Chapter 11 253 CHAPTER 11 QUESTIONS The basic rights of common stockholders, unless otherwise restricted in the articles of incorporation or bylaws, are as follows: (a) The right to vote in the election of directors and in the determination of certain corporate policies (b) The right to maintain one’s proportional interest in the corporation through purchase of additional stock issued by the company (In recent years, some states have eliminated this preemptive right.) Historically, par value was equal to the market value of the shares at issuance Par value was also sometimes viewed by the courts as the minimum contribution by investors These days, par values for common stocks are usually set at very low values (less than $1), so the importance of par value has decreased substantially Preferred stock is stock that carries certain preferences over common stock, such as prior claims to dividends and liquidation preferences Often preferred stock has no voting rights or only limited voting rights, and dividends are usually limited to a stated percentage or amount The special rights of a particular issue of preferred stock are set forth in the articles of incorporation and in the preferred stock certificates issued by the corporation When stock is issued for noncash assets or for services, the fair market value of the stock or the fair market value of the property or services, whichever is more objectively determinable, is used to record the transaction A company may repurchase its own stock for any of the following reasons: • To provide shares for incentive compensation plans • To obtain shares for convertible securities holders • To reduce the amount of equity • To invest excess cash temporarily • To protect against a hostile takeover • To improve per-share earnings • To display confidence that the stock is currently undervalued a The cost method of accounting for treasury stock records the treasury stock at cost, pending final disposition of the stock; the par value method treats the acquisition of treasury stock as effective or “constructive” retirement of outstanding stock b Total stockholders’ equity will be the same regardless of whether the cost method or the par value method is used to account for treasury stock The respective amounts of retained earnings and paid-in capital may differ, however The difference between the purchase price and the selling price of treasury stock is properly excluded from the income statement because treasury stock transactions cannot be considered to give rise to a gain or a loss Gain or loss arises from the utilization of assets or resources by the corporation in operating and investing activities Because the recognition of treasury stock as an asset is discouraged, transactions in treasury stock are considered capital transactions between the company and its stockholders and thus not give rise to a gain or a loss If warrants are detachable, the issuance proceeds are allocated between the security and the warrant, based on the relative fair market values of each If warrants are nondetachable, no allocation is made to recognize the value of the warrant The entire proceeds are assigned to the security to which the warrant is attached With the fair value method, total compensation expense is measured using the estimated fair value of the options as of the grant date With the intrinsic value method, total compensation expense is measured using the difference between the exercise price and the market price at the grant date For most plans, compensation expense using the intrinsic value method is zero The FASB recommends the fair value method 254 10 Companies must disclose the number of options outstanding, granted, and forfeited during the year, along with their weightedaverage exercise prices In addition, the weighted-average fair value of options granted during the year must be disclosed If the intrinsic value method is used, a company is also required to disclose (in each year) what net income would have been if the fair value method had been used 11 If an error is discovered in the current year, it is corrected with a correcting entry If a material error is discovered in a year subsequent to the error, the error is corrected by a prior-period adjustment whereby the beginning balance in Retained Earnings is adjusted Some errors are counterbalancing (e.g., inventory errors) and may need no correction 12 State incorporation laws are written to prevent corporations from wrongfully borrowing money and then funneling that money to shareholders One device to prevent this is to restrict the payment of cash dividends to the amount of retained earnings Retained earnings can also be restricted by private debt agreements in which lenders constrain the ability of a borrowing company to pay cash dividends 13 a June 15, 2005, is the date on which dividend action was formally taken July 10, 2005, is the date dividend checks will be mailed to stockholders June 30, 2005, is the date for determining the names of stockholders for purposes of the dividend; dividend checks will be mailed only to those stockholders whose names appear in the stockholders’ ledger at the close of business on this date The period between the date of declaration and the date of record gives stockholders a chance to adjust their holdings in light of the dividend action taken by the company The period between the date of record and the date of payment gives the corporation time to prepare dividend checks for mailing b The stock would normally be traded “ex-dividend” or days prior to June Chapter 11 30, 2005 A stockholder selling shares on or after that date would still receive the dividend on stock and, conversely, any person acquiring the stock between that date and July 10 would receive no dividend payment from the current declaration 14 With a stock split, the par value of each share is reduced, and the number of shares outstanding is increased The total par value of shares is unchanged With a stock dividend, the par value of each share is unchanged, and because the number of shares outstanding is increased, total par value is increased This par value increase is effected through a transfer to par value from Retained Earnings and/or Additional Paid-In Capital With a small stock dividend, the market value of the newly issued shares is transferred With a large stock dividend, the par value of the new shares is transferred 15 a A liquidating dividend is a distribution of contributed capital to stockholders b A liquidating dividend is paid when a corporation is undertaking a partial or complete liquidation 16 The four types of unrealized gains and losses shown as direct equity adjustments are • Foreign currency translation adjustment This adjustment arises from the change in the equity of foreign subsidiaries (as measured in terms of U.S dollars) that occurs as a result of changes in foreign currency exchange rates • Minimum pension liability adjustment This adjustment is created when additional pension liability must be recognized • Unrealized gains and losses on available-for-sale securities Availablefor-sale securities are those that were not purchased with the immediate intention to resell but will be held for an indefinite time Unrealized gains and losses arise because these securities must be reported on the balance sheet at their fair market value Chapter 11 • Unrealized gains and losses on derivatives Unrealized gains and losses from market value fluctuations of derivative instruments that are intended to manage risks associated with future sales or purchases are deferred to allow for proper matching 17 Each equity reserve account is associated with legal restrictions dictating whether it can be distributed to shareholders Therefore, the accounting for equity reserves 255 directly influences a firm's ability to pay dividends The most important distinction is whether the equity reserve is part of distributable or nondistributable equity PRACTICE EXERCISES PRACTICE 11−1 COMPUTATION OF DIVIDENDS, COMMON AND PREFERRED (1) Noncumulative 2004: Preferred shareholders (10,000 shares × 0.06 × $100 = $60,000) Amount $45,000 Comments No dividends in arrears; noncumulative Common shareholders $45,000 No remainder 2005: Preferred shareholders Amount $ 60,000 Common shareholders 40,000 $100,000 (2) Cumulative 2004: Preferred shareholders (10,000 shares × 0.06 × $100 = $60,000) Comments No dividends in arrears; noncumulative Amount $45,000 Comments $15,000 dividends in arrears Common shareholders $45,000 No remainder 2005: Preferred shareholders Amount $ 75,000 Common shareholders 25,000 $100,000 PRACTICE 11−2 Comments $60,000 + $15,000 in arrears ISSUANCE OF COMMON STOCK Cash (10,000 shares × $40) 400,000 Common Stock, $1 par (10,000 shares × $1) 10,000 Paid-In Capital in Excess of Par 390,000 PRACTICE 11−3 ACCOUNTING FOR STOCK SUBSCRIPTIONS Subscription: Common Stock Subscriptions Receivable Common Stock Subscribed Paid-In Capital in Excess of Par 300,000 10,000 290,000 Subscription amount = 10,000 shares × $30 = $300,000 Collection of initial 30 percent of the cash: Cash ($300,000 × 0.30) Common Stock Subscriptions Receivable 90,000 Collection of remaining cash and issuance of shares: Cash ($300,000 − $90,000) Common Stock Subscriptions Receivable 210,000 90,000 210,000 Common Stock Subscribed 10,000 Common Stock, $1 par (10,000 shares × $1) 10,000 PRACTICE 11−4 ISSUING STOCK IN EXCHANGE FOR SERVICES Salaries Expense 700,000 Common Stock, $0.50 par (25,000 shares × $0.50) Paid-In Capital in Excess of Par 687,500 12,500 Paid-in Capital in Excess of Par = $700,000 − $12,500 = $687,500 PRACTICE 11−5 ACCOUNTING FOR TREASURY STOCK: COST METHOD Treasury Stock Cash 300,000 300,000 $300,000/10,000 shares = $30 per share Cash 144,000 Treasury Stock (4,000 shares × $30) Paid-In Capital from Treasury Stock PRACTICE 11−6 120,000 24,000 ACCOUNTING FOR TREASURY STOCK: PAR VALUE METHOD Treasury Stock (10,000 shares × $1 par) Paid-In Capital in Excess of Par Retained Earnings ($300,000 − $200,000) Cash 10,000 190,000 100,000 300,000 Paid-In Capital in Excess of Par = 10,000 shares × ($20 − $1 par) = $190,000 Cash Treasury Stock Paid-In Capital in Excess of Par 144,000 4,000 140,000 PRACTICE 11−7 ACCOUNTING FOR STOCK WARRANTS Cash (20,000 units × $55) 1,100,000 Preferred Stock, $50 par (20,000 shares × $50) 1,000,000 Paid-In Capital in Excess of ParPreferred 40,000 Common Stock Warrants (20,000 warrants × $3) 60,000 Paid-In Capital in Excess of Par—Preferred = 20,000 shares × [($55 − $3) − $50 par] = $40,000 Cash (20,000 warrants × $20) Common Stock Warrants (20,000 warrants × $3) Common Stock, $1 par Paid-In Capital in Excess of ParCommon PRACTICE 11−8 400,000 60,000 20,000 440,000 ACCOUNTING FOR STOCK-BASED COMPENSATION Intrinsic value method Grant Date: No entry End of First Year: No entry because the exercise price is equal to (or greater than) the market price on the grant date Accordingly, no compensation expense is associated with these options, and an adjusting entry at the end of the first year is not needed Option Exercise Date: Cash (100,000 options × $30) 3,000,000 Common Stock, $1 par (100,000 shares × $1) 100,000 Paid-In Capital in Excess of Par 2,900,000 Fair value method Grant Date: No entry End of First Year: Compensation Expense ($300,000/3 years) 100,000 Paid-In Capital from Stock Options 100,000 Total compensation over the 3-year life of the options: 100,000 options × $3 = $300,000 The same adjusting entry would be made at the end of the second and the third years Option Exercise Date: Cash (100,000 options × $30) 3,000,000 Paid-In Capital from Stock Options 300,000 Common Stock, $1 par (100,000 shares × $1) 100,000 Paid-In Capital in Excess of Par 3,200,000 PRACTICE 11−9 DISCLOSURE FOR STOCK-BASED COMPENSATION Net income reported using the intrinsic value method $75,000 Less: Additional compensation expense using the fair value method Net income that would be reported using the fair value method$(25,000) 100,000 PRACTICE 11−10 ACCOUNTING FOR STOCK CONVERSION Preferred Stock, $50 par (10,000 shares × $50) 500,000 Paid-In Capital in Excess of ParPreferred 30,000 Common Stock, $1 par (50,000 shares × $1) 50,000 Paid-In Capital in Excess of ParCommon 480,000 PRACTICE 11−11 PRIOR-PERIOD ADJUSTMENTS Retained earnings, unadjusted beginning balance$50,000 Add prior-period adjustment 4,000 Retained earnings, adjusted beginning balance $54,000 Add: Net income 12,000 $66,000 Deduct: Dividends 4,500 Retained earnings, ending balance $61,500 PRACTICE 11−12 ACCOUNTING FOR DECLARATION AND PAYMENT OF DIVIDENDS Dividends (or Retained Earnings) Dividends Payable 35,000 Dividends Payable Cash 35,000 35,000 35,000 PRACTICE 11−13 ACCOUNTING FOR PROPERTY DIVIDENDS Dividends (or Retained Earnings) 270,000 Property Dividends Payable (10,000 shares × $20) 200,000 Gain on Distribution of Property Dividend 70,000 Gain on distribution of property dividend: 10,000 shares × ($27 − $20) = $70,000 Property Dividends Payable Investment SecuritiesWilsonville 200,000 200,000 PRACTICE 11−14 ACCOUNTING FOR SMALL STOCK DIVIDENDS Retained Earnings 30,000 Stock Dividends Distributable (1,000 shares × $1) 1,000 Paid-In Capital in Excess of Par 29,000 Reduction in retained earnings: 10,000 shares × 0.10 × $30 = $30,000 Stock Dividends Distributable Common Stock, $1 par 1,000 1,000 PRACTICE 11−15 LARGE STOCK DIVIDENDS AND STOCK SPLITS (1) 100% Large Stock Dividend: Retained Earnings* 10,000 Stock Dividends Distributable (10,000 shares × $1) 10,000 Reduction in retained earnings: 10,000 new shares × $1 = $10,000 *Alternatively, the debit can be to Paid-In Capital in Excess of Par Stock Dividends Distributable Common Stock, $1 par 1,000 1,000 (2) 2-for-1 Stock Split: There are no journal entries necessary with a stock split In this case, only a memorandum entry would be made to note the fact that the par value per share had been reduced to $0.50 and the number of shares outstanding had been increased to 20,000 PRACTICE 11−16 ACCOUNTING FOR LIQUIDATING DIVIDENDS Dividends (or Retained Earnings) Paid-In Capital in Excess of Par Dividends Payable 30,000 470,000 Dividends Payable Cash 500,000 500,000 500,000 PRACTICE 11−17 COMPREHENSIVE INCOME Net income (loss) Increase (decrease) from foreign currency Increase (decrease) in portfolio value Comprehensive income 2003 $(1,000) 350 (1,100) $(1,750) 2004 400 (800) (600) $(1,000) $ 2005 $1,700 (170) 420 $1,950 PRACTICE 11−18 ACCUMULATED OTHER COMPREHENSIVE INCOME (1) Retained earnings Retained earnings, January 1, 2003 Net loss Dividends Retained earnings (deficit), December 31, 2003 Net income Dividends Retained earnings (deficit), December 31, 2004 Net income Dividends Retained earnings (deficit), December 31, 2005 (2) $ (1,000) $(1,000) 400 (100) $ (700) 1,700 (300) $ 700 Accumulated other comprehensive income Accumulated other comprehensive income, January 1, 2003 $ Increase (decrease) from foreign currency 350 Increase (decrease) in portfolio value (1,100) Accumulated other comprehensive income (deficit), December 31, 2003 $ (750) Increase (decrease) from foreign currency (800) Increase (decrease) in portfolio value (600) Accumulated other comprehensive income (deficit), December 31, 2004 $(2,150) Increase (decrease) from foreign currency (170) Increase (decrease) in portfolio value 420 Accumulated other comprehensive income (deficit), December 31, 2005 $ (1,900) PRACTICE 11−19 INTERNATIONAL EQUITY RESERVES (1) Nondistributable Par value of shares Share premium Asset revaluation reserve Total nondistributable equity (2) $ 100 1,700 3,200 $5,000 Distributable Retained earnings Special reserve Total distributable equity $1,000 400 $1,400 PRACTICE 11−20 STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY Common Stock at Par Equity Begin $1,500 Paid-In Accumulated Capital Other in Excess Comprehensive of Par Income $10,000 $(2,200) Treasury Stock $(5,000) (a) Retained Total Stockholders’ Earnings $15,000 $19,300 4,500 (b) 300 300 Comprehensive income $4,800 (c) (1,000) (d) (e) End (1,200) 40 460 $1,540 $10,460 $4,500 $(1,000) (1,200) 500 $(1,900) $(6,200) $18,500 $22,400 Some argue that encouraging managers to focus on periodic income causes them to adopt a myopic, short-term emphasis in their decision making, to the overall detriment of a company Stock Option Plans Advantage: The objective of management should be to maximize the value of the shareholders’ investment The market value of the firm is a direct measure of shareholder wealth Therefore, by making management compensation a function of stock price, the managers automatically become interested in increasing the same thing that shareholders want increased—the stock price This should cause management to make decisions that will increase the long-term value of the firm instead of sacrificing long-term value for short-term reported profits Disadvantages: Stock prices frequently rise and fall because of events that have nothing to with management performance For example, in the fall of 1990, fear of war in the Middle East contributed to a significant decline in stock prices Conversely, stock prices sometimes rise in spite of management Between 1982 and 1987 and again in the 1990s, it was difficult for U.S firms not to experience an increase in stock price So, a stock option compensation plan results in management being paid based on something over which its control is limited This also causes management to experience more risk A stock price–based compensation plan may make perfect sense for senior management because their decisions presumably have a direct impact on firm value However, managers of divisions and departments typically have less of an impact, if any, on stock price Discussion Case 11–65 According to generally accepted accounting principles, transactions in a firm’s own stock not give rise to gains or losses An issuance of stock raises capital; a repurchase of stock reduces capital Gains, losses, revenues, and expenses should result only from the operations of the firm, not from capital transactions with stockholders Viewed in another way, though, treasury stock transactions affect the economic value of the firm Undeniably, a firm that buys its own stock at $47 per share and reissues it at $31.13 has suffered an economic loss A financial analyst quoted in Forbes said: “Anytime you make an investment with corporate assets and lose money, it’s a loss to shareholders and poor use of corporate capital.” Discussion Case 11–66 The discussion for this case should center around the management of cash and the company’s dividend policy The discussion should point out the fallacy that dividends are paid out of retained earnings rather than cash Although retained earnings ($900,000) are ample to cover the desired quarterly dividend of $48,300 (69,000 shares × $0.70), the cash balance is barely adequate to cover the dividend and will likely be needed to meet current obligations However, it may be that accounts receivable and inventory turn over relatively fast in comparison to required payments for accounts payable and other obligations From the facts in the case, it is difficult to determine exactly what the cash flow needs are If net income is expected to remain at or above $400,000, a total annual cash dividend of $193,200 (4 × $48,300) is not unreasonable The discussion should also include the relative importance of a consistent dividend policy versus the growth concept of “plowing” earnings back into the company If Largo feels strongly about a consistent dividend policy, the corporation could borrow money in order to meet its quarterly dividend payment Another possibility is to issue a stock dividend, thereby conserving cash while at the same time giving the stockholders a “dividend.” All factors such as those mentioned must be considered by Largo’s board of directors in determining the amount of dividends to be paid Discussion Case 11–67 On the ex-dividend date, Mycroft's shares should go down in price by the amount of the dividend, from $30.00 to $29.50 per share This assumes that if the stock is worth $30.00 with the expectation of receiving the $0.50 dividend, it must be worth that amount less the dividend amount when the right to receive the dividend is removed The actual evidence with prices is a bit more complicated than this simple example It has been shown that the stock price falls by about 80% of the dividend amount on the ex-dividend date One explanation for this is that before the 1986 Tax Reform Act, dividends were taxed at a higher rate than capital gains There is some evidence that—subsequent to the equalization of dividend and capital gains tax rates by the 1986 act—stock prices fell by the full amount of the dividend on ex-dividend dates Now consider the stock price implications of the dividend announcement on March 23 A dividend announcement has both signaling and cash flow implications First consider the signaling implications If the $0.50 per share dividend declared by Mycroft is down from, say, $0.75 per share in the previous quarter, the dividend decrease would probably be interpreted as bad news about Mycroft's future prospects Evidence has shown that announcements of dividend decreases are, on average, followed by earnings decreases in subsequent years Similarly, announcements of dividend increases are followed by subsequent earnings increases So, the announcement of a dividend increase or decrease conveys information about how management thinks the firm will in the future Dividend announcements involving no change from dividends in the previous quarter typically have no impact on stock prices A more difficult question is whether the cash flow implications of a dividend announcement have any impact on stock prices Stated more simply, investors prefer companies that pay high dividends, low-dividends, or does it make any difference? Theoretical models suggest that in the absence of taxes and transactions costs, whether a firm pays dividends or not makes no difference Investors will get their return through dividends with high-dividend firms and through share price appreciation (capital gains) with low-dividend firms, but the total return will be the same Others argue that investors actually prefer firms to pay low dividends because high-dividend firms are forced to borrow money or issue stock more frequently and these are costly transactions Also, investors have been said to prefer lowdividend firms because dividend income has sometimes been taxed at a higher rate than capital gains in the United States Another argument is that investors prefer high-dividend firms because dividend payments are concrete evidence of profitability and because a dividend bird in the hand is worth two capital gain birds in the bush In summary, arguments have been made for high dividends, low dividends, and for the fact that it makes no difference Clearly, there is no definitive answer In practice, we see wide diversity in firms’ dividend policies Discussion Case 11–68 The question of why a company splits its shares is a surprisingly difficult one to answer The conventional wisdom is that firms want their share prices to remain in a trading range—somewhere between $20 and $80 per share A share price that is too low gives the company the undesirable aura of a cheap penny stock On the other hand, so the conventional wisdom goes, if the price per share is too high, individual investors will not be able to afford a round lot (100 shares) Warren Buffett has used this argument for keeping the price per share of Berkshire Hathaway so high: He wants the price per share high enough that only serious investors can afford a share of stock In deciding between a stock split and a large stock dividend, Driftwood Construction Company should consider the following factors: • A large stock dividend will require a transfer from Retained Earnings and/or Additional Paid-In Capital If state incorporation laws restrict Driftwood’s dividend-paying ability to the amount of retained earnings or capital surplus, a large stock dividend could potentially harm its ability to pay cash dividends in the future If Driftwood is confident that future earnings will be sufficient to maintain the cash dividend level, a large stock dividend would not harm its ability to pay cash dividends • Driftwood’s par value per share of $20 is quite high As discussed in the chapter, most companies now have par values of less than $1 per share Driftwood’s par value seems out of date The company might consider a stock split just to get the par value per share down to a more common level Discussion Case 11–69 Items not included on the income statement receive much less attention than items that impact the “bottom line.” For example, The Wall Street Journal publishes the quarterly earnings report for all major companies However, it is very rare indeed for it to publish a firm’s statement of changes in stockholders’ equity So, a direct charge to Retained Earnings would be more likely to escape public scrutiny, and, it seems reasonable to think, this would make it more likely that companies deducting director bonuses directly from Retained Earnings would pay larger bonuses to their directors In the United States there are examples of companies lobbying for accounting rules that result in direct equity adjustments, bypassing the income statement A prominent example is the foreign currency translation adjustment Under FASB Statement No 8, any changes in a company’s equity because of relative changes in the currency values in foreign countries where that company had operations were to be reported as impacting net income for the year This rule was widely despised, and there was great pressure on the FASB to change it FASB Statement No 52 superseded FASB Statement No and mandates that the foreign currency translation adjustment be a direct adjustment to equity More recently, FASB Statement No 115 mandates that certain market value adjustments to securities available for sale be made directly to equity Accounting standards cannot and should not be neutral in their impact on companies By giving investors and creditors better information about companies, accounting standards will cause some companies to be more favorably evaluated The important thing is that accounting standard setters not choose in advance the companies or industries that they think should be benefited SOLUTIONS TO STOP & THINK Stop & Think (p 654): After looking at this comparison, why you think so few companies use the par value method? When a company’s stock price has increased since the time the stock was originally issued (as is true for most companies), the par value method reduces Retained Earnings when shares are repurchased Reduced retained earnings can hinder a firm’s ability to pay cash dividends The cost method does not involve a reduction to Retained Earnings until the repurchased shares are actually retired Stop & Think (p 661): Do financial statement users get the same information from disclosure of the fair value of employee stock options as they would get from recognition of the value of those options? This is the old recognition vs disclosure question One way to view this issue is that anyone with the time and talent to a detailed financial statement analysis does not care whether the information is recognized or disclosed However, someone who is analyzing dozens or hundreds of firms and must rely on summary data is going to miss information that is only disclosed, not recognized So, some financial statement users care whether information is recognized or just disclosed Stop & Think (p 669): You are hired as an accounting consultant by a company that is considering issuing either a 20% stock dividend or a 25% stock dividend From an accounting standpoint, which would you recommend? The surprising answer is contained in the boxed item "Using Stock Dividends as Signals" in this chapter A 20% stock dividend, because it requires the transfer of the market value of the new shares from Retained Earnings, causes a much larger decrease in retained earnings than does a 25% stock dividend that requires the transfer of only the par value If a firm is nervous about the size of its dividend pool, it should not declare a 20% stock dividend because this could drastically reduce retained earnings However, if a company is confident about its future ability to generate profits and pay cash dividends and it wants to proclaim this confidence in a public way, it should declare a 20% stock dividend This blatant reduction in the retained earnings safety net shows management’s optimism about the future SOLUTIONS TO STOP & RESEARCH Stop & Research (p 654): Obtain the most recent annual financial statements for General Electric and estimate what the company’s Retained Earnings balance would have been if the company had used the par value method rather than the cost method in accounting for its treasury stock Identify any assumptions that you make First, we must compute the par value per share, the average issuance price per share, and the average reacquisition cost per share: Par value: $0.594 billion/3.715018 billion shares = $0.16 per share APIC per share: $10.790 billion/3.715018 billion shares = $2.90 per share This assumes that all of the “other capital” is additional paid-in capital in excess of par This assumption is not completely correct, but that is all we have to go on Average Reacquisition cost per share: $22.567 billion/0.430175 billion shares = $52.46 per share Using the par value method, debits would be made as follows: Par value: 0.430175 billion shares x $0.16 per share = $0.069 billion APIC: 0.430175 billion shares x $2.90 per share = $1.247 billion Retained Earnings: 0.430175 billion shares ($52.46 – $0.16 – $2.90) per share = $21.251 billion Adjusted Retained Earnings balance: $54.484 billion – $21.251 billion = $33.233 billion A reduction of 39% In contrast, Microsoft does use the par value method Reported Retained Earnings at June 30, 2001, was $18.899 billion Retained Earnings reductions because of treasury stock purchases are as follows (in billions): 2001 2000 1999 1998 1997 1996 1995 1994 $ 5.680 4.686 2.886 2.631 3.010 1.344 0.668 0.331 Total $21.236 So, Microsoft’s Retained Earnings balance would be more than double if it had used the cost method Stop & Research (p 661): The IASB has added a “share-based payments” project to its agenda Find the current status of this project The best source of information for this question is the IASB’s Web site at http:// www.iasb.org.uk As of April 25, 2002, the IASB was still considering this issue Most users of financial statements were in favor of adoption of the fair value method Most preparers of financial statements were in favor of adopting the intrinsic value method commonly used in the United States The IASB appeared to be leaning toward the fair value method SOLUTIONS TO NET WORK EXERCISES Net Work Exercise (p 641): As of August 26, 2002, Microsoft’s stock price was $51.70 per share On that same date, the company’s P/E ratio was 37.04 The P/E ratio tells you how much the market values one dollar of current earnings of a company In general, the higher the P/E ratio, the higher the earnings growth expected in the future As of August 26, 2002, Berkshire Hathaway’s stock price was $74,800 per share The highest price per share in the preceding 52 weeks was $78,500 per share Net Work Exercise (p 645): Under its “Market Trends” heading, the Edustock Web site says the following about why stock prices increase and decrease “Why does the stock market go up and down? These fluctuations occur partly because companies make money, or lose money, but it is much more involved than that A stock is only worth what someone will pay for it Usually, if a company makes a lot of money, its value rises, because people are willing to pay more for a company’s stock if the company is doing well There are many other factors that affect the value of stocks One example is interest rates, or the amount of money you have to pay a bank to loan money, or how much it has to pay you to keep your money in their bank If interest rates are high, stock prices generally go down, because if people can make a decent amount of money, by keeping their money in banks, or buying bonds, they feel like they should not take the risk in the stock market Many other factors have an effect on the stock market—for example, the state of the economy If there is more money floating around, there is more flowing into companies making their prices rise Yet another factor is time of year and publicity Many stocks are seasonal, meaning they well during certain parts of the year, and worse during others An example is an ice company, the ones that package ice that you buy at the supermarket During the summer, with picnics, and sweltering heat, their product sells well, and thus their stock price goes up But during the winter, when people are not as interested in a picnic with 20 below temperatures, their price goes down Publicity has an effect on stock prices If an article comes out saying that company ABC has just invented this new type of ice that will revolutionize the industry, odds are their price will increase Conversely, if an article comes out saying that company ABC’s president is a crook, and stole the pension funds, it is a good bet that the price will go down.” The Edustock Web site says the following about the buying-on-margin “stock trick:” “Buying on margin is another trick which is basically buying stocks on borrowed money You must first set up a margin account, which has a minimum balance of 2000 dollars Once you have a margin account, you can borrow up to 50 percent of the cost of buying the stocks you want By borrowing 50 percent of the cost, you are controlling something twice as valuable as what you paid for This will enable you to gain more profits with less money For example, if you put in 500 dollars, and the broker lends you 500 dollars, then you have 1000 dollars to work with You then buy 100 stocks at 10 dollars a stock If the price for the stock increases to 15 dollars, and you sell at that price, then you have 1500 dollars You then pay back the broker the 500 dollars plus interest, and you have made roughly 1000 dollars, doubling your initial investment of 500 dollars If you had only invested 500 dollars of your own money, you would have only gotten 50 stocks Then, after selling them for 15 dollars, you would have made only 750 dollars, which is only 250 dollars more than your initial investment The risky part about this is that your losses are also magnified Had you bought 100 stocks on margin at 10 dollars, and the price had dropped to dollars, you would have lost all 500 of your dollars, since you have to pay the broker back his 500 dollars If you had invested only your 500 dollars and bought 50 stocks at 10 dollars, and the price dropped to dollars, then you would only have lost 250 dollars.” SOLUTIONS TO BOXED ITEMS Is It an Investment, or Is It a Loan? (pp 648–649) The material in the boxed item suggests that one possible way to deal with financial instruments that have characteristics of both debt and equity is to remove the division between liabilities and equities on the balance sheet and list sources of long-term capital according to their mix of debt and equity elements This is certainly possible for the balance sheet but would be a bit more difficult to implement with respect to the periodic payments of “interest” and “dividends.” Payments to debt holders are classified as interest and shown on the income statement; payments to equity holders are dividends and are not shown on the income statement One approach that would highlight the fact that interest on long-term debt is similar in nature to, say, dividends on mandatory redeemable preferred stock, is to present a combined income statement and statement of retained earnings such as the following: Income before deductions for amounts due to providers of long-term capital $xxx Interest on long-term bank loans (net of tax effect) xxx Interest on convertible debt (net of tax effect) xxx Dividends on mandatory redeemable preferred stock xxx Dividends on common stock xxx Increase (decrease) in retained earnings $xxx This format is presented only as a basis for discussion The important point is that proliferation of creative financial instruments is forcing accountants to grapple with the similarities and differences between debt and equity and between interest and dividends As a firm takes on more debt as a percentage of total financing, the chances that the firm will not be able to fully repay the debt increase In fact, if one thinks of an equity claim as a claim that is met when the firm does well but is not met when the firm does poorly and a debt claim as one that is almost always paid, debt in a firm that is highly leveraged (i.e., has a high percentage of debt) starts to look more like equity than debt So, the debt of B is much riskier than the debt of A—so much so that the debt of B is, in many respects, just like equity Strategic Timing of Stock Repurchases (pp 654 –655) In the absence of any other effects, a stock buyback will increase a firm's debt-to-equity ratio by reducing total equity However, if buybacks are part of an ongoing program and if additions to Retained Earnings from net income are sufficient to offset the reductions in equity from the buybacks, the buyback program may leave the debt-to-equity ratio unchanged Analysis of how a stock buyback will affect earnings per share leads to a series of "on the other hand" arguments: • At first glance, the buyback will indeed increase earnings per share (EPS) by decreasing the number of shares outstanding • On the other hand, the buyback consumes cash and thus reduces the amount of assets available to the firm Earnings are generated by assets, so a firm with decreased assets might be expected to suffer a reduction in earnings The buyback might cause EPS to go up or down because earnings would go down but so would shares outstanding • On the other hand, firms often argue that buybacks are funded with excess cash; in other words, the firm has assets that it is not able to put to efficient use Accordingly, earnings may not go down when these assets are removed from the firm If this is the case, earnings will remain unchanged, shares outstanding will decrease, and EPS will increase Using Stock Dividends as Signals (p 670) At first glance, it seems that the larger the stock dividend, the stronger the signal However, recall that the signaling argument hinges on the fact that stock dividends require transfers from Retained Earnings, thus constraining the ability to pay cash dividends in the future It is certainly true that a 20% stock dividend would require a larger transfer from Retained Earnings than a 10% stock dividend, and thus the 20% stock dividend would be a stronger positive signal about management's belief about the future prospects of the firm Because stock dividends of 25% or more involve the transfer of just the par value of the new shares instead of their market value, however, the transfer from Retained Earnings may actually be greater with a 20% stock dividend than with a 25% stock dividend For example, consider a firm with 100 shares outstanding, market value per share of $20, and par value per share of $1 A 20% stock dividend would result in $400 being transferred from Retained Earnings A 25% stock dividend would result in a transfer of just $25 from Retained Earnings Research has shown that the market reaction to the announcement of a 20% stock dividend is much more positive than is the reaction to the announcement of a 25% stock dividend The accounting effects of a 100% stock dividend are very different from the effects of a 2-for-1 stock split even though both result in the creation of the same number of new shares The required transfer from Retained Earnings (or Paid-In Capital in Excess of Par) that accompanies a 100% stock dividend can significantly impact the Stockholders' Equity section of the balance sheet A 100% stock dividend may hinder the issuing firm's ability to pay future cash dividends because the Retained Earnings balance is reduced; no such constraint arises when the issuance of the new shares is accounted for as a 2-for-1 stock split Accordingly, if a firm wants to send a signal to the market about how strong it is, it will choose to account for the distribution as a 100% stock dividend The rationale is that a weak firm could not afford to voluntarily reduce its Retained Earnings balance Stock market research confirms that a 100% stock dividend is viewed as being a stronger signal than a 2-for-1 stock split For New York Stock Exchange companies, the average price reaction to the announcement of a 100% stock dividend is a 2.70% increase, whereas the price reaction to the announcement of a 2-for-1 split is only a 0.93% increase COMPETENCY ENHANCEMENT OPPORTUNITIES Deciphering 11–1 (The Walt Disney Company) The par value of $0.01 for each share of Disney common stock can be found in the Equity section of the balance sheet The balance sheet also discloses that 2.1 billion shares had been issued as of September 30, 2001 Because total paid-in capital from common shares is $12.096 billion, the average issuance price is approximately $5.76 ($12.096 billion/2.1 billion shares) Like most U.S companies, Disney uses the cost method of accounting for treasury stock As of September 30, 2001, the average acquisition price of the shares in treasury was $17.14 ($1,395 million/81.4 million shares) Average reacquisition cost Less: Average issuance price Excess per share $17.14 5.76 $11.38 Estimated reduction in retained earnings if treasury shares are retired: 81.4 million shares × $11.38 per share = $926.33 million In fiscal 2001, the foreign currency translation adjustment was a debit (loss) of $22 million The change represents a net debit, or decrease in equity, in 2001 of $22 million This means that the foreign currencies in the countries where Disney has subsidiaries got weaker in 2001 relative to the U.S dollar Note of Disney’s 2001 financial statements says, “The following table reflects pro forma net income (loss) and earnings (loss) per share had the Company elected to adopt the fair value approach of Statement of Financial Accounting Standards No 123, Accounting for Stock-Based Compensation.” From this we can conclude that Disney did not elect to use the fair value method Accordingly, we can conclude that Disney uses the intrinsic value method Deciphering 11–2 (General Motors) General Motors is incorporated in Delaware In the notes to its 1993 financial statements, General Motors stated that the amount legally available for payment of cash dividends under Delaware law was materially higher than $4.870 billion, which was the company's capital surplus less the accumulated deficit Each of the three classes of common stock have a different number of votes in shareholder matters Each share of the $1 2/3 par common stock gets one vote, each share of the Class E common gets 1/8 vote, and each share of the Class H common gets 1/2 vote The Class E common stock was issued in conjunction with the acquisition of EDS (Ross Perot’s old company) The Class H common shares arose in the acquisition of Hughes Electronics, which was sold in January 1997 to Raytheon, a large defense contractor As of December 31, 2001, General Motors had only two of the 11 issues of capital stock outstandingthe $1 2/3 par value common stock and the Class H common stock Deciphering 11–3 (Swire Pacific Limited) Total revenue reserves of HK$41,583 million are distributable The U.S concept that most closely resembles Swire’s revenue reserve is retained earnings, in that retained earnings includes the retained profit for each year However, Swire’s revenue reserve includes items that are not included in a U.S company’s retained earnings balance Those items include exchange differences and the amount of acquired goodwill The capital redemption reserve ensures that distributable equity is reduced by the entire amount of cash used to repurchase the shares Property, Plant, and Equipment 28,752 Property Valuation Reserve 28,752 (Numbers in millions of Hong Kong dollars.) An increase in the recorded amount of property, plant, and equipment does not provide any extra cash for distribution to shareholders Thus, the property valuation reserve is not distributable In addition, if this reserve were distributable, the board of directors could potentially manipulate the appraised amounts of property, plant, and equipment in order to increase distributable reserves and make it possible for investors to remove cash from the corporation at the expense of creditors During 2001, the value of Swire’s property holdings dropped, resulting in a decrease in the property valuation reserve from 35,735 million Hong Kong dollars to 28,752 million This drop in value would be reflected as a reduction in the carrying value of Swire’s assets SAMPLE CPA EXAM QUESTIONS The correct answer is a At the time the options were granted, there was a difference of $30 per share between the option price of $20 and the market price of $50 This would result in compensation of $30 × 1,000 shares, or $30,000, recorded as follows: Compensation Expense Paid-In Capital from Stock Options 30,000 30,000 When the options are exercised, the credit would be reversed, the cash would be recorded, and the shares would be issued The entry would be: Cash Paid-In Capital from Stock Options Common Stock (par) Additional Paid-In Capital 20,000 30,000 10,000 40,000 Since the compensation would reduce earnings and ultimately retained earnings, the net effect on stockholders' equity would be $10,000 + $40,000 − $30,000, or an increase of $20,000 The correct answer is c No entry is made when rights are issued without consideration Common stock and additional paid-in capital would be affected if the rights are exercised The correct answer is c A sale of treasury stock for more than its cost would be recorded with a debit to Cash for the proceeds, a credit to Treasury Stock for the cost, and a credit to Additional Paid-In Capital for the excess The correct answer is c When converting foreign company financial statements into U.S dollars, any translation gain or loss is accumulated as part of accumulated other comprehensive income The discount or premium on bonds, including convertible bonds, is reported as an adjustment to the reported amount of bonds payable Organization costs are typically expensed as incurred Writing Assignment: Strategic accounting: par value or cost method? To: Board of Directors, J D Michael Company From: Me (Resident Accounting Expert) Subject: Choice of Accounting Method for Treasury Stock I recommend that we adopt the cost method of accounting for treasury stock purchases My reasons are as follows: • Prevailing practice Over 95% of the publicly traded companies in the United States use the cost method to account for treasury stock purchases Adoption of the par value method would raise eyebrows among analyststhey would think we are strange and would wonder what we are up to • Financial statement impact The par value method essentially results in repurchased shares being recorded as if they had been retired The most important implication is that, when shares are repurchased for more than their original issue price, the difference is recognized as a reduction in retained earnings So, any company that has had an increasing stock price, as we have, and uses the par value method will reduce its retained earnings balance every time it repurchases shares These reductions can be substantial For example, if The Walt Disney Company were to use the par value method, it would be required to reduce its reported retained earnings balance by approximately $926 million (see Deciphering 11–1) • Financial flexibility Because of the retained earnings reductions associated with use of the par value method, our ability to maintain our current level of cash dividends could be impaired State incorporation laws tie our cash dividend payments to the amount in retained earnings—use of the par value method would reduce the available pool of distributable funds For these reasons, I strongly recommend that we follow common industry practice and use the cost method of accounting for treasury stock purchases Research Project: When stock splits occur? The results of this research project will differ depending on the sample of firms selected However, academic research about stock splits offers the following general answers For more information, a good place to start is the following article: David L Ikenberry, Graeme Rankine, and Earl K Stice, “What Do Stock Splits Really Signal?” Journal of Financial and Quantitative Analysis, September 1996, p 357 • Frequency of stock splits Between 1975 and 1990, a total of 1,275 2-for-1 stock splits were completed by firms on the New York and American stock exchanges This averages out to about 80 per year More stock splits occur in years when the stock market as a whole experiences large returns • Trading range The commonly described trading range for share prices is between $20 and $80 per share Companies that enact 2-for-1 stock splits have share prices that are greater than 80% of the share prices for other firms of similar size • Stock returns before a split One finding is almost certain—firms that split their stock so after a period of rapid increase in price per share There are excess returns, over and above the average returns for all stocks in the market average, between 10% and 20% in the year before a firm declares a stock split • Stock returns after a split An interesting finding is that firms that declare stock splits continue to perform well in the year after the stock split declaration If you were to buy a portfolio of stock split firms the week after they announced their splits, you would earn an additional 8% (over the average market return) in the following year The Debate: Stock-based compensation: The line in the sand! Truth in Accounting Coalition: This group should echo the arguments made by Warren Buffett in Berkshire Hathaway’s 1993 annual report: • If options aren't a form of compensation, what are they? • If compensation isn't an expense, what is it? • If expenses shouldn't go into the calculation of earnings, where should they go? A common criticism is that it is difficult to compute the fair value of options on the grant date Assumptions, forecasts, and estimates are necessary to compute the value However, accountants don’t let these kinds of difficulties stop them from estimating pension expense, deferred income tax expense, or even bad debt expense An inexact estimate is better than an exact number, $0, that we know is wrong Regarding the claim that recording compensation expense for stock option plans will hurt high-tech companies, it is better to formulate public policy and protect vital industries through specific laws rather than indirectly through accounting manipulations As mentioned in the text, in 2002 the intrinsic value method came under some fire as being yet another example of a deceptive corporate reporting practice In an attempt to signal the soundness of its financial reporting, Coca-Cola announced in July 2002 that it would henceforth use the fair value method rather than the intrinsic value method Shortly thereafter, Washington Post Company announced that it was doing the same Not coincidentally, Warren Buffett sits on the board of directors of both companies Thus, another reason for using the fair value method is to signal conservative, high-quality financial reporting Save the Jobs!: It is naive to think that the FASB’s ill-conceived proposal would not impact the financial strength of vital U.S companies This is not an argument about accounting theory; real people could lose their jobs if companies are forced to cut back hiring and expansion plans because of reduced reported earnings caused by higher reported compensation expense Decisions impacting real companies and causing real people to lose their jobs should be made by elected officials, not by an appointed board of accountants Ethical Dilemma: Stock dividend instead of cash: The investors will never know! Declaring a stock dividend “in lieu” of a cash dividend is not unethical—this happens all the time And this wouldn't be the first time that a company thought it was fooling the investors Your key responsibility is to make sure investors know that this stock dividend is in place of the regular cash dividend—that is, this quarter there will be no cash dividend As far as the underlying reason for the cessation of cash dividends, it isn't your place to disclose private company information However, don't worry Investors aren't as stupid as Best Ski's board of directors thinks When the stock dividend is announced, investors will immediately begin to bombard Best Ski's corporate headquarters with questions If Best Ski is a large enough company, some enterprising financial press reporter will investigate and find out about the decline in orders The news will get out You just make sure the press release lets investors know the real story behind this particular 10% stock dividendthat cash dividends have been dropped Cumulative Spreadsheet Analysis See Cumulative Spreadsheet Analysis Solutions CD-ROM, provided with this manual Internet Search On November 29, 1975, Bill Gates wrote a letter to Microsoft co-founder Paul Allen in which Gates used the name "Micro-soft" to refer to their partnership If you had purchased one share of Microsoft stock at the initial public offering (IPO) on March 13, 1986, on September 16, 2002 you would have owned 144 shares of stock March 13, 1986 September 18, 1987 April 12, 1990 June 26, 1991 June 12, 1992 May 20, 1994 December 6, 1996 February 20, 1998 March 26, 1999 IPO 2-for-1 split 2-for-1 split 3-for-2 split 3-for-2 split 2-for-1 split 2-for-1 split 2-for-1 split 2-for-1 split share shares shares shares shares 18 shares 36 shares 72 shares 144 shares Microsoft regularly repurchases its own shares in order to provide shares to issue to employees under stock option and stock purchase plans For the year ended June 30, 2002, the weighted average option price for selected Microsoft employee stock options was as follows: Options granted during the year Options exercised during the year $62.50 12.82 The weighted average option price for options granted exceeds that for options exercised because: • • • Granted options are brand new; options can be exercised only after several years Microsoft's stock price has been generally rising over the past several years The option price is usually set near the market price of the stock as of the grant date ... error is discovered in a year subsequent to the error, the error is corrected by a prior-period adjustment whereby the beginning balance in Retained Earnings is adjusted Some errors are counterbalancing... PRACTICE 11−12 ACCOUNTING FOR DECLARATION AND PAYMENT OF DIVIDENDS Dividends (or Retained Earnings) Dividends Payable 35,000 Dividends Payable Cash 35,000 35,000 35,000 PRACTICE 11−13 ACCOUNTING. .. record gives stockholders a chance to adjust their holdings in light of the dividend action taken by the company The period between the date of record and the date of payment gives the corporation