Principals of Financial Accounting Final (Chapter 10)

Are dividends in arrears reported among the liabilities of the dividend-paying firm? If not, how are they reported, and why?

Do not become a liability of a corporation until they have been declared by the board of directors; they are not recorded as liabilities but disclosed in a footnote to the financial statements.

Why do corporations utilize different forms of equity?

Each form of equity offers a different advantage to the issuing corporation.

How is a preferred stock dividend calculated?

Established as one of the terms of the issue; fixed as a percentage of the par value.

Distinguish between retained earnings and accumulated other comprehensive income.

Gains and losses from certain nonowner transactions that bypass the income statement and go directly to stockholders' equity; retained earnings are what is left of the earnings that flow through the income statement after payment to the owners.

A corporation repurchases 10,000 shares of its common stock at $7 per share and later resells it for $11 per share. What is the affect on the income statement of this resell?

Never has an affect on the income statement.

Which entries are made (if any) at the declaration date, date of record, and date of payment for cash dividends?

On the declaration date, the company records the dividend by a debit to Dividends and a credit to Dividends Payable; no journal entry on the date of record; on the date of payment, the company records a debit to Dividends Payable and a credit to Cash.

What does a share of stock represent?

Part ownership of the company.

Discuss the similarities between preferred stock and debt.

Preferred dividends are a contractually defined amount and typically paid each year; both debt are preferred stock are paid off in full before common stockholders receive anything in liquidation; neither preferred stock nor debt provides voting rights; the value of preferred stock, like the value of debt, is most closely tied to interest rate levels and the company's overall credit worthiness.

How do common stock and preferred stock differ?

Preferred stock grants certain privileges, usually involving dividends, to its holders that are not granted to holders of common stock; common stock confers voting rights; dividends on common stock are more closely correlated with the success of the corporation than are preferred dividends; other differences: dividend preferences, conversion privileges, liquidation preferences, call provisions, and denial of voting rights. First two are advantages of stock holders and the last two are disadvantages.

What is the difference between a privately and publicly held corporation?

Privately is one whose stock is held by a relatively small group of private individuals. Publicly is one whose stock is owned and purchasable by the general public.

What does stockholders' equity represent?

Represents the owners' claims against the assets of a corporation after all liabilities have been deducted. Capital stock, retained earnings or deficit, accumulated other comprehensive income, and treasury stock.

Describe the statement of changes in stockholders' equity.

Shows changes in each of the Capital Stock accounts, changes in the number of shares outstanding, and changes in retained earnings.

How are dividend payout and profitability ratios useful to investors?

Stockholders want to understand: how the value of their shares of stock will change, and how the company will distribute any excess cash to stockholders; the results of these ratios are used to compare over time to evaluate trends, and to be compared to results from other companies in the industry.

What are retained earnings?

The accumulated earnings (or losses) over the entire life of the corporation that have not been paid out in dividends to stockholders; also known as deficit.

What balance sheet accounts are affected by the issuance of stock?

The contributions of stockholders are usually divided between two equity accounts on the basis of the par value of the stock; the par value multiplied by the number of shares sold is recorded in an account that describes the type of stock; when a company receives more than par value for newly issued stock, the excess over par is recorded in an account called Additional Paid-In Capital.

Describe how cumulative preferred stock differs from noncumulative preferred stock.

The cumulative dividend preference requires the eventual payment of all preferred dividends - both unpaid dividends from prior periods and any due in the current period - before any dividends are paid to common stockholders; preferred stock that does not have the cumulative feature does not have to pay preferred stockholders for years in which no dividends are paid.

What are authorized shares?

The maximum number of shares the corporation may issue in each class of stock; it is included in the corporate charter.

What is a stock warrant?

The right guaranteed by a corporation to purchase a specified number of shares of its common stock at a stated price and within a stated time period; warrants are used when bonds or preferred stock are sold to make those instruments more attractive to investors; when additional shares of stock are sold to the public, warrants are often issued to existing stockholders to provide them the opportunity to maintain their existing percentage level of ownership. Warrants are also issued in the form of stock options to employees and executives as compensation.

Give four reasons why a company might purchase treasury stock.

To buy out the ownership of one or more stockholders, to reduce the size of corporate operations, to reduce the number of outstanding shares of stock in attempt to increase earnings per share and market value per share, to acquire shares to be transferred to employees under stock bonus, stock option, or stock purchase plans.

Why do corporations issue stock?

To raise cash or capital in a way that eases the transfer of ownership and limits the liabilities of owners.

Describe the effect of cash versus a stock dividend on a company's stockholders' equity.

A cash dividend decreases stockholders' equity; a stock dividend does not change stockholders' equity, instead it transfers retained earnings into contributed capital accounts.

What is the difference between par value and stated value?

Both are measures of legal capital; par value is the establish minimum price for which each share must be issued but does not determine the economic value of the stock; if stock is issued without a par value, it may have a stated value per share to establish the legal capital.

How may a corporation's retained earnings be restricted?

By agreements with lenders, corporations board of directors, and various provisions of state law: am agreement between the corporation and bondholders may require that retained earnings never fall below a specified level so long as the bonds are outstanding, board of directors may set aside a portion of retained earnings and declare it unavailable for the payment of dividends, may be used to communicate to stockholders changes in dividend policy made necessary by expansion programs or other decisions of the board, and state law may require that dividends not reduce retained earnings below the cost of treasury stock.

Describe two ways corporations make payouts to stockholders.

Cash and additional shares of stock; when the corporation is liquidating, stockholders get to share in proportion to their holdings or have a residual claim.

What is the effect of a stock split on stockholders' equity account balances?

Changes the number of authorized shares and always changes the numbers of issued and outstanding shares; involves a decrease in the per-share par value and an increase in the number of shares outstanding; do not change any equity account balances.

Why would the number of shares issues be different from the number of shares outstanding?

Corporations can buy back their own stock; when purchases previously issued stock, it is called treasury stock; these shares are no longer outstanding and the number of shares outstanding is the number of issued shares actually in the hands of stockholders; when firms reacquire their own stock, the reacquired shares are not considered outstanding.

When are prior period adjustments used?

Corrections of errors in financial statements of prior periods and presented as adjustments to beginning retained earnings; adjustments arising from estimation errors or changes from one accounting principle to another are excluded from prior period adjustments.

Explain each of the following preferred stock dividend preferences: 1) current dividend preference, 2) cumulative dividend preference, and 3) participating dividend preference.

A current dividend preference provides that current dividends must be paid to preferred stockholders before any dividends are paid to common stockholders; A cumulative dividend preference requires the eventual payment of all preferred dividends before paid to common stockholders; participating dividend preference provides that preferred stockholders receive, in addition to the stated dividend, a share of amounts available for distribution as dividends to other classes of stock.

What is a stock dividend? How does it differ from a stock split?

A stock dividend transfers shares of stock from the corporation to its stockholders; stockholders receive additional shares of the corporations stock; a stock split increases the number of outstanding shares without altering the proportionate ownership of a corporation; unlike a stock dividend, a stock split involves a decrease in the per-share par value, with no capitalization of retained earnings; a stock issue that increases the number of shares of a corporation without changing the balances of its equity accounts; no journal entry is required to record a stock split.

How would the purchase of treasury stock affect the stockholders' equity section of a corporation's balance sheet?

A temporary reduction of equity rather than the acquisition of an investment; requires a debt to a contra-equity account - Treasury Stock.

Why might a corporation grant stock options to employees in lieu of a higher salary?

Allow cash-poor companies to compete for higher priced talent in the employee market; also, stock options are believed to better align the incentives of the employee with those of the stockholders by tying the employee's compensation to the stock price.

What are the benefits that common stockholders may receive?

Vote in the election of the board of directors, share in the profits and dividends of the company, keep the same percentage of ownership if new stock is issued (preemptive right), and share in the assets of liquidation in proportion to their holdings (residual claim).

What is treasury stock?

When a corporation purchases its own previously issued stock; the stock the corporation buys.

Compare and contrast cash dividends and liquidating dividends.

When retained earnings have been reduced to zero, any additional dividends must come from paid-in capital; these are called liquidating dividends and must be charged against Capital Stock accounts - first additional paid-in capital, then par value; payment of liquidating dividends usually accompanies the dissolution of the corporation and is regulated by various laws designed to protect the interests of creditors and other holders of nonresidual equity; liquidating dividends are a return of paid-in capital; a cash dividend transfers cash from the corporation to its stockholders; it does not get charged against Capital Stock accounts and does not occur when the company is in dissolution.