text
stringlengths 247
9.78k
|
|---|
SE 3. Smith Auto purchased a neighboring lot for a new building and parking lot.
Indicate whether each of the following expenditures is properly charged to (a) Land,
(b) Land Improvements, or (c) Buildings.
1. Paving costs 5. Building construction costs
2. Architects’ fee for building design 6. Lights around the property
3. Cost of clearing the property 7. Building permit
4. Cost of the property 8. Interest on the construction loan
LO2 Group Purchase
SE 4. Lian Company purchased property with a warehouse and parking lot for
$1,500,000. An appraiser valued the components of the property if purchased
separately as follows:
Land $ 400,000
Land improvements 200,000
Building 1,000,000
Total $1,600,000
Determine the cost to be assigned to each component.
LO3 Straight-Line Method
SE 5. Kelly’s Fitness Center purchased a new step machine for $16,500. The appa-
ratus is expected to last four years and have a residual value of $1,500. What will the
depreciation expense be for each year under the straight-line method?
508 CHAPTER 11 Long-Term Assets
LO3 Production Method
SE 6. Assume that the step machine in SE 5 has an estimated useful life of
10,000 hours and was used for 2,400 hours in year 1, 2,000 hours in year 2,
2,200 hours in year 3, and 1,400 hours in year 4. How much would depreciation
expense be in each year?
LO3 Double-Declining-Balance Method
SE 7. Assume that the step machine in SE 5 is depreciated using the double-
declining-balance method. How much would depreciation expense be in each
year?
LO4 Disposal of Plant Assets: No Trade-In
SE 8. Alarico Printing owned a piece of equipment that cost $16,200 and on which
it had recorded $9,000 of accumulated depreciation. The company disposed of
the equipment on January 2, the first day of business of the current year.
1. Calculate the carrying value of the equipment.
2. Calculate the gain or loss on the disposal under each of the following
assumptions:
a. The equipment was discarded as having no value.
b. The equipment was sold for $3,000 cash.
c. The equipment was sold for $8,000 cash.
LO5 Natural Resources
SE 9. Narda Company purchased land containing an estimated 4,000,000 tons of
ore for $16,000,000. The land will be worth $2,400,000 without the ore after
8 years of active mining. Although the equipment needed for the mining will
have a useful life of 20 years, it is not expected to be usable and will have no value
after the mining on this site is complete. Compute the depletion charge per ton
and the amount of depletion expense for the first year of operation, assuming that
600,000 tons of ore are mined and sold. Also, compute the first-year deprecia-
tion on the mining equipment using the production method, assuming a cost of
$19,200,000 with no residual value.
LO6 Intangible Assets: Computer Software
SE 10. Danya Company has created a new software application for PCs. Its
costs during research and development were $250,000. Its costs after the
working program was developed were $175,000. Although the company’s
copyright may be amortized over 40 years, management believes that the
product will be viable for only 5 years. How should the costs be accounted for? At
what value will the software appear on the balance sheet after 1 year?
Exercises
LO1 LO2 Discussion Questions
LO3
E 1. Develop a brief answer for each of the following questions:
1. Is carrying value ever the same as market value?
2. What major advantage does a company that has positive free cash flow have
over a company that has negative free cash flow?
3. What incentive does a company have to allocate more of a group purchase
price to land than to building?
4. Which depreciation method would best reflect the risk of obsolescence from
rapid technological changes?
Chapter Assignments 509
LO4 LO5 Discussion Questions
LO6 E 2. Develop a brief answer for each of the following questions:
1. When would the disposal of a long-term asset result in no gain or loss?
2. When would annual depletion not equal depletion expense?
3. Why would a firm amortize a patent over fewer years than the patent’s life? |
4. Why would a company spend millions of dollars on goodwill?
LO1 Management Issues
E 3. Indicate whether each of the following actions is primarily related to
(a) acquisition of long-term assets, (b) evaluating the financing of long-term
assets, or (c) applying the matching rule to long-term assets.
1. Deciding to use the production method of depreciation
2. Allocating costs on a group purchase
3. Determining the total units a machine will produce
4. Deciding to borrow funds to purchase equipment
5. Estimating the savings a new machine will produce and comparing that
amount to cost
6. Examining the trend of free cash flow over several years
7. Deciding whether to rent or buy a piece of equipment
LO1 Purchase Decision—Present Value Analysis
E 4. Management is considering the purchase of a new machine for a cost of
$12,000. It is estimated that the machine will generate positive net cash flows
of $3,000 per year for five years and will have a disposal price at the end of that
time of $1,000. Assuming an interest rate of 9 percent, determine if management
should purchase the machine. Use Tables 1 and 2 in the appendix on present value
tables to determine the net present value of the new machine.
LO1 Free Cash Flow
E 5. Zedek Corporation had net cash flows from operating activities during the
past year of $216,000. During the year, the company expended $462,000 for
property, plant, and equipment; sold property, plant, and equipment for $54,000;
and paid dividends of $50,000. Calculate the company’s free cash flow. What
does the result tell you about the company?
LO2 Special Types of Capital Expenditures
E 6. Tell whether each of the following transactions related to an office building
is a revenue expenditure (RE) or a capital expenditure (CE). In addition, indicate
whether each transaction is an ordinary repair (OR), an extraordinary repair (ER),
an addition (A), a betterment (B), or none of these (N).
1. The hallways and ceilings in the building are repainted at a cost of $6,250.
2. The hallways, which have tile floors, are carpeted at a cost of $28,000.
3. A new wing is added to the building at a cost of $105,470.
4. Furniture is purchased for the entrance to the building at a cost of $13,250.
5. The air-conditioning system is overhauled at a cost of $21,153. The overhaul
extends the useful life of the air-conditioning system by 10 years.
6. A cleaning firm is paid $150 per week to clean the newly installed carpets.
LO2 Determining Cost of Long-Term Assets
E 7. Colletta Manufacturing purchased land next to its factory to be used as a
parking lot. The expenditures incurred by the company were as follows: purchase
price, $600,000; broker’s fees, $48,000; title search and other fees, $4,400; demo-
lition of a cottage on the property, $16,000; general grading of property, $8,400;
paving parking lots, $80,000; lighting for parking lots, $64,000; and signs for
510 CHAPTER 11 Long-Term Assets
parking lots, $12,800. Determine the amounts that should be debited to the Land
account and the Land Improvements account.
LO2 Group Purchase
E 8. Joanna Mak purchased a car wash for $480,000. If purchased separately,
the land would have cost $120,000, the building $270,000, and the equipment
$210,000. Determine the amount that should be recorded in the new business’s
records for land, building, and equipment.
LO2 LO3 Cost of Long-Term Asset and Depreciation
E 9. Nick Santiago purchased a used tractor for $35,000. Before the tractor could
be used, it required new tires, which cost $2,200, and an overhaul, which cost
$2,800. Its first tank of fuel cost $150. The tractor is expected to last six years
and have a residual value of $4,000. Determine the cost and depreciable cost
of the tractor and calculate the first year’s depreciation under the straight-line
method.
LO3 Depreciation Methods
E 10. On January 13, 2010, Silverio Oil Company purchased a drilling truck for
$45,000. Silverio expects the truck to last five years or 200,000 miles, with an
estimated residual value of $7,500 at the end of that time. During 2011, the |
truck is driven 48,000 miles. Silverio’s year end is December 31. Compute the
depreciation for 2011 under each of the following methods: (1) straight-line,
(2) production, and (3) double-declining-balance. Using the amount computed
in (3), prepare the entry in journal form to record depreciation expense for the
second year, and show how the Drilling Truck account would appear on the bal-
ance sheet.
LO3 Double-Declining-Balance Method
E 11. Stop Burglar Alarm Systems Company purchased a computer for $2,240. It
has an estimated useful life of four years and an estimated residual value of $240.
Compute the depreciation charge for each of the four years using the double-
declining-balance method.
LO3 Revision of Depreciation Rates
E 12. Hope Hospital purchased a special X-ray machine. The machine, which
cost $311,560, was expected to last ten years, with an estimated residual
value of $31,560. After two years of operation (and depreciation charges
using the straight-line method), it became evident that the X-ray machine
would last a total of only seven years. The estimated residual value, how-
ever, would remain the same. Given this information, determine the new
depreciation charge for the third year on the basis of the revised estimated
useful life.
LO4 Disposal of Plant Assets
E 13. A piece of equipment that cost $32,400 and on which $18,000 of accumu-
lated depreciation had been recorded was disposed of on January 2, the first day
of business of the current year. For each of the following assumptions, compute
the gain or loss on the disposal.
1. The equipment was discarded as having no value.
2. The equipment was sold for $6,000 cash.
3. The equipment was sold for $18,000 cash.
Chapter Assignments 511
LO4 Disposal of Plant Assets
E 14. Samson Company purchased a computer on January 2, 2009, at a cost of
$1,250. The computer is expected to have a useful life of five years and a residual
value of $125. Assume that the computer is disposed of on July 1, 2012. Record
the depreciation expense for half a year and the disposal under each of the following
assumptions:
1. The computer is discarded.
2. The computer is sold for $200.
3. The computer is sold for $550.
LO5 Natural Resource Depletion and Depreciation of Related Plant Assets
E 15. Nelson Company purchased land containing an estimated 2.5 million tons
of ore for a cost of $4,400,000. The land without the ore is estimated to be
worth $250,000. During its first year of operation, the company mined and sold
375,000 tons of ore. Compute the depletion charge per ton. Compute the deple-
tion expense that Nelson should record for the year.
LO6 Amortization of Copyrights and Trademarks
E 16. The following exercise is about amortizing copyrights and trademarks.
1. Fulton Publishing Company purchased the copyright to a basic computer
textbook for $80,000. The usual life of a textbook is about four years. How-
ever, the copyright will remain in effect for another 50 years. Calculate the
annual amortization of the copyright.
2. Sloan Company purchased a trademark from a well-known supermarket for
$640,000. The management of the company argued that the trademark’s
useful life was indefinite. Explain how the cost should be accounted for.
LO6 Accounting for a Patent
E 17. At the beginning of the fiscal year, Andy Company purchased for $2,060,000
a patent that applies to the manufacture of a unique tamper-proof lid for medi-
cine bottles. Andy incurred legal costs of $900,000 in successfully defending use
of the lid by a competitor. Andy estimated that the patent would be valuable for
at least ten years.
During the first two years of operations, Andy Company successfully mar-
keted the lid. At the beginning of the third year, a study appeared in a consumer
magazine showing that children could in fact remove the lid. As a result, all orders
for the lids were canceled, and the patent was rendered worthless.
Prepare entries in journal form to record the following: (a) purchase of the
patent; (b) successful defense of the patent; (c) amortization expense for the first |
year; and (d) write-off of the patent as worthless.
Problems
LO1 LO2 Identification of Long-Term Assets Terminology
P 1. Listed below are common terms associated with long-term assets:
a. Tangible assets g. Depreciation
b. Natural resources h. Depletion
c. Intangible assets i. Amortization
d. Additions j. Revenue expenditure
e. Betterments k. Free cash flow
f. Extraordinary repair
512 CHAPTER 11 Long-Term Assets
Required
1. For each of the following statements, identify the term listed above with
which it is associated. (If two terms apply, choose the one that is most closely
associated.)
1. Periodic cost associated with intangible assets
2. Cost of constructing a new wing on a building
3. A measure of funds available for expansion
4. A group of assets encompassing property, plant, and equipment
5. Cost associated with enhancing a building but not expanding it
6. Periodic cost associated with tangible assets
7. A group of assets that gain their value from contracts or rights
8. Cost of normal repairs to a building
9. Assets whose value derives from what can be extracted from them
10. Periodic cost associated with natural resources
11. Cost of a repair that extends the useful life of a building
User insight (cid:2) 2. Assuming the company uses cash for all its expenditures, which of the items
listed above would you expect to see on the income statement? Which ones
would not result in an outlay of cash?
LO2 Determining Cost of Assets
P 2. Siber Computers constructed a new training center in 2010. You have
been hired to manage the training center. A review of the accounting records
shows the following expenditures debited to an asset account called Training
Center:
Attorney’s fee, land acquisition $ 35,200
Cost of land 597,000
Architect’s fee, building design 102,000
Building 1,025,000
Parking lot and sidewalk 135,600
Electrical wiring, building 168,000
Landscaping 55,000
Cost of surveying land 8,900
Training equipment, tables, and chairs 136,400
Installation of training equipment 65,600
Cost of grading the land 14,000
Cost of changes in building to soundproof rooms 58,700
Total account balance $2,401,400
During the center’s construction, an employee of Siber Computers worked
full-time overseeing the project. He spent two months on the purchase and prep-
aration of the site, six months on the construction, one month on land improve-
ments, and one month on equipment installation and training-room furniture
purchase and setup. His salary of $72,000 during this ten-month period was
charged to Administrative Expense. The training center was placed in operation
on November 1.
Required
1. Prepare a schedule with the following four column (account) headings: Land,
Land Improvements, Building, and Equipment. Place each of the above
expenditures in the appropriate column. Total the columns.
User insight (cid:2) 2. What impact does the classification of the items among several accounts have
on evaluating the profitability performance of the company?
Chapter Assignments 513
LO3 LO4 Comparison of Depreciation Methods
P 3. Ivan Manufacturing Company purchased a robot for $360,000 at the begin-
ning of year 1. The robot has an estimated useful life of four years and an esti-
mated residual value of $30,000. The robot, which should last 20,000 hours, was
operated 6,000 hours in year 1; 8,000 hours in year 2; 4,000 hours in year 3; and
2,000 hours in year 4.
Required
1. Compute the annual depreciation and carrying value for the robot for each
year assuming the following depreciation methods: (a) straight-line, (b) pro-
duction, and (c) double-declining-balance.
2. If the robot is sold for $375,000 after year 2, what would be the amount of
gain or loss under each method?
User insight (cid:2) 3. What conclusions can you draw from the patterns of yearly depreciation and
carrying value in requirement 1? Do the three methods differ in their effect
on the company’s profitability? Do they differ in their effect on the com-
pany’s operating cash flows? Explain.
LO3 LO4 Comparison of Depreciation Methods
P 4. Roman’s Construction Company purchased a new crane for $721,000 at the |
beginning of year 1. The crane has an estimated residual value of $70,000 and
an estimated useful life of six years. The crane is expected to last 20,000 hours.
It was used 3,600 hours in year 1; 4,000 hours in year 2; 5,000 hours in year
3; 3,000 hours in year 4; 2,400 hours in year 5; and 2,000 hours in year 6.
Required
1. Compute the annual depreciation and carrying value for the new crane for
each of the six years (round to the nearest dollar where necessary) under each
of the following methods: (a) straight-line, (b) production, and (c) double-
declining-balance.
2. If the crane is sold for $500,000 after year 3, what would be the amount of
gain or loss under each method?
User insight (cid:2) 3. Do the three methods differ in their effect on the company’s profitability? Do
they differ in their effect on the company’s operating cash flows? Explain.
LO5 Natural Resource Depletion and Depreciation of Related Plant Assets
P 5. Kulig Company purchased land containing an estimated 10 million tons
of ore for a cost of $3,300,000. The land without the ore is estimated to be
worth $600,000. The company expects that all the usable ore can be mined
in 10 years. Buildings costing $300,000 with an estimated useful life of
20 years were erected on the site. Equipment costing $360,000 with an esti-
mated useful life of 10 years was installed. Because of the remote location,
neither the buildings nor the equipment has an estimated residual value.
During its first year of operation, the company mined and sold 450,000 tons
of ore.
Required
1. Compute the depletion charge per ton.
2. Compute the depletion expense that Kulig should record for the year.
3. Determine the depreciation expense for the year for the buildings, making it
proportional to the depletion.
4. Determine the depreciation expense for the year for the equipment under
two alternatives: (a) making the expense proportional to the depletion and
(b) using the straight-line method.
514 CHAPTER 11 Long-Term Assets
User insight (cid:2) 5. Suppose the company mined and sold 250,000 tons of ore (instead of
450,000) during the first year. Would the change in the results in require-
ment 2 or 3 affect earnings or cash flows? Explain.
Alternate Problems
LO2 Determining Cost of Assets
P 6. Global Company was formed on January 1, 2010, and began constructing
a new plant. At the end of 2010, its auditor discovered that all expenditures
involving long-term assets had been debited to an account called Fixed Assets. An
analysis of the Fixed Assets account, which had a year-end balance of $2,659,732,
disclosed that it contained the following items:
Cost of land $ 320,600
Surveying costs 4,100
Transfer of title and other fees required by
the county 920
Broker’s fees for land 21,144
Attorney’s fees associated with land acquisition 7,048
Cost of removing timber from land 49,600
Cost of grading land 4,200
Cost of digging building foundation 35,100
Architect’s fee for building and land improvements
(80 percent building) 67,200
Cost of building construction 715,000
Cost of sidewalks 11,400
Cost of parking lots 54,400
Cost of lighting for grounds 80,300
Cost of landscaping 11,800
Cost of machinery 993,000
Shipping cost on machinery 55,300
Cost of installing machinery 176,200
Cost of testing machinery 21,600
Cost of changes in building to comply with safety
regulations pertaining to machinery 12,540
Cost of repairing building that was damaged in the
installation of machinery 8,900
Cost of medical bill for injury received by
employee while installing machinery 2,560
Cost of water damage to building during heavy
rains prior to opening the plant for operation 6,820
Account balance $2,659,732
Global Company sold the timber it cleared from the land to a firewood dealer for
$7,000. This amount was credited to Miscellaneous Income.
During the construction period, two of Global’s supervisors devoted full time
to the construction project. Their annual salaries were $51,000 and $39,000,
respectively. They spent two months on the purchase and preparation of the land,
six months on the construction of the building (approximately one-sixth of which |
was devoted to improvements on the grounds), and one month on machin-
ery installation. When the plant began operation on October 1, the supervisors
returned to their regular duties. Their salaries were debited to Factory Salaries
Expense.
Chapter Assignments 515
Required
1. Prepare a schedule with the following column headings: Land, Land Improve-
ments, Buildings, Machinery, and Expense. Place each of the above expen-
ditures in the appropriate column. Negative amounts should be shown in
parentheses. Total the columns.
User insight (cid:2) 2. What impact does the classification of the items among several accounts have
on evaluating the profitability performance of the company?
LO3 LO4 Comparison of Depreciation Methods
P 7. Relax Designs, Inc. purchased a computerized blueprint printer that will
assist in the design and display of plans for factory layouts. The cost of the
printer was $45,000, and its expected useful life is four years. The company
can probably sell the printer for $5,000 at the end of four years. The printer is
expected to last 6,000 hours. It was used 1,200 hours in year 1; 1,800 hours in
year 2; 2,400 hours in year 3; and 600 hours in year 4.
Required
1. Compute the annual depreciation and carrying value for the new blueprint
printer for each of the four years (round to the nearest dollar where neces-
sary) under each of the following methods: (a) straight-line, (b) production,
and (c) double-declining-balance.
2. If the printer is sold for $24,000 after year 2, what would be the gain or loss
under each method?
User insight (cid:2) 3. What conclusions can you draw from the patterns of yearly depreciation and
carrying value in requirement 1? Do the three methods differ in their impact
on profitability? Do they differ in their effect on the company’s operating
cash flows? Explain.
LO5 Natural Resource Depletion and Depreciation of Related Plant Assets
P 8. Fuentez Mining Company purchased land containing an estimated
20 million tons of ore for a cost of $8,800,000. The land without the ore is esti-
mated to be worth $1,600,000. The company expects that all the usable ore can
be mined in 10 years. Buildings costing $800,000 with an estimated useful life
of 30 years were erected on the site. Equipment costing $960,000 with an esti-
mated useful life of 10 years was installed. Because of the remote location, neither
the buildings nor the equipment has an estimated residual value. During its first
year of operation, the company mined and sold 1,600,000 tons of ore.
Required
1. Compute the depletion charge per ton.
2. Compute the depletion expense that Fuentez Mining should record for the
year.
3. Determine the depreciation expense for the year for the buildings, making it
proportional to the depletion.
4. Determine the depreciation expense for the year for the equipment under
two alternatives: (a) making the expense proportional to the depletion and
(b) using the straight-line method.
User insight (cid:2) 5. Suppose the company mined and sold 2,000,000 tons of ore (instead of
1,600,000) during the first year. Would the change in the results in require-
ments 2 or 3 affect earnings or cash flows? Explain.
LO3 LO4 Comparison of Depreciation Methods
P 9. Myles Construction Company purchased a new crane for $360,500 at the
beginning of year 1. The crane has an estimated residual value of $35,000 and
an estimated useful life of six years. The crane is expected to last 10,000 hours.
516 CHAPTER 11 Long-Term Assets
It was used 1,800 hours in year 1; 2,000 hours in year 2; 2,500 hours in year
3; 1,500 hours in year 4; 1,200 hours in year 5; and 1,000 hours in year 6.
Required
1. Compute the annual depreciation and carrying value for the new crane for
each of the six years (round to the nearest dollar where necessary) under each
of the following methods: (a) straight-line, (b) production, and (c) double-
declining-balance.
2. If the crane is sold for $250,000 after year 3, what would be the amount of
gain or loss under each method?
User insight (cid:2) 3. Do the three methods differ in their effect on the company’s profitability? Do |
they differ in their effect on the company’s operating cash flows? Explain.
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 Effect of Change in Estimates
C 1. The airline industry was hit particularly hard after the 9/11 attacks on the
World Trade Center in 2001. In 2002, Southwest Airlines, one of the healthier
airline companies, made a decision to lengthen the useful lives of its aircraft from
22 to 27 years. Shortly thereafter, following Southwest’s leadership, other airlines
made the same move.18 What advantage, if any, can the airlines gain by making
this change in estimate? Will it change earnings or cash flows and, if it does, will
the change be favorable or negative?
Some people argue that the useful lives and depreciation of airplanes are
irrelevant. They claim that because of the extensive maintenance and testing
airline companies are required by law to perform, the planes theoretically
can be in service for an indefinite future period. What is wrong with this
argument?
LO1 Impairment Test
C 2. The annual report for Costco Wholesale Corporation, the large discount
company, contains the following statement:
The company periodically evaluates the realizability of long-lived
assets for impairment when [circumstances] may indicate the carry-
ing amount of the asset may not be recoverable.19
What does the concept of impairment mean in accounting? What effect does
impairment have on profitability and cash flows? Why would the concept of
impairment be referred to as a conservative accounting approach?
LO6 Brands
C 3. Hilton Hotels Corporation and Marriott International provide hospitality
services. Hilton Hotels’ well-known brands include Hilton, Doubletree, Hamp-
ton Inn, Embassy Suites, Red Lion Hotels and Inns, and Homewood Suites.
Marriott also owns or manages properties with recognizable brand names, such as
Marriott Hotels, Resorts and Suites; Ritz-Carlton; Renaissance Hotels; Residence
Inn; Courtyard; and Fairfield Inn.
On its balance sheet, Hilton Hotels Corporation includes brands (net of
amortization) of $1.7 billion, or 19.5 percent of total assets. Marriott Interna-
tional, however, does not list brands among its intangible assets.20 What princi-
ples of accounting for intangibles would cause Hilton to record brands as an asset
Chapter Assignments 517
while Marriott does not? How will these differences in accounting for brands
generally affect the net income and return on assets of these two competitors?
LO2 Ethics and Allocation of Acquisition Costs
C 4. Raintree Company has purchased land and a warehouse for $18,000,000.
The warehouse is expected to last 20 years and to have a residual value equal
to 10 percent of its cost. The chief financial officer (CFO) and the controller
are discussing the allocation of the purchase price. The CFO believes that the
largest amount possible should be assigned to the land because this action will
improve reported net income in the future. Depreciation expense will be lower
because land is not depreciated. He suggests allocating one-third, or $6,000,000,
of the cost to the land. This results in depreciation expense each year of $540,000
[($12,000,000 (cid:4) $1,200,000) (cid:5) 20 years].
The controller disagrees. She argues that the smallest amount possible, say
one-fifth of the purchase price, should be allocated to the land, thereby saving
income taxes, since the depreciation, which is tax-deductible, will be greater.
Under this plan, annual depreciation would be $648,000 [($14,400,000 (cid:4)
$1,440,000) (cid:5) 20 years]. The annual tax savings at a 30 percent tax rate is
$32,400 [($648,000 (cid:4) $540,000) (cid:6) 0.30]. How would each decision affect the
company’s cash flows? Ethically, how should the purchase cost be allocated? Who
will be affected by the decision?
LO1 LO2 Long-Term Assets
LO3 LO6 C 5. To answer the following questions, refer to CVS Corporation’s annual report
in the Supplement to Chapter 5. Examine the balance sheets and the summary
of significant accounting policies on property and equipment in the notes to the |
financial statements.
1. What percentage of total assets in the most recent year was property and
equipment, net? Identify the major categories of CVS’s property and equip-
ment. Which is the most significant type of property and equipment? What
are leasehold improvements? How significant are these items, and what are
their effects on the earnings of the company?
2. Continue with the summary of significant accounting policies item on prop-
erty and equipment in the CVS annual report. What method of depreciation
does CVS use? How long does management estimate its buildings will last as
compared with furniture and equipment? What does this say about the com-
pany’s need to remodel its stores?
3. Refer to the note on impairment of long-lived assets in the summary of sig-
nificant accounting policies in CVS Corporation’s annual report. How does
the company determine if it has impaired assets?
LO1 Long-Term Assets and Free Cash Flows
C 6. Refer to the annual report of CVS Corporation and to the financial state-
ments of Southwest Airlines Co. in the Supplement to Chapter 5 to answer the
following questions:
1. Prepare a table that shows the net amount each company spent on property
and equipment (from the statement of cash flows), the total property and
equipment (from the balance sheet), and the percentage of the first figure to
the second for each of the past two years. Which company grew its property
and equipment at a faster rate?
2. Calculate free cash flow for each company for the past two years. What con-
clusions can you draw about the need for each company to raise funds from
debt and equity and the ability of each company to grow?
C H A P T E R
12
Contributed Capital
I n this chapter, we make the transition from the sole proprietor-
Making a
Statement ship form of business to the corporate form. We accomplish
this objective by focusing on long-term equity financing—that is,
INCOME STATEMENT
on the capital that stockholders invest in a corporation. The issues
Revenues
involved in equity financing include the type of stock a corpora-
– Expenses
tion issues, the dividends that it pays, and the treasury stock that it
= Net Income purchases. These issues can significantly affect return on equity and
other measures of profitability on which management’s compensa-
STATEMENT OF tion is based. Thus, ethics is a major concern. Management’s deci-
RETAINED EARNINGS
sions must be based not on personal gain, but on the value created
Beginning Balance
for the corporation’s owners.
+ Net Income
– Dividends
= Ending Balance LEARNING OBJECTIVES
LO1 Identify and explain the management issues related to
BALANCE SHEET
Assets Liabilities contributed capital. (pp. 520–528)
LO2 Identify the components of stockholders’ equity. (pp. 528–531)
Stockholders’
Equity LO3 Identify the characteristics of preferred stock. (pp. 531–534)
A = L + OE
LO4 Account for the issuance of stock for cash and other
assets. (pp. 534–538)
STATEMENT OF CASH FLOWS
Operating activities LO5 Account for treasury stock. (pp. 539–543)
+ Investing activities
+ Financing activities
= Change in Cash
+ Beginning Balance
= Ending Cash Balance
Most stock transactions only
impact the balance sheet and
the statement of cash flows.
518
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Why might Gammon’s
founders have chosen to form
GAMMON, INC.
a corporation rather than a
partnership?
In 2010, a group of investors in Arizona formed a corporation called (cid:2) How should a corporation
Gammon, Inc. The corporation’s state charter authorized it to issue account for its stock transactions
and dividends?
2 million shares of $1 par value common stock and 50,000 shares of
4 percent, $20 par value cumulative and convertible preferred stock. (cid:2) What measures should
Gammon’s initial public offering (IPO) (i.e., its first sale of stock stockholders use to evaluate the
return on their investments?
to the public) occurred on February 1, 2010, when it issued 200,000
shares of common stock for $250,000 and thereby realized its first
influx of contributed capital.
During its first year of operations, Gammon engaged in a number |
of other transactions involving common stock, as well as transactions
involving preferred stock, treasury stock, and dividends. In this chap-
ter, you will learn how to account for these transactions. You will also
learn why corporations are the dominant form of business in the U.S.
economy and how a corporation’s owners—its stockholders—can
evaluate the return on their investments.
551199
520 CHAPTER 12 Contributed Capital
Management
In Chapter 1, we defined a corporation as a business unit chartered by the state
Issues Related and legally separate from its owners—that is, its stockholders. Contributed capi-
tal, which refers to stockholders’ investments in a corporation, is a major means
to Contributed
of financing a corporation. Managing contributed capital requires an understand-
Capital ing of the corporate organization, its advantages and disadvantages, and the issues
involved in equity financing. It also requires familiarity with dividend policies, with
LO1 Identify and explain the how to use return on equity to evaluate performance, and with stock option plans.
management issues related to
The Corporate Form of Business
contributed capital.
The corporate form of business is well suited to today’s trends toward large orga-
nizations, international trade, and professional management. Although fewer in
number than sole proprietorships and partnerships, corporations dominate the
U.S. economy, in part because of their ability to raise large amounts of capital.
In 2004, the amount of new capital that corporations raised was $2,859 billion.
Even though 2008 was a down year for markets, the amount of new capital raised
by corporations exceeded $4 trillion of which about 90 percent was from bond
issues and 10 percent from stock issues.1
To form a corporation, most states require persons (called incorporators) to
sign an application and file it with the proper state official. This application con-
tains the articles of incorporation. If approved by the state, these articles, which
form the company charter, become a contract between the state and the incorpo-
rators. The company is then authorized to do business as a corporation.
The authority to manage a corporation is delegated by its stockholders to a
board of directors and by the board of directors to the corporation’s officers (see
Figure 12-1). That is, the stockholders elect a board of directors, which sets cor-
porate policies and chooses the corporation’s officers, who in turn carry out the
corporate policies in their management of the business.
Stockholders A unit of ownership in a corporation is called a share of stock. The
articles of incorporation state the maximum number of shares that a corpora-
tion is authorized to issue. The number of shares held by stockholders is the
outstanding stock; this may be less than the number authorized in the articles of
incorporation. To invest in a corporation, a stockholder transfers cash or other
resources to the corporation. In return, the stockholder receives shares of stock
representing a proportionate share of ownership in the corporation. Afterward,
the stockholder may transfer the shares at will. Corporations may have more than
one kind of stock.
Board of Directors As noted, a corporation’s board of directors decides
on major business policies. Among the board’s specific duties are authorizing
contracts, setting executive salaries, and arranging major loans with banks. The
declaration of dividends is also an important function of the board of directors.
Dividends are distributions of resources, generally in the form of cash, to stock-
holders, and only the board of directors has the authority to declare them. Paying
dividends is one way of rewarding stockholders for their investment when the
FIGURE 12-1
The Corporate Organization STOCKHOLDERS BOARD OF DIRECTORS CORPORATION’S OFFICERS
Invest in shares of Determines corporate Execute policy and
capital stock and elect policy, declares carry out day-to-day
board of directors dividends, and appoints operations
the corporation’s officers |
Management Issues Related to Contributed Capital 521
corporation has been successful in earning a profit. (The other way is through
a rise in the market value of the stock.) There is usually a delay of two or three
weeks between the time the board declares a dividend and the date of the actual
payment.
The composition of the board of directors varies from company to company,
but generally it includes several officers of the corporation and several outsiders.
The outsiders are called independent directors because they do not directly partici-
pate in managing the business.
Corporation’s Officers The corporate officers, appointed by the board of
directors to carry out corporate polices and run day-to-day operations, consist
of the operating officers—generally the president, or chief executive officer; vice
presidents; chief financial officer; and chief operating officer. Besides being respon-
sible for running the business, they have the duty of reporting the financial results
of their administration to the board of directors and the stockholders. Though
they must, at a minimum, make a comprehensive annual report, they generally
report more often. The annual report of large public corporations are available to
the public. Excerpts from many of them appear throughout this book.
Advantages and Disadvantages of Incorporation
Managers of a corporation must be familiar with the advantages and disadvan-
tages of this form of business. Some of the advantages are as follows:
(cid:2) Separate legal entity: As a separate legal entity, a corporation can buy and sell
property, sue other parties, enter into contracts, hire and fire employees, and
be taxed.
(cid:2) Limited liability: Because a corporation is a legal entity, separate from its
owners, its creditors can satisfy their claims only against the assets of the
corporation, not against the personal property of the corporation’s owners.
Because the owners are not responsible for the corporation’s debts, their lia-
bility is limited to the amount of their investment. In contrast, the personal
property of sole proprietors and partners generally is available to creditors.
(cid:2) Ease of capital generation: It is fairly easy for a corporation to raise capital
because shares of ownership in the business are available to a great number of
potential investors for a small amount of money. As a result, a single corpora-
tion can have many owners.
(cid:2) Ease of transfer of ownership: A share of stock, a unit of ownership in a cor-
poration, is easily transferable. A stockholder can normally buy and sell shares
without affecting the corporation’s activities or needing the approval of other
owners.
(cid:2) Lack of mutual agency: Mutual agency is not a characteristic of corporations.
If a stockholder tries to enter into a contract for the corporation, the corpo-
ration is not bound by the contract. But in a partnership, because of mutual
agency, all the partners can be bound by one partner’s actions.
(cid:2) Continuous existence: Because a corporation is a separate legal entity, an
owner’s death, incapacity, or withdrawal does not affect the life of the corpo-
ration. A corporation’s life is set by its charter and regulated by state laws.
(cid:2) Centralized authority and responsibility: The board of directors represents
the stockholders and delegates the responsibility and authority for the day-
to-day operation of the corporation to a single person, usually the president.
Operating power is not divided among the many owners of the business. The
522 CHAPTER 12 Contributed Capital
president may delegate authority over certain segments of the business to oth-
Study Note
ers, but he or she is held accountable to the board of directors. If the board is
Among the agencies that dissatisfied with the performance of the president, it can replace that person.
regulate corporations are the (cid:2) Professional management: Large corporations have many owners, most of
Public Company Accounting
whom are unequipped to make timely decisions about business operations. |
Oversight Board (PCAOB),
So, management and ownership are usually separate. This allows a corpora-
Securities and Exchange
tion to hire the best talent available to manage the business.
Commission (SEC), the
Occupational Safety and Health The disadvantages of corporations include the following:
Administration (OSHA), the
(cid:2) Government regulation: Corporations must meet the requirements of state
Federal Trade Commission
laws. As “creatures of the state,” they are subject to greater state control and
(FTC), the Environmental
regulation than are other forms of business. They must file many reports with
Protection Agency (EPA), the
the state in which they are chartered. Publicly held corporations must also
Nuclear Regulatory Commission
file reports with the Securities and Exchange Commission and with the stock
(NRC), the Equal Employment
exchanges on which they are listed. Meeting these requirements is very costly.
Opportunity Commission
(EEOC), the Interstate Commerce (cid:2) Taxation: A major disadvantage of the corporate form of business is double
Commission (ICC), the National
taxation. Because a corporation is a separate legal entity, its earnings are sub-
Transportation Safety Board
ject to federal and state income taxes, which may be as much as 35 percent of
(NTSB), the Federal Aviation
corporate earnings. If any of the corporation’s after-tax earnings are paid out
Administration (FAA), and
as dividends, the earnings are taxed again as income to the stockholders. In
the Federal Communications
contrast, the earnings of sole proprietorships and partnerships are taxed only
Commission (FCC).
once, as personal income to the owners.
(cid:2) Limited liability: Although limited liability is an advantage of incorporation,
it can also be a disadvantage. Limited liability restricts the ability of a small
Study Note corporation to borrow money. Because creditors can lay claim only to the
assets of a corporation, they may limit their loans to the level secured by those
Lenders to a small corporation
assets or require stockholders to guarantee the loans personally.
may require the corporation’s
officers to sign a promissory (cid:2) Separation of ownership and control: Just as limited liability can be a draw-
note, which makes them back of incorporation, so can the separation of ownership and control. Man-
personally liable for the debt. agement sometimes makes decisions that are not good for the corporation as
a whole. Poor communication can also make it hard for stockholders to exer-
cise control over the corporation or even to recognize that management’s
decisions are harmful.
Equity Financing
Equity financing is accomplished through the issuance of stock to investors in
exchange for assets, usually cash. Once the stock has been issued to them, the stock-
holders can transfer their ownership at will. When they do, they must sign their stock
certificates, documents showing the number of shares that they own, and send
them to the corporation’s secretary. In large corporations that are listed on the stock
exchanges, stockholders’ records are hard to maintain. Such companies can have mil-
lions of shares of stock, thousands of which change ownership every day. Therefore,
they often appoint independent registrars and transfer agents (usually banks and trust
companies) to help perform the secretary’s duties. The outside agents are responsible
for transferring the corporation’s stock, maintaining stockholders’ records, preparing
a list of stockholders for stockholders’ meetings, and paying dividends.
Par value and legal capital are important terms in equity financing:
(cid:2) Par value is an arbitrary amount assigned to each share of stock. It must be
recorded in the capital stock accounts, and it constitutes a corporation’s legal
capital.
Management Issues Related to Contributed Capital 523
(cid:2) Legal capital is the number of shares issued times the par value. It is the
minimum amount that a corporation can report as contributed capital.
Par value usually bears little if any relationship to the shares’ market value or |
book value. For example, the Internet search company Google sold its common
stock for $85 per share in its initial public offering, but the market value is now
much higher and its par value per share is only $0.001. Google’s legal capital is
only about $315,000 (315 million shares (cid:6) $0.001) even though the total mar-
ket value of its shares exceeds $180 billion.
To help with its initial public offering (IPO), a corporation often uses an
underwriter—an intermediary between the corporation and the investing public.
For a fee—usually less than 1 percent of the selling price—the underwriter guar-
antees the sale of the stock. The corporation records the amount of the net pro-
ceeds of the offering—what the public paid less the underwriter’s fees, legal and
printing expenses, and any other direct costs of the offering—in its capital stock
and additional paid-in capital accounts. Because of the size of its IPO, Google
used a group of investment banks headed by two well-known investment bankers,
Morgan Stanley and Credit Suisse First Boston.
The costs of forming a corporation are called start-up and organization
costs. These costs, which are incurred before a corporation begins operations,
include state incorporation fees and attorneys’ fees for drawing up the articles of
incorporation. They also include the cost of printing stock certificates, accoun-
tants’ fees for registering the firm’s initial stock, and other expenditures necessary
for the formation of the corporation. Because Google’s IPO was so large, the
fees of the lawyers, accountants, and underwriters who helped arrange the IPO
amounted to millions of dollars.
Theoretically, start-up and organization costs benefit the entire life of a cor-
Study Note pporation. For that reason, a case can be made for recording them as intangible
aassets and amortizing them over the life of the corporation. However, a corpora-
Start-up and organization costs
ttion’s life normally is not known, so accountants expense start-up and organiza-
are expensed when incurred.
ttion costs as they are incurred.
Advantages of Equity Financing Financing a business by issuing common
stock has several advantages:
(cid:2) It is less risky than financing with debts because a company does not pay divi-
dends on common stock unless the board of directors decides to pay them. In
contrast, if a company does not pay interest on bonds, it can be forced into
bankruptcy.
(cid:2) When a company does not pay a cash dividend, it can plow the cash gener-
ated by profitable operations back into the company’s operations. Google,
for instance, does not currently pay any dividends, and its issuance of com-
mon stock provides it with funds for expansion.
(cid:2) A company can use the proceeds of a common stock issue to maintain or
improve its debt to equity ratio.
Disadvantages of Equity Financing Issuing common stock also has certain
disadvantages:
(cid:2) Unlike interest on bonds, dividends paid on stock are not tax-deductible.
(cid:2) When a corporation issues more stock, it dilutes its ownership. Thus, the cur-
rent stockholders must yield some control to the new stockholders.
524 CHAPTER 12 Contributed Capital
Dividend Policies
A corporation’s board of directors has sole authority to declare dividends, but
senior managers, who usually serve as members of the board, influence dividend
policies. Receiving dividends is one of two ways in which stockholders can earn a
return on their investment in a corporation. The other way is to sell their shares
for more than they paid for them.
Although a corporation may have sufficient cash and retained earnings to pay
a dividend, its board of directors may not declare one for several reasons. The
corporation may need the cash for expansion; it may want to improve its overall
financial position by liquidating debt; or it may be facing major uncertainties,
such as a pending lawsuit or strike or a projected decline in the economy, which
makes it prudent to preserve resources.
A corporation pays dividends quarterly, semiannually, annually, or at other |
times declared by its board of directors. Most states do not allow a corporation
to declare a dividend that exceeds its retained earnings. When a corporation does
declare a dividend that exceeds retained earnings, it is, in essence, returning to
the stockholders part of their contributed capital. This is called a liquidating divi-
dend. A corporation usually pays a liquidating dividend only when it is going
out of business or reducing its operations.
Having sufficient retained earnings in itself does not justify the declaration of
a dividend. If a corporation does not have cash or other assets readily available for
distribution, it might have to borrow money to pay the dividend—an action most
boards of directors want to avoid.
Dividend Dates Three important dates are associated with dividends:
(cid:2) The declaration date is the date on which the board of directors formally
Study Note
declares that the corporation is going to pay a dividend. Because the legal
Entries for dividends are made obligation to pay the dividend arises at this time, a liability for Dividends
only on the declaration date and Payable is recorded and the Dividends account is debited on this date. In the
the payment date. accounting process, Retained Earnings will be reduced by the total dividends
declared during the period.
(cid:2) The record date is the date on which ownership of stock, and therefore the
right to receive a dividend, is determined. Persons who own the stock on
the record date will receive the dividend. No entry is made on this date.
Between the record date and the date of payment, the stock is said to be
ex-dividend. If the owner on the date of record sells the shares of stock
before the date of payment, the right to the dividend remains with that
person; it does not transfer with the shares to the second owner.
(cid:2) The payment date is the date on which the dividend is paid to the stock-
holders of record. On this date, the Dividends Payable account is eliminated,
and the Cash account is reduced.
Because an accounting period may end between the record date and the
payment date, dividends declared during the period may exceed the amount
paid for dividends. For example, in Figure 12-2, the accounting period ends
on December 31. The declaration date for the dividends is December 21, the
record date is December 31, and the payment date is January 11. In this case,
the statement of retained earnings for the accounting period will show a reduc-
tion to Retained Earnings in the amount of dividends declared, but the state-
ment of cash flows will not show the dividends because the cash has not yet
been paid out.
Management Issues Related to Contributed Capital 525
FIGURE 12-2 Assets = Liabilities + Stockholders’ Equity
Dividend Dates
Cash Dividends Payable Dividends Declared
Dr. Cr. Dr. Cr. Dr. Cr.
Jan. 11 28,000 Jan. 11 28,000 Dec. 21 28,000 Dec. 21 28,000
Payment Date Declaration
Date
Note: No entry necessary on Reduces
Dec. 31 record date Retained
Earnings
Evaluating Dividend Policies To evaluate the amount of dividends they
receive, investors use the dividends yield ratio. Dividends yield is computed by
dividing the dividends per share by the market price per share. Microsoft’s his-
tory of dividend payments provides an interesting example. Having built up a
large cash balance through its years of profitable operations, Microsoft increased
its annual dividend to $4.5 billion ($0.52 per share) in 2009.2 Using Microsoft’s
regular annual dividend as a more realistic measure of what investors can expect
in the future, its dividends yield is computed as follows:
Dividends per Share $0.52
Dividends Yield (cid:2) (cid:2) (cid:2) 1.8%
Market Price per Share $28
Because the yield on corporate bonds exceeds 5 percent, Microsoft share-
holders must expect some of their return to come from increases in the price of
the shares.
Companies usually pay dividends only when they have had profitable opera-
tions. For example, Apple Computer began paying dividends in 1987, but it
stopped those payments in 1996 to conserve cash after it suffered large operating |
losses in 1995. However, factors other than earnings affect the decision to pay
dividends. Among them are the following:
(cid:2) Industry policies: A company may change its dividend policy to bring it into
line with the prevailing policy in its industry. For example, despite positive
earnings, AT&T Corporation slashed its dividends by 83 percent. This action
put AT&T’s policy more in line with the policies of its peers in the telecom-
munications industry, most of which do not pay dividends.3
(cid:2) Volatility of earnings: If a company has years of good earnings followed by
years of poor earnings, it may want to keep dividends low to avoid giving a
false impression of sustained high earnings. For example, for years, General
Motors paid a fairly low but stable dividend but declared a bonus dividend in
especially good years.
(cid:2) Effect on cash flows: A company may not pay dividends because its opera-
tions do not generate enough cash to do so or because it wants to invest
cash in future operations. Abbott Laboratories increases its dividends per
share each year to reward its stockholders but also keeps back a portion of
its earnings to spend for other purposes, such as researching and develop-
ing new drugs that will generate revenue in the future. In a recent year, for
example, the company paid $1.44 per share dividend on earnings per share
of $3.16.4
526 CHAPTER 12 Contributed Capital
Recently, because of a 15 percent reduction in the tax rate on dividends,
attitudes toward dividends have changed. Many firms have either increased their
dividends or started to pay dividends for the first time. The special dividend by
Microsoft mentioned earlier is a good example of this effect.
Using Return on Equity to Measure Performance
Return on equity is the most important ratio associated with stockholders’
equity. It is also a common measure of management’s performance. For instance,
when BusinessWeek and Forbes rate companies on their success, return on equity is
the major basis of their evaluations. In addition, the compensation of top execu-
tives is often tied to return on equity benchmarks.
Google’s return on equity in 2008 is computed as follows:5
Return on Equity (cid:2) ________N_ _ e_t_ I_n_c_o_m__e _ _______
Average Stockholders’ Equity
$4,226,858
(cid:2) _______ _ ______ __ _____ ___ _______
($28,238,862 (cid:3) $22,689,679) (cid:5) 2
$4,226,858
(cid:2) ______ _ _____
$25,464,271
(cid:2) 16.6%
Google’s healthy return on equity of 16.6 percent depends, of course, on the
amount of net income the company earns. But it also depends on the level of
stockholders’ equity, which in turn depends on management decisions about the
amount of stock the company sells to the public. As more shares are sold, stock-
holders’ equity increases, and as a result, return on equity decreases. Management
can keep stockholders’ equity at a minimum by financing the business with cash
flows from operations and by issuing debt instead of stock. But, issuing bonds
and other types of debt increases a firm’s risk because the interest and principal of
the debt must be paid on time.
Management can also reduce the number of shares in the hands of the
public by buying back the company’s shares on the open market. The cost
of these shares, which are called treasury stock, has the effect of reducing
stockholders’ equity and thereby increasing return on equity. Many compa-
nies follow this practice instead of paying or increasing dividends. Their rea-
son for doing so is that it puts money into the hands of stockholders in the
form of market price appreciation without creating a commitment to higher
dividends in the future. For instance, in 2009, Microsoft purchased $9.4 bil-
lion of its common stock on the open market.6 Microsoft’s stock repurchases
will improve the company’s return on equity, increase its earnings per share,
and lower its price/earnings ratio.
The price/earnings (P/E) ratio is a measure of investors’ confidence in a
company’s future. It is calculated by dividing the market price per share by the
earnings per share. The price/earnings ratio will vary as market price per share |
fluctuates daily and the amount of earnings per share changes. Using the annual
earnings per share from Microsoft’s most recent income statement, its P/E ratio
can be calculated as follows:
Price/Earnings (P/E) Ratio (cid:2) _ M __ar _k _e _t _ P __ri _c _e _ p _e _r _ _S _h _a _ re _ (cid:2) _ $_2_7_._8_7_ (cid:2) 17.2 times
Earnings per Share $1.62
Management Issues Related to Contributed Capital 527
Because the market price is 17.2 times earnings, investors are paying a good price
in relation to earnings. They do so in the expectation that this software company
will continue to be successful.
Stock Options as Compensation
More than 97 percent of public companies encourage employees to invest in their
common stock through stock option plans.7 Most such plans give employees the
right to purchase stock in the future at a fixed price. Some companies offer stock
option plans only to management personnel, but others, including Google, make
them available to all employees. Because the market value of a company’s stock
is tied to a company’s performance, these plans are a means of both motivating
and compensating employees. As the market value of the stock goes up, the dif-
ference between the option price and the market price grows, which increases
the amount of compensation. Another key benefit of stock option plans is that
compensation expense is tax-deductible.
On the date stock options are granted, the fair value of the options must be
estimated. The amount in excess of the exercise price is recorded as compensa-
tion expense over the grant period.8 For example, suppose that on July 1, 2010,
a company grants its top executives the option to purchase 100,000 shares of
common stock at $15 per share. The fair value of the option must be estimated
on that date to determine compensation expense. Any one of several methods of
estimating the fair value of options at the grant date may be used; they are dealt
with in more advanced courses. Later, when the market price is $25 per share,
one of the firm’s vice presidents exercises her option and purchases 2,000 shares.
Although the vice president has a gain of $20,000 (the $50,000 market value less
the $30,000 option price), no compensation expense is recorded. The company
receives only the option price, not the current market value.
In one example of how firms value stock options, Google recognized $1.1 bil-
lion of stock-based compensation expense in 2008. This amount represented about
7.4 percent of the company’s total expenses and almost 26.5 percent of the net
income. Management used a well-known statistical method to estimate the option
values.9
Cash Flow Information
The best source of information concerning cash flows related to stock transactions
and dividends is the financing activities section of the statement of cash flows. For
instance, Microsoft’s cash flows from these activities are clearly revealed in this
partial section of the company’s statement of cash flows (in millions):
2009 2008
Financing Activities
Common stock issued $ 579 $ 3,494
Common stock repurchased (9,353) (12,533)
Common stock cash dividend (4,468) (3,805)
Note the increasing amounts of common stock repurchased (treasury stock) and
the increasing amounts of dividends from year to year. Both actions are a reflec-
tion of the company’s success.
528 CHAPTER 12 Contributed Capital
FOCUS ON BUSINESS PRACTICE
Politics and Accounting Don’t Mix
The FASB has long held that stock options should be financial statements. What was happening was that many
treated as an expense, but in trying to pass this rule, it has stock options were granted, and companies granting them
encountered heavy opposition from the technology indus- were very loose in how they accounted for them. Many
try, which is the largest user of stock options. Leaders of the of the stock transactions were backdated so that the exer-
technology industry have maintained that expensing stock cise price would be most advantageous to the executives
options would hurt their companies’ profits and growth. who were benefiting. The SEC has more than 100 ongoing |
The FASB argued that stock options are a form of com- criminal investigations of backdating practices. Estimates
pensation and therefore have value. The U.S. Congress got are that between 1994 to 2005, when the FASB finally ruled
involved and pressured the FASB to back down, using the that all publicly traded companies must expense stock
companies’ reasoning that stock options essentially have options, $246 billion of options compensation expense
no value and thus are not an expense on the income state- had been ignored, overstating reported earnings by
ment, although they should be mentioned in a note to the 7 percent.10
STOP
& APPLY
Indicate whether each of the following is related to (a) advantages of the corporate form of business,
(b) disadvantages of corporations, (c) dividend policies, (d) performance evaluation, or (e) stock options:
1. U.S. tax policies 5. Ease of ownership transfer
2. Return on equity 6. Distributing cash to stockholders
3. Separate legal entity 7. Need to deal with government regulation
4. E mployee’s right to purchase shares at
a given price
SOLUTION
1. b; 2. d; 3. a; 4. e; 5. a; 6. c; 7. b
Components
In a corporation’s balance sheet, the owners’ claims to the business are called
of Stockholders’ stockholders’ equity. As shown in Exhibit 12-1, this section of a corporate balance
sheet usually has at least three components.
Equity
(cid:2) Contributed capital: the stockholders’ investments in the corporation.
LO2 Identify the components (cid:2) Retained earnings: the earnings of the corporation since its inception, less
of stockholders’ equity. any losses, dividends, or transfers to contributed capital. Retained earnings
are reinvested in the business. They are not a pool of funds to be distributed
to the stockholders; instead, they represent the stockholders’ claim to assets
resulting from profitable operations.
(cid:2) Treasury stock: shares of its own stock that the corporation has bought back
on the open market. The cost of these shares is treated not as an investment,
but as a reduction in stockholders’ equity. By buying back the shares, the
corporation reduces the ownership of the business.
Components of Stockholders’ Equity 529
EXHIBIT 12-1
Stockholders’ Equity
Stockholders’ Equity Section
of a Balance Sheet Contributed capital
Preferred stock, $50 par value, 2,000 shares
authorized, issued, and outstanding $100,000
Common stock, $5 par value, 60,000 shares
authorized, 40,000 shares issued,
36,000 shares outstanding $200,000
Additional paid-in capital 100,000 300,000
Total contributed capital $400,000
Retained earnings 120,000
Total contributed capital and retained earnings $520,000
Less treasury stock–common (4,000 shares at cost) 40,000
Total stockholders’ equity $480,000
A category called “other items” may also appear in a company’s stockholders’
equity section. We discuss these items in a later chapter.
A corporation can issue two types of stock:
(cid:2) Common stock is the basic form of stock that a corporation issues; that is,
if a corporation issues only one type of stock, it is common stock. Because
shares of common stock carry voting rights, they generally provide their own-
ers with the means of controlling the corporation. Common stock is also
called residual equity, which means that if the corporation is liquidated, the
claims of all creditors and usually those of preferred stockholders rank ahead
of the claims of common stockholders.
(cid:2) To attract investors whose goals differ from those of common stockholders, a
corporation may also issue preferred stock. Preferred stock gives its owners
preference over common stockholders, usually in terms of receiving dividends
and in terms of claims to assets if the corporation is liquidated. (We describe
these preferences in more detail later in the chapter.)
FOCUS ON BUSINESS PRACTICE
Are You a First-Class or Second-Class Stockholder?
When companies go public, insiders—usually the founders of the public in its IPO. As a result, Class B holders control 78
the company or top management—often get first-class shares percent of the company.11 |
with extra votes, while outsiders get second-class shares with Shareholder advocates denounce the class division of
fewer votes. The class A and class B shares of Adolph Coors shares as undemocratic. They maintain that this practice
Company, the large brewing firm, are an extreme example. gives a privileged few shareholders all or most of the con-
The company’s class B shares, owned by the public, have no trol of a company and that it denies other shareholders vot-
votes except in the case of a merger. Its class A shares, held by ing power consistent with the risk they are taking. Defend-
the Coors family trust, have all the votes on other issues. ers of the practice argue that it shields top executives from
Google also has two classes of common shares. Both the market’s obsession with short-term results and allows
classes are identical except that each class B share is enti- them to make better long-term decisions. They also point
tled to ten votes and each class A share is entitled to only out that many investors don’t care about voting rights as
one vote. Class A shares are the ones that Google offered to long as the stock performs well.
530 CHAPTER 12 Contributed Capital
FIGURE 12-3
Relationship of Authorized Shares
Unissued Shares Outstanding Shares Treasury Shares
to Unissued, Issued, Outstanding,
and Treasury Shares
Issued Shares
Authorized Shares
In keeping with the convention of full disclosure, the stockholders’ equity
section of a corporate balance sheet gives a great deal of information about the
corporation’s stock. Under contributed capital, it lists the kinds of stock; their par
value; and the number of shares authorized, issued, and outstanding.
(cid:2) Authorized shares are the maximum number of shares that a corporation’s
state charter allows it to issue. Most corporations are authorized to issue more
shares than they need to issue at the time they are formed. Thus, they are
able to raise more capital in the future by issuing additional shares. When a
corporation issues all of its authorized shares, it cannot issue more without a
change in its state charter.
(cid:2) Issued shares are those that a corporation sells or otherwise transfers to stock-
holders. The owners of a corporation’s issued shares own 100 percent of the
business. Unissued shares have no rights or privileges until they are issued.
(cid:2) Outstanding shares are shares that a corporation has issued and that are still
in circulation. Treasury stock is not outstanding because it consists of shares
that a corporation has issued but that it has bought back and thereby put out
of circulation. Thus, a corporation can have more shares issued than are cur-
rently outstanding.
Figure 12-3 shows the relationship of authorized shares to issued, unissued, out-
standing, and treasury shares. In this regard, Google is an interesting example.
The company has 9 billion authorized shares of stock and only about 309 million
shares issued. With its excess of authorized shares, Google obviously has plenty of
flexibility for future stock transactions.
STOP
& APPLY
The following data are from the records of Garcia Corporation on December 31, 2011:
Balance
Preferred stock, $100 par value, 6 percent noncumulative,
5,000 shares authorized, issued, and outstanding $500,000
Common stock, $2 par value, 100,000 shares
authorized, 90,000 shares issued, and 85,000 shares
outstanding 180,000
Additional paid-in capital 489,000
Retained earnings 172,500
Treasury stock–common (5,000 shares, at cost) 110,000
Prepare a stockholders’ equity section for Garcia Corporation’s balance sheet.
(continued)
Preferred Stock 531
SOLUTION
Garcia Corporation
Balance Sheet
December 31, 2011
Stockholders’ Equity
Contributed capital
Preferred stock, $100 par value, 6 percent noncumulative,
5,000 shares authorized, issued, and outstanding $ 500,000
Common stock, $2 par value, 100,000 shares authorized,
90,000 shares issued, 85,000 shares outstanding $180,000
Additional paid-in capital 489,000 669,000
Total contributed capital $1,169,000
Retained earnings 172,500
Total contributed capital and retained earnings $1,341,500 |
Less treasury stock–common (5,000 shares at cost) 110,000
Total stockholders’ equity $1,231,500
Preferred Stock
Most preferred stock has one or more of the following characteristics: preference
as to dividends, preference as to assets if a corporation is liquidated, convertibility,
LO3 Identify the characteristics and a callable option. A corporation may offer several different classes of preferred
of preferred stock. stock, each with distinctive characteristics to attract different investors.
Preference as to Dividends
Study Note
Preferred stockholders ordinarily must receive a certain amount of dividends
Preferred stock has many
before common stockholders receive anything. The amount that preferred stock-
different characteristics. They
holders must be paid before common stockholders can be paid is usually stated
are rarely exactly the same from
in dollars per share or as a percentage of the par value of the preferred shares. For
company to company.
example, a company might pay an annual dividend of $4 per share on preferred
stock, or it might issue preferred stock at $50 par value and pay an annual divi-
dend of 8 percent of par value, which would also be $4 per share.
Preferred stockholders have no guarantee of ever receiving dividends. A company
must have earnings and its board of directors must declare dividends on preferred stock
before any liability arises. The consequences of not granting an annual dividend on
preferred stock vary according to whether the stock is noncumulative or cumulative:
(cid:2) If the stock is noncumulative preferred stock and the board of directors
fails to declare a dividend on it in any given year, the company is under no
obligation to make up the missed dividend in future years.
(cid:2) If the stock is cumulative preferred stock, the dividend amount per share
accumulates from year to year, and the company must pay the whole amount
before it pays any dividends on common stock.
Dividends not paid in the year they are due are called dividends in arrears. For
example, suppose that a corporation has 20,000 shares of $100 par value, 5 per-
cent cumulative preferred stock outstanding. If the corporation pays no dividends
in 2011, preferred dividends in arrears at the end of the year would amount to
$100,000 (20,000 shares (cid:6) $100 (cid:6) 0.05 (cid:2) $100,000). If the corporation’s board
declares dividends in 2012, the corporation must pay preferred stockholders the
532 CHAPTER 12 Contributed Capital
dividends in arrears plus their current year’s dividends before paying any dividends
on common stock.
Dividends in arrears are not recognized as liabilities because no liability exists
until the board of directors declares a dividend. A corporation cannot be sure it is
going to make a profit, so, of course, it cannot promise dividends to stockholders.
However, if it has dividends in arrears, it should report the amount either in the
body of its financial statements or in a note to its financial statements.
The following note is typical of one that might appear in a company’s annual
report:
On December 31, 2010, the company was in arrears by $37,851,000
($1.25 per share) on dividends to its preferred stockholders. The
company must pay all dividends in arrears to preferred stockholders
before paying any dividends to common stockholders.
Suppose that on January 1, 2011, a corporation issued 20,000 shares of $10 par
value, 6 percent cumulative preferred stock and 100,000 shares of common stock.
Operations in 2011 produced income of only $8,000. However, in the same year,
the corporation’s board of directors declared a $6,000 cash dividend to the pre-
ferred stockholders. Thus, the dividend picture at the end of 2011 was as follows:
2011 dividends due preferred stockholders $12,000
($200,000 (cid:6) 0.06)
Less 2011 dividends declared to preferred stockholders 6,000
2011 preferred stock dividends in arrears $ 6,000
Now suppose that in 2012, the corporation earns income of $60,000 and
wants to pay dividends to both the preferred and the common stockholders.
Because the preferred stock is cumulative, the corporation must pay the $6,000 in |
arrears on the preferred stock, plus the current year’s dividends on the preferred
stock, before it can distribute a dividend to the common stockholders. If the cor-
poration’s board of directors now declares a $24,000 dividend to be distributed
to preferred and common stockholders, the distribution would be as follows:
2012 declaration of dividends $24,000
Less 2011 preferred stock dividends in arrears 6,000
Amount available for 2012 dividends $18,000
Less 2012 dividends due preferred stockholders
($200,000 (cid:6) 0.06) 12,000
Remainder available to common stockholders $ 6,000
Preference as to Assets
Preferred stockholders often have preference in terms of their claims to a cor-
poration’s assets if the corporation is liquidated. If a corporation does go out of
business, these preferred stockholders have a right to receive the par value of their
stock or a larger stated liquidation value per share before the common stockhold-
Study Note
ers receive any share of the corporation’s assets. This preference can also extend
When preferred stockholders to any dividends in arrears owed to the preferred stockholders.
convert their shares to common
stock, they gain voting Convertible Preferred Stock
rights but lose the dividend
and liquidation preference. Like all preferred stockholders, owners of convertible preferred stock are more
Conversion back to preferred llikely than common stockholders to receive regular dividends. In addition, they
stock is not an option. can exchange their shares of preferred stock for shares of common stock at a
rratio stated in the company’s preferred stock contract. If the market value of the
Preferred Stock 533
company’s common stock increases, the conversion feature is attractive to stock-
holders because it allows them to share in the increase by converting their stock
to common stock.
Suppose, for instance, that a company issues 1,000 shares of 8 percent, $100
par value convertible preferred stock for $100 per share. Each share of stock can be
converted to five shares of the company’s common stock at any time. The market
value of the common stock at the time the company issues the convertible preferred
stock is $15 per share. In the past, an owner of the common stock could expect div-
idends of about $1 per share per year. The owner of one share of preferred stock,
on the other hand, now holds an investment that has a market value of about $75
and is also more likely than a common stockholder to receive dividends.
Now suppose that in the next several years, the corporation’s earnings
increase, the dividends paid to common stockholders increase to $3 per share,
and the market value of a share of common stock increases from $15 to $30.
Preferred stockholders can convert each of their preferred shares to five common
shares, thereby increasing their dividends from $8 on each preferred share to $15
($3 on each of five common shares). Moreover, the market value of each share of
preferred stock will be close to the $150 value of the five shares of common stock
because each share can be converted to five shares of common stock.
Callable Preferred Stock
Most preferred stock is callable preferred stock—that is, the issuing corporation
can redeem or retire it at a price stated in the preferred stock contract. An owner
of nonconvertible preferred stock must surrender it to the issuing corporation
when asked to do so. If the preferred stock is convertible, the stockholder can
either surrender the stock to the corporation or convert it to common stock when
the corporation calls the stock. The call price, or redemption price, is usually
higher than the stock’s par value. For example, preferred stock that has a $100
par value might be callable at $103 per share.
When preferred stock is called and surrendered, the stockholder is entitled to
the following:
(cid:2) The par value of the stock
(cid:2) The call premium
(cid:2) Any dividends in arrears
(cid:2) The current period’s dividend prorated by the proportion of the year to the
call date
FOCUS ON BUSINESS PRACTICE
How Does a Stock Become a Debt? |
Some companies have used the flexibility of preferred stocks conditions. Thus, these special preferred stocks are similar to
to create a type of stock that is similar to debt. Usually, stocks bonds in that they have a fixed maturity date. In addition,
do not have maturity dates, and companies do not buy them in much the same way as bonds require periodic interest
back except at the option of management. However, CMS payments at a fixed rate, these stocks require an annual divi-
Energy, Time Warner, Xerox, and other companies have dend payment, also at a fixed rate. Even though companies
issued preferred stock that is “mandatorily redeemable.” list these stocks in the stockholders’ equity section of their
This means that the issuing companies are required to buy balance sheets, the astute analyst will treat them as debt
back the stock at fixed future dates or under predetermined when calculating a company’s debt to equity ratio.12
534 CHAPTER 12 Contributed Capital
A corporation may decide to call its preferred stock for any of the following
reasons:
(cid:2) It may want to force conversion of the preferred stock to common stock
because the dividend that it pays on preferred shares is higher than the divi-
dend that it pays on the equivalent number of common shares.
(cid:2) It may be able to replace the outstanding preferred stock with a preferred
stock at a lower dividend rate or with long-term debt, which can have a lower
after-tax cost.
(cid:2) It may simply be profitable enough to retire the preferred stock.
STOP
& APPLY
Sung Corporation has 2,000 shares of $100 par value, 7 percent cumulative preferred stock out-
standing and 200,000 shares of $1 par value common stock outstanding. In the corporation’s first
three years of operation, its board of directors declared cash dividends as follows:
2010, none
2011, $20,000
2012, $30,000
Determine the total cash dividends paid to the preferred and common stockholders during each of the
three years.
SOLUTION
2010: None
2011: Preferred dividends in arrears (2,000 shares (cid:6) $100 (cid:6) 0.07) $14,000
Current year remainder to preferred ($20,000 (cid:4) $14,000) 6,000
Total to preferred stockholders $20,000
2012: Preferred dividends in arrears ($14,000 (cid:4) $6,000) $ 8,000
Current year to preferred (2,000 shares (cid:6) $100 (cid:6) 0.07) 14,000
Total to preferred stockholders $22,000
Total to common stockholders ($30,000 (cid:4) $22,000) 8,000
Total dividends in 2012 $30,000
Issuance of
A share of capital stock may be either par or no-par. The value of par stock is stated
Common Stock in the corporate charter and must be printed on each stock certificate. It can
be $0.01, $1, $5, $100, or any other amount established by the organizers of the
corporation. For instance, the par value of Google’s common stock is $0.001. The
LO4 Account for the issuance
par values of common stocks tend to be lower than those of preferred stocks.
of stock for cash and other
As noted earlier, par value is the amount per share that is recorded in a cor-
assets.
poration’s capital stock accounts, and it constitutes a corporation’s legal capital.
A corporation cannot declare a dividend that would cause stockholders’ equity to
fall below the firm’s legal capital. Par value is thus a minimum cushion of capital
that protects a corporation’s creditors. Any amount in excess of par value that a
corporation receives from a stock issue is recorded in its Additional Paid-in Capi-
tal account and represents a portion of its contributed capital.
No-par stock is capital stock that does not have a par value. A corporation
may issue stock without a par value for several reasons. For one thing, rather than
Issuance of Common Stock 535
recognizing par value as an arbitrary figure, investors may confuse it with the
Study Note
stock’s market value. For another, most states do not allow a stock issue below
Legal capital is the minimum par value, and this limits a corporation’s flexibility in obtaining capital.
amount a corporation can State laws often require corporations to place a stated value on each share of |
report as contributed capital. To stock that they issue, but even when this is not required, a corporation’s board of
protect creditors, a corporation directors may do so as a matter of convenience. The stated value can be any value
cannot declare a dividend that set by the board unless the state specifies a minimum amount, which is sometimes
would reduce capital below the the case. The stated value can be set before or after the shares are issued if the
amount of legal capital. state law is not specific.
Par Value Stock
When a corporation issues par value stock, the appropriate capital stock account
(usually Common Stock or Preferred Stock) is credited for the par value regard-
less of whether the proceeds are more or less than the par value.
When a corporation issues stock at a price greater than par value, as is usually
the case, the proceeds in excess of par are credited to an account called Additional
Paid-in Capital. For example, suppose Norek Corporation is authorized to issue
10,000 shares of $10 par value common stock and that it issues 5,000 shares at
$12 each on January 1, 2011. The T accounts and entry to record the issuance of
the stock at the price in excess of par value would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH COMMON STOCK
Dr. Cr. Dr. Cr.
Jan. 1 60,000 Jan. 1 50,000
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Jan. 1 10,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Jan. 1 Cash 60,000
(cid:3)60,000 (cid:3)50,000 Common Stock 50,000
(cid:3)10,000
Additional Paid-in Capital 10,000
Issued 5,000 shares of $10 par value
common stock for $12 per share
Cash is debited for the proceeds of $60,000 (5,000 shares (cid:6) $12), and Com-
mon Stock is credited for the total par value of $50,000 (5,000 shares (cid:6) $10).
Additional Paid-in Capital is credited for the difference of $10,000
(5,000 shares (cid:6) $2).
The amount in excess of par value is part of Norek Corporation’s contrib-
uted capital and will be included in the stockholders’ equity section of its balance
sheet. Immediately after the stock issue, this section of Norek’s balance sheet
would appear as follows:
Contributed capital
Common stock, $10 par value, 10,000 shares
authorized, 5,000 shares issued and outstanding $50,000
Additional paid-in capital 10,000
Total contributed capital $60,000
Retained earnings —
Total stockholders’ equity $60,000
536 CHAPTER 12 Contributed Capital
If a corporation issues stock for less than par value, an account called Dis-
count on Capital Stock is debited for the difference. The issuance of stock at a
discount rarely occurs; it is illegal in many states.
No-Par Stock
Most states require that all or part of the proceeds from a corporation’s issuance
Study Note
of no-par stock be designated as legal capital, which cannot be used unless the
When no-par stock has a corporation is liquidated. The purpose of this requirement is to protect the cor-
stated value, the stated value poration’s assets for creditors.
serves the same purpose as par Suppose that on January 1, 2011, Norek Corporation issues 5,000 shares of
value in that it represents the no-par common stock at $15 per share. The $75,000 (5,000 shares (cid:6) $15) in
minimum legal capital. proceeds would be recorded as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH COMMON STOCK
Dr. Cr. Dr. Cr.
Jan. 1 75,000 Jan. 1 75,000
A (cid:2) L (cid:3) SE Entry in Journal Form:
(cid:3)75,000 (cid:3)75,000
Dr. Cr.
Jan. 1 Cash 75,000
Common Stock 75,000
Issued 5,000 shares of no-par
common stock for $15 per share
Because the stock does not have a stated or par value, all proceeds of the issue are
credited to Common Stock and are part of the company’s legal capital.
As noted earlier, state laws may require corporations to put a stated value on
each share of stock that they issue. Assuming the same facts as above except that
Norek puts a $10 stated value on each share of its no-par stock, the T account
and entry would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH COMMON STOCK |
Dr. Cr. Dr. Cr.
Jan. 1 75,000 Jan. 1 50,000
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Jan. 1 25,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Jan. 1 Cash 75,000
(cid:3)75,000 (cid:3)50,000 Common Stock 50,000
(cid:3)25,000
Additional Paid-in Capital 25,000
Issued 5,000 shares of
no-par common stock with $10
stated value for $15 per share
Issuance of Common Stock 537
Notice that the legal capital credited to Common Stock is the stated value decided
by Norek’s board of directors. Also note that the Additional Paid-in Capital
account is credited for $25,000, which is the difference between the proceeds
($75,000) and the total stated value ($50,000).
Issuance of Stock for Noncash Assets
A corporation may issue stock in return for assets or services other than cash.
Transactions of this kind usually involve a corporation’s exchange of stock for
land or buildings or for the services of attorneys and others who help organize
the corporation. In such cases, the problem is to determine the dollar amount at
which the exchange should be recorded.
A corporation’s board of directors has the right to determine the fair mar-
Study Note kket value of the assets or services that the corporation receives in exchange for
iits stock. Generally, such a transaction is recorded at the fair market value of
In establishing the fair market
tthe stock that the corporation is giving up. If the stock’s fair market value can-
value of property that a
nnot be determined, the fair market value of the assets or services received can
corporation exchanges for stock,
bbe used.
a board of directors cannot be
For example, suppose that when Norek Corporation was formed on January 1,
arbitrary; it must use all the
22011, its attorney agreed to accept 200 shares of its $10 par value common
information at its disposal.
sstock for services rendered. At that time, the market value of the stock could not
bbe determined. However, for similar services, the attorney would have charged
NNorek $3,000. The T account and entry to record this noncash transaction is
as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
START-UP AND ORGANIZATION COSTS
Dr. Cr.
Jan. 1 3,000
COMMON STOCK
Dr. Cr.
Jan. 1 2,000
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Jan. 1 1,000
A (cid:2) L (cid:3) SE Entry in Journal Form:
(cid:4)3,000
Dr. Cr.
(cid:3)2,000
(cid:3)1,000 Jan. 1 Start-up and Organization Costs 3,000
Common Stock 2,000
Additional Paid-in Capital 1,000
Issued 200 shares of $10 par
value common stock for
attorney’s services
538 CHAPTER 12 Contributed Capital
Now suppose that two years later, Norek Corporation exchanged 500 shares
of its $10 par value common stock for a piece of land. At the time of the exchange,
Norek’s stock was selling on the market for $16 per share. The following
T account and entry records this exchange:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
LAND COMMON STOCK
Dr. Cr. Dr. Cr.
Jan. 1 8,000 Jan. 1 5,000
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Jan. 1 3,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Jan. 1 Land 8,000
(cid:3)8,000 (cid:3)5,000
Common Stock 5,000
(cid:3)3,000
Additional Paid-in Capital 3,000
Issued 500 shares of $10 par value
common stock with a market value
of $16 per share for a piece of land
STOP
& APPLY
Arena Company is authorized to issue 10,000 shares of common stock. The company sold
1,000 shares at $10 per share. Prepare entries in journal form to record the sale of stock for cash
under each of the following independent alternatives: (1) The stock has a par value of $2, and
(2) the stock has no-par value but a stated value of $1 per share.
SOLUTION
1. The stock has a par value of $2. Dr. Cr.
Cash 10,000
Common Stock 2,000
Additional Paid-in Capital 8,000
Issued 1,000 shares of $2 par value common stock at $10 per share
2. The stock has a no-par value but has a stated value of $1.
Cash 10,000
Common Stock 1,000
Additional Paid-in Capital 9,000
Issued 1,000 shares of no-par value common stock with a stated
value of $1 at $10 per share
Accounting for Treasury Stock 539
Accounting for
As we noted earlier, treasury stock is stock that the issuing company has reac- |
Treasury Stock quired, usually by purchasing shares on the open market. Although repurchasing
its own stock can be a severe drain on a corporation’s cash, it is common prac-
tice. In a recent year, 386, or 64 percent, of 600 large companies held treasury
LO5 Account for treasury stock.
stock.13
Among the reasons a company may want to buy back its own stock are the
Study Note following:
Treasury stock is not the same
(cid:2) It may want stock to distribute to employees through stock option plans.
as unissued stock. Treasury stock
represents shares that have (cid:2) It may be trying to maintain a favorable market for its stock.
been issued but are no longer
outstanding. Unissued shares, (cid:2) It may want to increase its earnings per share or stock price per share.
on the other hand, have never
been in circulation. (cid:2) It may want to have additional shares of stock available for purchasing other
companies.
(cid:2) It may want to prevent a hostile takeover.
A purchase of treasury stock reduces a company’s assets and stockholders’
equity. It is not considered a purchase of assets, as the purchase of shares in
another company would be. A company can hold treasury shares for an indefinite
period or reissue or retire them. Treasury shares have no rights until they are reis-
sued. Like unissued shares, they do not have voting rights, rights to dividends, or
rights to assets during liquidation of the company. However, there is one major
difference between unissued shares and treasury shares. A share of stock issued at
par value or greater and that was reacquired as treasury stock can be reissued at
less than par value without negative results.
Purchase of Treasury Stock
When treasury stock is purchased, it is recorded at cost. The par value, stated
value, or original issue price of the stock is ignored. As noted above, the purchase
reduces both a firm’s assets and its stockholders’ equity. For example, suppose
that on September 15, Amber Corporation purchases 2,000 shares of its com-
mon stock on the market at a price of $50 per share. The purchase would be
recorded as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH TREASURY STOCK–COMMON
Dr. Cr. Dr. Cr.
Sept. 15 100,000 Sept. 15 100,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Sept. 15 Treasury Stock–Common 100,000
(cid:4)100,000 (cid:4)100,000
Cash 100,000
Acquired 2,000 shares of the
company’s common stock for
$50 per share
540 CHAPTER 12 Contributed Capital
FOCUS ON BUSINESS PRACTICE
Are Share Buybacks Really Good?
Corporate America sets new records for share buybacks was experiencing record highs. Also, what is often not
every year: $10 billion in 1991; $123 billion in 2000; $197 stated publicly is that many shares do not stay out of
billion in 2004; and an estimated $500 billion in 2007. public hands because the companies recycle the stock
Home Depot, Inc., Wal-Mart, Inc., General Electric, into generous stock options for management and thus
Johnson & Johnson, and Microsoft, along with many do not achieve the stated goal of reducing outstanding
other companies, spent billions to boost their stock shares. Estimates are that perhaps half of the stock pur-
prices—but to no avail. The stated aim is to boost stock chased is little more than a “backdoor compensation”
prices and earnings per share by reducing the supply of for employees. Furthermore, many companies have bor-
stock in public hands. rowed money to repurchase stock, thereby increasing
According to renowned investor Warren Buffett and their debt to equity ratios. These companies later suffered
others, share buybacks are ill-advised. Many of the pur- reductions in their credit ratings and severe declines in
chases in 2007, for example, occurred when the market their stock prices.14
The stockholders’ equity section of Amber’s balance sheet shows the cost
Study Note
of the treasury stock as a deduction from the total of contributed capital and
Because treasury stock reduces retained earnings:
stockholders’ equity—the
Contributed capital
denominator of the return |
Common stock, $5 par value, 200,000 shares
on equity ratio—the return
authorized, 60,000 shares issued, 58,000 shares
on equity will increase when
outstanding $ 300,000
treasury shares are purchased
even though there is no Additional paid-in capital 60,000
increase in earnings. Total contributed capital $ 360,000
Retained earnings 1,800,000
Total contributed capital and retained earnings $2,160,000
Less treasury stock–common (2,000 shares at cost) 100,000
Total stockholders’ equity $2,060,000
Notice that the number of shares issued, and therefore the legal capital, has not
changed. However, the number of shares outstanding has decreased as a result of
the transaction.
Sale of Treasury Stock
Treasury shares can be sold at cost, above cost, or below cost. For example, sup-
pose that on November 15, Amber Corporation sells its 2,000 treasury shares for
$50 per share. The following T account and entry records the transaction:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH TREASURY STOCK–COMMON
Dr. Cr. Dr. Cr.
Nov. 15 100,000 Nov. 15 100,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Nov. 15 Cash 100,000
(cid:3)100,000 (cid:3)100,000 Treasury Stock–Common 100,000
Reissued 2,000 shares of
treasury stock for $50 per share
Accounting for Treasury Stock 541
When treasury shares are sold for an amount greater than their cost, the excess
of the sales price over cost should be credited to Paid-in Capital, Treasury Stock.
No gain should be recorded.
For instance, suppose that on November 15, Amber Corporation sells its
2,000 treasury shares for $60 per share. The T account and entry for the reissue
would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH TREASURY STOCK–COMMON
Dr. Cr. Dr. Cr.
Nov. 15 120,000 Nov. 15 100,000
PAID-IN CAPITAL–TREASURY STOCK
Dr. Cr.
Nov. 15 20,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Nov. 15 Cash 120,000
(cid:3)120,000 (cid:3)100,000
Treasury Stock–Common 100,000
(cid:3)20,000
Paid-in Capital–Treasury Stock 20,000
Sold 2,000 shares of treasury
stock for $60 per share; cost
was $50 per share
When treasury shares are sold below their cost, the difference is deducted
Study Note from Paid-in Capital, Treasury Stock. If this account does not exist or if its bal-
ance is insufficient to cover the excess of cost over the reissue price, Retained
Gains and losses on the reissue
Earnings absorbs the excess. No loss is recorded.
of treasury stock are never
For example, suppose that on September 15, Amber bought 2,000 shares
recognized as such. Instead, the
Retained Earnings and Paid-in of its common stock on the market at a price of $50 per share. On October 15,
Capital, Treasury Stock accounts the company sold 800 shares for $60 per share, and on December 15, it sold the
are used. remaining 1,200 shares for $42 per share. The T accounts and entries for these
three transactions are as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH TREASURY STOCK–COMMON
Dr. Cr. Dr. Cr.
Sept. 15 100,000 Sept. 15 100,000
A (cid:2) L (cid:3) SE Entry in Journal Form:
(cid:4)100,000 (cid:4)100,000
Dr. Cr.
Sept. 15 Treasury Stock–Common 100,000
Cash 100,000
Purchased 2,000 shares of
treasury stock at $50 per share
542 CHAPTER 12 Contributed Capital
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH TREASURY STOCK–COMMON
Dr. Cr. Dr. Cr.
Oct. 15 48,000 Oct. 15 40,000
PAID-IN CAPITAL–TREASURY STOCK
Dr. Cr.
Oct. 15 8,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Oct. 15 Cash 48,000
(cid:3)48,000 (cid:3)40,000 Treasury Stock–Common 40,000
(cid:3)8,000
Paid-in Capital–Treasury Stock 8,000
Sold 800 shares of treasury stock for
$60 per share; cost was $50 per share
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH PAID-IN CAPITAL–TREASURY STOCK
Dr. Cr. Dr. Cr.
Dec. 15 50,400 Dec. 15 8,000
RETAINED EARNINGS
Dr. Cr.
Dec. 15 1,600
TREASURY STOCK–COMMON
Dr. Cr.
Dec. 15 60,000
A (cid:2) L (cid:3) SE Entry in Journal Form:
(cid:3)50,400 (cid:4)8,000
Dr. Cr.
(cid:4)1,600
(cid:3)60,000 Dec. 15 Cash 50,400
Paid-in Capital–Treasury Stock 8,000
Retained Earnings 1,600 |
Treasury Stock–Common 60,000
Sold 1,200 shares of treasury stock
for $42 per share; cost was $50 per share
In the entry for the December 15 transaction, Retained Earnings is debited for
Study Note
$1,600 because the 1,200 shares were sold for $9,600 less than cost. That amount
Retained Earnings is debited is $1,600 greater than the $8,000 of paid-in capital generated by the sale of the
only when the Paid-in Capital, 400 shares of treasury stock on October 15.
Treasury Stock account has been
Retirement of Treasury Stock
depleted. In this case, the credit
balance of $8,000 is completely
If a company decides that it will not reissue treasury stock, it can, with the
exhausted before Retained
approval of its stockholders, retire the stock. When shares of stock are retired, all
Earnings absorbs the excess.
items related to those shares are removed from the associated capital accounts.
If the cost of buying back the treasury stock is less than the company received
when it issued the stock, the difference is recorded in Paid-in Capital, Retire-
ment of Stock. If the reacquisition cost is more than was received when the stock
was first issued, the difference is a reduction in stockholders’ equity and is deb-
ited to Retained Earnings. For instance, suppose that on November 15, Amber
Accounting for Treasury Stock 543
Corporation decides to retire the 2,000 shares of stock that it bought back for
$100,000. If the $5 par value common stock was originally issued at $6 per
share, this entry would record the retirement:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
COMMON STOCK
Dr. Cr.
Nov. 15 10,000
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Nov. 15 2,000
RETAINED EARNINGS
Dr. Cr.
Nov. 15 88,000
TREASURY STOCK–COMMON
Dr. Cr.
Nov. 15 100,000
Entry in Journal Form:
Dr. Cr.
A (cid:2) L (cid:3) SE Nov. 15 Common Stock 10,000
(cid:4)10,000 Additional Paid-in Capital 2,000
(cid:4)2,000
Retained Earnings 88,000
(cid:4)88,000
Treasury Stock–Common 100,000
(cid:3)100,000
Retired 2,000 shares that cost $50 per
share and were issued originally at $6 per share
STOP
& APPLY
Prepare in journal form the entries necessary to record the following stock transactions of the
Paulo Company during 2011:
May 1 P urchased 5,000 shares of its own $1 par value common stock for $10 per share, the
current market price.
17 Sold 1,000 shares of treasury stock purchased on May 1 for $11 per share.
SOLUTION
Dr. Cr.
May 1
Treasury Stock 50,000
Cash 50,000
Purchased 5,000 shares of Paulo Company’s
common stock at $10 per share
May 17
Cash 11,000
Treasury Stock 10,000
Paid-in Capital, Treasury Stock 1,000
Sold 1,000 shares of treasury stock
for $11 per share
544 CHAPTER 12 Contributed Capital
(cid:2) GAMMON, INC.: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we posed these questions:
• Why might Gammon’s founders have chosen to form a corporation rather than a
partnership?
• How should a corporation account for its stock transactions and dividends?
• What measures should stockholders use to evaluate the return on their investments?
Gammon’s founders might have chosen the corporate form of business rather than
a partnership because it is relatively easy for a corporation to raise capital by issuing
stock. Moreover, this approach to financing does not burden a company with debts and
interest payments. Among the several other advantages that corporations have over
partnerships are separate legal entity, ease of transfer of ownership, and continuous
Stock Transactions and existence.
Stockholders’ Equity As we noted in the Decision Point, Gammon’s state charter authorized it to issue
2 million shares of $1 par value common stock and 50,000 shares of 4 percent, $20 par
LO1 LO2
value cumulative and convertible preferred stock. We also noted that Gammon engaged
LO4
in a number of transactions involving stock and dividends during 2010. These transac-
tions were as follows:
Feb. 1 Issued 200,000 shares of common stock for $250,000.
15 Issued 6,000 shares of common stock for accounting and legal services.
The bills for these services totaled $7,200.
Mar. 15 Issued 240,000 shares of common stock to Tom Lee in exchange for a |
building and land appraised at $200,000 and $50,000, respectively.
Apr. 2 Purchased 40,000 shares of common stock for the treasury at $1.25
per share from a person who changed her mind about investing in the
company.
July 1 Issued 50,000 shares of preferred stock for $1,000,000.
Sept. 30 Sold 20,000 of the shares in the treasury for $1.50 per share.
Dec. 31 Fisher’s board of directors declared dividends of $49,820 payable on
January 15, 2011, to stockholders of record on January 7. Dividends
included preferred stock dividends of $20,000 for one-half year.
For the period ended December 31, 2010, Gammon reported net income of $80,000
and earnings per common share of $0.14. At December 31, the market price per com-
mon share was $1.60.
Required
1. Record Gammon’s stock transactions in T accounts.
2. Prepare the stockholders’ equity section of Gammon’s balance sheet as of
December 31, 2010. (Hint: Use net income and dividends to calculate retained
earnings.)
3. Calculate Gammon’s dividends yield on common stock, price/earnings ratio of
common stock, and return on equity.
Gammon, Inc.: Review Problem 545
Answers to
1. Entries in T accounts:
Review Problem
2. Stockholders’ equity section of the balance sheet:
546 CHAPTER 12 Contributed Capital
3. Dividends yield on common stock, price/earnings ratio of common stock, and
return on equity:
Dividends per Share (cid:2) _ __C_o_m_m__o _ n_ _S_to__ck_ _ D_i _v_id_e_n_d_ __ (cid:2) _ $_2_9_,8_2_0_ (cid:2) $0.07
Common Shares Outstanding 426,000
Dividends Yield (cid:2) _ _D _iv _i _d _e _n _d _s _ p __e _r _S _h _a _re _ _ (cid:2) _ $_0_.0_7_ (cid:2) 4.4%
Market Price per Share $1.60
Price/Earnings Ratio (cid:2) _ M _a _r _k _e _t _P _r _ic _ e _ p __e _r _S _h _a _r e _ (cid:2) _ $_1_.6_0_ (cid:2) 11.4 times
Earnings per Share $0.14
The opening balance of stockholders’ equity on February 1, 2010, was $250,000.
Return on Equity (cid:2) _ _______N_ e_t_ _In_c_o_m__e _ _______
Average Stockholders’ Equity
(cid:2) _ ($_ 1_ ,_ 5_ 1_ 7_ ,3_
8
_ _ 0$_ 8 (cid:3)_0_, 0 $_0 2_0 5_ 0_ _ ,0_ 0_ 0_ )_ (cid:5)__ 2_
(cid:2) _ $_8_0_,_0_0_0_
$883,690
(cid:2) 9.1%
Stop & Review 547
STOP
& REVIEW
LO1 Identify and explain Contributed capital is a critical component in corporate financing. Managing
the management contributed capital requires an understanding of the advantages and disadvan-
issues related to con- tages of the corporate form of business and of the issues involved in using equity
tributed capital. financing. Managers must also know how to determine dividend policies and
how to evaluate these policies using dividends yield, return on equity, and the
price/earnings ratio. The liability for payment of dividends arises on the date
the board of directors declares a dividend. The declaration is recorded with a
debit to Dividends and a credit to Dividends Payable. The record date—the date
on which ownership of the stock, and thus of the right to receive a dividend,
is determined—requires no entry. On the payment date, the Dividends Payable
account is eliminated, and the Cash account is reduced. Another issue involved in
managing contributed capital is using stock options as compensation.
LO2 Identify the compo- The stockholders’ equity section of a corporate balance sheet usually has at least
nents of stockholders’ three components: contributed capital, retained earnings, and treasury stock.
equity. Contributed capital consists of money raised through stock issues. A corporation
can issue two types of stock: common stock and preferred stock. Common stock-
holders have voting rights; they also share in the earnings of the corporation.
Preferred stockholders usually have preference over common stockholders in one
or more areas. Retained earnings are reinvested in the corporation; they represent
stockholders’ claims to assets resulting from profitable operations. Treasury stock
is stock that the issuing corporation has reacquired. It is treated as a deduction
from stockholders’ equity.
LO3 Identify the characteris- Preferred stock generally gives its owners first right to dividend payments. Only |
tics of preferred stock. after these stockholders have been paid can common stockholders receive any por-
tion of a dividend. If the preferred stock is cumulative and dividends are in arrears,
a corporation must pay the amount in arrears to preferred stockholders before it
pays any dividends to common stockholders. Preferred stockholders also usually
have preference over common stockholders in terms of their claims to corporate
assets if the corporation is liquidated. In addition, preferred stock may be convert-
ible to common stock, and it is often callable at the option of the corporation.
LO4 Account for the issuance Corporations normally issue their stock in exchange for cash or other assets. Most
of stock for cash and states require corporations to issue stock at a minimum value called legal capital.
other assets. Legal capital is represented by the stock’s par or stated value.
When stock is issued for cash at par or stated value, Cash is debited and Com-
mon Stock or Preferred Stock is credited. When stock is sold at an amount greater
than par or stated value, the excess is recorded in Additional Paid-in Capital.
When stock is issued for noncash assets, the general rule is to record the stock
at its market value. If this value cannot be determined, the fair market value of the
asset received is used to record the transaction.
LO5 Account for Treasury stock is stock that the issuing company has reacquired. A company may
treasury stock. buy back its own stock for several reasons, including a desire to create stock option
plans, maintain a favorable market for the stock, increase earnings per share, or
purchase other companies. Treasury stock is recorded at cost and is deducted
from stockholders’ equity. It can be reissued or retired. It is similar to unissued
stock in that it does not have rights until it is reissued.
548 CHAPTER 12 Contributed Capital
REVIEW of Concepts and Terminology
The following concepts and terms Initial public offering (IPO) 519 Share of stock 520 (LO1)
were introduced in this chapter: (Decision Point)
Start-up and organization
Articles of incorporation 520 (LO1) Issued shares 530 (LO2) costs 523 (LO1)
Authorized shares 530 (LO2) Legal capital 523 (LO1) Stated value 535 (LO4)
Callable preferred stock 533 (LO3) Liquidating dividend 524 (LO1) Stock certificates 522 (LO1)
Common stock 529 (LO2) Noncumulative preferred stock Stock option plans 527 (LO1)
531 (LO3)
Convertible preferred stock Treasury stock 526 (LO1)
532 (LO3) No-par stock 534 (LO4)
Underwriter 523 (LO1)
Cumulative preferred stock Outstanding shares 530 (LO2)
531 (LO3) Par value 522 (LO1) Key Ratios
Declaration date 524 (LO1) Payment date 524 (LO1) Dividends yield 525 (LO1)
Dividends 520 (LO1) Preferred stock 529 (LO2) Price/earnings (P/E) ratio
Dividends in arrears 531 (L03) 526 (LO1)
Record date 524 (LO1)
Double taxation 522 (LO1) Return on equity 526 (LO1)
Residual equity 529 (LO2)
Ex-dividend 524 (LO1)
Chapter Assignments 549
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Management Issues
SE 1. Indicate whether each of the following actions is related to (a) managing
under the corporate form of business, (b) using equity financing, (c) determining
dividend policies, (d) evaluating performance using return on equity, or (e) issuing
stock options:
1. Considering whether to make a distribution to stockholders
2. Controlling day-to-day operations
3. Determining whether to issue preferred or common stock
4. Compensating management based on the company’s meeting or exceeding
the targeted return on equity
5. Compensating employees by giving them the right to purchase shares at a
given price
6. Transferring shares without the approval of other owners
LO1 Advantages and Disadvantages of a Corporation
SE 2. Identify whether each of the following characteristics is an advantage or a
disadvantage of the corporate form of business:
1. Ease of transfer of ownership 4. Lack of mutual agency
2. Taxation 5. Government regulation
3. Separate legal entity 6. Continuous existence
LO1 Effect of Start-up and Organization Costs |
SE 3. At the beginning of 2011, Patel Company incurred the following
start-up and organization costs: (1) attorneys’ fees with a market value
of $20,000, paid with 12,000 shares of $1 par value common stock, and
(2) incorporation fees of $12,000. Calculate total start-up and organization
costs. What will be the effect of these costs on the income statement and
balance sheet?
LO1 Exercise of Stock Options
SE 4. On June 6, Aretha Dafoe exercised her option to purchase 20,000 shares
of Shalom Company $1 par value common stock at an option price of $8. The
market price per share was $8 on the grant date and $36 on the exercise date.
(1) When must the fair value of the option be estimated? (2) Is the market price
of the stock on the exercise date most relevant to Dafoe or to Shalom Company?
LO2 Stockholders’ Equity
SE 5. Prepare the stockholders’ equity section of Fina Corporation’s balance sheet
from the following accounts and balances on December 31, 2011:
Common Stock, $10 par value, 30,000 shares authorized,
20,000 shares issued, and 19,500 shares outstanding $200,000
Additional Paid-in Capital 100,000
Retained Earnings 15,000
Treasury Stock, Common (500 shares, at cost) 7,500
550 CHAPTER 12 Contributed Capital
LO1 Cash Dividends
SE 6. Tone Corporation has authorized 200,000 shares of $1 par value common
stock, of which 160,000 are issued and 140,000 are outstanding. On May 15,
the board of directors declared a cash dividend of $0.20 per share, payable on
June 15 to stockholders of record on June 1. Prepare the entries in T accounts, as
necessary, for each of the three dates.
LO3 Preferred Stock Dividends with Dividends in Arrears
SE 7. The Ferris Corporation has 2,000 shares of $100, 8 percent cumulative pre-
ferred stock outstanding and 40,000 shares of $1 par value common stock out-
standing. In the company’s first three years of operation, its board of directors
paid cash dividends as follows: 2010, none; 2011, $40,000; and 2012, $80,000.
Determine the total cash dividends and dividends per share paid to the preferred
and common stockholders during each of the three years.
LO4 Issuance of Stock
SE 8. Rattich Company is authorized to issue 50,000 shares of common stock.
The company sold 2,500 shares at $12 per share. Prepare entries in journal form
to record the sale of stock for cash under each of the following independent alter-
natives: (1) The stock has a par value of $5, and (2) the stock has no par value but
a stated value of $1 per share.
LO4 Issuance of Stock for Noncash Assets
SE 9. Embossing Corporation issued 32,000 shares of its $1 par value common
stock in exchange for land that had a fair market value of $200,000. Prepare in
journal form the entries necessary to record the issuance of the stock for the land
under each of these conditions: (1) The stock was selling for $7 per share on the
day of the transaction; (2) management attempted to place a value on the com-
mon stock but could not do so.
LO5 Treasury Stock Transactions
SE 10. Prepare in journal form the entries necessary to record the following stock
transactions of the Seoul Company during 2011:
Oct. 1 Purchased 2,000 shares of its own $2 par value common stock
for $20 per share, the current market price.
17 S old 500 shares of treasury stock purchased on October 1 for
$25 per share.
LO5 Retirement of Treasury Stock
SE 11. On October 28, 2011, the Seoul Company (SE 10) retired the remaining
1,500 shares of treasury stock. The shares were originally issued at $5 per share.
Prepare the necessary entry in journal form.
Exercises
LO1 LO2 Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. Why are most large companies established as corporations rather than as
partnerships?
2. Why do many companies like to give stock options as compensation?
3. If an investor sells shares after the declaration date but before the date of
record, does the seller still receive the dividend?
4. Why does a company usually not want to issue all its authorized shares?
Chapter Assignments 551
LO3 LO4 Discussion Questions |
LO5 E 2. Develop brief answers to each of the following questions:
1. Why would a company want to issue callable preferred stock?
2. What arguments can you give for treating preferred stock as debt rather than
equity when carrying out financial analysis?
3. What relevance does par value or stated value have to a financial ratio, such as
return on equity or debt to equity?
4. Why is treasury stock not considered an investment or an asset?
LO1 Dividends Yield and Price/Earnings Ratio
E 3. In 2011, Rainbow Corporation earned $8.80 per share and paid a dividend
of $4.00 per share. At year end, the price of its stock was $132 per share. Calcu-
late the dividends yield and the price/earnings ratio.
LO2 Stockholders’ Equity
E 4. The following accounts and balances are from the records of Stuard Corpo-
ration on December 31, 2011:
Preferred Stock, $100 par value, 9 percent cumulative,
10,000 shares authorized, 3,000 shares issued and
outstanding $300,000
Common Stock, $12 par value, 45,000 shares
authorized, 15,000 shares issued, and 14,250 shares
outstanding 180,000
Additional Paid-in Capital 97,000
Retained Earnings 11,500
Treasury Stock, Common (750 shares, at cost) 15,000
Prepare the stockholders’ equity section of Stuard Corporation’s balance sheet as
of December 31, 2011.
LO2 LO3 Characteristics of Common and Preferred Stock
E 5. Indicate whether each of the following characteristics is more closely associ-
ated with common stock (C) or preferred stock (P):
1. Often receives dividends at a set rate
2. Is considered the residual equity of a company
3. Can be callable
4. Can be convertible
5. More likely to have dividends that vary in amount from year to year
6. Can be entitled to receive dividends not paid in past years
7. Likely to have full voting rights
8. Receives assets first in liquidation
9. Generally receives dividends before other classes of stock
LO2 LO4 Stock Entries Using T Accounts; Stockholders’ Equity
E 6. Shark School Supply Corporation was organized in 2011. It was authorized
to issue 200,000 shares of no-par common stock with a stated value of $5 per
share, and 40,000 shares of $100 par value, 6 percent noncumulative p referred
stock. On March 1, the company issued 60,000 shares of its c ommon stock for
$15 per share and 8,000 shares of its preferred stock for $100 per share.
1. Record the issuance of the stock in T accounts.
2. Prepare the stockholders’ equity section of Shark School Supply Corpora-
tion’s balance sheet as it would appear immediately after the company issued
the common and preferred stock.
552 CHAPTER 12 Contributed Capital
LO1 Cash Dividends
E 7. Pine Corporation secured authorization from the state for 100,000 shares
of $10 par value common stock. It has 40,000 shares issued and 35,000 shares
outstanding. On June 5, the board of directors declared a $0.25 per share cash
dividend to be paid on June 25 to stockholders of record on June 15. Prepare
entries in T accounts to record these events.
LO1 LO5 Cash Dividends
E 8. Avena Corporation has 250,000 authorized shares of $1 par value common
stock, of which 100,000 are issued, including 10,000 shares of treasury stock. On
October 15, the corporation’s board of directors declared a cash dividend of $0.50
per share payable on November 15 to stockholders of record on November 1.
Prepare entries in T accounts for each of the three dates.
LO3 Cash Dividends with Dividends in Arrears
E 9. Ghana Corporation has 10,000 shares of its $100 par value, 7 percent
cumulative preferred stock outstanding and 50,000 shares of its $1 par value
common stock outstanding. In Ghana’s first four years of operation, its board
of directors paid cash dividends as follows: 2009, none; 2010, $120,000;
2011, $140,000; 2012, $140,000. Determine the dividends per share and
total cash dividends paid to the preferred and common stockholders during
each of the four years.
LO3 Cash Dividends on Preferred and Common Stock
E 10. Dylan Corporation pays dividends at the end of each year. The dividends that
it paid for 2010, 2011, and 2012 were $80,000, $60,000, and $180,000, respec- |
tively. Calculate the total amount of dividends Dylan Corporation paid in each of
these years to its common and preferred stockholders under both of the following
capital structures: (1) 20,000 shares of $100 par, 6 percent noncumulative preferred
stock and 60,000 shares of $10 par common stock; (2) 10,000 shares of $100 par,
7 percent cumulative preferred stock and 60,000 shares of $10 par common stock.
Dylan Corporation had no dividends in arrears at the beginning of 2010.
LO4 Issuance of Stock
E 11. Powet Net Company is authorized to issue 50,000 shares of common stock.
On August 1, the company issued 2,500 shares at $25 per share. Prepare entries
in journal form to record the issuance of stock for cash under each of the follow-
ing alternatives:
1. The stock has a par value of $25.
2. The stock has a par value of $10.
3. The stock has no par value.
4. The stock has a stated value of $1 per share.
LO4 Issuance of Stock for Noncash Assets
E 12. On July 1, 2011, Kosa, a new corporation, issued 20,000 shares of its com-
mon stock to finance a corporate headquarters building. The building has a fair
market value of $600,000 and a book value of $400,000. Because Kosa is a new
corporation, it is not possible to establish a market value for its common stock.
Record the issuance of stock for the building, assuming the following conditions:
(1) the par value of the stock is $10 per share; (2) the stock is no-par stock; and
(3) the stock has a stated value of $4 per share.
Chapter Assignments 553
LO5 Treasury Stock Transactions
E 13. Record in T accounts the following stock transactions of Pigua Corpora-
tion, which represent all the company’s treasury stock transactions during 2011:
May 5 Purchased 1,600 shares of its own $2 par value common stock
for $40 per share, the current market price.
17 S old 600 shares of treasury stock purchased on May 5 for
$44 per share.
21 S old 400 shares of treasury stock purchased on May 5 for
$40 per share.
28 Sold the remaining 600 shares of treasury stock purchased on
May 5 for $38 per share.
LO5 Treasury Stock Transactions Including Retirement
E 14. Record in T accounts the following stock transactions of Lopez Corpora-
tion, which represent all its treasury stock transactions for the year:
June 1 Purchased 2,000 shares of its own $15 par value common stock
for $35 per share, the current market price.
10 Sold 500 shares of treasury stock purchased on June 1 for $40
per share.
20 Sold 700 shares of treasury stock purchased on June 1 for $29
per share.
30 Retired the remaining shares purchased on June 1. The original
issue price was $21 per share.
Problems
LO1 LO2 Common Stock Transactions and Stockholders’ Equity
LO4
P 1. On March 1, 2011, Dora Corporation began operations with a charter from
the state that authorized 50,000 shares of $4 par value common stock. Over the
next quarter, the firm engaged in the transactions that follow.
Mar. 1 Issued 15,000 shares of common stock, $100,000.
2 P aid fees associated with obtaining the charter and starting up
and organizing the corporation, $12,000.
Apr. 10 Issued 6,500 shares of common stock, $65,000.
15 Purchased 2,500 shares of common stock, $25,000
May 31 The board of directors declared a $0.20 per share cash dividend
to be paid on June 15 to shareholders of record on June 10.
Required
1. Record the above transactions in T accounts.
2. Prepare the stockholders’ equity section of Dora Corporation’s balance sheet
on May 31, 2011. Net income earned during the first quarter was $15,000.
User insight (cid:2) 3. What effect, if any, will the cash dividend declaration on May 31 have on Dora
Corporation’s net income, retained earnings, and cash flows?
LO1 LO3 Preferred and Common Stock Dividends and Dividends Yield
P 2. The Rago Corporation had the following stock outstanding from 2009
through 2012:
Preferred stock: $100 par value, 8 percent cumulative, 5,000 shares authorized,
issued, and outstanding
Common stock: $10 par value, 100,000 shares authorized, issued, and outstanding
554 CHAPTER 12 Contributed Capital
The company paid $30,000, $30,000, $94,000, and $130,000 in divi- |
dends during 2009, 2010, 2011, and 2012, respectively. The market price per
common share was $7.25 and $8.00 per share at the end of years 2011 and
2012, respectively.
Required
1. Determine the dividends per share and the total dividends paid to common
stockholders and preferred stockholders in 2009, 2010, 2011, and 2012.
2. Perform the same computations, with the assumption that the preferred stock
was noncumulative.
3. Calculate the 2011 and 2012 dividends yield for common stock, using the
dividends per share computed in requirement 2.
User insight (cid:2) 4. How are cumulative preferred stock and noncumulative preferred stock simi-
lar to long-term bonds? How do they differ from long-term bonds?
LO1 LO2 Comprehensive Stockholders’ Equity Transactions
LO3 LO4 LO5 P 3. In January 2010, Janas Corporation was organized and authorized to issue
1,000,000 shares of no-par common stock and 25,000 shares of 5 percent, $50
par value, noncumulative preferred stock. The stock-related transactions for the
first year’s operations were as follows:
Account
Debited Credited
Account Dollar Account Dollar
Number Amount Number Amount
Jan. 19 Sold 7,500 shares of
common stock for
$15,750. State law
requires a minimum of 310 $7,500
$1 stated value per share. 110 $15,750 312 $8,250
21 I ssued 2,500 shares of
common stock to attor-
neys and accountants for
services valued at $5,500
and provided during the
organization of the cor-
poration. ____ ________ ____ ________
Feb. 7 Issued 15,000 shares
of common stock for
a building that had
an appraised value of
$39,000. ____ ________ ____ ________
Mar. 22 Purchased 5,000 shares
of its common stock at
$3 per share. ____ ________ ____ ________
July 15 Issued 2,500 shares
of common stock to
employees under a stock
option plan that allows
any employee to buy
shares at the current mar-
ket price, which is now
$3 per share. ____ ________ ____ ________
Chapter Assignments 555
Aug. 1 Sold 1,250 shares of
treasury stock for $4 per
share. ____ ________ ____ ________
Sept. 1 Declared a cash dividend
of $0.15 per common
share to be paid on Sep-
tember 25 to stockhold-
ers of record on Septem-
ber 15. ____ ________ ____ ________
15 Date of record for cash
dividends. ____ ________ ____ ________
25 Paid cash dividends to
stockholders of record on
September 15. ____ ________ ____ ________
Oct. 30 Issued 2,000 shares of
common stock for a piece
of land. The stock was
selling for $3 per share,
and the
land had a fair market
value of $6,000. ____ ________ ____ ________
Dec. 15 Issued 1,100 shares of
preferred stock for $50
per share. ____ ________ ____ ________
Required
1. For each of the above transactions, enter in the blanks provided the account
numbers and dollar amounts (as shown in the example) for the account(s)
debited and credited. The account numbers are listed below.
110 Cash 312 Additional Paid-in Capital
120 Land 313 Paid-in Capital, Treasury Stock
121 Building 340 Retained Earnings
220 Dividends Payable 341 Dividends
305 Preferred Stock 350 Treasury Stock, Common
310 Common Stock 510 Start-up and Organization Costs
User insight (cid:2) 2. Why is the stockholders’ equity section of the balance sheet an important
consideration in analyzing the performance of a company?
LO1 LO2 LO3 Comprehensive Stockholders’ Equity Transactions and Stockholders’ Equity
LO4 LO5
P 4. Kras, Inc., was organized and authorized to issue 50,000 shares of $100
par value, 9 percent preferred stock and 50,000 shares of no-par, $5 stated
value common stock on July 1, 2011. Stock-related transactions for Kras are
as follows:
July 1 Issued 10,000 shares of common stock at $11 per share.
1 Issued 500 shares of common stock at $11 per share for services
rendered in connection with the organization of the company.
2 Issued 1,000 shares of preferred stock at par value for cash.
10 Issued 2,500 shares of common stock for land on which the
asking price was $35,000. Market value of the stock was $12.
Management wishes to record the land at the market value of
the stock.
556 CHAPTER 12 Contributed Capital
Aug. 2 P urchased 1,500 shares of its common stock at $13 per share. |
10 Declared a cash dividend for one month on the outstanding pre-
ferred stock and $0.02 per share on common stock outstanding,
payable on August 22 to stockholders of record on August 12.
12 Date of record for cash dividends.
22 Paid cash dividends.
Required
1. Record the transactions in journal form.
2. Prepare the stockholders’ equity section of the balance sheet as it would
appear on August 31, 2011. Net income for July was zero and August was
$11,500.
User insight (cid:2) 3. Calculate dividends yield, price/earnings ratio, and return on equity. Assume
earnings per common share are $1.00 and market price per common share
is $20. For beginning stockholders’ equity, use the balance after the July
transactions.
User insight (cid:2) 4. Discuss the results in requirement 3, including the effect on investors’ returns
and the company’s profitability as it relates to stockholders’ equity.
LO1 LO5 Treasury Stock
P 5. The Rolek Company was involved in the following treasury stock transac-
tions during 2010:
a. Purchased 40,000 shares of its $1 par value common stock on the market for
$2.50 per share.
b. Purchased 8,000 shares of its $1 par value common stock on the market for
$2.80 per share.
c. Sold 22,000 shares purchased in a for $65,500.
d. Sold the other 18,000 shares purchased in a for $36,000.
e. Sold 3,000 of the remaining shares of treasury stock for $1.60 per share.
f. Retired all the remaining shares of treasury stock. All shares originally were
issued at $1.50 per share.
Required
1. Record the treasury stock transactions in T accounts.
User insight (cid:2) 2. What is the reasoning behind treating the purchase of treasury stock as a reduc-
tion in stockholders’ equity as opposed to treating it as an investment asset?
Alternate Problems
LO1 LO2 Common Stock Transactions and Stockholders’ Equity
LO4 LO5
P 6. Glass Corporation began operations on September 1, 2011. The corpora-
tion’s charter authorized 150,000 shares of $8 par value common stock. Glass
Corporation engaged in the following transactions during its first quarter:
Sept. 1 I ssued 25,000 shares of common stock, $250,000.
1 P aid an attorney $16,000 to help start up and organize the
corporation and obtain a corporate charter from the state.
Oct. 2 I ssued 40,000 shares of common stock, $480,000.
15 Purchased 5,000 shares of common stock for $75,000.
Nov. 30 D eclared a cash dividend of $0.40 per share to be paid on
December 15 to stockholders of record on December 10.
Chapter Assignments 557
Required
1. Prepare entries in T accounts to record the above transactions.
2. Prepare the stockholders’ equity section of Glass Corporation’s balance sheet
on November 30, 2011. Net income for the quarter was $40,000.
User insight (cid:2) 3. What effect, if any, will the cash dividend declaration on November 30 have
on net income, retained earnings, and cash flows?
LO1 LO3 Preferred and Common Stock Dividends and Dividends Yield
P 7. The Vegas Corporation had both common stock and preferred stock out-
standing from 2010 through 2012. Information about each stock for the three
years is as follows:
Type Par Value Shares Outstanding Other
Preferred $100 20,000 7% cumulative
Common 20 300,000
The company paid $70,000, $400,000, and $550,000 in dividends for 2010
through 2012, respectively. The market price per common share was $15 and
$17 per share at the end of years 2011 and 2012, respectively.
Required
1. Determine the dividends per share and total dividends paid to the common
and preferred stockholders each year.
2. Assuming that the preferred stock was noncumulative, repeat the computa-
tions performed in requirement 1.
3. Calculate the 2011 and 2012 dividends yield for common stock using divi-
dends per share computed in requirement 2.
User insight (cid:2) 4. How are cumulative preferred stock and noncumulative preferred stock simi-
lar to long-term bonds? How do they differ from long-term bonds?
LO1 LO2
Comprehensive Stockholders’ Equity Transactions and Financial Ratios
LO3 LO4 LO5
P 8. Stavski Plastics Corporation was chartered in the Commonwealth of Massa- |
chusetts. The company was authorized to issue 10,000 shares of $100 par value,
6 percent preferred stock and 50,000 shares of no-par common stock. The com-
mon stock has a $2 stated value. The stock-related transactions for the quarter
ended October 31, 2011, were as follows:
Aug. 3 Issued 10,000 shares of common stock at $22 per share.
15 I ssued 8,000 shares of common stock for land. Asking price for
the land was $100,000. Common stock’s market value was $12
per share. Management wishes to record the land at the market
value of the stock.
22 Issued 5,000 shares of preferred stock for $500,000.
Oct. 4 Issued 5,000 shares of common stock for $60,000.
10 P urchased 2,500 shares of common stock for the treasury for
$6,500.
15 D eclared a quarterly cash dividend on the outstanding preferred
stock and $0.10 per share on common stock outstanding, pay-
able on October 31 to stockholders of record on October 25.
25 Date of record for cash dividends.
31 Paid the cash dividends declared on October 15.
558 CHAPTER 12 Contributed Capital
Required
1. Record transactions for the quarter ended October 31, 2011, in T accounts.
2. Prepare the stockholders’ equity section of the balance sheet as of October 31,
2011. Net income for the quarter was $23,000.
User insight (cid:2) 3. Calculate dividends yield, price/earnings ratio, and return on equity. Assume
earnings per common share are $1.97 and market price per common share is
$25. For beginning stockholders’ equity, use the balance after the August
transactions.
User insight (cid:2) 4. Discuss the results in requirement 3, including the effect on investors’ returns
and the firm’s profitability as it relates to stockholders’ equity.
LO1 LO2 Comprehensive Stockholders’ Equity Transactions
LO3 LO4 LO5
P 9. In January 2011, Jones Corporation was organized and authorized to issue
2,000,000 shares of no-par common stock and 50,000 shares of 5 percent,
$50 par value, noncumulative preferred stock. The stock-related transactions for
the first year’s operations were as follows:
Account
Debited Credited
Account Dollar Account Dollar
Number Amount Number Amount
Jan. 19 Sold 15,000 shares
of common stock for
$31,500. State law
requires a minimum of 310 $15,000
$1 stated value per share. 110 $31,500 312 $16,500
21 Issued 5,000 shares of
common stock to attor-
neys and accountants for
services valued at $11,000
and provided during the
organization of the corpo-
ration. ____ ________ ____ ________
Feb. 7 Issued 30,000 shares
of common stock for
a building that had
an appraised value of
$78,000. ____ ________ ____ ________
Mar. 22 Purchased 10,000 shares
of its common stock at
$3 per share. ____ ________ ____ ________
July 15 Issued 5,000 shares
of common stock to
employees under a stock
option plan that allows
any employee to buy
shares at the current mar-
ket price, which is now
$3 per share. ____ ________ ____ ________
Aug. 1 Sold 2,500 shares of
treasury stock for $4 per
share. ____ ________ ____ ________
Chapter Assignments 559
Sept. 1 Declared a cash dividend
of $0.15 per common
share to be paid on
September 25 to stock-
holders of record on
September 15. ____ ________ ____ ________
15 Date of record for cash
dividends. ____ ________ ____ ________
25 Paid cash dividends to
stockholders of record on
September 15. ____ ________ ____ ________
Oct. 30 Issued 4,000 shares of
common stock for a piece
of land. The stock was
selling for $3 per share,
and the land had a fair
market value of $12,000. ____ ________ ____ ________
Dec. 15 Issued 2,200 shares of
preferred stock for $50
per share. ____ ________ ____ ________
Required
1. For each of the above transactions, enter in the blanks provided the account
numbers and dollar amounts (as shown in the example) for the account(s)
debited and credited. The account numbers are listed below.
110 Cash 312 Additional Paid-in Capital
120 Land 313 Paid-in Capital, Treasury Stock
121 Building 340 Retained Earnings
220 Dividends Payable 341 Dividends
305 Preferred Stock 350 Treasury Stock, Common
310 Common Stock 510 Start-up and Organization Costs
User insight (cid:2) 2. Why is the stockholders’ equity section of the balance sheet an important |
consideration in analyzing the performance of a company?
LO1 LO5 Treasury Stock
P 10. The Spivak Company was involved in the following treasury stock transac-
tions during 2011:
a. Purchased 80,000 shares of its $1 par value common stock on the market
for $2.50 per share.
b. Purchased 16,000 shares of its $1 par value common stock on the market
for $2.80 per share.
c. Sold 44,000 shares purchased in a for $131,000.
d. Sold the other 36,000 shares purchased in a for $72,000.
e. Sold 6,000 of the remaining shares of treasury stock for $1.60 per share.
f. Retired all the remaining shares of treasury stock. All shares originally were
issued at $1.50 per share.
Required
1. Record the treasury stock transactions in T accounts.
User insight (cid:2) 2. What is the reasoning behind treating the purchase of treasury stock as a reduc-
tion in stockholders’ equity as opposed to treating it as an investment asset?
560 CHAPTER 12 Contributed Capital
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 Reasons for Issuing Common Stock
C 1. DreamWorks Animation, led by billionaire Microsoft founder Paul Allen,
went public in a recent year with its class A common stock at $28 per share, rais-
ing $650 million. By the end of the first day, it was up 27 percent to $38 per
share, giving the company a value of almost $1 billion. This initial enthusiasm
did not last. By the end of 2007, the price was only around $25 per share.15 As
a growing company that has produced such animated hits as Shrek and Shrek II,
DreamWorks could have borrowed significant funds by issuing long-term debt.
What are some advantages of issuing common stock as opposed to bonds? What
are some disadvantages?
LO5 Purposes of Treasury Stock
C 2. Many companies in recent years have bought back their common stock. For
example, IBM, with large cash holdings, spent almost $18 billion over three years
repurchasing its stock.16 What are the reasons companies buy back their own shares?
What is the effect of common stock buybacks on earnings per share, return on
equity, return on assets, debt to equity, and the current ratio?
LO4 Effect of Stock Issue
C 3. When Google, Inc. went public with an IPO, it used an auction system that
allowed everyone to participate rather than allocating shares of stock to a few
insiders.17 The company’s IPO drew widespread attention. Announcements of
the IPO would have been similar to the following:
22,500,000 Shares
GOOGLE, INC.
$0.001 Par Value Common Stock
Price $85 a share
The gross proceeds of the IPO before issue costs were $1.9 billion.
Shown below is a portion of the stockholders’ equity section of the balance sheet
adapted from Google’s annual report, which was issued prior to this stock offering:
Stockholders’ Equity
(Dollar amounts in thousands)
Common Stock, $0.001 par value, 700,000,000 shares
authorized; 161,000,000 shares issued and outstanding $ 161
Additional paid-in capital 725,219
Retained earnings 191,352
1. Assume that the net proceeds to Google after issue costs were $1.8 billion.
Record the stock issuance on Google’s accounting records in journal form.
2. Prepare the portion of the stockholders’ equity section of the balance sheet
shown above after the issue of the common stock, based on the information
given. Round all answers to the nearest thousand.
3. Based on your answer in 2, did Google have to increase its authorized shares
to undertake this stock issue?
4. What amount per share did Google receive and how much did Google’s
underwriters receive to help in issuing the stock? What do underwriters do to
earn their fee?
Chapter Assignments 561
LO1 LO5 Treasury Stock or Dividends?
C 4. In your class, divide into small groups. Assume the president of a small com-
pany that has been profitable for several years but has not paid a dividend has
hired your group. The company has built up a cash reserve. It has 20 stockhold-
ers, but the president owns 40 percent of the company’s shares. Several of the
stockholders with smaller numbers of shares would like to sell their shares, but
there is no ready market. The president of the company has asked your group |
to determine whether it would be better to recommend to the board of direc-
tors that they pay a dividend to all stockholders or whether they should buy out
the smaller stockholders to hold shares in the treasury and possibly retire them.
In your group, decide which recommendation you will make to the president.
Develop a series of points to support your argument. Participate in a class debate
among teams who have chosen opposing positions.
LO2 LO5 Stockholders’ Equity
C 5. Refer to the CVS Corporation annual report in the Supplement to Chapter 5
to answer the following questions:
1. What type of capital stock does CVS have? What is the par value? How many
shares were authorized, issued, and outstanding at the end of f iscal 2008?
2. What is the dividends yield (use average price of stock in last quarter) for
CVS and its relationship to the investors’ total return? Does the company
rely mostly on stock or on earnings for its stockholders’ equity? (CVS’s
fourth quarter of 2008 high and low market prices were $34.90 and $23.19,
respectively).
3. Does the company have a stock option plan? To whom do the stock options
apply? Do employees have significant stock options? Given the market price
of the stock shown in the report, do these options represent significant value
to the employees?
LO1 LO5 Return on Equity, Treasury Stock, and Dividends Policy
C 6. Refer to the annual report of CVS Corporation and the financial statements
of Southwest Airlines Co. in the Supplement to Chapter 5.
1. Compute the return on equity for both companies for fiscal 2008 and
2007. Total stockholders’ equity for CVS and Southwest in 2006 was
$9,917.6 million and $6,449 million, respectively.
2. Did either company purchase treasury stock during these years? How will the
purchase of treasury stock affect return on equity and earnings per share?
3. Did either company issue stock during these years? What are the details?
4. Compare the dividend policy of the two companies.
C H A P T E R
13
Long-Term Liabilities
Making a L ong-term liabilities can be an attractive means of financing
Statement
the expansion of a business. By incurring long-term debt to
fund growth, a company may be able to earn a return that exceeds
INCOME STATEMENT
the interest it pays on the debt. When it does, it increases earn-
Revenues
ings for stockholders—that is, return on equity. Many companies
– Expenses
reward top managers with bonuses for improving return on equity.
= Net Income This incentive provides a temptation to incur too much debt, which
increases a company’s financial risk. Thus, in deciding on an appro-
STATEMENT OF priate level of debt, as in so many other management issues, ethics
RETAINED EARNINGS
is a major concern.
Beginning Balance
+ Net Income
LEARNING OBJECTIVES
– Dividends
= Ending Balance
LO1 Identify the management issues related to long-term
debt. (pp. 564–572)
BALANCE SHEET
Assets Liabilities LO2 Describe the features of a bond issue and the major
characteristics of bonds. (pp. 573–575)
Stockholders’ LO3 Record bonds issued at face value and at a discount or
Equity
premium. (pp. 575–579)
A = L + OE
LO4 Use present values to determine the value of bonds.
(pp. 579–581)
STATEMENT OF CASH FLOWS
Operating activities LO5 Amortize bond discounts and bond premiums using the
+ Investing activities
straight-line and effective interest methods. (pp. 581–589)
+ Financing activities
= Change in Cash
+ Beginning Balance SUPPLEMENTAL OBJECTIVES
= Ending Cash Balance
SO6 Account for the retirement of bonds and the conversion of
Long-term liability bonds into stock. (pp. 590–592)
transactions can impact all
financial statements. SO7 Record bonds issued between interest dates and year-end
adjustments. (pp. 592–595)
562
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) What should Wilson consider
in deciding to issue long-term
WILSON MANUFACTURING
debt?
COMPANY
(cid:2) How does one evaluate whether
a company has too much debt?
Wilson Manufacturing Company wants to expand its metal window (cid:2) How are long-term bonds
division, but it does not have enough long-term capital to finance accounted for in Wilson’s |
the project. As indicated in the data from Wilson’s balance sheets records?
that appear below, the company has until now been able to rely on
the issuance of capital stock to take care of its financing needs. (Note
the increase in stockholders’ equity between 2009 and 2010.) Not
included in the balance sheets are annual payments of $100,000 that
Wilson makes on long-term leases of various properties.
2010 2009
Total current liabilities $1,000,000 $ 800,000
Long-term debt 0 0
Total stockholders’ equity 3,200,000 3,000,000
Total liabilities and stockholders’ equity $4,200,000 $3,800,000
Wilson’s management is now considering how to finance expan-
sion of the metal window division. Several options are available, among
them the issuance of long-term bonds. In making its decision, manage-
ment will have to assess how much debt the company should carry
and how much risk it is undertaking by assuming long-term debt.
563
564 CHAPTER 13 Long-Term Liabilities
Management
Profitable operations and short-term credit seldom provide sufficient cash for a
Issues Related growing business. Growth usually requires investment in long-term assets and in
research and development and other activities that will produce income in future
to Issuing Long-
years. To finance these assets and activities, a company needs funds that will be
Term Debt available for long periods. Two key sources of long-term funds are the issuance of
capital stock and the issuance of long-term debt. The management issues related
LO1 Identify the management to long-term debt financing are whether to take on long-term debt, how much
issues related to long-term debt. long-term debt to carry, and what types of long-term debt to incur.
Deciding to Issue Long-Term Debt
A key decision for management is whether to rely solely on stockholders’ equity—
capital stock issued and retained earnings—for long-term funds or to rely partially
on long-term debt. Some companies, such as Microsoft and Apple Computer,
do not issue long-term debt, but like CVS and Southwest Airlines, most compa-
nies find it useful to do so.
Because long-term debt must be paid at maturity and usually requires
periodic payments of interest, issuing common stock has two advantages over
issuing long-term debt: (1) It does not have to be paid back, and (2) a company
normally pays dividends on common stock only if it earns sufficient income.
Issuing long-term debt, however, has the following advantages over issuing
common stock
(cid:2) No loss of stockholder control. When a corporation issues long-term
debt, common stockholders do not relinquish any of their control over the
company because bondholders and other creditors do not have voting rights.
But when a corporation issues additional shares of common stock, the votes
of the new stockholders may force current stockholders and management to
give up some control.
(cid:2) Tax effects. The interest on debt is tax-deductible, whereas dividends on
common stock are not. For example, if a corporation pays $100,000 in
interest and its income tax rate is 30 percent, its net cost will be $70,000
because it will save $30,000 on income taxes. To pay $100,000 in dividends
on common stock, the corporation would have to earn $142,857 before
income taxes [$100,000 (cid:5) (1 (cid:4) 0.30)].
(cid:2) Financial leverage. If a corporation earns more from the funds it raises
by incurring long-term debt than it pays in interest on the debt, the
excess will increase its earnings for the stockholders. This concept is called
financial leverage, or trading on equity. For example, if a company earns
12 percent on a $1,000,000 investment financed by long-term 10 percent
notes, it will earn $20,000 before income taxes ($120,000 (cid:4) $100,000).
The debt to equity ratio, explained on the following page, is considered
an overall measure of a company’s financial leverage.
Despite these advantages, debt financing is not always in a company’s best interest.
It may entail the following:
(cid:2) Financial risk. A high level of debt exposes a company to financial risk. |
A company whose plans for earnings do not pan out, whose operations are
subject to the ups and downs of the economy, or whose cash flow is weak may
be unable to pay the principal amount of its debt at the maturity date or even
to make periodic interest payments. Creditors can then force the company
into bankruptcy—something that has occurred often in the h eavily debt-
financed airline industry. TWA, Continental Airlines, and United A irlines
Management Issues Related to Issuing Long-Term Debt 565
filed for bankruptcy protection because they could not make payments on
their long-term debt and other liabilities. (While in bankruptcy, they restruc-
tured their debt and interest payments: TWA sold off its assets; Continental
and United survived to come out of bankruptcy.)
(cid:2) Negative financial leverage. Financial leverage can work against a company
if the earnings from its investments do not exceed its interest payments. For
example, many small Internet companies failed in recent years because they
relied too heavily on debt financing before developing sufficient resources to
ensure their survival.
Evaluating Long-Term Debt
The amount of long-term debt that companies carry varies widely. For many com-
panies, it is less than 1.0 times stockholders’ equity. However, as Figure 13-1 shows,
the average debt to equity for selected industries often exceeds 1.0 times stockhold-
ers’ equity. The range is from 77.7 to 192.7 times stockholders’ equity.
To assess how much debt to carry, managers compute the debt to equity
ratio. Using data from Wilson Manufacturing Company presented in the Decision
Point, we can compute its debt to equity ratio in 2010 as follows (in thousands):
Debt to Equity Ratio (cid:2) _____T __o _t a _l _ L __ia _b _i _li _t i _e _s _ ____
Total Stockholders’ Equity
(cid:2)
$1,000
(cid:2) 0.31 Times
$3,200
FIGURE 13-1 Times
Average Debt to Equity for Advertising 1.93
Selected Industries
Interstate
1.36
Trucking
Auto and
0.96
Home Supply
Grocery
0.78
Stores
Machinery 0.83
Computers 1.09
0 0.30 0.60 0.90 1.20 1.50 1.80 2.10
Service Industries Merchandising Industries Manufacturing Industries
Source: Data from Dun & Bradstreet, Industry Norms and Key Business Ratios, 2005–2006.
A debt to equity ratio of 0.31 times is relatively low, but it does not tell the
whole story. As we noted in the Decision Point, Wilson also has long-term leases
on various properties, which require annual payments of $100,000. Wilson struc-
tures these leases in such a way that they do not appear as liabilities on the balance
sheet. This practice is called off-balance-sheet financing and, as used by Wilson,
is entirely legal. The leases are, however, long-term commitments of cash payments
and so have the effect of long-term liabilities.
Financial leverage—using long-term debt to fund investments or operations
that increase return on equity—is advantageous as long as a company is able to
make timely interest payments and repay the debt at maturity. Because failure to
do so can force a company into bankruptcy, companies must assess the financial
risk involved. A common measure of how much risk a company undertakes by
566 CHAPTER 13 Long-Term Liabilities
assuming long-term debt is the interest coverage ratio. It measures the degree of
protection a company has from default on interest payments. Most analysts want
to see an interest coverage ratio of at least three or four times. Lower interest cov-
erage would mean the company is at risk from a downturn in the economy.
Wilson’s 2010 income statement shows that the company had income before
income taxes of $250 million and interest expense of $50 million. Using these
figures, we can compute Wilson’s interest coverage ratio as follows:
Interest Coverage Ratio (cid:2) Income Before Income Taxes (cid:3) Interest Expense
Interest Expense
$250,000 (cid:3) $50,000
(cid:2)
$50,000
$300,000
(cid:2)
$50,000
(cid:2) 6.0 Times
Wilson’s strong interest coverage ratio of 6.0 times shows that it is in no danger
of being unable to make interest payments. However, in computing this ratio, |
management will add the company’s off-balance-sheet rent expense of $100,000
to its interest expense. This procedure decreases the interest coverage ratio to
about 2.7 times. Although still adequate to cover interest payments, the adjusted
coverage ratio is far less robust, which demonstrates the significant effect that
off-balance-sheet financing for leases can have on a company’s financial situation.
Types of Long-Term Debt
To structure long-term financing to the best advantage of their companies, m anagers
must know the characteristics of the various types of long-term debt. The most
common are bonds payable, notes payable, mortgages payable, l ong-term leases,
pension liabilities, other post-retirement benefits, and deferred income taxes.
Bonds Payable Long-term bonds are the most common type of long-term
debt. They can have many different characteristics, including the amount of
interest, whether the company can elect to repay them before their maturity date,
and whether they can be converted to common stock. We cover bonds in detail
in later sections of this chapter.
Notes Payable Long-term notes payable, those that come due in more than
one year, are also very common. They differ from bonds mainly in the way the
FOCUS ON BUSINESS PRACTICE
How Does Debt Affect a Company’s Ability to Borrow?
Credit ratings by agencies like Standard & Poor’s reflect RATING AAA AA A BBB BB B CCC
the fact that the greater a company’s debt, the greater Debt/Equity Ratio* 4.5 34.1 42.9 47.9 59.8 76.0 75.7
its financial risk. Standard & Poor’s rates companies
from AAA (best) to CCC (worst) based on various factors, These ratings affect not only how much a company can bor-
including a company’s debt to equity ratio, as shown to row but also what the interest will cost. The lower its rating,
the right. the more a company must pay in interest, and vice versa.
*Averages of companies with similar ratings.
Management Issues Related to Issuing Long-Term Debt 567
TABLE 13-1
A B C D E
Monthly Payment Schedule on a
Interest for Unpaid
$100,000, 9 Percent Mortgage
Unpaid 1 Month at Balance
Balance at 1% on Unpaid Reduction in at End of
Payment Beginning Monthly Balance* Debt Period
Date of Period Payment (0.75% (cid:5) A) (B (cid:2) C) (A (cid:2) D)
June 1 $100,000
July 1 $100,000 $1,200 $750 $450 99,550
Aug. 1 99,550 1,200 747 453 99,097
Sept. 1 99,097 1,200 743 457 98,640
*Rounded to the nearest dollar.
contract with the creditor is structured. A long-term note is a promissory note
that represents a loan from a bank or other creditor, whereas a bond is a more
complex financial instrument that usually involves debt to many creditors. Analysts
often do not distinguish between long-term notes and bonds because they have
similar effects on the financial statements.
Mortgages Payable A mortgage is a long-term debt secured by real p roperty.
It is usually paid in equal monthly installments. Each monthly payment includes
interest on the debt and a reduction in the debt. Table 13-1 shows the first
three monthly payments on a $100,000, 9 percent mortgage. The mortgage was
obtained on June 1, and the monthly payments are $1,200. The T accounts and
entry to record the July 1 payment would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
A (cid:3) L (cid:4) SE CASH MORTGAGE PAYABLE MORTAGE INTEREST EXPENSE
(cid:4)1,200 (cid:4)450 (cid:4)750
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 1,200 July 1 450 July 1 750
Entry in Journal Form:
Dr. Cr.
July 1 Mortgage Payable 450
Mortgage Interest Expense 750
Cash 1,200
Made monthly mortgage payment
Notice from the entry and from Table 13-1 that the July 1 payment represents
interest expense of $750 ($100,000 (cid:6) 0.09 (cid:6) 1/ ) and a reduction in the debt of
12
$450 ($1,200 (cid:4) $750). Therefore, the July payment reduces the unpaid balance
to $99,550. August’s interest expense is slightly less than July’s because of the
decrease in the debt.
Long-Term Leases A company can obtain an operating asset in three ways:
1. By borrowing money and buying the asset
2. By renting the asset on a short-term lease |
3. By obtaining the asset on a long-term lease
The first two methods do not create accounting problems. When a company uses
the first method, it records the asset and liability at the amount paid, and the asset
is subject to periodic depreciation.
568 CHAPTER 13 Long-Term Liabilities
When a company uses the second method, the lease is short in relation to
the useful life of the asset, and the risks of ownership remain with the lessor. This
type of agreement is called an operating lease. Payments on operating leases are
properly treated as rent expense.
The third method is one of the fastest-growing ways of financing plant assets
in the United States today. A long-term lease on a plant asset has several advan-
tages. It requires no immediate cash payment, the rental payment is deducted in
full for tax purposes, and it costs less than a short-term lease. Acquiring the use
of plant assets under long-term leases does create several accounting challenges,
however.
Long-term leases may be carefully structured, as they are by companies like
Study Note CVS, so that they can be accounted for as operating leases. Accounting standards
require, however, that a long-term lease be treated as a capital lease when it
Under a capital lease, the lessee
meets the following conditions:
should record depreciation,
using any allowable method. (cid:2) It cannot be canceled.
(cid:2) Its duration is about the same as the useful life of the asset.
(cid:2) It stipulates that the lessee has the option to buy the asset at a nominal price
at the end of the lease.
A capital lease is thus more like a purchase or sale on installment than a rental.
Study Note The lessee in a capital lease should record an asset, depreciation on the asset, and
a long-term liability equal to the present value of the total lease payments dur-
A capital lease is in substance an
ing the lease term.1 Much like a mortgage payment, each lease payment consists
installment purchase, and the
partly of interest expense and partly of repayment of debt.
leased asset and related liability
Suppose, for example, that Polany Manufacturing Company enters into a
must be recognized at their
present value. long-term lease July 1 for a machine. The lease terms call for an annual payment
of $8,000 for six years, which approximates the useful life of the machine. At the
end of the lease period, the title to the machine passes to Polany. This lease is
clearly a capital lease and should be recorded as an asset and a liability.
Present value techniques can be used to place a value on the asset and on the
corresponding liability in a capital lease. Suppose Polany’s interest cost on the
unpaid part of its obligation is 8 percent. Using the factor for 8 percent and six
periods in Table 13-2 in the appendix on present values tables, we can compute
the present value of the lease payments as follows:
Periodic Payment (cid:6) Factor (cid:2) Present Value
$8,000 (cid:6) 4.623 (cid:2) $36,984
The T accounts and entry to record the lease is as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CAPITAL LEASE EQUIPMENT CAPITAL LEASE OBLIGATIONS
Dr. Cr. Dr. Cr.
36,984 36,984
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:3)36,984 (cid:3)36,984 Dr. Cr.
Capital Lease Equipment 36,984
Capital Lease Obligations 36,984
To record capital lease on machinery
Capital Lease Equipment is classified as a long-term asset. Capital Lease Obliga-
tions is classified as a long-term liability.
Management Issues Related to Issuing Long-Term Debt 569
TABLE 13-2
A B C D
Payment Schedule on an
Interest (8%)
8 Percent Capital Lease
on Unpaid Reduction of Balance of
Lease Obligation* Lease Obligation Lease Obligation
Year Payment (D (cid:5) 8%) (A (cid:2) B) (D (cid:2) C)
Beginning $36,984
1 $ 8,000 $ 2,959 $ 5,041 31,943
2 8,000 2,555 5,445 26,498
3 8,000 2,120 5,880 20,618
4 8,000 1,649 6,351 14,267
5 8,000 1,141 6,859 7,408
6 8,000 592† 7,408 —
$48,000 $11,016 $36,984
*Rounded to the nearest dollar.
†The last year’s interest equals $592 ($8,000 (cid:4) $7,408); it does not exactly equal $593 ($7,408 (cid:6) _ _8_ _ (cid:6) 1)
100 |
because of the cumulative effect of rounding.
Each year, Polany must record depreciation on the leased asset. Using
straight-line depreciation, a six-year life, and no residual value, the following
T accounts and entry would record the depreciation:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
ACCUMULATED DEPRECIATION– DEPRECIATION EXPENSE–
CAPITAL LEASE EQUIPMENT CAPITAL LEASE EQUIPMENT
Dr. Cr. Dr. Cr.
6,164 6,164
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:3)6,164 (cid:3)6,164 Dr. Cr.
Depreciation Expense–Capital Lease Equipment 6,164
Accumulated Depreciation–Capital Lease
Equipment 6,164
To record depreciation expense on capital lease
The interest expense for each year is computed by multiplying the interest rate
(8 percent) by the amount of the remaining lease obligation. Table 13-2 shows
these calculations. Using the data in the table, the first lease payment would be
recorded as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH CAPITAL LEASE OBLIGATIONS INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
8,000 5,041 2,959
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)8,000 (cid:4)5,041 (cid:4)2,959 Dr. Cr.
Interest Expense (Column B) 2,959
Capital Lease Obligations (Column C) 5,041
Cash (Column A) 8,000
Made payment on capital lease
570 CHAPTER 13 Long-Term Liabilities
This example suggests why companies are motivated to engage in off-
balance-sheet financing for leases. By structuring long-term leases so that they
can be accounted for as operating leases, companies avoid recording them on the
balance sheet as long-term assets and liabilities. This practice, which, as we have
noted, is legal, not only improves the debt to equity ratio by showing less debt on
the balance sheet; it also improves the return on assets by reducing the total assets.
Pension Liabilities Most employees of medium-sized and large companies are
covered by a pension plan, a contract that requires a company to pay benefits to
its employees after they retire. Some companies pay the full cost of the pension
plan, but in many companies, employees share the cost by contributing part of their
salaries or wages. The contributions from employer and employees are usually paid
into a pension fund, which is invested on behalf of the employees and from which
benefits are paid to retirees. Pension benefits typically consist of monthly payments
to retired employees and other payments upon disability or death.
Employers whose pension plans do not have sufficient assets to cover the
present value of their pension obligations must record the amount of the shortfall
as a liability on their balance sheets. If a pension plan has sufficient assets to cover
its obligations, no balance sheet reporting is required or permitted.
There are two kinds of pension plans:
(cid:2) Defined contribution plan. Under a defined contribution plan, the
Study Note
employer makes a fixed annual contribution, usually a percentage of the
employee’s gross pay; the amount of the contribution is specified in an agree-
Companies prefer defined
contribution plans because the ment between the company and the employees. Retirement payments vary
employees assume the risk that depending on how much the employee’s retirement account earns. Employ-
their pension assets will earn a ees usually control their own investment accounts, can make additional con-
sufficient return to meet their tributions of their own, and can transfer the funds if they leave the company.
retirement needs. Examples of defined contribution plans include 401(k) plans, profit-sharing
plans, and employee stock ownership plans (ESOPs).
(cid:2) Defined benefit plan. Under a defined benefit plan, the employer contrib-
Study Note
utes an amount annually required to fund estimated future pension liability
Accounting for a defined arising from employment in the current year. The exact amount of the liabil-
benefit plan is far more complex ity will not be known until the retirement and death of the current employ-
than accounting for a defined ees. Although the amount of future benefits is fixed, the annual contributions |
contribution plan. Fortunately, vary depending on assumptions about how much the pension fund will earn.
accountants can rely on the
Annual pension expense under a defined contribution plan is simple and pre-
calculations of professional
dictable. Pension expense equals the fixed amount of the annual contribution. In
actuaries, whose expertise
contrast, annual expense under a defined benefit plan is one of the most complex
includes the mathematics of
topics in accounting. The intricacies are reserved for advanced courses, but in
pension plans.
concept, the procedure is simple. Computation of the annual expense takes into
account the estimation of many factors, such as the average remaining service life
of active employees, the long-run return on pension plan assets, and future sal-
ary increases. A recent accounting standard requires companies and other entities
with defined benefit plans not backed by a fund sufficient to pay them to record
the unfunded portion as a liability.2 For many companies this can amount to
millions or even billions of dollars. For example, General Motors Corporation’s
pension liability of $11.4 billion is one factor that led to its government bailout
and subsequent bankruptcy.3
Because pension expense under a defined benefit plan is not predictable and
can vary from year to year, many companies are adopting the more predictable
defined contribution plans.
Management Issues Related to Issuing Long-Term Debt 571
FOCUS ON BUSINESS PRACTICE
Post-Retirement Liabilities Affect Everyone
The rule requiring recognition of unfunded pension plans bankruptcy.4 The state of New Jersey actually stopped set-
as liabilities impacts even government entities. Most gov- ting aside funds to pay for health care in order to give a tax
ernment entities have defined benefit pension plans and cut. No one added up the cost until the new accounting
provide post-retirement medical benefits. As a result, rule required it. The estimated cost to provide the health
states, school districts, and municipalities are all encounter- care promised to New Jersey’s current and future retirees is
ing previously ignored pension and health care liabilities. $58 billion, or twice the state’s annual budget.5 These cases,
For example, a series of evasive tactics in San Diego led to a while extreme, are not unusual. Citizens across the country
$1.1 billion shortfall, which almost caused the city to declare will face tax increases to pay for these liabilities.
Other Post-Retirement Benefits Many companies provide retired employ-
Study Note
ees not only with pensions but also with health care and other benefits. In the
Other post-retirement benefits past, these other post-retirement benefits were accounted for on a cash basis—
should be expensed as the that is, they were expensed when the benefits were paid, after an employee had
employee earns them, not when retired. More recent accounting standards hold that employees earn these ben-
they are paid after the employee efits during their employment and that, in accordance with the matching rule,
retires. This practice conforms to they should be estimated and accrued during the time the employee is working.6
the matching rule. The estimates must take into account assumptions about retirement age,
mortality, and, most significantly, future trends in health care benefits. Like pen-
sion benefits, such future benefits should be discounted to the current period. A
field test conducted by the Financial Executives Research Foundation determined
that the change to accrual accounting increased post-retirement benefits by two
to seven times the amount recognized on a cash basis.
Deferred Income Taxes Among the long-term liabilities on the balance sheets
of many companies, including Southwest Airlines, is an account called Deferred
Income Taxes. Deferred income taxes are the result of using different account-
ing methods to calculate income taxes on the income statement and income tax
Post-retirement benefits, such as
health care, are a type of long-term
debt for the company that provides |
them. Recent accounting standards
hold that employees earn these
benefits during their employment
and that the benefits should there-
fore be estimated and accrued while
the employee is working.
Courtesy of Steve Cole/iStockphoto.com.
572 CHAPTER 13 Long-Term Liabilities
liability on the income tax return. For instance, companies often use straight-line
depreciation for financial reporting and an accelerated method to calculate income
tax liability. Because straight-line depreciation is less than accelerated depreciation in
the early years of an asset’s life, the presumption is that the income taxes will eventu-
ally have to be paid. Thus, the difference is listed as a long-term liability, deferred
income taxes. Because companies try to manage their affairs to minimize income
taxes paid, deferred income taxes can become quite large. In Southwest Airlines’
case, they amount to about $1.9 billion or almost 20 percent of total liabilities.7 We
cover deferred income taxes in greater detail in a later chapter.
Cash Flow Information
The best source of information concerning cash flows about short-term and long-
term debt is the financing activities section of the statement of cash flows. For
instance, cash flows from these activities are clearly revealed in this partial section
of McDonald Corporation’s statement of cash flows (in millions):8
Financing Activities 2008 2007 2006
Net short-term borrowings $ 266.7 $ 101.3 $ 34.5
Long-term financing issuances 3,477.5 2,116.8 1.9
Long-term financing repayments (2,698.5) (1,645.5) (2,301.1)
Note that McDonald’s has little short-term borrowing and that the compa-
ny’s cash outflows for long-term borrowing exceeded cash inflows for long-
term borrowing by $1,049 million for all three years.
STOP
& APPLY
Each type of long-term liability below is closely related to one of the statements in the list that fol-
lows. Write the number of the liability next to the statement to which it applies.
1. Bonds payable _____ c. T he result of differences between
2. Long-term notes payable accounting income and taxable
3. Mortgage payable income
4. Long-term lease _____ d. D ebt that is secured by real estate
5. Pension liabilities
_____ e. P romissory note that is due in more
6. Other post-retirement benefits
than one year
7. Deferred income taxes
_____ f. M ay be based on a percentage of
_____ a. C ost of health care after employees’
employees’ wages or on future benefits
retirement
_____ g. C an be similar in form to an install-
_____ b. T he most common type of long-term
ment purchase
debt
SOLUTION
a. 6; b. 1; c. 7; d. 3; e. 2; f. 5; g. 4
The Nature of Bonds 573
The Nature A bond is a security, usually long term, representing money that a corporation bor-
of Bonds rows from the investing public. (Federal, state, and local governments also issue
bonds to raise money, as do foreign countries.) A bond entails a promise to repay
the amount borrowed, called the principal, on a specified date and to pay interest at
LO2 Describe the features of a
a specified rate at specified times—usually semiannually. In contrast to stockholders,
bond issue and the major char-
who are the owners of a corporation, bondholders are a corporation’s creditors.
acteristics of bonds.
When a public corporation decides to issue bonds, it must submit the appro-
priate legal documents to the Securities and Exchange Commission for permis-
sion to borrow the funds. The SEC reviews the corporation’s financial health and
Study Note
the specific terms of the bond indenture, which is a contract that defines the
An investor who purchases rights, privileges, and limitations of the bondholders. The bond indenture gen-
debt securities, such as bonds erally describes such things as the maturity date of the bonds, interest payment
or notes, is a creditor of the
dates, and the interest rate. It may also cover repayment plans and restrictions.
organization, not an owner.
Once the bond issue is approved, the corporation has a limited time in which to
issue the authorized bonds. As evidence of its debt to the bondholders, the cor- |
poration provides each of them with a bond certificate.
Bond Issue: Prices and Interest Rates
A bond issue is the total value of bonds issued at one time. For example, a
Study Note $1,000,000 bond issue could consist of a thousand $1,000 bonds. The prices of
bonds are stated in terms of a percentage of the face value, or principal, of the
When bonds with an interest
bonds. A bond issue quoted at 103½ means that a $1,000 bond costs $1,035
rate different from the market
($1,000 (cid:6) 1.035). When a bond sells at exactly 100, it is said to sell at face (or
rate are issued, they sell at
par) value. When it sells below 100, it is said to sell at a discount; above 100, at
a discount or premium. The
a premium. For instance, a $1,000 bond quoted at 87.62 would be selling at a
discount or premium acts as an
equalizing factor. discount and would cost the buyer $876.20.
Face Interest Rate and Market Interest Rate Two interest rates relevant
to bond prices are the face interest rate and the market interest rate:
(cid:2) The face interest rate is the fixed rate of interest paid to bondholders based
Study Note on the face value of the bonds. The rate and amount are fixed over the life of
the bond. To allow time to file with the SEC, publicize the bond issue, and
A bond sells at face value when
print the bond certificates, a company must decide in advance what the face
the face interest rate of the
interest rate will be. Most companies try to set the face interest rate as close as
bond is identical to the market
possible to the market interest rate.
interest rate for similar bonds on
the date of issue. (cid:2) The market interest rate is the rate of interest paid in the market on bonds
of similar risk.* It is also called the effective interest rate. The market interest
rate fluctuates daily. Because a company has no control over it, the market
interest rate often differs from the face interest rate on the issue date.
Discounts and Premiums If the market interest rate fluctuates from the face
interest rate before the issue date, the issue price of bonds will not equal their face
value. This fluctuation in market interest rate causes the bonds to sell at either a
discount or a premium:
(cid:2) A discount equals the excess of the face value over the issue price. The issue
price will be less than the face value when the market interest rate is higher
than the face interest rate.
*At the time this chapter was written, the market interest rates on corporate bonds were
volatile. Therefore, we use a variety of interest rates in our examples.
574 CHAPTER 13 Long-Term Liabilities
(cid:2) A premium equals the excess of the issue price over the face value. The issue
price will be more than the face value when the market interest rate is lower
than the face interest rate.
Discounts or premiums are contra and adjunct accounts, respectively, that are
subtracted from or added to bonds payable on the balance sheet.
Characteristics of Bonds
A bond indenture can be written to fit an organization’s financing needs. As a
Study Note result, the bonds issued in today’s financial markets have many different features.
We describe several of the more important features in the following paragraphs.
Do not confuse the terms
indenture and debenture. They
Unsecured and Secured Bonds Bonds can be either unsecured or
sound alike, but an indenture
is a bond contract, whereas secured. Unsecured bonds (also called debenture bonds) are issued on the
a debenture is an unsecured basis of a corporation’s general credit. Secured bonds carry a pledge of certain
bond. A debenture bond of a corporate assets as a guarantee of repayment. A pledged asset may be a specific
stable company actually might asset, such as a truck, or a general category of asset, such as property, plant,
be a less risky investment than and equipment.
a secured bond of an unstable
company. Term and Serial Bonds When all the bonds of an issue mature at the same
time, they are called term bonds. For instance, a company may decide to issue
$1,000,000 worth of bonds, all due 20 years from the date of issue. |
When the bonds of an issue mature on different dates, they are called serial
Study Note bonds. For example, suppose a $1,000,000 bond issue calls for paying $200,000
of the principal every five years. This arrangement means that after the first
An advantage of issuing serial
$200,000 payment is made, $800,000 of the bonds would remain outstanding
bonds is that the organization
for the next five years, $600,000 for the next five years, and so on. A company
retires the bonds over a period
may issue serial bonds to ease the task of retiring its debt—that is, paying off what
of years, rather than all at once.
it owes on the bonds.
Callable and Convertible Bonds When bonds are callable and convertible, a
company may be able to retire them before their maturity dates. When a company
does retire a bond issue before its maturity date, it is called early extinguishment
of debt. Doing so can be to a company’s advantage.
Callable bonds give the issuer the right to buy back and retire the bonds
before maturity at a specified call price, which is usually above face value. Call-
able bonds give a company flexibility in financing its operations. For example, if
bond interest rates drop, the company can call the bonds and reissue debt at a
lower interest rate. A company might also call its bonds if it has earned enough to
pay off the debt, if the reason for having the debt no longer exists, or if it wants
to restructure its debt to equity ratio. The bond indenture states the time period
and the prices at which the bonds can be redeemed.
Convertible bonds allow the bondholder to exchange a bond for a specified
number of shares of common stock. The face value of a convertible bond when
issued is greater than the market value of the shares to which it can be converted.
However, if the market price of the common stock rises above a certain level, the
value of the bond rises in relation to the value of the common stock. Even if the
stock price does not rise, the investor still holds the bond and receives both the
periodic interest payments and the face value at the maturity date.
One advantage of issuing convertible bonds is that the interest rate is usually
lower because investors are willing to give up some current interest in the hope
Accounting for the Issuance of Bonds 575
that the value of the stock will increase and the value of the bonds will there-
fore also increase. In addition, if the bonds are both callable and convertible and
the market value of the stock rises to a level at which the bond is worth more
than face value, management can avoid repaying the bonds by calling them for
redemption, thereby forcing the bondholders to convert their bonds into com-
mon stock. The bondholders will agree to convert because no gain or loss results
from the transaction.
Registered and Coupon Bonds Registered bonds are issued in the names
of the bondholders. The issuing organization keeps a record of the bondholders’
names and addresses and pays them interest by check on the interest payment
date. Most bonds today are registered. Coupon bonds are not registered with
the organization. Instead, they bear coupons stating the amount of interest due
and the payment date. The bondholder removes the coupons from the bonds on
the interest payment dates and presents them at a bank for collection.
STOP
& APPLY
Each term related to bonds below is the opposite to one of the terms in the list that follows. Write
the number of the term in the first list next to the term to which it opposes.
1. Face interest rate _____ a. Secured
2. Discount _____ b. Coupon
3. Unsecured
_____ c. Convertible
4. Term
_____ d. Premium
5. Registered
6. Callable _____ e. Market interest rate
7. Deferred income taxes _____ f. Serial
SOLUTION
a. 3; b. 5; c. 6; d. 2; e. 1; f. 4
Accounting
When the board of directors of a public corporation decides to issue bonds, the
for the Issuance company must submit the appropriate legal documents to the Securities and
Exchange Commission for authorization to borrow the funds. It is not neces-
of Bonds
sary to make an entry to record the authorization of a bond issue. However, |
most companies disclose the authorization in the notes to their financial state-
LO3 Record bonds issued at ments. The note lists the number and value of bonds authorized, the interest
face value and at a discount or rate, the interest payment dates, and the life of the bonds. In the sections that
premium. follow, we show how to record bonds issued at face value, at a discount, and
at a premium.
Bonds Issued at Face Value
Suppose Bharath Corporation issues $200,000 of 7 percent, five-year bonds on
January 1, 2010, at face value. The bond indenture states that interest is to be
576 CHAPTER 13 Long-Term Liabilities
paid on January 1 and July 1 of each year. The T accounts and entry to record the
bond issue is as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BONDS PAYABLE
Dr. Cr. Dr. Cr.
Jan. 1 200,000 Jan. 1 200,000
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:3)200,000 (cid:3)200,000 2010 Dr. Cr.
Jan. 1 Cash 200,000
Bonds Payable 200,000
Sold $200,000 of 7%
5-year bonds at face value
Once a corporation issues bonds, it must pay interest to the bondhold-
ers over the life of the bonds, usually semiannually, and the principal of the
Study Note
bonds at maturity. In this example, interest is paid on January 1 and July 1
of each year. Thus, Bharath would owe the bondholders $7,000 interest on
When calculating semiannual
interest, do not use the annual July 1, 2010:
rate (7 percent in this case).
Interest (cid:2) Principal (cid:6) Rate (cid:6) Time
Rather, use half the annual rate.
(cid:2) $200,000 (cid:6) __7_ _ (cid:6) 6/12 year
100
(cid:2) $7,000
Bharath would record the interest paid to the bondholders on each semi-
annual interest payment date (January 1 or July 1) as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
INTEREST PAYABLE BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr.
7,000 7,000
Entry in Journal Form:
A* (cid:3) L (cid:4) SE Dr. Cr.
(cid:4)7,000 (cid:4)7,000 July 1 Bond Interest Expense 7,000
Cash (Interest Payable) 7,000
*Assumes cash paid. Made semiannual interest payment
to bondholders of 7 percent, 5-year bonds
Bonds Issued at a Discount
Suppose Bharath Corporation issues $200,000 of 7 percent, five-year bonds at
95.9445 on January 1, 2010, when the market interest rate is 8 percent. In this
case, the bonds are being issued at a discount because the market interest rate
exceeds the face interest rate. The following T accounts and entry records the
issuance of the bonds at a discount:
Accountingfor the Issuanceof Bonds 577
FOCUS ON BUSINESS PRACTICE
100-Year Bonds Are Not for Everyone
In 1993, interest rates on long-term debt were at historically that followed Walt Disney’s lead by issuing 100-year bonds
low levels, which induced some companies to attempt to were the Coca-Cola Company, Columbia HCA Health-
lock in those low costs for long periods. One of the most care, Bell South, IBM, and even the People’s Republic of
aggressive companies in that regard was The Walt Disney China. Some analysts wondered if even Mickey Mouse could
Company, which issued $150 million of 100-year bonds at survive 100 years. Investors who purchase such bonds take
a yield of only 7.5 percent. It was the first time since 1954 a financial risk because if interest rates rise, which is always
that 100-year bonds had been issued. Among the others likely, the market value of the bonds will decrease.9
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND DISCOUNT
Dr. Cr. Dr. Cr.
Jan. 1 191,889 Jan. 1 8,111
BONDS PAYABLE
Dr. Cr.
Jan. 1 200,000
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:3)191,889 (cid:4)8,111 2010 Dr. Cr.
(cid:3)200,000
Jan. 1 Cash 191,889
Unamortized Bond Discount 8,111
Bonds Payable 200,000
Sold $200,000 of 7%, 5-year
bonds at 95.9445
Face amount of bonds $200,000
Less purchase price of bonds
($200,000 (cid:6) 0.959445) 191,889
Unamortized bond discount $ 8,111
In this entry, Cash is debited for the amount received ($191,889), Bonds
Payable is credited for the face amount ($200,000) of the bond liability, and the
difference ($8,111) is debited to Unamortized Bond Discount. If a balance sheet |
is prepared right after the bonds are issued at a discount, the liability for bonds
payable is reported as follows:
Long-term liabilities
7% bonds payable, due 1/1/2015 $200,000
Less unamortized bond discount 8,111 $191,889
Unamortized Bond Discount is a contra-liability account. Its balance is deducted
from the face amount of the bonds to arrive at the carrying value, or present
value, of the bonds. The bond discount is described as unamortized because it
will be amortized (written off) over the life of the bonds.
Bonds Issued at a Premium
When bonds have a face interest rate above the market rate for similar investments,
they are issued at a price above the face value, or at a premium. For e xample,
578 CHAPTER 13 Long-Term Liabilities
suppose Bharath Corporation issues $200,000 of 7 percent, five-year bonds for
$208,530 on January 1, 2010, when the market interest rate is 6 percent. This
means that investors will purchase the bonds at 104.265 percent of their face
value. The issuance would be recorded as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND PREMIUM
Dr. Cr. Dr. Cr.
Jan. 1 208,530 Jan. 1 8,530
BONDS PAYABLE
Dr. Cr.
Jan. 1 200,000
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:3)208,530 (cid:3)8,530 2010 Dr. Cr.
(cid:3)200,000
Jan. 1 Cash 208,530
Unamortized Bond Premium 8,530
Bonds Payable 200,000
Sold $200,000 of 7%, 5-year bonds
at 104.265
Right after this entry is made, bonds payable would be presented on the
Study Note balance sheet as follows:
The carrying amount is always Long-term liabilities
the face value of the bonds
7% bonds payable, due 1/1/2015 $200,000
less the unamortized discount
Plus unamortized bond premium 8,530 $208,530
or plus the unamortized
premium. The carrying amount
always approaches the face The carrying value of the bonds payable is $208,530, which equals the face value
value over the life of the bond. of the bonds plus the unamortized bond premium. The cash received from the
bond issue is also $208,530. This means that the purchasers were willing to pay a
premium of $8,530 to buy these bonds because their face interest rate was higher
than the market interest rate.
Bond Issue Costs
The costs of issuing bonds can amount to as much as 5 percent of a bond issue.
These costs often include the fees of underwriters, whom corporations hire to
take care of the details of marketing a bond issue. Because the issue costs benefit
the whole life of a bond issue, it makes sense to spread them over that period. It
is generally accepted practice to establish a separate account for these costs and to
amortize them over the life of the bonds.
Because issue costs decrease the amount of money a company receives from a
bond issue, they have the effect of raising the discount or lowering the premium on
the issue. Thus, bond issue costs can be spread over the life of the bonds through
the amortization of a discount or premium. This method simplifies recordkeeping.
In the rest of our discussion, we assume that all bond issue costs increase the dis-
counts or decrease the premiums on bond issues.
Using Present Value to Value a Bond 579
STOP
& APPLY
Gill Foods is planning to issue $1,000,000 in long-term bonds. Depending on market conditions,
Gill’s CPA advises that the bonds could be issued at (a) 99, (b) 100, or (b) 101. Calculate the
amount that Gill would receive under each alternative and indicate whether it is at face value, a
discount or a premium and the amount of each.
SOLUTION
(a) $1,000,000 (cid:6) 0.99 (cid:2) $990,000; a discount of $10,000
(b) $1,000,000 (cid:6) 1.00 (cid:2) $1,000,000; at face value; no discount or premium
(c) $1,000,000 (cid:6) 1.01 (cid:2) $1,010,000; a premium of $10,000
Using Present
A bond’s value is based on the present value of two components of cash flow: a
Value to Value series of fixed interest payments, and a single payment at maturity. The amount
of interest a bond pays is fixed over its life. However, the market interest rate
a Bond
varies from day to day. Thus, the amount investors are willing to pay for a bond |
varies as well.
LO4 Use present values to
determine the value of bonds.
Case 1: Market Rate Above Face Rate
Suppose a bond has a face value of $20,000 and pays fixed interest of $700 every
six months (a 7 percent annual rate). The bond is due in five years. If the market
interest rate today is 10 percent, what is the present value of the bond?
To answer this question, we use Table 2 in the appendix on present value
tables to calculate the present value of the periodic interest payments of $700,
and we use Table 1 in the same appendix to calculate the present value of the
single payment of $20,000 at maturity. Because interest payments are made every
six months, the compounding period is half a year. Thus, we have to convert
the annual rate to a semiannual rate of 5 percent (10 percent divided by two
six-month periods per year) and use ten periods (five years multiplied by two
six-month periods per year). With this information, we can compute the present
value of the bond as follows:
Present value of 10 periodic payments at 5%:
$700 (cid:6) 7.722 (from Table 2 in the appendix) $ 5,405.40
Present value of a single payment at the end of
10 periods at 5%: $20,000 (cid:6) 0.614
(from Table 1 in the appendix): 12,280.00
Present value of $20,000 bond $17,685.40
The market interest rate has increased so much since the bond was issued—
from 7 percent to 10 percent—that the value of the bond today is only $17,685.40.
That amount is all investors would be willing to pay at this time for a bond that
provides income of $700 every six months and a return of the $20,000 principal
in five years.
580 CHAPTER 13 Long-Term Liabilities
Case 2: Market Rate Below Face Rate
Figure 13-2 illustrates both of these examples—that is, when the market rate is
above the face rate (Case 1) and when the market rate is below the face rate (Case
2). If the market interest rate on the bond described on page 579 falls below the
face interest rate, say to 6 percent (3 percent semiannually), the present value of
the bond will be greater than the face value of $20,000:
Present value of 10 periodic payments at 3%:
$700 (cid:6) 8.530 (from Table 2 in the appendix) $ 5,971.00
Present value of a single payment at the end
of 10 periods at 3%: $20,000 (cid:6) 0.744
(from Table 1 in the appendix) 14,880.00
Present value of $20,000 bond $20,851.00
FIGURE 13-2 Using Present Value to Value a $20,000, 7 Percent, Five-Year Bond
Case 1: Face Rate = 7%
Interest Payments: $700 each six-month period
Market Rate = 10%
Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Period 8 Period 9 Period 10
10 6-month periods = 5 years
Present Value Repayment
$700 × 7.722 = $5,405.40 $20,000
Present
Value of
Bond
$17,685.40
Present Value
$20,000 × 0.614 = $12,280.00
Case 2: Face Rate = 7%
Interest Payments: $700 each six-month period
Market Rate = 6%
Period 1 Period 2 Period 3 Period 4 Period 5 Period 6 Period 7 Period 8 Period 9 Period 10
10 6-month periods = 5 years
Present Value Repayment
$700 × 8.530 = $5,971.00 $20,000
Present
Value of
Bond
$20,851.00
Present Value
$20,000 × 0.744 = $14,880.00
Amortization of Bond Discounts and Premiums 581
STOP
& APPLY
Tyler Company’s $900,000 bond issue pays semiannual interest of $16,000 and is due in 20 years.
Assume that the market interest rate is 6 percent. Calculate the amount that Tyler will receive.
(Calculate the present value of each bond issue and sum.)
SOLUTION
Present value of 40 periodic payments of 3% (from Table 2*):
$16,000 (cid:6) 23.115* (cid:2) $369,840
Present value of a single payment at the end of 20 years (40 periods) at 3% (from Table 1*):
$500,000 (cid:6) 0.307** (cid:2) 153,500
Total value of the bond issue $523,340
Total amount that Tyler will receive:
$369,840 (cid:3) $523,340 (cid:2) $893,180
*From Table 2 in the appendix on present value tables
**From Table 1 in the appendix on present value tables
Amortization of
A bond discount or premium represents the amount by which the total i nterest
Bond Discounts cost is higher or lower than the total interest payments. To record interest expense
properly and ensure that the carrying value of bonds payable at maturity equals |
and Premiums
face value, it is necessary to systematically reduce the bond discount or premium—
that is, to amortize them—over the life of the bonds. This is accomplished by
LO5 Amortize bond discounts
using either the straight-line method or the effective interest method.
and bond premiums using
the straight-line and effective
Amortizing a Bond Discount
interest methods.
In one of our earlier examples, Bharath Corporation issued $200,000 of five-year
bonds at a time when the market interest rate of 8 percent exceeded the face
interest rate of 7 percent. The bonds sold for $191,889, resulting in an unamor-
tized bond discount of $8,111.
Because a bond discount affects interest expense in each year of a bond
issue, the bond discount should be amortized over the life of the bond issue. In
this way, the unamortized bond discount will decrease gradually over time, and
the carrying value of the bond issue (face value less unamortized discount) will
gradually increase. By the maturity date, the carrying value of the bond issue will
equal its face value, and the unamortized bond discount will be zero.
In the following sections, we calculate Bharath Corporation’s total i nterest
cost and amortize its bond discount using the straight-line and the effective
interest methods.
Study Note Calculating Total Interest Cost When a corporation issues bonds at a
discount, the market (or effective) interest rate that it pays is greater than the
A bond discount is a component
face interest rate on the bonds. The reason is that the interest cost is the stated
of interest cost because it
interest payments plus the amount of the bond discount. That is, although the
represents the amount in
company does not receive the full face value of the bonds on issue, it still must
excess of the issue price that
pay back the full face value at maturity. The difference between the issue price
a corporation must pay on the
maturity date. and the face value must be added to the total interest payments to arrive at the
actual interest expense.
582 CHAPTER 13 Long-Term Liabilities
The full cost to Bharath Corporation of issuing its bonds at a discount is as
follows:
Cash to be paid to bondholders
Face value at maturity $200,000
Interest payments ($200,000 (cid:6) 0.07 (cid:6) 5 years) 70,000
Total cash paid to bondholders $270,000
Less cash received from bondholders 191,889
Total interest cost $ 78,111
Or, alternatively:
Interest payments ($200,000 (cid:6) 0.07 (cid:6) 5 years) $ 70,000
Bond discount 8,111
Total interest cost $ 78,111
The total interest cost of $78,111 is made up of $70,000 in interest pay-
ments and the $8,111 bond discount. Thus, the bond discount increases the
interest paid on the bonds from the face interest rate to the market interest
rate. The m arket (or effective) interest rate is the real interest cost of the bond
over its life.
To have each year’s interest expense reflect the market interest rate, the d iscount
must be allocated over the remaining life of the bonds as an increase in the interest
expense each period. Thus, interest expense for each period will exceed the actual
payment of interest by the amount of the bond discount amortized over the period.
This process of allocation is called amortization of the bond discount.
Some bonds do not require periodic interest payments. These bonds, called
Study Note zero coupon bonds, are simply a promise to pay a fixed amount at the matu-
rity date. They are issued at a large discount because the only interest that the
The discount on a zero coupon
buyer earns or the issuer pays is the discount. For example, a five-year, $200,000
bond represents the interest
zero coupon bond issued when the market rate is 10 percent, compounded
that will be paid (in its entirety)
semiannually, would sell for only $122,800. That amount is the present value of
on the maturity date.
a single payment of $200,000 at the end of five years. The discount of $77,200
($200,000 (cid:4) $122,800) is the total interest cost, which is amortized over the life
of the bond.
Straight-Line Method The straight-line method equalizes amortiza- |
tion of a bond discount for each interest period. Using our example of Bharath
Corporation, the interest payment dates of the bond issue are January 1 and
July 1 of each year, and the bonds mature in five years. With the straight-line
method, the amount of the bond discount amortized and the interest expense for
each semiannual period are calculated in four steps:
1. Total Interest Payments (cid:2) Interest Payments per Year (cid:6) Life of Bonds
(cid:2) 2 (cid:6) 5 (cid:2) 10
2. Amortization of Bond Discount per Interest Period (cid:2) _ ___B__o_n_ d_ _D_i_s_co__ u_n_t_ ___
Total Interest Payments
$8,111
(cid:2) _____ __
10
(cid:2) $811*
3. Cash Interest Payment (cid:2) Face Value (cid:6) Face Interest Rate (cid:6) Time
(cid:2) $200,000 (cid:6) 0.07 (cid:6) 6/12 (cid:2) $7,000
Amortization of Bond Discounts and Premiums 583
4. Interest Expense per Interest Period (cid:2) Interest Payment (cid:3) A mortization of
Bond Discount
(cid:2) $7,000 (cid:3) $811 (cid:2) $7,811
On July 1, 2010, the first semiannual interest date, the T accounts and entry
would be:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND DISCOUNT BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 7,000 July 1 811 July 1 7,811
A* (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)7,000 (cid:3)811 (cid:4)7,811 2010 Dr. Cr.
July 1 Bond Interest Expense 7,811
*Assumes cash paid.
*Rounded. Unamortized Bond Discount 811
Cash 7,000
Paid semiannual interest to
bondholders and amortized the discount
on 7%, 5-year bonds
Notice that the bond interest expense is $7,811, but the amount paid to the
bondholders is the $7,000 face interest payment. The difference of $811 is the
credit to Unamortized Bond Discount. This lowers the debit balance of Unamor-
tized Bond Discount and raises the carrying value of the bonds payable by $811
each interest period. If no changes occur in the bond issue, this entry will be
made every six months for the life of the bonds. When the bond issue matures,
the Unamortized Bond Discount account will have a zero balance, and the car-
rying value of the bonds will be $200,000—exactly equal to the amount due the
bondholders.
Although the straight-line method has long been used, it has a certain weak-
ness. When it is used to amortize a discount, the carrying value goes up each
period, but the bond interest expense stays the same; thus, the rate of interest falls
over time. Conversely, when this method is used to amortize a premium, the rate
of interest rises over time. The Accounting Principles Board therefore holds that
the straight-line method should be used only when it does not lead to a material
difference from the effective interest method.10 A material difference is one that
affects the evaluation of a company.
Effective Interest Method When the effective interest method is used to
compute the interest and amortization of a bond discount, a constant interest
rate is applied to the carrying value of the bonds at the beginning of each inter-
est period. This constant rate is the market rate (i.e., the effective rate) at the
time the bonds were issued. The amount amortized each period is the difference
between the interest computed by using the market rate and the actual interest
paid to bondholders.
As an example, we use the same facts we used earlier—a $200,000 bond issue
at 7 percent, with a five-year maturity and interest to be paid twice a year. The
market rate at the time the bonds were issued was 8 percent, so the bonds sold for
$191,889, a discount of $8,111. Table 13-3 shows the interest and amortization
of the bond discount.
584 CHAPTER 13 Long-Term Liabilities
The amounts in the table for period 1 were computed as follows:
Column A: The carrying value of the bonds is their face value less the unamor-
tized bond discount ($200,000 (cid:4) $8,111 (cid:2) $191,889).
Column B: The interest expense to be recorded is the effective interest. It is
found by multiplying the carrying value of the bonds by the market interest rate
for one-half year ($191,889 (cid:6) 0.08 (cid:6) 6/12 (cid:2) $7,676). |
Column C: The interest paid in the period is a constant amount computed by
Study Note multiplying the face value of the bonds by their face interest rate by the interest
time period ($200,000 (cid:6) 0.07 (cid:6) 6/12 (cid:2) $7,000).
Whether a bond is sold at a
discount or a premium, its Column D: The discount amortized is the difference between the effective inter-
carrying value will equal its face est expense to be recorded and the interest to be paid on the interest payment
value on the maturity date. date ($7,676 (cid:4) $7,000 (cid:2) $676).
Column E: The unamortized bond discount is the balance of the bond dis-
count at the beginning of the period less the current period amortization
of the discount ($8,111 (cid:4) $676 (cid:2) $7,435). The unamortized discount
decreases in each interest payment period because it is amortized as a portion
of interest expense.
Column F: The carrying value of the bonds at the end of the period is the carry-
ing value at the beginning of the period plus the amortization during the period
($191,889 (cid:3) $676 (cid:2) $192,565). Notice that the sum of the carrying value and
the unamortized discount (column F (cid:3) column E) always equals the face value of
the bonds ($192,565 (cid:3) $7,435 (cid:2) $200,000).
The entry to record the interest expense is exactly like the one when the
straight-line method is used. However, the amounts debited and credited to the
TABLE 13-3 Interest and Amortization of a Bond Discount: Effective Interest Method
A B C D E F
Semiannual Semiannual Unamortized
Interest Interest Bond
Carrying Expense at Payment to Amortization Discount Carrying
Semiannual Value at 8% to Be Bondholders of Bond at End of Value at End
Interest Beginning Recorded* (3 1/2% (cid:5) Discount Period of Period
Period of Period (4% (cid:5) A) $200,000) (B (cid:2) C) (E (cid:2) D) (A (cid:4) D)
0 $8,111 $191,889
1 $191,889 $7,676 $7,000 $676 7,435 192,565
2 192,565 7,703 7,000 703 6,732 193,268
3 193,268 7,731 7,000 731 6,001 193,999
4 193,999 7,760 7,000 760 5,241 194,759
5 194,758 7,790 7,000 790 4,451 195,549
6 195,548 7,822 7,000 822 3,629 196,371
7 196,370 7,855 7,000 855 2,774 197,226
8 197,225 7,889 7,000 889 1,885 198,115
9 198,114 7,925 7,000 925 960 199,040
10 199,038 7,960† 7,000 960 — 200,000
*Rounded to the nearest dollar.
Amortization of Bond Discounts and Premiums 585
various accounts are different. Using the effective interest method, the T accounts
and entry for July 1, 2010, would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND DISCOUNT BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 7,000 July 1 676 July 1 7,676
A* (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)7,000 (cid:3)676 (cid:4)7,676 2010 Dr. Cr.
July 1 Bond Interest Expense 7,676
*Assumes cash paid.
Unamortized Bond Discount 676
Cash 7,000
Paid semiannual interest to
bondholders and amortized the discount
on 7%, 5-year bonds
Although an interest and amortization table is useful because it can be pre-
Study Note pared in advance for all periods, it is not necessary to have one to determine the
amortization of a discount for any one interest payment period. It is necessary
The bond interest expense
only to multiply the carrying value by the effective interest rate and subtract the
recorded exceeds the amount
interest payment from the result. For example, the amount of discount to be
of interest paid because of
amortized in the seventh interest payment period is $855, calculated as follows:
the amortization of the bond
($196,370 (cid:6) 0.04) (cid:4) $7,000.
discount. The matching rule
Figure 13-3, which is based on the data in Table 13-3, shows how the e ffective
dictates that the discount be
amortized over the life of the interest method affects the amortization of a bond discount. Notice that the car-
bond. rying value (the issue price) is initially less than the face value, but that it gradually
increases toward face value over the life of the bond issue. Notice also that interest
expense exceeds interest payments by the amount of the bond d iscount amortized.
$200,000
$191,889
0
Years
eulaV
gniyrraC |
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
$7,000
2.5
Years
esnepxE
tseretnI
FIGURE 13-3
Face Value
Carrying Value and Interest Expense—
Bonds Issued at a Discount
UNAMORTIZED DISCOUNT
Carrying Value = Face Value – Unamortized Discount
Interest Expense = Carrying Value Market Interest Rate Time
$7,962
$7,676
Study Note
BOND DISCOUNT AMORTIZED
The bond interest increases
each period because the
carrying value of the bonds (the
Interest Payments = Face Value Face Interest Rate Time
principal on which the interest
is calculated) increases each
period. 0 0.5 1 1.5 2 3 3.5 4 4.5 5
586 CHAPTER 13 Long-Term Liabilities
Interest expense increases gradually over the life of the bond because it is based on
the gradually increasing carrying value (multiplied by the market interest rate).
Amortizing a Bond Premium
In our earlier example of bonds issued at a premium, Bharath Corporation
issued $200,000 of five-year bonds at a time when the market interest rate was
6 percent and the face interest rate was 7 percent. The bonds sold for $208,530,
which resulted in an unamortized bond premium of $8,530. Like a discount, a
premium must be amortized over the life of the bonds so that it can be matched
to its effects on interest expense during that period. In the following sections, we
calculate Bharath’s total interest cost and amortize its bond premium using the
straight-line and effective interest methods.
Calculation of Total Interest Cost Because the bondholders paid more
Study Note than face value for the bonds, the premium of $8,530 ($208,530 (cid:4) $200,000)
represents an amount that the bondholders will not receive at maturity. The
A bond premium is deducted
premium is in effect a reduction, in advance, of the total interest paid on the
from interest payments in
bonds over the life of the bond issue. The total interest cost over the issue’s life
calculating total interest
can be computed as follows:
because a bond premium
represents an amount over the Cash to be paid to bondholders
face value of a bond that the Face value at maturity $200,000
corporation never has to return
Interest payments ($200,000 (cid:6) 0.07 (cid:6) 5 years) 70,000
to the bondholders. In effect, it
Total cash paid to bondholders $270,000
reduces the higher-than-market
interest the corporation is Less cash received from bondholders 208,530
paying on the bond. Total interest cost $ 61,470
Alternatively, the total interest cost can be computed as follows:
Interest payments ($200,000 (cid:6) 0.07 (cid:6) 5 years) $ 70,000
Less bond premium 8,530
Total interest cost $ 61,470
Notice that the total interest payments of $70,000 exceed the total interest cost
of $61,470 by $8,530, the amount of the bond premium.
Straight-Line Method Under the straight-line method, the bond premium is
spread evenly over the life of the bond issue. As with bond discounts, the amount
of the bond premium amortized and the interest expense for each semiannual
period are computed in four steps:
1. Total Interest Payments (cid:2) Interest Payments per Year (cid:6) Life of Bonds
(cid:2) 2 (cid:6) 5 (cid:2) 10
2. Amortization of Bond Premium per Interest Period (cid:2) ____B__o_n_ d_ _P_r_e_m_i_ u_m__ ___
Total Interest Payments
$8,530
(cid:2) _____ __
10
(cid:2) $853
3. Cash Interest Payment (cid:2) Face Value (cid:6) Face Interest Rate (cid:6) Time
(cid:2) $200,000 (cid:6) 0.07 (cid:6) 6/12 (cid:2) $7,000
4. Interest Expense per Interest Period (cid:2) Interest Payment
(cid:4) Amortization of Bond Premium
(cid:2) $7,000 (cid:4) $853 (cid:2) $6,147
Amortization of Bond Discounts and Premiums 587
On July 1, 2010, the first semiannual interest date, the T accounts and
entry would be like this:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND DISCOUNT BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 7,000 July 1 853 July 1 6,147
A* (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)7,000 (cid:4)853 (cid:4)6,147 2010 Dr. Cr.
July 1 Bond Interest Expense 6,147
*Assumes cash paid.
Unamortized Bond Discount 853
Cash 7,000
Paid semiannual interest to
bondholders and amortized the discount |
on 7%, 5-year bonds
Note that the bond interest expense is $6,147, but the amount that
Study Note bondholders receive is the $7,000 face interest payment. The difference of $853
is the debit to Unamortized Bond Premium. This lowers the credit balance of
The bond interest expense
the Unamortized Bond Premium account and the carrying value of the bonds
recorded is less than the
payable by $853 each interest period. If the bond issue remains unchanged, the
amount of the interest paid
same entry will be made on every semiannual interest date over the life of the
because of the amortization
bond issue. When the bond issue matures, the balance in the Unamortized Bond
of the bond premium. The
Premium account will be zero, and the carrying value of the bonds payable will
matching rule dictates that the
premium be amortized over be $200,000—exactly equal to the amount due the bondholders.
the life of the bond. As noted earlier, the straight-line method should be used only when it does
not lead to a material difference from the effective interest method.
Effective Interest Method Under the straight-line method, the effective inter-
est rate changes constantly, even though the interest expense is fixed, because the
effective interest rate is determined by comparing the fixed interest expense with a
carrying value that changes as a result of amortizing the discount or premium. To
apply a fixed interest rate over the life of the bonds based on the actual market rate
at the time of the bond issue, one must use the effective interest method. With this
method, the interest expense decreases slightly each period (see Table 13-4, column B)
because the amount of the bond premium amortized increases slightly (column D).
This occurs because a fixed rate is applied each period to the gradually decreasing
carrying value (column A). The first interest payment is recorded as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH UNAMORTIZED BOND DISCOUNT BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 7,000 July 1 744 July 1 6,256
A* (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)7,000 (cid:4)744 (cid:4)6,256 2010 Dr. Cr.
July 1 Bond Interest Expense 6,256
*Assumes cash paid.
Unamortized Bond Discount 744
Cash 7,000
Paid semiannual interest to
bondholders and amortized the discount
on 7%, 5-year bonds
588 CHAPTER 13 Long-Term Liabilities
TABLE 13-4 Interest and Amortization of a Bond Premium: Effective Interest Method
A B C D E F
Semiannual Semiannual
Interest Interest Unamortized
Expense at Payment to Amortization Bond Premium Carrying
Carrying Value 6% to Be Bondholders of Bond at End of Value at End
Semiannual at Beginning Recorded* (3 1/2% (cid:5) Premium Period of Period
Interest Period of Period (3% (cid:5) A) $200,000) (C (cid:2) B) (E (cid:2) D) (A (cid:2) D)
0 $8,530 $208,530
1 $208,530 $6,256 $7,000 $744 7,786 207,786
2 207,786 6,234 7,000 766 7,020 207,020
3 207,020 6,211 7,000 789 6,231 206,231
4 206,231 6,187 7,000 813 5,418 205,418
5 205,418 6,163 7,000 837 4,581 204,581
6 204,581 6,137 7,000 863 3,718 203,718
7 203,718 6,112 7,000 888 2,830 202,830
8 202,830 6,085 7,000 915 1,915 201,915
9 201,915 6,057 7,000 943 972 200,972
10 200,972 6,028† 7,000 972 — 200,000
*Rounded to the nearest dollar.
†Last period’s interest expense equals $6,028 ($7,000 (cid:4) $972); it is actually equal to $6,029 ($200,972 (cid:6) 0.03) but the difference is because
of the cumulative effect of rounding.
$208,530
$200,000
0
Years
eulaV
gniyrraC
Carrying Value = Face Value + Unamortized Premium
Face Value
0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
$6,028
esnepxE
tseretnI
FIGURE 13-4
Carrying Value and Interest Expense—
Bonds Issued at a Premium
UNAMORTIZED PREMIUM
Interest Payments = Face Value Face Interest Rate Time
$7,000
BOND PREMIUM AMORTIZED
$6,256
Interest Expense = Carrying Value Market Interest Rate Time
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Years
Amortization of Bond Discounts and Premiums 589
Note that the unamortized bond premium (column E) decreases gradually to
zero as the carrying value decreases to the face value (column F). To find the |
amount of premium amortized in any one interest payment period, subtract the
effective interest expense (the carrying value times the effective interest rate,
column B) from the interest payment (column C). In semiannual interest period
5, for example, the amortization of premium is $837, which is calculated in the
following manner: $7,000 (cid:4) ($205,418 (cid:6) 0.03).
Figure 13-4, which is based on the data in Table 13-4, shows how the
effective interest method affects the amortization of a bond premium. Notice that
the c arrying value (issue price) is initially greater than the face value, but that it
gradually decreases toward the face value over the life of the bond issue. Notice
also that interest payments exceed interest expense by the amount of the premium
amortized. Interest expense decreases gradually over the life of the bond because
it is based on the gradually decreasing carrying value (multiplied by the market
interest rate).
STOP
& APPLY
On June 1, Lazo Corporation issues $4,000,000 of 8 percent, 20-year bonds at 97. Interest is
payable semiannually, on May 31 and November 30. Lazo’s fiscal year ends on November 30.
1. U sing the straight-line method of amortiza- 2. U sing the effective interest method and
tion, prepare entries in journal form for assuming the same facts as above except that
June 1 and November 30. the market rate of interest is 9 percent, prepare
the entry in journal form for November 30.
SOLUTION
1. Straight-line method
Dr. Cr.
June 1 Cash 3,880,000
Unamortized Bond Discount 120,000
Bonds Payable 4,000,000
Issue of $4,000,000 of 8%,
20-year bonds at 97
$4,000,000 (cid:6) 0.97 (cid:2) $3,880,000
Nov. 30 Bond Interest Expense 163,000
Unamortized Bond Discount 3,000
Cash 160,000
Paid bondholders semiannual interest and
amortized the discount on 8%, 20-year bonds
$120,000 (cid:5) 40 periods (cid:2) $3,000
$4,000,000 (cid:6) 0.04 (cid:2) $160,000
2. Effective interest method
Nov. 30 Bond Interest Expense 174,600
Unamortized Bond Discount 14,600
Cash 160,000
Paid bondholders semiannual interest and
amortized the discount on 8%, 20-year bonds
$3,880,000 (cid:6) 0.045 (cid:2) $174,600
$4,000,000 (cid:6) 0.04 (cid:2) $160,000
590 CHAPTER 13 Long-Term Liabilities
Retirement
Usually, companies pay bonds when they are due—on the maturity date. However,
of Bonds as we noted in our earlier discussion of callable and convertible bonds, retiring a
bond issue before its maturity date can be to a company’s advantage. For example,
SO6 Account for the retirement when interest rates drop, many companies refinance their bonds at the lower rate,
much like homeowners who refinance their mortgage loans when interest rates go
of bonds and the conversion of
down. Even though companies usually pay a premium for early extinguishment of
bonds into stock.
bond debt, what they save on interest can make the refinancing cost-effective.
Calling Bonds
Let’s suppose that Bharath Corporation can call, or retire, at 105 the $200,000 of
bonds it issued at a premium (104.265) on January 1, 2010, and that it decides
to do so on July 1, 2013. The retirement thus takes place on the seventh interest
payment date. Assume that the entry for the required interest payment and the
amortization of the premium has been made. The T accounts and entry to record
the retirement of the bonds is as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BONDS PAYABLE LOSS ON RETIREMENT OF BONDS
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 210,000 July 1 200,000 July 1 7,170
UNAMORTIZED BOND PREMIUM
Dr. Cr.
July 1 2,830
Entry in Journal Form:
2013 Dr. Cr.
July 1 Bonds Payable 200,000
Unamortized Bond Premium 2,830
Loss on Retirement of Bonds 7,170
Cash 210,000
Retired 7% bonds at 105
A (cid:3) L (cid:4) SE In this entry, the cash paid is the face value times the call price ($200,000 (cid:6)
(cid:4)210,000 (cid:4)200,000 (cid:4)7,170 1.05 (cid:2) $210,000). The unamortized bond premium can be found in column E
(cid:4)2,830
of Table 13-4. The loss on retirement of bonds occurs because the call price
of the bonds is greater than the carrying value ($210,000 (cid:4) $202,830 (cid:2)
$7,170). |
Sometimes, a rise in the market interest rate can cause the market value of
bonds to fall considerably below their face value. If it has the cash to do so, the
company may find it advantageous to purchase the bonds on the open market
and retire them, rather than wait and pay them off at face value. A gain is recog-
nized for the difference between the purchase price of the bonds and the carrying
value of the retired bonds.
For example, suppose that because of a rise in interest rates, Bharath Corpo-
ration is able to purchase the $200,000 bond issue on the open market at 85. The
T accounts and entry would be as follows:
Retirement of Bonds 591
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BONDS PAYABLE GAIN ON RETIREMENT OF BONDS
Dr. Cr. Dr. Cr. Dr. Cr.
July 1 170,000 July 1 200,000 July 1 32,830
UNAMORTIZED BOND PREMIUM
Dr. Cr.
July 1 2,830
Entry in Journal Form:
2013 Dr. Cr.
July 1 Bonds Payable 200,000
Unamortized Bond Premium 2,830
Cash 170,000
Gain on Retirement of Bonds 32,830
Purchased and retired 7% bonds at 85
A (cid:3) L (cid:4) SE Converting Bonds
(cid:4)170,000 (cid:4)200,000 (cid:3)32,830
(cid:4)2,830 When a bondholder converts bonds to common stock, the company records the
common stock at the carrying value of the bonds. The bond liability and the
unamortized discount or premium are written off the books. For this reason,
no gain or loss on the transaction is recorded. For example, suppose Bharath
Corporation does not call its bonds on July 1, 2013. Instead, the corporation’s
bondholders decide to convert all their bonds to $8 par value common stock
under a convertible provision of 40 shares of common stock for each $1,000
bond. The T accounts and entry would be as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
BONDS PAYABLE COMMON STOCK
Dr. Cr. Dr. Cr.
July 1 200,000 July 1 64,000
UNAMORTIZED BOND PREMIUM ADDITIONAL PAID-IN CAPITAL
Dr. Cr. Dr. Cr.
July 1 2,830 July 1 138,830
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)200,000 (cid:3)64,000
2013 Dr. Cr.
(cid:4)2,830 (cid:3)138,830
July 1 Bonds Payable 200,000
Unamortized Bond Premium 2,830
Common Stock 64,000
Additional Paid-in Capital 138,830
Converted 7% bonds payable into $8 par 138, 828 value
common stock at a rate of 40 shares for each
$1,000 bond
The unamortized bond premium is found in column E of Table 13-4. At a
rate of 40 shares for each $1,000 bond, 8,000 shares will be issued, with a total
par value of $64,000 (8,000 (cid:6) $8). The Common Stock account is credited for
the amount of the par value of the stock issued. In addition, Additional Paid-in
592 CHAPTER 13 Long-Term Liabilities
Capital is credited for the difference between the carrying value of the bonds and
the par value of the stock issued ($202,830 (cid:4) $64,000 (cid:2) $138,830). No gain or
loss is recorded.
STOP
& APPLY
Schiff Stores has outstanding $100,000 of 7 percent bonds callable at 103. On July 1, immediately
after recording the payment of the semiannual interest and the amortization of the premium, the
unamortized bond premium equaled $2,500. On that date, all of the bonds were called and retired.
a. H ow much cash must be paid to retire the b. I s there a gain or loss on retirement, and if
bonds? so, how much is it?
SOLUTION
(1) Amount paid: $100,000 (cid:6) 1.03 = $103,000
(2) There is a loss on retirement of $500, computed as follows:
Cash paid – Book value: $103,000 (cid:4) ($100,000 (cid:3) $2,500) (cid:2) $500
Other Bonds
Among the other issues involved in accounting for bonds payable are the sale of
Payable Issues bonds between interest payment dates and the year-end accrual of bond interest
expense.
SO7 Record bonds issued
between interest dates and Sale of Bonds Between Interest Dates
year-end adjustments.
Although corporations may issue bonds on an interest payment date, as in our
previous examples, they often issue them between interest payment dates. When
that is the case, they generally collect from the investors the interest that would
have accrued for the partial period preceding the issue date, and at the end of the |
first interest period, they pay the interest for the entire period. In other words,
the interest collected when bonds are sold is returned to investors on the next
interest payment date.
There are two reasons for following this procedure:
1. From a practical standpoint, if a company issued bonds on several differ-
ent days and did not collect the accrued interest, records would have to be
maintained for each bondholder and date of purchase. The interest due each
bondholder would therefore have to be computed for a different time period.
Clearly, this procedure would involve large bookkeeping costs. On the other
hand, if accrued interest is collected when the bonds are sold, the corporation
can pay the interest due for the entire period on the interest payment date,
thereby eliminating the extra computations and costs.
2. When accrued interest is collected in advance, the amount is subtracted from
the full interest paid on the interest payment date. Thus, the resulting interest
expense represents the amount for the time the money was borrowed.
For example, suppose Bharath Corporation sold $200,000 of 7 percent, five-
year bonds for face value on May 1, 2010, rather than on January 1, 2010. The
T accounts and entry to record the sale of the bonds is as follows:
Other Bonds Payable Issues 593
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BONDS PAYABLE BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
May 1 204,667 May 1 200,000 May 1 4,667
Entry in Journal Form:
2010 Dr. Cr.
May 1 Cash 204,667
Bond Interest Expense 4,667
Bonds Payable 200,000
Sold 7%, 5-year bonds at face value plus
4 months’ accrued interest
$200,000 (cid:6) 0.07 (cid:6) 4/12 (cid:2) $4,667
A (cid:3) L (cid:4) SE Cash is debited for the amount received, $204,667 (the face value of $200,000
(cid:3)204,667 (cid:3)200,000 (cid:3)4,667
plus four months’ accrued interest of $4,667). Bond Interest Expense is credited
for the $4,667 of accrued interest, and Bonds Payable is credited for the face
value of $200,000.
When the first semiannual interest payment date arrives, this T account and
entry is made:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr.
July 1 7,000 July 1 7,000
A* (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)7,000 (cid:4)7,000 2010 Dr. Cr.
July 1 Bond Interest Expense 7,000
*Assumes cash paid.
Cash 7,000
Paid semiannual interest
$200,000 (cid:6) 0.07 (cid:6) 6/12 (cid:2) $7,000
Notice that the entire half-year interest is debited to Bond Interest Expense and
credited to Cash because the corporation pays bond interest every six months,
in full six-month amounts. Figure 13-5 illustrates this process. The actual inter-
est expense for the two months that the bonds were outstanding is $2,333. This
amount is the net balance of the $7,000 debit to Bond Interest Expense on
July 1 less the $4,667 credit to Bond Interest Expense on May 1. You can see
these steps clearly in the following T account:
BOND INTEREST EXPENSE
Dr. Cr.
Bal. 0 May 1 4,667
July 1 7,000
Bal. 2,333
YYear-End Accrual of Bond Interest Expense
Study Note
BBond interest payment dates rarely correspond with a company’s fiscal year. There-
Remember that adjusting ffore, an adjustment must be made to accrue the interest expense on the bonds from
entries never affect cash. tthe last interest payment date to the end of the fiscal year. In addition, any discount
oor premium on the bonds must be amortized for the partial period.
594 CHAPTER 13 Long-Term Liabilities
FIGURE 13-5 Bond interest paid to buyer at
Interest Expense When Bonds Are interest payment date = $7,000
Issued Between Interest Dates January 1, 2010 July 1, 2010
May 1, 2010
Accrued bond interest Date of Bond interest expense
paid by buyer at issuance to issuer = $2,333
issuance = $4,667
In our example of bonds issued at a premium, Bharath Corporation issued
$200,000 of bonds on January 1, 2010, at 104.265 percent of face value. Sup-
pose Bharath’s fiscal year ends on September 30, 2010. In the period since the
interest payment and amortization of the premium on July 1, three months’ |
worth of interest has accrued. Under the effective interest method, the following
adjusting T account and entry would be made:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
UNAMORTIZED BOND PREMIUM BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr.
Sept. 30 383 Sept. 30 3,117
BOND INTEREST PAYABLE
Dr. Cr.
Sept. 30 3,500
A (cid:3) L (cid:4) SE Entry in Journal Form:
(cid:4)383 (cid:4)3,117 2010 Dr. Cr.
(cid:3)3,500
Sept. 30 Bond Interest Expense 3,117
Unamortized Bond Premium 383
Bond Interest Payable 3,500
To record accrual of interest on 7% bonds
payable for 3 months and amortization
of one-half of the premium for the
second interest payment period
This entry covers one-half of the second interest period. Unamortized Bond
Premium is debited for $383, which is one-half of $766, the amortization of
the premium for the second period from Table 13-4. Bond Interest Payable
is c redited for $3,500, three months’ interest on the face value of the bonds
Study Note ($200,000 (cid:6) 0.07 (cid:6) 3/12). The net debit figure of $3,117 ($3,500 (cid:4) $383) is
the bond interest expense for the three-month period.
The matching rule dictates that
On the interest payment date of January 1, 2011, the entry to pay the
both the accrued interest and
bondholders and amortize the premium is as follows:
the amortization of a premium
or discount be recorded at
year end.
Other Bonds Payable Issues 595
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
CASH BOND INTEREST PAYABLE BOND INTEREST EXPENSE
Dr. Cr. Dr. Cr. Dr. Cr.
Jan. 1 7,000 Jan. 1 3,500 Jan. 1 3,117
UNAMORTIZED BOND PREMIUM
Dr. Cr.
Jan. 1 383
Entry in Journal Form:
2011 Dr. Cr.
Jan. 1 Bond Interest Expense 3,117
Bond Interest Payable 3,500
Unamortized Bond Premium 383
Cash 7,000
Paid semiannual interest, including interest previously
accrued, and amortized the premium for the period
since the end of the fiscal year
A (cid:3) L (cid:4) SE One-half ($3,500) of the amount paid ($7,000) was accrued on September 30.
(cid:4)7,000 (cid:4)3,500 (cid:4)3,117 Unamortized Bond Premium is debited for $383, the remaining amount to be
(cid:4)383 amortized for the period ($766 (cid:4) $383). The resulting bond interest expense is the
amount that applies to the three-month period from October 1 to December 31.
Bond discounts are recorded at year end in the same way as bond premi-
ums. The difference is that the amortization of a bond discount increases interest
expense instead of decreasing it.
STOP
& APPLY
Hardin Associates is authorized to issue $1,000,000 in bonds on January 1. The bonds carry a face
interest rate of 8 percent, which is to be paid on January 1 and July 1. Prepare entries in journal form
for (a) the issue of the bonds on April 1 at 100 and (b) the interest payment on July 1. (c) How
much was the total interest expense for the first six months of the year?
SOLUTION
(a) April 1 Cash 1,020,000
Bonds Payable 1,000,000
Bond Interest Expense 20,000
Issuance of 8 percent bonds
(b) July 1 Bond Interest Expense 40,000
Cash 40,000
Interest payment
(c) Total interest expense: $40,000 (cid:4) $20,000 (cid:2) $20,000
596 CHAPTER 13 Long-Term Liabilities
(cid:2)WILSON MANUFACTURING COMPANY: REVIEW PROBLEM
In the Decision Point at the beginning of the chapter, we noted that the management
of Wilson Manufacturing Company was considering how to finance the expansion of its
metal window division. We posed these questions:
• What should Wilson consider in deciding to issue long-term debt?
• How does one evaluate whether a company has too much debt?
• How are long-term bonds accounted for in Wilson’s records?
Wilson’s management considered issuing more common stock to finance the expan-
sion or obtaining a new building for the division by taking on another long-term
lease. Ultimately, however, it decided to raise capital by issuing long-term bonds. In
reaching this decision, management evaluated how much debt the company should
carry and how much risk the assumption of long-term debt posed by computing the
Amortization Schedule, company’s debt to equity ratio and interest coverage ratio. It also calculated the effect of |
off-balance-sheet financing of a long-term lease.
Bond Issue, Bond
Wilson’s bond indenture stated that the company would issue $2,500,000 of
Retirement, Bond
8 percent, five-year bonds on January 1, 2011, and would pay interest semiannually on
Conversion, and Debt
June 30 and December 31 in each of the five years. It also stated that the bonds would
Analysis be callable at 104 and that each $1,000 bond would be convertible to 30 shares of
LO1 LO3 $10 par value common stock.
Wilson sold the bonds on January 1, 2011, at 96 because the market rate of inter-
LO5 SO6
est for similar investments was 9 percent. It decided to amortize the bond discount by
using the effective interest method. On July 1, 2013, management called and retired
half the bonds, and investors converted the other half to common stock.
Required
1. Prepare an interest and amortization schedule for the first five interest periods.
2. Prepare entries in journal form to record the sale of the bonds, the first two
interest payments, the bond retirement, and the bond conversion.
3. User insight: Using the figures presented for Wilson in the Decision Point and
recalling that the company had income before income taxes of $250 million and
interest expense of $50 million, compute its debt to equity ratio and interest
coverage ratio in the first year of the bond issue. What is your assessment of
Wilson’s level of debt?
Wilson Manufacturing Company: Review Problem 597
Answers to
1. Schedule for the first five interest periods:
Review Problem
2. Entries in journal form:
598 CHAPTER 13 Long-Term Liabilities
3. Ratios computed subsequent to bond issue:
(Total Liabilities (cid:3) Bond Issue less Discount)
Debt to Equity Ratio (cid:2) __________ _________ _ ________ _ ________
Stockholders’ Equity
$1,000,000 (cid:3) $2,400,000
=
$3,200,000
$3,400,000
(cid:2) _ _________
$3,200,000
(cid:2) 1.06 Times
Income Before Income Taxes (cid:3) Interest Expense (cid:3)
Interest Coverage (cid:2) Bond Interest Expense
Interest Expense (cid:3) Bond Interest Expense
$250,000 (cid:3) $50,000 (cid:3) $216, 360
(cid:2) ______ $_ 5_ 0_ ,_
0
_ 0_ 0_ (cid:3)__ $_ 2_ 1_ 6_ ,_ 3_ 6_ 0_ _____
$516,360
(cid:2) _ _______
$266,360
(cid:2) 1.94 Times
The increased debt will represent more risk, especially since W ilson has long-
term lease obligations.
Stop & Review 599
STOP
& REVIEW
LO1 Identify the manage- Long-term debt is used to finance assets and business activities, such as research
ment issues related to and development, that will produce income in future years. The management
long-term debt. issues related to long-term debt are whether to take on long-term debt, how much
debt to carry, and what types of debt to incur. The advantages of issuing long-
term debt are that common stockholders do not relinquish any control, interest
on debt is tax-deductible, and financial leverage can increase earnings. The disad-
vantages are that interest and principal must be paid on time and financial leverage
can work against a company if an investment is not successful. The level of debt
can be evaluated using the debt to equity ratio and the interest coverage ratio.
Common types of long-term debt are bonds, notes, mortgages, long-term leases,
pension liabilities, other post-retirement benefits, and deferred income taxes.
LO2 Describe the features A bond is a security that represents money borrowed from the investing public.
of a bond issue and the When a corporation issues bonds, it enters into a contract, called a bond inden-
major characteristics of ture, with the bondholders. The bond indenture defines the terms of the bond
bonds. issue. A bond issue is the total value of bonds issued at one time. The prices of
bonds are stated in terms of a percentage of the face value, or principal, of the
bonds. The face interest rate is the fixed rate of interest paid to bondholders based
on the face value. The market interest rate is the rate of interest paid in the market
on bonds of similar risk. If the market rate fluctuates from the face interest rate
before the bond issue date, the bonds will sell at either a discount or a premium. |
A corporation can issue several types of bonds, each having different char-
acteristics. For example, a bond issue may or may not require security (secured
versus unsecured bonds). It may be payable at a single time (term bonds) or
at several times (serial bonds). And the holder may receive interest automati-
cally (registered bonds) or may have to return coupons to receive interest payable
(coupon bonds). Bonds may also be callable and convertible.
LO3 Record bonds issued at Bondholders pay face value for bonds when the interest rate on the bonds
face value and at a dis- approximates the market rate for similar investments. The issuing corporation
count or premium. records the bond issue at face value as a long-term liability in the Bonds Payable
account. Bonds are issued at a discount when their face interest rate is lower than
the market rate for similar investments. The difference between the face value and
the issue price is debited to Unamortized Bond Discount. Bonds are issued at a
premium when their face interest rate is greater than the market interest rate on
similar investments. The difference between the issue price and the face value is
credited to Unamortized Bond Premium.
LO4 Use present values to The value of a bond is determined by summing the present values of (1) the series
determine the value of of fixed interest payments of the bond issue and (2) the single payment of the face
bonds. value at maturity. Tables 1 and 2 in the appendix on present value tables should
be used in making these computations.
LO5 Amortize bond discounts The straight-line method allocates a fixed portion of a bond discount or premium
and bond premiums each interest period to adjust the interest payment to interest expense. The effec-
using the straight-line tive interest method, which is used when the effects of amortization are material,
and eff ective interest applies a constant rate of interest to the carrying value of the bonds. To find
methods. interest and the amortization of discounts or premiums, the effective interest rate
is applied to the carrying value of the bonds (face value minus the discount or
600 CHAPTER 13 Long-Term Liabilities
plus the premium) at the beginning of the interest period. The amount of the dis-
count or premium to be amortized is the difference between the interest figured
by using the effective rate and that obtained by using the face rate. The results of
using the effective interest method on bonds issued at a discount or a premium
are summarized below and compared with issuance at face value:
Bonds Issued at
Face Value Discount Premium
Trend in carrying value Constant Increasing Decreasing
over bond term
Trend in interest expense Constant Increasing Decreasing
over bond term
Interest expense versus Interest expense (cid:2) Interest expense (cid:8) Interest expense (cid:9)
interest payments interest payments interest payments interest payments
Classification of bond Not applicable Contra-liability Adjunct-liability (added to
discount or premium (deducted from Bonds Payable)
Bonds Payable)
Supplemental Objectives
SO6 Account for the
Callable bonds can be retired before maturity at the option of the issuing corpora-
retirement of bonds and
tion. The call price is usually an amount greater than the face value of the bonds,
the conversion of bonds in which case the corporation recognizes a loss on the retirement of the bonds.
into stock. Sometimes, a rise in the market interest rate causes the market value of the bonds
to fall below face value. If a company purchases its bonds on the open market at a
price below carrying value, it recognizes a gain on the transaction.
Convertible bonds allow the bondholder to convert bonds to the issuing
corporation’s common stock. When bondholders exercise this option, the com-
mon stock issued is recorded at the carrying value of the bonds being converted.
No gain or loss is recognized.
SO7 Record bonds issued When bonds are sold between the interest payment dates, the issuing corpora-
between interest tion collects from investors the interest that has accrued since the last interest |
dates and year-end payment date. When the next interest payment date arrives, the corporation pays
adjustments. the bondholders interest for the entire interest period.
When the end of a corporation’s fiscal year does not fall on an interest payment
date, the corporation must accrue bond interest expense from the last interest
payment date to the end of its fiscal year. This accrual results in the i nclusion of
the interest expense in the year it is incurred.
REVIEW of Concepts and Terminology
The following concepts and terms Bond issue 573 (LO2) Coupon bonds 575 (LO2)
were introduced in this chapter:
Callable bonds 574 (LO2) Deferred income taxes 571 (LO1)
Bond 573 (LO2)
Call price 574 (LO2) Defined benefit plan 570 (LO1)
Bond certificate 573 (LO2)
Capital lease 568 (LO1) Defined contribution plan
Bond indenture 573 (LO2) 570 (LO1)
Convertible bonds 574 (L02)
Stop & Review 601
Discount 573 (LO2) Operating lease 568 (LO1) Straight-line method 582 (LO5)
Early extinguishment of Other post-retirement Term bonds 574 (LO2)
debt 574 (LO2) benefits 571 (LO1)
Unsecured bonds 574 (LO2)
Effective interest method 583 (LO5) Pension fund 570 (LO1)
Zero coupon bonds 582 (LO5)
Face interest rate 573 (LO2) Pension plan 570 (LO1)
Financial leverage 564 (LO1) Premium 574 (LO2) Key Ratio
Market interest rate 573 (LO2) Registered bonds 575 (LO2) Interest coverage ratio 566 (LO1)
Mortgage 567 (LO1) Secured bonds 574 (LO2)
Off-balance-sheet Serial bonds 574 (LO2)
financing 565 (LO1)
602 CHAPTER 13 Long-Term Liabilities
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Bond Versus Common Stock Financing
SE 1. Indicate whether each of the following is an advantage or a disadvantage of
using long-term bond financing rather than issuing common stock.
1. Interest paid on bonds is tax deductible.
2. Investments are sometimes not as successful as planned.
3. Financial leverage can have a negative effect when investments do not earn as
much as the interest payments on the related debt.
4. Bondholders do not have voting rights in a corporation.
5. Positive financial leverage may be achieved.
LO1 Types of Long-Term Liabilities
SE 2. Place the number of the liability next to the statement to which it applies.
1. Bonds payable ___ a. May result in a capital lease
2. Long-term notes payable ___ b. Differences in income taxes on
3. Mortgage payable accounting income and taxable income
4. Long-term lease ___ c. The most popular form of long-term
5. Pension liabilities financing
6. Other post-retirement ___ d. Often used to purchase land and
benefits buildings
7. Deferred income taxes ___ e. Often used interchangeably with bonds
payable
___ f. Future health care costs are a major
component
___ g. May include 401(k), ESOPs, or profit-
sharing
LO1 Mortgage Payable
SE 3. Karib Corporation purchased a building by signing a $150,000 long-term
mortgage with monthly payments of $1,200. The mortgage carries an interest rate
of 8 percent. Prepare a monthly payment schedule showing the monthly p ayment,
the interest for the month, the reduction in debt, and the unpaid balance for the
first three months. (Round to the nearest dollar.)
LO4 Valuing Bonds Using Present Value
SE 4. Rogers Paints, Inc., is considering the sale of two bond issues. Choice A is a
$600,000 bond issue that pays semiannual interest of $32,000 and is due in 20 years.
Choice B is a $600,000 bond issue that pays semiannual interest of $30,000 and is
due in 15 years. Assume that the market interest rate for each bond is 12 percent.
Calculate the amount that Rogers Paints will receive if both bond issues occur. (Cal-
culate the present value of each bond issue and sum.)
LO3 LO5 Straight-Line Method
SE 5. On April 1, 2010, Morimoto Corporation issued $8,000,000 in 8 percent,
five-year bonds at 98. The semiannual interest payment dates are April 1 and
October 1. Prepare entries in journal form for the issue of the bonds by Morim-
oto on April 1, 2010, and the first two interest payments on October 1, 2010,
and April 1, 2011. Use the straight-line method and ignore year-end accruals. |
Chapter Assignments 603
LO3 LO5 Effective Interest Method
SO7 SE 6. On March 1, 2011, Fast Freight Company sold $400,000 of its 9 percent,
20-year bonds at 109.9. The semiannual interest payment dates are March 1 and
September 1. The market interest rate is 8 percent. The firm’s fiscal year ends
August 31. Prepare entries in journal form to record the sale of the bonds on
March 1, the accrual of interest and amortization of premium on August 31, and
the first interest payment on September 1. Use the e ffective interest method to
amortize the premium.
SO6 Bond Retirement
SE 7. The Silk Corporation has outstanding $200,000 of 8 percent bonds c allable
at 104. On December 1, immediately after the payment of the semiannual i nterest
and the amortization of the bond discount were recorded, the unamortized bond
discount equaled $5,250. On that date, $120,000 of the bonds were called and
retired. Prepare the entry in journal form to record the retirement of the bonds
on December 1.
SO6 Bond Conversion
SE 8. The Tramot Corporation has $2,000,000 of 6 percent bonds outstand-
ing. There is $40,000 of unamortized discount remaining on the bonds after
the March 1, 2011, semiannual interest payment. The bonds are convertible at
the rate of 20 shares of $10 par value common stock for each $1,000 bond. On
March 1, 2011, bondholders presented $1,200,000 of the bonds for conversion.
Prepare the entry in journal form to record the conversion of the bonds.
SO7 Bond Issue Between Interest Dates
SE 9. Downey Corporation sold $400,000 of 9 percent, 10-year bonds for face
value on September 1, 2011. The issue date of the bonds was May 1, 2011.
The company’s fiscal year ends on December 31, and this is its only bond issue.
Record the sale of the bonds on September 1 and the first semiannual interest
payment on November 1, 2011. What is the bond interest expense for the year
ended December 31, 2011?
LO3 LO5 Year-End Accrual of Bond Interest
SO7 SE 10. On October 1, 2010, Tender Corporation issued $500,000 of 9 percent
bonds at 96. The bonds are dated October 1 and pay interest semiannually. The
market rate of interest is 10 percent, and the company’s year end is December
31. Prepare the entries in journal form to record the issuance of the bonds, the
accrual of the interest on December 31, 2010, and the payment of the first semi-
annual i nterest on April 1, 2011. Assume the company uses the effective interest
method to amortize the bond discount.
Exercises
LO1 LO2 Discussion Questions
SO6
E 1. Develop brief answers to each of the following questions:
1. How does a lender assess the risk that a borrower may default—that is, not
pay interest and principal when due?
2. If a company with a high debt to equity ratio wants to increase its debt when
the economy is weak, what kind of bond might it issue?
3. Why might a company lease a long-term asset rather than buy it and issue
long-term bonds?
4. Why are callable and convertible bonds considered to add to management’s
future flexibility in financing a business?
604 CHAPTER 13 Long-Term Liabilities
LO3 LO4 Discussion Questions
LO5 SO7 E 2. Develop brief answers to each of the following questions:
1. What determines whether bonds are issued at a discount, premium, or face
value?
2. Why does the market price of a bond vary over time?
3. When is it acceptable to use the straight-line method to amortize a bond
discount or premium?
4. Why must the accrual of bond interest be recorded at the end of an account-
ing period?
LO1 Interest Coverage Ratio
E 3. Compute the interest coverage ratios for 2010 and 2011 from the partial
income statements of Chimney Corporation that appear below. State whether the
ratio improved or worsened over time.
2011 2010
Income from operations $23,890 $18,460
Interest expense 5,800 3,300
Income before income taxes $18,090 $15,160
Income taxes 5,400 4,500
Net income $12,690 $10,660
LO1 Mortgage Payable
E 4. Victory Corporation purchased a building by signing a $150,000 long-term
mortgage with monthly payments of $2,000. The mortgage carries an interest
rate of 12 percent. |
1. Prepare a monthly payment schedule showing the monthly payment, the
interest for the month, the reduction in debt, and the unpaid balance for the
first three months. (Round to the nearest dollar.)
2. Prepare entries in journal form to record the purchase and the first two
monthly payments.
LO1 Recording Lease Obligations
E 5. Tapas Corporation has leased a piece of equipment that has a useful life of
12 years. The terms of the lease are payments of $43,000 per year for 12 years.
Tapas currently is able to borrow money at a long-term interest rate of 8 percent.
(Round answers to the nearest dollar.)
1. Calculate the present value of the lease.
2. Prepare the entry in journal form to record the lease agreement.
3. Prepare the entry in journal form to record depreciation of the equipment for
the first year using the straight-line method.
4. Prepare the entries in journal form to record the lease payments for the first
two years.
LO4 Valuing Bonds Using Present Value
E 6. Avanti, Inc., is considering the sale of two bond issues. Choice A is a $800,000
bond issue that pays semiannual interest of $64,000 and is due in 20 years.
Choice B is a $800,000 bond issue that pays semiannual interest of $60,000 and
is due in 15 years. Assume that the market interest rate for each bond is 8 percent.
Calculate the amount that Avanti, Inc., will receive if both bond issues are made.
(Hint: Calculate the present value of each bond issue and sum.)
Chapter Assignments 605
LO4 Valuing Bonds Using Present Value
E 7. Use the present value tables in the appendix on present value tables to
calculate the issue price of a $300,000 bond issue in each of the following inde-
pendent cases. Assume interest is paid semiannually.
a. A 10-year, 8 percent bond issue; the market interest rate is 10 percent.
b. A 10-year, 8 percent bond issue; the market interest rate is 6 percent.
c. A 10-year, 10 percent bond issue; the market interest rate is 8 percent.
d. A 20-year, 10 percent bond issue; the market interest rate is 12 percent.
e. A 20-year, 10 percent bond issue; the market interest rate is 6 percent.
LO4 Zero Coupon Bonds
E 8. The state of Ohio needs to raise $25,000,000 for highway repairs. Officials
are considering issuing zero coupon bonds, which do not require periodic interest
payments. The current market interest rate for the bonds is 8 percent. What face
value of bonds must be issued to raise the needed funds, assuming the bonds will
be due in 30 years and compounded annually? How would your answer change if
the bonds were due in 50 years? How would both answers change if the market
interest rate were 6 percent instead of 8 percent?
LO3 LO5 Straight-Line Method
E 9. DNA Corporation issued $4,000,000 in 8 percent, 10-year bonds on
February 1, 2010, at 115. Semiannual interest payment dates are January 31 and
July 31. Use the straight-line method and ignore year-end accruals.
1. With regard to the bond issue on February 1, 2010:
a. How much cash is received?
b. How much is Bonds Payable?
c. What is the difference between a and b called and how much is it?
2. With regard to the bond interest payment on July 31, 2010:
a. How much cash is paid in interest?
b. How much is the amortization?
c. How much is interest expense?
3. With regard to the bond interest payment on January 31, 2011:
a. How much cash is paid in interest?
b. How much is the amortization?
c. How much is interest expense?
LO3 LO5 Straight-Line Method
E 10. Nina Corporation issued $8,000,000 in 6 percent, five-year bonds on
March 1, 2010, at 92. The semiannual interest payment dates are S eptember 1
and March 1. Prepare entries in journal form for the issue of the bonds by Nina
on March 1, 2010, and the first two interest payments on September 1, 2010,
and March 1, 2011. Use the straight-line method and ignore y ear-end accruals.
LO3 LO5 Effective Interest Method
E 11. The Smart Company sold $500,000 of 8 percent, 20-year bonds on April 1,
2011, at 105. The semiannual interest payment dates are March 31 and Septem-
ber 30. The market interest rate is 7.5 percent. The company’s fiscal year ends |
September 30. Use the effective interest method to calculate the amortization.
1. With regard to the bond issue on April 1, 2011:
a. How much cash is received?
b. How much is Bonds Payable?
c. What is the difference between a and b called and how much is it?
606 CHAPTER 13 Long-Term Liabilities
2. With regard to the bond interest payment on September 30, 2011:
a. How much cash is paid in interest?
b. How much is the amortization?
c. How much is interest expense?
3. With regard to the bond interest payment on March 31, 2012:
a. How much cash is paid in interest?
b. How much is the amortization?
c. How much is interest expense?
LO3 LO5 Effective Interest Method
E 12. On March 1, 2010, Knap Corporation issued $1,200,000 of 6 percent, five-
year bonds. The semiannual interest payment dates are February 28 and August 31.
Because the market rate for similar investments was 7 p ercent, the bonds had to be
issued at a discount. The discount on the issuance of the bonds was $49,900. The
company’s fiscal year ends February 28. Prepare entries in journal form to record
the bond issue on March 1, 2010, the payment of interest, and the amortization
of the discount on August 31, 2010 and on February 28, 2011. Use the effective
interest method. (Round answers to the nearest dollar.)
SO6 Bond Retirement
E 13. The Rondo Corporation has outstanding $400,000 of 8 percent bonds callable
at 104. On September 1, immediately after recording the payment of the semian-
nual interest and the amortization of the discount, the unamortized bond discount
equaled $10,500. On that date, $240,000 of the bonds was called and retired.
1. How much cash must be paid to retire the bonds?
2. Is there a gain or loss on retirement, and if so, how much is it?
SO6 Bond Conversion
E 14. The Jolly Corporation has $400,000 of 6 percent bonds outstanding.
There is $20,000 of unamortized discount remaining on these bonds after the
July 1, 2011, semiannual interest payment. The bonds are convertible at the rate
of 20 shares of $5 par value common stock for each $1,000 bond. On July 1,
2011, bondholders presented $300,000 of the bonds for conversion.
1. Is there a gain or loss on conversion, and if so, how much is it?
2. How many shares of common stock are issued in exchange for the bonds?
3. In dollar amounts, how does this transaction affect the total liabilities and the
total stockholders’ equity of the company? In your answer, show the effects
on four accounts.
LO5 SO7 Effective Interest Method and Interest Accrual
E 15. The long-term debt section of the Midwest Corporation’s balance sheet at
the end of its fiscal year, December 31, 2010, is as follows:
Long-term liabilities
Bonds payable—8%, interest payable
1/1 and 7/1, due 12/31/16 $250,000
Less unamortized bond discount 20,000 $230,000
Using the effective interest method, prepare entries in journal form relevant to
the interest payments on July 1, 2011, December 31, 2011, and January 1, 2012.
Assume a market interest rate of 10 percent.
LO4 SO6 Time Value of Money and Early Extinguishment of Debt
E 16. Anna’s, Inc., has a $350,000, 4 percent bond issue that was issued a n umber
of years ago at face value. There are now 10 years left on the bond issue, and the
Chapter Assignments 607
market interest rate is 8 percent. Interest is paid semiannually. The company pur-
chases the bonds on the open market at the calculated current market value and
retires the bonds.
1. Using present value tables, calculate the current market value of the bond issue.
2. Is there a gain or loss on retirement of the bonds, and if so, how much is it?
LO3 SO7 Bond Issue on and Between Interest Dates
E 17. Jigar Tech, Inc., is authorized to issue $1,800,000 in bonds on June 1. The
bonds carry a face interest rate of 9 percent, which is to be paid on June 1 and
December 1. Prepare entries in journal form for the issue of the bonds by Jigar
Tech, Inc., under the assumptions that (a) the bonds are issued on September 1
at 100 and (b) the bonds are issued on June 1 at 105.
SO7 Bond Issue Between Interest Dates
E 18. Arif Corporation sold $400,000 of 12 percent, 10-year bonds at face value |
on September 1, 2011. The issue date of the bonds was May 1, 2011.
1. Record the sale of the bonds on September 1 and the first semiannual i nterest
payment on November 1, 2011.
2. The company’s fiscal year ends on December 31, and this is its only bond issue.
What is the bond interest expense for the year ended December 31, 2011?
LO3 LO5 Year-End Accrual of Bond Interest
SO7
E 19. Hinali Corporation issued $1,000,000 of 7 percent bonds on October 1,
2010, at 96. The bonds are dated October 1 and pay interest semiannually. The
market interest rate is 8 percent, and Hinali’s fiscal year ends on December 31. Pre-
pare the entries in journal form to record the issuance of the bonds, the accrual of
the interest on December 31, 2010, and the first semiannual interest payment on
April 1, 2011. Assume the company uses the effective interest method to amortize
the bond discount.
Problems
LO1 Lease Versus Purchase
P 1. Shen Corporation can either lease or buy a small garage next to its business
that will provide parking for its customers. The company can lease the building
for a period of 12 years, which approximates the useful life of the facility and thus
qualifies as a capital lease. The terms of the lease are payments of $12,000 per
year for 12 years. Shen currently is able to borrow money at a long-term interest
rate of 9 percent. The company can purchase the building by signing an $80,000
long-term mortgage with monthly payments of $1,000. The mortgage also car-
ries an interest rate of 9 percent.
Required
1. With regard to the lease option,
a. Calculate the present value of the lease. (Round answers to the nearest
dollar.)
b. Prepare the entry in journal form to record the lease agreement.
c. Prepare the entry in journal form to record depreciation of the building
for the first year using the straight-line method.
d. Prepare the entries in journal form to record the lease payments for the
first two years.
2. With regard to the purchase option,
a. Prepare a monthly payment schedule showing the monthly payment, the
interest for the month, the reduction in debt, and the unpaid balance for
the first three months. (Round to the nearest dollar.)
608 CHAPTER 13 Long-Term Liabilities
b. Prepare entries in journal form to record the purchase and the first two
monthly payments.
User insight (cid:2) 3. Based on your calculations, which option seems to be best? Aside from cost,
name an advantage and a disadvantage of each option.
LO1 LO2 Bond Terminology
LO3
P 2. Listed below are common terms associated with bonds:
a. Bond certificate j. Coupon bonds
b. Bond issue k. Callable bonds
c. Bond indenture l. Convertible bonds
d. Unsecured bonds m. Face interest rate
e. Debenture bonds n. Market interest rate
f. Secured bonds o. Effective interest rate
g. Term bonds p. Bond premium
h. Serial bonds q. Bond discount
i. Registered bonds
Required
1. For each of the following statements, identify the category above with which
it is associated. (If two statements apply, choose the category with which it is
most closely associated.)
1. Occurs when bonds are sold at more than face value
2. Rate of interest that will vary depending on economic conditions
3. Bonds that may be exchanged for common stock
4. Bonds that are not registered
5. A bond issue in which all bonds are due on the same date
6. Occurs when bonds are sold at less than face value
7. Rate of interest that will be paid regardless of market conditions
8. Bonds that may be retired at management’s option
9. A document that is evidence of a company’s debt
10. Same as market rate of interest
11. Bonds for which the company knows who owns them
12. A bond issue for which bonds are due at different dates
13. The total value of bonds issued at one time
14. Bonds whose payment involves a pledge of certain assets
15. Same as debenture bonds
16. Contains the terms of the bond issue
17. Bonds issued on the general credit of the company
User insight (cid:2) 2. What effect will a decrease in interest rates below the face interest rate and
before a bond is issued have on the cash received from the bond issue? What |
effect will the decrease have on interest expense? What effect will the decrease
have on the amount of cash paid for interest?
LO3 LO5 Bond Basics—Straight-Line Method, Retirement and Conversion
SO6
P 3. Murcia Corporation has $4,000,000 of 8 percent, 25-year bonds dated
May 1, 2011, with interest payable on April 30 and October 31. The compa-
ny’s fiscal year ends on December 31, and it uses the straight-line method to
amortize bond premiums or discounts. The bonds are callable after 10 years
at 103 or convertible into 40 shares of $10 par value common stock.
Required
1. Assume the bonds are issued at 103.5 on May 1, 2011.
a. How much cash is received?
b. How much is Bonds Payable?
Chapter Assignments 609
c. What is the difference between a and b called, and how much is it?
d. With regard to the bond interest payment on October 31, 2011:
(1) How much cash is paid in interest?
(2) How much is the amortization?
(3) How much is interest expense?
2. Assume the bonds are issued at 96.5 on May 1, 2011.
a. How much cash is received?
b. How much is Bonds Payable?
c. What is the difference between a and b called, and how much is it?
d. With regard to the bond interest payment on October 31, 2011:
(1) How much cash is paid in interest?
(2) How much is the amortization?
(3) How much is interest expense?
3. Assume the issue price in requirement 1 and that the bonds are called and
retired 10 years later.
a. How much cash will have to be paid to retire the bonds?
b. Is there a gain or loss on the retirement, and if so, how much is it?
4. Assume the issue price in requirement 2 and that the bonds are converted to
common stock 10 years later.
a. Is there a gain or loss on conversion, and if so, how much is it?
b. How many shares of common stock are issued in exchange for the bonds?
c. In dollar amounts, how does this transaction affect the total liabilities
and the total stockholders’ equity of the company? In your answer, show
the effects on four accounts.
User insight (cid:2) 5. Assume that after 10 years market interest rates have dropped significantly
and that the price of the company’s common stock has risen significantly.
Also assume that management wants to improve its credit r ating by reducing
its debt to equity ratio and that it needs what cash it currently has for expan-
sion. Would management prefer the approach and result in requirement
3 or 4? Explain your answer. What would be a disadvantage of the approach
you chose?
LO3 LO5 Bond Transactions—Effective Interest Method
P 4. Dygat Corporation has $10,000,000 of 9 percent, 20-year bonds dated
June 1, 2010 with interest payment dates of May 31 and November 30. The
company’s fiscal year ends November 30. It uses the effective interest method to
amortize bond premiums or discounts.
Required
1. Assume the bonds are issued at 109.9 on June 1 to yield an effective interest rate
of 8 percent. Prepare entries in journal form for June 1, 2010, November 30,
2010, and May 31, 2011. (Round amounts to the nearest dollar.)
2. Assume the bonds are issued at 91.4 on June 1 to yield an effective interest rate
of 10 percent. Prepare entries in journal form for June 1, 2010, N ovember 30,
2010, and May 31, 2011. (Round amounts to the nearest dollar.)
User insight (cid:2) 3. Explain the role that market interest rates play in causing a premium in
requirement 1 and a discount in requirement 2.
LO3 LO5 Bonds Issued at a Discount and a Premium—Effective Interest Method
SO7
P 5. Johnson Corporation issued bonds twice during 2010. The transactions
were as follows:
2010
Jan. 1 Issued $1,000,000 of 7.5 percent, 10-year bonds dated January 1,
2010, with interest payable on June 30 and December 31. The
610 CHAPTER 13 Long-Term Liabilities
bonds were sold at 96.6, resulting in an effective interest rate of
8 percent.
Apr. 1 Issued $2,000,000 of 8.5 percent, 10-year bonds dated April 1,
2010, with interest payable on March 31 and S eptember 30. The
bonds were sold at 103.4, resulting in an effective interest rate of
8 percent.
June 30 Paid semiannual interest on the January 1 issue and a mortized the |
discount, using the effective interest method.
Sept. 30 P aid semiannual interest on the April 1 issue and amortized the
premium, using the effective interest method.
Dec. 31 Paid semiannual interest on the January 1 issue and a mortized the
discount, using the effective interest method.
31 Made an end-of-year adjusting entry to accrue interest on the
April 1 issue and to amortize half the premium applicable to the
second interest period.
2011
Mar. 31 Paid semiannual interest on the April 1 issue and amortized the
premium applicable to the second half of the second interest
period.
Required
1. Prepare entries in journal form to record the bond transactions. (Round
amounts to the nearest dollar.)
User insight (cid:2) 2. Describe the effect of the above transactions on profitability and liquidity by
answering the following questions.
a. What is the total interest expense in 2010 for each of the bond issues?
b. What is the total cash paid in 2010 for each of the bond issues?
c. What differences, if any, do you observe, and how do you explain them?
Alternate Problems
LO3 LO5 Bond Basics—Straight-line Method, Retirement, and Conversion
SO6
P 6. Golden Corporation has $20,000,000 of 7 percent, 20-year bonds dated
June 1, 2010, with interest payment dates of May 31 and November 30. After
10 years, the bonds are callable at 104, and each $1,000 bond is convertible into
25 shares of $20 par value common stock. The company’s fiscal year ends on
December 31. It uses the straight-line method to amortize bond premiums or
discounts.
Required
1. Assume the bonds are issued at 103 on June 1, 2010.
a. How much cash is received?
b. How much is Bonds Payable?
c. What is the difference between a and b called, and how much is it?
d. With regard to the bond interest payment on November 30, 2010:
(1) How much cash is paid in interest?
(2) How much is the amortization?
(3) How much is interest expense?
2. Assume the bonds are issued at 97 on June 1, 2010.
a. How much cash is received?
b. How much is Bonds Payable?
c. What is the difference between a and b called, and how much is it?
d. With regard to the bond interest payment on November 30, 2010:
Chapter Assignments 611
(1) How much cash is paid in interest?
(2) How much is the amortization?
(3) How much is interest expense?
3. Assume the issue price in requirement 1 and that the bonds are called and
retired 10 years later.
a. How much cash will have to be paid to retire the bonds?
b. Is there a gain or loss on the retirement, and if so, how much is it?
4. Assume the issue price in requirement 2 and that the bonds are converted to
common stock 10 years later.
a. Is there a gain or loss on the conversion, and if so, how much is it?
b. How many shares of common stock are issued in exchange for the
bonds?
c. In dollar amounts, how does this transaction affect the total liabilities
and the total stockholders’ equity of the company? In your answer, show
the effects on four accounts.
User insight (cid:2) 5. Assume that after 10 years, market interest rates have dropped significantly
and that the price on the company’s common stock has risen significantly.
Also assume that management wants to improve its credit r ating by reducing
its debt to equity ratio and that it needs what cash it has for expansion. Which
approach would management prefer—the approach and result in require-
ment 3 or 4? Explain your answer. What would be a disadvantage of the
approach you chose?
LO3 LO5 Bond Transactions—Effective Interest Method
P 7. Jose Corporation has $4,000,000 of 9 percent, 25-year bonds dated
March 1, 2010, with interest payable on February 28 and August 31. The
company’s f iscal year end is February 28. It uses the effective interest method
to amortize bond premiums or discounts. (Round amounts to the nearest
dollar.)
Required
1. Assume the bonds are issued at 110.7 on March 1, 2010, to yield an effective
interest rate of 8 percent. Prepare entries in journal form for March 1, 2010,
August 31, 2010, and February 28, 2011.
2. Assume the bonds are issued at 90.87 on March 1, 2010, to yield an effective |
interest rate of 10 percent. Prepare entries in journal form for March 1, 2010,
August 31, 2010, and February 28, 2011.
User insight (cid:2) 3. Explain the role that market interest rates play in causing a premium in
requirement 1 and a discount in requirement 2.
LO3 LO5 Bonds Issued at a Discount and a Premium—Effective Interest Method
SO7
P 8. Rago Corporation issued bonds twice during 2010. A summary of the
transactions involving the bonds follows.
2010
Jan. 1 Issued $3,000,000 of 7 percent, 10-year bonds dated January 1,
2010, with interest payable on June 30 and December 31. The
bonds were sold at 107.4, resulting in an effective interest rate of
6 percent.
Mar. 1 Issued $2,000,000 of 7.5 percent, 10-year bonds dated March 1,
2010, with interest payable March 1 and September 1. The bonds
were sold at 96.6, resulting in an effective interest rate of 8 percent.
June 30 P aid semiannual interest on the January 1 issue and amortized the
premium, using the effective interest method.
612 CHAPTER 13 Long-Term Liabilities
Sept. 1 P aid semiannual interest on the March 1 issue and amortized the
discount, using the effective interest method.
Dec. 31 P aid semiannual interest on the January 1 issue and amortized the
premium, using the effective interest method.
31 M ade an end-of-year adjusting entry to accrue interest on the
March 1 issue and to amortize two-thirds of the discount appli-
cable to the second interest period.
2011
Mar. 1 P aid semiannual interest on the March 1 issue and amortized the
remainder of the discount applicable to the second interest period.
Required
1. Prepare entries in journal form to record the bond transactions. (Round
amounts to the nearest dollar.)
User insight (cid:2) 2. Describe the effect on profitability and liquidity by answering the following
questions.
a. What is the total interest expense in 2010 for each of the bond issues?
b. What is the total cash paid in 2010 for each of the bond issues?
c. What differences, if any, do you observe and how do you explain them?
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO1 Effect of Long-Term Leases
C 1. Many companies use long-term leases to finance long-term assets. Although
these leases are similar to mortgage payments, they are structured in such a way
that they qualify as operating leases. As a result, the lease commitments do not
appear on the companies’ balance sheets.
In a recent year, Continental Airlines had almost $15 billion in total o perating
lease commitments, of which $1.5 billion was due in the current year. Further,
the airline had total assets of $12.686 billion and total liabilities of $12.581
billion. Because of heavy losses in previous years, its stockholders’ equity was only
$0.105 billion.11
What effect do these types of leases have on the balance sheet? Why would
the use of these long-term leases make a company’s debt to equity ratio, inter-
est coverage ratio, and free cash flow look better than they really are? What is a
capital lease? How does the application of capital lease accounting provide insight
into a company’s financial health?
LO2 SO6 Bond Issue
C 2. Eastman Kodak, the photography company, issued a $1 billion bond issue.
Even though the company’s credit rating was low, the bond issue was well received
by the investment community because the company offered attractive terms. The
offering comprised $500 million of 10-year unsecured notes and $500 million of
30-year convertible bonds. The convertibles were c allable after seven years and
would be convertible into common stock about 40 to 45 percent higher than the
current price.12
What are unsecured notes? Why would they carry a relatively high interest
rate? What are convertible securities? Why are they good for the investor and
for the company? Why would they carry a relatively low interest rate? What does
callable mean? What advantage does this feature give the company?
Chapter Assignments 613
LO2 SO3 Bond Interest Rates and Market Prices
C 3. Dow Chemical is one of the largest chemical companies in the world.
Among its long-term liabilities was a bond due in 2011 that carried a face inter- |
est rate of 6.125 percent.13 This bond sold on the New York Stock Exchange
at 104 5/8. Did this bond sell at a discount or a premium? Assuming the bond
was originally issued at face value, did interest rates rise or decline after the date
of issue? Would you have expected the market rate of interest on this bond to
be more or less than 6.125 percent? Did the current market price affect either
the amount that the company paid in semiannual interest or the amount of
interest expense for the same period? Explain your answers.
LO2 Characteristics of Convertible Debt
C 4. Amazon.com, Inc., gained renown as an online marketplace for books, records,
and other products. Although the increase in its stock price was initially meteoric,
only recently has the company begun to earn a profit. To support its enormous
growth, Amazon.com issued $500,000,000 in 6.845 percent convertible notes
due in 2010 at face value. Interest is payable on February 1 and August 1. The
notes are convertible into common stock at a price of $112 per share, which at
the time of issue was above the market price. The market value of Amazon.com’s
common stock has been quite volatile, from $39 to $95 in 2007.14
What reasons can you suggest for Amazon.com’s management choosing
notes that are convertible into common stock rather than simply issuing non-
convertible notes or issuing common stock directly? Are there any disadvantages
to this approach? If the price of the company’s common stock goes to $100 per
share, what would be the total theoretical value of the notes? If the holders of the
notes were to elect to convert the notes into common stock, what would be the
effect on the company’s debt to equity ratio, and what would be the effect on
the percentage ownership of the company by other stockholders?
LO1 Business Practice, Long-Term Debt, Leases, and Pensions
C 5. To answer the following questions, refer to the financial statements and the
notes to the financial statements in CVS Corporation’s annual report in the Sup-
plement to Chapter 5:
1. Is it the practice of CVS to own or lease most of its buildings?
2. Does CVS lease property predominantly under capital leases or under operat-
ing leases? How much was rental expense for operating leases in 2008?
3. Does CVS have a defined benefit pension plan? Does it offer post-retirement
benefits?
LO1 Use of Debt Financing
C 6. Refer to the annual report of CVS Corporation and the financial statements
of Southwest Airlines Co. in the Supplement to Chapter 5. Calculate the debt
to equity ratio and the interest coverage ratio for both companies’ two most
recent years. Find the note to the financial statements that contains informa-
tion on leases and lease commitments by CVS. Southwest’s lease expenses were
$469 million and $527 million in 2007 and 2008, respectively, and total lease
commitments for future years were $2,032 million. What effect do the total lease
commitments and lease expense have on your assessment of the ratios you calcu-
lated? Evaluate and comment on the relative performance of the two companies
with regard to debt financing. Which company has more risk of not being able to
meet its interest obligations? How does leasing affect the analysis? Explain.
C H A P T E R The Corporate
14 Income Statement
and the Statement of
Stockholders’ Equity
Making a
A s we pointed out in an earlier chapter, earnings manage-
Statement
ment—the practice of manipulating revenues and expenses
INCOME STATEMENT
to achieve a specific outcome—is unethical when companies use it
Revenues
to create misleading financial statements. Users of financial state-
– Expenses
ments consider the possibility of earnings management by assess-
ing the quality, or sustainability, of a company’s earnings. To do
= Net Income
so, they evaluate how the components of the company’s income
statement affect earnings. In this chapter, we focus on those com-
STATEMENT OF
RETAINED EARNINGS
ponents. We also cover earnings per share, the statement of stock-
Beginning Balance
holders’ equity, stock dividends and stock splits, and book value |
+ Net Income
per share.
– Dividends
= Ending Balance
LEARNING OBJECTIVES
BALANCE SHEET
Assets Liabilities LO1 Define quality of earnings, and identify the components of a
corporate income statement. (pp. 616–621)
Stockholders’
LO2 Show the relationships among income taxes expense,
Equity
deferred income taxes, and net of taxes. (pp. 621–625)
A = L + OE
LO3 Compute earnings per share. (pp. 625–627)
STATEMENT OF CASH FLOWS LO4 Define comprehensive income, and describe the statement of
Operating activities
stockholders’ equity. (pp. 627–630)
+ Investing activities
+ Financing activities
LO5 Account for stock dividends and stock splits. (pp. 630–635)
= Change in Cash
+ Beginning Balance LO6 Calculate book value per share. (pp. 635–636)
= Ending Cash Balance
The corporate income statement
aids in the analysis of profitability
and links to stockholders’ equity,
which in turn links to the
stockholders’ equity section of
the balance sheet.
614
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Should Kowalski, Inc., declare a
KOWALSKI, INC. stock split?
(cid:2) Should the company raise
capital by issuing preferred
Walter Kowalski is the chief executive officer of Kowalski, Inc., a stock?
manufacturing company that his father founded 25 years ago. The
(cid:2) Should the company pay cash
company’s fiscal year just ended on June 30, 2010, and Walter is now
dividends or use cash to buy
considering what steps to take in the next fiscal year with regard to back its own stock?
stockholders’ equity. The current status of the company’s stockhold-
ers’ equity is as follows:
Contributed capital
Common stock, no par value, $6 stated value,
500 shares authorized, 125 shares
issued and outstanding $ 750,000
Additional paid-in capital 410,000
Total contributed capital $1,160,000
Retained earnings 485,000
Total stockholders’ equity $1,645,000
Among the questions Walter is wrestling with are whether the
company should declare a stock split, whether it should issue pre-
ferred stock to raise capital, and whether it should pay cash dividends
or use cash to buy back its own stock. In this chapter, you will learn
about these issues, as well as about the structure and content of the
corporate income statement and its interpretation.
615
616 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
Performance
Net income (net earnings) is the measure most commonly used to evaluate a
Measurement: company’s performance. In fact, a survey of 2,000 members of the Association
for Investment Management and Research indicated that the two most important
Quality of Earnings
economic measures in evaluating common stocks were expected changes in earn-
Issues
ings per share and expected return on equity.1 Net income is a key component of
both measures.
LO1 Define quality of earnings, Because of the importance of net income, or the “bottom line,” in measur-
and identify the components of ing a company’s prospects, there is significant interest in evaluating the quality of
a corporate income statement. the net income figure, or the quality of earnings. The quality of a company’s
earnings refers to the substance of earnings and their sustainability into future
accounting periods. For example, if earnings increase because of a gain on the sale
of an asset, this portion of earnings will not be sustained in the future.
The accounting estimates and methods that a company uses affect the quality
of its earnings, as do these components of the income statement:
(cid:2) Gains and losses on transactions
(cid:2) Write-downs and restructurings
(cid:2) Non-operating items
Because management has choices in the content and positioning of these income
statement components, there is a potential for managing earnings to achieve
specific income targets. It is therefore critical for users of income statements to
understand these factors and take them into consideration when evaluating a
Study Note company’s performance.
Exhibit 14-1 shows the components of a typical corporate income statement.
It is important to know which
Net income or loss (the “bottom line” of the income statement) includes all rev- |
items included in earnings
enues, expenses, gains, and losses over the accounting period. When a company
are recurring and which are
has both continuing and discontinued operations, the operating income section
one-time items. Income from
is called income from continuing operations. Income from continuing opera-
continuing operations before
tions before income taxes may include gains or losses on the sale of assets, write-
nonoperating items gives a
downs, and restructurings. The income taxes expense section of the statement is
clear signal about future results.
subject to special accounting rules.
In assessing a company’s
As you can see in Exhibit 14-1, the section of a corporate income statement
future earnings potential,
that follows income taxes contains such nonoperating items as discontinued oper-
nonoperating items are
excluded because they are not ations and extraordinary gains (or losses). Another item that may appear in this
expected to continue. section is the write-off of goodwill when its value has been impaired. Earnings per
share information appears at the bottom of the statement.
FOCUS ON BUSINESS PRACTICE
Why Do Investors Study Quality of Earnings?
Analysts for Twentieth Century Mutual Funds, a major $1.30 per share. Further investigation, however, shows that
investment company now merged with American Century the per share number includes a one-time gain on the sale
Investments Corporation, make adjustments to a com- of assets, which accounts for an increase of $0.25 per share.
pany’s reported financial performance to create a more Twentieth Century would list the company as earning only
accurate picture of the company’s ongoing operations. For $1.05 per share. “These kinds of adjustments help assure
example, suppose a paper manufacturer reports earnings of long-term decisions aren’t based on one-time events.”2
Performance Measurement: Quality of Earnings Issues 617
EXHIBIT 14-1 Corporate Income Statement
Vistula Corporation
Income Statement
For the Year Ended December 31, 2010
Revenues $ 1,850,000
Costs and expenses (1,100,000)
Operating items
Gain on sale of assets 300,000
before income
Write-downs of assets (50,000)
taxes
Restructurings (150,000)
Income from continuing operations
before income taxes $ 850,000
Income taxes expense 289,000
Income taxes
Income from continuing operations $ 561,000
Discontinued operations
Income from operations of discontinued
segment (net of taxes, $70,000) $ 180,000
Nonoperating
Loss on disposal of segment (net of taxes,
items
$84,000) (146,000) 34,000
Income before extraordinary items $ 595,000
Extraordinary gain (net of taxes, $24,000) 74,000
Net income $ 669,000
Earnings per common share:
Income from continuing operations $ 2.81
Earnings per share Discontinued operations (net of taxes) 0.17
information Income before extraordinary items $ 2.98
Extraordinary gain (net of taxes) 0.37
Net income $ 3.35
The Effect of Accounting Estimates and Methods
Users of financial statements need to be aware of the impact that accounting esti-
mates and methods have on the income that a firm reports. As you know, to
comply with the matching rule, accountants must assign revenues and expenses
to the periods in which they occur. If they cannot establish a direct relationship
between revenues and expenses, they systematically allocate the expenses among
the accounting periods that benefit from them, and in doing so, they must make
estimates and exercise judgment. An accounting estimate should be based on real-
istic assumptions, but there is latitude in making the estimate, and the final judg-
ment will affect the net income that appears on a company’s income statement.
For example, when a company acquires an asset, the accountant must esti-
mate the asset’s useful life. Technological obsolescence could shorten the asset’s
expected useful life, and regular maintenance and repairs could lengthen it.
Although the actual useful life cannot be known with certainty until some future
date, the accountant’s estimate of it affects both current and future operating
income. Other areas that require accounting estimates include the residual value |
of assets, uncollectible accounts receivable, sales returns, total units of produc-
tion, total recoverable units of natural resources, amortization periods, warranty
claims, and environmental cleanup costs.
618 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
Accounting estimates are not equally important to all firms. Their impor-
Study Note tance depends on the industry in which a firm operates. For example, estimated
uncollectible receivables for a credit card firm, such as American Express, or for
Although companies in the
a financial services firm, such as Bank of America, can have a material impact
same industry may have
on earnings, but estimated useful life may be less important because depreciable
comparable earnings, their
assets represent only a small percentage of the firm’s total assets. Walgreens has
quality of earnings may not
be comparable. To assess the very few receivables, but it has substantial investments in depreciable assets. Thus,
quality of a company’s reported estimates of useful life and residual value are much more important to Walgreens
earnings, you must know the than an estimate of uncollectible accounts receivable.
estimates and methods it uses The accounting methods a firm uses also affect its operating income. Gener-
to compute income. Generally ally accepted accounting methods include uncollectible receivable methods (per-
accepted accounting principles centage of net sales and aging of accounts receivable), inventory methods (LIFO,
allow several methods, all FIFO, and average-cost), depreciation methods (accelerated, production, and
yielding different results. straight-line), and revenue recognition methods. All these methods are designed
to match revenues and expenses, but the expenses are estimates, and the period
or periods benefited cannot be demonstrated conclusively. In practice, it is hard
to justify one method of estimation over another.
Different accounting methods have different effects on net income. Some meth-
ods are more conservative than others because they tend to produce a lower net
income in the current period. For example, suppose that two companies have simi-
lar operations, but one uses FIFO for inventory costing and the straight-line (SL)
method for computing depreciation, whereas the other uses LIFO for inventory
costing and the double-declining-balance (DDB) method for computing deprecia-
tion. The income statements of the two companies might appear as follows:
FIFO and SL LIFO and DDB
Net sales $462,500 $462,500
Cost of goods available for sale $200,000 $200,000
Less ending inventory 30,000 25,000
Cost of goods sold $170,000 $175,000
Gross margin $292,500 $287,500
Less depreciation expense $ 20,000 $ 40,000
Less other expenses 85,000 85,000
Total operating expenses $105,000 $125,000
Income from continuing operations
before income taxes $187,500 $162,500
The income from continuing operations before income taxes (operating
income) for the firm that uses LIFO and DDB is lower because in periods of ris-
ing prices, the LIFO inventory costing method produces a higher cost of goods
sold, and in the early years of an asset’s useful life, accelerated depreciation yields
a higher depreciation expense. The result is lower operating income. However,
future operating income should be higher.
Although the choice of accounting method does not affect cash flows except
for possible differences in income taxes, the $25,000 difference in operating
income stems solely from the choice of accounting methods. Estimates of the
useful lives and residual values of plant assets could lead to an even greater dif-
ference. In practice, of course, differences in net income occur for many reasons,
but the user of financial statements must be aware of the discrepancies that can
occur as a result of the accounting methods used in preparing the statements. In
Performance Measurement: Quality of Earnings Issues 619
FOCUS ON BUSINESS PRACTICE
Beware of the Bottom Line!
In the second quarter of 2007, McDonald’s posted its a recent year. Its income jumped by 31 percent due to a tax |
second-ever loss: $711.7 million. Is this cause for concern? settlement and an accounting restatement. Without these
In fact, it is misleading: The company is actually in a period items, its revenue and income would have been up less
of rapidly growing revenues and profits. The loss resulted than 1 percent, and soup sales—its main product—actually
from a one-time, noncash impairment of $1.6 billion related dropped by 6 percent. The lesson to be learned is to look
to investments in Latin America. In another example, beyond the “bottom line” to the components of the income
Campbell Soup showed unrealistically positive results in statement when evaluating a company’s performance.3
general, an accounting method or estimate that results in lower current earnings
produces a better quality of operating income.
The latitude that companies have in their choice of accounting methods and
estimates could cause problems in the interpretation of financial statements were
it not for the conventions of full disclosure and consistency. As noted in an earlier
chapter, full disclosure requires management to explain the significant account-
ing policies used in preparing the financial statements in a note to the statements.
Consistency requires that the same accounting procedures be followed from year
to year. If a change in procedure is made, the nature of the change and its mon-
etary effect must be explained in a note.
Gains and Losses
When a company sells or otherwise disposes of operating assets or marketable
securities, a gain or loss generally results. Although these gains or losses appear
in the operating section of the income statement, they usually represent one-time
events. They are not sustainable, ongoing operations, and management often has
some choice as to their timing. Thus, from an analyst’s point of view, they should
be ignored when considering operating income.
Write-Downs and Restructurings
Management has considerable latitude in deciding when an asset is no longer of
value to the company. When management makes this judgment, a write-down or
restructuring occurs.
(cid:2) A write-down, also called a write-off, is a reduction in the value of an asset
below its carrying value on the balance sheet.
(cid:2) A restructuring is the estimated cost of a change in a company’s operations.
It usually involves the closing of facilities and the laying off of personnel.
Both write-downs and restructurings reduce current operating income and
boost future income by shifting future costs to the current accounting period.
They are often an indication of poor management decisions in the past, such
as paying too much for the assets of another company or making operational
changes that do not work out. Companies sometimes take all possible losses in
the current year so that future years will be “clean” of these costs. Such “big
baths,” as they are called, commonly occur when a company is having a bad
620 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
FOCUS ON BUSINESS PRACTICE
Can You Believe “Pro Forma” Earnings?
Companies must report earnings in accordance with relied on pro forma results. More recent research has
GAAP, but many also report “pro forma” earnings. Pro shown that after the bubble burst in 2001–2002 and after
forma reporting of earnings, in the words of one analyst, the Enron collapse, the number of companies reporting
means that they “have thrown out the bad stuff.”4 In other pro forma earnings declined significantly.5 The invest-
words, when companies report pro forma earnings, they ment community learned that GAAP earnings are a better
are telling the investment community to ignore one-time benchmark of a company’s performance because they are
losses and nonoperating items, which may reflect bad based on recognized standards used by all companies,
decisions in the past. In the late 1990s, technology firms whereas there is no generally accepted way to report pro
with high growth rates and volatile or low earnings and forma earnings. They are whatever the company wants |
firms that unexpectedly missed earnings targets widely you to see.
year. They also often occur in years when there is a change in management. The
new management takes a “big bath” in the current year so it can show improved
results in future years.
In a recent year, 35 percent of 600 large companies had write-downs of tangible
assets, and 42 percent had restructurings. Another 12 percent had write-downs or
charges related to intangible assets, often involving goodwill.6
Nonoperating Items
The nonoperating items that appear on the income statement include discontin-
ued operations and extraordinary gains and losses, both of which can significantly
affect net income. In Exhibit 14-1, earnings per common share for income from
continuing operations is $2.81, but when all the nonoperating items are taken
into consideration, net income per share is $3.35.
Discontinued operations are segments of a business, such as a separate
major line of business or ones that serve a separate class of customer, that are no
longer part of a company’s operations. To make it easier to evaluate a company’s
ongoing operations, generally accepted accounting principles require that gains
and losses from discontinued operations be reported separately on the income
statement.
In Exhibit 14-1, the disclosure of discontinued operations has two parts. One
part shows that after the decision to discontinue, the income from operations of
the disposed segment was $180,000 (net of $70,000 taxes). The other part shows
that the loss from the disposal of the segment was $146,000 (net of $84,000 tax
savings). (The computation of the gains or losses involved in discontinued opera-
tions is covered in more advanced accounting courses.)
Extraordinary items are “events or transactions that are distinguished by
their unusual nature and by the infrequency of their occurrence.”7 Items usually
treated as extraordinary include the following:
1. An uninsured loss from flood, earthquake, fire, or theft
2. A gain or loss resulting from the passage of a new law
3. The expropriation (taking) of property by a foreign government
In Exhibit 14-1, the extraordinary gain was $74,000 after taxes of $24,000.
Income Taxes 621
STOP
& APPLY
Assume the following data apply to Ace, Inc.: net sales, $180,000; cost of goods sold, $87,500; loss
from discontinued operations (net of taxes of $17,500), $50,000; loss on disposal of discontinued
operations (net of taxes of $4,000), $12,500; operating expenses, $32,500; income taxes expense on
continuing operations, $25,000. From this information, prepare the company’s income statement for
the year ended December 31, 2011. (Ignore earnings per share information.)
SOLUTION
Ace, Inc.
Income Statement
For the Year Ended December 31, 2011
Net sales $180,000
Cost of goods sold 87,500
Gross margin $ 92,500
Operating expenses 32,500
Income from continuing operations before income taxes $ 60,000
Income taxes expense 25,000
Income from continuing operations $ 35,000
Discontinued operations
Loss from discontinued operations (net of taxes,
$17,500) ($50,000)
Loss on disposal of discontinued operations (net of taxes,
$4,000) (12,500) (62,500)
Net loss ($ 27,500)
Income Taxes
Corporations determine their taxable income (the amount on which they pay
taxes) by deducting allowable expenses from taxable income. The federal tax laws
LO2 Show the relationships determine which expenses corporations may deduct. (Rules for calculating and
among income taxes expense, reporting taxable income in specialized industries, such as banking, insurance,
deferred income taxes, and net mutual funds, and cooperatives, are highly technical and may vary significantly
of taxes. from the ones we discuss in this chapter.)
Table 14-1 shows the tax rates that apply to a corporation’s taxable income.
A corporation with taxable income of $70,000 would have a federal income tax
liability of $12,500: $7,500 (the tax on the first $50,000 of taxable income) plus
$5,000 (25 percent of the $20,000 earned in excess of $50,000).
Income taxes expense is recognized in the accounting records on an accrual |
Study Note
basis. It may or may not equal the amount of taxes a corporation actually pays.
The amount a corporation pays is determined by the rules of the income tax code.
Many people think it is illegal to
As we noted earlier in the text, small businesses often keep both their accounting
keep accounting records on a
different basis from income tax records and tax records on a cash basis, so that the income taxes expense on their
records. However, the Internal income statements equals their income taxes. This practice is accrual as long as
Revenue Code and GAAP often the difference between the income calculated on an accrual basis and the income
do not agree. To work with two calculated for tax purposes is not material. However, the purpose of accounting
conflicting sets of guidelines, is not to determine taxable income and tax liability, but to determine net income
the accountant must keep two in accordance with GAAP.
sets of records. Management has an incentive to use methods that minimize its firm’s tax lia-
bility. But accountants, who are bound by accrual accounting and the materiality
622 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
TABLE 14-1
Taxable Income Tax Liability
Tax Rate Schedule for Corporations,
2008 But Not Of the Amount
Over Over Over
$ 50,000 0 (cid:3) 15% —
$ 50,000 75,000 $ 7,500 (cid:3) 25% $ 50,000
75,000 100,000 13,750 (cid:3) 34% 75,000
100,000 335,000 22,250 (cid:3) 39% 100,000
335,000 10,000,000 113,900 (cid:3) 34% 335,000
10,000,000 15,000,000 3,400,000 (cid:3) 35% 10,000,000
15,000,000 18,333,333 5,150,000 (cid:3) 38% 15,000,000
18,333,333 — 6,416,667 (cid:3) 35% 18,333,333
Note: Tax rates are subject to change by Congress.
concept, cannot let tax procedures dictate their method of preparing financial
statements if the result would be misleading. The difference between accounting
income and taxable income, especially in large businesses, can be material. This
discrepancy can result from differences in the timing of the recognition of rev-
enues and expenses under accrual accounting and the tax method. The following
table shows some possible variations:
Accrual Accounting Tax Method
Expense recognition Accrual or deferral At time of expenditure
Accounts receivable Allowance Direct charge-off
Inventories Average-cost FIFO
Depreciation Straight-line Accelerated cost recovery
Deferred Income Taxes
Study Note
Income tax allocation is the method used to accrue income taxes expense on the
The discrepancy between
basis of accounting income when accounting income and taxable income differ. The
GAAP-based tax expense and
account used to record the difference between income taxes expense and income
Internal Revenue Code-based
taxes payable is called Deferred Income Taxes. For example, in the income state-
tax liability creates the need
ment in Exhibit 14-1, Vistula Corporation has income taxes expense of $289,000.
for the Deferred Income Taxes
Suppose, however, that Vistula’s actual income taxes payable are $184,000. The
account.
following T account and entry show how income tax allocation would treat this
situation:
A (cid:3) L (cid:4) SE Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
(cid:4)184,000 (cid:3)289,000
(cid:4)105,000
INCOME TAXES PAYABLE INCOME TAXES EXPENSE
Dr. Cr. Dr. Cr.
Dec. 31 184,000 Dec. 31 289,000
DEFERRED INCOME TAXES
Dr. Cr.
Dec. 31 105,000
Entry in Journal Form:
2010 Dr. Cr.
Dec. 31 Income Taxes Expense 289,000
Income Taxes Payable 184,000
Deferred Income Taxes 105,000
To record estimated current
and deferred income taxes
Income Taxes 623
In other years, Vistula’s Income Taxes Payable may exceed its Income Taxes
Study Note Expense. In this case, the entry is the same except that Deferred Income Taxes is
debited.
Deferred Income Taxes is
The Financial Accounting Standards Board has issued specific rules for
classified as a liability when
recording, measuring, and classifying deferred income taxes.8 Deferred income
it has a credit balance and as
taxes are recognized for the estimated future tax effects resulting from temporary |
an asset when it has a debit
differences in the valuation of assets, liabilities, equity, revenues, expenses, gains,
balance. It is further classified
and losses for tax and financial reporting purposes. Temporary differences include
as either current or long-
term depending on when it is revenues and expenses or gains and losses that are included in taxable income
expected to reverse. before or after they are included in financial income. In other words, the recog-
nition point for revenues, expenses, gains, and losses is not the same for tax and
financial reporting.
For example, advance payments for goods and services, such as magazine
subscriptions, are not recognized as income until the products are shipped. How-
ever, for tax purposes, advance payments are usually recognized as revenue when
cash is received. As a result, taxes paid exceed taxes expense, which creates a
deferred income taxes asset (or prepaid taxes).
Classification of deferred income taxes as current or noncurrent depends
on the classification of the asset or liability that created the temporary differ-
ence. For example, the deferred income taxes asset mentioned above would
be classified as current if unearned subscription revenue were classified as a
current liability. On the other hand, the temporary difference arising from
depreciation is related to a long-term depreciable asset. Therefore, the result-
ing deferred income taxes would be classified as long-term. If a temporary
difference is not related to an asset or liability, it is classified as current or
noncurrent based on its expected date of reversal. (Temporary differences and
the classification of deferred income taxes that results are covered in depth
in more advanced courses.) Each year, the balance of the Deferred Income
Taxes account is evaluated to determine whether it still accurately represents
the expected asset or liability in light of legislated changes in income tax laws
and regulations.
In any given year, the amount a company pays in income taxes is deter-
mined by subtracting (or adding) the deferred income taxes for that year from
(or to) income taxes expense. In subsequent years, the amount of deferred
income taxes can vary based on changes in tax laws and rates. A survey of
the financial statements of 600 large companies indicates the importance
of deferred income taxes to financial reporting. About 68 percent reported
deferred income taxes with a credit balance in the long-term liability section
of their balance sheets.9
Net of Taxes
The phrase net of taxes indicates that taxes (usually income taxes) have been
taken into account in reporting an item in the financial statements. The phrase
is used in a corporate income statement when a company has items that must
be disclosed in a separate section. Each such item should be reported net of the
applicable income taxes to avoid distorting the income taxes expense associated
with ongoing operations and the resulting net operating income.
For example, assume that a corporation with operating income before
income taxes of $240,000 has a total tax expense of $132,000 and that the
total income includes a gain of $200,000 on which a tax of $60,000 is due.
Also assume that the gain is not part of the corporation’s normal operations
and must be disclosed separately on the income statement as an extraordinary
624 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
item. This is how the income taxes expense would be reported on the income
statement:
Operating income before income taxes $240,000
Income taxes expense 72,000
Income before extraordinary item $168,000
Extraordinary gain (net of taxes, $60,000) 140,000
Net income $308,000
If all the income taxes expense were deducted from operating income before
income taxes, both the income before extraordinary item and the extraordinary
gain would be distorted.
The procedure is the same in the case of an extraordinary loss. For example,
given the same facts except that the income taxes expense is only $12,000 because
of a $200,000 extraordinary loss, the result is a $60,000 tax savings: |
Operating income before income taxes $240,000
Income taxes expense 72,000
Income before extraordinary item $168,000
Extraordinary loss (net of taxes, $60,000) (140,000)
Net income $ 28,000
In Exhibit 14-1, the total of the income tax items for Vistula Corporation is
$299,000. That amount is allocated among five statement components, as f ollows:
Income taxes expense on income from continuing operations $289,000
Income taxes on income from a discontinued segment 70,000
Income tax savings on the loss on the disposal of the segment (84,000)
Income taxes on extraordinary gain 24,000
Total income taxes expense $299,000
STOP
& APPLY
Jose Corporation reported the following accounting income before income taxes, income taxes
expense, and net income for 2010 and 2011:
2010 2011
Income before income taxes $42,000 $42,000
Income taxes expense 13,245 13,245
Net income $28,755 $28,755
On the balance sheet, deferred income taxes liability increased by $5,760 in 2010 and decreased by
$2,820 in 2011.
1. H ow much was actually payable in income 2. P repare entries in journal form to record
taxes for 2010 and 2011? estimated current and deferred income taxes
for 2010 and 2011.
SOLUTION
1. Income taxes calculated:
2010 2011
Income taxes expense $13,245 $13,245
Decrease (increase) in deferred income taxes (5,760) 2,820
Income taxes payable $ 7,485 $16,065
Earnings per Share 625
2. Entries prepared:
Dr. Cr.
2010 Income Taxes Expense 13,245
Deferred Income Taxes 5,760
Income Taxes Payable 7,485
To record estimated current and deferred
income taxes for 2010
2011 Income Taxes Expense 13,245
Deferred Income Taxes 2,820
Income Taxes Payable 16,065
To record estimated current and deferred
income taxes for 2011
Earnings per
Readers of financial statements use earnings per share to judge a company’s per-
Share formance and to compare it with the performance of other companies. Because
this information is so important, the Accounting Principles Board concluded
that earnings per share of common stock should be presented on the face of the
LO3 Compute earnings
income statement.10 As shown in Exhibit 14-1, this information is usually dis-
per share.
closed just below net income.
A corporate income statement always shows earnings per share for income
from continuing operations and other major components of net income. For
Study Note
example, if a company has a gain or loss on discontinued operations or on extraor-
Earnings per share is a measure dinary items, its income statement may present earnings per share amounts for
of a corporation’s profitability. the gain or loss.
It is one of the most closely Exhibit 14-2 shows how Motorola, the well-known manufacturer of tele-
watched financial ratios in the communications equipment, pres ents earnings per share on its income statement.
business world. Its disclosure As you can see, the statement covers three years, and discontinued operations
on the income statement is
had positive effects on earnings per share in two of the three years. However,
required.
the earnings per share for continuing operations is a better indicator of the com-
pany’s future performance. The company is discontinuing some operations by
EXHIBIT 14-2 Motorola’s Earnings
per Share Presentation Years Ended December 31
2008 2007 2006
Earnings (loss) per common share:
Basic:
Continuing operations ($1.87) ($0.05) $1.33
__
Discontinued operations 0.03 0.17
($1.87) ($0.02) $1.50
Diluted:
Continuing operations ($1.87) ($0.05) $1.30
__
Discontinued operations 0.03 0.16
($1.87) ($0.02) $1.46
Weighted averages common shares
outstanding:
Basic 2,265.40 2,312.70 2,446.30
Diluted 2,265.40 2,312.70 2,504.20
Source: Motorola, Inc., Annual Report, 2008.
626 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
selling or otherwise disposing of non-core divisions. Note that earnings per share
are reported as basic and diluted.
Basic Earnings per Share
Basic earnings per share is the net income applicable to common stock divided
by the weighted-average number of common shares outstanding. To compute
this figure, one must determine if the number of common shares outstanding |
changed during the year and if the company paid dividends on preferred stock.
When a company has only common stock and the number of shares outstand-
ing is the same throughout the year, the earnings per share computation is s imple.
Exhibit 14-1 shows that Vistula Corporation had net income of $669,000. If
Vistula had 200,000 shares of common stock outstanding during the entire year,
the earnings per share of common stock would be computed as follows:
$669,000
Earnings per Share (cid:2) (cid:2) $3.35* per Share
200,000 Shares
If the number of shares outstanding changes during the year, it is necessary
to figure the weighted-average number of shares outstanding for the year. Sup-
pose that from January 1 to March 31, Vistula Corporation had 200,000 shares
outstanding; from April 1 to September 30, it had 240,000 shares outstanding;
and from October 31 to December 31, it had 260,000 shares outstanding. The
weighted-average number of common shares outstanding and basic earnings per
share would be determined this way:
200,000 shares (cid:6) 3/ year 50,000
12
240,000 shares (cid:6) 6/ year 120,000
12
260,000 shares (cid:6) 3/ year 65,000
12
Weighted-average common shares outstanding 235,000
Net Income
Basic Earnings per Share (cid:2)
Weighted-Average Common Shares Outstanding
$669,000
(cid:2) ______ __ ____ __ (cid:2) $2.85 per Share
235,000 Shares
If a company has nonconvertible preferred stock outstanding, the dividend
for that stock must be subtracted from net income before earnings per share for
common stock are computed. Suppose that Vistula Corporation has preferred
stock on which it pays an annual dividend of $47,000. Earnings per share on
common stock would be $2.65 [($669,000 (cid:4) $47,000) (cid:5) 235,000 shares].
Diluted Earnings per Share
Companies can have a simple capital structure or a complex capital structure.
(cid:2) A company has a simple capital structure if it has no preferred stocks, bonds,
or stock options that can be converted to common stock. A company with a
simple capital structure computes earnings per share as shown above.
(cid:2) A company that has issued securities or stock options that can be converted to
common stock has a complex capital structure. These securities and options
have the potential of diluting the earnings per share of common stock.
*This number is rounded, as are some other results of computations that follow.
Comprehensive Income and the Statement of Stockholders’ Equity 627
Potential dilution means that the conversion of stocks or bonds or the exercise
of stock options can increase the total number of shares of common stock that
a company has outstanding and thereby reduce a current stockholder’s propor-
tionate share of ownership in the company. For example, suppose that a per-
son owns 10,000 shares of a company’s common stock, which equals 2 percent
of the outstanding shares of 500,000. Now suppose that holders of convertible
bonds c onvert the bonds into 100,000 shares of stock. The person’s
10,000 shares would then equal only 1.67 percent (10,000 (cid:5) 600,000) of the
outstanding shares. In addition, the added shares outstanding would lower earn-
ings per share and would most likely lower market price per share.
When a company has a complex capital structure, it must report two e arnings
per share figures: basic earnings per share and diluted earnings per share.11 Diluted
earnings per share are calculated by adding all potentially dilutive securities to the
denominator of the basic earnings per share calculation. This figure shows stock-
holders the maximum potential effect of dilution on their ownership position. As
you can see in Exhibit 14-2, the dilution effect for Motorola is not large, only
4 cents per share in 2006 ($1.50 (cid:4) $1.46) and none in 2007 or 2008, because the
company’s only dilutive securities are a relatively few stock options.
STOP
& APPLY
During 2011, Sasha Corporation reported a net income of $1,529,500. On January 1, 2011, Sasha
had 350,000 shares of common stock outstanding, and it issued an additional 210,000 shares of |
common stock on October 1. The company has a simple capital structure.
1. Determine the weighted-average number 2. Compute earnings per share.
of common shares outstanding.
SOLUTION
1. Weighted-average number of common shares outstanding:
350,000 shares (cid:6) 9/ 262,500
12
560,000 shares (cid:6) 3/ 140,000
12
Weighted-average number of common shares outstanding 402,500
2. Earnings per share:
$1,529,500 (cid:5) 402,500 shares (cid:2) $3.80
Comprehensive
The concept of comprehensive income and the statement of stockholders’ equity
Income and the provide further explanation of the income statement and the balance sheet and
serve as links between those two statements.
Statement of
Stockholders’
Comprehensive Income
Equity
Some items that are not stock transactions affect stockholders’ equity. These
items, which come from sources other than stockholders and that account for the
LO4 Define comprehensive
change in a company’s equity during an accounting period, are called comprehen-
income, and describe the state-
sive income. Comprehensive income includes net income, changes in unrealized
ment of stockholders’ equity.
investment gains and losses, and other items affecting equity, such as foreign cur-
rency translation adjustments. The FASB takes the position that these changes in
stockholders’ equity should be summarized as income for a period.12 Companies
628 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
EXHIBIT 14-3 eBay’s Statement of Comprehensive Income
Years Ended December 31
(In thousands) 2008 2007 2006
Net income $1,779,474 $ 348,251 $1,125,639
Other comprehensive income
Foreign currency translation (553,490) 645,202 588,150
Unrealized gains (losses) on investments, net (464,171) 589,566 8,327
Unrealized gains (losses) on cash flow hedges 40,522 (175) (194)
Estimated tax provision on above items 179,348 (229,514) (3,216)
Net change in other comprehensive income ($ 797,791) $1,005,079 $ 593,097
Comprehensive income $ 981,683 $1,353,330 $1,718,706
Source: eBay Inc., Annual Report, 2008.
may report comprehensive income and its components in a separate financial state-
ment, as eBay does in Exhibit 14-3, or as a part of another financial statement.
In a recent survey of 600 large companies, 579 reported comprehensive
income. Of these, 83 percent reported comprehensive income in the statement
of stockholders’ equity, 13 percent reported it in a separate statement, and only
4 percent reported it in the income statement.13 In Exhibit 14-4, we follow the most
common practice and show it as a part of the statement of stockholders’ equity.
EXHIBIT 14-4 Statement of Stockholders’ Equity
Crisanti Corporation
Statement of Stockholders’ Equity
For the Year Ended December 31, 2010
Preferred
Stock $100 Common Accumulated
Par Value Stock Additional Other
8% $10 Paid-in Retained Treasury Comprehensive
Convertible Par Value Capital Earnings Stock Income Total
Balance, December 31, 2009 $ 800,000 $600,000 $ 600,000 $1,200,000 $3,200,000
Net income 540,000 540,000
Foreign currency translation
adjustment ($20,000) (20,000)
Issuance of 10,000 shares of
common stock 100,000 400,000 500,000
Conversion of 2,000 shares of
preferred stock to 6,000 shares
of common stock (200,000) 60,000 140,000 —
10 percent stock dividend
on common stock,
7,600 shares 76,000 304,000 (380,000) —
Purchase of 1,000 shares of
treasury stock ($48,000) (48,000)
Cash dividends
Preferred stock (48,000) (48,000)
Common stock (95,200) (95,200)
Balance, December 31, 2010 $ 600,000 $836,000 $1,444,000 $1,216,800 ($48,000) ($20,000) $4,028,800
Comprehensive Income and the Statement of Stockholders’ Equity 629
The Statement of Stockholders’ Equity
The statement of stockholders’ equity, also called the statement of changes in
Study Note
stockholders’ equity, summarizes changes in the components of the stockholders’
The statement of stockholders’ equity section of the balance sheet. Most companies use this statement in place of
equity is a labeled calculation the statement of retained earnings because it reveals much more about the stock- |
of the change in each holders’ equity transactions that took place during the accounting period.
stockholders’ equity account For example, in Crisanti Corporation’s statement of stockholders’ equity
over an accounting period. in Exhibit 14-4, the first line shows the beginning balance of each account in
the stockholders’ equity section of the balance sheet. Each subsequent line dis-
closes the effects of transactions on those accounts. Crisanti had a net income of
$540,000 and a foreign currency translation loss of $20,000, which it reported as
accumulated other comprehensive income. These two items together resulted in
comprehensive income of $520,000.
Crisanti’s statement of stockholders’ equity also shows that during 2010, the
Study Note
firm issued 10,000 shares of common stock for $500,000, had a conversion of
$200,000 of preferred stock to common stock, declared and issued a 10 percent
The ending balances on the
statement of stockholders’ stock dividend on common stock, purchased treasury stock for $48,000, and paid
equity are transferred to the cash dividends on both preferred and common stock. The ending balances of
stockholders’ equity section of the accounts appear at the bottom of the statement. Those accounts and bal-
the balance sheet. ances make up the stockholders’ equity section of Crisanti’s balance sheet on
December 31, 2010, as shown in Exhibit 14-5.
Retained Earnings
The Retained Earnings column in Exhibit 14-4 has the same components as the
statement of retained earnings. As we explained earlier in the text, retained earnings
represent stockholders’ claims to assets that arise from the earnings of the business.
Retained earnings equal a company’s profits since its inception, minus any losses,
dividends to stockholders, or transfers to contributed capital.
It is important to remember that retained earnings are not the assets them-
selves. The existence of retained earnings means that assets generated by profitable
EXHIBIT 14-5 Stockholders’ Equity
Crisanti Corporation
Section of a Balance Sheet
Balance Sheet
December 31, 2010
Stockholders’ Equity
Contributed capital
Preferred stock, $100 par value, 8 percent
convertible, 20,000 shares authorized,
6,000 shares issued and outstanding $ 600,000
Common stock, $10 par value, 200,000 shares
authorized, 83,600 shares issued,
82,600 shares outstanding $ 836,000
Additional paid-in capital 1,444,000 2,280,000
Total contributed capital $2,880,000
Retained earnings 1,216,800
Total contributed capital and retained earnings $4,096,800
Less: Treasury stock, common (1,000 shares, at cost) $ 48,000
Foreign currency translation adjustment 20,000 68,000
Total stockholders’ equity $4,028,800
630 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
ooperations have been kept in the company to help it grow or meet other business
Study Note
nneeds. A credit balance in Retained Earnings is not directly associated with a spe-
A deficit is a negative (debit) ccific amount of cash or designated assets. Rather, it means that assets as a whole
balance in Retained Earnings. hhave increased.
It is not the same as a net Retained Earnings can have a debit balance. Generally, this happens when
loss, which reflects a firm’s aa company’s dividends and subsequent losses are greater than its accumulated
performance in just one pprofits from operations. In this case, the company is said to have a deficit (debit
accounting period. bbalance) in Retained Earnings. A deficit is shown in the stockholders’ equity sec-
ttion of the balance sheet as a deduction from contributed capital.
STOP
& APPLY
Indicate which of the following items would appear on the statement of stockholders’ equity:
a. Preferred stock cash dividends f. Purchase of treasury stock
b. Loss on disposal of segment g. Income from continuing operations
c. Issuance of common stock h. Net income
d. Stock dividend i. A ccumulated other comprehensive
e. Income tax expense income
SOLUTION
a, c, d, f, h, i
Stock Dividends
Two transactions that commonly modify the content of stockholders’ equity are |
and Stock Splits stock dividends and stock splits. In the discussion that follows, we describe how
to account for both kinds of transactions.
LO5 Account for stock divi-
dends and stock splits. Stock Dividends
A stock dividend is a proportional distribution of shares among a corporation’s
stockholders. Unlike a cash dividend, a stock dividend involves no distribution of
assets, and so it has no effect on a firm’s assets or liabilities. A board of directors
may declare a stock dividend for the following reasons:
1. It may want to give stockholders some evidence of the company’s success
without affecting working capital, which would be the case if it paid a cash
Study Note dividend.
The declaration of a stock 2. It may want to reduce the stock’s market price by increasing the number of
dividend results in a reshuffling shares outstanding. (This goal is, however, more often met by a stock split.)
of stockholders’ equity—that is,
3. It may want to make a nontaxable distribution to stockholders. Stock divi-
a portion of retained earnings is
dends that meet certain conditions are not considered income and are there-
converted to contributed capital.
fore not taxed.
Total stockholders’ equity is not
affected. 4. It may want to increase the company’s permanent capital by transferring an
amount from retained earnings to contributed capital.
Stock Dividends and Stock Splits 631
A stock dividend does not affect total stockholders’ equity. Basically, it trans-
Study Note
fers a dollar amount from retained earnings to contributed capital. The amount
transferred is the fair market value (usually, the market price) of the additional
For a small stock dividend, the
shares that the company issues. The laws of most states specify the minimum
portion of retained earnings
transferred is determined by value of each share transferred, which is normally the minimum legal capital (par
multiplying the number of or stated value). When stock distributions are small—less than 20 to 25 percent
shares to be distributed by the of a company’s outstanding common stock—generally accepted accounting prin-
stock’s market price on the ciples hold that market value reflects their economic effect better than par or
declaration date. stated value. For this reason, market price should be used to account for small
stock dividends.14
To illustrate how to account for a stock dividend, suppose that stockholders’
equity in Rivera Corporation is as follows:
Contributed capital
Common stock, $5 par value, 50,000 shares
authorized, 15,000 shares issued and outstanding $ 75,000
Additional paid-in capital 15,000
Total contributed capital $ 90,000
Retained earnings 450,000
Total stockholders’ equity $540,000
Now suppose that on February 24, the market price of Rivera’s stock is $20 per
share, and on that date, its board of directors declares a 10 percent stock dividend
to be distributed on March 31 to stockholders of record on March 15. No entry
is needed for the date of record (March 15). The T accounts and entries for the
declaration and distribution of the stock dividend are as follows:
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
STOCK DIVIDENDS
Dr. Cr.
Feb. 24 30,000
COMMON STOCK DISTRIBUTABLE
Dr. Cr.
Feb. 24 7,500
ADDITIONAL PAID-IN CAPITAL
Dr. Cr.
Feb. 24 22,500
Entry in Journal Form:
Declaration Date 2010 Dr. Cr.
A (cid:3) L (cid:4) SE Feb. 24 Stock Dividends 30,000
(cid:4)30,000 Common Stock Distributable 7,500
(cid:3) 7,500 Additional Paid-in Capital 22,500
(cid:3)22,500
Declared a 10 percent stock
dividend on common stock,
distributable on March 31
to stockholders of record
on March 15:
15,000 shares (cid:6) 0.10 (cid:2) 1,500 shares
1,500 shares (cid:6) $20/share (cid:2) $30,000
1,500 shares (cid:6) $5/share (cid:2) $7,500
632 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
Assets (cid:2) Liabilities (cid:3) Stockholders’ Equity
COMMON STOCK DISTRIBUTABLE
Dr. Cr.
Mar. 31 7,500
COMMON STOCK
Dr. Cr.
Mar. 31 7,500
Entry in Journal Form:
Distribution Date 2010 Dr. Cr.
A (cid:3) L (cid:4) SE Mar. 31 Common Stock Distributable 7,500 |
(cid:4)7,500
Common Stock 7,500
(cid:3)7,500
Distributed a stock dividend
of 1,500 shares
This stock dividend permanently transfers the market value of the stock,
$30,000, from retained earnings to contributed capital and increases the number
of shares outstanding by 1,500. The Stock Dividends account is used to record
the total amount of the stock dividend. When the Stock Dividends account is
closed to Retained Earnings at the end of the accounting period, Retained Earn-
ings is reduced by the amount of the stock dividend. Common Stock Distribut-
able is credited for the par value of the stock to be distributed (1,500 (cid:6) $5 (cid:2)
$7,500).
In addition, when the market value is greater than the par value of the stock,
the Additional Paid-in Capital account must be credited for the amount by which
Study Note
the market value exceeds the par value. In our example, the total market value of the
stock dividend ($30,000) exceeds the total par value ($7,500) by $22,500. On the
Common Stock Distributable
date of distribution, Common Stock Distributable is debited and Common Stock is
is a contributed capital
(stockholders’ equity) account, credited for the par value of the stock ($7,500).
not a liability account. When Common Stock Distributable is not a liability account because there is no
the shares are issued, Common obligation to distribute cash or other assets. The obligation is to distribute addi-
Stock Distributable is converted tional shares of capital stock. If financial statements are prepared between the dec-
to the Common Stock account. laration date and the date of distribution, Common Stock Distributable should
be reported as part of contributed capital:
Contributed capital
Common stock, $5 par value, 50,000 shares
authorized, 15,000 shares issued and outstanding $ 75,000
Common stock distributable, 1,500 shares 7,500
Additional paid-in capital 37,500
Total contributed capital $120,000
Retained earnings 420,000
Total stockholders’ equity $540,000
This example demonstrates the following points:
1. Total stockholders’ equity is the same before and after the stock dividend.
2. The assets of the corporation are not reduced, as they would be by a cash
dividend.
3. The proportionate ownership in the corporation of any individual stockholder
is the same before and after the stock dividend.
Stock Dividends and Stock Splits 633
To illustrate these points, suppose a stockholder owns 500 shares before the
stock dividend. After the 10 percent stock dividend is distributed, this stock-
holder would own 550 shares, as shown below:
Stockholders’ Equity
Before After
Dividend Dividend
Common stock $ 75,000 $ 82,500
Additional paid-in capital 15,000 37,500
Total contributed capital $ 90,000 $120,000
Retained earnings 450,000 420,000
Total stockholders’ equity $ 540,000 $540,000
Shares outstanding 15,000 16,500
Stockholders’ equity per share $ 36.00 $ 32.73
Stockholders’ Investment
Shares owned 500 550
Shares outstanding 15,000 16,500
Percentage of ownership 31/% 31/%
3 3
Proportionate investment
($540,000 (cid:6) 31/%) $ 18,000 $ 8,000
3
Both before and after the stock dividend, stockholders’ equity totals $540,000,
aand the stockholder owns 31/ percent of the company. The proportionate invest-
3
Study Note
mment (stockholders’ equity times percentage of ownership) remains at $18,000.
All stock dividends have an effect on the market price of a company’s stock.
When a stock dividend greater
than 20 to 25 percent is BBut some stock dividends are so large that they have a material effect. For exam-
declared, the transfer from pple, a 50 percent stock dividend would cause the market price of the stock to
retained earnings is based on ddrop about 33 percent because the increase is now one-third of shares outstand-
the stock’s par or stated value, iing. The AICPA has decided that large stock dividends—those greater than 20 to
not on its market value. 225 percent—should be accounted for by transferring the par or stated value of the
sstock on the declaration date from retained earnings to contributed capital.15
Stock Splits |
A stock split occurs when a corporation increases the number of shares of stock
Study Note
issued and outstanding, and reduces the par or stated value proportionally. A
company may plan a stock split when it wants to lower its stock’s market value per
Stock splits and stock dividends
share and increase the demand for the stock at this lower price. It may do so if the
reduce earnings per share
because they increase the market price has become so high that it hinders the trading of the stock or if it
number of shares issued and wants to signal to the market its success in achieving its operating goals.
outstanding. Cash dividends Nike achieved these strategic objectives in a recent year by declaring a 2-for-1
have no effect on earnings per stock split and increasing its cash dividend.16 After the stock split, the number of
share. the company’s outstanding shares doubled, thereby cutting the share price from
about $80 per share to $40 per share. The stock split left each stockholder’s total
wealth unchanged but increased the income stockholders received from divi-
dends. The stock split was a sign that Nike has continued to do well.
To illustrate a stock split, suppose that MUI Corporation has 15,000 shares
of $5.00 par value stock outstanding and the market value is $70.00 per share.
The corporation plans a 2-for-1 split. This split will lower the par value to
$2.50 and increase the number of shares outstanding to 30,000. A stockholder
who previously owned 200 shares of the $5.00 par value stock would own
400 shares of the $2.50 par value stock after the split. When a stock split occurs,
634 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
FOCUS ON BUSINESS PRACTICE
Do Stock Splits Help Increase a Company’s Market Price?
Stock splits tend to follow the market. When the market it any sweeter, just frothier. There is no fundamental rea-
went up dramatically in 1998, 1999, and 2000, there were son a stock should go up because of a stock split. When
record numbers of stock splits—more than 1,000 per Rambus Inc., a developer of high-speed memory technol-
year. At the height of the market in early 2000, stock split- ogy, announced a 4-for-1 split on March 10, 2000, its stock
ters included such diverse companies as Alcoa, Apple rose more than 50 percent, to $471 per share.17 But when
Computer, Chase Manhattan, Intel, NVIDIA, Juniper the market deflated in 2001, its stock dropped to less than
Networks, and Tiffany & Co. Some analysts liken stock $10 per share. Research shows that stock splits have no
splits to the air a chef whips into a mousse: It doesn’t make long-term effect on stock prices.
the market value tends to fall in proportion to the increase in outstanding
shares of stock. For example, MUI’s 2-for-1 stock split would cause the price
of its stock to drop by approximately 50 percent, to about $35.00. It would
also halve earnings per share and cash dividends per share (unless the board
increased the dividend). The lower price and increase in shares tend to promote
the buying and selling of shares.
A stock split does not increase the number of shares authorized, nor does it
change the balances in the stockholders’ equity section of the balance sheet. It sim-
ply changes the par value and number of shares issued, both shares outstanding and
treasury stock. Thus, an entry is unnecessary. However, it is appropriate to docu-
ment the change with a memorandum entry in the general journal. For example:
July 15 The 15,000 shares of $5 par value common stock issued and
outstanding were split 2 for 1, resulting in 30,000 shares of $2.50 par
value common stock issued and outstanding.
The change for MUI Corporation is as follows:
Before Stock Split
Contributed capital
Common stock, $5 par value, 50,000 shares
authorized; 15,000 shares issued and
outstanding $ 75,000
Additional paid-in capital 15,000
Total contributed capital $ 90,000
Retained earnings 450,000
Total stockholders’ equity $540,000
After Stock Split
Study Note
Contributed capital
A stock split affects only the |
Common stock, $2.50 par value,
calculation of common stock.
50,000 shares authorized, 30,000 shares
In this case, there are twice as
issued and outstanding $ 75,000
many shares after the split,
Additional paid-in capital 15,000
but par value is half of what
Total contributed capital $ 90,000
it was.
Retained earnings 450,000
Total stockholders’ equity $540,000
Book Value 635
Although the per share amount of stockholders’ equity is half as much after
the split, the stockholder’s proportionate interest in the company remains the
same. Thus, a stockholder’s wealth and ownership interest in the company are
not materially affected by a stock split.
If the number of split shares will exceed the number of authorized shares,
the corporation’s board of directors must secure state and stockholders’ approval
before it can issue the additional shares.
STOP
& APPLY
Abbie Corporation’s board of directors declared a 2 percent stock dividend applicable to the out-
standing shares of its $10 par value common stock, of which 1,000,000 shares are authorized,
300,000 are issued, and 100,000 are held in the treasury. It then declared a 2-for-1 stock split on
issued shares. How many authorized, issued, and treasury shares existed after each of these transac-
tions? What is the par value per share?
SOLUTION
Stock dividend applies to outstanding shares:
(300,000 shares (cid:4) 100,000 shares) (cid:6) 0.02 (cid:2) 4,000 shares
Stock split applies to all issued shares:
304,000 shares (cid:6) 2 (cid:2) 608,000 shares
Authorized shares are unchanged (1,000,000, but par value is now $5 per share); issued shares are 608,000; and
outstanding shares are 408,000 (400,000 (cid:3) 8,000)
Book Value
The word value is associated with shares of stock in several ways. Par value or stated
value is set when the stock is authorized, and it establishes a company’s legal capital.
LO6 Calculate book value per Neither par value nor stated value has any relationship to a stock’s book value or
share. market value. The book value of stock represents a company’s total assets less its
liabilities. It is simply the stockholders’ equity in a company or, to put it another
way, it represents a company’s net assets. The book value per share is therefore
the equity of the owner of one share of stock in the net assets of a company. That
value, of course, generally does not equal the amount a stockholder receives if the
company is sold or liquidated because in most cases, assets are recorded at historical
cost, not at their current market value. Book value per share is often used as a guide
for stock transactions by private companies for which there is no ready market for
the company’s stock.
If a company has only common stock outstanding, book value per share is
calculated by dividing stockholders’ equity by the number of common shares
outstanding. Common stock distributable is included in the number of shares
outstanding, but treasury stock is not. For example, if a firm has total stockhold-
ers’ equity of $2,060,000 and 58,000 shares outstanding, the book value per
share of its common stock would be $35.52 ($2,060,000 (cid:5) 58,000 shares).
If a company has both preferred and common stock, determining the book
value per share is not so simple. Generally, the preferred stock’s call value (or par
value, if a call value is not specified) and any dividends in arrears are subtracted
from stockholders’ equity to determine the equity pertaining to common stock.
636 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
As an illustration, refer to the stockholders’ equity section of Crisanti Corpora-
tion’s balance sheet in Exhibit 14-5. If Crisanti has no dividends in arrears and
its preferred stock is callable at $105, the equity pertaining to its common stock
would be calculated as follows:
Total stockholders’ equity $4,028,800
Less equity allocated to preferred
stockholders (6,000 shares (cid:6) $105) 630,000
Equity pertaining to common stockholders $3,398,800
As indicated in Exhibit 14-5, Crisanti has 82,600 shares of common stock out- |
standing (83,600 shares issued less 1,000 shares of treasury stock). Its book val-
ues per share are computed as follows:
Preferred stock: $630,000 (cid:5) 6,000 shares (cid:2) $105 per share
Common stock: $3,398,800 (cid:5) 82,600 shares (cid:2) $41.15 per share
If we assume the same facts except that Crisanti’s preferred stock is 8 percent
cumulative and that one year of dividends is in arrears, the stockholders’ equity
would be allocated as follows:
Total stockholders’ equity $4,028,800
Less call value of outstanding preferred shares $630,000
Dividends in arrears ($600,000 (cid:6) 0.08) 48,000
Equity allocated to preferred stockholders 678,000
Equity pertaining to common stockholders $3,350,800
The book values per share would then be as follows:
Preferred stock: $678,000 (cid:5) 6,000 shares (cid:2) $113 per share
Common stock: $3,350,800 (cid:5) 82,600 shares (cid:2) $40.57 per share
STOP
& APPLY
Using the data from the stockholders’ equity section of Park Corporation’s balance sheet shown
below, compute the book value per share for both the preferred and common stock.
Contributed capital
Preferred stock, $100 par value, 6 percent cumulative, 20,000 shares
authorized, 2,000 shares issued and outstanding* $ 200,000
Common stock, $5 par value, 200,000 shares authorized,
100,000 shares issued and outstanding 500,000
Additional paid-in capital 300,000
Total contributed capital $1,000,000
Retained earnings 500,000
Total stockholders’ equity $1,500,000
* The preferred stock is callable at $104 per share, and one year’s dividends are in arrears.
SOLUTION
Preferred stock book value per share:
$104 (cid:3) $6 (cid:2) $110
Common stock book value per share:
[$1,500,000 (cid:4) (2,000 preferred shares (cid:6) $110)] (cid:5) 100,000 common shares (cid:2) $12.80
Kowalski, Inc.: Review Problem 637
(cid:2) KOWALSKI, INC.: REVIEW PROBLEM
In the Decision Point at the beginning of this chapter, we noted that just after
Kowalski, Inc.’s fiscal year ended on June 30, 2010, Walter Kowalski, the company’s CEO,
was deliberating about the following questions regarding stockholders’ equity:
• Should Kowalski, Inc., declare a stock split?
• Should the company raise capital by issuing preferred stock?
• Should the company pay cash dividends or use cash to buy back its own stock?
The following transactions show how the company responded to these questions dur-
ing the fiscal year that ended on June 30, 2011.
a. The board of directors declared a 2-for-1 stock split.
b. The board of directors obtained authorization to issue 25,000 shares of $100 par
Stock Transactions and value, 6 percent noncumulative preferred stock, callable at $104.
Stockholders’ Equity c. The company issued 6,000 shares of common stock for a building appraised at
LO4 LO5 $48,000.
LO6
d. It bought back 4,000 shares of its common stock for $32,000.
e. It issued 10,000 shares of preferred stock for $100 per share.
f. It sold 2,500 shares of treasury stock for $17,500.
g. It declared cash dividends of $6 per share on preferred stock and $0.20 per
share on common stock.
h. It declared a 10 percent stock dividend on common stock to be distributed
after the end of the fiscal year. The market value was $10 per share.
i. It closed net income for the year, $170,000.
j. It closed the Dividends and Stock Dividends accounts to Retained Earnings.
Required
1. Using the data presented in the Decision Point and the data in the list above,
record the stockholders’ equity components of the preceding transactions in
T accounts. Indicate when there is no entry.
2. Using the data presented in the Decision Point and the data in the list above,
prepare the stockholders’ equity section of the company’s balance sheet on
June 30, 2011.
3. User insight: Compute the book values per share of common stock on June 30,
2010 and 2011, and of preferred stock on June 30, 2011, using the end-of-year
shares outstanding. If Kowalski’s stock is not traded in any market, how can the
value of the stock be measured?
638 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity |
Answers to
1. Entries in T accounts:
Review Problem
a. No entry (memorandum in journal)
b. No entry (memorandum in journal)
2. Stockholders’ equity section of the balance sheet:
Kowalski, Inc.: Review Problem 639
3. Book values:
June 30, 2010
Common Stock: $1,645,000 (cid:5) 125,000 shares (cid:2) $13.16 per share
June 30, 2011
Preferred Stock: Call price of $104 per share equals book value per share
Common Stock:
($2,737,600 (cid:4) $1,040,000) (cid:5) (254,500 shares (cid:3) 25,450 shares)
$1,697,600 (cid:5) 279,950 shares (cid:2) $6.06 per share*
*Rounded.
When there is no ready market for a company’s common or preferred stock, book value
per share is often used as a guide for determining the stock’s value.
640 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
STOP
& REVIEW
LO1 Defi ne quality of earn- The quality of earnings refers to the substance of earnings and their sustainabil-
ings, and identify the ity into future accounting periods. The quality of a company’s earnings may be
components of a corpo- affected by the accounting methods and estimates it uses and by the gains and
rate income statement. losses, write-downs and restructurings, and nonoperating items that it reports on
its income statement.
When a company has both continuing and discontinued operations, the operat-
ing income section of its income statement is called income from continuing opera-
tions. Income from continuing operations before income taxes is affected by choices
of accounting methods and estimates and may contain gains and losses on the sale
of assets, write-downs, and restructurings. The income taxes expense section of the
statement is subject to special accounting rules. The lower part of the statement may
contain such nonoperating items as discontinued operations and extraordinary gains
and losses. Earnings per share information appears at the bottom of the statement.
LO2 Show the relation- Income taxes expense is the tax applicable to income from operations on an
ships among income accrual basis. Income tax allocation is necessary when there is a material difference
taxes expense, deferred between accrual-based accounting income and taxable income—that is, between
income taxes, and net of the income taxes expense reported on the income statement and actual income
taxes. tax liability. The difference between income taxes expense and income taxes pay-
able is debited or credited to an account called Deferred Income Taxes. The
phrase net of taxes indicates that taxes have been taken into account in reporting
an item in the financial statements.
LO3 Compute earnings Readers of financial statements use earnings per share to evaluate a compa-
per share. ny’s performance and to compare it with the performance of other companies.
Earnings per share of common stock are presented on the face of the income
statement. The amounts are computed by dividing the income applicable to com-
mon stock by the number of common shares outstanding for the year. If the
number of shares outstanding varied during the year, the weighted-average num-
ber of common shares outstanding is used in the computation. A company that
has a complex capital structure must disclose both basic and diluted earnings per
share on the face of its income statement.
LO4 Defi ne comprehensive Comprehensive income includes all items from sources other than stockholders
income, and describe the that account for changes in stockholders’ equity during an accounting period.
statement of stockhold- The statement of stockholders’ equity summarizes changes over the period in
ers’ equity. each component of the stockholders’ equity section of the balance sheet. This
statement reveals much more than the statement of retained earnings does about
the transactions that affect stockholders’ equity.
LO5 Account for stock divi- A stock dividend is a proportional distribution of shares among a corporation’s
dends and stock splits. stockholders. The following is a summary of the key dates and accounting treat-
ments of stock dividends: |
Key Date Stock Dividend
Declaration date Debit Stock Dividends for the market value
of the stock to be distributed (if the stock
dividend is small), and credit Common Stock
Distributable for the stock’s par value and
Additional Paid-in Capital for the excess of
the market value over the stock’s par value.
Stop & Review 641
Key Date Stock Dividend
Record date No entry is needed.
Date of distribution Debit Common Stock Distributable and credit
Common Stock for the par value of the stock.
A company usually declares a stock split to reduce the market value of its
stock and thereby improve the demand for the stock. Because the par value of the
stock normally decreases in proportion to the number of additional shares issued,
a stock split has no effect on the dollar amount in stockholders’ equity. A stock
split does not require an entry, but a memorandum entry in the general journal
is appropriate.
LO6 Calculate book value Book value per share is stockholders’ equity per share. It is calculated by divid-
per share. ing stockholders’ equity by the number of common shares outstanding. When a
company has both preferred and common stock, the call or par value of the pre-
ferred stock and any dividends in arrears are deducted from stockholders’ equity
before dividing by the common shares outstanding.
REVIEW of Concepts and Terminology
The following concepts and terms Income from continuing Stock dividend 630 (LO5)
were introduced in this chapter: operations 616 (LO1)
Stock split 633 (LO5)
Book value 635 (LO6) Income tax allocation 622 (LO2)
Write-down 619 (LO1)
Complex capital Net of taxes 623 (LO2)
structure 626 (LO3) Quality of earnings 616 (LO1) Key Ratios
Comprehensive income 627 (LO4) Restructuring 619 (LO1) Basic earnings per share 626 (LO3)
Deferred Income Taxes 622 (LO2) Retained earnings 629 (LO4) Book value per share 635 (LO6)
Deficit 630 (LO4) Simple capital structure 626 (LO3) Diluted earnings per
Discontinued o perations 620 (LO1) share 627 (LO3)
Statement of stockholders’
Extraordinary items 620 (LO1) equity 629 (LO4)
642 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
CHAPTER ASSIGNMENTS
BUILDING Your Basic Knowledge and Skills
Short Exercises
LO1 Quality of Earnings
SE 1. Each of the items listed below is a quality of earnings issue. Indicate whether
the item is (a) an accounting method, (b) an accounting estimate, or (c) a non-
operating item. For any item for which the answer is (a) or (b), indicate which
alternative is usually the more conservative choice.
1. LIFO versus FIFO
2. Extraordinary loss
3. 10-year useful life versus 15-year useful life
4. Straight-line versus accelerated method
5. Discontinued operations
6. Immediate write-off versus amortization
7. Increase versus decrease in percentage of uncollectible accounts
LO1 Corporate Income Statement
SE 2. Assume that Jefferson Corporation’s chief financial officer gave you the fol-
lowing information: net sales, $360,000; cost of goods sold, $175,000; loss from
discontinued operations (net of income tax benefit of $35,000), $100,000; loss
on disposal of discontinued operations (net of income tax benefit of $8,000),
$25,000; operating expenses, $65,000; income taxes expense on continuing oper-
ations, $50,000. From this information, prepare the company’s income statement
for the year ended June 30, 2011. (Ignore earnings per share information.)
LO2 Corporate Income Tax Rate Schedule
SE 3. Using the corporate tax rate schedule in Table 14-1, compute the income
tax liability for taxable income of (1) $800,000 and (2) $40,000,000.
LO3 Earnings per Share
SE 4. During 2010, Wells Corporation reported a net income of $1,338,400. On
January 1, Wells had 720,000 shares of common stock outstanding. The company
issued an additional 480,000 shares of common stock on August 1. In 2010, the
company had a simple capital structure. During 2011, there were no transactions
involving common stock, and the company reported net income of $1,740,000.
Determine the weighted-average number of common shares outstanding for |
2010 and 2011. Also compute earnings per share for 2010 and 2011.
LO4 Statement of Stockholders’ Equity
SE 5. Refer to the statement of stockholders’ equity for Crisanti Corporation in
Exhibit 14-4 to answer the following questions: (1) At what price per share were the
10,000 shares of common stock sold? (2) What was the conversion price per share of
the common stock? (3) At what price was the common stock selling on the date of
the stock dividend? (4) At what price per share was the treasury stock purchased?
LO4 LO5 Effects of Stockholders’ Equity Actions
SE 6. Tell whether each of the following actions will increase, decrease, or have
no effect on total assets, total liabilities, and total stockholders’ equity:
1. Declaration of a stock dividend 3. Stock split
2. Declaration of a cash dividend 4. Purchase of treasury stock
Chapter Assignments 643
LO5 Stock Dividends
SE 7. On February 15, Asher Corporation’s board of directors declared a 2 per-
cent stock dividend applicable to the outstanding shares of its $10 par value
common stock, of which 400,000 shares are authorized, 260,000 are issued, and
40,000 are held in the treasury. The stock dividend was distributed on March 15
to stockholders of record on March 1. On February 15, the market value of the
common stock was $15 per share. On March 30, the board of directors declared
a $0.50 per share cash dividend. No other stock transactions have occurred.
Record, as necessary, the transactions of February 15, March 1, March 15, and
March 30.
LO5 Stock Split
SE 8. On August 10, 2010, the board of directors of Karton, Inc. declared a
3-for-1 stock split of its $9 par value common stock, of which 200,000 shares
were authorized and 62,500 were issued and outstanding. The market value on
that date was $60 per share. On the same date, the balance of additional paid-in
capital was $1,500,000, and the balance of retained earnings was $1,625,000.
Prepare the stockholders’ equity section of the company’s balance sheet after
the stock split. What entry, if any, is needed to record the stock split?
LO6 Book Value for Preferred and Common Stock
SE 9. Using data from the stockholders’ equity section of Soong Corporation’s
balance sheet shown below, compute the book value per share for both the pre-
ferred and the common stock.
Contributed capital
Preferred stock, $100 par value, 8 percent cumulative,
20,000 shares authorized, 1,000 shares issued and
outstanding* $ 100,000
Common stock, $10 par value, 200,000 shares
authorized, 80,000 shares issued and outstanding 800,000
Additional paid-in capital 1,032,000
Total contributed capital $1,932,000
Retained earnings 550,000
Total stockholders’ equity $2,482,000
*The preferred stock is callable at $108 per share, and one-year’s dividends are in arrears.
Exercises
LO1 LO2 Discussion Questions
E 1. Develop brief answers to each of the following questions:
1. In what way is selling an investment for a gain potentially a negative in evalu-
ating quality of earnings?
2. Is it unethical for new management to take an extra large write-off (a “big
bath”) in order to reduce future costs? Why or why not?
3. What is an argument against the recording of deferred income taxes?
4. Why is it useful to disclose discontinued operations separately on the income
statement?
LO3 LO4 Discussion Questions
LO5 LO6
E 2. Develop brief answers to each of the following questions:
1. What is one way a company can improve its earnings per share without
improving its earnings or net income?
644 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
2. Why is comprehensive income a part of stockholders’ equity?
3. Upon receiving shares of stock from a stock dividend, why should the stock-
holder not consider the value of the stock as income?
4. What is the effect of a stock dividend or a stock split on book value per share?
LO1 Effect of Alternative Accounting Methods
E 3. At the end of its first year of operations, a company calculated its ending
merchandise inventory according to three different accounting methods, as fol- |
lows: FIFO, $95,000; average-cost, $90,000; LIFO, $86,000. If the company
used the average-cost method, its net income for the year would be $34,000.
1. Determine net income if the company used the FIFO method.
2. Determine net income if the company used the LIFO method.
3. Which method is more conservative?
4. Will the consistency convention be violated if the company chooses to use
the LIFO method? Why or why not?
5. Does the full-disclosure convention require disclosure of the inventory
method used in the financial statements?
LO1 Corporate Income Statement
E 4. Assume that the Cetnar Corporation’s chief financial officer gave you the follow-
ing information: net sales, $1,900,000; cost of goods sold, $1,050,000; extraordinary
gain (net of income taxes of $3,500), $12,500; loss from discontinued operations (net
of income tax benefit of $30,000), $50,000; loss on disposal of discontinued opera-
tions (net of income tax benefit of $13,000), $35,000; selling expenses, $50,000;
administrative expenses, $40,000; income taxes expense on continuing operations,
$300,000. From this information, prepare the company’s income statement for the
year ended June 30, 2011. (Ignore earnings per share information.)
LO1 Corporate Income Statement
E 5. The items below are components of Patel Corporation’s income statement
for the year ended December 31, 2011. Recast the income statement in proper
multistep form, including allocating income taxes to appropriate items (assume
a 30 percent income tax rate) and showing earnings per share figures (100,000
shares outstanding).
Sales $ 555,000
Cost of goods sold (275,000)
Operating expenses (112,500)
Restructuring (55,000)
Total income taxes expense for period (89,550)
Income from discontinued operations 80,000
Gain on disposal of discontinued operations 70,000
Extraordinary gain 36,000
Net income $ 208,950
Earnings per share $ 2.09
LO2 Corporate Income Tax Rate Schedule
E 6. Using the corporate tax rate schedule in Table 14-1, compute the income tax
liability for the following situations:
Situation Taxable Income
A $ 70,000
B 85,000
C 320,000
Chapter Assignments 645
LO2 Income Tax Allocation
E 7. The Danner Corporation reported the following accounting income before
income taxes, income taxes expense, and net income for 2011 and 2012:
2011 2012
Income before income taxes $280,000 $280,000
Income taxes expense 88,300 88,300
Net income $191,700 $191,700
On the balance sheet, deferred income taxes liability increased by $38,400 in
2011 and decreased by $18,800 in 2012.
1. How much did Danner actually pay in income taxes for 2011 and 2012?
2. Prepare entries in journal form to record income taxes expense for 2011 and
2012.
LO3 Earnings per Share
E 8. During 2011, Arthur Corporation reported a net income of $3,059,000.
On January 1, Arthur had 2,800,000 shares of common stock outstanding. The
company issued an additional 1,680,000 shares of common stock on October 1.
In 2011, the company had a simple capital structure. During 2012, there were
no transactions involving common stock, and the company reported net income
of $4,032,000.
1. Determine the weighted-average number of common shares outstanding
each year.
2. Compute earnings per share for each year.
LO4 Statement of Stockholders’ Equity
E 9. The stockholders’ equity section of Erich Corporation’s balance sheet on
December 31, 2010, follows.
Contributed capital
Common stock, $2 par value, 500,000 shares
authorized, 400,000 shares issued
and outstanding $ 800,000
Additional paid-in capital 1,200,000
Total contributed capital $ 2,000,000
Retained earnings 4,200,000
Total stockholders’ equity $ 6,200,000
Prepare a statement of stockholders’ equity for the year ended December 31,
2011, assuming these transactions occurred in sequence in 2011:
a. Issued 10,000 shares of $100 par value, 9 percent cumulative preferred
stock at par after obtaining authorization from the state.
b. Issued 40,000 shares of common stock in connection with the conversion of
bonds having a carrying value of $600,000.
c. Declared and issued a 2 percent common stock dividend. The market value |
on the date of declaration was $14 per share.
d. Purchased 10,000 shares of common stock for the treasury at a cost of
$16 per share.
e. Earned net income of $460,000.
f. Declared and paid the full-year’s dividend on preferred stock and a dividend
of $0.40 per share on common stock outstanding at the end of the year.
g. Had foreign currency translation adjustment of negative $100,000.
646 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
LO5 Journal Entries: Stock Dividends
E 10. Snols Corporation has 30,000 shares of its $1 par value common stock out-
standing. Record in journal form the following transactions as they relate to the
company’s common stock:
July 17 Declared a 10 percent stock dividend on common stock to be
distributed on August 10 to stockholders of record on July 31.
Market value of the stock was $5 per share on this date.
31 Date of record.
Aug. 10 Distributed the stock dividend declared on July 17.
Sept. 1 Declared a $0.50 per share cash dividend on common stock to
be paid on September 16 to stockholders of record on
September 10.
LO5 Stock Split
E 11. Fernandez Corporation currently has 500,000 shares of $1 par value com-
mon stock authorized with 200,000 shares outstanding. The board of directors
declared a 2-for-1 split on May 15, 2010, when the market value of the com-
mon stock was $2.50 per share. The retained earnings balance on May 15 was
$700,000. Additional paid-in capital on this date was $20,000. Prepare the
stockholders’ equity section of the company’s balance sheet before and after the
stock split. What entry, if any, would be necessary to record the stock split?
LO5 Stock Split
E 12. On January 15, 2010, the board of directors of Tower International
declared a 3-for-1 stock split of its $12 per value common stock, of which
3,200,000 shares were authorized and 800,000 were issued and outstand-
ing. The market value on that date was $45 per share. On the same date,
the balance of additional paid-in capital was $16,000,000, and the balance
of retained earnings was $32,000,000. Prepare the stockholders’ equity sec-
tion of the company’s balance sheet before and after the stock split. What
entry, if any, is needed to record the stock split?
LO6 Book Value for Preferred and Common Stock
E 13. Below is the stockholders’ equity section of Hegel Corporation’s balance sheet.
Determine the book value per share for both the preferred and the common stock.
Contributed capital
Preferred stock, $100 per share,
6 percent cumulative, 10,000 shares
authorized, 200 shares issued and outstanding* $ 20,000
Common stock, $5 par value, 100,000 shares authorized,
10,000 shares issued, 9,000 shares outstanding 50,000
Additional paid-in capital 28,000
Total contributed capital $ 98,000
Retained earnings 95,000
Total contributed capital and retained earnings $193,000
Less treasury stock, common (1,000 shares at cost) 15,000
Total stockholders’ equity $178,000
*The preferred stock is callable at $105 per share, and one-year’s dividends are in arrears.
Chapter Assignments 647
Problems
LO1 Effect of Alternative Accounting Methods
P 1. Matka Corporation began operations in 2011. At the beginning of the year,
the company purchased plant assets of $450,000, with an estimated useful life
of 10 years and no residual value. During the year, the company had net sales of
$650,000, salaries expense of $100,000, and other expenses of $40,000, exclud-
ing depreciation. In addition, Matka Corporation purchased inventory as follows:
Jan. 15 200 units at $400 $ 80,000
Mar. 20 100 units at $408 40,800
June 15 400 units at $416 166,400
Sept. 18 300 units at $412 123,600
Dec. 9 150 units at $420 63,000
Total 1,150 units $473,800
At the end of the year, a physical inventory disclosed 250 units still on hand. The
managers of Matka Corporation know they have a choice of accounting methods,
but they are unsure how those methods will affect net income. They have heard
of the FIFO and LIFO inventory methods and the straight-line and double-
declining-balance depreciation methods.
Required |
1. Prepare two income statements for Matka Corporation, one using the
FIFO and straight-line methods and the other using the LIFO and double-
declining-balance methods. Ignore income taxes.
2. Prepare a schedule accounting for the difference in the two net income figures
obtained in requirement 1.
User insight (cid:2) 3. What effect does the choice of accounting method have on Matka’s inven-
tory turnover? What conclusions can you draw? Use the year-end balance to
compute the ratio.
User insight (cid:2) 4. How does the choice of accounting methods affect Matka’s return on assets?
Assume the company’s only assets are cash of $40,000, inventory, and plant
assets. Use year-end balances to compute the ratios. Is your evaluation of
Matka’s profitability affected by the choice of accounting methods?
LO1 LO2 Corporate Income Statement
LO3
P 2. Information concerning operations of Camping Gear Corporation during
2011 is as follows:
a. Administrative expenses, $90,000
b. Cost of goods sold, $420,000
c. Extraordinary loss from an earthquake (net of taxes, $36,000), $60,000
d. Sales (net), $900,000
e. Selling expenses, $80,000
f. Income taxes expense applicable to continuing operations, $105,000
Required
1. Prepare the corporation’s income statement for the year ended December 31,
2011, including earnings per share information. Assume a weighted average
of 50,000 common shares outstanding during the year.
User insight (cid:2) 2. Which item in Camping Gear Corporation’s income statement affects
the company’s quality of earnings? Why does it have an effect on quality of
earnings?
648 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
LO1 LO2 Corporate Income Statement and Evaluation of Business Operations
LO3 P 3. During 2012, Vitos Corporation engaged in two complex transactions to
improve the business—selling off a division and retiring bonds. The company
has always issued a simple, single-step income statement, and the accountant has
accordingly prepared the December 31 year-end income statements for 2011 and
2012, as shown below.
Vitos Corporation
Income Statements
For the Years Ended December 31, 2012 and 2011
2012 2011
Net sales $ 2,000,000 $ 2,400,000
Cost of goods sold (1,100,000) (1,200,000)
Operating expenses (450,000) (300,000)
Income taxes expense (358,200) (270,000)
Income from discontinued operations 320,000
Gain on disposal of discontinued operations 280,000
Extraordinary gain on retirement of bonds 144,000
Net income $ 835,800 $ 630,000
Earnings per share $ 2.09 $ 1.58
Robert Vitos, the president of Vitos Corporation, is pleased to see that both
net income and earnings per share increased by almost 33 percent from 2011 to
2012, and he intends to announce to the company’s stockholders that the plan to
improve the business has been successful.
Required
1. Recast the 2012 and 2011 income statements in proper multistep form,
including allocating income taxes to appropriate items (assume a 30 percent
income tax rate) and showing earnings per share figures (400,000 shares
outstanding).
User insight (cid:2) 2. What is your assessment of Vitos Corporation’s plan and business operations
in 2012?
LO4 LO5
Dividends, Stock Splits, and Stockholders’ Equity
P 4. The stockholders’ equity section of the balance sheet of Lim Mills, Inc., as of
December 31, 2010, was as follows:
Contributed capital
Common stock, $3 par value, 1,000,000 shares
authorized, 80,000 shares issued and outstanding $240,000
Additional paid-in capital 75,000
Total contributed capital $315,000
Retained earnings 240,000
Total stockholders’ equity $555,000
A review of the stockholders’ equity records of Lim Mills, Inc., disclosed the
following transactions during 2011:
Mar. 25 T he board of directors declared a 5 percent stock dividend to
stockholders of record on April 20 to be distributed on May 1.
The market value of the common stock was $21 per share.
Chapter Assignments 649
Apr. 20 Date of record for stock dividend.
May 1 Issued stock dividend.
Sept. 10 Declared a 3-for-1 stock split.
Dec. 15 D eclared a 10 percent stock dividend to stockholders of |
record on January 15 to be distributed on February 15. The
market price on this date is $9 per share.
Required
1. Record the stockholders’ equity components of the transactions for Lim
Mills, Inc., in T accounts.
2. Prepare the stockholders’ equity section of the company’s balance sheet as of
December 31, 2011. Assume net income for 2011 is $494,000.
User insight (cid:2) 3. If you owned 2,000 shares of Lim Mills stock on March 1, 2011, how many
shares would you own on February 15, 2012? Would your proportionate
share of the ownership of the company be different on the latter date from
what it was on the former date? Explain your answer.
LO4 LO5 Dividends and Stock Split Transactions and Stockholders’ Equity
P 5. The stockholders’ equity section of Acerin Moving and Storage Corpora-
tion’s balance sheet as of December 31, 2010, appears below.
Contributed capital
Common stock, $2 par value, 6,000,000 shares
authorized, 1,000,000 shares
issued and outstanding $2,000,000
Additional paid-in capital 800,000
Total contributed capital $2,800,000
Retained earnings 2,160,000
Total stockholders’ equity $4,960,000
The company engaged in the following stockholders’ equity transactions
during 2011:
Mar. 5 Declared a $0.40 per share cash dividend to be paid on April 6
to stockholders of record on March 20.
20 Date of record.
Apr. 6 Paid the cash dividend.
June 17 Declared a 10 percent stock dividend to be distributed
August 17 to stockholders of record on August 5. The mar-
ket value of the stock was $14 per share.
Aug. 5 Date of record for the stock dividend.
17 Distributed the stock dividend.
Oct. 2 Split its stock 2 for 1.
Dec. 27 Declared a cash dividend of $0.20 payable January 27, 2012,
to stockholders of record on January 14, 2012.
Required
1. Record the 2011 transactions in journal form.
2. Prepare the stockholders’ equity section of the company’s balance sheet as of
December 31, 2011. Assume net income for the year is $800,000.
User insight (cid:2) 3. If you owned some shares of Acerin, would you expect the total value of your
shares to go up or down as a result of the stock dividends and stock split?
What intangibles might affect the stock value?
650 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
Alternate Problems
LO4 LO5 Comprehensive Stockholders’ Equity Transactions
LO6
P 6. On December 31, 2011, the stockholders’ equity section of Koval Corpora-
tion’s balance sheet appeared as follows:
Contributed capital
Common stock, $8 par value, 400,000 shares
authorized, 120,000 shares issued and outstanding $ 960,000
Additional paid-in capital 2,560,000
Total contributed capital $3,520,000
Retained earnings 1,648,000
Total stockholders’ equity $5,168,000
The following are selected transactions involving stockholders’ equity in 2012:
Jan. 4 The board of directors obtained authorization for
40,000 shares of $40 par value noncumulative preferred stock
that carried an indicated dividend rate of $4 per share and was
callable at $42 per share.
14 The company sold 24,000 shares of the preferred stock at $40
per share and issued another 4,000 in exchange for a building
valued at $160,000.
Mar. 8 The board of directors declared a 2-for-1 stock split on the
common stock.
Apr. 20 After the stock split, the company purchased 6,000 shares
of common stock for the treasury at an average price of
$12 per share.
May 4 The company sold 2,000 of the shares purchased on April 20,
at an average price of $16 per share.
July 15 The board of directors declared a cash dividend of $4 per
share on the preferred stock and $0.40 per share on the
common stock.
25 Date of record.
Aug. 15 Paid the cash dividend.
Nov. 28 The board of directors declared a 15 percent stock dividend
when the common stock was selling for $20 per share to be
distributed on January 5 to stockholders of record on
December 15.
Dec. 15 Date of record for the stock dividend.
Required
1. Record the above transactions in journal form.
2. Prepare the stockholders’ equity section of the company’s balance sheet
as of December 31, 2012. Net loss for 2012 was $436,000. (Hint: Use |
T accounts to keep track of transactions.)
User insight (cid:2) 3. Compute the book value per share for preferred and common stock
(including common stock distributable) on December 31, 2011 and
2012, using end-of-year shares outstanding. What effect would you
expect the change in book value to have on the market price per share of
the company’s stock?
Chapter Assignments 651
LO1 LO2 Corporate Income Statement
LO3 P 7. Income statement information for Nguyen Corporation in 2011 is as f ollows:
a. Administrative expenses, $110,000
b. Cost of goods sold, $440,000
c. Extraordinary loss from a storm (net of taxes, $10,000), $20,000
d. Income taxes expense, continuing operations, $42,000
e. Net sales, $890,000
f. Selling expenses, $190,000
Required
1. Prepare Nguyen Corporation’s income statement for 2011, including earn-
ings per share, assuming a weighted average of 100,000 shares of common
stock outstanding for 2011.
User insight (cid:2) 2. Which item in Nguyen Corporation’s income statement affects the compa-
ny’s quality of earnings? Why does it have this effect?
LO4 LO5 Dividends, Stock Splits, and Stockholders’ Equity
P 8. The stockholders’ equity section of the balance sheet of Rago Corporation as
of December 31, 2010, was as follows:
Contributed capital
Common stock, $4 par value, 250,000 shares
authorized, 100,000 shares issued and outstanding $ 400,000
Additional paid-in capital 500,000
Total contributed capital $ 900,000
Retained earnings 600,000
Total stockholders’ equity $1,500,000
Rago Corporation had the following transactions in 2011:
Feb. 28 The board of directors declared a 10 percent stock dividend
to stockholders of record on March 25 to be distributed on
April 5. The market value on this date is $16.
Mar. 25 Date of record for stock dividend.
Apr. 5 Issued stock dividend.
Aug. 3 Declared a 2-for-1 stock split.
Nov. 20 Purchased 9,000 shares of the company’s common stock at
$8 per share for the treasury.
Dec. 31 Declared a 5 percent stock dividend to stockholders of record
on January 25 to be distributed on February 5. The market
value per share was $9.
Required
1. Record the stockholders’ equity components of the transactions for Rago
Corporation in T accounts.
2. Prepare the stockholders’ equity section of the company’s balance sheet as of
December 31, 2011. Assume net income for 2011 is $54,000.
User insight (cid:2) 3. If you owned 500 shares of Rago stock on February 1, 2011, how many
shares would you own on February 5, 2012? Would your proportionate share
of the ownership of the company be different on the latter date from what it
was on the former date? Explain your answer.
652 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
LO4 LO5 Comprehensive Stockholders’ Equity Transactions
LO6 P 9. On December 31, 2010, the stockholders’ equity section of Tsang Corpora-
tion’s balance sheet appeared as follows:
Contributed capital
Common stock, $8 par value, 200,000 shares
authorized, 60,000 shares issued and outstanding $ 480,000
Additional paid-in capital 1,280,000
Total contributed capital $1,760,000
Retained earnings 824,000
Total stockholders’ equity $2,584,000
The following are selected transactions involving stockholders’ equity in 2011.
On January 4, the board of directors obtained authorization for 20,000 shares of
$40 par value noncumulative preferred stock that carried an indicated dividend
rate of $4 per share and was callable at $42 per share. On January 14, the com-
pany sold 12,000 shares of the preferred stock at $40 per share and issued another
2,000 in exchange for a building valued at $80,000. On March 8, the board
of directors declared a 2-for-1 stock split on the common stock. On April 20,
after the stock split, the company purchased 3,000 shares of common stock for the
treasury at an average price of $12 per share; 1,000 of these shares subsequently were
sold on May 4 at an average price of $16 per share. On July 15, the board of directors
declared a cash dividend of $4 per share on the preferred stock and $0.40 per share
on the common stock. The date of record was July 25. The dividends were paid on |
August 15. The board of directors declared a 15 percent stock dividend on Novem-
ber 28, when the common stock was selling for $20. The date of record for the stock
dividend was December 15, and the dividend was to be distributed on January 5.
Required
1. Record the above transactions in journal form.
2. Prepare the stockholders’ equity section of the company’s balance sheet
as of December 31, 2011. Net loss for 2011 was $218,000. (Hint: Use
T accounts to keep track of transactions.)
User insight (cid:2) 3. Compute the book value per share for preferred and common stock (includ-
ing common stock distributable) on December 31, 2010 and 2011, using
end-of-year shares outstanding. What effect would you expect the change in
book value to have on the market price per share of the company’s stock?
LO1 Effect of Alternative Accounting Methods
P 10. Zeigler Corporation began operations in 2010. At the beginning of the year,
the company purchased plant assets of $900,000, with an estimated useful life of
10 years and no residual value. During the year, the company had net sales of
$1,300,000, salaries expense of $200,000, and other expenses of $80,000, exclud-
ing depreciation. In addition, Zeigler Corporation purchased inventory as follows:
Jan. 15 400 units at $400 $160,000
Mar. 20 200 units at $408 81,600
June 15 800 units at $416 332,800
Sept. 18 600 units at $412 247,200
Dec. 9 300 units at $420 126,000
Total 2,300 units $947,600
Chapter Assignments 653
At the end of the year, a physical inventory disclosed 500 units still on hand. The
managers of Zeigler Corporation know they have a choice of accounting meth-
ods, but they are unsure how those methods will affect net income. They have
heard of the FIFO and LIFO inventory methods and the straight-line and double-
declining-balance depreciation methods.
Required
1. Prepare two income statements for Zeigler Corporation, one using the
FIFO and straight-line methods and the other using the LIFO and double-
declining-balance methods. Ignore income taxes.
2. Prepare a schedule accounting for the difference in the two net income fig-
ures obtained in requirement 1.
User insight (cid:2) 3. What effect does the choice of accounting method have on Zeigler’s inven-
tory turnover? What conclusions can you draw? Use the year-end balance to
compute the ratio.
User insight (cid:2) 4. How does the choice of accounting methods affect Zeigler’s return on assets?
Assume the company’s only assets are cash of $80,000, inventory, and plant
assets. Use year-end balances to compute the ratios. Is your evaluation of
Zeigler’s profitability affected by the choice of accounting methods?
ENHANCING Your Knowledge, Skills, and Critical Thinking
LO5 Stock Split
C 1. When Crocs, the shoe company, reported in early 2007 that its first-quarter earn-
ings had increased from the previous year, its stock price jumped to over $80 per share.
At the same time, the company announced a 2-for-1 stock split.18 What is a stock split
and what effect does it have on the company’s stockholders’ equity? What effect will
it likely have on the market value of the company’s stock? In light of your answers, do
you think the stock split is positive for the company and for its stockholders?
LO1 Classic Quality of Earnings Case
C 2. On Tuesday, January 19, 1988, IBM reported greatly increased earnings for the
fourth quarter of 1987. Despite this reported gain in earnings, the price of IBM’s
stock on the New York Stock Exchange declined by $6 per share to $111.75. In
sympathy with this move, most other technology stocks also declined.19
IBM’s fourth-quarter net earnings rose from $1.39 billion, or $2.28 a share, to
$2.08 billion, or $3.47 a share, an increase of 49.6 percent and 52.2 percent over
the same period a year earlier. Management declared that these results demonstrated
the effectiveness of IBM’s efforts to become more competitive and that, despite the
economic uncertainties of 1988, the company was planning for growth.
The apparent cause of the stock price decline was that the huge increase in |
income could be traced to nonrecurring gains. Investment analysts pointed out
that IBM’s high earnings stemmed primarily from such factors as a lower tax
rate. Despite most analysts’ expectations of a tax rate between 40 and 42 per-
cent, IBM’s was a low 36.4 percent, down from the previous year’s 45.3 percent.
Analysts were also disappointed in IBM’s revenue growth. Revenues within the
United States were down, and much of the company’s growth in revenues came
through favorable currency translations, increases that might not be repeated. In
fact, some estimates of IBM’s fourth-quarter earnings attributed $0.50 per share
to currency translations and another $0.25 to tax-rate changes.
Other factors contributing to IBM’s rise in earnings were one-time transac-
tions, such as the sale of Intel Corporation stock and bond redemptions, along
with a corporate stock buyback program that reduced the amount of stock out-
standing in the fourth quarter by 7.4 million shares.
654 CHAPTER 14 The Corporate Income Statement and the Statement of Stockholders’ Equity
The analysts were concerned about the quality of IBM’s earnings. Identify
four quality of earnings issues reported in the case and the analysts’ concern about
each. In percentage terms, what is the impact of the currency changes on fourth-
quarter earnings? Comment on management’s assessment of IBM’s performance.
Do you agree with management? (Optional question: What has IBM’s subse-
quent performance been?) Be prepared to discuss your answers in class.
Jackson Electronics, Inc.
Consolidated Statement of Stockholders’ Equity
For the Year Ended September 30, 2011
(In thousands)
Accumulated
Additional Treasury Other
Preferred Common Paid-in Retained Stock, Comprehensive
Stock Stock Capital Earnings Common Income Total
Balance at
September 30, 2010 $ 2,756 $3,902 $14,149 $119,312 ($ 942) $139,177
(1) Net income 18,753 18,753
(2) Unrealized gain on
available for-sale
securities $12,000 12,000
(3) Redemption and
retirement of preferred
stock (27,560 shares) (2,756) (2,756)
(4) Stock options exer-
cised (89,000 shares) 89 847 936
(5) Purchases of
common stock
for treasury
(501,412 shares) (12,552) (12,552)
(6) Issuance of common
stock (148,000 shares)
in exchange for con-
vertible subordinated
debentures 148 3,635 3,783
(7) Issuance of common
stock (715,000 shares)
for cash 715 24,535 25,250
(8) Issuance of
500,000 shares of com-
mon stock in exchange
for investment in
Electrix Company shares 500 17,263 17,763
(9) Cash dividends—
common stock
($0.80 per share) (3,086) (3,086)
Balance at
September 30, 2011 $ 0 $5,354 $60,429 $134,979 ($13,494) $12,000 $199,268
Chapter Assignments 655
LO1 LO4 Interpretation of Statement of Stockholders’ Equity
C 3. The consolidated statement of stockholders’ equity for Jackson Electronics,
Inc., a manufacturer of a broad line of electrical components, is presented on the
previous page. It has nine summary transactions.
1. Prepare an entry in journal form with an explanation for each transaction.
In each case, if applicable, determine the average price per common share.
At times, you will have to make assumptions about an offsetting part of the
entry. For example, assume debentures (long-term bonds) are recorded at
face value and that employees pay cash for stock purchased under company
incentive plans.
2. Define comprehensive income and determine the amount for Jackson
Electronics.
LO2 Analysis of Income Taxes from Annual Report
C 4. In its 2008 annual report, Nike, Inc., the athletic sportswear company, pro-
vided the following data about its current and deferred income tax provisions (in
millions):
2008
Current income taxes due $ 920.1
Deferred income taxes (300.6)
Total provision for income taxes $ 619.5
1. What were the 2008 income taxes on the income statement? Record in jour-
nal form the overall income tax liability for 2008, using income tax allocation
procedures.
2. Nike’s balance sheet contains both deferred income tax assets and deferred
tax liabilities. How do such deferred income tax assets arise? How do such
deferred income tax liabilities arise? Given the definition of liabilities, do you |
see a potential problem with the company’s classifying deferred income taxes
as a liability? Why or why not?
LO1 LO4 Corporate Income Statement and Statement of Stockholders’ Equity
C 5. Refer to CVS Corporation’s annual report in the Supplement to Chapter 5 to
answer the following questions:
1. Does CVS have discontinued operations or extraordinary items? Are there
any items that would lead you to question the quality of CVS’s earnings?
Would you say the income statement for CVS is relatively simple or relatively
complex? Why?
2. What transactions most often affect the stockholders’ equity section of the
CVS balance sheet? (Hint: Examine the statements of stockholders’ equity.)
LO6 Book Value and Market Value
C 6. Refer to the annual report for CVS Corporation and the financial statements
for Southwest Airlines Co. in the Supplement to Chapter 5. Compute the 2008
and 2007 book value per share for both companies and compare the results to the
average stock price of each in the fourth quarter of 2008 as shown in the notes to
the financial statements. Southwest’s average price per share was $11.01 in 2008
and $13.59 in 2007. How do you explain the differences in book value per share,
and how do you interpret their relationship to market prices?
C H A P T E R
15 The Statement
of Cash Flows
Making a
C ash flows are the lifeblood of a business. They enable a com-
Statement
pany to pay expenses, debts, employees’ wages, and taxes,
INCOME STATEMENT and to invest in the assets it needs for its operations. Without suf-
Revenues ficient cash flows, a company cannot grow and prosper. Because of
the importance of cash flows, one must be alert to the possibility
– Expenses
that items may be incorrectly classified in a statement of cash flows
= Net Income
and that the statement may not fully disclose all pertinent informa-
tion. This chapter identifies the classifications used in a statement
STATEMENT OF
of cash flows and explains how to analyze the statement.
RETAINED EARNINGS
Beginning Balance
+ Net Income
LEARNING OBJECTIVES
– Dividends
LO1 Describe the principal purposes and uses of the statement of
= Ending Balance
cash flows, and identify its components. (pp. 658–663)
BALANCE SHEET LO2 Analyze the statement of cash flows. (pp. 663–667)
Assets Liabilities
LO3 Use the indirect method to determine cash flows from
operating activities. (pp. 668–674)
Stockholders’
Equity
LO4 Determine cash flows from investing activities. (pp. 674–677)
A = L + OE
LO5 Determine cash flows from financing activities. (pp. 678–681)
STATEMENT OF CASH FLOWS
Operating activities
+ Investing activities
+ Financing activities
= Change in Cash
+ Beginning Balance
= Ending Cash Balance
The statement of cash flows
explains the changes in cash
on the balance sheet.
656
DECISION POINT (cid:2) A USER’S FOCUS (cid:2) Why were Lopata Corporation’s
operating cash flows less than its
LOPATA CORPORATION
net income, and why did its cash
and cash equivalents decline
during the year?
Lopata Corporation is a distributor of accessories for cell phones,
iPods, iPhones, and other small electronic devices. Lopata’s man- (cid:2) What measures do managers,
stockholders, and potential
agers have just finished preparing the company’s financial state-
investors use to evaluate the
ments for 2011. Although they are satisfied with net sales for the
strength of a company’s cash
year—$825,000—they are concerned because cash flows from
flows and liquidity?
operating activities are less than net income ($58,300 vs. $82,200)
and because cash and cash equivalents decreased by $8,000 dur-
ing the year. They have also noted that the company has recently
been having difficulty paying its bills on time.
Strong cash flows are critical to achieving and maintaining liquid-
ity. If Lopata Corporation’s cash flows are insufficient to maintain cur-
rent operations or finance future growth, the company will have to
sell investments, borrow funds, or issue stock. On the other hand, if
its cash flows are strong, Lopata can use excess cash to reduce debt,
thereby lowering its debt to equity ratio and improving its financial |
position. That, in turn, can increase the market value of its stock,
which will increase stockholders’ value.
Lopata’s statement of cash flows will provide the company’s
managers, as well as its stockholders and potential investors, with
information that is essential to evaluating the strength of the com-
pany’s cash flows and liquidity.
657
658 CHAPTER 15 The Statement of Cash Flows
Overview of the
The statement of cash flows shows how a company’s operating, investing, and
Statement of financing activities have affected cash during an accounting period. It explains the
net increase (or decrease) in cash during the period. For purposes of preparing
Cash Flows
this statement, cash is defined as including both cash and cash equivalents. Cash
equivalents are investments that can be quickly converted to cash; they have a
LO1 Describe the principal pur- maturity of 90 days or less when they are purchased. They include money market
poses and uses of the statement accounts, commercial paper, and U.S. Treasury bills. A company invests in cash
of cash flows, and identify its equivalents to earn interest on cash that would otherwise be temporarily idle.
components. Suppose, for example, that a company has $1,000,000 that it will not need
for 30 days. To earn a return on this amount, the company could place the cash
in an account that earns interest (such as a money market account), lend the
cash to another corporation by purchasing that corporation’s short-term notes
(commercial paper), or purchase a short-term obligation of the U.S. government
Study Note
(a Treasury bill).
Money market accounts, Because cash includes cash equivalents, transfers between the Cash account
commercial paper (short-term and cash equivalents are not treated as cash receipts or cash payments. On the
notes), and U.S. Treasury bills statement of cash flows, cash equivalents are combined with the Cash account.
are considered cash equivalents Cash equivalents should not be confused with short-term investments, or market-
because they are highly liquid, able securities. These items are not combined with the Cash account on the state-
temporary (90 days or less) ment of cash flows; rather, purchases of marketable securities are treated as cash
holding places for cash not outflows, and sales of marketable securities are treated as cash inflows.
currently needed to operate the
business.
Purposes of the Statement of Cash Flows
TThe primary purpose of the statement of cash flows is to provide information
about a company’s cash receipts and cash payments during an accounting period.
A secondary purpose is to provide information about a company’s operating,
investing, and financing activities during the accounting period. Some informa-
tion about those activities may be inferred from other financial statements, but
the statement of cash flows summarizes all transactions that affect cash.
Uses of the Statement of Cash Flows
The statement of cash flows is useful to management, as well as to investors and
creditors.
(cid:2) Management uses the statement of cash flows to assess liquidity, to determine
dividend policy, and to evaluate the effects of major policy decisions involv-
ing investments and financing. Examples include determining if short-term
financing is needed to pay current liabilities, deciding whether to raise or
lower dividends, and planning for investing and financing needs.
(cid:2) Investors and creditors use the statement to assess a company’s ability to man-
age cash flows, to generate positive future cash flows, to pay its liabilities, to pay
dividends and interest, and to anticipate its need for additional financing.
Classification of Cash Flows
The statement of cash flows has three major classifications: operating, invest-
ing, and financing activities. The components of these activities are illustrated in
Figure 15-1 and summarized below.
1. Operating activities involve the cash inflows and outflows from activi-
ties that enter into the determination of net income. Cash inflows in this
Overview of the Statement of Cash Flows 659 |
category include cash receipts from the sale of goods and services and from
the sale of trading securities. Trading securities are a type of marketable
security that a company buys and sells for the purpose of making a profit
in the near term. Cash inflows also include interest and dividends received
on loans and investments. Cash outflows include cash payments for wages,
inventory, expenses, interest, taxes, and the purchase of trading securities.
In effect, accrual-based income from the income statement is changed to
reflect cash flows.
2. Investing activities involve the acquisition and sale of property, plant,
and equipment and other long-term assets, including long-term invest-
ments. They also involve the acquisition and sale of short-term marketable
FIGURE 15-1 Classification of Cash Inflows and Cash Outflows
CASH INFLOWS ACTIVITIES CASH OUTFLOWS
To pay wages
From sale of goods and
To purchase inventory
services to customers
To pay expenses
From receipt of interest or
O PERATING
dividends on loans or
ACTIVITIES
investments
To pay interest
From sale of marketable
To pay taxes
securities (trading)
To purchase marketable
securities (trading)
From sale of property, plant, To purchase property, plant,
and equipment and other and equipment and other
long-term assets long-term assets
From sale of short-term To purchase short-term
marketable securities INVESTING marketable securities
(except trading) and ACTIVITIES (except trading) and
long-term investments long-term investments
From collection of loans To make loans
To reacquire preferred or
common stock
From sale of preferred or
common stock
FINANCING
ACTIVITIES To repay debt
From issuance of debt
To pay dividends
660 CHAPTER 15 The Statement of Cash Flows
securities, other than trading securities, and the making and collecting
Study Note of loans. Cash inflows include the cash received from selling marketable
securities and long-term assets and from collecting on loans. Cash out-
Operating activities involve the
flows include the cash expended on purchasing these securities and assets
day-to-day sale of goods and
and the cash lent to borrowers.
services, investing activities
involve long-term assets and 3. Financing activities involve obtaining resources from stockholders and
investments, and financing providing them with a return on their investments and obtaining resources
activities deal with stockholders’ from creditors and repaying the amounts borrowed or otherwise settling
equity accounts and debt
the obligations. Cash inflows include the proceeds from stock issues and
(borrowing).
from short- and long-term borrowing. Cash outflows include the repay-
ments of loans (excluding interest) and payments to owners, including
cash dividends. Treasury stock transactions are also considered financing
activities. Repayments of accounts payable or accrued liabilities are not
considered repayments of loans; they are classified as cash outflows under
operating activities.
Required Disclosure of Noncash Investing
and Financing Transactions
Companies occasionally engage in significant noncash investing and financ-
ing transactions. These transactions involve only long-term assets, long-term
liabilities, or stockholders’ equity. For instance, a company might exchange a
long-term asset for a long-term liability, settle a debt by issuing capital stock,
or take out a long-term mortgage to purchase real estate. Noncash transactions
represent significant investing and financing activities, but they are not reflected
on the statement of cash flows because they do not affect current cash inflows
or outflows. They will, however, affect future cash flows. For this reason, it is
required that they be disclosed in a separate schedule or as part of the statement
of cash flows.
Format of the Statement of Cash Flows
Amazon.com is the largest online retailer in the world and one of the 500 largest
companies in the United States. Exhibit 15-1 shows the company’s consolidated
statements of cash flows for 2008, 2007, and 2006.
(cid:2) The first section of the statement of cash flows is cash flows from operating |
activities. When the indirect method is used to prepare this section, it begins
with net income and ends with cash flows from operating activities. This is
the method most commonly used; we discuss it in detail later in the chapter.
(cid:2) The second section, cash flows from investing activities, shows cash transac-
tions involving capital expenditures (for property and equipment) and loans.
Cash outflows for capital expenditures are usually shown separately from cash
inflows from their disposal. However, when the inflows are not material,
some companies combine these two lines to show the net amount of outflow
as Amazon.com does.
(cid:2) The third section, cash flows from financing activities, shows debt and com-
mon stock transactions, as well as payments for dividends and treasury stock.
(cid:2) A reconciliation of the beginning and ending balances of cash appears at the
bottom of the statement. These cash balances will tie into the cash balances
of the balance sheets.
Overview of the Statement of Cash Flows 661
EXHIBIT 15-1 Consolidated Statement of Cash Flows
Amazon.com, Inc.
Consolidated Statements of Cash Flows
For the Years Ended
(In millions) 2008 2007 2006
Operating Activities
Net income $ 645 $ 476 $ 190
Adjustments to reconcile net income to net cash from operating activities:
Depreciation and amortization 287 246 205
Stock-based compensation 275 185 101
Deferred income taxes (5) (99) 22
Excess tax benefits from stock-based compensation (159) (257) (102)
Other (60) 22 2
Changes in operating assets and liabilities:
Inventories (232) (303) (282)
Accounts receivable, net and other (218) (255) (103)
Accounts payable 812 928 402
Accrued expenses and other 247 429 241
Additions to unearned revenue and other 105 33 26
Net cash provided by operating activities $1,697 $ 1,405 $ 702
Investing Activities
Purchases of fixed assets, including software and website development $ (333) $ (224) ($ 216)
Acquisitions, net of cash received and other (494) (75) (32)
Sales and maturities of marketable securities and other investments 1,305 1,271 1,845
Purchases of marketable securities and other investments (1,677) (930) (1,930)
Net cash provided by (used in) investing activities ($1,199) $ 42 ($ 333)
Financing Activities
Proceeds from exercises of stock options $ 11 $ 91 $ 35
Excess tax benefits from exercises of stock options 159 257 102
Common stock repurchased (Treasury stock) (100) (248) (252)
Proceeds from long-term debt and other 87 24 98
Repayments of long-term debt and capital lease obligations (355) (74) (383)
Net cash provided by (used in) financing activities ($ 198) $ 50 ($ 400)
$ (70) $ 20 $ 40
Foreign-currency effect on cash and cash equivalents
Net (Decrease) Increase in Cash and Cash Equivalents $ 230 $ 1,517 $ 9
Cash and Cash Equivalents, beginning of year 2,539 1,022 1,013
Cash and Cash Equivalents, end of year $ 2,769 $ 2,539 $1,022
Source: Amazon.com, Inc., Annual Report, 2008 (adapted).
662 CHAPTER 15 The Statement of Cash Flows
FOCUS ON BUSINESS PRACTICE
How Universal Is the Statement of Cash Flows?
Despite the importance of the statement of cash flows in do not address the statement of cash flows, international
assessing the liquidity of companies in the United States, accounting standards require it, and international financial
there has been considerable variation in its use and for- markets expect it to be presented. As a result, most multi-
mat in other countries. For example, in many countries, national companies include the statement in their financial
the statement shows the change in working capital rather reports. Most European countries adopted the statement of
than the change in cash and cash equivalents. Although the cash flows when the European Union adopted international
European Union’s principal directives for financial reporting accounting standards.
Ethical Considerations and the Statement
of Cash Flows
Although cash inflows and outflows are not as subject to manipulation as earnings
are, managers are acutely aware of users’ emphasis on cash flows from operations |
as an important measure of performance. Thus, an incentive exists to overstate
these cash flows.
In earlier chapters, we cited an egregious example of earnings management.
As you may recall, by treating operating expenses of about $10 billion over sev-
eral years as purchases of equipment, WorldCom reduced reported expenses and
improved reported earnings. In addition, by classifying payments of operating
expenses as investments on the statement of cash flows, it was able to show an
improvement in cash flows from operations. The inclusion of the expenditures in
the investing activities section did not draw special attention because the com-
pany normally had large capital expenditures.
Another way a company can show an apparent improvement in its performance
is through lack of transparency, or lack of full disclosure, in its financial statements.
For instance, securitization—the sale of batches of accounts receivable—is clearly
a means of financing, and the proceeds from it should be shown in the financing
section of the statement of cash flows. However, because the accounting standards
are somewhat vague about where these proceeds should go, some companies net
the proceeds against the accounts receivable in the operating section of the state-
ment and bury the explanation in the notes to the financial statements. By doing
so, they make collections of receivables in the operating activities section look
better than they actually were. It is not illegal to do this, but from an ethical stand-
point, it obscures the company’s true performance.
STOP
& APPLY
Filip Corporation engaged in the transactions listed below. Identify each transaction as (a) an operat-
ing activity, (b) an investing activity, (c) a financing activity, (d) a noncash transaction, or (e) not on
the statement of cash flows. (Assume the indirect method is used.)
1. Purchased office equipment, a long- 3. Sold land at cost.
term investment. 4. Issued long-term bonds for plant assets.
2. Decreased accounts receivable. 5. Increased inventory.
(continued)
Analyzing Cash Flows 663
6. Issued common stock. 10. Purchased a 60-day Treasury bill.
7. Repurchased common stock. 11. Purchased a long-term investment.
8. Issued notes payable. 12. Declared and paid a cash dividend.
9. Increased income taxes payable.
SOLUTION
1. b; 2. a; 3. b; 4. d; 5. a; 6. c; 7. c; 8. c; 9. a; 10. e (cash equivalent); 11. b; 12. c
Analyzing Like the analysis of other financial statements, an analysis of the statement of cash
Cash Flows flows can reveal significant relationships. Two areas on which analysts focus when
examining a company’s statement of cash flows are cash-generating efficiency and
free cash flow.
LO2 Analyze the statement
of cash flows. Can a Company Have Too Much Cash?
Before the bull market ended in 2007, many companies had accumulated large
amounts of cash. Exxon Mobil, Microsoft, and Cisco Systems, for example, had
amassed more than $100 billion in cash. At that time, the average large company
in the United States had 7 percent of its assets in cash.
Increased cash can be a benefit or a potential risk. Many companies put
their cash to good use. Of course they are wise to have cash on hand for
emergencies. They may also invest in productive assets, conduct research and
development, pay off debt, buy back stock, or pay dividends. Sometimes, how-
ever, shareholders suffer when executives are too conservative and keep the
money in low-paying money market accounts or make unwise acquisitions.
For the user of financial statements, the lesson is that it is important to look
closely at the components of the statement of cash flows to see how manage-
ment is spending its cash.1
Cash-Generating Efficiency
Managers accustomed to evaluating income statements usually focus on the
bottom-line result. While the level of cash at the bottom of the statement of cash
flows is certainly an important consideration, such information can be obtained
from the balance sheet. The focal point of cash flow analysis is on cash inflows
and outflows from operating activities. These cash flows are used in ratios that |
measure cash-generating efficiency, which is a company’s ability to generate
cash from its current or continuing operations. The ratios that analysts use to
compute cash-generating efficiency are cash flow yield, cash flows to sales, and
cash flows to assets.
In this section, we compute these ratios for Amazon.com in 2008 using
data for net income and net cash flows from Exhibit 15-1 and the following
information from Amazon.com’s 2008 annual report (all dollar amounts are in
millions).
2008 2007 2006
Net Sales $19,166 $14,835 $10,711
Total Assets 8,314 6,485 4,363
664 CHAPTER 15 The Statement of Cash Flows
Cash flow yield is the ratio of net cash flows from operating activities to net
income:
Net Cash Flows from Operating Activities
Cash Flow Yield (cid:2)
Net Income
$1,697
(cid:2)
$645
(cid:2) 2.6 Times*
For most companies, the cash flow yield should exceed 1.0. In 2008,
Amazon.com performed much better than this minimum. With a cash flow yield
of 2.6 times, Amazon.com generated about $2.60 of cash for every dollar of net
income.
The cash flow yield needs to be examined carefully. Keep in mind, for instance,
that a firm with significant depreciable assets should have a cash flow yield greater
than 1.0 because depreciation expense is added back to net income to arrive at cash
flows from operating activities. If special items, such as discontinued operations,
appear on the income statement and are material, income from continuing opera-
tions should be used as the denominator. Also, an artificially high cash flow yield
may result if a firm has very low net income, which is the denominator in the ratio.
Cash flows to sales is the ratio of net cash flows from operating activities to
sales:
Net Cash Flows from Operating Activities
Cash Flows to Sales (cid:2)
Sales
$1,697
(cid:2)
$19,166
(cid:2) 8.9%*
Thus, Amazon.com generated positive cash flows to sales of 8.9 percent in 2008.
Another way to state this result is that every dollar of sales generates 8.9 cents in cash.
Cash flows to assets is the ratio of net cash flows from operating activities to
average total assets:
Net Cash Flows from Operating Activities
Cash Flows to Assets (cid:2)
Average Total Assets
$1,697
(cid:2)
($8,314 (cid:3) $6,485) (cid:5) 2
(cid:2) 22.9%*
At 22.9 percent, Amazon.com’s cash flows to assets ratio indicates that for every
dollar of assets, the company generates almost 23 cents. This excellent result is
higher than its cash flows to sales ratio because of its good asset turnover ratio
(sales (cid:5) average total assets) of 2.6 times (22.9% (cid:5) 8.9%). Cash flows to sales
and cash flows to assets are closely related to the profitability measures of profit
margin and return on assets. They exceed those measures by the amount of the
cash flow yield ratio because cash flow yield is the ratio of net cash flows from
operating activities to net income.
*Rounded.
Analyzing Cash Flows 665
Asking the Right Questions About
the Statement of Cash Flows
Most readers of financial statements are accustomed to looking at the “bottom
line” to get an overview of a company’s financial status. They look at total assets
on the balance sheet and net income on the income statement. However, the
statement of cash flows requires a different approach because the bottom line of
cash on hand does not tell the reader very much; changes in the components of
the statement during the year are far more revealing.
In interpreting a statement of cash flows, it pays to know the right questions
to ask. To illustrate, let’s use Amazon.com as an example.
(cid:2) In our discussion of cash flow yield, we saw that Amazon.com generated
about $2.60 of cash from operating activities for every dollar of net income in
2007. What are the primary reasons that cash flows from operating activities
differed from net income?
For Amazon.com, the largest positive items in 2008 were accounts payable
and depreciation. They are added to net income for different reasons. Accounts
payable represents an increase in the amount owed to creditors, whereas depre-
ciation represents a noncash expense that is deducted in arriving at net income. |
Amazon.com’s two largest negative items were increases in inventories and receiv-
ables. As a growing company, Amazon.com was managing its operating cycle by
generating cash from creditors to pay for increases in inventories and receivables.
(cid:2) Amazon.com had a use of almost $1.2 billion in cash in 2008 due to pur-
chases of fixed assets, acquisitions. What were its most important investing
activities other than capital expenditures?
The company managed its investing activities by purchasing fixed assets, mak-
ing acquisitions, and making active use of investments in marketable securities
and other investments. Due to the company’s success in generating cash flows
from operations, it was able to purchase more marketable securities and other
investments than it sold during the year.
(cid:2) Amazon.com’s financing activities show a relatively small use of cash of about
$200 million. How did the company manage its financing activities during
that fiscal year?
Exercise of stock options and the tax effects of stock-based compensation
provided funds to buy back treasury stock and pay off some long-term debt.
Because of its good cash flow from operations, Amazon.com did not need long-
term financing.
Free Cash Flow
As we noted in an earlier chapter, free cash flow is the amount of cash that
remains after deducting the funds a company must commit to continue oper-
ating at its planned level. If free cash flow is positive, it means that the com-
pany has met all of its planned cash commitments and has cash available to
reduce debt or to expand. A negative free cash flow means that the company
will have to sell investments, borrow money, or issue stock in the short term
to continue at its planned level; if a company’s free cash flow remains negative
for several years, it may not be able to raise cash by issuing stocks or bonds.
On the statement of cash flows, cash commitments for current and continu-
ing operations, interest, and income taxes are incorporated in cash flows from
current operations.
666 CHAPTER 15 The Statement of Cash Flows
FOCUS ON BUSINESS PRACTICE
Cash Flows Tell All
In early 2001, the telecommunications industry began one generating enough cash flows to cover capital expendi-
of the biggest market crashes in history. Could it have been tures. Although cash flows from sales in the next three years
predicted? The capital expenditures that telecommunica- stayed at about 20 percent of sales, free cash flows turned
tions firms must make for equipment, such as cable lines very negative, and almost half of capital expenditures had
and computers, are sizable. When the capital expendi- to be financed by debt instead of operations, making these
tures (a negative component of free cash flow) of 41 tele- companies more vulnerable to the downturn in the economy
communications companies are compared with their cash that occurred in 20012 and especially in 2008. The predictive
flows from sales over the six years preceding the crash, an reliability of free cash flow was confirmed in a later study that
interesting pattern emerges. In the first three years, both showed that of 100 different measures, stock price to free
capital expenditures and cash flows from sales were about cash flow was the best predictor of future increases in stock
20 percent of sales. In other words, operations were price.3
Amazon.com has a stated primary financial objective of “long-term sustain-
Study Note able growth in free cash flow.”4 The company definitely achieved this objective in
2008. Its free cash flow for this year is computed as follows (in millions):
The computation for free
cash flow sometimes uses net Free Cash Flow (cid:2) N et Cash Flows from Operating Activities (cid:4) Dividends (cid:4)
capital expenditures in place of Purchases of Plant Assets (cid:3) Sales of Plant Assets
purchases of plant assets (cid:3) sales
(cid:2) $1,697 (cid:4) $0 (cid:4) $333 (cid:3) $0
of plant assets.
(cid:2) $1,364
Purchases of plant assets (capital expenditures) and sales (dispositions) of
plant assets, if any, appear in the investing activities section of the statement |
Subsets and Splits