13

Equity Financing
Overview
After discussing debt financing in Chapter 12, we now turn to the other kind of financing
available to businessesequity 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 isnt 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 doesnt 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 isnt 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 (usually) is
one of several means by which the Retained Earnings account is adjusted.

13-2

Chapter 13

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 dont 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

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 dont 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 dont want their stake in the
business to be diminished. At the same time, the existing common stockholders dont
want, or dont 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 a
liquidation. As mentioned on page 13-1, with the reduced risk can also come a reduced
reward for the preferred shareholders. When the company performs well, or is expected
to perform well, preferred shareholders dont receive the kinds of returns that common
stockholders do. They also dont 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).

Chapter 13

13-3

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 dont 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.

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.

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 total
of three credits (Paid-In Capital in Excess of Par Value, Additional Paid-In Capital, and
Stock Warrant).

13-4

Chapter 13

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 wasnt 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 arent
exercised, the expense associated with the granting of them is never reversed or taken
off of the books.

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).

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.

Chapter 13

13-5

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).

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 item dividended to shareholders
receives a credit.

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.

LO11 Prepare a statement of changes in stockholders equity.

13-6

Chapter 13

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 solutioneven if I dont 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 toolkita 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 directors
b. the right to maintain ones 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.

Chapter 13

13-7

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, 2011, 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, 2013, 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, 2011?
a. $420,000
b. $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 options
b. 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 depreciation
b. 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

13-8

Chapter 13

MC13-9 (LO9) Kearney Company declared a cash dividend on its common stock in
December 2010, payable in January 2011. 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, 2011 (all items are net of income taxes):
Income from continuing operations
Income (loss) from discontinued operations
Unrealized gain (loss) on available-for-sale securities
(Increase) Decrease in minimum pension liability
Unrealized gain (loss) on derivative instruments
Foreign currency translation adjustment, increase
(decrease) in stockholders' equity

$1,300
(200)
30
(72)
(12)
180

Comprehensive income (loss) for the year ended December 31, 2011 is
a. ($74).
b. $1,226.
c. $1,426.
d. $126.
MC13-11 (LO11) Which of the following is NOT found on a statement of changes in
stockholders equity?
a. Revenue
b. Treasury Stock
c. Retained Earnings
d. Accumulated Gains (Losses) Not Affecting Retained Earnings

Chapter 13

13-9

Matching
Matching 13-1 (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
___ 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

a. preferred stock that provides for additional dividends to

be paid to preferred stockholders after dividends of a
specified amount are paid to common stockholders
b. 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 corporations 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

13-10

Chapter 13

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.
___ 1. additional paidin capital
___ 2. subscription
___ 3. business
combination
___ 4. purchase
method
___ 5. treasury stock
___ 6. cost method
___ 7. par (or stated)
value method

a. a method of accounting for treasury stock purchases in

which the entire amount of the treasury stock is shown as
a subtraction from equity
b. the investment by stockholders in excess of the amounts
assignable to capital stock as par or stated value, as well
as invested capital from other sources, such as sale of
treasury stock
c. stock issued but subsequently bought back by the same
company and held for possible future reissuance or
retirement
d. accounting for a business combination whereby the asset
and liability values of the purchased company are
recorded at their market values; goodwill is recognized
e. the combining of two businesses accomplished through
the exchange of cash or an exchange of stock
f. method of accounting for treasury stock purchases in
which the repurchased shares are accounted for as if
they were being retired
g. a contract between the purchaser of stock and the issuer
in which the purchaser promises to buy shares of the
issuing companys stock

Matching 13-3 (LO4, LO5) Listed below are the terms and associated definitions from
the chapter for LO4 and LO5. Match the correct definition letter with each term number.
___ 1.
___ 2.
___ 3.
___ 4.

stock rights
stock warrants
stock options
detachable
warrants
___ 5. nondetachable
warrants
___ 6. performancebased stock
option plan
___ 7. stock
appreciation
rights (SARs)

a. awards an employee a cash amount equal to the market

value of the issuing firms shares above a specified
threshold price
b. cannot be traded separately from the security with which
they were originally issued
c. dependent on how well the individual or company
performs after the date the options are granted
d. generally issued in conjunction with the issuance of
another security
e. can be traded separately from the security with which
they were originally issued
f. granted to officers or employees as part of a
compensation plan; allow for the purchase of shares at a
specified exercise price
g. issued to existing shareholders to buy shares of stock in
order to maintain their proportionate ownership interests

Chapter 13

13-11

Matching 13-4 (LO8, LO9) Listed below are the terms and associated definitions from
the chapter for LO8 and LO9. Match the correct definition letter with each term number.
___ 1. appropriated
retained
earnings
___ 2. cash dividend
___ 3. property
dividend
___ 4. nonreciprocal
transfer to
owners
___ 5. small stock
dividend
___ 6. large stock
dividend
___ 7. stock split
___ 8. liquidating
dividend

a. a stock dividend of 25% or more of the shares

outstanding
b. a dividend paid in the form of some asset other than cash
c. amount of retained earnings restricted (i.e., made
unavailable for dividend payments) at the discretion of
the board of directors
d. a stock dividend of less than 25% of the shares
outstanding
e. a distribution to stockholders representing a return of a
portion of their contributed capital
f. a reduction in the par or stated value of stock
accompanied by a proportionate increase in the number
of shares outstanding
g. the payment of cash to shareholders in proportion to the
number of shares owned
h. transfer of cash or property to shareholders in which
nothing is received by the company in return

Matching 13-5 (LO10, LO11) Listed below are the terms and associated definitions
from the chapter for LO10 and LO11. Match the correct definition letter with each term
number.
___ 1. foreign
currency
translation
adjustment
___ 2. minimum
pension liability
adjustment
___ 3. available-forsale securities
___ 4. derivative
___ 5. equity reserve
___ 6. statement of
changes in
stockholders
equity

a. negative equity item resulting from the adjustment to

pension liability to ensure that at least a minimum
pension liability is reported
b. a financial instrument, such as an option or a future, that
derives its value from the movement of a price, an
exchange rate, or an interest rate associated with some
other item
c. a partition of total equity common in the financial
statements of foreign companies; each has specific legal
restrictions dictating whether it can be distributed to
shareholders
d. equity item arising from the change in the equity of
foreign subsidiaries resulting from changes in foreign
currency exchange rates
e. a report that summarizes the reasons for the changes in
all equity accounts during a period of time
f. investment securities not intended for immediate trading
but, in the case of debt securities, not intended to be held
until maturity

13-12

Chapter 13

Problems
Problem 13-1 (LO2)
The following transactions relate to the stockholders' equity transactions of Kati
Corporation for its initial year of existence.
a.

Jan. 7

b.
c.

Jan. 28
Feb. 3

d.

Feb. 24

e.

Sept. 12

f.

Oct. 1

Articles of incorporation are filed with the state. The state authorized
the issuance of 10,000 shares of $50 par value preferred stock and
200,000 shares of $10 par value common stock.
Issued 40,000 shares of common stock for $14 per share.
Issued 80,000 shares of common stock in exchange for land and
buildings that have an appraised value of $250,000 and $1,000,000,
respectively. The stock traded at $15 per share on that date on the
over-the-counter market.
Issued 2,000 shares of common stock to Salisbury and Associates,
Attorneys-at-Law, in payment for legal services rendered in
connection with incorporation. The company charged the amount to
organization costs. The market value of the stock was $16 per share.
Received subscriptions for 10,000 shares of preferred stock at $53
per share. A 40 percent down payment accompanied the
subscriptions. The balance is due on October 1.
Received the final payment for 10,000 shares.

Prepare journal entries to record the foregoing transactions. Identify the entries by letter
(af).
Problem 13-2 (LO3)
On July 1, Renne Corporation reacquired 10,000 shares of its $1 par value common
stock at $34. The stock was originally issued at $18. All 10,000 shares were resold on
November 1 at $45.
Provide the journal entries required to record the reacquisition and the subsequent
resale of the stock using the (1) par-value method and the (2) cost method of
accounting for treasury stock.

Chapter 13

13-13

Problem 13-3 (LO1, LO9)

Lux Company paid cash dividends totaling $150,000 in 2009 and $75,000 in 2010. In
2011, Bennett intends to pay cash dividends of $800,000. Compute the amount of cash
dividends per share to be received by common stockholders in 2011 under each of the
following assumptions. Treat each case independently. There were no dividends in
arrears as of January 1, 2009.
1. 25,000 shares of common stock; 100,000 shares of 6 percent, $50 par cumulative
preferred stock
2. 25,000 shares of common stock; 50,000 shares of 6 percent, $50 par noncumulative
preferred stock
3. 25,000 shares of common stock; 70,000 shares of 6 percent, $100 par cumulative
preferred stock

Solutions, Approaches, and Explanations

MC13-1
Answer: c
Approach and explanation: Choices a and d pertain to common stocknot preferred
stock. Choice b relates only to stock rights (which generally only apply to some shares
of common stocknot preferred stock). When additional shares of preferred stock are
issued, they are usually a new kind of preferred shares (with a different dividend rate
than prior issues based on the current market).
Again, shares of preferred stock arent necessarily better; they merely pay dividends
(which are limited and stated) before shares of common stock. Preferred shareholders
also tend to get paid before common shareholders, but after creditors, in a liquidation of
a corporation.
MC13-2
Answer: d
Approach and explanation: Dont confuse the word par when used in conjunction with
stock with the word par when used in conjunction with bonds. Bonds are usually sold
at a price very near the par value. Common stock is seldom sold at a price near the par
value. Preferred stock, on the other hand, is frequently sold at a price near the par
value.
The liquidation value of common stock is whatever is left over in a corporation after all
the creditors and preferred stockholders are taken care of. Par value has nothing to do
with this.

13-14

Chapter 13

The book value of common stock is the price the shares were sold at initially (less fees).
This amount is usually much more than the par value. Choices b and c are the same
thing. If you knew that you could safely rule out those choices since they both couldnt
be correct, then there is only one correct choice.
MC13-3
Answer: b
Approach and explanation: Whether the cost or par-value method is used for the
recording of treasury stock doesnt matter. Neither will result in income being reported
when treasury stock is resold, reissued, or retired. Therefore, you can safely rule out
choices c and d.
So then the question is, When, if ever, is Retained Earnings affected by the resale of
treasury stock? Under the cost method (the method most widely used), Retained
Earnings receives a debit if treasury stock is sold for less than it was purchased for if
the Paid-In Capital from Treasury Stock account is at, or reduced to, zero. Retained
Earnings can also be debited if shares are retired, under the cost method, after being
purchased back for more than the original issue price.
Under the par-value method, treasury stock that is purchased for more than the original
issue price is always recorded, in part, as a debit to Retained Earnings. This is why the
par-value method is not usually used in practice since companies usually have more
reductions in retained earnings under this method.
MC13-4
Answer: c
Approach and explanation: Rule number one of this chapter is that Common Stock does
not receive credits for amounts beyond the par value. With that in mind, you can rule out
choices a and b.
The next rule is that you should not account for something prematurely. Similar to taking
out a line of credit, until cash is actually drawn down on that line of credit, a credit to a
liability does not take place. Similarly, when rights have been issued, nothing, from an
accounting standpoint, has really taken place yetno cash has come in and no shares
have been issued. There is no entry to make at this point which should, or will, affect the
face of the financial statements.
It is when the rights are exercised, cash is received, and shares are actually issued that
the following entry (assuming all of the rights are exercised at the same time) should be
made:
Cash
Common Stock
Additional Paid-In Capital

180,000
10,000
170,000

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13-15

MC13-5
Answer: b
Approach and explanation: The total compensation expense is calculated on the date of
grant and then expensed evenly over the vesting period. How much a company pays to
acquire treasury stock is irrelevant to the compensation expense calculation. Another
item to note is that it doesnt matter how many of the employees are expected to stay
with the company or how many actually do stay. Compensation expense is still
recognized even if they leave the company in 2012 or, given past turnover rates, it is
expected that some may leave in 2012.
The calculation is as follows:
$7 60,000 = $420,000 of compensation expense
Vesting period (not exercisable period) = 2 years
$420,000/2 = $210,000 of compensation expense in each year (2011 and 2012)
MC13-6
Answer: d
Approach and explanation: The first thing to note is the not in the question. Underline
it, highlight it, or circle itdo something so that you dont miss it. With that in mind, you
should be looking for three choices that are liabilities and one that is not (and likely to be
equity since that is what this chapter is about).
The first three choices are the ones discussed in the chapter that sound like equity, but,
in substance, are actually more like liabilities and, hence, required to be classified as
such. The reason why a certain number of shares is equity, whereas a dollar value of
shares is not, is that if a number of shares is required to be issued, the person to whom
the shares will be issued essentially becomes an owner at that point. They will begin to
share in the risks and rewards that other equity interests will share in.
On the other hand, a person receiving a dollar value of shares will have their number of
shares change between now and the time they are actually issued and, hence, will not
share the risk and reward of other equity owners in the meantime. Once they actually
receive the shares, the liability is turned into equity as they will begin to be an equity
investor at that point.
MC13-7
Answer: c
Approach and explanation: The only time Retained Earnings is adjusted in a conversion
is in the rare situation in which the common stock par value is high. Here are examples
of the other choices:

13-16

Chapter 13

Choices a and b:
Preferred Stock
Common Stock
Additional Paid-In CapitalCommon Stock

1,000,000
1,000
999,000

Or if the par value of the common stock was also high, but not as high as the preferred
stock:
Preferred Stock
Common Stock
Additional Paid-In CapitalCommon Stock

1,000,000
100,000
900,000

Choice d:
Preferred Stock
Additional Paid-In CapitalPreferred Stock
Common Stock
Additional Paid-In CapitalCommon Stock

100,000
50,000
1,000
900,000

Remember that preferred stock usually sells at or very near its par value, unlike
common stock. Therefore, the par value and the fair value of preferred stock are
frequently numbers that are close in value. Common stock, on the other hand, usually
sells for much more than its par value. If the company has been around for a long time
the fair value of shares of common stock can be dozens, or even hundreds, of times
greater than the par value.
MC13-8
Answer: d
Approach and explanation: The first item to note is, of course, the not in the question.
After you have circled, underlined, or highlighted it, realize that three of the choices will
add to Retained Earnings and one will do nothing, or will result in a subtraction, to
Retained Earnings. With that in mind, analyze each choice independently, and write a +,
, or 0 for the effect each action or event will have on Retained Earnings next to each
choice.
A change from an accelerated depreciation method to the straight-line method is a
change in accounting principle that will require prior financial statements to be restated.
Restating those income statements with less depreciation under the newly adopted
method will increase net income in prior years, thereby increasing Retained Earnings.
Put a + next to choice a and move on.
Net income that is earned during the period is probably the easiest of the four choices.
Net income will, of course, increase Retained Earnings. Put a + next to choice b and
move on.

Chapter 13

13-17

For choice c, youll need to recall information from a few chapters back. Remember this
formula?
Beginning inventory
+ Purchases
= Cost of goods available for sale
Ending inventory
= Cost of goods sold
If ending inventory was too low, then that means that cost of goods sold was too high
and income was understated in the previous year. If income was understated and that
understatement is now being corrected, the effect is to increase Retained Earnings now.
Put a + next to choice c and move on. Do not just assume that choice d is correct,
based on your other three + marks, without thinking it through first.
What happens in a 2-for-1 stock split? No journal entry is made. Rather, the number of
shares outstanding doubles and the par value gets cut in half. Therefore, choice d earns
a 0 mark next to it and you can circle it as being the correct answer.
MC13-9
Answer: c
Approach and explanation: On the date of declaration, what has happened? A liability
has been created called Dividends Payable. That account receives a credit for the
amount of the declaration. The missing debit must, therefore, be to Retained Earnings.
So Retained Earnings is affected, but not with an increase. Choices a and b can be
crossed off.
On the date of payment, what has happened? Cash has been paid, so Cash receives a
credit. The liability created on the date of declaration is no longer owed, so Dividends
Payable will receive a debit to bring it to a zero balance. That means Retained Earnings
isnt affected on the date of payment.
MC13-10
Answer: b
Approach and explanation: The solution to this question is as simple as adding up all
the numbers given.
MC13-11
Answer: a
Approach and explanation: The only piece of the income statement that you will find on
the statement of changes in stockholders equity is net income. Therefore, Revenue
(choice a) is the correct answer as it is not found on this statement too.
Even though Treasury Stock (choice b) decreases stockholders equity, any company
that had repurchased its own shares would show Treasury Stock both on this statement
and on the balance sheet (as negative numbers).

13-18

Chapter 13

Retained Earnings (choice c) is a part of stockholders equity even though it doesnt

represent contributed capital.
Perhaps the trickiest one is Accumulated Gains (Losses) Not Affecting Retained
Earnings (choice d) as it sounds like the opposite of Retained Earnings and, hence,
something that possibly could be correct if Retained Earnings (choice c) is not.
However, this item is actually very similar to Retained Earnings in that it isnt contributed
capital.
What is it exactly? This category of items are those that go into comprehensive income
but not net income. Net income is closed out to Retained Earnings but other,
comprehensive income items, are not. Hence, this separate account tracks
comprehensive income adjustment items over the years.
The textbook uses the above term as an example in the case of IBMs statement of
changes in stockholders equity. Other companies sometimes use a phrase that more
closely describes where these items are coming from like Accumulated Other
Comprehensive Income (Loss).
Matching 13-1
1.
d
2.
h
3.
j
4.
c
5.
i
6.
e
7.
a
8.
g
9.
b
10.
f
Complete these terminology matching exercises without looking back at the textbook or
on to the glossary. After all, you probably wont have those as a reference at test time.
Learning through trial and error causes the item to be learned better and to stick in your
memory longer than if you just look at the textbook, glossary, or a dictionary and cook
book the answers. Sure you may get the answer correct on your first attempt, but
missing something is sometimes best for retention. Dont be afraid of failure while
studying and practicing.

Chapter 13

13-19

Matching 13-2
1.
b
2.
g
3.
e
4.
d
5.
c
6.
a
7.
f
Matching 13-3
1.
g
2.
d
3.
f
4.
e
5.
b
6.
c
7.
a
Matching 13-4
1.
c
2.
g
3.
b
4.
h
5.
d
6.
a
7.
f
8.
e
Matching 13-5
1.
d
2.
a
3.
f
4.
b
5.
c
6.
e
Problem 13-1
a. No entry is required for the authorization of shares.
b. Cash
Common Stock
Paid-In Capital in Excess of Par
Common Stock
a
b

40,000 $14 = $560,000

40,000 $10 = $400,000

560,000a
400,000b
160,000

13-20

c. Land
Buildings
Common Stock
Paid-In Capital in Excess of Par
Common Stock
a

Chapter 13

240,000
960,000
800,000a
400,000

80,000 $10 = $800,000

Note: The fair market value of the stock is more readily determinable than the value
of the real property because it was traded on the over-the-counter market on the
transaction date. The value of the stock should be assigned to the land and buildings
in proportion to their appraised values:
Cost of Land = $250,000/($250,000 + $1,000,000) $1,200,000 = $240,000
Cost of Building = $1,000,000/($250,000 + $1,000,000) $1,200,000 = $960,000
d. Organization Costs
Common Stock
Paid-In Capital in Excess of Par
Common Stock
a
b

12,000

212,000a
318,000
500,000b
30,000

(10,000 $53) 0.40 = $212,000

10,000 $50 = $500,000

f. Cash
Subscriptions Receivable
Preferred Stock Subscribed
Preferred Stock
a

20,000b

2,000 $16 = $32,000

2,000 $10 = $20,000

e. Cash
Subscriptions Receivable
Preferred Stock Prescribed
Paid-In Capital in Excess of Par
Preferred Stock
a

32,000a

(10,000 $53) 0.60 = $318,000

318,000a
318,000
500,000
500,000

Chapter 13

13-21

Problem 13-2
Fill in the pieces you know first and the missing pieces will likely come to you easier. For
instance, the cash portion of each entry is the easiest part to figure out. Since it is the
only credit (when it is a credit), or the only debit (when it is a debit), you know you have
to come up with the other side of the entry to equal cash.
Retained Earnings will never increase from dealings in treasury stock.
Finally, the name of the method gives away whether the par value of the treasury stock
needs to be considered or not.
(1)

July

Nov.

1 Treasury Stock
Additional Paid-In Capital
Treasury Stock
Retained Earnings
Cash
1 Cash
Treasury Stock
Additional Paid-In Capital
Treasury Stock

10,000a
170,000b
160,000
340,000c
450,000d
10,000
440,000

10,000 $1 = $10,000
10,000 $17 = $170,000
c
10,000 $34 = $340,000
d
10,000 $45 = $450,000
b

(2)

July

Nov.

1 Treasury Stock
Cash

340,000

1 Cash
Treasury Stock
Additional Paid-In Capital
Treasury Stock

450,000

340,000

340,000
110,000

13-22

Chapter 13

Problem 13-3
1. Preferred dividends per year: 100 shares $3 (0.06 $50) = $300,000
Preferred dividends in 2009:

Preferred dividends in 2009

Paid
$150,000

In Arrears
$150,000

Paid
$75,000

In Arrears
$ 75,000
300,000
$375,000

Preferred dividends in 2010:

Arrearage from 2009

Arrearage from 2010
Total in arrears at 12/31/10
Preferred dividends in 2011:
Arrearage from 2009 and 2010
Current year preferred dividend
Total preferred dividends paid in 2011

$375,000
300,000
$675,000

Remainder to common: $800,000 $675,000 = $125,000

Common dividends per share: $125,000/25,000 shares = $5 per share
2. Preferred dividends per year: 50,000 shares $3 = $150,000
Dividends in arrears for 2009: $0
Dividends in arrears for 2010: $0
Dividends paid on preferred shares for 2011: $150,000
Remainder to common: $800,000 $150,000 = $650,000
Common dividends per share: $650,000/25,000 shares = $26 per share

Chapter 13

13-23

3. Preferred dividends per year: 70,000 shares $6 (0.06 $100) = $420,000

Preferred dividends in 2009:

Preferred dividends in 2009

Paid
$150,000

In Arrears
$270,000

Paid
$75,000

In Arrears
$195,000
420,000
$615,000

Preferred dividends in 2010:

Arrearage from 2009

Arrearage from 2010
Total in arrears at 12/31/10
Preferred dividends in 2011:

Total dividends paid in 2011

Total in arrears at 12/31/10
Amount available for preferred dividend in 2011

$800,000
615,000
$185,000

Total preferred dividends in 2011: $800,000 [with $135,000 ($420,000 $185,000)

still in arrears]
Remainder to common: $0
Common dividends per share: $0

Glossary
Note that Appendix C in the rear portion of the textbook contains a comprehensive
glossary for all of the terms used in the textbook. That is the place to turn to if you need
to look up a word but dont know which chapter(s) it appeared in. The glossary below is
identical with one major exception: It contains only those terms used in Chapter 13. This
abbreviated glossary can prove quite useful when reviewing a chapter, when studying
for a quiz for a particular chapter, or when studying for an exam which covers only a few
chapters including this one. Use it in those instances instead of wading through the 19
pages of comprehensive glossary in the textbook trying to pick out just those words that
were used in this chapter.
additional paid-in capital The investment by stockholders in excess of the amounts
assignable to capital stock as par or stated value, as well as invested capital from
other sources, such as sale of treasury stock.

13-24

Chapter 13

appropriated retained earnings Amount of retained earnings restricted (i.e., made

unavailable for dividend payments) at the discretion of the board of directors.
available-for-sale securities Investment securities not intended for immediate trading
but, in the case of debt securities, not intended to be held until maturity.
board of directors Group elected by the shareholders to oversee the strategic and
long-run planning for the corporation.
business combination The combining of two businesses accomplished through the
exchange of cash or an exchange of stock.
callable A security, such as a bond or a preferred stock, that can be redeemed and
canceled at the option of the issuing company.
cash dividend The payment of cash to shareholders in proportion to the number of
shares owned.
convertible Securities, such as bonds and preferred stock, whose terms permit the
holder to convert the investment into common stock of the issuing company.
cost method Method of accounting for treasury stock purchases in which the entire
cost of the treasury stock is shown as a subtraction from equity.
cumulative preferred stock Preferred stock that has a right to receive current
dividends as well as any dividends in arrears before common stockholders receive
any dividends.
derivative A financial instrument, such as an option or a future, that derives its value
from the movement of a price, an exchange rate, or an interest rate associated with
some other item.
detachable warrants Stock warrants that can be traded separately from the security
with which they were originally issued.
dividends in arrears Dividends on cumulative preferred stock that are passed or not
paid. Dividends in arrears must be paid before any dividends can be paid to
common stockholders.
equity reserve A partition of total equity common in the financial statements of foreign
companies. Each equity reserve has specific legal restrictions dictating whether it
can be distributed to shareholders.
foreign currency translation adjustment Equity item arising from the change in the
equity of foreign subsidiaries resulting from changes in foreign currency exchange
rates.
large stock dividend

A stock dividend of 25% or more of the shares outstanding.

liquidating dividend A distribution to stockholders representing a return of a portion

of their contributed capital.
minority interest The amount of equity investment made by outside shareholders to
consolidated subsidiaries that are not 100% owned by the parent.

Chapter 13

13-25

minimum pension liability adjustment Negative equity item resulting from the
adjustment to pension liability to ensure that at least a minimum pension liability is
reported.
noncontrolling interest The term used by the FASB to replace minority interest and
directs that this item be classified in the consolidated balance sheet as part of equity.
noncumulative preferred stock Preferred stock that has no claim on any prior year
dividends that may have been passed.
nondetachable warrants Stock warrants that cannot be traded separately from the
security with which they were originally issued.
nonreciprocal transfer to owners Transfer of cash or property to shareholders in
which nothing is received by the company in return.
par (or stated) value method Method of accounting for treasury stock purchases in
which the repurchased shares are accounted for as if they were being retired.
par value A nominal value that is assigned to stock by the terms of a corporations
charter.
participating preferred stock Preferred stock that provides for additional dividends to
be paid to preferred stockholders after dividends of a specified amount are paid to
common stockholders.
performance-based stock option plan Option plan in which the terms are
dependent on how well the individual or company performs after the date the options
are granted.
pooling-of-interest method A way to account for a business combination that
assumes a merger of two equals; neither of the merging companies is thought of as
purchasing the other.
property dividend A dividend paid in the form of some asset other than cash.
purchase method A method of accounting for a business combination whereby the
asset and liability values of the purchased company are recorded at their market
values; goodwill is recognized.
redeemable preferred stock Preferred stock that may be redeemed 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.
small stock dividend A stock dividend of less than 25% of the shares outstanding.
stated value A nominal value that may be assigned to no-par stock by the board of
directors of a corporation; similar in concept to par value.
statement of changes in stockholders equity A report that summarizes the
reasons for the changes in all equity accounts during a period of time.
stock appreciation rights (SARs) Awards an employee a cash amount equal to the
market value of the issuing firms shares above a specified threshold price.

13-26

Chapter 13

stock options Rights granted to officers or employees as part of a compensation

plan; the options allow for the purchase of shares at a specified exercise price.
stock rights Rights issued to existing shareholders to buy shares of stock in order to
maintain their proportionate ownership interests.
stock split A reduction in the par or stated value of stock accompanied by a
proportionate increase in the number of shares outstanding.
stock warrants Rights to purchase shares of stock; warrants are generally issued in
conjunction with the issuance of another security.
subscription A contract between the purchaser of stock and the issuer in which the
purchaser promises to buy shares of the issuing companys stock.
treasury stock Stock issued but subsequently bought back by the same company
and held for possible future reissuance or retirement.