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225. Discuss the reasons that investors buy preferred stock and the dividend rights of preferred stockholders.
Owners of preferred stock have a claim on the assets of a firm that is senior to the claim of common
shareholders. Preferred shares also carry special rights. The senior status and special rights may induce certain
226. Discuss the various laws and contracts that govern the rights and obligations of a shareholder:
Various laws and contracts govern the rights and obligations of a shareholder:
227. Discuss callable preferred shares from the issuer’s point-of-view.
Call Provisions
228. Describe convertible preferred share features from the perspective of the preferred shareholders and the
issuing firms. Preferred shares may provide for redemption by the issuing firm in the future. What types of
redemption rights or obligations do redeemable preferred shares carry?
Convertible Feature
Convertible preferred shares give the holder of preferred shares the right (that is, the option)—but not the
obligation—to convert the preferred shares into a specified number of common shares under certain specified
Redemption Right or Obligation
Preferred shares may provide for redemption by the issuing firm in the future. Redeemable preferred shares
carry one of three types of redemption rights or obligations:
229. Describe common stockholder rights.
COMMON SHAREHOLDERS’ EQUITY
230. Discuss why firms may issue capital stock (preferred or common) for cash or for noncash assets. Discuss
the issuance of capital stock for services received.
ISSUING CAPITAL STOCK
Firms may issue capital stock (preferred or common) for cash or for noncash assets. Some
issuances of common stock result from various option arrangements.
231. Corporations often sell, or exchange for goods and services, various call options on their shares. Describe
the process of issuing call options.
ISSUE UNDER OPTION ARRANGEMENTS
Corporations often sell, or exchange for goods and services, various call options on their shares.
A call option gives the holder the right to acquire shares of common stock at a fixed or determinable price,
called the strike price or exercise price. If the market price of the shares increases above the exercise price, the
holder of the option can benefit by exercising the option to purchase shares. The excess of the market price over
the exercise price is the option’s intrinsic value.
232. Discuss how stock warrants are used.
Stock Warrants
233. Describe the accounting for employee stock options (ESOs).
Employee Stock Option Plans
The exercise date is the date employees exchange the option and cash for shares of common stock. The
exercise price is the price specified in the stock option contract for purchasing the common stock. The market
price is the price of the stock as it trades in the market.
The value of a stock option results from two elements:
One cannot measure the amount of the benefit element before the exercise date. Stock options with exercise
prices less than the current market price of the stock (described as in the money) have a higher value, other
things equal, than stock options with exercise prices exceeding the current market price of the stock (described
as out of the money). The time value element results from the possibility of increases in the market price of the
stock during the exercise period. Time value is larger the longer the exercise period and the more volatile the
market price of the stock. A stock option whose exercise price exceeds the current market price (zero intrinsic
value and therefore zero value for the benefit element) has economic value because of the possibility that the
market price will exceed the exercise price on the exercise date (positive value for the second element). As the
expiration date of the option approaches, the value of the second element approaches zero.
The accounting for employee stock options involves the following:
234. Compare the features of stock options and stock rights. What are stock warrants?
Stock Rights
Like stock options, stock rights give their holder the right to acquire shares of stock at a specified price. The
major differences between stock options and stock rights are as follows: Firms grant stock options to
employees. Employees receive them as a form of compensation and in general may not transfer or sell them to
others; therefore, they do not trade in public markets.
Stock Warrants
235. What are convertible bonds and convertible preferred stock and how does U.S. GAAP and IFRS account
for their issuance? Describe the accounting for conversion of convertible bonds and convertible preferred.
Convertible Bonds or Preferred Stock
Convertible bonds and convertible preferred stock permit the owner either to hold the security as a bond or
preferred stock or to convert the security into shares of common stock. The owner cannot detach and transfer, or
separately exercise, the conversion option as the owner can for a bond or preferred stock issued with a separable
Accounting for the conversion of bonds or preferred stock into common stock uses either carrying values or fair
values to record the conversion, although practice is evolving.
236. Discuss corporate distributions to shareholders.
CORPORATE DISTRIBUTIONS
Firms use net assets (assets minus liabilities) to generate more net assets through the earnings
process. Firms typically retain some or all of the net assets generated by earnings, causing
net assets to increase, along with retained earnings, which is the component of shareholders’
equity showing the cause of that increase in net assets. The retention of net assets generated
by earnings generally increases the market price of the firm’s common shares. Some firms pay periodic
One example of a limitation of the declaration of dividends provides that the board may not declare dividends
“out of capital,” that is, debited against the contributed capital accounts, which result from fund-raising
transactions with owners, but must declare them “out of earnings” by debiting them against the Retained
Earnings account, which results from earnings transactions. The wording and the interpretation of this rule vary
among jurisdictions. “Capital” may mean the par or stated value of outstanding common shares or the total
237. Why do corporate directors usually declare dividends less than the legal maximum and thereby allow
retained earnings to increase as a matter of corporate financial policy?
Dividends and Corporate Financial Policy
Directors usually declare dividends less than the legal maximum and thereby allow retained earnings to increase
as a matter of corporate financial policy for several reasons:
238. Discuss the accounting for a firm paying dividends in cash, other assets, or shares of its common stock.
ACCOUNTING FOR DIVIDENDS
A firm may pay dividends in cash, other assets, or shares of its common stock.
Once the board of directors declares a dividend, the dividend becomes a legal liability of the corporation.
Dividends Payable appears as a current liability on the balance sheet if the firm has not yet paid the dividends
by the end of the accounting period.
Property Dividends
Corporations sometimes distribute assets other than cash when paying a dividend; such a dividend is known as a
dividend in kind or a property dividend. The accounting for property dividends resembles that for cash
dividends, except that when the firm pays the dividend, it credits the asset given up, rather than Cash. The
The stock dividend relabels a portion of the retained earnings that had been legally available for dividend
declarations as a more permanent form of shareholders’ equity, because the firm has used some funds
represented by past earnings to expand plant facilities or to replace assets at increased prices or to retire bonds.
The firm does not have this cash available for cash dividends. The stock dividend does not affect the availability
of cash on hand or cash that the firm has already invested; rather, the stock dividend signals to readers of the
balance sheet, perhaps more clearly than before, the commitment to investment.
