Chapter 15: Stockholders' Equity

Question 1

Incremental Method

for valuing stock issued with other securities

Answer 1

When fair value for all securities cannot be determined

uses whichever fair value is known as value for that part and then the remainder for the other

If no values are known the securities may require expert appraisal

Question 2

Stockholders’ equity disclosures

Answer 2

Rights and privileges of securities outstanding

• dividend and liquidation preferences
• participation rights, unusual voting rights
• call prices and dates
• conversion or exercise prices and pertinent dates
• sinking fund requirements
• significant contract terms

Note to disclose restrictions on retained earnings

(some may go directly in the equity section, not the notes)

Question 3

Statement of Stockholders’ Equity

Answer 3

Often in columnar format with columns or all SE accounts

Rows:

• beginning balance
• addition and deduction transactions (listed out)
• balance at end of period

Requirement to show changes in each SE account, can be done in multiple ways

Question 4

Redeemable Preferred Stock

Answer 4

has mandatory redemption period

very like a debt

must now be classified as a liability and measured as such

Question 5

Equity Ratios

Answer 5

Evaluate profitability and long-term solvency

• Return on common stockholders’ equity (ROE)
• Payout Ratio
• Book value per share

Question 6

Return on Common Stockholder’s Equity

Answer 6

ROE
measures company profitability: dollars of net income for each dollar of investment

comparative between companies also helpful

= (net income - preferred dividends) / average common stockholders’ equity

Average common stockholders’ equity = total SE less PAR VALUE of preferred stock

expressed as a percentage

Question 7

Trading on Equity

Answer 7

Using borrowed money or issuing preferred stocks in the hope of obtaining a higher rate of return on the money used

ROE > ROA (return on total assets)

Question 8

Recording stock issued in non-cash transactions

Answer 8

Companies should record stock issued for services or property other than cash at either the fair value of the stock issued or the fair value of the non-cash consideration received - whichever is more clearly determinable

Avoid using book, par, or stated values to value

Question 9

Recording preferred stock: cumulative vs non-cumulative

Answer 9

When a dividend is declared

Non-cumulative: preferred stockholders receive their dividend (% of par) and remaining is distributed to common stockholders

Cumulative: preferred stockholders receive their dividends PLUS any dividends on past non-dividend years, only then is remaining dividend distributed to common stockholders

Question 10

Watered stock

Answer 10

Stock held at too high value due to overvaluation of property/ services received in exchange

Question 11

Par/stated value method for recording purchase of treasury stock

Answer 11

Debit treasury stock at par value (may be debit common stock?)

shown on balance sheet as reduction to capital stock only

Question 12

Cost method for recording purchase of treasury stock

Answer 12

More popular than the par/stated value method

Debit Treasury stock (at acquisition cost)
Credit Cash

Shown on balance sheet as a reduction to stockholder’s equity

No consideration for the original price on the sale of stock

Question 13

Reporting Treasury stock on the balance sheet

Answer 13

Stockholders’ Equity section of the balance sheet

Paid in Capital

Common Stock

Question 14

Reporting Treasury stock on the balance sheet

Answer 14

Stockholders’ Equity section of the balance sheet

Paid in Capital
       Treasury Stock 
        Common Stock
        PIC
          Total Paid In Capital
Retained Earnings
     Total Paid in capital and retained earnings
Less cost of treasury stock
      Total stockholders' equity

Disclose number of shares

Question 15

Secret Reserves

Answer 15

When a corporation undervalues its recorded assets

• excessive depreciation / amortization
• undervaluing exchanges
• misstating expenses vs capital expenditures

Understatement of an asset/ overstatement of liabilities

Question 16

Convertible preferred stock

Answer 16

Allows stockholder to exchange preferred shares for common at a predetermined ratio

Book value method employed, no gain or loss recognized

Question 17

Recording costs of issuing stock

Answer 17

Record as a reduction to amount paid in
ONLY direct costs
- underwriting, accounting/legal fees, printing, taxes

issue costs - cost of financing

Question 18

Reporting preferred stock disclosures

Answer 18

Must disclose pertinent rights of any preferred stock outstanding

Question 19

Recording stock issued for a receivable

Answer 19

Receivable recorded as contra-equity account

(risk of collection is high)

generally just don’t record equity until cash is received

Question 20

Reasons companies buy back shares

Answer 20

• tax efficient distributions to stockholders (lower capital gain tax on sale of stock)
• increase EPS / return on equity
• increase ratios without changing performance
• to provide stock for employees compensation or merger needs
• to thwart takeover attempts / reduce number of stockholders
• to make a market for the stock (creates demand)

Question 21

Leveraged buyout

Answer 21

(LBO)

company borrows money to finance stock repurchases

Question 22

Treasury stock

Answer 22

Corporation’s own stock, reacquired after having been issued and fully paid

NOT AN ASSET + ownership does not give any rights to company to act as own shareholder

purchase recorded at cost (cost method - normally) or par (par method - occasionally)

in most states is a restriction on retained earnings

Question 23

Considerations on declaring a dividend

Answer 23

• agreements with creditors and state requirements of restricted retained earnings
• need to hold earning to finance growth
• liquidity / flexibility of assets
• buffer for potential future issues
• availability of funds for dividends or liabilities

Question 24

Characteristics of the corporate form

Answer 24

• influence state corporate law
• use of capital stock or share system
• development of a variety of ownership interests

Question 25

Steps to issuing stock

Answer 25

1) state authorizes stock (certificate of incorporation/ charter) 2) corporation offers shares for sale & enters into contract to sell 3) in receipt for cash shares are issues (this is when journal entry occurs)

Question 26

Recording sale of treasury stock

Answer 26

Use inventory costing methods for repurchase price Debit cash Credit treasury stock at repurchase cost if sell ABOVE repurchase price: Credit PIC - Treasury stock If sell below repurchase price: Debit PIC - Treasury stock if it is available if not Debit retained earnings

Question 27

Business incorporation acts

Answer 27

vary by state - account follows provisions of laws Definition of terms may vary between states

Question 28

Gains

Answer 28

Gains on sales only occurs when selling assets, additional money from stock is "additional paid in capital"

Question 29

Retiring treasury stock

Answer 29

Board of directors decision - treasury stock cancelled - issued shares decrease Retired = authorized and unissued Debit paid in capital (common stock, preferred stock, APIC) Credit Treasury stock

Question 30

Dividend policy disclosures

Answer 30

Encouraged by SEC to include in annual report

Question 31

Recording cash dividends

Answer 31

on date of declaration: Debit Retained Earnings Credit Dividends payable (may potentially use "cash dividends declared" account that is closed to RE at year end Date of record: no entry Date of payment: Debit Dividends Payable Credit cash

Question 32

Recording preferred stock dividends | non-participating vs participating

Answer 32

After preferred dividend is assigned non-participating: all remaining dividend distributed among common stock Participating- may be specified in the contract. otherwise: - common stock receives like percentage of par value outstanding - remainder of dividend is divided by TOTAL par value to find rate of participation - multiple by part to determine amount of participation between common and preferred

Question 33

Payout Ratio

Answer 33

Ratio of cash dividends to net income - if preferred stock exists do not include = cash dividends on common stock / net income available to common stockholders DO NOT subtract non-controlling interest

Question 34

Book value per share

Answer 34

The amount each share would receive if the company were liquidated, based on the balance sheet = common stockholders' equity / outstanding common shares

Question 35

Recording property dividends

Answer 35

1) record gain (credit) or loss (debit) as necessary 2) record dividend declared Debit Retained Earnings or Property Dividends Declared Credit Property Dividends Payable 3) at date of distribution: debit property dividends payable credit property account

Question 36

Recording liquidating dividends

Answer 36

Date of declaration: Debit Retained earnings Debit PIC-Common stock Credit dividends payable Date of payment: Debit Dividends Payable Credit Cash

Question 37

Recording Ordinary stock dividend

Answer 37

(ordinary dividend = less than 20-25%) MUST BE PROPORTIONATE Date of declaration: Transfer retained earnings to paid in capital: Debit Retained Earnings (fair value) Credit common stock dividend distributable (par value) Credit PIC - common stock Distribution Debit common stock distributable Credit common stock

Question 38

Large stock dividend

Answer 38

Should really be called stock split up Stock dividend of more than 20-25% (SEC says 25%) number of shares previously outstanding more resembles stock split than dividend and reduces unit market price still require transfer par value of stock issued from retained earnings split up effected in the form of a dividend

Question 39

Recording a stock dividend

Answer 39

No assets paid out or liability incurred

Question 40

Shareholder Rights

Answer 40

In the absence of restrictive provisions - to share proportionately in profits and losses - to share proportionately in management (by voting for directors - to share proportionately in corporate assets upon liquidation - to share proportionately in any new issue of stock of the same class (called the preemptive right, prevents dilution of ownership)

Question 41

Registrar or transfer agent

Answer 41

provide services to corporations to record and transfer stock (maintaining required records)

Question 42

Components of stockholders equity

Answer 42

``` contributed capital/ paid in capital: - capital stock - additional paid in capital Earned capital - retained earnings Other - accumulated other comprehensive income ```

Question 43

Book value per share with preferred stock

Answer 43

Any dividends in arrears current year requirements + participating potential dividends for preferred stock must be removed from the stockholders' equity before dividing by common shares outstanding

Question 44

Accumulated other comprehensive income

Answer 44

Not retained earnings or contributed capital ex: unrealized gains and losses on AFS debt/ investments/ derivative transactions

Question 45

Preferred stock features

Answer 45

Depend on the contract, - preference as to dividend (amount expressed as % of par value, or if no par value expressed as $/share) - preference as to assets in event of liquidation - convertible into common stock - callable at the option of the corporation - non-voting

Question 46

Stock dividends

Answer 46

The issuance by a corporation of its own stock to its stockholders on a pro rata basis essentially reclassifies retained earnings to contributed capital stockholders maintain proportionate interest - book value per share is lower

Question 47

Cumulative preferred stock

Answer 47

Accumulated dividends in arrears (must make up missed years of preferred stock before paying common stock) no liability is recorded until the dividend is declared - cumulative status just disclosed in financial statements most preferred stock is cumulative

Question 48

Participating preferred stock

Answer 48

receives preferred dividends AND dividends at the same rate as common stockholders if excess over preferred rare

Question 49

Stockholders' equity

Answer 49

Residual interest = net assets (aka assets - liabilities) a claim against a portion of total assets, not specific assets amount depends on profitability

Question 50

Recording a stock split

Answer 50

no accounting entry- just a memorandum note on the changed par value/ changed quantity

Question 51

Callable preferred stock

Answer 51

company may call (redeem) all standing shares call/ redemption price pre-set generally above issue price (which sets a ceiling on share price when redeemed must pay dividends in arrears

Question 52

Stock split

Answer 52

Reduces market price of stock - same total values - multiplied shares Shareholders retain % ownership now more shares for sale at a lower price Reverse stock splits also happen (unsplitting)

Question 53

Recording stock sold below par value

Answer 53

Rarely occurs Discount on par value recorded as a DEBIT to additional paid-in capital (Equity account, credit NB) may be able to call on purchaser/ holder to pay difference to avoid loss on liquidation

Question 54

Recording issuance of par value stock

Answer 54

Debit Cash Credit preferred stock/ common stock at par Credit PIC - preferred stock/ common stock

Question 55

No Par Stock

Answer 55

- illegal in some states - may be considered legal capital - reduces flexibility of paying dividends - may have higher taxes - some states may require to have a stated value (minimum price of stock)

Question 56

Recording issuance of no par stock

Answer 56

NO PIC Debit Cash Credit Common Stock if has stated value may use APIC account for amount over stated value

Question 57

Recording lump sum sales of stock with other securities

Answer 57

proportional method or incremental method

Question 58

Proportional method for valuing stock issued with other securities

Answer 58

used if there is a sound basis for determining relative value value allocated based on % of total fair value

Question 59

Types of dividends

Answer 59

- Cash dividends - property dividends (in kind0 - liquidating dividends expect for stock dividends all dividends reduce total stockholders' equity

Question 60

Property dividends

Answer 60

dividends in kind: most often securities or stock in other companies (investments) (sometimes merchandise, real estate) Date of declaration - restate at fair value the property to be distributed (recognize gain or loss)

Question 61

Cash dividend process

Answer 61

1) Date of declaration (dividend = current liability) 2) date of record - all stockholders on current list will receive a dividend 3) date of payment generally a significant lag between one and three may be an amount per share or a percent of par no dividends on treasury stock

Question 62

Other considerations for computing book value per share

Answer 62

- # of authorized and UN issued shares - treasury shares on hand - commitments of issuance of unissued / treasury shares - rights and privileges of stock authorized - if liquidating value of preferred stock is greater than carrying value of amount use liquidating amount in book value computation

Question 63

Liquidating dividend

Answer 63

Dividend not based on retained earnings (base on paid in capital, REDUCES paid-in-capital) a return of the stockholders' investment may take place over an extended period as company disposes of assets DISCLOSE

Question 64

Small (ordinary) stock dividend

Answer 64

Stock dividend less than 20-25% of common shares outstanding at time of declaration company required to transfer the fair value of the stock issued from retained earnings

Question 65

Treasury shares and stock dividends

Answer 65

May be state requirements

Question 66

Balance sheet stockholders' equity

Answer 66

Capital stock List types of stock, par value/no par, any preferred dividends, shares outstanding, issued, and authorized total capital stock PIC List types Total paid in capital (stock + PIC) Retained earnings Total paid in capital and retained earnings Less Treasury stock + accumulated comprehensive other loss/ income Total stockholder's equity