fair value of the patent is $150,000.
Patents 150,000
Common Stock (10,000 shares 3 $10 per share) 100,000
Paid-in Capital in Excess of Par—Common Stock 50,000
3. Marlowe cannot readily determine the fair value of the stock nor the fair value of
the patent. An independent consultant values the patent at $125,000 based on dis-
counted expected cash fl ows.
Patents 125,000
Common Stock (10,000 shares 3 $10 share) 100,000
Paid-in Capital in Excess of Par—Common Stock 25,000
In corporate law, the board of directors has the power to set the value of noncash
transactions. However, boards sometimes abuse this power. The issuance of stock for
property or services has resulted in cases of overstated corporate capital through inten-
tional overvaluation of the property or services received. The overvaluation of the
stockholders’ equity resulting from inflated asset values creates watered stock. The cor-
poration should eliminate the “water” by simply writing down the overvalued assets.
If, as a result of the issuance of stock for property or services, a corporation under-
values the recorded assets, it creates secret reserves. An understated corporate structure
(secret reserve) may also result from other methods: excessive depreciation or amortization
charges, expensing capital expenditures, excessive write-downs of inventories or receiv-
ables, or any other understatement of assets or overstatement of liabilities. An example
of a liability overstatement is an excessive provision for estimated product warranties that
ultimately results in an understatement of owners’ equity, thereby creating a secret reserve.
Costs of Issuing Stock
When a company like Walgreens issues common stock, it should report direct costs in-
curred to sell stock, such as underwriting costs, accounting and legal fees, printing costs,
and taxes, as a reduction of the amounts paid in. Walgreens therefore debits issue costs
to Paid-in Capital in Excess of Par—Common Stock because they are unrelated to cor-
porate operations. In effect, issue costs are a cost of financing. As such, issue costs |
should reduce the proceeds received from the sale of the stock.
Corporate Capital 829
Walgreens should expense management salaries and other indirect costs related to
the stock issue because it is difficult to establish a relationship between these costs and
the sale proceeds. In addition, Walgreens expenses recurring costs, primarily registrar
and transfer agents’ fees, as incurred.
What do the numbers mean? THE CASE OF THE DISAPPEARING RECEIVABLE
Sometimes companies issue stock but may not receive cash which it received a note receivable. Enron then increased its
in return. As a result, a company records a receivable. assets (by recording a receivable) and stockholders’ equity, a
Controversy existed regarding the presentation of this re- move the company now calls an accounting error. As a result
ceivable on the balance sheet. Some argued that the company of this accounting treatment, Enron overstated assets and
should report the receivable as an asset similar to other re- stockholders’ equity by $172 million in its 2000 audited fi nan-
ceivables. Others argued that the company should report the cial statements and by $828 million in its unaudited 2001
receivable as a deduction from stockholders’ equity (similar statements. This $1 billion overstatement was 8.5 percent of
to the treatment of treasury stock). The SEC settled this issue: Enron’s previously reported stockholders’ equity at that time.
It requires companies to use the contra equity approach As Lynn Turner, former chief accountant of the SEC,
because the risk of collection in this type of transaction is noted, “It is a basic accounting principle that you don’t
often very high. record equity until you get cash, and a note doesn’t count as
This accounting issue surfaced in Enron’s accounting. cash.” Situations like this led investors, creditors, and suppli-
Starting in early 2000, Enron issued shares of its common ers to lose faith in the credibility of Enron, which eventually
stock to four “special-purpose entities” in exchange for caused its bankruptcy.
Source: Adapted from Jonathan Weil, “Basic Accounting Tripped Up Enron—Financial Statements Didn’t Add Up—Auditors Overlook
a Simple Rule,” Wall Street Journal (November 11, 2001), p. C1.
Reacquisition of Shares
Companies often buy back their own shares. In fact, share buybacks now exceed
4 LEARNING OBJECTIVE
dividends as a form of distribution to stockholders. For example, oil producer
Describe the accounting for treasury
ConocoPhillips, healthcare–products giant Johnson & Johnson, and discount
stock.
retailer Wal-Mart Stores have ambitious buyback plans. As shown in Illustra-
tion 15-3, companies in the S&P 500 are on track to buy back more than $429 billion of
their own shares in 2012.6
ILLUSTRATION 15-3
Share Buybacks in 2012
*Annualized, based on data through June.
Source: J.P. Morgan.
Corporations purchase their outstanding stock for several reasons:
1. To provide tax-effi cient distributions of excess cash to shareholders. Capital gain
rates on sales of stock to the company by the stockholders have been approximately
half the ordinary tax rate for many investors. This advantage has been somewhat
diminished by recent changes in the tax law related to dividends.
6 T. Lauricella, “Post-Rally Risks in U.S. Stocks,” Wall Street Journal (October 1, 2012), p. C11.
)snoillib
ni(
skcabyub
kcots
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$800
600
400
200
$429
billion
0
2000’02 ’04 ’06 ’08 ’10 ’12*
830 Chapter 15 Stockholders’ Equity
2. To increase earnings per share and return on equity. Reducing both shares outstand-
ing and stockholders’ equity often enhances certain performance ratios. However,
strategies to hype performance measures might increase performance in the short-
run, but these tactics add no real long-term value.
3. To provide stock for employee stock compensation contracts or to meet potential
merger needs. Honeywell Inc. reported that it would use part of its purchase of one
million common shares for employee stock option contracts. Other companies
acquire shares to have them available for business acquisitions. |
4. To thwart takeover attempts or to reduce the number of stockholders. By reducing
the number of shares held by the public, existing owners and managements bar
“outsiders” from gaining control or signifi cant infl uence. When Ted Turner attempted
to acquire CBS, CBS started a substantial buyback of its stock. Companies may also
use stock purchases to eliminate dissident stockholders.
5. To make a market in the stock. As one company executive noted, “Our company is
trying to establish a fl oor for the stock.” Purchasing stock in the marketplace creates
a demand. This may stabilize the stock price or, in fact, increase it.
Some publicly held corporations have chosen to “go private,” that is, to eliminate
public (outside) ownership entirely by purchasing all of their outstanding stock. Com-
panies often accomplish such a procedure through a leveraged buyout (LBO), in which
the company borrows money to finance the stock repurchases.
Underlying Concepts
After reacquiring shares, a company may either retire them or hold them in
As we indicated in Chapter 2, an the treasury for reissue. If not retired, such shares are referred to as treasury
asset should have probable future stock (treasury shares). Technically, treasury stock is a corporation’s own stock,
economic benefi ts. Treasury reacquired after having been issued and fully paid.
stock simply reduces common Treasury stock is not an asset. When a company purchases treasury stock,
stock outstanding. a reduction occurs in both assets and stockholders’ equity. It is inappropriate to
imply that a corporation can own a part of itself. A corporation may sell trea-
sury stock to obtain funds, but that does not make treasury stock a balance sheet asset.
When a corporation buys back some of its own outstanding stock, it has not acquired an
asset; it reduces net assets.
The possession of treasury stock does not give the corporation the right to vote, to
exercise preemptive rights as a stockholder, to receive cash dividends, or to receive assets
upon corporate liquidation. Treasury stock is essentially the same as unissued capital
stock. No one advocates classifying unissued capital stock as an asset in the balance
sheet.7
What do the numbers mean? BUYBACKS—GOOD OR BAD?
As indicated in Illustration 15-3, companies have ramped up came as the prices of shares in the S&P 500 dropped 3.3 per-
repurchases of their own stock. Notable buyback companies cent, meaning that companies bought more shares during a
are ExxonMobil, which recently bought back $5 billion of its period when the market was falling. That is a far cry from
stock during that period, and ConocoPhillips, which repur- some previous surges in buybacks, such as the one in the
chased $3.1 billion of its shares. The surge in repurchases fourth quarter of 2007, when companies repurchased a record
7The possible justification for classifying these shares as assets is that the company will use
them to liquidate a specific liability that appears on the balance sheet. Accounting Trends and
Techniques—2012 reported that out of 500 companies surveyed, 341 disclosed treasury stock,
but none classified it as an asset.
Corporate Capital 831
dollar amount of shares even as the stock market was their shareholders over the long run. For example, drug-makers
peaking. Merck, Pfi zer, and Amgen spent heavily on stock repur-
Is this good or bad news for investors? Maybe neither. chases, possibly at the expense of research and development.
While it might appear that companies are getting better at And whether the buyback is a good thing appears to depend
timing their purchases (when prices are falling), they also a lot on why the company did the buyback and what the re-
buy shares for reasons that go beyond giving a boost to purchased shares were used for.
shareholders—everything from mergers and acquisitions to One study found that companies often increased their
eliminating the impact of equity compensation. And unlike buybacks when earnings growth slowed. This allowed the
dividend payments, buybacks haven’t been shown to make companies to prop up earnings per share (based on fewer |
investors better off in the long run. For example, from 2004, shares outstanding). Furthermore, many buybacks do not
when companies fi rst were required to disclose monthly actually result in a net reduction in shares outstanding.
share repurchases, through the end of 2011, 31 percent of S&P For example, companies such as Microsoft and Broadcom
500 companies have seen the value of those shares fall and bought back shares to meet share demands for stock option
just 36 percent have returned more than 7 percent. As one exercises, resulting in higher net shares outstanding when
analyst notes, “It’s important to look at what a company is they reissued the repurchased shares to the option holders
paying relative to what its shares are worth. If they overpay, upon exercise. In this case, the buyback actually indicated
wealth is being transferred to the sellers.” a further dilution in the share ownership in the buyback
The conventional wisdom is that companies which buy company.
back shares believe their shares are undervalued. Thus, ana- This does not mean you should never trust a buyback sig-
lysts view the buyback announcement as an important piece nal. But if the buyback is intended to manage the company’s
of inside information about future company prospects. On earnings or if the buyback results in dilution, take a closer
the other hand, buybacks can actually hurt businesses and look.
Sources: Adapted from W. Lazonick, “The Buyback Boondoggle,” BusinessWeek (August 24, 2009); and B. Levisohn, “Beware All Those
Buybacks,” Wall Street Journal (September 29–30, 2012), p. B9.
Purchase of Treasury Stock
Companies use two general methods of handling treasury stock in the accounts: the cost Gateway to
the Profession
method and the par value method. Both methods are generally acceptable. The cost
method enjoys more widespread use.8 Discussion of Using Par or
Stated Value for Treasury
• The cost method results in debiting the Treasury Stock account for the reacquisition Stock Transactions
cost and in reporting this account as a deduction from the total paid-in capital and
retained earnings on the balance sheet.
• The par (stated) value method records all transactions in treasury shares at their par
value and reports the treasury stock as a deduction from capital stock only.
No matter which method a company uses, most states consider the cost of the treasury
shares acquired as a restriction on retained earnings.
Companies generally use the cost method to account for treasury stock. This method
derives its name from the fact that a company maintains the Treasury Stock account at
the cost of the shares purchased.9 Under the cost method, the company debits the
Treasury Stock account for the cost of the shares acquired. Upon reissuance of the shares,
it credits the account for this same cost. The original price received for the stock does not
affect the entries to record the acquisition and reissuance of the treasury stock.
To illustrate, assume that Pacific Company issued 100,000 shares of $1 par value
common stock at a price of $10 per share. In addition, it has retained earnings of $300,000.
8Accounting Trends and Techniques—2012 indicates that of its selected list of 500 companies, of the
341 companies with treasury stock, all carried common stock in treasury at cost. Only one
company carried preferred stock in treasury.
9If making numerous acquisitions of blocks of treasury shares at different prices, a company
may use inventory costing methods—such as specific identification, average-cost, or FIFO—to
identify the cost at date of reissuance.
832 Chapter 15 Stockholders’ Equity
Illustration 15-4 shows the stockholders’ equity section on December 31, 2013, before
purchase of treasury stock.
ILLUSTRATION 15-4
Stockholders’ equity
Stockholders’ Equity
Paid-in capital
with No Treasury Stock
Common stock, $1 par value, 100,000 shares
issued and outstanding $ 100,000
Additional paid-in capital 900,000
Total paid-in capital 1,000,000
Retained earnings 300,000
Total stockholders’ equity $1,300,000
On January 20, 2014, Pacific acquires 10,000 shares of its stock at $11 per share. |
Pacific records the reacquisition as follows.
January 20, 2014
Treasury Stock 110,000
Cash 110,000
Note that Pacific debited Treasury Stock for the cost of the shares purchased. The
original paid-in capital account, Common Stock, is not affected because the number
of issued shares does not change. The same is true for the Paid-in Capital in Excess of
Par—Common Stock account. Pacific deducts treasury stock from total paid-in capital
and retained earnings in the stockholders’ equity section.
Illustration 15-5 shows the stockholders’ equity section for Pacific after purchase of
the treasury stock.
ILLUSTRATION 15-5
Stockholders’ equity
Stockholders’ Equity
Paid-in capital
with Treasury Stock
Common stock, $1 par value, 100,000 shares
issued and 90,000 outstanding $ 100,000
Additional paid-in capital 900,000
Total paid-in capital 1,000,000
Retained earnings 300,000
Total paid-in capital and retained earnings 1,300,000
Less: Cost of treasury stock (10,000 shares) 110,000
Total stockholders’ equity $1,190,000
Pacific subtracts the cost of the treasury stock from the total of common stock, addi-
tional paid-in capital, and retained earnings. It therefore reduces stockholders’ equity.
Many states require a corporation to restrict retained earnings for the cost of treasury
stock purchased. The restriction keeps intact the corporation’s legal capital that it
temporarily holds as treasury stock. When the corporation sells the treasury stock, it
lifts the restriction.
Pacific discloses both the number of shares issued (100,000) and the number in the
treasury (10,000). The difference is the number of shares of stock outstanding (90,000).
The term outstanding stock means the number of shares of issued stock that stock-
holders own.
Sale of Treasury Stock
Companies usually reissue or retire treasury stock. When selling treasury shares, the
accounting for the sale depends on the price. If the selling price of the treasury stock
equals its cost, the company records the sale of the shares by debiting Cash and crediting
Corporate Capital 833
Treasury Stock. In cases where the selling price of the treasury stock is not equal to cost,
then accounting for treasury stock sold above cost differs from the accounting for trea-
sury stock sold below cost. However, the sale of treasury stock either above or below
cost increases both total assets and stockholders’ equity.
Sale of Treasury Stock above Cost. When the selling price of shares of treasury stock
exceeds its cost, a company credits the difference to Paid-in Capital from Treasury Stock.
To illustrate, assume that Pacific acquired 10,000 shares of its treasury stock at $11 per
share. It now sells 1,000 shares at $15 per share on March 10. Pacific records the entry as
follows.
March 10, 2014
Cash 15,000
Treasury Stock 11,000
Paid-in Capital from Treasury Stock 4,000
There are two reasons why Pacific does not credit $4,000 to Gain on Sale of Treasury
Stock. (1) Gains on sales occur when selling assets; treasury stock is not an asset. (2) A
gain or loss should not be recognized from stock transactions with its own stockholders.
Thus, Pacific should not include paid-in capital arising from the sale of treasury stock in
the measurement of net income. Instead, it lists paid-in capital from treasury stock sepa-
rately on the balance sheet, as a part of paid-in capital.
Sale of Treasury Stock below Cost. When a corporation sells treasury stock below its
cost, it usually debits the excess of the cost over selling price to Paid-in Capital from
Treasury Stock. Thus, if Pacific sells an additional 1,000 shares of treasury stock on
March 21 at $8 per share, it records the sale as follows.
March 21, 2014
Cash 8,000
Paid-in Capital from Treasury Stock 3,000
Treasury Stock 11,000
We can make several observations based on the two sale entries (sale above cost and
sale below cost). (1) Pacific credits Treasury Stock at cost in each entry. (2) Pacific uses Paid-
in Capital from Treasury Stock for the difference between the cost and the resale price of the
shares. (3) Neither entry affects the original paid-in capital account, Common Stock. |
After eliminating the credit balance in Paid-in Capital from Treasury Stock, the
corporation debits any additional excess of cost over selling price to Retained Earnings.
To illustrate, assume that Pacific sells an additional 1,000 shares at $8 per share on
April 10. Illustration 15-6 shows the balance in the Paid-in Capital from Treasury Stock
account (before the April 10 purchase).
ILLUSTRATION 15-6
Paid-in Capital from Treasury Stock
Treasury Stock
Mar. 21 3,000 Mar. 10 4,000 Transactions in Paid-in
Balance 1,000 Capital Account
In this case, Pacific debits $1,000 of the excess to Paid-in Capital from Treasury
Stock. It debits the remainder to Retained Earnings. The entry is:
April 10, 2014
Cash 8,000
Paid-in Capital from Treasury Stock 1,000
Retained Earnings 2,000
Treasury Stock 11,000
834 Chapter 15 Stockholders’ Equity
Retiring Treasury Stock
The board of directors may approve the retirement of treasury shares. This decision
results in cancellation of the treasury stock and a reduction in the number of shares of
issued stock. Retired treasury shares have the status of authorized and unissued
shares. The accounting effects are similar to the sale of treasury stock except that
corporations debit the paid-in capital accounts applicable to the retired shares instead
of cash. For example, if a corporation originally sells the shares at par, it debits Com-
mon Stock for the par value per share. If it originally sells the shares at $3 above par
value, it also debits Paid-in Capital in Excess of Par—Common Stock for $3 per share
at retirement.
PREFERRED STOCK
As noted earlier, preferred stock is a special class of shares that possesses certain
LEARNING OBJECTIVE 5
preferences or features not possessed by the common stock.10 The following
Explain the accounting for and
features are those most often associated with preferred stock issues.
reporting of preferred stock.
1. Preference as to dividends.
2. Preference as to assets in the event of liquidation.
3. Convertible into common stock.
4. Callable at the option of the corporation.
5. Nonvoting.
The features that distinguish preferred from common stock may be of a more
restrictive and negative nature than preferences. For example, the preferred stock may
be nonvoting, noncumulative, and nonparticipating.
Companies usually issue preferred stock with a par value, expressing the dividend
preference as a percentage of the par value. Thus, holders of 8 percent preferred stock
with a $100 par value are entitled to an annual dividend of $8 per share. This stock is
commonly referred to as 8 percent preferred stock. In the case of no-par preferred
stock, a corporation expresses a dividend preference as a specific dollar amount per
share, for example, $7 per share. This stock is commonly referred to as $7 preferred
stock.
A preference as to dividends does not assure the payment of dividends. It merely
assures that the corporation must pay the stated dividend rate or amount applicable
to the preferred stock before paying any dividends on the common stock.
A company often issues preferred stock (instead of debt) because of a high debt-to-
equity ratio. In other instances, it issues preferred stock through private placements
with other corporations at a lower-than-market dividend rate because the acquiring
corporation receives largely tax-free dividends (owing to the IRS’s 70 percent or 80
percent dividends received deduction).
Features of Preferred Stock
A corporation may attach whatever preferences or restrictions, in whatever combination
it desires, to a preferred stock issue, as long as it does not specifically violate its state
incorporation law. Also, it may issue more than one class of preferred stock. We discuss
the most common features attributed to preferred stock on the next page.
10Accounting Trends and Techniques—2012 reports that of its 500 surveyed companies, 35 had
preferred stock outstanding.
Preferred Stock 835
Cumulative Preferred Stock
Cumulative preferred stock requires that if a corporation fails to pay a dividend in any
year, it must make it up in a later year before paying any dividends to common stock- |
holders. If the directors fail to declare a dividend at the normal date for dividend action,
the dividend is said to have been “passed.” Any passed dividend on cumulative pre-
ferred stock constitutes a dividend in arrears. Because no liability exists until the board
of directors declares a dividend, a corporation does not record a dividend in arrears as
a liability but discloses it in a note to the financial statements. A corporation seldom
issues noncumulative preferred stock because a passed dividend is lost forever to the
preferred stockholder. As a result, this stock issue would be less marketable.
Participating Preferred Stock
Holders of participating preferred stock share ratably with the common stockholders
in any profit distributions beyond the prescribed rate. That is, 5 percent preferred stock,
if fully participating, will receive not only its 5 percent return, but also dividends at the
same rates as those paid to common stockholders if paying amounts in excess of 5 per-
cent of par or stated value to common stockholders. Note that participating preferred
stock may be only partially participating. Although seldom used, examples of compa-
nies that have issued participating preferred stock are LTV Corporation, Southern
California Edison, and Allied Products Corporation.
Convertible Preferred Stock
Convertible preferred stock allows stockholders, at their option, to exchange preferred
shares for common stock at a predetermined ratio. The convertible preferred stock-
holder not only enjoys a preferred claim on dividends but also has the option of convert-
ing into a common stockholder with unlimited participation in earnings.
Callable Preferred Stock
Callable preferred stock permits the corporation at its option to call or redeem the
outstanding preferred shares at specified future dates and at stipulated prices.
Many preferred issues are callable. The corporation usually sets the call or redemp-
tion price slightly above the original issuance price and commonly states it in terms
related to the par value. The callable feature permits the corporation to use the capital
obtained through the issuance of such stock until the need has passed or it is no longer
advantageous.
The existence of a call price or prices tends to set a ceiling on the market price of the
preferred shares unless they are convertible into common stock. When a corporation
redeems preferred stock, it must pay any dividends in arrears.
Redeemable Preferred Stock
Recently, more and more issuances of preferred stock have features that make the secu-
rity more like debt (legal obligation to pay) than an equity instrument. For example,
redeemable preferred stock has a mandatory redemption period or a redemption fea-
ture that the issuer cannot control.
Previously, public companies were not permitted to report these debt-like preferred
stock issues in equity, but they were not required to report them as a liability either.
There were concerns about classification of these debt-like securities, which may have
been reported as equity or in the “mezzanine” section of balance sheets between debt
and equity. There also was diversity in practice as to how dividends on these securities
were reported. The FASB now requires debt-like securities, such as redeemable
See the FASB
preferred stock, to be classified as liabilities and be measured and accounted for similar Codification section
to liabilities. [1] (page 856).
836 Chapter 15 Stockholders’ Equity
What do the numbers mean? A CLASS (B) ACT
Some companies grant preferences to different shareholders powers. The same is true for the Ford family’s control of Ford
by issuing different classes of common stock. Recent stock bids Motor Co. Class B shares are often criticized for protecting
put the spotlight on dual-class stock structures. For example, owners’ interest at the expense of shareholder return. These
ownership of Dow Jones & Co. was controlled by family shares often can determine if a takeover deal gets done, or not.
members who owned Class B shares, which carry super voting Here are some notable companies with two-tiered shares. |
Votes Controlled by Votes Controlled by
Company Class B Shareholders Company Class B Shareholders
Ford 40% Estée Lauder 88%
New York Times 70% Polo Ralph Lauren 88%
Meredith 71% Martha Stewart Living 91%
Cablevision Systems 73% 1-800-Flowers 93%
Google 78%
Data: Bloomberg Financial Markets, BusinessWeek, company documents.
For most retail investors, voting rights are not that important. voting control. This was one of the main reasons Facebook
Indeed, in 2011, 20 companies (including Zynga, Groupon, gave when it created a dual-class share structure in 2009. In
and LinkedIn) went public in the United States with two or that IPO, Facebook founder Mark Zuckerberg owns only a
more classes of stock. For family-controlled companies, issu- quarter of the stock but still holds 57 percent of Facebook’s
ing newer classes of lower or nonvoting stock effectively voting rights. Thus, investors must carefully compare the
creates currency for acquisitions, increases liquidity, or puts apparent bargain prices for some classes of stock—they may
a public value on the company without diluting the family’s end up as second-class citizens with no voting rights.
Sources: Adapted from Andy Serwer, “Dual-Listed Companies Aren’t Fair or Balanced,” Fortune (September 20, 2004), p. 83; Alex Halperin, “A
Class (B) Act,” BusinessWeek (May 28, 2007), p. 12; The Big Number, “20 Companies That Went Public in 2011 with Two or More Classes of Stock,”
Wall Street Journal (February 8, 2012), p. B5; and MoneyWatch, “Facebook’s IPO by the Important Numbers,” www.cbsnews.com (May 17, 2012).
Accounting for and Reporting Preferred Stock
The accounting for preferred stock at issuance is similar to that for common stock. A
corporation allocates proceeds between the par value of the preferred stock and addi-
tional paid-in capital. To illustrate, assume that Bishop Co. issues 10,000 shares of $10
par value preferred stock for $12 cash per share. Bishop records the issuance as follows.
Cash 120,000
Preferred Stock 100,000
Paid-in Capital in Excess of Par—Preferred Stock 20,000
Thus, Bishop maintains separate accounts for these different classes of shares.
In contrast to convertible bonds (recorded as a liability on the date of issue), corpo-
rations consider convertible preferred stock as a part of stockholders’ equity. In addi-
tion, when exercising convertible preferred stock, there is no theoretical justification for
recognition of a gain or loss. A company recognizes no gain or loss when dealing with
stockholders in their capacity as business owners. Instead, the company employs the
book value method: debit Preferred Stock, along with any related Paid-in Capital in
Excess of Par—Preferred Stock, and credit Common Stock and Paid-in Capital in Excess
of Par—Common Stock (if an excess exists).
Preferred stock generally has no maturity date. Therefore, no legal obligation exists
to pay the preferred stockholder. As a result, companies classify preferred stock as part
of stockholders’ equity. Companies generally report preferred stock at par value as the
first item in the stockholders’ equity section. They report any excess over par value as
part of additional paid-in capital. They also consider dividends on preferred stock as a
distribution of income and not an expense. Companies must disclose the pertinent
rights of the preferred stock outstanding. [2]
Dividend Policy 837
DIVIDEND POLICY
Dividend payouts can be important signals to the market. The practice of paying
6 LEARNING OBJECTIVE
dividends declined sharply in the 1980s and 1990s as companies focused on growth
Describe the policies used in
and plowed profits back into the business. A resurgence in dividend payouts is
distributing dividends.
due in large part to the dividend tax cut of 2003, which reduced the rate of tax on
dividends to 15 percent (quite a bit lower than the ordinary income rate charged in the
past). In addition, investors who were burned by accounting scandals in recent years
began demanding higher payouts in the form of dividends. Why? A dividend check |
provides proof that at least some portion of a company’s profits is genuine.11 As one
analyst noted, “Companies with the ability to grow dividends over time tend to be
durable businesses with strong cash flow and relatively predictable earnings. . . .
So you’re more likely to get a return on your investment year in and year out.”
Determining the proper amount of dividends to pay is a difficult financial manage-
ment decision. Companies paying dividends are extremely reluctant to reduce or elimi-
nate their dividend. They fear that the securities market might negatively view this a ction.
As a consequence, dividend-paying companies will make every effort to continue to do
so. In addition, the type of shareholder the company has (taxable or nontaxable, retail
investor or institutional investor) plays a large role in determining dividend policy.
Very few companies pay dividends in amounts equal to their legally available
retained earnings. The major reasons are as follows.
1. To maintain agreements (bond covenants) with specifi c creditors, to retain all or a
portion of the earnings, in the form of assets, to build up additional protection
against possible loss.
2. To meet state corporation requirements, that earnings equivalent to the cost of trea-
sury shares purchased be restricted against dividend declarations.
3. To retain assets that would otherwise be paid out as dividends, to fi nance growth
or expansion. This is sometimes called internal fi nancing, reinvesting earnings, or
“plowing” the profi ts back into the business.
4. To smooth out dividend payments from year to year by accumulating earnings in
good years and using such accumulated earnings as a basis for dividends in bad years.
5. To build up a cushion or buffer against possible losses or errors in the calculation of profi ts.
The reasons above are self-explanatory except for the second. The laws of some
states require that the corporation restrict its legal capital from distribution to stock-
holders, to protect against loss for creditors.12 The applicable state law determines the
legality of a dividend.
Financial Condition and Dividend Distributions
Effective management of a company requires attention to more than the legality of div-
idend distributions. Management must also consider economic conditions, most impor-
tantly, liquidity. Assume an extreme situation as shown in Illustration 15-7 (page 838).
11“Dividend Stocks: Yield, Growth, and Possible Tax Hikes,” T. Rowe Price Report (Fall 2011). From
1926 to 2011, dividends have contributed 42% of the total return of the S&P 500 Index. See
“Dividend Growth Stocks May Be Timely as the Economy Sputters,” T. Rowe Price Report (Fall 2011).
12If the corporation buys its own outstanding stock, it reduces its legal capital and distributes
assets to stockholders. If permitted, the corporation could, by purchasing treasury stock at any
price desired, return to the stockholders their investments and leave creditors with little or no
protection against loss.
838 Chapter 15 Stockholders’ Equity
ILLUSTRATION 15-7
BALANCE SHEET
Balance Sheet, Showing a
Lack of Liquidity Plant assets $500,000 Capital stock $400,000
$500,000 Retained earnings 100,000
$500,000
The depicted company has a retained earnings credit balance. Unless restricted, it
can declare a dividend of $100,000. But because all its assets are plant assets used in
operations, payment of a cash dividend of $100,000 would require the sale of plant assets
or borrowing.
Even if a balance sheet shows current assets, as in Illustration 15-8, the question
remains as to whether the company needs its cash for other purposes.
ILLUSTRATION 15-8
BALANCE SHEET
Balance Sheet, Showing
Cash but Minimal Cash $100,000 Current liabilities $ 60,000
Working Capital Plant assets 460,000 Capital stock $400,000
$560,000 Retained earnings 100,000 500,000
$560,000
The existence of current liabilities strongly implies that the company needs some of
the cash to meet current debts as they mature. In addition, day-to-day cash requirements
for payrolls and other expenditures not included in current liabilities also require cash. |
Thus, before declaring a dividend, management must consider availability of
funds to pay the dividend. A company should not pay a dividend unless both the present
and future financial position warrant the distribution.
The SEC encourages companies to disclose their dividend policy in their annual
report, especially those that (1) have earnings but fail to pay dividends, or (2) do not
expect to pay dividends in the foreseeable future. In addition, the SEC encourages com-
panies that consistently pay dividends to indicate whether they intend to continue this
practice in the future.
Types of Dividends
Companies generally base dividend distributions either on accumulated profits
LEARNING OBJECTIVE 7
(that is, retained earnings) or on some other capital item such as additional paid-in
Identify the various forms of dividend
capital. Dividends are of the following types.
distributions.
1. Cash dividends.
2. Property dividends.
3. Liquidating dividends.
Although commonly paid in cash, companies occasionally pay dividends in stock
or some other asset.13 All dividends, except for stock dividends, reduce the total stock-
holders’ equity in the corporation. When declaring a stock dividend, the corporation
does not pay out assets or incur a liability. It issues additional shares of stock to each
stockholder and nothing more.
13Accounting Trends and Techniques—2012 reported that of its 500 surveyed companies, 343 paid a
cash dividend on common stock, 33 paid a cash dividend on preferred stock, 2 issued stock
dividends, and 1 issued or paid dividends in kind. Some companies declare more than one type
of dividend in a given year.
Dividend Policy 839
The natural expectation of any stockholder who receives a dividend is that the
corporation has operated successfully. As a result, he or she is receiving a share of its
profits. A company should disclose a liquidating dividend—that is, a dividend not based
on retained earnings—to the stockholders so that they will not misunderstand its source.
Cash Dividends
The board of directors votes on the declaration of cash dividends. Upon approval of the
resolution, the board declares a dividend. Before paying it, however, the company must
prepare a current list of stockholders. For this reason, there is usually a time lag between
declaration and payment. For example, the board of directors might approve a resolu-
tion at the January 10 (date of declaration) meeting and declare it payable February 5
(date of payment) to all stockholders of record January 25 (date of record).14 In this
example, the period from January 10 to January 25 gives time for the company to complete
and register any transfers in process. The time from January 25 to February 5 provides
an opportunity for the transfer agent or accounting department, depending on who
does this work, to prepare a list of stockholders as of January 25 and to prepare and mail
dividend checks.
A declared cash dividend is a liability. Because payment is generally required
very soon, it is usually a current liability. Companies record the following entries to
record the declaration and payment of a cash dividend. To illustrate, Roadway Freight
Corp. on June 10 declared a cash dividend of 50 cents a share on 1.8 million shares
payable July 16 to all stockholders of record June 24.
At date of declaration (June 10)
Retained Earnings (Cash Dividends Declared) 900,000
Dividends Payable 900,000
At date of record (June 24)
No entry
At date of payment (July 16)
Dividends Payable 900,000
Cash 900,000
To set up a ledger account that shows the amount of dividends declared during
the year, Roadway Freight might debit Cash Dividends Declared instead of Retained
Earnings at the time of declaration. It then closes this account to Retained Earnings at
year-end.
A company may declare dividends either as a certain percent of par, such as a 6 percent
dividend on preferred stock, or as an amount per share, such as 60 cents per share on
no-par common stock. In the first case, the rate multiplied by the par value of outstanding
shares equals the total dividend. In the second, the dividend equals the amount per |
share multiplied by the number of shares outstanding. Companies do not declare or
pay cash dividends on treasury stock.
Dividend policies vary among corporations. Some companies, such as JP Morgan
Chase, Clorox Co., and Tootsie Roll Industries, take pride in a long, unbroken string of
quarterly dividend payments. They would lower or pass the dividend only if forced to
do so by a sustained decline in earnings or a critical shortage of cash.
14Theoretically, the ex-dividend date is the day after the date of record. However, to allow time
for transfer of the shares, the stock exchanges generally advance the ex-dividend date two to
four days. Therefore, the party who owns the stock on the day prior to the expressed ex-dividend
date receives the dividends. The party who buys the stock on and after the ex-dividend date
does not receive the dividend. Between the declaration date and the ex-dividend date, the
market price of the stock includes the dividend.
840 Chapter 15 Stockholders’ Equity
“Growth” companies, on the other hand, pay little or no cash dividends because
their policy is to expand as rapidly as internal and external financing permit. For
example, Questcor Pharmaceuticals Inc. has never paid cash dividends to its common
stockholders. These investors hope that the price of their shares will appreciate in value.
The investors will then realize a profit when they sell their shares. Many companies
focus more on increasing share price, stock repurchase programs, and corporate earnings
than on dividend payout.
Property Dividends
Dividends payable in assets of the corporation other than cash are called property divi-
dends or dividends in kind. Property dividends may be merchandise, real estate, or
investments, or whatever form the board of directors designates. Ranchers Exploration
and Development Corp. reported one year that it would pay a fourth-quarter dividend
in gold bars instead of cash. Because of the obvious difficulties of divisibility of units
and delivery to stockholders, the usual property dividend is in the form of securities of
other companies that the distributing corporation holds as an investment.
For example, after ruling that DuPont’s 23 percent stock interest in General Motors
(GM) violated antitrust laws, the Supreme Court ordered DuPont to divest itself of the
GM stock within 10 years. The stock represented 63 million shares of GM’s 281 million
shares then outstanding. DuPont could not sell the shares in one block of 63 million.
Further, it could not sell 6 million shares annually for the next 10 years without
severely depressing the value of the GM stock. DuPont solved its problem by declar-
ing a property dividend and distributing the GM shares as a dividend to its own
stockholders.
When declaring a property dividend, the corporation should restate at fair value
the property it will distribute, recognizing any gain or loss as the difference between
the property’s fair value and carrying value at date of declaration. The corporation may
then record the declared dividend as a debit to Retained Earnings (or Property Divi-
dends Declared) and a credit to Property Dividends Payable, at an amount equal to the
fair value of the distributed property. Upon distribution of the dividend, the corpora-
tion debits Property Dividends Payable and credits the account containing the distrib-
uted asset (restated at fair value).
For example, Trendler, Inc. transferred to stockholders some of its equity investments
costing $1,250,000 by declaring a property dividend on December 28, 2013, to be distrib-
uted on January 30, 2014, to stockholders of record on January 15, 2014. At the date of
declaration, the securities have a fair value of $2,000,000. Trendler makes the following
entries.
At date of declaration (December 28, 2013)
Equity Investments 750,000
Unrealized Holding Gain or Loss—Income 750,000
Retained Earnings (Property Dividends Declared) 2,000,000
Property Dividends Payable 2,000,000
At date of distribution (January 30, 2014)
Property Dividends Payable 2,000,000
Equity Investments 2,000,000 |
Liquidating Dividends
Some corporations use paid-in capital as a basis for dividends. Without proper disclosure
of this fact, stockholders may erroneously believe the corporation has been operating at
a profit. To avoid this type of deception, intentional or unintentional, a clear statement
of the source of every dividend should accompany the dividend check.
Dividend Policy 841
Dividends based on other than retained earnings are sometimes described as liqui-
dating dividends. This term implies that such dividends are a return of the stockholder’s
investment rather than of profits. In other words, any dividend not based on earnings
reduces corporate paid-in capital and to that extent, it is a liquidating dividend. Com-
panies in the extractive industries may pay dividends equal to the total of accumulated
income and depletion. The portion of these dividends in excess of accumulated income
represents a return of part of the stockholder’s investment.
For example, McChesney Mines Inc. issued a “dividend” to its common stockholders
of $1,200,000. The cash dividend announcement noted that stockholders should consider
$900,000 as income and the remainder a return of capital. McChesney Mines records the
dividend as follows.
At date of declaration
Retained Earnings 900,000
Paid-in Capital in Excess of Par—Common Stock 300,000
Dividends Payable 1,200,000
At date of payment
Dividends Payable 1,200,000
Cash 1,200,000
In some cases, management simply decides to cease business and declares a liqui-
dating dividend. In these cases, liquidation may take place over a number of years to
ensure an orderly and fair sale of assets. For example, when Overseas National Airways
dissolved, it agreed to pay a liquidating dividend to its stockholders over a period of
years equivalent to $8.60 per share. Each liquidating dividend payment in such cases
reduces paid-in capital.
Stock Dividends and Stock Splits
Stock Dividends
If management wishes to “capitalize” part of the earnings (i.e., reclassify amounts
8 LEARNING OBJECTIVE
from earned to contributed capital) and thus retain earnings in the business on a
Explain the accounting for small and
permanent basis, it may issue a stock dividend. In this case, the company distrib-
large stock dividends, and for stock
utes no assets. Each stockholder maintains exactly the same proportionate interest splits.
in the corporation and the same total book value after the company issues the
stock dividend. Of course, the book value per share is lower because each stock-
holder holds more shares.
A stock dividend therefore is the issuance by a corporation of its own stock to
its stockholders on a pro rata basis, without receiving any consideration. In record-
ing a stock dividend, some believe that the company should transfer the par value
of the stock issued as a dividend from retained earnings to capital stock. Others
believe that it should transfer the fair value of the stock issued—its market value at
the declaration date—from retained earnings to capital stock and additional paid-in
capital.
The fair value position was adopted, at least in part, in order to influence the
stock dividend policies of corporations. Evidently in 1941, both the New York Stock
Exchange and many in the accounting profession regarded periodic stock dividends as
objectionable. They believed that the term dividend when used with a distribution of
additional stock was misleading because investors’ net assets did not increase as a
result of this “dividend.” As a result, these groups decided to make it more difficult
for corporations to sustain a series of such stock dividends out of their accumulated
842 Chapter 15 Stockholders’ Equity
earnings, by requiring the use of fair value when it substantially exceeded
Underlying Concepts book value.15
By requiring fair value, the intent When the stock dividend is less than 20–25 percent of the common shares
was to punish companies that outstanding at the time of the dividend declaration, the company is therefore
used stock dividends. This required to transfer the fair value of the stock issued from retained earnings. |
approach violates the neutrality Stock dividends of less than 20–25 percent are often referred to as small (ordi-
concept (that is, that standards- nary) stock dividends. This method of handling stock dividends is justified on
setting should be even-handed). the grounds that “many recipients of stock dividends look upon them as distri-
butions of corporate earnings and usually in an amount equivalent to the fair
value of the additional shares received.” [3] We consider this argument unconvincing. It
is generally agreed that stock dividends are not income to the recipients. Therefore,
sound accounting should not recommend procedures simply because some recipients
think they are income.16
To illustrate a small stock dividend, assume that Vine Corporation has outstanding
1,000 shares of $100 par value common stock and retained earnings of $50,000. If Vine
declares a 10 percent stock dividend, it issues 100 additional shares to current stockholders.
If the fair value of the stock at the time of the stock dividend is $130 per share, the entry is:
At date of declaration
Retained Earnings 13,000
Common Stock Dividend Distributable 10,000
Paid-in Capital in Excess of Par—Common Stock 3,000
Note that the stock dividend does not affect any asset or liability. The entry merely
reflects a reclassification of stockholders’ equity. If Vine prepares a balance sheet
between the dates of declaration and distribution, it should show the common stock
dividend distributable in the stockholders’ equity section as an addition to common
stock (whereas it shows cash or property dividends payable as current liabilities).
When issuing the stock, the entry is:
At date of distribution
Common Stock Dividend Distributable 10,000
Common Stock 10,000
No matter what the fair value is at the time of the stock dividend, each stockholder
retains the same proportionate interest in the corporation.
Some state statutes specifically prohibit the issuance of stock dividends on treasury
stock. In those states that permit treasury shares to participate in the distribution accom-
panying a stock dividend or stock split, the planned use of the treasury shares influences
corporate practice. For example, if a corporation issues treasury shares in connection
with employee stock options, the treasury shares may participate in the distribution
because the corporation usually adjusts the number of shares under option for any stock
dividends or splits. But no useful purpose is served by issuing additional shares to the
treasury stock without a specific purpose, since they are essentially equivalent to authorized
but unissued shares.
15This was perhaps the earliest instance of “economic consequences” affecting an accounting
pronouncement. The Committee on Accounting Procedure described its action as required by
“proper accounting and corporate policy.” See Stephen A. Zeff, “The Rise of ‘Economic Conse-
quences,’” The Journal of Accountancy (December 1978), pp. 53–66.
16One study concluded that small stock dividends do not always produce significant amounts of
extra value on the date after issuance (ex date) and that large stock dividends almost always fail
to generate extra value on the ex-dividend date. Taylor W. Foster III and Don Vickrey, “The
Information Content of Stock Dividend Announcements,” The Accounting Review, Vol. LIII, No. 2
(April 1978), pp. 360–370.
Dividend Policy 843
To continue with our example of the effect of the small stock dividend, note in
Illustration 15-9 that the stock dividend does not change the total stockholders’ equity.
Also, it does not change the proportion of the total shares outstanding held by each
stockholder.
ILLUSTRATION 15-9
Before dividend
Effects of a Small (10%)
Common stock, 1,000 shares at $100 par $100,000
Stock Dividend
Retained earnings 50,000
Total stockholders’ equity $150,000
Stockholders’ interests:
A. 400 shares, 40% interest, book value $ 60,000
B. 500 shares, 50% interest, book value 75,000
C. 100 shares, 10% interest, book value 15,000
$150,000
After declaration but before distribution of 10% stock dividend |
If fair value ($130) is used as basis for entry:
Common stock, 1,000 shares at $100 par $100,000
Common stock distributable, 100 shares at $100 par 10,000
Paid-in capital in excess of par—common stock 3,000
Retained earnings ($50,000 2 $13,000) 37,000
Total stockholders’ equity $150,000
After declaration and distribution of 10% stock dividend
If fair value ($130) is used as basis for entry:
Common stock, 1,100 shares at $100 par $110,000
Paid-in capital in excess of par—common stock 3,000
Retained earnings ($50,000 2 $13,000) 37,000
Total stockholders’ equity $150,000
Stockholders’ interest:
A. 440 shares, 40% interest, book value $ 60,000
B. 550 shares, 50% interest, book value 75,000
C. 110 shares, 10% interest, book value 15,000
$150,000
Stock Splits
If a company has undistributed earnings over several years and accumulates a sizable
balance in retained earnings, the market value of its outstanding shares likely increases.
Stock issued at prices less than $50 a share can easily attain a market price in excess of
$200 a share. The higher the market price of a stock, however, the less readily some in-
vestors can purchase it.
The managements of many corporations believe that better public relations depend
on wider ownership of the corporation stock. They therefore target a market price
sufficiently low to be within range of the majority of potential investors. To reduce the
market price of shares, they use the common device of a stock split. For example, after
its stock price increased by 25-fold, Qualcomm Inc. split its stock 4-for-1. Qualcomm’s
stock had risen above $500 per share, raising concerns that Qualcomm could not meet
an analyst target of $1,000 per share. The split reduced the analysts’ target to $250, which
it could better meet with wider distribution of shares at lower trading prices.17
From an accounting standpoint, Qualcomm records no entry for a stock split.
However, it enters a memorandum note to indicate the changed par value of the shares
17Another classic case is Coca-Cola. Coca-Cola recently split its stock for the 11th time. If it had
not done all of these splits, one of Coke’s original shares would be worth $10.3 million. See
S. Jakab, “Coca-Cola’s Currency Is Its Resilience,” Wall Street Journal (July 16, 2012).
844 Chapter 15 Stockholders’ Equity
and the increased number of shares. Illustration 15-10 shows the lack of change in stock-
holders’ equity for a 2-for-1 stock split on 1,000 shares of $100 par value stock with the
par being halved upon issuance of the additional shares.
ILLUSTRATION 15-10
Stockholders’ Equity before 2-for-1 Split Stockholders’ Equity after 2-for-1 Split
Effects of a Stock Split
Common stock, 1,000 shares Common stock, 2,000 shares
at $100 par $100,000 at $50 par $100,000
Retained earnings 50,000 Retained earnings 50,000
$150,000 $150,000
What do the numbers mean? SPLITSVILLE
Stock splits were all the rage in the booming stock market traded, not the dollar amount. Others are concerned that
of the 1990s. Of major companies on the New York Stock low-priced shares are easier for would-be scamsters to
Exchange, fewer than 80 companies split shares in 1990. By manipulate. And if a company’s per share price falls below
1998, with stock prices soaring, over 200 companies split $1 for 30 consecutive days, it is a violation of stock exchange
shares. Although the split does not increase a stockholder’s listing requirements.
proportionate ownership of the company, studies show that Some companies are considering reverse stock splits in
split shares usually outperform those that don’t split, as well which, say, 5 shares are consolidated into one. Thus, a stock
as the market as a whole, for several years after the split. In previously trading at $5 per share would be part of an un-
addition, the splits help the company keep the shares in more split share trading at $25. Unsplitting might thus avoid some
attractive price ranges. of the negative consequences of a low trading price. The
What about when the market “turns south”? A number downside to this strategy is that analysts might view reverse |
of companies who split their shares in the boom markets splits as additional bad news about the direction of the stock
of the 1990s have since seen their share prices decline to a price. For example, Webvan, a failed Internet grocer, did a
point considered too low. For example, Lucent traded at 1-for-25 reverse split just before it entered bankruptcy. And
less than $5 a share following a 4-for-1 split. For some in- struggling Tenet Healthcare executed a 1-for-4 reverse split
vestors, these low-priced stocks are unattractive because in combination with a debt restructuring, in order to get its
some brokerage commissions rely on the number of shares stock price into a more favorable trading range.
Sources: Adapted from David Henry, “Stocks: The Case for Unsplitting,” BusinessWeek Online (April 1, 2002); and M. Murphy, “Tenet CFO
Says Reverse Split Could Help Land New Business,” Wall Street Journal (October 2, 2012).
Stock Split and Stock Dividend Differentiated
From a legal standpoint, a stock split differs from a stock dividend. How? A stock split
increases the number of shares outstanding and decreases the par or stated value per
share. A stock dividend, although it increases the number of shares outstanding, does
not decrease the par value; thus, it increases the total par value of outstanding shares.
The reasons for issuing a stock dividend are numerous and varied. Stock dividends
can be primarily a publicity gesture because many consider stock dividends as divi-
dends. Another reason is that the corporation may simply wish to retain profits in the
business by capitalizing a part of retained earnings. In such a situation, it makes a transfer
on declaration of a stock dividend from earned capital to contributed capital.
A corporation may also use a stock dividend, like a stock split, to increase the
marketability of the stock, although marketability is often a secondary consideration. If
the stock dividend is large, it has the same effect on market price as a stock split. When-
ever corporations issue additional shares for the purpose of reducing the unit market
price, then the distribution more closely resembles a stock split than a stock divi-
dend. This effect usually results only if the number of shares issued is more than
20–25 percent of the number of shares previously outstanding. [4] A stock dividend of
more than 20–25 percent of the number of shares previously outstanding is called a
Dividend Policy 845
large stock dividend.18 Such a distribution should not be called a stock dividend but
instead “a split-up effected in the form of a dividend” or “stock split.”
Also, since a split-up effected in the form of a dividend does not alter the par value
per share, companies generally are required to transfer the par value amount from
retained earnings. In other words, companies transfer from retained earnings to capital
stock the par value of the stock issued, as opposed to a transfer of the market price of
the shares issued as in the case of a small stock dividend.19 For example, Brown Group,
Inc. at one time authorized a 2-for-1 split, effected in the form of a stock dividend. As a
result of this authorization, it distributed approximately 10.5 million shares, and trans-
ferred more than $39 million representing the par value of the shares issued from
Retained Earnings to the Common Stock account.
To illustrate a large stock dividend (stock split-up effected in the form of a dividend),
Rockland Steel, Inc. declared a 30 percent stock dividend on November 20, payable Decem-
ber 29 to stockholders of record December 12. At the date of declaration, 1,000,000 shares,
par value $10, are outstanding and with a fair value of $200 per share. The entries are:
At date of declaration (November 20)
Retained Earnings 3,000,000
Common Stock Dividend Distributable 3,000,000
Computation: 1,000,000 shares 300,000 Additional shares
3 30% 3 $10 Par value
300,000 $3,000,000
At date of distribution (December 29)
Common Stock Dividend Distributable 3,000,000
Common Stock 3,000,000
Illustration 15-11 summarizes and compares the effects in the balance sheet and |
related items of various types of dividends and stock splits.
ILLUSTRATION 15-11
Declaration and
Effects of Dividends and
Distribution of
Declaration Payment Stock Splits on Financial
of of Small Large Statement Elements
Cash Cash Stock Stock Stock
Effect on: Dividend Dividend Dividend Dividend Split
Retained earnings Decrease –0– Decreasea Decreaseb –0–
Capital stock –0– –0– Increaseb Increaseb –0–
Additional paid-in
capital –0– –0– Increasec –0– –0–
Total stockholders’
equity Decrease –0– –0– –0– –0–
Working capital Decrease –0– –0– –0– –0–
Total assets –0– Decrease –0– –0– –0–
Number of shares
outstanding –0– –0– Increase Increase Increase
aMarket price of shares. bPar or stated value of shares. cExcess of market price over par.
18The SEC has added more precision to the 20–25 percent rule. Specifically, the SEC indicates
that companies should consider distributions of 25 percent or more as a “split-up effected in the
form of a dividend.” Companies should account for distributions of less than 25 percent as a
stock dividend. The SEC more precisely defined GAAP here. As a result, public companies
follow the SEC rule.
19Often, a company records a split-up effected in the form of a dividend as a debit to Paid-in
Capital instead of Retained Earnings to indicate that this transaction should affect only paid-in
capital accounts. No reduction of retained earnings is required except as indicated by legal
requirements. For homework purposes, assume that the debit is to Retained Earnings. See, for example,
Taylor W. Foster III and Edmund Scribner, “Accounting for Stock Dividends and Stock Splits:
Corrections to Textbook Coverage,” Issues in Accounting Education (February 1998).
846 Chapter 15 Stockholders’ Equity
What do the numbers mean? DIVIDENDS UP, DIVIDENDS DOWN
As the economy recovered from the fi nancial crisis, a number favorable, an investment strategy focusing on stocks with
of U.S. companies increased their dividend payout in a sign the potential of increasing dividends may be particularly
of growing confi dence and rising cash balances. For example, timely. Said one market watcher, “Investors too often over-
early in 2011 a number of companies increased dividends, look the importance of dividends, particularly the contribu-
including CVS/Caremark Corp., Family Dollar Stores Inc., tion to total return from reinvested dividends. . . . Dividends
and Schlumberger Ltd. The number was up from the prior also can provide a good hedge against infl ation in the form of
year amid concerns that dividend payouts would level off a growing stream of income.”
if the economy slows. A look at the returns for “dividend growers” compared to
In such a slow growth environment, with interest rates “dividend cutters” in the following chart supports the advice
persistently low and the tax treatment of dividends still to keep an eye on dividend growth.
16%
12
12.1%
11.6%
11.1% 10.7%
9.8%
8
4
0
Dividend Dividend Russell 1000 Non-dividend Dividend
Growers Payers Index Payers Cutters
As indicated, from 1979 through the end of 2011, stocks in the the very highest—and a high dividend growth rate. This is
Russell 1000 Index that were growing their dividends out- because high yields sometimes are a function of beaten-
performed dividend-paying stocks, the index itself, non- down stock prices due to poor corporate earnings prospects
dividend-paying stocks, and stocks that cut their dividends. or other issues. Indeed, in such cases, dividend cuts could be
During that time, an investment of $100 in dividend growers in the offi ng. By contrast, stocks that have performed best
would have risen to $4,018 compared with $3,134 based on historically have been those in which the company’s true
the index return. Dividend payers outperformed non-dividend growth potential has been undervalued by investors. Thus,
payers during down and fl at markets, and offered lower companies with growing dividends are signaling confi dence
volatility of returns in all market environments. about their future earnings and most likely to perform well |
Furthermore, the best performers are stocks with the throughout market cycles, which make them good candidates
combination of a relatively high yield—though not always for long-term growth.
Disclosure of Restrictions on Retained Earnings
Many corporations restrict retained earnings or dividends, without any formal journal
entries. Such restrictions are best disclosed by note. Parenthetical notations are sometimes
used, but restrictions imposed by bond indentures and loan agreements commonly
require an extended explanation. Notes provide a medium for more complete explana-
tions and free the financial statements from abbreviated notations. The note disclosure
should reveal the source of the restriction, pertinent provisions, and the amount of
retained earnings subject to restriction, or the amount not restricted.
Restrictions may be based on the retention of a certain retained earnings balance,
the ability to maintain certain working capital requirements, additional borrowing, and
snruteR
dezilaunnA
Russell 1000 Index Returns by Dividend Policy, From 12/31/1978 Through 9/30/2011
Source: T. Rowe Price analysis based on Compustat data.
Source: “Dividend Growth Stocks May Be Timely as the Economy Sputters,” T. Rowe Price Report (Fall 2011).
Presentation and Analysis of Stockholders’ Equity 847
other considerations. The example from the annual report of Alberto-Culver Company
in Illustration 15-12 shows a note disclosing potential restrictions on retained earnings
and dividends.
ILLUSTRATION 15-12
Alberto-Culver Company
Disclosure of Restrictions
Note 3 (in part): The $200 million revolving credit facility, the term note, and the receivables agreement on Retained Earnings
impose restrictions on such items as total debt, working capital, dividend payments, treasury stock and Dividends
purchases, and interest expense. At year-end, the company was in compliance with these arrangements,
and $220 million of consolidated retained earnings was not restricted as to the payment of dividends.
PRESENTATION AND ANALYSIS
OF STOCKHOLDERS’ EQUITY
Presentation
Balance Sheet
9 LEARNING OBJECTIVE
Illustration 15-13 shows a comprehensive stockholders’ equity section from
Indicate how to present and analyze
the balance sheet of Frost Company that includes most of the equity items we
stockholders’ equity.
discussed in this chapter.
ILLUSTRATION 15-13
FROST COMPANY
Comprehensive
STOCKHOLDERS’ EQUITY
Stockholders’ Equity
DECEMBER 31, 2014
Presentation
Capital stock
Preferred stock, $100 par value, 7% cumulative,
100,000 shares authorized, 30,000 shares
issued and outstanding $ 3,000,000
Common stock, no-par, stated value $10 per share,
500,000 shares authorized, 400,000 shares issued 4,000,000
Common stock dividend distributable, 20,000 shares 200,000
Total capital stock 7,200,000
Additional paid-in capital20
Excess over par—preferred $150,000
Excess over stated value—common 840,000 990,000
Total paid-in capital 8,190,000
Retained earnings 4,360,000
Total paid-in capital and retained earnings 12,550,000
Less: Cost of treasury stock (2,000 shares, common) 190,000
Accumulated other comprehensive loss21 360,000
Total stockholders’ equity $12,000,000
20Accounting Trends and Techniques—2012 reports that of its 500 surveyed companies, 465 had
additional paid-in capital.
21Companies may include a number of items in the “Accumulated other comprehensive income
(loss).” Accounting Trends and Techniques—2012 reports that of its 500 surveyed companies, 407
reported cumulative translation adjustments, 386 reported defined benefit postretirement plan
adjustments (discussed in Chapter 20), 286 reported changes in the fair value of derivatives
(discussed in Appendix 17A), and 218 reported unrealized losses/gains on certain investments
(discussed in Chapter 17). A number of companies had more than one item.
848 Chapter 15 Stockholders’ Equity
Frost should disclose the pertinent rights and privileges of the various securities
outstanding. For example, companies must disclose all of the following: dividend and
liquidation preferences, participation rights, call prices and dates, conversion or exer- |
cise prices and pertinent dates, sinking fund requirements, unusual voting rights, and
significant terms of contracts to issue additional shares. Liquidation preferences should
be disclosed in the equity section of the balance sheet, rather than in the notes to the
financial statements, to emphasize the possible effect of this restriction on future cash
flows. [5]
Statement of Stockholders’ Equity
The statement of stockholders’ equity is frequently presented in the following basic
format.
1. Balance at the beginning of the period.
2. Additions.
3. Deductions.
4. Balance at the end of the period.
Companies must disclose changes in the separate accounts comprising stockholders’
equity, to make the financial statements sufficiently informative. Such changes may
be disclosed in separate statements or in the basic financial statements or notes
thereto.22
A columnar format for the presentation of changes in stockholders’ equity items in
published annual reports is gaining in popularity. An example is ConAgra Foods’ state-
ment of common stockholders’ equity, shown in Illustration 15-14.
ConAgra Foods, Inc. and Subsidiaries
For the Fiscal Year Ended May 2012
Accumulated
Additional Other
(Dollars in millions except Common Common Paid-in Retained Comprehensive Treasury Noncontrolling Total
per share amounts) Shares Stock Capital Earnings Income (Loss) Stock Interests Equity
Balance of May 29, 2011 567.9 $2,839.7 $899.1 $4,690.3 $ (91.2) $(3,668.2) $ 7.0 $4,676.7
Stock option and incentive plans 3.9 (1.3) 252.9 255.5
Currency translation adjustment, net of
reclassification adjustment (52.0) (4.4) (56.4)
Repurchase of common shares (352.4) (352.4)
Unrealized loss on securities (0.1) (0.1)
Derivative adjustment, net of reclassification
adjustment (89.1) (89.1)
Acquisition of majority interest in ATFL 92.6 92.6
Activities of noncontrolling interests (1.5) 1.3 (0.2)
Pension and postretirement healthcare benefits (66.7) (66.7)
Dividends declared on common stock;
$0.95 per share (391.8) (391.8)
Net income attributable to ConAgra Foods, Inc. 467.9 467.9
Balance at May 27, 2012 567.9 $2,839.7 $901.5 $4,765.1 $(299.1) $(3,767.7) $96.5 $4,536.0
ILLUSTRATION 15-14
Columnar Format for
Statement of Common 22Accounting Trends and Techniques—2012 reports that of the 500 companies surveyed, 486
Stockholders’ Equity presented statements of stockholders’ equity, 4 presented separate statements of retained
earnings only, 1 presented combined statements of income and retained earnings, and
9 presented changes in equity items in the notes only.
Presentation and Analysis of Stockholders’ Equity 849
Analysis
Analysts use stockholders’ equity ratios to evaluate a company’s profitability and long- Gateway to
term solvency. We discuss and illustrate the following three ratios below. the Profession
Financial Analysis Primer
1. Return on common stock equity.
2. Payout ratio.
3. Book value per share.
Return on Common Stock Equity
The return on common stock equity, often referred to as return on equity (ROE),
measures profitability from the common stockholders’ viewpoint. This ratio shows how
many dollars of net income the company earned for each dollar invested by the owners.
Return on equity also helps investors judge the worthiness of a stock when the overall
market is not doing well. For example, Best Buy shares dropped nearly 40 percent,
along with the broader market in 2001–2002. But a review of its return on equity during
this period and since shows a steady return of 20 to 22 percent while the overall market
ROE declined from 16 percent to 8 percent. More importantly, Best Buy and other stocks,
such as 3M and Procter & Gamble, recovered their lost market value, while other stocks
with less robust ROEs stayed in the doldrums.
Return on equity equals net income less preferred dividends, divided by average
common stockholders’ equity. For example, assume that Gerber’s Inc. had net in-
come of $360,000, declared and paid preferred dividends of $54,000, and average
common stockholders’ equity of $2,550,000. Illustration 15-15 shows how to compute |
Gerber’s ratio.
ILLUSTRATION 15-15
Return on Net Income2Preferred Dividends
5 Computation of Return
Common Stock Equity Average Common Stockholders’ Equity
on Common Stock Equity
$360,0002$54,000
5
$2,550,000
512%
As shown in Illustration 15-15, when preferred stock is present, income available to
common stockholders equals net income less preferred dividends. Similarly, the amount
of common stock equity used in this ratio equals total stockholders’ equity less the par
value of preferred stock.
A company can improve its return on common stock equity through the prudent use
of debt or preferred stock financing. Trading on the equity describes the practice of using
borrowed money or issuing preferred stock in hopes of obtaining a higher rate of return
on the money used. Shareholders win if return on the assets is higher than the cost of
financing these assets. When this happens, the return on common stock equity will exceed
the return on total assets. In short, the company is “trading on the equity at a gain.” In
this situation, the money obtained from bondholders or preferred stockholders earns
enough to pay the interest or preferred dividends and leaves a profit for the common
stockholders. On the other hand, if the cost of the financing is higher that the rate earned
on the assets, the company is trading on equity at a loss and stockholders lose.
Payout Ratio
Another ratio of interest to investors, the payout ratio, is the ratio of cash dividends
to net income. If preferred stock is outstanding, this ratio equals cash dividends paid
to common stockholders, divided by net income available to common stockholders.
850 Chapter 15 Stockholders’ Equity
For example, assume that Troy Co. has cash dividends of $100,000 and net income of
$500,000, and no preferred stock outstanding. Illustration 15-16 shows the payout ratio
computation.
ILLUSTRATION 15-16
Cash Dividends
Computation of Payout Payout Ratio 5
Net Income
Ratio
$100,000
5
$500,000
5 20%
Recently, the payout ratio has plummeted. In 1982, more than half of earnings were
converted to dividends. In the fourth quarter of 2011, just 36 percent of the earnings of
the S&P 500 was distributed via dividends.23
Book Value per Share
You will A much-used basis for evaluating net worth is found in the book value or equity value
want to
per share of stock. Book value per share of stock is the amount each share would receive
read the
if the company were liquidated on the basis of amounts reported on the balance sheet.
IFRS INSIGHTS
However, the figure loses much of its relevance if the valuations on the balance sheet fail
on pages 874–880
to approximate fair value of the assets. Book value per share equals common stock-
for discussion of holders’ equity divided by outstanding common shares. Assume that Chen Corpora-
IFRS related to
tion’s common stockholders’ equity is $1,000,000 and it has 100,000 shares of common
stockholders’ equity.
stock outstanding. Illustration 15-17 shows its book value per share computation.
ILLUSTRATION 15-17
Book Value Common Stockholders’ Equity
Computation of Book 5
per Share Outstanding Shares
Value per Share
$1,000,000
5
100,000
5 $10 per share
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
Additional Paid-in
Capital, 825
book value per share, 850
1 Discuss the characteristics of the corporate form of organization.
callable preferred stock, 835
Among the specific characteristics of the corporate form that affect accounting are
cash dividends, 839
the (1) influence of state corporate law, (2) use of the capital stock or share system, and
common stock, 824
(3) development of a variety of ownership interests. In the absence of restrictive provi-
contributed (paid-in)
sions, each share of stock carries the right to share proportionately in (1) profits and
capital, 824
losses, (2) management (the right to vote for directors), (3) corporate assets upon liqui-
convertible preferred
dation, and (4) any new issues of stock of the same class (called the preemptive right).
stock, 835
cost method, 831 2 Identify the key components of stockholders’ equity. Stockholders’ or |
cumulative preferred owners’ equity is classified into two categories: contributed capital and earned capital.
stock, 835 Contributed capital (paid-in capital) describes the total amount paid in on capital stock.
dividend in arrears, 835 Put another way, it is the amount that stockholders invested in the corporation for use
earned capital, 824 in the business. Contributed capital includes items such as the par value of all outstand-
ing capital stock and premiums less any discounts on issuance. Earned capital is the
large stock dividend, 845
leveraged buyout
23R. Shaw, “S&P 500 Dividend Payout Ratio Still Giving Off Caution Signals,” http://seekingalpha.com
(LBO), 830
(January 16, 2012).
Summary of Learning Objectives 851
capital that develops if the business operates profitably; it consists of all undistributed liquidating dividends,
income that remains invested in the company. 839, 841
lump-sum sales, 827
3 Explain the accounting procedures for issuing shares of stock. Accounts
no-par stock, 826
are kept for the following different types of stock. Par value stock: (a) preferred stock or
Paid-in Capital in Excess
common stock, (b) paid-in capital in excess of par or additional paid-in capital, and
of Par, 825
(c) discount on stock. No-par stock: common stock or common stock and additional paid-
par (stated) value
in capital, if stated value used. Stock issued in combination with other securities (lump-sum
method, 831
sales): The two methods of allocation available are (a) the proportional method and
participating preferred
(b) the incremental method. Stock issued in noncash transactions: When issuing stock for
stock, 835
services or property other than cash, the company should record the property or services
payout ratio, 849
at either the fair value of the stock issued, or the fair value of the noncash consideration
received, whichever is more clearly determinable. preemptive right, 823
preferred stock, 824, 834
4 Describe the accounting for treasury stock. The cost method is generally
property dividends, 840
used in accounting for treasury stock. This method derives its name from the fact that a
redeemable preferred
company maintains the Treasury Stock account at the cost of the shares purchased.
stock, 835
Under the cost method, a company debits the Treasury Stock account for the cost of the
residual interest, 825
shares acquired and credits it for this same cost upon reissuance. The price received for
retained earnings, 824
the stock when originally issued does not affect the entries to record the acquisition and
return on common stock
reissuance of the treasury stock.
equity, 849
5 Explain the accounting for and reporting of preferred stock. Preferred small (ordinary) stock
stock is a special class of shares that possesses certain preferences or features not pos- dividends, 842
sessed by the common stock. The features that are most often associated with preferred stated value, 826
stock issues are (1) preference as to dividends, (2) preference as to assets in the event of
statement of stockholders’
liquidation, (3) convertible into common stock, (4) callable at the option of the corpora- equity, 848
tion, and (5) nonvoting. At issuance, the accounting for preferred stock is similar to that
stock dividends, 841
for common stock. When convertible preferred stock is converted, a company uses the
stock split, 843
book value method. It debits Preferred Stock, along with any related Paid-in Capital in
stockholders’ (owners’)
Excess of Par—Preferred Stock and credits Common Stock and Paid-in Capital in Excess
equity, 825
of Par—Common Stock (if an excess exists).
trading on the equity, 849
6 Describe the policies used in distributing dividends. The state incorpora- treasury stock, 830
tion laws normally provide information concerning the legal restrictions related to the
payment of dividends. Corporations rarely pay dividends in an amount equal to the
legal limit. This is due, in part, to the fact that companies use assets represented by
undistributed earnings to finance future operations of the business. If a company is |
considering declaring a dividend, it must ask two preliminary questions. (1) Is the condi-
tion of the corporation such that the dividend is legally permissible? (2) Is the condition
of the corporation such that a dividend is economically sound?
7 Identify the various forms of dividend distributions. Dividends are of the
following types: (1) cash dividends, (2) property dividends, (3) liquidating dividends
(dividends based on other than retained earnings), and (4) stock dividends (the issuance
by a corporation of its own stock to its stockholders on a pro rata basis, but without
receiving consideration).
8 Explain the accounting for small and large stock dividends, and for Gateway to
stock splits. Generally accepted accounting principles require that the accounting for the Profession
small stock dividends (less than 20–25 percent) rely on the fair value of the stock issued. Expanded Discussion of
When declaring a common stock dividend, a company debits Retained Earnings at the fair Quasi-Reorganization
value of the stock it distributes. The entry includes a credit to Common Stock Dividend
Distributable at par value times the number of shares, with any excess credited to Paid-in
Capital in Excess of Par—Common Stock. If the number of shares issued exceeds 20–25
percent of the shares outstanding (large stock dividend), it debits Retained Earnings at par
value and credits Common Stock Distributable—there is no additional paid-in capital.
A stock dividend is a capitalization of retained earnings that reduces retained earn-
ings and increases certain contributed capital accounts. The par value per share and total
852 Chapter 15 Stockholders’ Equity
stockholders’ equity remain unchanged with a stock dividend, and all stockholders
retain their same proportionate share of ownership. A stock split results in an increase or
decrease in the number of shares outstanding, with a corresponding decrease or increase
in the par or stated value per share. No accounting entry is required for a stock split.
9 Indicate how to present and analyze stockholders’ equity. The stock-
holders’ equity section of a balance sheet includes capital stock, additional paid-in capital,
and retained earnings. A company might also present additional items such as treasury
stock and accumulated other comprehensive income. Companies often provide a state-
ment of stockholders’ equity. Common ratios that use stockholders’ equity amounts are
return on common stock equity, payout ratio, and book value per share.
APPENDIX 15A DIVIDEND PREFERENCES AND BOOK VALUE PER SHARE
DIVIDEND PREFERENCES
Illustrations 15A-1 to 15A-4 indicate the effects of various dividend preferences
LEARNING OBJECTIVE 10
on dividend distributions to common and preferred stockholders. Assume that in
Explain the different types of preferred
2014, Mason Company is to distribute $50,000 as cash dividends, its outstanding
stock dividends and their effect on
book value per share. common stock has a par value of $400,000, and its 6 percent preferred stock has a
par value of $100,000. Mason would distribute dividends to each class, employing
the assumptions given, as follows.
1. If the preferred stock is noncumulative and nonparticipating:
ILLUSTRATION 15A-1
Preferred Common Total
Dividend Distribution,
6% of $100,000 $6,000 $ 6,000
Noncumulative and
The remainder to common $44,000 44,000
Nonparticipating
Preferred Totals $6,000 $44,000 $50,000
2. If the preferred stock is cumulative and nonparticipating, and Mason Company did
not pay dividends on the preferred stock in the preceding two years:
ILLUSTRATION 15A-2
Preferred Common Total
Dividend Distribution,
Dividends in arrears, 6% of $100,000 for 2 years $12,000 $12,000
Cumulative and
Current year’s dividend, 6% of $100,000 6,000 6,000
Nonparticipating
The remainder to common $32,000 32,000
Preferred, with
Totals $18,000 $32,000 $50,000
Dividends in Arrears
3. If the preferred stock is noncumulative and is fully participating:24
24When preferred stock is participating, there may be different agreements as to how the
participation feature is to be executed. However, in the absence of any specific agreement the |
following procedure is recommended:
a. After the preferred stock is assigned its current year’s dividend, the common stock will
receive a “like” percentage of par value outstanding. In example (3) in Illustration 15A-3,
this amounts to 6 percent of $400,000.
b. In example (3), shown in Illustration 15A-3, the remainder of the declared dividend is
$20,000. We divide this amount by total par value ($500,000) to find the rate of participa-
tion to be applied to each class of stock. In this case, the rate of participation is 4 percent
($20,000 4 $500,000), which we then multiply by the par value of each class of stock to
determine the amount of participation.
Appendix 15A: Dividend Preferences and Book Value per Share 853
ILLUSTRATION 15A-3
Preferred Common Total
Dividend Distribution,
Current year’s dividend, 6% $ 6,000 $24,000 $30,000 Noncumulative and
Participating dividend of 4% 4,000 16,000 20,000 Fully Participating
Totals $10,000 $40,000 $50,000 Preferred
The participating dividend was determined as follows.
Current year’s dividend:
Preferred, 6% of $100,000 5 $ 6,000
Common, 6% of $400,000 5 24,000 $ 30,000
Amount available for participation ($50,000 2 $30,000) $ 20,000
Par value of stock that is to participate ($100,000 1 $400,000) $500,000
Rate of participation ($20,000 4 $500,000) 4%
Participating dividend:
Preferred, 4% of $100,000 $ 4,000
Common, 4% of $400,000 16,000
$ 20,000
4. If the preferred stock is cumulative and is fully participating, and Mason Company
did not pay dividends on the preferred stock in the preceding two years:
ILLUSTRATION 15A-4
Preferred Common Total
Dividend Distribution,
Dividends in arrears, 6% of $100,000 for 2 years $12,000 $12,000 Cumulative and Fully
Current year’s dividend, 6% 6,000 $24,000 30,000 Participating Preferred,
Participating dividend, 1.6% ($8,000 4 $500,000) 1,600 6,400 8,000
with Dividends in
Totals $19,600 $30,400 $50,000 Arrears
BOOK VALUE PER SHARE
Book value per share in its simplest form is computed as net assets divided by outstand-
ing common shares at the end of the year. The computation of book value per share
b ecomes more complicated if a company has preferred stock in its capital structure. For
example, if preferred dividends are in arrears, if the preferred stock is participating, or
if preferred stock has a redemption or liquidating value higher than its carrying amount,
the company must allocate retained earnings between the preferred and common stock-
holders in computing book value.
To illustrate, assume that the following situation exists.
ILLUSTRATION 15A-5
Stockholders’ equity Preferred Common
Computation of Book
Preferred stock, 5% $300,000
Value per Share—No
Common stock $400,000
Dividends in Arrears
Excess of issue price over par of common stock 37,500
Retained earnings 162,582
Totals $300,000 $600,082
Common shares outstanding 4,000
Book value per share $150.02
The situation in Illustration 15A-5 assumes that no preferred dividends are in ar-
rears and that the preferred is not participating. Now assume that the same facts exist
except that the 5 percent preferred is cumulative, participating up to 8 percent, and that
dividends for three years before the current year are in arrears. Illustration 15A-6 (page 854)
854 Chapter 15 Stockholders’ Equity
shows how to compute the book value of the common stock, assuming that no action
has yet been taken concerning dividends for the current year.
ILLUSTRATION 15A-6
SSttoocckkhhoollddeerrss’’ eeqquuiittyy PPrreeffeerrrreedd CCoommmmoonn
Computation of Book
PPrreeffeerrrreedd ssttoocckk,, 55%% $$330000,,000000
Value per Share—with
CCoommmmoonn ssttoocckk $$440000,,000000
Dividends in Arrears
EExxcceessss ooff iissssuuee pprriiccee oovveerr ppaarr ooff ccoommmmoonn ssttoocckk 3377,,550000
RReettaaiinneedd eeaarrnniinnggss : 162,582
T oDtailvsi dends in arrears (3 years at 5% a year) $30405,,000000 $600,082
Current year requirement at 5% 15,000 20,000
Shares outstanding 4,000
Participating—additional 3% 9,000 12,000
Book value per share $150.02
Remainder to common 61,582
Totals $369,000 $531,082 |
Shares outstanding 4,000
Book value per share $132.77
In connection with the book value computation, the analyst must know how to
handle the following items: the number of authorized and unissued shares; the number
of treasury shares on hand; any commitments with respect to the issuance of unissued
shares or the reissuance of treasury shares; and the relative rights and privileges of the
various types of stock authorized. As an example, if the liquidating value of the pre-
ferred stock is higher than its carrying amount, the liquidating amount should be used
in the book value computation.
SUMMARY OF LEARNING OBJECTIVE
FOR APPENDIX 15A
10 Explain the different types of preferred stock dividends and their effect
on book value per share. The dividend preferences of preferred stock affect the
dividends paid to stockholders. Preferred stock can be (1) cumulative or noncumulative,
and (2) fully participating, partially participating, or nonparticipating. If preferred divi-
dends are in arrears, if the preferred stock is participating, or if preferred stock has a
redemption or liquidation value higher than its carrying amount, allocate retained earn-
ings between preferred and common stockholders in computing book value per share.
DEMONSTRATION PROBLEM
D’Ouville Company was formed on July 1, 2011. It was authorized to issue 500,000 shares of $10 par value
common stock and 100,000 shares of 8%, $25 par value, cumulative and nonparticipating preferred stock.
D’Ouville Company has a July 1–June 30 fiscal year. The following information relates to the stockholders’
equity accounts of D’Ouville Company.
Common Stock: Prior to the 2013–2014 fiscal year, D’Ouville Company had 110,000 shares of outstanding
common stock issued as follows.
1. 95,000 shares were issued for cash on July 1, 2011, at $31 per share.
2. On July 24, 2011, 5,000 shares were exchanged for a plot of land which cost the seller $70,000 in 2005
and had an estimated fair value of $220,000 on July 24, 2011.
3. 10,000 shares were issued on March 1, 2013, for $42 per share.
During the 2013–2014 fiscal year, the following transactions regarding common stock took place.
November 30, 2013 D’Ouville purchased 2,000 shares of its own stock on the open market at $39 per
share. D’Ouville uses the cost method for treasury stock.
Demonstration Problem 855
December 15, 2013 D’Ouville declared a 5% stock dividend for stockholders of record on January 15,
2014, to be issued on January 31, 2014. D’Ouville was having a liquidity problem
and could not afford a cash dividend at the time. D’Ouville’s common stock was
selling at $52 per share on December 15, 2013.
June 20, 2014 D ’Ouville sold 500 shares of its own common stock that it had purchased on
November 30, 2013, for $21,000.
Preferred Stock: D’Ouville issued 100,000 shares of preferred stock at $44 per share on July 1, 2012.
Cash Dividends: D’Ouville has followed a schedule of declaring cash dividends in December and June,
with payment being made to stockholders of record in the following month. The cash dividends which
have been declared since inception of the company through June 30, 2014, are shown below.
Declaration Common Preferred
Date Stock Stock
12/15/12 $0.30 per share $0.50 per share
6/15/13 $0.30 per share $0.50 per share
12/15/13 — $0.50 per share
No cash dividends were declared during June 2014 due to the company’s liquidity problems.
Retained Earnings: As of June 30, 2013, D’Ouville retained earnings account had a balance of $550,000. For
the fiscal year ending June 30, 2014, D’Ouville reported net income of $120,000.
Instructions
Prepare the stockholders’ equity section of the balance sheet, including appropriate notes, for D’Ouville
Company as of June 30, 2014, as it should appear in its annual report to the shareholders.
Solution
D’OUVILLE COMPANY
STOCKHOLDERS’ EQUITY
JUNE 30, 2014
Capital stock
4% preferred stock, $25 par value, cumulative and
nonparticipating, 100,000 shares authorized,
100,000 shares issued and outstanding—Note A $2,500,000
Common stock, $10 par value, 500,000 shares |
authorized, 115,400 shares issued, with
1,500 shares held in the treasury 1,154,000
Additional paid-in capital
On preferred stock $1,900,000
On common stock 2,711,800*
On treasury stock 1,500 4,613,300
Total paid-in capital 8,267,300
Retained earnings 339,200**
Total paid-in capital and retained earnings 8,606,500
Less: Treasury stock, 1,500 shares at cost 58,500
Total stockholders’ equity $8,548,000
Note A: D’Ouville Company is in arrears on the preferred stock in the amount of $100,000.
*Premium on Common Stock:
Issue of 95,000 shares 3 ($31 2 $10) $1,995,000
Issue of 5,000 shares for plot of land ($220,000 2 $50,000) 170,000
10,000 shares issued (3/1/13) [10,000 3 ($42 2 $10)] 320,000
5,400 shares as dividend [5,400 3 ($52 2 $10)] 226,800
$2,711,800
**Retained Earnings:
Beginning balance 1 Income 2 Stock dividend 2 Preferred dividend 5 Ret. earnings, ending balance
$550,000 1 $120,000 2 $280,800 2 $50,000 5 $339,200
856 Chapter 15 Stockholders’ Equity
FASB CODIFICATION
FASB Codification References
[1] FASB ASC 480-10-05. [Predecessor literature: “Accounting for Certain Financial Instruments with Characteristics of Both
Liabilities and Equity,” Statement of Financial Accounting Standards No. 150 (Norwalk Conn.: FASB, 2003).]
[2] FASB ASC 505-10-50-3. [Predecessor literature: “Disclosure of Information about Capital Structure,” Statement of Financial
Accounting Standards No. 129 (Norwalk, Conn.: FASB, 1997).]
[3] FASB ASC 505-20-05-2. [Predecessor literature: American Institute of Certified Public Accountants, Accounting Research and
Terminology Bulletins, No. 43 (New York: AICPA, 1961), Ch. 7, par. 10.]
[4] FASB ASC 505-20-25-3. [Predecessor literature: American Institute of Certified Public Accountants, Accounting Research and
Terminology Bulletins, No. 43 (New York: AICPA, 1961), par. 13.]
[5] FASB ASC 505-10-50-3. [Predecessor literature: “Disclosure of Information about Capital Structure,” Statement of Financial
Accounting Standards No. 129 (Norwalk, Conn.: FASB, February 1997), par. 4.]
Exercises
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and prepare responses to
the following. Provide Codification references for your responses.
CE15-1 Access the glossary (“Master Glossary”) to answer the following.
(a) What is a “convertible security”?
(b) What is a “stock dividend”?
(c) What is a “stock split”?
(d) What are “participation rights”?
CE15-2 At what percentage point can the issuance of additional shares still qualify as a stock dividend, as opposed to a stock
split?
CE15-3 A company plans to issue shares and wants to know the SEC’s stance on the accounting treatment for the costs of issuing
stock. Can these costs be deferred, or must they be expensed immediately?
CE15-4 If a company chooses to purchase its own shares and then either (1) retires the repurchased shares and issues additional
shares, or (2) resells the repurchased shares, can a gain or loss be recognized by the company? Why or why not?
An additional Codification case can be found in the Using Your Judgment section, on page 873.
Be sure to check the book’s companion website for a Review and Analysis Exercise,
with solution.
Brief Exercises, Exercises, Problems, and many more learning and assessment tools
and resources are available for practice in WileyPLUS.
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
QUESTIONS
1. In the absence of restrictive provisions, what are the basic 5. Explain each of the following terms: authorized capital
rights of stockholders of a corporation? stock, unissued capital stock, issued capital stock, out-
2. Why is a preemptive right important? standing capital stock, and treasury stock.
3. Distinguish between common and preferred stock. 6. What is meant by par value, and what is its significance to
stockholders?
4. Why is the distinction between paid-in capital and re-
tained earnings important?
Questions 857
7. Describe the accounting for the issuance for cash of no- 21. Dividends are sometimes said to have been paid “out of re- |
par value common stock at a price in excess of the stated tained earnings.” What is the error, if any, in that statement?
value of the common stock. 22. Distinguish among: cash dividends, property dividends,
8. Explain the difference between the proportional method liquidating dividends, and stock dividends.
and the incremental method of allocating the proceeds of 23. Describe the accounting entry for a stock dividend, if any.
lump-sum sales of capital stock.
Describe the accounting entry for a stock split, if any.
9. What are the different bases for stock valuation when 24. Stock splits and stock dividends may be used by a corpo-
assets other than cash are received for issued shares of ration to change the number of shares of its stock out-
stock? standing.
10. Explain how underwriting costs and accounting and legal (a) What is meant by a stock split effected in the form of a
fees associated with the issuance of stock should be dividend?
recorded.
(b) From an accounting viewpoint, explain how the stock
11. For what reasons might a corporation purchase its own stock? split effected in the form of a dividend differs from an
12. Discuss the propriety of showing: ordinary stock dividend.
(a) Treasury stock as an asset. (c) How should a stock dividend that has been declared
but not yet issued be classified in a balance sheet? Why?
(b) “Gain” or “loss” on sale of treasury stock as additions
to or deductions from income. 25. The following comment appeared in the notes of Colo-
rado Corporation’s annual report: “Such distributions,
(c) Dividends received on treasury stock as income.
representing proceeds from the sale of Sarazan, Inc., were
13. What features or rights may alter the character of pre- paid in the form of partial liquidating dividends and were
ferred stock? in lieu of a portion of the Company’s ordinary cash divi-
14. Dagwood Inc. recently noted that its 4% preferred stock dends.” How would a partial liquidating dividend be ac-
and 4% participating preferred stock, which are both counted for in the financial records?
cumulative, have priority as to dividends up to 4% of 26. This comment appeared in the annual report of MacCloud
their par value. Its participating preferred stock partici- Inc.: “The Company could pay cash or property dividends
pates equally with the common stock in any dividends on the Class A common stock without paying cash or
in excess of 4%. What is meant by the term participating? property dividends on the Class B common stock. But if
Cumulative? the Company pays any cash or property dividends on the
15. Where in the financial statements is preferred stock Class B common stock, it would be required to pay at least
normally reported? the same dividend on the Class A common stock.” How is
a property dividend accounted for in the financial records?
16. List possible sources of additional paid-in capital.
27. For what reasons might a company restrict a portion of its
17. Satchel Inc. purchases 10,000 shares of its own previously
retained earnings?
issued $10 par common stock for $290,000. Assuming the
shares are held in the treasury with intent to reissue, what 28. How are restrictions of retained earnings reported?
effect does this transaction have on (a) net income, (b) total *2 9. McNabb Corp. had $100,000 of 7%, $20 par value pre-
assets, (c) total paid-in capital, and (d) total stockholders’ ferred stock and 12,000 shares of $25 par value common
equity? stock outstanding throughout 2014.
18. Indicate how each of the following accounts should be (a) Assuming that total dividends declared in 2014 were
classified in the stockholders’ equity section. $64,000, and that the preferred stock is not cumulative
(a) Common Stock. but is fully participating, common stockholders should
receive 2014 dividends of what amount?
(b) Retained Earnings.
(b) Assuming that total dividends declared in 2014 were
(c) Paid-in Capital in Excess of Par—Common Stock.
$64,000, and that the preferred stock is fully partici-
(d) Treasury Stock.
pating and cumulative with preferred dividends in |
(e) Paid-in Capital from Treasury Stock. arrears for 2013, preferred stockholders should re-
(f) Paid-in Capital in Excess of Stated Value—Common Stock. ceive 2014 dividends totaling what amount?
(g) Preferred Stock. (c) Assuming that total dividends declared in 2014 were
$30,000, that the preferred stock is cumulative, non-
19. What factors influence the dividend policy of a company?
participating, and was issued on January 1, 2013, and
20. What are the principal considerations of a board of direc- that $5,000 of preferred dividends were declared and
tors in making decisions involving dividend declarations? paid in 2013, the common stockholders should receive
Discuss briefly. 2014 dividends totaling what amount?
858 Chapter 15 Stockholders’ Equity
BRIEF EXERCISES
3 BE15-1 Buttercup Corporation issued 300 shares of $10 par value common stock for $4,500. Prepare
Buttercup’s journal entry.
3 BE15-2 Swarten Corporation issued 600 shares of no-par common stock for $8,200. Prepare Swarten’s
journal entry if (a) the stock has no stated value, and (b) the stock has a stated value of $2 per share.
4 9 BE15-3 Wilco Corporation has the following account balances at December 31, 2014.
Common stock, $5 par value $ 510,000
Treasury stock 90,000
Retained earnings 2,340,000
Paid-in capital in excess of par—common stock 1,320,000
Prepare Wilco’s December 31, 2014, stockholders’ equity section.
3 BE15-4 Ravonette Corporation issued 300 shares of $10 par value common stock and 100 shares of $50 par
value preferred stock for a lump sum of $13,500. The common stock has a market price of $20 per share,
and the preferred stock has a market price of $90 per share. Prepare the journal entry to record the issuance.
3 BE15-5 On February 1, 2014, Buffalo Corporation issued 3,000 shares of its $5 par value common stock for
land worth $31,000. Prepare the February 1, 2014, journal entry.
3 BE15-6 Moonwalker Corporation issued 2,000 shares of its $10 par value common stock for $60,000. Moon-
walker also incurred $1,500 of costs associated with issuing the stock. Prepare Moonwalker’s journal entry
to record the issuance of the company’s stock.
4 BE15-7 Sprinkle Inc. has outstanding 10,000 shares of $10 par value common stock. On July 1, 2014,
Sprinkle reacquired 100 shares at $87 per share. On September 1, Sprinkle reissued 60 shares at $90 per
share. On November 1, Sprinkle reissued 40 shares at $83 per share. Prepare Sprinkle’s journal entries to
record these transactions using the cost method.
4 BE15-8 Arantxa Corporation has outstanding 20,000 shares of $5 par value common stock. On August 1,
2014, Arantxa reacquired 200 shares at $80 per share. On November 1, Arantxa reissued the 200 shares at
$70 per share. Arantxa had no previous treasury stock transactions. Prepare Arantxa’s journal entries to
record these transactions using the cost method.
5 BE15-9 Hinges Corporation issued 500 shares of $100 par value preferred stock for $61,500. Prepare Hinges’s
journal entry.
6 BE15-10 Woolford Inc. declared a cash dividend of $1.00 per share on its 2 million outstanding shares. The
dividend was declared on August 1, payable on September 9 to all stockholders of record on August 15.
Prepare all journal entries necessary on those three dates.
6 7 BE15-11 Cole Inc. owns shares of Marlin Corporation stock classified as an available-for-sale investment.
At December 31, 2014, the available-for-sale securities were carried in Cole’s accounting records at their
cost of $875,000, which equals their fair value. On September 21, 2015, when the fair value of the securities
was $1,200,000, Cole declared a property dividend whereby the Marlin securities are to be distributed on
October 23, 2015 to stockholders of record on October 8, 2015. Prepare all journal entries necessary on those
three dates.
6 7 BE15-12 Graves Mining Company declared, on April 20, a dividend of $500,000 payable on June 1. Of this
amount, $125,000 is a return of capital. Prepare the April 20 and June 1 entries for Graves.
8 BE15-13 Green Day Corporation has outstanding 400,000 shares of $10 par value common stock. The |
corporation declares a 5% stock dividend when the fair value of the stock is $65 per share. Prepare the
journal entries for Green Day Corporation for both the date of declaration and the date of distribution.
8 BE15-14 Use the information from BE15-13, but assume Green Day Corporation declared a 100% stock
dividend rather than a 5% stock dividend. Prepare the journal entries for both the date of declaration and
the date of distribution.
10 * BE15-15 Nottebart Corporation has outstanding 10,000 shares of $100 par value, 6% preferred stock and
60,000 shares of $10 par value common stock. The preferred stock was issued in January 2014, and no
dividends were declared in 2014 or 2015. In 2016, Nottebart declares a cash dividend of $300,000. How will
the dividend be shared by common and preferred stockholders if the preferred is (a) noncumulative and
(b) cumulative?
Exercises 859
EXERCISES
3 E15-1 (Recording the Issuances of Common Stock) During its first year of operations, Collin Raye
Corporation had the following transactions pertaining to its common stock.
Jan. 10 Issued 80,000 shares for cash at $6 per share.
Mar. 1 Issued 5,000 shares to attorneys in payment of a bill for $35,000 for services rendered in helping the
company to incorporate.
July 1 Issued 30,000 shares for cash at $8 per share.
Sept. 1 Issued 60,000 shares for cash at $10 per share.
Instructions
(a) Prepare the journal entries for these transactions, assuming that the common stock has a par value
of $5 per share.
(b) Prepare the journal entries for these transactions, assuming that the common stock is no-par with a
stated value of $3 per share.
3 E15-2 (Recording the Issuance of Common and Preferred Stock) Kathleen Battle Corporation was orga-
nized on January 1, 2014. It is authorized to issue 10,000 shares of 8%, $100 par value preferred stock, and
500,000 shares of no-par common stock with a stated value of $1 per share. The following stock transactions
were completed during the first year.
Jan. 10 Issued 80,000 shares of common stock for cash at $5 per share.
Mar. 1 Issued 5,000 shares of preferred stock for cash at $108 per share.
Apr. 1 Issued 24,000 shares of common stock for land. The asking price of the land was $90,000; the fair
value of the land was $80,000.
May 1 Issued 80,000 shares of common stock for cash at $7 per share.
Aug. 1 Issued 10,000 shares of common stock to attorneys in payment of their bill of $50,000 for services
rendered in helping the company organize.
Sept. 1 Issued 10,000 shares of common stock for cash at $9 per share.
Nov. 1 Issued 1,000 shares of preferred stock for cash at $112 per share.
Instructions
Prepare the journal entries to record the above transactions.
3 E15-3 (Stock Issued for Land) Twenty-five thousand shares reacquired by Elixir Corporation for $53
per share were exchanged for undeveloped land that has an appraised value of $1,700,000. At the time of
the exchange, the common stock was trading at $62 per share on an organized exchange.
Instructions
(a) Prepare the journal entry to record the acquisition of land assuming that the purchase of the stock
was originally recorded using the cost method.
(b) Briefly identify the possible alternatives (including those that are totally unacceptable) for quantify-
ing the cost of the land and briefly support your choice.
3 E15-4 (Lump-Sum Sale of Stock with Bonds) Faith Evans Corporation is a regional company which is an
SEC registrant. The corporation’s securities are thinly traded on NASDAQ. Faith Evans Corp. has issued
10,000 units. Each unit consists of a $500 par, 12% subordinated debenture and 10 shares of $5 par common
stock. The investment banker has retained 400 units as the underwriting fee. The other 9,600 units were
sold to outside investors for cash at $880 per unit. Prior to this sale, the 2-week ask price of common stock
was $40 per share. Twelve percent is a reasonable market yield for the debentures, and therefore the par
value of the bonds is equal to the fair value.
Instructions
(a) Prepare the journal entry to record Evans’ transaction, under the following conditions. |
(1) Employing the incremental method.
(2) Employing the proportional method, assuming the recent price quote on the common stock
reflects fair value.
(b) Briefly explain which method is, in your opinion, the better method.
3 5 E15-5 (Lump-Sum Sales of Stock with Preferred Stock) Dave Matthew Inc. issues 500 shares of $10 par
value common stock and 100 shares of $100 par value preferred stock for a lump sum of $100,000.
Instructions
(a) Prepare the journal entry for the issuance when the market price of the common shares is $165 each
and market price of the preferred is $230 each. (Round to nearest dollar.)
860 Chapter 15 Stockholders’ Equity
(b) Prepare the journal entry for the issuance when only the market price of the common stock is known
and it is $170 per share.
3 4 E15-6 (Stock Issuances and Repurchase) Lindsey Hunter Corporation is authorized to issue 50,000 shares
of $5 par value common stock. During 2014, Lindsey Hunter took part in the following selected transactions.
1. Issued 5,000 shares of stock at $45 per share, less costs related to the issuance of the stock totaling $7,000.
2. Issued 1,000 shares of stock for land appraised at $50,000. The stock was actively traded on a
national stock exchange at approximately $46 per share on the date of issuance.
3. Purchased 500 shares of treasury stock at $43 per share. The treasury shares purchased were issued
in 2010 at $40 per share.
Instructions
(a) Prepare the journal entry to record item 1.
(b) Prepare the journal entry to record item 2.
(c) Prepare the journal entry to record item 3 using the cost method.
4 E15-7 (Effect of Treasury Stock Transactions on Financials) Joe Dumars Company has outstanding
40,000 shares of $5 par common stock which had been issued at $30 per share. Joe Dumars then entered into
the following transactions.
1. Purchased 5,000 treasury shares at $45 per share.
2. Resold 2,000 of the treasury shares at $49 per share.
3. Resold 500 of the treasury shares at $40 per share.
Instructions
Use the following code to indicate the effect each of the three transactions has on the financial statement
categories listed in the table below, assuming Joe Dumars Company uses the cost method (I 5 Increase;
D 5 Decrease; NE 5 No effect).
Stockholders’ Paid-in Retained Net
# Assets Liabilities Equity Capital Earnings Income
1
2
3
3 E15-8 (Preferred Stock Entries and Dividends) Otis Thorpe Corporation has 10,000 shares of $100 par
value, 8%, preferred stock and 50,000 shares of $10 par value common stock outstanding at December 31,
2014.
Instructions
Answer the questions in each of the following independent situations.
(a) If the preferred stock is cumulative and dividends were last paid on the preferred stock on Decem-
ber 31, 2011, what are the dividends in arrears that should be reported on the December 31, 2014,
balance sheet? How should these dividends be reported?
(b) If the preferred stock is convertible into seven shares of $10 par value common stock and 4,000
shares are converted, what entry is required for the conversion assuming the preferred stock was
issued at par value?
(c) If the preferred stock was issued at $107 per share, how should the preferred stock be reported in
the stockholders’ equity section?
3 4 E15-9 (Correcting Entries for Equity Transactions) Pistons Inc. recently hired a new accountant with
extensive experience in accounting for partnerships. Because of the pressure of the new job, the accountant
was unable to review what he had learned earlier about corporation accounting. During the first month, he
made the following entries for the corporation’s capital stock.
May 2 Cash 192,000
Capital Stock 192,000
(Issued 12,000 shares of $5 par value common
stock at $16 per share)
10 Cash 600,000
Capital Stock 600,000
(Issued 10,000 shares of $30 par value preferred
stock at $60 per share)
Exercises 861
May 15 Capital Stock 15,000
Cash 15,000
(Purchased 1,000 shares of common stock for the
treasury at $15 per share)
31 Cash 8,500
Capital Stock 5,000
Gain on Sale of Stock 3,500
(Sold 500 shares of treasury stock at $17 per share) |
Instructions
On the basis of the explanation for each entry, prepare the entries that should have been made for the
capital stock transactions.
3 4 E15-10 (Analysis of Equity Data and Equity Section Preparation) For a recent 2-year period, the
balance sheet of Santana Dotson Company showed the following stockholders’ equity data at December 31
(in millions).
2014 2013
Additional paid-in capital $ 931 $ 817
Common stock 545 540
Retained earnings 7,167 5,226
Treasury stock 1,564 918
Total stockholders’ equity $7,079 $5,665
Common stock shares issued 218 216
Common stock shares authorized 500 500
Treasury stock shares 34 27
Instructions
(a) Answer the following questions.
(1) What is the par value of the common stock?
(2) What is the cost per share of treasury stock at December 31, 2014, and at December 31, 2013?
(b) Prepare the stockholders’ equity section at December 31, 2014.
7 8 E15-11 (Equity Items on the Balance Sheet) The following are selected transactions that may affect stock-
holders’ equity.
1. Recorded accrued interest earned on a note receivable.
2. Declared a cash dividend.
3. Declared and distributed a stock split.
4. Approved a retained earnings restriction.
5. Recorded the expiration of insurance coverage that was previously recorded as prepaid insurance.
6. Paid the cash dividend declared in item 2 above.
7. Recorded accrued interest expense on a note payable.
8. Declared a stock dividend.
9. Distributed the stock dividend declared in item 8.
Instructions
In the following table, indicate the effect each of the nine transactions has on the financial statement
elements listed. Use the following code: I 5 Increase, D 5 Decrease, NE 5 No effect.
Stockholders’ Paid-in Retained Net
Item Assets Liabilities Equity Capital Earnings Income
862 Chapter 15 Stockholders’ Equity
7 E15-12 (Cash Dividend and Liquidating Dividend) Lotoya Davis Corporation has 10 million shares of
common stock issued and outstanding. On June 1, the board of directors voted an 80 cents per share cash
dividend to stockholders of record as of June 14, payable June 30.
Instructions
(a) Prepare the journal entry for each of the dates above assuming the dividend represents a distribu-
tion of earnings.
(b) How would the entry differ if the dividend were a liquidating dividend?
8 E15-13 (Stock Split and Stock Dividend) The common stock of Alexander Hamilton Inc. is currently
selling at $120 per share. The directors wish to reduce the share price and increase share volume prior to a
new issue. The per share par value is $10; book value is $70 per share. Nine million shares are issued and
outstanding.
Instructions
Prepare the necessary journal entries assuming the following.
(a) The board votes a 2-for-1 stock split.
(b) The board votes a 100% stock dividend.
(c) Briefly discuss the accounting and securities market differences between these two methods of
increasing the number of shares outstanding.
8 E15-14 (Entries for Stock Dividends and Stock Splits) The stockholders’ equity accounts of G.K.
Chesterton Company have the following balances on December 31, 2014.
Common stock, $10 par, 300,000 shares issued and outstanding $3,000,000
Paid-in capital in excess of par—common stock 1,200,000
Retained earnings 5,600,000
Shares of G.K. Chesterton Company stock are currently selling on the Midwest Stock Exchange at $37.
Instructions
Prepare the appropriate journal entries for each of the following cases.
(a) A stock dividend of 5% is declared and issued.
(b) A stock dividend of 100% is declared and issued.
(c) A 2-for-1 stock split is declared and issued.
7 8 E15-15 (Dividend Entries) The following data were taken from the balance sheet accounts of Masefield
Corporation on December 31, 2013.
Current assets $540,000
Debt investments 624,000
Common stock (par value $10) 500,000
Paid-in capital in excess of par 150,000
Retained earnings 840,000
Instructions
Prepare the required journal entries for the following unrelated items.
(a) A 5% stock dividend is declared and distributed at a time when the market price per share
is $39.
(b) The par value of the common stock is reduced to $2 with a 5-for-1 stock split. |
(c) A dividend is declared January 5, 2014, and paid January 25, 2014, in bonds held as an investment.
The bonds have a book value of $100,000 and a fair value of $135,000.
6 7 E15-16 (Computation of Retained Earnings) The following information has been taken from the ledger
8 accounts of Isaac Stern Corporation.
Total income since incorporation $317,000
Total cash dividends paid 60,000
Total value of stock dividends distributed 30,000
Gains on treasury stock transactions 18,000
Unamortized discount on bonds payable 32,000
Instructions
Determine the current balance of retained earnings.
9 E15-17 (Stockholders’ Equity Section) Bruno Corporation’s post-closing trial balance at December 31,
2014, is shown on the next page.
Exercises 863
BRUNO CORPORATION
POST-CLOSING TRIAL BALANCE
DECEMBER 31, 2014
Dr. Cr.
Accounts payable $ 310,000
Accounts receivable $ 480,000
Accumulated depreciation—buildings 185,000
Additional paid-in capital in excess
of par—common 1,300,000
From treasury stock 160,000
Allowance for doubtful accounts 30,000
Bonds payable 300,000
Buildings 1,450,000
Cash 190,000
Common stock ($1 par) 200,000
Dividends payable (preferred stock—cash) 4,000
Inventory 560,000
Land 400,000
Preferred stock ($50 par) 500,000
Prepaid expenses 40,000
Retained earnings 301,000
Treasury stock (common at cost) 170,000
Totals $3,290,000 $3,290,000
At December 31, 2014, Bruno had the following number of common and preferred shares.
Common Preferred
Authorized 600,000 60,000
Issued 200,000 10,000
Outstanding 190,000 10,000
The dividends on preferred stock are $4 cumulative. In addition, the preferred stock has a preference in
liquidation of $50 per share.
Instructions
Prepare the stockholders’ equity section of Bruno’s balance sheet at December 31, 2014.
(AICPA adapted)
4 7 E15-18 (Dividends and Stockholders’ Equity Section) Anne Cleves Company reported the following
amounts in the stockholders’ equity section of its December 31, 2013, balance sheet.
8
Preferred stock, 10%, $100 par (10,000 shares
authorized, 2,000 shares issued) $200,000
Common stock, $5 par (100,000 shares authorized,
20,000 shares issued) 100,000
Additional paid-in capital 125,000
Retained earnings 450,000
Total $875,000
During 2014, Cleves took part in the following transactions concerning stockholders’ equity.
1. Paid the annual 2013 $10 per share dividend on preferred stock and a $2 per share dividend on
common stock. These dividends had been declared on December 31, 2013.
2. Purchased 1,700 shares of its own outstanding common stock for $40 per share. Cleves uses the cost
method.
3. Reissued 700 treasury shares for land valued at $30,000.
4. Issued 500 shares of preferred stock at $105 per share.
5. Declared a 10% stock dividend on the outstanding common stock when the stock is selling for
$45 per share.
6. Issued the stock dividend.
7. Declared the annual 2014 $10 per share dividend on preferred stock and the $2 per share dividend
on common stock. These dividends are payable in 2015.
864 Chapter 15 Stockholders’ Equity
Instructions
(a) Prepare journal entries to record the transactions described above.
(b) Prepare the December 31, 2014, stockholders’ equity section. Assume 2014 net income was $330,000.
9 E15-19 (Comparison of Alternative Forms of Financing) Shown below is the liabilities and stockholders’
equity section of the balance sheet for Jana Kingston Company and Mary Ann Benson Company. Each has
assets totaling $4,200,000.
Jana Kingston Co. Mary Ann Benson Co.
Current liabilities $ 300,000 Current liabilities $ 600,000
Long-term debt, 10% 1,200,000 Common stock ($20 par) 2,900,000
Common stock ($20 par) 2,000,000 Retained earnings (Cash
Retained earnings (Cash dividends, $328,000) 700,000
dividends, $220,000) 700,000
$4,200,000 $4,200,000
For the year, each company has earned the same income before interest and taxes.
Jana Kingston Co. Mary Ann Benson Co.
Income before interest and taxes $1,200,000 $1,200,000
Interest expense 120,000 –0–
1,080,000 1,200,000
Income taxes (45%) 486,000 540,000
Net income $ 594,000 $ 660,000
At year end, the market price of Kingston’s stock was $101 per share, and Benson’s was $63.50. |
Instructions
(a) Which company is more profitable in terms of return on total assets?
(b) Which company is more profitable in terms of return on common stock equity?
(c) Which company has the greater net income per share of stock? Neither company issued or reacquired
shares during the year.
(d) From the point of view of net income, is it advantageous to the stockholders of Jana Kingston Co. to
have the long-term debt outstanding? Why?
(e) What is the book value per share for each company?
9 E15-20 (Trading on the Equity Analysis) Presented below is information from the annual report of
Emporia Plastics, Inc.
Operating income $ 532,150
Bond interest expense 135,000
397,150
Income taxes 183,432
Net income $ 213,718
Bonds payable $1,000,000
Common stock 875,000
Retained earnings 375,000
Instructions
(a) Compute the return on common stock equity and the rate of interest paid on bonds. (Assume
balances for debt and equity accounts approximate averages for the year.)
(b) Is Emporia Plastics Inc. trading on the equity successfully? Explain.
10 *E 15-21 (Preferred Dividends) The outstanding capital stock of Edna Millay Corporation consists of 2,000
shares of $100 par value, 8% preferred, and 5,000 shares of $50 par value common.
Instructions
Assuming that the company has retained earnings of $90,000, all of which is to be paid out in dividends,
and that preferred dividends were not paid during the 2 years preceding the current year, state how much
each class of stock should receive under each of the following conditions.
(a) The preferred stock is noncumulative and nonparticipating.
(b) The preferred stock is cumulative and nonparticipating.
Exercises Set B 865
(c) The preferred stock is cumulative and participating. (Round dividend rate percentages to four
decimal places.)
10 * E15-22 (Preferred Dividends) Matt Schmidt Company’s ledger shows the following balances on
December 31, 2014.
7% Preferred stock—$10 par value, outstanding 20,000 shares $ 200,000
Common stock—$100 par value, outstanding 30,000 shares 3,000,000
Retained earnings 630,000
Instructions
Assuming that the directors decide to declare total dividends in the amount of $366,000, determine how
much each class of stock should receive under each of the conditions stated below. One year’s dividends
are in arrears on the preferred stock.
(a) The preferred stock is cumulative and fully participating.
(b) The preferred stock is noncumulative and nonparticipating.
(c) The preferred stock is noncumulative and is participating in distributions in excess of a 10%
dividend rate on the common stock.
10 * E15-23 (Preferred Stock Dividends) Cajun Company has outstanding 2,500 shares of $100 par, 6% pre-
ferred stock and 15,000 shares of $10 par value common. The following schedule shows the amount of
dividends paid out over the last 4 years.
Instructions
Allocate the dividends to each type of stock under assumptions (a) and (b). Express your answers in per-
share amounts using the format shown below.
Assumptions
(a) (b)
Preferred, noncumulative, Preferred, cumulative,
and nonparticipating and fully participating
Year Paid-out Preferred Common Preferred Common
2012 $13,000
2013 $26,000
2014 $57,000
2015 $76,000
10 * E15-24 (Computation of Book Value per Share) Morgan Sondgeroth Inc. began operations in January
2012 and reported the following results for each of its 3 years of operations.
2012 $260,000 net loss 2013 $40,000 net loss 2014 $800,000 net income
At December 31, 2014, Morgan Sondgeroth Inc. capital accounts were as follows.
8% cumulative preferred stock, par value $100; authorized, issued,
and outstanding 5,000 shares $500,000
Common stock, par value $1.00; authorized 1,000,000 shares;
issued and outstanding 750,000 shares $750,000
Morgan Sondgeroth Inc. has never paid a cash or stock dividend. There has been no change in the
capital accounts since Sondgeroth began operations. The state law permits dividends only from retained
earnings.
Instructions
(a) Compute the book value of the common stock at December 31, 2014.
(b) Compute the book value of the common stock at December 31, 2014, assuming that the preferred |
stock has a liquidating value of $106 per share.
EXERCISES SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of exercises.
866 Chapter 15 Stockholders’ Equity
PROBLEMS
3 4 P15-1 (Equity Transactions and Statement Preparation) On January 5, 2014, Phelps Corporation received
9 a charter granting the right to issue 5,000 shares of $100 par value, 8% cumulative and nonparticipating
preferred stock, and 50,000 shares of $10 par value common stock. It then completed these transactions.
Jan. 11 Issued 20,000 shares of common stock at $16 per share.
Feb. 1 Issued to Sanchez Corp. 4,000 shares of preferred stock for the following assets: equipment with a fair
value of $50,000; a factory building with a fair value of $160,000; and land with an appraised value of
$270,000.
July 29 Purchased 1,800 shares of common stock at $17 per share. (Use cost method.)
Aug. 10 Sold the 1,800 treasury shares at $14 per share.
Dec. 31 Declared a $0.25 per share cash dividend on the common stock and declared the preferred dividend.
Dec. 31 Closed the Income Summary account. There was a $175,700 net income.
Instructions
(a) Record the journal entries for the transactions listed above.
(b) Prepare the stockholders’ equity section of Phelps Corporation’s balance sheet as of December 31,
2014.
4 9 P15-2 (Treasury Stock Transactions and Presentation) Clemson Company had the following stockhold-
ers’ equity as of January 1, 2014.
Common stock, $5 par value, 20,000 shares issued $100,000
Paid-in capital in excess of par—common stock 300,000
Retained earnings 320,000
Total stockholders’ equity $720,000
During 2014, the following transactions occurred.
Feb. 1 Clemson repurchased 2,000 shares of treasury stock at a price of $19 per share.
Mar. 1 800 shares of treasury stock repurchased above were reissued at $17 per share.
Mar. 18 500 shares of treasury stock repurchased above were reissued at $14 per share.
Apr. 22 600 shares of treasury stock repurchased above were reissued at $20 per share.
Instructions
(a) Prepare the journal entries to record the treasury stock transactions in 2014, assuming Clemson uses
the cost method.
(b) Prepare the stockholders’ equity section as of April 30, 2014. Net income for the first 4 months of
2014 was $130,000.
3 4 P15-3 (Equity Transactions and Statement Preparation) Hatch Company has two classes of capital stock
7 8 outstanding: 8%, $20 par preferred and $5 par common. At December 31, 2014, the following accounts were
included in stockholders’ equity.
Preferred Stock, 150,000 shares $ 3,000,000
Common Stock, 2,000,000 shares 10,000,000
Paid-in Capital in Excess of Par—Preferred Stock 200,000
Paid-in Capital in Excess of Par—Common Stock 27,000,000
Retained Earnings 4,500,000
The following transactions affected stockholders’ equity during 2015.
Jan. 1 30,000 shares of preferred stock issued at $22 per share.
Feb. 1 50,000 shares of common stock issued at $20 per share.
June 1 2-for-1 stock split (par value reduced to $2.50).
July 1 30,000 shares of common treasury stock purchased at $10 per share. Hatch uses the cost method.
Sept. 15 10,000 shares of treasury stock reissued at $11 per share.
Dec. 31 The preferred dividend is declared, and a common dividend of 50¢ per share is declared.
Dec. 31 Net income is $2,100,000.
Instructions
Prepare the stockholders’ equity section for Hatch Company at December 31, 2015. Show all supporting
computations.
Problems 867
3 5 P15-4 (Stock Transactions—Lump Sum) Seles Corporation’s charter authorized issuance of 100,000
shares of $10 par value common stock and 50,000 shares of $50 preferred stock. The following transactions
involving the issuance of shares of stock were completed. Each transaction is independent of the others.
1. Issued a $10,000, 9% bond payable at par and gave as a bonus one share of preferred stock, which at
that time was selling for $106 a share.
2. Issued 500 shares of common stock for equipment. The equipment had been appraised at $7,100; the
seller’s book value was $6,200. The most recent market price of the common stock is $16 a share. |
3. Issued 375 shares of common and 100 shares of preferred for a lump sum amounting to $10,800. The
common had been selling at $14 and the preferred at $65.
4. Issued 200 shares of common and 50 shares of preferred for equipment. The common had a fair
value of $16 per share; the equipment has a fair value of $6,500.
Instructions
Record the transactions listed above in journal entry form.
4 P15-5 (Treasury Stock—Cost Method) Before Gordon Corporation engages in the treasury stock transac-
tions listed below, its general ledger reflects, among others, the following account balances (par value of its
stock is $30 per share).
Paid-in Capital in Excess of Par—Common Stock Common Stock Retained Earnings
$99,000 $270,000 $80,000
Instructions
Record the treasury stock transactions (given below) under the cost method of handling treasury stock; use
the FIFO method for purchase-sale purposes.
(a) Bought 380 shares of treasury stock at $40 per share.
(b) Bought 300 shares of treasury stock at $45 per share.
(c) Sold 350 shares of treasury stock at $42 per share.
(d) Sold 110 shares of treasury stock at $38 per share.
4 7 P15-6 (Treasury Stock—Cost Method—Equity Section Preparation) Washington Company has the
9 following stockholders’ equity accounts at December 31, 2014.
Common Stock ($100 par value, authorized 8,000 shares) $480,000
Retained Earnings 294,000
Instructions
(a) Prepare entries in journal form to record the following transactions, which took place during 2015.
(1) 280 shares of outstanding stock were purchased at $97 per share. (These are to be accounted for
using the cost method.)
(2) A $20 per share cash dividend was declared.
(3) The dividend declared in (2) above was paid.
(4) The treasury shares purchased in (1) above were resold at $102 per share.
(5) 500 shares of outstanding stock were purchased at $105 per share.
(6) 350 of the shares purchased in (5) above were resold at $96 per share.
(b) Prepare the stockholders’ equity section of Washington Company’s balance sheet after giving effect
to these transactions, assuming that the net income for 2015 was $94,000. State law requires restric-
tion of retained earnings for the amount of treasury stock.
4 7 P15-7 (Cash Dividend Entries) The books of Conchita Corporation carried the following account balances
as of December 31, 2014.
Cash $ 195,000
Preferred Stock (6% cumulative, nonparticipating, $50 par) 300,000
Common Stock (no-par value, 300,000 shares issued) 1,500,000
Paid-in Capital in Excess of Par—Preferred Stock 150,000
Treasury Stock (common 2,800 shares at cost) 33,600
Retained Earnings 105,000
The company decided not to pay any dividends in 2014.
The board of directors, at their annual meeting on December 21, 2015, declared the following: “The
current year dividends shall be 6% on the preferred and $.30 per share on the common. The dividends in
arrears shall be paid by issuing 1,500 shares of treasury stock.” At the date of declaration, the preferred is
selling at $80 per share, and the common at $12 per share. Net income for 2015 is estimated at $77,000.
868 Chapter 15 Stockholders’ Equity
Instructions
(a) Prepare the journal entries required for the dividend declaration and payment, assuming that they
occur simultaneously.
(b) Could Conchita Corporation give the preferred stockholders 2 years’ dividends and common stock-
holders a 30 cents per share dividend, all in cash?
7 8 P15-8 (Dividends and Splits) Myers Company provides you with the following condensed balance sheet
information.
Assets Liabilities and Stockholders’ Equity
Current assets $ 40,000 Current and long-term liabilities $100,000
Equity investments (trading) 60,000 Stockholders’ equity
Equipment (net) 250,000 Common stock ($5 par) $ 20,000
Intangibles 60,000 Paid-in capital in excess of par 110,000
Total assets $410,000 Retained earnings 180,000 310,000
Total liabilities and
stockholders’ equity $410,000
Instructions
For each transaction below, indicate the dollar impact (if any) on the following five items: (1) total assets,
(2) common stock, (3) paid-in capital in excess of par, (4) retained earnings, and (5) stockholders’ equity. |
(Each situation is independent.)
(a) Myers declares and pays a $0.50 per share cash dividend.
(b) Myers declares and issues a 10% stock dividend when the market price of the stock is $14 per share.
(c) Myers declares and issues a 30% stock dividend when the market price of the stock is $15 per share.
(d) Myers declares and distributes a property dividend. Myers gives one share of its equity investment
(ABC stock) for every two shares of Myers Company stock held. Myers owns 10,000 shares of ABC.
ABC is selling for $10 per share on the date the property dividend is declared.
(e) Myers declares a 2-for-1 stock split and issues new shares.
3 4 P15-9 (Stockholders’ Equity Section of Balance Sheet) The following is a summary of all relevant trans-
7 9 actions of Vicario Corporation since it was organized in 2014.
In 2014, 15,000 shares were authorized and 7,000 shares of common stock ($50 par value) were issued
at a price of $57. In 2015, 1,000 shares were issued as a stock dividend when the stock was selling for $60.
Three hundred shares of common stock were bought in 2016 at a cost of $64 per share. These 300 shares are
still in the company treasury.
In 2015, 10,000 preferred shares were authorized and the company issued 5,000 of them ($100 par
value) at $113. Some of the preferred stock was reacquired by the company and later reissued for $4,700
more than it cost the company.
The corporation has earned a total of $610,000 in net income after income taxes and paid out a total of
$312,600 in cash dividends since incorporation.
Instructions
Prepare the stockholders’ equity section of the balance sheet in proper form for Vicario Corporation as of
December 31, 2016. Account for treasury stock using the cost method.
8 P15-10 (Stock Dividends and Stock Split) Oregon Inc. $10 par common stock is selling for $110 per share.
Four million shares are currently issued and outstanding. The board of directors wishes to stimulate inter-
est in Oregon common stock before a forthcoming stock issue but does not wish to distribute capital at this
time. The board also believes that too many adjustments to the stockholders’ equity section, especially
retained earnings, might discourage potential investors.
The board has considered three options for stimulating interest in the stock:
1. A 20% stock dividend.
2. A 100% stock dividend.
3. A 2-for-1 stock split.
Instructions
Acting as financial advisor to the board, you have been asked to report briefly on each option and, consid-
ering the board’s wishes, make a recommendation. Discuss the effects of each of the foregoing options.
7 8 P15-11 (Stock and Cash Dividends) Earnhart Corporation has outstanding 3,000,000 shares of common
9 stock of a par value of $10 each. The balance in its Retained Earnings account at January 1, 2014, was
$24,000,000, and it then had Paid-in Capital in Excess of Par—Common Stock of $5,000,000. During 2014,
Problems 869
the company’s net income was $4,700,000. A cash dividend of $0.60 a share was declared on May 5, 2014,
and was paid June 30, 2014, and a 6% stock dividend was declared on November 30, 2014, and distributed
to stockholders of record at the close of business on December 31, 2014. You have been asked to advise on
the proper accounting treatment of the stock dividend.
The existing stock of the company is quoted on a national stock exchange. The market price of the
stock has been as follows.
October 31, 2014 $31
November 30, 2014 $34
December 31, 2014 $38
Instructions
(a) Prepare the journal entry to record the declaration and payment of the cash dividend.
(b) Prepare the journal entry to record the declaration and distribution of the stock dividend.
(c) Prepare the stockholders’ equity section (including schedules of retained earnings and additional
paid-in capital) of the balance sheet of Earnhart Corporation for the year 2014 on the basis of the
foregoing information. Draft a note to the financial statements setting forth the basis of the account-
ing for the stock dividend, and add separately appropriate comments or explanations regarding the |
basis chosen.
3 4 P15-12 (Analysis and Classification of Equity Transactions) Penn Company was formed on July 1, 2012.
7 8 It was authorized to issue 300,000 shares of $10 par value common stock and 100,000 shares of 8% $25 par
value, cumulative and nonparticipating preferred stock. Penn Company has a July 1–June 30 fiscal year.
9
The following information relates to the stockholders’ equity accounts of Penn Company.
Common Stock
Prior to the 2014–2015 fiscal year, Penn Company had 110,000 shares of outstanding common stock issued
as follows.
1. 85,000 shares were issued for cash on July 1, 2012, at $31 per share.
2. On July 24, 2012, 5,000 shares were exchanged for a plot of land which cost the seller $70,000 in 2006
and had an estimated fair value of $220,000 on July 24, 2012.
3. 20,000 shares were issued on March 1, 2013, for $42 per share.
During the 2014–2015 fiscal year, the following transactions regarding common stock took place.
November 30, 2014 Penn purchased 2,000 shares of its own stock on the open market at $39 per share.
Penn uses the cost method for treasury stock.
December 15, 2014 Penn declared a 5% stock dividend for stockholders of record on January 15, 2015,
to be issued on January 31, 2015. Penn was having a liquidity problem and could
not afford a cash dividend at the time. Penn’s common stock was selling at $52 per
share on December 15, 2014.
June 20, 2015 Penn sold 500 shares of its own common stock that it had purchased on November
30, 2014, for $21,000.
Preferred Stock
Penn issued 40,000 shares of preferred stock at $44 per share on July 1, 2013.
Cash Dividends
Penn has followed a schedule of declaring cash dividends in December and June, with payment being
made to stockholders of record in the following month. The cash dividends which have been declared since
inception of the company through June 30, 2015, are shown below.
Declaration Common Preferred
Date Stock Stock
12/15/13 $0.30 per share $1.00 per share
6/15/14 $0.30 per share $1.00 per share
12/15/14 — $1.00 per share
No cash dividends were declared during June 2015 due to the company’s liquidity problems.
Retained Earnings
As of June 30, 2014, Penn’s retained earnings account had a balance of $690,000. For the fiscal year ending
June 30, 2015, Penn reported net income of $40,000.
Instructions
Prepare the stockholders’ equity section of the balance sheet, including appropriate notes, for Penn
Company as of June 30, 2015, as it should appear in its annual report to the shareholders.
(CMA adapted)
870 Chapter 15 Stockholders’ Equity
PROBLEMS SET B
See the book’s companion website, at www.wiley.com/college/kieso, for an additional
set of problems.
CONCEPTS FOR ANALYSIS
CA15-1 (Preemptive Rights and Dilution of Ownership) Wallace Computer Company is a small, closely
held corporation. Eighty percent of the stock is held by Derek Wallace, president. Of the remainder, 10% is
held by members of his family and 10% by Kathy Baker, a former officer who is now retired. The balance
sheet of the company at June 30, 2014, was substantially as shown below.
Assets Liabilities and Stockholders’ Equity
Cash $ 22,000 Current liabilities $ 50,000
Other 450,000 Common stock 250,000
$472,000 Retained earnings 172,000
$472,000
Additional authorized common stock of $300,000 par value had never been issued. To strengthen the cash
position of the company, Wallace issued common stock with a par value of $100,000 to himself at par for
cash. At the next stockholders’ meeting, Baker objected and claimed that her interests had been injured.
Instructions
(a) Which stockholder’s right was ignored in the issue of shares to Derek Wallace?
(b) How may the damage to Baker’s interests be repaired most simply?
(c) If Derek Wallace offered Baker a personal cash settlement and they agreed to employ you as an
impartial arbitrator to determine the amount, what settlement would you propose? Present your
calculations with sufficient explanation to satisfy both parties.
CA15-2 (Issuance of Stock for Land) Martin Corporation is planning to issue 3,000 shares of its own |
$10 par value common stock for two acres of land to be used as a building site.
Instructions
(a) What general rule should be applied to determine the amount at which the land should be recorded?
(b) Under what circumstances should this transaction be recorded at the fair value of the land?
(c) Under what circumstances should this transaction be recorded at the fair value of the stock issued?
(d) Assume Martin intentionally records this transaction at an amount greater than the fair value of the
land and the stock. Discuss this situation.
CA15-3 (Conceptual Issues—Equity) Statements of Financial Accounting Concepts set forth financial
accounting and reporting objectives and fundamentals that will be used by the Financial Accounting
Standards Board in developing standards. Concepts Statement No. 6 defines various elements of financial
statements.
Instructions
Answer the following questions based on SFAC No. 6.
(a) Define and discuss the term “equity.”
(b) What transactions or events change owners’ equity?
(c) Define “investments by owners” and provide examples of this type of transaction. What financial
statement element other than equity is typically affected by owner investments?
(d) Define “distributions to owners” and provide examples of this type of transaction. What financial
statement element other than equity is typically affected by distributions?
(e) What are examples of changes within owners’ equity that do not change the total amount of owners’
equity?
CA15-4 (Stock Dividends and Splits) The directors of Merchant Corporation are considering the issu-
ance of a stock dividend. They have asked you to discuss the proposed action by answering the following
questions.
Using Your Judgment 871
Instructions
(a) What is a stock dividend? How is a stock dividend distinguished from a stock split (1) from a legal
standpoint, and (2) from an accounting standpoint?
(b) For what reasons does a corporation usually declare a stock dividend? A stock split?
(c) Discuss the amount, if any, of retained earnings to be capitalized in connection with a stock dividend.
(AICPA adapted)
CA15-5 (Stock Dividends) Kulikowski Inc., a client, is considering the authorization of a 10% common
stock dividend to common stockholders. The financial vice president of Kulikowski wishes to discuss the
accounting implications of such an authorization with you before the next meeting of the board of directors.
Instructions
(a) The first topic the vice president wishes to discuss is the nature of the stock dividend to the recipient.
Discuss the case against considering the stock dividend as income to the recipient.
(b) The other topic for discussion is the propriety of issuing the stock dividend to all “stockholders of
record” or to “stockholders of record exclusive of shares held in the name of the corporation as
treasury stock.” Discuss the case against issuing stock dividends on treasury shares.
(AICPA adapted)
CA15-6 (Stock Dividend, Cash Dividend, and Treasury Stock) Mask Company has 30,000 shares of
$10 par value common stock authorized and 20,000 shares issued and outstanding. On August 15, 2014,
Mask purchased 1,000 shares of treasury stock for $18 per share. Mask uses the cost method to account for
treasury stock. On September 14, 2014, Mask sold 500 shares of the treasury stock for $20 per share.
In October 2014, Mask declared and distributed 1,950 shares as a stock dividend from unissued shares
when the market price of the common stock was $21 per share.
On December 20, 2014, Mask declared a $1 per share cash dividend, payable on January 10, 2015, to
shareholders of record on December 31, 2014.
Instructions
(a) How should Mask account for the purchase and sale of the treasury stock, and how should the
treasury stock be presented in the balance sheet at December 31, 2014?
(b) How should Mask account for the stock dividend, and how would it affect the stockholders’ equity
at December 31, 2014? Why?
(c) How should Mask account for the cash dividend, and how would it affect the balance sheet at
December 31, 2014? Why? |
(AICPA adapted)
CA15-7 (Treasury Stock—Ethics) Lois Kenseth, president of Sycamore Corporation, is concerned about
several large stockholders who have been very vocal lately in their criticisms of her leadership. She thinks
they might mount a campaign to have her removed as the corporation’s CEO. She decides that buying
them out by purchasing their shares could eliminate them as opponents, and she is confident they would
accept a “good” offer. Kenseth knows the corporation’s cash position is decent, so it has the cash to com-
plete the transaction. She also knows the purchase of these shares will increase earnings per share, which
should make other investors quite happy. (Earnings per share is calculated by dividing net income avail-
able for the common shareholders by the weighted-average number of shares outstanding. Therefore, if the
number of shares outstanding is decreased by purchasing treasury shares, earnings per share increases.)
Instructions
Answer the following questions.
(a) Who are the stakeholders in this situation?
(b) What are the ethical issues involved?
(c) Should Kenseth authorize the transaction?
USING YOUR JUDGMENT
FINANCIAL REPORTING
Financial Reporting Problem
The Procter & Gamble Company (P&G)
The financial statements of P&G are presented in Appendix 5B. The company’s complete annual report,
including the notes to the financial statements, can be accessed at the book’s companion website, www.
wiley.com/college/kieso.
872 Chapter 15 Stockholders’ Equity
Instructions
Refer to P&G’s financial statements and the accompanying notes to answer the following questions.
(a) What is the par or stated value of P&G’s preferred stock?
(b) What is the par or stated value of P&G’s common stock?
(c) What percentage of P&G’s authorized common stock was issued at June 30, 2011?
(d) How many shares of common stock were outstanding at June 30, 2011, and June 30, 2010?
(e) What was the dollar amount effect of the cash dividends on P&G’s stockholders’ equity?
(f) What is P&G’s return on common stock equity for 2011 and 2010?
(g) What is P&G’s payout ratio for 2011 and 2010?
(h) What was the market price range (high/low) of P&G’s common stock during the quarter ended
June 30, 2011?
Comparative Analysis Case
The Coca-Cola Company and PepsiCo, Inc.
Instructions
Go to the book’s companion website and use information found there to answer the following questions
related to The Coca-Cola Company and PepsiCo, Inc.
(a) What is the par or stated value of Coca-Cola’s and PepsiCo’s common or capital stock?
(b) What percentage of authorized shares was issued by Coca-Cola at December 31, 2011, and by PepsiCo
at December 31, 2011?
(c) How many shares are held as treasury stock by Coca-Cola at December 31, 2011, and by PepsiCo at
December 31, 2011?
(d) How many Coca-Cola common shares are outstanding at December 31, 2011? How many PepsiCo
shares of capital stock are outstanding at December 31, 2011?
(e) What amounts of cash dividends per share were declared by Coca-Cola and PepsiCo in 2011? What
were the dollar amount effects of the cash dividends on each company’s stockholders’ equity?
(f) What are Coca-Cola’s and PepsiCo’s return on common/capital stock equity for 2011 and 2010? Which
company gets the higher return on the equity of its shareholders?
(g) What are Coca-Cola’s and PepsiCo’s payout ratios for 2011?
(h) What was the market price range (high/low) for Coca-Cola’s common stock and PepsiCo’s capital
stock during the fourth quarter of 2011? Which company’s (Coca-Cola’s or PepsiCo’s) stock price
increased more (%) during 2011?
Financial Statement Analysis Cases
Case 1 Kellogg Company
Kellogg Company is the world’s leading producer of ready-to-eat cereal products. In recent years, the
company has taken numerous steps aimed at improving its profitability and earnings per share. Presented
below are some basic facts for Kellogg.
2011 2010
Net sales $13,198 $12,397
Net income 1,229 1,240
Total assets 11,901 11,847
Total liabilities 10,139 9,693
Common stock, $0.25 par value 105 105
Capital in excess of par value 522 495 |
Retained earnings 6,721 6,122
Treasury stock, at cost 3,130 2,650
Number of shares outstanding (in millions) 357 366
Instructions
(a) What are some of the reasons that management purchases its own stock?
(b) Explain how earnings per share might be affected by treasury stock transactions.
(c) Calculate the ratio of debt to assets for 2010 and 2011, and discuss the implications of the change.
Using Your Judgment 873
Case 2 Wiebold, Incorporated
The following note related to stockholders’ equity was reported in Wiebold, Inc.’s annual report.
On February 1, the Board of Directors declared a 3-for-2 stock split, distributed on February 22 to share-
holders of record on February 10. Accordingly, all numbers of common shares, except unissued shares
and treasury shares, and all per share data have been restated to reflect this stock split.
On the basis of amounts declared and paid, the annualized quarterly dividends per share were
$0.80 in the current year and $0.75 in the prior year.
Instructions
(a) What is the significance of the date of record and the date of distribution?
(b) Why might Wiebold have declared a 3-for-2 for stock split?
(c) What impact does Wiebold’s stock split have on (1) total stockholders’ equity, (2) total par value,
(3) outstanding shares, and (4) book value per share?
Accounting, Analysis, and Principles
On January 1, 2014, Agassi Corporation had the following stockholders’ equity accounts.
Common Stock ($10 par value, 60,000 shares issued and outstanding) $600,000
Paid-in Capital in Excess of Par—Common Stock 500,000
Retained Earnings 620,000
During 2014, the following transactions occurred.
Jan. 15 Declared and paid a $1.05 cash dividend per share to stockholders.
Apr. 15 Declared and paid a 10% stock dividend. The market price of the stock was $14 per share.
May 15 Reacquired 2,000 common shares at a market price of $15 per share.
Nov. 15 Reissued 1,000 shares held in treasury at a price of $18 per share.
Dec. 31 Determined that net income for the year was $370,000.
Accounting
Journalize the above transactions. (Include entries to close net income to Retained Earnings.) Determine
the ending balances for Paid-in Capital, Retained Earnings, and Stockholders’ Equity.
Analysis
Calculate the payout ratio and the return on common stock equity.
Principles
R. Federer is examining Agassi’s financial statements and wonders whether the “gains” or “losses” on
Agassi’s treasury stock transactions should be included in income for the year. Briefly explain whether,
and the conceptual reasons why, gains or losses on treasury stock transactions should be recorded in
income.
BRIDGE TO THE PROFESSION
Professional Research: FASB Codifi cation
Recall from Chapter 13 that Hincapie Co. (a specialty bike-accessory manufacturer) is expecting growth
in sales of some products targeted to the low-price market. Hincapie is contemplating a preferred stock
issue to help finance this expansion in operations. The company is leaning toward participating preferred
stock because ownership will not be diluted, but the investors will get an extra dividend if the company
does well. The company management wants to be certain that its reporting of this transaction is transparent
to its current shareholders and wants you to research the disclosure requirements related to its capital
structure.
Instructions
If your school has a subscription to the FASB Codification, go to http://aaahq.org/ascLogin.cfm to log in and
prepare responses to the following. Provide Codification references for your responses.
874 Chapter 15 Stockholders’ Equity
(a) Identify the authoritative literature that addresses disclosure of information about capital structure.
(b) Find definitions of the following:
(1) Securities.
(2) Participation rights.
(3) Preferred stock.
(c) What information about securities must companies disclose? Discuss how Hincapie should report the
proposed preferred stock issue.
Additional Professional Resources
See the book’s companion website, at www.wiley.com/college/kieso, for professional
simulations as well as other study resources. |
IFRS INSIGHTS
The primary IFRS related to stockholders’ equity are IAS 1 (“Presentation of Finan-
LEARNING OBJECTIVE 11
cial Statements”), IAS 32 (“Financial Instruments: Presentation”), and IAS 39
Compare the procedures for accounting
(“Financial Instruments: Recognition and Measurement”).
for stockholders’ equity under GAAP
and IFRS.
RELEVANT FACTS
Following are the key similarities and differences between GAAP and IFRS related to
stockholders’ equity.
Similarities
• The accounting for the issuance of shares and purchase of treasury stock are similar
under both IFRS and GAAP.
• The accounting for declaration and payment of dividends and the accounting for
stock splits are similar under both IFRS and GAAP.
Differences
• Major differences relate to terminology used, introduction of concepts such as revalu-
ation surplus, and presentation of stockholders’ equity information.
• Many countries have different investor groups than the United States. For example, in
Germany, fi nancial institutions like banks are not only the major creditors but often
are the largest shareholders as well. In the United States and the United Kingdom,
many companies rely on substantial investment from private investors.
• The accounting for treasury share retirements differs between IFRS and GAAP. Under
GAAP, a company has three options: (1) charge the excess of the cost of treasury
shares over par value to retained earnings, (2) allocate the difference between paid-in
capital and retained earnings, or (3) charge the entire amount to paid-in capital. Under
IFRS, the excess may have to be charged to paid-in capital, depending on the original
transaction related to the issuance of the shares.
• The statement of changes in equity is usually referred to as the statement of stock-
holders’ equity (or shareholders’ equity) under GAAP.
• Both IFRS and GAAP use the term retained earnings. However, IFRS relies on the term
“reserve” as a dumping ground for other types of equity transactions, such as other
comprehensive income items as well as various types of unusual transactions related
IFRS Insights 875
to convertible debt and share option contracts. GAAP relies on the account Accumu-
lated Other Comprehensive Income (Loss). We also use this account in the discussion
below, as it appears this account is gaining prominence within the IFRS literature.
• Under IFRS, it is common to report “revaluation surplus” related to increases or
decreases in items such as property, plant, and equipment; mineral resources; and
intangible assets. The term surplus is generally not used in GAAP. In addition, unrealized
gains on the above items are not reported in the fi nancial statements under GAAP.
ABOUT THE NUMBERS
Equity
Equity is the residual interest in the assets of the company after deducting all liabilities.
Equity is often referred to as shareholders’ equity, stockholders’ equity, or corporate
capital. Equity is often subclassified on the statement of financial position (balance
sheet) into the following categories (as discussed in Chapter 5).
1. Share capital. 4. Accumulated other comprehensive income.
2. Share premium. 5. Treasury shares.
3. Retained earnings. 6. Non-controlling interest (minority interest).
Such classifications help financial statement users to better understand the legal or other
restrictions related to the ability of the company to pay dividends or otherwise use its
equity for certain defined purposes. Companies often make a distinction between con-
tributed capital (paid-in capital) and earned capital. Contributed capital (paid-in capi-
tal) is the total amount paid in on capital shares—the amount provided by shareholders
to the corporation for use in the business. Contributed capital includes items such as the
par value of all outstanding shares and premiums less discounts on issuance. Earned
capital is the capital that develops from profitable operations. It consists of all undistrib-
uted income that remains invested in the company. Retained earnings represents the
earned capital of the company.
As indicated above, equity is a residual interest and therefore its value is derived |
from the amount of the corporations’ assets and liabilities. Only in unusual cases will a
company’s equity equal the total fair value of its shares. For example, BMW recently
had total equity of €20,265 million and a market capitalization of €21,160 million.
BMW’s equity represents the net contributions from shareholders (from both majority
and minority shareholders) plus retained earnings and accumulated other comprehen-
sive income. As a residual interest, its equity has no existence apart from the assets
and liabilities of BMW—equity equals net assets. Equity is not a claim to specific assets
but a claim against a portion of the total assets. Its amount is not specified or fixed; it
depends on BMW’s profitability. Equity grows if it is profitable. It shrinks, or may disap-
pear entirely, if BMW loses money.
Issuance of Ordinary Shares
Under IFRS, the accounting for share issuances is similar to GAAP. The primary differ-
ence is the account titles. GAAP uses an account, Common Stock, for the par value of
shares, while IFRS uses an account labeled Share Capital. What about no-par shares? In
some countries, as in the United States, the total issue price for no-par shares may be
considered legal capital, which could reduce the flexibility in paying dividends. Corpo-
rations sell no-par shares, like par value shares, for whatever price they will bring. How-
ever, unlike par value shares, corporations issue them without a premium or a discount.
The exact amount received represents the credit to ordinary or preference shares.
876 Chapter 15 Stockholders’ Equity
For example, Video Electronics Corporation is organized with 10,000 ordinary
shares authorized without par value. Video Electronics makes only a memorandum
entry for the authorization, inasmuch as no amount is involved. If Video Electronics
then issues 500 shares for cash at $10 per share, it makes the following entry.
Cash 5,000
Share Capital—Ordinary 5,000
If it issues another 500 shares for $11 per share, Video Electronics makes this entry.
Cash 5,500
Share Capital—Ordinary 5,500
True no-par shares should be carried in the accounts at issue price without any share
premium reported. But some countries require that no-par shares have a stated value.
The stated value is a minimum value below which a company cannot issue it. Thus, in-
stead of being no-par shares, such stated-value shares become, in effect, shares with a
very low par value. It thus is open to all the criticism and abuses that first encouraged
the development of no-par shares.
If no-par shares have a stated value of $5 per share but sell for $11, all such amounts
in excess of $5 are recorded as share premium, which in many jurisdictions is fully or
partially available for dividends. Thus, no-par value shares, with a low stated value,
permit a new corporation to commence its operations with share premium that may
exceed its stated capital. For example, if a company issued 1,000 of the shares with a $5
stated value at $15 per share for cash, it makes the following entry.
Cash 15,000
Share Capital—Ordinary 5,000
Share Premium—Ordinary 10,000
Most corporations account for no-par shares with a stated value as if they were par
value shares with par equal to the stated value.
Accounting for and Reporting Preference Shares
The accounting for preference shares at issuance is similar to that for ordinary shares. A
corporation allocates proceeds between the par value of the preference shares and share
premium. To illustrate, assume that Bishop Co. issues 10,000 shares of $10 par value
preference shares for $12 cash per share. Bishop records the issuance as follows.
Cash 120,000
Share Capital—Preference 100,000
Share Premium—Preference 20,000
Thus, Bishop maintains separate accounts for these different classes of shares. Corpora-
tions consider convertible preference shares as a part of equity. In addition, when exercis-
ing convertible preference shares, there is no theoretical justification for recognition of a
gain or loss. A company recognizes no gain or loss when dealing with shareholders in |
their capacity as business owners. Instead, the company employs the book value method:
debit Share Capital—Preference, along with any related Share Premium—Preference;
credit Share Capital—Ordinary and Share Premium—Ordinary (if an excess exists).
Preference shares generally have no maturity date. Therefore, no legal obligation
exists to pay the preference shareholder. As a result, companies classify preference
shares as part of equity. Companies generally report preference shares at par value as
the first item in the equity section. They report any excess over par value as part of share
premium. They also consider dividends on preference shares as a distribution of income
and not an expense. Companies must disclose the pertinent rights of the preference
shares outstanding.
IFRS Insights 877
Presentation of Equity
Statement of Financial Position
Illustration IFRS15-1 shows a comprehensive equity section from the statement of finan-
cial position of Frost Company that includes the equity items we discussed previously.
ILLUSTRATION
FROST COMPANY
IFRS15-1
EQUITY
DECEMBER 31, 2014 Comprehensive Equity
Presentation
Share capital—preference, $100 par value, 7% cumulative,
100,000 shares authorized, 30,000 shares issued and outstanding $3,000,000
Share capital—ordinary, no-par, stated value $10 per share,
500,000 shares authorized, 400,000 shares issued 4,000,000
Ordinary share dividend distributable 200,000 $ 7,200,000
Share premium—preference 150,000
Share premium—ordinary 840,000 990,000
Retained earnings 4,360,000
Treasury shares (2,000 ordinary shares) (190,000)
Accumulated other comprehensive loss (360,000)
Total equity $12,000,000
Frost should disclose the pertinent rights and privileges of the various securities out-
standing. For example, companies must disclose all of the following: dividend and liquida-
tion preferences, participation rights, call prices and dates, conversion or exercise prices
and pertinent dates, sinking fund requirements, unusual voting rights, and significant
terms of contracts to issue additional shares. Liquidation preferences should be disclosed
in the equity section of the statement of financial position, rather than in the notes to the
financial statements, to emphasize the possible effect of this restriction on future cash flows.
Presentation of Statement of Changes in Equity
Companies are also required to present a statement of changes in equity. The statement
of changes in equity includes the following.
1. Total comprehensive income for the period, showing separately the total amounts
attributable to owners of the parent and to non-controlling interests.
2. For each component of equity, the effects of retrospective application or retrospec-
tive restatement.
3. For each component of equity, a reconciliation between the carrying amount at the
beginning and the end of the period, separately disclosing changes resulting from:
(a) Profi t or loss;
(b) Each item of other comprehensive income; and
(c) Transactions with owners in their capacity as owners, showing separately con-
tributions by and distributions to owners and changes in ownership interests in ILLUSTRATION
IFRS15-2
subsidiaries that do not result in a loss of control.
Statement of Changes
A typical statement of changes in equity is shown in Illustration IFRS15-2. in Equity
Unrealized Holding Gain Unrealized Holding Gain
Share Retained (Loss) on Non-Trading (Loss) on Property, Plant,
Capital Earnings Equity Investments and Equipment Total
Balance—December 31, 2014 $600,000 $120,000 $22,000 $15,000 $ 757,000
Issue of Ordinary Shares 200,000 200,000
Total Comprehensive Income 70,000 11,000 8,000 89,000
Dividends (20,000) (20,000)
Balance—December 31, 2015 $800,000 $170,000 $33,000 $23,000 $1,026,000
878 Chapter 15 Stockholders’ Equity
In addition, companies are required to present, either in the statement of changes in
equity or in the notes, the amount of dividends recognized as distributions to owners
during the period and the related amount per share.
ON THE HORIZON
As indicated in earlier discussions, the IASB and the FASB are currently working on a |
project related to financial statement presentation. An important part of this study is to
determine whether certain line items, subtotals, and totals should be clearly defined and
required to be displayed in the financial statements. For example, it is likely that the
statement of changes in equity and its presentation will be examined closely. In addi-
tion, the options of how to present other comprehensive income under GAAP will
change in any converged standard.
IFRS SELF-TEST QUESTIONS
1. Which of the following does not represent a pair of GAAP/IFRS-comparable terms?
(a) Additional paid-in capital/Share premium.
(b) Treasury stock/Repurchase reserve.
(c) Common stock/Share capital—ordinary.
(d) Preferred stock/Preference shares.
2. Under IFRS, the amount of capital received in excess of par value would be credited to:
(a) Retained Earnings. (c) Share Premium.
(b) Contributed Capital. (d) Par value is not used under IFRS.
3. The term reserves is used under IFRS with reference to all of the following except:
(a) gains and losses on revaluation of property, plant, and equipment.
(b) capital received in excess of the par value of issued shares.
(c) retained earnings.
(d) fair value differences.
4. Which of the following is false?
(a) Under GAAP, companies cannot record gains on transactions involving their own shares.
(b) Under IFRS, companies cannot record gains on transactions involving their own shares.
(c) Under IFRS, the statement of stockholders’ equity is a required statement.
(d) Under IFRS, a company records a revaluation surplus when it experiences an increase in the
price of its common stock.
5. Under IFRS, a purchase by a company of its own shares results in:
(a) an increase in treasury shares. (c) a decrease in equity.
(b) a decrease in assets. (d) All of the above.
IFRS CONCEPTS AND APPLICATION
IFRS15-1 Where can authoritative IFRS guidance related to stockholders’ equity be found?
IFRS15-2 Briefly describe some of the similarities and differences between GAAP and IFRS with respect to
the accounting for stockholders’ equity.
IFRS15-3 Briefly discuss the implications of the financial statement presentation project for the reporting
of stockholders’ equity.
IFRS15-4 Mary Tokar is comparing a GAAP-based company to a company that uses IFRS. Both companies
report equity investments. The IFRS company reports unrealized losses on these investments under the
heading “Reserves” in its equity section. However, Mary can find no similar heading in the GAAP-based
company financial statements. Can Mary conclude that the GAAP-based company has no unrealized gains
or losses on its non-trading equity investments? Explain.
IFRS15-5 Explain each of the following terms: authorized ordinary shares, unissued ordinary shares, is-
sued ordinary shares, outstanding ordinary shares, and treasury shares.
IFRS Insights 879
IFRS15-6 Indicate how each of the following accounts should be classified in the equity section.
(a) Share Capital—Ordinary. (e) Share Premium—Treasury.
(b) Retained Earnings. (f) Share Capital—Preference.
(c) Share Premium—Ordinary. (g) Accumulated Other Comprehensive Income.
(d) Treasury Shares.
IFRS15-7 Kaymer Corporation issued 300 shares of $10 par value ordinary shares for $4,500. Prepare
Kaymer’s journal entry.
IFRS15-8 Wilco Corporation has the following account balances at December 31, 2014.
Share capital—ordinary, $5 par value $ 510,000
Treasury shares 90,000
Retained earnings 2,340,000
Share premium—ordinary 1,320,000
Instructions
Prepare Wilco’s December 31, 2014, equity section.
IFRS15-9 Ravonette Corporation issued 300 shares of $10 par value ordinary shares and 100 shares of
$50 par value preference shares for a lump sum of $13,500. The ordinary shares have a market price of $20
per share, and the preference shares have a market price of $90 per share.
Instructions
Prepare the journal entry to record the issuance.
IFRS15-10 Weisberg Corporation has 10,000 shares of $100 par value, 6%, preference shares and 50,000
ordinary shares of $10 par value outstanding at December 31, 2014. |
Instructions
Answer the questions in each of the following independent situations.
(a) If the preference shares are cumulative and dividends were last paid on the preference shares on
December 31, 2011, what are the dividends in arrears that should be reported on the December 31,
2014, statement of financial position? How should these dividends be reported?
(b) If the preference shares are convertible into seven shares of $10 par value ordinary shares and 3,000
shares are converted, what entry is required for the conversion, assuming the preference shares
were issued at par value?
(c) If the preference shares were issued at $107 per share, how should the preference shares be reported
in the equity section?
IFRS15-11 Teller Corporation’s post-closing trial balance at December 31, 2014, was as follows.
TELLER CORPORATION
POST-CLOSING TRIAL BALANCE
DECEMBER 31, 2014
Dr. Cr.
Accounts payable $ 310,000
Accounts receivable $ 480,000
Accumulated depreciation—building and equipment 185,000
Allowance for doubtful accounts 30,000
Bonds payable 700,000
Building and equipment 1,450,000
Cash 190,000
Dividends payable on preference shares—cash 4,000
Inventories 560,000
Land 400,000
Prepaid expenses 40,000
Retained earnings 201,000
Share capital—ordinary ($1 par value) 200,000
Share capital—preference ($50 par value) 500,000
Share premium—ordinary 1,000,000
Share premium—treasury 160,000
Treasury shares—ordinary at cost 170,000
Totals $3,290,000 $3,290,000
880 Chapter 15 Stockholders’ Equity
At December 31, 2014, Teller had the following number of ordinary and preference shares.
Ordinary Preference
Authorized 600,000 60,000
Issued 200,000 10,000
Outstanding 190,000 10,000
The dividends on preference shares are $4 cumulative. In addition, the preference shares have a preference
in liquidation of $50 per share.
Instructions
Prepare the equity section of Teller’s statement of financial position at December 31, 2014.
Professional Research
IFRS15-12 Hincapie Co. (a specialty bike-accessory manufacturer) is expecting growth in sales of some
products targeted to the low-price market. Hincapie is contemplating a preference share issue to help fi-
nance this expansion in operations. The company is leaning toward preference shares because ownership
will not be diluted, but the investors will get an extra dividend if the company does well. The company
management wants to be certain that its reporting of this transaction is transparent to its current sharehold-
ers and wants you to research the disclosure requirements related to its capital structure.
Instructions
Access the IFRS authoritative literature at the IASB website (http://eifrs.iasb.org/). (Click on the IFRS tab and
then register for free eIFRS access if necessary.) When you have accessed the documents, you can use the
search tool in your Internet browser to respond to the following questions. (Provide paragraph citations.)
(a) Identify the authoritative literature that addresses disclosure of information about capital structure.
(b) What information about share capital must companies disclose? Discuss how Hincapie should
report the proposed preference share issue.
International Financial Reporting Problem
Marks and Spencer plc
IFRS15-13 The financial statements of Marks and Spencer plc (M&S) are available at the book’s com-
panion website or can be accessed at http://annualreport.marksandspencer.com/_assets/downloads/Marks-
and-Spencer-Annual-report-and-financial-statements-2012.pdf.
Instructions
Refer to M&S’s financial statements and the accompanying notes to answer the following questions.
(a) What is the par or stated value of M&S’s preference shares?
(b) What is the par or stated value of M&S’s ordinary shares?
(c) What percentage of M&S’s authorized ordinary shares was issued at 31 March 2012?
(d) How many ordinary shares were outstanding at 31 March 2012, and 2 April 2011?
(e) What was the pound amount effect of the cash dividends on M&S’s equity?
(f) What is M&S’s return on ordinary share equity for 2012 and 2011?
(g) What is M&S’s payout ratio for 2012 and 2011? |
ANSWERS TO IFRS SELF-TEST QUESTIONS
1. b 2. c 3. b 4. d 5. d
Remember to check the book’s companion website to fi nd additional
resources for this chapter.
This page is intentionally left blank
Dilutive Securities and
Earnings per Share
1 Describe the accounting for the issuance, 5 Discuss the controversy involving stock
conversion, and retirement of convertible securities. compensation plans.
2 Explain the accounting for convertible preferred stock. 6 Compute earnings per share in a simple capital
structure.
3 Contrast the accounting for stock warrants and for
stock warrants issued with other securities. 7 Compute earnings per share in a complex capital
structure.
4 Describe the accounting for stock compensation
plans.
Kicking the Habit
Some habits die hard. Take stock options—called by some “the crack cocaine of incentives.” Stock options
are a form of compensation that gives key employees the choice to purchase shares at a given (usually
lower-than-market) price. For many years, companies were hooked on these products. Why? The combi-
nation of a hot equity market and favorable accounting treatment made stock options the incentive of
choice. They were compensation with no expense to the companies that granted them, and they were
popular with key employees, so companies granted them with abandon. However, the accounting rules
that took effect in 2005 required expensing the fair value of stock options. This new treatment has made it
easier for companies to kick this habit.
As shown in the chart above, a review of option use for the U.S. companies in the S&P 500 indicates
a decline in the use of option-based compensation and an increase in restricted-stock plans. Fewer com-
panies are granting stock options, following implementation of stock-option expensing. As a spokesperson
at one company commented, “Once you begin expensing options, the attractiveness significantly drops.”
RETPAHC 16
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
Grants Composition
($ in billions)
$80
70
$14.54 $13.21
60 $23.57 $20.59
50
$15.83
40
30 $57.16 $59.04
$47.72 $47.72
20 $38.31
10
0
2007 2008 2009 2010 2011
Options Restricted stock and other
CONCEPTUAL FOCUS
> See the Underlying Concepts on pages 890
and 897.
> Read the Evolving Issue on page 890
In the 1990s, executives with huge option stockpiles had an for a discussion of convertible debt.
almost irresistible incentive to do whatever it took to increase the
INTERNATIONAL FOCUS
stock price and cash in their options. By reining in options, many
companies are taking the first steps toward curbing both out-of-
control executive pay and the era of corporate corruption that it > See the International Perspectives on
pages 885, 892, 896, 901, and 904.
spawned.
As indicated earlier, some of the ways that companies are > Read the IFRS Insights on pages 941–949
for a discussion of:
curbing option grants include replacing options with restricted
—Accounting for convertible debt
shares. Further analysis of these trends indicates that restricted-
—Employee share-purchase plans
stock use is more than 10 times the magnitude of options grants
in the financial industry. Even after excluding financial companies
from the statistics, restricted shares are now the plan of choice.
And in the information technology area (where in the past, share options were heavily favored), the fair value of restricted-share
plans exceeds that for share options. In this industry, some companies are simply reducing option grants, without offering a
replacement, while others, like Microsoft and Yahoo!, have switched to restricted-stock plans completely. Is this a good
trend? Most believe it is; the requirement to expense stock-based compensation similar to other forms of compensation has
changed the focus of compensation plans to rewarding talent and performance without breaking the bank. The positive
impact on corporate behavior, while hard to measure, should benefit investors in years to come.
Sources: Adapted from: Louis Lavelle, “Kicking the Stock-Options Habit,” BusinessWeek Online (February 16, 2005). Graph from J. Ciesielski, |
“S&P 500 Executive Pay: The Bread Keeps Rising,” The Analyst’s Accounting Observer (June 25, 2012).
As the opening story indicates, companies are rethinking the
PREVIEW OF CHAPTER 16
use of various forms of stock-based compensation. The purpose of
this chapter is to discuss the proper accounting for stock-based
compensation. In addition, the chapter examines issues related to other types of financial instruments, such as
convertible securities, warrants, and contingent shares, including their effects on reporting earnings per share.
The content and organization of the chapter are as follows.
Dilutive Securities and
Earnings per Share
Accounting for Stock Computing Earnings
Dilutive Securities
Compensation per Share
• Debt and equity • Stock-option plans • Simple capital structure
• Convertible debt • Restricted stock • Complex capital structure
• Convertible preferred stock • Employee stock-purchase plans
• Stock warrants • Disclosure of compensation plans
• Debate
883
884 Chapter 16 Dilutive Securities and Earnings per Share
DILUTIVE SECURITIES
Debt and Equity
Many of the controversies related to the accounting for financial instruments
LEARNING OBJECTIVE 1
such as stock options, convertible securities, and preferred stock relate to whether
Describe the accounting for the
companies should report these instruments as a liability or as equity. For example,
issuance, conversion, and retirement
companies should classify nonredeemable common shares as equity because the
of convertible securities.
issuer has no obligation to pay dividends or repurchase the stock. Declaration of
dividends is at the issuer’s discretion, as is the decision to repurchase the stock. Simi-
larly, preferred stock that is not redeemable does not require the issuer to pay dividends
or repurchase the stock. Thus, nonredeemable common or preferred stock lacks an im-
portant characteristic of a liability—an obligation to pay the holder of the common or
preferred stock at some point in the future.
However the classification is not as clear-cut for other financial instruments. For
example, in Chapter 15 we discussed the accounting for mandatorily redeemable
preferred stock. Companies originally classified this security as part of equity. The SEC
then prohibited equity classification, and most companies classified these securities
between debt and equity on the balance sheet in a separate section often referred to as
See the FASB
Codification section the “mezzanine section.” The FASB now requires companies to report these types of
(page 923). securities as a liability.1 [1]
In this chapter, we discuss securities that have characteristics of both debt and
equity. For example, a convertible bond has both debt and equity characteristics. Should
a company classify this security as debt, as equity, or as part debt and part equity? In
addition, how should a company compute earnings per share if it has convertible bonds
and other convertible securities in its capital structure? Convertible securities as well as
options, warrants, and other securities are often called dilutive securities because upon
exercise they may reduce (dilute) earnings per share.
Accounting for Convertible Debt
Convertible bonds can be changed into other corporate securities during some speci-
fied period of time after issuance. A convertible bond combines the benefits of a bond
with the privilege of exchanging it for stock at the holder’s option. Investors who pur-
chase it desire the security of a bond holding (guaranteed interest and principal) plus
the added option of conversion if the value of the stock appreciates significantly.
Corporations issue convertibles for two main reasons. One is to raise equity capital
without giving up more ownership control than necessary. To illustrate, assume a com-
pany wants to raise $1 million; its common stock is selling at $45 a share. To raise the
$1 million, the company would have to sell 22,222 shares (ignoring issue costs). By selling
1,000 bonds at $1,000 par, each convertible into 20 shares of common stock, the company |
could raise $1 million by committing only 20,000 shares of its common stock.
1 The FASB (and IASB) have studied the accounting for financial instruments with characteristics
of both debt and equity. At one time, the Boards proposed a definition of equity that is far more
restrictive than current practice. Under the proposed “basic ownership approach,” only common
stock is classified as equity. All other instruments (e.g., preferred stock, options, and convertible
debt) are classified as liabilities. Instruments classified as liabilities are measured at fair value,
and changes are reported in income. Adoption of a narrow definition provides fewer opportu-
nities to structure instruments and arrangements to achieve a desired accounting treatment.
See “Financial Instruments with Characteristics of Equity” (November 30, 2007) at http://www.fasb.org.
While the Boards have agreed on some provisions to improve and simplify the financial reporting
requirements for financial instruments with characteristics of debt and equity, the project is
currently inactive as the Boards have focused on other major convergence projects.
Dilutive Securities 885
A second reason to issue convertibles is to obtain debt financing at cheaper rates.
Many companies could issue debt only at high interest rates unless they attach a
convertible covenant. The conversion privilege entices the investor to accept a lower
interest rate than would normally be the case on a straight debt issue. For example,
Amazon.com at one time issued convertible bonds that pay interest at an effective yield
of 4.75 percent. This rate was much lower than Amazon would have had to pay by issuing
straight debt. For this lower interest rate, the investor receives the right to buy Amazon’s
common stock at a fixed price until the bond’s maturity.2
As indicated earlier, the accounting for convertible debt involves reporting issues at
the time of (1) issuance, (2) conversion, and (3) retirement.
At Time of Issuance
The method for recording convertible bonds at the date of issue follows the International
method used to record straight debt issues. None of the proceeds are re- Perspective
corded as equity. Companies amortize to the maturity date any discount or
IFRS requires that the issuer of
premium that results from the issuance of convertible bonds. Why this treat- convertible debt record the
ment? Because it is difficult to predict when, if at all, conversion will occur. liability and equity components
However, the accounting for convertible debt as a straight debt issue is contro- separately.
versial; we discuss it more fully later in the chapter.
At Time of Conversion
If converting bonds into other securities, a company uses the book value method to
record the conversion. The book value method records the securities exchanged for the
bond at the carrying amount (book value) of the bond.
To illustrate, assume that Hilton, Inc. has a $1,000 bond that is convertible into 10
shares of common stock (par value $10). At the time of conversion, the unamortized
premium is $50. Hilton records the conversion of the bonds as follows.
Bonds Payable 1,000
Premium on Bonds Payable 50
Common Stock 100
Paid-in Capital in Excess of Par—Common Stock 950
Support for the book value approach is based on the argument that an agreement
was established at the date of the issuance either to pay a stated amount of cash at
maturity or to issue a stated number of shares of equity securities. Therefore, when the
debtholder converts the debt to equity in accordance with the preexisting contract terms,
the issuing company recognizes no gain or loss upon conversion.
Induced Conversions
Sometimes the issuer wishes to encourage prompt conversion of its convertible debt
to equity securities in order to reduce interest costs or to improve its debt to equity
ratio. Thus, the issuer may offer some form of additional consideration (such as cash or
common stock), called a “sweetener,” to induce conversion. The issuing company
reports the sweetener as an expense of the current period. Its amount is the fair value |
of the additional securities or other consideration given.
2As with any investment, a buyer has to be careful. For example, Wherehouse Entertainment Inc.,
which had 6¼ percent convertibles outstanding, was taken private in a leveraged buyout. As a
result, the convertible was suddenly as risky as a junk bond of a highly leveraged company with
a coupon of only 6¼ percent. As one holder of the convertibles noted, “What’s even worse is that
the company will be so loaded down with debt that it probably won’t have enough cash flow to
make its interest payments. And the convertible debt we hold is subordinated to the rest of
Wherehouse’s debt.” These types of situations make convertibles less attractive and lead to the
introduction of takeover protection covenants in some convertible bond offerings. Or, sometimes
convertibles are permitted to be called at par, and therefore the conversion premium may be lost.
886 Chapter 16 Dilutive Securities and Earnings per Share
Assume that Helloid, Inc. has outstanding $1,000,000 par value convertible deben-
tures convertible into 100,000 shares of $1 par value common stock. Helloid wishes to
reduce its annual interest cost. To do so, Helloid agrees to pay the holders of its convert-
ible debentures an additional $80,000 if they will convert. Assuming conversion occurs,
Helloid makes the following entry.
Debt Conversion Expense 80,000
Bonds Payable 1,000,000
Common Stock 100,000
Paid-in Capital in Excess of Par—Common Stock 900,000
Cash 80,000
Helloid records the additional $80,000 as an expense of the current period and not as a
reduction of equity.
Some argue that the cost of a conversion inducement is a cost of obtaining equity
capital. As a result, they contend, companies should recognize the cost of conversion as
a cost of (a reduction of) the equity capital acquired, and not as an expense. However,
the FASB indicated that when an issuer makes an additional payment to encourage
conversion, the payment is for a service (bondholders converting at a given time) and
should be reported as an expense. The issuing company does not report this expense as
an extraordinary item. [2]
Retirement of Convertible Debt
As indicated earlier, the method for recording the issuance of convertible bonds follows
that used in recording straight debt issues. Specifically this means that issuing compa-
nies should not attribute any portion of the proceeds to the conversion feature, nor
should it credit a paid-in capital account.
Although some raise theoretical objections to this approach, to be consistent,
companies need to recognize a gain or loss on retiring convertible debt in the same
way that they recognize a gain or loss on retiring nonconvertible debt. For this reason,
companies should report differences between the cash acquisition price of debt and its
carrying amount in current income as a gain or loss.
Convertible Preferred Stock
Convertible preferred stock includes an option for the holder to convert preferred
LEARNING OBJECTIVE 2
shares into a fixed number of common shares. The major difference between account-
Explain the accounting for convertible
ing for a convertible bond and convertible preferred stock at the date of issue is
preferred stock.
their classification. Convertible bonds are considered liabilities, whereas convertible
preferreds (unless mandatory redemption exists) are considered part of stockholders’
equity.
In addition, when stockholders exercise convertible preferred stock, there is no theo-
retical justification for recognizing a gain or loss. A company does not recognize a gain
or loss when it deals with stockholders in their capacity as business owners. Therefore,
companies do not recognize a gain or loss when stockholders exercise convertible
preferred stock.
In accounting for the exercise of convertible preferred stock, a company uses
the book value method. It debits Preferred Stock, along with any related Paid-in
Capital in Excess of Par—Preferred Stock, and it credits Common Stock and Paid-in
Capital in Excess of Par—Common Stock (if an excess exists). The treatment differs |
when the par value of the common stock issued exceeds the book value of the pre-
ferred stock. In that case, the company usually debits Retained Earnings for the
difference.
Dilutive Securities 887
To illustrate, assume Host Enterprises issued 1,000 shares of common stock (par
value $2) upon conversion of 1,000 shares of preferred stock (par value $1) that was
originally issued for a $200 premium. The entry would be:
Convertible Preferred Stock 1,000
Paid-in Capital in Excess of Par—Preferred Stock 200
Retained Earnings 800
Common Stock 2,000
The rationale for the debit to Retained Earnings is that Host has offered the pre-
ferred stockholders an additional return to facilitate their conversion to common stock.
In this example, Host charges the additional return to retained earnings. Many states,
however, require that this charge simply reduce additional paid-in capital from other
sources.
What do the numbers mean? HOW LOW CAN YOU GO?
Financial engineers are always looking for the next innova- In essence, the investors are paying interest to STM, and STM
tion in security design to meet the needs of both issuers records interest revenue. Why would investors do this? If
and investors. Consider the convertible bonds issued by the stock price rises, as many thought it would for STM and
STMicroelectronics (STM). STM’s 10-year bonds have a many tech companies at this time, these bond investors could
zero coupon and are convertible into STM common stock at convert and get a big gain in the stock.
an exercise price of $33.43. When issued, the bonds sold at Investors did get some additional protection in the deal:
an effective yield of 20.05 percent. That’s right—a negative They can redeem the $1,000 bonds after three years and
yield. receive $975 (and after fi ve and seven years, for lower
How could this happen? When STM issued the bonds, amounts), if it looks like the bonds will never convert. In the
investors thought the options to convert were so valuable end, STM has issued bonds with a signifi cant equity compo-
that they were willing to take zero interest payments and nent. And because the entire bond issue is classifi ed as debt,
invest an amount in excess of the maturity value of the bonds. STM records negative interest expense.
Source: STM Financial Reports. See also Floyd Norris, “Legal but Absurd: They Borrow a Billion and Report a Profi t,” The New York Times
(August 8, 2003), p. C1.
Stock Warrants
Warrants are certificates entitling the holder to acquire shares of stock at a certain
3 LEARNING OBJECTIVE
price within a stated period. This option is similar to the conversion privilege in a
Contrast the accounting for stock
convertible bond. Warrants, if exercised, become common stock and usually have
warrants and for stock warrants issued
a dilutive effect (reduce earnings per share) similar to that of the conversion of
with other securities.
convertible securities. However, a substantial difference between convertible secu-
rities and stock warrants is that upon exercise of the warrants, the holder has to pay a
certain amount of money to obtain the shares.
The issuance of warrants or options to buy additional shares normally arises under
three situations:
1. When issuing different types of securities, such as bonds or preferred stock, companies
often include warrants to make the security more attractive—by providing an
“equity kicker.”
2. Upon the issuance of additional common stock, existing stockholders have a
preemptive right to purchase common stock fi rst. Companies may issue warrants
to evidence that right.
3. Companies give warrants, often referred to as stock options, to executives and
employees as a form of compensation.
888 Chapter 16 Dilutive Securities and Earnings per Share
The problems in accounting for stock warrants are complex and present many
difficulties—some of which remain unresolved. The following sections address the
accounting for stock warrants in the three situations listed above.
Stock Warrants Issued with Other Securities
Warrants issued with other securities are basically long-term options to buy common |
stock at a fixed price. Generally the life of warrants is five years, occasionally 10 years;
very occasionally, a company may offer perpetual warrants.
A warrant works like this. Tenneco, Inc. offered a unit comprising one share of
stock and one detachable warrant. As its name implies, the detachable stock warrant
can be detached (separated) from the stock and traded as a separate security. The
Tenneco warrant in this example is exercisable at $24.25 per share and good for five
years. The unit (share of stock plus detachable warrant) sold for 22.75 ($22.75). Since the
price of the common stock the day before the sale was 19.88 ($19.88), the difference
suggests a price of 2.87 ($2.87) for the warrant.
The investor pays for the warrant in order to receive the right to buy the stock, at a
fixed price of $24.25, sometime in the future. It would not be profitable at present for the
purchaser to exercise the warrant and buy the stock, because the price of the stock was
much below the exercise price.3 But if, for example, the price of the stock rises to $30,
the investor gains $2.88 ($30 2 $24.25 2 $2.87) on an investment of $2.87, a 100 percent
increase! If the price never rises, the investor loses the full $2.87 per warrant.4
A company should allocate the proceeds from the sale of debt with detachable
stock warrants between the two securities.5 The profession takes the position that two
separable instruments are involved, that is, (1) a bond and (2) a warrant giving the
holder the right to purchase common stock at a certain price. Companies can trade
detachable warrants separately from the debt. This allows the determination of a fair
value. The two methods of allocation available are:
1. The proportional method.
2. The incremental method.
Proportional Method. At one time, AT&T issued bonds with detachable five-year
warrants to buy one share of common stock (par value $5) at $25. At the time, a share of
AT&T stock was selling for approximately $50. These warrants enabled AT&T to price
its bond offering at par with an 8¾ percent yield (quite a bit lower than prevailing rates
at that time). To account for the proceeds from this offering, AT&T would place a value
on the two securities: (1) the value of the bonds without the warrants, and (2) the value
of the warrants. The proportional method then allocates the proceeds using the propor-
tion of the two amounts, based on fair values.
For example, assume that AT&T’s bonds (par $1,000) sold for 99 without the warrants
soon after their issue. The market price of the warrants at that time was $30. (Prior to sale
the warrants will not have a fair value.) The allocation relies on an estimate of fair value,
generally as established by an investment banker, or on the relative fair value of the bonds
and the warrants soon after the company issues and trades them. The price paid for 10,000,
$1,000 bonds with the warrants attached was par, or $10,000,000. Illustration 16-1 shows
the proportional allocation of the bond proceeds between the bonds and warrants.
3Later in this discussion, we will show that the value of the warrant is normally determined on
the basis of a relative fair value approach because of the difficulty of imputing a warrant value
in any other manner.
4From the illustration, it is apparent that buying warrants can be an “all or nothing” proposition.
5A detachable warrant means that the warrant can sell separately from the bond. GAAP makes a
distinction between detachable and nondetachable warrants because companies must sell nondetach-
able warrants with the security as a complete package. Thus, no allocation is permitted. [3]
Dilutive Securities 889
ILLUSTRATION 16-1
Fair value of bonds (without warrants) ($10,000,000 3 .99) $ 9,900,000
Proportional Allocation
Fair value of warrants (10,000 3 $30) 300,000
of Proceeds between
Aggregate fair value $10,200,000
Bonds and Warrants
$9,900,000
Allocated to bonds: 3$10,000,0005$ 9,705,882
$10,200,000
$300,000
Allocated to warrants: 3$10,000,0005$ 294,118
$10,200,000
Total allocation $10,000,000 |
In this situation, the bonds sell at a discount. AT&T records the sale as follows.
Cash 9,705,882
Discount on Bonds Payable 294,118
Bonds Payable 10,000,000
In addition, AT&T sells warrants that it credits to paid-in capital. It makes the following
entry.
Cash 294,118
Paid-in Capital—Stock Warrants 294,118
AT&T may combine the entries if desired. Here, we show them separately, to indicate
that the purchaser of the bond is buying not only a bond but also a possible future claim
on common stock in the form of the stock warrant.
Assuming investors exercise all 10,000 warrants (one warrant per one share of
stock), AT&T makes the following entry.
Cash (10,000 3 $25) 250,000
Paid-in Capital—Stock Warrants 294,118
Common Stock (10,000 3 $5) 50,000
Paid-in Capital in Excess of Par—Common Stock 494,118
What if investors fail to exercise the warrants? In that case, AT&T debits Paid-in
Capital—Stock Warrants for $294,118 and credits Paid-in Capital—Expired Stock
Warrants for a like amount. The additional paid-in capital reverts to the former stock-
holders.
Incremental Method. In instances where a company cannot determine the fair value of
either the warrants or the bonds, it applies the incremental method used in lump-sum
security purchases (as explained in Chapter 15, page 827). That is, the company uses
the security for which it can determine the fair value. It allocates the remainder of the
purchase price to the security for which it does not know the fair value.
For example, assume that the fair value of the AT&T warrants is $300,000, but the
company cannot determine the fair value of the bonds without the warrants. Illustra-
tion 16-2 shows the amount allocated to the warrants and the stock in this case.
ILLUSTRATION 16-2
Lump-sum receipt $10,000,000
Incremental Allocation of
Allocated to the warrants (300,000)
Proceeds between Bonds
Balance allocated to bonds $ 9,700,000
and Warrants
Conceptual Questions. The question arises whether the allocation of value to the
warrants is consistent with the handling of convertible debt, in which companies
allocate no value to the conversion privilege. The FASB stated that the features of a
890 Chapter 16 Dilutive Securities and Earnings per Share
convertible security are inseparable in the sense that choices are mutually exclusive.
The holder either converts the bonds or redeems them for cash, but cannot do both. No
basis, therefore, exists for recognizing the conversion value in the accounts.
Underlying Concepts The Board, however, indicated that the issuance of bonds with detachable
warrants involves two securities, one a debt security, which will remain out-
Reporting a convertible bond
standing until maturity, and the other a warrant to purchase common stock.
solely as debt is not represen-
At the time of issuance, separable instruments exist. The existence of two instru-
tationally faithful. However, the
ments therefore justifies separate treatment. Nondetachable warrants, however,
cost constraint is used to justify
do not require an allocation of the proceeds between the bonds and the war-
the failure to allocate between
rants. Similar to the accounting for convertible bonds, companies record the
debt and equity.
entire proceeds from nondetachable warrants as debt.6
Evolving Issue IS THAT ALL DEBT?
Many argue that the conversion feature of a convertible bond We agree with this position. In both situations (convert-
is not significantly different in nature from the call repre- ible debt and debt issued with warrants), the investor has
sented by a warrant. The question is whether, although the made a payment to the company for an equity feature—the
legal forms differ, sufficient similarities of substance exist to right to acquire an equity instrument in the future. The only
support the same accounting treatment. Some contend that real distinction between them is that the additional payment
inseparability per se is an insufficient basis for restricting made when the equity instrument is formally acquired takes
allocation between identifiable components of a transaction. different forms. The warrant holder pays additional cash to |
Examples of allocation between assets of value in a single the issuing company; the convertible debt holder pays for
transaction do exist, such as allocation of values in basket pur- stock by forgoing the receipt of interest from conversion date
chases and separation of principal and interest in capitalizing until maturity date and by forgoing the receipt of the matu-
long-term leases. Critics of the current accounting for con- rity value itself. Thus, the difference is one of method or form
vertibles say that to deny recognition of value to the conver- of payment only, rather than one of substance. However,
sion feature merely looks to the form of the instrument and until the profession officially reverses its stand with respect
does not deal with the substance of the transaction. In an to accounting for convertible debt, companies will continue
exposure draft on this subject (project now inactive), the FASB to report convertible debt and bonds issued with nondetach-
indicates that companies should separate the debt and equity able warrants solely as debt.
components of securities such as convertible debt or bonds
issued with nondetachable warrants (see footnotes 1 and 6).
Rights to Subscribe to Additional Shares
If the directors of a corporation decide to issue new shares of stock, the old stockholders
generally have the right (preemptive privilege) to purchase newly issued shares in
proportion to their holdings. This privilege, referred to as a stock right, saves existing
stockholders from suffering a dilution of voting rights without their consent. Also, it
may allow them to purchase stock somewhat below its fair value. Unlike the warrants
issued with other securities, the warrants issued for stock rights are of short duration.
The certificate representing the stock right states the number of shares the holder of
the right may purchase. Each share of stock owned ordinarily gives the owner one stock
right. The certificate also states the price at which the new shares may be purchased. The
6GAAP requires that for convertible debt that can be settled in cash, companies should account
for the liability and equity components separately. In deliberations of the debt/equity project
(see footnote 1), the FASB has proposed that all convertible bonds be separated into liability and
equity components. As indicated, this project is inactive at this time. [4] Academic research
indicates that estimates of the debt and equity components of convertible bonds are subject to
considerable measurement error. See Mary Barth, Wayne Landsman, and Richard Rendleman, Jr.,
“Option Pricing–Based Bond Value Estimates and a Fundamental Components Approach to
Account for Corporate Debt,” The Accounting Review (January 1998). This and other challenges
explain in part the extended time needed to develop new standards in this area.
Dilutive Securities 891
price is normally less than the current market price of such shares, which gives the
rights a value in themselves. From the time they are issued until they expire, holders of
stock rights may purchase and sell them like any other security.
Companies make only a memorandum entry when they issue rights to existing
stockholders. This entry indicates the number of rights issued to existing stockholders
in order to ensure that the company has additional unissued stock registered for issu-
ance in case the rights are exercised. Companies make no formal entry at this time because
they have not yet issued stock nor received cash.
If holders exercise the stock rights, a cash payment of some type usually is involved.
If the company receives cash equal to the par value, it makes an entry crediting Com-
mon Stock at par value. If the company receives cash in excess of par value, it credits
Paid-in Capital in Excess of Par—Common Stock. If it receives cash less than par value,
a debit to Paid-in Capital in Excess of Par—Common Stock is appropriate.
Stock Compensation Plans
The third form of warrant arises in stock compensation plans to pay and motivate
employees. This warrant is a stock option, which gives key employees the option to |
purchase common stock at a given price over an extended period of time.
A consensus of opinion is that effective compensation programs are ones that do the
following: (1) base compensation on employee and company performance, (2) motivate
employees to high levels of performance, (3) help retain executives and allow for re-
cruitment of new talent, (4) maximize the employee’s after-tax benefit and minimize the
employer’s after-tax cost, and (5) use performance criteria over which the employee has
control. Straight cash-compensation plans (salary and perhaps a bonus), though impor-
tant, are oriented to the short run. Many companies recognize that they need a longer-
term compensation plan in addition to the cash component.
Long-term compensation plans attempt to develop company loyalty among key
employees by giving them “a piece of the action”—that is, an equity interest. These
plans, generally referred to as stock-based compensation plans, come in many forms.
Essentially, they provide the employee with the opportunity to receive stock if the per-
formance of the company (by whatever measure) is satisfactory. Typical performance
measures focus on long-term improvements that are readily measurable and that bene-
fit the company as a whole, such as increases in earnings per share, revenues, stock
price, or market share.
As indicated in our opening story, companies are changing the way they use stock-
based compensation. Illustration 16-3 indicates that option expense is a much smaller ele-
ment of compensation relative to restricted stock at companies such as Ford and Wal-Mart.
ILLUSTRATION 16-3
Company Fair Value of Option Grants Fair Value of Restricted Stock Grants
2011 Company Equity
Disney $120.6 $515.1
Grants ($ in millions)
Ford 37.3 124.4
Urban Outfitters 1.0 35.8
Wal-Mart Stores 19.6 550.9
The major reasons for this change are two-fold. Critics often cited the indiscriminate
use of stock options as a reason why company executives manipulated accounting
numbers in an attempt to achieve higher share price. As a result, many responsible
companies decided to cut back on the issuance of options, both to avoid such accounting
manipulations and to head off investor doubts. In addition, GAAP now results in
companies recording a higher expense when stock options are granted.
The data reported in Illustration 16-4 (page 892) reinforce the point that the fair value
of stock grants is significant and increasing. The study documents that compensation
892 Chapter 16 Dilutive Securities and Earnings per Share
increased 7.7 percent for S&P 500 executives in 2011, with equity grants being the big-
gest source of growth.
ILLUSTRATION 16-4
($ in millions) 2011 % Change from 2010
Compensation Elements
Salary $ 1,781.3 0.2%
Bonus 648.8 22.8
Fair value of equity grants 8389.1 13.8
Non-equity incentive compensation 2719.2 22.9
Pension benefits 1309.2 11.9
All other 590.6 7.8
Total executive compensation $15,438.2 7.7%
Illustration 16-4 shows that cash compensation is less than 20 percent of total compen-
sation. The fair value of equity grants comprised approximately 54 percent of total
compensation.
The Major Reporting Issue. Suppose that as an employee for Hurdle Inc., you receive
options to purchase 10,000 shares of the firm’s common stock as part of your compensa-
tion. The date you receive the options is referred to as the grant date. The options are
good for 10 years. The market price and the exercise price for the stock are both $20 at
the grant date. What is the value of the compensation you just received?
Some believe that what you have received has no value. They reason that because
the difference between the market price and the exercise price is zero, no compensation
results. Others argue these options do have value. If the stock price goes above $20 any
time in the next 10 years and you exercise the options, you may earn substantial com-
pensation. For example, if at the end of the fourth year, the market price of the stock is
$30 and you exercise your options, you earn $100,000 [10,000 options 3 ($30 2 $20)], |
ignoring income taxes.
International The question for Hurdle is how to report the granting of these options. One
Perspective approach measures compensation cost by the excess of the market price of the
stock over its exercise price at the grant date. This approach is referred to as
IFRS follows the same model
the intrinsic-value method. It measures what the holder would receive today if
as GAAP for recognizing
share-based compensation. the option was immediately exercised. That intrinsic value is the difference
between the market price of the stock and the exercise price of the options at
the grant date. Using the intrinsic-value method, Hurdle would not recognize any com-
pensation expense related to your options because at the grant date the market price
equaled the exercise price. (In the preceding paragraph, those who answered that the
options had no value were looking at the question from the intrinsic-value approach.)
The second way to look at the question of how to report the granting of these
options bases the cost of employee stock options on the fair value of the stock options
granted. Under this fair value method, companies use acceptable option-pricing models
to value the options at the date of grant. These models take into account the many factors
that determine an option’s underlying value.7
GAAP requires that companies recognize compensation cost using the fair value
method. [5] The FASB position is that companies should base the accounting for the cost
of employee services on the fair value of compensation paid. This amount is presumed
to be a measure of the value of the services received. We will discuss more about
the politics of GAAP in this area later (see “Debate over Stock-Option Accounting,”
page 897). Let’s first describe the procedures involved.
7These factors include the volatility of the underlying stock, the expected life of the options, the
risk-free rate during the option life, and expected dividends during the option life.
Accounting for Stock Compensation 893
ACCOUNTING FOR STOCK COMPENSATION
Stock-Option Plans
Stock-option plans involve two main accounting issues: 4 LEARNING OBJECTIVE
Describe the accounting for stock
1. How to determine compensation expense. compensation plans.
2. Over what periods to allocate compensation expense.
Determining Expense
Under the fair value method, companies compute total compensation expense based
on the fair value of the options expected to vest on the date they grant the options to the
employee(s) (i.e., the grant date).8 Public companies estimate fair value by using an
option-pricing model, with some adjustments for the unique factors of employee stock
options. No adjustments occur after the grant date in response to subsequent changes in
the stock price—either up or down.
Allocating Compensation Expense
In general, a company recognizes compensation expense in the periods in which its
employees perform the service—the service period. Unless otherwise specified, the ser-
vice period is the vesting period—the time between the grant date and the vesting date.
Thus, the company determines total compensation cost at the grant date and allocates it
to the periods benefited by its employees’ services.
Stock Compensation Example
An example will help show the accounting for a stock-option plan. Assume that on
November 1, 2013, the stockholders of Chen Company approve a plan that grants the
company’s five executives options to purchase 2,000 shares each of the company’s
$1 par value common stock. The company grants the options on January 1, 2014. The
executives may exercise the options at any time within the next 10 years. The option
price per share is $60, and the market price of the stock at the date of grant is $70 per share.
Under the fair value method, the company computes total compensation expense
by applying an acceptable fair value option-pricing model (such as the Black-Scholes
option-pricing model). To keep this illustration simple, we assume that the fair value
option-pricing model determines Chen’s total compensation expense to be $220,000. |
Basic Entries. Under the fair value method, a company recognizes the value of the options
as an expense in the periods in which the employee performs services. In the case of
Chen Company, assume that the expected period of benefit is two years, starting with the
grant date. Chen would record the transactions related to this option contract as follows.
At date of grant (January 1, 2014)
No entry.
To record compensation expense for 2014 (December 31, 2014)
Compensation Expense 110,000
Paid-in Capital—Stock Options ($220,000 4 2) 110,000
To record compensation expense for 2015 (December 31, 2015)
Compensation Expense 110,000
Paid-in Capital—Stock Options 110,000
8“To vest” means “to earn the rights to.” An employee’s award becomes vested at the date that
the employee’s right to receive or retain shares of stock or cash under the award is no longer
contingent on remaining in the service of the employer.
894 Chapter 16 Dilutive Securities and Earnings per Share
As indicated, Chen allocates compensation expense evenly over the two-year
service period.
Exercise. If Chen’s executives exercise 2,000 of the 10,000 options (20 percent of the
options) on June 1, 2017 (three years and five months after date of grant), the company
records the following journal entry.
June 1, 2017
Cash (2,000 3 $60) 120,000
Paid-in Capital—Stock Options (20% 3 $220,000) 44,000
Common Stock (2,000 3 $1.00) 2,000
Paid-in Capital in Excess of Par—Common Stock 162,000
Expiration. If Chen’s executives fail to exercise the remaining stock options before their
expiration date, the company transfers the balance in the Paid-in Capital—Stock
Options account to a more properly titled paid-in capital account, such as Paid-in
Capital—Expired Stock Options. Chen records this transaction at the date of expiration
as follows.
January 1, 2024 (expiration date)
Paid-in Capital—Stock Options 176,000
Paid-in Capital—Expired Stock Options 176,000
(80% 3 $220,000)
Adjustment. An unexercised stock option does not nullify the need to record the costs
of services received from executives and attributable to the stock option plan. Under
GAAP, a company therefore does not adjust compensation expense upon expiration of
the options.
However, if an employee forfeits a stock option because the employee fails to
satisfy a service requirement (e.g., leaves employment), the company should adjust the
estimate of compensation expense recorded in the current period (as a change in esti-
mate). A company records this change in estimate by debiting Paid-in Capital—Stock
Options and crediting Compensation Expense for the amount of cumulative compensa-
tion expense recorded to date (thus decreasing compensation expense in the period of
forfeiture).
Restricted Stock
As indicated earlier, many companies also use restricted stock (in some cases, replacing
options altogether) to compensate employees. Restricted-stock plans transfer shares of
stock to employees, subject to an agreement that the shares cannot be sold, transferred,
or pledged until vesting occurs. Similar to stock options, these shares are subject to
forfeiture if the conditions for vesting are not met.9
Major advantages of restricted-stock plans are:
1. Restricted stock never becomes completely worthless. In contrast, if the stock price
does not exceed the exercise price for a stock option, the options are worthless. The
restricted stock, however, still has value.
2. Restricted stock generally results in less dilution to existing stockholders. Restricted-
stock awards are usually one-half to one-third the size of stock options. For example,
9Most companies base vesting on future service for a period of generally three to five years.
Vesting may also be conditioned on some performance target such as revenue, net income, cash
flows, or some combination of these three factors. The employee also collects dividends on the
restricted stock, and these dividends generally must be repaid if forfeiture occurs.
Accounting for Stock Compensation 895
if a company issues stock options on 1,000 shares, an equivalent restricted-stock |
offering might be 333 to 500 shares. The reason for the difference is that at the end
of the vesting period, the restricted stock will have value, whereas the stock options
may not. As a result, fewer shares are involved in restricted-stock plans, and
therefore less dilution results if the stock price rises.
3. Restricted stock better aligns the employee incentives with the companies’ incen-
tives. The holder of restricted stock is essentially a stockholder and should be more
interested in the long-term objectives of the company. In contrast, the recipients of
stock options often have a short-run focus which leads to taking risks to hype the
stock price for short-term gain to the detriment of the long-term.10
The accounting for restricted stock follows the same general principles as account-
ing for stock options at the date of grant. That is, the company determines the fair value
of the restricted stock at the date of grant (usually the fair value of a share of stock) and
then expenses that amount over the service period. Subsequent changes in the fair value
of the stock are ignored for purposes of computing compensation expense.
Restricted Stock Example
Assume that on January 1, 2014, Ogden Company issues 1,000 shares of restricted
stock to its CEO, Christie DeGeorge. Ogden’s stock has a fair value of $20 per share on
January 1, 2014. Additional information is as follows.
1. The service period related to the restricted stock is fi ve years.
2. Vesting occurs if DeGeorge stays with the company for a fi ve-year period.
3. The par value of the stock is $1 per share.
Ogden makes the following entry on the grant date (January 1, 2014).
Unearned Compensation 20,000
Common Stock (1,000 3 $1) 1,000
Paid-in Capital in Excess of Par—Common Stock (1,000 3 $19) 19,000
The credits to Common Stock and Paid-in Capital in Excess of Par—Common Stock
indicate that Ogden has issued shares of stock. The debit to Unearned Compensation
(often referred to as Deferred Compensation Expense) identifies the total compensation
expense the company will recognize over the five-year period. Unearned Compensation
represents the cost of services yet to be performed, which is not an asset. Consequently,
the company reports Unearned Compensation in stockholders’ equity in the balance
sheet, as a contra equity account (similar to the reporting of treasury stock at cost).
At December 31, 2014, Ogden records compensation expense of $4,000 (1,000 shares 3
$20 3 20%) as follows.
Compensation Expense 4,000
Unearned Compensation 4,000
Ogden records compensation expense of $4,000 for each of the next four years (2015,
2016, 2017, and 2018).
10One important rationale for moving away from options to restricted stock is summarized by
Bill Gates of Microsoft: “When you win [with options], you win the lottery. And when you don’t
win, you still want it. I can imagine an employee going home at night and considering two
wildly different possibilities with his compensation program. Either he can buy six summer
homes or no summer homes. Either he can send his kids to college 50 times, or no times. The
variation is huge; much greater than most employees have an appetite for. And so as soon as
they saw that options could go both ways, we proposed an economic equivalent. So what we do
now is give shares, not options.” See http://www.mystockoptions.com/pdfs/Restricted%20Stock.pdf.
896 Chapter 16 Dilutive Securities and Earnings per Share
What happens if DeGeorge leaves the company before the five years has elapsed?
In this situation, DeGeorge forfeits her rights to the stock, and Ogden reverses the
compensation expense already recorded.
For example, assume that DeGeorge leaves on February 3, 2016 (before any expense
has been recorded during 2016). The entry to record this forfeiture is as follows.
Common Stock 1,000
Paid-in Capital in Excess of Par—Common Stock 19,000
Compensation Expense ($4,000 3 2) 8,000
Unearned Compensation 12,000
In this situation, Ogden reverses the compensation expense of $8,000 recorded
through 2015. In addition, the company debits Common Stock and Paid-in Capital in |
Excess of Par—Common Stock, reflecting DeGeorge’s forfeiture. It credits the balance of
Unearned Compensation since none remains when DeGeorge leaves Ogden.
This accounting is similar to accounting for stock options when employees do not
fulfill vesting requirements. Recall that once compensation expense is recorded for
stock options, it is not reversed. The only exception is if the employee does not fulfill the
vesting requirement, by leaving the company before vesting occurs.
In Ogden’s restricted-stock plan, vesting never occurred because DeGeorge left the
company before she met the service requirement. Because DeGeorge was never vested,
she had to forfeit her shares. Therefore, the company must reverse compensation expense
recorded to date.11
Employee Stock-Purchase Plans
Employee stock-purchase plans (ESPPs) generally permit all employees to purchase
stock at a discounted price for a short period of time. The company often uses such
plans to secure equity capital or to induce widespread ownership of its common stock
among employees. These plans are considered compensatory unless they satisfy all
three conditions presented below.
1. Substantially all full-time employees may participate on an equitable basis.
2. The discount from market is small. That is, the discount does not exceed the per
share amount of costs avoided by not having to raise cash in a public offering. If the
amount of the discount is 5 percent or less, no compensation needs to be recorded.
3. The plan offers no substantive option feature.
International For example, Masthead Company’s stock-purchase plan allowed employees
Perspective who met minimal employment qualifications to purchase its stock at a 5 percent
IFRS requires that any discount reduction from market price for a short period of time. The reduction from market
from the market price in price is not considered compensatory. Why? Because the per share amount of the
employee stock-purchase plans costs avoided by not having to raise the cash in a public offering equals 5 percent.
be recorded as compensation Companies that offer their employees a compensatory ESPP should record
expense. the compensation expense over the service life of the employees. It will be dif-
ficult for some companies to claim that their ESPPs are non-compensatory (and
therefore not record compensation expense) unless they change their discount policy
which in the past often was 15 percent. If they change their discount policy to 5 percent,
participation in these plans will undoubtedly be lower. As a result, it is likely that some
companies will end up dropping these plans.
11There are numerous variations on restricted-stock plans, including restricted-stock units (for
which the shares are issued at the end of the vesting period) and restricted-stock plans with
performance targets, such as EPS or stock price growth.
Accounting for Stock Compensation 897
Disclosure of Compensation Plans
Companies must fully disclose the status of their compensation plans at the end of
the periods presented. To meet these objectives, companies must make extensive
disclosures. Specifically, a company with one or more share-based payment arrange-
ments must disclose information that enables users of the financial statements to
understand:
1. The nature and terms of such arrangements that existed during the period and the
potential effects of those arrangements on shareholders.
2. The effect on the income statement of compensation cost arising from share-based
payment arrangements.
3. The method of estimating the fair value of the goods or services received, or the
fair value of the equity instruments granted (or offered to grant), during the
period.
4. The cash fl ow effects resulting from share-based payment arrangements.
Illustration 16-5 (on page 898) presents the type of information disclosed for com-
pensation plans.
Debate over Stock-Option Accounting
The FASB faced considerable opposition when it proposed the fair value method
5 LEARNING OBJECTIVE
for accounting for stock options. This is not surprising, given that the fair value |
Discuss the controversy involving stock
method results in greater compensation costs relative to the intrinsic-value model.
compensation plans.
One study documented that, on average, companies in the Standard & Poor’s 500
stock index overstated earnings in a recent year by 10 percent through the use of
the intrinsic-value method. (See the “What Do the Numbers Mean” box on page 899.)
Nevertheless, some companies, such as Coca-Cola, General Electric, Wachovia, Bank
One, and The Washington Post, decided to use the fair value method. As the CFO of
Coca-Cola stated, “There is no doubt that stock options are compensation. If they
weren’t, none of us would want them.”
Yet many in corporate America resisted the fair value method. Many small high-
technology companies were especially vocal in their opposition, arguing that only
through offering stock options can they attract top professional management. They
contended that recognizing large amounts of compensation expense under
Underlying Concepts
these plans places them at a competitive disadvantage against larger companies
that can withstand higher compensation charges. As one high-tech executive The stock-option controversy
stated, “If your goal is to attack fat-cat executive compensation in multi- involves economic-consequence
billion dollar firms, then please do so! But not at the expense of the people issues. The FASB believes
companies should follow the
who are ‘running lean and mean,’ trying to build businesses and creating jobs
neutrality concept. Others
in the process.”
disagree, noting that factors
The stock-option saga is a classic example of the difficulty the FASB faces in
other than accounting theory
issuing new accounting guidance. Many powerful interests aligned against the
should be considered.
Board. Even some who initially appeared to support the Board’s actions later
reversed themselves. These efforts undermine the authority of the FASB, which in turn
damages confidence in our financial reporting system.
Transparent financial reporting—including recognition of stock-based expense—
should not be criticized because companies will report lower income. We may
not like what the financial statements say, but we are always better off when the
statements are representationally faithful to the underlying economic substance of
transactions.
898 Chapter 16 Dilutive Securities and Earnings per Share
ILLUSTRATION 16-5
Stock-Option Plan
Stock-Option Plan
The Company has a share-based compensation plan. The compensation cost that has been charged
Disclosure
against income for the plan was $29.4 million, and $28.7 million for 2014 and 2013, respectively.
The Company’s 2014 Employee Share-Option Plan (the Plan), which is shareholder-approved,
permits the grant of share options and shares to its employees for up to 8 million shares of common
stock. The Company believes that such awards better align the interests of its employees with those of
Description of plan
its shareholders. Option awards are generally granted with an exercise price equal to the market price
of the Company’s stock at the date of grant; those option awards generally vest based on 5 years of
continuous service and have 10-year contractual terms. Share awards generally vest over five years.
Certain option and share awards provide for accelerated vesting if there is a change in control (as defined
by the Plan).
The fair value of each option award is estimated on the date of grant using an option valuation
model based on the assumptions noted in the following table.
2014 2013
Valuation model
Expected volatility 25%–40% 24%–38%
assumptions
Weighted-average volatility 33% 30%
Expected dividends 1.5% 1.5%
Expected term (in years) 5.3–7.8 5.5–8.0
Risk-free rate 6.3%–11.2% 6.0%–10.0%
A summary of option activity under the Plan as of December 31, 2014, and changes during the
year then ended are presented below.
Weighted-
Weighted- Average Aggregate
Average Remaining Intrinsic
Shares Exercise Contractual Value
Options (000) Price Term ($000)
Outstanding at January 1, 2014 4,660 42
Granted 950 60 |
Option plan activity
Exercised (800) 36
and balances Forfeited or expired (80) 59
Outstanding at December 31, 2014 4,730 47 6.5 85,140
Exercisable at December 31, 2014 3,159 41 4.0 75,816
The weighted-average grant-date fair value of options granted during the years 2014 and 2013 was
$19.57 and $17.46, respectively. The total intrinsic value of options exercised during the years ended
December 31, 2014 and 2013, was $25.2 million, and $20.9 million, respectively.
As of December 31, 2014, there was $25.9 million of total unrecognized compensation cost related
to nonvested share-based compensation arrangements granted under the Plan. That cost is expected to
Option expense be recognized over a weighted-average period of 4.9 years. The total fair value of shares vested during
the years ended December 31, 2014 and 2013, was $22.8 million and $21 million, respectively.
Restricted-Stock Awards
The Company also has a restricted-stock plan. The Plan is intended to retain and motivate the Company’s
Chief Executive Officer over the term of the award and to bring his total compensation package closer
to median levels for Chief Executive Officers of comparable companies. The fair value of grants during
the year was $1,889,000, or $35.68 per share, equivalent to 92% of the market price of a share of the
Company’s Common Stock on the date the award was granted.
Restricted-stock activity for the year ended 2014 is as follows.
Restricted-stock plan
details Shares Price
Outstanding at December 31, 2013 57,990 —
Granted 149,000 $12.68
Vested (19,330) —
Forfeited — —
Outstanding at December 31, 2014 187,660
By leaving stock-based compensation expense out of income, reported income is
biased. Biased reporting not only raises concerns about the credibility of companies’
reports, but also of financial reporting in general. Even good companies get tainted by
the biased reporting of a few “bad apples.” If we write standards to achieve some social,
economic, or public policy goal, financial reporting loses its credibility.
Computing Earnings per Share 899
What do the numbers mean? A LITTLE HONESTY GOES A LONG WAY
As you have learned, GAAP requires companies to expense earnings. And indeed, Merrill Lynch estimated that if all
compensation paid in the form of stock options. However, S&P 500 companies were to expense options, reported profi ts
before the change to require expensing, some companies would fall by as much as 10 percent.
voluntarily expensed options rather than simply disclosing Yet, this small band of big-name companies voluntarily
the estimated costs in the notes to the fi nancial statements. made the switch to expensing, and investors for the most
You might think investors would punish companies that part showered them with love. As shown in the following
decided to expense stock options. After all, most of corporate table, with a few exceptions, the stock prices of the “expensers,”
America has been battling for years to avoid having to expense from Cinergy to The Washington Post, outpaced the market
them, worried that accounting for those perks would destroy after they announced the change.
% Change
Since
Estimated EPS Announcement
Without With Options Company
Company Options Expensed Stock Price
Cinergy $ 2.80 $ 2.77 22.4%
The Washington Post 20.48 20.10 16.4
Computer Associates 20.46 20.62 11.1
Fannie Mae 6.15 6.02 6.7
Bank One 2.77 2.61 2.6
General Motors 5.84 5.45 2.6
Procter & Gamble 3.57 3.35 22.3
Coca-Cola 1.79 1.70 26.2
General Electric 1.65 1.61 26.2
Amazon.com 0.04 20.99 211.4
Sources: Merrill Lynch; company reports.
The market’s general positive reaction to the expensing of reporting. It is puzzling why some companies continued to
stock options provides a good case study supporting the fi ght implementation of the expensing rule.
value that investors place on transparent accounting and
Source: David Stires, “A Little Honesty Goes a Long Way,” Fortune (September 2, 2002), p. 186. Reprinted by permission. See also Troy Wolverton,
“Foes of Expensing Welcome FASB Delay,” TheStreet.com (October 15, 2004). |
COMPUTING EARNINGS PER SHARE
As indicated earlier, stockholders and potential investors widely use earnings per
6 LEARNING OBJECTIVE
share in evaluating the profitability of a company. As a result, much attention is
Compute earnings per share in a
given to earnings per share by the financial press. Earnings per share indicates the
simple capital structure.
income earned by each share of common stock. Thus, companies report earnings
per share only for common stock. For example, if Oscar Co. has net income of
$300,000 and a weighted average of 100,000 shares of common stock outstanding for
the year, earnings per share is $3 ($300,000 4 100,000). Because of the importance of
earnings per share information, most companies must report this information on the
face of the income statement.12 [6] The exception, due to cost-benefit considerations, is
nonpublic companies.13 Generally, companies report earnings per share information below
12For an article on the usefulness of reported EPS data and the application of the qualitative
characteristics of accounting information to EPS data, see Lola W. Dudley, “A Critical Look at
EPS,” Journal of Accountancy (August 1985), pp. 102–111.
13A nonpublic enterprise is an enterprise (1) whose debt or equity securities are not traded in a
public market on a foreign or domestic stock exchange or in the over-the-counter market (includ-
ing securities quoted locally or regionally), or (2) that is not required to file financial statements
with the SEC. An enterprise is not considered a nonpublic enterprise when its financial statements
are issued in preparation for the sale of any class of securities in a public market.
900 Chapter 16 Dilutive Securities and Earnings per Share
net income in the income statement. Illustration 16-6 shows Oscar Co.’s income state-
ment presentation of earnings per share.
ILLUSTRATION 16-6
Net income $300,000
Income Statement
Presentation of EPS Earnings per share $3.00
When the income statement contains intermediate components of income (such as
discontinued operations or extraordinary items), companies should disclose earnings
per share for each component. The presentation in Illustration 16-7 is representative.
ILLUSTRATION 16-7
Earnings per share:
Income Statement
Income from continuing operations $4.00
Presentation of EPS
Loss from discontinued operations, net of tax 0.60
Components
Income before extraordinary item 3.40
Extraordinary gain, net of tax 1.00
Net income $4.40
These disclosures enable the user of the financial statements to recognize the effects
on EPS of income from continuing operations, as distinguished from income or loss
from irregular items.14
Earnings per Share—Simple Capital Structure
A corporation’s capital structure is simple if it consists only of common stock or
includes no potential common stock that upon conversion or exercise could dilute
earnings per common share. A capital structure is complex if it includes securities that
could have a dilutive effect on earnings per common share.
The computation of earnings per share for a simple capital structure involves two
items (other than net income)—(1) preferred stock dividends and (2) weighted-average
number of shares outstanding.
Preferred Stock Dividends
As we indicated earlier, earnings per share relates to earnings per common share. When a
company has both common and preferred stock outstanding, it subtracts the current-
year preferred stock dividend from net income to arrive at income available to com-
mon stockholders. Illustration 16-8 shows the formula for computing earnings per
share.
ILLUSTRATION 16-8
Net Income2Preferred Dividends
Formula for Computing Earnings per Share5
Weighted-Average Number of Shares Outstanding
Earnings per Share
In reporting earnings per share information, a company must calculate income
available to common stockholders. To do so, the company subtracts dividends on
preferred stock from each of the intermediate components of income (income from
continuing operations and income before extraordinary items) and finally from net
income. If a company declares dividends on preferred stock and a net loss occurs, the |
14Companies should present, either on the face of the income statement or in the notes to the
financial statements, per share amounts for discontinued operations and extraordinary items.
Computing Earnings per Share 901
company adds the preferred dividend to the loss for purposes of computing International
the loss per share. Perspective
If the preferred stock is cumulative and the company has net income but
The FASB and the IASB are
declares no dividend in the current year, it subtracts an amount equal to the working together on a project
dividend that it should have declared for the current year only. If the stock is to improve EPS accounting by
cumulative and the company reports a net loss, but declares no dividend in simplifying the computational
the current year, it adds an amount equal to the dividend to the net loss. The guidance and thereby increasing
company should have included dividends in arrears for previous years in the the comparability of EPS data on
previous years’ computations. an international basis.
Weighted-Average Number of Shares Outstanding
In all computations of earnings per share, the weighted-average number of shares
outstanding during the period constitutes the basis for the per share amounts reported.
Shares issued or purchased during the period affect the amount outstanding. Compa-
nies must weight the shares by the fraction of the period they are outstanding. The
rationale for this approach is to find the equivalent number of whole shares outstanding
for the year.
To illustrate, assume that Franks Inc. has changes in its common stock shares out-
standing for the period as shown in Illustration 16-9.
ILLUSTRATION 16-9
Date Share Changes Shares Outstanding
Shares Outstanding,
January 1 Beginning balance 90,000
Ending Balance—
April 1 Issued 30,000 shares for cash 30,000
Franks Inc.
120,000
July 1 Purchased 39,000 shares (39,000)
81,000
November 1 Issued 60,000 shares for cash 60,000
December 31 Ending balance 141,000
Franks computes the weighted-average number of shares outstanding as follows.
ILLUSTRATION 16-10
(C)
Weighted-Average
(A) (B) Weighted
Number of Shares
Dates Shares Fraction of Shares
Outstanding Outstanding Year (A 3 B) Outstanding
Jan. 1–Apr. 1 90,000 3/12 22,500
Apr. 1–July 1 120,000 3/12 30,000
July 1–Nov. 1 81,000 4/12 27,000
Nov. 1–Dec. 31 141,000 2/12 23,500
Weighted-average number of shares outstanding 103,000
As Illustration 16-10 shows, 90,000 shares were outstanding for three months, which
is equivalent to 22,500 whole shares for the entire year. Because Franks issued additional
shares on April 1, it must weight these shares for the time outstanding. When the com-
pany purchased 39,000 shares on July 1, it reduced the shares outstanding. Therefore,
from July 1 to November 1, only 81,000 shares were outstanding, which is equivalent to
27,000 shares. The issuance of 60,000 shares increases shares outstanding for the last
two months of the year. Franks then makes a new computation to determine the proper
weighted shares outstanding.
902 Chapter 16 Dilutive Securities and Earnings per Share
Stock Dividends and Stock Splits. When stock dividends or stock splits occur, compa-
nies need to restate the shares outstanding before the stock dividend or split, in order to
compute the weighted-average number of shares. For example, assume that Vijay Cor-
poration had 100,000 shares outstanding on January 1 and issued a 25 percent stock
dividend on June 30. For purposes of computing a weighted-average for the current year,
it assumes the additional 25,000 shares outstanding as a result of the stock dividend to be
outstanding since the beginning of the year. Thus, the weighted-average for the year
for Vijay is 125,000 shares.
Companies restate the issuance of a stock dividend or stock split, but not the issu-
ance or repurchase of stock for cash. Why? Because stock splits and stock dividends do
not increase or decrease the net assets of the company. The company merely issues
additional shares of stock. Because of the added shares, it must restate the weighted- |
average shares. Restating allows valid comparisons of earnings per share between
periods before and after the stock split or stock dividend. Conversely, the issuance or
purchase of stock for cash changes the amount of net assets. As a result, the company
either earns more or less in the future as a result of this change in net assets. Stated
another way, a stock dividend or split does not change the shareholders’ total investment—
it only increases (unless it is a reverse stock split) the number of common shares repre-
senting this investment.
To illustrate how a stock dividend affects the computation of the weighted-average
number of shares outstanding, assume that Sabrina Company has the following changes
in its common stock shares during the year.
ILLUSTRATION 16-11
Date Share Changes Shares Outstanding
Shares Outstanding,
January 1 Beginning balance 100,000
Ending Balance—Sabrina
March 1 Issued 20,000 shares for cash 20,000
Company
120,000
June 1 60,000 additional shares
(50% stock dividend) 60,000
180,000
November 1 Issued 30,000 shares for cash 30,000
December 31 Ending balance 210,000
Sabrina computes the weighted-average number of shares outstanding as follows.
ILLUSTRATION 16-12
(D)
Weighted-Average
(A) (C) Weighted
Number of Shares
Dates Shares (B) Fraction Shares
Outstanding—Stock Outstanding Outstanding Restatement of Year (A 3 B 3 C)
Issue and Stock Dividend
Jan. 1–Mar. 1 100,000 1.50 2/12 25,000
Mar. 1–June 1 120,000 1.50 3/12 45,000
June 1–Nov. 1 180,000 5/12 75,000
Nov. 1–Dec. 31 210,000 2/12 35,000
Weighted-average number of shares outstanding 180,000
Sabrina must restate the shares outstanding prior to the stock dividend. The com-
pany adjusts the shares outstanding from January 1 to June 1 for the stock dividend, so
that it now states these shares on the same basis as shares issued subsequent to the stock
dividend. Sabrina does not restate shares issued after the stock dividend because they
are on the new basis. The stock dividend simply restates existing shares. The same type
of treatment applies to a stock split.
Computing Earnings per Share 903
If a stock dividend or stock split occurs after the end of the year but before issuing
the financial statements, a company must restate the weighted-average number of
shares outstanding for the year (and any other years presented in comparative form).
For example, assume that Hendricks Company computes its weighted-average number
of shares as 100,000 for the year ended December 31, 2014. On January 15, 2015, before
issuing the financial statements, the company splits its stock 3 for 1. In this case, the
weighted-average number of shares used in computing earnings per share for 2014 is
now 300,000 shares. If providing earnings per share information for 2013 as comparative
information, Hendricks must also adjust it for the stock split.
Comprehensive Example
Let’s study a comprehensive illustration for a simple capital structure. Darin Corpora-
tion has income before extraordinary item of $580,000 and an extraordinary gain, net
of tax, of $240,000. In addition, it has declared preferred dividends of $1 per share on
100,000 shares of preferred stock outstanding. Darin also has the following changes in
its common stock shares outstanding during 2014.
ILLUSTRATION 16-13
Dates Share Changes Shares Outstanding
Shares Outstanding,
January 1 Beginning balance 180,000
Ending Balance—
May 1 Purchased 30,000 treasury shares (30,000)
Darin Corp.
150,000
July 1 300,000 additional shares
(3-for-1 stock split) 300,000
450,000
December 31 Issued 50,000 shares for cash 50,000
December 31 Ending balance 500,000
To compute the earnings per share information, Darin determines the weighted-
average number of shares outstanding as follows.
ILLUSTRATION 16-14
(D)
Weighted-Average
(A) (C) Weighted
Number of Shares
Dates Shares (B) Fraction Shares
Outstanding Outstanding Restatement of Year (A 3 B 3 C) Outstanding
Jan. 1–May 1 180,000 3 4/12 180,000
May 1–July 1 150,000 3 2/12 75,000
July 1–Dec. 31 450,000 6/12 225,000
Weighted-average number of shares outstanding 480,000
In computing the weighted-average number of shares, the company ignores the |
shares sold on December 31, 2014, because they have not been outstanding during the
year. Darin then divides the weighted-average number of shares into income before
extraordinary item and net income to determine earnings per share. It subtracts its preferred
dividends of $100,000 from income before extraordinary item ($580,000) to arrive at
income before extraordinary item available to common stockholders of $480,000
($580,000 2 $100,000).
Deducting the preferred dividends from the income before extraordinary item
also reduces net income without affecting the amount of the extraordinary item. The
904 Chapter 16 Dilutive Securities and Earnings per Share
final amount is referred to as income available to common stockholders, as shown in
Illustration 16-15.
ILLUSTRATION 16-15
(C)
Computation of Income
(A) (B) Earnings
Available to Common
Income Weighted per Share
Stockholders Information Shares (A 4 B)
Income before extraordinary item available to
common stockholders $480,000* 480,000 $1.00
Extraordinary gain (net of tax) 240,000 480,000 0.50
Income available to common stockholders $720,000 480,000 $1.50
*$580,000 2 $100,000
Darin must disclose the per share amount for the extraordinary item (net of tax)
either on the face of the income statement or in the notes to the financial statements.
Illustration 16-16 shows the income and per share information reported on the face of
Darin’s income statement.
ILLUSTRATION 16-16
Income before extraordinary item $580,000
Earnings per Share, with
Extraordinary gain, net of tax 240,000
Extraordinary Item
Net income $820,000
Earnings per share:
Income before extraordinary item $1.00
Extraordinary item, net of tax 0.50
Net income $1.50
Earnings per Share—Complex Capital Structure
The EPS discussion to this point applies to basic EPS for a simple capital structure.
LEARNING OBJECTIVE 7
One problem with a basic EPS computation is that it fails to recognize the poten-
Compute earnings per share in a
tial impact of a corporation’s dilutive securities. As discussed at the beginning of
complex capital structure.
the chapter, dilutive securities are securities that can be converted to common
stock.15 Upon conversion or exercise by the holder, the dilutive securities reduce (dilute)
earnings per share. This adverse effect on EPS can be significant and, more importantly,
unexpected unless financial statements call attention to their potential dilutive effect.
As indicated earlier, a complex capital structure exists when a corporation has
convertible securities, options, warrants, or other rights that upon conversion or exercise
could dilute earnings per share. When a company has a complex capital structure, it
generally reports both basic and diluted earnings per share.
Computing diluted EPS is similar to computing basic EPS. The difference is that
diluted EPS includes the effect of all potential dilutive common shares that were
International
outstanding during the period. The formula in Illustration 16-17 shows the rela-
Perspective
tionship between basic EPS and diluted EPS.
The provisions in GAAP are
Some securities are antidilutive. Antidilutive securities are securities that
substantially the same as those
upon conversion or exercise increase earnings per share (or reduce the loss per
in International Accounting
share). Companies with complex capital structures will not report diluted EPS
Standard No. 33, “Earnings per
if the securities in their capital structure are antidilutive. The purpose of
Share,” issued by the IASB.
presenting both basic and diluted EPS is to inform financial statement users of
15Issuance of these types of securities is typical in mergers and compensation plans.
Computing Earnings per Share 905
ILLUSTRATION 16-17
Relationship between
Basic and Diluted EPS
Net Income –
Preferred Dividends Impact of Options,
EPS =− − Impact of
Weighted-Average Convertibles Warrants, and Other
Number of Shares Dilutive Securities
Outstanding
Basic EPS
Diluted EPS
situations that will likely occur (basic EPS) and also to provide “worst case” dilutive
situations (dilutive EPS). If the securities are antidilutive, the likelihood of conversion or |
exercise is considered remote. Thus, companies that have only antidilutive securities
must report only the basic EPS number. We illustrated the computation of basic EPS in
the prior section. In the following sections, we address the effects of convertible and
other dilutive securities on EPS calculations.
Diluted EPS—Convertible Securities
At conversion, companies exchange convertible securities for common stock. Compa-
nies measure the dilutive effects of potential conversion on EPS using the if-converted
method. This method for a convertible bond assumes (1) the conversion of the convert-
ible securities at the beginning of the period (or at the time of issuance of the security, if
issued during the period), and (2) the elimination of related interest, net of tax. Thus, the
additional shares assumed issued increase the denominator—the weighted-average
number of shares outstanding. The amount of interest expense, net of tax associated
with those potential common shares, increases the numerator—net income.
Comprehensive Example—If-Converted Method. As an example, Mayfield Corporation
has net income of $210,000 for the year and a weighted-average number of common
shares outstanding during the period of 100,000 shares. The basic earnings per share is
therefore $2.10 ($210,000 4 100,000). The company has two convertible debenture bond
issues outstanding. One is a 6 percent issue sold at 100 (total $1,000,000) in a prior year
and convertible into 20,000 common shares. The other is a 10 percent issue sold at 100
(total $1,000,000) on April 1 of the current year and convertible into 32,000 common
shares. The tax rate is 40 percent.
As Illustration 16-18 shows, to determine the numerator for diluted earnings per
share, Mayfield adds back the interest on the if-converted securities, less the related
tax effect. Because the if-converted method assumes conversion as of the beginning of
the year, Mayfield assumes that it pays no interest on the convertibles during the year.
The interest on the 6 percent convertibles is $60,000 for the year ($1,000,000 3 6%). The
increased tax expense is $24,000 ($60,000 3 0.40). The interest added back net of taxes is
$36,000 [$60,000 2 $24,000, or simply $60,000 3 (1 2 0.40)].
ILLUSTRATION 16-18
Net income for the year $210,000
Computation of Adjusted
Add: Adjustment for interest (net of tax)
Net Income
6% debentures ($60,000 3 [1 2 .40]) 36,000
10% debentures ($100,000 3 9/12 3 [1 2 .40]) 45,000
Adjusted net income $291,000
906 Chapter 16 Dilutive Securities and Earnings per Share
Continuing with the information in Illustration 16-18, because Mayfield issues
10 percent convertibles subsequent to the beginning of the year, it weights the shares. In
other words, it considers these shares to have been outstanding from April 1 to the end
of the year. As a result, the interest adjustment to the numerator for these bonds reflects
the interest for only nine months. Thus, the interest added back on the 10 percent
convertible is $45,000 [$1,000,000 3 10% 3 9/12 year 3 (1 2 0.4)]. The final item in
Illustration 16-18 shows the adjusted net income. This amount becomes the numerator
for Mayfield’s computation of diluted earnings per share.
Mayfield then calculates the weighted-average number of shares outstanding,
as shown in Illustration 16-19. This number of shares becomes the denominator for
Mayfield’s computation of diluted earnings per share.
ILLUSTRATION 16-19
Weighted-average number of shares outstanding 100,000
Computation of
Add: Shares assumed to be issued:
Weighted-Average
6% debentures (as of beginning of year) 20,000
Number of Shares 10% debentures (as of date of issue, April 1; 9/12 3 32,000) 24,000
Weighted-average number of shares adjusted for dilutive securities 144,000
In its income statement, Mayfield reports basic and diluted earnings per share.16
Illustration 16-20 shows this dual presentation.
ILLUSTRATION 16-20
Net income for the year $210,000
Earnings per Share
Disclosure Earnings per Share (Note X)
Basic earnings per share ($210,000 4 100,000) $2.10
Diluted earnings per share ($291,000 4 144,000) $2.02 |
Other Factors. The example above assumed that Mayfield sold its bonds at the face
amount. If it instead sold the bonds at a premium or discount, the company must adjust
the interest expense each period to account for this occurrence. Therefore, the interest
expense reported on the income statement is the amount of interest expense, net of tax,
added back to net income. (It is not the interest paid in cash during the period.)
In addition, the conversion rate on a dilutive security may change during the period
in which the security is outstanding. For the diluted EPS computation in such a situa-
tion, the company uses the most dilutive conversion rate available. For example, as-
sume that a company issued a convertible bond on January 1, 2013, with a conversion
rate of 10 common shares for each bond starting January 1, 2015. Beginning January 1,
2018, the conversion rate is 12 common shares for each bond, and beginning January 1,
2022, it is 15 common shares for each bond. In computing diluted EPS in 2013, the com-
pany uses the conversion rate of 15 shares to one bond.
A final issue relates to preferred stock. For example, assume that Mayfield’s 6 per-
cent convertible debentures were instead 6 percent convertible preferred stock. In that
case, Mayfield considers the convertible preferred as potential common shares. Thus, it
includes them in its diluted EPS calculations as shares outstanding. The company does
not subtract preferred dividends from net income in computing the numerator. Why
16Conversion of bonds is dilutive because EPS with conversion ($2.02) is less than basic EPS
($2.10). See Appendix 16B for a comprehensive evaluation of antidilution with multiple
securities.
Computing Earnings per Share 907
not? Because for purposes of computing EPS, it assumes conversion of the convertible
preferreds to outstanding common stock. The company uses net income as the
numerator—it computes no tax effect because preferred dividends generally are not
tax-deductible.
Diluted EPS—Options and Warrants
A company includes in diluted earnings per share stock options and warrants outstand-
ing (whether or not presently exercisable), unless they are antidilutive. Companies use
the treasury-stock method to include options and warrants and their equivalents in EPS
computations.
The treasury-stock method assumes that the options or warrants are exercised at the
beginning of the year (or date of issue if later), and that the company uses those pro-
ceeds to purchase common stock for the treasury. If the exercise price is lower than the
market price of the stock, then the proceeds from exercise are insufficient to buy back all
the shares. The company then adds the incremental shares remaining to the weighted-
average number of shares outstanding for purposes of computing diluted earnings per
share.
For example, if the exercise price of a warrant is $5 and the market price of the stock
is $15, the treasury-stock method increases the shares outstanding. Exercise of the
warrant results in one additional share outstanding, but the $5 received for the one
share issued is insufficient to purchase one share in the market at $15. The company
needs to exercise three warrants (and issue three additional shares) to produce enough
money ($15) to acquire one share in the market. Thus, a net increase of two shares
outstanding results.
To see this computation using larger numbers, assume 1,500 options outstanding at
an exercise price of $30 for a common share and a common stock market price per share
of $50. Through application of the treasury-stock method, the company would have
600 incremental shares outstanding, computed as shown in Illustration 16-21.17
ILLUSTRATION 16-21
Proceeds from exercise of 1,500 options (1,500 3 $30) $45,000
Computation of
Shares issued upon exercise of options 1,500 Incremental Shares
Treasury shares purchasable with proceeds ($45,000 4 $50) (900)
Incremental shares outstanding (potential common shares) 600
Thus, if the exercise price of the option or warrant is lower than the market price of |
the stock, dilution occurs. An exercise price of the option or warrant higher than the
market price of the stock reduces common shares. In this case, the options or warrants
are antidilutive because their assumed exercise leads to an increase in earnings per
share.
For both options and warrants, exercise is assumed only if the average market
price of the stock exceeds the exercise price during the reported period.18 As a practical
17The incremental number of shares may be more simply computed:
Market price2Option price
3Number of options5Number of shares
Market price
$502$30
31,500 options5600 shares
$50
18Options and warrants have essentially the same assumptions and computational problems,
although the warrants may allow or require the tendering of some other security, such as debt,
in lieu of cash upon exercise. In such situations, the accounting becomes quite complex and is
beyond the scope of this textbook.
908 Chapter 16 Dilutive Securities and Earnings per Share
matter, a simple average of the weekly or monthly prices is adequate, so long as the
prices do not fluctuate significantly.
Comprehensive Example—Treasury-Stock Method. To illustrate application of the
treasury-stock method, assume that Kubitz Industries, Inc. has net income for the period
of $220,000. The average number of shares outstanding for the period was 100,000 shares.
Hence, basic EPS—ignoring all dilutive securities—is $2.20. The average number of
shares related to options outstanding (although not exercisable at this time), at an option
price of $20 per share, is 5,000 shares. The average market price of the common stock
during the year was $28. Illustration 16-22 shows the computation of EPS using the
treasury-stock method.
ILLUSTRATION 16-22
Basic Earnings Diluted Earnings
Computation of Earnings
per Share per Share
per Share—Treasury-
Average number of shares related to options outstanding 5,000
Stock Method
Option price per share 3 $20
Proceeds upon exercise of options $100,000
Average market price of common stock $28
Treasury shares that could be repurchased with
proceeds ($100,000 4 $28) 3,571
Excess of shares under option over the treasury shares
that could be repurchased (5,000 2 3,571)—potential
common incremental shares 1,429
Average number of common shares outstanding 100,000 100,000
Total average number of common shares outstanding
and potential common shares 100,000 (A) 101,429 (C)
Net income for the year $220,000 (B) $220,000 (D)
Earnings per share $2.20 (B 4 A) $2.17 (D 4 C)
Contingent Issue Agreement
In business combinations, the acquirer may promise to issue additional shares—referred
to as contingent shares—under certain conditions. Sometimes the company issues these
contingent shares as a result of a passage-of-time condition or upon the attainment of a
certain earnings or market price level. If this passage-of-time condition occurs during
the current year, or if the company meets the earnings or market price by the end of the
year, the company considers the contingent shares as outstanding for the computation
of diluted earnings per share.19
For example, assume that Watts Corporation purchased Cardoza Company and
agreed to give Cardoza’s stockholders 20,000 additional shares in 2017 if Cardoza’s net
income in 2016 is $90,000. In 2015, Cardoza’s net income is $100,000. Because Cardoza
has already attained the 2016 stipulated earnings of $90,000, in computing diluted
earnings per share for 2015, Watts would include the 20,000 contingent shares in the
shares-outstanding computation.
Antidilution Revisited
In computing diluted EPS, a company must consider the aggregate of all dilutive
securities. But first it must determine which potentially dilutive securities are in fact
individually dilutive and which are antidilutive. A company should exclude any
19In addition to contingent issuances of stock, other situations that might lead to dilution are the
issuance of participating securities and two-class common shares. The reporting of these types
of securities in EPS computations is beyond the scope of this textbook. |
Computing Earnings per Share 909
security that is antidilutive, nor can the company use such a security to offset dilutive
securities.
Recall that including antidilutive securities in earnings per share computations
increases earnings per share (or reduces net loss per share). With options or warrants,
whenever the exercise price exceeds the market price, the security is antidilutive. Con-
vertible debt is antidilutive if the addition to income of the interest (net of tax) causes a
greater percentage increase in income (numerator) than conversion of the bonds causes
a percentage increase in common and potentially dilutive shares (denominator). In
other words, convertible debt is antidilutive if conversion of the security causes com-
mon stock earnings to increase by a greater amount per additional common share than
earnings per share was before the conversion.
To illustrate, assume that Martin Corporation has a 6 percent, $1,000,000 debt issue
that is convertible into 10,000 common shares. Net income for the year is $210,000, the
weighted-average number of common shares outstanding is 100,000 shares, and the tax
rate is 40 percent. In this case, assumed conversion of the debt into common stock at the
beginning of the year requires the following adjustments of net income and the weighted-
average number of shares outstanding.
ILLUSTRATION 16-23
Net income for the year $210,000 Average number of shares
Test for Antidilution
Add: Adjustment for interest outstanding 100,000
(net of tax) on 6% Add: Shares issued upon assumed
debentures conversion of debt 10,000
$60,000 3 (1 2 .40) 36,000 Average number of common and
Adjusted net income $246,000 potential common shares outstanding 110,000
Basic EPS 5 $210,000 4 100,000 5 $2.10
Diluted EPS 5 $246,000 4 110,000 5 $2.24 5 Antidilutive
As a shortcut, Martin can also identify the convertible debt as antidilutive by
comparing the EPS resulting from conversion, $3.60 ($36,000 additional earnings 4
10,000 additional shares), with EPS before inclusion of the convertible debt, $2.10.
Companies should ignore antidilutive securities in all calculations and in comput-
ing diluted earnings per share. This approach is reasonable. The profession’s intent was
to inform the investor of the possible dilution that might occur in reported earnings per
share and not to be concerned with securities that, if converted or exercised, would
result in an increase in earnings per share. Appendix 16B to this chapter provides an
extended example of how companies consider antidilution in a complex situation with
multiple securities.
EPS Presentation and Disclosure
A company with a complex capital structure would present its EPS information as follows.
ILLUSTRATION 16-24
Earnings per common share
EPS Presentation—
Basic earnings per share $3.30
Complex Capital
Diluted earnings per share $2.70 Structure
When the earnings of a period include irregular items, a company should show per
share amounts (where applicable) for the following: income from continuing opera-
tions, income before extraordinary items, and net income. Companies that report a dis-
continued operation or an extraordinary item should present per share amounts for
those line items either on the face of the income statement or in the notes to the financial
statements. Illustration 16-25 (page 910) shows a presentation reporting extraordinary items.
910 Chapter 16 Dilutive Securities and Earnings per Share
ILLUSTRATION 16-25
Basic earnings per share
EPS Presentation, with
Income before extraordinary item $3.80
Extraordinary Item
Extraordinary item (0.80)
Net income $3.00
Diluted earnings per share
Income before extraordinary item $3.35
Extraordinary item (0.65)
Net income $2.70
A company must show earnings per share amounts for all periods presented. Also,
the company should restate all prior period earnings per share amounts presented for
stock dividends and stock splits. If it reports diluted EPS data for at least one period, the
company should report such data for all periods presented, even if it is the same as basic |
EPS. When a company restates results of operations of a prior period as a result of an
error or a change in accounting principle, it should also restate the earnings per share
data shown for the prior periods. Complex capital structures and dual presentation of
earnings per share require the following additional disclosures in note form.
1. Description of pertinent rights and privileges of the various securities outstanding.
2. A reconciliation of the numerators and denominators of the basic and diluted per
share computations, including individual income and share amount effects of all
securities that affect EPS.
3. The effect given preferred dividends in determining income available to common
stockholders in computing basic EPS.
4. Securities that could potentially dilute basic EPS in the future that were excluded in
the computation because they would be antidilutive.
5. Effect of conversions subsequent to year-end, but before issuing statements.
Illustration 16-26 presents the reconciliation and the related disclosure to meet the
requirements of this standard.20 [7]
ILLUSTRATION 16-26
For the Year Ended 2014
Reconciliation for Basic
Income Shares Per Share
and Diluted EPS
(Numerator) (Denominator) Amount
Income before extraordinary item $7,500,000
Less: Preferred stock dividends 45,000
Basic EPS 7,455,000 3,991,666 $1.87
Warrants 30,768
Convertible preferred stock 45,000 308,333
4% convertible bonds (net of tax) 60,000 50,000
Diluted EPS $7,560,000 4,380,767 $1.73
Stock options to purchase 1,000,000 shares of common stock at $85 per share were outstanding during
the second half of 2014 but were not included in the computation of diluted EPS because the options’
exercise price was greater than the average market price of the common shares. The options were still
outstanding at the end of year 2014 and expire on June 30, 2024.
20Note that GAAP has specific disclosure requirements regarding stock-based compensation
plans and earnings per share disclosures as well. The earnings per share effects of noncontrol-
ling interest (discussed in Chapter 4) should also be presented, with the amounts of income from
continuing operations and discontinued operations (if present), attributable to the controlling
interest disclosed. However, only the net income attributable to the controlling interest should
be used in computing earnings per share.
Computing Earnings per Share 911
What do the numbers mean? PRO FORMA EPS CONFUSION
Many companies are reporting pro forma EPS numbers along ($600 million) that it overwhelmed its operating profi t; these
with GAAP-based EPS numbers in the fi nancial information expenses took operating profi t negative to the tune of $406
provided to investors. Pro forma earnings generally exceed million. The accounting? Zynga “window dressed” the expense
GAAP earnings because the pro forma numbers exclude by encouraging Wall Street analysts to use a non-GAAP
such items as restructuring charges, impairments of assets, pro forma accounting fi gure—“adjusted earnings before
R&D expenditures, and stock compensation expense. Here interest, taxes, depreciation and amortization”—that ignores
are some examples. the stock compensation. LinkedIn and Groupon also use
non-GAAP metrics that exclude stock compensation. LinkedIn’s
GAAP Pro Forma
Company EPS EPS $30 million stock-compensation expense roughly halved
its operating profi t, while Groupon’s $94 million took oper-
Adaptec $(0.62) $ 0.05
Corning (0.24) 0.09 ating profi t $203 million into the red. Wall Street analysts
General Motors (0.41) 0.85 tend to go along with the accounting hocus-pocus, as it
Honeywell International (0.38) 0.44 allows them to justify higher valuations for stocks. Investors
International Paper (0.57) 0.14
should remember, however, that employee equity awards are
Qualcomm (0.06) 0.20
real costs.
Broadcom (6.36) (0.13)
Lucent Technologies (2.16) (0.27) As discussed in Chapter 4, SEC Regulation G requires
Source: Company press releases. companies to provide a clear reconciliation between pro
forma and GAAP information. And this applies to EPS mea- |
Another case of possibly misleading pro forma reporting
sures as well. This reconciliation is especially important,
is the case of social media darlings Facebook, Zynga, and
given the spike in pro forma reporting by companies adding
Groupon. For example, social gaming company Zynga
back employee stock-option expense.
recently reported so much stock-compensation expense
Sources: See M. Moran, A. J. Cohen, and K. Shaustyuk, “Stock Option Expensing: The Battle Has Been Won; Now Comes the Aftermath,”
Portfolio Strategy/Accounting, Goldman Sachs (March 17, 2005); and R. Winkler, “Stock and Awe at Facebook and Zynga,” Wall Street Journal
(February 16, 2012).
Summary of EPS Computation
As you can see, computation of earnings per share is a complex issue. It is a controver-
sial area because many securities, although technically not common stock, have many of
its basic characteristics. Indeed, some companies have issued these other securities
rather than common stock in order to avoid an adverse dilutive effect on earnings per
share. Illustrations 16-27 and 16-28 (page 912) display the elementary points of calculat-
ing earnings per share in a simple capital structure and in a complex capital structure.
ILLUSTRATION 16-27
Calculating EPS, Simple
Simple Capital Structure Capital Structure
(Single Presentation of EPS)
Compute Income Applicable to Common Stock
(Net Income minus Preferred Dividends)
Compute Weighted-Average Number of
Shares Outstanding
Income Applicable to Common Stock
EPS =
Weighted-Average Number of Shares Outstanding
912 Chapter 16 Dilutive Securities and Earnings per Share
ILLUSTRATION 16-28
Calculating EPS,
Complex Capital
Complex Capital Structure
Structure (Dual Presentation of EPS)
BASIC EARNINGS PER SHARE DILUTED EARNINGS PER SHARE
(Include all potentially dilutive securities)
Formula Convertible securities
Income Applicable to Common Stock (Always include if dilutive)
Weighted-Average Number of Shares Outstanding
Options and warrants
(Always include if dilutive)
Contingent issuance agreements
(Always include if dilutive)
You will
want to
read the Formula
IFRS INSIGHTS Income Applicable to Common Stock
on pages 941–949 Adjusted for Interest (net of tax) and Preferred
Dividends on All Dilutive Securities
for discussion of IFRS Weighted-Average Number of Shares
related to dilutive Assuming Maximum Dilution from
securities and All Dilutive Securities
earnings per share.
KEY TERMS
SUMMARY OF LEARNING OBJECTIVES
antidilutive securities, 904
basic EPS, 904
complex capital
1 Describe the accounting for the issuance, conversion, and retirement
structure, 900
of convertible securities. The method for recording convertible bonds at the date
convertible bonds, 884
of issuance follows that used to record straight debt issues. Companies amortize any
convertible preferred
discount or premium that results from the issuance of convertible bonds, assuming the
stock, 886
bonds will be held to maturity. If companies convert bonds into other securities, the
detachable stock
principal accounting problem is to determine the amount at which to record the securi-
warrants, 888
ties exchanged for the bonds. The book value method is considered GAAP. The retire-
diluted EPS, 904
ment of convertible debt is considered a debt retirement, and the difference between the
dilutive securities,
carrying amount of the retired convertible debt and the cash paid should result in a gain
884, 904
or loss.
earnings per share, 899
fair value method, 892 2 Explain the accounting for convertible preferred stock. When convert-
grant date, 892 ible preferred stock is converted, a company uses the book value method. It debits
Preferred Stock, along with any related Paid-in Capital in Excess of Par—Preferred
if-converted method, 905
Stock, and credits Common Stock and Paid-in Capital in Excess of Par—Common Stock
income available
(if an excess exists).
to common
stockholders, 900 3 Contrast the accounting for stock warrants and for stock warrants
incremental method, 889 issued with other securities. Stock warrants: Companies should allocate the pro- |
induced conversion, 885 ceeds from the sale of debt with detachable warrants between the two securities.
Appendix 16A: Accounting for Stock-Appreciation Rights 913
Warrants that are detachable can be traded separately from the debt, and therefore com- intrinsic-value
panies can determine their fair value. Two methods of allocation are available: the pro- method, 892
portional method and the incremental method. Nondetachable warrants do not require proportional method, 888
an allocation of the proceeds between the bonds and the warrants; companies record the restricted-stock plans, 894
entire proceeds as debt. Stock rights: No entry is required when a company issues rights service period, 893
to existing stockholders. The company needs only to make a memorandum entry to indi- simple capital
cate the number of rights issued to existing stockholders and to ensure that the company structure, 900
has additional unissued stock registered for issuance in case the stockholders exercise stock option, 891
the rights.
stock-based
4 Describe the accounting for stock compensation plans. Companies compensation
plans, 891
must use the fair value approach to account for stock-based compensation. Under this
stock right, 890
approach, a company computes total compensation expense based on the fair value of
treasury-stock
the options that it expects to vest on the grant date. Companies recognize compensation
method, 907
expense in the periods in which the employee performs the services. Restricted-stock
warrants, 887
plans follow the same general accounting principles as those for stock options. Compa-
nies estimate total compensation cost at the grant date based on the fair value of the re- weighted-average
number of shares
stricted stock; they expense that cost over the service period. If vesting does not occur,
outstanding, 901
companies reverse the compensation expense.
5 Discuss the controversy involving stock compensation plans. When
first proposed, there was considerable opposition to the recognition provisions con-
tained in the fair value approach. The reason: that approach could result in substantial,
previously unrecognized compensation expense. Corporate America, particularly the
high-technology sector, vocally opposed the proposed standard. They believed that the
standard would place them at a competitive disadvantage with larger companies that
can withstand higher compensation charges. Offsetting such opposition is the need for
greater transparency in financial reporting, on which our capital markets depend.
6 Compute earnings per share in a simple capital structure. When a com-
pany has both common and preferred stock outstanding, it subtracts the current-year
preferred stock dividend from net income to arrive at income available to common
stockholders. The formula for computing earnings per share is net income less preferred
stock dividends, divided by the weighted-average number of shares outstanding.
7 Compute earnings per share in a complex capital structure. A complex
capital structure requires a dual presentation of earnings per share, each with equal
prominence on the face of the income statement. These two presentations are referred to
as basic earnings per share and diluted earnings per share. Basic earnings per share re-
lies on the number of weighted-average common shares outstanding (i.e., equivalent to
EPS for a simple capital structure). Diluted earnings per share indicates the dilution of
earnings per share that will occur if all potential issuances of common stock that would
reduce earnings per share takes place. Companies with complex capital structures
should exclude antidilutive securities when computing earnings per share.
APPENDIX 16A ACCOUNTING FOR STOCK-APPRECIATION RIGHTS
A major disadvantage of many stock-option plans is that an executive must pay
8 LEARNING OBJECTIVE
income tax on the difference between the market price of the stock and the option
Explain the accounting for stock-
price at the date of exercise. This feature of stock-option plans (those referred to as |
appreciation rights plans.
nonqualified) can be a financial hardship for an executive who wishes to keep the
stock (rather than sell it immediately) because he or she would have to pay not
914 Chapter 16 Dilutive Securities and Earnings per Share
only income tax but the option price as well. In another type of plan (an incentive plan),
the executive pays no taxes at exercise but may need to borrow to finance the exercise
price, which leads to related interest cost.
One solution to this problem was the creation of stock-appreciation rights (SARs).
In this type of plan, the company gives an executive the right to receive compensation
equal to the share appreciation. Share appreciation is the excess of the market price of
the stock at the date of exercise over a pre-established price. The company may pay the
share appreciation in cash, shares, or a combination of both.
The major advantage of SARs is that the executive often does not have to make a
cash outlay at the date of exercise, but receives a payment for the share appreciation.
Unlike shares acquired under a stock-option plan, the company does not issue the shares
that constitute the basis for computing the appreciation in a SARs plan. Rather, the com-
pany simply awards the executive cash or stock having a fair value equivalent to the
appreciation. The accounting for stock-appreciation rights depends on whether the
company classifies the rights as equity or as a liability.
SARS—SHARE-BASED EQUITY AWARDS
Companies classify SARs as equity awards if at the date of exercise, the holder receives
shares of stock from the company upon exercise. In essence, SARs are essentially equiv-
alent to a stock option. The major difference relates to the form of payment. With the
stock option, the holder pays the exercise price and then receives the stock. In an equity
SAR, the holder receives shares in an amount equal to the share-price appreciation (the
difference between the market price and the pre-established price). The accounting for
SARs when they are equity awards follows the accounting used for stock options. At the
date of grant, the company determines a fair value for the SAR and then allocates this
amount to compensation expense over the service period of the employees.
SARS—SHARE-BASED LIABILITY AWARDS
Companies classify SARs as liability awards if at the date of exercise, the holder receives
a cash payment. In this case the holder is not receiving additional shares of stock but a
cash payment equal to the amount of share-price appreciation. The company’s compen-
sation expense therefore changes as the value of the liability changes.
A company uses the following approach to record share-based liability awards:
1. Measure the fair value of the award at the grant date and accrue compensation over
the service period.
2. Remeasure the fair value each reporting period, until the award is settled. Adjust
the compensation cost each period for changes in fair value prorated for the portion
of the service period completed.
3. Once the service period is completed, determine compensation expense each subse-
quent period by reporting the full change in market price as an adjustment to
compensation expense.
For liability awards, the company estimates the fair value of the SARs, using an
option-pricing model. The company then allocates this total estimated compensation
cost over the service period, recording expense (or a decrease in expense if fair value
declines) in each period. At the end of each period, total compensation expense reported
to date should equal the percentage of the total service period that has elapsed, multiplied
by the total estimated compensation cost.
Appendix 16A: Accounting for Stock-Appreciation Rights 915
For example, assume that the service period is 40 percent complete and total
estimated compensation is $100,000. The company reports cumulative compensation
expense to date of $40,000 ($100,000 3 .40).
The method of allocating compensation expense is called the percentage approach.
In this method, in the first year of, say, a four-year plan, the company charges one- |
fourth of the estimated cost to date. In the second year, it charges off two-fourths, or
50 percent, of the estimated cost to date, less the amount already recognized in the first
year. In the third year, it charges off three-fourths of the estimated cost to date, less the
amount recognized previously. In the fourth year, it charges off the remaining compensa-
tion expense.
A special problem arises when the exercise date is later than the service period. In
the previous example, if the stock-appreciation rights were not exercised at the end of
four years, in the fifth year the company would have to account for the difference in the
market price and the pre-established price. In this case, the company adjusts compensa-
tion expense whenever a change in the market price of the stock occurs in subsequent
reporting periods, until the rights expire or are exercised, whichever comes first.
Increases or decreases in the fair value of the SAR between the date of grant and
the exercise date, therefore, result in a change in the measure of compensation. Some
periods will have credits to compensation expense if the fair value decreases from one
period to the next. The credit to compensation expense, however, cannot exceed previ-
ously recognized compensation expense. In other words, cumulative compensation
expense cannot be negative.
STOCK-APPRECIATION RIGHTS EXAMPLE
Assume that American Hotels, Inc. establishes a stock-appreciation rights plan on
January 1, 2014. The plan entitles executives to receive cash at the date of exercise for the
difference between the market price of the stock and the pre-established price of $10
on 10,000 SARs. The fair value of the SARs on December 31, 2014, is $3, and the service
period runs for two years (2014–2015). Illustration 16A-1 indicates the amount of com-
pensation expense to be recorded each period, assuming that the executives hold the
SARs for three years, at which time they exercise the rights.
STOCK-APPRECIATION RIGHTS
SCHEDULE OF COMPENSATION EXPENSE
(1) (2) (3) (4) (5)
Cumulative
Cumulative Compensation
Fair Compensation Percentage Accrued Expense Expense Expense
Date Value Recognizablea Accruedb to Date 2014 2015 2016
12/31/14 $3 $30,000 50% $ 15,000 $15,000
55,000 $55,000
12/31/15 7 70,000 100% 70,000
(20,000) $(20,000)
12/31/16 5 50,000 100% $ 50,000
aCumulative compensation for unexercised SARs to be allocated to periods of service.
bThe percentage accrued is based upon a two-year service period (2014–2015).
ILLUSTRATION 16A-1
In 2014, American Hotels records compensation expense of $15,000 because Compensation Expense,
50 percent of the $30,000 total compensation cost estimated at December 31, 2014, is Stock-Appreciation
Rights
allocable to 2014. In 2015, the fair value increased to $7 per right ($70,000 total). The
916 Chapter 16 Dilutive Securities and Earnings per Share
company recorded additional compensation expense of $55,000 ($70,000 minus
$15,000).
The executives held the SARs through 2016, during which time the fair value declined
to $5 (and the obligation to the executives equals $50,000). American Hotels recognizes
the decrease by recording a $20,000 credit to compensation expense and a debit to
Liability under Stock-Appreciation Plan. Note that after the service period ends, since
the rights are still outstanding, the company adjusts the rights to market at December
31, 2016. Any such credit to compensation expense cannot exceed previous charges to
expense attributable to that plan.
As the company records the compensation expense each period, the corresponding
credit is to a liability account, because the company will pay the stock appreciation in
cash. American Hotels records compensation expense in the first year as follows.
Compensation Expense 15,000
Liability under Stock-Appreciation Plan 15,000
The company would credit the liability account for $55,000 again in 2015. In 2016,
when it records negative compensation expense, American would debit the account for
$20,000. The entry to record the negative compensation expense is as follows. |
Liability under Stock-Appreciation Plan 20,000
Compensation Expense 20,000
At December 31, 2016, the executives receive $50,000 (which equals the market price
of the shares less the pre-established price). American would remove the liability with
the following entry.
Liability under Stock-Appreciation Plan 50,000
Cash 50,000
Compensation expense can increase or decrease substantially from one period to
the next. The reason is that compensation expense is remeasured each year, which can
lead to large swings in compensation expense.
KEY TERMS
SUMMARY OF LEARNING OBJECTIVE
percentage approach, 915
FOR APPENDIX 16A
share appreciation, 914
stock-appreciation rights
(SARs), 914
8 Explain the accounting for stock-appreciation rights plans. The accounting
for stock-appreciation rights depends on whether the rights are classified as equity- or
liability-based. If equity-based, the accounting is similar to that used for stock options.
If liability-based, companies remeasure compensation expense each period and allocate
it over the service period using the percentage approach.
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE
This appendix illustrates the method of computing dilution when many securities
LEARNING OBJECTIVE 9
are involved. We present the following section of the balance sheet of Webster
Compute earnings per share in a
Corporation for analysis. Assumptions related to the capital structure follow the
complex situation.
balance sheet.
Appendix 16B: Comprehensive Earnings per Share Example 917
ILLUSTRATION 16B-1
WEBSTER CORPORATION
Balance Sheet for
BALANCE SHEET (PARTIAL)
Comprehensive
AT DECEMBER 31, 2014
Illustration
Long-term debt
Notes payable, 14% $ 1,000,000
8% convertible bonds payable 2,500,000
10% convertible bonds payable 2,500,000
Total long-term debt $ 6,000,000
Stockholders’ equity
10% cumulative, convertible preferred stock, par value $100;
100,000 shares authorized, 25,000 shares issued and outstanding $ 2,500,000
Common stock, par value $1, 5,000,000 shares authorized,
500,000 shares issued and outstanding 500,000
Additional paid-in capital 2,000,000
Retained earnings 9,000,000
Total stockholders’ equity $14,000,000
Notes and Assumptions
December 31, 2014
1. Options were granted in July 2012 to purchase 50,000 shares of common stock at $20 per share.
The average market price of Webster’s common stock during 2014 was $30 per share. All options
are still outstanding at the end of 2014.
2. Both the 8 percent and 10 percent convertible bonds were issued in 2013 at face value. Each
convertible bond is convertible into 40 shares of common stock. (Each bond has a face value of
$1,000.)
3. The 10 percent cumulative, convertible preferred stock was issued at the beginning of 2014 at par.
Each share of preferred is convertible into four shares of common stock.
4. The average income tax rate is 40 percent.
5. The 500,000 shares of common stock were outstanding during the entire year.
6. Preferred dividends were not declared in 2014.
7. Net income was $1,750,000 in 2014.
8. No bonds or preferred stock were converted during 2014.
The computation of basic earnings per share for 2014 starts with the amount based
upon the weighted-average number of shares outstanding, as shown in Illustration 16B-2.
ILLUSTRATION 16B-2
Net income $1,750,000
Computation of Earnings
Less: 10% cumulative, convertible preferred stock dividend requirements 250,000
per Share—Simple
Income applicable to common stockholders $1,500,000
Capital Structure
Weighted-average number of shares outstanding 500,000
Earnings per common share ($1,500,000 4 500,000) $3.00
Note the following points concerning this calculation.
1. When preferred stock is cumulative, the company subtracts the preferred dividend
to arrive at income applicable to common stock, whether the dividend is declared
or not.
2. The company must compute earnings per share of $3 as a starting point, because it
is the per share amount that is subject to reduction due to the existence of convertible
securities and options.
918 Chapter 16 Dilutive Securities and Earnings per Share |
DILUTED EARNINGS PER SHARE
The steps for computing diluted earnings per share are:
1. Determine, for each dilutive security, the per share effect assuming exercise/conversion.
2. Rank the results from step 1 from smallest to largest earnings effect per share. That
is, rank the results from most dilutive to least dilutive.
3. Beginning with the earnings per share based upon the weighted-average number of
shares outstanding ($3), recalculate earnings per share by adding the smallest per
share effects from step 2. If the results from this recalculation are less than $3, proceed
to the next smallest per share effect and recalculate earnings per share. Continue
this process so long as each recalculated earnings per share is smaller than the previ-
ous amount. The process will end either because there are no more securities to test
or a particular security maintains or increases earnings per share (is antidilutive).
We’ll now apply the three steps to Webster Corporation. (Note that net income and
income available to common stockholders are not the same if preferred dividends are
declared or cumulative.) Webster Corporation has four securities that could reduce EPS:
options, 8 percent convertible bonds, 10 percent convertible bonds, and the convertible
preferred stock.
The first step in the computation of diluted earnings per share is to determine a per
share effect for each potentially dilutive security. Illustrations 16B-3 through 16B-6
illustrate these computations.
ILLUSTRATION 16B-3
Number of shares under option 50,000
Per Share Effect of
Option price per share 3 $20
Options (Treasury-Stock
Proceeds upon assumed exercise of options $1,000,000
Method), Diluted
Earnings per Share Average 2014 market price of common $30
Treasury shares that could be acquired with proceeds ($1,000,000 4 $30) 33,333
Excess of shares under option over treasury shares
that could be repurchased (50,000 2 33,333) 16,667
Per share effect:
Incremental Numerator Effect None
5 5 $0
Incremental Denominator Effect 16,667 shares
ILLUSTRATION 16B-4
Interest expense for year (8% 3 $2,500,000) $200,000
Per Share Effect of 8%
Income tax reduction due to interest (40% 3 $200,000) 80,000
Bonds (If-Converted
Interest expense avoided (net of tax) $120,000
Method), Diluted
Earnings per Share Number of common shares issued assuming conversion of bonds
(2,500 bonds 3 40 shares) 100,000
Per share effect:
Incremental Numerator Effect $120,000
5 5 $1.20
Incremental Denominator Effect 100,000 shares
ILLUSTRATION 16B-5
Interest expense for year (10% 3 $2,500,000) $250,000
Per Share Effect of 10%
Income tax reduction due to interest (40% 3 $250,000) 100,000
Bonds (If-Converted
Interest expense avoided (net of tax) $150,000
Method), Diluted
Earnings per Share Number of common shares issued assuming conversion of bonds
(2,500 bonds 3 40 shares) 100,000
Per share effect:
Incremental Numerator Effect $150,000
5 5 $1.50
Incremental Denominator Effect 100,000 shares
Appendix 16B: Comprehensive Earnings per Share Example 919
ILLUSTRATION 16B-6
Dividend requirement on cumulative preferred (25,000 shares 3 $10) $250,000
Per Share Effect of 10%
Income tax effect (dividends not a tax deduction) none
Convertible Preferred
Dividend requirement avoided $250,000
(If-Converted Method),
Number of common shares issued assuming conversion of preferred Diluted Earnings per
(4 3 25,000 shares) 100,000 Share
Per share effect:
Incremental Numerator Effect $250,000
5 5 $2.50
Incremental Denominator Effect 100,000 shares
Illustration 16B-7 shows the ranking of all four potentially dilutive securities.
ILLUSTRATION 16B-7
Effect
Ranking of per Share
per Share
Effects (Smallest to
1. Options $ 0
Largest), Diluted
2. 8% convertible bonds 1.20
Earnings per Share
3. 10% convertible bonds 1.50
4. 10% convertible preferred 2.50
The next step is to determine earnings per share giving effect to the ranking in
Illustration 16B-7. Starting with the earnings per share of $3 computed previously, add
the incremental effects of the options to the original calculation, as follows.
ILLUSTRATION 16B-8
Options
Recomputation of EPS |
Income applicable to common stockholders $1,500,000
Using Incremental Effect
Add: Incremental numerator effect of options none
of Options
Total $1,500,000
Weighted-average number of shares outstanding 500,000
Add: Incremental denominator effect of options (Illustration 16B-3) 16,667
Total 516,667
Recomputed earnings per share ($1,500,000 4 516,667 shares) $2.90
Since the recomputed earnings per share is reduced (from $3 to $2.90), the effect of
the options is dilutive. Again, we could have anticipated this effect because the average
market price ($30) exceeded the option price ($20).
Assuming that Webster converts the 8 percent bonds, recomputed earnings per
share is as shown in Illustration 16B-9.
ILLUSTRATION 16B-9
8% Convertible Bonds
Recomputation of EPS
Numerator from previous calculation $1,500,000
Using Incremental Effect
Add: Interest expense avoided (net of tax) 120,000
of 8% Convertible Bonds
Total $1,620,000
Denominator from previous calculation (shares) 516,667
Add: Number of common shares assumed issued upon conversion of bonds 100,000
Total 616,667
Recomputed earnings per share ($1,620,000 4 616,667 shares) $2.63
Since the recomputed earnings per share is reduced (from $2.90 to $2.63), the effect
of the 8 percent bonds is dilutive.
Next, assuming Webster converts the 10 percent bonds, the company recomputes
earnings per share as shown in Illustration 16B-10 (page 920).
920 Chapter 16 Dilutive Securities and Earnings per Share
ILLUSTRATION 16B-10
10% Convertible Bonds
Recomputation of EPS
Numerator from previous calculation $1,620,000
Using Incremental Effect
Add: Interest expense avoided (net of tax) 150,000
of 10% Convertible
Bonds Total $1,770,000
Denominator from previous calculation (shares) 616,667
Add: Number of common shares assumed issued upon conversion of bonds 100,000
Total 716,667
Recomputed earnings per share ($1,770,000 4 716,667 shares) $2.47
Since the recomputed earnings per share is reduced (from $2.63 to $2.47), the effect
of the 10 percent convertible bonds is dilutive.
The final step is the recomputation that includes the 10 percent preferred stock. This
is shown in Illustration 16B-11.
ILLUSTRATION 16B-11
10% Convertible Preferred
Recomputation of EPS
Numerator from previous calculation $1,770,000
Using Incremental Effect
Add: Dividend requirement avoided 250,000
of 10% Convertible
Preferred Total $2,020,000
Denominator from previous calculation (shares) 716,667
Add: Number of common shares assumed issued upon conversion of preferred 100,000
Total 816,667
Recomputed earnings per share ($2,020,000 4 816,667 shares) $2.47
Since the recomputed earnings per share is not reduced, the effect of the 10 percent
convertible preferred is not dilutive. Diluted earnings per share is $2.47. The per share
effects of the preferred are not used in the computation.
Finally, Illustration 16B-12 shows Webster Corporation’s disclosure of earnings per
share on its income statement.
ILLUSTRATION 16B-12
Net income $1,750,000
Income Statement
Presentation, EPS Basic earnings per common share (Note X) $3.00
Diluted earnings per common share $2.47
A company uses income from continuing operations (adjusted for preferred divi-
dends) to determine whether potential common stock is dilutive or antidilutive. Some
refer to this measure as the control number. To illustrate, assume that Barton Company
provides the following information.
ILLUSTRATION 16B-13
Income from continuing operations $2,400,000
Barton Company Data
Loss from discontinued operations 3,600,000
Net loss $1,200,000
Weighted-average number of shares outstanding 1,000,000
Potential common stock 200,000
Demonstration Problem 921
Barton reports basic and dilutive earnings per share as follows.
ILLUSTRATION 16B-14
Basic earnings per share
Basic and Diluted EPS
Income from continuing operations $2.40
Loss from discontinued operations 3.60
Net loss $1.20
Diluted earnings per share
Income from continuing operations $2.00
Loss from discontinued operations 3.00
Net loss $1.00
As Illustration 16B-14 shows, basic earnings per share from continuing operations is |
higher than the diluted earnings per share from continuing operations. The reason: The
diluted earnings per share from continuing operations includes an additional 200,000
shares of potential common stock in its denominator.21
Companies use income from continuing operations as the control number because
many of them show income from continuing operations (or a similar line item above net
income if it appears on the income statement) but report a final net loss due to a loss on Gateway to
the Profession
discontinued operations. If a company uses final net loss as the control number, basic
and diluted earnings per share would be the same because the potential common shares EPS Illustration with Multiple
Dilutive Securities
are antidilutive.22
KEY TERM
SUMMARY OF LEARNING OBJECTIVE
control number, 920
FOR APPENDIX 16B
9 Compute earnings per share in a complex situation. For diluted EPS,
make the following computations. (1) For each potentially dilutive security, determine
the per share effect assuming exercise/conversion. (2) Rank the results from most dilu-
tive to least dilutive. (3) Recalculate EPS starting with the most dilutive, and continue
adding securities until EPS does not change or becomes larger.
DEMONSTRATION PROBLEM
On January 1, 2013, Scutaro Company issued 10-year, $200,000 face value, 6% bonds at par (payable annu-
ally on January 1). Each $1,000 bond is convertible into 30 shares of Garner $2 par value common stock. The
company has had 10,000 shares of common stock (and no preferred stock) outstanding throughout its life.
None of the bonds have been converted as of the end of 2014.
21A company that does not report a discontinued operation but reports an extraordinary item
should use that line item (for example, income before extraordinary items) as the control
number.
22If a company reports a loss from continuing operations, basic and diluted earnings per share
will be the same because potential common stock will be antidilutive, even if the company
reports final net income. The FASB believes that comparability of EPS information will be
improved by using income from continuing operations as the control number.
922 Chapter 16 Dilutive Securities and Earnings per Share
Scutaro also has adopted a stock-option plan that granted options to key executives to purchase 4,000
shares of the company’s common stock. The options were granted on January 2, 2013, and were exercis-
able 2 years after the date of grant if the grantee was still an employee of the company. The options ex-
pired 6 years from the date of grant. The option price was set at $4, and the fair value option-pricing
model determines the total compensation expense to be $18,000. All of the options were exercised during
the year 2015: 3,000 on January 3 when the market price was $6, and 1,000 on May 1 when the market price
was $7 a share. (Ignore all tax effects.)
Instructions
(a) Prepare the journal entry Scutaro would have made on January 1, 2013, to record the issuance of the
bonds.
(b) Prepare the journal entry to record interest expense and compensation expense in 2014.
(c) Scutaro’s net income in 2014 was $30,000 and was $27,000 in 2013. Compute basic and diluted earn-
ings per share for Scutaro for 2014 and 2013. Scutaro’s average stock price was $4.40 in 2013 and
$5 in 2014.
(d) Assume that 75 percent of the holders of Scutaro’s convertible bonds convert their bonds to stock
on June 30, 2015, when Scutaro’s stock is trading at $8 per share. Scutaro pays $2 per bond to
induce bondholders to convert. Prepare the journal entry to record the conversion.
Solution
(a) Under U.S. GAAP, proceeds from the issuance of convertible debt are recorded entirely as debt.
Cash 200,000
Bonds Payable 200,000
(b) December 31, 2014
Interest Expense 12,000
Interest Payable 12,000
[To record interest expense for 2014
($200,000 3 6%)]
Compensation Expense 9,000
Paid-in Capital—Stock Options 9,000
[To record compensation expense
for 2014 (1/2 3 $18,000)]
(c) Basic EPS 2014 2013
Net income (a) $30,000 $27,000
Outstanding shares (b) 10,000 10,000 |