14.2

Question 1

How would a stock split affect the par value of the stock and the company’s shareholders’ equity?

Par value:
Shareholder’s equity:

Answer 1

Decrease
No effect

A stock split reduces the par value of the stock and increases the number of shares outstanding, making it more attractive to investors. As with a stock dividend, each shareholder’s proportionate interest in the company and total book value remain unchanged.

Question 2

The format displayed is used by Gee, Inc., for its Year 4 statement of changes in equity. When both the 100% and the 5% stock dividends were declared and distributed, Gee’s common stock was selling for more than its $1 par value.

Common Stock $1 par
Balance at 1/1/Year 4: $90,000

Additional Paid-in Capital
Balance at 1/1/Year 4: $80,000

Retained Earnings
Balance at 1/1/Year 4: $175,000

How would the 5% stock dividend affect the additional paid-in capital and retained earnings amounts reported in Gee’s Year 4 statement of equity?

Additional Paid-in Capital:
Retained Earnings:

Answer 2

Increase

Decrease

Question 3

A retained earnings appropriation can be used to

Answer 3

Restrict earnings available for dividends.

Transfers to and from accounts properly designated as appropriated retained earnings (such as general purpose contingency reserves or provisions for replacement costs of fixed assets) are always excluded from the determination of net income. However, appropriation of retained earnings is permitted if it is displayed within the equity section and is clearly identified. The effect of the appropriation is to restrict the amount of retained earnings available for dividends, not to set aside assets.

Question 4

Sanders Company effects self-insurance against loss from fire by appropriating an amount of retained earnings each year equal to the amount that would otherwise be paid out as fire insurance premiums. According to current accounting literature, the procedure used by Sanders is

Answer 4

Acceptable provided that fire losses are not charged against the appropriation.

An expense is not accrued prior to the occurrence of the event for which an entity self-insures. The fair value of the property diminishes only if the event actually occurs. But an appropriation of retained earnings is acceptable to disclose the self-insurance policy if, when a fire loss occurs, the entry appropriating retained earnings is reversed, and the loss is debited to income of the period of loss and not to retained earnings.

Question 5

At December 31, Year 3 and Year 4, 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 3, dividends in arrears on the preferred stock were $12,000. Cash dividends declared in Year 4 totaled $44,000. What amounts were payable on each class of stock?

Preferred Stock:
Common Stock

Answer 5

$36,000
$8,000

Given that the preferred stock is cumulative, preferred dividends in arrears and the dividends for the current period must be paid before common shareholders may receive any dividends. The preferred dividends for the year ending December 31, Year 4, are $24,000 (4,000 shares × $100 par value × 6%). Consequently, the preferred shareholders should receive $36,000 ($12,000 Year 3 dividends in arrears + $24,000 Year 4 dividends). The common shareholders will receive the remaining $8,000 ($44,000 – $36,000).

Question 6

Ashe Corp. was organized on January 1, with authorized capital of 100,000 shares of $20 par value common stock. During the year, Ashe had the following transactions affecting equity:

January 10 - issued 25,000 shares at $22 a share
March 25 - issued 1,000 shares for legal services when the fair value was $24 a share
September 30 - issued 5,000 shares for a tract of land when the fair value was $26 a share

What amount should Ashe report for additional paid-in capital at December 31?

Answer 6

$84,000

Question 7

East Co. issued 2,000 shares of its $5 par common stock to Krannik as compensation for 1,000 hours of legal services performed. Krannik usually bills $200 per hour for legal services. On the date of issuance, the stock was trading on a public exchange at $160 per share. By what amount should the additional paid-in capital account increase?

Answer 7

$310,000

When stock is issued for property or services, the transaction is recorded at the fair value of the stock or of the property or services received. In this case, the value of the stock is used because it is more objective. The $320,000 (2,000 shares × $160 market price) should be allocated as follows: $10,000 (2,000 shares × $5 par) to common stock and $310,000 to additional paid-in capital.

Question 8

A corporation declared a dividend, a portion of which was liquidating. How does this declaration affect each of the following?

Additional Paid-in Capital:
Retained Earnings:

Answer 8

Decrease
Decrease

The portion of a dividend that is liquidating results in a distribution in excess of the corporation’s retained earnings. The effect of a liquidating dividend is to decrease contributed capital. Additional paid-in capital is debited first to the extent available before other contributed capital accounts are charged. Thus, declaration of a cash dividend, a portion of which is liquidating, decreases both additional paid-in capital and retained earnings.

Question 9

Blue Co. issued preferred stock with detachable common stock warrants at a price that exceeded both the par value and the fair value of the preferred stock. At the time the warrants are exercised, Blue’s total equity is increased by the

Cash received upon exercise of the warrants:
Carrying amount of the warrants:

Answer 9

Yes
No

When shares of preferred stock with detachable common stock warrants are issued at a price that exceeds both the par value and the fair value of the preferred stock, the consideration received must be allocated between the preferred stock and the detachable warrants. The amount allocated to the stock warrants outstanding should be recorded in the equity section as contributed capital. At the time the warrants are exercised, contributed capital will reflect both the cash received upon the exercise of the warrants and the carrying amount of the warrants. Total equity, however, will be increased only by the amount of cash received because the carrying amount of the warrants is already included in total equity.

Question 10

Wood Co. owns 2,000 shares of Arlo, Inc.’s 20,000 shares of $100 par, 6% cumulative, nonparticipating preferred stock and 1,000 shares (2%) of Arlo’s common stock. During Year 2, Arlo declared and paid dividends of $240,000 on preferred stock. No dividends had been declared or paid during Year 1. In addition, Wood received a 5% common stock dividend from Arlo when the quoted market price of Arlo’s common stock was $10 per share. What amount should Wood report as dividend income in its Year 2 income statement?

Answer 10

$24,000

Dividends, including those in arrears on preferred stock, are not liabilities of the investee or assets of the investor until the date of declaration. Thus, Wood should not recognize income from the dividends in arrears until Year 2. Stock dividends are not recognized as income. Because Wood owns 10% of the outstanding preferred stock (2,000 ÷ 20,000), it receives 10% of the dividends or $24,000 ($240,000 × .10).

Question 11

Underhall, Inc.’s common stock is currently selling for $108 per share. Underhall is planning a new stock issue in the near future and would like to stimulate interest in the company. The Board, however, does not want to distribute capital at this time. Therefore, Underhall is considering whether to offer a 2-for-1 common stock split or a 100% stock dividend on its common stock. The best reason for opting for the stock split is that

Answer 11

It will not impair the company’s ability to pay dividends in the future.

A 2-for-1 stock split doubles the number of shares outstanding; retained earnings is not affected. Under a stock dividend, however, a portion of retained earnings is reclassified as common stock. Since dividends are restricted by the amount of available retained earnings, a stock dividend, but not a stock split, will impair the firm’s ability to pay dividends in the future.

Question 12

Lem Co., which accounts for treasury stock under the par-value method, acquired 100 shares of its $6 par value common stock for $10 per share. The shares had originally been issued by Lem for $7 per share. By what amount would Lem’s additional paid-in capital from common stock decrease as a result of the acquisition?

Answer 12

$100

The entry for issuance of the stock was
Cash $700
Common stock ($6 per share) $600
Additional paid-in capital 100

The par-value method treats a treasury stock purchase as a constructive retirement. Assuming no balance in paid-in capital from treasury stock transactions, the entry for the treasury stock purchase using the par-value method is
Treasury stock $600
Additional paid-in capital 100
Retained earnings 300
Cash $1,000

Question 13

If a corporation sells some of its treasury stock at a price that exceeds its cost, this excess should be

Answer 13

Credited to additional paid-in capital.

Under the par value method, when treasury stock is reissued, cash is debited and treasury stock is credited for par value. Any excess of cash received is credited to additional paid-in capital. If the price is less than the par value, the debit is to an additional paid-in capital account or retained earnings. Under the cost method, treasury stock is credited at cost, and an additional paid-in capital account is credited for the excess of the proceeds over the cost.

Question 14

On January 2, Year 5, Lake Mining Co.’s board of directors declared a cash dividend of $400,000 to shareholders of record on January 18, Year 5, payable on February 10, Year 5. The dividend is permissible under law in Lake’s state of incorporation. Selected data from Lake’s December 31, Year 4, balance sheet are as follows:

Accumulated depletion: $100,000
Capital stock: 500,000
Additional paid-in capital: 150,000
Retained earnings: 300,000

The $400,000 dividend includes a liquidating dividend of

Answer 14

$100,000

A common practice of companies whose major activity is the exploitation of depletable resources is to pay dividends in amounts up to the sum of retained earnings and accumulated depletion. However, any distribution by a corporation to its shareholders in excess of the dollar balance in the retained earnings account is considered a liquidating dividend and return of capital to the shareholders. Consequently, the liquidating dividend equals $100,000 ($400,000 dividend – $300,000 retained earnings).

Question 15

On July 1, Vail Corp. issued rights to shareholders to subscribe to additional shares of its common stock. One right was issued for each share owned. A shareholder could purchase one additional share for 10 rights plus $15 cash. The rights expired on September 30. On July 1, the market price of a share with the right attached was $40, while the market price of one right alone was $2. Vail’s equity on June 30 included the following:

Common stock, $25 par value,
4,000 shares issued and outstanding: $100,000
Additional paid-in capital: 60,000
Retained earnings: 80,000

By what amount should Vail’s retained earnings decrease as a result of issuance of the stock rights on July 1?

Answer 15

$0

When stock rights are issued for no consideration, only a memorandum entry is made. When stock rights are exercised and stock is issued, the issuing company will reflect the proceeds as an increase in common stock and additional paid-in capital. Thus, retained earnings will not be affected when rights are either issued or exercised.

Question 16

In Year 1, Rona Corp. issued 5,000 shares of $10 par value common stock for $100 per share. In Year 7, Rona reacquired 2,000 shares at $150 per share from the estate of one of its deceased officers and immediately canceled these 2,000 shares. Rona uses the cost method in accounting for its treasury stock transactions. In connection with the retirement of these 2,000 shares, Rona should debit

Additional Paid-in Capital:
Retained Earnings:

Answer 16

$180,000
$100,000

The 2,000 shares of stock were originally issued for $100 per share, a total of $200,000. Of this amount, $20,000 (2,000 shares × $10 par) should have been credited to common stock, with the remaining $180,000 [2,000 shares × ($100 – $10)] credited to additional paid-in capital. When these 2,000 shares are purchased at $150 per share and retired, common stock and additional paid-in capital should be debited for $20,000 and $180,000, respectively, which were the amounts related to the reacquired shares originally credited to those accounts. Moreover, $100,000 [2,000 shares × ($150 – $100)] should be debited to retained earnings (assuming no previous treasury stock transactions that resulted in additional paid-in capital). Because the stock was immediately retired, this journal entry would be made whether the treasury stock is accounted for under the cost method or the par value method.

Question 17

In Year 2, Fogg, Inc., issued $10 par value common stock for $25 per share. No other common stock transactions occurred until March 31, Year 4, when Fogg acquired some of the issued shares for $20 per share and retired them. Which of the following statements accurately states an effect of this acquisition and retirement?

Answer 17

Additional paid-in capital is decreased.

When shares of common stock are reacquired and retired, contributed capital should be debited for the amount that was credited upon the issuance of the securities. In addition, because the acquisition of a company’s own shares is an equity transaction, no gain or loss should be reflected in the determination of income. The entry is to debit common stock at par (number of shares × $10) and additional paid-in capital [number of shares × ($25 – $10)], and to credit additional paid-in capital from retirement of common stock [number of shares × ($25 – $20)] and cash (number of shares × $20). The net effect is to decrease total additional paid-in capital.

Question 18

Asp Co. was organized on January 2, Year 4, with 30,000 authorized shares of $10 par common stock. During Year 4, the corporation had the following capital transactions:

January 5 - Issued 20,000 shares at $15 per share
July 14 - Purchased 5,000 shares at $17 per share
December 27 - Reissued the 5,000 shares held in treasury at $20 per share

Asp used the par-value method to record the purchase and reissuance of the treasury shares. It had no prior treasury stock transactions. In its December 31, Year 4, balance sheet, what amount should Asp report as additional paid-in capital?

Answer 18

$125,000

Under the par-value method, additional paid-in capital is debited for $25,000 (5,000 shares × $5 excess of the issue price over par) when the treasury stock is acquired. Treasury stock is debited for the $50,000 par value (5,000 shares × $10), and retained earnings is debited for $10,000 [5,000 shares × ($17 – $15)]. When the stock is reissued, additional paid-in capital is credited for $50,000 (5,000 shares × $10 excess over par). Thus, ending additional paid-in capital is $125,000 ($100,000 – $25,000 + $50,000).

Question 19

Tyler Corporation purchased 10,000 shares of its own $5 par-value common stock for $25 per share. This stock originally sold for $28 per share. Tyler used the cost method to record this transaction. If the par-value method had been used rather than the cost method, which of the following accounts would show a different dollar amount?

Answer 19

Additional paid-in capital and treasury stock.

Under the cost method, the treasury stock account was debited for the full market price of the shares; had the par-value method been used, treasury stock would only have been debited for the par value of the shares. Under the cost method, the additional paid-in capital account was not affected; had the par-value method been used, additional paid-in capital would have been debited for the excess of the market price of the shares over par.

Question 20

Which one of the following statements regarding dividends is correct?

Answer 20

The declaration and payment of a 10% stock dividend will result in a reduction of retained earnings at the fair market value of the stock.

When a small stock dividend is declared (less than 20% to 25% of the previously outstanding common shares), retained earnings is debited for the fair value of the stock.