Accounting Standards Codification Section 710, Compensation, applies to the following:

A liability is required to be accrued for the cost of compensation for future absences if all
of the following conditions are met except when:

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A. The employer's obligation related to the employee's rights to receive compensation for future
absences is attributable to the employee's services already rendered.
B. The obligation relates to the rights that vest or accumulate.
C. Payment of the compensation is probable.
D. The amount cannot reasonably be estimated.
Explanation

Choice "D" is correct. To accrue the cost of compensation for future absences, the cost
must be probable and estimable.

If the amount cannot reasonably be estimated, then an expense cannot be

recorded. Note the word "except" in the question.

Choices "A", "B", and "C" are incorrect. To accrue the cost of compensation for future
absences, the cost must be attributable to services already rendered, the employee's
rights must accumulate or vest, and payment must be probable and estimable.
A company has $100 million of debt that is due in March, Year 3. In December, Year 2,
the company entered into a noncancelable agreement with its lender to refinance the
debt with the same interest rate and with the full principal due in December, Year 5.
How should the debt be classified on the December, Year 2, balance sheet of the
company?

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A. Classified as a current liability.
B. Classified as a long-term liability.
C. Considered as an off-balance sheet liability.
D. Classified as a contingent liability.
Explanation

Choice "B" is correct. Under U.S. GAAP, a short-term obligation may be excluded from
current liabilities and included in non-current debt if the company intends to refinance it
on a long-term basis and the intent is supported by the ability to do so as evidenced
either by the actual refinancing prior to the issuance of the financial statements or the
existence of a noncancelable financing agreement from a lender having the financial
resources to accomplish the refinance.

The existence of a noncancelable financing agreement is sufficient for allowing the

reclassification from a short-term liability to a long-term liability. While the liability would
have been classified as current had no agreement been made by December 31, Year 2,
the noncancelable agreement was in place as of year-end, which requires the
reclassification of the liability to long term.

Choice "A" is incorrect. The classification of a current liability would have been correct
without the noncancelable agreement with the lender to refinance the debt.

Choice "C" is incorrect. This debt obligation must be reflected on the balance sheet and
would not be considered an off-balance sheet liability.

Choice "D" is incorrect. The debt obligation is due on a specified date and is not
contingent on any future event other than the passage of time. The principal amount
must be paid in December, Year 5. This liability does not meet the definition of a
contingency.
Timber Corp. has $5,000,000 of long-term debt maturing on April 1, Year 2. On
December 1, Year 1, based on its expected available cash, Timber decides to refinance
$4,000,000 of the debt. The bank issues Timber a six-year, 12 percent note on
December 15, Year 1. The entire proceeds of this loan will be used on April 1, Year 2, to
pay the long-term debt due on that date. Timber prepares financial statements on
December 31. Describe the liability classification of the $5,000,000 debt, maturing April
1, Year 2, on Timber Corp.'s balance sheet on December 31, Year 1.

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A. The entire $5,000,000 is current.
B. The entire $5,000,000 is long-term.
C. $1,000,000 is current, while $4,000,000 is long-term.
D. $4,000,000 is current, while $1,000,000 is long-term.
Explanation

Choice "C" is correct. Under U.S. GAAP, short-term obligations may be included in non-
current debt (and therefore excluded from current liabilities) if the intent is to refinance
on a long-term basis and the intent is supported by the ability to do so. Evidence of
intent includes actual refinancing prior to issuing financial statements or the existence of
a noncancelable financing agreement from a lender having the financial resources to
accomplish the refinancing.

In this situation, $4,000,000 of the $5,000,000 had been refinanced on December 15,
Year 1. The refinancing not only occurred prior to issuing Year 1 financial statements,
but it occurred prior to year-end. The $4,000,000 can therefore be considered non-
current and the remaining $1,000,000 will be considered current as it is coming due on
April 1, Year 2.

Choice "A" is incorrect. Because a portion of the $5,000,000 debt was refinanced prior
to December 31 of Year 1 by getting a new six-year note and the entire proceeds of this
loan will be used on April 1, Year 2, to pay the long-term debt due on that date, the
entire amount is not considered current as of December 31, Year 1.

Choice "B" is incorrect. Because a portion of the $5,000,000 debt was refinanced prior
to December 31 of Year 1 and the entire proceeds of this loan will be used on April 1,
Year 2, to pay the long-term debt due on that date, the entire debt is not considered
long-term as of December 31, Year 1.

Choice "D" is incorrect. Because a portion of the $5,000,000 debt was refinanced prior
to December 31 of Year 1 by getting a new six-year note and the entire proceeds of this
loan will be used on April 1, Year 2, to pay the long-term debt due on that date, the
portion that is not paid off in Year 2 will be considered long-term and the portion paid in
Year 2 is considered current as of December 31, Year 1.
A manufacturer produced 80,000 units and sold them for $1,200 each. The company
estimates that 4 percent of the units will have a defect, which will cost an estimated $95
each to repair. During this year, the company honored $159,000 in actual assurance-
type warranty costs. Using the assurance warranty approach, what would be the
balance of the warranty liability account at the end of its first year of operations?

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A. $463,000
B. $304,000
C. $159,000
D. $145,000
Explanation

Choice “D” is correct. An assurance warranty provides the customer a guarantee that
the product/service will work properly for the period covered. If the product/service does
not work properly within this time frame, the seller will correct the situation by repairing
the product, substituting a new product/service, or reimbursing the customer. The
liability and the related expense are recognized in the year of sale to match the cost
with the corresponding revenue from selling the product. The total liability is reduced by
actual expenditures through the period.

In this scenario, the company estimated that four percent of the 80,000 units will have
defects costing $95 per repair:

80,000 units sold × 4% = 3,200 estimated defective units × $95 per repair = $304,000
warranty liability

The total warranty liability should be reduced by actual expenditures for honoring the
warranty during the year in the amount of $159,000:

$304,000 warranty liability – $159,000 actual warranty costs = $145,000 end-of-year

warranty liability

Choice “A” is incorrect. This is the sum of the estimated repair costs and the actual
expenditures. The actual assurance-type warranty costs during the year should not be
added to the original warranty liability account balance.

Choice “B” is incorrect. This balance of $304,000 represents the total estimated repair
costs (i.e., the original warranty liability recorded). The total estimated repair costs
should be reduced by actual warranty costs during the period.

Choice “C” is incorrect. This balance represents actual assurance-type warranty costs
honored during the year, not the balance of the warranty liability account at the end of
the year. These costs should reduce the previous warranty liability account balance.
Beginning January 1, Year 1, Center Co. offered a five-year warranty from date of sale
on each of the company's products sold on/after January 1, Year 1. The warranty offer
was part of a program to increase sales. Fulfilling the terms of the warranty is expected
to cost Center Co. 4 percent of sales. Sales made under warranty in Year 1 totaled
$9,000,000, and one-fifth of the units sold were returned. These units were repaired or
replaced at a cost of $65,000. The amount of warranty expense that should appear on
Center's Year 1 income statement is:

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A. $360,000.
B. $137,000.
C. $72,000.
D. $65,000.
Explanation

Choice “A” is correct. Products are frequently sold with warranties. These warranty
obligations provide to customers assurances surrounding the quality of products sold.
Warranty obligations require the seller to repair or replace defective merchandise sold
to customers. When warranty obligations are meant to ensure the quality of goods sold,
a separate performance obligation associated with the warranty does not exist.

The seller estimates the related warranty expense and obligation and records the
related expense and obligation in the same period as the period in which the sale took
place. As such, for Year 1, Center Co. records warranty expense of $360,000 based on
4 percent of sales of $9,000,000.

Choice “B” is incorrect. There is no combination of numbers to produce the $137,000

indicated as the warranty expense.

Choice “C” is incorrect. This answer incorrectly calculates the warranty expense as one-
fifth of total estimated warranty obligation of $360,000. The warranty obligation (4
percent of sales) is entirely expensed in the year of the sale.

Choice “D” is incorrect. This answer incorrectly treats as the warranty expense the cost
of units repaired or replaced during the year. The warranty extends over a five-year
period. The $65,000 relates solely to the claims in the first year. The expense is 4
percent of Year 1 sales of $9,000,000.
As part of a program to increase sales, Chatham Inc. began offering a three-year
warranty on all products sold on/after January 1, Year 1. Chatham's Year 1 sales were
$3,850,000; the cost of the warranty is expected to be 4 percent of sales. The actual
Year 1 warranty expenditures consisted of $45,000 in labor and $13,000 in parts. The
amount of warranty expense that should appear on Chatham's income statement for
Year 1 is:

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A. $45,000.
B. $58,000.
C. $109,000.
D. $154,000.
Explanation

Choice “D” is correct. Products are frequently sold with warranties. These warranty
obligations provide to customers assurances surrounding the quality of products sold.
Warranty obligations require the seller to repair or replace defective merchandise sold
to customers. When warranty obligations are meant to ensure the quality of goods sold,
a separate performance obligation associated with the warranty does not exist.

The seller estimates the related warranty expense and obligation and records the
related expense and obligation in the same period in which the sale took place. As
such, for Year 1, Chatham Inc. records warranty expense of $154,000 based on 4
percent of sales of $3,850,000.

Choice “A” is incorrect. $45,000 is the actual labor cost expenditures for Year 1. This
does not represent the warranty expense to be accrued according to the accrual basis.

Choice “B” is incorrect. $58,000 is the actual expenditures for labor and parts in Year 1.
This does not represent the warranty expense to be accrued according to the accrual
basis.

Choice “C” is incorrect. This answer incorrectly calculates the warranty expense as 4
percent of sales of $3,850,000, but this answer then erroneously subtracted $45,000 in
labor expenses associated with warranty costs.
Paxton Co. started offering a three-year warranty on its products sold on/after June 1,
Year 1. Paxton's actual sales for the fiscal year ended May 31, Year 2, were
$2,695,000. The total cost of the warranty is expected to be 3 percent of sales. The
actual warranty expenditures for the fiscal year ended May 31, Year 2, were $31,500 in
labor and $9,100 in parts. The amount of warranty expense that should appear on
Paxton's income statement for the fiscal year ended May 31, Year 2, is:

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A. $31,500.
B. $40,600.
C. $49,350.
D. $80,850.
Explanation

Choice “D” is correct. Products are frequently sold with warranties. These warranty
obligations provide to customers assurances surrounding the quality of products sold.
Warranty obligations require the seller to repair or replace defective merchandise sold
to customers. When warranty obligations ensure the quality of goods sold, a separate
performance obligation associated with the warranty does not exist.

The seller estimates the related warranty expense and obligation and records the
related expense and obligation in the same period in which the sale took place. As
such, for the fiscal year ended May 31, Year 2, Paxton would record warranty expense
in the amount of $80,850: 3% × $2,695,000 sales for the fiscal year ended May 31, Year
2.

Choice “A” is incorrect. $31,500 is the actual labor cost expenditures for the year ended
May 31, Year 2. This does not represent the warranty expense to be accrued according
to the accrual basis.

Choice “B” is incorrect. $40,600 is the actual expenditures for labor and parts for the
year ended May 31, Year 2. This does not represent the warranty expense to be
accrued according to the accrual basis.

Choice “C” is incorrect. This answer calculates the warranty expense as $80,850, which
is 3 percent of sales of $2,695,000, but this answer then incorrectly subtracts $31,500 in
labor associated with warranty costs.
Vadis Co. sells appliances that include a three-year warranty. Service calls under the
warranty are performed by an independent mechanic under a contract with Vadis. The
warranty cannot be purchased separately. Based on experience, warranty costs are
estimated at $30 for each machine sold. When should Vadis recognize these warranty
costs?

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A. Evenly over the life of the warranty.
B. When the service calls are performed.
C. When payments are made to the mechanic.
D. When the machines are sold.
Explanation

Choice "D" is correct. Warranty costs should be recognized when the machines are
sold. The concept is that of matching revenues and the related expenses in the period
of benefit. Because the warranty cannot be purchased separately, the warranty is
included in the selling price of the machine and is not considered a distinct service.

Choice "A" is incorrect. The warranty costs would not be recognized evenly over the life
of the warranty.

Choice "B" is incorrect. The warranty costs would not be recognized when the service
calls are performed.

Choice "C" is incorrect. The warranty costs would not be recognized when the
payments are made to the mechanic.
Emmons Industries manufactures and sells a pipe fitting used by oil and gas
companies. Emmons provides a three-year warranty against manufacturer defects.
Industry experience with similar products indicates warranty costs are approximately 2
percent of sales. Sales of the pipe fitting in Year 1 were $2 million and actual warranty
expenditures were $15,000 for the first year. What amount will Emmons report as a
warranty liability at the end of the year?

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A. $40,000
B. $25,000
C. $15,000
D. $0
Explanation

Choice "B" is correct. Assurance-type warranties provide the customer a guarantee that
the product/service will work properly for the time period covered. If the product/service
does not work properly, then the seller will correct the situation by repairing the problem,
substituting a new product/service, or possibly reimbursing the customer. With this type
of warranty, the liability and the related expense are recognized in the year of sale to
"match" the cost with the corresponding revenue from selling the product.

Emmons Industries will record warranty expense and an increase to the warranty
liability of $40,000 during the year: $2 million sales revenue × 2% warranty expense
rate. Actual expenditures incurred for warranty work reduce the warranty liability. So,
the $40,000 increase to warranty liability will be decreased during the year by $15,000
actual warranty repairs during the year. The end-of-year warranty liability balance will be
$25,000: $40,000 increase during the year – $15,000 actual warranty repairs during the
year.

Choice "A" is incorrect. Emmons Industries will record warranty expense and an
increase to the warranty liability of $40,000 during the year: $2 million sales revenue ×
2% warranty expense rate. Warranty repairs during the year reduce the liability. The
$15,000 will reduce the warranty liability.

Choice "C" is incorrect. Actual warranty repair costs incurred during the year reduce the
overall liability for warranties of the product.

Choice "D" is incorrect. Assurance-type warranties are contingent losses that are
probable and can be reasonably estimated. Liabilities associated with these types of
warranties must be accrued and accounted for at year-end.
Which one of the following transactions would affect retained earnings but not additional
paid-in capital?

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A. Declaration of a small stock dividend.
B. Decrease in the value of an available-for-sale investment.
C. Impairment of a long-term asset.
D. Purchase of treasury stock using the cost method.
Explanation

Choice "C" is correct. Additional paid-in capital (APIC) is generally contributed capital in
excess of par value or stated value. It can also arise from many different types of
transactions, such as treasury stock (a company's buying and re-selling its own shares),
liquidating dividends (paying out more in dividends than available retained earnings),
bond conversions, and large and small stock dividends.

Retained earnings is the accumulated earnings or losses during the life of a corporation
not paid out in the form of a dividend. Retained earnings is impacted by transactions
involving net income/(loss) for a period, dividends (cash, property, and stock), prior
period adjustments, and the cumulative effect of retrospective changes in accounting.

The impairment of a long-term asset will result in a loss recorded on the income
statement. Losses flow to net income, and each period net income is closed out to
retained earnings. Therefore, an impairment loss will not affect additional paid-in capital.

Choice "A" is incorrect. A small stock dividend will impact both APIC and retained
earnings. When a small stock dividend is recorded, it represents a reclassification out of
retained earnings and into the capital stock accounts using the fair value of the stock.

Choice "B" is incorrect. A decrease in the value of an available-for-sale investment will

impact the reported amount of the investment on the balance sheet to fair value with
any unrealized holding gains or losses reported in other comprehensive income. This
transaction would not affect retained earnings or additional paid-in capital.

Choice "D" is incorrect. Treasury stock purchases under the cost method affect neither
additional paid-in capital nor retained earnings. Under the cost method, purchases of
treasury stock require a credit to the cash account and a debit in the same amount to
the Treasury Stock account, a contra-equity account.
The book value per share calculation of a corporation is usually significantly different
from the market value of the stock's selling price due to the:

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A. Use of accrual accounting in preparing financial statements.
B. Use of the matching principle in preparing financial statements.
C. Omission of the number of preferred shares outstanding at year-end in the calculation.
D. Use of historical costs in preparing financial statements.
Explanation

Choice "D" is correct. The book value per share is reflective of the historical costs
associated with issued shares. The recording of stock issuances at historical cost is
consistent with the conceptual framework and requirement to record transactions at
amounts that are reflective of costs associated with them.

Book value per share is not adjusted for changes that occur within the markets for
goods and services that can either drive increases or decreases in the value of a
company. The market will attempt to project growth opportunities for companies and
industries along with demand and consumer preferences. Therefore, the market value
of a stock will often vary drastically from the book value of the stock.

Choice "A" is incorrect. Accrual accounting enables businesses to record revenues and
expenses in the absence of the receipt or payment of cash. This answer does not
explain differences between book value and market value of stocks.

Choice "B" is incorrect. The matching principle is directly related to the recognition of all
expenses incurred in order to generate revenues during a reporting period. This answer
choice does not explain the differences between book value and market value of stocks.

Choice "C" is incorrect. The omission of preferred shares outstanding in the calculation
of book value per share does not explain the differences between (i) book value per the
financial statements and (ii) fair value based on the market. The common stock's fair
value based upon the market takes into consideration that the preferred shareholders
have limited priority to some distributions if the company were to liquidate.
Unless specifically restricted, each share of common stock carries all of the following
rights except the right to share proportionately in:

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A. Operating profits.
B. The vote for directors.
C. Corporate assets upon liquidation.
D. Cumulative dividends.
Explanation

Choice "D" is correct. Common stock represents basic ownership within a corporation.
Many rights exist to common stockholders. This stock ownership entitles holders to
share in the earnings of the corporation when dividends are declared. Common stock
often has voting rights, and while not guaranteed corporate assets upon dissolution of
the company, any remaining assets after creditors and preferred stockholders are
satisfied would be directed to common stockholders.

Preferred stockholders may have a cumulative feature associated with it. When this
feature is present, dividends not declared and paid during the period vest to the
preferred shareholders and are referred to as dividend in arrears. The cumulative
feature is unique to preferred shares and is not associated with common stock
ownership.

Choice "A" is incorrect. Common stockholders have a right to share in the operating
profits of an organization if dividends are declared.

Choice "B" is incorrect. Common stockholders have the right to vote for Board of
Directors.

Choice "C" is incorrect. Common stockholders are not guaranteed corporate assets
upon liquidation, but as owners, they do have right to any corporate assets remaining
after creditors and preferred stockholders are satisfied.
A publicly traded corporation issues 10,000 shares of new common stock for $50 per
share. The common stock has a par value of $5 per share. Which one of the following
statements is correct?

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A. Cash increases by $500,000, and common stock increases by $500,000.
B. Additional paid-in capital increases by $500,000; no other accounts are affected.
C. Cash increases by $500,000; common stock increases by $50,000; and additional paid-in
capital increases by $450,000.
D. Cash increases by $450,000; common stock increases by $50,000, and additional paid-in
capital increases by $500,000.
Explanation

Choice “C” is correct. When common stock is originally issued or sold to investors, the
par value of the stock is recorded in the appropriate stock account. Any amount the
corporation receives in excess of the par value or stated value of the stock is accounted
for as additional paid-in capital.

The cash account increases by the full amount received in the transaction:

10,000 shares × $50 per share = $500,000 cash increase

The common stock account increases by the amount of par value of the stock issued:

10,000 shares × $5 par value per share = $50,000 common stock increase

Additional paid-in capital increases by the amount the corporation receives in excess of
the par value:

10,000 shares × $45 per share = $450,000 additional paid-in capital increase

Choice “A” is incorrect. While cash increases by $500,000, common stock will only
increase by the par value of the shares issued. The excess must be recorded as paid-in
capital.

Choice “B” is incorrect. Additional paid-in capital is not the only account affected by this
transaction. Additional paid-in capital should be the excess the corporation receives
over the par value of the stock and in this scenario, that amount does not equal
$500,000.

Choice “D” is incorrect. Cash will increase by the total amount of cash received in the
transaction. In addition, the increase to additional paid-in capital should be the excess
the corporation receives over the par value of the stock.
On September 1, Year 1, Royal Corp., a newly formed company, had the following
stock issued and outstanding:

 Common stock, no par, $1 stated value, 5,000 shares originally issued for $15
per share.
 Preferred stock, $10 par value, 1,500 shares originally issued for $25 per share.

Royal's September 1, Year 1, statement of stockholders' equity should report:

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Additional
Common Preferred Paid-In
Stock Stock capital

A. 5,000 15,000 92,500

B. 5,000 37,500 70,000

C. 75,000 37,500 0

D. 75,000 15,000 22,500

Explanation

Choice "A" is correct.

Common stock (5,000 shares × $1 stated value) 5,000

Preferred stock (1,500 shares × $10 par value) 15,000

Additional paid-in capital from:

Common stock ($15 − $1) × 5,000 shares = 70,000
Preferred stock ($25 − $10) × 1,500 shares = 22,500
92,500

$5,000, common stock; $15,000 preferred stock; $92,500 APIC.

Harbor Company acquired an interest in the common stock of I-Bar Corporation in
exchange for $15,000 cash and computer equipment with a book value of $60,000 and
a fair market value of $50,000. As a result of this transaction, Harbor should record its
investment in I-Bar at:

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A. $50,000
B. $60,000
C. $65,000
D. $75,000
Explanation

Choice "C" is correct. In an asset exchange having commercial substance, gains and
losses are recognized in their entirety based on the difference between the fair market
value of the asset given up and its net book value. The basis of the property acquired is
equal to the fair market value of the property given up (book value plus gain or minus
loss) plus cash paid or minus cash received. The basis of Harbor's investment in I-Bar is
computed as follows:

Choices "A", "B", and "D" are incorrect, per the above.
Corporations purchase their outstanding stock for all of the following reasons except to:

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A. Increase earnings per share by reducing the number of shares outstanding.
B. Prevent a takeover.
C. Make a market in the stock.
D. Improve short-term cash flow.
Explanation

Choice "D" is correct. Repurchases of stock take place when a company goes to the
market and reacquires previously issued shares of stock. Shares reacquired during
these transactions are referred to as Treasury Stock. When a company reacquires its
own stock, ownership of the shares reverts to the company.

The reasons for repurchasing stock from the market vary. One reason is to prevent a
takeover of the company. Additionally, when a company believes the stock is
undervalued in the market, shares can be repurchased until the market value of the
stock increases. Repurchasing stock reduces the number of shares held by investors
and can result in improved financial ratios, such as earnings per share. Shares may
also be needed by the company to provide stock options to employees as a form of
compensation and long-term investment within the company.

Choice "A" is incorrect. An increase to earnings per share based on reduction in shares
outstanding is a reason for the repurchase of stock.

Choice "B" is incorrect. The prevention of a takeover is a reason for the repurchase of
stock.

Choice "C" is incorrect. When management believes stock is undervalued in the market,
repurchasing shares until the market increases to appropriate valuation is a reason for
the repurchase of stock.
When Treasury Stock is accounted for at cost, the cost is reported on the balance sheet
as a(n):

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A. Reduction of retained earnings.
B. Reduction of additional paid-in-capital.
C. Unallocated reduction of shareholders' equity.
D. Reduction of additional paid-in-capital and retained earnings.
Explanation

Choice "C" is correct. Treasury Stock represents the reacquisition of previously issued
shares. Treasury shares held by a company represent the difference between issued
and outstanding shares of stock. There are many reasons companies repurchase
shares of stock from the market. Treasury shares represent a contra equity account (a
reduction) in the stockholders' equity section of the balance sheet.

When Treasury Stock is accounted for using the cost method, the shares are recorded
at reacquisition cost. The entire cost of the repurchase is captured within the Treasury
Stock account with no gain/loss determined until the shares are either reissued back
into the market or retired. That gain/loss does not appear on the income statement or in
other comprehensive income.

Choice "A" is incorrect. Treasury Stock reacquired under the cost method does not
reduce retained earnings. The entire cost of the shares is captured within the Treasury
Stock account and shown as a reduction to (a contra equity account in) total
shareholders' equity.

Choice "B" is incorrect. Treasury Stock reacquired under the cost method does not
reduce additional paid-in capital. The cost method captures the entire cost of
reacquisition within the Treasury Stock account (a contra equity account). However, if
the par value method is utilized when accounting for the Treasury Stock, additional
paid-in capital is reduced based on original excesses at issuance.

Choice "D" is incorrect. Treasury Stock reacquired under the cost method does not
reduce additional paid-in capital and retained earnings. The cost method captures the
entire cost of reacquisition within the Treasury Stock account (a contra equity account).
However, if the par value method is utilized when accounting for the Treasury Stock,
additional paid-in capital is reduced based on original excesses at issuance. Retained
earnings will also be reduced under the par value method of accounting for any
repurchase price in excess of the initial issuance.
On January 5, 1995, Norton Company issued five thousand shares of common stock
with a par value of $100. The proceeds received were at the issue price of $120 per
share. On June 4, 1996, the company reacquired 500 shares at $115 per share.

Under the cost method of accounting for Treasury Stock, the amount debited to the
Treasury Stock account is:

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A. $57,500.
B. $50,000.
C. $60,000.
D. $10,000.
Explanation

Choice "A" is correct. Treasury Stock represents the reacquisition of previously issued
shares. Treasury Stock held by a company represents the difference between issued
and outstanding shares of stock. There are two methods of accounting for treasury
shares of stock: the cost method and the par value method. Treasury shares represent
a contra equity account in the stockholders' equity section of the balance sheet.

When Treasury Stock is accounted for using the cost method, the shares are recorded
at reacquisition cost. The entire cost of the repurchase is captured within the Treasury
Stock account (a contra equity account) with no gain/loss determined until the shares
are either reissued back into the market or retired (note that a gain or loss on Treasury
Stock is never reported in the income statement or in the statement of comprehensive
income). The 500 shares reacquired by Norton Company were repurchased at a price
of $115 per share (500 shares × $115 per share = $57,500) and recorded under the
cost method.

Therefore, the journal entry recorded to capture this event is as follows:

DR Treasury Stock 57,500

CR Cash 57,500

Choice "B" is incorrect. The entire cost of the shares is captured within the Treasury
Stock account, a contra equity account, and shown as a reduction to shareholders'
equity. This answer choice incorrectly uses the par value of the stock to reflect the debit
to the Treasury Stock account. The par value of the stock would be used for the debit to
Treasury Stock, if the par value method were used.

Choice "C" is incorrect. The entire cost of the shares is captured within the Treasury
Stock account, a contra equity account, and shown as a reduction to shareholders'
equity. This answer choice incorrectly uses the original issuance price of $120 per share
On September 26, Year 2, Midge Enterprises repurchased for $32 per share 100,000
shares of its 1,000,000 shares of common stock outstanding that have a $5 par value.
On November 15 of Year 2, 75,000 of the shares were reissued for $35 per share. On
January 15 of Year 3, 10,000 shares were reissued for $30 per share. If the cost
method of accounting for treasury stock is used, what is the balance in the paid-in
capital treasury stock account in Year 3?

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A. $245,000
B. $225,000
C. $205,000
D. $20,000
Explanation

Choice "C" is correct. Treasury shares are recorded and carried at their reacquisition
cost. A gain (or loss) occurs when treasury stock is reissued (resold) and the selling
price on the subsequent reissue (resale) of the treasury stock is greater than (or less
than) the cost of the previously reacquired stock. The account "additional paid-in
capital—treasury stock" is increased for gains and decreased for losses (if there is an
existing balance in the account) when treasury stock is reissued (resold) at prices that
differ from the previous reacquisition cost. If the loss from the resale is greater than the
amount in the "additional paid-in capital—treasury stock" account, the amount of that
loss in excess of the amount in the "additional paid-in capital—treasury stock" account
decreases retained earnings.

On November 15, Year 2, Midge Enterprises reissued (resold) 75,000 shares for $35
per share. That $35-per-share selling price of the stock reissued exceeds the
reacquisition cost by $3 per share: $35-per-share resale price – $32 previous
reacquisition cost. The $3 "gain" is recorded in the additional paid-in capital—treasury
stock account at $3 gain per share × 75,000 shares = $225,000.

On January 15, Year 3, 10,000 shares are reissued (resold) for $30 per share, which is
less than the previous reacquisition cost of $32, resulting in a $2-per-share "loss:" $30-
per-share resale price – $32 previous reacquisition cost. The total "loss" is $20,000: $2-
per-share "loss" × 10,000 shares resold. Because the additional paid-in capital—
treasury stock account has a balance of at least $20,000, the $20,000 "loss" decreases
the additional paid-in capital—treasury stock account; so the new balance in additional
paid-in capital—capital stock is $205,000: $225,000 previous balance – $20,000 on
account of the "loss."

Nov. 15, Year 2, Selling price > Reacquisition Increase APIC—treasury stock = $225,000
price
Jan. 15, Year 3, Selling price < Reacquisition Decrease APIC—treasury stock = –20,000
price
Which one of the following transactions may result in a debit to "additional paid-in
capital?"

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A. Premiums on capital stock issued
B. Sale of Treasury Stock below cost
C. Receipt of equipment in exchange for shares
D. Conversion of convertible bonds
Explanation

Choice "B" is correct. When shares of stock have a designated par or stated value
associated with them, that amount denotes stated capital. When stock is sold, the par or
stated value is credited directly into the capital stock account. When proceeds from the
issuances of stock result in excesses above par or stated value, the additional paid-in
capital account is credited to capture these amounts.

When Treasury Stock is sold at an amount below its reacquisition cost, the company
experiences a loss on the sale of the stock back into the market. In order to account for
this loss, the company would determine if any balance exists in additional paid-in
capital—Treasury Stock. If a credit balance exists, the loss is accounted for by a debit to
additional paid-in capital—Treasury Stock. If no balance exists, the loss is captured with
a debit to retained earnings.

Choice "A" is incorrect. Premiums (excesses over par) are accounted for by crediting
the additional paid-in capital for any proceeds received in excess of the par or stated
value of the stock. This answer incorrectly identifies this as a debit.

Choice "C" is incorrect. The receipt of equipment in exchange for ownership of the
company would result in an increase in the capital stock account based on par or stated
value of the stock and an increase to additional paid-in capital for any excess (the fair
value of the equipment in excess of the par or stated value of the stock distributed in
exchange for the receipt of the equipment). The sum of the two increases would equal
the fair value of the equipment received.

Choice "D" is incorrect. Conversions of convertible bonds into shares of stock would
result in increases in the capital stock accounts with any excesses over par being
captured with a credit to the additional paid-in capital account.
On December 1, Charles Company's Board of Directors declared a cash dividend of $1
per share on the 50,000 shares of common stock outstanding. The company also has
5,000 shares of Treasury Stock. Shareholders of record on December 15 are eligible for
the dividend, which is to be paid on January 1. On December 1, the company should:

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A. Make no accounting entry.
B. Debit retained earnings for $50,000.
C. Debit retained earnings for $55,000.
D. Debit retained earnings for $50,000 and paid-in-capital for $5,000.
Explanation

Choice "B" is correct. When cash dividends are declared by the Board of Directors,
three dates are significant in accounting for the dividend: the declaration date, the date
of record, and the payment date. At the date of declaration, a liability is created and
must be recorded by company. Additionally, the date of record establishes the owners
of the stock entitled to receipt of the dividends. The payment date is the payment of
cash to owners and therefore eliminates the liability created at declaration date.

On the December 1 declaration date, the company would record the following:

DR Retained earnings $50,000

CR Dividends payable $50,000

Choice "A" is incorrect. At December 1, a dividend was declared by management, and

as a result, a liability has been created for the company. An accounting entry is required
in order to record the reduction to retained earnings and the creation of dividend
payable.

Choice "C" is incorrect. This answer choice incorrectly includes Treasury shares in the
calculation of the dividend payable to owners. Dividends are not paid on Treasury
shares held by the corporation, and only the common stock outstanding of 50,000
shares is eligible for the cash dividend of $1 per share.

Choice "D" is incorrect. This answer choice incorrectly includes Treasury shares in the
calculation of the dividend payable to owners. Dividends are not paid on Treasury
shares held by the corporation, and only the common stock outstanding of 50,000
shares is eligible for the cash dividend of $1 per share.
Division Corporation has 20,000 shares of $5.00 participating 9 percent cumulative
preferred stock and 100,000 shares of $2.00 common stock. On July 1, the board of
Division declared a $30,000 dividend at the time the common stock was selling for $25
per share and the preferred stock was selling for $30. The total dividends paid to each
class of stock on the payment date was:

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Preferred Common

A. $10,000 $20,000

B. $16,000 $14,000

C. $12,500 $17,500

D. $9,500 $20,500
Explanation

Choice "A" is correct. Participating preferred stock splits dividend distributions with
common shareholders only after the common shareholders have received percentage
dividends equivalent to preferred shareholders. The remaining dividend is shared in
relation to relative capitalization. The following calculation illustrates the distribution of
dividends by share classification.

Preferred Common Capitalization Dividends

Dividends
Total dividends declared $30,000
Shares 20,000 100,000
Par value $5.00 $2.00
Total capitalization $100,000 $200,000 $300,000
Preferred dividend rate 9% 9%
Dividends $9,000 $18,000 $27,000
Relative capitalization 33.3% 66.7%
Undistributed dividends subject to $1,000 $2,000 $3,000
participation
Total dividends per class $10,000 $20,000 $30,000

Choice "B" is incorrect. This answer presumes no distribution to common shareholders

prior to application of participation features.
An appropriation of retained earnings by the Board of Directors of a corporation for
bonded indebtedness will result in:

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A. A decrease in cash on the balance sheet with an equal increase in the investment and funds
section of the balance sheet.
B. The setting aside of cash to be used for the payment of interest on the bonds at specified
future dates.
C. A decrease in the total amount of retained earnings presented on the balance sheet.
D. The disclosure that management does not intend to distribute assets, in the form of dividends,
equal to the amount of the appropriation.
Explanation

Choice "D" is correct. At times, amounts available for distribution to owners of the
company are reduced by management. These types of restrictions designate a portion
of the retained earnings as being unavailable for dividend distribution. Instances that
might trigger an appropriation of retained earnings may include repayments of debt,
contingencies, or future plant expansion.

The restrictions do not result in the setting aside of cash, but rather, communicate the
intentions of management related to that portion of the retained earnings. A disclosure
note to the financial statements will articulate these restrictions.

Choice "A" is incorrect. The appropriation of retained earnings does not result in the
setting aside of cash, but rather, a communication of the intentions of management.

Choice "B" is incorrect. The appropriation of retained earnings does not result in the
setting aside of cash, but rather, a communication of the intentions of management.
While the appropriation may be associated with debt repayments, no cash is set aside
as a result of the appropriation.

Choice "C" is incorrect. There is no decrease in retained earnings associated with an

appropriation of the funds. Total retained earnings remain unchanged; however, a
portion of the dollars is appropriated based on management's intention.
A corporation’s common stock has a market price that is greater than its par value. The
corporation is considering a small stock dividend, a large stock dividend, or a stock split.
Which of the following would change additional paid-in-capital on the balance sheet?

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A. The stock split only.
B. The small stock dividend and the stock split only.
C. The large stock dividend and the stock split only.
D. The small stock dividend only.
Explanation

Choice “D” is correct. Stock dividends distribute additional shares of a company's own
stock to its shareholders. When less than 20 to 25 percent of the shares previously
outstanding are declared as a stock dividend, the dividend is treated as a small stock
dividend because the issuance is not expected to affect the market price of the stock.
The fair market value of the stock dividend at the date of declaration is transferred from
retained earnings to capital stock and additional paid-in capital.

Large stock dividends may be expected to reduce the market price of the stock,
therefore, only the par value of the stock dividend is transferred from retained earnings
to capital stock with no impact to additional paid-in capital.

Stock splits occur when a corporation issues additional shares of its own stock (without
charge) to current shareholders and reduces the par value per share proportionately
with no impact to additional paid-in capital.

The small stock dividend is the only transaction in the scenario that affects additional
paid-in capital.

Choice “A” is incorrect. Stock splits occur when a corporation issues additional shares
of its own stock (without charge) to current shareholders and reduces the par value per
share proportionately. This does not affect additional paid-in capital. There is no change
in the total book value of the shares outstanding. Thus, the memo entry to acknowledge
a stock split is merely a formality. A stock split usually does not affect retained earnings
or total shareholders' equity.

Choice “B” is incorrect. While the small stock dividend does affect additional paid-in
capital, the stock split does not. Stock splits occur when a corporation issues additional
shares of its own stock (without charge) to current shareholders and reduces the par
value per share proportionately. Stock splits do not affect additional paid-in capital.

Choice “C” is incorrect. Neither the large stock dividend nor the stock split affect
additional paid-in capital. In the case of large stock dividend transactions, the par value
of the stock dividend is transferred from retained earnings to capital stock with no
A publicly traded corporation that prepares financial statements using U.S. GAAP
issues a 5 percent stock dividend on its 100,000 shares outstanding of $10 par value
stock. The current market price is $18 per share. The company has retained earnings of
$2,650,000. What is the impact on retained earnings?

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A. Decrease of $40,000.
B. Decrease of $50,000.
C. Decrease of $90,000.
D. No impact.
Explanation

Choice “C” is correct. Stock dividends distribute additional shares of a company's own
stock to its shareholders. When less than 20 to 25 percent of the shares previously
outstanding are declared as a stock dividend, the dividend is treated as a small stock
dividend because the issuance is not expected to affect the market price of the stock.
The fair market value of the stock dividend at the date of declaration is transferred from
retained earnings to capital stock and additional paid-in capital.

An issuance of five percent constitutes a small stock dividend. Retained earnings is

decreased by the number of shares issued multiplied by the current market price per
share.

100,000 shares outstanding × 5% = 5,000 shares issued

5,000 shares issued × $18 current market price per share = $90,000 decrease to
retained earnings

Choice “A” is incorrect. This is the impact on additional paid-in capital, not retained
earnings, and is the number of shares multiplied by the current market price less the par
value per share. Small stock dividends consider the fair market value of the stock
dividend at the date of declaration.

Choice “B” is incorrect. This is the impact on common stock, not retained earnings, and
is the number of shares issued multiplied by the par value per share. Small stock
dividends consider the fair market value of the stock dividend at the date of declaration.

Choice “D” is incorrect. While there is no effect on total shareholders' equity, paid-in
capital and par value are substituted for retained earnings to record a small stock
dividend transaction (i.e., retained earnings are "capitalized" and made part of paid-in
capital).
How would a 5% stock dividend affect each of the following?

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Total
stockholders' Retained
Assets equity earnings

A. Increase Increase Decrease

B. No effect Decrease Decrease

C. No effect No effect Decrease

D. Decrease Decrease No effect

Explanation

Choice "C" is correct. No effect on assets. No effect on equity. Decrease to retained

earnings.

Rule: A stock dividend (less than 20-25% of the stock outstanding) transfers the FMV of
the stock dividend at declaration date from retained earnings to capital stock and paid-in
capital. There is no effect on total stockholders' equity because all transfers take place
within stockholders' equity.
England Enterprises' shareholders' equity on December 31, Year 1, includes the
following:

Common stock, $3 par, authorized 10 million shares;

issued and outstanding, 7.5 million shares $22,500,000
Add'l paid-in capital: CS 90,000,000
Retained earnings 78,750,000

On June 30 of Year 2, the board of directors declared a 5 percent stock dividend on

common shares to be distributed on July 15. The market price of the stock on June 30
was $25, and on July 15 the market value was $30. Determine the value of the stock
dividend.

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A. $1,125,000
B. $9,375,000
C. $12,500,000
D. $13,125,000
Explanation

Choice "B" is correct. When less than 20 to 25 percent of the shares previously
outstanding are declared as a stock dividend, the dividend is treated as a small stock.
The fair market value of the stock dividend at the date of the declaration of the small
stock dividend—not at the date of the distribution of the small stock dividend—is
transferred from retained earnings to capital stock and additional paid-in capital.

The fair market value of the stock dividend at the date of declaration is $9,375,000: 5%
multiplier × 7,500,000 shares outstanding on dividend declaration date × $25-per-share
market price on date of declaration = $9,375,000 value of small stock dividend (and
amount to be transferred from retained earnings).

Choice "A" is incorrect. This answer choice incorrectly used the stock's $3 par value,
rather than the stock's market value ($25) on the date of the declaration of the small
stock dividend, to compute—incorrectly—the value of the small stock dividend: 5%
multiplier × 7,500,000 shares outstanding on dividend declaration date × $3 par value =
$1,125,000 incorrect answer choice.

Choice "C" in incorrect. This answer choice incorrectly uses the number of shares of
stock authorized to be issued (10,000,000 shares), rather than the number of shares
outstanding (7,500,000), to compute—incorrectly—the value of the small stock dividend:
5% multiplier × 10,000,000 shares authorized to be issued on dividend declaration date
× $25-per-share market price on date of declaration = $12,500,000 incorrect answer
choice.