Financial 7 - Stockholder Equity

Method of accounting for treasury stock - cost method

- Treasury shares are recorded and carried at their reacquisition cost - APIC from T/S is credited for gains/debited for losses when treasury stocks are issued at prices different from reacquisition cost. Loss can decrease RE if APIC from T/S doesn't have a balance large enough to absorb the loss

Classification of retained earnings

1. appropriated 2. unappropriated

"authorized" capital stock

A corporation's charter contains the amounts of each class of stock that it may legally issue, and this is called "authorized" capital stock.

stock option - accounting for stock issued to employees

A stock option is the right to purchase shares of a corporation's capital stock under fixed conditions of time, place, and amount. Under traditional stock option and stock purchase plans, an employer corporation grants options to purchase shares of its stock, often at a price lower than the prevailing market . Most purchaser must retain the stock for a minimum period, thus eliminating the possibility of speculation. Compensation cost is measured by the fair value based on an option pricing model; noncompensatory or compensatory.

Stock rights

A stock right provides an existing shareholder with the opportunity to buy additional shares. The right usually carries a price below the stock's market price on the date the rights are granted. The issuance of stock rights requires a memorandum entry only.

procedure

Bring retained earnings to zero ( i . e . , eliminate the deficit) against additional paid in capital Example in book

On April 1, Hyde Corp., a newly formed company, had the following stock issued and outstanding: Common stock, no par, $1 stated value, 20,000 shares originally issued for $30 per share. Preferred stock, $10 par value, 6,000 shares originally issued for $50 per share. Hyde's April 1 statement of stockholders' equity should report: (common stock, preferred stock, APIC)

CS 20000, PS 60000, APIC 820000 Common and preferred stock are recorded at the number of shares issued times stated or par value. Any excess is paid-in capital.

Callable (Redeemable) Preferred Stock

Callable preferred stock may be called (repurchased) at a specified price (at the option of the issuing corporation). The aggregate or the per share amount at which the preferred stock is callable must be disclosed either on the balance sheet or in the footnotes.

On January 1, Year 1, a company issued its employees 10,000 shares of restricted stock. On January 1, Year 2, the company issued to its employees an additional 20,000 shares of restricted stock. Additional information about the company's stock is as follows: Date Fair value of stock (per share) January 1, Year 1 $20 December 31, Year 1 22 January 1, Year 2 25 December 31, Year 2 30 The shares vest at the end of a four-year period. There are no forfeitures. What amount should be recorded as compensation expense for the 12-month period ended December 31, Year 2?

Choice "a" is correct. Compensation cost for restricted share plans is determined using the following formula: Total compensation cost = Market price of the share on date of grant × Number of restricted shares awarded Using the above formula, the total compensation cost for Year 1 is $20.00 × 10,000 shares = $200,000. Using the above formula, the total compensation cost for Year 2 is $25.00 × 20,000 shares = $500,000. Total compensation cost is allocated to compensation expense on a straight-line basis over the time period in which the employee must provide service. This company has a four-year service period. The compensation expense for the 12 months ended December 31, Year 2 would be one fourth of the compensation cost of Year 1, which is $50,000 (1/4 × $200,000) and one fourth of the compensation cost of Year 2, which is $125,000 (1/4 × $500,000), for a total of $175,000.

A company issued rights to its existing shareholders without consideration. The rights allowed the recipients to purchase unissued common stock for an amount in excess of par value. When the rights are issued, which of the following accounts will be increased? a. Common Stock b. Additional PIC

Choice "a" is correct. No entry is made when the rights are issued since no consideration is given. If the rights are exercised and stock is issued, then common stock and additional paid-in capital increase.

On January 15, Year 1, Rico Co. declared its annual cash dividend on common stock for the year ended January 31, Year 1. The dividend was paid on February 9, Year 1, to stockholders of record as of January 28, Year 1. On what date should Rico decrease retained earnings by the amount of the dividend? a. January 15, Year 1 b. January 31, Year 1 c. January 28, Year 1 d. February 9, Year 1

Choice "a" is correct. The date of declaration is the date the board of directors formally approves a divided. A liability is created (dividends payable), and retained earnings is reduced (debited).

Which of the following financial instruments issued by a public company should be reported on the issuer's books as a liability on the date of issuance? a. Cumulative preferred stock. b. Preferred stock that is convertible to common stock five years from the issue date. c. Common stock that contains an unconditional redemption feature. d. Common stock that is issued at a 5% discount as part of an employee share purchase plan.

Choice "c" is correct. Common stock that contains an unconditional redemption feature should be reported on the issuer's books as a liability on the date of issuance because there is an obligation of a cash outflow in the future that the company has no ability to preve

Quoit, Inc. issued preferred stock with detachable common stock warrants. The issue price exceeded the sum of the warrants' fair value and the preferred stock's par value. The preferred stock's fair value was not determinable. What amount should be assigned to the warrants outstanding? a.The proportion of the proceeds that the warrants' fair value bears to the preferred stock's par value. b.Excess of proceeds over the par value of the preferred stock. c. The fair value of the warrants. d.Total proceeds.

Choice "c" is correct. The fair value of the warrants is credited to paid in capital.

The primary purpose of a quasi-reorganization is to give a corporation the opportunity to: a. Obtain relief from its creditors. b. Revalue understated assets to their fair values. c. Eliminate a deficit in retained earnings. d. Distribute the stock of a newly-created subsidiary to its stockholders in exchange for part of their stock in the corporation.

Choice "c" is correct. The primary purpose of a quasi-reorganization is to eliminate a retained earnings deficit so that future earnings will be available for dividends rather than limited to offsetting the retained earnings deficit. ARB 43 Ch 1A para. 2

CAPITAL STOCK (legal capital)

Legal capital is the amount of capital that must be retained by the corporation for the protection of creditors. The par or stated value of both preferred and common stock is legal capital and is frequently referred to as "capital" stock.

East Corp., a calendar-year company, had sufficient retained earnings in Year 1 as a basis for dividends, but was temporarily short of cash. East declared a dividend of $100,000 on April 1, Year 1, and issued promissory notes to its stockholders in lieu of cash. The notes, which were dated April 1, Year 1, had a maturity date of March 31, Year 2, and a 10% interest rate. How should East account for the scrip dividend and related interest? a. Debit retained earnings for $100,000 on April 1, Year 1, and debit interest expense for $10,000 on March 31, Y2. b. Debit retained earnings for $110,000 on March 31, Y2. c. Debit retained earnings for $100,000 on April 1, Year 1, and debit interest expense for $7,500 on December 31, Y1

Choice "d" is correct. Dr. Retained earnings on April 1, Year 1 $ 100,000 Cr. Notes payable to stockholders $ 100,000 Dr. Interest expense on Dec. 31, Year 1 7,500 Cr. Accrued interest payable 7,500

Cyan Corp. issued 20,000 shares of $5 par common stock at $10 per share. On December 31, Year 1, Cyan's retained earnings were $300,000. In March, Year 2, Cyan reacquired 5,000 shares of its common stock at $20 per share. In June, Year 2, Cyan sold 1,000 of these shares to its corporate officers for $25 per share. Cyan uses the cost method to record treasury stock. Net income for the year ended December 31, Year 2, was $60,000. At December 31, Year 2, what amount should Cyan report as retained earnings? a. $375,000 b. $365,000 c. $380,000 d. $360,000

Choice "d" is correct. $360,000 retained earnings at 12/31/Year 2 ($300 + $60). Because all treasury stock transactions were recorded under the "cost method," and the resale of treasury stock was at a price that exceeded its acquisition price, none of the treasury stock transactions affected retained earnings.

In a compensatory stock option plan for which the grant and exercise dates are different, the stock options outstanding account should be reduced at the: a. Date of grant. b. Beginning of the vesting period. c. Beginning of the service period. d. Exercise date.

Choice "d" is correct. Stock options outstanding are reduced at the exercise date.

Book Value per Common Share

Common shareholders' equity/ Common shares outstanding

Compensatory Stock Option/Purchase Plans (example in book)

Compensatory stock options and stock purchase plans are valued at the fair value of the options issued .

Convertible Preferred Stock

Convertible preferred stock may be exchanged for common stock (at the option of the stockholder) at a specified conversion rate.

Date of record

The date of record is the date the board of directors specifies as the date the names of the shareholders to receive the dividend are determined. (no J/E)

expiration of option

Dr. APIC - stock option Cr. APIC - expired stock option (remaining balance in the stock option account - part of total compensation expense)

J/E to record issuance of stock previously subscribed

Dr. CS subscribed (800 shares @$10) 8000 Cr. CS (issued) 8000

J/E to record exercise of stock rights

Dr. Cash Cr. Common stock Cr. Additional paid-in capital

J/E to record subscription

Dr. Cash $85000 Cr. Subscription receivable $85000

Date of payment

Dr. Dividend payable Cr. Cash

journal entry to record appropriation be made or reverse when the purpose of appropriation has occured

Dr. Retained earnings (unappropriated) -- Reduce Cr. Retained earnings appropriated for (purpose) -- Increase

Example of small stock dividend Capital Corporation has 100,000 shares of $10 par value common stock outstanding. The company declares a stock dividend of 5,000 shares when the fair market value is $15 (on the date of declaration). 5,000 shares/100,000 shares = 5%, which is considered a small stock dividend. What is the journal entry to record the dividend?

Dr. Retained earnings 75000 (5000x$15) Cr. Common stock 50000 Cr. APIC 25000

J/E to record sale of stock subscription

Dr. Subscriptions receivable (1,000 shares @ sales price of $100/share $ 100,000 Cr. Common stock subscribed ($10 par x 1,000 shares) $10,000 Cr. Additional paid-in capital ( 1,000 shares x $90 share) 90,000

Date of declaration

The declaration date is the date the board of directors formally approves a dividend . Dr. Retained Earnings Cr. Dividend Payables

Par Value

Generally, preferred stock is issued with a par value, but common stock may be issued with or without a par value. No-par common stock may be issued as true no-par stock or no-par stock with a stated value. Any excess of the actual amount received over the par or stated value of the stock is accounted for as additional paid-in capital.

retained earnings definition

Is accumulated earnings (or losses) during the life of the corporation; does not include treasury stock

During Year 1, Brad Co. issued 5,000 shares of $100 par convertible preferred stock for $110 per share. One share of preferred stock can be converted into three shares of Brad's $25 par common stock at the option of the preferred shareholder. On December 31, Year 2, when the market value of the common stock was $40 per share, all of the preferred stock was converted. What amount should Brad credit to Common Stock and to Additional Paid-in Capital - Common Stock as a result of the conversion?

Issuance of Preferred Stock: Dr. Cash $ 550,000 Cr. Preferred Stock $ 500,000 Cr. APIC - PS 50,000 Conversion to Common Stock: Dr. Preferred Stock $ 500,000 Dr. APIC - PS 50,000 Cr. Common Stock $ 375,000 Cr. APIC - CS 175,000

EXAMPLE - ACCOUNTING FOR STOCK OPTIONS On January 1, Year 1, ABC Co. granted options exercisable after December 31, Year 2, to purchase 10,000 shares of $5 par common stock for $25 per share. On the grant date, the market price of the stock was $20 per share. Using an acceptable valuation model, the options had a total fair value of $50,000. The options are to serve as compensation for services during Year 1 and Year 2.

J/E allocating compensation cost to Y1 and Y2 compensation - accruing expense Dr. Compensation expense 25000 Cr. APIC - Stock option 25000 J/E recording exercise of option Dr. Cash 250000 Dr. APIC 50000 Cr. CS 50000 Cr. APIC excess of par 250000 (a plug)

Example of large stock dividend LMT Corp. declares a 40% stock dividend on its 1,000,000 shares of outstanding $10 par common stock (5,000,000 authorized ). On the date of declaration, LMT stock is selling for $20 per share. Total stock dividend (.40 x 1,000,000) Value of 400,000 shares @ $10 per share (par)

J/E to record declaration of stock dividend at par: Dr. Retained earnings 4000000 Cr. Common stock distributable 4000000 J/E to record distribution of stock dividend Dr. Common stock distributable 4000000 Cr. Capital stock, $10 par common 4000000

Mandatorily Redeemable Preferred Stock (Liability)

Mandatorily redeemable preferred stock is issued with a maturity date. Similar to debt, mandatorily redeemable preferred stock must be bought back by the company on the maturity date. Mandatorily redeemable preferred stock must be classified as a liability, unless the redemption is required to occur only upon the liquidation or termination of the reporting entity.

Formula

Net income/loss Dividends (cash, property, and stock) declared ± Prior period adjustments ± Accounting changes reported retrospectively + Adjustment from quasi-reorganization Retained Earnings

Calculate retained earnings (formula)

Net income/losses - Dividend (cash, FV of property dividend, stock) declared +/- Prior period adjustment +/- Accounting changes reported retrospectively + Adjustment from quasi-reorganization = Change in retained earnings (net of tax)

Godart Co. issued $4,500,000 notes payable as a scrip dividend that matured in five years. At maturity, each shareholder of Godart's three million shares will receive payment of the note principal plus interest. The annual interest rate was 10%. What amount should be paid to the stockholders at the end of the fifth year? a. $450,000 b. $2,250,000 c. $4,500,000 d. $6,750,000

Note: For purposes of this question, to clarify the question, we are assuming that what the examiners mean is that each shareholder will receive his/her "portion" of the note receivable plus interest; however, the interpretation does not really make any difference because the question is what amount should be paid to the stockholders (in total). Further, there is nothing about a note that automatically says the interest on the note has to be simple interest. Many notes are short-term (less than a year), and the issue thus never arises. Choice "d" is correct. The annual interest rate on the notes is 10% assumed to be non-compounding (the question does not say that, or indicate it in any way, but it is the only way to get the answer that the examiners have provided). Simple interest each year is $450,000 ($4,500,000 x .10), and 5 years of this interest is $2,250,000. The note principal plus interest is thus $4,500,000 plus $2,250,000, or $6,750,000.

Division Corporation has 20,000 shares of $5.00 participating 9 percent cumulative preferred stock and 100,000 shares of $2.00 common stock. On July 1, the board of Division declared a $30,000 dividend at the time the common stock was selling for $25 per share and the preferred stock was selling for $30. The total dividends paid to each class of stock on the payment date was:

Participating preferred stock splits dividend distributions with common shareholders only after the common shareholders have received percentage dividends equivalent to preferred shareholders. The remaining dividend is shared in relation to relative capitalization. The following calculation illustrates the distribution of dividends by share classification. Originally PSD = 9000, CSD = 18000. Based on total capitalism (PS cap = 33%, CS cap = 67%), PS shareholders get extra $1000, CS shareholders get extra $2000

Preference upon Liquidation

Preferred stock may include a preference to assets upon liquidation of the entity. If the liquidation preference is significantly greater than the par or stated value, the liquidation preference must be disclosed . The disclosure of the liquidation preference must be in the equity section of the balance sheet, not in the notes to the financial statements.

Property dividend

Property dividends distribute noncash assets (e.g . , inventory, investment securities, etc. ) to shareholders. FMV, treat as a sale

RETAINED EARNINGS

RE (or deficit) is accumulated earnings (or losses) during the life of the corporation that have not been paid out as dividends. The amount of accumulated retained earnings is reduced by distributions to stockholders and transfers to APIC for stock dividends. Retained earnings does not include treasury stock or accumulated other comprehensive income. If the retained earnings account has a negative balance, it is called a deficit.

Large stock dividend

Reduce RE by par, reduce EPS

liquidating dividend

The dividend is a liquidating dividend to the extent that the dividend exceeded retained earnings.

At December 31, Year 1 and Year 2, Carr Corp. had outstanding 4,000 shares of $100 par value 6% cumulative preferred stock and 20,000 shares of $10 par value common stock. At December 31, Year 1, dividends in arrears on the preferred stock were $12,000. Cash dividends declared in Year 2 totaled $44,000. Of the $44,000, what amounts were payable on each class of stock?

Rule: Cumulative preferred stock dividends are paid on par value (not sales price) of preferred stock and have a "preference" over common stock dividends until all past preferred stock dividends are paid. 36000 preferred dividend and 8000 common dividend

On November 2, Year 1, Finsbury, Inc. issued warrants to its stockholders giving them the right to purchase additional $20 par value common shares at a price of $30. The stockholders exercised all warrants on March 1, Year 2. The shares had market prices of $33, $35, and $40 on November 2, Year 1, December 31, Year 1, and March 1, Year 2, respectively. What were the effects of the warrants on Finsbury's additional paid-in capital and net income?

Rule: That portion of proceeds in excess of stocks' par value is credited to "additional paid-in-capital" at the time the rights are exercised. Choice "a" is correct. The rights were exercised in Year 2. The exercise of stock rights increases additional paid-in capital, but has no effect on "net income."

If a corporation sells some of its treasury stock at a price that exceeds its cost, this excess should be: a. Credited to additional paid-in capital. b. Treated as a reduction in the carrying amount of remaining treasury stock. c. Credited to retained earnings. d. Reported as a gain in the income statement.

Rule: There is no gain or loss on the purchase and/or sale of treasury stock. Any "difference" goes to "paid-in capital," or if there is not enough paid-in capital to absorb a loss, the loss would be debited (subtracted) from "retained earnings." Choice "a" is correct. When treasury stock is sold at a price that exceeds its cost, the excess would be credited to "paid-in capital."

At December 31, Year 1, Eagle Corp. reported $1,750,000 of appropriated retained earnings for the construction of a new office building, which was completed in Year 2 at a total cost of $1,500,000. In Year 2, Eagle appropriated $1,200,000 of retained earnings for the construction of a new plant. Also, $2,000,000 of cash was restricted for the retirement of bonds due in Year 3. In its Year 2 balance sheet, Eagle should report what amount of appropriated retained earnings? a. $2,950,000 b. $1,450,000 c. $3,200,000 d. $1,200,000

Rule: When the purpose of the appropriation has been achieved, it should be restored to unappropriated retained earnings. Choice "d" is correct. $1,200,000 appropriated retained earnings at Dec. 31, Year 2 (for the construction of a new plant only).

Scrip Dividends

Scrip dividends are simply a special form of notes payable whereby a corporation commits to paying a dividend at some later date. Scrip dividends may be used when there is a cash shortage. Dr. Retained earnings Cr. Notes payable

Stock dividend on treasury stock Stock split on treasury stock

Stock dividends are generally not distributed on treasury stock because such stock is not considered outstanding. However, an exception is made when ( 1 ) the company is maintaining a ratio of treasury shares to shares outstanding in order to meet stock option or other contractual commitments or (2) state law requires that treasury stock be protected from dilution. Same for stock split

Participating Preferred Stock

The participating feature provides that preferred shareholders share (participate) with common shareholders in dividends in excess of a specific amount. The participation may be full or partial

Quasi-Reorganization

The purposes of a quasi-reorganization are to restate overvalued assets to their lower fair values (and thus reduce future depreciation ) and to eliminate a retained earnings deficit (and thus facilitate the declaration of dividends).

Common Stockholders' Equity Formula

Total shareholders' equity - Preferred stock outstanding (at greater of call price or par value) - Cumulative preferred dividends in arrears = Common shareholders' equity

"issued" capital stock

When part or all of the authorized capital stock is issued , it is called "issued" capital stock

Non-Cumulative Preferred Stock

With non-cumulative preferred stock, dividends not paid in any year do not accumulate

Non-compensatory option purchase plan - GAAP Must meet all requirements Under I F RS, employee stock purchase plans and stock options a re generally considered to be compensatory.

a . Substantially all full-time employees meeting limited employee qualifications may participate. Excluded are officers and employees own ing a specific amount of the outstanding stock in the corporation. b. Stock is offered to eligible employees equally, but may limit the total amount of shares purchased . c. The time permitted to exercise the rights is limited to a reasonable period. d . Any discount from the market price is no greater than would be a reasonable offer of stock to shareholders

stock subscription

a corporation sells its capital stock by subscription. This means that a contractual agreement to sell a specified number of shares at an agreed-upon price on credit is entered into. Upon full payment of the subscription, a stock certificate evidencing ownership in the corporation is issued - treated like a contract, usually at discount, sell capital stock

Cumulative Preferred Stock

all or part of the preferred dividend not paid in any year accumulates and must be paid in the future before dividends can be paid to common shareholders. The accu mulated amount is referred to as dividends in arrears. The amount of d ividends in arrears is not a legal liability, but it must be disclosed

Stock split

applied retrospectively, no J/E recorded

On which of the following dates is a public entity required to measure the cost of employee services in exchange for an award of equity interests, based on the fair market value of the award? a. Date of vesting. b. Date of restriction lapse. c. Date of grant. d. Date of exercise.

c. Date of grant.

grant date

date option is issued

appropriated retained earnings

disclose to shareholders (usually common) that some of the RE are not available to pay dividends because they have been restricted for legal or contractual reasons (e.g. a bond indenture) or as management act (e.g. plan expansion); may not be used to absorb costs or losses and may not be transferred to income

fair value

given, determined by option pricing model

option price (exercise price)

is the price at which the underlying stock can be purchased pursuant to the option contract.

Small stock dividend

less than 20%-25% of the shares previously outstanding are distributed, no dividend income reported by shareholders, reduce RE by FMV of stock

Fully participating

means that preferred shareholders participate in excess d ividends without limit. Generally, preferred shareholders receive their preference dividend first, and then additional dividends are shared between common and preferred shareholders Proration of Remaining Dividends According to Par Values (example in book)

Partially participating

preferred shareholders participate in excess dividends, but to a limited extent (e. g . , a percentage limit).

Donated Stock

recorded at fair value There is no change in total shareholders' equity as a result of the donation, but the number of shares outstanding decreases, resulting in higher book value per common share.

"outstanding" capital stock

the amount of issued capital stock in the hands of shareholders

exercise date

the option holder must use the option to purchase the underlying

vesting period

the period over which the employee has to perform services in order to earn the right to exercise the options (i.e., the time from the grant date to the vesting date). Compensation is recognized over the service period (i.e., the period the employee performs the service), and this is generally the vesting period.