Chapter 16 Under The Par Value Method Treasury Stock

C16-6 (AICPA adapted solution)

1. There are four basic rights inherent in ownership of common stock. The first right is that

common shareholders may participate in the actual management of the corporation

through participation and voting at the corporate stockholders meeting. Second, a

2. Preferred stock is a form of capital stock that is afforded special privileges not normally

afforded common shareholders in return for giving up one or more rights normally

conveyed to common shareholders. The most common right given up by preferred

shareholders is the right to participate in management (voting rights), and, in return, the

corporation grants one or more preferences to the preferred shareholder. The most

common preferences granted to preferred shareholders are these:

a. Dividends may be paid to common shareholders only after dividends have been

paid to preferred shareholders.

d. Preferred shareholders may be granted a participation clause that allows them to

receive additional dividends beyond their normal dividend if common shareholders

receive dividends of greater percentage than preferred shareholders. This

participation may be on a one-to-one basis (fully participating); common

C16-7

1. Treasury stock is the capital stock of a corporation that has been legally issued by the

2. A corporation may acquire treasury stock in order to have shares available for issuance in

stock option and purchase plans, to use in the conversion of preferred stock or bonds, to

3. Under the cost method, upon reacquisition of the capital stock the Treasury Stock account

is debited for the reacquisition cost. Upon reissuance, Cash is debited for the amount

4. On the corporation’s balance sheet it deducts the balance of the Treasury Stock account

from the total of contributed capital, retained earnings, and accumulated other

C16-8 (AICPA adapted solution)

1. Treasury stock is stock previously issued by the corporation but subsequently repurchased

4. A stock warrant is physical evidence of stock rights. The warrant specifies the number of

C16-9 (AICPA adapted solution)

1. The compensation expense for 2010 is equal to the estimated fair value on January 2, 2010

2. If the forfeiture was included in the estimate on January 2, 2010 of the fair value of the

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C16-9 (continued)

3. Cash was increased by the share option price [90% of the quoted market price on January

C16-10

1. An SAR plan involves share appreciation rights (SAR’s) that are rights granted to key

employees which enable them to receive cash, stock, or a combination of both equal to

2. There are two differences between accounting for an SAR plan and a fixed compensatory

share option plan. First, the adjustments (increases or decreases) that are made each year

3. In each year, the SAR compensation is recorded by debiting Compensation Expense and

crediting SAR Compensation Payable. The yearly amount is determined by first multiplying

the fair value per SAR times the number of shares to determine the total compensation

C16-11

To: Tom

From: Student

The type of plan that you are considering establishing is called a performance-based

Specifying the Terms

The terms of the plan must be precise in specifying how “earnings” is defined, how the

increase in earnings is measured, and over what period is earnings calculated.

C16-11 (continued)

The increase in earnings may be specified in several ways. First, the increase may be

stated in a dollar amount. A problem with this approach is that it does not take into

consideration the increase relative to the initial base amount of earnings. An alternative

approach which considers the relative growth is to express the increase in terms of a

percentage of the base earnings. Finally, if the company is in a growing market, earnings

Accounting for the Plan

Two issues of concern in accounting for a performance-based compensatory share option

plan are (1) the measurement of the total compensation cost, and (2) the recognition of

the compensation expense.

The total compensation cost is measured based on the fair value of the share options that

actually become vested (when the executives rights to exercise the options are not

The total amount of compensation cost is recognized as compensation expense (and an

increase in common stock option warrants) on a straight-line basis over the service period.

If a change is made during the service period in the estimated options expected to vest

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C16-12

1. Convertible preferred stock is preferred stock that may be converted under specified

conditions, at the stockholder’s option, into a specified number of common shares. This

convertible preferred stock is similar to preferred stock issued with common stock warrants

2. Because an investor is acquiring dual rights (both preferred and common) in the

acquisition of these securities, even though the legal form of the securities is different, the

3. GAAP differentiates between the generally accepted accounting treatment of

convertible bonds and bonds with attached common stock warrants. The conclusion

appears equally applicable to preferred stock. When a corporation issues convertible

C16-13 (AICPA adapted solution)

1. Under the cost method, treasury stock is debited for the purchase price of the shares even

though the purchase price is less than the par value.

2. Under the cost method, treasury stock is debited for the purchase price of the shares.

Under the par value method, treasury stock is debited for the par value of the shares, and

C16-13 (continued)

3. Under the cost method, treasury stock is credited for the original cost (purchase price) of

the shares, and the excess of the original cost (purchase price) over the sales price first is

4. Under the cost method, treasury stock is credited for the original cost (purchase price) of

the shares, and the excess of the sales price over the original cost (purchase price) is

5. There is no effect on net income as a result of treasury stock transactions.

C16-14

FASB Statement of Concepts No. 6 defines equity as “the residual interest in the assets of a

company that remains after deducting the liabilities.” That is, the equity in a company is

the ownership interest; equity arises because of ownership rights. Equity represents the

C16-15

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C16-15 (continued)

6. The company has a 2002 Stock Option Plan under which a maximum of 120 million shares

of the company’s common stock may be issued or transferred to certain officers and

C16-16

Note to Instructor: This case does not have a definitive answer. From a financial reporting

perspective, GAAP is identified and summarized. From an ethical perspective, various

issued are raised for discussion purposes.

From a financial reporting perspective, the company president is wrong. Smaller

event, contrary to what the president says, the corporation’s net income and earnings per

share will be affected by the compensatory share option plan. While it is true that the

corporation will save cash from not having to pay bonuses to its employees in the short run,

it will not receive as much cash when the options are exercised as it would if it had sold the

stock for cash at that time.

Whether you and the other executives will be “better managers” will depend on whether

each of you is motivated more by the potential for receiving cash bonuses or by the

potential of being able to purchase the corporation’s stock at a “bargain price.” In part,

C16-16 (continued)

stock. Also, since the corporation will not receive as much cash for the stock as it would

have if it had sold the stock to the public, this may affect its liquidity. This, in turn, may

ANSWERS TO RESEARCH SIMULATIONS

R16-1

Note to Instructor: Students are expected to cite references to GAAP in their research of

this issue. They might use the FARS electronic database, pronouncements listed on the

According to FTB 85-6, par. 3, (FASB Cod. # 505-30-50-3 and 30-3), a purchase of treasury

stock at a price significantly in excess of the current market price creates a presumption

that the purchase price includes amounts attributable to items (e.g., to settle litigation)

other than the shares purchased. If the purchase of treasury stock includes the receipt of

stated or unstated rights, privileges, or agreements in addition to the capital stock, only the

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R16-2

Note to Instructor: Students are expected to cite references to GAAP in their research of

To: Head Accountant

From: Assistant Accountant

I have researched the issue of how to record the retirement of the company’s outstanding

10% bonds in exchange for cash, 1,000 shares of 7%, $100 par preferred stock, and stock

The GAAP related to these issues is located in several pronouncements.

APB 14 (FASB Cod. # 470-20) deals with convertible debt, conversion of convertible debt,

and debt with stock purchase warrants. Although it deals with debt, the GAAP seem

FAS 140 (FASB Cod. # 405-20), and APB 26 (FASB Cod. # 470-50), deals with liability

extinguishments. FAS 140, par. 16 (FASB Cod. # 405-20-40-1), states that a debtor

derecognizes a liability if it is extinguished. A liability can be extinguished by paying cash

and/or other financial assets. APB 26, par. 20 (FASB Cod. # 470-50-40-2), states that the

difference between the reacquisition price and the book value of extinguished debt shall

be recognized currently in the income of the period of extinguishment as a loss or gain.

R16-2 (continued)

This transaction involves the extinguishment of debt by the issuance of new equity

securities (and cash). It also could be construed, in part, as a troubled-debt restructuring

Based on my evaluation, I suggest the following journal entry be made to record the

transaction:

7/1 Bonds Payable, 10% 185,000

Premium on 10% bonds Payable 25,000