Deck 15: Equity

Question 1

A company has not paid dividends on its cumulative nonvoting preferred stock for 20 years. Healthy earnings have been reported each year, but they have been retained to support the growth of the company. The board of directors appropriately authorized management to offer the preferred shareholders an exchange of bonds and common stock for all the preferred stock. The exchange is about to be consummated. Which of the following best describes the effect of the exchange on the company?

A) The statute of limitations applies; hence, cumulative dividends of only seven years need to be paid on the preferred stock exchanged.
B) The company should record a gain for income determination purposes to the extent that dividends in arrears do not have to be paid in the exchange transaction.
C) Gain or loss should be recognized on the exchange by the company, and the exchange would have to be approved by the Securities and Exchange Commission.
D) Regardless of the market value of the bonds and common stock, no gain or loss should be recognized by the company on the exchange, and no dividends need to be paid on the preferred stock exchanged.

Answer 1

D

Question 2

The par value method of reporting a treasury stock transaction

A) Will be reported in the balance sheet as a reduction of total stockholders' equity.
B) Results in no change to total stockholders' equity.
C) Results in a reduction in the number of shares that are available to be sold to prospective investors.
D) Assumes constructive retirement of the treasury shares.

Answer 2

D

Question 3

A primary source of stockholders' equity is

A) Income retained by the corporation.
B) Appropriated retained earnings.
C) Contributions by stockholders.
D) Both income retained by the corporation, and contributions by stockholders.

Answer 3

D

Question 4

The pre-emptive right of a common stockholder is the right to

A) Share proportionately in corporate assets upon liquidation.
B) Share proportionately in any new issues of stock of the same class.
C) Receive cash dividends before they are distributed to preferred stockholders.
D) Exclude preferred stockholders from voting rights.

Question 5

At the date of the financial statements, common stock shares issued would exceed common stock shares outstanding as a result of the

A) Declaration of a stock split.
B) Declaration of a stock dividend.
C) Purchase of treasury stock.
D) Payment in full of subscribed stock.

Question 6

Stock that has a fixed per-share amount printed on each stock certificate is called

A) Stated value stock.
B) Fixed value stock.
C) Uniform value stock.
D) Par value stock.

Question 7

Stockholders' equity is generally classified into two major categories:

A) Contributed capital and appropriated capital.
B) Appropriated capital and retained earnings.
C) Retained earnings and unappropriated capital.
D) Earned capital and contributed capital.

Question 8

According to the FASB ASC, redeemable preferred stock should be

A) Included in the common stock section.
B) Included as a liability.
C) Excluded from the stockholders' equity section.
D) Included as a contra item in the stockholders' equity section.

Question 9

For a compensatory stock option plan for which the date of grant and measurement date are the same, compensation cost should be recognized in the income statement

A) At the date of retirement
B) Of each period in which services are rendered
C) At the exercise date
D) At the adoption date of the plan

Question 10

Treasury shares are

A) Shares held as an investment by the treasurer of the corporation.
B) Shares held as an investment of the corporation.
C) Issued and outstanding shares.
D) Issued but not outstanding shares.

Question 11

A restriction of retained earnings is most likely to be required by the

A) Exhaustion of potential benefits of the investment credit
B) Purchase of treasury stock
C) Payment of last maturing series of a serial bond issue
D) Amortization of past service costs related to a pension plan

Question 12

Payment of a dividend in stock

A) Increases the current ratio
B) Decreases the amount of working capital
C) Increases total stockholders' equity
D) Decreases book value per share of stock outstanding

Question 13

On December 31, 2017, when the Conn Company's stock was selling at $36 per share, its capital accounts were as follows: Capital stock (par value $20, 100,000 shares issued) $2,000,000
Premium on capital stock 800,000
Retained Earnings 4,550,000
If a 100 percent stock dividend were declared and the par value per share remained at
$20

A) No entry would need to be made to record the dividend
B) Capital stock would increase to $5,600,000
C) Capital stock would increase to $4,000,000
D) Total capital would decrease

Question 14

Which of the following features of preferred stock makes the security more like debt than an equity instrument?

A) Participating
B) Voting
C) Redeemable
D) Noncumulative

Question 15

When a stock dividend is small, for example a 10% stock dividend,

A) Retained earnings is not reduced because the dividend is immaterial.
B) Retained earnings is reduced by the fair value of the stock.
C) Retained earnings is reduced to the par value of the stock.
D) Paid-in capital in excess of par value is unaffected.

Question 16

The directors of Corel Corporation, whose $40 par value common stock is currently selling at $50 per share, have decided to issue a stock dividend. The corporation has an authorization for 200,000 shares of common, has issued 110,000 shares of which 10,000 shares are now held as treasury stock, and desires to capitalize $400,000 of the retained earnings balance. To accomplish this, the percentage of stock dividend that the directors should declare is

A) 10
B) 8
C) 5
D) 2

Question 17

Which of the following represents the total number of shares that a corporation may issue under the terms of its charter?

A) Authorized shares
B) Issued shares
C) Unissued shares
D) Outstanding shares

Question 18

A feature common to both stock splits and stock dividends is

A) A transfer to earned capital of a corporation.
B) No impact on total stockholders' equity.
C) An increase in total liabilities of a corporation.
D) A reduction in the contributed capital of a corporation.

Question 19

In a corporate form of business organization, legal capital is best defined as

A) The amount of capital the state of incorporation allows the company to accumulate over its existence.
B) The amount of net assets that cannot be distributed to stockholder
C) The amount of capital the federal government allows a corporation to generate.
D) The total capital raised by a corporation within the limits set by the Securities and Exchange Commission.

Question 20

The cumulative feature of preferred stock

A) Limits the amount of cumulative dividends to the par value of the preferred stock.
B) Requires that dividends not paid in any year must be made up in a later year before dividends are distributed to common shareholders.
C) Means that the shareholder can accumulate preferred stock until it is equal to the par value of common stock at which time it can be converted into common stock.
D) Enables a preferred stockholder to accumulate dividends until they equal the par value of the stock and receive the stock in place of the cash dividends.

Question 21

How would a stock split affect each of the following? Total Stockholders' Additional
Assets Equity Paid-in Capital

A) Increase Increase No effect
B) No effect No effect No effect
C) No effect No effect Increase
D) Decrease Decrease Decrease

Question 22

How would the declaration and subsequent issuance of a 10 percent stock dividend by the issuer affect each of the following when the market value of the shares exceeds the par value of the stock? Common Stock Additional Paid-in Capital

A) No effect No effect
B) No effect Increase
C) Increase No effect
D) Increase Increase

Question 23

The purchase of treasury stock

A) Decreases common stock authorized
B) Decreases common stock issued
C) Decreases common stock outstanding
D) Has no effect on common stock outstanding

Question 24

The rate of return on common stock equity is calculated by dividing

A) Net income less preferred dividends by average common stockholders' equity.
B) Net income by average common stockholders' equity.
C) Net income less preferred dividends by ending common stockholders' equity.
D) Net income by ending common stockholders' equity.

Question 25

The dollar amount of total stockholders' equity remains the same when there is a (an)

A) Issuance of preferred stock in exchange for convertible debentures
B) Issuance of nonconvertible bonds with detachable stock purchase warrants
C) Declaration of a stock dividend
D) Declaration of a cash dividend

Question 26

A feature common to both stock splits and stock dividends is

A) A reduction in total capital of a corporation
B) A transfer from earned capital to paid-in capital
C) A reduction in book value per share
D) Inclusion in conventional statement of source and application of funds

Question 27

Gilbert Corporation issued a 40-percent stock dividend of its common stock that had a par value of $10 before and after the dividend. At what amount should retained earnings be capitalized for the additional shares issued?

A) There should be no capitalization of retained earnings
B) Par value
C) Market value on the declaration date
D) Market value on the payment date

Question 28

When a dividend paid to stockholders who own mandatorily redeemable preferred stock, the company must report the dividend

A) As an adjustment to retained earnings in its statement of owners' equity.
B) As interest expense in the income statement.
C) As a reduction to other comprehensive income.
D) In the financing activities section of the statement of cash flows.

Question 29

What is the most likely effect of a stock split on the par value per share and the number of shares outstanding? Par Value Number of shares
Per share outstanding

A) Decrease Increase
B) Decrease No effect
C) Increase Increase
D) No effect No effect

Question 30

As a minimum, how large in relation to total outstanding shares may a stock distribution be before it should be accounted for as a stock split instead of a stock dividend?

A) No less than 2 to 5 percent
B) No less than 10 to 15 percent
C) No less than 20 to 25 percent
D) No less than 45 to 50 percent

Question 31

When a stock option plan for employees is compensatory, the measurement date for determining compensation cost is the

A) Date the option plan is adopted, provided it precedes the date on which the options may first be exercised by less than one operating cycle
B) Date on which the options may first be exercised (if the first actual exercise is within the same operating period) or the date on which a recipient first exercises any of his options
C) First date on which are known both the number of shares than an individual employee is entitled to receive and the option or purchase price, if any
D) Date each option is granted

Question 32

Under which of the theories of equity is a manager's goals considered as important as those of the common stockholder.

A) Proprietary theory.
B) Commander theory.
C) Entity theory.
D) Enterprise theory.

Question 33

A company with a $2,000,000 deficit undertakes a quasi-reorganization on November 1, 2020. Certain assets will be written down by $400, 000 to their present fair market value. Liabilities will remain the same. Capital stock was $3,000,000 and additional paid-in capital was $1,000,000 before the quasi-reorganization. How would the entries to accomplish these changes on November 1, 2020, affect each of the following? Capital Stock Total Stockholders' Equity

A) No effect No effect
B) No effect Decrease
C) Decrease Decrease
D) Decrease No effect

Question 34

Which of the theories of equity is consistent with the definition of equity that is found in Statement of Financial Accounting Concepts No. 6?

A) Proprietary theory.
B) Commander theory.
C) Entity theory.
D) Enterprise theory.

Question 35

Assuming the issuing company has only one class of stock, a transfer from retained earnings to capital stock equal to the market value of the shares issued is ordinarily a characteristic of

A) Either a stock dividend or a stock split
B) Neither a stock dividend nor a stock split
C) A stock split but not a stock dividend
D) A stock dividend but not a stock split

Question 36

The equation, assets = equities, expresses which of the following theories of equity?

A) Proprietary theory.
B) Commander theory.
C) Entity theory.
D) Enterprise theory.

Question 37

A company with a substantial deficit undertakes a quasi-reorganization. Certain assets will be written down to their present fair market value. Liabilities will remain the same. How would the entries to record the quasi-reorganization affect each of the following? Contributed Capital Retained Earnings

A) Increase Decrease
B) Decrease No effect
C) Decrease Increase
D) No effect Increase

Question 38

Under the residual equity theory

A) A business is viewed as a social institution.
B) Management is responsible for maximizing the wealth of common stockholders.
C) A manager's goals are considered as important as those of the common stockholders.
D) Equities are viewed as restrictions on assets.

Question 39

Which of the following securities must be reported as a liability because they have the characteristics of both liabilities and equity, but the liability characteristic is dominant?

A) Redeemable preferred stock.
B) Stock options issued with a debt security.
C) Detachable stock options.
D) Mandatorily redeemable preferred stock.

Question 40

When preferred stock is converted to common stock

A) The debt-to-equity ratio decreases.
B) The debt-to-equity ratio increases.
C) The debt-to-equity ratio is unchanged.
D) A gain or loss is reported in earnings for the difference between the fair value of the common stock and the book value of the preferred stock that was converted.

Question 41

When employees are granted options as part of a compensatory stock option plan,

A) Total compensation is measured using a fair value method.
B) Total compensation is measured using the intrinsic method.
C) Total compensation is measured when the options are in the money.
D) Total compensation is measured using the difference between the strike price and the fair value of the options on the grant date.

Question 42

How did SFAS No. 123R change accounting for stock options?

Question 43

List and discuss four advantages of the corporate form of organization.

Question 44

What is mandatorily redeemable preferred stock and how is it accounted for under the provisions of SFAS No. 150 (FASB ASC 480-10)?

Question 45

Discuss the following theories of equity:
a. Proprietary
According to the proprietary theory, the firm is owned by some specified person or group. The ownership interest may be represented by a sole proprietor, a partnership, or a number of stockholders. The assets of the firm belong to these owners, and any liabilities of the firm are also the owners' liabilities. Revenues received by the firm immediately increase the owner's net interest in the firm. Likewise, all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. This theory holds that all profits or losses immediately become the property of the owners, and not the firm, whether or not they are distributed. Therefore, the firm exists simply to provide the means to carry on transactions for the owners, and the net worth or equity section of the balance sheet should be viewed as
assets - liabilities = proprietorship
Under the proprietary theory, financial reporting is based on the premise that the owner is the primary focus of a company's financial statements. The proprietary theory is particularly applicable to sole proprietorships where the owner is the decision maker. When the form of the enterprise grows more complex, and the ownership and management separate, this theory becomes less acceptable.
b. Entity
The rise of the corporate form of organization, (1) was accompanied by the separation of ownership and management, (2) conveyed limited liability to the owners, and (3) resulted in the legal definition of a corporation as though it were a person, encouraged the evolution of new theories of ownership. Among the first of these theories was the entity theory. From an accounting standpoint, the entity theory can be expressed as
assets = equities
The entity theory, like the proprietary theory, is a point of view toward the firm and the people concerned with its operation. This viewpoint places the firm, and not the owners, at the center of interest for accounting and financial reporting purposes. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm, and the firm exists as a separate and distinct entity apart from these groups. The assets and liabilities belong to the firm, not to its owners. As revenue is received, it becomes the property of the entity, and as expenses are incurred, they become obligations of the entity. Any profits belong to the entity and accrue to the stockholders only when a dividend is declared. Under this theory, all the items on the right-hand side of the balance sheet, except retained earnings (it belongs to the firm), are viewed as claims against the assets of the firm, and individual items are distinguished by the nature of their claims. Some items are identified as creditor claims and others are identified as owner claims; nevertheless, they are all claims against the firm as a separate entity.
c. Fund
The use of the fund theory would abandon the personal relationship advocated by the proprietary theory and the personalization of the firm advocated by the entity theory. Under the fund approach, the measurement of net income plays a role secondary to satisfying the special interests of management, social control agencies (e.g., government agencies), and the overall process of credit extension and investment. The fund theory is expressed by the following equation:
assets = restrictions on assets
This theory explains the financial reporting of an organization in terms of three features, as follows:

Question 46

Obtain the financial statements of a company and ask the students to compute the:
a. Return on common stockholders' equity.
b. Financial structure ratio
The answer to this question is dependent on the company selected.

Question 47

Discuss the following special features of preferred stock:
a. Convertible
A conversion feature allows preferred shareholders to exchange their shares for common shares. It is included on a preferred stock issue to make it more attractive to potential investors. Usually, a conversion feature is attached to allow the corporation to sell its preferred shares at a relatively lower dividend rate than is found on other securities with the same degree of risk. The conversion rate is normally set above the current relationship of the market value of the common share to the market value of the preferred convertible shares.
b. Call
Call provisions allow the corporation to reacquire preferred stock at some predetermined amount. Corporations include call provisions on securities because of uncertain future conditions. Current conditions dictate the return on investment that will be attractive to potential investors, but conditions may change so that the corporation may offer a lower return on investment in the future. In addition, market conditions may make it necessary to promise a certain debt-equity relationship at the time of issue. Call provisions allow the corporation to take advantage of future favorable conditions and indicate how the securities may be retired. The existence of a call price tends to set an upper limit on the market price of nonconvertible securities, since investors will not normally be inclined to purchase shares that could be recalled momentarily at a lower price.
c. Cumulative
Preferred shareholders normally have a preference as to dividends. That is, no common dividends may be paid in any one year until all required preferred dividends for that year are paid. Usually, corporations also include added protection for preferred shareholders in the form of a cumulative provision. This provision states that if all or any part of the stated preferred dividend is not paid in any one year, the unpaid portion accumulates and must be paid in subsequent years before any dividend can be paid on common stock. Any unpaid dividend on cumulative preferred stock constitutes a dividend in arrears and should be disclosed in the notes to the financial statements, even though it is not a liability until the board of directors of the corporation actually declares it. Dividends in arrears are important in predicting future cash flows and as an indicator of financial flexibility and liquidity.
d. Participating
Participating provisions allow preferred stockholders to share dividends in excess of normal returns with common stockholders. For example, a participating provision might indicate that preferred shares are to participate in dividends on a 1:1 basis with common stock on all dividends in excess of $5 per share. This provision requires that any payments of more than $5 per share to the common stockholder also be made on a dollar-for-dollar basis to each share of preferred.
e. Redemption
A redemption provision indicates that the shareholder may exchange preferred stock for cash in the future. The redemption provision may include a mandatory maturity date or may specify a redemption price. If so, the financial instrument embodies an obligation to transfer assets, and would meet the definition of a liability, rather than equity. The SEC requires separate disclosure of mandatorily redeemable preferred shares because of their separate nature. FASB ASC 480-10-50-4 requires that a mandatorily redeemable financial instrument be classified as a liability unless redemption is required to occur only upon the liquidation or termination of the issuing company.

Question 48

Discuss the components of a corporation's balance sheet capital section.
a. Appropriated
a. Legal capital-par, stated value, or entire proceeds if no par or stated value accompanies the stock issue
b. Additional paid-in capital-amounts received in excess of par or stated value
b. Unappropriated

Question 49

Define and discuss the two methods of accounting for treasury stock.

Question 50

Discuss the difference between a stock dividend and a stock split. Include in your discussion, the reasons a company might issue either a stock dividend or a stock split.

Question 51

Distinguish between noncompensitory and compensatory stock option plans.

Question 52

Define and discuss accounting for stock warrants.