QUESTIONS Module 8 Equity Recognition & Owner Financing

Employee stock options potentially dilute earnings per share (EPS). What can companies do to offset these dilutive effects and how might this action affect the balance sheet?

Many companies repurchase shares (as treasury stock) in order to offset the dilutive effects of stock options, because stock options increase the number of outstanding shares in the diluted EPS calculation. Stock repurchases typically decrease cash, which has immediate and ongoing economic effects. Some companies increase debt to repurchase stock. Analysts need to be concerned about the consequences of increased leverage solely to manage diluted EPS.

Define par value stock. What is the significance of a stock's par value from an accounting and analysis perspective?

Par value stock is stock that has a face value printed (identified) on the stock certificate. Historically, par value was the minimum selling price for one share. From an accounting and analysis standpoint, there are no implications. The par value of the common stock is the amount added to the common stock account when the company sells stock. The remainder of the sale price is added to the additional paid-in-capital account. Stockholders' equity increases by the total amount regardless of whether one or two accounts (line items) are used.

Describe the accounting for a convertible bond. Can the conversion ever result in the recognition of a gain in the income statement?

When a convertible bond is converted, the company removes the net book value of the debt from the balance sheet. That is, the company removes both the face amount and any associated unamortized premium or discount. The stock is, then, issued for a "purchase price" equal to the bond's net book value (face amount net of any unamortized premium or discount). Then, the purchase price is allocated to common stock and additional paid-in capital. No gain or loss is ever reported upon conversion.

What items are typically reported under the stockholders' equity category of accumulated other comprehensive income (AOCI)?

Accumulated other comprehensive income (AOCI) represents changes in stockholders' equity that are caused by factors other than net income and transactions with the company's shareholders. There are four typical items in AOCI, including: • Unrealized gains (losses) on available-for-sale securities • Foreign-currency translation adjustments • Unrealized gains (losses) on certain types of derivatives • Certain pension liability adjustments.

Describe the difference between contributed capital and earned capital. Specifically, how can earned capital be considered as an investment by the company's stockholders?

Contributed capital represents the total investment "contributed" by shareholders when they purchase stock. It is considered contributed because the company is under no legal obligation to repay the shareholders. Earned capital represents the cumulative net income that the company has earned, less the portion of that income that has been paid out to shareholders in the form of dividends. When profit is earned, the company can either pay out a portion of that profit as a dividend or reinvest the earnings in order to grow the company. In fact, many companies title the Retained Earnings account Reinvested Earnings or Undistributed Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends.

When a company reports negative retained earnings on the balance sheet (a deficit), can we conclude that the company has reported significant net losses on the income statement?

One conclusion from negative retained earnings is that the company has reported cumulative net losses in excess of cumulative net income. But there are other explanations. It could be that the company has repurchased and cancelled (retired) stock and the excess of the buyback price over the original issue price exceeds the cumulative net income. This scenario is not impossible, considering that current stock prices can be many times higher than its original issue price. A second possibility is that the company has paid out dividends in excess of net income. This occurs most frequently for real-estate trust firms and limited liability partnerships.

What are the basic differences between preferred stock and common stock? That is, what are the typical features of preferred stock?

There are a number of differences between preferred and common stock. Typically, preferred stock has the following features: 1) Preferential claim to dividends and to assets in liquidation, 2) Cumulative dividend rights, and 3) No voting rights.

Distinguish between authorized shares and issued shares. Why might the number of shares issued be more than the number of shares outstanding?

A corporation's authorized stock is the maximum number of shares of stock it may issue. When the corporation is formed, its charter specifies the authorized amounts and classes of stock. A corporation can later amend its charter to change the amount of authorized capital, but such actions must be approved by the company's shareholders. Shares that have been sold and issued to stockholders are the company's issued stock. Shares that have been sold and issued can be subsequently reacquired by the corporation—these shares are called treasury stock. When treasury stock is held, the issued shares exceed the outstanding shares.

A corporation has total stockholders' equity of $ 18,995,250 and one class of $2 par value common stock. The corporation has 500,000 shares authorized; 300,000 shares issued; and 15,000 shares as treasury stock. What is its book value per share?

The book value per share of common stock is the total stockholders' equity divided by the number of shares outstanding. Shares outstanding are 300,000 issued less 15,000 treasury shares. Thus book value is $18,995,250 / (300,000 - 15,000) = $66.65 per share.

What information is reported in a statement of stockholders' equity?

The statement of stockholders' equity analyzes and reconciles changes in all major components of stockholders' equity during an accounting period. The statement starts with the beginning balances of key stockholders' equity accounts, reports the items that explain the changes in these accounts, and ends with the period end balances.

If a corporation purchases I 0,000 shares of its own common stock at $ I 0 per share and resells them at $14 per share, where would the $40,000 increase in capital be reported in the financial statements? Why is no gain reported?

The $40,000 increase is not included on the income statement as income or gain. The $40,000 is properly treated as additional paid in capital and is shown as such in the stockholders' equity section of the balance sheet. GAAP prohibits companies from reporting gains or losses from stock transactions with their own shareholders, therefore no gain is reported. This proscription is justified because treasury stock transactions are considered capital rather than operating transactions. GAAP does not permit corporations to "own" themselves. Thus, the company's treasury stock is not shown as an investment.

Define stock split. What are the major reasons for a stock split?

A stock split refers to the issuance of additional shares to the current stockholders in proportion to their ownership interests. This is normally accompanied by a proportionate reduction in the par or stated value of the stock. For example, a 2 for 1 stock split doubles the number of shares outstanding and halves the par or stated value of the shares. Consequently, there is no change to the company's balance sheet; the amount of contributed capital remains the same after the stock split. The market value of the stock typically falls to half in the event of a 2:1 stock split. The major reason for a stock split is to reduce the share price of the stock. It is believed that when the stock price is very high, few investors can afford to purchase the stock. Another possible reason is to lead shareholders to believe that there has been some distribution of value.

What are three common forms of stock-based compensation and why do companies use such forms of compensation?

Common forms of stock-based compensation include stock grants, stock appreciation rights, stock options and stock purchase plans. Companies use stock based plans to create "shareholders" of the employees. This give the employees the incentive to think and make decisions like shareholders. Presumably, this will improve firm performance and increase firm value.

How does the account "additional paid-in capital" (APIC) arise? Does the amount of APIC reported on the balance sheet relative to the common stock amount provide any information about the financial condition of the company?

Contributed capital is divided into two accounts: the common or preferred stock account at par and additional paid-in capital. The common stock or preferred stock accounts at par increase by the par value of each share issued. But, if companies sell shares for more than par, it is the market price of the stock that determines the company's proceeds. The difference between the share's market price and its par value is added to the additional paid-in capital account. The breakdown of contributed capital between the common or preferred stock accounts and additional paid-in capital is not informative —it does not yield any implications regarding the financial condition of the company.

What is meant by the market cap of a company and how is it determined?

Market cap is short for market capitalization and it is the market value of the company's stock. To calculate market cap we multiply the number of shares outstanding by the price per share. Market cap changes continually during each trading day as the stock price changes.

What is meant by preferred dividends in arrears? If dividends are two years in arrears on $500,000 of 6% preferred stock, and dividends are declared at the end of this year, what amount of total dividends must the company pay to preferred stockholders before paying any dividends to common stockholders?

Preferred dividends in arrears are the cumulative preferred dividends on preferred stock that have not been paid to date. The dividends in arrears and a current dividend must be paid to preferred stockholders before common stockholders can receive any dividends. The company must pay preferred stockholders $90,000 in dividends ($500,000 0.06 3 years = $90,000) before paying any dividends to common stockholders.

What features make preferred stock similar to debt? Similar to common stock?

Preferred stock is similar to debt when 1. Dividends are cumulative.2. Dividends are nonparticipating.3. Preferred stockholders have preference to assets in liquidation.Preferred stock is similar to common stock when1. Dividends are not cumulative.2. Dividends are fully participating.3. It is convertible into common stock.4. Preferred stockholders do not have a preference to assets in liquidation.

Define treasury stock. Why might a corporation acquire treasury stock? How is treasury stock reported in the balance sheet?

Treasury stock is stock, previously issued, that the corporation has reacquired from stockholders on the open market. A corporation might repurchase treasury stock to give to employees who exercise stock options or to offset dilution resulting from option grants. Companies can return value to shareholders via stock buy backs—the cash is distributed to shareholders who chose to sell their stock to the company. It is sometimes used by management to increase stock price when management believes its stock is inappropriately underpriced. On the balance sheet, treasury stock is carried at its cost (the cash the corporation pays to acquire the stock) and is shown as a deduction (a negative amount) on the balance sheet. Thus, total stockholders' equity is net of treasury stock, which is known as a contra-equity account.