Solution manual intermediate accounting 7th by nelson spiceland ch18

Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Chapter 18 Shareholders’ Equity AACSB assurance of learning standards in accounting and business education require documentation of outcomes assessment Although schools, departments, and faculty may approach assessment and its documentation differently, one approach is to provide specific questions on exams that become the basis for assessment To aid faculty in this endeavor, we have labeled each question, exercise, and problem in Intermediate Accounting, 7e, with the following AACSB learning skills: Questions AACSB Tags Exercises AACSB Tags 18–1 18–2 18–3 18–4 18–5 18–6 18–7 18–8 18–9 18–10 18–11 18–12 18–13 18–14 18–15 18–16 18–17 18–18 18–19 18–20 18–21 18–22 18–23 18–24 Reflective thinking Reflective thinking, Communications Reflective thinking, Communications Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking Reflective thinking, Communications Reflective thinking Reflective thinking Reflective thinking Reflective thinking Analytic Analytic Reflective thinking, Communications 18–1 18–2 18–3 18–4 18–5 18–6 18–7 18–8 18–9 18–10 18–11 18–12 18–13 18–14 18–15 18–16 18–17 18–18 18–19 18–20 18–21 18–22 18–23 18–24 18–25 Reflective thinking Communications Reflective thinking Analytic Analytic Reflective thinking Analytic, Communications Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic, Communications Analytic Analytic, Communications Analytic Analytic Analytic Reflective thinking, Analytic Communications Analytic, Communications Reflective thinking, Analytic Diversity, Reflective thinking Analytic Reflective thinking Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Analytic Diversity, Reflective thinking CPA/CMA Brief Exercises 18–1 18–2 18–3 18–4 18–5 18–6 18–7 18–8 18–9 18–10 18–11 18–12 18–13 18–14 18–15 18–16 Solutions Manual, Vol.2, Chapter 18 Analytic Analytic Analytic Analytic Reflective thinking Analytic Diversity, Reflective thinking Diversity, Reflective thinking Reflective thinking Analytic Reflective thinking © The McGraw-Hill Companies, Inc., 2013 18–1 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Problems 18–1 18–2 18–3 18–4 18–5 18–6 18–7 18–8 18–9 18–10 18–11 18–12 18–13 Analytic Analytic Analytic Analytic Analytic Analytic Reflective thinking, Analytic Analytic Analytic Reflective thinking Analytic Analytic Analytic © The McGraw-Hill Companies, Inc., 2013 18–2 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com QUESTIONS FOR REVIEW OF KEY TOPICS Question 18–1 The two primary sources of shareholders’ equity are amounts invested by shareholders in the corporation and amounts earned by the corporation on behalf of its shareholders Invested capital is reported as paid-in capital and earned capital is reported as retained earnings Question 18–2 The three primary ways a company can be organized are (1) a sole proprietorship, (2) a partnership, or (3) a corporation Transactions are accounted for the same regardless of the form of business organization with the exception of the method of accounting for capital—the ownership interest in the company Several capital accounts (as discussed in this chapter) are used to record changes in ownership interests for a corporation, rather than recording all changes in ownership interests in a single capital account for each owner, as we for sole proprietorships and partnerships Question 18–3 In the eyes of the law, a corporation is a separate legal entity—separate and distinct from its owners The owners are not personally liable for debts of the corporation So, shareholders generally may not lose more than the amounts they invest when they purchase shares This is perhaps the single most important advantage of corporate organization over a proprietorship or a partnership Question 18–4 “Not-for-profit” corporations such as churches, hospitals, universities, and charities, are not organized for profit and not sell stock Some not-for-profit corporations, such as the Federal Deposit Insurance Corporation (FDIC), are government owned Question 18–5 Corporations that are organized for profit may be publicly held or privately (or closely) held The stock of publicly held corporations is available for purchase by the general public Shares might be traded on organized national stock exchanges or available “over-the-counter” from securities dealers Privately held companies' shares are held by only a few individuals and are not available to the general public Question 18–6 Corporations are formed in accordance with the corporation laws of individual states The Model Business Corporation Act serves as the guide to states in the development of their corporation statutes, presently as the model for the majority of states Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–3 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 18–7 The ownership rights held by common shareholders, unless specifically withheld by agreement with the shareholders, are: a The right to vote on policy issues b The right to share in profits when dividends are declared (in proportion to the percentage of shares owned by the shareholder) c The right to share in the distribution of any assets remaining at liquidation after other claims are satisfied Question 18–8 The “preemptive right” is the right to maintain one’s percentage share of ownership when new shares are issued When granted, each shareholder is offered the opportunity to buy the same percentage of any new shares issued as the percentage of shares he/she owns at the time For reasons of practicality, the preemptive right usually is excluded Question 18–9 The typical rights of preferred shares usually include one or both of the following: a A preference to a predesignated amount of dividends, that is, a stated dollar amount per share or percent of par value per share This means that when the board of directors of a corporation declares dividends, preferred shareholders will receive the specified dividend prior to any dividends being paid to common shareholders b A preference over common shareholders in the distribution of assets in the event the corporation is dissolved Question 18–10 If preferred shares are noncumulative, dividends not declared in any given year need never be paid However, if cumulative, when the specified dividend is not paid in a given year, the unpaid dividends accumulate and must be made up in a later dividend year before any dividends are paid on common shares These unpaid dividends are called “dividends in arrears.” Question 18–11 Par value was defined by early corporation laws as the amount of net assets not available for distribution to shareholders (as dividends or otherwise) However, now the concepts of “par value” and “legal capital” have been eliminated entirely from the Model Business Corporation Act Most shares continue to bear arbitrarily designated par values, typically nominal amounts Although many states already have adopted these provisions, most established corporations issued shares prior to changes in the state statutes So, most companies still have par value shares outstanding and continue to issue previously authorized par value shares © The McGraw-Hill Companies, Inc., 2013 18–4 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 18–12 Comprehensive income is a broader view of the change in shareholders’ equity than traditional net income It is the total nonowner change in equity for a reporting period It encompasses all changes in equity except those caused by transactions with owners Transactions between the corporation and its owners (shareholders) primarily include dividends and the sale or purchase of shares of the company’s stock Most nonowner changes (e g., revenues and expenses) are reported in the income statement So, the changes other than the ones that are part of net income are those reported as “other comprehensive income.” Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods The components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement Regardless of the choice a company makes, the presentation will report net income, other components of comprehensive income, and total comprehensive income The second attribute—the comprehensive income accumulated over the current and prior periods— is reported as a separate component of shareholders’ equity This amount represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years Question 18–13 Components of comprehensive income created during the reporting period can be reported in either (a) an expanded version of the income statement or (b) a separate statement immediately following the income statement Regardless of the placement a company chooses, the presentation is similar It will report net income, other components of comprehensive income, and total comprehensive income Question 18–14 The statement of shareholders’ equity reports the transactions that cause changes in its shareholders’ equity account balances It shows the beginning and ending balances in primary shareholders’ equity accounts and any changes that occur during the years reported Typical reasons for changes are the sale of additional shares of stock, the acquisition of treasury stock, net income, and the declaration of dividends Question 18–15 The measurement objective is that the transaction should be recorded at fair value This might be the fair value of the shares or of the noncash assets or services received, whichever evidence of fair value seems more clearly evident This is consistent with the general practice of recording any noncash transaction at market value Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–5 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (continued) Question 18–16 The cash received usually is the sum of the separate market values of the separate securities However, when the total selling price is not equal to the sum of the separate market prices, the total selling price is allocated in proportion to their relative market values Question 18–17 Share issue costs reduce the net cash proceeds from selling the shares and thus paid-in capital— excess of par On the other hand, debt issue costs are recorded in a separate “debt issue costs” account and amortized to expense over the life of the debt The difference often is justified by the presumption that share issue costs and debt issue costs are fundamentally different because a debt issue has a fixed maturity, but that selling shares represents a perpetual equity interest Concept Statement disagrees, stating that debt issue costs should be treated the same way as share issue costs But, Concept Statements not constitute GAAP, and the currently prescribed practice is to record debt issue costs as assets and expense the asset over the maturity of the debt Question 18–18 The same accounts that previously were increased when the shares were sold are decreased when the shares are retired Specifically, common (or preferred) stock and paid-in capital—excess of par are reduced by the same amounts they were increased by when the shares were originally sold If the cash paid to repurchase the shares differs from the amount originally paid in, accounting for the difference depends on whether the cash paid to repurchase the shares is less than or more than the price previously received when the shares were sold When less cash is distributed to shareholders to retire shares than originally paid in, some of the original investment remains and is labeled paid-in capital—share repurchase When more cash is distributed to shareholders to retire shares than originally was paid in for those shares, the additional amount is viewed as a dividend on the original investment, and thus a reduction of retained earnings (unless previous share repurchases have created a balance in paid-in capital—share repurchase, which would be reduced first) Question 18–19 The purchase of treasury stock and its subsequent resale are considered to be a “single transaction.” The purchase of treasury stock is perceived as a temporary reduction of shareholders' equity, to be reversed later when the treasury stock is resold, so the cost of acquiring the shares is “temporarily” debited to the treasury stock account Allocating the effects to specific shareholders’ equity accounts is deferred until the shares are subsequently reissued © The McGraw-Hill Companies, Inc., 2013 18–6 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Answers to Questions (concluded) Question 18–20 For a stock dividend of less than 25%, a "small" stock dividend, the fair value of the additional shares distributed is transferred from retained earnings to paid-in capital The reduction in retained earnings is the same amount as if cash dividends were paid equal to the market value of the shares issued The treatment is consistent with the belief that per share prices remain unchanged by stock dividends This is not logical If the value of each share were to remain the same when additional shares are distributed without compensation, the total value of the company would grow simply because additional stock certificates are distributed Instead, the market price per share will decline in proportion to the increase in the number of shares distributed in a stock dividend Question 18–21 The effect and maybe the motivation for the 2-for-1 stock split is to reduce the per share market price (by half) This will likely increase the stock’s marketability by making it attractive to a larger number of potential investors The appropriate accounting treatment of a stock split is to make no journal entry, which avoids the reclassification of “earned” capital as “invested” capital However, if the stock distribution is referred to as a "stock split effected in the form of a stock dividend," and the per share par value of the shares is not changed, a journal entry is recorded that increases the common stock account by the par value of the additional shares To avoid reducing retained earnings Brandon can reduce (debit) paid-in capital—excess of par to offset the credit to common stock, although it’s permissible to debit retained earnings Question 18–22 When a company decreases, rather than increases, its outstanding shares, a reverse stock split occurs A 1-for-2 reverse stock split would cause one million $1 par shares to become one-half million $2 par shares No journal entry would be recorded, so no account balances will change But the market price per share would double, and the par amount per share would double Question 18–23 You would be entitled to 3.2 shares (4% x 80 shares) Since cash in lieu of payments usually are made when shareholders are entitled to fractions of whole shares, you probably would receive shares and cash equal to the market value of 1/5 of one share Sometimes fractional share rights are issued for the partial shares, which would entitle you to a fractional share right for 1/5 of a share Question 18–24 A quasi reorganization allows a company to (1) write down inflated asset values and (2) eliminate an accumulated deficit in retained earnings The following steps are taken: Assets and liabilities are revalued to reflect their fair values, with corresponding credits or debits to retained earnings This may temporarily increase the deficit The debit balance in retained earnings is eliminated against additional paid-in capital When additional paid-in capital is not sufficient to absorb the entire deficit, capital stock is debited Disclosure is provided to indicate the date the deficit was eliminated and when the new accumulation of earnings began Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–7 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com BRIEF EXERCISES Brief Exercise 18–1 Two attributes of other comprehensive income are reported: (1) the components of comprehensive income created during the reporting period ($15 million in this instance) and (2) the comprehensive income accumulated over the current and prior periods ($50 million at the end of this year) The $50 million represents the cumulative sum of the changes in each component created during each reporting period throughout all prior years Since this amount increased by $15 million, the balance must have been $35 million last year Brief Exercise 18–2 ($ in millions) Cash (8 million shares x $12 per share) Common stock (8 million shares x $1 par per share) Paid-in capital—excess of par (remainder) © The McGraw-Hill Companies, Inc., 2013 18–8 96 88 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 18–3 Lewelling’s paid-in capital—excess of par will increase by $860,000: 4,000 hours x $240 less $100,000 par Journal entry (not required): Legal expense (4,000 hours x $240) Common stock (100,000 shares x $1 par per share) Paid-in capital—excess of par (remainder) 960,000 100,000 860,000 Brief Exercise 18–4 Hamilton’s shareholders’ equity will increase by $3,500,000 as a result of this transaction Journal entry (not required): Inventory of motors (1,000 x $3,500) Common stock Solutions Manual, Vol.2, Chapter 18 3,500,000 3,500,000 © The McGraw-Hill Companies, Inc., 2013 18–9 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 18–5 MLS’s common shareholders’ will receive dividends of $18 million as a result of the 2013 distribution Preferred Common 2011 2012 2013 $20 million* 20 million** 32 million*** 0 $18 million (remainder) * $24 million current preference (6% x $400 million), thus $4 million dividends in arrears ** $24 million current preference (6% x $400 million), thus another $4 million dividends in arrears *** $8 million dividends in arrears plus the $24 million current preference Brief Exercise 18–6 Horton’s total paid-in capital will decline by $17 million, the price paid to buy back the shares Journal entry (not required): ($ in millions) Common stock (2 million shares x $1 par) Paid-in capital—excess of par (2 million shares x $9*) Paid-in capital—share repurchase (difference) Cash (2 million shares x $8.50 per share) 18 17 * Paid-in capital—excess of par: $900 ÷ 100 million shares © The McGraw-Hill Companies, Inc., 2013 18–10 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–4 (continued) Requirement Comprehensive income is a more expansive view of the change in shareholders’ equity than traditional net income It is the total nonowner change in equity for a reporting period In fact, it encompasses all changes in equity other than from transactions with owners Transactions between the corporation and its shareholders primarily include dividends and the sale or purchase of shares of the company’s stock Most nonowner changes are reported in the income statement So, the changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” Two attributes of other comprehensive income are reported: (1) components of comprehensive income created during the reporting period and (2) the comprehensive income accumulated over the current and prior periods The first of these—components of comprehensive income created during the reporting period—can be reported either (a) as an extension of the income statement or (b) in a separate statement, immediately following the income statement Regardless of the placement a company chooses, the presentation is similar It will report net income, other components of comprehensive income, and total comprehensive income, similar to the following: ($ in millions) Net income $xxx Other comprehensive income: Net unrealized holding gains (losses) on investments (net of tax)† $x Gains (losses) from and amendments to postretirement plans (net of tax)‡ (x) Deferred gains (losses) from derivatives (net of tax)§ x Gains (losses) from foreign currency translation (net of tax)* x xx Comprehensive income $xxx † ‡ § * Changes in the fair value of some equity securities Gains and losses due to revising assumptions or market returns differing from expectations, and prior service cost from amending the plan (described in Chapter 17) When a derivative designated as a cash flow hedge is adjusted to fair value, the gain or loss is deferred as a component of comprehensive income and included in earnings later, at the same time as earnings are affected by the hedged transaction (described in the Derivatives Appendix to the text) Gains or losses from changes in foreign currency exchange rates when translating financial statements of foreign subsidiaries The amount could be an addition to or reduction in shareholders’ equity (This item is discussed elsewhere in the accounting curriculum.) © The McGraw-Hill Companies, Inc., 2013 18–78 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–4 (concluded) This is the measure of comprehensive income Cisco reported in the disclosure note Notice that each component is reported net of its related income tax expense or income tax benefit The second measure—the comprehensive income accumulated over the current and prior periods—is reported as a separate component of shareholders’ equity This is what Cisco reported in its balance sheet as indicated in Requirement ($1,294 million in 2011) Be sure to realize this amount represents the cumulative sum of the changes in each component created during each reporting period (the disclosure note) throughout all prior years Requirement One component of Other comprehensive Income for Cisco Is "Change in unrealized gains on investments.” For reporting purposes, investments in some marketable equity securities are reported at their fair values The holding gains and losses from writing these securities up or down to fair value are not reported in the income statement, but instead are reported as a component of Other comprehensive income in the balance sheet This makes up the greatest part of Cisco’s Other comprehensive income From the information Cisco's financial statements provide, we can determine how the company calculated the $1,294 million accumulated other comprehensive income at the end of fiscal 2011: ($ in millions) Accumulated other comprehensive income (loss), 2010 Change in net unrealized gains on investments Change in derivative instruments Change in cumulative translation adjustment and other Change in minority interest Accumulated other comprehensive income (loss), 2011 $623 169 (21) 538 (15) $1,294 Requirement Nonowner changes other than those that are part of traditional net income are the ones reported as “other comprehensive income.” As described in Requirement 3, besides changes in the market value of some equity securities, these changes might include Net unrecognized gains (losses) on pensions, Deferred gains (losses) from derivatives, and Gains (losses) from foreign currency translation Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–79 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Judgment Case 18–5 Requirement Alcoa has two choices of how to account for the buyback: The shares can be formally retired The shares can be called “treasury stock” Regardless of the choice, total shareholders’ equity will be the same Cash is paid to repurchase stock so the effect is to decrease both cash and shareholders’ equity However, the choice does affect how individual shareholders’ accounts are reported in the balance sheet Formally retiring shares restores the balances in both the Common stock account and Paid-in capital—excess of par to what those balances would have been if the shares never had been issued at all Any net increase in assets resulting from the sale and subsequent repurchase is reflected as Paid-in capital—share repurchase On the other hand, any net decrease in assets resulting from the sale and subsequent repurchase is reflected as a reduction in retained earnings In contrast, when a share repurchase is viewed as treasury stock, the cost of the treasury stock is simply reported as a reduction in total shareholders’ equity Alcoa would account for the purchase of the treasury stock by debiting treasury stock and crediting cash for the cost of the purchase The treasury stock should be presented separately in the shareholders' equity section of Alcoa’s balance sheet as an unallocated reduction of shareholders' equity These shares are considered issued but not part of common stock outstanding If later resold for an amount greater than cost, Alcoa should account for the sale of the treasury stock by debiting cash for the selling price, crediting treasury stock for cost, and crediting additional paid-in capital from reacquired stock for the excess of the selling price over the cost On the other hand, if the shares were retired, Alcoa would simply record any subsequent sale as it would the sale of any new shares Requirement Alcoa can choose not to make any journal entry for the stock split Alternatively, Alcoa can choose to effect the split “in the form of a stock dividend.” In that case, Alcoa would account for the stock split by debiting paid-in capital for the par per share multiplied by the shares distributed Total shareholders' equity does not change This prevents the par per share from changing Alcoa should then credit common stock for the same amount © The McGraw-Hill Companies, Inc., 2013 18–80 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–5 (concluded) Requirement Alcoa should account for the cash dividend on the declaration date by debiting retained earnings and crediting cash dividends payable for $.25 per share multiplied by the number of shares outstanding A cash dividend is a distribution to the corporation's shareholders The liability for this distribution is incurred on the declaration date, and it is a current liability because it is payable within one year The effect of the cash dividend on Alcoa's balance sheet is an increase in current liabilities and a decrease in retained earnings Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–81 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 18–6 sample memo: Memorandum To: Les Kramer Supervisor From: {your name} Re: Share issue costs Date: {current date} This memo is in response to your request for information about how IBR accounted for share issue costs in its recent equity offering When a company sells shares, it obtains the legal, promotional, and accounting services necessary to effect the sale The cost of these services reduces the net proceeds from selling the shares Paid-in capital—excess of par is credited for the excess of the proceeds over the par value of the shares sold Thus, the effect of share issue costs is to reduce the amount credited to that account This treatment differs from how debt issue costs are recorded The costs associated with a debt issue are recorded in a separate “debt issue costs” account and amortized to expense over the life of the debt In IBR’s case, the shares sold for a total of $53.289 million (2,395,000 shares times $22.25 per share) Since paid-in capital—excess of par is credited for the excess of the $50.2 million net proceeds over the par amount of the shares sold, the effect of share issue costs (underwriting discount and offering expenses) is to reduce the amount credited to that account In particular, IBR would have recorded the following journal entry upon the issue of the shares ($ in 000s) Cash (given) Common stock ($.10 par x 2,395 shares) Paid-in capital—excess of par (difference) 50,200.0 239.5 49,960.5* * This amount reflects the reduction for share issue costs (underwriting discount and offering expenses) Please let me know if I can provide you additional information © The McGraw-Hill Companies, Inc., 2013 18–82 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–6 (concluded) Suggested Grading Concepts And Grading Scheme: Content (80% ) 30 Accounting for share issue costs Nature of costs Reduces the net proceeds from selling the shares Effect of share issue costs is to reduce the amount credited to paid-in capital 10 “Debt issue costs” recorded in a separate account and amortized to expense over the life of the debt 10 IBR’s accounting Paid-in capital—excess of par is credited for the excess of the $50.2 million net proceeds over the par amount of the shares sold 30 Journal entry Cash $50,200,000 Common stock $239,500 Paid-in capital—excess of par $49,960,500 Bonus (5) The FASB has suggested in Concept Statement that debt issue costs should be treated the same way as share issue costs But Concept Statements not constitute GAAP, so until new GAAP, the prescribed practice is to record debt issue costs as assets and expense the asset over the maturity of the debt 80–85 points Writing (20%) Terminology and tone appropriate to the audience of supervisor Organization permits ease of understanding Introduction that states purpose Paragraphs separate main points English Word selection Spelling Grammar 20 points Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–83 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Analysis Case 18–7 Requirement The ratio is computed by dividing net income by average shareholders' equity Rate of return on shareholders’ equity = Net income Average shareholders’ equity = $487 [$2,931 + 2,671] ÷ = 17.4% NYSE average = 18.8% The return on shareholders' equity is an important ratio for the owners of a company It measures the ability of company management to generate net income from the resources that owners provide AGF’s return is comparable to other firms, although slightly less Like most ratios, though, it should not be viewed in isolation For example, when the return on shareholders’ equity is greater than the return on assets, management is using debt funds to enhance the earnings for stockholders The return on assets is a measure of a company's ability to use assets profitably, regardless of how the assets were financed It is computed by dividing net income by average total assets Rate of return on assets = Net income Average total assets = $487 [$5,345 + 4,684] ÷ = 9.7% AGF is in this enviable position and, therefore, has favorable financial leverage We discussed financial leverage in Chapter 14 © The McGraw-Hill Companies, Inc., 2013 18–84 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–7 (concluded) Requirement Earnings per share, in its simplest form, is simply a firm’s net income divided by the number of shares outstanding throughout the year It expresses a firm’s profitability on a per share basis Earnings per share = Income available to common shareholders Average shares outstanding = $487 181 = $2.69 To complement the return on shareholders’ equity ratio, analysts sometimes calculate the earnings-price ratio in order to relate earnings to the market value of equity This ratio is the earnings per share divided by the market price per share: Earnings-price ratio = Earnings per share Market price per share = $2.69 $47 = 5.7% The earnings-price ratio measures the return on the market value of common stock Remember, shareholders’ equity is a measure of the book value of equity The market value of a share of stock (or of total shareholders’ equity) usually is different from its book value AGF’s return on market value is somewhat higher than the average return for the stocks listed on the New York Stock Exchange in a comparable time period (5.4%) So, even though the return on book value is a little lower than average, a closer look at the return to market value shows AGF to be at least in line with its industry Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–85 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Ethics Case 18–8 Discussion should include these elements Return on assets: Rate of return on assets is net income divided by assets The lower the asset base, the higher the percentage return A noncash transaction should be recorded at fair value This should be the fair value of the consideration given or the asset (in this case) received The asset has no readily available fair value because it is custom-made The value of debt the Swiss firm is asking for probably provides a good indication of the fair value of the asset Ethical Dilemma: Is the desire to boost return justification for questionable accounting treatment of the transaction? Who is affected? Benson Sharp Other managers? The company’s auditor, if any This is a private company Shareholders (probably few) The employees The creditors © The McGraw-Hill Companies, Inc., 2013 18–86 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Research Case 18–9 The results students report will vary depending on the companies chosen It can be interesting to have students compare in class their findings with those of their classmates Typical items that affect retained earnings are dividends (cash, property, or stock) and net income or loss Treasury stock or retired stock transactions also affect retained earnings Typical transactions that affect common stock are new stock issues, treasury stock or retired stock transactions, and conversions of other securities into common stock Were any of these transactions identified in Requirement also? The statement of shareholders’ equity explains why and how the various shareholders’ equity items on the balance sheet change from year to year Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–87 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Communication Case 18–10 You may wish to suggest to your students that they consult the FASB 1990 Discussion Memorandum, “Distinguishing between Liability and Equity Instruments and Accounting for Instruments with Characteristics of Both,” which sets forth the most common arguments on the issues in this case Or, you may prefer that they think for themselves and approach the issue from scratch There is no right or wrong answer Both views can and often are convincingly defended The process of developing and synthesizing the arguments likely will be more beneficial than any single solution Each student should benefit from participating in the process, interacting first with his or her partner, then with the class as a whole It is important that each student actively participate in the process Domination by one or two individuals should be discouraged A significant benefit of this case is that it forces students’ consideration and acceptance of the fact that both liabilities and equities are claims to an enterprise’s assets It also requires them to carefully consider the profession’s definitions of those elements Arguments brought out in the FASB DM include the following: Arguments Supporting View 1: Some students likely will argue that convertible bonds and other similar instruments can be appropriately classified in the two existing categories on the basis of existing distinctions and definitions For instance, they might focus on the characteristic of a liability that requires that the enterprise issuing it have little or no discretion to avoid the future sacrifice of economic benefits Concepts Statement defines liabilities as: probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events [paragraph 35] Three essential characteristics of a liability are: a It embodies a present duty or responsibility to one or more other entities for settlement by probable future transfer or use of assets at a specified or determinable date, on occurrence of a specified event, or on demand b The duty or responsibility obligates a particular entity, leaving it little or no discretion to avoid the future sacrifice c The transaction or other event obligating the entity has already happened © The McGraw-Hill Companies, Inc., 2013 18–88 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–10 (continued) Equity of a business enterprise is defined simply as the residual interest: the difference between an enterprise's assets and its liabilities The essential characteristics of equity focus on the conditions for transferring assets to the holders of equity interests Usually, a company is not obligated to transfer assets to owners except in the event of liquidation unless it voluntarily acts to so, such as by declaring a dividend A company’s liabilities and equity are mutually exclusive claims to or interests in its assets by others, and liabilities take precedence over ownership interests A company may have two or more classes of equity, such as preferred stock and common stock; no class has an unconditional right to receive distributions of assets other than in liquidation and then only after all liabilities have been settled That is the essential distinction between liabilities and equity A liability entails an obligation to transfer assets or provide services in the future, while an equity instrument does not The distinction between liabilities and equity is important to reported financial position So, whether an issue of convertible bonds is classified as a liability or as equity affects both reported amounts of total liabilities and equity and summary amounts based on those amounts, such as ratios The distinction also is critical in measuring income Comprehensive income is defined in Concepts Statement to include all changes in equity during a period other than those resulting from transactions with owners Income includes only inflows in excess of the amount needed to maintain capital Without a distinction between the claims of creditors and those of owners, measurement of income is not possible Reported income also is affected Convertible bonds have features of both debt (fixed interest and principal payments) and equity (ability to participate in the benefits of stock ownership) If convertible bonds are treated as an equity instrument, the interest payments are not deducted in determining the issuer's net income However, if they are deemed to be liability, the interest would be reported as an expense and deducted in determining net income Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–89 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–10 (continued) Arguments Supporting View 2: Arguments here center on the “entity theory” of accounting first proposed by W A Paton in 1922, which views the accounting equation as: Assets = Equities with equities including both what are termed liabilities and equity in the current conceptual framework A central feature of this theory is that profits are determined with reference to all capital suppliers That is, profits are determined before deducting either interest or dividends Both interest and dividends, and income taxes as well, are treated as distributions of profits Examples of possible formats of a balance sheet and an income statement under this alternative suggested by the DM follow Balance Sheet Cash Investments Inventory Plant and equipment $ 2,050 5,000 7,000 Accounts payable Mortgage Bonds Preferred stock Common stock Retained earnings Total equities Total liabilities and equities 15,000 Total assets $29,050 $ 1,200 4,000 5,000 5,000 4,800 9,050 18,850 $29,050 Income Statement Sales Cost of goods sold Selling and other expenses Excess of revenues over expenses $30,000 10,000 4,000 $16,000 Interest on mortgage Interest on bonds Income taxes Preferred dividends Earnings attributable to common stock Common dividends Earnings retained 300 400 5,000 450 $ 9,850 800 $ 9,050 © The McGraw-Hill Companies, Inc., 2013 18–90 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Case 18–10 (concluded) or, alternatively: Sales Cost of goods sold Selling and other expenses Enterprise net income $30,000 10,000 4,000 $16,000 Interest on mortgage Interest on bonds Income taxes Preferred dividends Common dividends Earnings retained 300 400 5,000 450 800 $ 9,050 Many issues would have to be resolved if this approach were to be seriously pursued For instance, would all present liabilities be treated as "equities"? If not, which would be treated differently? Today the distinction between short term and long term is not considered to be particularly relevant for at least some companies, so it might be questionable to distinguish on that basis Another possibility would be to treat only liabilities incurred in exchange for cash proceeds as "equities." However, labor, inventory, and the like also are "capital" in a broad sense, so it may be hard to justify treating obligations incurred to acquire them differently from obligations to pay cash The concept of income under this approach is another question Would an attempt to eliminate the line between liabilities and equity make it inappropriate to attempt to measure income, or would it merely change the underlying concept and measure of net income? These are only two possible questions, but students favoring Alternative should discuss its overall effect on the financial statements, including the concept and measurement of income Solutions Manual, Vol.2, Chapter 18 © The McGraw-Hill Companies, Inc., 2013 18–91 Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Air France–KLM Case Requirement Air France–KLM lists four items in the shareholders’ equity section of the balance sheet If AF used U.S GAAP, Issued share capital would be Common stock, Reserves and retained earnings would be separated into retained earnings and one or more other accounts The term reserves is considered misleading and thus is discouraged under U.S GAAP For example, what would be called Investment revaluation reserve under IFRS might be called Net gains (losses) on investments— AOCI What would be called Investment revaluation reserve under IFRS might be called Net gains (losses) foreign currency translation—AOCI Often firms using IFRS will use the term Share premium for Paid-in capital— excess of par and Investment in own shares for Treasury stock Requirement Note 27.4 indicates that the items that comprise “Reserves and retained earnings” as reported in the balance sheet are Legal reserve, Distributable reserves, Derivatives reserves, Available for sale securities reserves, Other reserves, Net income (loss)—group share If AF used U.S GAAP, the first two of those would not be listed as shareholders’ equity What AF called Derivatives reserves might be called Net gains (losses) on derivatives–AOCI What AF called Available for sale securities reserves under IFRS might be called Net gains (losses) on investments— AOCI Other reserves might be Net gains (losses) foreign currency translation— AOCI or Postretirement benefit gains (losses)—AOCI Net income (loss)—Group share is equivalent to retained earnings but not included as a component of “reserves” under U.S GAAP Requirement The order of presentation of the components of the balance sheet usually is different between U.S GAAP and IFRS AF lists Non-current assets before current assets and Non-current liabilities before current liabilities Also, within Total equity and liabilities, Shareholders’ equity is listed first Each of these is the opposite order from what we see under U.S GAAP © The McGraw-Hill Companies, Inc., 2013 18–92 Intermediate Accounting, 7e ... 88 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 18–3 Lewelling’s paid-in capital—excess of par will increase by $860,000:... 2013 18–10 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 18–7 Agee’s total paid-in capital will decline by $18 million... 67 70 Intermediate Accounting, 7e Find more slides, ebooks, solution manual and testbank on www.downloadslide.com Brief Exercise 18–9 Cox’s paid-in capital—share repurchase will increase by $7