Chapter 12
Shareholders’ Equity
Multiple Choice Questions
1. A corporation issued common stock instead of debt to finance the purchase of nondepreciable property. Which statement is True?
a. Ownership by existing shareholders will be diluted.
b. The company’s debt/equity ratio will be higher.
c. Income tax expense will be lower because expenses increase.
d. Net income will be lower.
Answer: A
2. Which one of the following is a result of a company issuing common stock instead of debt
to finance the purchase of property?
a. Leverage will be more effective.
b. The company will probably experience cash flow problems.
c. It will have a lower debt/equity ratio.
d. It will report a lower net income.
Answer: C
3. What is the effect of a corporation appropriating retained earnings for the cost of treasury
stock purchased?
a. Contributed capital is overstated.
b. A portion of retained earnings is restricted from the payment of dividends.
c. Owner’s equity is reduced by the amount of the appropriation.
d. Income is overstated.
Answer: B
4. Information related to Lamar Co. for the years ending December 31, 2010 and 2009
follows:
Dividends declared for 2010 totaled $20,000. How much was generated through operations?
a. $30,000
b. $50,000
c. $10,000
d. $70,000
Answer: B
5. A corporation generated assets by issuing equity securities and through profitable
operations. Which effects likely occurred?
a. Common stock and retained earnings increased.
b. Common stock increased and retained earnings stayed the same.
c. Retained earnings increased, and there was no effect on common stock.
d. Liabilities and common stock increased.
Answer: A
6. Which one of the following is a valid reason for a stock split?
a. To increase ownership percentages of individual shareholders
b. To adjust the market price of the shares to a level where more individuals can afford to
invest in the stock
c. To increase reported net income during subsequent accounting periods
d. To increase the book value per share of common stock
Answer: B
7. Which one of the following transactions cause a decrease to retained earnings?
a. Selling treasury stock
b. Incurring net income for the period
c. Declaring a stock dividend
d. Paying a cash dividend that was previously declared
Answer: C
8. On which date would you make no journal entry?
a. Date of declaration of cash dividend
b. Date of record of cash dividend
c. Date of payment of cash dividend
d. Date of declaring a stock dividend
Answer: B
9. Baker Company has 200,000 shares of common stock outstanding. The company declares
a stock dividend of 58,000 shares. According to GAAP, this dividend should be treated as:
a. a small stock dividend.
b. a prior period adjustment.
c. a large stock dividend.
d. a purchase of treasury stock.
Answer: C
10. Cash dividends are paid based on the number of shares which are
a. authorized.
b. issued.
c. outstanding.
d. outstanding minus the number of treasury shares.
Answer: C
11. Which one of the following represents the economic effects of declaring and issuing a
stock dividend?
a. Has no effect on total assets or total shareholders' equity
b. Decreases the debt/equity ratio
c. Decreases total shareholders' equity
d. Increases the current ratio
Answer: A
12. Which one of the following represents the economic effects of issuing a 2-for-1 stock
split?
a. No effect on par value per share or retained earnings
b. Decrease par value per share, and no effect on retained earnings
c. No effect on par value per share, and decrease retained earnings
d. Increase par value per share and retained earnings
Answer: B
13. Which one of the following is an effect when a company buys back it own shares of
stock?
a. Leverage is affected.
b. It will pay more dividends.
c. It will have a higher debt/equity ratio.
d. Fixed assets will decrease.
Answer: C
14. On January 1, 2010, Garner Corp. had 10,000 shares of $1 par value common stock
issued and outstanding. The stock was selling at $10 per share. During 2010, Garner declared
and issued a 10% stock dividend. The stock dividend causes
a. total shareholders' equity to increase by $1,000.
b. net income to decrease by $1,000.
c. earnings per share to decrease by $10,000.
d. no change in total shareholders' equity
Answer: D
15. If a corporation uses retention of earnings to finance the purchase of property instead of
issuing equity securities, then
a. it will have a higher debt/equity ratio.
b. it will pay more dividends.
c. leverage is being used.
d. a company’s earnings per share will decrease.
Answer: A
16. If a corporation issues debt instead of common stock to finance the purchase of property,
then the corporation has
a. a disadvantage of higher tax payments because dividends are a bigger deduction than
interest.
b. no ability to avoid interest payments from the debt issuance under any circumstances.
c. required dividend payments that are usually double-taxed.
d. a higher earnings per share.
Answer: B
17. Which one of the following is a characteristic of equity as opposed to debt?
a. Voting rights are typically attached.
b. There is a fixed maturity date.
c. There is a legal contract.
d. There is a fixed payment schedule.
Answer: A
18. Which one of the following serves to differentiate debt from equity?
a. Interest on debt may be deferred, but dividends are a legal liability and must be paid every
year.
b. Interest on debt is tax deductible while dividends to equity investors are not.
c. Debt has a maturity date which is much shorter than the maturity period of equity.
d. Debt holders are appointed while the board of directors elects equity holders.
Answer: B
19. Which of the following is considered to be an important economic consequence of
incentive compensation plans using stock options?
a. dilution of ownership interests.
b. the current ratio is affected.
c. the effects on the financial statements are costly to quantify.
d. the effect on cash flows
Answer: A
20. If preferred stock, which can be exchanged for long-term debt in three years, is classified
as an equity financial instrument instead of a liability, then
a. the current ratio declines.
b. earnings per share is less than if the preferred stock was reported as debt.
c. fixed assets and net worth increase.
d. the debt/equity ratio is less than if the preferred stock was reported as debt.
Answer: D
21. Which one of the following is ‘debt’ with the appearance of ‘equity’?
a. Long-term debt with a rate of interest that depends upon the current prime rate of interest
b. Long-term debt that can be converted into common stock
c. Notes payable in ten years
d. Convertible bonds
Answer: B
22. If preferred stock is cumulative, then
a. preferred dividends are a percentage of corporate profits.
b. dividends in arrears must be paid before common shareholders receive dividends.
c. dividends are a percentage of the market value of the preferred stock.
d. payment of dividends is legally guaranteed to shareholders each year.
Answer: B
23. If preferred stock is participating, then
a. preferred dividends are a percentage of corporate profits.
b. preferred shareholders vote in the election of the members of the board of directors.
c. preferred shareholders share in the remaining amount of dividend with common
shareholders.
d. dividends in arrears must be paid before common shareholders receive dividends.
Answer: C
24. Which one of the following would most likely require a restriction of retained earnings?
a. The sale of a plant asset
b. A sale of treasury stock
c. A declaration of cash dividends
d. An appropriation declared by the Board of Directors
Answer: D
25. Simon Corp’s $1 par value, common stock was selling for $20 per share. Simon Corp’s
owners’ equity accounts were as follows:
How many shares of common stock are outstanding?
a. 30,000
b. 600,000
c. 800,000
d. Not enough information to determine.
Answer: C
26. Which one of the following events increases the debt/equity ratio?
a. Purchase of inventory on account
b. Sale of treasury stock for less than its cost
c. The payment of cash dividends that were previously recorded
d. Recognition of net income for the year
Answer: A
27. Treasury stock is
a. an asset representing a corporate investment in itself.
b. highly-valued stock owned by a corporation.
c. illegal for U.S. corporations.
d. a decrease of shareholders' equity.
Answer: D
28. If preferred stock is specified as 8% preferred stock, then preferred
a. dividends are a percentage of the par value of the preferred stock.
b. shareholders vote in the election of the members of the board of directors.
c. dividends are a percentage of corporate profits.
d. dividends in arrears must be paid before common shareholders receive dividends.
Answer: A
29. Dividends in arrears
a. are preferred dividends that have been declared but not paid.
b. must be legally paid in the future.
c. are dividends that have not been declared on cumulative preferred stock.
d. are reported as a liability on the balance sheet until paid.
Answer: C
30. Preferred stock is preferred by investors as compared to common stock because
a. it pays higher dividends than common.
b. it has advantages of special rights to dividends and/or asset claims during liquidation.
c. preferred stock pays dividends and common stock pays interest.
d. dividends are expected to grow exponentially.
Answer: B
31. Dividends in arrears on cumulative preferred stock
a. increase liabilities.
b. decrease retained earnings.
c. have no effect on the balance sheet but are disclosed in the footnotes.
d. increase the debt/equity ratio.
Answer: C
32. Which one of the following events decreases the current ratio?
a. A decrease in the number of common shares outstanding
b. Sale of treasury stock for more than its cost
c. Sale of treasury stock for less than its cost
d. Purchase of treasury stock
Answer: D
33. On January 1, 2010, Susann, Inc. declared a 15% stock dividend on its common stock
when the market value of the common stock was $20 per share. Shareholders' equity before
the stock dividend was declared consisted of:
What happened to retained earnings as a result of the stock dividend declaration?
a. $6,000 decrease
b. $7,500 decrease
c. $15,000 decrease
d. No change
Answer: C
34. Dividends are not paid on
a. noncumulative preferred stock.
b. nonparticipating preferred stock.
c. treasury common stock.
d. outstanding common shares.
Answer: C
35. If a company sells its treasury stock for more than it cost and records a gain on the
income statement, then
a. income and shareholders' equity are overstated.
b. only income is overstated.
c. only shareholders' equity is overstated.
d. the income statement and balance sheet are properly stated.
Answer: B
36. What effect will the acquisition of treasury stock have on shareholders' equity?
a. No effect
b. Increase
c. Depends on whether it cost more or less than the par value of the stock
d. Decrease
Answer: D
37. Which one of the following events increases the debt/equity ratio?
a. Purchase of treasury stock
b. Sale of treasury stock for more than its cost
c. Sale of treasury stock for less than its cost
d. Payment of cash dividends that were previously declared
Answer: A
38. A company declared cash dividends in 2009, and paid the dividends in 2010. The
payment in 2010
a. decreases the debt/equity ratio.
b. increases the number of shares of stock outstanding.
c. decreases shareholders’ equity.
d. decreases net income.
Answer: A
39. The declaration of cash dividends
a. increases total expenses.
b. decreases current liabilities.
c. decreases earnings per share.
d. increases the debt/equity ratio.
Answer: D
40. The payment of previously declared cash dividends
a. increases the debt/equity ratio.
b. increases current liabilities.
c. increases earnings per share.
d. decreases total liabilities.
Answer: D
41. Dividends payable is recorded at the date of
a. issue.
b. record.
c. declaration.
d. payment.
Answer: C
42. If dividends paid are recorded as an expense, then
a. income and retained earnings are understated.
b. only income is understated.
c. only retained earnings is understated.
d. the income statement and balance sheet are correct.
Answer: B
43. An ordinary 20% stock dividend
a. causes no change in retained earnings.
b. decreases assets.
c. increases contributed capital.
d. is reported on the income statement.
Answer: C
44. All of the following statements are True regarding the appropriations of retained earnings
except:
a. Appropriations of retained earnings restrict retained earnings from future dividend
payments.
b. Appropriations of retained earnings involve the restriction of cash.
c. Appropriations of retained earnings must be decided upon by the board of directors.
d. Appropriations of retained earnings do not change the amount of total stockholders’ equity.
Answer: B
45. Chambers Corporation has total assets of $800,000 as of December 31, 2010 and total
liabilities of $400,000. Contributed capital as of December 31, 2009 and December 31, 2010
is $150,000. Chambers Corporation incurred a $50,000 net loss for the year ended December
31, 2010. If Chambers declared and paid $80,000 in dividends in 2010, their retained
earnings at the beginning of 2010 would have been.
a. $220,000.
b. $280,000
c. $380,000.
d. $440,000.
Answer: C
46. Garnett Corporation’s balance sheet reflects total assets of $500,000 as of December 31,
2009 and total liabilities of $150,000. Garnett’s balance sheet also reflects $50,000 of
preferred stock outstanding on December 31, 2009. In the early 1990’s, when Garnett was
started up, Garnett issued 50,000 shares of no-par common stock, a one-time event that
accounted for its entire contributed capital, other than the preferred stock. Garnett had
repurchased 15,000 shares of its common stock in 2008 from a retiring shareholder, which is
now treasury stock. As of December 31, 2009 the book value of each outstanding share of
Garnett’s common stock is:
a. $6.00
b. $8.57
c. $10.00
d. $14.29.
Answer: B
47. Smith Corporation’s balance sheet reflects total assets of $3 million as of December 31,
2010 and total liabilities of $1.8 million. Smith has 100,000 shares of common stock
outstanding. The market value of the stock is $9 per share. Smith’s market to book ratio is:
a. 0.75.
b. 7.50.
c. 12.00.
d. 13.33.
Answer: A
48. Cavendish Corporation’s balance sheet reflects total assets of $250 million as of
November 30, 2010 and total liabilities of $200 million. Cavendish issues $100 million of
preferred stock, receiving $100 million in cash. After issuing the preferred stock Cavendish’s
debt to equity ratio is:
a. 0.67.
b. 1.33.
c. .4.00
d. 6.00
Answer: B
49. Choice Corporation had 100,000 shares of commons stock outstanding on January 1,
1995. On January 1, 2010 Choice purchased 5,000 shares of its own common stock to fund a
stock option plan for it’s executives. On December 31, 2010 Choice announced a 3 to 1 stock
split. Choice’s net income for 2010 was $400,000. How much should Choice report as
earnings per share for 2010?
a. $1.33.
b. $1.40.
c. $4.00
d. $4.21
Answer: B
50. The following information was taken from the statement of shareholders’ equity of
Carnival Industries:
The journal entry to record the issuance of preferred stock during 2010 would include:
a. a debit to Preferred Stock for $900.
b. a credit to Preferred Stock for $500.
c. a credit to Additional Paid in Capital for $500.
d. a credit to Cash for $500.
Answer: B
51. The shareholders’ equity section of Manning Company as of December 31, 2010 follows:
The company declares and distributes a 3 percent stock dividend on the outstanding shares.
The market price of the stock is $85 per share. The journal entry to record the stock dividend
would include:
a. a debit to Additional Paid-In Capital, Common Stock for $25,500.
b. a credit to Common Stock for $1,800.
c. a credit to Stock Dividend for $25,500.
d. a debit to Additional Paid-In Capital, Common Stock for $23,700.
Answer: B
52. The shareholders’ equity section of Manning Company as of December 31, 2010 follows:
The company declares a 12 percent stock dividend on the outstanding shares. The market
price of the stock is $90. The journal entry to record the stock dividend would include:
a. a credit to Additional Paid-In Capital, Common Stock for $100,800.
b. a debit to Common Stock for $7,200.
c. a credit to Stock Dividend for $108,000.
d. a debit to Additional Paid-In Capital, Common Stock for $108,000.
Answer: A
53. The shareholders’ equity section of Jason Company as of December 31, 2010 follows:
On January 15, the company repurchased 1,500 shares of its own common stock at $60 to
hold as treasury stock. Which of the following would be included in the journal entry
recorded on January 15?
a. a credit to Retained Earnings for $90,000.
b. a debit to Cash for $90,000.
c. a debit to Treasury Stock for $90,000.
d. a debit to Common Stock for $90,000.
Answer: C
54. The shareholders’ equity section of Jason Company as of December 31, 2010 follows:
On January 15, the company repurchased 1,500 shares of its own stock at $60 for treasury
stock. On January 16, as part of a compensation package, the company reissued half of the
treasury shares to executives who exercised stock options for $20 per share. On January 28,
the company reissued the remainder of the treasury stock on the open market for $66 per
share. Which of the following would be included in the journal entry recorded on January 16?
a. a debit to Cash for $15,000.
b. a debit to Treasury Stock for $45,000.
c. a credit to Additional Paid-In Capital for $45,000.
d. a credit to Additional Paid-In Capital for $15,000.
Answer: A
55. The shareholders’ equity section of the Jason Company as of December 31, 2010 is as
follows:
On January 15, the company repurchased 1,500 shares of its own stock at $60 for treasury
stock. On January 16, as part of a compensation package, the company reissued half of the
treasury shares to executives who exercised stock options for $20 per share. On January 28,
the company reissued the remainder of the treasury stock on the open market for $65 per
share. Which of the following would be included in the journal entry recorded on January 28?
a. a credit to Treasury Stock for $48,750.
b. a credit to Additional Paid-In Capital, Treasury Stock for $48,750.
c. a debit to Cash for $45,000.
d. a credit to Additional Paid-In Capital, Treasury Stock for $3,750.
Answer: D
56. The shareholders’ equity section of Winters Company contained the following balances as
of December 31, 2010:
During 2011, Winters entered into the following transaction: On May 13, the company
repurchased 55 shares of its common stock in the open market at $25 per share. Which of the
following would be included in the journal entry for May 13?
a. a debit to Cash for $1,375.
b. a credit to Common Stock for $1,375.
c. a debit to Common Stock for $1,375.
d. a debit to Treasury Stock for $1,375.
Answer: D
57. The shareholders’ equity section of Winters Company contained the following balances as
of December 31, 2010:
During 2011, Winters entered into the following transaction: On September 26, the company
issued 200 shares of its 10 percent preferred stock at $23 per share. Which of the following
would be included in the September 26 journal entry?
a. a debit to Preferred Stock for $3,000.
b. a credit to Cash for $4,600.
c. a debit to Cash for $3,000.
d. a credit to Additional Paid-In Capital, 10% Preferred Stock for $1,600.
Answer: D
58. The shareholders’ equity section of Winters Company contained the following balances as
of December 31, 2010:
On September 26,2011, Winters issued 200 shares of its 10 percent preferred stock at $23 per
share. On December 2, the company declared a cash dividend of $1,050, which was paid on
December 27. Winters did not declare or pay any dividends during 2010. If Winters uses a
separate dividend account for each type of stock, which of the following would be included in
the journal entry to record the declaration of the 10% Preferred stock dividend?
a. a credit to 10% Preferred Cash Dividend for $600.
b. a debit to Dividend Expense for $600.
c. a credit to Dividends Payable for $600.
d. a debit to Cash for $600.
Answer: C
59. The shareholders’ equity section of Winters Company contained the following balances as
of December 31, 2010:
During 2011, Winters entered into the following transaction: On December 2, the company
declared a cash dividend of $1,050, which was paid on December 27. Winters did not declare
or pay any dividends during 2010. If Winters uses a separate dividend account for each type
of stock, which of the following would be included in the journal entry to record the
declaration of the 12% Preferred stock dividend?
a. a debit to 12% Preferred Cash Dividend for $180.
b. a debit to Dividend Expense for $180.
c. a debit to Dividends Payable for $180.
d. a debit to Cash for $180.
Answer: A
60. The shareholders’ equity section of Winters Company contained the following balances as
of December 31, 2010:
During 2011, Winters entered into the following transaction: On December 2, the company
declared a cash dividend of $1,050, which was paid on December 27. Winters did not declare
or pay any dividends during 2010. Based on this information, what amount of dividends
should be declared and paid to shareholders’ with common stock?
a. $350
b. $420
c. $570
d. $385
Answer: C
$1,050 – 300 – 180 = $570
61. The shareholders’ equity section of Samuels Company were reported on the balance
sheets for December 31:
Based on this information, how many shares of preferred stock were issued in 2010 and what
was the average issue price?
a. 4,000 shares and $112.50 per share
b. 160 shares and $88.75 per share
c. 800 shares and $250 per share
d. 1,600 shares and $112.50 per share
Answer: D
62. The shareholders’ equity section of Samuels Company were reported on the balance
sheets for December 31:
Based on this information, how many shares of common stock were issued in 2010 and what
was the average issue price?
a. 21,000 shares and $7.82 per share
b. 30,000 share and $6.00 per share
c. 85,000 shares and $9.73 per share
d. 24,000 shares and $7.50 per share
Answer: D
Matching Questions
1. Management wishes to obtain financing. For each attribute/characteristic listed in 1
through 5, determine which type of financing it describes from management’s perspective by
placing a D in the space if it applies to debt financing, or E if it applies to equity financing.
Answer:
1. E
2. D
3. D
4. D
5. E
2. Identify the effect of the accounting equation (a through k) of each transaction in 1 through
9 below. You may use each letter more than once or not at all.
Answer:
1. e
2. b
3. d
4. h
5. a
6. k
7. j
8. k
9. k
3. Select the effect (a, b, or c) that each transaction listed in 1 through 9 would most likely
cause on the debt/equity ratio.
Answer:
1. b
2. a
3. c
4. b
5. a
6. c
7. c
8. c
9. c
4. Indicate the effect of each of the following transactions (1 through 6) on total shareholders’
equity by selecting the letter of the effect (a, b, and c) and placing it in the space provided.
Answer:
1. b
2. a
3. c
4. b
5. a
6. c
Short Problems
1. Total dividends of $7,000 are declared when one year of dividends are in arrears on 1,000
shares of $8 cumulative preferred stock. How much of the $7,000 of dividends goes to the
common shareholders?
Answer: Allocation to preferred = 1,000 x $8 = $8,000 limited to amount declared = $7,000
Allocation to common = $0
2. The following information from St. Paul Supply, Inc.is provided for 2010 and 2009:
Additional paid-in capital - common 80,000 50,000
Retained earnings 500,000 500,000
Net income 60,000 40,000
Additional information:
No preferred dividends were declared during 2009. The market price of the common stock
was $25 at December 31, 2010. Calculate the book value per share of common stock at
December 31, 2010.
Answer: ($40,000 + $80,000 + $500,000)/8,000 = $77.50 per common share
3. Total dividends of $40,000 are declared when one year of dividends is in arrears on 5,000
shares of $3 cumulative preferred stock. Calculate dividends on common stock.
Answer: $40,000 – [5,000 x $3 x 2] = $10,000
4. Total dividends of $13,000 are declared when two years of dividends are in arrears on
1,000 shares of par $50, 10%, cumulative preferred stock. Calculate the dividends that were
declared on common stock.
Answer: Arrears for preferred: 10% x $50 x 1,000 x 2 years = $10,000
Arrears and current year for preferred: $10,000 + $3,000 = $13,000
$0 (current year is limited by total dividends declared)
5. The board of directors desires to pay $40,000 of dividends to its common shareholders
when two years of dividends are in arrears on 1,000 shares of $20 par, 10% cumulative
preferred stock. How much total dividends must be declared?
Answer: (1,000 x $20 x 10%) x 3 years = $6,000
$6,000 + $40,000 = $46,000
6. On January 23, Borders Corporation purchased 1,000 shares of its own common stock for
$30 a share. On March 31, it sold 600 of those shares for $42 a share. How much is the gain
reported on the income statement resulting from the sale of treasury stock?
Answer: $ 0 (no gains from treasury stock transactions)
7. Canton Corporation shareholders' equity section of its balance sheet as of December 31,
2009 is as follows:
The following events occurred during 2010:
March 3 - 5,000 shares of authorized and unissued common stock were sold for $22 per
share.
March 16 - Declared a cash dividend of $3 per share payable May 15 to holders of record
on May 5.
A. At March 31, 2010, how many more shares of stock can be issued?
B. At March 31, 2010, how many shares are issued and outstanding?
Answer: A. Authorized but not issued: 40,000 – (10,000 + 5,000) = 25,000 shares
B. 10,000 + 5,000 = 15,000
8. If an investor owns 8% of a corporation prior to a 2-for-1 stock split, what percentage does
the investor own after receiving 2 shares of $5 par value stock for each $10 par value share of
stock?
Answer: 8%
9. The shareholders' equity section of Campbell Co.’s balance sheet follows:
A. Assume all of the treasury stock was sold for $4,800. Calculate the following amounts:
1. Additional paid-in capital—treasury stock
2. Retained earnings
3. Total shareholders' equity
B. Assume all of the treasury stock was sold for $850. Calculate the following amounts:
1. Additional paid-in capital—treasury stock
2. Retained earnings
3. Total shareholders' equity
Answer:
10. Immediately before Cavecreek Corporation purchased 4,000 shares of its own common
stock for $25 a share, it had total liabilities of $200,000 and total shareholders' equity of
$520,000. Calculate Cavecreek’s debt/equity ratio immediately subsequent to the purchase of
the treasury stock.
Answer: 4,000 x $25 = $100,000
Debt/equity ratio: $200,000/[$520,000 - $100,000] = 0.48
11. Immediately before Zorro Corporation sold 4,000 shares of its own common stock for
$30 a share, it had total liabilities of $200,000 and total shareholders' equity of $520,000.
Determine Zorro’s debt/equity ratio immediately subsequent to the stock issue.
Answer: 4,000 x $30 = $120,000
Debt/equity ratio: $200,000/[$520,000 + $120,000] = 0.31
12. Immediately before Cayman Corporation issued 2,000 shares of its common stock for $15
a share, it had total liabilities of $150,000 and total shareholders' equity of $300,000. Cayman
had 10,000 shares of common stock outstanding prior to the new issuance. Calculate
Cayman’s debt/equity ratio immediately after the new issuance.
Answer: 2,000 x $15 = $30,000
Debt/equity ratio: $150,000/[$300,000 + $30,000] = 0.45
13. On January 23, Bennington Corporation, for the first time in its short history, purchased
200 shares of its own common stock for $40 a share. On March 31, it sold 100 of those shares
for $45 a share. Prepare the journal entry recording the March 31st transaction.
Answer:
14. On January 23, Oakley Co., for the first time in its short history, purchased 200 shares of
its own common stock for $40 a share. On March 31, it sold 100 of those shares for $45 a
share and properly recorded $500 as additional paid-in capital. On April 15, it sold the
remaining 100 shares for $35 a share. Prepare the journal entry to record the April 15th
transaction.
Answer:
15. On January 23, Bayshore Corporation, for the first time in its short history, purchased 200
shares of its own common stock for $40 a share. On March 31, it sold 100 of those shares for
$45 a share and properly recorded $500 as additional paid-in capital. On April 15, it sold the
remaining 100 shares for $30 a share. Prepare the journal entry to record the April 15th
transaction.
Answer:
16. The shareholders' equity section of Maven Corporation's balance sheet as of December
31, 2008 is as follows:
The following events occurred during 2009:
February 1 - 400 shares of authorized and unissued common stock were sold for $4 per
share.
June 16 - A 15% stock dividend was declared and issued. Market value per share is
currently $18.
October 11 - A three-for-one split was carried out. Market value was $21 per share.
November 4 - A cash dividend of $4.20 per share was declared, payable January 12 to
shareholders of record on November 30.
How many shares of common stock are outstanding at December 31, 2009? Determine the
balance in the common stock account at December 31, 2009.
Answer: Outstanding shares: [2,000 + 400 + (15% x 2,400)] x 3 = 8,280
Common stock: 8,280 x $1 = $8,280
17. An 8% stock dividend was declared and distributed on 3,000 shares of par $10 common
stock when its market price was $32. Prepare the journal entry required by the stock
dividend.
Answer:
18. Cullen Distribution Corporation's contributed capital section of its balance sheet follows:
During the last two years, Cullen Distribution Corporation did not declare any dividends to
its shareholders. This year, Cullen declares and pays total dividends of $100,000. Calculate
the dividends paid separately to preferred and common shareholders if the preferred stock is
cumulative.
Answer:
Preferred dividends = $650,000 x 4% x 3 years = $78,000
Common dividends = $100,000 – $78,000 = $22,000
19. A 10% stock dividend was declared and distributed to shareholders of 60,000 outstanding
shares of Meadville Company’s $10 par value common stock; at that time the common
stock’s market price was $32. Prepare the journal entry required by the stock dividend.
Answer:
20. A sequence of events affecting the shareholders' equity section of Malabar Corporation
follows:
A. On January 21, 8,000 shares of $10 par value common stock were issued for $160,000.
B. On May 16, a 3-for-1 stock split was distributed.
C. On December 23, $8,000 of cash dividends on outstanding common stock were declared.
The dividends will be paid in 30 days.
For each entry, state how the event changed assets, liabilities, and shareholders' equity.
Answer: A. Assets and shareholders' equity increase by $160,000
B. No change in assets, liabilities, or shareholders' equity
C. Liabilities increase and shareholders' equity decreases by $8,000
21. Immediately before a 15% stock dividend was declared and distributed on 20,000 shares
of par $8 stock, the market price of the Coolidge Corporation’s stock was $18. Coolidge has
total liabilities of $150,000 and total shareholders' equity of $450,000.
Required:
(1) Give the journal entry to record the declaration and distribution of the stock dividend.
(2) Calculate Coolidge’s current ratio immediately after the stock dividend and comment.
Answer:
22. Immediately before a 3-for-1 stock split was declared and distributed on 20,000 shares of
par $80 stock, Mikah Company has total liabilities of $260,000 and total shareholders' equity
of $320,000. Calculate Mikah Company’s debt/equity ratio immediately after the stock split.
Answer: Debt/equity ratio = $260,000/$320,000 = 0.81
23. Immediately before a $4,000 cash dividend was declared on 20,000 shares of par $80
stock, Sea Breeze Corporation has total liabilities of $220,000 and total shareholders’ equity
of $180,000. Calculate Sea Breeze’s debt/equity ratio before and after the declaration of the
cash dividend and indicate the effect the declaration had on this ratio.
Answer: Before: Debt/equity ratio = $220,000/$180,000 = 1.22
Liabilities: $220,000 + $4,000 = $224,000; OE: $180,000 - $4,000 = $176,000
After: Debt/equity ratio = $224,000/$176,000 = 1.27
The debt/equity ratio increases because additional liabilities were incurred.
24. Tropical Corporation has the following amounts as other revenue and expenses on its
income statement.
List the items that do not belong on the income statement and indicate where each should be
reported.
Answer: Gain from sale of treasury stock - $21,000
Report as Additional Paid-in Capital—Treasury Stock as an addition in shareholders’ equity
on the balance sheet
Appropriated retained earnings for self-insurance - $1,000
Report in shareholders’ equity on the balance sheet immediately below unappropriated
retained earnings
Preferred dividends - $11,000
Report as a deduction on the statement of shareholders’ equity
Common dividends - $6,000
Report as a deduction on the statement of shareholders’ equity
25. If a corporation distributes a 4-for-3 stock split on its $5 common stock, how much is the
par value after the split?
Answer: (3 x $5)/4 = $3.75
26. Gomer Paper Corporation has the following balance sheet accounts immediately
preceding an investing and financing decision:
A long-term debt covenant specifies that Gomer Paper’s debt/equity ratio cannot be greater
than 1.0 and its current ratio must be at least 2.0.
Gomer Paper is going to invest $70,000 in new equipment. It is considering two methods of
financing the investment. It can use $10,000 of its own money and obtain $60,000 from the
issue of long-term debt. Alternatively, Gomer Paper can use $15,000 of its own money and
obtain the remaining financing from the issue of stock.
A. Recalculate the balance sheet amounts given above for each of the two financing
alternatives immediately after financing is achieved and the investment is undertaken.
B. Use numerical calculations to determine if the debt covenants are respected under each of
the two financing alternatives. If the covenants are broken for each alternative, suggest
financing options that Gomer Paper might use to finance the $70,000 investment in
equipment.
Answer:
B: The debt/equity ratio exceeds that allowed (1.0) by the debt covenant if debt is used to
finance investment in equipment. The current ratio is less than that allowed (2.0) if the
investment is financed by a stock issue.
The maximum cash that Gomer Paper can use for investment is $10,000 and the most debt it
can issue without issuing stock is $39,500. Therefore, Gomer Paper must issue more stock
and use less of its own money or issue stock and debt using less of its own money.
Short Essay Questions
1. Seneca Corporation has the following balance sheet accounts immediately preceding an
investing and financing decision:
A long-term debt covenant specifies that Seneca’s debt/equity ratio cannot be greater than 1.0
and current ratio cannot be less than 2.0.
Seneca is going to invest $600,000 in a new machine that will keep Seneca Corporation in an
excellent competitive position in a very competitive industry. In order to finance this
investment, Seneca will use its cash, issue long-term debt, and issue common stock.
However, besides having to adhere to the debt covenants, Mr. Seneca, the sole owner of
Seneca Corporation, will not issue more than $100,000 of common stock so that he can retain
at least a 50% ownership in his corporation.
Can Seneca Corporation finance the $600,000 investment and still adhere to the debt
covenants and allow Seneca to retain at least 50% ownership? If Seneca cannot finance the
machine within the parameters given, suggest possible means for Seneca to finance the
needed acquisition of the machine.
Answer: The $600,000 investment cannot be raised within the parameters set by the debt
covenants or fulfill Mr. Seneca's desire to retain control of his corporation. The current ratio
restriction limits Seneca Corp.'s ability to finance the investment from retained earnings
(internally generated financing) to $190,000. Using this cash leaves the current ratio at a
dangerous, but acceptable, level of 2.0 and $410,000 to be raised by debt or/and equity issues.
If Seneca Corp. issues the maximum of $100,000 of common stock, then total shareholders'
equity would be $850,000 and $310,000 would have to be raised from debt issue. However,
the debt/equity restriction limits total debt to $850,000. Existing debt is $750,000. Therefore,
only $100,000 financing from debt is available. This leaves Seneca $210,000 short of the
financing required.
There are not many options for Seneca. He might try to renegotiate the debt covenants,
exhibiting to the creditors that their future money is more secure with a competitive company
than one that adheres to the covenants. Alternatively, Mr. Seneca might have to lose control
of his company. This might be quite costly to Mr. Seneca, personally, for frequently in these
situations, the new corporation "retires" the old entrepreneur.
There are several other financing possibilities not considered in the problem. First, if the
purchase can be delayed for one year in which there are no dividends and there is a profit of
at least $210,000 with good cash flows, then the $210,000 could be obtained from cash flow
generated from operations and additional debt could be secured within the debt/equity ratio
ceiling. Second, Seneca might try to secure the machine under an operating lease. Thus he
would have use of the machine without the liability on the balance sheet. Third, nonvoting
preferred stock might be issued. If this market is available, Mr. Seneca can increase
shareholders' equity without diluting his ownership of the corporation. Finally, Seneca might
be able to secure personal debt and use that money to buy stock in his company. If he could
obtain $105,000 at what may likely be a high interest rate, and invest it in Seneca
Corporation's common stock, then he could retain control and issue $105,000 more corporate
debt. However, there are a lot of "ifs" in these possibilities.
An algebraic "trick" would help Mr. Seneca use the money from retained earnings and still
meet the current ratio minimum. Seneca Corporation now has current assets of $430,000 and
current liabilities of $120,000. This releases $190,000 to use for the investment and still
maintain a 2.0 current ratio. If $100,000 of current liabilities are paid, then Seneca would
have $330,000 of current assets and $20,000 of current liabilities. This releases $290,000 for
use in investment (assuming the current assets are very liquid). Also, by reducing current
liabilities by $100,000, $100,000 more long-term debt can be issued and still have the
debt/equity ratio be less than or equal to one. However, this is "operating on the edge" and
any downturn in sales and cash provided by operations would result in financial disaster. A
combination of all the above might be appropriate.
2. For what reasons might a company purchase treasury stock?
Answer: The most common reason companies purchase treasury stock is to support employee
compensation plans. This makes stock available to distribute to employees as they exercise
stock options. Purchasing treasury stock can also increase the market price of a company's
outstanding stock. Occasionally the announcements of a treasury repurchase trigger the
market to purchase shares. As a result of supply and demand, the market values of stock rise.
Acquiring treasury stock can increase a company's earnings per share, because it reduces the
number of shares outstanding. Often treasury stock purchases are made to return cash to
shareholders, much like a dividend.
3. What rights do preferred shareholders have that common shareholders do not?
Answer: Preferred shareholders usually receive dividend payments before common
shareholders, assuming that the board declares a dividend. Since the amount of preferred
dividends is expressed based as a percentage of par value or is a dollar amount per share of
the preferred stock, preferred shareholders typically feel more assured of receiving a fixed, or
at least a more stable, minimum dividend. Cumulative preferred shareholders benefit by
receiving dividends during the current period from periods in which dividends were not paid
or declared in the past (dividends in arrears). Participating preferred stock allows preferred
shareholders to share in any remaining dividends once the right to the annual dividend
payment has been satisfied.
4. Identify the two components of shareholders' equity. How do they differ?
Answer: Shareholders' equity consists of contributed capital and earned capital. Contributed
capital reflects contributions from a company's owners, and includes preferred stock,
common stock, and additional paid-in capital. Earned capital, also known as retained
earnings, is a measure of assets that have been generated through a company’s profitable
operations that have not been paid to the owners in the form of dividends.
5. Explain par value.
Answer: Par value is an arbitrary amount assigned to a share of stock. It has little legal or
economic significance and only serves to determine a value to assign to a company's stock
account. At one time par value represented a legal concept under state law in some states that
was intended to protect creditors, but over time the concept proved to be largely ineffective.
6. Which characteristics make equity financing more advantageous than debt financing?
Answer: Equity financing represents amounts contributed from a company's owners. No legal
contract is associated as with True debt financing. This allows the corporation no obligation
towards the equity investors. Equity financing has no fixed maturity date, which allows the
company to avoid the stress of meeting a payment deadline. Dividend payments are
discretionary with equity financing, while debt financing requires periodic interest payments.
7. What factors influence corporate dividend strategies?
Answer: Factors that influence a company's dividend strategy include the nature, financial
condition, legal constraints, and the desired image of the company. In order to declare cash
dividends a company must have sufficient cash. Before declaring, a company must be sure
that its operating cash needs are met. A company growing very quickly is likely to avoid
dividend payments in order to reinvest the funds for leveraging. Investors in companies that
pay little or no dividends receive their investment returns in the form of stock price
appreciation. Some companies consistently increase dividends from year to year. This is often
done to increase shareholder loyalty, and to demonstrate to shareholders consistent growth
regardless of how well the company does from one year to the next. State laws and debt
covenants may limit the payment of dividends.
8. How does the behavior of stock prices relate to the riskiness of equity securities?
Answer: Stock prices are usually more volatile than bond prices on the major security
exchanges due to the risk associated with stock investments. As compared to debt
investments, equity includes no security provisions, and debt holders have a higher priority
claim if a company goes into liquidation.
9. Why is debt financing considered less expensive than equity financing?
Answer: Issuing debt is attractive because interest payments are tax deductible—that is,
interest is reported as an expense on the tax return which reduces the amount of taxes a
company is obligated to pay. Dividends are not considered an expense for either accounting
or tax purposes, which allows a company to report a higher net income, but creates larger tax
payments. Tax payments have a negative impact on cash flows of a company.
10. How do the book value and market value of stock compare?
Answer: Market value is the amount at which stock can be exchanged on the open market.
This amount changes from day-to-day based on changes in market conditions. Book value is
based on the dollar amounts reported in shareholders’ equity. Book value is generally
calculated per common share and represents the net assets per share of outstanding stock.
11. How is the excess of cash receipts over the original cost of treasury stock accounted for
and reported in financial statements?
Answer: When cash is received in an amount that exceeds the original cost of treasury stock,
the difference is reported as a credit to Additional Paid-in Capital—Treasury Stock. This
amount appears as an addition in the shareholders’ equity section of the balance sheet. While
some may view this excess amount received as a profit, GAAP does not allow a company to
report this item on the income statement as a gain or loss. A company earns profits through
the earning power of its assets. Treasury stock is not an asset, so profits acquired as a result of
using it are considered only a contributed capital amount for a company.
12. What makes preferred stock questionable in classification?
Answer: Preferred stock, an equity investment, has characteristics that resemble debt.
Preferred stock dividends are sometimes consTrued as interest because of the percent or per
share amount that is attached to each share of preferred stock. Preferred shareholders cannot
vote, making the status of preferred investors closer to that of debt investors who also cannot
vote.
13. What balance sheet condition does a deficit create?
Answer: A deficit is a negative balance in retained earnings on the balance sheet. In
determining the net worth of a company, total liabilities are subtracted from total assets. A
deficit in retained earnings combined with a normal balance in contributed capital accounts
may make a company appear to have a positive net worth although a deficit could still exist.
A deficit is not an attractive feature to users of financial statements.
Note: It is public knowledge that the federal government has a deficit. A government entity is
not a for-profit entity so the balance sheet structure is somewhat different. The government
has no retained earnings and contributed capital, so the entire difference between assets and
liabilities shows up as a negative amount.
14. What is the purpose of the date of record?
Answer: The date of record serves as a point in time for determining specifically who the
shareholders are. When dividends are declared, the list of shareholders on that date may be
different than the list on the date of record. Only holders of stock on the date of record
receive dividends. No journal entries are recorded on the date of record.
15. How does an appropriation of retained earnings affect the income statement and assets of
a company?
Answer: An appropriation of retained earnings is a journal entry that restricts a portion of
retained earnings from the payment of future dividends. No asset, liability, revenue, or
expense is affected when an appropriation is made. The unappropriated retained earnings
account is reduced with a debit and the amount is credited to appropriated retained earnings.
An appropriation does not allocate cash or any other funds, nor does it recognize a loss for
any purpose.
16. What is the purpose of a prior period adjustment?
Answer: A prior period adjustment is a correction in the current period of an accounting error
made in a previous period. The journal entry necessary to correct the error increases or
decreases the balance sheet account that contained the error and then increases or decreases
retained earnings directly.
17. From a business perspective, how does a stock split differ from a small stock dividend?
How are they similar?
Answer: A stock dividend requires a company to distribute additional shares of stock to
existing shareholders. An investor who previously held 10 shares when a company issues a
10 percent dividend now holds 11 shares. A stock split modifies the par value of stock. The
corporation asks investors to return previous stock certificates, and then distributes new stock
certificates that have a different par value. The corporation distributes no assets, and the
investor receives no assets for both a stock split and a small stock dividend. In both cases, the
number of shares issued is usually increased. (A reverse stock split will cause a decrease.)
IFRS Question
1. Under US GAAP, companies must provide a description of the changes in comprehensive
income as either a separate statement or as a part of the statement of changes in stockholders’
equity. Under IFRS, companies must also provide a description of the changes in
comprehensive income in a:
A. Statement of Recognized Income and Expense
B. Statement of Unrecognized Income and Expense
C. Statement of Retained Earnings
D. Income Statement
Answer: A
Test Bank for Financial Accounting: In an Economic Context
Jamie Pratt
9780470635292, 9781119537571, 9781119444367
