CH-18 Shareholders Equity – Intermediate Accounting : Book Guide

Chapter 18 Shareholders’ Equity 1 Chapter 18 Shareholders’ Equity QUESTIONS FOR REVIEW OF KEY TOPICS Question 18-1 The two primary sources of shareholders’ equity are amounts invested by shareholders in the corporation and amounts earned by the corporation on behalf of its shareholders. Invested capital is reported as paid-in capital and earned capital is reported as retained earnings. Question 18-2 The statement of shareholders’ equity reports the transactions that cause changes in its shareholders’ equity account balances. It shows the beginning and ending balances in primary shareholders’ equity accounts and any changes that occur during the years reported. Typical reasons for changes are the sale of additional shares of stock, the acquisition of treasury stock, net income, and the declaration of dividends. Question 18-3 Comprehensive income is a broader view of the change in shareholders’ equity than traditional net income. It is the total nonowner change in equity for a reporting period. It encompasses all changes in equity except those caused by transactions with owners. Transactions between the corporation and its owners (shareholders) primarily include dividends and the sale or purchase of shares of the company’s stock. Most nonowner changes (e. g., revenues and expenses) are reported in the income statement. So, the changes other than the ones that are part of traditional net income are those reported as “other comprehensive income.” Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The components of comprehensive income created during the reporting period - can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) in a disclosure note. Regardless of the choice a company makes, the presentation will report net income, other components of comprehensive income, and total comprehensive income. The second attribute - the comprehensive income accumulated over the current and prior periods – is reported as a separate component of shareholders’ equity. This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years. 2 Answers to Questions (continued) Question 18-4 The three primary ways a company can be organized are (1) a single proprietorship, (2) a partnership, or (3) a corporation. Transactions are accounted for the same regardless of the form of business organization with the exception of the method of accounting for capital – the ownership interest in the company. Several capital accounts (as discussed in this chapter) are used to record changes in ownership interests for a corporation, rather than recording all changes in ownership interests in a single capital account for each owner, as we do for single proprietorships and partnerships. Question 18-5 In the eyes of the law, a corporation is a separate legal entity – separate and distinct from its owners. The owners are not personally liable for debts of the corporation. So, shareholders generally may not lose more than the amounts they invest when they purchase shares. This is perhaps the single most important advantage of corporate organization over a proprietorship or a partnership. Question 18-6 “Not-for-profit” corporations, such as churches, hospitals, universities, and charities, are not organized for profit and do not sell stock. Some not-for-profit corporations, such as the Federal Deposit Insurance Corporation (FDIC), are government owned. Question 18-7 Corporations that are organized for profit may be publicly held or privately (or closely) held. The stock of publicly held corporations is available for purchase by the general public. Shares might be traded on organized national stock exchanges available “over-the-counter” from securities dealers. Privately held companies' shares are held by only a few individuals and are not available to the general public. Question 18-8 Corporations are formed in accordance with the corporation laws of individual states. The Model Business Corporation Act serves as the guide to states in the development of their corporation statutes, presently as the model for the majority of states. Question 18-9 The ownership rights held by common shareholders, unless specifically withheld by agreement with the shareholders, are: a. The right to vote on policy issues. b. The right to share in profits when dividends are declared (in proportion to the percentage of shares owned by the shareholder). c. The right to share in the distribution of any assets remaining at liquidation after other claims are satisfied. 3 Answers to Questions (continued) Question 18-10 The “preemptive right” is the right to maintain one’s percentage share of ownership when new shares are issued. When granted, each shareholder is offered the opportunity to buy the same percentage of any new shares issued as the percentage of shares he/she owns at the time. For reasons of practicality, the preemptive right usually is excluded. Question 18-11 The typical rights of preferred shares usually include one or both of the following: a. A preference to a predesignated amount of dividends, i.e., a stated dollar amount per share or % of par value per share. This means that when the board of directors of a corporation declares dividends, preferred shareholders will receive the specified dividend prior to any dividends being paid to common shareholders. b. A preference over common shareholders in the distribution of assets in the event the corporation is dissolved. Question 18-12 If preferred shares are noncumulative, dividends not declared in any given year need never be paid. However, if cumulative, when the specified dividend is not paid in a given year, the unpaid dividends accumulate and must be made up in a later dividend year before any dividends are paid on common shares. These unpaid dividends are called “dividends in arrears.” Question 18-13 Par value was defined by early corporation laws as the amount of net assets not available for distribution to shareholders (as dividends or otherwise). However, now the concepts of “par value” and “legal capital” have been eliminated entirely from the Model Business Corporation Act. Most shares continue to bear arbitrarily designated par values, typically nominal amounts. Although many states already have adopted these provisions, most established corporations issued shares prior to changes in the state statutes. So, most companies still have par value shares outstanding and continue to issue previously authorized par value shares. Question 18-14 An argument can be made that, when shares are issued without restriction at the time of sale, this account is an asset, similar to accounts receivable. However, when shares are withheld or restricted until the selling price is received, the receivable should be reported as a contra equity account – a reduction in paid-in capital. This is the prevailing practice. This means reporting total paid-in capital only to the extent that unrestricted shares are outstanding. This is the preferred practice. Question 18-15 The measurement objective is that the transaction should be recorded at fair market value. This might be the fair value of the shares or of the noncash assets or services received, whichever evidence of fair market value seems more clearly evident. This is consistent with the general practice of recording any noncash transaction at market value. 4 Answers to Questions (continued) Question 18-16 The cash received usually is the sum of the separate market values of the separate securities. However, when the total selling price is not equal to the sum of the separate market prices, the total selling price is allocated in proportion to their relative market values. Question 18-17 Share issue costs reduce the net cash proceeds from selling the shares and thus paid-in capital – excess of par. On the other hand, debt issue costs are recorded in a separate “debt issue costs” account and amortized to expense over the life of the debt. The difference often is justified by the presumption that share issue costs and debt issue costs are fundamentally different because a debt issue has a fixed maturity, but that selling shares represents a perpetual equity interest. Concept Statement 6 disagrees, stating that debt issue costs should be treated the same way as share issue costs. But, Concept Statements do not constitute GAAP, and the currently prescribed practice is to record debt issue costs as assets and expense the asset over the maturity of the debt. Question 18-18 The same accounts that previously were increased when the shares were sold are decreased when the shares are retired. Specifically, common (or preferred) stock and paid-in capital – excess of par are reduced by the same amounts they were increased by when the shares were originally sold. If the cash paid to repurchase the shares differs from the amount originally paid in, accounting for the difference depends on whether the cash paid to repurchase the shares is less than or more than the price previously received when the shares were sold. When less cash is distributed to shareholders to retire shares than originally paid in, some of the original investment remains and is labeled paid-in capital – share repurchase. When more cash is distributed to shareholders to retire shares than originally was paid in for those shares, the additional amount is viewed as a dividend on the original investment, and thus a reduction of retained earnings (unless previous share repurchases have created a balance in paid-in capital – share repurchase which would be reduced first). Question 18-19 The purchase of treasury stock and its subsequent resale are considered to be a “single transaction.” The purchase of treasury stock is perceived as a temporary reduction of shareholders' equity, to be reversed later when the treasury stock is resold, so the cost of acquiring the shares is “temporarily” debited to the treasury stock account. Allocating the effects to specific shareholders’ equity accounts is deferred until the shares are subsequently reissued. 5 Answers to Questions (concluded) Question 18-20 For a stock dividend of less than 25%, a "small" stock dividend, the fair market value of the additional shares distributed is transferred from retained earnings to paid-in capital The reduction in retained earnings is the same amount as if cash dividends were paid equal to the market value of the shares issued. The treatment is consistent with the belief that per share prices remain unchanged by stock dividends. This is not logical. If the value of each share were to remain the same when additional shares are distributed without compensation, the total value of the company would grow simply because additional stock certificates are distributed. Instead, the market price per share will decline in proportion to the increase in the number of shares distributed in a stock dividend. Question 18-21 The effect and maybe the motivation for the stock split is to reduce the per share market price (by half). This will likely increase the stock’s marketability by making it attractive to a larger number of potential investors. The appropriate accounting treatment of a stock split is to make no journal entry, which avoids the reclassification of “earned” capital as “invested” capital. However, if the stock distribution is referred to as a "stock split effected in the form of a stock dividend," and the per share par value of the shares is not changed, a journal entry is recorded that increases the common stock account by the par value of the additional shares. To avoid reducing retained earnings Brandon can reduce (debit) paid-in capital – excess of par to offset the credit to common stock, although it’s permissible to debit retained earnings. Question 18-22 When a company decreases, rather than increases, its outstanding shares a reverse stock split occurs. A 1 for 2 reverse stock split would cause one million $1 par shares to become one- half million $2 par shares. No journal entry would be recorded, so no account balances will change. But the market price per share would double, and the par amount per share would double. Question 18-23 You would be entitled to 3.2 shares (4% x 80 shares). Since cash payments usually are made when shareholders are entitled to fractions of whole shares, you probably would receive 3 shares and cash equal to the market value of 1/5 of one share. Sometimes fractional share rights are issued for the partial shares, which would entitle you to a fractional share right for 1/5 of a share. Question 18-24 A quasi reorganization allows a company to (1) write down inflated asset values and (2) eliminate an accumulated deficit in retained earnings. The following steps are taken: 1. Assets and liabilities are revalued to reflect their fair market values, with corresponding credits or debits to retained earnings. This may temporarily increase the deficit. 6 2. The debit balance in retained earnings is eliminated against additional paid-in capital. When additional paid-in capital is not sufficient to absorb the entire deficit, capital stock is debited. 3. Disclosure is provided to indicate the date the deficit was eliminated and when the new accumulation of earnings began. 7 BRIEF EXERCISES Brief Exercise 18-1 Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period ($15 million in this instance) and (2) the comprehensive income accumulated over the current and prior periods ($50 million at the end of this year). The $50 million represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years. Since this amount increased by $15 million, the balance must have been $35 million last year. Brief Exercise 18-2 ($ in millions) Cash (8 million shares x $12 per share) .................................. 96 Common stock (8 million shares x $1 par per share) .............. 8 Paid-in capital – excess of par (remainder) .................... 88 8 Brief Exercise 18-3 Lewelling’s paid-in capital – excess of par will increase by $860,000: 4,000 hours x $240 less $100,000 par. Journal entry (not required): Legal expense (4,000 hours x $240) .................................... 960,000 Common stock (100,000 shares x $1 par per share) ............... 100,000 Paid-in capital – excess of par (remainder) .................... 860,000 Brief Exercise 18-4 Horton’s total paid-in capital will decline by $17 million, the price paid to buy back the shares. Journal entry (not required): ($ in millions) Common stock (2 million shares x $1 par) ................................... 2 Paid-in capital – excess of par (2 million shares x $9*) ................. 18 Paid-in capital – share repurchase (difference) ..................... 3 Cash (2 million shares x $8.50 per share) .................................. 17 * Paid-in capital – excess of par: $900 ÷ 100 million shares 9 Brief Exercise 18-5 Agee’s total paid-in capital will decline by $18 million because recording the transaction involves a $1 million reduction of retained earnings and an $18 million reduction in paid-in capital accounts. Journal entries (not required): First buyback ($ in millions) Common stock (1 million shares x $1 par) ................................... 1 Paid-in capital – excess of par (1 million shares x $15*) ............ 15 Paid-in capital – share repurchase (difference) ..................... 2 Cash (1 million shares x $14) .................................................. 14 * $16 - $1 par Second buyback Common stock (1 million shares x $1 par) ................................... 1 Paid-in capital – excess of par (1 million shares x $15*) ............ 15 Paid-in capital – share repurchase (balance from first buyback) .. 2 Retained earnings (difference) .................................................. 1 Cash (1 million shares x $19) .................................................. 19 * $16 - $1 par 10 Brief Exercise 18-6 Jennings’ retained earnings will decline by $2 million because the $67 million sale price is less than the sum of the cost of the treasury stock ($70 million) and paid-in capital from the previous treasury stock sale ($1 million). Journal entries (not required): Purchase of treasury stock ($ in millions) Treasury stock (2 million shares x $70) ....................................... 140 Cash .................................................................................... 140 First sale of treasury stock Cash (1 million shares x $71) ...................................................... 71 Treasury stock (1 million shares x $70) ................................... 70 Paid-in capital – share repurchase (remainder) ..................... 1 Second sale of treasury stock Cash (1 million shares x $67) ...................................................... 67 Paid-in capital – share repurchase (balance from first sale) ........ 1 Retained earnings (remainder) .................................................. 2 Treasury stock (1 million shares x $70) ................................... 70 11 Brief Exercise 18-7 Cox’ paid-in capital – share repurchase will increase by $7 million as determined in the following journal entry: ($ in millions) Cash (1 million shares x $29) ...................................................... 29 Paid-in capital – share repurchase (difference) ..................... 7 Treasury stock (1 million shares x $22*) ................................. 22 * 2 million shares x $20 = $40 million 1 million shares x $26 = 26 million 3 million shares $66 million $66 million ÷ 3 million shares = $22 average cost per share Brief Exercise 18-8 Cox’ paid-in capital – share repurchase will increase by $9 million as determined in the following journal entry: ($ in millions) Cash (1 million shares x $29) ...................................................... 29 Paid-in capital – share repurchase (difference) ..................... 9 Treasury stock (1 million shares x $20*) ................................. 20 * 2 million shares x $20 = $40 million (first million at $20) 1 million shares x $26 = 26 million $66 million 12 Brief Exercise 18-9 Declaration date ($ in millions) Retained earnings .............................................................. 868.96 Cash dividends payable (10,862 million shares x $.08) ..... 868.96 Date of record no entry Payment date Cash dividends payable ................................................... 868.96 Cash ............................................................................. 868.96 Brief Exercise 18-10 Declaration date Loss on investment ($37,000 - 35,000) ............................... 2,000 Investment in GE stock ................................................ 2,000 Retained earnings (1,000 shares at $35 per share) ...................... 35,000 Property dividends payable ......................................... 35,000 Payment date Property dividends payable ............................................. 35,000 Investment in GE stock ................................................ 35,000 Brief Exercise 18-11 ($ in millions) Retained earnings (3 million* shares at $25 per share) .............. 75 Common stock (3 million* shares at $1 par per share) ....... 3 Paid-in capital – excess of par (remainder) ..................... 72 * 5% x 60 million shares = 3 million shares 13 Brief Exercise 18-12 If a stock split is not to be effected in the form of a stock dividend, no entry is recorded. Since the shares double, but the balance in the common stock account is not changed, the par per share is reduced, to $.50 in this instance. Brief Exercise 18-13 Paid-in capital – excess of par 60 Common stock (60 million shares* x $1 par per share) 60 * 100% x 60 million shares = 60 million shares If the per share par value of the shares is not to be changed, the stock distribution is referred to as a "stock split effected in the form of a stock dividend." In that case, the journal entry increases the common stock account by the par value of the additional shares. This prevents the increase in shares from reducing (by half in this case) the par per share. The par is $1 before and after the split. 14 EXERCISES Exercise 18-1 Requirement 1 Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income. It is the total nonowner change in equity for a reporting period. In fact, it encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company’s stock. Most nonowner changes are reported in the income statement. So, the changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” Requirement 2 Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The second measure - the comprehensive income accumulated over the current and prior periods – is reported in the balance sheet as a separate component of shareholders’ equity. This is what Kaufman reported in its balance sheet ($107 million in 2006). Be sure to realize this amount represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years. 15 Exercise 18-1 (continued) Requirement 3 Kaufman's 2006 balance sheet amount ($107 million) differs from the 2006 amount reported in the disclosure note. On the other hand, the comprehensive income created during the reporting period can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) in a disclosure note. This is the measure of comprehensive income Kaufman reported in the disclosure note. Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income, similar to the following: ($ in millions) Net income $xxx Other comprehensive income: Net unrealized holding gains (losses) on investments (net of tax)† $ x Net unrecognized loss on pensions (net of tax)‡ (x) Deferred gains (losses) from derivatives (net of tax)§ x Gains (losses) from foreign currency translation (net of tax)* x xx Comprehensive income $xxx † Changes in the market value of securities available-for-sale. ‡ Reporting a pension liability sometimes requires recording this (described in Chapter 17). It often is called pension liability adjustment. § When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text). * Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum.) Notice that each component is reported net of its related income tax expense or income tax benefit. 16 Exercise 18-1 (concluded) Requirement 4 From the information Kaufman's financial statements provide, we can determine how the company calculated the $107 million accumulated other comprehensive income in 2006: ($ in millions) Accumulated other comprehensive income, 2005 $75 Change in net unrealized gains on investments 34 Change in “other” (2) Accumulated other comprehensive income, 2006 $ 107 Exercise 18-2 Cash (3 million shares x $17.15 per share) .............................. 51,450,000 Common stock (3 million shares x $.01 par per share) ....... 30,000 Paid-in capital – excess of par (remainder) .................... 51,420,000 17 Exercise 18-3 Requirement 1 ($ in millions) Cash (28 million shares x $20 per share) ................................................. 560 Common stock (28 million shares x $1 par per share) ......................... 28 Paid-in capital – excess of par (remainder) ..................................... 532 Requirement 2 ($ in millions) Cash (50% x $560 million) .................................................................... 280 Receivable from share purchase contract (50% x $560 million) .......... 280 Common stock (28 million shares x $1 par per share) ......................... 28 Paid-in capital – excess of par (remainder) ..................................... 532 Requirement 3 Shareholders’ equity: ($ in millions) Common stock, 28 million shares at $1 par .................................... $ 28 Paid-in capital – excess of par .......................................................... 532 Less: Receivable from share purchase contract ........................... (280) $280 Retained earnings .............................................................................. 50 Total shareholders’ equity ............................................................ $330 Requirement 4 ($ in millions) Cash (50% x $560 million) .................................................................... 280 Receivable from share purchase contract (50% x $560 million) ........ 280 Requirement 5 Shareholders’ equity: ($ in millions) Common stock, 28 million shares at $1 par .................................... $ 28 Paid-in capital – excess of par .......................................................... 532 Retained earnings .............................................................................. 115 Total shareholders’ equity ................................................................ $675 18 19 Exercise 18-4 February 12 Cash (2 million shares x $9 per share) ................................ 18,000,000 Common stock (2 million shares x $1 par).................... 2,000,000 Paid-in capital – excess of par (difference) ................... 16,000,000 February 13 Legal expenses (40,000 shares x $9 per share) .................. 360,000 Common stock (40,000 shares x $1 par) ....................... 40,000 Paid-in capital – excess of par (difference) ................... 320,000 Note: Because 2 million shares sold the previous day for $9 per share, it’s reasonable to assume a $9 per share fair value. February 13 Cash ............................................................................. 945,000 Common stock (80,000 shares x $1 par) ...................... 80,000 Paid-in capital – excess of par, common* ............... 640,000 Preferred stock (4,000 shares x $50 par) ....................... 200,000 Paid-in capital – excess of par, preferred** ............ 25,000 * 80,000 shares x [$9 market value - $1 par] ** Since the value of the common shares is known ($720,000), the market value of the preferred ($225,000) is assumed from the total selling price ($945,000). November 15 Property, plant, and equipment (cash value) .................. 3,688,000 Common stock (380,000 shares at $1 par per share) ...... 380,000 Paid-in capital – excess of par (difference) ................ 3,308,000 20 Exercise 18-5 Williams Industries must report the 20 million Class B shares among its long- term liabilities in its balance sheet, not as part of shareholders’ equity. The “triggering event,” the death of J.P Williams, is certain to occur even though its timing may not be. A share or other financial instrument is considered to be mandatorily redeemable if it embodies an unconditional obligation that requires the issuer to redeem the instrument with cash or other assets at a specified or determinable date or upon an event certain to occur. Events certain to occur include the death or termination of employment of an individual, since both events, like taxes, are inevitable. Because Williams has the right but not the obligation to repurchase the Class A shares if a change in ownership of the voting common shares changes, there is no unconditional obligation to repurchase the Class B shares. They are classified as equity. 21 Exercise 18-6 Requirement 1 ($ in millions) Cash ($424 million – $2 million) .................................................. 422 Common stock (15 million shares at $1 par per share) ............... 15 Paid-in capital – excess of par (difference) ........................... 407 Requirement 2 In recording the sale of shares above, the cost of services related to the sale reduced the net proceeds from selling the shares. Since paid-in capital – excess of par is credited for the excess of the proceeds over the par amount of the shares sold, the effect of share issue costs is to reduce the amount credited to that account. On the other hand, the costs associated with a debt issue are recorded in a separate “debt issue costs” account and amortized to expense over the life of the debt (Chapter 14). Some argue that share issue costs and debt issue costs are fundamentally different. This view is that a debt issue has a fixed maturity so, like interest expense, debt issue costs are part of the expense of borrowing funds for that period of time (recorded in a separate expense account – “debt issue expense”.) On the other hand, selling shares represents a perpetual equity interest. Just as dividends paid on that capital investment are not an expense, neither are the share issue costs of obtaining that capital investment. Expensing debt issue costs presently is required by GAAP. However, the FASB has suggested in Concept Statement 6 that those costs should be treated the same way as share issue costs, meaning that the debt issue costs would reduce the recorded amount of the debt instead of being recorded separately as an asset. Since Concept Statements do not constitute GAAP, until a new FASB Standard is issued to supersede APB Opinion 21, the accepted practice is to record debt issue costs as assets and expense the asset over the maturity of the debt. 22 Exercise 18-7 1. January 7, 2006 ($ in millions) Common stock (2 million shares x $1 par) ................................... 2 Paid-in capital – excess of par (2 million shares x $3*) ................. 6 Retained earnings (difference) .................................................. 2 Cash (2 million shares x $5 per share) ....................................... 10 * Paid-in capital – excess of par: $300 ÷ 100 million shares 2. August 23, 2006 Common stock (4 million shares x $1 par) ................................... 4 Paid-in capital – excess of par (4 million shares x $3) ................... 12 Paid-in capital – share repurchase (difference) ..................... 2 Cash (4 million shares x $3.50 per share) .................................. 14 3. July 25, 2007 Cash (3 million shares x $6 per share) ........................................... 18 Common stock (3 million shares x $1 par)............................... 3 Paid-in capital – excess of par (difference) ............................... 15 23 Exercise 18-8 1. January 2, 2006 ($ in millions) Common stock (10 million shares x $1 par) ................................. 10 Paid-in capital – excess of par (10 million shares x $33*) ........... 330 Paid-in capital – share repurchase (difference) ..................... 15 Cash (10 million shares x $32.50) ............................................ 325 * $34 - $1 par 2. March 3, 2006 Common stock (10 million shares x $1) ...................................... 10 Paid-in capital – excess of par (10 million shares x $33*) ............. 330 Paid-in capital – share repurchase (available balance) ............... 15 Retained earnings (remainder) .................................................. 5 Cash (10 million shares x $36) ................................................ 360 * $34 - $1 par 3. August 13, 2006 Cash (1 million shares x $42) ...................................................... 42 Common stock (1 million shares x $1) .................................... 1 Paid-in capital – excess of par (remainder) ........................... 41 4. December 15, 2006 Cash (2 million shares x $36) ...................................................... 72 Common stock (2 million shares x $1) .................................... 2 Paid-in capital – excess of par (remainder) ........................... 70 24 Exercise 18-9 1. January 23, 2006 ($ in millions) Treasury stock (10 million shares x $20) ..................................... 200 Cash .................................................................................... 200 2. September 3, 2006 Cash (1 million shares x $21) ...................................................... 21 Treasury stock (1 million shares x $20) ................................... 20 Paid-in capital – share repurchase (remainder) ..................... 1 3. November 4, 2006 Cash (1 million shares x $18) ...................................................... 18 Paid-in capital – share repurchase (from 2.) ............................. 1 Retained earnings (remainder) .................................................. 1 Treasury stock (1 million shares x $20) ................................... 20 25 Exercise 18-10 1. February 12, 2006 ($ in millions) Treasury stock (1 million shares x $13) ....................................... 13 Cash .................................................................................... 13 2. June 9, 2007 Treasury stock (2 million shares x $10) ....................................... 20 Cash .................................................................................... 20 3. May 25, 2008 Cash (2 million shares x $15) ...................................................... 30 Paid-in capital – share repurchase (difference) ..................... 8 Treasury stock (2 million shares x $11*) ................................. 22 * 1 million shares x $13 = $13 million 2 million shares x $10 = 20 million 3 million shares $33 million $33 million ÷ 3 million shares = $11 average cost per share 4. May 25, 2008 Cash (2 million shares x $15) ...................................................... 30 Paid-in capital – share repurchase (difference) ..................... 7 Treasury stock (FIFO cost*) ................................................. 23 * 1 million shares x $13 = $13 million 1 million shares x $10 = 10 million $23 million 26 Exercise 18-11 Requirement 1 Method A – Reacquired shares are treated as treasury stock. Method B – Reacquired shares are retired with their status restored to that of authorized but unissued shares. Requirement 2 Reacquired shares that are retired have their status restored to that of authorized but unissued shares. Although theoretically identical to retired shares, treasury shares are treated as issued, but not outstanding shares – at the same time both (a) issued and (b) not outstanding. This artificial status has provided companies an effective device to evade the superficial constraints imposed on par value shares. Treasury stock is reported as a reduction in total shareholders' equity, not associated with any specific shareholders’ equity account. By either method total shareholders’ equity is the same. Retiring shares clearly is conceptually superior because it effectively restores the shares to the status of being authorized, but unissued, shares. Treated as treasury stock, the cost of acquiring the shares is “temporarily” debited to the treasury stock account. Recording the effects on specific shareholders’ equity accounts is delayed until later when the shares are reissued. In the meantime, the shares assume the artificial status of being neither unissued nor outstanding. 27 Exercise 18-12 This is a change in accounting principle. ($ in millions) Common stock ($1 par x 4 million shares retired) ........................ 4 Paid-in capital – excess of par (average amount above par at which the retired shares originally sold: $800 million .................. ÷ 200 million shares = $4; $4 x 4 million shares retired) .............. 16 Retained earnings (difference) .................................................. 5 Treasury stock (cost of the shares retired) ................................ 25 UMC applies the new way of reporting reacquired shares retrospectively; that is, to all prior periods as if it always had used that method. In other words, all financial statement amounts for individual periods affected by the change and that are included for comparison with the current financial statements are revised. In each prior period reported, then, UMC would reduce Common stock by $4 million, Paid-in capital – excess of par by $16 million, Retained earnings by $5 million, and Treasury stock by $25 million. The effect of the change on each line item affected should be disclosed for each period reported as well as any adjustment for periods prior to those reported. Also, the nature of and justification for the change should be described in the disclosure notes. Exercise 18-13 1. a 2. c 28 Exercise 18-14 Requirement 1. Retirement of common shares ($ in millions) Common stock (5 million shares x $1 par per share) .................... 5 Paid-in capital – excess of par ($22 – 5 – 2) ............................. 15 Retained earnings (given) ......................................................... 2 Cash (given) ......................................................................... 22 Net income closed to retained earnings Income summary ............................................................................. 88 Retained earnings (given) ..................................................... 88 Declaration of a cash dividend Retained earnings (given) ......................................................... 33 Cash ............................................................................................... 33 Declaration of a stock dividend Retained earnings (given) ......................................................... 20 Common stock ([105-5] x 4%) million shares at $1 par per share) 4 Paid-in capital – excess of par (difference) ........................... 16 Requirement 2. Brenner-Jude Corporation Statement of Retained Earnings FOR THE YEAR ENDED DECEMBER 31, 2006 ($ in millions) Balance at January 1 $ 90 Net income for the year 88 Deductions: Retirement of common stock (2) Cash dividends of $.33 per share (33) 4% stock dividend (20) Balance at December 31 $123 29 Exercise 18-15 Preferred Common 2006 $ 8 million $ 0 2007 20 million* 0 2008 20 million** 130 million (remainder) * $8 million dividends in arrears plus $12 million of the $16 million current preference. ** $4 million dividends in arrears plus the $16 million current preference. Exercise 18-16 April 1, 2006 Retained earnings (300,000* shares at $30 per share) ................ 9,000,000 Common stock (300,000* shares at $1 par per share) ......... 300,000 Paid-in capital – excess of par (remainder) ..................... 8,700,000 * 10% x 3 million shares issued and outstanding or, alternatively: April 1, 2006 Retained earnings ....................................................................... 9,000,000 Common stock dividends distributable ........................ 300,000 Paid-in capital – excess of par ..................................... 8,700,000 June 1, 2006 Common stock dividends distributable .................................. 300,000 Common stock ............................................................. 300,000 30 Exercise 18-17 Requirement 1. Paid-in capital – excess of par 24,500 Common stock (24.5 million shares* x $.001 par per share) 24,500 * 100% x 24.5 million shares = 24.5 million shares Requirement 2. If the per share par value of the shares is not to be changed, the stock distribution is referred to as a "stock split effected in the form of a stock dividend." In that case, the journal entry in requirement 1 increases the common stock account by the par value of the additional shares. This prevents the increase in shares from reducing (by half in this case) the par per share. Requirement 3. If Hanmi’s stock price had been $36 at the time of the split, its approximate value after the split (other things equal) would be $18. The same pie is sliced into twice as many pieces, so each piece is worth half as much. 31 Exercise 18-18 Requirement 1 A stock dividend or stock split usually results in some shareholders being entitled to fractions of whole shares. For instance, if a company declares a 25% stock dividend, or equivalently a 5 for 4 stock split, a shareholder owning 10 shares would be entitled to 2 1/2 shares. Another shareholder with 15 shares would be entitled to 3 3/4 shares. Paying shareholders the cash equivalent of the fractional shares simplifies matters for both the corporation and shareholders. Requirement 2 ($ in millions) Retained earnings (36 million* x $21 per share) .............................. 756 Common stock ([36 million* – 2 million] x $1 par) ................. 34 Paid-in capital – excess of par ([36 million* – 2 million] x [$21 - 1 = $20 per share]) ............... 680 Cash (2 million shares at $21 market price per share) .................. 42 * 4% x 900 million shares = 36 million additional shares 32 Exercise 18-19 Requirement 1 a. March 3 – declaration date Investment in Leasco International stock ........................ 20,000 Gain on appreciation of investment ($720,000 - $700,000) 20,000 Retained earnings (240,000 shares at $3 per share) .................... 720,000 Property dividends payable ......................................... 720,000 March 15 – date of record no entry March 31 – payment date Property dividends payable ............................................. 720,000 Investment in Leasco International stock .................... 720,000 b. May 3 Paid-in capital – excess of par, common* ........................ 90,000 Common stock (25% x [364,000 - 4,000] shares at $1 par) .. 90,000 *alternatively, retained earnings may be debited. c. July 5 Retained earnings (9,000* x $11 per share) ................................ 99,000 Common stock (9,000* x $1 par) .................................... 9,000 Paid-in capital – excess of par, common (difference) ..... 90,000 * 2% x [360,000 + 90,000 shares] = 9,000 additional shares 33 Exercise 18-19 (concluded) d. December 1 – declaration date Retained earnings .............................................................. 7,920 Cash dividends payable ($90,000 par x 8.8%) ................. 7,920 December 20 – date of record no entry December 28 – payment date Cash dividends payable ................................................... 7,920 Cash ............................................................................. 7,920 e. December 1 – declaration date Retained earnings .............................................................. 229,500 Cash dividends payable (459,000* x $.50) ..................... 229,500 * 360,000 + 90,000 + 9,000 = 459,000 shares December 20 – date of record no entry December 28 – payment date Cash dividends payable ................................................... 229,500 Cash ............................................................................. 229,500 Requirement 2 Paid-in capital: Preferred stock, 8.8%, 90,000 shares at $1 par ............ $ 90,000 Common stock, 463,0001 shares at $1 par .................. 463,000 Paid-in capital – excess of par, preferred ..................... 1,437,000 Paid-in capital – excess of par, common ...................... 2,574,000 2 Retained earnings........................................... 9,488,580 3 Treasury stock, at cost; 4,000 common shares ............ (44,000) Total shareholders’ equity ........................................... $14,008,580 1 364,000 + 90,000 + 9,000 = 463,000 shares 2 $2,574,000 - 90,000 + 90,000 = $2,574,000 3 $9,735,000 - 720,000 - 99,000 - 7,920 - 229,500 + 810,000 = $9,488,580 34 Exercise 18-20 1. d 2. b 3. a Exercise 18-21 The return on shareholders' equity is computed by dividing net income by average shareholders' equity. [$200 – 120]* ÷ ([$600 + 520] /2) = 14.29% * increase in retained earnings, which equals net income since no dividends were paid The ratio is a summary measure of profitability often used by investors and potential investors, particularly common shareholders. It measures the ability of company management to generate net income from the resources that owners provide. However, because shareholders’ equity is a measure of the book value of equity, investors often relate earnings to the market value of equity, calculating the earnings-price ratio. Information available in the exercise is insufficient to do so. 35 Exercise 18-22 AMTC Cash (7.5 million shares x $13.546) ..................... 101,595,000 Common stock (7.5 million sh. x $.001 par) ... 7,500 Paid-in capital – excess of par (difference) ...... 101,587,500 PSI Cash (9 million shares x $15.20) .......................... 136,800,000 Common stock (9 million shares x $.01 par) .. 90,000 Paid-in capital – excess of par (difference) ...... 136,710,000 Exercise 18-23 Requirement 1 ($ in millions) Common stock (10.5 million shares x $.01) ............ .105 Paid-in capital – excess of par (10.5 million shares x $36.12) 379.260 Retained earnings (difference) 618.135 Cash ($1 billion / $95 = 10.5 million shares) 997.500 Note: This assumes ConocoPhillips retires the shares it buys back rather than accounting for them as treasury stock. If it treated the shares as treasury stock the entry would be: Treasury stock 997.5 Cash 997.5 Requirement 2 ConocoPhillips is referring to the fact that stock options and stock awards increase the number of shares and thus decrease earnings per share, other things being equal. This effect would partially be offset by decreasing the number of shares through share repurchase. 36 Exercise 18-24 1. b. Par value represents a stock’s legal capital. It is an arbitrary value assigned to stock before it is issued. Par value represents a shareholder’s liability ceiling because, as long as the par value has been paid in to the corporation, the shareholders obtain the benefits of limited liability. 2. c. Common shareholders usually have preemptive rights, which means they have the right to purchase any new issues of stock in proportion to their current ownership percentages. The purpose of a preemptive right is to allow shareholders to maintain their current percentages of ownership. Given that Smith had 2,000,000 shares outstanding ($10,000,000 / $5), an investor with 20,000 shares has a 1% ownership. Hence, this investor must be allowed to purchase 4,000 (1% x 400,000 shares) of the additional shares. 3. b. A stock dividend is a transfer of equity from retained earnings to paid-in capital. The debit is to retained earnings, and the credits are to common stock and additional paid-in capital. More shares are outstanding following the stock dividend, but every shareholder maintains the same percentage of ownership. In effect, a stock dividend divides the pie (the corporation) into more pieces, but the pie is still the same size. Hence, a corporation will have a lower EPS and a lower carrying amount per share following a stock dividend, but every shareholder will be just as well off as previously. 37 PROBLEMS Problem 18-1 PART A Jan. 9 ($ in millions) Cash (40 million shares x $20 per share) ....................................... 800 Common stock (40 million shares x $1 par) ............................. 40 Paid-in capital – excess of par (difference) ............................... 760 Mar. 11 Equipment (5,000 shares x $20 per share) ......................... 100,000 Common stock (5,000 shares x $1 par) ........................ 5,000 Paid-in capital – excess of par (difference) ................... 95,000 PART B Jan. 12 ($ in millions) Land ........................................................................................ 2 Revenue – donation of land ................................................ 2 Note: Donated assets are recorded as revenue at the fair value of the assets received, not paid-in capital (SFAS 116). This is discussed in Chapter 10. Sept. 1 ($ in millions) Common stock (2 million shares x $1 par) ................................... 2 Paid-in capital – excess of par (2 million shares x $19) ...................................................................... 38 Retained earnings (difference) .................................................. 10 Cash .................................................................................... 50 Dec. 1 ($ in millions) Cash ........................................................................................ 26 Common stock .................................................................... 1 Paid-in capital – excess of par ........................................... 25 38 Problem 18-2 Requirement 1 a. February 5, 2006 ($ in millions) Retirement Treasury Stock Common stock (6 million sh. x $1) 6 Treasury stock (6 million sh. x $10) 60 Paid-in capital – excess of par Cash 60 (6 million shares x $7*) 42 Paid-in capital – share repurchase 1 Retained earnings (plug) 11 Cash 60 * Paid-in capital – excess of par: $1,680 ÷ 240 b. July 9, 2006 Cash (2 million sh. x $12) 24 Cash (2 million sh. x $12) 24 Common stock (2 million sh. x $1) 2 Treasury stock (2 million sh. x $10) 20 Paid-in capital – excess of par 22 Paid-in capital–sh. repurchase 4 c. November 14, 2008 Cash (2 million sh. x $7) 14 Cash (2 million sh. x $7) 14 Common stock (2 million sh. x $1) 2 Paid-in cap.- sh. repurchase ($1 + 4 ) 5 Paid-in capital – excess of par 12 Retained earnings (plug) 1 Treasury stock (2 million sh. x $10) 20 39 Problem 18-2 (concluded) Requirement 2 Shareholders’ Equity $ in millions Treasury Retirement Stock Paid-in capital: Common stock, 240 million shares at $1 par, ............... $ 238 $ 240 Paid-in capital – excess of par ...................................... 1,672 * 1,680 Paid-in capital – share repurchase .................................. 0 0 Retained earnings ......................................................... 1,089 ** 1,099 *** Less: treasury stock, 2 million shares (at cost) .......... (20) Total shareholders’ equity ............................................ $2,999 $2,999 * 1,680 - 42 + 22 + 12 ** 1,100 - 11 *** 1,100 - 1 or, alternatively: Paid-in capital: Common stock, 240 million shares at $1 par, ............... $ 238 $ 240 Additional paid-in capital .............................................. 1,672 * 1,680 Retained earnings ......................................................... 1,089 ** 1,099 *** Less: treasury stock, 2 million shares (at cost) .......... (20) Total shareholders’ equity ............................................ $2,999 $2,999 * 1,680 - 42 + 22 + 12 ** 1,100 - 11 *** 1,100 - 1 40 Problem 18-3 Requirement 1 February 15, 2006 (a) Retired Common stock (300,000 shares x $1 par) ........................ 300,000 Paid-in capital – excess of par (300,000 shares x $5) .................................................... 1,500,000 Retained earnings (difference) ....................................... 600,000 Cash (300,000 shares x $8) ........................................... 2,400,000 (b) Accounted for as treasury stock Treasury stock (300,000 shares x $8) .............................. 2,400,000 Cash (300,000 shares x $8) ........................................... 2,400,000 February 17, 2007 (a) Retired Common stock (300,000 shares x $1 par) ........................ 300,000 Paid-in capital – excess of par (300,000 shares x $5) ...................................................... 1,500,000 Paid-in capital – share repurchase (difference) .......... 150,000 Cash (300,000 shares x $5.50) ...................................... 1,650,000 (b) Accounted for as treasury stock Treasury stock (300,000 shares x $5.50) ......................... 1,650,000 Cash (300,000 shares x $5.50) ...................................... 1,650,000 41 Problem 18-3 (concluded) November 9, 2008 (a) Retired Cash (200,000 shares x $7) ............................................... 1,400,000 Common stock (200,000 shares x $1 par) ..................... 200,000 Paid-in capital – excess of par (difference) ................ 1,200,000 (b) Accounted for as treasury stock Cash (200,000 shares x $7) ............................................... 1,400,000 Retained earnings ......................................................... 200,000 Treasury stock (200,000 shares x $8 FIFO cost) ............ 1,600,000 Requirement 2 Shareholders’ Equity SHARES RETIRED TREASURY STOCK Paid-in capital: Common stock, $1 par, ........................................ $ 5,600,000 $ 6,000,000 Paid-in capital – excess of par .............................. 28,200,000 30,000,000 Paid-in capital – share repurchase ........................ 150,000 0 Retained earnings ............................................... 130,900,000* 131,300,000** Less: treasury stock, 400,000 shares (at cost) ... (2,450,000) Total shareholders’ equity ................................... $164,850,000 $164,850,000 * $86,500,000 - 600,000 + 14,000,000 + 15,000,000 + 16,000,000 **$86,500,000 + 14,000,000 + 15,000,000 + 16,000,000 - 200,000 or, alternatively: Paid-in capital: Common stock, $1 par, ........................................ $ 5,600,000 $ 6,000,000 Additional paid-in capital ..................................... 28,350,000 30,000,000 Retained earnings ............................................... 130,900,000* 131,300,000** Less: treasury stock, 400,000 shares (at cost) ... (2,450,000) Total shareholders’ equity ................................... $164,850,000 $164,850,000 42 Problem 18-4 2004 Retained earnings ......................................................... 160,500 Income summary...................................................... 160,500 2005 Income summary .......................................................... 2,240,900 Retained earnings .................................................... 2,240,900 Common stock (110,000 shares at $1 par per share) ............. 110,000 Paid-in capital – excess of par (110,000 shares x $4) ........ 440,000 Retained earnings (given) .............................................. 212,660 Cash (total) ................................................................ 762,660 * Paid-in capital – excess of par: $7,420 ÷ 1,855 = $4 Retained earnings (given) .............................................. 698,000 Cash dividends payable ......................................... 698,000 Cash dividends payable .............................................. 698,000 Cash ........................................................................ 698,000 2006 Income summary .......................................................... 3,308,700 Retained earnings .................................................... 3,308,700 Retained earnings (given) .............................................. 242,000 Common stock (34,900 shares at $1 par per share) ....... 34,900 Paid-in capital – excess of par (difference) ................ 207,100 Retained earnings ......................................................... 889,950 Cash dividends payable .......................................... 889,950 Cash dividends payable .............................................. 889,950 Cash ........................................................................ 889,950 43 Problem 18-5 Requirement 1 2006 a. November 1 – declaration date Retained earnings ......................................................... 84,000,000 Cash dividends payable (105 million shares at $.80/share) 84,000,000 November 15 – date of record no entry December 1 – payment date Cash dividends payable .............................................. 84,000,000 Cash ........................................................................ 84,000,000 2007 b. March 1 – declaration date Investment in Warner bonds ........................................ 300,000 Gain on appreciation of investment ($1.6 million - 1.3 million) ......................................... 300,000 Retained earnings ........................................................ 1,600,000 Property dividends payable ................................... 1,600,000 March 13– date of record no entry April 5– payment date Property dividends payable ........................................ 1,600,000 Investment in Warner bonds ................................... 1,600,000 c. July 12 Retained earnings (5,250,000* x $21 per share) .............. 110,250,000 Common stock ([5,250,000* – 250,000] x $1 par) .... 5,000,000 Paid-in capital – excess of par ([5,250,000* – 250,000] x $20 per share) ................. 100,000,000 Cash (250,000 shares at $21 market price per share) .... 5,250,000 * 5% x 105,000,000 shares = 5,250,000 additional shares 44 Problem 18-5 (continued) d. November 1 – declaration date Retained earnings ......................................................... 88,000,000 Cash dividends payable (110,000,000* x $.80) .............. 88,000,000 * 105,000,000 + 5,000,000 = 110,000,000 shares November 15 – date of record no entry December 1 – payment date Cash dividends payable .............................................. 88,000,000 Cash ........................................................................ 88,000,000 2008 e. January 15 Paid-in capital – excess of par ..................................... 55,000,000 Common stock (55,000,000* shares at $1 par) ............. 55,000,000 * 110,000,000 shares x 50% = 55,000,000 shares f. November 1 – declaration date Retained earnings ......................................................... 107,250,000 Cash dividends payable (165,000,000 * x $.65) ............. 107,250,000 * 105,000,000 + 5,000,000 + 55,000,000 = 165,000,000 shares November 15 – date of record no entry December 1 – payment date Cash dividends payable .............................................. 107,250,000 Cash ........................................................................ 107,250,000 45 Problem 18-5 (concluded) Requirement 2 Branch-Rickie Corporation Statement of Shareholders’ Equity For the Years Ended Dec. 31, 2006, 2007, and 2008 ($ in 000s) Common Stock Additional Paid-in Capital Retained Earnings Total Shareholders’ Equity Jan. 1, 2006 105,000 630,000 970,000 1,705,000 Net income 330,000 330,000 Cash dividends (84,000) (84,000) Dec. 31, 2006 105,000 630,000 1,216,000 1,951,000 Property dividends (1,600) (1,600) Common stock dividend 5,000 100,000 (110,250) (5,250) Net income 395,000 395,000 Cash dividends (88,000) (88,000) Dec. 31, 2007 110,000 730,000 1,411,150 2,251,150 3 for 2 split effected in the form of a stock dividend 55,000 (55,000) Net income 455,000 455,000 Cash dividends (107,250) (107,250) Dec. 31, 2008 165,000 675,000 1,758,900 2,598,900 46 Problem 18-6 2006 ($ in millions) Cash ........................................................................................ 120 Receivable from share purchase contract ............................... 360 Preferred stock (1 million shares x $10 par per share) ............... 10 Paid-in capital – excess of par, preferred ........................... 470 Cash ........................................................................................ 70 Common stock (7 million shares x $1 par per share) ................. 7 Paid-in capital – excess of par, common ........................... 63 Retained earnings .................................................................... 1 Cash dividends payable, preferred .................................... 1 Cash dividends payable, preferred ......................................... 1 Cash ................................................................................... 1 Retained earnings .................................................................... 16 Cash dividends payable, common ..................................... 16 Cash dividends payable, common ......................................... 16 Cash ................................................................................... 16 Income summary ..................................................................... 290 Retained earnings ............................................................... 290 2007 ($ in millions) Cash ........................................................................................ 360 Receivable from share purchase contract ........................... 360 Common stock (3 million shares x $1 par) .................................. 3 Paid-in capital – excess of par (3 million shares x $9*) .............. 27 Retained earnings (given) ......................................................... 20 Cash (total) ........................................................................... 50 * [$495 million + $63 million] ÷ [55 million + 7 million shares] = $9 weighted average amount per share in excess of par 47 Problem 18-6 (concluded) ($ in millions) Retained earnings .................................................................... 1 Cash dividends payable, preferred .................................... 1 Cash dividends payable, preferred ......................................... 1 Cash ................................................................................... 1 Retained earnings .................................................................... 20 Cash dividends payable, common ..................................... 20 Cash dividends payable, common ......................................... 20 Cash ................................................................................... 20 Paid-in capital – excess of par, preferred ............................... 5 Preferred stock .............................................................................. 5 Income summary ..................................................................... 380 Retained earnings ............................................................... 380 2008 ($ in millions) Retained earnings ................................................................... 65 Common stock ................................................................... 6 Paid-in capital – excess of par, common ............................ 59 Retained earnings .................................................................... 1 Cash dividends payable, preferred .................................... 1 Cash dividends payable, preferred ......................................... 1 Cash ................................................................................... 1 Retained earnings .................................................................... 22 Cash dividends payable, common ..................................... 22 Cash dividends payable, common ......................................... 22 Cash ................................................................................... 22 Income summary ..................................................................... 412 Retained earnings ............................................................... 412 48 Problem 18-7 Requirement 1 The statement of shareholders’ equity explains why and how the various shareholders’ equity items on the balance sheet change from year to year. The statement shows the beginning and ending balances in primary shareholders’ equity accounts and any changes that occur during the years reported (usually three years). Typical reasons for changes are the sale of additional shares of stock, the acquisition of treasury stock, net income, and the declaration of dividends. Requirement 2 HP accounts for its share repurchases by formally retiring them. The Statement of Shareholders’ Equity reports the repurchase of common stock and yet has no column in the Statement of Shareholders’ Equity for treasury stock. If the buybacks were viewed as the purchase of treasury shares, a Treasury Stock account would have been employed. Requirement 3 The price HP paid for the shares repurchased in 2004 was more than the average price at which HP had sold the shares previously. We know this because the Statement of Shareholders’ Equity reports a reduction in retained earnings resulting from that transaction. This occurs only when the cash paid exceeds the reduction in Common stock and Paid-in capital – excess of par: ($ in millions) Common stock (172,468,000 shares x $.01 par per share) ... 1 Additional paid-in capital*(given) ................................ 3,100 Retained earnings (given) .............................................. 208 Cash (given: change in total shareholders’ equity) ........... 3,309 *consisting of Paid-in capital – excess of par (shares x paid-in per share in excess of par when sold), and possibly Paid-in capital – share repurchase (if any balance remained from previous buybacks when the cash paid was less than the selling price.) 49 Problem 18-7 (continued) Requirement 4 Comprehensive income is the total nonowner change in equity for a reporting period. It encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its owners primarily include dividends and the sale or purchase of shares of the company’s stock. Most nonowner changes are reported in the income statement ($3,497 million for HP). The changes other than those that are part of traditional net income are reported as “Other comprehensive income.” Requirement 5 The change in Comprehensive income in 2004 was due to (1) net income ($3,497 million), (2) a net unrealized loss on investment securities classified as available for sale ($20 million), (3) a deferred gain from derivatives ($28 million), (4) an adjustment of the minimum pension liability ($13 million), and (5) foreign currency translation gain ($21 million). Each of the last four items is considered other comprehensive income and not discussed in detail in this chapter. Here’s a summary: For reporting purposes, investments in marketable equity securities are categorized as either (a) held-to-maturity, (b) trading securities, or (c) available for sale. Trading securities and securities available for sale are reported at their fair values. The holding gains and losses from writing these securities available for sale up or down to fair value are not reported in the income statement, but instead are reported as a component of Other comprehensive income in the balance sheet. (described in Chapter 12). When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text). 50 Problem 18-7 (concluded) Reporting an additional minimum pension liability sometimes requires a reduction in shareholders’ equity (see Chapter 17). The intangible pension asset debited when an additional minimum pension liability is increased represents future economic benefits as would arise from employee goodwill associated with incurring a prior service cost by, say, amending the pension formula to be more generous. However, the minimum liability adjustment is to cover an underfunded pension plan (ABO exceeds plan assets). The portion of the underfunding due to the obligation including prior service cost is appropriately represented by an intangible asset, but any portion of the underfunding due to the obligation including unrecognized net losses is not. If not reported as an intangible asset, then, where should it be reported? As we noted in Chapter 17, pension gains and losses are not recognized currently in earnings. Neither are gains and losses from adjusting securities available-for-sale recognized currently in earnings, as noted above. Consistent with reporting unrealized gains and losses from adjusting investment securities to fair value as part of other comprehensive income, we also report unrealized losses from adjusting the pension liability as part of other comprehensive income. Gains and losses from changes in foreign currency exchange rates are discussed elsewhere in your accounting curriculum, but also are included in other comprehensive income but not net income. The components of comprehensive income created during the reporting period can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity (as HP does), or (c) in a disclosure note. Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income. This is the measure of comprehensive income HP reported in the Statement of Shareholders’ Equity. The comprehensive income accumulated over the current and prior periods is reported as a separate component of shareholders’ equity. In HP’s case, this amount is a net loss of $243 million. This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years. 51 Problem 18-8 Requirement 1 Cash ($385,000 – 1,500) .......................................................... 383,500 Common stock (30,000 shares at $1 par per share)................. 30,000 Paid-in capital – excess of par (remainder) ........................ 353,500 Requirement 2 Retained earnings ................................................................. 60,000 Cash dividends payable (30,000 shares x $2) ..................... 60,000 Requirement 3 Cash dividends payable ...................................................... 60,000 Cash ................................................................................ 60,000 Requirement 4 Common stock (10% x $30,000) ............................................. 3,000 Paid-in capital – excess of par (10% x $353,500) ....................... 35,350 Retained earnings (difference) ............................................... 1,150 Cash (given) ...................................................................... 39,500 52 Problem 18-9 Assumption A – noncumulative Preferred Common Total $150 Current preference $10 (10% x $100) (10) $140 Remainder to common $140 (140) 0 Allocation $10 $140 Assumption B – cumulative Preferred Common Total $150 Dividends in arrears: -2004 $10 (10% x $100) (10) -2005 10 (10% x $100) (10) Current preference 10 (10% x $100) (10) $120 Remainder to common $120 (120) 0 Allocation $30 $120 53 Problem 18-10 Transactions N 1. Sale of common stock N 2. Purchase of treasury stock at a cost less than the original issue price N 3. Purchase of treasury stock at a cost greater than the original issue price D 4. Declaration of a property dividend N 5. Sale of treasury stock for more than cost D 6. Sale of treasury stock for less than cost I 7. Net income for the year D 8. Declaration of a cash dividend N 9. Payment of a previously declared cash dividend N 10. Issuance of convertible bonds for cash D 11. Declaration and distribution of a 5% stock dividend N 12. Retirement of common stock at a cost less than the original issue price D 13. Retirement of common stock at a cost greater than the original issue price N(orD) 14. A stock split effected in the form of a stock dividend N 15. A stock split in which the par value per share is reduced (not effected in the form of a stock dividend) D 16. A net loss for the year 54 Problem 18-11 A stock dividend is the distribution of additional shares of stock to current shareholders of the corporation. The investor receives no assets, only additional shares. Because each shareholder receives the same percentage increase in shares, an investor’s proportional interest in (percentage ownership of) the investee corporation remains unchanged. So, when additional shares are received from a stock dividend, no journal entry is needed. The same investment is simply represented by a larger number of shares. Of course, the investment per share is now less, an effect that must be considered if a portion of the investment is sold. To record the investment ($ in millions) Investment in L&K Corporation shares ................................. 52.8 Cash (1.2 million shares x $44) ................................................ 52.8 To record the sale of shares ......................... Cash (200,000 shares x $46) ........................................................ 9.2 Investment in L&K shares (200,000 shares x $44) ................. 8.8 Gain on sale of investments (difference) ............................... .4 10% stock dividend There is no entry for the stock dividend, but a new investment per share must be calculated for use later when the shares are sold: $44 million* . = $40 per share 1,000,000 shares x 1.10 * $52.8 – 8.8 = $44 To record the sale of shares Cash (100,000 shares x $43) ........................................................ 4.3 Investment in L&K shares (100,000 shares x $40) ................. 4.0 Gain on sale of investments (difference) ............................... .3 Note: If a financial reporting date falls between the acquisition and sale of shares, and the investment is adjusted to fair value on that date, the treatment of the stock dividend would be the same. That is, the new investment per share still would be the investment balance divided by the number of shares after 55 the stock dividend. But the investment balance now would be its fair value on the last reporting date rather than its cost. 56 Problem 18-12 Part A Requirement 1 January 2 Cash (amount received) ...................................................... 30,000,000 Common stock ($1 par x 3,000,000 shares) ..................... 3,000,000 Paid-in capital – excess of par, common (difference) ... 27,000,000 January 2 Cash (amount received) ...................................................... 20,000,000 Preferred stock ($5 par x 1,000,000 shares) ......................... 5,000,000 Paid-in capital – excess of par, preferred (difference) .. 15,000,000 Requirement 2 Nicklaus Corporation Balance Sheet-Shareholders' Equity Section March 31, 2006 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares $ 5,000,000 Common stock, $1 par, authorized 5,000,000 shares, issued and outstanding 3,000,000 shares 3,000,000 Paid-in capital – excess of par 42,000,000 Retained earnings 1,000,000 Total shareholders' equity $51,000,000 57 Problem 18-12 (continued) Part B Requirement 1 June 30 Treasury stock ($12 x 200,000 shares) ................................ 2,400,000 Cash ............................................................................ 2,400,000 July 31 Cash ($15 x 50,000 shares) .................................................. 750,000 Treasury stock ($12 x 50,000 shares) .............................. 600,000 Paid-in capital – share repurchase [($15-$12) x 50,000 shares] ........................................... 150,000 September 30 Cash ($10 x 50,000 shares) .................................................. 500,000 Paid-in capital – share repurchase [($12-$10) x 50,000 shares] .............................................. 100,000 Treasury stock ($12 x 50,000 shares) .............................. 600,000 Requirement 2 Nicklaus Corporation Balance Sheet - Shareholders' Equity Section September 30, 2006 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares $ 5,000,000 Common stock, $1 par, authorized 5,000,000 shares issued 3,000,000 shares, 2,900,0001 shares outstanding 3,000,000 Paid-in capital – excess of par 42,000,000 Paid-in capital – share repurchase2 50,000 Retained earnings3 4,000,000 $54,050,000 Less: Treasury stock (200,000 shares at cost) (1,200,000) Total shareholders' equity $52,850,000 1 3,000,000 - 200,000 + 50,000 + 50,000 2 $150,000 - 100,000 3 $1,000,000 + 3,000,000 58 Problem 18-12 (continued) Part C Requirement 1 October 1 NO ENTRY November 1 Retained earnings ............................................................ 540,000 Dividends payable – common ($.05 x 5,800,0001) ........ 290,000 Dividends payable – preferred ($.25 x 1,000,000) ......... 250,000 November 15 NO ENTRY December 1 Dividends payable – common ........................................ 290,000 Dividends payable – preferred ....................................... 250,000 Cash ............................................................................ 540,000 Note: Dividends are not paid on shares held in the treasury. Cash dividends are paid only on the 5,800,000 common shares outstanding. December 2 Retained earnings ($10 fair value x 58,000 shares2) 580,000 Common stock dividends distributable ($.50 par x 58,000 shares) ....................... 29,000 Paid-in capital – excess of par, common (difference) ... 551,000 December 28 Common stock dividends distributable .......................... 29,000 Common stock ............................................................ 29,000 1 (3,000,000 - 200,000 + 50,000 + 50,000) x 2 = 5,800,000 shares 2 1% x 5,800,000 shares 59 Problem 18-12 (continued) Requirement 2 Nicklaus Corporation Balance Sheet-Shareholders' Equity Section December 31, 2006 Shareholders' equity Preferred stock, $5 par, authorized 1,000,000 shares, issued and outstanding 1,000,000 shares $ 5,000,000 Common stock, $.50 par, authorized 10,000,000 shares, issued 6,058,000 shares and 5,858,0001 shares outstanding 3,029,000 Paid-in capital – excess of par2 42,551,000 Paid-in capital – share repurchase 50,000 Retained earnings3 5,380,000 $56,010,000 Less: Treasury stock (100,000 shares at cost) (1,200,000) Total shareholders' equity $54,810,000 1 5,800,000 + 58,000 2 $27,000,000 + 15,000,000 + 551,000 3 $4,000,000 - 540,000 - 580,000 + 2,500,000 60 Problem 18-12 (concluded) Requirement 3 Nicklaus Corporation Statement of Shareholders’ Equity For the Year Ended Dec. 31, 2006 ($ in 000s) Preferred Stock Common Stock Additional Paid-in Capital Retained Earnings Treasury Stock (at cost) Total Share- holders’ Equity Jan. 2, 2006 –– –– –– –– –– –– Issuance of preferred stock 5,000 15,000 20,000 Issuance of common stock 3,000 27,000 30,000 Purchase of treasury stock (2,400) (2,400) Sale of treasury stock 50 1,200 1,250 Net income 6,500 6,500 Common cash dividends (290) (290) Preferred cash dividends (250) (250) Stock dividend 29 551 (580) 0 _____ _____ _____ _____ _____ _____ Dec. 31, 2006 5,000 3,029 42,601 5,380 (1,200) 54,810 61 Problem 18-13 Requirement 1 To revalue assets: Retained earnings .................................................................... 105 Inventory ........................................................................... 105 Land ........................................................................................ 5 Retained earnings ................................................................ 5 To eliminate a portion of the deficit against available additional paid- in capital: Additional paid-in capital ....................................................... 60 Retained earnings ................................................................ 60 To eliminate the remainder of the deficit against common stock: Common stock ........................................................................ 240 Retained earnings ................................................................ 240 Requirement 2 Champion Chemical Corporation BALANCE SHEET At January 1, 2006 ($ in millions) Cash $ 20 Receivables 40 Inventory 125 Land 45 Buildings and equipment (net) 90 $320 Liabilities $240 Common stock (320 million shares at $.25 par ) 80 Additional paid-in capital 0 Retained earnings (deficit) (0) $320 62 CASES Real World Case 18-1 Requirement 1. Assuming the shares are issued at the midpoint of the price range indicated, $14.50 per share, Dolby Laboratories would raise $14.50 x 27.5 million shares = $398.75 million before any underwriting discount and offering expenses Requirement 2. $ in millions Cash (determined above) .......................................................... 398.750 Common stock (27.5 million shares x $.01 par) ...................... .275 Paid-in capital – excess of par (difference) ......................... 398.475 63 Analysis Case 18-2 Sessel’s Department Stores, Inc. Statement of Shareholders’ Equity For the Years Ended December 31, 2006, 2005, and 2004 ($ in 000s) Preferred Series A Stock Series B Common Stock Additional Paid- in Capital Retained Earnings Total Share- holders’ Equity Dec. 31, 2003 $ – $ – $1,288 $ 88,468 $19,178 $108,934 Net income 13,494 13,494 Issuance of common stock 12 814 826 Dec. 31, 2004 1,300 89,282 32,672 123,254 Net income 12,126 12,126 Issuance of common stock 558 112,148 112,706 Dec. 31, 2005 1,858 201,430 44,798 248,086 Net income 32,2561 32,256 Issuance of shares 57,700 6,592 1044 20,0025 84,398 Conversion of Series B preferred stock (6,592) 322 6,5603 Preferred dividends (3,388) (3,388) Dec. 31, 2006 $57,700 $ – $1,994 $227,992 $73,666 $361,352 1 [$73,666,000 – 44,798,000] + 3,388,000 = $32,256,000 2 320,000 shares x $.10 par = $32,000 3 $6,592,000 - 32,000 = $6,560,000 4 [$1,994,000 – 1,858,000] - 32,000 = $104,000 5 [$227,992,000 – 201,430,000] – 6,560,000 = $20,002,000 64 Communication Case 18-3 This case encourages students to consider the larger question of the factors that differentiate whether financial instruments qualify for recognition as assets or part of equity. It also requires them to carefully consider the profession’s definitions of those elements. You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case. Or, you may prefer that they think for themselves and approach the issue from scratch. There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. Arguments brought out in the FASB DM include the following: Some argue that receivables held for stock issued or to be issued are assets that should be recognized and reported as such. Others contend that, unless payment has been received before the financial statements are issued or unless there is strong evidence of intent and ability to pay, the receivables should be reported as a reduction of stockholders' equity (par. 174). At least for public companies, present practice follows the second view, except in very limited circumstances when there is substantial evidence of ability and intent to pay within a reasonably short period of time. (par. 175). An enterprise that offers a stock subscription puts aside stock to be issued in exchange for the subscriber's promise to pay for the shares. When all the consideration is received, the stock is issued. The Revised Model Business Corporation Act provides that the purchaser of shares is liable to the corporation for the consideration for which shares were authorized to be issued. The Act also provides that post-incorporation stock subscriptions are simple contracts and are therefore subject to contract law. Under contract law, "a corporation may compel a stock subscriber to make payment to the corporation, on call, in accordance with the terms of the subscription agreement." In other words, a corporation has 65 a legally enforceable claim against one who subscribes to an issue of its stock (par. 176). 66 Case 18-3 (concluded) The Act specifically validates "any tangible or intangible property or benefit to the corporation" as consideration for the issue of shares. As discussed above, it also provides that a stockholder is obligated to pay the consideration established in the agreement. While notes receivable are valid consideration for the issuance of shares, the Act adds that the company may restrict transfer of those shares until the note is paid. If payment is not made, the restricted shares can be canceled. However, if shares are issued without restriction, "they are validly issued insofar as the adequacy of consideration is concerned." Although the stockholder's obligation to pay for the stock was satisfied with the note and the shares issued therefore cannot be canceled, the stockholder has a continuing obligation under the note (par. 178). Arguments Supporting View 1: Proponents of the view that receivables for stock should be deducted from equity note that the enterprise's ultimate recourse if the receivable is not collected may be to not issue the stock subscribed or to cancel restricted stock issued for a note. In addition, some argue that the enterprise may not intend to pursue collection from an owner. They contend that collection of the receivable therefore is sufficiently uncertain that the receivable does not qualify as a recognizable asset. Further, receivables for stock differ from other receivables because receivables for stock are not obtained in exchange for transferring assets or providing services, which some consider to be significant (par. 179). Arguments Supporting View 2: Proponents of the view that receivables for stock are recognizable assets argue that the receivables fit the definition of assets in Concepts Statement 6 because they embody probable future economic benefits. Receivables for stock issued or to be issued are legally binding, giving the enterprise a legally enforceable claim against the purchaser of the shares. Concepts Statement 6 says that although assets usually are obtained at a cost, that feature is not an essential characteristic of assets. Therefore, a receivable is not disqualified from being an asset merely because it was obtained in exchange for stock rather than in exchange for an asset (par. 180). Proponents also argue that the question of collectibility does not require equity treatment. Collectibility of all receivables needs to be assessed regularly and provision made for uncollectible amounts. Assessment of the collectibility of a receivable from an owner should consider all pertinent factors, including the enterprise's intent to pursue collection. Moreover, receivables for stock issued or to be issued might be displayed separately from other receivables to inform investors and creditors of the nature of the receivables (par. 181). 67 Research Case 18-4 Requirement 1. Cisco reports Accumulated other comprehensive income (loss) in its balance sheet as a component of shareholders’ equity as follows: ($ in millions) Shareholders' equity: 2004 2003 Preferred stock Common stock and additional paid-in capital 22,450 21,116 Retained earnings 3,164 6,559 Accumulated other comprehensive income (loss) 212 354 Total shareholders' equity $25,826 $28,029 Requirement 2. Cisco relies on SFAS Number 130, “Reporting Comprehensive Income” when reporting comprehensive income. The requirement became effective for fiscal years beginning after December 15, 1997. Requirement 3. Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income. It is the total nonowner change in equity for a reporting period. In fact, it encompasses all changes in equity other than from transactions with owners. Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company’s stock. Most nonowner changes are reported in the income statement. So, the changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods. The first of these - components of comprehensive income created during the reporting period - can be reported either (a) as an additional section of the income statement, (b) as part of the statement of shareholders’ equity, or (c) in a disclosure note. Regardless of the placement a company chooses, the presentation is similar. It will report net income, other components of comprehensive income, and total comprehensive income, similar to the following: 68 Case 18-4 (continued) ($ in millions) Net income $xxx Other comprehensive income: Net unrealized holding gains (losses) on investments (net of tax)† $ x Net unrecognized loss on pensions (net of tax)‡ (x) Deferred gains (losses) from derivatives (net of tax)§ x Gains (losses) from foreign currency translation (net of tax)* x xx Comprehensive income $xxx † Changes in the market value of securities available-for-sale. ‡ Reporting a pension liability sometimes requires recording this (described in Chapter 17). It often is called pension liability adjustment. § When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text). * Gains or losses from changes in foreign currency exchange rates. The amount could be an addition to or reduction in shareholders’ equity. (This item is discussed elsewhere in your accounting curriculum.) This is the measure of comprehensive income Cisco reported in the disclosure note. Notice that each component is reported net of its related income tax expense or income tax benefit. The second measure - the comprehensive income accumulated over the current and prior periods – is reported as a separate component of shareholders’ equity. This is what Cisco reported in its balance sheet as indicated in Requirement 1 ($212 million in 2004). Be sure to realize this amount represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years. 69 Case 18-4 (concluded) Requirement 4. The primary component of Other comprehensive Income for Cisco Is "Change in net unrealized gains on investments.” For reporting purposes, investments in marketable equity securities are categorized as either (a) held-to-maturity, (b) trading securities, or (c) available for sale. Trading securities and securities available for sale are reported at their fair values. The holding gains and losses from writing these securities available for sale up or down to fair value are not reported in the income statement, but instead are reported as a component of Other comprehensive income in the balance sheet. This makes up the greatest part of Cisco’s Other comprehensive income. From the information Cisco's financial statements provide, we can determine how the company calculated the $212 million accumulated other comprehensive income in fiscal 2004: ($ in millions) Accumulated other comprehensive income (loss), 2003 $354 Change in net unrealized gains on investments (77) Change in “other” 19 Minority interest (84) Accumulated other comprehensive income (loss), 2004 $ 212 Requirement 5. Nonowner changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” As described in Requirement 3, besides changes in the market value of securities available for sale, these changes might include Net unrecognized loss on pensions, Deferred gain (loss) from derivatives, and Gains (losses) from foreign currency translation. 70 Judgment Case 18-5 Requirement 1 Alcoa has two choices of how to account for the buyback: 1. The shares can be formally retired. 2. The shares can be called “treasury stock” Regardless of the choice, total shareholders’ equity will be the same. Cash is paid to repurchase stock so the effect is to decrease both cash and shareholders’ equity. However, the choice does affect how individual shareholders’ accounts are reported in the balance sheet. Formally retiring shares restores the balances in both the Common stock account and Paid-in capital – excess of par to what those balances would have been if the shares never had been issued at all. Any net increase in assets resulting from the sale and subsequent repurchase is reflected as Paid-in capital – share repurchase. On the other hand, any net decrease in assets resulting from the sale and subsequent repurchase is reflected as a reduction in retained earnings. In contrast, when a share repurchase is viewed as treasury stock, the cost of the treasury stock is simply reported as a reduction in total shareholders’ equity. Alcoa would account for the purchase of the treasury stock by debiting treasury stock and crediting cash for the cost of the purchase. The treasury stock should be presented separately in the shareholders' equity section of Alcoa’s balance sheet as an unallocated reduction of shareholders' equity. These shares are considered issued but not part of common stock outstanding. If later resold for an amount greater than cost, Alcoa should account for the sale of the treasury stock by debiting cash for the selling price, crediting treasury stock for cost, and crediting additional paid-in capital from reacquired stock for the excess of the selling price over the cost. On the other hand, if the shares were retired, Alcoa would simply record any subsequent sale as it would the sale of any new shares. Requirement 2 Alcoa can choose not to make any journal entry for the stock split. Alternatively, Alcoa can choose to effect the split “in the form of a stock dividend.” In that case, Alcoa would account for the stock split by debiting paid-in capital for the par per share multiplied by the shares distributed. Total 71 shareholders' equity does not change. This prevents the par per share from changing. Alcoa should then credit common stock for the same amount. 72 Case 18-5 (concluded) Requirement 3 Alcoa should account for the cash dividend on the declaration date by debiting retained earnings and crediting cash dividends payable for $.25 per share multiplied by the number of shares outstanding. A cash dividend is a distribution to the corporation's shareholders. The liability for this distribution is incurred on the declaration date, and it is a current liability because it is payable within one year. The effect of the cash dividend on Alcoa's balance sheet is an increase in current liabilities and a decrease in retained earnings. 73 Communication Case 18-6 sample memo: Memorandum To: Les Kramer Supervisor From: {your name} Re: Share issue costs Date: {current date} This memo is in response to your request for information about how IBR accounted for share issue costs in its recent equity offering. When a company sells shares, it obtains the legal, promotional, and accounting services necessary to effect the sale. The cost of these services reduces the net proceeds from selling the shares. Paid-in capital – excess of par is credited for the excess of the proceeds over the par value of the shares sold. Thus, the effect of share issue costs is to reduce the amount credited to that account. This treatment differs from how debt issue costs are recorded. The costs associated with a debt issue are recorded in a separate “debt issue costs” account and amortized to expense over the life of the debt. In IBR’s case, the shares sold for a total of $53.289 million (2,395,000 shares times $22.25 per share). Since paid-in capital – excess of par is credited for the excess of the $50.2 million net proceeds over the par amount of the shares sold, the effect of share issue costs (underwriting discount and offering expenses) is to reduce the amount credited to that account. In particular, IBR would have recorded the following journal entry upon the issue of the shares. ($ in 000s) Cash (given) ................................................................. 50,200.0 Common stock ($.10 par x 2,395 shares) .................... 239.5 Paid-in capital – excess of par (difference) ............. 49,960.5* * This amount reflects the reduction for share issue costs (underwriting discount and offering expenses). Please let me know if I can provide you additional information. 74 Case 18-6 (concluded) Suggested Grading Concepts And Grading Scheme: Content (80% ) 30 Accounting for share issue costs. Nature of costs. Reduces the net proceeds from selling the shares. Effect of share issue costs is to reduce the amount credited to paid-in capital. 10 “Debt issue costs” recorded in a separate account and amortized to expense over the life of the debt. 10 IBR’s accounting. Paid-in capital – excess of par is credited for the excess of the $50.2 million net proceeds over the par amount of the shares sold. 30 Journal entry. Cash $50,200,000. Common stock $239,500. Paid-in capital – excess of par $49,960,500. Bonus (5) The FASB has suggested in Concept Statement 6 that debt issue costs should be treated the same way as share issue costs. But Concept Statements do not constitute GAAP, so until a new FASB Standard is issued to supersede APB Opinion 21, the prescribed practice is to record debt issue costs as assets and expense the asset over the maturity of the debt. 80-85 points Writing (20%) 5 Terminology and tone appropriate to the audience of supervisor. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English. Word selection. Spelling. Grammar. 20 points 75 Analysis Case 18-7 Requirement 1 The ratio is computed by dividing net income by average shareholders' equity. The return on shareholders' equity is an important ratio for the owners of a company. It measures the ability of company management to generate net income from the resources that owners provide. IGF’s return is comparable to other firms, although slightly less. Like most ratios, though, it should not be viewed in isolation. For example, when the return on shareholders’ equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders. The return on assets is a measure of a company's ability to use assets profitably, regardless of how the assets were financed. It is computed by dividing net income by average total assets. IGF is in this enviable position and therefore has favorable financial leverage. We discussed financial leverage in Chapter 14. Rate of return on = Net income shareholders’ equity Average shareholders’ equity = $487 [$2,931 + 2,671] / 2 = 17.4% NYSE average = 18.8% Rate of return on = Net income assets Average total assets = $487 [$5,345 + 4,684] / 2 = 9.7% 76 Case 18-7 (concluded) Requirement 2 Earnings per share, in its simplest form, is simply a firm’s net income divided by the number of shares outstanding throughout the year. It expresses a firm’s profitability on a per share basis. To complement the return on shareholders’ equity ratio, analysts sometimes calculate the earnings-price ratio in order to relate earnings to the market value of equity. This ratio is the earnings per share divided by the market price per share: The earnings-price ratio measures the return on the market value of common stock. Remember, shareholders’ equity is a measure of the book value of equity. The market value of a share of stock (or of total shareholders’ equity) usually is different from its book value. IGF’s return on market value is somewhat higher than the average return for the stocks listed on the New York Stock Exchange in a comparable time period (5.4%). So, even though the return on book value is a little lower than average, a closer look at the return to market value shows IGF to be at least in line with its industry. Earnings per share = Income available to common shareholders Average shares outstanding = $487 181 = $2.69 Earnings-price ratio = Earnings per share Market price per share = $2.69 $47 = 5.7% 77 International Case 18-8 The report should indicate similarities and differences between the United States and the chosen country focusing on the following issues: a. How shareholders’ equity is defined. b. The categories by which it is reported in the financial statements. c. What if any requirements exist to separately maintain “legal capital.” d. Restrictions on dividend payments and how dividends are reported. e. Whether a Statement of Shareholders’ Equity, or equivalent, is reported. Ethics Case 18-9 Discussion should include these elements. Return on assets: Rate of return on assets is net income divided by assets. The lower the asset base, the higher the percentage return. A noncash transaction should be recorded at fair value. This should be the fair value of the consideration given or the asset (in this case) received. The asset has no readily available fair value because it is custom-made. The value of debt the Swiss firm is asking for probably provides a good indication of the fair value of the asset. Ethical Dilemma: Is the desire to boost return justification for questionable accounting treatment of the transaction? Who is affected? Benson Sharp Other managers? The company’s auditor, if any. This is a private company. Shareholders (probably few) The employees The creditors 78 Research Case 18-10 The results students report will vary depending on the companies chosen. It can be interesting to have students compare in class their findings with those of their classmates. Typical items that affect retained earnings are dividends (cash, property, or stock) and net income or loss. Treasury stock or retired stock transactions also affect retained earnings. Typical transactions that affect common stock are new stock issues, treasury stock or retired stock transactions, and conversions of other securities into common stock. Were any of these transactions identified in requirement 3 also? The statement of shareholders’ equity explains why and how the various shareholders’ equity items on the balance sheet change from year to year. 79 Real World Case 18-11 Requirement 1 Since the base amount of the preferred shares is $25 and the dividend preference is 6.785%, the dividends paid annually to a preferred shareholder owning 100 shares are: $25 x 100 shares x 6.785% = $169.63. Requirement 2 If dividends are not paid in 2005 and 2006, but are paid in 2007, the shareholder will receive $169.63 x 3 = $508.89. The prior years’ unpaid dividends are paid because the shares are cumulative. Otherwise, only the $169.63 current year dividend would be paid. When preferred shares are cumulative, this means that if the specified dividend is not paid in a given year, the unpaid dividends (called “dividends in arrears”) accumulate and must be made up in a later dividend year before any dividends are paid on common shares. Requirement 3 If the investor chooses to convert the shares in 2005, the investor will receive $25/$30.31 x 100 shares = 82.48 shares of common stock for his/her 100 shares. The .48 fractional share likely would be paid in cash equal to the current market price per share times .48. Requirement 4 If AMCON chooses to redeem the shares in 2006, the investor will be paid $2,800 for his/her 100 shares: 100 shares at the redemption price of $28 ($25 x 112%). 80 Communication Case 18-12 You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case. Or, you may prefer that they think for themselves and approach the issue from scratch. There is no right or wrong answer. Both views can and often are convincingly defended. The process of developing and synthesizing the arguments will likely be more beneficial than any single solution. Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole. It is important that each student actively participate in the process. Domination by one or two individuals should be discouraged. A significant benefit of this case is its forcing students’ consideration and acceptance of the fact that both liabilities and equities are claims to an enterprise’s assets. It also requires them to carefully consider the profession’s definitions of those elements. Arguments brought out in the FASB DM include the following: Arguments Supporting View 1: Some students likely will argue that convertible bonds and other similar instruments can be appropriately classified in the two existing categories on the basis of existing distinctions and definitions. For instance, they might focus on the characteristic of a liability that requires that the enterprise issuing it have little or no discretion to avoid the future sacrifice of economic benefits. Concepts Statement 6 defines liabilities as: . . . probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events. [paragraph 35] Three essential characteristics of a liability are: a. It embodies a present duty or responsibility to one or more other entities for settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand. b. The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice. c. The transaction or other event obligating the entity has already happened. 81 Case 18-12 (continued) Equity of a business enterprise is defined simply as the residual interest: the difference between an enterprise's assets and its liabilities. The essential characteristics of equity focus on the conditions for transferring assets to the holders of equity interests. Usually, a company is not obligated to transfer assets to owners except in the event of liquidation unless it voluntarily acts to do so, such as by declaring a dividend. A company’s liabilities and equity are mutually exclusive claims to or interests in its assets by others, and liabilities take precedence over ownership interests. A company may have two or more classes of equity, such as preferred stock and common stock; no class has an unconditional right to receive distributions of assets other than in liquidation and then only after all liabilities have been settled. That is the essential distinction between liabilities and equity. A liability entails an obligation to transfer assets or provide services in the future, while an equity instrument does not. The distinction between liabilities and equity is important to reported financial position. So, whether an issue of convertible bonds is classified as a liability or as equity affects both reported amounts of total liabilities and equity and summary amounts based on those amounts, such as ratios. The distinction also is critical in measuring income. Comprehensive income is defined in Concepts Statement 6 to include all changes in equity during a period other than those resulting from transactions with owners. Income includes only inflows in excess of the amount needed to maintain capital. Without a distinction between the claims of creditors and those of owners, measurement of income is not possible. Reported income also is affected. Convertible bonds have features of both debt (fixed interest and principal payments) and equity (ability to participate in the benefits of stock ownership). If convertible bonds are treated as an equity instrument, the interest payments are not deducted in determining the issuer's net income. However, if they are deemed to be liability, the interest would be reported as an expense and deducted in determining net income. 82 Case 18-12 (continued) Arguments Supporting View 2: Arguments here center on the “entity theory” of accounting first proposed by W. A. Paton in 1922 which views the accounting equation as: Assets = Equities with equities including both what are termed liabilities and equity in the current conceptual framework. A central feature of this theory is that profits are determined with reference to all capital suppliers. That is, profits are determined before deducting either interest or dividends. Both interest and dividends, and income taxes as well, are treated as distributions of profits. Examples of possible formats of a balance sheet and an income statement under this alternative suggested by the DM follow. Balance Sheet Cash $ 2,050 Accounts payable $1,200 Investments 5,000 Mortgage 4,000 Inventory 7,000 Bonds 5,000 Plant and Preferred stock 5,000 equipment 15,000 Common stock 4,800 Retained earnings 9,050 ______ Total equities 18,850 Total liabilities Total assets $29,050 and equities $29,050 Income Statement Sales $30,000 Cost of goods sold 10,000 Selling and other expenses 4,000 Excess of revenues over expenses $16,000 Interest on mortgage 300 Interest on bonds 400 Income taxes 5,000 Preferred dividends 450 Earnings attributable to common stock $9,850 Common dividends 800 Earnings retained $9,050 83 Case 18-12 (concluded) or, alternatively: Sales $30,000 Cost of goods sold 10,000 Selling and other expenses 4,000 Enterprise net income $16,000 Interest on mortgage 300 Interest on bonds 400 Income taxes 5,000 Preferred dividends 450 Common dividends 800 Earnings retained $9,050 Many issues would have to be resolved if this approach were to be seriously pursued. For instance, would all present liabilities be treated as "equities"; if not, which would be treated differently? Today the distinction between short-term and long-term is not considered to be particularly relevant for at least some companies, so it might be questionable to distinguish on that basis. Another possibility would be to treat only liabilities incurred in exchange for cash proceeds as "equities." However, labor, inventory, and the like also are "capital" in a broad sense, so it may be hard to justify treating obligations incurred to acquire them differently from obligations to pay cash. The concept of income under this approach is another question. Would an attempt to eliminate the line between liabilities and equity make it inappropriate to attempt to measure income, or would it merely change the underlying concept and measure of net income? These are only two possible questions, but students favoring Alternative 2 should discuss its overall effect on the financial statements, including the concept and measurement of income. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482