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Chapter 15
Multiple Choice

For a compensatory stock option plan for which the date of grant and
measurement date are the same, compensation cost should be recognized in the income statement
a. At the date of retirement
b. Of each period in which services are rendered
c. At the exercise date
d. At the adoption date of the plan

Answer d
2. Payment of a dividend in stock
a. Increases the current ratio
b. Decreases the amount of working capital
c. Increases total stockholders equity
d. Decreases book value per share of stock outstanding
Answer d
3. The directors of Corel Corporation, whose $40 par value common stock is currently selling at $50
per share, have decided to issue a stock dividend. The corporation has an authorization for
200,000 shares of common, has issued 110,000 shares of which 10,000 shares are now held as
treasury stock, and desires to capitalize $400,000 of the retained earnings balance. To accomplish
this, the percentage of stock dividend that the directors should declare is
a. 10
b. 8
c. 5
d. 2
Answer a
4. When a stock dividend is small, for example a 10% stock dividend,
a. Retained earnings is not reduced because the dividend is immaterial .
b. Retained earnings is reduced by the fair value of the stock.
c. Retained earnings is reduced to the par value of the stock.
d. Paid-in capital in excess of par value is unaffected.
Answer b

The par value method of reporting a treasury stock transaction

a. Will be reported in the balance sheet as a reduction of total stockholders equity.
b. Results in no change to total stockholders equity.

c. Results in a reduction in the number of shares that are available to be sold to prospective
d. Assumes constructive retirement of the treasury shares.
Answer d
6. On December 31, 2010, when the Conn Companys stock was selling at $36 per share, its capital
accounts were as follows
Capital stock (par value $20,
100,000 shares issued)
Premium on capital stock
Retained Earnings
If a 100 percent stock dividend were declared and the par value per share remained at
a. No entry would need to be made to record the dividend
b. Capital stock would increase to $5,600,000
c. Capital stock would increase to $4,000,000
d. Total capital would decrease
Answer c
7. A company has not paid dividends on its cumulative nonvoting preferred stock for 20 years.
Healthy earnings have been reported each year, but they have been retained to support the growth
of the company. The board of directors appropriately authorized management to offer the
preferred shareholders an exchange of bonds and common stock for all the preferred stock. The
exchange is about to be consummated. Which of the following best describes the effect of the
exchange on the company?
a. The statute of limitations applies; hence, cumulative dividends of only seven years need to be
paid on the preferred stock exchanged.
b. The company should record an extraordinary gain for income determination purposes to the
extent that dividends in arrears do not have to be paid in the exchange transaction.
c. Gain or loss should be recognized on the exchange by the company, and the exchange would
have to be approved by the Securities and Exchange Commission.
d. Regardless of the market value of the bonds and common stock, no gain or loss should be
recognized by the company on the exchange, and no dividends need to be paid on the
preferred stock exchanged.
Answer d

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

a. Exhaustion of potential benefits of the investment credit
b. Purchase of treasury stock
c. Payment of last maturing series of a serial bond issue
d. Amortization of past service costs related to a pension plan

Answer b
9. A feature common to both stock splits and stock dividends is


A reduction in total capital of a corporation

A transfer from earned capital to paid-in capital
A reduction in book value per share
Inclusion in conventional statement of source and application of funds

Answer c
10. Assuming the issuing company has only one class of stock, a transfer from retained earnings to
capital stock equal to the market value of the shares issued is ordinarily a characteristic of
a. Either a stock dividend or a stock split
b. Neither a stock dividend nor a stock split
c. A stock split but not a stock dividend
d. A stock dividend but not a stock split
Answer d
11. When a stock option plan for employees is compensatory, the measurement date for determining
compensation cost is the
a. Date the option plan is adopted, provided it precedes the date on which the options may first
be exercised by less than one operating cycle
b. Date on which the options may first be exercised (if the first actual exercise is within the
same operating period) or the date on which a recipient first exercises any of his options
c. First date on which are known both the number of shares than an individual employee is
entitled to receive and the option or purchase price, if any
d. Date each option is granted
Answer c
12. As a minimum, how large in relation to total outstanding shares may a stock distribution be
before it should be accounted for as a stock split instead of a stock dividend?
a. No less than 2 to 5 percent
b. No less than 10 to 15 percent
c. No less than 20 to 25 percent
d. No less than 45 to 50 percent
Answer b
13. The dollar amount of total stockholders equity remains the same when there is a (an)
a. Issuance of preferred stock in exchange for convertible debentures
b. Issuance of nonconvertible bonds with detachable stock purchase warrants
c. Declaration of a stock dividend
d. Declaration of a cash dividend
Answer c
14. A company with a substantial deficit undertakes a quasi-reorganization. Certain assets will be
written down to their present fair market value. Liabilities will remain the same. How would the
entries to record the quasi-reorganization affect each of the following?
Contributed Capital

Retained Earnings


No effect

No effect

Answer c
15. What is the most likely effect of a stock split on the par value per share and the number of shares
Par Value
Number of shares
Per share
No effect
No effect
No effect
Answer a
16. Gilbert Corporation issued a 40percent stock split-up of its common stock that had a par value
of $10 before and after the split-up. At what amount should retained earnings be capitalized for
the additional shares issued?
a. There should be no capitalization of retained earnings
b. Par value
c. Market value on the declaration date
d. Market value on the payment date
Answer c
17. How would the declaration and subsequent issuance of a 10 percent stock dividend by the issuer
affect each of the following when the market value of the shares exceeds the par value of the

Common Stock
No effect
No effect

Additional Paid-in Capital

No effect
No effect

Answer d
18. A company with a $2,000,000 deficit undertakes a quasi-reorganization on November 1, 2010.
Certain assets will be written down by $400, 000 to their present fair market value. Liabilities
will remain the same. Capital stock was $3,000,000 and additional paid-in capital was $1,000,000
before the quasi-reorganization. How would the entries to accomplish these changes on
November 1, 2010, affect each of the following?
Capital Stock

No effect

Total Stockholders
No effect


No effect

No effect

Answer d
19. How would a stock split affect each of the following?
Total Stockholders
No effect
No effect
No effect
No effect

Paid-in Capital
No effect
No effect

Answer b
20. The purchase of treasury stock
a. Decreases common stock authorized
b. Decreases common stock issued
c. Decreases common stock outstanding
d. Has no effect on common stock outstanding
Answer d
21. The equation, assets = equities, expresses which of the following theories of equity?
a. Proprietary theory.
b. Commander theory.
c. Entity theory.
d. Enterprise theory.
Answer c
22. Under the residual equity theory
a. A business is viewed as a social institution.
b. Management is responsible for maximizing the wealth of common stockholders.
c. A managers goals are considered as important as those of the common stockholders.
d. Equities are viewed as restrictions on assets..
Answer b
23. Under which of the theories of equity is a managers goals considered as important as those of the
common stockholder.
a. Proprietary theory.
b. Commander theory.
c. Entity theory.
d. Enterprise theory.
Answer b

24. Which of the theories of equity is consistent with the definition of equity that is found in
Statement of Financial Accounting Concepts No. 6?
a. Proprietary theory.
b. Commander theory.
c. Entity theory.
d. Enterprise theory.
Answer a
25. Which of the following securities must be reported as a liability because they have the
characteristics of both liabilities and equity, but the liability characteristic is dominant?
a. Redeemable preferred stock.
b. Stock options issued with a debt security .
c. Detachable stock options.
d. Mandatorily redeemable preferred stock.
Answer d
26. When a dividend paid to stockholders who own mandatorily redeemable preferred stock, the
company must report the dividend
a. As an adjustment to retained earnings in its statement of owners equity .
b. As an expense in the income statement.
c. As a reduction to other comprehensive income.
d. In the financing activities section of the statement of cash flows.
Answer b
27. When preferred stock is converted to common stock
a. The debt-to-equity ratio decreases.
b. The debt-to-equity ratio increases.
c. The debt-to-equity ratio is unchanged.
d. A gain or loss is reported in earnings for the difference between the fair value of the common
stock and the book value of the preferred stock that was converted .
Answer c
28. When employees are granted options as part of a compensatory stock option plan,
a. Total compensation is measured using a fair value method.
b. Total compensation is measured using the intrinsic method.
c. Total compensation is measured when the options are in the money.
d. Total compensation is measured using the difference between the strike price and the fair
value of the options on the grant date.
Answer c

1. Discuss the following theories of equity:


According to the proprietary theory, the firm is owned by some specified

person or group. The ownership interest may be represented by a sole
proprietor, a partnership, or a number of stockholders. The assets of the firm
belong to these owners, and any liabilities of the firm are also the owners
liabilities. Revenues received by the firm immediately increase the owners
net interest in the firm. Likewise, all expenses incurred by the firm
immediately decrease the net proprietary interest in the firm. This theory
holds that all profits or losses immediately become the property of the
owners, and not the firm, whether or not they are distributed. Therefore, the
firm exists simply to provide the means to carry on transactions for the
owners, and the net worth or equity section of the balance sheet should be
viewed as
assets liabilities = proprietorship
Under the proprietary theory, financial reporting is based on the premise that the owner is the
primary focus of a companys financial statements. The proprietary theory is particularly
applicable to sole proprietorships where the owner is the decision maker. When the form of the
enterprise grows more complex, and the ownership and management separate, this theory
becomes less acceptable.

The rise of the corporate form of organization, (1) was accompanied by
the separation of ownership and management, (2) conveyed limited
liability to the owners, and (3) resulted in the legal definition of a
corporation as though it were a person, encouraged the evolution of new
theories of ownership. Among the first of these theories was the entity
theory. From an accounting standpoint, the entity theory can be expressed
assets = equities
The entity theory, like the proprietary theory, is a point of view toward the
firm and the people concerned with its operation. This viewpoint places
the firm, and not the owners, at the center of interest for accounting and
financial reporting purposes. The essence of the entity theory is that
creditors as well as stockholders contribute resources to the firm, and the
firm exists as a separate and distinct entity apart from these groups. The
assets and liabilities belong to the firm, not to its owners. As revenue is
received, it becomes the property of the entity, and as expenses are
incurred, they become obligations of the entity. Any profits belong to the
entity and accrue to the stockholders only when a dividend is declared.
Under this theory, all the items on the right-hand side of the balance
sheet, except retained earnings (it belongs to the firm), are viewed as
claims against the assets of the firm, and individual items are

distinguished by the nature of their claims. Some items are identified as

creditor claims and others are identified as owner claims; nevertheless,
they are all claims against the firm as a separate entity.

The use of the fund theory would abandon the personal relationship
advocated by the proprietary theory and the personalization of the firm
advocated by the entity theory. Under the fund approach, the
measurement of net income plays a role secondary to satisfying the
special interests of management, social control agencies (e.g.,
government agencies), and the overall process of credit extension and
investment. The fund theory is expressed by the following equation:
assets = restrictions on assets
This theory explains the financial reporting of an organization in terms of
three features, as follows:
1. Fund. an area of attention defined by the activities and operations
surrounding any one set of accounting records and for which a selfbalancing set of accounts is created.
2. Assets. economic services and potentials.
3. Restrictions. limitations on the use of assets.

These features are applied to each homogeneous set of activities and

functions within the organization, thereby providing a separate
accounting for each area of economic concern.
The fund theory has not gained general acceptance in financial accounting; it is more
suitable to governmental accounting.

The commander approach is offered as a replacement for the proprietary
and entity theories because it is argued that the goals of the manager
(commander) are at least equally important to those of the proprietor or
entity. The proprietary, entity, and fund approaches emphasize persons,
personalization, and funds, respectively, but the commander theory
emphasizes control. Everyone who has resources to deploy is viewed as a
The commander theory, unlike the proprietary, entity, and fund
approaches, has applicability to all organizational forms (sole

proprietorships, partnerships, and corporations). The form of organization

does not negate the applicability of the commander view because the
commander can take on more than one identity in any organization. In
sole proprietorships or partnerships, the proprietors or partners are both
owners and commanders. Under the corporate form, both the managers
and the stockholders are commanders in that each maintains some
control over resources. (Managers control the enterprise resources, and
stockholders control returns on investment emerging from the enterprise.)
A commander theorist would argue that the notion of control is broad
enough to encompass all relevant parties to the exclusion of none. The
function of accounting, then, takes on an element of stewardship, and the
question of where resource increments flow is not relevant. Rather, the
relevant factor is how the commander allocates resources to the benefit of
all parties. Responsibility accounting is consistent with the commander
theory. Responsibility accounting identifies the revenues and costs that
are under the control of various commanders within the organization,
and the organizations financial statements are constructed to highlight
the contributions of each level of control to enterprise profits. The
commander theory is not on the surface a radical move from current
accounting practices, and it has generated little reaction in accounting

Under the enterprise theory, business units, most notably those listed on
national or regional stock exchanges, are viewed as social institutions,
composed of capital contributors having a common purpose or purposes
and, to a certain extent, roles of common action. Management within
this framework essentially maintains an arms-length relationship with
owners and has as its primary responsibilities (1) the distribution of
adequate dividends and (2) the maintenance of friendly terms with
employees, consumers, and government units. Because this theory
applies only to large nationally or regionally traded issues, it is generally
considered to have only a minor impact on accounting theory, or the
development of accounting principles and practices.


Residual equity
Residual equity is defined as the equitable interest in organizations
assets which will absorb the effect upon those assets of any economic
event that no interested party has specifically agreed to. Here, the
common shareholders hold the residual equity in the enterprise by virtue of
having the final claim on income, yet they are the first to be charged for

losses. The residual equity holders are vital to the firms existence in that
they are the highest risk takers and provide a substantial volume of capital
during the firms developmental stage.
The residual equity theory is formulated as
assets specific equities = residual equities
Under this approach, the residual of assets, net of the claim of specific
equity holders (creditors and preferred stockholders), accrue to residual
owners. In this framework, the role of financial reporting is to provide
prospective and current residual owners with information regarding
enterprise resource flows so that they can assess the value of their residual
claim. Management is in effect a trustee responsible for maximizing the
wealth of residual equity holders. Income accrues to the residual owners
after the claims of specific equity holders are met. Thus, the income to
specific equity holders, including interest on debt and dividends to
preferred stockholders, would be deducted in arriving at residual net
income. This theory is consistent with models that are formulated in the
finance literature, with current financial statement presentation of earnings
per share, and with the Conceptual Frameworks emphasis on the
relevance of projecting cash flows. Again, as with the fund, commander,
and enterprise theories, the residual equity approach has gained little
attention in financial accounting.

What is mandatorily redeemable preferred stock and how is it accounted for under the
provisions of SFAS No. 150 (FASB ASC 480-10)?
Redemption provisions on preferred stock are common features of
agreements entered into among the owners of closely held businesses. These
agreements, which are often referred to as shareholders or buysell
agreements, provide for the orderly disposition of the owners investment in
the company upon their separation from the company, usually at retirement,
disability, or death. Because there is no market for the equity securities of a
closely held company, departing owners or their heirs must rely on the
company or the remaining owners to provide them with liquidity. Redemption
by the company is usually favored over requiring the remaining owners to
fund a buyout because the remaining owners may not have the necessary
financial resources. Prior to the guidance contained at FASB ASC 480 owners
equity that was redeemable pursuant to a buysell agreement was accounted
for as equity, not debt, and the existence and significant terms of the buysell
agreement are required to be described in the notes to financial statements.
In 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial
Instruments with Characteristics of Both Liabilities and Equity, (See FASB

ASC 480). This guidance requires companies to record and report mandatorily
redeemable preferred stock (MRPS) as a liability on their balance sheets, and
the dividends on these securities as interest expense. Most companies
previously disclosed MRPS between the liability and stockholders equity
sections (i.e., the mezzanine section) of the balance sheet.

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

Several advantages accrue to the corporate form and help explain its
emergence. Among these are:
1. Limited liability. A stockholders loss on his or her investment is limited
to the amount of the amount invested (unless on the date of acquisition,
the purchase price of the shares acquired was less than their par value).
Creditors may not look to the assets of individual owners for debt
repayments in the event of a liquidation, as is possible in the case of sole
proprietorships and partnerships.
2. Continuity. The corporations life is not affected by the death or
resignation of owners.
3. Investment liquidity. Corporate shares may be freely exchanged on the
open market. Many shares are listed on national security exchanges,
thereby improving their marketability.
4. Variety of ownership interest. Shares of corporate stock usually contain
four basic rights: the right to vote for members of the board of directors of
the corporation and thereby participate in management, the right to
receive dividends, the right to receive assets on the liquidation of the
corporation, and the preemptive right to purchase additional shares in the
same proportion to current ownership interest if new issues of stock are
marketed. Shareholders may sacrifice any or all of these rights in return
for special privileges. This results in an additional class of stock termed
preferred stock, which may have either or both of the following features:
a. Preference as to dividends.
b. Preference as to assets in liquidation.


Discuss the components of a corporations balance sheet capital section.

The components of a corporations capital section are classified by source in
the following manner:


Paid-in capital (contributed capital)

A. Legal capital-par, stated value, or entire proceeds if no par or stated
value accompanies the stock issue
B. Additional paid-in capitalamounts received in excess of par or
stated value


Earned capital



III. Other comprehensive income


Discuss the following special features of preferred stock:

A conversion feature allows preferred shareholders to exchange their shares for common
shares. It is included on a preferred stock issue to make it more attractive to potential
investors. Usually, a conversion feature is attached to allow the corporation to sell its
preferred shares at a relatively lower dividend rate than is found on other securities with the
same degree of risk. The conversion rate is normally set above the current relationship of the
market value of the common share to the market value of the preferred convertible shares.


Call provisions allow the corporation to reacquire preferred stock at
some predetermined amount. Corporations include call provisions on
securities because of uncertain future conditions. Current conditions
dictate the return on investment that will be attractive to potential
investors, but conditions may change so that the corporation may offer a
lower return on investment in the future. In addition, market conditions
may make it necessary to promise a certain debtequity relationship at
the time of issue. Call provisions allow the corporation to take advantage
of future favorable conditions and indicate how the securities may be
retired. The existence of a call price tends to set an upper limit on the
market price of nonconvertible securities, since investors will not
normally be inclined to purchase shares that could be recalled
momentarily at a lower price.


Preferred shareholders normally have a preference as to dividends. That
is, no common dividends may be paid in any one year until all required
preferred dividends for that year are paid. Usually, corporations also
include added protection for preferred shareholders in the form of a
cumulative provision. This provision states that if all or any part of the
stated preferred dividend is not paid in any one year, the unpaid portion
accumulates and must be paid in subsequent years before any dividend
can be paid on common stock. Any unpaid dividend on cumulative
preferred stock constitutes a dividend in arrears and should be disclosed
in the notes to the financial statements, even though it is not a liability
until the board of directors of the corporation actually declares it.
Dividends in arrears are important in predicting future cash flows and as
an indicator of financial flexibility and liquidity.


Participating provisions allow preferred stockholders to share dividends in
excess of normal returns with common stockholders. For example, a
participating provision might indicate that preferred shares are to
participate in dividends on a 1:1 basis with common stock on all
dividends in excess of $5 per share. This provision requires that any
payments of more than $5 per share to the common stockholder also be
made on a dollar-for-dollar basis to each share of preferred.


A redemption provision indicates that the shareholder may exchange
preferred stock for cash in the future. The redemption provision may
include a mandatory maturity date or may specify a redemption price. If
so, the financial instrument embodies an obligation to transfer assets,
and would meet the definition of a liability, rather than equity. The SEC
requires separate disclosure of manditorily redeemable preferred shares
because of their separate nature. FASB ASC 480-10-50-4 requires that a
manditorily redeemable financial instrument be classified as a liability
unless redemption is required to occur only upon the liquidation or
termination of the issuing company.


How did SFAS No. 123R change accounting for stock options?
SFAS 123R ( FASB ASC 718), requires companies issuing stock options to
estimate the compensation expense arising from the granting of stock
options by using a fair value method and to disclose this estimated
compensation expense on their income statements. This treatment differs
from the previous requirement to estimate compensation expense on the
date of the grant as the difference between the option price and the market


Define and discuss accounting for stock warrants.

Stock warrants are certificates that allow holders to acquire shares of stock at
certain prices within stated periods. These certificates are generally issued
under one of two conditions:
1. As evidence of the preemptive right of current shareholders to purchase
additional shares of common stock from new stock issues in proportion to
their current ownership percentage.

2. As an inducement originally attached to debt or preferred shares to

increase the marketability of these securities.

Under current practice, the accounting for the preemptive right of existing
shareholders creates no particular problem. These warrants are recorded only
as memoranda in the formal accounting records. In the event warrants of this
type are exercised, the value of the shares of stock issued is measured at the
amount of cash exchanged.
Detachable warrants attached to other securities require a separate valuation because they may be
traded on the open market. The amount to be attributed to these types of warrants depends on
their value in the securities market. Their value is measured by determining the percentage
relationship of the price of the warrant to the total market price of the security and warrant, and
applying this percentage to the proceeds of the security issue. This procedure should be followed
whether the warrants are associated with bonds or with preferred stock.

Discuss the difference between a stock dividend and a stock split. Include in your
discussion, the reasons a company might issue either a stock dividend or a stock split.
Corporations may have accumulated earnings but not have the funds
available to distribute these earnings as cash dividends to stockholders. In
such cases, the company may elect to distribute some of its own shares of
stock as dividends to current stockholders. Distributions of this type are
termed stock dividends. When stock dividends are minor, relative to the total
number of shares outstanding, retained earnings is reduced by the market
value of the shares distributed. Capital stock and additional paid-in capital
are increased by the par value of the shares and any excess, respectively. In
theory, a relatively small stock dividend will not adversely affect the
previously established market value of the stock. The rationale behind stock
dividend distributions is that the stockholders will receive additional shares
with the same value per share as those previously held. Nevertheless, stock
dividends are not income to the recipients. They represent no distribution of
corporate assets to the owners and are simply a reclassification of ownership
A procedure somewhat similar to stock dividends, but with a different
purpose, is a stock split. The most economical method of purchasing and
selling stock in the stock market is in blocks of 100 shares, and this practice
affects the marketability of the stock. The higher the price of an individual
share of stock, the fewer are the number of people able to purchase the stock
in blocks of 100. For this reason, many corporations seek to maintain the
price of their stock within certain ranges. When the price climbs above that
range, the firm may decide to issue additional shares to all existing
stockholders (or split the stock). In a stock split, each stockholder receives a

stated multiple of the number of shares currently held (usually two or three
for one), which lowers the market price per share. In theory, this lower price
should be equivalent to dividing the current price by the multiple of shares in
the split, but intervening variables in the marketplace frequently affect prices
simultaneously. A stock split does not cause any change in the stockholders
equity section except to increase the number of actual shares outstanding
and reduce the par or stated value per share. No additional values are
assigned to the shares of stock issued in a stock split because no distribution
of assets or reclassification of ownership interests occurs.


Define and discuss the two methods of accounting for treasury stock.
Two methods of accounting for treasury stock are found in current practice:
the cost method and the par value method. Under the cost method, the
presumption is that the shares acquired will be resold, and two events are
assumed: (1) the purchase of the shares by the corporation and (2) the
reissuance to a new stockholder. The reacquired shares are recorded at cost,
and this amount is disclosed as negative stockholders equity by deducting it
from total capital until the shares are resold. Because treasury stock
transactions are transactions with owners, any difference between the
acquisition price and the sales price is generally treated as an adjustment to
paid-in capital (unless sufficient additional paid-in capital is not available to
offset any loss; in such cases retained earnings is charged).
Under the par value method, it is assumed that the corporations relationship with the original
stockholder is ended. The transaction is in substance a retirement; hence, the shares are
considered constructively retired. Therefore, legal capital and additional paid-in capital are
reduced for the original issue price of the reacquired shares. Any difference between the original
issue price and the reacquisition price is treated as an adjustment to additional paid-in capital
(unless a sufficient balance is not available to offset a loss and retained earnings is charged).
The par value of the reacquired shares is disclosed as a deduction from capital stock until the
treasury shares are reissued.

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