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Module 8 Equity Recognition and Owner Financing Learning Objectives – coverage by question True/False

Multiple Choice

Exercises

Problems

Essays

LO1 – Describe and analyze accounting for contributed capital, including stock sales and repurchases, and equity based compensation.

1-11

1-9

1-12

1-5, 8

1-4

LO2 – Explain and analyze accounting for earned capital, including cash dividends, stock dividends, and comprehensive income.

11-15

10-18

10-18

2-7, 8

5-7

LO3 – Describe and interpret accounting for equity carve-outs and convertible debt.

15 - 17

19-25

19-21

8-10

8

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-1

Module 8: Equity Recognition and Owner Financing

True/False Topic: Stock Splits LO: 1 1. A stock split is a monetary transaction. Consequently, a company that splits its stock must make several financial statement adjustments.

Answer: False Rationale: A stock split is not a monetary transaction and, as such, there are no financial statement adjustments needed.

Topic: Gains (Losses) on Stock Transactions LO: 1 2. When there is a purchase and sale of stock, or a payment of dividends, there is never any gain or loss recorded.

Answer: True Rationale: Any “gains” or “losses” incurred due to the purchase and sale of stock are reflected as increases (decreases) in the paid-in-capital component of stockholders’ equity. Dividends are reflected as decreases in the retained earnings component of stockholders’ equity.

Topic: Stock Repurchase LO: 1 3. Kimberly-Clark recently repurchased 5.6 million shares of common stock at a price of $43 per share.

One plausible reason for this is that the company feels that its stock is overvalued at the current market price.

Answer: False Rationale: Companies often repurchase their own stock to send a message to the investment community that their stock is undervalued. If the company believed its stock was overvalued, there would be no rationale to buy an overpriced security.

Topic: Stock Repurchase LO: 1 4. When Kimberly-Clark recently repurchased its stock, this action “downsized” the company. This has the opposite financial statement effects as stock issuance.

Answer: True Rationale: The action of repurchasing stock has the opposite financial statement effects of stock issuance – cash is reduced and shareholder equity is reduced.

©Cambridge Business Publishers, 2013 8-2

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Preferred Preference in Bankruptcy LO: 1 5. If HJ Heinz loses its dominance in the ketchup market and eventually becomes bankrupt, its preferred shareholders carry senior positions as claimants in bankruptcy vis-à-vis common shareholders.

Answer: True Rationale: Preferred shareholders carry senior positions to common shareholders as claimants in bankruptcy.

Topic: Paid-in Capital LO: 1 6. Retained earnings and accumulated other comprehensive income (AOCI) can be found in the contributed capital section of stockholders’ equity.

Answer: False Rationale: Retained earnings and AOCI are found in the “earned capital” portion of the stockholders’ equity section of the balance sheet.

Topic: Employee Stock Options LO: 1 7. When stock options are granted, the contributed capital increase is equal to the number of options granted multiplied by the estimated fair-value of the stock on the grant date.

Answer: False Rationale: It is the estimated fair-value of the option on the grant date and not that of the underlying stock.

Topic: Employee Stock Options Grants (Numerical calculation required) LO: 1 8. Vickery Inc. reports 3,969,000 stock options granted during fiscal 2012 at a weighted-average fairvalue of $13.67. The average vesting period for these options is three years. Vickery should record a $54,256,230 expense on its income statement related to this option grant.

Answer: False Rationale: Because the options have a three-year vesting period on average, Vickery should record the expense over the vesting period, or $18,085,410 per year.

Topic: Employee Stock Options Exercises (Numerical calculation required) LO: 1 9. Pfieffer and Company’s stock option footnote discloses before tax stock option expense of $518 million for fiscal 2012. The after tax stock option expense is disclosed as $337 million dollars. Dell must increase its deferred tax assets by $181 million on its balance sheet for 2012.

Answer: True Rationale: Pfieffer would record the difference between before and after tax stock option expense as an increase to deferred tax assets on its books. The expense reduces book income but is not taxdeductible until the options are exercised.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-3

Topic: Sale of Treasury Stock LO: 1 10. A re-issuance of treasury stock at a price lower than what it was repurchased for results in a loss on the income statement.

Answer: False Rationale: There is no gain or loss on the re-issuance of treasury stock in the income statement.

Instead, the difference between the proceeds received and the original repurchase price of the treasury stock is reflected as an increase or decrease in additional paid-in capital component of stockholders’ equity.

Topic: Cost vs. Market Value of Stockholders’ Equity LO: 1 & 2 11. Stockholders’ equity is not accounted for at current fair value.

Answer: True Rationale: Stockholders’ equity is accounted for at historical cost, just like assets and liabilities.

Topic: Income Statement Treatment of Dividends LO: 2 12. A company is worse off by paying cash dividends because it must record a loss for this transaction in its income statement.

Answer: False Rationale: Payment of cash dividends reduces cash and retained earnings, and is not recorded as an expense in the income statement.

Topic: Cash Dividends LO: 2 13. In 2006, Target paid $750 million of cash dividends. These dividends reduced assets and reduced retained earnings.

Answer: True Rationale: Cash dividends result in a reduction in cash and retained earnings.

Topic: Large Stock Dividends LO: 2 14. When a “large” stock dividend is paid out, retained earnings are reduced by the par value of the stock.

Answer: True Rationale: Since it is a large stock dividend, retained earnings is reduced by the par value of the dividend. Retained earnings are reduced by the market value of the stock dividend only if this is a “small” stock dividend (percentage of outstanding shares distributed is less than 20 – 25%).

©Cambridge Business Publishers, 2013 8-4

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Comprehensive Income LO: 2 15. Net income is generally viewed as a more inclusive measure of performance than comprehensive income.

Answer: False Rationale: Comprehensive income is a more inclusive notion of company performance because it includes all recognized changes in equity that occur during a period, except those resulting from investments by owners and distribution to owners.

Topic: Equity Carve-Outs LO: 3 16. Equity carve-outs make it easier to evaluate the individual business units of a conglomerate.

Answer: True Rationale: By carving out the business unit, the assets, liabilities and equity due to that single business unit are more apparent and not combined with the parent company and other subsidiaries.

Topic: Split-Offs LO: 3 17. Pro rata distributions associated with split-offs, can result in the company reporting gains or losses on the carve out.

Answer: False Rationale: Only non pro rata split-offs can yield gains or losses. Pro rata distributions are recorded at book value, thus, there is no possible gain or loss.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-5

Multiple Choice Topic: Stock Repurchase LO: 1 1. Why might a company repurchase its own stock?

A) It believes that the market undervalues its shares B) To offset dilutive effects of employee stock options granted C) To recognize an economic gain when the treasury shares are later sold for a profit D) To improve earnings per share by reducing the denominator E) All of the above Answer: E Rationale: Companies may repurchase shares to keep the outstanding shares constant in order to reduce the dilutive effect on earnings per share that may occur when employees exercise stock options.

Topic: Par Value LO: 1 2. Which best describes par value for a stock?

A) An arbitrary amount set by the company for each share of stock B) The value of the stock if it is not sold for a premium or discount C) The current market value of the stock D) The value at which stock shares were originally issued E) None of the above Answer: A Rationale: The par value is an arbitrary amount specified in the corporate charter for each share of stock. Generally it has no substance from a financial reporting or analysis perspective.

Topic: Paid-In Capital LO: 1 3. Which one of the following items is not a component of contributed capital?

A) Preferred stock B) Retained earnings C) Common stock D) Additional paid-in capital E) All of the above Answer: B Rationale: Retained earnings is a separate component of stockholders’ equity section. It is typically referred to as “earned” capital.

©Cambridge Business Publishers, 2013 8-6

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Stock Split LO: 1 4. In May 2011, Cerner Corporation. announced a 2-for-1 stock split. On the split date, Cerner had about 83.25 million shares outstanding. After the split the number of shares outstanding was: A) 124.875 million B) 83.25 million C) 41.625 million D) 166.5 million E) None of the above Answer: D Rationale: A 2-for-1 stock split means that the company distributes one additional share of stock for every share owned by a current shareholder. 83.25 million × 2 = 166.5 million.

Topic: Accounting for Stock Issuance LO: 1 5. If a company issues 1,000 shares of common stock at a market price of $40 per share, which of the following is the correct balance sheet effect?

A) Increase cash by $40,000 and increase contributed capital by $40,000 B) Increase cash by $40,000 and increase earned capital by $40,000 C) Increase stock revenues by $40,000 D) Stock issuances are not reported on the balance sheet E) None of the above Answer: A Rationale: Cash increases by the number of shares issued times the market price; contributed capital also increases by the same amount. The latter is broken down into two segments: 1. common stock, which increases by the original par value of the shares sold, and 2. additional paid-in capital, which makes up the balance. Revenue is an Income Statement category and therefore irrelevant in this case.

Topic: Accounting for Stock Option Grants (Numerical calculation required) LO: 1 6. Ebay’s footnote regarding employee stock compensation details the grant of 8.418 million options during the year of 2011, the fair-value of which was computed as $9.87. If the options have, on average, a four-year vesting schedule and the company faces a 35% tax rate on income, what affect would this option grant have on ebay’s accounts in 2011?

A) B) C) D) E)

$ 7,269,995 increase to deferred tax asset, $7,269,995 decrease to tax expense $29,079,981 increase to deferred tax asset, $29,079,981 decrease to tax expense $ 7,269,995 decrease to deferred tax asset, $7,269,995 increase to tax expense $29,079,981 decrease to deferred tax asset, $29,079,981 increase to tax expense Indeterminable since the number of options exercised is unknown.

Answer: A Rationale: To compute the expense for the current grant, we must multiply the value of the options by the number granted and recognize this amount over the vesting period of the options.

8,418,000 × $9.87 = $83,085,660/4 = $20,771,415 We credit this amount to paid-in capital and debit wage expense.

In order to determine the deferred tax asset, we take the expense and multiply it by the tax rate: $20,771,415 × 0.35 = $7,269,995 Because of the timing difference between the recognition of the expense and the tax deductibility of the expense, we record a deferred tax asset on the balance sheet and a credit to tax expense.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-7

Topic: Accounting for Stock Option Exercises (Numerical calculation required) LO: 1 7. During fiscal 2011, Abercrombie & Fitch reported the exercise of 1,573,351 shares at a weightedaverage exercise price of $29.62. If Abercrombie’s stock was trading at $59.64 in January and $18.31 in December, which of the following details an impact of this transaction on Abercrombie’s accounts?

A) A decrease of $46,602,657 to additional paid-in capital B) An increase of $47,231,997 to cash C) A decrease of $93,834,654 to additional paid-in capital D) An increase of $46,602,657 to cash E) None of the above Answer: B Rationale: The exercise of 1,573,351 shares at the price of $29.62 would imply: 1,573,351 × $29.62 = $46,602,657 This amount is credited to paid-in capital and debited to cash. The amount the stock is trading at doesn’t impact the financial statements of the company.

Topic: Accounting for Restricted Stock (Numerical calculation required) LO: 1 8. Redek’s Travel Co. compensates its executives with restricted stock. During 2012, the company granted 8,000 shares of $1 par value restricted common stock that will vest over eight (8) years. The market value of the shares was $5 at the time of the grant.

What is the impact of this transaction on additional paid-in capital?

A) Increase additional paid-in capital by $32,000 B) Increase additional paid-in capital by $6,000 C) Increase additional paid-in capital by $40,000 D) Increase additional paid-in capital by $8,000 E) Paid-in capital is not impacted by this transaction.

Answer: A Rationale: Like a regular stock issuance, the compensation is split between common stock and paid in capital. The vesting period doesn’t pertain to the impact on paid-in capital, but will be used to offset deferred compensation over time.

8,000 × $1 par value = $8,000 increase to common stock 8,000 × $4 = $32,000 increase to additional paid-in capital Topic: Treasury Stock Transaction (Numerical calculation required) LO: 1 9. On its 2010 balance sheet, Walgreen Co, reports treasury stock at cost of $3,101 million. The company has a total of 1,025,400,000 shares issued and 938,605,503 shares outstanding. What average price did Walgreen pay for treasury shares?

A) $ 3.02 B) $ 3.30 C) $ 3.57 D) $35.73 E) None of the above Answer: D Rationale: Price per share is total treasury shares at cost divided by treasury shares. $3,101,000,000 / (1,025,400,000 – 938,605,503) = $35.73 per share.

©Cambridge Business Publishers, 2013 8-8

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Preferred Dividends LO: 2 10. The 2012 financial statements of Fixx Corporation report that the company paid dividends of $17,350,000 to its preferred shareholders before paying dividends to its common shareholders. This practice is called: A) Liquidation preference B) Treasury preference C) Dividend preference D) Stock ownership preference E) None of the above Answer: C Rationale: Dividend preference refers to the fact that preferred shareholders receive dividends on their shares before common shareholders receive their dividends.

Topic: Reconciling Retained Earnings (Numerical calculation required) LO: 2 11. Michalko Inc. reported retained earnings of $149,100 on December 31, 2012. During the year, Michalko recorded net income of $70,246 and paid dividends of $20,778. The company had no other transactions that affected retained earnings.

What must retained earnings have been on December 31, 2011?

A) B) C) D) E)

$ 79,632 $169,878 $ 99,632 $190,656 None of the above

Answer: C Rationale: Beginning retained earnings can be backed into from ending retained earnings and the flows to retained earnings. Adding back the dividends and subtracting out the income will give us the retained earnings Michalko began the year with: $149,100 + $20,778 - $70,246 = $99,632.

Topic: Small Stock Dividends (Numerical calculation required) LO: 2 12. Elgin Experts, Inc., declares a small stock dividend of 17% of the outstanding shares of common stock. Currently, Elgin Experts has 1,400,000 shares of $1 par value common stock outstanding. The current market price of the stock is $82.53 per share. Elgin Experts will record a dividend of: A) $ 1,400,000 B) $115,542,000 C) $ 19,404,140 D) $ 19,642,140 E) None of the above Answer: D Rationale: Retained earnings are reduced by market value for small stock dividends: 1,400,000 shares × 17% × market value per share $82.53 = $19,642,140

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-9

Topic: Large Stock Dividend (Numerical calculation required) LO: 2 13. Daisy and Company announces a large stock dividend of 73% of the 2.4 million outstanding shares of common stock. The current price per share is $7.89. Par value of the stock is $0.01 per share. What effect does this dividend have on retained earnings?

A) $24,000 decrease B) $17,520 decrease C) $18,936,000 decrease D) $13,823,280 decrease E) None of the above Answer: B Rationale: Retained earnings are reduced by the par value of the stock = 2.4 million shares × 73% × $0.01 = $17,520 Topic: Comprehensive Income LO: 2 14. Which of the following should not be included in accumulated other comprehensive income?

A) Minimum pension liability B) Currency translation adjustment C) Unrealized gains and losses on available-for-sale securities D) Unrealized gains and losses on trading securities E) None of the above Answer: D Rationale: Unrealized gain on trading securities is recorded in the income statement rather than as equity, while all the other three items should be categorized within comprehensive income.

Topic: Accumulated Other Comprehensive Income (Numerical calculation required) LO: 2 15. Affymetrix, Inc., reported a net gain of $79,000 on its foreign assets due to the weakening of the U.S. dollar in 2011. In the same year, the company disclosed unrealized gains of $2,271,000 on its available-for-sale securities and a $211,000 unrealized gain on its trading securities. The company also reported a $1,710,000 loss on the sale of some equipment.

Which of the following best describes the impact of these transactions on Affymetrix, Inc.’s accounts?

A) $ 851,000 increase to net income.

B) $2,350,000 increase to accumulated other comprehensive income.

C) $2,350,000 increase to net income.

D) $2,561,000 increase to accumulated other comprehensive income.

E) None of the above Answer: B Rationale: Only the gain on Affymetrix’s foreign currency translation and the gain on its available-forsale securities should be included in accumulated other comprehensive income. These items are kept separate from income until sold and hence do not impact it.

©Cambridge Business Publishers, 2013 8-10

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Common Stock Dividend (Numerical calculation required) LO: 2 16. Stephen Inc. has 20,000 common shares issued at a $2 par value of which 16,000 are outstanding. If Stephen has no other outstanding stock, what size dividend must be paid such that each share receives $3?

A) $120,000 B) $60,000 C) $96,000 D) $48,000 E) None of the above Answer: D Rationale: Only outstanding shares are included in dividend distributions. Hence, to pay 16,000 shares $3 each, Stephen must pay: 16,000 × $3 = $48,000 Topic: Common Stock Dividend With Cumulative Preferred (Numerical calculation required) LO: 2 17. As of 2012, Sommers Corp. has $10 par, 5% preferred stock, 4,000 shares outstanding, and $1 par common stock with 20,000 shares outstanding. The preferred stock is cumulative and preferred stockholders last received a dividend in 2009. If the company wants to distribute $2 per share to the common stockholders in 2012, what is the total amount of dividends that the company must pay in the current year?

A) $46,000 B) $ 6,000 C) $40,000 D) $ 2,000 E) None of the above Answer: A Rationale: Since the preferred stock is cumulative, it must be paid in arrears for 2010, 2011 and 2012 before common holders can be paid anything in 2012. $10 × 0.05 × 4,000 = $2,000 preferred dividend per year. $2,000 × 3 years = $6,000.

In order to give common holders $2 per share, Sommers must pay $40,000 ($2 × 20,000 shares).

Altogether, Sommers must pay $6,000 + $40,000 = $46,000.

Topic: Noncontrolling Interest LO: 2 18. Which of the following is not a correct statement about noncontrolling interest?

A) Noncontrolling interest is reported as a component of stockholders’ equity on the balance sheet.

B) Noncontrolling interest represents their claim to their proportionate share of the net assets and net income of the subsidiary in which they own stock.

C) Noncontrolling interest is a residual claim, like that of any other shareholder.

D) Noncontrolling interests are entitled to preference in dividends and payouts in liquidation.

Answer: D Rationale: Noncontrolling interests are not entitled to preference in dividends and payouts in liquidation.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-11

Topic: Equity Carve-Out LO: 3 19. The equity carve-out in which the parent company distributes the subsidiary’s shares as a dividend to shareholders is called which of the following?

A) Sell-Off B) Spin-Off C) Split-Off D) Stock Split E) None of the above Answer: B Rationale: A spin-off is an equity carve-out in which the parent company offers the subsidiary’s shares to current parent company shareholders as a dividend.

Topic: Convertible Securities LO: 3 20. Convertible preferred stock conveys what additional benefit over common stock?

A) Convertible preferred stock has a fixed dividend yield.

B) Unpaid dividends on convertible preferred stock are paid before common stock dividends.

C) Convertible preferred stock has a senior claimant position in bankruptcy.

D) Convertible stock can be converted into the company’s debt security.

E) All of the above Answer: C Rationale: A preferred security has a senior claim over common stock. While convertible preferred often has a fixed dividend, it is not always the case. Cumulative dividends are as frequent as noncumulative.

Topic: Equity Carve-Outs LO: 3 21. Which of the following transactions is similar to a repurchase of stock in its accounting treatment?

A) Sell-off B) Spin-off C) Split-off D) Carve-out E) None of the above Answer: C Rationale: In a pro rata split-off situation, treasury stock is increased by the book value of the investment in the subsidiary. In a non pro rata split-off, treasury stock is increased by the market value of the investment in the subsidiary. Shares of the subsidiary are paid to shareholders.

©Cambridge Business Publishers, 2013 8-12

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Equity Carve-Outs LO: 3 22. In November 2004, Kraft Foods sold its confectionery business to Wrigley for $1.85 billion cash, which consisted primarily of the following key candy brands: Lifesavers, Altoids, and Crème Savers.

This deal is referred to as a: A) Split-off B) Sell-off C) Spin-off D) Carve-off E) None of the above Answer: B Rationale: This is a sell-off. Kraft sold-off these brands because they do not fit with the “middle-of-thesupermarket” nature of their other products.

Topic: Equity Carve-Out LO: 3 23. In this form of equity carve-out, the parent company exchanges stock that it owns in the subsidiary for some of the parent shares owned by its shareholders: A) Sell-Off B) Spin-Off C) Split-Off D) None of the above Answer: C Rationale: After completing a split-off, the subsidiary is an independent, publicly traded company.

Topic: Equity Carve-Out (Numerical calculation required) LO: 3 24. Mikayla Co. recently underwent a sell-off of its home gardening and repair subsidiary, Cass Co., to an independent party. If Mikayla recorded a gain of $40,934 on the carve out and received $61,350 cash for the sale, what are the net assets of Cass Co.?

A) $102,284 B) $122,616 C) $ 19,040 D) $ 20,416 E) None of the above Answer: D Rationale: The net assets of the subsidiary must be the difference between the sale price of the company and the gain on the sale: $61,350 - $40,934 = $20,416

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-13

Topic: Equity Carve-Out (Numerical calculation required) LO: 3 25. Bicycles Inc. decided to split-off its subsidiary Spinners Co. On January 2012, Bicycles Inc. tendered 25,000 shares of Spinners Co.’s $6 par value stock to its current shareholders in a non pro rata distribution. On the day of the offer, Spinners Co. was trading for $68 a share. Bicycles Inc. had the investment in Spinners Co. recorded at $2,000,000 on their balance sheet.

What would Bicycles Inc. record on its income statement as a result of this transaction?

A) $300,000 gain B) $300,000 loss C) $150,000 loss D) $150,000 gain E) No gain or loss is recorded on split-offs.

Answer: B Rationale: In a non pro rata split-off, the parent’s treasury stock account is increased by the market value of the subsidiary’s shares. Since this will not necessarily match the amount the parent has the subsidiary recorded at on its books, a gain or loss is recorded on the sale on the income statement. In this case, we calculate it as follows: 25,000 × $68 = $1,700,000 increase to treasury stock and $2,000,000 – $1,700,000 = $300,000 loss on the income statement.

©Cambridge Business Publishers, 2013 8-14

Financial Statement Analysis & Valuation, 3rd Edition

Exercises Topic: Financial Statements Effects of Treasury Stock LO:1 1. On November 6, 2012, Mortar Industries, a brick construction company, repurchased 1,000 of its $0.20 par value common shares for $16 cash per share. On February 6, 2013, Mortar Industries reissues the 1,000 common shares for $24 cash per share. a. What is the change in the treasury stock account on November 6, 2012? b. On February 6, does Mortar Industries recognize a profit from the $8 per share increase in the stock’s market value? c. What is the change in the treasury stock account as a result of the February 6, 2013 transaction? d. What is the change in the additional paid-in capital account as a result of the February 6, 2013 transaction?

Answer: a. The treasury stock contra-equity account increased by $16,000 (1,000 shares × $16 per share). b. There is an economic profit in that the company has $8,000 more cash. But there is no accounting profit from treasury stock transactions. c.

The treasury stock contra-equity account decreases by the original cost of the shares, $16 per share. The treasury shares account has a zero balance.

d. The additional paid-in capital account increases by $8,000 ($24 - $16) × 1,000 shares.

Topic: Understanding Shares Issued and Average Price LO: 1 2. Following is the stockholders’ equity section of the 2012 balance sheet for Kling Company: STOCKHOLDERS' EQUITY Common stock: $0.20 par value, authorized 600,000 shares; 100,000 shares outstanding Additional paid-in capital Retained earnings Treasury stock: 10,000 shares Total stockholders' equity

October 31 2012 $ 20,000 351,000 30,000 (100,000) $301,000

a. Compute the number of shares issued at October 31, 2012. b. At what average issue price were the shares issued? c. At what average cost were the treasury shares purchased?

Answer: a. Shares outstanding + Shares in treasury = Shares issued.

100,000 + 10,000 = 110,000 b. (Common Stock + Additional Paid-In Capital) / Shares issued = Issue price ($20,000 + $351,000) / 110,000 = $3.37 c.

Treasury stock / Treasury shares = Cost per treasury share $100,000 / 10,000 = $10 per share

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-15

Topic: Analyzing Stock Splits LO: 1 3. On June 20, 2012, David and Company announced a 5 for 1 stock split. After the split, the company will have about 21.2 million shares outstanding. Shares traded for about $300 a share the day the split was announced. a. b. c. d.

What is a 5 for 1 stock split?

Why do companies like David and Company split their stock?

How many shares were outstanding when the stock split was announced?

How will the equity section of the balance sheet be affected by this stock split?

Answer: a. A 5 for 1 stock split means the company distributes four additional shares for every share owned by a shareholder. Although each investor owns five times as many shares, his percentage ownership in the company is unchanged. b. The stock price of the company is relatively high at $300 per share. This might be a barrier to potential investors. The company might be trying to broaden ownership by reducing the market price to around $60 a share. c.

There were 21,200,000 / 5 = 4,240,000 shares outstanding.

d. Because stock splits are not monetary transactions, they do not affect the balance sheet.

However, several descriptive items will change: the shares issued and outstanding will increase by a factor of 5 and the par value of the shares (if they are par value shares) will decrease by a factor of 5.

Topic: Analyzing Impact of Stock Split LO: 1 4. On May 31, 2012, Beni Inc. has 200,000 shares of $9 par value common stock issued and outstanding. The balance sheet reports account balances as follows (excerpts only): Common stock: Paid in capital in excess of par value:

$1,800,000 4,000,000

On June 2, the company splits its stock 3-for-2. a. How many shares of common stock are issued and outstanding immediately after the stock split?

What is the par value of common stock after the split? b. What is the balance of common stock account immediately after the stock split? c. What is the balance in Paid in capital (in excess of par value) after the stock split?

Answer: a. Immediately after the stock split, 300,000 shares of $6 par value common stock are issued and outstanding. b. The stock split does not change the common stock account balance. The account balance is $1,800,000 before and after the stock split. c.

The stock split does not change the paid in capital in excess of par value account. The account balance is $4,000,000 before and after the stock split.

©Cambridge Business Publishers, 2013 8-16

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Stock Splits LO: 1 5. On 6/1/2012, Bonnie, Inc. announced a 3-for-2 stock split, in the form of a dividend, to be distributed on June 30, 2012, to stockholders of record on June 10, 2012. a. What is a 3-for-2 stock split? b. How will the Bonnie, Inc., balance sheet be affected by this split?

Answer: a. A 3-for-2 stock split means the company distributes one additional share for every two shares owned by a shareholder. Although each investor owns one-and-a-half times as many shares, his percentage ownership in the company is unchanged as the par value of the shares is reduced proportionately. b. Because stock splits are not monetary transactions, they do not affect the balance sheet (other than recording the increase in the number of shares outstanding). On the other hand, stock dividends reduce retained earnings and increase paid-in capital.

Topic: Computing Contributed Capital Amounts LO: 1 6. Following is the stockholders’ equity section of a recent balance sheet for Exchange, Inc. (all values in thousands except share data): Stockholders’ Equity: Preferred stock, $.01 par value, authorized shares – 100,000,000, issued shares – none Common stock, $1 par value, authorized shares, – 500,000,000, issued shares – 352,874,468 Capital in excess of par Retained earnings Accumulated other comprehensive loss Common stock in treasury, at cost – 81,316,925 shares Total stockholders’ equity a. b. c. d.

$

352,874 584,288 3,950,164 (133,432) (3,746,600) $ 1,007,294

Verify the $352,874 balance for the common stock account.

What was the average issue price for the common shares issued?

How many common shares are outstanding as of year-end?

What was the average cost at which the treasury stock was purchased?

Answer: a. Shares issued (352,874,468) × par value ($1) = Common stock account balance $352,874,000 (rounded) b. (Common stock + Capital in excess of par) / shares issued = Average issue price ($352,874,000 + $584,288,000) / 352,874,468 = $2.66 per share c.

Shares Issued (352,874,468) – Treasury shares (81,316,925) = Shares outstanding = 271,557,543

d. Treasury stock ($3,746,600,000) / treasury shares (81,316,925) = treasury cost per share = $46.07 per share

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-17

Topic: Employee Stock Option Grants LO: 1 7. In their 2011 10-K report, eBay reported a stock option grant of 8,418 million options during the year, the fair-value of which was computed as $9.87. If the options have, on average, a four-year vesting period. What expense did the company report in 2011 related to this grant?

Answer: In order to compute the amount we should expense for the current grant, we must multiply the value of the options by the number granted and recognize this amount over the vesting period of the options. 8,418 million × $9.87 = $83,085.66 million / 4 = $20,771 million Topic: Employee Stock Option Exercise LO: 1 8. During fiscal 2011, Abercrombie & Fitch reported the exercise of 1,573,351 shares at a weightedaverage exercise price of $29.62. a. How much cash did Abercrombie & Fitch receive from this exercise? b. What was the impact to shareholders’ equity as a result of this exercise?

Answer: a. The exercise of 1,573,351 shares at the price of $29.62 would imply: 1,573,351 × $29.62 = $46,602,657 b. The exercise of these options increased common stock by the par value of the 1,573,351 shares issued and increased additional paid in capital for the difference between the par value and the total cash received of, $46,602,657.

Topic: Restricted Stock Plan LO: 1 9. Smart Phones Inc. implemented a restricted stock plan in early 2012. The company transferred 400,000, $2 par shares to the restricted stock plan, that day the stock was trading at $17.18. The restricted shares vest over three years. Use the financial statement effects template below to record the transfer of the shares in 2012 and the vesting in 2013.

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Income Statement

LiabilContrib.

Earned Rev+ + ities Capital Capital enues

–

ExpenNet = ses Income

2012 transfer 400,000 restricted shares

=

–

=

2013 vesting of one-third of the restricted shares

=

–

=

©Cambridge Business Publishers, 2013 8-18

Financial Statement Analysis & Valuation, 3rd Edition

Answer: Income Statement

Balance Sheet Cash Noncash + = Asset Assets

Transaction

LiabilContrib.

Earned RevExpen+ + – ities Capital Capital enues ses

2012 transfer 400,000 restricted shares

=

+800,000 (CS) +6,072,000 (APIC) -6,872,000 (Deferred Comp)

2013 vesting of one-third of the restricted shares

=

+2,290,667 (Deferred Comp)

–

-2,290,667 (Retained earnings)

–

=

Net Income

=

-2,290,667 (Wages expense)

=

-2,290,667

Topic: Understanding Stockholders’ Equity Accounts LO: 1 & 2 10. Kimberly Clark’s 2012 Statement of Cash Flows included the following excerpt: Financing Activities Cash dividends paid Net (decrease) increase in short-term debt Proceeds from issuance of long-term debt Repayments of long-term debt Proceeds from exercise of stock options Acquisitions of common stock for the treasury Other

($ millions) $ (1,099) 13 839 (107) 435 (1,246) (19)

Which of Kimberly Clark’s financing activities listed above, affected equity accounts? For each item involving equity, specify which equity accounts were affected and the direction of the effect.

Answer: “Cash dividends paid” reduced retained earnings by $1,099 million.

“Proceeds from exercise of stock options” increased common stock (at par, if the company has par value for its common stock), and increased additional paid-in capital.

“Acquisitions of common stock for the treasury” decreased total equity. The treasury stock account increased but it is a contra-equity account, which decreases equity.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-19

Topic: Accounting for Stockholders’ Equity Transactions LO: 1 & 2 11. Carper Corporation’s statement of stockholders’ equity on December 31, 2011 is as follows: 6% cumulative preferred stock, $50 par,10,000 shares authorized; 5,000 shares issued and outstanding Common stock, $2 par, 500,000 share authorized; 245,000 shares issued and outstanding Paid-in capital in excess of par - Preferred stock Paid-in capital in excess of par - Common stock Retained earnings Total stockholders’ equity

$250,000 490,000 10,000 1,960,000 (100,000) $2,610,000

The following transactions occurred during 2012: Jan 15 Apr 14 Jul 3 Nov 1

Issued 1,500 shares of preferred stock for $50 per share.

Issued 75,000 shares of common stock for $10 per share.

Repurchased 20,000 shares of common stock at $6 per share.

Sold 10,000 shares of treasury stock bought on July 3 for $18 per share.

Use the financial statement effects template, below, to record these transactions.

Income Statement

Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabilities

+

Contrib.

Capital

+

Earned Capital

Revenues

–

Expenses

=

Jan 15

=

–

=

Apr 14

=

–

=

July 3

=

–

=

Nov 1

=

–

=

©Cambridge Business Publishers, 2013 8-20

Net Income

Financial Statement Analysis & Valuation, 3rd Edition

Answer: Income Statement

Balance Sheet Transaction

Cash Asset

Jan 15

+75,000

2

3

Noncash Assets

=

Liabilities

+

Contrib.

Capital

+

Earned Capital

Revenues

–

Expenses

=

=

+75,0001 Preferred Stock

–

=

–

=

Apr 14

+750,000

=

+150,0002 Common Stock +600,000 APIC

July 3

-120.000

=

-120,000 Treasury Stock

–

=

=

+60,0003 Treasury Stock +120,000 APIC

–

=

Nov 1

1

+

+180,000

Net Income

1,500 shares issued at $50 = $75,000 for cash. Preferred stock is increased by the par value of the shares issued (1,500 × $50 = $75,000) and additional paid-in capital for the preferred stock is not affected.

75,000 shares issued at $10 = $750,000 in cash proceeds. Common stock is increased by the par value of the shares issued (75,000 × $2 = $150,000) and additional paid-in capital is increased for the balance.

Cash received is 10,000 × $18 = $180,000. Treasury stock is reduced by its original cost of 10,000 shares × $6 = $60,000, thus increasing paid-in capital, and additional paid-in capital is increased for the balance, $120,000.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-21

Topic: Analyzing Equity Transactions LO: 1 & 2 12. Giraffe and Company reported the following transactions on a recent statement of stockholders’ equity a. Declare and pay cash dividends of $3.12 per common share. There are 150,500 shares issued and outstanding. b. Repurchase 2,246 shares at $30 per share. c. Issue 131 shares of common stock under employee stock option plan. Exercise price is $30 per share and market price is $52 per share.

Assume that the par value of common stock is $2 per share. Use the financial statement effects template, below to record these transactions.

Income Statement

Balance Sheet Transaction

Cash Asset

+

Noncash Assets

=

Liabilities

Contrib.

Capital

+

+

Earned Capital

Revenues

–

Expenses

=

a) Declare and pay cash dividend

=

–

=

b) Acquire treasury stock

=

–

=

c) Issue stock for option exercises

=

–

=

Net Income

Answer: Income Statement

Balance Sheet Transaction

Cash Asset

a) Declare and pay cash dividend

-469,560

=

b) Acquire treasury stock

-67,380

=

=

c) Issue stock for option exercises 1 2 3

+

Noncash Assets

+3,930

=

Liabilities

+

Contrib.

Capital

+

Earned Capital -469,560 (Retained Earnings)

Revenues

–

Expenses

=

–

=

-67,380 (Treasury Stock)

–

=

+262 (Common Stock) +3,668 (APIC)

–

=

Net Income

$469,560 = 150,500 shares × $3.12 per share. $67, 380 = 2,246 treasury shares repurchased × $30 per share Common stock increases by $262 (par value) and additional paid-in capital increases for the rest, $3,668

©Cambridge Business Publishers, 2013 8-22

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Computing Retained Earnings LO: 2 13. The stockholders’ equity of Granny’s Geraniums Inc. at December 31, 2011, appears below: Common stock, $16 par value, 200,000 shares authorized,120,000 shares issued and outstanding Paid-in capital in excess of par value Retained earnings

2,640,000 1,000,000 1,480,000

During 2012, the following transactions occurred: June 15: June 30: December 10: December 31:

Declared a 10% common stock dividend when market value was $30 per share Issued the stock dividend declared on June 15.

Declared a cash dividend of $3.00 per share to be paid in January 2010.

Recognized net income of $ 752,000.

Compute the year-end balance of the retained earnings for 2012.

Answer: Retained earnings December 31, 2011 Net income Stock dividends (120,000 shares × 10% × $30 market value) Cash dividends (132,000 shares × $3.00 per share) Retained earnings December 31, 2009

$1,480,000 752,000 (360,000) (396,000) $1,476,000

Topic: Analyzing Accumulated Other Comprehensive Income LO: 2 14. Alleghany Corporation reported on its 2011 statement of common stockholders’ equity, that unrealized losses on available-for-sale investments had increased by $11,324 thousand during the year. How do these losses affect net income? Do these losses affect Alleghany’s total stockholders’ equity? What equity account(s) will be affected?

Answer: Unrealized losses (or gains) on available-for-sale investments have no effect on net income. Only realized losses and gains flow to the income statement. The unrealized losses (or gains) will affect accumulated other comprehensive income (a stockholders’ equity account).

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-23

Topic: Cash Dividends With Cumulative Preferred LO: 2 15. At the start of 2008, Cambridge Company has 10,000 outstanding shares of preferred stock, each with a $50 par value and a cumulative 8% annual dividend. The company also has 18,000 shares of common stock outstanding with par value of $20 per share. At the beginning of 2012, the company has a 3-for-2 common stock split. The company pays total cash dividends as follows.

2008 2009 2010 2011 2012

$0 $ 30,000 $114,000 $ 91,400 $ 65,000

Calculate the dividends paid to each category of stockholders, in total and per share.

Answer: Total Preferred

Total Common

2008

$

0

$

0

2009

$30,000

$

2010

Per share Preferred $

Per share Common

0

$

0

0

$3.00 ($30,000/10,000)

$

0

$90,000

$24,000

$9.00 ($90,000/10,000)

$1.33 (24,000/18,000)

2011

$40,000

$51,400

$4.00 ($40,000/10,000)

$2.86 (51,400/18,000)

2012

$40,000

$25,000

$4.00 ($40,000/10,000)

$0.93 (25,000/27,000)

Dividend for preferred stock per year: 10,000 shares × $50 par × 8% = $ 40,000 For 2008 and 2009, preferred stock dividends are in arrears. The preferred dividend in 2010 is $40,000 per year × 3 years) - $30,000 paid in 2009 = $90,000. The remainder ($114,000 - $90,000 = $24,000) is paid to common stockholders. In 2012, because of the 3-for-2 stock split, the number of common shares is 27,000.

©Cambridge Business Publishers, 2013 8-24

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Cash Dividends With Cumulative Preferred Stock LO: 2 16. Ferriss Imports has the following stock outstanding: 15,000 shares of $90 par value, 8% cumulative preferred stock 100,000 shares of $2 par value, common stock The company declares and pays the following dividends for the past four years: 2009 2010 2011 2012

$ 50,000 $318,000 $262,000 No dividends are paid

Compute the total cash dividends paid to each class of stock in 2009 through 20012.

Answer: Preferred dividends are: 15,000 shares × $90 par × 8% = $108,000

2009

2010

2011

2012

Current year dividend Left in arrears Arrearage from prior years Current year dividend Left in arrears Arrearage from prior years Current year dividend Left in arrears Arrearage from prior years Current year dividend Left in arrears

Test Bank, Module 8

Preferred $ 50,000

Common $ 0 0

58,000 108,000

0 152,000 0

0 108,000

0 154,000 0

0 0 0

0 0 0

$58,000

0

0

$108,000

©Cambridge Business Publishers, 2013 8-25

Topic: Analyzing Comprehensive Income LO: 2 17. Darden Restaurants Inc. reports the following comprehensive income in its 2012 consolidated financial statements ($ in millions): Comprehensive income: Net earnings Other comprehensive income (loss): Foreign currency adjustment Change in fair value of marketable securities net of tax Change in fair value of derivatives, net of tax Net unamortized gain (loss) arising during period, including amortization of unrecognized net actuarial loss, net of taxes Other comprehensive income (loss) Total comprehensive income

$475.5 (1.2) (0.1) (45.6) (39.9) (86.8) $388.7

a. In general, why do net earnings and comprehensive income differ? b. How do foreign currency adjustments affect comprehensive income? c. During the year did the U.S. dollar strengthen or weaken vis-à-vis the foreign currencies that Darden uses?

Answer: a. Comprehensive income is a more inclusive notion of company performance than net income. It includes all changes in equity that occur during a period except those resulting from contributions by and distributions to owners. It’s important to note that comprehensive income includes both net income and other items such as changes in unrealized gains on available-for-sale securities. b. Financial statements prepared according to U.S. GAAP must be reported in $US. This means that financial statements of foreign subsidiaries must be translated into $US before they are consolidated with those of the U.S. parent company. This translation process can markedly alter both the balance sheet values. Changes during the year in assets and liabilities because of changes in foreign currency rates do not flow to net income. Instead they go to comprehensive income. c.

During the year the U.S. dollar strengthened vis-à-vis the foreign currencies that Darden uses.

The net assets of foreign subs, translated to U.S. dollars, decreased during the year and thus, equity decreased by $1.2 million. Net assets decreased because foreign currencies weakened and thus foreign assets and liabilities were worth less in U.S $ terms.

©Cambridge Business Publishers, 2013 8-26

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Computing Retained Earnings LO: 2 18. The stockholders’ equity accounts of Video Over, Inc. include the following at May 31, 2011: Common stock, $2 par value, 90,000 shares authorized; 10,000 shares outstanding Additional paid-in capital in excess of par value Accumulated other comprehensive income Retained earnings Total equity

$20,000 39,800 (2,380) 154,000 $211,420

During 2012, the following transactions occurred: March 15 May 31 May 31

Declared and issued cash dividends of $2 per share Recorded unrealized loss on available-for-sale securities of $6,600.

Recorded net income of $200,000

Calculate the year-ending balance of retained earnings for May 31, 2012.

Answer: Retained earnings May 31, 2011 Net income Dividends Retained earnings May 31, 2012

$154,000 200,000 (20,000) $334,000

Topic: Understanding Split-Offs LO: 3 19. Tesoro’s Inc. decided to split off its gift retail subsidiary named Regalos y Mas (RM). Assume Tesoro’s holds 1 million shares of RM at a net book value $20 million and the current market value of RM shares is $25 per share. Assume a 1 to 1 share transaction. a. What would be the effect on the balance sheet if shares are distributed pro rata? b. What would be the effect on the balance sheet if shares are distributed non pro rata?

Answer: a. In a pro rata split off, the investment asset would be reduced by the book value of the investment, $20 million, and treasury stock is increased by the same amount. b. In a non pro rata split off, the investment asset would be reduced by the book value of the investment, $20 million, and treasury stock is increased by the market value of the shares ($25 million). Tesoro’s Inc would recognize a gain on the income statement for the difference of $5 million.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-27

Topic: Financial Statement Effects of a Spin-Off LO: 3 20. Briehan Inc. has an investment on its balance sheet for Kirsh Corp, with a book value of $44 million.

Briehan has decided to divest itself of 55% of its Kirsh investment. To accomplish this, Briehan will distribute 1 share of Kirsh stock for every 5 shares of Briehan stock as a dividend to existing Briehan shareholders. a. What kind of equity carve-out is Briehan Inc. planning? b. What is the effect on the Briehan Inc. balance sheet of this spin-off? c. What is the effect on the Briehan Inc. income statement of this spin-off in the current period?

Answer: a. This is a spin-off because existing Briehan Inc. shareholders now own the Kirsh stock directly. b. A spin-off is treated like a dividend. Retained earnings and the investment asset are both reduced by the net book value of the investment, 55% × $44 million = $24.2 million. c.

There is no income statement effect of any dividend. However, the spun-off subsidiary, Kirsh, will be reclassified as discontinued operations in the current and prior year.

Topic: Analyzing Convertible Debt LO: 3 21. Vector Group Ltd. reported the following in its 2011 10K report: In July 2006, the Company sold $110,000,000 of its 3.875% variable interest senior convertible debentures due 2026 in a private offering to qualified institutional buyers in accordance with Rule 144A under the Securities Act of 1933…The debentures are convertible into the Company’s common stock at the holder’s option. The conversion price at December 31, 2011 was $16.05 per share (approximately 62.3300 shares of common stock per $1,000 principal amount of the note), is subject to adjustment for various events, including the issuance of stock dividends.

The company’s December 31, 2011, balance sheet reports the following: Common stock, par value $0.10 per share, authorized 150,000,000 shares, issued 83,022,812 and outstanding 79,441,991 shares Additional paid-in capital

$

7,944,000 0

If all of the convertible debentures were converted to common stock on January 1, 2012, what would the common stock and additional paid-in capital account totals be?

Answer: The debentures total $110,000,000. At a conversion price of $16.05, the debentures would be converted to 6,853,583 shares. Common stock would increase by par ($0.10 per share), and additional paid in capital would increase by the rest ($15.95 per share).

December 31, 2011 Common stock, par value $0.10 per share Additional paid-in capital ©Cambridge Business Publishers, 2013 8-28

$

7,944,000 0

Conversion 6,853,583 shares × $0.10 = $685,358 6,853,583 shares × $15.95 = $109,314,649

January 1, 2012 $

8,629,358

$109,314,649

Financial Statement Analysis & Valuation, 3rd Edition

Problems Topic: Accounting for Stock-Based Compensation LO: 1 1. The following is a summary of the stock option activity at NetFlix during 2011.

Options Outstanding

Balances as of December 31, 2010 Authorized Granted Exercised Balances as of December 31, 2011

Shares Available for Grant 2,038,502 5,700,000 (724,994) — 7,013,508

Number of Shares 2,892,130 — 724,994 (659,370) 2,957,754

Weighted-Average Exercise Price 36.11 — 154.09 29.11 66.59

Required: a. How many options did NetFlix grant to employees during the year? At what price may NetFlix employees buy shares in the future for options granted during 2011? b. How many options did employees exercise during the year? c. When employees exercised their options during 2011, how much cash did NetFlix receive? d. Assume that NetFlix granted options “at the money” during 2011. How much profit did employees make at exercise?

Answer: a. NetFlix granted 724,994 options to employees during 2011. The weighted-average exercise price is $154.09 for shares granted during the year. b. Employees exercised 659,370 options during the year. c.

Cash paid at exercise = number of options exercised × exercise price. During 2011 cash paid to exercise = 659,370 × $29.11 = $19,194,261.

d. If NetFlix granted options “at the money” during 2011 then the average stock price during 2011 was $154.09. The profit employees make on each share they exercised will be the difference between the current stock price ($154.09) and the exercise price ($29.11). Total profit on exercise was: 659,370 options exercised × ($154.09 - $29.11) = $82,408,063.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-29

Topic: Stockholders’ Equity Computations LO: 1 & 2 2. Below are excerpts from the 2011 Alleghany Corporation and Subsidiaries’ balance sheet and statement of stockholders’ equity: (in thousands) Common stock Shares authorized: 2011 and 2010 – 22,000,000; issued and outstanding 2011 – 9,117,787; 2010 – 9,300,448 Contributed capital

2011

2010

9,118 938,037

9,118 928,816

Accumulated other comprehensive income

155,532

170,262

Treasury stock, at cost (2011 – 566,141 shares; 2010 – 351,532)

(167,319)

(99,686)

Retained earnings

1,990,309

1,900,358

Total stockholders’ equity

$2,925,677

$2,908,868

(in thousands) Balance at December 31, 2010 Net earnings Other comprehensive loss, net: Retirement plans Change in unrealized gains on investments, net Comprehensive income Dividends paid Stock based compensation Treasury stock purchase Other, net Balance at December 31, 2011

Common Stock $9,118 –

Contributed Capital $928,816 –

–

–

– – – – – – $9,118

– – 8,408 101 – 712 $938,037

Accumulated Other Comprehensive Income $170,262 –

Treasury Stock (99,686) –

Retained Earnings $1,900,358 143,251

Stockholders’ Equity $2,908,868 $ 143,251

(3,407)

–

–

(3,407)

(11,324) (14,731) – – – 1 $155,532

– – 49,405 – (120,325) 3,287 ($167,319)

– 143,251 (58,360) – – 5,060 $1,990,309

(11,324) 128,520 (547) 101 (120,325) 9,060 $2,925,677

Required: a. How many common shares are issued at year-end 2011? b. What is the par value of Alleghany’s common stock? c. At what average price was the common stock issued as of 2011? d. Explain the treasury stock transaction of 120,325 during the year. e. Did Alleghany pay dividends during the year? Explain. f. How much was net income in 2011? How much was comprehensive income? Explain the difference between the two.

Answer: a. Common shares issued at year-end 2011: 9,117,787 b. Par value of Alleghany’s common stock: $9,118,000 / 9,117,787 = $1 c. Average price of the common stock issued as of 2011: ($9,118,000 + $938,037,000) / 9,117,787 = $103.88 d. During 2011 the company repurchased $120,325,000 of common stock. e. The company paid $58,360,000 in stock dividends in 2011. f. Alleghany reported net income in 2011 of $143,251,000 and comprehensive income of $128,520 thousand. There are two differences between the two: retirement plans (a loss of $3,407 thousand) and changes in fair-value of investment (a loss of $11,324 thousand). Both of these items affect the company’s equity (net assets) but not net income under current GAAP.

©Cambridge Business Publishers, 2013 8-30

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Analyzing Contributed and Earned Capital LO: 1 & 2 3 Following is the stockholders’ equity section of the Spirit Airlines, Inc. 2011 balance sheet (in thousands): Common stock, $.0001 par value (shares authorized— 240,000,000, shares issued – 61,954,576) Non-voting common stock, $.0001 par value (shares authorized— 50,000,000, shares issued – 10,576,180) Additional paid-in capital Treasury stock, at cost 8,215 shares Accumulated deficit Total shareholders’ equity

6 1 496,136 (129) (29,308) $466,706

Required: a. Spirit has 240 million shares of common stock authorized, but only 61,954,576 shares issued.

Why is there a difference between these two numbers? b. Verify that Spirit’s common stock balance is $6 thousand, and its non-voting common stock is $1 thousand. c. What is an “accumulated deficit”? d. How many common shares did Spirit have outstanding at the end of the year? Do not include the non-voting stock. e. Calculate the average cost at which Spirit repurchased its common stock.

Answer: a. The number of shares authorized is formally set forth in an operating agreement created in conjunction with a firm’s initial public offering. It can only be increased or decreased by an affirmative shareholder vote. A firm can issue any number of shares up to the amount formally authorized. Note that issued shares includes both those outstanding (i.e., trading in the market) and those in the treasury (i.e., repurchased stock). b. Common stock: 61,954,576 shares issued × $.0001 par value = $6,195, rounded to $6 thousand.

Non-voting common stock: 10,576,180 shares issued x $.0001 par value = $1,058, rounded to $1 thousand. c.

Accumulated deficit is negative retained earnings. Spirit has had cumulative losses that exceed any net income that the company made.

d. Common shares outstanding = common shares issued – treasury shares repurchase = 61,954,576 – 8,215 = 61,946,361 outstanding e. $129,000 / 8,215 = $15.70 per share

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-31

Topic: Understanding Contributed and Earned Capital LO: 1 & 2 4. Following is the stockholders’ equity section of the 2011 Kellogg Corporation balance sheet (in

millions): Common stock, $0.25 par value, 1,000,000,000 shares authorized, issued: 419,484,087 shares in 2011 and 419,272,027 shares in 2010 Capital in excess of par value Retained earnings Treasury stock at cost, 62,182,500 shares in 2011 and 53,667,635 shares in 2010 Accumulated other comprehensive (loss) Total Kellogg Company equity Noncontrolling interests Total equity

2011

2010

$ 105 522 6,721

$ 105 495 6,122

(3,130) (2,458) 1,760 2 $1,762

(2,650) (1,914) 2,158 (4) $2,154

Required: a. How many common shares are issued at year end 2011? b. At what average price was the common stock issued as of 2011? c. How many common shares are outstanding at year end 2011? d. How many shares of treasury stock (net) did Kellogg acquire during 2011? e. At what average price did Kellogg acquire treasury stock during 2011? f. In general, what is accumulated other comprehensive income? List three items that affect this account. g. What is noncontrolling interest?

Answer: a. There were 419,484,087 common shares issued at year end 2011. b. Average price of common stock = (Common stock + capital in excess of par value) / common shares issued. ($105 million + $522 million) / 419,484,087 = $1.49 c.

Common shares outstanding = Common shares issued – Treasury shares. 419,484,087 – 62,182,500 = 357,301,587.

d. The treasury shares acquired during the year can be calculated as the difference between treasury shares at the beginning and at the end of the year. 62,182,500 – 53,667,635 = 8,514,865. e. The difference between the treasury shares account at the beginning and at the end of the year is an approximate measure of the cost of the treasury shares acquired during the year: $3,130 million - $2,650 million = $480 million. The company acquired 8,514,865 shares during the year. The average price was $480 million / 8,514,865 shares = $56.37. f.

Accumulated other comprehensive income (AOCI) includes changes to equity that have not yet impacted income and are, therefore, not reflected in retained earnings. These changes to equity could be changes to assets or to liabilities, but the important fact is that the changes are not included in current period income. Items that affect this account include: unrealized gains and losses on available-for-sale securities, pension adjustments, foreign currency translation gains and losses on assets and liabilities, and unrealized gains and losses on derivatives used for hedging future cash flows and anticipated transactions.

g. Noncontrolling interest represents the equity of noncontrolling (minority) shareholders who only have a claim on the net assets of one or more of the subsidiaries in the consolidated entity. The equity of the noncontrolling interest is increased (decreased) by the income (loss) attributable to the noncontrolling shareholders and is decreased by the dividends paid to the noncontrolling shareholders. ©Cambridge Business Publishers, 2013 8-32

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Financial Statement Effects of Stock Transactions LO: 1 & 2 5. The following information is from 2011 statement of stockholders’ equity for Dynegy, Inc. Stockholders' equity (in millions, except shares) Common stock, par value $.01 (123,585,877 shares issued 2011, 121,687,198 shares issued 2010) Additional paid-in capital Subscriptions receivable Accumulated other comprehensive loss, net of tax Accumulated deficit Treasury stock, at cost (731,407 shares 2011; 628,014 shares 2010) Total stockholders' equity

2011 $

2010

1 6,077 (2) (53) (4,841)

$

(20,724) $18,287

1 6,067 (2) (53) (3,196) (15,321) $17,568

Dynegy has 420 million shares of common stock authorized. Assume the following transactions occurred during the 2013.

Jan 5 Feb 26 Jul 15

Declare and pay a cash dividend of $2.25 per share.

Split stock 2-for-1 reducing the par value of the stock to $0.005 Issue a large stock dividend of 70% of the outstanding shares of common stock

Required: a. Use the financial statement effects template below to record the three transactions. b. How did the cash dividend affect the company’s profitability for the year? c. What effects does the stock split have on Dynegy’s financial statements? d. What effects does the stock split have on an individual stockholder?

Income Statement

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Liabil+ ities

Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

Jan 5

=

–

=

Feb 26

=

–

=

Jul 15

=

–

=

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-33

Answer: a. (in millions) Income Statement

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Jan 5

-276

=

Feb 26

NO ENTRY

=

Jul 15

1 2

=

Liabil+ ities

Contrib. + Capital

Earned Capital -276.1 (Retained Earnings)

+1

-12 (Retained Earnings)

Revenues

–

ExpenNet = ses Income

–

=

–

=

–

=

$2.25 per share × 122,854,470 shares outstanding = $276.4 million 80% × 245,708,940 shares outstanding (adjusted for the split) = 196,567,152 196,567,152 × .005 (par value adjusted for the split) = $982,836 Common stock is increased by the par value of $982,836. There is no effect on additional paid-in capital because this is a large stock dividend recorded at par.

b. The cash dividend payment has no effect on profitability. They are a direct reduction to retained earnings, thus bypassing the income statement. c.

Even though there is an increase in the shares outstanding, the split has no effect on common stock in the statement of stockholders’ equity. Outstanding shares are doubled and par value is halved, thus producing no effect on common stock. The same holds true for additional paid-in capital. There is no monetary transaction in excess of par, so additional paid-in capital shows no change.

d. The stockholder now holds twice as many shares as before the split. Due to the fact that there are now double the shares outstanding, the stockholders’ percentage ownership remains the same.

©Cambridge Business Publishers, 2013 8-34

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Interpreting Accumulated Other Comprehensive Income (Loss) Disclosures LO: 2 6. Verizon Communications Inc. reported the following in its 2011 statement of shareholders’ equity.

Accumulated Other Comprehensive Income (Loss) Balance at beginning of year Foreign currency translation adjustments Unrealized gains (losses) on marketable securities Unrealized gains (losses) on cash flow hedges Defined benefit pension and postretirement plans Other comprehensive income (loss) Balance at end of year

$ 1,049 (119) (7) 30 316 220 $1,269

Required: a. In general, what is “Accumulated other comprehensive income (loss)”? b. Explain each of the following components of Verizon’s accumulated other comprehensive loss account: • Foreign currency translation adjustment • Unrealized gains on marketable securities • Defined benefit pension and postretirement plans c. If the U.S. $ strengthens in 2012 vis-à-vis the foreign currency of Verizon’s foreign subsidiaries, what will be the effect on the foreign currency translation adjustment?

Answer: a. Comprehensive income includes changes in equity during a period (assets less liabilities) other than those resulting from investments by owners and distributions to owners. It is a broader concept than net income. Accumulated other comprehensive income is the cumulative effect of these other non-income items. That is, this account maintains a running balance of the cumulative differences between net income and comprehensive income. The account is part of shareholders’ equity. b. Foreign currency translation adjustment – Financial statements prepared in U.S. GAAP must be reported in $US. This means that financial statements of Verizon’s foreign subsidiaries must be translated into $US before they are consolidated. This translation process can have different effects on the value of different balance sheet accounts. The difference in the translated amounts of various accounts is added to or subtracted from accumulated other comprehensive income.

Unrealized gains on marketable securities – this reflects the fact that Verizon’s available-for-sale securities decreased in value during the year but Verizon has not yet sold the securities and realized the losses.

Defined benefit pension and postretirement plans – This amount it probably due to unrealized gains on pension investments or can derive from changes in pension plans that decrease the pension liability. c.

If the U.S. $ strengthens in 2012 the foreign currency translation adjustment will be a decrease to other comprehensive income. With a stronger US currency, the net assets of foreign subs will be less and this will decrease equity.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-35

Topic: Stock Dividend LO: 2 7. John Smart, a sagacious investor, prefers the stock of a company with a higher ratio of retained earnings to contributed capital (common stock plus paid-in capital). The ratio should preferably be above 2.0, in John Smart’s opinion. He finds Cargo Company acceptable because the equity breakdown at year-end is as follows: Common stock, par $1

$20,200

Additional paid-in capital

$35,000

Retained Earnings

$140,000

The financial statement footnotes of Cargo reveal that the company paid a stock dividend on the last day of the fiscal year. Specifically, the firm declared a stock dividend equivalent to 22% of the (then) outstanding shares and recorded the transaction as a large stock dividend. Assume that the stock price was $12 per share on the date the stock dividend was recorded.

Required: a. Calculate the ratio that John Smart is interested in, using the year-end numbers, above. b. Prepare the shareholders’ equity for Cargo showing the balances immediately before the company recorded the large stock dividend. Recalculate the ratio that John Smart is interested in, using the numbers before the stock dividend. c. Did Cargo and Company account for the dividend properly as a large stock dividend? d. Prepare a pro forma statement of shareholders’ equity treating the stock dividend as a small stock dividend. Recalculate the ratio that John Smart is interested in, using these pro forma numbers. e. What advice would you give John Smart?

©Cambridge Business Publishers, 2013 8-36

Financial Statement Analysis & Valuation, 3rd Edition

Answer: a. Using the year-end numbers, the ratio is $140,000 / ($20,200 + $35,000) = 2.54. b. After the dividend there are $20,200 / $1 par = 20,200 common shares outstanding. The dividend was 22% of common shares. Therefore there were 16,557 common shares issued before the dividend (20,200 / 1.22 = 16,557 shares). With a large stock dividend, the par value of the 3,643 shares granted as a dividend, is transferred from retained earnings to common stock.

Stockholders’ equity before the dividend was: Common stock, par $1

$16,557

Additional paid-in capital

$35,000

Retained Earnings

$143,643

Ratio was: $143,643 / ($16,557 + $35,000) = 2.79 c.

Yes, Cargo and Company accounted for the dividend properly. However, Cargo could have accounted for this as a small stock dividend because 22% is between 20% and 25%, the breakpoint of the two categories.

d. With a small stock dividend, the market value of the 3,643 shares granted as a dividend, is transferred from retained earnings to common stock and APIC. The market value was $12, so retained earnings would be reduced by $43,716 ($12 × 3,643 = $43,716). Common stock would be increased by the par value of $3,643, and the remaining $40,073 would be added to additional paid-in capital, Stockholders’ equity after the dividend would be: Common stock, par $1

$20,200

Additional paid-in capital

$75,073

Retained earnings

$99,927

Using these pro forma numbers, the adjusted ratio is $99,927 / ($20,200 + $75,073) = 1.05 e. John Smart should consider using a different ratio to assess investments. The ratio of earned to contributed capital can be informative but is affected drastically by the way the company accounts for stock dividends. There is no economic difference when stock dividends are issued so John Smart should not use a ratio that indicates that there are differences.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-37

Topic: Accounting for Shareholders’ Equity Transactions LO: 1, 2, & 3 8. The following is an excerpt from the 2012 statement of cash flows of Rocky Mountain Company.

(in thousands) Cash flows from financing activities Proceeds from issuance of convertible preferred stock, net of issuance costs Proceeds from issuance of subsidiary common stock, net of issuance costs Principal payments on long-term debt Treasury stock acquisitions Net cash provided from discontinued operations Tax benefit on stock options exercised Convertible preferred stock dividends paid Other, net Discontinued operations Net cash provided by (used in) financing activities

2012

2011

2010

$580,844

—

—

172,576 — (78,372) — 2,672 (16,684) 4,810 — $665,846

— — — — — — $ 6,978 17,982 $24,960

— $(16,000) — 9,132 — — 5,368 (5,430) $(6,930)

A footnote to the Rocky Mountain Company financial statements included the following: (a) Mandatory Convertible Preferred Stock On June 23, 2012, Rocky Mountain Company completed an offering of 1,132,000 shares of its 5.75% mandatory convertible preferred stock (the “Preferred Stock”) at a public offering price of $529.20 per share, resulting in net proceeds of $580.8 million. At any time prior to June 15, 2015, holders of the Preferred Stock may elect to convert each share of Preferred Stock into 0.8475 shares of Common Stock, subject to anti-dilution adjustments.

Required: a. Use the financial statements effects template below to record the convertible preferred stock issued during 2012. The company reduced additional paid-in capital for the issuance costs paid to the underwriter. b. Use the financial statements effects template below to record the treasury stock acquired. c. Use the financial statements effects template below to record the dividend paid to preferred stockholders. d. Assume that on January 1, 2013, all preferred shares are converted to $2 par common stock.

Explain how Rocky Mountain Company’s balance sheet will be affected by this conversion. How would total equity change?

Income Statement

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Liabil+ ities

Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

a) Issue convertible preferred

=

–

=

b) Acquire treasury stock

=

–

=

c) Pay preferred dividend

=

–

=

©Cambridge Business Publishers, 2013 8-38

Financial Statement Analysis & Valuation, 3rd Edition

Answer: (in thousands) Income Statement

Balance Sheet Transaction

a) Issue convertible preferred

b) Acquire treasury stock

c) Pay preferred dividend

Cash Noncash + = Asset Assets

Liabil+ ities

Contrib. + Capital

+580,844

=

+599,054 (Preferred Stock) -18,210 (APIC)

-78,372

=

-78,372 (Treasury Stock)

-16,684

=

Earned Capital

Revenues

-16,684 (Retained Earnings)

–

ExpenNet = ses Income

–

=

–

=

–

=

* Sold 1,132,000 preferred shares at $529.20 per share = $599,054 thousand. The cash received is net of issuance costs.

This amounts to $18,210 thousand and reduces additional paid-in capital.

d. The preferred stock would come off the balance sheet at the entire amount of $599,054,000 ($529.20 × 1,132,000). The preferred stock would be converted to common: 1,132,000 shares of preferred stock × 0.8475 = 959,370 shares of common stock. The par value of the common stock would be increased by $1,918,740. The additional paid-in capital account would be increased by the difference ($599,054,000 - $1,918,740 = $597,135,260). Total equity would not change.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-39

Topic: Accounting for Preferred Stock Conversion LO: 3 9. During the year, Angi’s Advertising, Inc., had several stockholders’ equity transactions, which are summarized in the following table. Preferred stock has a par value of $60 and is convertible into common stock at the ratio of 1:1. The common stock has a par value of $6.

Convertible Redeemable Preferred Stock

Common Stock

Additional Paid-In Capital

Retained Earnings

Total

$800,000

$300,000

$ 88,000

$246,000

$1,434,000

64,000

64,000

Balance 12/31/11 Net Income Sale of common stock Conversion of redeemable preferred stock Balance 12/31/12

150,000

300,000

450,000

(60,000)

6,000

54,000

0

$740,000

$456,000

$442,000

$310,000

$1,948,000

a. How many shares of common stock did Angi’s Advertising sell during the year and at what price per share? b. How many shares of preferred stock were converted during the year? c. Why would a company such as Angi’s Advertising offer a conversion feature on preferred stock? d. Why would a shareholder exercise the conversion privilege? e. What dividends did Mt. Blanche pay during the year?

Answer: a. The common stock account increased by $150,000. Given that the par value is $6, this means that 25,000 shares were sold during the year. The additional paid in capital account increased by $300,000. Thus the total cost per common share was $18 per share: $12 + $6 = $18 per share b. Preferred stock account decreased by $60,000. Given that par on these share is $60, 1,000 shares were converted during the year. c.

When a conversion option is offered, the security yields a higher price than it would otherwise.

d. Shareholders exercise their conversion privilege to gain voting rights and/or to participate in value creation. Preferred shares do not trade for much above par because the return is restricted to the dividend – to increase the value, the shareholder converts to common shares which can increase far above par. e. No dividends were paid in 2012 – the table shows that retained earnings increased by net income but did not decrease for dividends.

©Cambridge Business Publishers, 2013 8-40

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Interpreting a Spin-Off Transaction LO: 3 10. Creative Communications Inc. reported the following in its 2012 annual report.

On November 17, 2012, we completed the spin-off of Phones Etc. to shareowners of Creative. Creative distributed a dividend of one share of Phones Etc. common stock for every 20 shares of Creative common stock. Cash was paid for fractional shares. The distribution of Phones Etc. common stock is considered a tax-free transaction for us and for our shareowners, except for the cash payments for fractional shares which are generally taxable.

We recorded pretax charges of $234 million ($202 million after-tax, or $.06 per diluted share) for costs related to the spin-off of Phones Etc.. These costs primarily consisted of banking and legal fees, as well as filing fees, printing and mailing costs.

Required: a. Explain the accounting for spin-offs. b. How did the spin-off affect Creative’s net income in 2012? c. Use the financial statements effect template, below, to show the spin-off effects on Creative’s financial statements. Assume the book value of Phones Etc. was $6 million.

Income Statement

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Liabil+ ities

Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income

Spin-off

=

–

=

Fees

=

–

=

Answer: a. A spin-off is accounted for as a dividend. Both Creative’s investment in Phones Etc. (the asset) and retained earnings account are reduced by the book value of the Phones Etc. shares distributed. b. As is the case with all dividends, there is no effect on Creative’s income statement from the spinoff itself. The assets on Creative’s balance sheet are reduced by the book value of the Phones Etc. investment and its stockholders’ equity is reduced by the same amount through a reduction in retained earnings for the “spin-off” dividend. The fees associated with the spin-off are expensed and this reduced Creative’s net income by $202 million. c.

Income Statement

Balance Sheet Transaction

Cash Noncash + = Asset Assets

Spin-off

Fees

Test Bank, Module 8

-202

Liabil+ ities

Contrib. + Capital

Earned Capital

Revenues

–

ExpenNet = ses Income =

-6 (Equity = Method Investment)

-6 (Retained Earnings)

–

=

-202 (Retained Earnings)

–

+202 (Expenses)

=

-202

©Cambridge Business Publishers, 2013 8-41

Essay Questions Topic: Preferred Stock Benefits LO: 1 1. What are some of the benefits received from being a preferred stockholder vs. a common stock holder?

Answer: Dividend Preference: Preferred shareholders receive dividends on their shares before common shareholders do. Also, in the event that dividends are not paid in a year and are in arrears, some preferred stock contracts include a cumulative provision that stipulates that any dividends in arrears must first be paid to preferred shareholders, together with the current year’s dividends, before any dividends are paid to common shareholders.

Liquidation Preference: If a company fails, its assets are sold and the proceeds are paid to the debtholders and stockholders of the company. Preferred stockholders receive payment in full before common stockholders.

Conversion privileges: The par value received upon liquidation of a company limits the upside potential in that the claim of preferred shareholder is fixed. This constraint can be overcome by inclusion of a conversion privilege that allows preferred stockholders to convert their shares into common shares at a predetermined conversion ratio.

Participation feature: This feature allows preferred shareholders to share ratably with common stockholders in dividends. The dividend preference over common shares can be a benefit when dividend payments are meager. But a fixed dividend yield limits upside potential of preferred stock if the company performs exceptionally well. This limitation can be overcome with a participation feature.

Topic: Stock Buyback LO: 1 2. Many companies buy back their outstanding stock on an annual basis. List several reasons a company might want to repurchase shares of its stock, as well as the financial statement effects of this action.

Answer: 1) If managers believe that the market undervalues their company’s stock, they may repurchase shares in hopes that this will send a signal to the market. If the market value of the shares does indeed rise, the company will be able to realize a “gain” (not reported in the income statement, however) on the resale of the shares.

2) A firm may buy back shares to offset the dilutive effects of executive stock option programs.

When executives (or any employees with stock options) exercise their stock options, the number of shares outstanding increases along with the cash received. These additional shares are viewed as dilutive, as they reduce the earnings per share amount. Thus, many companies will repurchase an equivalent number of shares in order to keep outstanding shares constant.

3) A company may have excess cash and or marketable securities. This can create some agency problems and stockholders might push for the company to rid itself of excess. Equity and cash are both reduced by the price of the shares repurchased (calculated as the number of shares repurchased times the market value per share).

©Cambridge Business Publishers, 2013 8-42

Financial Statement Analysis & Valuation, 3rd Edition

Topic: Stock Split LO: 1 3. What is a stock split? Why do firms split their stock?

Answer: A stock split is the pro rata issuance of shares with a corresponding reduction in the par value of the shares. Since this is not a monetary transaction, total stockholders’ equity is unaffected. Companies split their stock to reduce the per share stock price, which will presumably increase investor interest, which will in turn increase stock price.

Topic: Stock Issuances and Repurchases LO: 1 4. Discuss the impact of stock issuance and repurchase on the balance sheet and income statement.

Answer: Stock Issuance: Companies generally issue stock to raise cash and other assets for operations or to retire debt. Stock issuances only affect the balance sheet and have no impact on the Income statement.

Stock Repurchase: This transaction occurs when a company buys some of the shares back from the market at the prevailing market value. Stock repurchases represent a downsizing of the company.

This transaction is recorded in the balance sheet as a reduction of cash and paid-in capital, with no effect on the income statement.

Topic: Dividend Payments and Stock Price LO: 2 5. As a shareholder of General Mills, how would you react to the following announcement? How would you expect the stock price to move? How does the company reflect the payment of cash dividends in its financial statements?

General Mills (NYSE: GIS) said today that its board of directors has approved an 8 percent dividend increase for General Mills common stock. The new quarterly dividend of $0.33 per share is payable Aug. 1, 2012, to shareholders of record July 10, 2012.

The new annualized dividend rate of $1.32 per share represents a yield of roughly 3.4 percent at recent market prices for General Mills shares.

“We view dividends and dividend growth as a key component of value creation for shareholders,” said General Mills Chairman and Chief Executive Officer Ken Powell. Over the past five years, which was a challenging period for the capital markets overall, General Mills’ dividends per share increased at an 11 percent compound annual rate. The company’s dividend yield has averaged roughly 3 percent over this same period.

General Mills has one of the longest dividend histories in corporate America. The company and its predecessor firm have paid shareholder dividends, without interruption or reduction, for 113 years.

Answer: The financial world closely monitors dividend payments. It is commonly perceived that the level of dividend payments is correlated to expected long-term core earnings – these are earnings which relate to core business operations. As a result, dividend increases typically bring about stock price increases.

Test Bank, Module 8

©Cambridge Business Publishers, 2013 8-43

Topic: Comparing Large and Small Stock Dividends LO: 2 6. Explain the accounting treatment difference between a large and a small stock dividend.

Answer: In a small stock dividend, retained earnings are reduced by the market value of the dividend shares and contributed capital is increased by the same amount. For large stock dividends, retained earnings are reduced by the par value of the dividend shares and common stock is increased by the same amount.

Topic: Comprehensive Income LO: 2 7. Why do some suggest that comprehensive income is a more inclusive measure of company performance?

Answer: Comprehensive income includes all changes to equity other than those arising from capital transactions (e.g., sales and purchases of stock). Many items bypass the income statement, such as foreign currency adjustments, unrealized changes in market values of available-for-sale securities and derivatives, minimum pension liability adjustments, and changes in the market value of certain security investments. Consequently, some assert that comprehensive income is a more inclusive measure of performance than net income.

Topic: Equity Carve-Out LO: 3 8. Why would a corporate manager decide to use an equity carve-out to maximize shareholder value?

Answer: Consolidated financial statements often make it difficult to determine the performance of individual business units, thus complicating their evaluation by investors. Conglomerates will use sell-offs, spinoffs and split-offs to separate individual operating units from the remaining corporations, thus making it easier for the market to value these subsidiaries.

Topic: Equity Carve-Out LO: 3 9. Early in 2012, Pfizer announced that it intended to move its animal health business into a separate, publicly-traded company. If Pfizer also plans to award some of its key employees with its own stock, what actions can it take to achieve these results? If the market value of the subsidiary is larger than the book value, and if the board members of the company prefer high profitability, what actions should the general manager take?

Answer: Pfizer can sell off the subsidiary, use the cash to repurchase its stocks, and then award the repurchased stocks to its employees. It can also split-off the subsidiary in exchange for some of its own stocks, which, in turn, could be distributed to employees.

If the split-off is based on a pro rata distribution, then sell-off may more suitably cater to the board because a split-off based on pro rata distribution does not involve income statement changes. With a sell-off, there is a gain on sale of subsidiary, which will be reflected on the income statement.

©Cambridge Business Publishers, 2013 8-44

Financial Statement Analysis & Valuation, 3rd Edition