Chapter 15 Intermediate Accounting: Questions

1. In the absence of restrictive provisions, what are the basic rights of stockholders of a corporation?

1. The basic rights of each stockholder (unless otherwise restricted) are to share proportionately: (1) in profits, (2) in management (the right to vote for directors), (3) in corporate assets upon liquidation, and (4) in any new issues of stock of the same class (preemptive right).

13. What features or rights may alter the character of preferred stock?

13. The character of preferred stock can be altered by being cumulative or noncumulative, partici-pating or nonparticipating, convertible or nonconvertible, callable or noncallable, or redeemable.

23. Describe the accounting entry for a stock dividend, if any. Describe the accounting entry for a stock split, if any.

23. A stock dividend results in the transfer from retained earnings to paid-in capital of an amount equal to the fair value of each share (if the dividend is less than 20-25%) or the par value of each share (if the dividend is greater than 20-25%). No formal journal entries are required for a stock split, but a notation in the ledger accounts would be appropriate to show that the par value of the shares has changed.

27. For what reasons might a company restrict a portion of its retained earnings?

27. Retained earnings are restricted because of legal or contractual restrictions, or the necessity to protect the working capital position.

28. How are restrictions of retained earnings reported?

28. Restrictions of retained earnings are best disclosed in a note to the financial statements. This allows a more complete explanation of the restriction.

8. Explain the difference between the proportional method and the incremental method of allocating the proceeds of lump-sum sales of capital stock.

8. The proportional method is used to allocate the lump sum received on sales of two or more classes of securities when the fair value or other sound basis for determining relative value is available for each class of security. In instances where the fair value of all classes of securities is not determinable in a lump-sum sale, the incremental method must be used. The value of the securities is used for those classes that are known and the remainder is allocated to the class for which the value is not known.

9. What are the different bases for stock valuation when assets other than cash are received for issued shares of stock?

9. The general rule to be applied when stock is issued for services or property other than cash is that the property or services be recorded at either their fair value or the fair value of the stock issued, whichever is more clearly determinable. If neither is readily determinable, the value to be assigned is generally established by the board of directors.

*29. McNabb Corp. had $100,000 of 7%, $20 par value preferred stock and 12,000 shares of $25 par value common stock outstanding throughout 2014. (a) Assuming that total dividends declared in 2014 were $64,000, and that the preferred stock is not cumulative but is fully participating, common stockholders should receive 2014 dividends of what amount? (b) Assuming that total dividends declared in 2014 were $64,000, and that the preferred stock is fully participating and cumulative with preferred dividends in arrears for 2013, preferred stockholders should receive 2014 dividends totaling what amount? (c) Assuming that total dividends declared in 2014 were $30,000, that the preferred stock is cumulative, nonparticipating, and was issued on January 1, 2013, and that $5,000 of preferred dividends were declared and paid in 2013, the common stockholders should receive 2014 dividends totaling what amount?

*29. Preferred Common Total (a) Current year's dividend, 7% $ 7,000 $21,000a $28,000 Participating dividend of 9% 9,000 27,000 36,000 Totals $16,000 $48,000 $64,000 a(see schedule below for computation of amounts) The participating dividend was determined as follows: Current year's dividend: Preferred, 7% of $100,000 = $ 7,000 Common, 7% of $300,000 = 21,000 $ 28,000 Amount available for participation ($64,000 - $28,000) $ 36,000 Par value of stock that is to participate ($100,000 + $300,000) $400,000 Rate of participation ($36,000 ÷ $400,000) 9% Participating dividend: Preferred, 9% of $100,000 $ 9,000 Common, 9% of $300,000 27,000 Dividends $ 36,000 (b) Preferred Common Total Dividends in arrears, 7% of $100,000 $ 7,000 $ 7,000 Current year's dividend, 7% 7,000 $21,000 28,000 Participating dividend 7.25% ($29,000 ÷ $400,000)* 7,250 21,750 29,000 Totals $21,250 $42,750 $64,000 *(The same type of schedule as shown in (a) could be used here) (c) Preferred Common Total Dividends in arrears ($100,000 X 7%) - $5,000 $2,000 $ 2,000 Current year's dividend, 7% 7,000 7,000 Remainder to common $21,000 21,000 Totals $9,000 $21,000 $30,000

10. Explain how underwriting costs and accounting and legal fees associated with the issuance of stock should be recorded.

10. The direct costs of issuing stock, such as underwriting costs, accounting and legal fees, printing costs, and taxes, should be reported as a reduction of the amounts paid in. Issue costs are therefore debited to Paid-in Capital in Excess of Par—Common Stock because they are unrelated to corporate operations.

11. For what reasons might a corporation purchase its own stock?

11. The major reasons for purchasing its own shares are: (1) to provide tax-efficient distributions of excess cash to shareholders, (2) to increase earnings per share and return on equity, (3) to provide stock for employee stock compensation contracts or to meet potential merger needs, (4) to thwart takeover attempts or to reduce the number of stockholders, and (5) to make a market in the stock.

12. Discuss the propriety of showing: (a) Treasury stock as an asset. (b) "Gain" or "loss" on sale of treasury stock as additions to or deductions from income. (c) Dividends received on treasury stock as income.

12. (a) Treasury stock should not be classified as an asset since a corporation cannot own itself. (b) The "gain" or "loss" on sale of treasury stock should not be treated as additions to or deductions from income. If treasury stock is carried in the accounts at cost, these so-called gains or losses arise when the treasury stock is sold. These "gains" or "losses" should be considered as additions to or reductions of paid-in capital. In some instances, the "loss" should be charged to Retained Earnings. "Gains" or "losses" arising from treasury stock transactions are not included as a component of net income since dealings in treasury stock represent capital transactions. (c) Dividends on treasury stock should never be included as income, but should be credited directly to retained earnings, against which they were incorrectly charged. Since treasury stock cannot be considered an asset, dividends on treasury stock are not properly included in net income.

18. Indicate how each of the following accounts should be classified in the stockholders' equity section. (a) Common Stock. (b) Retained Earnings. (c) Paid-in Capital in Excess of Par—Common Stock. (d) Treasury Stock. (e) Paid-in Capital from Treasury Stock. (f) Paid-in Capital in Excess of Stated Value—Common Stock. (g) Preferred Stock.

18. The answers are summarized in the table below: Account/ Classification (a) Common Stock Paid-in capital—capital stock (b) Retained Earnings Retained earnings (c) Paid-in Capital in Excess of Par— Paid-in capital—additional paid-in capital Common Stock (d) Treasury Stock Deducted from total paid-in capital and retained earnings (e) Paid-in Capital from Treasury Stock Paid-in capital—additional paid-in capital (f) Paid-in Capital in Excess of Stated Paid-in capital—additional paid-in capital Value—Common Stock (g) Preferred Stock Paid-in capital—capital stock

14. Dagwood Inc. recently noted that its 4% preferred stock and 4% participating preferred stock, which are both cumulative, have priority as to dividends up to 4% of their par value. Its participating preferred stock participates equally with the common stock in any dividends in excess of 4%. What is meant by the term participating? Cumulative?

14. Nonparticipating means the security holder is entitled to no more than the specified fixed dividend. If the security is partially participating, it means that in addition to the specified fixed dividend the security may participate with the common stock in dividends up to a certain stated rate or amount. A fully participating security shares pro rata with the common stock dividends declared without limitation. In this case, Dagwood Inc. has a fully participating preferred stock. Cumulative means dividends not paid in any year must be made up in a later year before any profits can be distributed to common stockholders. Any dividends not paid on cumulative preferred stock constitute a dividend in arrears. A dividend in arrears is not a liability until the board of directors declares a dividend.

15. Where in the financial statements is preferred stock normally reported?

15. Preferred stock is generally reported at par value as the first item in the stockholders' equity section of a company's balance sheet. Any excess over par value is reported as part of additional paid-in capital.

16. List possible sources of additional paid-in capital.

16. Additional paid-in capital results from: (1) issuance of common stock or preferred stock in excess of par premiums on stock issued, (2) sale of treasury stock above cost, (3) recapitalizations or revisions in the capital structure, (4) conversion of convertible bonds or preferred stock, and (5) declaration of a small stock dividend.

17. Satchel Inc. purchases 10,000 shares of its own previously issued $10 par common stock for $290,000. Assuming the shares are held in the treasury with intent to reissue, what effect does this transaction have on (a) net income, (b) total assets, (c) total paid-in capital, and (d) total stockholders' equity?

17. When treasury stock is purchased, the Treasury Stock account is debited and Cash is credited at cost ($290,000 in this case). Treasury Stock is a contra stockholders' equity account and Cash is an asset. Thus, this transaction has: (a) no effect on net income, (b) decreases total assets, (c) has no effect on total paid-in capital, and (d) decreases total stockholders' equity.

19. What factors influence the dividend policy of a company?

19. The dividend policy of a company is influenced by (1) the availability of cash, (2) the stability of earnings, (3) current earnings, (4) prospective earnings, (5) the existence or absence of contractual restrictions on working capital or retained earnings, and (6) a retained earnings balance.

2. Why is a preemptive right important?

2. The preemptive right protects existing shareholders from dilution of their ownership share in the event the corporation issues new shares.

20. What are the principal considerations of a board of directors in making decisions involving dividend declarations? Discuss briefly.

20. In declaring a dividend, the board of directors must consider the condition of the corporation such that a dividend is (1) legally permissible and (2) economically sound. In general, directors should give consideration to the following factors in determining the legality of a dividend declaration: (1) Retained earnings, unless legally encumbered in some manner, is usually the correct basis for dividend distribution. (2) In some states, additional paid-in capital may be used for dividends, although such dividends may be limited to preferred stock. (3) Deficits in retained earnings and debits in paid-in capital accounts must be restored before payment of any dividends. (4) Dividends in some states may not reduce retained earnings below the cost of treasury stock held. In order that dividends be economically sound, the board of directors should consider: (1) the availability (liquidity) of assets for distribution; (2) agreements with creditors; (3) the effect of a dividend on investor perceptions (e.g. maintaining an expected "payout ratio"); and (4) the size of the dividend with respect to the possibility of paying dividends in future bad years. In addition, the ability to expand or replace existing facilities should be considered.

21. Dividends are sometimes said to have been paid "out of retained earnings." What is the error, if any, in that statement?

21. Cash dividends are paid out of cash. A balance must exist in retained earnings to permit a legal distribution of profits, but having a balance in retained earnings does not ensure the ability to pay a dividend if the cash situation does not permit it.

22. Distinguish among: cash dividends, property dividends, liquidating dividends, and stock dividends.

22. A cash dividend is a distribution in cash while a property dividend is a distribution in assets other than cash. Any dividend not based on retained earnings is a liquidating dividend. A stock dividend is the issuance of additional shares of the corporation's stock in a nonreciprocal exchange involving existing stockholders with no change in the par or stated value.

24. Stock splits and stock dividends may be used by a corporation to change the number of shares of its stock outstanding. (a) What is meant by a stock split effected in the form of a dividend? (b) From an accounting viewpoint, explain how the stock split effected in the form of a dividend differs from an ordinary stock dividend. (c) How should a stock dividend that has been declared but not yet issued be classified in a balance sheet? Why?

24. (a) A stock split effected in the form of a dividend is a distribution of corporate stock to present stockholders in proportion to each stockholder's current holdings and can be expected to cause a material decrease in the market price per share of the stock. GAAP specifies that a distribution in excess of 20% to 25% of the number of shares previously outstanding would cause a material decrease in the market price. This is a characteristic of a stock split as opposed to a stock dividend, but, for legal reasons, the term "dividend" must be used for this distribution. From an accounting viewpoint, it should be disclosed as a stock split effected in the form of a dividend because it meets the accounting definition of a stock split as explained above. (b) The stock split effected in the form of a dividend differs from an ordinary stock dividend in the amount of other paid-in capital or retained earnings to be capitalized. An ordinary stock dividend involves capitalizing (charging) retained earnings equal to the fair value of the stock distributed. A stock split effected in the form of a dividend involves charging retained earnings for the par (stated) value of the additional shares issued. Another distinction between a stock dividend and a stock split is that a stock dividend usually involves distributing additional shares of the same class of stock with the same par or stated value. A stock split usually involves distributing additional shares of the same class of stock but with a proportionate reduction in par or stated value. The aggregate par or stated value would then be the same before and after the stock split. (c) A declared but unissued stock dividend should be classified as part of paid-in capital rather than as a liability in a balance sheet. A stock dividend affects only capital accounts; that is, retained earnings is decreased and paid-in capital is increased. Thus, there is no debt to be paid, and, consequently, there is no severance of corporate assets when a stock dividend is issued. Furthermore, stock dividends declared can be revoked by a corporation's board of directors any time prior to issuance. Finally, the corporation usually will formally announce its intent to issue a specific number of additional shares, and these shares must be reserved for this purpose.

25. The following comment appeared in the notes of Colorado Corporation's annual report: "Such distributions, representing proceeds from the sale of Sarazan, Inc., were paid in the form of partial liquidating dividends and were in lieu of a portion of the Company's ordinary cash dividends." How would a partial liquidating dividend be accounted for in the financial records?

25. A partially liquidating dividend will be debited both to Retained Earnings and Paid-in Capital in Excess of Par. The portion of dividends that is a return of capital should be debited to Paid-in Capital in Excess of Par.

26. This comment appeared in the annual report of MacCloud Inc.: "The Company could pay cash or property dividends on the Class A common stock without paying cash or property dividends on the Class B common stock. But if the Company pays any cash or property dividends on the Class B common stock, it would be required to pay at least the same dividend on the Class A common stock." How is a property dividend accounted for in the financial records?

26. A property dividend is a nonreciprocal transfer of nonmonetary assets between company and its owners. A transfer of a nonmonetary asset to a stockholder or to another entity in a non-reciprocal transfer should be recorded at the fair value of the asset transferred, and a gain or loss should be recognized on the disposition of the asset.

3. Distinguish between common and preferred stock.

3. Preferred stock commonly has preference to dividends in the form of a fixed dividend rate and a preference over common stock to remaining corporate assets in the event of liquidation. Preferred stock usually does not give the holder the right to share in the management of the company. Common stock is the residual security possessing the greater risk of loss and the greater potential for gain; it is guaranteed neither dividends nor assets upon dissolution but it generally controls the management.

4. Why is the distinction between paid-in capital and retained earnings important?

4. The distinction between paid-in capital and retained earnings is important for both legal and economic points of view. Legally, dividends can be declared out of retained earnings in all states, but in many states dividends cannot be declared out of paid-in capital. Economically, management, stockholders, and others look to earnings for the continued existence and growth of the corporation.

5. Explain each of the following terms: authorized capital stock, unissued capital stock, issued capital stock, outstanding capital stock, and treasury stock.

5. Authorized capital stock—the total number of shares authorized by the state of incorporation for issuance. Unissued capital stock—the total number of shares authorized but not issued. Issued capital stock—the total number of shares issued (distributed to stockholders). Outstanding capital stock—the total number of shares issued and still in the hands of stockhold¬ers (issued less treasury stock). Treasury stock—shares of stock issued and repurchased by the issuing corporation but not retired.

6. What is meant by par value, and what is its significance to stockholders?

6. Par value is an arbitrary, fixed per share amount assigned to a stock by the incorporators. It is recognized by the state of incorporation as the amount that must be paid in for each share if the stock is to be fully paid when issued. If not fully paid, the shareholder has a contingent liability for the discount that results.

7. Describe the accounting for the issuance for cash of nopar value common stock at a price in excess of the stated value of the common stock.

7. The issuance for cash of no-par value common stock at a price in excess of the stated value of the common stock is accounted for as follows: (1) Cash is debited for the proceeds from the issuance of the common stock. (2) Common Stock is credited for the stated value of the common stock. (3) Paid-in Capital in Excess of Stated Value Common Stock is credited for the excess of the proceeds from the issuance of the common stock over its stated value.