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239. Describe the accounting for stock splits and reverse stock splits.
STOCK SPLITS
Stock splits (or, more technically, split-ups) resemble stock dividends. The corporation issues additional shares
of stock to shareholders in proportion to their existing holdings. The firm receives no additional assets. Firms
typically execute a stock split following one of two approaches:
Firms may also execute a reverse stock split. In this case, firms reduce the number of outstanding shares, either
by increasing the par value of the stock or by simply canceling outstanding shares.
A stock split (or a stock dividend) usually reduces the market value per share, all else equal, in inverse
240. Discuss why firms repurchase their own stock?
STOCK REPURCHASES
Treasury stock or treasury shares are shares a firm has previously issued and later reacquired. Treasury shares
do not receive dividends, do not have voting rights, and do not enter the calculation of earnings per share,
because corporation laws do not consider them outstanding shares for these purposes.
Reasons for reacquiring outstanding common stock include the following:
241. Discuss the accounting for treasury shares.
ACCOUNTING FOR TREASURY SHARES
U.S. GAAP and IFRS on accounting for repurchases and reissuances of treasury shares follow the principle that
a corporation does not report a gain or loss on transactions involving its own shares. Even though the firm may
sell (technically, reissue) the shares for more, or less, than their acquisition cost, accounting does not report the
economic gain, or economic loss, as a component of accounting income. The required accounting views
treasury stock purchases and sales as financing, not operating, transactions and therefore debits (for economic
losses) or credits (for economic gains) the contributed capital accounts for the adjustments for reissue of
treasury shares. The amounts bypass net income, other comprehensive income and Accumulated Other
Comprehensive Income, and often Retained Earnings (depending on the specific accounting method used).
U.S. GAAP provides for three approaches to the accounting for treasury shares:
All three approaches reduce shareholders’ equity but the specific accounts affected differ. All
three approaches are consistent with IFRS, which requires only that firms reduce shareholders’ equity for the
acquisition cost of the shares and report no gain or loss on treasury share transactions.
Cost Method for Repurchased Shares
When a firm reacquires common shares under the cost method, it debits the Treasury Shares—Common account
with the total amount paid to reacquire the shares.
The Treasury Stock—Common account has a debit balance and therefore reduces total
shareholders’ equity.
The constructive retirement method differs from the par value method in only one way: the debit is to Common
Stock, not Treasury Stock—Common. Firms use this method when management and the governing board do
not intend to reissue shares within a reasonable amount of time or when jurisdiction-specific corporation laws
define reacquired shares as retired shares.
In some cases, particularly when the reissue results from the exercise of employee stock
options, the amount paid by the firm to reacquire the treasury shares exceeds the subsequent
reissue price. If the firm uses the cost method, it debits the balance to Additional Paid-
242. Discuss GAAP reporting of income transactions.
OVERVIEW OF GAAP REPORTING OF INCOME TRANSACTIONS
U.S. GAAP and IFRS require firms to initially report the results of most income transactions in the income
statement instead of bypassing the income statement and reporting the amounts in some other shareholders’
equity account. This reporting reflects the emphasis most analysts and investors place on the income statement
when evaluating a firm’s operating performance and the concern that statement users may overlook income
transactions reported elsewhere. U.S. GAAP and IFRS recognize that some income transactions are central to a
firm’s principal business activities and recur, while others are either peripheral or nonrecurring. Firms must
report items in their income statements in various categories to inform statement users about the nature of
income items.
Changes in the fair values of assets and liabilities affect the value of a firm as they occur. U.S. GAAP and IFRS
recognize some of these fair value changes in net income as they occur even though the firm has not yet sold the
asset for cash or settled the liability– events that confirm the amount of the value change. Firms must delay
reporting fair value changes of other assets and liabilities in net income until confirming events occur. In the
meantime, firms include such value changes in Other Comprehensive Income and then close them to
Accumulated Other Comprehensive Income, a component of shareholders’ quity.
Firms sometimes discover errors in amounts previously reported, change their accounting principles, or change
estimates made in applying their accounting principles. U.S. GAAP and IFRS require firms to retrospectively
restate previously reported amounts for material corrections of errors and some changes in accounting
principles, and to adjust current and future amounts for changes in accounting estimates and some changes in
accounting principles.
There are four types of earnings transactions:
REPORTING RECURRING/NONRECURRING AND CENTRAL/PERIPHERAL ACTIVITIES
An analyst likely asks two questions when using a firm’s past profitability to project its likely future
profitability:
243. What are extraordinary items?
Extraordinary Gains and Losses
244. Discuss the accounting and reporting of unrealized gains and losses from changes in fair values of certain
assets and liabilities under U.S. GAAP and IFRS.
UNREALIZED GAINS AND LOSSES FROM CHANGES IN FAIR VALUES OF CERTAIN ASSETS AND
LIABILITIES
The FASB and IASB have increasingly required or permitted firms to report certain assets
and liabilities at their fair values (or the lower of fair value or carrying value) at the end of
each period instead of their historical (or acquisition) costs. Examples discussed in previous
chapters include the following:
When a firm increases or decreases the carrying values of assets and liabilities to reflect
fair values, the question arises as to how it should treat the offsetting credit (gain) or debit
(loss). At the time of the remeasurement, the firm has not yet realized the gains or losses.
That is, the firm has not yet sold the asset or settled (or transferred) the liability. In some
cases U.S. GAAP and IFRS require firms to recognize the gains and losses in measuring net
income in the period of the revaluation, even though the firm has not yet realized the gain
or loss in a cash transaction. For example, firms include losses from decreases in the carrying
Other comprehensive income for a reporting period includes changes in the fair value
of marketable equity securities available for sale and changes in the fair value of derivatives
used as cash flow hedges. Other comprehensive income also includes gains and losses related to retirement
plans not yet recognized in measuring retirement benefits expense. Accumulated Other Comprehensive
Income, a shareholders’ equity account on the balance sheet, reports the cumulative amounts of other
245. Explain how U.S. GAAP and IFRS distinguish the accounting for (1) corrections of errors, (2) adjustments
for changes in accounting principles, and (3) adjustments for changes in accounting estimates.
ADJUSTMENTS FOR ERRORS AND ACCOUNTING CHANGES
U.S. GAAP and IFRS distinguish the accounting for (1) corrections of errors, (2) adjustments
for changes in accounting principles, and (3) adjustments for changes in accounting estimates.
Reporting Correction of Errors
Changes in estimates do not always relate to recurring accrual accounting measurements,
such as depreciable lives. Some changes in estimates concern unusual or nonrecurring events.
Consider, for example, a litigation situation in which a court this period finds a firm responsible
246. Describe the calculation of earnings and book value per share.
EARNINGS AND BOOK VALUE PER SHARE
Publicly held firms that apply U.S. GAAP or IFRS must show earnings per common share data in the body of
247. Describe items appearing in accumulated other comprehensive income. What is comprehensive income
and what does the shareholders’ equity section of the balance sheet report?
ACCUMULATED OTHER COMPREHENSIVE INCOME
Unrealized Gains and Losses on Marketable Securities
Firms measure marketable equity securities classified as available for sale at fair value
and record the unrealized changes in fair value as an element of other comprehensive income.
