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EXAMPLE TEST QUESTIONS

Chapter 15
Multiple Choice
1.

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

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

The par value method of reporting a treasury stock transaction
a. Will be reported in the balance sheet as a reduction of total stockholders’ equity.
b. Results in no change to total stockholders’ equity.

000 shares issued) $2. On December 31. Payment of last maturing series of a serial bond issue d. Answer d 8. Results in a reduction in the number of shares that are available to be sold to prospective investors. Capital stock would increase to $4. hence. Exhaustion of potential benefits of the investment credit b.000 If a 100 percent stock dividend were declared and the par value per share remained at $20 a.000 d.550. Assumes constructive retirement of the treasury shares. Healthy earnings have been reported each year. c. Answer d 6. The statute of limitations applies. The company should record an extraordinary gain for income determination purposes to the extent that dividends in arrears do not have to be paid in the exchange transaction.c. No entry would need to be made to record the dividend b. Gain or loss should be recognized on the exchange by the company. d. cumulative dividends of only seven years need to be paid on the preferred stock exchanged. Which of the following best describes the effect of the exchange on the company? a.000 Premium on capital stock 800. when the Conn Company’s stock was selling at $36 per share. The board of directors appropriately authorized management to offer the preferred shareholders an exchange of bonds and common stock for all the preferred stock. A company has not paid dividends on its cumulative nonvoting preferred stock for 20 years. b. its capital accounts were as follows Capital stock (par value $20. A restriction of retained earnings is most likely to be required by the a. d. 2010. A feature common to both stock splits and stock dividends is . and no dividends need to be paid on the preferred stock exchanged.000. The exchange is about to be consummated. but they have been retained to support the growth of the company. no gain or loss should be recognized by the company on the exchange. and the exchange would have to be approved by the Securities and Exchange Commission.000. Purchase of treasury stock c. Regardless of the market value of the bonds and common stock. 100. Capital stock would increase to $5. Amortization of past service costs related to a pension plan Answer b 9. Total capital would decrease Answer c 7.000 c.600.000 Retained Earnings 4.

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

000 to their present fair market value.a.000 before the quasi-reorganization. At what amount should retained earnings be capitalized for the additional shares issued? a. c.000. A company with a $2.000 deficit undertakes a quasi-reorganization on November 1. How would the entries to accomplish these changes on November 1. b. Market value on the declaration date d. Increase Decrease Decrease No effect Decrease No effect Increase Increase Answer c 15. b. Decrease No effect c. Market value on the payment date Answer c 17. 2010. affect each of the following? Capital Stock a. Common Stock No effect No effect Increase Increase Additional Paid-in Capital No effect Increase No effect Increase Answer d 18. Par value c. What is the most likely effect of a stock split on the par value per share and the number of shares outstanding? Par Value Number of shares Per share outstanding a. There should be no capitalization of retained earnings b.000. d. How would the declaration and subsequent issuance of a 10 percent stock dividend by the issuer affect each of the following when the market value of the shares exceeds the par value of the stock? a. Capital stock was $3. Liabilities will remain the same. No effect Total Stockholders’ Equity No effect . 2010.000. c. d. Gilbert Corporation issued a 40percent stock split-up of its common stock that had a par value of $10 before and after the split-up. No effect No effect Answer a 16. Certain assets will be written down by $400.000 and additional paid-in capital was $1. Increase Increase d. Decrease Increase b.

The purchase of treasury stock a. Entity theory. d. Answer c 22. Proprietary theory. d. Has no effect on common stock outstanding Answer d 21. Proprietary theory. c. b.. Commander theory. Answer b 23. expresses which of the following theories of equity? a. assets = equities. Under the residual equity theory a. d. b. Decreases common stock issued c. Equities are viewed as restrictions on assets. No effect Decrease Decrease Decrease Decrease No effect Answer d 19. How would a stock split affect each of the following? Total Stockholders’ Assets Equity a. A manager’s goals are considered as important as those of the common stockholders. Management is responsible for maximizing the wealth of common stockholders. c. a. c. The equation. No effect No effect d. Commander theory.b. No effect No effect c. Decreases common stock outstanding d. d. Entity theory. Under which of the theories of equity is a manager’s goals considered as important as those of the common stockholder. c. Enterprise theory. Decreases common stock authorized b. Enterprise theory. Increase Increase b. Decrease Decrease Additional Paid-in Capital No effect No effect Increase Decrease Answer b 20. A business is viewed as a social institution. b. Answer b .

c. b. Total compensation is measured using the difference between the strike price and the fair value of the options on the grant date. The debt-to-equity ratio is unchanged. d. 1. b. In the financing activities section of the statement of cash flows. Mandatorily redeemable preferred stock. d. a. d. When preferred stock is converted to common stock a. Answer a 25. c. As an adjustment to retained earnings in its statement of owners’ equity . When a dividend paid to stockholders who own mandatorily redeemable preferred stock. As an expense in the income statement. A gain or loss is reported in earnings for the difference between the fair value of the common stock and the book value of the preferred stock that was converted . d. Answer b 27. Enterprise theory. but the liability characteristic is dominant? a. Total compensation is measured using the intrinsic method. the company must report the dividend a. Entity theory.24. Detachable stock options. c. Answer c 28. Stock options issued with a debt security . Total compensation is measured using a fair value method. Proprietary theory. Total compensation is measured when the options are in the money. Redeemable preferred stock. b. As a reduction to other comprehensive income. Which of the following securities must be reported as a liability because they have the characteristics of both liabilities and equity. When employees are granted options as part of a compensatory stock option plan. b. 6? a. c. b. The debt-to-equity ratio increases. Answer d 26. Answer c Essay a. Commander theory. The debt-to-equity ratio decreases. Discuss the following theories of equity: Proprietary . Which of the theories of equity is consistent with the definition of equity that is found in Statement of Financial Accounting Concepts No. c. d.

and not the firm. This theory holds that all profits or losses immediately become the property of the owners. The ownership interest may be represented by a sole proprietor. except retained earnings (it belongs to the firm). financial reporting is based on the premise that the owner is the primary focus of a company’s financial statements. and the ownership and management separate.According to the proprietary theory. b. Entity The rise of the corporate form of organization. The assets of the firm belong to these owners. whether or not they are distributed. and the firm exists as a separate and distinct entity apart from these groups. and any liabilities of the firm are also the owners’ liabilities. the entity theory can be expressed as assets = equities The entity theory. and the net worth or equity section of the balance sheet should be viewed as assets – liabilities = proprietorship Under the proprietary theory. Any profits belong to the entity and accrue to the stockholders only when a dividend is declared. the firm exists simply to provide the means to carry on transactions for the owners. and individual items are . Revenues received by the firm immediately increase the owner’s net interest in the firm. or a number of stockholders. are viewed as claims against the assets of the firm. Among the first of these theories was the entity theory. (2) conveyed limited liability to the owners. As revenue is received. From an accounting standpoint. they become obligations of the entity. this theory becomes less acceptable. and (3) resulted in the legal definition of a corporation as though it were a person. it becomes the property of the entity. Likewise. This viewpoint places the firm. Therefore. and as expenses are incurred. all expenses incurred by the firm immediately decrease the net proprietary interest in the firm. a partnership. The assets and liabilities belong to the firm. Under this theory. The essence of the entity theory is that creditors as well as stockholders contribute resources to the firm. The proprietary theory is particularly applicable to sole proprietorships where the owner is the decision maker. all the items on the right-hand side of the balance sheet. at the center of interest for accounting and financial reporting purposes. When the form of the enterprise grows more complex. is a point of view toward the firm and the people concerned with its operation. not to its owners. (1) was accompanied by the separation of ownership and management. like the proprietary theory. the firm is owned by some specified person or group. and not the owners. encouraged the evolution of new theories of ownership.

The commander theory. and the overall process of credit extension and investment. personalization. respectively.. thereby providing a separate accounting for each area of economic concern. nevertheless. and funds. c. The fund theory is expressed by the following equation: assets = restrictions on assets This theory explains the financial reporting of an organization in terms of three features.distinguished by the nature of their claims. has applicability to all organizational forms (sole .g. government agencies). it is more suitable to governmental accounting. and fund approaches. Some items are identified as creditor claims and others are identified as owner claims. unlike the proprietary. Fund The use of the fund theory would abandon the personal relationship advocated by the proprietary theory and the personalization of the firm advocated by the entity theory. —limitations on the use of assets. Commander The commander approach is offered as a replacement for the proprietary and entity theories because it is argued that the goals of the manager (commander) are at least equally important to those of the proprietor or entity. and fund approaches emphasize persons. entity. 2. —economic services and potentials. The proprietary. entity. These features are applied to each homogeneous set of activities and functions within the organization. social control agencies (e. Everyone who has resources to deploy is viewed as a commander. d. but the commander theory emphasizes control. The fund theory has not gained general acceptance in financial accounting. they are all claims against the firm as a separate entity. Assets. —an area of attention defined by the activities and operations surrounding any one set of accounting records and for which a selfbalancing set of accounts is created. as follows: 1. Fund. Restrictions. Under the fund approach. the measurement of net income plays a role secondary to satisfying the special interests of management. 3.

partnerships. the common shareholders hold the residual equity in the enterprise by virtue of having the final claim on income.proprietorships. it is generally considered to have only a minor impact on accounting theory. both the managers and the stockholders are commanders in that each maintains some control over resources. the proprietors or partners are both owners and commanders. are viewed as social institutions. takes on an element of stewardship. and the organization’s financial statements are constructed to highlight the contributions of each level of control to enterprise profits. consumers. Under the corporate form. and government units.) A commander theorist would argue that the notion of control is broad enough to encompass all relevant parties to the exclusion of none. (Managers control the enterprise resources. Responsibility accounting is consistent with the commander theory. In sole proprietorships or partnerships. Residual equity Residual equity is defined as “the equitable interest in organization’s assets which will absorb the effect upon those assets of any economic event that no interested party has specifically agreed to. to a certain extent. yet they are the first to be charged for .” Management within this framework essentially maintains an arm’s-length relationship with owners and has as its primary responsibilities (1) the distribution of adequate dividends and (2) the maintenance of friendly terms with employees. the relevant factor is how the commander allocates resources to the benefit of all parties. and stockholders control returns on investment emerging from the enterprise. business units. and it has generated little reaction in accounting circles. f. Responsibility accounting identifies the revenues and costs that are under the control of various “commanders” within the organization. The commander theory is not on the surface a radical move from current accounting practices. most notably those listed on national or regional stock exchanges. and corporations). then. The form of organization does not negate the applicability of the commander view because the commander can take on more than one identity in any organization. Enterprise Under the enterprise theory. The function of accounting. or the development of accounting principles and practices. composed of capital contributors having “a common purpose or purposes and. Rather. and the question of where resource increments flow is not relevant. roles of common action. Because this theory applies only to large nationally or regionally traded issues. e.” Here.

” (See FASB . Prior to the guidance contained at FASB ASC 480 owners’ equity that was redeemable pursuant to a buy–sell agreement was accounted for as equity. provide for the orderly disposition of the owners’ investment in the company upon their separation from the company. departing owners or their heirs must rely on the company or the remaining owners to provide them with liquidity. and the existence and significant terms of the buy–sell agreement are required to be described in the notes to financial statements. as with the fund. What is mandatorily redeemable preferred stock and how is it accounted for under the provisions of SFAS No. Management is in effect a trustee responsible for maximizing the wealth of residual equity holders. accrue to residual owners. The residual equity holders are vital to the firm’s existence in that they are the highest risk takers and provide a substantial volume of capital during the firm’s developmental stage. “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. Thus. Because there is no market for the equity securities of a closely held company. with current financial statement presentation of earnings per share. or death. the FASB issued SFAS No. In 2003. not debt. Income accrues to the residual owners after the claims of specific equity holders are met. and enterprise theories. commander. Again. the income to specific equity holders. The residual equity theory is formulated as assets –specific equities = residual equities Under this approach. These agreements. and with the Conceptual Framework’s emphasis on the relevance of projecting cash flows. would be deducted in arriving at residual net income. disability. which are often referred to as shareholders’ or buy–sell agreements. the role of financial reporting is to provide prospective and current residual owners with information regarding enterprise resource flows so that they can assess the value of their residual claim. the residual of assets. 2. 150 (FASB ASC 480-10)? Redemption provisions on preferred stock are common features of agreements entered into among the owners of closely held businesses. the residual equity approach has gained little attention in financial accounting. usually at retirement. net of the claim of specific equity holders (creditors and preferred stockholders).losses. 150. This theory is consistent with models that are formulated in the finance literature. including interest on debt and dividends to preferred stockholders. In this framework. Redemption by the company is usually favored over requiring the remaining owners to fund a buyout because the remaining owners may not have the necessary financial resources.

Preference as to assets in liquidation. or entire proceeds if no par or stated value accompanies the stock issue B. Additional paid-in capital—amounts received in excess of par or stated value II. Among these are: 1. 3. the right to receive dividends. —Corporate shares may be freely exchanged on the open market. 3.. 4. Paid-in capital (contributed capital) A. Preference as to dividends. thereby improving their marketability. Many shares are listed on national security exchanges.. This guidance requires companies to record and report mandatorily redeemable preferred stock (MRPS) as a liability on their balance sheets. List and discuss four advantages of the corporate form of organization. Several advantages accrue to the corporate form and help explain its emergence. 2. Most companies previously disclosed MRPS between the liability and stockholders’ equity sections (i. Shareholders may sacrifice any or all of these rights in return for special privileges.e. Legal capital-par. This results in an additional class of stock termed preferred stock. Continuity. Variety of ownership interest. b. and the dividends on these securities as interest expense. as is possible in the case of sole proprietorships and partnerships. Discuss the components of a corporation’s balance sheet capital section. Creditors may not look to the assets of individual owners for debt repayments in the event of a liquidation. The components of a corporation’s capital section are classified by source in the following manner: I. Investment liquidity. 4. the purchase price of the shares acquired was less than their par value). Appropriated . the right to receive assets on the liquidation of the corporation. —The corporation’s life is not affected by the death or resignation of owners. the mezzanine section) of the balance sheet. which may have either or both of the following features: a. stated value. —Shares of corporate stock usually contain four basic rights: the right to vote for members of the board of directors of the corporation and thereby participate in management. Earned capital A. —A stockholder’s loss on his or her investment is limited to the amount of the amount invested (unless on the date of acquisition. Limited liability. and the preemptive right to purchase additional shares in the same proportion to current ownership interest if new issues of stock are marketed.ASC 480).

Current conditions dictate the return on investment that will be attractive to potential investors. Corporations include call provisions on securities because of uncertain future conditions. b. Call provisions allow the corporation to take advantage of future favorable conditions and indicate how the securities may be retired. even though it is not a liability until the board of directors of the corporation actually declares it. . since investors will not normally be inclined to purchase shares that could be recalled momentarily at a lower price. This provision states that if all or any part of the stated preferred dividend is not paid in any one year. Dividends in arrears are important in predicting future cash flows and as an indicator of financial flexibility and liquidity. Cumulative Preferred shareholders normally have a preference as to dividends. Usually. a. a conversion feature is attached to allow the corporation to sell its preferred shares at a relatively lower dividend rate than is found on other securities with the same degree of risk. Unappropriated III. Usually. but conditions may change so that the corporation may offer a lower return on investment in the future. c. Discuss the following special features of preferred stock: Convertible A conversion feature allows preferred shareholders to exchange their shares for common shares. The existence of a call price tends to set an upper limit on the market price of nonconvertible securities. the unpaid portion accumulates and must be paid in subsequent years before any dividend can be paid on common stock. Other comprehensive income 5. no common dividends may be paid in any one year until all required preferred dividends for that year are paid.B. That is. corporations also include added protection for preferred shareholders in the form of a cumulative provision. It is included on a preferred stock issue to make it more attractive to potential investors. The conversion rate is normally set above the current relationship of the market value of the common share to the market value of the preferred convertible shares. market conditions may make it necessary to promise a certain debt–equity relationship at the time of issue. In addition. Call Call provisions allow the corporation to reacquire preferred stock at some predetermined amount. Any unpaid dividend on cumulative preferred stock constitutes a dividend in arrears and should be disclosed in the notes to the financial statements.

Participating Participating provisions allow preferred stockholders to share dividends in excess of normal returns with common stockholders. These certificates are generally issued under one of two conditions: 1. requires companies issuing stock options to estimate the compensation expense arising from the granting of stock options by using a fair value method and to disclose this estimated compensation expense on their income statements. .d. Stock warrants are certificates that allow holders to acquire shares of stock at certain prices within stated periods. How did SFAS No. FASB ASC 480-10-50-4 requires that a manditorily redeemable financial instrument be classified as a liability unless redemption is required to occur only upon the liquidation or termination of the issuing company. As evidence of the preemptive right of current shareholders to purchase additional shares of common stock from new stock issues in proportion to their current ownership percentage. This treatment differs from the previous requirement to estimate compensation expense on the date of the grant as the difference between the option price and the market price. rather than equity. Define and discuss accounting for stock warrants. and would meet the definition of a liability. 7. a participating provision might indicate that preferred shares are to participate in dividends on a 1:1 basis with common stock on all dividends in excess of $5 per share. 6. Redemption A redemption provision indicates that the shareholder may exchange preferred stock for cash in the future. 123R change accounting for stock options? SFAS 123R ( FASB ASC 718). e. This provision requires that any payments of more than $5 per share to the common stockholder also be made on a dollar-for-dollar basis to each share of preferred. the financial instrument embodies an obligation to transfer assets. The redemption provision may include a mandatory maturity date or may specify a redemption price. If so. For example. The SEC requires separate disclosure of manditorily redeemable preferred shares because of their separate nature.

the accounting for the preemptive right of existing shareholders creates no particular problem.2. A procedure somewhat similar to stock dividends. When the price climbs above that range. retained earnings is reduced by the market value of the shares distributed. and applying this percentage to the proceeds of the security issue. stock dividends are not income to the recipients. This procedure should be followed whether the warrants are associated with bonds or with preferred stock. the fewer are the number of people able to purchase the stock in blocks of 100. the firm may decide to issue additional shares to all existing stockholders (or split the stock). Include in your discussion. The most economical method of purchasing and selling stock in the stock market is in blocks of 100 shares. the value of the shares of stock issued is measured at the amount of cash exchanged. Under current practice. Distributions of this type are termed stock dividends. Detachable warrants attached to other securities require a separate valuation because they may be traded on the open market. When stock dividends are minor. Corporations may have accumulated earnings but not have the funds available to distribute these earnings as cash dividends to stockholders. They represent no distribution of corporate assets to the owners and are simply a reclassification of ownership interests. The higher the price of an individual share of stock. a relatively small stock dividend will not adversely affect the previously established market value of the stock. respectively. As an inducement originally attached to debt or preferred shares to increase the marketability of these securities. and this practice affects the marketability of the stock. but with a different purpose. the company may elect to distribute some of its own shares of stock as dividends to current stockholders. In the event warrants of this type are exercised. The rationale behind stock dividend distributions is that the stockholders will receive additional shares with the same value per share as those previously held. The amount to be attributed to these types of warrants depends on their value in the securities market. Discuss the difference between a stock dividend and a stock split. is a stock split. In such cases. Nevertheless. 8. Capital stock and additional paid-in capital are increased by the par value of the shares and any excess. For this reason. each stockholder receives a . relative to the total number of shares outstanding. the reasons a company might issue either a stock dividend or a stock split. Their value is measured by determining the percentage relationship of the price of the warrant to the total market price of the security and warrant. These warrants are recorded only as memoranda in the formal accounting records. In theory. many corporations seek to maintain the price of their stock within certain ranges. In a stock split.

but intervening variables in the marketplace frequently affect prices simultaneously. Because treasury stock transactions are transactions with owners. The transaction is in substance a retirement. and two events are assumed: (1) the purchase of the shares by the corporation and (2) the reissuance to a new stockholder. this lower price should be equivalent to dividing the current price by the multiple of shares in the split. Under the cost method. it is assumed that the corporation’s relationship with the original stockholder is ended. in such cases retained earnings is charged). which lowers the market price per share. Any difference between the original issue price and the reacquisition price is treated as an adjustment to additional paid-in capital (unless a sufficient balance is not available to offset a “loss” and retained earnings is charged). The reacquired shares are recorded at cost. Define and discuss the two methods of accounting for treasury stock. and this amount is disclosed as negative stockholders’ equity by deducting it from total capital until the shares are resold. Obtain the financial statements of a company and ask the students to compute the: a. Two methods of accounting for treasury stock are found in current practice: the cost method and the par value method. 9. Therefore.stated multiple of the number of shares currently held (usually two or three for one). The par value of the reacquired shares is disclosed as a deduction from capital stock until the treasury shares are reissued. Return on common stockholders’ equity. any difference between the acquisition price and the sales price is generally treated as an adjustment to paid-in capital (unless sufficient additional paid-in capital is not available to offset any “loss”. hence. . Financial structure ratio The answer to this question is dependent on the company selected. Under the par value method. b. the shares are considered constructively retired. No additional values are assigned to the shares of stock issued in a stock split because no distribution of assets or reclassification of ownership interests occurs. legal capital and additional paid-in capital are reduced for the original issue price of the reacquired shares. A stock split does not cause any change in the stockholder’s equity section except to increase the number of actual shares outstanding and reduce the par or stated value per share. 10. In theory. the presumption is that the shares acquired will be resold.