Module 5 Q5-1. Revenue must be realized or realizable and earned before it can be

reported in the income statement. Realized or realizable means that the company’s net assets have increased, that is, the company has received an asset (for example, cash or accounts receivable) or satisfied a liability (for example, unearned revenue) as a result of the transaction. Earned means that the company has done everything it must do under the terms of the sale.

For retailers, like Abercrombie & Fitch, revenue is generally earned

when title to the merchandise passes to the buyer (e.g., when the buyer takes possession of the merchandise), and the right of return period has passed or returns can be estimated with some certainty. For companies operating under long-term contracts, the earnings process is typically measured using the percentage of completion method, that is, by the percentage of costs incurred relative to total expected costs.

Q5-2. Investors and analysts often use financial statements to forecast

future financial performance of the company. Extraordinary items are, by definition, not expected to continue to affect the profits and cash flows of the company. Accordingly, the financial statements separately report extraordinary items from continuing operations to yield an income measure that is more likely to persist into the future.

Q5-3. In order for an item to be classified as extraordinary, it must be

both unusual and infrequent. Examples include the destruction of property by natural disaster or the expropriation of assets by a foreign government. Gains and losses on early retirement of long-term bonds, once the most common type of extraordinary item, are no longer considered extraordinary unless they meet the tests outlined above. Other events not likely to be included as extraordinary items include asset write-downs, gains and losses on the sales of assets, and costs related to an employee strike. IFRS does not permit any items to be reported as extraordinary.

Q5-4. Basic earnings per share uses reported net income and common

shares outstanding in its computation. Diluted earnings per share

include the effects of dilutive securities, assuming that they are exercised at the beginning of the year (or when issued if issued during the year). The numerator, thus, adds back any dividends paid on convertible preferred stock and interest expense that would have been avoided on convertible debt. The denominator reflects the additional common shares assumed to be issued upon conversion of convertible securities or upon the exercise of options.

Securities cannot be included in the diluted EPS computation if

they are antidilutive. Antidilutive securities are those that cause an increase, rather than a decrease in basic EPS. An example is employee stock options whose exercise price exceeds the current market price (underwater or out-of-the-money options).

Q5-6. Restructuring costs consist of three general categories: asset

write-downs, accruals for severance and relocation costs, and accruals of other restructuring-related costs. Asset write-downs reduce assets’ net book value and are recognized in the income statement as an expense. Liability accruals for severance and other expenses create a liability and yield a corresponding expense that reduces income and equity.

Big bath refers to a company’s overestimating the amount of asset

write-downs or liability accruals to deliberately reduce current period earnings so as to remove future expenses from the balance sheet. Big baths create ‘reserves’ that can be used to increase future period earnings.

Q5-7. Under current US GAAP, research and development costs must be

expensed as they are incurred. This policy applies to all R&D costs, including fixed-asset costs, unless the fixed assets have alternative future uses. Equipment relating to a specific research project with no alternative use would, therefore, be expensed rather than capitalized and subsequently depreciated.

Under IFRS, all research costs are expensed as incurred. However,

certain development costs are capitalized if they meet criteria for existence of an asset. These capitalized costs are amortized over the expected useful life of the intangible asset.

U.S. accounting standard-setters have justified this “expense as

incurred” treatment for R&D costs on the grounds that the outputs from research and development activities are very difficult to

identify and measure. There is such high uncertainty about the amount and timing of any expected cash flows, that recognition as assets (capitalization) is unwarranted.

Q5-9. Pro forma income adjusts GAAP income to eliminate (and

sometimes add) various items that the company believes do not reflect continuing, ongoing operations. Such pro forma disclosures are most often reported in earnings and press releases but occasionally as part of the published 10-Ks or other annual reports provided for shareholders. The SEC requires that reported pro forma income be reconciled to its GAAP equivalent.

Non-GAAP information has the potential to confuse the reader

about the true financial performance of the company. This was cause for SEC concern. Also, pro forma numbers are not subject to accepted accounting standards (and, thus, we observe differing definitions of pro forma across companies), are not typically audited, and are subject to complete management latitude in what is and is not included and how items are measured.

Q5-10. Unearned revenue is cash a company receives from customers

but has not yet been earned. Until the company earns the revenue, the amount received is a liability. If the company expects to earn the revenue in the coming year, it is a current liability; otherwise, it’s a long-term liability. Examples of unearned revenue include: customer deposits, gift cards, season tickets, membership fees, future software upgrades, partial payments in advance, and layaway plans of retailers.

E5-22

Company Revenue Recognition

a. The Limited

When the customer takes the merchandise and the right of return period has expired or costs of returns can be reasonably estimated.

b. Boeing Corporation

Revenue is recognized under long-term contracts under the percentage-of-completion method.

c. Supervalu When the customer takes the merchandise and payment is received.

d. MTV When the content is aired by the TV stations.

e. Real estate developer

When title to the houses is transferred to the buyers.

f. Bank of America

Interest is earned by the passage of time. Each period, Bank of America accrues income on each of its loans and establishes an account receivable on its balance sheet.

g. Harley-Davidson

When title to the motorcycles is transferred to the buyer. Harley will also set up a reserve for anticipated warranty costs and recognize the expected warranty cost expense when it recognizes the sales revenue.

h. Time-Warner When the magazines are sent to subscribers. Subscriptions received in advance are deferred revenue (a liability) until the magazines are mailed.

E5-25 a.

($ millions) Percentage of Completion Method

Year

Costs incurred

Percent of total

expected costs

Revenue recognized

(percentage of costs incurred

total contract amount)

Income (Revenue – Costs

incurred)

2012 $15 18% ($15/$85)

$ 21.6 $ 6.6

2013 40 47% ($40/$85)

56.4 16.4

2014 30 35% ($30/$85)

42.0 12.0

$85 $120.0 $35.0

b. The percentage-of-completion method provides a good estimate of the revenue and income earned in each period. This method is acceptable under GAAP for contracts spanning more than one accounting period. Note that recognition of revenue and income is not affected by the cash received.

E5-28 a. The following items are operating:

Net sales

Finance and interest income

Other income

Cost of sales

Research and development expenses

Selling, administrative and general expenses

Other operating expenses

Provision for income taxes (the portion that relates to operating profit)

Equity in income of unconsolidated affiliates; this relates to Deere’s investments in companies over which it exerts significant influence, but does not control. This income is viewed as operating so long as the related investment is considered an operating asset.

Interest expense is the only nonoperating item. b. John Deere’s finance and interest income is categorized as operating.

Deere’s financial services business segment provides loans and leases for equipment sold to dealers as well as purchasing end-customer receivables from those dealers. The financing activities can, thus, be viewed as an extension of the sales process, quite unlike the investment in marketable securities unrelated to the company’s activities. These captive finance operations are generally viewed as operating.

P5-35 a. Equipment sales – revenue is normally earned when title to the

equipment passes to the customer who either purchases the equipment for cash or on credit. If there are undelivered parts or if the company must install and test the equipment for the customer, then revenue would not be recognized until those deliverables are completed. Supplies, paper and other – the company likely recognizes revenue on these sales at the time the goods are shipped. Service, outsourcing and rentals – revenue from services is normally earned as the service is performed, usually ratably over the service contract period. The same applies to outsourcing and rentals. The company may use the percentage of completion method if there are long-term service contracts involved. Finance income – revenue from finance income (interest earned) is recognized with the passage of time. For example, each period, Xerox accrues interest on its loans and leases based on the interest rates stipulated in the contracts.

b.

Revenue in $ As % of Total Revenue

2010 2009 2008 2010 2009 2008

Sales ................................ 7,234 6,646 8,325 33.4% 43.8% 47.3% Service, outsourcing and

rentals .......................... 13,739 7,820 8,485 63.5% 51.5% 48.2%

Total Revenues .................. 21,633 15,179 17,608

In 2010, revenue from services was nearly twice as large as revenue from sales (63.5% versus 33.4%). This was not the case in prior years, when the two types of revenue accounted for roughly the same amount. Revenue from Services grew by 76% during 2010 ($13,739 / $7,820 = 1.757), which was significantly higher than the 9% revenue growth in Sales ($7,234 / $6,646 = 1.088).

P5-35 (continued)

c. In $ As % of Total Revenue

2010 2009 2008 2010 2009 2008

R&D expenses ................ 781 840 884 3.6% 5.5% 5.0%

Total Revenues .............. 21,633 15,179 17,608

In 2008 and 2009, R&D spending was 5 to 5.5% of total revenue. This dropped significantly in 2010. One explanation is that R&D spending in dollars dropped while revenues increased. Another explanation is that services revenue increased dramatically during the year. This type of revenue is likely not directly related to R&D. Sales of equipment are more impacted by R&D spending. Therefore, using total revenues to scale R&D spending makes it appear that the company has cut way back on research. A better denominator would be Equipment sales revenue, which yields proportions of 20.2% in 2010, 23.7% in 2009, and 18.9% in 2008.

d. 1. Restructuring costs typically fall into three general categories. (i) accrual of liabilities for items, such as employee severance payments, (ii) gains or losses from the write-off of assets, such as plant assets and goodwill, and (iii) other restructuring and exit costs including legal fees and costs to cancel contracts such as leases.

2. These restructuring costs are expensed in the current period despite

the fact that the impaired assets may not be formally written off and the employees not paid their severance until future periods. In any event, most analysts treat restructuring costs as transitory (one-time occurrences). Accordingly, while restructuring costs should impact the analysis, they typically do not affect the analysis to the same degree as more persistent items such as recurring revenues and expenses.

1. Some companies regularly report restructuring costs. Many analysts

treat these costs as recurring operating expenses and do not consider them to be transitory items. This treatment implies that these costs are more persistent in nature.

P5-35 (concluded)

2. Negative expense typically implies that an accrual in one or more previous year(s) is overstated and the company is reversing the overstatement in the current year. As a result, the previous year’s expense was overstated, thus underestimating profit for that year.

e. Companies are not required to separately disclose revenue and expense

items unless they are deemed to be material. If not separately disclosed, these items are aggregated with other immaterial items. Such aggregation generally reduces the informativeness of income statements. More problematic is that revenues and expenses can be comingled in this “other” category to yield a small (net) number that obscures the magnitude of the individual items comprising this category. (Be aware that some companies net recurring operating losses with nonrecurring nonoperating gains, yielding an immaterial amount for “other.”)

D5-48 a. The affected parties include the managers who are making the decision,

as well as the company, its current and future stakeholders, the company’s auditors, suppliers, and current and future employees of a firm with lower ethical standards. The sphere of parties who are affected by ethical decisions is often much wider than one first believes.

b. The most common response of those supporting the proposed action is

a Machiavellian argument (the “ends justify the means”). The argument goes that the company will soon return to profitability and affected parties will benefit from the higher profitability that the subsequent reversal of the deferred tax asset allowance will provide.

Other points to consider include the long-term effects of creating a permissive environment that condones such action, including other employee actions that may be counter to the interests of the company (cheating on expense reports, etc.), possible retribution (termination, litigation, criminal actions) against responsible employees if the activity is discovered, etc.

Module 6 Q6-1. When a company increases its allowance for uncollectible

accounts, it also records bad debt expense in the income statement. If a company overestimates the allowance account, bad debt expense is too high and net income is understated. As well, accounts receivable (net of the allowance account) and total assets are both understated on the balance sheet. In future periods, the company will not need to add as much to its allowance account since it is already overestimated (or, it can reverse the excess existing allowance balance). As a result, future net income will be higher.

On the other hand, if a company underestimates its allowance

account, then current net income will be overstated. In future periods, however, net income will be understated as the company must add to the allowance account and report higher bad debts expense as accounts are written off.

Q6-2. If inventory costs are stable, the per unit dollar cost of inventories

(beginning or ending) tends to be approximately the same under different inventory costing methods and the choice of method does not materially affect net income. To see this, remember that FIFO profits include holding gains on inventories. If the inflation rate is low (or inventories turn quickly), there will be less holding gains (inflationary profit) in inventory.

Q6-3. FIFO holding gains occur when the costs of earlier purchased

inventory are matched against current selling prices. Holding gains on inventories increase with an increase in the inflation rate and a decrease in the inventory turnover rate. Conversely, if the inflation rate is low or inventories turn quickly, there will be fewer holding gains (inflationary profit) in inventory.

Q6-4. If inventory costs are rising, (a) Last-in, first-out yields the lowest

ending inventory (b) Last-in, first-out yields the lowest net income, (c) First-in, first-out yields the highest ending inventory, (d) First-in, first-out yields the highest net income, (e) Last in, first-out yields the highest cash flow because taxes are lowest.

Q6-5. When costs are consistently rising, LIFO inventory costing method yields a significant tax benefit because LIFO increases COGS which reduces pretax income and taxes payable.

Q6-7. As an asset is used up, its cost is removed from the balance sheet

and transferred to the income statement as expense. Capitalization of costs onto the balance sheet and subsequent removal as expense is the essence of accrual accounting. If a depreciable asset is immediately expensed upon purchase, profit would be too low in the year of purchase and too high in later years as revenues earned by the asset are not matched with a corresponding cost. The proper matching of expenses and revenues is essential for proper income measurement.

Q6-8. When a company revises its estimate of an asset's useful life or its

salvage value, depreciation expense must be recalculated. One way is to depreciate the current undepreciated cost of the asset (original cost – accumulated depreciation) using the revised assumptions of remaining useful life and salvage value.

Q6-11. The gain or loss on the sale of a PPE asset is calculated as the

difference between the sales proceeds and the asset's net book value. Sales proceeds in excess of net book values create gains; sales proceeds less than net book values cause losses. Factors that affect the size of the gain or loss include the amount of sales proceeds (the selling price) and depreciation assumptions. Because accumulated depreciation at the time of the asset’s sale affects the net book value, the depreciation rate and salvage values used to compute depreciation expense affect the gain or loss.

E 6-22 a. Bad debts expense computation

$90,000 1% = $ 900

20,000 2% = 400

11,000 5% = 550

6,000 10% = 600

4,000 25% = 1,000 Total required balance in allowance $3,450 Less: Unused balance before adjustment (520) Bad debt expense for the year $2,930

b.

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Record bad debts expense

-2,930 Allowance for Uncollectible

Accounts

=

-2,930

Retained Earnings

–

+2,930 Bad Debt Expense

= -2,930

c. Accounts receivable, net = $131,000 - $3,450 = $127,550

Reported in the balance sheet as follows: Accounts receivable, net of allowance of $3,450 ....................... $127,550

E6-27

Units Cost

Beginning Inventory 1,000 $ 20,000 Purchases: #1 1,800 39,600 #2 800 20,800 #3 1,200 34,800 Goods available for sale 4,800 $115,200 Units in ending inventory = 4,800 – 2,800 = 2,000 a. First-in, first-out

Units Cost Total

1,200 @ $29 = $34,800 800 @ $26 = 20,800

Ending Inventory 2,000 $55,600

Cost of goods available for sale $115,200 Less: Ending inventory 55,600 Cost of goods sold $ 59,600

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Record FIFO cost of goods sold

-59,600

Inventory =

-59,600 Retained Earnings

–

+59,600 Cost of Goods Sold

= -59,600

b. Last-in, first-out

Units Cost Total

1,000 @ $20 = $20,000 1,000 @ $22 = 22,000

Ending inventory 2,000 $42,000

Cost of goods available for sale $115,200 Less: Ending inventory 42,000 Cost of goods sold $ 73,200

c. Average cost

$115,200 / 4,800 = $24 average unit cost 2,000 × $24 = $48,000 ending inventory $115,200 - $48,000 = $67,200 cost of goods sold (or 2,800 × $24)

d. 1. In most circumstances, the first-in, first-out method most closely reflects the physical flow of inventory. First-in, first-out physical flow is critical when inventory is perishable or in situations in which the earliest items acquired are moved out first because of risk of deterioration or obsolescence such as technology products and retail items.

2. Last-in, first-out yields the highest cost of goods sold expense during

periods of rising unit costs, which in turn, results in the lowest taxable income and the lowest income tax.

3. The first-in, first-out method results in the lowest cost of goods sold,

and the largest amount of income, in periods of rising prices. Of course, this assumes that prices will continue to rise as they have in the past. Companies cannot change inventory costing methods without justification, and the change may be restricted by tax laws as well.

E6-29

Units Cost Total

Beginning inventory 100 @ $46 = $ 4,600 Purchases: Purchase #1 650 @ 42 = 27,300 Purchase #2 550 @ 38 = 20,900 Purchase #3 200 @ 36 = 7,200 Cost of goods available for sale 1,500 $60,000

a. First-in, first-out

Units Cost Total

200 @ $36 = $ 7,200 150 @ 38 = 5,700

Ending inventory .......................... 350 $12,900 Cost of goods available for sale . $60,000 Less: Ending inventory ............... 12,900 Cost of goods sold ....................... $47,100

b. Average cost

Cost of Goods Available for Sale/Total Units Available for Sale = $60,000 / 1,500 = $40 Average Unit Cost Ending Inventory = 350 units × $40 = $14,000 Cost of goods available for sale $60,000 Less: Ending inventory 14,000 Cost of goods sold $46,000

c. Last-in, first-out

Units Cost Total

100 @ $46 = $ 4,600 250 @ 42 = 10,500

Ending inventory ......................... 350 $15,100 Cost of goods available for sale $60,000 Less: Ending inventory .............. 15,100 Cost of goods sold ...................... $44,900

E6-31 a. Straight line: ($80,000 - $5,000) / 5 years = $15,000 per year

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Record $15,000 depreciation as part of COGS*

-15,000

Accumulated Depreciation

=

-15,000 Retained Earnings

–

+15,000 Cost of Goods Sold*

= -15,000

* Because the equipment is used exclusively in the manufacturing process, the

depreciation is more accurately recorded as part of cost of goods sold and not as depreciation expense.

b. Double-declining-balance: Twice straight-line rate = 2 × (100%/5) = 40%

Year Book Value × Rate Depreciation Expense

1 $80,000 × 0.40 = $32,000

2 ($80,000 - $32,000) × 0.40 = 19,200

3 ($80,000 - $51,200) × 0.40 = 11,520

4 ($80,000 - $62,720) × 0.40 = 6,912

5 5,368**

Total $75,000

** The calculated depreciation expense of $4,147 [($80,000 - $69,632) × 0.40] is not enough to result in the $5,000 salvage value. Therefore, we adjust the depreciation in year 5 to $5,368 so that the total depreciation expense is $75,000. This is called a “plug.”

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Record $32,000 depreciation as part of COGS*

-32,000

Accumulated Depreciation

=

-32,000 Retained Earnings

–

+32,000 Cost of Goods Sold*

= -32,000

E6-35 $ millions a. Average useful life = Depreciable asset cost / Depreciation expense

= ($8,579 - $113 - $478) / $540 = 14.8 years

Note: We eliminate land and construction in progress from the numerator because land is never depreciated and construction in progress represents assets that are not in service yet and are, consequently, not yet depreciable. The footnote indicates that buildings have estimated average useful lives of 23 years, machinery and equipment of 11 years, dies, etc of 7 years, and all other of 5 years.

b. Percent used up = Accumulated depreciation/ Depreciable asset cost

= $4,856 / ($8,579 - $113 - $478) = 60.8%

Assuming that assets are replaced evenly as they are used up, we would expect assets to be 50% “used up,” on average. Deere’s 60.8% is higher than this average. The implication is that Deere will require higher capital expenditures in the near future to replace aging assets.

Module 7 Q7-1. Current liabilities are obligations that require payment within the

coming year or operating cycle, whichever is longer.

Generally, current liabilities are settled with existing current assets or operating cash flows.

Q7-2. An accrual is the recognition of an event in the financial

statements even though no external transaction has occurred. Accruals can involve both liabilities (and expenses) and assets (and revenues).

Accruals are vital to the fair presentation of the financial condition of a company as they impact both the recognition of revenue and the matching of expenses.

Q7-3. The coupon rate is the rate specified on the face of the bond. It is

used to compute the amount of cash interest paid to the bondholder. The market rate is the rate of return expected by investors who purchase the bonds. The market rate determines the market price of the bond. It incorporates the current risk-free rate, expectations about the relative riskiness of the borrower, and the rate of inflation. In general, there is an inverse relation between the bond’s market rate and the bond’s market price.

Q7-5. Debt ratings reflect the relative riskiness of the rated company. This

riskiness relates to the probability of default (e.g., not repaying the principal and interest when due). Higher debt ratings result in higher market prices for the bonds and a correspondingly lower effective interest rate for the issuer. Lower debt ratings result in lower market prices for the bonds and a correspondingly higher effective interest rate for the issuer.

M7-9 a. Accounts Payable, $110,000 (current liability).

b. Not recorded as a liability; an accounting transaction has not yet occurred

because Basu did not receive the drill press before year-end.

c. Liability for Product Warranty, $2,200 (current liability).

d. Bonuses Payable, $30,000 (current liability)—computed as $600,000 5%. This liability must be reported because the bonus relates to operating results of 2012.

M7-10 a. Boston Scientific is offering bonds (maturing 2040) with a coupon

(stated) rate of 7.375% when the market rate (yield) is lower at 5.873%. To obtain this expected rate of return, the bonds must sell at a premium price of 120.71 (120.71% of par). The other bonds also sell at a premium, but the premium is smaller because the market rate and the coupon rate are closer than that for the bonds maturing in 2040.

b. The first bond matures in 2040 while the second matures in 2020. The

market generally demands a higher rate (yield) for a longer maturity debt instrument.

M7-18 a. Financial leverage (which measures debt levels) is one of the ratios that

credit-rating agencies use to determine their ratings. Generally, the higher (lower) the financial leverage, the lower (higher) the bond rating. Therefore, by reducing its financial leverage, Cummins will improve its bond rating. In short, all else equal, less debt suggests a greater likelihood of payment on that lower level of debt.

b. Higher credit ratings on debt issues, reduce the yield expected by

investors and, therefore, higher debt issuance proceeds realized by the issuing company. This implies that a higher credit rating for Cummins will lower its borrowing costs.

M7-19 a. Selling price for $500,000, 9% bonds discounted at 8% (4% semiannually):

Present value of principal repayment ($500,000 0.45639a) .......... $228,195

Present value of interest payments ($22,500 13.59033b) ............. 305,782

Selling price of bonds ......................................................................... $533,977 aTable 1, 20 periods at 4%. bTable 2, 20 periods at 4%.

Calculator inputs: N =20, I/YR = 4, PMT = 22,500, FV = 500,000, PV = 533,975.82

b. Selling price for $500,000, 9% bonds discounted at 10% (5% semiannually):

Present value of principal repayment ($500,000 0.37689a) .......... $188,445

Present value of interest payments ($22,500 12.46221b) ............. 280,400

Selling price of bonds ......................................................................... $468,845 aTable 1, 20 periods at 5%. bTable 2, 20 periods at 5%.

Calculator inputs: N =20, I/YR = 5, PMT = 22,500, FV = 500,000, PV = 468,844.47

M7-20 a. Selling price of zero coupon bonds discounted at 8%

Present value of principal repayment ($500,000 0.45639a) ......... $228,195 aTable 1, 20 periods at 4%

Calculator inputs: N =20, I/YR = 4, PMT = 0, FV = 500,000, PV = 228,193.47

b. Selling price of zero coupon bonds discounted at 10%

Present value of principal repayment ($500,000 0.37689a) ......... $188,445 aTable 1, 20 periods at 5%

Calculator inputs: N =20, I/YR = 5, PMT = 0, FV = 500,000, PV = 188,444.74

M7-21

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

a. Purchases $300 of inventory on credit

+300 Inventory

= +300

Accounts Payable

– =

b. Sells inventory for $420 on credit

+420

Accounts Receivable

=

+420

Retained Earnings

+420 Sales – = +420

c. Records $300 cost of sales

–300 Inventory

=

–300

Retained Earnings

– +300

Cost of Sales

= –300

d. Receives $420 cash for accounts receivable

+420 Cash

–420 Accounts

Receivable

=

– =

e. Pays $300 cash to settle accounts payable

–300 Cash =

–300 Accounts Payable

– =

Module 8 Q8-1. Par value stock is stock that has a face value printed (identified) on

the stock certificate. Historically, par value was the minimum selling price for one share.

From an accounting and analysis standpoint, there are no implications. The par value of the common stock is the amount added to the common stock account when the company sells stock. The remainder of the sale price is added to the additional paid-in-capital account. Stockholders’ equity increases by the total amount regardless of whether one or two accounts (line items) are used.

Q8-2. Typically, preferred stock has the following features: 1) Preferential

claim to dividends and to assets in liquidation, 2) Cumulative dividend rights, and 3) No voting rights.

Q8-3. Preferred stock is similar to debt when

1. Dividends are cumulative. 2. Dividends are nonparticipating. 3. Preferred stockholders have preference to assets in liquidation.

Preferred stock is similar to common stock when 1. Dividends are not cumulative. 2. Dividends are fully participating. 3. It is convertible into common stock. 4. Preferred stockholders do not have a preference to assets in

liquidation. Q8-4. Dividends in arrears on preferred stock are the cumulative preferred

dividends that have not been paid to date. The dividends in arrears and a current dividend must be paid to preferred stockholders before common stockholders can receive any dividends. In the example, the company must pay preferred stockholders $90,000 in

dividends ($500,000 0.06 3 years = $90,000) before paying any dividends to common stockholders.

Q8-5. A corporation's authorized stock is the maximum number of shares

of stock it may issue. When the corporation is formed, its charter specifies the authorized amounts and classes of stock. A corporation can later amend its charter to change the amount of

authorized capital, but such actions must be approved by the company’s shareholders. Shares that have been sold and issued to stockholders are the company's issued stock.

Shares that have been sold and issued can be subsequently reacquired by the corporation—these shares are called treasury stock. When treasury stock is held, the issued shares exceed the outstanding shares.

Q8-6. Contributed capital represents the total investment “contributed” by

shareholders when they purchase stock. It is considered contributed because the company is under no legal obligation to repay the shareholders. Earned capital represents the cumulative net income that the company has earned, less the portion of that income that has been paid out to shareholders in the form of dividends.

When profit is earned, the company can either pay out a portion of that profit as a dividend or reinvest the earnings in order to grow the company. In fact, many companies title the Retained Earnings account as Reinvested Earnings. Earned capital, thus, represents an implicit investment by the shareholders in the form of forgone dividends.

Q8-7. Contributed capital is dividend into two accounts: the common or preferred stock account at par and additional paid-in capital. The common stock or preferred stock accounts at par increase by the par value of each share issued. But, if companies sell shares for more than par, it is the market price of the stock that determines the company’s proceeds. The difference between the share’s market price and its par value is added to the additional paid-in capital account. The breakdown of contributed capital between the common or preferred stock accounts and additional paid-in capital is not informative – it does not yield any implications regarding the financial condition of the company.

Q8-8. A stock split refers to the issuance of additional shares to the

current stockholders in proportion to their ownership interests. This is normally accompanied by a proportionate reduction in the par or stated value of the stock. For example, a 2-for-1 stock split doubles the number of shares outstanding and halves the par or stated value of the shares. The market value of the stock typically falls to half in the event of a 2:1 stock split. Consequently, there is no change to the company’s balance sheet; the amount of contributed capital remains the same after the stock split. The major reason for a stock

split is to reduce the share price of the stock. It is believed that when the stock price is very high, few investors can afford to purchase the stock. Another possible reason is to lead shareholders to believe that there has been some distribution of value.

Q8-9. Treasury stock is stock, previously issued, that the corporation has

reacquired from shareholders.

A corporation might repurchase treasury stock to give to employees who exercise stock options or to offset dilution resulting from option grants. It is also used by management to prop up stock price when management believes its stock is inappropriately underpriced.

On the balance sheet, treasury stock is carried at its cost (the cash the corporation pays to acquire the stock) and is shown as a deduction (a negative amount) on the balance sheet. Thus, total stockholders' equity is net of treasury stock, which is known as a contra-equity account.

Q8-10. The $2,400 increase should not be shown on the income statement

as income or gain. The $2,400 is properly treated as additional paid-in capital and is shown as such in the stockholders' equity section of the balance sheet. The latter treatment is justified because treasury stock transactions are considered capital rather than operating transactions. GAAP does not permit corporations to “own” themselves. Thus, the company’s treasury stock is not shown as an investment. GAAP prohibits companies from reporting gains or losses from stock transactions with their own shareholders, therefore no gain is reported.

Q8-11. The book value per share of common stock is the total

stockholders' equity divided by the number of shares outstanding. Shares outstanding are 300,000 issued less 40,000 treasury shares. Thus book value is $4,628,000 / 260,000 = $17.80 per share.

Q8-12. A stock dividend is the distribution of additional shares of a

corporation's stock to its existing stockholders. A stock dividend does not change a stockholder's relative ownership interest, because each stockholder owns the same fractional share of the corporation before and after the stock dividend. There is empirical evidence, however, suggesting that the stock price does not decline fully to compensate for the additional shares issued. That is, if a company does a 2-for-1 stock split, the market price of each share should be half as much after the split. This does not always happen.

The price usually falls by only 45 to 48% of the pre-split price. One hypothesis to explain this phenomenon is that, by splitting the stock, the company is sending a signal to the market that the firm is going to have a price increase (which warrants the split).

Q8-14. Many companies repurchase shares (as treasury stock) in order to

offset the dilutive effects of stock options, because stock options increase the number of outstanding shares in the diluted EPS calculation. Stock repurchases typically decrease cash, which has immediate and ongoing economic effects. Some companies increase debt to repurchase stock. Analysts need to be concerned about the consequences of increased leverage solely to prop up diluted EPS.

M8-28

Distribution to Preferred Common

a. $1,000,000 6% ..................................................... $60,000 Balance to common .............................................. $100,000 Per share $60,000 / 20,000 shares .............................. $3.00 $100,000 / 80,000 shares ............................ $1.25

b. $1,000,000 6% 2 years .................................... $120,000 Balance to common .............................................. $40,000 Per share $120,000 / 20,000 shares ............................ $6.00 $40,000 / 80,000 shares .............................. $0.50 M8-29

BAMBER COMPANY STATEMENT OF RETAINED EARNINGS

FOR YEAR ENDED DECEMBER 31, 2012

Retained Earnings, December 31, 2011 ........................... $347,000

Add: Net Income ................................................................. 94,000

441,000

Less: Cash Dividends Declared ....................................... $35,000

Stock Dividends Declared ....................................... 28,000 63,000

Retained Earnings, December 31, 2012 ........................... $378,000

E8-34

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Feb 20: Issued 10,000 shares of $1 par value common stock at $25 cash per share

+250,000 Cash

=

+10,000 Common

Stock

+240,000 Additional

Paid-in Capital

– =

Feb 21: Issued 15,000 shares of $100 par value 8% preferred stock at $275 cash per share

+4,125,000 Cash =

+1,500,000 Preferred

Stock

+2,625,000 Additional

Paid-in Capital

– =

Jun 30: Purchased 2,000 shares of common stock at $15 per share

–30,000 Cash =

–30,000 Treasury

Stock – =

Sep 25: Sold 1,000 shares of treasury stock at $21 cash per share

+21,000 Cash

=

+15,000 Treasury

Stock

+6,000 Additional

Paid-in Capital

– =

E8-38

Distribution to

Preferred Common

a. Year 1 $ 0 $ 0

Year 2: Dividends in

arrears from Year 1

($750,000 8%) $ 60,000 Current year dividend

($750,000 8%) 60,000 Balance to common _______ $160,000

Total for Year 2 $120,000 $160,000

Year 3: Current year dividend

($750,000 8%) $ 60,000 $ 0

b. Year 1 $ 0 $ 0

Year 2: Current year dividend

($750,000 8%) $ 60,000 Balance to common $220,000

Year 3: Current year dividend

($750,000 8%) $ 60,000 $ 0

E8-43 a.

Balance Sheet Income Statement

Transaction Cash Asset

+ Noncash Assets

= Liabil- ities

+ Contrib. Capital

+ Earned Capital

Rev-enues

– Expen-

ses =

Net Income

Apr 1: Issue stock dividend on common stock

1

=

+250,000 Common

Stock

-250,000 Retained Earnings

– =

Dec 7: Issue 3% stock dividend on common stock

2

=

+15,000 Common

Stock

+27,000 Additional

Paid-in Capital

+ -42,000 Retained Earnings

– =

Dec 20: Pay cash dividends on preferred and common stock

3

-102,400 Cash

=

-102,400 Retained Earnings

– =

1 Large stock dividends are recorded at par value. The company reduces Retained Earnings and

increases Common Stock by $250,000 (50,000 shares 100% $5 par value). There is no effect on APIC.

2 Small stock dividends are recorded at market value. The company reduces Retained Earnings

by the market value of the shares to be distributed (3% 100,000 shares $14 per share =

$42,000). Common Stock increases by the par value of the shares distributed (3% 100,000 $5 = $15,000) and APIC increases by the balance ($27,000).

3 Total dividends are 4,000 $5 = $20,000 for the preferred shares and 103,000 $0.80 = $82,400 for the common shares. Retained Earnings and Cash decrease to reflect the payment.

b.

KINNEY COMPANY STATEMENT OF RETAINED EARNINGS

FOR YEAR ENDED DECEMBER 31, 2012

Retained Earnings, December 31, 2011 $656,000

Add: Net Income 253,000

909,000

Less: Cash Dividends Declared $102,400

Stock Dividends Declared 292,000 394,400

Retained Earnings, December 31, 2012 $514,600