Module 17Stockholders’ Equity

Common Stock

A corporation is an entity that is legally separate from its owners. When a corporation is formed, it issues capital stock to the owners. Stockholders have limited liability, and ownership in a corporation is readily transferable.

Corporations can have two basic types of stockholders. Common stockholders have the right to do the following: Vote in the election of directors and establish some company policies, Maintain a proportionate interest in the corporation by purchasing additional stock

(called the preemptive right), Share in profits when dividends are declared, Share in distribution of assets when the company is liquidated. Thus, of stockholders, common stockholders have the greater risk associated with a company but also enjoy the greater benefits if the company is successful.

Preferred stockholders have some other privileges (discussed later) but in exchange are usually granted only some of the rights that common stockholders have.

Some terms used in the balance sheet related to common stock include the following: Number of authorized shares refers to the total number of shares that a corporation

may issue as stated in its corporate charter. Number of shares issued refers to the total number of shares that a corporation has

actually issued. This cannot be more than the number of authorized shares. Number of shares outstanding refers to the number of shares issued that

stockholders still hold. This number is obtained by subtracting the number of shares repurchased by the corporation that it still holds (called treasury stock) from the number of shares issued.

Thus, the number of shares authorized is the highest, and the number of shares outstanding is the lowest of the three numbers listed.

Issuance of Common Stock

Par value is the dollar amount per share established by a corporation’s articles of incorporation. Par value has some legal significance and is also referred to as legal capital. Par value has no relation to the market value of common stock. Some companies have no par value. In such instances, stated value (established by the board of directors) is used for accounting purposes. Stated value is treated similarly to par value.

When companies issue stock, the cash (or other assets and/or benefits) received is usually more than the par value. That is, the market value per share sold is higher than par value. The difference between the value of assets or benefits received by the company and the par value is recorded in the account Additional Paid-in Capital, also called Paid-in Capital in Excess of Par.

ExampleAdams Company issued 100 shares of $2 par common stock for $10 each. Prepare the journal entry for the transaction.Account Debit CreditCash (step 1) 1,000 Common Stock (step 2) 200 Additional Paid-in Capital (step 3) 800Note the following:1. Since the company issued 100 shares for $10 each, the cash received is $1,000.2. Since the par value per share is $2 and 100 shares have been issued, the Common Stock account is credited for $200.3. The “plug” number to make debits equal credits is $800, the amount of the credit to Additional Paid-in Capital.

Capital stock also can be issued for consideration other than cash. For example, a company might receive property (such as land or a building) and in return offer common stock. Companies also can offer to pay for services obtained from others (such as a lawyer or business consultant) in the form of common stock. In such transactions, the fair market value of the stock or the fair market value of the property or services received, whichever can be more objectively determined, is used as the amount of the transaction.

ExampleBall Company obtained land with a market value of $50,000 and in return issued 2,000 shares of $10 par common stock. The journal entry for the transaction follows: Account Debit CreditLand (step 1) 50,000 Common Stock (step 2) 20,000 Additional Paid-in Capital (step 3) 30,000Note the following:1. The Land account is debited for the market value of the acquired property. 2. The Common Stock account is credited for the shares issued, at par value.3. The difference (plug number) is credited to the Additional Paid-in Capital account.

ExampleCharles Company obtained a building and in return issued 1,000 shares of $10 par value common stock. The market price of the common stock was $40 per share. The journal entry for the transaction follows: Account Debit CreditBuilding (step 1) 40,000 Common Stock (step 2) 10,000 Additional Paid-in Capital (step 3) 30,000Note the following:1. The building’s market value is not known, but the market value of the stock is known. Since the market value of the asset acquired must equal the market value of stock given, the market value for the building must be $40,000 ($40 per share times 1,000 shares). 2. The Common Stock account is credited for the shares issued at par value.3. The difference (plug number) is credited to the Additional Paid-in Capital account.

Treasury Stock

Corporations can decide to buy back their stock for a variety of reasons. For example, a corporation might believe that its stock is undervalued and decide to increase demand by buying back some of it. If supply is relatively unchanged and demand increases, the market price of the stock will increase. Alternatively, a corporation might have a significant amount of cash and decide that the best use of cash (that is, the best return on investment) is to buy back its own stock. Other reasons for buying treasury stock include (1) having enough stock to issue for stock option plans and (2) making hostile takeover attempts more difficult.

Treasury stock is not considered an asset but a contra-equity. Thus, if Corporation X buys stock of Corporation Y, the investment will be shown on the balance sheet of Corporation X. However, if Corporation X were to buy back its own stock, it is shown as a reduction from stockholders’ equity, not as an asset on the balance sheet.

Two methods are used to account for treasury stock transactions: the cost method and the par value method. The cost method is widely used, and the par value method is used in practice only rarely. Hence, we focus only on the cost method.

Note that the cost method recognizes no gains or losses from treasury stock transactions because treasury stock is not considered an asset. Any differences between the price paid and price received for treasury stock is recorded in Additional Paid-in Capital accounts.

ExampleOn March 1, 2002, Rose Corporation purchased 1,000 shares of treasury stock for $12 per share. It then sold 600 of the treasury shares for $14 per share on June 1, 2002, and the remaining 400 shares for $8 per share on November 1, 2002. The journal entries for the transactions follow: March 1: Purchase 1,000 shares of treasury stock at $12 per share. This is recorded with a credit to Cash and a debit to Treasury Stock.Account Debit CreditTreasury Stock 12,000 Cash 12,000

June 1: Sold 600 shares of treasury stock for $14 per share. Account Debit CreditCash (step 1) 8,400 Treasury Stock (600 @ $12) (step 2) 7,200 Additional Paid-in Capital from Treasury Stock (step 3) 1,200Note the following:1. Cash is debited for the total amount received ($8,400).2. Since the treasury shares were purchased for $12 per share and are carried at cost, the Treasury Stock account is credited based on the cost of the shares sold, or only $7,200 (600 shares at $12 each).3. The difference (plug number) is a credit to Paid-in Capital from Treasury Stock.

November 1: Sold 400 shares of treasury stock for $8 per share.Account Debit Credit

Cash (step 1) 3,200Additional Paid-in Capital from Treasury Stock (step 3) 1,200Additional Paid-in Capital from Common Stock (step 4) 400 Treasury stock (400 @ $12) (step 2) 4,800Note the following:1. Cash is debited for the total amount received ($3,200).2. Since the treasury shares were purchased for $12 per share and are carried at cost, the Treasury Stock account is credited based on the cost of the shares sold, or only $4,800 (400 shares at $12 each).3. When treasury stock is sold for less than cost, first reduce any existing credit balance in the Additional Paid-in Capital account related to treasury stock. 4. If further reductions are needed (to make debits equal credits), record the additional debits in the Additional Paid-in Capital from Common Stock account.

Preferred Stock

Preferred stockholders give up some of the rights of common stockholders but acquire one or more of benefits (preferences). Usually, they have a preference with respect to dividends. That is, a company must pay the applicable dividend to the preferred stockholders first before paying a dividend to common stockholders. In addition, preferred stockholders have priority over common stockholders if the company is liquidated and the stockholders must be repaid their investment.

Corporations need not pay dividends each year. For reasons such as inadequate cash, a company might decide not to pay a dividend in a particular year. When a corporation fails to declare a dividend in any year, dividends continue to accrue to the holders of cumulative preferred stock. That is, the dividends on cumulative preferred stock accumulate even if the corporation declares no dividends. Any dividends not declared (passed) are referred to as dividends in arrears. In contrast, dividends do not accumulate for noncumulative preferred stock.

Preferred stockholders are usually paid a fixed amount. Thus, if a company issues 2,000 shares of 5%, $100 par value preferred stock, the preferred dividend per share each year is $5 (5% of $100). The total preferred dividends paid will be $10,000 ($5 times 2,000 shares).

Sometimes preferred stockholders obtain additional dividends. Participating preferred stock enables the holders to receive, in addition to the normal preferred dividend, any extra dividend available after normal dividends have been paid to preferred and common stockholders.

Convertible preferred stock provides the owner with the option to exchange (that is, convert) the preferred stock into common stock (or some other security) issued by the corporation. The exchange ratio (the number of common shares issued when the preferred stock is converted) is specified in the conversion provisions when the convertible preferred stock is issued. Convertibles are attractive because if the company

does well and the common stock price goes up, the holders of the convertible preferred stock can convert the stock and enjoy the benefits of a common stock. However, if the company is not doing well (and the common stock price is not high), increasing in value the holders of the convertible preferred need not convert; they will continue to receive the preferred dividends.

Callable preferred stock provides the company the right to call (that is, buy back) and cancel the preferred stock in the future. The call provision usually includes a premium (thus, the call price is an amount higher than the issue price).

Redeemable preferred stock provides the stockholder the right to redeem (that is, sell back to the company) the preferred stock in the future. The redemption can be either mandatory (at a specified time) or at the option of the preferred stockholder. The redemption option (especially when it is mandatory) makes redeemable preferred stock somewhat similar to a loan because the company can be forced to repay the proceeds from the stock in the future. The Security and Exchange Commission prohibits mandatory redeemable preferred stock from being included as a part of stockholders’ equity in the balance sheet. (As a result, it is usually shown between the liabilities and stockholders’ equity sections in the “mezzanine” section.

The journal entries when preferred stock is issued are straightforward and are similar to the issuance of common stock. The journal entries for preferred stock dividends are similar to the journal entries required when dividends are declared and paid on common stock and are discussed in detail later.

Conversion of Preferred Stock

When convertible preferred stock is converted, the book value method is used. That is, the market value of the common stock is ignored because gain or loss cannot be recognized on a transaction involving only equity accounts. The journal entries focus only on the book value of the preferred and common stock.

Since the convertible preferred stock no longer exists after conversion, the Preferred Stock account and the associated Additional Paid-in Capital on Preferred Stock account are debited (when equity accounts are reduced, they are debited). Since new common stock is issued upon conversion, the Common Stock account and the associated Additional Paid-in Capital on Common Stock are credited (when equity accounts are increased, they are credited).

ExampleOn January 1, 2001, Kent Company issued 200 shares of $100 par convertible preferred stock at $150 per share. Each share of preferred stock is convertible into four shares of $10 par common stock. On December 31, 2002, all shares of preferred stock were converted. Prepare the journal entry for the conversion.

Account Debit CreditPreferred Stock (step 1) 20,000Additional Paid-in Capital on Preferred Stock (step 2) 10,000

Common Stock (step 3) 8,000 Additional Paid-in Capital on Common Stock (step 4) 22,000Note the following:1. Since each $100 par preferred stock was issued for $150, the additional paid-in capital per preferred share is $50. Thus, the total additional paid-in capital associated with the preferred stock is $10,000 ($50 x 200 shares).2. Each preferred share is convertible into four shares of common stock. Thus, a total of 800 shares of common stock must have been issued upon conversion (200 preferred shares x four common shares per preferred share).3. Par value of common stock is $10. Hence, the credit to the Common Stock account is $8,000 ($10 per share x 800 shares).4. The plug number to make debits equal credits is a credit of $22,000 to the Additional Paid-in Capital on Common Stock account.

What if the plug number in this journal entry is a debit? That is, what if each preferred stock is convertible into 16 shares of common stock? In this case, steps 1 and 2 are the same. However, the total number of common stock issued upon conversion is 3,200 (200 shares of preferred stock x 16 shares of common stock per preferred stock). Thus, step 3 now involves a credit of $32,000 ($10 par value x 3,200 shares of common stock). Hence, to make debits equal credits, $2,000 is debited to the Retained Earnings account.

Calling of Preferred Stock

As with conversion of preferred stock, when a company calls a callable preferred stock, no gain or loss is recognized. As noted previously, the call price is usually higher than the issue price. The difference between the issue price and the call price is recorded as a debit to the Retained Earnings account.

On January 1, 2001, Lomas Company issued 200 shares of $100 par callable preferred stock at $120 per share. On December 31, 2002, it calls all shares of preferred stock for $125 per share. Prepare the journal entry for calling of preferred shares.

Account Debit CreditPreferred Stock (step 1) 20,000Additional Paid-in Capital on Preferred Stock (step 2) 4,000Retained Earnings (step 4) 1,000 Cash (step 3) 25,000Note the following:1. Since 200 shares of preferred stock have been called, the debit to the Preferred Stock account is $20,000 ($100 x 200 shares).2. Since each $100 par preferred stock was issued for $120, the additional paid-in capital per preferred share is $20. Thus, the total additional paid-in capital associated with the preferred stock is $4,000 ($20 x 200 shares).3. Each preferred share is called at $125. Thus, the corporation pays total cash of $25,000 ($125 x 200 preferred shares).4. The plug number to make debits equal credits is a $1,000 debit to the Retained Earnings account.

Sometimes the call price is lower than the issue price. In such cases, the plug number is a credit to the Additional Paid-in Capital account.

Dividends

Dividends may be viewed as a return of equity to a corporation’s owners. Dividends may be paid in cash or property. The board of directors is responsible for issues related to the amount, timing, and types of dividend paid to shareholders.

Three dates are relevant in the context of dividends. The date of declaration is the date the board of directors formally declares that a dividend will be paid to shareholders. The date of record is the future date that the board specifies for identifying those stockholders in the corporation’s records to receive dividends. The date of payment is the date the dividends are actually paid to the shareholders.

The journal entry on the date of declaration of a dividend is as follows:Debit Retained Earnings

Credit Dividend PayableNote that dividends may be declared on both common stock and preferred stock. In such situations, separate credit entries are made for the two types of stock. Thus, the credit entries are to Common Stock Dividend Payable and Preferred Stock Dividend Payable.

No journal entry is required on the date of record.

The journal entry on the date of payment is as follows:Debit Dividend Payable

Credit CashNote that if some property other than cash is given to shareholders, the credit entry is for the appropriate asset. For example, a corporation might have investments in the securities (stocks or bonds) of other entities that it wishes to dispose of through a dividend paid to the shareholders.

Stock Dividends

A stock dividend is the distribution of additional shares to the existing shareholders. Such additional shares are made on a proportional basis. For example, if a company declares a 10% stock dividend, a shareholder currently owning 2,000 shares receives an additional 200 shares (0.10 x 2000).

Because each shareholder still has the same proportional ownership of the company and the shareholder has received no other assets, this is an economic non-event for the shareholder. That is, because a pizza has been cut into 11 slices as opposed to 10 slices does not mean that there is more pizza. Similarly, because a shareholder now has 2,200 shares after the stock dividend as opposed to 2,000 shares before the stock dividend, the shareholder does not have any more (or less) wealth.

The market price per share changes after a stock dividend in the opposite direction. Thus, if a company had 10,000 shares outstanding and the market price was $22 per share, the market value of the company is $220,000. After a 10% stock dividend, 11,000 are shares outstanding. Because nothing else has changed, the overall market value of the company is still $220,000. Hence, the price per share after the stock dividend is $20 ($220,000/11,000 shares).

Accounting for a stock dividend varies depending on its size. If the stock dividend is less than 25%, it is considered a small stock dividend. In such instances, an amount equal to the market value of the new shares issued is transferred from the Retained Earnings account to the Common Stock and the Additional Paid-in Capital (if any) accounts.

If the stock dividend is more than 25%, it is considered a large stock dividend. In such instances, the market value is ignored and the transfer from the Retained Earnings account is at the book value of the shares.

ExampleGreig Company has 10,000 shares of $1 par common stock outstanding. The stock’s market value was $12 per share when the company declared a 10% stock dividend. Prepare the necessary journal entries.

This is considered a small stock dividend because the dividend is less than 25%. The number of new shares issued is 1,000 (10% of 10,000 shares). The market value of the new shares is $12,000 ($12 per share x 1,000 shares). Thus, the journal entries are as follows:(a) When the stock dividend is declared, this journal entry is made:Account Debit CreditRetained Earnings 12,000 Stock Dividends Distributable 1,000 Additional Paid-in Capital on Common Stock 11,000

(b) When the stock dividend is paid, this entry is made:Account Debit CreditStock Dividends Distributable 1,000 Common Stock 1,000

As noted previously, if the stock dividend is more than 25%, it is a large stock dividend, and the Retained Earnings account is debited only by the amount of par value of the new shares issued.

ExampleLewis Company has 10,000 shares of $1 par common stock outstanding. The market value of the stock was $15 per share when the company declared a 30% stock dividend. Prepare the necessary journal entries.

This is considered a large stock dividend because the dividend is more than 25%. The number of new shares issued is 3,000 (10,000 shares x 0.30). The market value is ignored, and only par value is considered. The total debit to Retained Earnings is $3,000 ($1 x 3,000 shares). The journal entries are as follows:(a) When the stock dividend is declared:

Account Debit CreditRetained Earnings 3,000 Stock Dividends Distributable 3,000

(b) When the stock dividend is paid:Account Debit CreditStock Dividends Distributable 3,000 Common Stock 3,000

Note that after a stock dividend (large or small), the total amount of stockholders’ equity does not change. Only the component amounts within stockholders’ equity have changed. Specifically, the Retained Earnings account is reduced but the Common Stock account (and, in the case of small stock dividends, the Additional Paid-in Capital account, if needed) is increased.

Also note that the total number of shares issued and outstanding have increased, but the par value of the stock remains the same as before the dividend.

Stock Splits

If the directors of a corporation believe that the market price per share of its stock is too high, they can order a stock split. A stock split involves increasing the number of shares outstanding with a corresponding decrease in the par value. However, just like a stock dividend, this is a non-event as far as the total value of the company is concerned.

Although the number of shares increases by the split factor (the ratio of new shares to the old shares), the market price per share decreases by exactly the same factor. If a corporation has 1,000 shares of $10 par common stock outstanding and decides to order a two-for-one split when previously there was one share, now there are two shares. However, because nothing else has changed, the price per share decreases exactly by one-half after the split. (Just because a pizza is cut into eight slices as opposed to four slices does not mean that the total amount of pizza available has increased. It means only that the number of pizza slices has doubled.)

Thus, stock splits are quite similar to stock dividends. However, there are some differences. First, unlike a stock dividend, a stock split changes the par value of the stock. The new par value equals the old par value divided by the split factor. For example, if a corporation has 1,000 shares of $10 par common stock and decides to order a two-for-one split, it will have 2,000 shares of $5 par common stock after the split.Second, unlike a stock dividend, a stock split does not involve a journal entry. Only a memorandum entry (changing the number of shares and the par value) is required.

Stock Option Plans

A stock option gives the holder the right, but not the obligation, to purchase stock at some time in the future for a set price. The predetermined price is known as the option price or exercise price. An option is valuable if the stock price is expected to increase.

The date when the options are granted is known as the grant date. The date when the option holder becomes eligible to exercise the option (that is, buy the stock at the exercise price) is known as the vesting date. The date when the option holder actually exercises the option (that is, buys the stock) is known as the exercise date.

ExampleThe current market price of the stock of TechNerd Company is $20 per share. You have the option to buy 100 shares of the company at $20 per share, and the vesting period is three years. You expect the company’s stock price to be $45 three years from now. The option is valuable because three years from now, you can buy 100 shares at $20 each and immediately sell them in the market for $45 each if your expectation is correct.

Options have become important in employee compensation, especially in high-tech industries. Some employees make many times more from their stock options than from their regular salaries.

Stock option plans have two broad categories: noncompensatory and compensatory. The main objective of a noncompensatory stock option plan is to enable widespread employee stock ownership of the company rather than to provide additional benefits for only some employees. Such a plan has the following features: Almost all full-time employees (subject to some requirements) are eligible to

participate in the plan. Employees can purchase the company stock at a discount (usually, between 5 to

15%) from the market price. Employees decide within a certain time period if they want to participate in the plan.

The objective of a compensatory stock option plan is to provide additional compensation to a select group of employees. Accounting for such plans has been the subject of great controversy in recent years and is discussed in detail later.

Two methods are used to measure the value of stock option plans. The intrinsic value method calculates the value of a stock option based on the exercise price and the current market price. Thus, if the current market price is $25 per share and the option exercise price is $20, the intrinsic value per option is $5.

Most companies set the exercise price of the options at the current market price. For example, in the preceding example, TechNerd Company set the exercise price at $20, which was the market price at that time. This means that the intrinsic value of an option is zero.

However, the option is still considered valuable because the company’s stock price is expected to increase in the future. This fact is recognized by the fair value method, which assigns a value to the option based on various factors, such as the expected increase in stock price, the volatility of the stock price, and the amount of dividends expected to be received before the option is exercised. The fair value of options is determined through complex formulas, and the most widely used method uses the Black-Scholes option pricing formula (details of which are usually covered in finance courses).

Fixed Stock Option Plans

The two types of compensatory stock option plans are (1) fixed stock and (2) performance-based stock. For a fixed stock option plan, details such as the number of options given and the exercise price are set at the date the options are granted. In contrast, for a performance-based stock option plan, the exercise price or the number of shares varies depending on the future performance (of the company, or a division, or the individual).

Example of Fixed Stock Option PlanTechZ company has 300 employees, and on January 1, 2002 it adopted a compensatory stock option plan granting each employee the right to purchase 100 shares of $1 par common stock at $20 per share. The vesting period is three years, and the market price on the day the options were granted also was $20. The fair value of each option has been determined using the Black-Scholes method to be $15. Calculate the compensation expense each period.

The total number of options is 30,000 (100 shares x 300 employees). The total value of the options is $450,000 ($15 per option x 30,000 options).Since the vesting period is three years, this total amount is spread over three years, giving $150,000 per year.This is recorded as follows:Account Debit CreditCompensation Expense 150,000 Additional Paid-in Capital, Stock Options 150,000

Assume that after three years all employees exercise their options. This means that the corporation will receive $600,000 from the employees and will issue 30,000 shares of $1 par common stock. Note that the Additional Paid-in Capital, Stock Options account must be eliminated because the options no longer exist, having been converted into stock. However, the Additional Paid-in Capital on Common Stock account must now be credited for the plug number to make debits equal credits. The journal entry follows:Account Debit CreditCash 600,000Additional Paid-in Capital, Stock Options 150,000 Common stock 30,000 Additional Paid-in Capital on Common Stock 720,000

In this example, we assumed that all the employees would remain with the corporation until the options are vested. However, almost all companies experience employee turnover. Hence, companies estimate the number of employees who will stay until the options are vested, and only this estimate is used to calculate compensation expense (and the corresponding journal entry). Furthermore, estimates can change over time, so that the compensation expense can change from period to period even if the number of options or the exercise price remain unchanged. Issues associated with turnover estimates are illustrated later, in Demonstration Problem 3.

Performance-Based Stock Option Plan

For a performance-based stock option plan, the exercise price or the number of shares varies depending on the corporation’s future performance. For example, a company might estimate that the number of options per employee will vary depending on future performance as follows. If the company achieves sales of at least $50 million (but less than $75 million) for

the year ending December 31, 2004, each employee will receive 100 options. If the company achieves sales between $75 million and $100 million for the year

ended December 31, 2004, each employee will receive 125 options. If the company achieves sales more than $100 million for the year ended December

31, 2004, each employee will receive 150 options.

In such instances, the company estimates at the end of the first and second years the expected performance for the third year. (Note that by the end of the third year, the actual performance and the actual number of options granted are also known.) Based on such expectations, the company calculates the number of options to be granted and the related compensation cost. The important thing to remember is that as expectations are updated, there must be a “catch-up” for compensation expense.

Example of Performance-Based Option PlanFor example, assume that at the end of the first year, the company estimated the total expected value of options to be granted to be $240,000. However, at the end of the second year, the company estimates the total expected value of the options to be granted to be $300,000.

At the end of the first year, the relevant value of options to be recognized is one-third of the estimated total value at that time, or $80,000 (one-third of $240,000). Thus, the Compensation Expense account is debited for $80,000 at the end of the first year.

As of the end of the second year, since two-thirds of the plan period has elapsed, the relevant value of options to be recognized is $200,000 (two-thirds of the revised estimate of the total amount of $300,000). Since the company recognized the option value of only $80,000 in the first year, the amount recognized as compensation expense in the second year is $120,000 ($200,000 – $80,000)

Glossary

Authorized Share refers to the total number of shares that a corporation can issue as stated in the corporate charter.

Book value methodCallable preferred stock provides the company the right to call (that is, buy back) and cancel the preferred stock in the future.

Common stockholdersCompensatory stock option plan seeks to provide additional compensation to a select group of employees.

Convertible preferred stock provides the owner the option to exchange (that is, convert) the preferred stock into common stock (or some other security) issued by the corporation.

Corporation is an entity that is legally separate from its owners.

Cost methodCumulative preferred stock accumulates dividends in years when dividends are not declared and will be paid later.

Date of declaration is the date the board of directors formally declares that a dividend will be paid to shareholders.

Date of payment is the date the dividends are actually paid to the shareholders.

Date of record is date on which those listed in the company’s records as stockholders are identified to receive the dividends.

Dividends in arrears are any dividends on cumulative preferred stock not declared (passed).

Exercise date is the date the option holder actually exercises an option to buy stock.

Exercise price is the predetermined price at which an option holder can purchase stock (or any other security or item on which there is an option).

Fair value methodFixed stock option plan is a compensatory stock option plan that specifies details such as the number of options and the exercise price on the date the options are granted.

Grant date is the date when the options are granted.

Intrinsic value methodNoncompensatory stock option plan seeks to have widespread employee stock ownership of the company. Providing additional benefits for only some employees is not the main objective of such a plan.

Noncumulative preferred stock does not accumulate dividends in a period when dividends are not declared.

Participating preferred stock enables the holders to obtain, in addition to the normal preferred dividend, any extra dividend available after the normal dividends have been paid to preferred and common stockholders.

Par value is the dollar amount per share established by the articles of incorporation. Par value has some legal significance and is also referred to as the legal capital.

Performance-based stock option plan is a compensatory stock option plan that has some elements (such as the exercise price or the number of shares) that vary depending on some specified future performance.

Preferred stockholders have some privileges (such as priority with respect to dividends and at liquidation) but in exchange usually do not have the right to vote for the directors.

Redeemable preferred stock provides the stockholder the right to redeem (that is, sell it back to the company) the preferred stock in the future.

Shares issued refers to the total number of shares that a corporation has actually issued.

Shares outstanding refers to the number of shares issued still held by shareholders. This is obtained by subtracting the number of treasury shares from the number of shares issued.

Stated value is established by the board of directors and is used for accounting purposes when there is no par value; treated similarly to par value.

Stock dividend distributes additional shares to the existing shareholders on a proportional basis.

Stock options provide the right, but not the obligation, to purchase stock at some time in the future at a set price.

Stock splits increase the number of shares outstanding with a decrease in the par value.

Treasury stock refers to shares bought back by the company (and not yet reissued or canceled).

Vesting date is the date the option holder becomes eligible to exercise the option (that is, buy the stock at the exercise price).

Demonstration Problem 1Cone Company

Cone Company had the following transactions related to its common stock ($10 par value) during the year ended December 31, 2002. Prepare the journal entries using the cost method.

DateMarch 1 Issued 3,000 shares for $12 per share.May 1 Purchased 1,000 shares for $14 per share.June 1 Sold 500 shares of treasury stock at $16 per share.July 1 Sold an additional 300 shares of treasury stock at $11 per share.August 1 Sold an additional 200 shares of treasury stock at $8 per share.

Solution to Demonstration Problem 1, Cone Company

March 1: Issued 3,000 shares for $12 per share:Account Debit CreditCash 36,000 Common Stock 30,000 Additional Paid-in Capital on Common Stock 6,000

May 1: Purchased 1,000 shares for $14 per share:Account Debit CreditTreasury Stock 14,000 Cash 14,000

June 1: Sold 500 shares of treasury stock for $16 per share:Account Debit CreditCash 8,000 Treasury Stock (500 @ $14) 7,000 Additional Paid-in Capital from Treasury Stock 1,000

July 1: Sold 300 shares of treasury stock for $11 per share:Account Debit CreditCash 3,300Additional Paid-in Capital from Treasury Stock 900 Treasury Stock (300 @ $14) 4,200

August 1: Sold 200 shares of treasury stock for $8 per share:Account Debit CreditCash (step 1) 1,600Additional Paid-in Capital from Treasury Stock (step 3) 100Additional Paid-in Capital on Common Stock (step 4) 1,100 Treasury Stock (200 @ $14) (step 2) 2,800

Demonstration Problem 2Travis Company

The stockholders’ equity section of the balance sheet of Travis Company had the following information as of January 1, 2002:

Common stock, $1 par, 200,000 shares issued and outstanding $ 200,000Paid-in capital in excess of par 800,000Retained earnings 3,000,000

During the year, the following transactions took place:March 1 Declared and distributed a 10% stock dividend.June 1 Effected a two-for-one stock split.October 1 Declared and distributed a 30% stock dividend.December 31 Declared cash dividend of $1 per share, payable February 1, 2003.The market price of Travis Company’s stock was $20 on March 1, $30 on June 1, $22 on October 1, and $24 on December 31 (effective before that day’s transaction noted).Prepare the required journal entries.

Solution to Demonstration Problem 2, Travis Company

March 1: Declared and distributed 10% stock dividend.The number of shares outstanding as of March 1 is 200,000.The number of new shares issued for stock dividend is 20,000 (200,000 x 0.10).This is a small stock dividend, so the Retained Earnings account is debited by market price ($20 per share) times the number of new shares issued.Since the shares were issued the same day, Common Stock is credited (for par value).The entry Additional Paid-in Capital is for the plug number to make debits equal credits.The total number of shares of common stock ($1 par) after the stock dividend is 220,000.

Account Debit CreditRetained Earnings (step 1) 400,000 Common Stock (step 2) 20,000 Additional Paid-in Capital on Common Stock (step 3) 380,000

June 1: Effected a two-for-one stock split.No journal entry is made, but a memorandum is recorded.The number of shares issued and outstanding doubles to 440,000, and the new par value is $0.50 per share.

October 1: Declared and distributed 30% stock dividend.Number of shares outstanding as of October 1 is 440,000.Number of new shares issued for stock dividend is 132,000 (440,000 x 0.30)This is a large stock dividend, so Retained Earnings is debited by par value times the number of new shares issued, $66,000 ($0.50 x 132,000).The total number of shares of common stock ($1 par) after the stock dividend is 572,000.

Account Debit CreditRetained Earnings 66,000 Common Stock 66,000

December 31: Declared cash dividend of $1 per share, payable February 1, 2003.Account Debit CreditRetained Earnings 572,000 Dividend Payable 572,000

Demonstration Problem 3ZZNET Company

ZZNET company has 200 employees, and on January 1, 2002, adopted a performance- based stock option plan. The company will grant each employee the right to purchase its $1 par common stock at $15 per share. The fair value of each option has been determined to be $12, but the number of options per employee will vary depending on the company’s future performance as follows:

If Fiscal Year 2004 Sales Is Then Number of Options per EmployeeLess than $200 million 100

Between $200 million and $250 million 150More than $250 million 200

The company’s estimates (and actual results) related to fiscal 2004 sales were as follows: On December 31, 2002, the company estimated that fiscal year 2004 sales would be

$180 million. The company revised its estimate on December 31, 2003, to $220 million. Actual sales for fiscal year 2004 were $260 million. The company initially estimated that as of December 31, 2004, 190 employees would still be with the company but revised its estimate on December 31, 2003, to only 180 of the eligible employees. On December 31, 2004, only 175 of the eligible employees were still working with the company.Calculate the compensation expense each period.

Solution to Demonstration Problem 3, ZZNET Company

1. As of December 31, 2002, the estimated number of options to be granted is 100 per employee because the estimated fiscal 2004 sales revenue is $180 million. Only 190 employees are expected to be with the company, so total options expected to be granted equal 19,000 (100 options x 190 employees).2. The fair value of each option is $12.3. The total cost of options expected to be granted is $228,000 ($12 x 19,000 options).4. As of December 31, 2002, only one-third of the vesting period had expired.5. Total estimated compensation cost to date is $76,000 ($228,000 x 0.33).6. No compensation expense had been recognized in prior periods (because 2002 is the first year).7. Hence, current period compensation expense is $76,000.Repeat these calculations for the other two years as shown here:

2002 2003 2004Estimated number of eligible employees 190 180 175Estimated number of options per employee 100 150 200Estimated total number of options to be granted 19,000 27,000 35,000Fair value of each option $12 $12 $12Estimated total compensation cost $228,000 $324,000 $420,000Fraction of period 1/3 2/3 3/3Estimated compensation cost to date $76,000 $216,000 $420,000Compensation expense recognized in prior periods $0 $76,000 $216,000Current period compensation expense $75,000 $140,000 $204,000

Calculations for year ending December 31, 2003:1. As of December 31, 2003, the estimated number of options to be granted is 150 per employee because estimated sales for fiscal 2004 total $220 million. Only 180 employees are expected to be with the company, so total options expected to be granted are 27,000 (150 x 180 employees).2. The fair value of each option x $12.3. The total cost of options expected to be granted is $324,000 ($12 x 27,000 options).4. As of December 31, 2002, two-thirds of the vesting period have expired.5. Total estimated compensation cost to date is $216,000 ($324,000 x 0.66).6. Total compensation expense recognized in prior periods is $76,000.7. Current period compensation expense totals $140,000 ($216,000 – $76,000).

Complete the table for 2004. Note that 200 options will be issued per employee for the 175 eligible employees because the actual sales for 2004 were $260 million. Also note that the total compensation expense recognized in prior periods is $216,000 ($76,000 in 2002 and $140,000 in 2003), so current compensation expense in 2004 is $204,000.

Practice Problem 1Hill Company

Hill Company had the following transactions related to its common stock ($1 par value) during the year ended December 31, 2002. Prepare the journal entries using the cost method.

DateFebruary 1 Issued 5,000 shares for $9 per share.April 1 Purchased 2,000 shares for $10 per share.June 1 Sold 1,000 shares of treasury stock at $11 per share.August 1 Sold an additional 400 shares of treasury stock at $9 per share.December 1 Sold an additional 500 shares of treasury stock at $8 per share.

Solution to Practice Problem 1, Hill Company

February 1: Issued 5,000 shares for $9 per share:Account Debit CreditCash 45,000 Common Stock 5,000 Additional Paid-in Capital on Common Stock 40,000

April 1: Purchased 2,000 shares for $10 per share:Account Debit CreditTreasury Stock 20,000 Cash 20,000

June 1: Sold 1,000 shares of treasury stock for $11 per share:Account Debit CreditCash 11,000 Treasury Stock (1,000 @ $10) 10,000 Additional Paid-in Capital from Treasury Stock 1,000

August 1: Sold 400 shares of treasury stock for $9 per share:Account Debit CreditCash 3,600Additional Paid-in Capital from Treasury Stock 400 Treasury stock (400 @ $10) 4,000

December 31: Sold 500 shares of treasury stock for $8 per share:Account Debit CreditCash (step 1) 4,000Additional Paid-in Capital from Treasury Stock (step3) 600Additional Paid-in Capital on Common Stock (step 4) 400 Treasury stock (500 @ $10) (step 2) 5,000

Practice Problem 2Conway Company

The stockholders’ equity section of the balance sheet of Conway Company had the following information as of January 1, 2002:

Common stock, $1 par, 100,000 shares issued and outstanding $ 100,000Paid-in capital in excess of par 900,000Retained earnings 7,000,000

During the year, the following transactions took place:April 1 Declared and distributed a 5% stock dividend.July 1 Effected a two-for-one stock split.December 31 Declared cash dividend of $1.50 per share, payable February 15, 2003.The market price of Conway Company’s stock was $16 on April 1, $24 on July 1, and $14 on December 31 (effective before that day’s transaction noted).Prepare the following:a. The required journal entries.b. The stockholders’ equity section of the balance sheet as of December 31, 2002,

if the net income for the year ended December 31, 2002, was $2,000,000.

Solution to Practice Problem 2, Conway Company

April 1: Journal entriesDeclared and distributed 5% stock dividend.The number of shares outstanding as of March 1 is 100,000.The number of new shares issued for stock dividend is 5,000 (100,000 x 0.05).This is a small stock dividend, so Retained Earnings is debited for the market price ($16 per share) times the number of new shares issued.The total number of shares of common stock ($1 par) after the stock dividend is 105,000.

Account Debit CreditRetained Earnings 80,000 Common Stock 5,000 Additional Paid-in Capital on Common Stock 75,000

July 1: Effected a two-for-one stock split.No journal entry is made, but a memorandum is recorded.The number of shares issued and outstanding doubles to 210,000, and the new par value is be $0.50 per share.

December 31: Declared cash dividend of $1.50 per share, payable February 15, 2003.Account Debit CreditRetained Earnings 315,000 Dividend Payable 315,000

Stockholders’ equity section of balance sheet

Common stock, $0.50 par, 210,000 shares issued and outstanding $ 105,000Additional paid-in capital on common stock 975,000Retained earnings 8,605,000Total stockholders’ equity $ 9,685,000

Note:Ending retained earnings = $7,000,000 – $80,000 – $315,000 + $2,000,000

= $8,605,000

Practice Problem 3XTEK Company

XTEK company has 150 employees, and on January 1, 2002, adopted a performance- based stock option plan. The company will grant each employee the right to purchase its $1 par common stock at $20 per share. The number of options per employee will vary depending on the company’s future performance as follows:

If Fiscal Year 2004 Sales Is Number of Options per Employee Less than $25 million 100

Between $25 million and $30 million 120More than $30 million 140

The company’s estimates (and actual results) related to fiscal 2004 sales were as follows: On December 31, 2002, the company estimated that fiscal year 2004 sales would be

$23 million. The company revised its estimate on December 31, 2003, to $27 million. Actual sales for fiscal year 2004 were $31 million. The fair value of each option has been determined to be $15 using the Black-Scholes method. Calculate the compensation expense each period.

Solution to Practice Problem 3, XTEK Company

1. As of December 31, 2002, the estimated number of options to be granted is 100 per employee because estimated sales for fiscal 2004 is only $23 million, so total options expected to be granted equal 15,000 (100 options for 150 employees).2. The fair value of each option is $15.3. The total cost of options expected to be granted is $225,000 ($15 x 15,000 options).4. As of December 31, 2002, only one-third of the vesting period had expired.5. Total estimated compensation cost to date is $75,000 ($225,000 x 0.33).6. No compensation expense has been recognized in prior periods (because 2002 is the first year).7. Hence, current period compensation expense is $75,000.Repeat these calculations, for the other two years, as shown here.

2002 2003 2004Estimated total number of options to be granted 15,000 18,000 21,000Fair value of each option $15 $15 15Estimated total compensation cost $225,000 $270,000 $315,000Fraction of period 1/3 2/3 3/3Estimated compensation cost to date $75,000 $180,000 $315,000Compensation expense recognized in prior periods $0 $75,000 $180,000Current period compensation expense $75,000 $105,000 $135,000

Calculations for year ending December 31, 2003:1. As of December 31, 2003, the estimated number of options to be granted is 120 per employee because estimated sales for fiscal 2004 is $27 million. Thus, total options expected to be granted are 18,000 (120 options x 150 employees).2. The fair value of each option is $15.3. The total cost of options expected to be granted is $270,000 ($15 x 18,000 options).4. As of December 31, 2002, two-thirds of the vesting period have expired.5. Total estimated compensation cost to date is $180,000 ($270,000 x 0.66).6. Total compensation expense recognized in prior periods is $75,000.7. Current period compensation expense totals $105,000 ($180,000 – $75,000).

Complete the table for 2004. Note that 140 options will be issued per employee because the actual sales for 2004 were $31 million. Also note that the total compensation expense recognized in prior periods is $180,000 ($75,000 in 2002 and $105,000 in 2003).

Practice Problem 4

1. Dividends in arrears arises only with respect toa. cumulative preferred stock.b. noncumulative preferred stock.c. callable preferred stock.d. convertible preferred stock.

2. Stock for which the issuer has the right to buy back and cancel the preferred stock at any time is calleda. cumulative preferred stock.b. noncumulative preferred stock.c. callable preferred stock.d. convertible preferred stock.

3. Requirements of the Securities and Exchange Commission prohibit the following from being included in the stockholders’ equity section of the balance sheet:a. cumulative preferred stock.b. mandatory redeemable preferred stock.c. callable preferred stock.d. convertible preferred stock.

4. When a small stock dividend is declared, the procedure is toa. debit Retained Earnings based on the stock’s par value. b. credit Retained Earnings based on the stock’s market value.c. debit Retained Earnings based on the stock’s market value. d. make no journal entry.

5. When a stock split is declared, the procedure is toa. debit Retained Earnings based on the stock’s par value. b. credit Retained Earnings based on the stock’s market value.c. debit Retained Earnings based on the stock’s market value.d. make no journal entry.

6. George Company declared and paid cash dividends of $3 per share on its common stock. No journal entry is recorded on thea. date of declaration.b. date of record.c. date of payment.d. date of declaration and date of record.

7. Which of the following leads to a decrease in the par value of common stock?a. both stock dividend and stock split.

b. stock dividend but not stock split.c. stock split but not stock dividend.d. neither stock split nor stock dividend.

8. When treasury stock is reissued for cash,a. both gains and losses related to the resale can be recorded.b. only losses related to the resale can be recorded,c. only gains related to the resale can be recorded.d. neither gains nor losses related to the resale can be recorded.

Homework Problem 1Webb Company

Webb Company had the following transactions related to its common stock ($1 par value) during the year ended December 31, 2002. Prepare the journal entries using the cost method.

DateMarch 1 Issued 6,000 shares for $12 per share.June 1 Purchased 2,000 shares for $14 per share.July 1 Sold 1,000 shares of treasury stock at $15 per share.September 1 Sold an additional 600 shares of treasury stock at $10 per share.December 1 Sold an additional 200 shares of treasury stock at $8 per share.

Solution to Homework Problem 1, Webb Company

February 1: Issued 6,000 shares for $12 per share:Account Debit CreditCash 72,000 Common Stock 6,000 Additional Paid-in Capital on Common Stock 66,000

April 1: Purchased 2,000 shares for $14 per share:Account Debit CreditTreasury Stock 28,000 Cash 28,000

June 1: Sold 1,000 shares of treasury stock for $15 per share:Account Debit CreditCash 15,000 Treasury Stock (1,000 @ $14) 14,000 Additional Paid-in Capital from Treasury Stock 1,000

August 1: Sold 600 shares of treasury stock for $10 per share:Account Debit CreditCash 6,000Additional Paid-in Capital from Treasury Stock 1,000Additional Paid-in Capital on Common Stock 1,400 Treasury Stock (600 @ $14) 8,400

December 1: Sold 200 shares of treasury stock for $8 per share:Account Debit CreditCash 1,600Additional Paid-in Capital on Common Stock 1,200 Treasury Stock (200 @ $14) 2,800

Homework Problem 2Weston Company

The stockholders’ equity section of the balance sheet of Weston Company had the following information as of January 1, 2002:

Common stock, $10 par, 50,000 shares issued and outstanding $ 500,000Paid-in capital in excess of par 2,500,000Retained earnings 9,000,000

During the year, the following transactions took place:February 1 Effected a two-for-one stock split.July 1 Declared and distributed a 15% stock dividend.December 31 Declared cash dividend of $2 per share, payable February 1, 2003.The market price of Travis Company’s stock was $30 on February 1, $18 on July 1, and $21 on December 31 (effective before that day’s transaction noted).Prepare the required journal entries.

Solution to Homework Problem 2, Weston Company

February 1: Effected a two-for-one stock split.No journal entry is made, but a memorandum is recorded.After the split, there are 100,000 shares of $5 par common stock.

July 1: Declared and distributed 15% stock dividend.The number of shares outstanding before the stock dividend is 100,000.The number of new shares issued for stock dividend is 15,000 (15% of 100,000).This is a small stock dividend, so Retained Earnings is debited for the market price ($18 per share) times the number of new shares issued.Total number of shares of common stock ($5 par) after the stock dividend is 115,000.

Account Debit CreditRetained Earnings 270,000 Common Stock 75,000 Additional Paid-in Capital on Common Stock 195,000

December 31: Declared cash dividend of $2 per share, payable February 1, 2003.Account Debit CreditRetained Earnings 230,000 Dividend Payable 230,000

Homework Problem 3DOTDOT Company

DOTDOT company has 60 employees, and on January 1, 2002, adopted a performance- based stock option plan. The company will grant each employee the right to purchase its $1 par common stock at $5 per share. The fair value of each option has been determined to be $10. The number of options per employee will vary depending on the company’s future performance as follows:

If Fiscal Year 2004 Sales Is Number of Options per EmployeeLess than $100 million 150

Between $100 million and $125 million 180More than $125 million 200

The company’s estimates (and actual results) related to fiscal 2004 sales were as follows: On December 31, 2002, the company estimated that fiscal year 2004 sales would be

$80 million. The company revised its estimate on December 31, 2003, to $110 million. Actual sales for fiscal year 2004 were $145 million. Calculate the compensation expense each period.

Solution to Homework Problem 3, DOTDOT Company

2002 2003 2004Estimated number of options per employee 150 180 200Estimated total number of options to be granted 9,000 10,800 12,000Fair value of each option $10 $10 $10Estimated total compensation cost $90,000 $108,000 $120,000Fraction of period 1/3 2/3 3/3Estimated compensation cost to date $30,000 $72,000 $120,000Compensation expense recognized in prior periods $0 $30,000 $72,000Current period compensation expense $30,000 $42,000 $48,000

Homework Problem 4

1. Preferred stockholders do not have preferences with respect to a. dividends.b. liquidation distributions.c. voting for directors.d. all of the above.

2. When preferred stock is converted into common stock,a. both gains and losses related to conversion can be recorded.b. only losses related to conversion can be recorded.c. only gains related to conversion can be recorded.d. neither gains nor losses related to conversion can be recorded.

3. The date when the option holder becomes eligible to buy the stock at the exercise price is known as thea. grant date.b. vesting date.c. exercise date.d. measurement date.

4. When a large stock dividend is declared, the procedure is toa. debit Retained Earnings based on par value of the stock.b. credit Retained Earnings based on the stock’s market value.c. debit Retained Earnings based on the stock’s market value.d. make no journal entry.

5. Dividends are paid to stockholders as of thea. date of declaration.b. date of journal entry.c. date of record.d. date of payment.

6. Thomas Company declared and paid cash dividends of $2 per share on its common stock. The Retained Earnings account must be reduced on thea. date of declarationb. date of journal entryc. date of recordd. date of payment

7. Which of the following leads to an increase in stockholders’ equity?a. both stock dividend and stock split.b. stock dividend but not stock split.c. stock split but not stock dividend.d. neither stock split nor stock dividend.

8. Adams Company issued 1,000 shares of its $5 par common stock and in return obtained land with a market value of $20,000 from Quincy Company. Adams Company records this transaction with aa. debit to Additional Paid-in Capital of $15,000.b. debit to Additional Paid-in Capital of $5,000..c. credit to Additional Paid-in Capital of $ 5,000.d. credit to Additional Paid-in Capital of $15,000.