Professional Documents
Culture Documents
Owners Equity
QUESTIONS
Q10-1.
Common shares represent the residual ownership of the entity, and the owners have a claim to
the earnings and assets of the entity after the claims of the creditors and preferred shareholders
have been satisfied. Preferred shares rank in claim ahead of common shares. Preferred shares
have rights that must be satisfied before common shareholders' rights. These preferred rights
pertain to the payment of dividends and/or to the distribution of assets in the event of liquidation.
Dividends on preferred shares must be paid before dividends can be paid to common
shareholders. If the corporation is liquidated, preferred shareholders' claims to assets must be
satisfied before the common shareholders' claims. Therefore its riskier for an investor to own
common shares than preferred shares because preferred shares have priority to dividends and
residual claim of a liquidated company.
Q10-2.
Leverage is the use of debt to attempt to increase the return earned on the equity investment of
the owners. Leverage is attractive because any profits earned from investing borrowed money,
above the cost of borrowing, go to the owners. But leverage is risky because the cost of
borrowing must be paid, regardless of how well or poorly the entity is performing. Another
advantage of leverage is that interest on debt is tax deductible and so part of the cost of
borrowing is financed by the government/taxpayers..
Q10-3.
Financing a new business with a high proportion of debt is difficult because lenders might be
reluctant to lend. The higher the debt to equity ratio the higher the risk therefore if debt was
approved it would be at a much higher interest rate and income made has to be allocated to
service the debt first. As primary concern of a lender is the repayment of the loan. When lending
to a corporation the owners of the company dont have an obligation to payback any outstanding
debt should the company go bankrupt. As a result, lenders will often ask lenders to personally
secure loans to mitigate the risk of default. A company with a high proportion of debt (meaning
the owners have invested relatively little) may be problematic to lenders because with little to
lose the owners may be prepared to take more risk than if they had a larger stake in the company.
If a new entity was financed with 90% debt the lender would be absorbing a lot of risk and more
importantly the borrower would have relatively little risk because he would have little at stake in
the business (only a 10% interest in the total investment).
Page 10-1
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-4.
A corporation is a separate legal entity from its owners, whereas proprietorships and partnerships
are simply extensions of the owner(s). Corporations pay taxes whereas partnerships and
proprietorships dont (the partners or proprietor pay the tax). The corporation continues to
operate when the owners die or no longer wish to own the business. The income of the
proprietorship or partnership is income in the hands of the owners when its earned, but in the
hands of shareholders of a corporation only when its distributed as dividends. The liability of
owners of a corporation is limited (unless the owners provide personal guarantees to creditors),
but the liability of proprietors and partners is unlimited except in the case of LLPs.
Q10-5.
Common shares represent the residual interest in an entity because the common shareholders
receive what is left over after all other claims are satisfied. This means that in the event of
liquidation, the common shareholders receive the remaining assets after all liabilities and claims
of creditors and other (preferred) shareholders have been settled. Common shareholders are
entitled to all profits of a corporation once interest and dividends to preferred shareholders have
been paid.
Q10-6.
Both debt and equity are sources of financing for an entity, but equity doesnt provide any
binding commitments for repayment of the original amount, or any periodic payments. For debt,
failure to make payments as agreed is an event with legal consequences. The entity can issue
debt without sharing control of the entity or of profits over and above the agreed payments.
Equity implies ownership and owners will have a say in the activities of the corporation. Debt
holders have far less say than do shareholders. The cost of debt is tax deductible whereas the cost
of equity isnt.
To the entity, equity is less risky because its possible to operate for many years without making
cash payments to the shareholders. However, a share in the votes of the entity must usually be
provided to the new shareholders and all shareholders are entitled to their share of the earnings.
When debt is issued, and the entity is successful, there is no requirement to share the success
with creditors.
It isnt possible to determine which is best for a particular entity without understanding the
underlying risk of the business, the industry and related costs.
Page 10-2
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-7.
Not-for-profit organizations (NFPO) are economic entities whose objective is to provide services
and not to make a profit. NFPOs dont have owners or ownership shares that can be traded or
sold. Any "income" earned by the NFPO is reinvested in the organization. An NFPO may be
formed to pursue environmental issues, or fund cancer research or to build homes for those who
otherwise may not be able to afford them. In many cases, the beneficiaries of the organizations
activities may be different from those who contributed the funds. Success for NFPOs isnt
measured by the ability to earn a profit, but by whether the organization has been effective in
pursuing its mission. As a result, the traditional income statement isnt appropriate because the
bottom line doesnt represent the residual gain or loss of the owners. Its simply the excess of
revenues over expenses.
Q10-8.
There are no owners of NFPOs that have a residual claim on the equity of the organization.
Without owners, there cant be a representation of the owners interest in the entity. However, to
prepare a balance sheet, the difference between assets and liabilities must be represented.
Instead, there is a statement of resources or net assets that shows the excess of assets over
liabilities. This section of the balance sheet represents contributions (often classified by any
restrictions on the contributions) to the NFPO and the extent to which the inflows of the entity
differ from the costs of operations.
Q10-9.
In limited liability partnerships, some of the partners have limited liability protection. Limited
liability partners arent liable personally for the debts of the limited liability partnership and are
less involved in management of the entity. General partners manage the organization and are
liable for debts just as in the case of proprietorships. The nature of a partnership is that the
partners arent protected from the risks of the partnerships activities. The general partner
maintains the existence of the residual party that bears risk while providing protection to the
other partners. If there wasnt at least one general partner, creditors would be much less willing
to lend to the entity, since the owners would have a minimal commitment to ensuring that the
obligations of the entity are met.
Q10-10.
Dividends are distributions of the earnings of a corporation to the owners and are discretionary.
Interest is a payment on debt to lenders. Interest isnt discretionary and isnt dependent on the
earning of profits. This treatment is consistent with the view that net income reflects changes in
the wealth of the shareholders. In this view, dividends arent a cost of doing business but a
distribution to the shareholders. In this sense, dividends dont represent a change in the wealth of
the shareholders but a change in the form of the wealth (the wealth is cash in the hands of the
shareholders instead of an increased value of the shares). Interest payments are expensed because
interest is a cost that the corporation must incur to borrow money.
Page 10-3
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-11.
Par value is an amount assigned to a share of stock in the articles of incorporation. Without par,
the full amount invested by investors is credited to common stock. With par value shares, the par
value is credited to common stock and the amount in excess of par is credited to contributed
surplus.
Q10-12.
i.
The company would pay $100,000 to the bondholders each year, and the amount would be an
expense on the income statement, reducing before-tax income by $100,000 and after-tax income
by $70,000.
The net cash cost would be $70,000 per year.
ii.
The company would pay $65,000 per year to shareholders, which would represent the net cash
cost. There would be no effect on the income statement or tax effect.
Q10-13.
Stock price is an indicator of an entitys performance so managers will always be concerned
about the price of the stock. Another likely reason that management would be concerned about
the falling share price is that managements performance evaluation may be linked to the share
price and there may be implications for compensation, either in the form of bonuses or stock
options. Management may also be concerned that shareholders may replace them with a new
management team.
Q10-14.
Changes in share price arent reflected in the entitys financial statements. Financial statements
prepared in accordance with IFRS or ASPE account for shares at their exchange value (the
amount investors paid for them).
Q10-15.
A stock dividend is the distribution of a corporation's own shares to its existing shareholders. The
number of shares a shareholder receives depends on the number of shares owned on the date of
declaration. A stock splits the division of an entity's shares into a larger number of units, each
with a smaller value. A stock split is really nothing more than a big stock dividend. There is no
accounting effect of a stock splitthe amounts in the retained earnings and common share
accounts are unchanged. No journal entries are required to record a stock split. Measures such as
earnings per share that are dependent on the number of shares outstanding do change. A stock
dividend results in a transfer from retained earnings to common stock based on the market value
of the stock or some other basis. There is no economic significance to either stock splits or
dividends.
Page 10-4
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-16.
Retained earnings is the sum of the earnings of the entity since it was established less any
dividends that have been distributed. In addition to net income and payments of dividends,
adjustments to retained earnings include corrections of errors, the retroactive application of
changes in accounting policy and share retirements. The amount in retained earnings is an
indirect investment because the decision to retain the earnings is made by the company, not by
the investors. Earnings retention is an investment because profits (not necessarily cash) arent
being distributed to shareholders but are being kept for use by the company.
Q10-17.
Property dividends are paid with property instead of cash. The dividend is recorded at the market
value of the property at the date the dividend is declared. If the market value of the property isnt
equal to its carrying amount on the date the dividend is declared, a gain or loss is reported on the
income statement for the difference.
Q10-18
Accumulated other comprehensive income is an accumulation of revenues, expenses, gains and
losses that arent included in net income. These represent transactions with non-owners that
arent included in the calculation of net income and include certain unrealized gains and losses.
This is only required for companies reporting under IFRS (ASPE doesnt require calculation of
comprehensive income). It appears in the equity section of the balance sheet and is the
accumulation of other comprehensive income. Its analogous to retained earnings is that it
accumulates an amount reported on the income statement/statement of comprehensive income.
Q10-19.
The idea is appealing from the perspective that it creates an incentive for the executives to take
actions to increase the value of the firm, which is in the interest of shareholders. Its also a means
of providing compensation to the executives without using up cash. For a small and growing
company, it can be difficult and costly to raise cash by issuing additional stock. However, it also
creates incentives for management to prop up the share price by means, such as accounting
manipulations that dont increase the economic value of the firm.
Q10-20.
Employee stock options impose a cost on shareholders because they allow the employees to
obtain a claim on the wealth of the firm for an amount less than the market value of that wealth.
Thus the options dilute the value of the shareholders investment.
Page 10-5
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-21.
One would only pay $500 to lock in the price of a car if there was an expectation that the
increase in car prices would exceed $500 by an amount sufficient to compensate for the time
value of money, the risk that prices would not increase, and the risk that for some reason, the
student was unable to purchase a new car after graduation. If the price guarantee could be sold, it
would increase in value as car prices increased and decrease as car prices fell. The guarantee
only has value if it provides benefits which are savings from the price that would otherwise be
paid.
Q10-22.
An action or event has economic consequences if it causes a change in someones wealth.
Accounting has the potential for many economic consequences. A decision by a company to
disclose unfavorable information earlier than was previously intended will probably result in a
decrease in the share price. Any shareholder who was planning to sell shares in the firm a few
days later will receive less for the shares than if the announcement had been delayed. Similarly,
delaying revenue recognition will reduce net income and the managements bonuses if it is
directly related to income. Accounting has economic consequences because decisions are based
on accounting information and economic outcomes can be based on accounting numbers.
Q10-23.
Even though the accounting choices dont change the underlying economic activity of the firm,
many numbers on the financial statements do change and accordingly, many individuals may be
affected. In general, any economic outcome that depends on an accounting measurement (such as
the current ratio) can be affected by accounting choices. Employees with a profit-sharing plan
may receive more or less after a change. The customers of a telephone company will pay more or
less for the same rate-regulated services if the rates are based on some target return on equity for
the shareholders of the utility. In other words, while the underlying economic activity may not
change the representation of that activity will change and these changes may affect economic
decisions and economic outcomes.
Q10-24.
The book value of the equity of the firm is simply the total of the assets less the total of liabilities
as determined by the accounting policies selected by management. The market value of the firm
is the amount that the investors are willing to pay for the shares of the firm. The market value
fluctuates daily with changes in expectations of the future profitability and risk of the firm along
with variations in stock prices generally. An important reason the values differ is that the book
value reflects only past transactions while market value includes expected future profits. Market
value will also reflect assets ignored in the book valuefor example, research, brand names, and
human capital. Book value per share equals shareholders equity number of common shares
outstanding.
Page 10-6
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-25.
Equity is simply the difference between assets and liabilities. It represents the book value of the
company, but not necessarily the market value. Market value is impacted by factors such as risk,
future cash flow and profit predictions, the fair value of the assets, and synergies among assets.
Therefore the owner of the business is likely incorrect as there would be very few instances
where carrying amount and market value were equal.
Q10-26.
The number of shares authorized is the maximum number of shares of a particular type a firm
can issue and is specified in the articles of incorporation. The number of shares outstanding are
the shares that have been issued by the firm and are still in the hands of shareholders.
Q10-27.
Preferred shares rank ahead of common shares both in receiving dividends and in the case of the
liquidation of the firm. Dividends on preferred shares arent guaranteed, even if the preferred
shares have a cumulative feature. The board of directors could chose to never pay a dividend to
any shareholders. However, if the preferred shares are cumulative, no dividends can be paid to
common shareholders until all preferred dividends in arrears are paid.
Q10-28.
The only thing a stock dividend gives a shareholder is something to sell if cash is preferred.
Otherwise, the real choice is no dividend versus a cash dividend. The drawback is that selling
shares results in transactions costsyou have to pay to sell the shares. Cash dividends change
the form of wealth of shareholders by converting the value of the shares into cash. If an investor
desires cash, a cash dividend is attractive. Dividends attract tax so receiving a cash dividend
might be unattractive to shareholders who dont need cash. Stock dividends dont have any
immediate tax implications until they are cashed in.
Q10-29.
Most companies retain some of their earnings because they have attractive opportunities for
investment with the cash. Its less costly to retain cash than to pay out the dividends to
shareholders and issue new shares or incur new debt to raise more cash.
Q10-30.
Earnings per share is the portion of the earnings of the firm that is attributable to each common
share. Since preferred shareholders have a claim on earnings before common shareholders, the
dividends due to the preferred shareholders must be subtracted. Earnings per share isnt an
indication of the amount of dividends that shareholders can currently expect to receive because
EPS doesnt necessarily represent cash on hand to pay a dividend. Also, the simple fact that an
entity has made a profit doesnt necessarily make it desirable to pay a dividend because it may
have attractive investment alternatives that can earn a good return for the shareholders.
Page 10-7
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-31.
When a company buys back shares and the shares are retired the weighted average number of
shares goes down, hence EPS would increase. The economic impact to the company is the cash
or other consideration is paid to buy back the shares so resources are decreased. In addition, the
share price of the company might change as a result of the buy back.
Q10-32
The dividend yield of a share is the amount of dividends divided by the current share price and is
indicator of the dividend performance of the company. The dividend payout ratio is the dividends
paid divided by the companys net income. It represents the size of the payout in proportion to
earnings, the smaller the ratio the more earning are retained within the company. It isnt
necessarily a bad situation if both are zero since it means that the company isnt paying
dividends. Not paying dividends can mean the company is keeping its cash for other uses and
doesnt mean that future payout isnt a possibility. Growing companies will typically not payout
dividends as it holds back distribution to fund future growth.
Q10-33.
When an accounting policy is changed, its applied retroactively, so the retained earnings must be
revised to the amount that would have resulted if the new policy had always been followed in the
past. Similarly, errors in previous years financial statements are corrected retroactively so
previous years retained earnings would be restated to reflect the amount that would have been
reported had the error not been made.
Q10-34.
Lenders wish to limit the risk that there may not be sufficient assets to repay them in the case of
liquidation of the entitys assets. One way to do that is to force the shareholders to retain a
minimum equity position in the company. By lowering the risk, lenders will also be prepared to
offer a lower interest rate. From the entitys standpoint management might offer limits on
dividend payments to reduce the risk to creditors and thereby lower the cost of borrowing.
Q10-35.
Property dividends are a distribution of wealth to owners of the company. What is being
distributed to shareholders is the market value of the property, not the carrying amount. An
alternative to the property dividend would be to sell the property and distribute the cash.
Therefore it makes sense that the accounting would be the same for either alternative. Property
dividends are uncommon because there are few assets that can be divided in small portions. For
example, land, buildings and machinery cant be distributed in small portions of varying size.
Page 10-8
Copyright 2013 McGraw-Hill Ryerson Ltd.
Q10-36
A change in accounting policy is a change in the method that is used to account for a particular
transaction. A change in accounting estimate is a revision of a judgment that is made about
something that cant be determined precisely, such as the length of time that an asset will
contribute to revenues or the amount for which the asset can be sold at the end of its useful life.
A change in accounting estimate is applied prospectively, meaning that the past financial
statements arent restated. A change in accounting policy is applied retrospectively, meaning that
past financial statements are restated to reflect the new policy so that the past financial
statements appear as if the new policy had always been used.
Page 10-9
Copyright 2013 McGraw-Hill Ryerson Ltd.
EXERCISES
E10-1
To: Mr. Wong and Mr. Ismail
Depending on your business goals there are both advantages and disadvantages with setting the
company up as a corporation versus a partnership. I will outline some of the benefits and
drawbacks of each.
Corporation:
Advantages
There is limited liability which means that each partners personal assets are protected under the
business endeavour. This means as a shareholder your losses will not exceed what you invest in
the company.
As a corporation you may also draw salaries for individual efforts but also have the ability to
have additional payouts in the form of dividends.
A corporation has unlimited life and has many tax shelter opportunities that can be explored
should you decide on this route.
Customers may feel they are contracting with a larger company if its incorporated.
Disadvantages
There are costs associated with incorporating your company as well as additional administrative
costs such as corporate tax returns and record keeping.
If there isnt enough equity investment in the company, lenders will not lend to the corporation
without personal guarantees.
Partnership:
Advantages
Disadvantages
Any debt incurred by the partnership is a liability to the partners as well as the partnership. In
other words, personal assets are at risk if the partnership defaults to lenders.
Negligence by any partner in the business will be shared by all partners.
From what I presented above I leave it to you to choose the direction you would like to take. I
would, however, recommend the partnership since its easy to set-up and doesnt require
incorporation. In the future should the business become success you may want to revisit
incorporation when the business is established to take advantage of what incorporating has to
offer.
Page 10-10
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-2.
a.
Dr.
Cash (assets +)
4,500,000
Cr.
Common shares (equity +)
To record the issue of 200,000 common shares
4,500,000
b.
No journal entry is required for a stock split.
c.
December 9, 2017
Dr.
Retained earnings (equity )
250,000
Cr.
Dividends payable (liabilities +)
250,000
250,000
d.
Dr.
250,000
Cash (assets +)
6,000,000
Cr.
Common stock ($0.01 x 300,000)
(equity +)
Contributed surplus (equity +)
3,000
5,997,000
e.
Dr.
900,000
2,100,000
Page 10-11
Copyright 2013 McGraw-Hill Ryerson Ltd.
Page 10-12
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-3.
a.
i.
Dr.
Retained Earnings (equity )
200,000
Cr.
Dividend payable (liability +)
200,000
Dr.
200,000
ii.
Dr.
iii.
Dr.
iv.
Dr.
200,000
Cash (asset +)
3,000,000
Cr.
Common shares (equity +)
3,000,000
Cash (asset +)
1,000,000
Cr.
Preferred shares (equity +)
1,000,000
Patent (asset +)
Cr.
Common shares (equity +)
380,000
380,000
v.
Dr.
200,000
200,000
200,000
vi.
Dr.
286,000
viii.
No entry required.
Page 10-13
Copyright 2013 McGraw-Hill Ryerson Ltd.
b.
Beginning
Net Income
i
ii
iii
iv
v
vi
vii
Ending
Date
31-Dec-17
31-Dec-18
During
During
During
During
During
During
During
31-Dec-18
Asset
Liability
Preferred Stock
$1,500,000
($200,000)
3,000,000
1,000,000
380,000
(200,000)
3,000,000
380,000
1,560,000
$3,980,000
286,000
$286,000
$2,500,000
31-Dec-17
31-Dec-18
%
10%
100,000
10%
20,000
520,000
10%
20,000
Stock dividend
Total
Retained Earnings
$9,110,000
1,250,000
(200,000)
1,000,000
31-Dec-18
80,000
Owners' Equity
Common Stock
$1,200,000
$6,140,000
Total Common
Total O/E
Total Common
Total O/E
Net Income
(200,000)
(1,560,000)
(286,000)
$8,114,000
$14,254,000
16,754,000
10,310,000
11,810,000
$1,250,000
Dividend
$40,000
10,000
2,000
52,000
52,000
572,000
Shareholders equity:
Preferred stock Authorized, 200,000 shares, outstanding 80,000
Common stock Authorized, unlimited, outstanding 572,000
Retained earnings
Total
$2,500,000
6,140,000
8,114,000
$16,754,000
Page 10-14
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-4.
Owners' Equity
Beginning
Net
Income
i
ii
iii
iv
v
vi
ix
Date
31-Dec-16
31-Dec-17
During
During
During
During
During
During
Asset
Liability
(75,000,000)
24,000,000
7,500,000
25,000,000
(2,750,000)
31-Dec-17
Common
shares
425,000,000
Accumulated.
OCI
(1,750,000)
Retained
earnings
195,500,000
200,000
31,000,000
(75,000,000)
24,000,000
7,500,000
25,000,000
(2,750,000)
(20,960,000)
20,960,000
During
Ending
Preferred
shares
40,000,000
86,853,000
(21,250,000)
86,853,000
(86,853,000)
47,500,000
%
2%
Dividend
2,500,000
3,000,000
2%
60,000
750,000
494,960,000
(1,550,000)
40,937,000
3,000,000
2,750,000
131,000,000
Stock dividend
2,620,000
Total
133,620,000
2%
60,000
2,620,000
x$8
=20,960,000 (vi)
Shareholders' equity
Preferred Stock (Authorized, 5,000,000; Outstanding,
2,750,000)
Common Stock (Authorized, 400,000,000; Outstanding,
133,620,000)
Accumulated OCI
Retained Earnings
Total
47,500,000
494,960,000
(1,550,000)
40,937,000
581,847,000
Page 10-15
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-5.
Dr.
Land (asset +)
250,000
Cr.
Retained earnings (equity +)
250,000
The land had been expensed for $250,000. After the correction, retained earnings would be
$3,500,000. Since the adjustment is for correcting an error, beginning retained earnings is
adjusted and prior years comparative income statements restated. The adjustment has no bearing
on the current year and the error results in prior years statements being misstated so retroactive
adjustment makes sense.
E10-6.
Dr.
Retained earnings (equity )
1,400,000
Cr.
Accumulated depreciation
1,400,000
(contra asset )
(3,500,000/10 x 4 years)
By the end of 2016, retained earnings must be reduced by $1,400,000 to $16,400,000. The
adjustment has no bearing on the current year and the error results in prior years statements
being misstated so retroactive adjustment makes sense. The proper depreciation expense would
be recorded in 2017 and the comparative statements for 2016 would include the depreciation
expense
E10-7.
31-Dec-16
2017
31-Dec-17
Accumulated OCI
OCI
Accumulated OCI
245,000
(95,000)
150,000
E10-8.
2014
$
2015
($42,000)
2016
$195,000
2017
$101,000
2018
$155,000
(11,150)
15,000
(28,700)
(10,000)
Comprehensive income
(53,150)
210,000
72,300
145,000
512,000
425,000
550,000
525,000
525,000
16,850
5,700
20,700
-8,000
(18,000)
45,000
70,000
126,000
155,000
Net income
Retained earnings
Accumulated
comprehensive income
Dividends
other
Page 10-16
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-9.
a. Number of Shares - Issued
Preferred Stock
Common Stock
25,000
25,000
12
Months
Weighted
Average
Common
500,000
12
100%
500,000
50,000
11
92%
45,833
75,000
42%
31,250
625,000
577,083
b.
31-Dec-18
Net Income
1,950,000
Preferred Dividends
100,000
577,083
Basic EPS
$3.21
c.
Owners' Equity
Date
Asset
Liability
Preferred Stock
Common Stock
Beginning
Net
Income
31-Dec-17
1,250,000
1,800,000
31-Jan-18
200,000
200,000
ii
31-Jul-18
350,000
350,000
31-Dec-18
Retained Earnings
6,880,000
1,950,000
iii
During
(100,000)
(100,000)
iv
During
(400,000)
(400,000)
Ending
31-Dec-18
50,000
1,250,000
31-Dec-18
31-Dec-17
31-Dec-18
2,350,000
8,330,000
10,680,000
Total O/E
11,930,000
8,680,000
Total O/E
9,930,000
Net Income
1,950,000
Page 10-17
Copyright 2013 McGraw-Hill Ryerson Ltd.
31-Dec.-18
Net income
$1,950,000
Preferred dividend
100,000
Common shareholders equity (2017)
8,680,000
Common shareholders equity (2018) 10,680,000
ROE
19.11%
d.
Preferred stock (authorized 100,000, outstanding 25,000)
$ 1,250,000
Common stock (authorized 1,000,000, outstanding 625,000)
2,350,000
Retained earnings
8,330,000
Total shareholders equity
$11,930,000
E10-10.
Basic Earnings per share = (Net income- preferred dividends)/ Weighted average: common
shares
Situation
Net Income
Preferred Dividends
100,000
525,000
(200,000)
250,000
25,000,000
50,000
100,000
1,000,000
(50,000)
2,000,000
0.5
0.5
(25,000)
1,000,000
100,000
250,000
1,000,000
800,000
10,000,000
100,000
225,000
1,000,000
800,000
11,000,000
1.00
2.11
-0.20
0.19
2.18
Weighted-average number of
common shares outstanding
Basic EPS (Dec. 31, 2018)
Page 10-18
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-11.
a.
i.
Dr.
ii.
Dr.
Cash (asset +)
1,000,000
Cr.
Common shares (equity +)
Cash (asset +)
1,250,000
Cr.
Preferred shares (equity +)
1,000,000
1,250,000
iii.
Dr.
120,000
120,000
iv.
No entry is required.
v.
Dr.
100,000
100,000
60,000
60,000
b.
Beginning
Net Income
i
ii
iii
iv
v
vi
Ending
Date
31-Dec-16
31-Dec-17
2-Jan-17
28-Feb-17
30-Jun-17
30-Sep-17
31-Dec-17
31-Dec-17
31-Dec-17
Asset
Liability
Preferred Stock
-
1,000,000
1,250,000
(120,000)
(100,000)
(60,000)
1,970,000
Owners' Equity
Common Stock
4,000,000
Retained Earnings
2,375,000
1,150,000
1,000,000
1,250,000
(120,000)
1,250,000
5,000,000
(100,000)
(60,000)
3,245,000
31-Dec-17
Total Common
Total O/E
Total Common
Total O/E
8,245,000
9,495,000
6,375,000
6,375,000
31-Dec-16
Page 10-19
Copyright 2013 McGraw-Hill Ryerson Ltd.
Common Stock
1,000,000
12
Months
12
%
100%
200,000
12
100%
50,000
1,200,000
600,000
50,000
0.50
600,000
Weighted
Average
Common
1,000,000
200,000
1,200,000
600,000
600,000
2016
$0
4,000,000
2,375,000
$6,375,000
2017
$1,250,000
5,000,000
3,245,000
$9,495,000
c.
Common stock (outstanding 1,000,000)
Retained earnings
Total shareholders equity
2016
4,000,000
2,375,000
$6,375,000
The shareholders equity section of the December 31, 2016 balance sheet indicates that
1,000,000 common shares were outstanding while the comparative information at December 31,
2017 shows that 500,000 shares were outstanding. The reason is the effect of the reverse split
during 2017.
Page 10-20
Copyright 2013 McGraw-Hill Ryerson Ltd.
d.
Basic Earnings per share
31-Dec-17
Net Income
Preferred dividends.
Weighted average number
of common shares
Basic EPS
Return on Equity
1,150,000
100,000
600,000
1.75
31-Dec-17
Net income
Preferred dividends
Common shareholders equity (2016)
Common shareholders equity (2017)
ROE
Since the number of shares from the previous year was halved as a result of the reverse stock
split, EPS for 2016 would be reported as $3.50 in the 2017 annual report.
e.
There is no reason to expect that the reverse stock split affected the operating results of the
company. The motivations for stock splits usually relate to financing considerations, not
operating benefits. The reverse split would affect reported EPS but the change in the
measurement doesnt affect the actual performance.
Page 10-21
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-12.
a.
i.
Dr.
Cash
Cr.
Common stock
(100,000 shares* $10 per share)
ii.
Dr.
1,000,000
1,000,000
400,000
400,000
iii.
Dr.
Cash
Cr.
Preferred stock
(1,500 shares * $100 per share)
150,000
150,000
b.
Net Income
i
ii
iii
Ending
30-Jun-18
30-Jun-18
Date
30-Jun-18
1-Jul-17
During
During
30-Jun-18
Asset
Liability
1,000,000
400,000
150,000
1,550,000
Preferred
Shares
Owners' Equity
Common
Shares
Retained
Earnings
(50,000)
# of Shares - Issued
Preferred
Common
Shares
Shares
1,000,000
400,000
-
150,000
150,000
1,400,000
100,000
50,000
(50,000)
1,500
1,500
150,000
$1,350,000
1,500,000
(50,000)
$ 150,000
1,400,000
(50,000)
$1,500,000
c.
Yes, Kamsack could pay dividends on June 30, 2018. Positive retained earnings isnt a
requirement for the payment of dividends. If it did pay dividends, then the dividend could be
considered a partial return of the common shareholders original investment or it would reduce
negative (or deficit) retained earnings even more As long as Kamsack can meet its current
liabilities, they have no restrictive covenants preventing the payment of dividends and they have
the means to pay the dividends, then they can pay dividends.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-22
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-13.
a.
i
DR
11,000,000
Cash
Common shares
ii
Cash
11,000,000
4,000,000
Preferred shares
iii
Retained earnings
4,000,000
1,125,000
Cash
iv
No entry is required
Patent
1,125,000
960,000
Common shares
vi
Retained earnings
960,000
112,500
Cash
vii
CR
112,500
Retained earnings
3,876,000
Cash
3,876,000
b.
Beginning
Net Income
i
ii
iii
iv
v
vi
vii
Ending
Date
1-Jul-17
30-Jun-18
1-Aug-17
30-Nov-17
31-Dec-17
30-Apr-18
29-Jun-18
30-Jun-18
30-Jun-18
30-Jun-18
Asset
Liability
11,000,000
4,000,000
(1,125,000)
960,000
(112,500)
(3,876,000)
10,366,500
Preferred Stock
2,000,000
Owners' Equity
Common Stock
Accumulated OCI
8,000,000
85,000
100,000
11,000,000
Retained Earnings
11,900,000
4,500,000
4,000,000
(1,125,000)
960,000
6,000,000
19,960,000
185,000
30-Jun-18
Total Common
Total O/E
Total Common
Total O/E
Net Income
31,431,500
37,431,500
1-Jul-17
30-Jun-18
(112,500)
(3,876,000)
11,286,500
19,985,000
21,985,000
4,500,000
Page 10-23
Copyright 2013 McGraw-Hill Ryerson Ltd.
Common Stock
1,000,000
12
Months
12
%
100%
500,000
11
92%
1,500,000
4,500,000
60,000
50,000
3
0
75,000
0%
4,560,000
Weighted
Average
Common
1,000,000
458,333
1,458,333
4,375,000
4,375,000
Shareholders' equity
2018
6,000,000
2017
2,000,000
19,960,000
185,000
11,286,500
37,431,500
8,000,000
85,000
11,900,000
21,985,000
c.
Shareholders' equity
Preferred Stock (Outstanding, 25,000)
Common Stock (Outstanding,
1,000,000)
Accumulated OCI
Retained Earnings
Total
2017
2,000,000
8,000,000
85,000
11,900,000
21,985,000
The shareholders equity section of the June 30, 2017 balance sheet indicates that 1,000,000
common shares were outstanding while the comparative information for 2017 in the June 30,
2018 financial statements shows that 3,000,000 shares were outstanding. The reason is the effect
of the split during 2018.
d.
30-Jun-18
Net Income
Preferred Div.
Weighted average number of common shares
Basic EPS
4,500,000
112,500
4,375,000
1.00
If EPS was reported in the 2017 annual report as $1.80, it would be reported as $0.60 in the 2018
annual report to reflect the stock split.
Return on Equity
Page 10-24
Copyright 2013 McGraw-Hill Ryerson Ltd.
30-Jun-18
Net income
Preferred Dividends
Common shareholders' equity
(2017)
Common shareholders' equity
(2018)
ROE
4,500,000
112,500
19,985,000
37,431,500
17.07%
e.
There is no reason to expect that the stock split would affect the operating results of the
company. The motivations for stock splits usually relate to financing considerations, not
operating benefits. The reported EPS of the company would be quite different as a result of the
split but there is no change in performance as a result of the split. The companys income is just
being allocated to twice as many shares.
E10-14.
a.
Number of Shares - Issued
Weighted
12
Preferred Stock
Common Stock
50,000
50,000
Average Number
Months
of Common Shares
400,000
12
100%
400,000
40,000
58%
23,333
50,000
25%
12,500
490,000
435,833
31-Dec-17
Net Income
Preferred Dividend
Weighted average common stock
Basic EPS
$750,000
250,000
435,833
1.15
b.
Its difficult to estimate future dividends from the information provided. Net income doesnt give
a strong clue about the amount of dividends investors should expect. Net income isnt cash and
the company may have a policy of reinvesting income. In 2017, no common dividends were paid
and this might be the best indicator. The ability to pay dividends depends on the availability of
cash and the ability to generate cash. The willingness to pay dividends depends on the
investment opportunities available and the need for cash by the entity. At times management will
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-25
Copyright 2013 McGraw-Hill Ryerson Ltd.
pay dividends to show a sign of strength despite poor earnings however its ultimately up to the
board of directors.
Page 10-26
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-15
a.
Number of Shares - Issued
Weighted
12
Preferred Stock
1,000,000
Common Stock
Average
Months
Common
75,000,000
12
100%
75,000,000
(5,000,000)
50%
(2,500,000)
1,000,000
70,000,000
72,500,000
31-Dec-17
Net Income
11,700,000
Preferred Dividend
2,500,000
72,500,000
Basic EPS
0.127
b.
Its difficult to estimate future dividends from the information provided. Net income doesnt give
a strong clue about the amount of dividends investors should expect. Net income isnt cash and
the company may have a policy of reinvesting income. In 2017, no common dividends were paid
and this might be the best indicator. The ability to pay dividends depends on the availability of
cash and the ability to generate cash. The willingness to pay dividends depends on the
investment opportunities available and the need for cash by the entity. At times management will
pay dividends to show a sign of strength despite poor earnings however its ultimately up to the
board of directors.
Page 10-27
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-16.
a.
The conversion has no cash effect and doesnt appear on the statement of cash flows.
b.
No cash is involved in this transaction so its presented as a non-cash transaction as additional
information to the statement of cash flows.
c.
The split has no cash effect and doesnt appear on the statement of cash flows.
d.
Payment of dividends is a payment to owners and is presented as an outflow in the financing or
operating sections under IFRS. Under IFRS this is a choice. ASPE requires cash dividends to be
classified as cash from financing activities.
e.
Payment of dividends is a payment to owners and is presented as an outflow in the financing or
operating sections under IFRS. Under IFRS this is a choice. ASPE requires cash dividends to be
classified as cash from operations.
f.
The declaration of dividends has no cash effect and doesnt appear on the statement of cash
flows.
g.
The issuance would appear in the financing section since the inflow raises cash from
shareholders.
h
The issue would appear in the financing section since the inflow raises cash from shareholders.
i
The stock dividend has no cash effect and doesnt appear on the statement of cash flows.
j.
No cash is involved in a property dividend so its presented as a non-cash transaction as
additional information to the statement of cash flows.
k.
The repurchase is a financing activity outflow because it returns cash to shareholders.
l.
The cash inflow when the shares are issued will be presented in the financing section.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-28
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-17.
a.
Dr.
Cash (asset +)
Cr.
Common stock (equity +)
b.
Dr.
c.
Dr.
750,000
750,000
Cash (asset+)
750,000
Cr.
Common stock
Contributed surplus (equity +)
2,500
747,500
Cash (asset +)
750,000
Cr.
Common stock (equity +)
Contributed surplus (equity +)
25,000
725,000
d.
The effect of par value on the financial statements is only one of presentation and classification.
There is no economic or legal significance to the use of par value. Instead of the full proceeds of
the shares going to the common stock account, the par value of the shares goes to the common
stock account and the remainder to contributed surplus.
Page 10-29
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-18.
a.
i.
Dr.
Retained Earnings (equity )
2,500,000
Cr.
Cash/Dividend Payable (asset )
2,500,000
ii.
Dr.
2,500,000
iii.
Dr.
Retained Earnings
2,500,000
Cr.
Common stock
2,500,000
(500,000 shares x 5% x $100)
This entry assumes the company uses the market value method. If the cost method was used the
amount of the entry would be $375,000.
b.
Date
31-Dec-17
i
Ending
ii
Asset
(2,500,000)
1,500,000
(2,500,000)
Ending
iii
Ending
Owners' Equity
Common
Retained
Stock
Earnings
7,500,000
12,500,000
(2,500,000)
7,500,000
10,000,000
1,500,000
(2,500,000)
7,500,000
11,500,000
2,500,000 (2,500,000)
10,000,000
10,000,000
# of Shares Issued
Common
Stock
500,000
500,000
500,000
500,000
25,000
525,000
500,000
500,000
Common stock
Retained
earnings
Shareholders
equity
Cash
Dividend
7,500,000
Property
Dividend
7,500,000
Stock
Dividend
10,000,000
10,000,000
11,500,000
10,000,000
17,500,000
19,000,000
20,000,000
c.
i
Total O/E
Net Income
17,500,000
1,750,000
ii
Total O/E
Net Income
19,000,000
3,250,000
iii
Total O/E
Net Income
20,000,000
1,750,000
Page 10-30
Copyright 2013 McGraw-Hill Ryerson Ltd.
Weighted average
Number of
common shares
Basic EPS
500,000
3.50
Weighted average
Number of
common shares
Basic EPS
500,000
6.50
Weighted average
Number of
common shares
Basic EPS
500,000
3.50
If the stock dividend was declared at a time other than December 31 the weighted average
number of shares would be different.
d.
There are significant differences among the alternatives. The property and stock dividends
conserve cash, although issuing the property dividend probably will bring the gain into income
and trigger an additional cash outflow for income taxes. If cash is scarce, the company may wish
to avoid the cash dividend. The property dividend sacrifices an asset that could be valuable to the
company that may result in a loss of future cash flows from the investment. A stock dividend has
bookkeeping implications only.
e.
Dr.
Dr.
Cash
Cr.
Cr.
2,500,000
Gain on disposal of investments
Investment in Judson
Retained Earnings
Cr.
Cash
1,500,000
1,000,000
2,500,000
2,500,000
Page 10-31
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-19
a.
For: 2016
Dividend Payout Ratio
=
=
=
=
Dividend Yield
=
=
For 2017:
Dividend Payout Ratio
=
=
=
=
Dividend Yield
=
=
Dividend payout ratio represents what ratio of net income is paid out to shareholders for a given
period. Dividend yield is the per share return based of the market price per share.
b.
The dividend payout ratio decreased because despite making more net income the company did
not increase the total amount of dividends paid out to its shareholders. Dividend yield decreased
because the market value of the shares increased but the amount of dividend per share didnt
change.
c.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-32
Copyright 2013 McGraw-Hill Ryerson Ltd.
EPS is the income earned per common share while dividends are paid at the discretion of
management. Management may have chosen to retain its earning and not payout to its
shareholders to help finance other business opportunities or because it was unsure it could
sustain a higher dividend.
d.
High ratios arent always attractive. The dividend payout ratio increases as net income falls and
the dividend yield increases as share price falls, holding the dividend constant. Lower net income
and lower share price may imply poorer performance in future and therefore the inability of the
entity to maintain the level of dividends. In other words, if the dividend payout and yield are
increasing because of deteriorating performance, dividends may have to be cut in the future.
Also, companies with attractive investment opportunities would be better off investing cash than
paying dividends so for a growing company high ratios might be economically disadvantageous
to investors.
Page 10-33
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-20
a.
2016
Dividend Payout Ratio =
=
=
=
Dividend Yield
=
=
2017
Dividend Payout Ratio
=
=
=
=
Dividend Yield
=
=
Dividend Payout Ratio represents what ratio of net income is paid out to shareholders for a given
period. Dividend yield is the return based of the market price per share.
b.
The dividend yield changed because the market price of the companys shares increased even
though dividends per share staying the same (stock prices rise for a variety of reasons). The
payout ratio stayed the same because there was no change in the net income and total amount of
dividends paid to shareholders in each year.
Page 10-34
Copyright 2013 McGraw-Hill Ryerson Ltd.
c.
This will depend on the individual investor and their preference. High dividend payout ratios and
dividend yield maybe more desirable for investors looking for cash flow, for example retirees
relying on dividends as a source of income. An investor not looking for an immediate return may
rather the company hold the funds to re-invest in the business hence reducing the need to borrow
or issuing new shares. There are also different tax implications depending on earnings from
dividends versus capital gains/loss from the sale of the shares in the future.
Page 10-35
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-21
a.
Dividend Payout Ratio
=
Dividend Yield
EPS
Return on Equity
*Avg. common shareholders equity = (Current common equity + Previous common equity)/2
Assumption: Abney doesnt have any preferred shares.
Amounts are in thousands of dollars, except for
per share amounts:
Common dividends declared
Cash dividends declared per common share
Net income
Common shareholders' equity
Market price per share on December 31
Weighted average number of shares outstanding
Dividend Payout Ratio
Dividend Yield
Basic EPS
ROE
2017
$1,109,000
1.61
1,227,000
15,503,000
37.99
689,326
2016
$1,015,000
1.56
1,374,000
15,220,000
36.19
651,185
2015
$833,000
1.46
1,440,000
12,898,000
33.17
569,170
0.90
0.0424
1.78
0.080
0.74
0.0431
$
2.11
0.098
0.58
0.0440
2.53
0.127
2014
9,785,000
b. The company is increasing its dividend per share year over year despite a reduction in net
income over the same periods. This may be a result of management trying to demonstrate
strength by increasing payouts to draw attention away from the reduction in earnings. The result
is an increasing dividend payout ratio year over year. The company may believe that its capable
of sustaining the amount of dividend despite the decrease in net income. However, this may be a
concern as the payout ratio approaches 1, which means it is paying out almost all of its income in
dividends.
Dividend yield has decreased slightly because the increase in dividends paid per share is
increasing at a slower rate than the increase in market price per share resulting in a lowering
ratio. The rising share price suggests the markets arent too concerned about the decreasing net
income.
Page 10-36
Copyright 2013 McGraw-Hill Ryerson Ltd.
Earnings per share has gone down year over year as a result of two factors i) the increase in
the number of shares issued and ii) the decrease in net income year over year. Both factors
contribute to the reduction.
Return on equity is also decreasing due to both a decrease in net income from 2015 to 2017
and the increase in capital investment from new share issuance. It can also be observed that
equity position is also increasing as a result of an increase in retained earnings from year to year
as not all net income is paid to shareholders in the form of dividends.
Overall, the performance measures of EPS and ROE suggest deteriorating performance.
Dividend payout has increased but its very high and rising because of the declining net income
and increasing dividend. This is probably not sustainable in the longer term. The dividend yield
is a bright spot because despite the other concerns stock price is rising.
Page 10-37
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-22.
a.
Owners' Equity
Date
31-Dec-17
Common
Stock
Total
Equity
Shares
Common
Shares
6,000,000
9,000,000
3,000,000
6,000,000
9,000,000
2,000,000
3,000,000
6,000,000
9,000,000
2,000,000
ii
300,000
(300,000)
Ending
3,300,000
5,700,000
9,000,000
2,200,000
3,000,000
6,000,000
9,000,000
2,000,000
1,000,000
6,000,000
9,000,000
3,000,000
i
Ending
31-Dec-17
31-Dec-17
iii
Ending
3,000,000
Retained
Earnings
3,000,000
2,000,000
-
200,000
b. The underlying economic activity doesnt change as a result of these different arrangements
and neither does the ownership (each owner owns the same proportion of shares before and after
the stock split and stock dividend. As a result the shareholders should be indifferent to the
different arrangements. Earnings per share will decrease as more shares are issued so it will be
lowest after the stock split and highest if nothing is done.
Page 10-38
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-23.
a.
Dr.
Cash
Non-cash assets
Cr.
Partners Capital - Irving
Partners Capital - Ruth
40,000
100,000
40,000
100,000
b.
Statement of Partners Equity
For the year ended December 31, 2017
Beginning Capital
% share of income
Share of income
Drawings
Capital, December 31, 2017
Irving
$40,000
28.57%
24,000
(10,000)
54,000
Ruth
$100,000
71.43%
60,000
(14,000)
146,000
Total
$140,000
100%
84,000
(24,000)
200,000
Revenues
Expenses
Net income
$184,000
100,000
$84,000
Page 10-39
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-24.
a.
Dr.
Loader
275,000
Cr.
Cash
To record the purchase of a loader Nov. 12, 2013
275,000
b.
Original depreciation estimate = (275,000-25,000)/10 = $25,000/year
Original cost
Accumulated depreciation
Carrying value
Salvage value
Depreciable base
Useful life remaining
Annual depreciation
Dr.
$275,000
75,000
200,000
35,000
165,000
5
$33,000
(25,000 x 3)
Depreciation expense
33,000
Cr.
Accumulated depreciation
33,000
To record the depreciation expense for fiscal 2017.
This is the entry to record the depreciation expense in 2017. No adjustment is made to correct
the initial estimate. Changes in estimates are done prospectively.
Page 10-40
Copyright 2013 McGraw-Hill Ryerson Ltd.
c.
Dr.
Depreciation expense
25,000
Cr.
Accumulated depreciation
25,000
To record the depreciation expense for fiscal 2014.
This is the entry that would have originally been recorded. Since this is a change in an
accounting estimate, changes are made prospectively and therefore no journal entries are
required to adjust previously recorded transactions.
d.
Dr.
Depreciation expense
33,000
Cr.
Accumulated depreciation
33,000
To record the depreciation expense for fiscal 2018.
e.
Straight line
Year End
Oct. 31
Cost
Accumulated
Carrying
Depreciation
Depreciation
Amount
Expense
(AD)
(CA)
(DE)
Purchase
$275,000
$0
$275,000
$0
31-Oct-14
275,000
25,000
250,000
25,000
31-Oct-15
275,000
50,000
225,000
25,000
31-Oct-16
275,000
75,000
200,000
25,000
31-Oct-17
275,000
108,000
167,000
33,000
31-Oct-18
275,000
141,000
134,000
33,000
31-Oct-19
275,000
174,000
101,000
33,000
31-Jan-20
275,000
182,250
92,750
8,250
Total
182,250
Proceeds $42,000
Carrying Amount
92,750
Loss (50,750)
31-Jan-20
Dr.
Depreciation expense
8,250
Cr.
Accumulated depreciation
8,250
To record depreciation expense for three months (Nov, Dec, & Jan - fiscal 2020)
Dr.
Dr.
Dr.
Cash
42,000
Accumulated depreciation
182,250
Loss on disposal of loader
50,750
Cr.
Loader
To record the sale of the loader Jan. 31, 2020
275,000
Page 10-41
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-25.
a.
Stamping Machine
Taxes
Delivery & installation
Total
$30,000
2,100
1,000
$33,100
Dr.
Machinery
33,100
Cr.
Cash
To record the purchase of the stamping machine
33,100
Cost
33,100
33,100
33,100
33,100
2018
33,100
Number of units
over life
Cost
RV
Accumulated
Depreciation
(AD)
0
3,732
22,392
30,478
Carrying
Amount
(CA)
33,100
29,368
10,708
2,622
Depreciation
Expense
(DE)
0
3,732
18,660
8,086
31,100
2,000
Total
250,000
33,100
2,000
% units of
production
%
number of units
produced
12.00%
60.00%
26.00%
30,000
150,000
65,000
622
2.00%
5,000
31,100
100%
250,000
estimate
purchase price + associated costs
residual value
Page 10-42
Copyright 2013 McGraw-Hill Ryerson Ltd.
c.
[Since management changed the estimated useful life during fiscal 2017, the effect of the change
in estimate begins in 2017 and is applied prospectively from then forward.]
Depreciation per unit = (10,708 1,000 = 9,708)/160,000 = 0.0607 per unit for 2017, 2018, and
2019.
Units of production
number
of units
produced
Year end
Dec. 31
Purchase
2015
2016
Cost
33,100
33,100
33,100
Accumulated
Depreciation
(AD)
0
3,732
22,392
Carrying
Amount
(CA)
33,100
29,368
10,708
Depreciation
Expense
(DE)
0
3,732
18,660
% units of
production
%
12.00%
60.00%
30,000
150,000
2017
33,100
28,460
4,641
6,067
62.50%
100,000
2018
33,100
31,493
1,607
3,034
31.25%
50,000
2019
33,100
32,100
1,000
607
6.25%
10,000
9,708
100%
160,000
Total
Number of units
over life
Carrying Amount
on Dec. 31, 2016
RV
160,000
estimate
$10,708
1,000
residual value
Page 10-43
Copyright 2013 McGraw-Hill Ryerson Ltd.
E10-26.
Current Ratio =
Current Assets
1.33
1.03
2.09
0.29
0.03
Current liabilities
Current assets
$100,000
Current liabilities
75,000
Debt to Equity =
Total Liabilities
Total Equity
Total liabilities
$185,000
Total Equity
179,000
Price to Book =
Market Value
Book Value
$15.00
25,000
Market value
375,000
179,000
$10,000
Net Income
35,000
Dividend Yield =
$0.40
15.00
Return on Assets =
35,000
Interest expense
11,000
tax rate
Return on Equity =
*100%
0.13
18%
364,000
330,000
*100%
Net Income
$35,000
0.23
Page 10-44
Copyright 2013 McGraw-Hill Ryerson Ltd.
preferred dividends
Common stock
AOCI
Retained earnings
common share equity
Basic EPS =
5,000
2017
2016
70,000
50,000
5,000
-4,000
79,000
59,000
154,000
105,000
$35,000
5,000
20,000
Page 10-45
Copyright 2013 McGraw-Hill Ryerson Ltd.
PROBLEMS
P10-1.
Debt-to-equity ratio =Liabilities Owners equity
Return on Equity = (Net income preferred dividends) Average common share equity;
Dividend payout ratio = Common annual cash dividends Net income
Price to Book ratio = Market value (MV) Carrying amount (BV);
MV = (Price per share) * (number of outstanding common shares); BV = Assets Liabilities;
(Assumption that market price isnt affected by decisions made)
Debt-to-equity
ratio
Return
on equity
Dividend
payout
ratio
Price-tobook ratio
1.2:1
12.40%
25%
2.1
No effect
No effect
No effect
No effect
Decrease
No effect
No effect
No effect
Decrease
Decrease
No effect
Decrease
Increase
Increase
No effect
Increase
Increase
Increase
Increase
Increase
1 Stock dividend
2
3
1.
Dr.
2.
Dr.
3.
Dr.
4.
Dr.
5.
Dr.
R/E (OE-)
Cr.
Common Stock (OE+)
Dividend Payable (L-)
Cr. Cash (A-)
Land (A+)
Cr. Common Stock (OE+)
Common stock (OE-)
Cr.
Cash (A-)
Retained earnings (OE-)
Cr. Cash (A-)
Page 10-46
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-2.
Current ratio = Current assets Current liabilities;
Dividend Yield = Common dividend per share Current market share price
Basic EPS = (Net income preferred dividends) Weighted average common shares outstanding
Return on assets = (Net income + interest expense * (1 tax rate)) Average total assets;
(Assume that market price isnt affect by decisions made)
Return on
assets
Basic
earnings
per share
Current ratio
Dividend yield
6.90%
$1.72
1.23
3.10%
Decrease
Decrease
Increase
No Effect
No effect
Decrease
No effect
No Effect
2
3
4 Declaration of a cash dividend
No effect
Decrease
No effect
Unknown
No effect
No effect
Decrease
No Effect
No effect
No effect
No effect
Decrease
5 common shares
1.
Dr.
Cash (A+)
Cr.
Common Stock (OE+)
Assume share issue has no effect on share price and dividend per share isnt affected.
2.
Dr.
5.
No journal entry.
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-47
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-3
Current ratio = Current assets Current liabilities;
Dividend Yield = Common dividend per share Current market share price
Basic EPS = (Net income preferred dividends) Weighted average common shares outstanding
Return on assets = (Net income + interest expense * (1 tax rate) Average total assets;
(assumption that market price isnt affect by decisions made)
Return on
assets
6.90%
Basic
earnings
per share
$1.72
Current ratio
Dividend yield
1.23
3.10%
No effect
Decrease
No Effect
Increase
Increase
No Effect
Increase
No effect
Decrease
Decrease
No Effect
No effect
Increase
Increase
Decrease
No effect
No effect
No Effect
Decrease
Increase
1.
Dr.
Land (A+)
Cr. Common shares (OE+)
Common shares (OE-)
Cr.
Cash (A-)
Retained earnings (OE-)
Cr.
Cash (A-)
P10-4
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-48
Copyright 2013 McGraw-Hill Ryerson Ltd.
Return on
equity
12.40%
Dividend
payout ratio
25%
Price-to-book
ratio
2.1
Decrease
Decrease
Increase
Decrease
Decrease
Decrease
Increase
Decrease
2
3
4 Declaration of a cash dividend
No Effect
No effect
Increase
No effect
Increase
Increase
Increase
No effect
No Effect
No effect
No effect
Increase
5 common shares
1.
Dr.
Cash (A+)
Cr.
Common Stock (OE+)
Assume that more shares means more dividends if dividend per share doesnt change. Assume
sale of shares has no impact on stock price so PB ratio decreases.
2.
Dr.
5.
No journal entry required.
Page 10-49
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-5.
Assume that the debt or equity is issued at the beginning of the year.
a., b.
New equity or debt required
Interest rate
tax rate
$15,000,000
$15,000,000
8%
16%
16%
Good Outcome
Equity
Debt
$15,000,000
$15,000,000
8%
16%
16%
Poor Outcome
Equity
Debt
Operating income
Interest expense (after tax of
16%)
$3,500,000
$3,500,000
$500,000
$500,000
1,008,000
1,008,000
Net income
$3,500,000
$2,492,000
$500,000
($508,000)
10,000,000
7,500,000
10,000,000
7,500,000
$0.35
$0.33
$0.05
-$0.07
$10,000,000
$10,000,000
$10,000,000
$10,000,000
28,500,000
12,492,000
25,500,000
9,492,000
19,250,000
11,246,000
17,750,000
9,746,000
18.18%
22.16%
2.82%
(5.21)%
c. The advantages of more debt are that the debt is tax deductible and doesnt dilute the owners
control of the firms decisions. When the return on the assets exceeds the cost of debt, the
wealth of the shareholders is increased. Unfortunately, when the firm doesnt do well, the
negative effect is exaggerated. Additionally, the extra debt increases the risk of the firm, or
the probability that the firm wont be able to make the interest payments. Equity doesnt have
any fixed costs associated with it and is less risky to the company. However, its more costly
than debt and dilutes ownership.
d. Given the nature of the business, this doesnt appear to be an attractive loan. Probably most
of the operating costs are cash costs. If the poor outcome was realized, the company would
have difficulty making the interest payment and the likelihood of repaying the principal is
remote. If the two outcomes are equally likely, I would not want to make this loan. Some
assessment of the probabilities of the two outcomes would help. (Note that different
responses are possible here.)
e. The use of debt is somewhat attractive if the outcome is good but unattractive if the outcome
is poor. The interest rate seems very reasonable for a venture that is quite risky. The most
optimistic outcome still requires an interest cost (8%) which isnt much lower than the return
on shareholders equity (22.16%), although the after tax cost is 6.72%. The pessimistic
outcome results in cash flow problems. If the first year is representative of future years, it
wont be possible to repay the debt, assuming that the operating expenses are mostly cash
costs. If the debt cant be repaid, the shareholders will lose their investment.
P10-6
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-50
Copyright 2013 McGraw-Hill Ryerson Ltd.
a.
New equity or debt required
Interest rate
tax rate
Operating income
Interest expense (after tax of 15%)
3,000,000
3,000,000
9%
15%
15%
Good Outcome
Equity
Debt
1,125,000
1,125,000
3,000,000
3,000,000
9%
15%
15%
Poor Outcome
Equity
Debt
250,000
229,500
Net income
250,000
229,500
1,125,000
895,500
250,000
20,500
6,000,000
7,125,000
3,000,000
3,895,500
6,000,000
6,250,000
3,000,000
3,020,500
6,562,500
17.14%
3,447,750
25.97%
6,125,000
4.08%
3,010,250
0.68%
b.
The advantages of more debt are that the debt is tax deductible and doesnt dilute the owners
control of the firms decisions. When the return on the assets exceeds the cost of debt, the wealth
of the shareholders is increased. Unfortunately, when the firm doesnt do well, the negative effect
is exaggerated. Additionally, the extra debt increases
the risk of the firm, or the probability that the firm will not be able to make the interest
payments. Equity doesnt have any fixed costs associated with it and is less risky to the company.
However, its more costly than debt and dilutes ownership.
c.
Given the nature of the business, this may appear to be an attractive loan as under the worst case
scenario Thomas still makes enough income to service the debt. Also the renovations would
increase the value of the mall. However I would make sure that Thomas personally secures the
loan as he still has $3 million he can use to service the debt. If the two outcomes are equally
likely, I would make the loan as both results in a positive income and given Thomas past
entrepreneurial success he should continue to be a successful business man. Some assessment of
the probabilities of the two outcomes would help solidify the decision. (Note that different
responses are possible here.)
d.
The use of debt certainly appears attractive in particular, the most optimistic outcome; even with
the interest cost (9%) it yielded a higher return on shareholders equity (25.97%). The pessimistic
outcome has the reverse affect however no net losses are suffered and the return on equity from
investing the whole $6 million is only 4%. With such a low return on equity in the worst case
scenario Thomas should be able to yield a much better return on his remaining $3 million when
invested elsewhere. As a result I would advise Thomas to pursue debt as an option to finance his
endeavor.
Page 10-51
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-7.
(Note: tax effects from expensing stock options are ignored for ease of computation)
a.
Options not
Options expensed
expensed
Revenues
$37,345,000
$37,345,000
Expenses:
Cost of sales
SG&A expenses
Interest expense
Cost of stock options
Other expenses
Income tax expense
Net income
18,525,000
4,560,000
3,535,000
5,700,000
1,340,000
$3,685,000
18,525,000
4,560,000
3,535,000
1,200,000
5,700,000
1,340,000
$2,485,000
b.
Stock Options not expensed
Owners' Equity
Number of Shares
- Issued
Weighted
Average
31-Dec-17
Net income
3,685,000
Common
Weighted-average number of
common shares outstanding
7,000,000
100%
7,000,000
Basic EPS
0.53
Y E - Dec. 31
Dividend
Date
Common
Shares
Retained
Earnings
31-Dec-16
21,500,000
18,950,000
During
Net Income
31-Dec-17
Ending
31-Dec-17
21,500,000
7,000,000
Time
12
(700,000)
3,685,000
7,000,000
31-Dec-17
21,935,000
31-Dec-16
Total
Equity
Total
Equity
31-Dec-17
Net Income
31-Dec-17
Common
Shares
Net income
3,685,000
43,435,000
43,435,000
40,450,000
40,450,000
3,685,000
ROE
8.79%
Page 10-52
Copyright 2013 McGraw-Hill Ryerson Ltd.
Date
Number of Shares
- Issued
Common
Shares
Retained
Earnings
Common
Shares
Time
21,500,000
18,950,000
7,000,000
12
Weighted
Average
%
100%
Common
7,000,000
Dividend During
(700,000)
2,485,000
7,000,000
Contributed Surplus
1,200,000
31-Dec-17 Ending
21,500,000
31-Dec-16
21,935,000
Total
Equity
Total
Equity
31-Dec-17
Net Income
31-Dec-17
31-Dec-17
Net income
Weighted-average number of
common shares outstanding
Basic EPS
2,485,000
7,000,000
0.36
31-Dec-17
Net income
2,485,000
43,435,000
CS equity (2017)
43,435,000
40,450,000
CS equity (2016)
40,450,000
2,485,000
ROE
5.92%
c. The alternative accounting treatments have no implications for cash flow. There is no differential payment made to employees and
there is no differential tax effect. There are possible secondary cash effects if there are payments dependent on financial statement
numbers, in particular in this case, net income.
Page 10-53
Copyright 2013 McGraw-Hill Ryerson Ltd.
d. The managers would prefer not to expense the options since that will reduce income and
draw attention to the full value of the compensation they receive.
e. Expensing the stock options would seem to better represent what the company is giving up to
obtain the services of the companys management during the period. Another perspective is
that the options are intended to motivate managements actions and priorities in the future. As
a simple example, management of a certain company may see opportunities to add value to
the firm, but recognize that they are already being well paid for the size of the firm. They see
that these opportunities are risky with little personal payoff if they succeed but a significant
chance they will be fired if the initiatives dont go well. When employees are issued stock
options, the payoff to them for adding value to the firm is similar to that of the shareholders.
Under this scenario, the options will benefit the future, not the past and should be expensed
in the future, not the period when they are issued. Another view is that by granting options,
nothing is being given up at the time the options are granted. At that time the exercise price is
usually above the market price and unless the market price rises, the options will not be
exercised and are essentially worthless. This view ignores the fact that options are a desirable
form of compensation.
f. It would seem that the shareholders should benefit from full disclosure of all information that
would permit them to assess the options. Each year, they should be informed of all new and
existing issues of stock options, the terms of those issues including their economic value, and
the accounting treatment that has been followed. This information will permit the
shareholders to assess the current compensation that is granted to management and will bring
to light any excessively generous arrangements.
The shareholders should also be informed of the current holdings of each member of
management, so that they can assess the self-interest of management and watch for any
possible distortions in the incentives, such as those at Enron, to misstate earnings and
manipulate the stock price.
This information will also enable shareholders to predict possible dilution of their claims on
the firm that could result from future issues of shares with minimal cash inflow.
Page 10-54
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-8.
(Note: tax effects from expensing stock options are ignored for ease of computation)
a.
Revenues
Expenses:
Cost of sales
SG&A expenses
Interest expense
Cost of stock options
Other expenses
Income tax expense
Total Expenses
Net Income
2017
Options Not
Expensed
$34,500,000
2017
Options
Expensed
$34,500,000
15,200,000
4,800,000
3,500,000
15,200,000
4,800,000
3,500,000
1,800,000
5,900,000
1,220,000
32,420,000
$2,080,000
5,900,000
1,220,000
30,620,000
$3,880,000
b.
Options Not Expensed
Year End
31-Mar
Owners' Equity
Date
Preferred
Stock
Common
Stock
Retained
Earnings
Common
Stock
Time
16,000,000
9,000,000
14,850,000
400,000
8,000,000
12
15,530,000
400,000
8,000,000
24,530,000
40,530,000
23,850,000
39,850,000
Net Income
3,880,000
Beginning
31-Mar-16
Preferred dividend
31-Mar-17
(1,200,000)
Cash dividends
31-Mar-17
(2,000,000)
Net Income
31-Mar-17
3,880,000
Ending
31-Mar-17
31-Mar-17
31-Mar-16
16,000,000
9,000,000
31-Mar-17
Preferred
Stock
%
100%
Weighted
average number
of common shares
8,000,000
8,000,000
EPS
Net Income
3,880,000
Preferred dividend.
1,200,000
8,000,000
Basic EPS
0.34
Net income
3,880,000
Preferred dividend
1,200,000
23,850,000
24,530,000
ROE
Page 10-55
Copyright 2013 McGraw-Hill Ryerson Ltd.
ROE
11.08%
Options Expensed
Every item is the same other than the net income. In this case, although the net income is lower
by $1,800,000, the contributed surplus is higher by $1,800,000. Therefore, total equity made up
of retained earnings, contributed surplus and capital stock remains the same as though the
options had not been expensed.
31-Mar-17
31-Mar-16
31-Mar-17
24,530,000
40,530,000
23,850,000
39,850,000
Net Income
2,080,000
EPS
Net Income
2,080,000
Preferred dividend.
1,200,000
8,000,000
Basic EPS
0.11
Net income
2,080,000
Preferred dividend
1,200,000
23,850,000
24,530,000
ROE
3.64%
ROE
c. The alternative accounting treatments have no implications for cash flow. There is no
differential payment made to employees and there is no differential tax effect. There are
possible secondary cash effects if there are payments dependent on financial statement
numbers, in particular in this case, net income.
d. The managers would prefer not to expense the options since that will reduce income and
draw attention to the full value of the compensation they receive.
e. Expensing the stock options would seem to better represent what the company is giving up
by obtaining the services of the companys management during the period. Another
perspective is that the options are intended to motivate managements actions and priorities
in the future. As a simple example, management of a certain company may see opportunities
to add value to the firm, but recognize that they are already being well paid for the size of the
firm. They see that these opportunities are risky with little personal payoff if they succeed but
a significant chance they will be fired if the initiatives dont go well. When they are issued
stock options, the payoff to them for adding value to the firm is similar to that of the
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-56
Copyright 2013 McGraw-Hill Ryerson Ltd.
shareholders. Under this scenario, the options will benefit the future, not the past and should
be expensed in the future, not the period when they are issued. Another view is that by
granting options, nothing is being given up at the time the options are granted. At that time,
the exercise price is usually above the market price and unless the market price rises, the
options will not be exercised and are essentially worthless. This view ignores the fact that
options are a desirable form of compensation.
f. It would seem that the shareholders should benefit from full disclosure of all information that
would permit them to assess the options. Each year, they should be informed of all new and
existing issues of stock options, the terms of those issues including their economic value and
the accounting treatment that has been followed. This information will permit the
shareholders to assess the current compensation that is granted to management and will bring
to light any excessively generous arrangements.
The shareholders should also be informed of the current holdings of each member of
management, so that they can assess the self-interest of management and watch for any
possible distortions in the incentives, such as those at Enron, to misstate earnings and
manipulate the stock price.
This information will also enable shareholders to predict possible dilution of their claims on
the firm that could result from future issues of shares with minimal cash inflow.
Page 10-57
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-9.
a.
Average amount paid by shareholders for the shares already outstanding is used to determine the
amount that will be transferred from Retained earnings to common stock for the accounting for
the stock dividend.
(5,750,000)/1,000,000 = $5.75 per share
Owners' Equity
Year End
Dec. 31
Common
Shares
Date
Weighted
Average Number
of Common Shares
Retained
Earnings
Common
Shares
Time
5,750,000
$ 12,450,000
1,000,000
12
100%
1,000,000
575,000
(575,000)
100,000
75%
75,000
Beginning
Stock
dividend
Cash
dividends
31-Dec-16
Stock Split
Cash
dividends
30-Jun-17
15-Oct-17
(1,980,000)
Net Income
31-Dec-17
3,500,000
Ending
31-Dec-17
6,325,000
12,295,000
31-Dec-17
Total Equity
18,620,000
31-Dec-16
Total Equity
18,200,000
31-Dec-17
Net Income
3,500,000
31 Mar-17
15-Apr-17
(1,100,000)
1,075,000
2,200,000
After Split
3,225,000
3,300,000
$6,325,000
12,295,000
$18,620,000
31-Dec-17
Net Income
3,500,000
Weighted-average number of
commons shares outstanding
3,225,000
Basic EPS
1.09
3,500,000
Weighted-average number of
commons shares outstanding
1,000,000
Page 10-58
Copyright 2013 McGraw-Hill Ryerson Ltd.
Basic EPS
3.5
c.
A typical shareholder who owned 1,000 shares in fiscal 2016 and held on to them throughout
fiscal 2017 would have received the following payments in dividends.
Number of
shares
31-Dec-16
Dividend
1,000
Cash received
$2.50
$2,500
OR
1-Apr-17
1,100
$1.00
$1,100
15-May-10
3,300
$0.60
$1,980
31-Dec-17
$3,080
A sophisticated shareholder should be happy even though the dividend has decreased on a per
share basis because the total amount of dividend received is greater after the share dividend and
split.
d. This assumes market price was stable other than the stock dividend and stock split. It also
assumes that the market response to the dividend is exactly proportional to the change in the
number of shares.
Date
Change
31-Dec-17
# of shares
Market value
$18.20
3,300,000
$60,060,000
30-Jun-17
Price * 3
$54.60
1,100,000
$60,060,000
15-Apr-17
Price *1.1
$60.06
1,000,000
$60,060,000
The market value of shares before the stock dividend and stock split would have been $60.06 per
share. The total market value remains unchanged. When there is a stock split or dividend, the
number of shares will increase but there will be a corresponding decrease in price per share to
reflect the dilution of the total outstanding shares. Excluding all other factors that affect market
price the total market value will remain unchanged after a stock split or stock dividend.
e.
This assumes that the same amount of dividend would be paid under both scenarios.
Price to Book =
31-Dec-17
Market Value
Book Value
$18.20
3,300,000
$60,060,000
18,620,000
Price to Book =
$3.23
$60.06
1,000,000
Market value
$60,060,000
$18,620,000
Page 10-59
Copyright 2013 McGraw-Hill Ryerson Ltd.
Price-to-book ratio
$3.23
The price to book ratio isnt affected by the stock dividend and split if total dividends remain the
same.
f.
Dividend Payout Ratio =
Dividend Yield =
With
Split and Dividend
Common Annual Cash Dividends
3,080,000
Net Income
3,500,000
0.88
3.08
18.20
Dividend Yield
0.17
Dividend payout ratio and yield arent affected by a stock split or stock dividend as its a
function of the total dividends paid out relative to net income, provided that the amount of
dividends paid doesnt change. If the amount of dividends changes (as it did in this question) the
ratios would change.
Page 10-60
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-10.
Average amount paid by common shareholders for the shares already outstanding is used to determine the amount that will be
transferred from retained earnings to common stock for the accounting for the stock dividend.
$18,500,000/2,000,000 = $9.25 per share
Number of Shares Issued
Owners' Equity
Year End
Nov. 30
Date
Preferred
Stock
Common
Stock
Retained
Earnings
Beginning
30-Nov-16
$ 4,000,000
$ 18,500,000
$ 23,450,000
Stock dividend
15-Mar-17
1,850,000
(1,850,000)
Preferred dividend
15-May-17
Stock Split
Preferred
Stock
200,000
Common
Stock
Time
2,000,000
12
100%
2,000,000
200,000
8.5
71%
141,667
(600,000)
2,141,667
15-Jul-17
6,600,000
8,566,667
200,000
8,800,000
8,566,667
30-Nov-17
39,050,000
30-Nov-16
Total Equity-common
41,950,000
30-Nov-17
Net Income
6,500,000
Cash dividends
15-Aug-17
(8,800,000)
Net Income
30-Nov-17
6,500,000
Ending
30-Nov-17
4,000,000
Weighted Average
Number
of Common Shares
20,350,000
18,700,000
The equity section of Aguanish Inc. balance sheet on November 30, 2017
Preferred shares (authorized, issued, and outstanding: 200,000)
Common stock (Unlimited number of shares authorized, outstanding 8,800,000)
Retained earnings
Total shareholders equity
$4,000,000
20,350,000
18,700,000
$43,050,000
Page 10-61
Copyright 2013 McGraw-Hill Ryerson Ltd.
b.
30-Nov-17
Net Income
6,500,000
Preferred Dividend
600,000
Weighted-average number of
shares outstanding
8,566,667
Basic EPS
0.69
6,500,000
Preferred Dividend
600,000
Weighted-average number of
common shares outstanding
2,000,000
Basic EPS
2.95
c.
A typical shareholder who owned 1,000 shares in fiscal 2016 and held on to them throughout
fiscal 2017 would have received the following payments in dividends.
30-Nov-16
30-Nov-17
number of
shares
1,000
4,400
dividend
$5.00
$1.00
cash received
$5,000.00
$4,400.00
A sophisticated shareholder would not be happy with the decrease in the amount of dividend
received because he or she is worse off after the stock dividend and stock split because he/she
would have received less in dividends.
d. This assumes market price was stable other than the stock dividend and stock split. It also
assumes that the market response to the dividend is exactly proportional to the change in the
number of shares.
Date
Change
30-Nov-17
# of shares
Market value
$120.00
8,800,000
$1,056,000,000
15-Jul-17
Price * 4
$480.00
2,200,000
$1,056,000,000
15-Mar-17
Price *1.1
$528.00
2,000,000
$1,056,000,000
The market value of shares before the stock dividend and stock split would have been $528 per
share. The total market value remains unchanged. When there is a stock split or dividend, the
number of shares will increase but there will be a corresponding decrease in the price per share
to reflect the dilution of the total outstanding shares. Excluding all other factors that affect
market price, the total market value will remain unchanged after a stock split or stock dividend.
e.
The price to book ratio will not be affected by the stock dividend and split provided that the
amount of dividends is unchanged. In this case the total dividend decreased so the calculation
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-62
Copyright 2013 McGraw-Hill Ryerson Ltd.
would be different. However, a change in dividend would probably mean the share price
wouldnt be proportional. The calculation below assumes the same amount of dividend.
Price to Book =
30-Nov-17
market value per share
Market Value
Book Value
$120.00
8,800,000
1,056,000,000
39,050,000
27.04
$528.00
2,000,000
1,056,000,000
39,050,000
27.04
f. There are no economic benefits or drawbacks to the shareholder as both transactions only
results in the company being divided into smaller pieces. Both stock splits and stock dividends
dont improve/reduce the shareholders economic position so long as it doesnt affect how
dividends are paid out and the market doesnt act favourably or unfavourably to the decision. In
this example there appears to be an impact to the shareholder because the amount of dividend
paid to shareholders has decreased.
Page 10-63
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-11.
a.
Kugluktuks bonds have a commitment to repay the principal at a definite maturity date and a
regular interest payment that must be made, both of which are characteristics of debt. The bonds
rank ahead of equity in the case of liquidation. The bondholders have no influence on decisions
of the company. However, since its highly likely that the bonds will be converted to equity, we
could view the issue as really an equity issue, which is expressed for a short time in a form that is
less risky to the investors. The fact that the company, not the investors, will decide whether to
convert the bonds makes it difficult to assess the appropriate treatment. (The principal
component of the bond should be considered equity if the company has the option to repay the
bond through the issuance of common shares at a fixed or predetermined price. If the conversion
is at a price that is equivalent or greater than the fair market value of the shares then its
considered a financial liability. It appears in this case that the principal will be recovered because
its highly likely the bonds will be converted before maturity, which implies that the bondholder
will get an exchange equal to the market value.)
b.
Dr.
Cash
Cr.
200,000
Long-term debt
200,000
Cash
Cr.
200,000
Common stock
200,000
Page 10-64
Copyright 2013 McGraw-Hill Ryerson Ltd.
full disclosure, users perceptions of the leverage and profitability should be the same either way.
However, managers of public companies might not always behave in this way and may be more
concerned about the measurements in the financial statements.
g.
Potentially there are many consequences of classifying the bonds as equity or debt. There may be
covenants attached to existing debt that would be violated if more debt were issued. Management
bonuses based on income would be higher if the interest payments were treated as dividends. The
perceptions that investors and lenders have of the companys profitability and leverage depend
on the time the users take to examine carefully the financial statements and the notes. However,
the underlying economic activity of the entity and its actual underlying risk and capital structure
arent affected by how the securities are accounted for with the exception of tax effects.
Page 10-65
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-12.
a. The preferred shares have a commitment to repay the principal before a definite maturity date,
which is a characteristic of debt. The annual dividend payment is specified, which is a
characteristic of debt, but the dividend payments dont have to be made if management elects not
to. The dividend is cumulative, but its conceivable that the company could choose not to pay
any dividends to common shareholders until the preferred shares are redeemed. Assuming that
the dividends are paid, the definite schedule of redemption makes this issue very much like debt.
b. Dr. Cash
Cr.Long-term debt
500,000
500,000
500,000
500,000
Page 10-66
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-13.
a., b.
Revenue
Common
Preferred
Shares
Shares
5,600,000
Bonds
5,600,000
5,600,000
Expenses
4,600,000
4,600,000
4,600,000
1,000,000
1,000,000
1,000,000
Interest expense
425,000
Net Income
1,000,000
1,000,000
575,000
150,000
150,000
86,250
850,000
850,000
850,000
850,000
488,750
488,750
300,000
1,250,000
1,000,000
1,000,000
0.68
0.55
0.49
Preferred stock
Common stock
5,000,000
13,500,000
8,500,000
8,500,000
6,912,500
6,800,000
6,738,750
20,412,500
20,300,000
15,238,750
20,412,500
15,300,000
15,238,750
15,500,000
15,500,000
15,500,000
17,956,250
15,400,000
15,369,375
850,000
550,000
488,750
4.73%
3.57%
3.18%
Retained earnings
7,500,000
0.37
7,500,000
0.37
12,500,000
0.82
Note that because the financing was arranged at the beginning of the year, it would also be
reasonable to include the effects of the financing in the beginning shareholders equity.
Page 10-67
Copyright 2013 McGraw-Hill Ryerson Ltd.
c.
To the management:
The financing alternatives have significant implications for the future of your firm. If more
common shares are issued, the percentage of the voting shares owned by the current shareholders
will be significantly diluted, although they will still control the firm. Depending on the
distribution of the existing ownership, the new shareholders may represent a very significant
voting bloc. A very important cash flow advantage of common shares is that there is no
commitment to make payments of dividends or redeem the shares. The probability that the firm
will fail should the investment not pay off as quickly as expected is much lower. If preferred
shares are issued, there will be no dilution of control, but the investors in those shares will expect
dividends. The $300,000 each year in dividends could create cash flow problems if the firm
experiences financial difficulty. While the dividends on the preferred dont have to be paid,
failure to do so will make it necessary to not pay dividends on common shares until the preferred
dividends are paid up in full. Also, the preferred shares are redeemable after eight years, although
there is no indication that this is a mandatory redemption. A benefit of preferred shares, however,
is that its a way to raise equity temporarily without sharing fully in the success of the business.
The debt alternative has the benefit of tax deductibility but there is an obligation to pay the
annual interest payments and the need to repay or refinance the debt in 12 years.
Given the expectation that the firm will continue to expand over the next few years, the longterm plan must include some mix of debt and equity. The question then becomes one of the
optimal sequence of issuing each. The debt option raises the risk of violating the 1:1 limit of the
debt-to-equity ratio, although if profitability is expected in the near future, retained earnings will
grow and shareholders equity will increase over time. It will likely be advantageous to wait to
issue common shares until there is more evidence to support managements predictions of future
profits. In that case, fewer shares will need to be issued to raise a given amount of cash and less
dilution of control will result. Debt is desirable if future profits and cash flows are fairly certain
so that the company can meet its obligations. Debt is preferred since with debt there is no need to
share profits. However, the greater the uncertainty about future profits and cash flows (both in
timing and amount) the less attractive debt becomes.
Page 10-68
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-14.
a. and b.
Traditional
Revenue
Expenses
Interest expense
Income taxes
Preferred Dividends
Common Dividends
Net income
$2,450,000
1,400,000
170,000
115,000
Measure A
$2,450,000
1,400,000
170,000
115,000
Measure B
$2,450,000
1,400,000
75,000
$765,000
$690,000
$1,050,000
Measure C
$2,450,000
1,400,000
170,000
115,000
75,000
150,000
$540,000
a.
The traditional measure of income views the firm from the perspective of the shareholders
owning the residual interest in the firm. Distributions to all other interests than equity are
expenses to the firm. Net income shows how much is left over after compensating all other
providers of resources to the firm.
b.
The table above shows three other income statements; others are possible.
Alternative A reflects the idea that preferred shares arent really different than debt. The only real
owners of the firm are those who vote and therefore affect the decisions of the company.
Alternative B shows the view that governments, lenders and providers of equity capital have
differing forms of claims on the company. Finally, Alternative C is somewhat similar but treats
all those resource providers as outsiders with the residual belonging to the entity and not to any
group of providers of capital.
Page 10-69
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-15.
Report to the board of directors:
The idea that the firm would implement an annual common share dividend seems rather
questionable. Cash from operations has increased over the last two years after being negative
during 2014 and 2015 when the company was implementing its growth strategy. However, cash
from operations, even if expected to remain steady or grow from the $565,000 generated in 2017,
is still not adequate to cover the estimated investing requirements of between $450,000 and
$750,000 each year. On the other hand, Kintores cash balance has increased over the last two
years and one must determine the optimal cash level for the company. It would probably be a
mistake to begin to offer a dividend now and later reduce or cancel the dividend. It certainly
doesnt make sense to borrow money to pay dividends so while the existence of the line of credit
provides a buffer for cash shortfalls for paying the dividend, borrowing to pay the dividend
doesnt really make sense. A better strategy would be to clearly communicate to the shareholders
that you expect to continue to invest for the foreseeable future.
I would not therefore recommend that you initiate a dividend until the growth phase of the
company has ended and the need for cash is reduced.
Page 10-70
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-16
Report to Bank:
Below is my preliminary analysis of Ferland Air Ltd. based on the information provided.
Ferlands balance sheet has been steadily improving over the five years examined. The amount of
long-term debt has decreased by almost $5 million since 2013, including a decrease of $2.2
million in 2017. The amount of debt has decreased since 2013 by about 27 percent. While the
company is still financed more by debt than equity, the proportion of debt has decreased
significantly since 2013. In 2013 Ferlands debt-to-equity ratio was 2.18 and in 2017 it had fallen
to 1.12. This is a positive sign as the company has become less dependent on debt. This indicates
a stronger balance sheet because of the lower debt load and its presumed ability to pay down the
debt. We can also consider the amount of non-operating debt Ferland has (long-term debt
(including the current portion)) divided by equity. The amount of this type of debt financing as a
proportion of equity has also decreased significantly (see the exhibit below)
Over the five year period retained earnings has more than doubled, indicating a profitable
operation. The company has also been able to raise almost $2.8 million in equity from the sale of
common stock.
It must be noted that Ferland still has a significant amount of debt and this represents risk since
interest must be paid. The airline industry often faces significant challenges so ongoing
profitability is not assured.
In conclusion, Ferlands balance sheet has shown significant improvement over the last five
years and an additional loan of $2 million would result in slightly less debt than the company had
in 2016.
Ferland Air Ltd.
Summarized Liabilities and Shareholders Equity
For the years ended December 31,
2017
2016
2015
Current operating liabilities
$8,104,788 $7,278,350 $7,171,600
Current portion of long-term debt
2,297,363
2,149,588
2,076,450
Long-term debt
10,834,313 13,148,900 14,836,188
Common share capital
8,877,138
8,807,225
6,413,475
Retained earnings
10,099,725
8,740,025
7,639,638
2014
$5,215,488
2,167,088
15,720,425
6,330,713
5,692,063
2013
$3,880,100
1,925,950
16,157,738
6,123,800
3,951,538
1,740,525
23,103,001
12,022,776
11,049,057
21,963,788
10,075,338
1,359,700
21,236,464
18,976,863
18,262,057
1,100,387
22,576,838
17,547,250
15,800,182
1,947,575
24,084,238
14,053,113
13,037,945
Page 10-71
Copyright 2013 McGraw-Hill Ryerson Ltd.
1.12
1.29
1.71
1.92
2.18
P10-17
To Mr. Bindloss:
There are benefits and shortcomings to each financing alternative. Bindloss balance sheet
appears to be in a good shape. The debt to equity ratio is 0.70, meaning there is $0.70 of
liabilities for every dollar of equity. Considering only financing liabilities provides a debt-toequity ratio of 0.425 (bank loans plus long-term debt, including the current portion). The
$425,000 of debt the company has seems higher for a company in the oil and gas industry where
resource prices can be quite volatile.
Borrowing the $750,000 would bring your debt-to equity ratio up to 1.45:1 and increase the
amount of debt to $1,175,000. This will add risk to the company since the debt comes with fixed
interest and, in the case of the new loan, principal repayments. You should make sure that any
new financing arrangements are consistent with the terms of the existing loans. You should make
sure that existing covenants arent in violation and double check if there are any new ones with
this loan. There is also a matter of servicing the principal and interest payments. In 2017 year
you paid $195,000 in dividends to yourself, which is half your earnings for the year. The new
loan would require principal repayments of $150,000 along with new interest payments of
$67,500 in the first year. As a result, how quickly the project generates positive cash flows and
the amount of the cash flows may affect your future payout when going with the debt option.
There are pros to using debt to finance your company. First, interest payments are tax deductible
and if an increase in income exceeds the interest charged you as 100% equity owner will enjoy
all benefits in excess of the interest cost. This would mean in the first year you would need to
make an additional $67,500 in net income before interest to breakeven (ignoring taxes). However
since you are in a cyclical industry you will also bear all the risk should the company not do as
well.
Financing the project using equity would mean a dilution in ownership. While you still maintain
control with a 75% ownership, your future earning will have to be shared with the new
shareholders. For example the current years dividends of $0.26 per share would mean an
additional payout of $65,000 to the new shareholder. This is equal to the interest payment but
isnt tax deductible for the business. Therefore every time dividends are paid, all common
shareholders will have to be paid also. An equity investment does have its positive elements.
First off if the company requires additional leveraging to fund more projects the option to borrow
remains open with an improved debt to equity ratio. Also because of the cyclical nature of the
industry, your risk is now shared with another investor, while under debt the lender has to be paid
regardless of performance. With control you may also choose to not pay dividends when times
are bad and if the company does well you may buy back the ownership in your company.
I hope my analysis has helped with your decision but I do leave with one last note. Your
decision must take into account the companys future cash flow, your personal financial
dependencies on dividends and the expected return on investment. For example if your project
Page 10-72
Copyright 2013 McGraw-Hill Ryerson Ltd.
isnt expected to generate income over the next few years the equity financing option maybe the
safer bet.
P10-18.
a.
Straight line
Year End
Sept. 30
Cost
Accumulated
Depreciation
Carrying
Amount
Depreciation
Expense
(AD)
(CA)
(DE)
Purchase
4,100,000
4,100,000
30-Sep-15
4,100,000
770,000
3,330,000
770,000
30-Sep-16
4,100,000
1,540,000
2,560,000
770,000
30-Sep-17
4,100,000
2,017,000
2,083,000
477,000
30-Sep-18
4,100,000
2,494,000
1,606,000
477,000
30-Sep-19
4,100,000
2,971,000
1,129,000
477,000
30-Sep-20
4,100,000
3,448,000
652,000
477,000
30-Sep-21
4,100,000
3,925,000
175,000
477,000
Total
3,925,000
= CA in 2016
Original estimate
Change in estimate
Cost
4,100,000
Cost
2,560,000
RV
250,000
RV
175,000
UL
UL Remaining
770,000
DE=
477,000
Annual depreciation expense (2015 and 2016) = ($4,100,000 - $250,000)/5 = $770,000. The
carrying amount of the machine on September 30, 2016 would have been $2,560,000.
b.
The change in accounting estimate would be implemented prospectively, so the depreciation
expense in 2015 and 2016 wouldnt change from $770,000 per year.
c.
Annual depreciation expense in 2017 forward will be = ($2,560,000 175,000)/5 = $477,000.
The carrying amount on September 30, 2017 would be $2,083,000 after adjusting for the change
in estimate.
d.
The change has no immediate real economic impact, but it will have consequences because it
means the company will be able to get benefits from the asset for two more years. As a result the
John Friedlan, Financial Accounting: A Critical Approach, 4th edition
Solutions Manual
Page 10-73
Copyright 2013 McGraw-Hill Ryerson Ltd.
cost per year of using the machine decreases and net income decreases. For financial reporting
purposes the company has depreciated too much in the earlier years resulting in change in the
return on asset ratio. The debt to equity ratio will also be affected as with the higher depreciation
expense taken in the earlier years would have resulted in a higher debt to equity ratio had the
estimate been correct. The users of the financial statements will see a reduction in income from
the increased depreciation expense as well as lower carrying amounts of the asset over the
remaining useful life prior to the change in estimate. There may be some information on the
revised useful life because it says something about the need for capital expenditures later than
expected. Whether a user could infer this from the change would depend on if and how the
information was disclosed. In any case, there will be a decrease in the amount of depreciation in
the remaining years.
e.
The change in estimate may be objective under some circumstances although in most cases there
will be a fair bit of discretion as to the amount and timing of the change in estimate. The way that
this change is described indicates that management intends to replace the machine at the end of
fiscal 2021. A change of estimate that reflects a clear intent can probably be considered
objective. However, management doesnt always have to be completely forthright with its
intentions. There are alternative motivations for the same change, such as increasing income to
achieve some benefit (higher bonuses, more satisfied investors, higher returns on assets or equity,
etc.). Note that income tax effects would not be a consideration as depreciation for tax purposes
would be calculated using CCA and therefore the estimates that management makes for financial
reporting would not be relevant.
Page 10-74
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-19.
Nisku
Grimsby
$451,563
$451,563
1,000,000
4,000,000
Basic EPS
$0.452
$0.113
Net Income
451,563
451,563
3,735,937
3,735,937
4,000,000
4,000,000
0.12
0.12
$4,000,000
$4,000,000
451,563
451,563
187,500
187,500
$3,735,937
$3,735,937
Net Income
Preferred Dividends
Weighted average common shares outstanding
Preferred Dividends
ROE
Nisku and Grimsby are identical in every respect except for the number of shares outstanding.
Nisku has 1,000,000 shares outstanding and Grimsby has 4,000,000. As a result, EPS for Nisku
is higher.
In most instances, an investor would be indifferent in choosing between these two companies.
The only factor that may be a consideration is that the shares in Grimsby are likely less
expensive and if an investor only had a small amount to invest, it may be a more affordable
option. For example, if shares of Nisku were $1,000 and shares of Grimsby were $250
(maintaining the 4:1 ratio) and I only had $500 to invest, I would have to choose Grimsby. In
most instances however, investors would be indifferent. The fact that EPS is higher for Nisku
would have no bearing on a decision.
Page 10-75
Copyright 2013 McGraw-Hill Ryerson Ltd.
P10-20
a.
Kepenkeck
$23,750,000
-
Opeongo
$23,750,000
-
50,000,000
$0.48
100,000,000
$0.24
$8,000,000
50,000,000
$0.16
$8,000,000
100,000,000
$0.08
$8,000,000
23,750,000
0.34
$8,000,000
23,750,000
0.34
$0.16
15.00
0.01
$0.08
7.50
0.01
Net Income
Preferred Dividends
Weighted average common shares
outstanding
Basic EPS
b.
Kepenkeck and Opeongo are identical in every respect except for the number of shares
outstanding and the market price per share. Kepenkeck has 50,000,000 shares outstanding and
Opeongo has 100,000,000 which are proportional to the market price per share at $15.00 and
$7.50. Both companies have the same market value of equity. Therefore the performance
measures are effectively the same. Kepenkecks earnings per share and dividends per share are
two times that of Opeongos, but Opeongo has twice as many shares outstanding. Net income
and total dividends are the same for the two companies. The payout ratio and dividend yield are
the same for the two companies.
Page 10-76
Copyright 2013 McGraw-Hill Ryerson Ltd.
Examine the information provided in Exhibit 11-8 and find the following information:
a.
Retained earnings on March 31, 2005 = $103,011,000
Retained earnings on March 31, 2004 = $81,972,000
b.
Common dividends2005 = $0
Common dividends2004 = $0
Preferred dividends2005 = $0
Preferred dividends2004 = $0
c.
Total shareholders equity on March 31, 2005 = $185,871,000
Total shareholders equity on March 31, 2004 = $155,101,000
d.
Balance in the capital stock account on March 31, 2005 = $73,542,000
Balance in the capital stock account on March 31, 2004 = $68,557,000
e.
Net earnings for the year ended March 31, 2005 = $23,207,000
Net earnings for the year ended March 31, 2004 = $19,024,000
f.
Net assets on March 31, 2005 = $185,871,000
(=$626,728 - $182,782 - $258,075)
Net assets on March 31, 2004 = $155,101,000
(=$437,553 - $86,386 - $196,084)
g.
Contributed surplus on March 31, 2005 = $805,000
Contributed surplus on March 31, 2004 = $183,000
h.
Comprehensive earnings for fiscal 2005 = $27,331,000
Comprehensive earnings for fiscal 2004 = $23,240,000
FS10-2
EPS 2005
EPS 2004
ROE 2005
ROE 2004
$23,207,000
29,777,374
= $0.78
$19,024,000
= $0.67
28,569,704
$23,207,000
($185,871,000 + $155,101,000) 2
$19,024,000
($155,101,000 + $123,406,000) 2
13.6%
13.7%
Debt-to-equity
=
ratio 2005
$182,782,000 + $258,075,000
$185,871,000
= 2.37
Debt-to-equity
=
ratio 2004
$86,368,000 + $196,084,000
$155,101,000
= 1.82
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EPS and ROE are very stable over the two years examined. EPS increased by $0.11 per share, an
increase of about 16%. This indicates improved performance in 2005 (not withstanding any
accounting changes or opportunistic accounting choices). The return on equity is virtually
unchanged over the two years, indicating consistent performance on the equity investors
investment. However, the debt-to-equity ratio has increased significantly and appears to be due
to more long term debt and more accrued liabilities than in 2004. We would have to look into
why this has occurred. It isnt possible to make any absolute judgements on these ratios because
ratios must be analyzed in relation to benchmarks. The two year period available isnt longenough to draw definitive conclusions, and it would be helpful to have comparable firms,
industry norms, and a longer time series of FirstServices information for a more thorough
analysis.
FS10-3
a.
b.
c.
d.
e.
An unlimited number of Subordinate Voting Shares having one vote per share;
and
Preference
0
Preference
0
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Copyright 2013 McGraw-Hill Ryerson Ltd.
FS10-4
The multiple voting shares represent 4.4% of total number of common shares outstanding
(1,325,694 30,192,788). The multiple voting shares have 20 votes each while the subordinate
voting shares have one vote each. The multiple voting shares have 47.9% of the votes while
representing only 4.4% of the total number of shares [(1,325,694 X 20) / (1,325,694 X 20) +
28,867,094].
The multiple voting shares allow the owner to have more influence than represented by the
actual number of shares owned. This type of arrangement is found in some Canadian companies
where the founding family is able to control or have significant influence over their companies
while obtaining significant investment from the public but having a relatively small proportion of
the outstanding common shares.
FS10-5
a.
During the year ended March 31, 2005, the Company repurchased 218,072 subordinate
voting shares.
b.
FirstService paid $2,698,000 for the shares, an average price of $12.37 per share.
(Amount paid was found on the cash flow statement. $12.37 = $2,698,000/218,072.)
c.
Dr. Capital Stock
530
Dr. Retained Earnings
2,168
Cr. Cash
2,698
d.
The repurchase of shares would appear as an outflow of cash in the financing
activities section of the cash flow statement. Since the transaction involves FirstServices
stock, classification as a financing activity makes sense.
FS10-6
a.
b.
c.
The Company has a stock option plan for certain officers and key full-time employees of
the Company and its subsidiaries. Options are granted at the market price for the
underlying shares on the date of grant. Each option vests over a four-year term and
expires five years from the date granted and allows for the purchase of one Subordinate
Voting Share. Options are exercisable in either US or Canadian dollars. At March 31,
2005, there were 1,844,000 options outstanding to 41 individuals at prices ranging from
$6.00 to $17.29 (C$9.10 to C$21.40) per share, expiring on various dates through 2010.
As at March 31, 2005, there were 333,500 options available for future grants.
There were 1,844,000 options outstanding on March 31, 2005. On March 31, 2005,
915,500 options were exercisable.
There were 496,500 options granted during 2005 at an average exercise price of $13.63.
The journal entry to record issuance of the options is:
Dr. Compensation expense
622,000
Cr. Contributed surplus
622,000
[Note: Amount for the journal entry can be found in the cash from operations sections of
the cash flow statement or the statement of shareholders equity.]
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d.
During 2005 911,130 options were exercised for cash at an average price of $6.42. Net
proceeds from the sale of the shares was $5,515,000. The journal entry to record the
transactions is:
Dr. Cash
5,515,000
Dr. Contributed Surplus
622,000
Cr. Capital Stock
6,137,000
e.
During 2005 30,000 options expired or were forfeited. An employee would allow an
option to expire without exercising it if the exercise price were greater than the market
price. The employee would not want to pay more for the shares than their market value.
Some options may be forfeited if an employee leaves their job with the company.
FirstService expensed $622,000 as a result of granting stock options to employees.
The stock option expense is added back to net earnings when calculating cash from
operations because the options dont involve a payment of cash to the employees. The
expense is the value of the options granted.
The share compensation plan is intended as a motivational device for employees. By
owning stock options (or shares) employees have incentives to maximize the share price
of the company. A high share price is desirable to the shareholders so the options
motivate the managers to act in the best interests of the shareholders (because the
managers are also acting in their own best interests).
f.
g.
h.
F10-7
FirstServices contributed surplus account relates to stock option compensation expense
accounting. Contributed surplus is credited at the time the stock option compensation expense is
recorded. As stock options are exercised, contributed surplus is reduced and capital stock is
credited. For 2005 the journal entry required would be:
Dr. Compensation expense
Cr. Contributed surplus
622,000
622,000
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F10-8
a.
b.
c.
d.
On December 15, 2004, the Company completed a 2 for 1 stock split effected in the form
of a stock dividend. This means that for each share owned a shareholder received a
second share and the total number of shares outstanding doubled.
Amounts on the financial statements arent affected by a stock split. Only per share
amounts, such as earnings per share, are affected.
No journal entry is necessary to record a stock split.
There would be half as many shares of each class reported in 2004 since as a result of the
stock split the number of shares outstanding would double. Thus,
# of shares outstanding on
March 31, 2004 as reported
in the 2005 annual report
28,174,036
1,325,694
# of shares outstanding on
March 31, 2004 as reported
in the 2004 annual report
14,087,018
662,847
Since there are twice as many shares earnings per share would be half what it would have
been had there been no stock split.
The stock split doubled the number of shares outstanding. It had no real economic
significance (it did not create any value or wealth) so its reasonable to expect that the
stock price fell by 50% as a result of the split. A 50% decrease in the stock price would
leave the market value of the entire company the same as before the stock split.
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