Chapter 1313-1
13
Equity Financing
Overview
After discussing debt financing in Chapter 12, we now turn to the other kind of financing available to businesses—equity financing. Like debt financing, equity financing, once you delve below the surface of what you probably covered in your introductory accounting course, can be quite complex. It isn’t as simple as selling shares of stock for which you debit Cash and credit Common Stock.
One of the complexities involves various kinds of stock. There is not only the common, voting stock. There are also a wide variety of preferred stock possibilities. Preferred stock doesn’t mean that it is “better” stock. For instance, as far as voting goes, preferred shares are usually inferior to common shares. When a company performs really well, or the prospects for performance are favorable, common shares tend to appreciate in value (sometimes substantially). Preferred shares, on the other hand, tend to produce only minor fluctuations in price. Preferred share pricing is tied much more to changes in interest rates and company credit ratings than to company performance.
This example shows how preferred shares usually act more like debt than equity. The bonds discussed in the prior chapter also change in value based on changes in interest rates and company credit ratings. Some preferred shares (mandatorily redeemable preferred shares) are so similar to debt that they are actually classified as liabilities on the balance sheet.
Some of the other complexities discussed in this chapter include stock that isn’t quite stock yet like rights, warrants, and options. Options, in particular, are common in U.S. corporations and, hence, the new accounting treatment for them is important to understand well.
Finally, financing cuts both ways. The chapter discusses not only the obtaining of cash and issuing of stock and other equity instruments, but also the repurchase of stock (treasury stock) and the payment of dividends. The payment of dividends is one of several means by which the Retained Earnings account is adjusted.
Learning Objectives
Refer to the Review of Learning Objectives at the end of the chapter. It is crucial that this section of the chapter is second nature to you before you attempt the homework, a quiz, or exam. This important piece of the chapter serves as your CliffsNotes or “cheat sheet” to the basic concepts and principles that must be mastered.
If after reading this section of the chapter you still don’t feel comfortable with all of the Learning Objectives covered, you will need to spend additional time and effort reviewing those concepts that you are struggling with.
The following “Tips, Hints, and Things to Remember” are organized according to the Learning Objectives (LOs) in the chapter and should be gone over after reading each of the LOs in the textbook.
Tips, Hints, and Things to Remember
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LO1 – Identify the rights associated with ownership of common and preferred stock.
Why? Why would a business have two kinds of stock? Why not stick to one? Companies generally don’t issue preferred stock initially. It is when the business has grown to a sufficient size, yet more cash is needed, that the issuance of preferred shares is sometimes considered. Preferred shares, rather than more common shares, are sometimes issued because the common shareholders don’t want their stake in the business to be diminished. At the same time, the existing common stockholders don’t want, or don’t have the resources, to put more money into the business. By issuing a different kind of stock, the company is able to raise additional funds without taking on more debt (which their current creditors may not allow), while at the same time not reducing the stake current owners have in the business.
How? Preferred stock and common stock have little in common outside the word “stock.” Preferred shareholders get paid first when it comes to dividends and in liquidation. As mentioned on page 13-1, with the reduced risk can also result ina reduced reward for the preferred shareholders. When the company performs well, or is expected to perform well, preferred shareholders don’t receive the kinds of returns that common stockholders do. They also don’t have any voting rights, which can be a primary motivator for some shareholders (like those taking over the company who need not buy up the preferred shares).
LO2 – Record the issuance of stock for cash, on a subscription basis, and in exchange for noncash assets or for services.
How? When stock is issued for cash, there are usually two accounts that receive a credit. The first is the Common Stock account, which gets a credit equal to the par value of the stock issued. For example, if the par value is $1 and 20,000 shares are issued, then Common Stock will be credited $20,000. The difference between the actual amount of cash received and the credit to Common Stock receives the remaining credit to an account called Paid-In Capital in Excess of Par Value or Additional Paid-In Capital.
If someone (or some business) is going to provide other assets or services in exchange for stock, the corporation is essentially giving the person (or business) stock instead of cash. This is frequently the case with new, small corporations that don’t have cash.
Another way of looking at it is to pretend the corporation is giving cash for the services or assets and then the cash is going right back into the corporation for stock. If that was the case, the corporation would be giving cash to the extent of the fair market value of the items received. Therefore, these transactions should be booked based on the fair market value of the assets or services. If the stock trades on an exchange, then the fair market value of the stock is known and can be used as a firmer number than an appraisal of assets or estimate of the value of the services.
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LO3 – Use both the cost and par value methods to account for stock repurchases.
How? The cost method is the simpler of the two. When shares are repurchased, the contra-equity account of Treasury Stock is the only account debited under the cost method. Under the par value method, as the name implies, the Treasury Stock account is only debited to the extent of the par value of the stock reacquired. Other accounts (Additional Paid-In Capital and maybe Retained Earnings) make up the difference.
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LO4 – Account for the issuance of stock rights and stock warrants.
How? There is nothing difficult about accounting for warrants. When cash comes in for stock that has a warrant attached to it, Cash, of course, receives a debit. The credit is allocated between the value of the warrant and the stock it is attached to. If the stock has a par value, then an additional paid-in capital account will also be credited for a totalof three credits (Paid-In Capital in Excess of Par Value, Additional Paid-In Capital, and StockWarrant).
LO5 – Compute the compensation expense associated with the granting of employee stock options.
How? Stock options are now accounted for using a fair-value approach. Compensation expense is recognized based on the fair value of the options at the grant date evenly over the period the options vest. This wasn’t usually the case until recently. Hence, it is probably an area that is likely to be tested on the CPA Exam. Even if the options aren’t exercised, the expense associated with the granting of them is never reversed or taken off of the books.
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LO6 – Determine which equity-related items should be reported in the balance sheet as liabilities.
Why? There are several items that sound like equity but for which FASB has ruled should be listed as a liability since the substance of these instruments looks more like a liability than their names imply. The major ones listed in this chapter include mandatorily redeemable preferred shares, written put options, and obligations to issue shares at a certain dollar value (rather than a certain number of shares).
The written put options issued by companies to which the put option applies should be distinguished from other put options traded on the open market. Written put options, in the sense discussed in this chapter, deal with only those written by the company (not those that can be purchased and sold on something like the Chicago Board Options Exchange which are written by the exchange instead of by the companies being traded).
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LO7 – Distinguish between stock conversions that require a reduction in retained earnings and those that do not.
How? It is rare that a reduction in retained earnings is necessary when preferred stock is converted into common stock. Usually, you simply need to take the preferred stock off the books and put the common stock on the books at the same amount (with the plug going as a credit to Additional Paid-In Capital). However, in the rare circumstance in which you are missing a debit in this entry (because the common stock has a high par value),Retained Earnings will receive that debit.
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LO8 – List the factors that impact the Retained Earnings balance.
How? You have hopefully already mastered the most common changes in the Retained Earnings balance: income increases the credit balance and dividends reduce the balance. Outside of those entries there are a couple that can affect it in either direction: error corrections and some changes in accounting principle. Finally, there are two that can only decrease the balance: some treasury stock transactions and some stock conversions (as mentioned in the rare circumstance for LO7).
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LO9 – Properly record cash dividends, property dividends, small and large stock dividends, and stock splits.
How? Generally, the recording of a dividend, regardless of the type of dividend, is a two-step process with similar components. On the date of declaration, Retained Earnings (or Dividends, which gets closed out to Retained Earnings) receives a debit, and Dividends Payable receives a credit. Sometimes (in the case of noncash dividends), another account receives a debit or a credit as well. Then, on the date of payment, Dividends Payable receives a debit, and the accountthat is the dividend to shareholders receives a credit.
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LO10 – Explain the background of unrealized gains and losses recorded as part of accumulated other comprehensive income, and list the major types of equity reserves found in foreign balance sheets.
How? Some equity items are not reported on the income statement but instead are reported as part of accumulated other comprehensive income. The most common of these equity items is unrealized gains and losses from foreign currency exchange rate changes, changes in market value of an available-for-sale investment, and fluctuations in the value of some derivatives.
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LO11 – Prepare a statement of changes in stockholders’ equity.
Why? Understanding how to prepare the statement of changes in stockholders’ equity is important. Take your time in reviewing the example provided in the text.
The following sections, featuring various multiple choice questions, matching exercises, and problems, along with solutions and approaches to arriving at the solutions, is intended to develop your problem-solving and critical-thinking abilities. While learning through trial and error can be effective for improving your quiz and exam scores, and it can be a more interesting way to study than merely re-reading a chapter, that is only a secondary objective in presenting this information in this format.
The main goal of the following sections is to get you thinking, “How can I best approach this problem to arrive at the correct solution—even if I don’t know enough at this point to easily arrive at the proper results?” There is not one simple approach that can be applied to all questions to arrive at the right answer. Think of the following approaches as possibilities, as tools that you can place in your problem-solving toolkit—a toolkit that should be consistently added to. Some of the tools have yet to even be created or thought of. Through practice, creative thinking, and an ever-expanding knowledge base, you will be the creator of the additional tools.
Multiple Choice
MC13-1 (LO1)Which of the following shareholder rights is most commonly enhanced in an issue of preferred stock?
a. / the right to vote for the board of directorsb. / the right to maintain one’s proportional interest in the corporation
c. / the right to receive a full cash dividend before dividends are paid to other classes of stock
d. / the right to vote on major corporate issues
MC13-2 (LO2)The par value of common stock represents the
a. / liquidation value of the stock.b. / book value of the stock.
c. / amount received by the corporation when the stock was originally issued.
d. / legal nominal value assigned to the stock.
MC13-3 (LO3)Gains and losses on the purchase and resale of treasury stock may be reflected only in
a. / Paid-In Capital accounts.b. / Paid-In Capital and Retained Earnings accounts.
c. / income, Paid-In Capital, and Retained Earnings accounts.
d. / income and Paid-In Capital accounts.
MC13-4 (LO4)A company issued rights to its existing shareholders to acquire, at $18 per share, 10,000 unissued shares of common stock with a par value of $1 per share. Common Stock will be credited for
a. / $18 per share when the rights are exercised.b. / $18 per share when the rights are issued.
c. / $1 per share when the rights are exercised.
d. / $1 per share when the rights are issued.
MC13-5 (LO5)On January 1, 2013, Watson Corporation granted stock options to key employees for the purchase of 60,000 shares of the company's common stock at $25 per share. The options are intended to compensate employees for the next two years. The options are exercisable within a four-year period beginning January 1, 2015, by grantees still employed by the company. The fair value of the options based on the market price of Watson's common stock at the date of grant is $7 per share. Watson plans to distribute up to 60,000 shares of treasury stock when options are exercised. The treasury stock was acquired by Watson at a cost of $28 per share and was recorded under the cost method. How much should Watson charge to Compensation Expense for the year ended December 31, 2013?
a. / $420,000b. / $210,000
c. / $180,000
d. / $90,000
MC13-6 (LO6)Which of the following items should NOT be reported as a liability on the balance sheet?
a. / written put optionsb. / mandatorily redeemable preferred shares
c. / obligation to issue shares of a certain dollar value
d. / obligation to issue a certain number of shares
MC13-7 (LO7)An adjustment to Retained Earnings as a result of a conversion of preferred stock to common stock most likely would occur when par value of the
a. / preferred stock is high relative to fair value of the common stock.b. / common stock is less than the book value of the preferred stock.
c. / common stock exceeds the book value of the preferred stock.
d. / preferred stock is low relative to fair value of the common stock.
MC13-8 (LO8)Which of the following actions or events does NOT result in an addition to Retained Earnings?
a. / a change from the double-declining-balance method to the straight-line method of depreciationb. / net income earned for the period
c. / the correction of an error in which ending inventory was understated in a previous year
d. / the issuance of a 2-for-1 stock split
MC13-9 (LO9)Kearney Company declared a cash dividend on its common stock in December 2012, payable in January 2013. Retained Earnings would
a. / increase on the date of declaration.b. / not be affected on the date of declaration.
c. / not be affected on the date of payment.
d. / decrease on the date of payment.
MC13-10 (LO10)Slattery Company reported the following for the year ended December 31, 2013(all items are net of income taxes):
Income from continuing operations / $1,300Income (loss) from discontinued operations / (200)
Unrealized gain (loss) on available-for-sale securities / 30
(Increase) Decrease in minimum pension liability / (72)
Unrealized gain (loss) on derivative instruments / (12)
Foreign currency translation adjustment, increase (decrease) in stockholders' equity / 180
Comprehensive income (loss) for the year ended December 31, 2013is
a. / ($74).b. / $1,226.
c. / $1,426.
d. / $126.
MC13-11 (LO11)Which of the following isNOT found on a statement of changes in stockholders’ equity?
a. / Revenueb. / Treasury Stock
c. / Retained Earnings
d. / Accumulated Gains (Losses) Not Affecting Retained Earnings
Matching
Matching13-1 (LO1)Listed below are the terms and associated definitions from the chapter for LO1. Match the correct definition letter with each term number.
___ 1.board of directors / a.preferred stock that provides for additional dividends to be paid to preferred stockholders after dividends of a specified amount are paid to common stockholdersb.a security, such as a bond or a preferred stock, that can be redeemed and canceled at the option of the issuing company
c.has a right to receive current dividends as well as any dividends in arrears before common stockholders receive any dividends
d.group elected by the shareholders to oversee the strategic and long-run planning for the corporation
e.preferred stock that has no claim on any prior year dividends that may have been “passed”
f.preferred stock that may be turned into cash at the option of the holder, at a fixed price on a specific date, or upon other conditions not solely within the control of the issuer
g.securities, such as bonds and preferred stock, whose terms permit the holder to convert the investment into common stock of the issuing company
h.a nominal value that is assigned to stock by the terms of a corporation’s charter
i.dividend on cumulative preferred stock that are passed or not paid
j.a nominal value that may be assigned to no-par stock by the board of directors of a corporation
___ 2.par value
___ 3.stated value
___ 4.cumulative preferred stock
___ 5.dividends in arrears
___ 6.noncumulative preferred stock
___ 7.participating preferred stock
___ 8.convertible
___ 9.callable
___ 10.redeemable preferred stock
Matching 13-2 (LO2, LO3)Listed below are the terms and associated definitions from the chapter for LO2 and LO3. Match the correct definition letter with each term number.