Introduction to Accounting:

The Language of Business

Lesson 9: Debt and Equity Financing
Supplemental Textbook

Business Learning Software, Inc

 Debt and Equity: Part 1

Notes receivable and notes payable

A note (also called a promissory note) is an unconditional written promise by a borrower (maker) to pay a
definite sum of money to the lender (payee) on demand or on a specific date. On the balance sheet of the lender
(payee), a note is a receivable; on the balance sheet of the borrower (maker), a note is a payable. Since the note is
usually negotiable, the payee may transfer it to another party, who then receives payment from the maker. Look
at the promissory note in Exhibit 1.
A customer may give a note to a business for an amount due on an account receivable or for the sale of a large
item such as a refrigerator. Also, a business may give a note to a supplier in exchange for merchandise to sell or
to a bank or an individual for a loan. Thus, a company may have notes receivable or notes payable arising from
transactions with customers, suppliers, banks, or individuals.
Companies usually do not establish a subsidiary ledger for notes. Instead, they maintain a file of the actual
notes receivable and copies of notes payable.
Most promissory notes have an explicit interest charge. Interest is the fee charged for use of money over a
period. To the maker of the note, or borrower, interest is an expense; to the payee of the note, or lender, interest
is a revenue. A borrower incurs interest expense; a lender earns interest revenue. For convenience, bankers
sometimes calculate interest on a 360-day year; we calculate it on that basis in this text. (Some companies use a
365-day year.)

Exhibit 1: Promissory note

The basic formula for computing interest is:

Interest=Principal× Rate×Time , or I= P× R×T
Principal is the face value of the note. The rate is the stated interest rate on the note; interest rates are
generally stated on an annual basis. Time, which is the amount of time the note is to run, can be either days or
months.
To show how to calculate interest, assume a company borrowed USD 20,000 from a bank. The note has a
principal (face value) of USD 20,000, an annual interest rate of 10 per cent, and a life of 90 days. The interest
calculation is:
 90
Interest= USD 20,000×0.10×
360
Interest = USD 500
Note that in this calculation we expressed the time period as a fraction of a 360-day year because the interest
rate is an annual rate.
The maturity date is the date on which a note becomes due and must be paid. Sometimes notes require
monthly installments (or payments) but usually all of the principal and interest must be paid at the same time as
in Exhibit 1. The wording in the note expresses the maturity date and determines when the note is to be paid. A
note falling due on a Sunday or a holiday is due on the next business day. Examples of the maturity date wording
are:
• On demand. "On demand, I promise to pay..." When the maturity date is on demand, it is at the option of
the holder and cannot be computed. The holder is the payee, or another person who legally acquired the
note from the payee.
• On a stated date. "On 2010 July 18, I promise to pay..." When the maturity date is designated, computing
the maturity date is not necessary.
• At the end of a stated period.
(a) "One year after date, I promise to pay..." When the maturity is expressed in years, the note
matures on the same day of the same month as the date of the note in the year of maturity.
(b) "Four months after date, I promise to pay..." When the maturity is expressed in months, the note
matures on the same date in the month of maturity. For example, one month from 2010 July 18, is
2010 August 18, and two months from 2010 July 18, is 2010 September 18. If a note is issued on the
last day of a month and the month of maturity has fewer days than the month of issuance, the note
matures on the last day of the month of maturity. A one-month note dated 2010 January 31, matures
on 2010 February 28.
(c) “Ninety days after date, I promise to pay..." When the maturity is expressed in days, the exact
number of days must be counted. The first day (date of origin) is omitted, and the last day (maturity
date) is included in the count. For example, a 90-day note dated 2010 October 19, matures on 2008
January 17, as shown here:
Life of note (days) 90 days
Days remaining in October not counting date of origin of note:
Days to count in October (31 - 19) 12
Total days in November 30
Total Days in December 31 73
Maturity date in January 17 days

Sometimes a company receives a note when it sells high-priced merchandise; more often, a note results from
the conversion of an overdue account receivable. When a customer does not pay an account receivable that is
due, the company (creditor) may insist that the customer (debtor) gives a note in place of the account receivable.
This action allows the customer more time to pay the balance due, and the company earns interest on the balance
until paid. Also, the company may be able to sell the note to a bank or other financial institution.
To illustrate the conversion of an account receivable to a note, assume that Price Company (maker) had
purchased USD 18,000 of merchandise on August 1 from Cooper Company (payee) on account. The normal
credit period has elapsed, and Price cannot pay the invoice. Cooper agrees to accept Price's USD 18,000, 15 per
cent, 90-day note dated September 1 to settle Price's open account. Assuming Price paid the note at maturity and
both Cooper and Price have a December 31 year-end, the entries on the books of the payee and the maker are:
 Cooper Company, Payee
Accounts Receivable—Price Company (+A)
Aug. 1 18,000
Sales (+SE) 18,000
To record sale of merchandise on account.
Sept. 1 Notes Receivable (+A) 18,000
Accounts Receivable—Price Company (-A) 18,000
To record exchange of a note from Price
Company for open account.
Nov. 30 Cash (+A) 18,675
Notes Receivable (-A) 18,000
90
Interest Revenue ($18,000 X 0.15 X /360). (+SE) 675
To record receipt of Price Company note principal
and interest.
Price Company, Maker
Purchase (+A)
Aug. 1 18,000
Accounts Payable—Cooper Company (+L) 18,000
To record purchase of merchandise on account.
Sept. 1 Accounts Payable—Cooper Company (-L) 18,000
Notes Payable (+L) 18,000
To record exchange of a note to Cooper Company
for open account.
Nov. 30 Notes Payable (-L) 18,000
90
Interest Expense ($18,000 X 0.15 X /360). (-SE) 675
Cash (-A) 18,675
To record payment of note principal and interest.

The USD 18,675 paid by Price to Cooper is called the maturity value of the note. Maturity value is the amount
that the maker must pay on a note on its maturity date; typically, it includes principal and accrued interest, if any.
Sometimes the maker of a note does not pay the note when it becomes due. The next section describes how to
record a note not paid at maturity.
A dishonored note is a note that the maker failed to pay at maturity. Since the note has matured, the holder or
payee removes the note from Notes Receivable and records the amount due in Accounts Receivable (or Dishonored
Notes Receivable).
At the maturity date of a note, the maker should pay the principal plus interest. If the interest has not been
accrued in the accounting records, the maker of a dishonored note should record interest expense for the life of the
note by debiting Interest Expense and crediting Interest Payable. The payee should record the interest earned and
remove the note from its Notes Receivable account. Thus, the payee of the note should debit Accounts Receivable
for the maturity value of the note and credit Notes Receivable for the note's face value and Interest Revenue for the
interest. After these entries have been posted, the full liability on the note—principal plus interest—is included in
the records of both parties. Interest continues to accrue on the note until it is paid, replaced by a new note, or
written off as uncollectible. To illustrate, assume that Price did not pay the note at maturity. The entries on each
party's books are:
Cooper Company, Payee
Nov. 30 Accounts Receivable—Price Company (+A) 18,675
Notes Receivable (-A) 18,000
Interest Revenue (+SE) 675
To record dishonor of Price Company note.
Price Company, Maker
Nov. 30 Interest Expense (-SE) 675
Interest Payable (+L) 675
To record interest on note payable.

When unable to pay a note at maturity, sometimes the maker pays the interest on the original note or includes
the interest in the face value of a new note that replaces the old note. Both parties account for the new note in the
same manner as the old note. However, if it later becomes clear that the maker of a dishonored note will never pay,

Introduction to Accounting : The Language of Business – Supplemental Textbook 4

the payee writes off the account with a debit to Uncollectible Accounts Expense (or to an account with a title such as
Loss on Dishonored Notes) and a credit to Accounts Receivable. The debit should be to the Allowance for
Uncollectible Accounts if the payee made an annual provision for uncollectible notes receivable.
Assume that Price Company pays the interest at the maturity date and issues a new 15 per cent, 90-day note for
USD 18,000. The entries on both sets of books would be:
Cooper Company, Payee Price Company, Maker
Cash (+A) 675 Interest Expense (-SE) 675
Interest Revenue 675 Cash (-A) 675
(+SE) To record the
To record the payment of interest on
receipt of interest note to Cooper
on Price Company Company.
note.
(Optional entry) 18,000 (Optional entry) 18,000
Notes Receivable (+A) 18,000 Notes Payable (-L) 18,000
Notes Receivable (-A) Notes Payable (+L)
To replace old 15%, To replace old 15%,
90-day note from 90-day note to Cooper
Price Company with Company with new
new 15%, 90-day 15%, 90-day note.
note.

Although the second entry on each set of books has no effect on the existing account balances, it indicates that
the old note was renewed (or replaced). Both parties substitute the new note, or a copy, for the old note in a file of
notes.
Now assume that Price Company does not pay the interest at the maturity date but instead includes the interest
in the face value of the new note. The entries on both sets of books would be:
Cooper Company, Payee Price Company, Maker
Notes Receivable (+A) 18,675 Interest Expense (-SE) 675
Interest Revenue (+SE) 675 Notes Payable (-L) 18,000
Notes Receivable (-A) 18,000 Notes Payable (+L) 18,675
To record the To record the
replacement of the replacement of the
old Price Company old $18,000, 15%,
$18,000, 15%, 90- 90-day note to
day note with a Cooper Company with
new $18,675, 15%, a new $18,675, 15%,
90-day note. 90-day note.

On an interest-bearing note, even though interest accrues, or accumulates, on a day-to-day basis, usually both
parties record it only at the note's maturity date. If the note is outstanding at the end of an accounting period,
however, the time period of the interest overlaps the end of the accounting period and requires an adjusting entry at
the end of the accounting period. Both the payee and maker of the note must make an adjusting entry to record the
accrued interest and report the proper assets and revenues for the payee and the proper liabilities and expenses for
the maker. Failure to record accrued interest understates the payee's assets and revenues by the amount of the
interest earned but not collected and understates the maker's expenses and liabilities by the interest expense
incurred but not yet paid.
Payee's books To illustrate how to record accrued interest on the payee's books, assume that the payee, Cooper
Company, has a fiscal year ending on October 31 instead of December 31. On October 31, Cooper would make the
following adjusting entry relating to the Price Company note:
Oct. 31 Interest Receivable (+A) 450
Interest Revenue ($18,000 X 0.15 X 60/360) (+SE) 450
To record interest earned on Price Company note
for the period September 1 through October 31.

5
 The Interest Receivable account shows the interest earned but not yet collected. Interest receivable is a
current asset in the balance sheet because the interest will be collected in 30 days. The interest revenue appears in
the income statement. When Price pays the note on November 30, Cooper makes the following entry to record the
collection of the note's principal and interest:
Nov. 30 Cash (+A) 18,675
Notes Receivable (-A) 18,000
Interest Receivable (-A) 450
Interest Revenue (+SE) 225
To record collection of Price Company note and
interest.

Note that the entry credits the Interest Receivable account for the USD 450 interest accrued from September 1
through October 31, which was debited to the account in the previous entry, and credits Interest Revenue for the
USD 225 interest earned in November.
Maker's books Assume Price Company's accounting year also ends on October 31 instead of December 31.
Price's accounting records would be incomplete unless the company makes an adjusting entry to record the liability
owed for the accrued interest on the note it gave to Cooper Company. The required entry is:
Oct. 31 Interest Expense ($18,000 X 0.15 X 60/360) (-SE) 450
Interest Payable (+L) 450
To record accrued interest on note to Cooper
Company for the period September 1 through
October 31.

The Interest Payable account, which shows the interest expense incurred but not yet paid, is a current
liability in the balance sheet because the interest will be paid in 30 days. Interest expense appears in the income
statement. When the note is paid, Price makes the following entry:
Nov. 30 Notes Payable (-L) 18,000
Interest Payable (-L) 450
Interest Expense (-SE) 225
Cash (-A) 18,675
To record payment of principal and interest on
note to Cooper Company.

In this illustration, Cooper's financial position made it possible for the company to carry the Price note to the
maturity date. Alternatively, Cooper could have sold, or discounted, the note to receive the proceeds before the
maturity date. This topic is reserved for a more advanced text.

Short-term financing through notes payable

A company sometimes needs short-term financing. This situation may occur when (1) the company's cash
receipts are delayed because of lenient credit terms granted customers, or (2) the company needs cash to finance
the buildup of seasonal inventories, such as before Christmas. To secure short-term financing, companies issue
interest-bearing or non interest-bearing notes.
Interest-bearing notes To receive short-term financing, a company may issue an interest-bearing note to a
bank. An interest-bearing note specifies the interest rate charged on the principal borrowed. The company receives
from the bank the principal borrowed; when the note matures, the company pays the bank the principal plus the
interest.
Accounting for an interest-bearing note is simple. For example, assume the company's accounting year ends on
December 31. Needham Company issued a USD 10,000, 90-day, 9 per cent note on 2009 December 1. The
following entries would record the loan, the accrual of interest on 2009 December 31 and its payment on 2010
March 1:

Introduction to Accounting : The Language of Business – Supplemental Textbook 6

2009 1 Cash (+A) 10,000
Dec. Notes Payable (+L) 10,000
To record 90-day bank loan.
31 Interest Expense (-SE) 75
Interest Payable (+L) 75
To record accrued interest on a note payable at
year-end ($10,000 X 0.09 X 30/360).
2010 1 Notes Payable (-L) 10,000
Mar. 60
Interest Expense ($10,000 X 0.09 X /360) (-SE) 150
Interest Payable (-L) 75
Cash (-A) 10,225
To record principal and interest paid on bank
loan.

Non interest-bearing notes (discounting notes payable) A company may also issue a non interest-
bearing note to receive short-term financing from a bank. A non interest-bearing note does not have a stated
interest rate applied to the face value of the note. Instead, the note is drawn for a maturity amount less a bank
discount; the borrower receives the proceeds. A bank discount is the difference between the maturity value of the
note and the cash proceeds given to the borrower. The cash proceeds are equal to the maturity amount of a note
less the bank discount. This entire process is called discounting a note payable. The purpose of this process is to
introduce interest into what appears to be a non interest-bearing note. The meaning of discounting here is to
deduct interest in advance.
Because interest is related to time, the bank discount is not interest on the date the loan is made; however, it
becomes interest expense to the company and interest revenue to the bank as time passes. To illustrate, assume that
on 2009 December 1, Needham Company presented its USD 10,000, 90-day, non interest-bearing note to the bank,
which discounted the note at 9 per cent. The discount is USD 225 (USD 10,000 X 0.09 X 90/360), and the proceeds
to Needham are USD 9,775. The entry required on the date of the note's issue is:

7
2009
Dec. 1 Cash (+A) 9,775
Discount on Notes Payable (-L) 225
Notes Payable (+L) 10,000
Issued a 90-day note to bank.

Needham credits Notes Payable for the face value of the note. Discount on notes payable is a contra account
used to reduce Notes Payable from face value to the net amount of the debt. The balance in the Discount on Notes
Payable account appears on the balance sheet as a deduction from the balance in the Notes Payable account.
Over time, the discount becomes interest expense. If Needham paid the note before the end of the fiscal year, it
would charge the entire USD 225 discount to Interest Expense and credit Discount on Notes Payable. However, if
Needham's fiscal year ended on December 31, an adjusting entry would be required as follows:
2009
Dec. 31 Interest Expense (-SE) 75
Discount on Notes Payable (+L) 75
To record accrued interest on note payable at
year-end.

This entry records the interest expense incurred by Needham for the 30 days the note has been outstanding. The
expense can be calculated as USD 10,000 X 0.09 X 30/360, or 30/90 X USD 225. Notice that for entries involving
discounted notes payable, no separate Interest Payable account is needed. The Notes Payable account already
contains the total liability that will be paid at maturity, USD 10,000. From the date the proceeds are given to the
borrower to the maturity date, the liability grows by reducing the balance in the Discount on Notes Payable contra
account. Thus, the current liability section of the 2009 December 31, balance sheet would show:
Current Liabilities:
Notes payable $ 10,000
Less: Discount on notes payable 150 $ 9,850

When the note is paid at maturity, the entry is:

2010
Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150
Cash (-A) 10,000
Discount on Notes Payable (+L) 150
To record note payment and interest expense.

The T-accounts for Discount on Notes Payable and for Interest Expense appear as follows:
Discount on Notes Payable Interest Expense
2009 2009 2009 2009
Dec. 1 225 Dec. 31 75 Dec. 31 75 Dec. 31 To close 75
Dec. 31 Balance 150 2010 2010
Mar. 1 150 Mar. 1 150

In Exhibit 2, we compare the journal entries for interest-bearing notes and non-interest-bearing notes used by
Needham Company.

Introduction to Accounting : The Language of Business – Supplemental Textbook 8

 Interest-Bearing Notes Non interest-Bearing Notes
2009 2009
Dec. 1 Cash (+A) 10,000 Dec. 1 Cash (+A) 9,775
Notes Payable (+L) 10,00 Discount on Notes Payable (-L) 225
0
To record 90-day bank loan, Notes Payable (+L) 10,000
To record 90-day bank loan.
31 Interest Expense (-SE) 75 31 Interest Expense (-SE) 75
Interest Payable (+L) 75 Discount on Notes Payable (+L) 75
To record accrued interest on To record accrued interest on a
a note payable at year-end. note payable at year-end.
2010 2010
Mar. 1 Notes Payable (-L) 10,000 Mar. 1 Notes Payable (-L) 10,000
Interest Expense (-SE) 150 Interest Expense (-SE) 150
Interest Payable (-L) 75 Cash (-A) 10,000
Cash (-A) 10,22 Discount on Notes Payable (+L) 150
To record note principal and 5 To record note payment and
interest payment. interest expense.

Exhibit 2: Comparison between interest-bearing notes and noninterest-bearing notes

9
 Debt and Equity: Part 2

Learning objectives
After studying this chapter, you should be able to:
• State the advantages and disadvantages of the corporate form of business.
• List the values commonly associated with capital stock and give their definitions.
• List the various kinds of stock and describe the differences between them.
• Present in proper form the stockholders' equity section of a balance sheet.
• Account for the issuances of stock for cash and other assets.
• Determine book values of both preferred and common stock.
• Analyze and use the financial results—return on average common stockholders' equity.

The accountant as a corporate treasurer

Most people think of the stock market as a place to buy and sell stock. However, few people give much thought
to the other side of this transaction. The original purpose of the stock market is to allow corporations to raise the
money needed to expand into new markets, invent new products, open new stores, and create new jobs. The initial
public issuance of stock (i.e. going public) is one of the most significant milestones in the life of a public company.
For most individual investors, trading is done by stockbrokers. Who handles the stock transactions within a
company? The treasurer or the person that performs the treasury functions is this person. This role requires
someone with a strong background in accounting and finance.
When a company decides to issue bonds or additional shares of stock, the treasurer is the person responsible for
executing the transaction at the lowest cost to the entity. The treasurer works closely with investment bankers and
lawyers to get the stocks or bonds marketed and issued in accordance with state and federal laws. When a company
issues stock for the first time (initial public offering, or IPO), the task requires a thorough review of the financial
position of the company and the public disclosure of this information for perhaps the first time. The
treasurer/accountant must prepare what is called a prospectus. Among other things, the prospectus includes
financial accounting information that is used in setting the price of the IPO.
The treasurer maintains custody of, or has access to, stocks owned by an entity and stock that is under the
control of the entity. The treasurer also plays a pivotal role in the distribution of cash and stock dividends. The
primary function of this position is controlling the cash inflows and outflows of the entity. A career as a corporate
treasurer can involve the oversight of billions of dollars of stock, and the individual can earn a six-figure salary.
In this chapter, you study the corporate form of business organization in greater detail than in preceding
chapters. Although corporations are fewer in number than single proprietorships and partnerships, corporations
possess the bulk of our business capital and currently supply us with most of our goods and services.
This chapter discusses the advantages and disadvantages of the corporation, how to form and direct a
corporation, and some of the unique situations encountered in accounting for and reporting on the different classes
of capital stock. It is written from a US perspective, so you should be aware that laws and common practices may be
different in other countries.

Introduction to Accounting : The Language of Business – Supplemental Textbook 10

 The corporation
A corporation is an entity recognized by law as possessing an existence separate and distinct from its owners;
that is, it is a separate legal entity. Endowed with many of the rights and obligations possessed by a person, a
corporation can enter into contracts in its own name; buy, sell, or hold property; borrow money; hire and fire
employees; and sue and be sued.
Corporations have a remarkable ability to obtain the huge amounts of capital necessary for large-scale business
operations. Corporations acquire their capital by issuing shares of stock; these are the units into which
corporations divide their ownership. Investors buy shares of stock in a corporation for two basic reasons. First,
investors expect the value of their shares to increase over time so that the stock may be sold in the future at a profit.
Second, while investors hold stock, they expect the corporation to pay them dividends (usually in cash) in return for
using their money. Part 3 discusses the various kinds of dividends and their accounting treatment.

Advantages of the corporate form of business

Corporations have many advantages over single proprietorships and partnerships. The major advantages a
corporation has over a single proprietorship are the same advantages a partnership has over a single
proprietorship. Although corporations have more owners than partnerships, both have a broader base for
investment, risk, responsibilities, and talent than do single proprietorships. Since corporations are more
comparable to partnerships than to single proprietorships, the following discussion of advantages contrasts the
partnership with the corporation.
• Easy transfer of ownership. In a partnership, a partner cannot transfer ownership in the business to
another person if the other partners do not want the new person involved in the partnership. In a publicly held
(owned by many stockholders) corporation, shares of stock are traded on a stock exchange between unknown
parties; one owner usually cannot dictate to whom another owner can or cannot sell shares.
• Limited liability. Each partner in a partnership is personally responsible for all the debts of the business.
In a corporation, the stockholders are not personally responsible for its debts; the maximum amount a
stockholder can lose is the amount of his or her investment. However, when a small, closely held corporation
(owned by only a few stockholders) borrows money, banks and lending institutions often require an officer of
the small corporation to sign the loan agreement. Then, the officer has to repay the loan if the corporation does
not.
• Continuous existence of the entity. In a partnership, many circumstances, such as the death of a
partner, can terminate the business entity. These same circumstances have no effect on a corporation because
it is a legal entity, separate and distinct from its owners.
• Easy capital generation. The easy transfer of ownership and the limited liability of stockholders are
attractive features to potential investors. Thus, it is relatively easy for a corporation to raise capital by issuing
shares of stock to many investors. Corporations with thousands of stockholders are not uncommon.
• Professional management. Generally, the partners in a partnership are also the managers of that
business, regardless of whether they have the necessary expertise to manage a business. In a publicly held
corporation, most of the owners (stockholders) do not participate in the day-to-day operations and
management of the entity. They hire professionals to run the business on a daily basis.

11
 • Separation of owners and entity. Since the corporation is a separate legal entity, the owners do not
have the power to bind the corporation to business contracts. This feature eliminates the potential problem of
mutual agency that exists between partners in a partnership. In a corporation, one stockholder cannot
jeopardize other stockholders through poor decision making.
The corporate form of business has the following disadvantages:
• Double taxation. Because a corporation is a separate legal entity, its net income is subject to double
taxation. The corporation pays a tax on its income, and stockholders pay a tax on corporate income received as
dividends.
• Government regulation. Because corporations are created by law, they are subject to greater regulation
and control than single proprietorships and partnerships.
• Entrenched, inefficient management. A corporation may be burdened with an inefficient
management that remains in control by using corporate funds to solicit the needed stockholder votes to back
its positions. Stockholders scattered across the country, who individually own only small portions of a
corporation's stock, find it difficult to organize and oppose existing management.
• Limited ability to raise creditor capital. The limited liability of stockholders makes a corporation an
attractive means for accumulating stockholder capital. At the same time, this limited liability feature restrains
the amount of creditor capital a corporation can amass because creditors cannot look to stockholders to pay
the debts of a corporation. Thus, beyond a certain point, creditors do not lend some corporations money
without the personal guarantee of a stockholder or officer of the corporation to repay the loan if the
corporation does not.
Corporations are chartered by the state. Each state has a corporation act that permits the formation of
corporations by qualified persons. Incorporators are persons seeking to bring a corporation into existence. Most
state corporation laws require a minimum of three incorporators, each of whom must be of legal age, and a majority
of whom must be citizens of the United States.
The laws of each state view a corporation organized in that state as a domestic corporation and a corporation
organized in any other state as a foreign corporation. If a corporation intends to conduct business solely within
one state, it normally seeks incorporation in that state because most state laws are not as severe for domestic
corporations as for foreign corporations. Corporations conducting interstate business usually incorporate in the
state that has laws most advantageous to the corporation being formed. Important considerations in choosing a
state are the powers granted to the corporation, the taxes levied, the defenses permitted against hostile takeover
attempts by others, and the reports required by the state.
Once incorporators agree on the state in which to incorporate, they apply for a corporate charter. A corporate
charter is a contract between the state and the incorporators, and their successors, granting the corporation its
legal existence. The application for the corporation's charter is called the articles of incorporation.
After supplying the information requested in the incorporation application form, incorporators file the articles
with the proper office in the state of incorporation. Each state requires different information in the articles of
incorporation, but most states ask for the following:
• Name of corporation.
• Location of principal offices.

Introduction to Accounting : The Language of Business – Supplemental Textbook 12

 • Purposes of business.
• Number of shares of stock authorized, class or classes of shares, and voting and dividend rights of each
class of shares.
• Value of assets paid in by the incorporators (the stockholders who organize the corporation).
• Limitations on authority of the management and owners of the corporation.
On approving the articles, the state office (frequently the secretary of state's office) grants the charter and
creates the corporation.
As soon as the corporation obtains the charter, it is authorized to operate its business. The incorporators call the
first meeting of the stockholders. Two of the purposes of this meeting are to elect a board of directors and to adopt
the bylaws of the corporation.
The bylaws are a set of rules or regulations adopted by the board of directors of a corporation to govern the
conduct of corporate affairs. The bylaws must be in agreement with the laws of the state and the policies and
purposes in the corporate charter. The bylaws contain, along with other information, provisions for: (1) the place,
date, and manner of calling the annual stockholders' meeting; (2) the number of directors and the method for
electing them; (3) the duties and powers of the directors; and (4) the method for selecting officers of the
corporation.
Organization costs are the costs of organizing a corporation, such as state incorporation fees and legal fees
applicable to incorporation. The firm debits these costs to an account called Organization Costs. The Organization
Costs account is an asset because the costs yield benefits over the life of the corporation; if the fees had not been
paid, no corporate entity would exist. Since the account is classified on the balance sheet as an intangible asset, it is
amortized over its finite useful life. Most organizations write off these costs fairly rapidly because they are small in
amount.
As an illustration, assume that De-Leed Corporation pays state incorporation fees of USD 10,000 and attorney's
fees of USD 5,000 for services rendered related to the acquisition of a charter with the state. The entry to record
these costs is:
Organization Costs (+A) 15,000
Cash (-A) 15,000
To record costs incurred in organizing corporation.

Assuming the corporation amortizes the organization costs over a 10-year period, this entry records
amortization at the end of the year:
Amortization Expense—Organization Costs (-SE) 1,500
Organization Costs (-A) 1,500
To record organization costs amortization expense.
(15,000/10 years = $1,500).

Management of the corporation is through the delegation of authority from the stockholders to the directors to
the officers, as shown in the organization chart in Exhibit 3. The stockholders elect the board of directors. The
board of directors formulates the broad policies of the company and selects the principal officers, who execute the
policies.
Stockholders Stockholders do not have the right to participate actively in the management of the business
unless they serve as directors and/or officers. However, stockholders do have certain basic rights, including the
right to (1) dispose of their shares, (2) buy additional newly issued shares in a proportion equal to the percentage of

13
shares they already own (called the preemptive right), (3) share in dividends when declared, (4) share in assets
in case of liquidation, and (5) participate in management indirectly by voting at the stockholders' meeting.
The preemptive right allows stockholders to maintain their percentage of ownership in a corporation when
additional shares are issued. For example, assume Joe Thornton owns 10 per cent of the outstanding shares of
Corporation X. When Corporation X decides to issue 1,000 additional shares of stock, Joe Thornton has the right to
buy 100 (10 per cent) of the new shares. Should he decide to do so, he maintains his 10 per cent interest in the
corporation. If he does not wish to exercise his preemptive right, the corporation may sell the shares to others. 1

Exhibit 3: Typical corporation's organization chart

Normally, companies hold stockholders' meetings annually. At the annual stockholders' meeting, stockholders
indirectly share in management by voting on such issues as changing the charter, increasing the number of
authorized shares of stock to be issued, approving pension plans, selecting the independent auditor, and other
related matters.
At stockholders' meetings, each stockholder is entitled to one vote for each share of voting stock held.
Stockholders who do not personally attend the stockholders' meeting may vote by proxy. A proxy is a legal
document signed by a stockholder, giving a designated person the authority to vote the stockholder's shares at a
stockholders' meeting.
Board of directors Elected by the stockholders, the board of directors is primarily responsible for
formulating policies for the corporation. The board appoints administrative officers and delegates to them the
execution of the policies established by the board. The board's more specific duties include: (1) authorizing
contracts, (2) declaring dividends, (3) establishing executive salaries, and (4) granting authorization to borrow
money. The decisions of the board are recorded in the minutes of its meetings. The minutes are an important
source of information to an independent auditor, since they may serve as notice to record transactions (such as a
dividend declaration) or to identify certain future transactions (such as a large loan).
Corporate officers A corporation's bylaws usually specify the titles and duties of the officers of a corporation.
The number of officers and their exact titles vary from corporation to corporation, but most have a president,
several vice presidents, a secretary, a treasurer, and a controller.

1 Some corporations have eliminated the preemptive right because the preemptive right makes it difficult to issue
large blocks of stock to the stockholders of another corporation to acquire that corporation.

Introduction to Accounting : The Language of Business – Supplemental Textbook 14

 The president is the chief executive officer (CEO) of the corporation. He or she is empowered by the bylaws to
hire all necessary employees except those appointed by the board of directors.
Most corporations have more than one vice president. Each vice president is responsible for one particular
corporate operation, such as sales, engineering, or production. The corporate secretary maintains the official
records of the company and records the proceedings of meetings of stockholders and directors. The treasurer is
accountable for corporate funds and may supervise the accounting function within the company. A controller
carries out the accounting function. The controller usually reports to the treasurer of the corporation.

Documents, books, and records relating to capital stock

Capital stock consists of transferable units of ownership in a corporation. Each unit of ownership is called a
share of stock. Typically, traders sell between 100 and 400 million shares of corporate capital stock every business
day on stock exchanges, such as the New York Stock Exchange and the American Stock Exchange, and on the over-
the-counter market. These sales (or trades) seldom involve the corporation issuing the stock as a party to the
exchange. Existing stockholders sell their shares to other individual or institutional investors. The physical transfer
of the stock certificates follows these trades.
A stock certificate is a printed or engraved document serving as evidence that the holder owns a certain
number of shares of capital stock. When selling shares of stock, the stockholder signs over the stock certificate to
the new owner, who presents it to the issuing corporation. When the old certificate arrives, the issuing corporation
cancels the certificate and attaches it to its corresponding stub in the stock certificate book. The issuer prepares a
new certificate for the new owner. To determine the number of shares of stock outstanding at any time, the issuer
sums the shares shown on the open stubs (stubs without certificates attached) in the stock certificate book.
Among the more important records maintained by a corporation is the stockholders' ledger. The stockholders'
ledger contains a group of subsidiary accounts showing the number of shares of stock currently held by each
stockholder. Since the ledger contains an account for each stockholder, in a large corporation this ledger may have
more than a million individual accounts. Each stockholder's account shows the number of shares currently or
previously owned, their certificate numbers, and the dates on which shares were acquired or sold. Entries are made
in the number of shares rather than in dollars.
The stockholders' ledger and the stock certificate book contain the same information, but the stockholders'
ledger summarizes it alphabetically by stockholder. Since a stockholder may own a dozen or more certificates, each
representing a number of shares, this summary enables a corporation to (1) determine the number of shares a
stockholder is entitled to vote at a stockholders' meeting and (2) prepare one dividend check per stockholder rather
than one per stock certificate.
Many large corporations with actively traded shares turn the task of maintaining reliable stock records over to
an outside stock-transfer agent and a stock registrar. The stock-transfer agent, usually a bank or trust company,
transfers stock between buyers and sellers for a corporation. The stock-transfer agent cancels the certificates
covering shares sold, issues new stock certificates, and makes appropriate entries in the stockholders' ledger. It
sends new certificates to the stock registrar, typically another bank, that maintains separate records of the shares
outstanding. This control system makes it difficult for a corporate employee to issue stock certificates fraudulently
and steal the proceeds.

15
 T he minutes book, kept by the secretary of the corporation, is (1) a record book of the actions taken at
stockholders' and board of directors' meetings and (2) the written authorization for many actions taken by
corporate officers. Remember that all actions taken by the board of directors and the stockholders must be in
accordance with the provisions in the corporate charter and the bylaws. The minutes book contains a variety of
data, including:
• A copy of the corporate charter.
• A copy of the bylaws.
• Dividends declared by the board of directors.
• Authorization for the acquisition of major assets.
• Authorization for borrowing.
• Authorization for increases or decreases in capital stock.

Par value and no-par capital stock

Many times, companies issue par value stock. Par value is an arbitrary amount assigned to each share of a
given class of stock and printed on the stock certificate. Par value per share is no indication of the amount for which
the stock sells; it is simply the amount per share credited to the capital stock account for each share issued. Also,
the total par value of all issued stock often constitutes the legal capital of the corporation. The concept of legal
capital protects creditors from losses. Legal capital, or stated capital, is an amount prescribed by law (usually
the par value or stated value of shares issued) below which a corporation may not reduce stockholders' equity
through declaration of dividends or other payments to stockholders. Stated value relates to no-par stock and is
explained below. Legal capital does not guarantee that a company can pay its debts, but it does keep a company
from compensating owners to the detriment of creditors. The formula for determining legal capital is:
Legal Capital=Shares Issued X Par Stated Value
In 1912, the state of New York first enacted laws permitting the issuance of no-par stock (stock without par
value). Many other states have passed similar, but not uniform, legislation.
A corporation might issue no-par stock for two reasons. One reason is to avoid confusion. The use of a par value
may confuse some investors because the par value usually does not conform to the market value. Issuing a stock
with no par value avoids this source of confusion.
A second reason is related to state laws regarding the original issue price per share. A discount on capital
stock is the amount by which the shares' par value exceeds their issue price. Thus, if stock with a par value of USD
100 is issued at USD 80, the discount is USD 20. Most states do not permit the original issuance of stock at a
discount. Only Maryland, Georgia, and California allow its issuance. The original purchasers of the shares are
contingently liable for the discount unless they have transferred (by contract) the discount liability to subsequent
holders. If the contingent liability has been transferred, the present stockholders are contingently liable to creditors
for the difference between par value and issue price. Although this contingent liability seldom becomes an actual
liability, the issuance of no-par stock avoids such a possibility.
The board of directors of a corporation issuing no-par stock may assign a stated value to each share of capital
stock. Stated value is an arbitrary amount assigned by the board to each share of a given class of no-par stock. The
board may set this stated value, like par value, at any amount, although some state statutes specify a minimum

Introduction to Accounting : The Language of Business – Supplemental Textbook 16

amount, such as USD 5 per share. If not specified by applicable state law, the board may establish stated value
either before or after the shares are issued.

Other values commonly associated with capital stock

Market value is the price of shares of capital stock bought and sold by investors in the market; it is the value of
greatest interest to investors. Market price is directly affected by (1) all the factors that influence general economic
conditions, (2) investors' expectations concerning the corporation, and (3) the corporation's earnings.
Book value per share is the amount per share that each stockholder would receive if the corporation were
liquidated without incurring any further expenses and if assets were sold and liabilities liquidated at their recorded
amounts. A later section discusses book value per share in greater detail.
Liquidation value is the amount a stockholder would receive if a corporation discontinued operations and
liquidated by selling its assets, paying its liabilities, and distributing the remaining cash among the stockholders.
Since the assets might be sold for more or less than the amounts at which they are recorded in the corporation's
accounts, liquidation value may be more or less than book value. If only one class of capital stock is outstanding,
each stockholder would receive, per share, the amount obtained by dividing the remaining cash by the number of
outstanding shares. If two or more classes of stock are outstanding, liquidation value depends on the rights of the
various classes.
A corporation issues certain capital stock with the stipulation that it has the right to redeem it. Redemption
value is the price per share at which a corporation may call in (or redeem) its capital stock for retirement.

Capital stock authorized and outstanding

The corporate charter states the number of shares and the par value, if any, per share of each class of stock that
the corporation is permitted to issue. Capital stock authorized is the number of shares of stock that a
corporation is entitled to issue as designated in its charter.
A corporation might not issue all of its authorized stock immediately; it might hold some stock for future
issuance when additional funds are needed. If all authorized stock has been issued and more funds are needed, the
state of incorporation must consent to an increase in authorized shares.
The authorization to issue stock does not trigger a journal entry. Instead, companies note the authorization in
the capital stock account in the ledger (and often in the general journal) as a reminder of the number of shares
authorized. Capital stock issued is the number of shares of stock sold and issued to stockholders.
Capital stock outstanding is the number of authorized shares of stock issued and currently held by
stockholders. The total ownership of a corporation rests with the holders of the capital stock outstanding. For
example, when a corporation authorized to issue 10,000 shares of capital stock has issued only 8,000 shares, the
holders of the 8,000 shares own 100 per cent of the corporation.
Each outstanding share of stock of a given class carries rights and privileges identical to any other outstanding
share of that class. Shares authorized but not yet issued are referred to as unissued shares (the previous example
had 2,000 unissued shares). No rights or privileges are attached to these shares until they are issued; they are not
entitled to dividends, nor can they be voted at stockholders' meetings.
The number of shares issued and the number of shares outstanding may be different. Issued stock has been
issued at some time, while outstanding shares are currently held by stockholders. All outstanding stock is issued

17
stock, but the reverse is not necessarily true. The difference is due to shares returned to the corporation by
stockholders; it is called treasury stock. Part 3 discusses treasury stock.

An accounting perspective:

Business insight

SCI Systems, Inc., designs, manufactures, and distributes electronic products for a wide variety of
industries. The following illustration is adapted from the company's balance sheet. The
stockholders' equity section shows the actual number of shares of common stock authorized and
outstanding and shows the dollar amounts in thousands:

June 30
Common stock, USD0.10 par value; authorized 2001 2000
500,000,000 common shares, issued
147,132,428 shares in 2001 and 144,996,374
shares in 2000. USD 14,713 USD 14,500
Classes of capital stock
A corporation may issue two basic classes or types of capital stock—common and preferred.
If a corporation issues only one class of stock, this stock is common stock. All of the stockholders enjoy equal
rights. Common stock is usually the residual equity in the corporation. This term means that all other claims
against the corporation rank ahead of the claims of the common stockholder.
Preferred stock is a class of capital stock that carries certain features or rights not carried by common stock.
Within the basic class of preferred stock, a company may have several specific classes of preferred stock, each with
different dividend rates or other features.
Companies issue preferred stock to avoid: (1) using bonds with fixed interest charges that must be paid
regardless of the amount of net income; (2) issuing so many additional shares of common stock that earnings per
share are less in the current year than in prior years; and (3) diluting the common stockholders' control of the
corporation, since preferred stockholders usually have no voting rights.
Unlike common stock, which has no set maximum or minimum dividend, the dividend return on preferred stock
is usually stated at an amount per share or as a percentage of par value. Therefore, the firm fixes the dividend per
share. Exhibit 4 shows the various classes and combinations of capital stock outstanding for a sample of 600
companies.

Introduction to Accounting : The Language of Business – Supplemental Textbook 18

 2006 2005 2004 2003
Common stock with:
No preferred stock 516 502 507 514
One class of preferred stock 73 81 80 71
Two classes of p referred stock 9 14 10 10
Three or more classes of
preferred stock 2 3 3 5
Total Companies 600 600 600 600

Companies included above

with two or more classes of
common stock
62 70 59 66

Exhibit 4: Capital structures

Source: Based on American Institute of Certified Public Accountants, Accounting Trends & Techniques (New
York: AICPA, 2004), p. 307.

Types of preferred stock

When a corporation issues both preferred and common stock, the preferred stock may be:
• Preferred as to dividends. It may be noncumulative or cumulative.
• Preferred as to assets in the event of liquidation.
• Convertible or nonconvertible.
• Callable.
A dividend is a distribution of assets (usually cash) that represents a withdrawal of earnings by the owners.
Dividends are normally paid in cash.
Stock preferred as to dividends means that the preferred stockholders receive a specified dividend per
share before common stockholders receive any dividends. A dividend on preferred stock is the amount paid to
preferred stockholders as a return for the use of their money. For no-par preferred stock, the dividend is a specific
dollar amount per share per year, such as USD 4.40. For par value preferred stock, the dividend is usually stated as
a percentage of the par value, such as 8 per cent of par value; occasionally, it is a specific dollar amount per share.
Most preferred stock has a par value.
Usually, stockholders receive dividends on preferred stock quarterly. Such dividends—in full or in part—must be
declared by the board of directors before paid. In some states, corporations can declare preferred stock dividends
only if they have retained earnings (income that has been retained in the business) at least equal to the dividend
declared.
Noncumulative preferred stock Noncumulative preferred stock is preferred stock on which the right
to receive a dividend expires whenever the dividend is not declared. When noncumulative preferred stock is
outstanding, a dividend omitted or not paid in any one year need not be paid in any future year. Because omitted
dividends are lost forever, noncumulative preferred stocks are not attractive to investors and are rarely issued.
Cumulative preferred stock Cumulative preferred stock is preferred stock for which the right to receive
a basic dividend, usually each quarter, accumulates if the dividend is not paid. Companies must pay unpaid
cumulative preferred dividends before paying any dividends on the common stock. For example, assume a company
has cumulative, USD 10 par value, 10 per cent preferred stock outstanding of USD 100,000, common stock

19
outstanding of USD 100,000, and retained earnings of USD 30,000. It has paid no dividends for two years. The
company would pay the preferred stockholders dividends of USD 20,000 (USD 10,000 per year times two years)
before paying any dividends to the common stockholders.
Dividends in arrears are cumulative unpaid dividends, including the quarterly dividends not declared for the
current year. Dividends in arrears never appear as a liability of the corporation because they are not a legal liability
until declared by the board of directors. However, since the amount of dividends in arrears may influence the
decisions of users of a corporation's financial statements, firms disclose such dividends in a footnote. An
appropriate footnote might read: "Dividends in the amount of USD 20,000, representing two years' dividends on
the company's 10 per cent, cumulative preferred stock, were in arrears as of 2007 December 31".
Most preferred stocks are preferred as to assets in the event of liquidation of the corporation. Stock preferred
as to assets is preferred stock that receives special treatment in liquidation. Preferred stockholders receive the par
value (or a larger stipulated liquidation value) per share before any assets are distributed to common stockholders.
A corporation's cumulative preferred dividends in arrears at liquidation are payable even if there are not enough
accumulated earnings to cover the dividends. Also, the cumulative dividend for the current year is payable. Stock
may be preferred as to assets, dividends, or both.
Convertible preferred stock is preferred stock that is convertible into common stock of the issuing
corporation. Many preferred stocks do not carry this special feature; they are nonconvertible. Holders of
convertible preferred stock shares may exchange them, at their option, for a certain number of shares of common
stock of the same corporation.
Investors find convertible preferred stock attractive for two reasons: First, there is a greater probability that the
dividends on the preferred stock will be paid (as compared to dividends on common shares). Second, the
conversion privilege may be the source of substantial price appreciation. To illustrate this latter feature, assume
that Olsen Company issued 1,000 shares of 6 per cent, USD 100 par value convertible preferred stock at USD 100
per share. The stock is convertible at any time into four shares of Olsen USD 10 par value common stock, which has
a current market value of USD 20 per share. In the next several years, the company reported much higher net
income and increased the dividend on the common stock from USD 1 to USD 2 per share. Assume that the common
stock now sells at USD 40 per share. The preferred stockholders can: (1) convert each share of preferred stock into
four shares of common stock and increase the annual dividend they receive from USD 6 to USD 8; (2) sell their
preferred stock at a substantial gain, since it sells in the market at approximately USD 160 per share, the market
value of the four shares of common stock into which it is convertible; or (3) continue to hold their preferred shares
in the expectation of realizing an even larger gain at a later date.
If all 1,000 shares of USD 100 par value Olsen Company preferred stock are converted into 4,000 shares of USD
10 par value common stock, the entry is:
Preferred Stock (-SE) 100,000
Common Stock (+SE) 40,000
Paid-In Capital in Excess of Par Value—Common (+SE) 60,000
To record the conversion of preferred stock into
common stock.

Introduction to Accounting : The Language of Business – Supplemental Textbook 20

 An accounting perspective:

Business insight

In the early 1970s, only about 10 per cent of undergraduate degrees in accounting were awarded to
women. This percentage increased steadily, and by the mid-1980s approximately half of all
undergraduate accounting degrees were earned by women. By 1996, the rate increased to slightly
more than half. This rate is more than twice the rate in the medical and legal professions. For more
information see "Accounting's Big Gender Switch," Business Week, January 20, 1997, p. 20.

Most preferred stocks are callable at the option of the issuing corporation. Callable preferred stock means
that the corporation can inform nonconvertible preferred stockholders that they must surrender their stock to the
company. Also, convertible preferred stockholders must either surrender their stock or convert it to common
shares.
Preferred shares are usually callable at par value plus a small premium of 3 or 4 per cent of the par value of the
stock. This call premium is the difference between the amount at which a corporation calls its preferred stock for
redemption and the par value of the stock.
An issuing corporation may force conversion of convertible preferred stock by calling in the preferred stock for
redemption. Stockholders who do not want to surrender their stock have to convert it to common shares. When
preferred stockholders surrender their stock, the corporation pays these stockholders par value plus the call
premium, any dividends in arrears from past years, and a prorated portion of the current period's dividend. If the
market value of common shares into which the preferred stock could be converted is higher than the amount the
stockholders would receive in redemption, they should convert their preferred shares to common shares. For
instance, assume that a stockholder owns 1,000 shares of convertible preferred stock. Each share is callable at USD
104 per share, convertible to two common shares (currently selling at USD 62 per share), and entitled to USD 10 of
unpaid dividends. If the issuing corporation calls in its preferred stock, it would give the stockholder either (1) USD
114,000 [(USD 104 + USD 10) X 1,000] if the shares are surrendered or (2) common shares worth USD 124,000
(USD 62 X 2,000) if the shares are converted. Obviously, the stockholder should convert these preferred shares to
common shares.
Why would a corporation call in its preferred stock? Corporations call in preferred stock for many reasons: (1)
the outstanding preferred stock may require a 12 per cent annual dividend at a time when the company can secure
capital to retire the stock by issuing a new 8 per cent preferred stock; (2) the issuing company may have been
sufficiently profitable to retire the preferred stock out of earnings; or (3) the company may wish to force conversion
of its convertible preferred stock because the cash dividend on the equivalent common shares is less than the
dividend on the preferred shares.

Balance sheet presentation of stock

The stockholders' equity section of a corporation's balance sheet contains two main elements: paid-in capital
and retained earnings. Paid-in capital is the part of stockholders' equity that normally results from cash or other
assets invested by owners. Paid-in capital also results from services performed for the corporation in exchange for

21
capital stock and from certain other transactions discussed in Part 3. As stated earlier, retained earnings is the
part of stockholders' equity resulting from accumulated net income, reduced by dividends and net losses. Net
income increases the Retained Earnings account balance and net losses decrease it. In addition, dividends declared
to stockholders decrease Retained Earnings. Since Retained Earnings is a stockholders' equity account and
represents accumulated net income retained by the company, it normally has a credit balance. We discuss retained
earnings in more detail in Part 3.
The following illustration shows the proper financial reporting for preferred and common stock. Assume that a
corporation is authorized to issue 10,000 shares of USD 100 par value, 6 per cent, cumulative, convertible preferred
stock (five common for one preferred), all of which have been issued and are outstanding; and 200,000 shares of
USD 10 par value common stock, of which 80,000 shares are issued and outstanding. The stockholders' equity
section of the balance sheet (assuming USD 450,000 of retained earnings) is:
Stockholders' equity:
Paid-in capital:
Preferred stock – USD 100 par value, 6 per
cent cumulative, convertible (5 common for 1
preferred); authorized, issued, and
outstanding, 10,000 shares $ 1,000,000
Common stock – USD 10 par value; authorized,
200,000 shares; issued and outstanding 80,000
shares 800,000
Total paid-in capital $ 1,800,000
Retained earnings 450,000
Total stockholders' equity 2,250,000

Notice that the balance sheet lists preferred stock before common stock because the preferred stock is preferred
as to dividends, assets, or both. The company discloses the conversion rate in a parenthetical note within the
description of preferred stock or in a footnote.

An accounting perspective:

Business insight

WHX corporation in its 1999 annual report provided the following presentation of preferred stock
in the stockholders' equity second of its balance sheet:

1999

Stockholders' equity:
Preferred stock—$.10 par value:
authorized 10,000 shares; issued
and outstanding: 5,883 shares $588.3M
Stock issuances for cash
Each share of common or preferred capital stock either has a par value or lacks one. The corporation's charter
determines the par value printed on the stock certificates issued. Par value may be any amount—1 cent, 10 cents, 16
cents, USD 1, USD 5, or USD 100. Low par values of USD 10 or less are common in our economy.
As previously mentioned, par value gives no clue as to the stock's market value. Shares with a par value of USD 5
have traded (sold) in the market for more than USD 600, and many USD 100 par value preferred stocks have
traded for considerably less than par. Par value is not even a reliable indicator of the price at which shares can be
issued. New corporations can issue shares at prices well in excess of par value or for less than par value if state laws

Introduction to Accounting : The Language of Business – Supplemental Textbook 22

permit. Par value gives the accountant a constant amount at which to record capital stock issuances in the capital
stock accounts. As stated earlier, the total par value of all issued shares is generally the legal capital of the
corporation.
To illustrate the issuance of stock for cash, assume a company issues 10,000 authorized shares of USD 20 par
value common stock at USD 22 per share. The following entry records the issuance:
Cash (+A) 220,000
Common Stock (+SE) 200,000
Paid-In Capital in Excess of Par Value—Common (+SE) 20,000
To record the issuance of 10,000 shares of stock for cash.

Notice that the credit to the Common Stock account is the par value (USD 20) times the number of shares
issued. The accountant credits the excess over par value (USD 20,000) to Paid-In Capital in Excess of Par Value; it
is part of the paid-in capital contributed by the stockholders. Thus, paid-in capital in excess of par (or stated)
value represents capital contributed to a corporation in addition to that assigned to the shares issued and recorded
in capital stock accounts. The paid-in capital section of the balance sheet appears as follows:
Paid-in capital:
Common stock—par value, $20; 10,000 shares
authorized, issued and outstanding $ 200,000
Paid-in capital in excess of par value—common 20,000
Total paid-in capital $ 220,000

When it issues no-par stock with a stated value, a company carries the shares in the capital stock account at the
stated value. Any amounts received in excess of the stated value per share represent a part of the paid-in capital of
the corporation and the company credits them to Paid-In Capital in Excess of Stated Value. The legal capital of a
corporation issuing no-par shares with a stated value is usually equal to the total stated value of the shares issued.
To illustrate, assume that the DeWitt Corporation, which is authorized to issue 10,000 shares of common stock
without par value, assigns a stated value of USD 20 per share to its stock. DeWitt issues the 10,000 authorized
shares for cash at USD 22 per share. The entry to record this transaction is:
Cash (+A) 220,000
Common Stock (+SE) 200,000
Paid-In Capital in Excess of Stated Value—Common 20,000
(+SE)
To record issuance of 10,000 shares of stock for cash.

The paid-in capital section of the balance sheet appears as follows:

Paid-in capital:
Common stock—par value, $20; 10,000 shares
authorized, issued and outstanding $ 200,000
Paid-in capital in excess of stated value—common 20,000
Total paid-in capital $ 220,000

DeWitt carries the USD 20,000 received over and above the stated value of USD 200,000 permanently as paid-
in capital because it is a part of the capital originally contributed by the stockholders. However, the legal capital of
the DeWitt Corporation is USD 200,000.
A corporation that issues no-par stock without a stated value credits the entire amount received to the capital
stock account. For instance, consider the DeWitt Corporation's issuance of no-par stock. If no stated value had been
assigned, the entry would have been as follows:
Cash (+A) 220,000
Common Stock (+SE) 200,000
To record issuance of 10,000 shares for cash.

23
 Since the company may issue shares at different times and at differing amounts, its credits to the capital stock
account are not uniform amounts per share. This contrasts with issuing par value shares or shares with a stated
value.
To continue our example, the paid-in capital section of the company's balance sheet would be as follows:
Paid-in capital:
Common stock—without par or stated value; 10,000
shares authorized, issued and outstanding $ 220,000
Total paid-in capital $ 220,000

The actual capital contributed by stockholders is USD 220,000. In some states, the entire amount received for
shares without par or stated value is the amount of legal capital. The legal capital in this example would then be
equal to USD 220,000.

Capital stock issued for property or services

When issuing capital stock for property or services, companies must determine the dollar amount of the
exchange. Accountants generally record the transaction at the fair value of (1) the property or services received or
(2) the stock issued, whichever is more clearly evident.
To illustrate, assume that the owners of a tract of land deeded it to a corporation in exchange for 1,000 shares of
USD 12 par value common stock. The firm can only estimate the fair market value of the land. At the time of the
exchange, the stock has an established total market value of USD 14,000. The required entry is:
Land (+A) 14,000
Common Stock (+SE) 12,000
Paid-In Capital in Excess of Par Value—Common 2,000
(+SE)
To record the receipt of land for capital stock.

As another example, assume a firm issues 100 shares of common stock with a par value of USD 40 per share in
exchange for legal services received in organizing as a corporation. No shares have been traded recently, so there is
no established market value. The attorney previously agreed to a price of USD 5,000 for these legal services but
decided to accept stock in lieu of cash. In this example, the correct entry is:
Organization Costs (+A) 5,000
Common Stock (+SE) 4,000
Paid-In Capital in Excess of Par Value—Common 1,000
(+SE)
To record the receipt of legal services for capital stock.

The company should value the services at the price previously agreed on since that value is more clearly evident
than the market value of the shares. It should debit an intangible asset account because these services benefit the
corporation throughout its entire life. The company credits the amount by which the value of the services received
exceeds the par value of the shares issued to a Paid-In Capital in Excess of Par Value—Common account.

Balance sheet presentation of paid-in capital in excess of par (or stated) value—
Common or preferred
Accountants credit amounts received in excess of the par or stated value of shares to a Paid-In Capital in Excess
of Par (or Stated) Value—Common (or Preferred) account. They carry the amounts received in excess of par or
stated value in separate accounts for each class of stock issued. Using the following assumed data, the stockholders'
equity section of the balance sheet of a company with both preferred and common stock outstanding would appear
as follows:
Stockholders' equity:
Paid-in capital:

Introduction to Accounting : The Language of Business – Supplemental Textbook 24

 Preferred stock—$100 par value, 6%
cumulative; 1,000 shares authorized,
issued, and outstanding $100,000
Common stock—without par value, stated
value, $5; 100,000 shares authorized,
80,000 shares; issued and outstanding 400,000 $ 500,000
Paid-in capital in excess of par (or stated)
value:
From preferred stock issuances $ 5,000
From common stock issuances 20,000 25,000
Total paid-in capital $ 525,000
Retained earnings 200,000
Total stockholders' equity $ 725,000

The total book value of a corporation's outstanding shares is equal to its recorded net asset value—that is, assets
minus liabilities. Quite simply, the amount of net assets is equal to stockholders' equity. When only common stock
is outstanding, companies compute the book value per share by dividing total stockholders' equity by the
number of common shares outstanding. In calculating book value, they assume that (1) the corporation could be
liquidated without incurring any further expenses, (2) the assets could be sold at their recorded amounts, and (3)
the liabilities could be satisfied at their recorded amounts. Assume the stockholders' equity of a corporation is as
follows:
Stockholders' equity:
Paid-in capital:
Common stock—without par value, stated
value, $10; authorized, 20,000 shares;
issued and outstanding, 15,000 shares $ 150,000
Paid-in capital in excess of stated value 10,000
Total paid-in capital $ 160,000
Retained earnings 50,000
Total stockholders' equity $ 210,000
To determine the book value per share of the
stock:
Total stockholders' equity $210,000
Total shares outstanding ÷15,000
Book value per share $ 14

When two or more classes of capital stock are outstanding, the computation of book value per share is more
complex. The book value for each share of stock depends on the rights of the preferred stockholders. Preferred
stockholders typically are entitled to a specified liquidation value per share, plus cumulative dividends in arrears,
since most preferred stocks are preferred as to assets and are cumulative. In each case, the specific provisions in the
preferred stock contract govern. To illustrate, assume the Celoron Corporation's stockholders' equity is as follows:
Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6%
cumulative; 5,000 shares authorized,
issued, and outstanding $ 500,000
Common stock—$10 par value, 200,000
shares authorized, issued and outstanding 2,000,000
Paid-in capital in excess of par value—preferred 200,000
Total paid-in capital $2,700,000
Retained earnings 400,000
Total stockholders' equity $3,100,000

The preferred stock is 6 per cent, cumulative. It is preferred as to dividends and as to assets in liquidation to the
extent of the liquidation value of USD 100 per share, plus any cumulative dividends on the preferred stock.
Dividends for four years (including the current year) are unpaid. You would calculate the book values of each class
of stock as follows:

25
Total stockholders' equity Total Per Share
$3,100,000
Book value of preferred stock (5,000 $ 500,000
shares) 120,000 620,000 $124.00*
Liquidation value (5,000 shares X $100) $2,480,000 12.40T
Dividends (4 years at $30,000)
Book value of common stock (200,000 shares)
* $620,000 ÷ 5,000 shares.
T $2,480,000 ÷ 200,000 shares.

Notice that Celoron did not assign the paid-in capital in excess of par value—preferred to the preferred stock in
determining the book values. Celoron assigned only the liquidation value and cumulative dividends on the
preferred stock to the preferred stock.
Assume now that the features attached to the preferred stock are the same except that the preferred
stockholders have the right to receive USD 103 per share in liquidation. The book values of each class of stock
would be:
Total stockholders' equity Total Per Share
$3,100,000
Book value of preferred stock (5,000 shares)
Liquidation value (5,000 shares X $103) $ 515,000
Dividends (4 years at $30,000) 120,000 635,000 $ 127.00
Book value of common stock (200,000 shares) $2,465,000 12.33

Book value rarely equals market value of a stock because many of the assets have changed in value due to
inflation. Thus, the market prices of the shares of many corporations traded regularly are different from their book
values.

An accounting perspective:

Business insight

The Wall Street Journal publishes the New York Stock Exchange (NYSE) Composite Transactions
each Monday through Friday except when the exchange is closed. For each stock listed on the
NYSE, it lists the following data. We use data for the Kellogg Company, which produces ready-to-
eat cereals and other food products, as recently reported in The Wall Street Journal as an example:
52 Weeks

The first column reflects the stock price percentage change for the calendar year to date, adjusted
for stock splits and dividends over 10 per cent. The next two columns show the high and low price
over the preceding 52 weeks plus the current week. The next two columns show the company name
(Kellogg) and the NYSE's symbol (K) for that company. The Div column is the annual dividend
based on the last quarterly, semiannual, or annual declaration. Yield per cent is calculated as
dividends paid divided by the current market price. The PE ratio is the closing market price divided

Introduction to Accounting : The Language of Business – Supplemental Textbook 26

 by the total earnings per share for the most recent four quarters. The Vol 100s column shows the
unofficial daily total of shares traded, quoted in hundreds. Thus, 995,700 shares of Kellogg's were
traded that day. The next to last column shows the closing price for that day. The final column
shows the change in the closing price as compared to the closing price of the preceding day.

Analyzing and using the financial results—Return on average common stockholders'

equity
Stockholders' equity is particularly important to managers, creditors, and investors in determining the return on
equity, which is the return on average common stockholders' equity.
The return on average common stockholders' equity measures what a given company earned for its
common stockholders from all sources as a percentage of the common stockholders' investment. From the common
stockholders' point of view, it is an important measure of the income-producing ability of the company. The ratio's
formula is:
Net income available for common stockholders
Return on average common stockholders ' equity=
Averagecommon stockholders 'equity
If preferred stock is outstanding, the numerator is net income minus the annual dividend on preferred stock,
and the denominator is the average total book value of common stock. If no preferred stock is outstanding, the
numerator is net income, and the denominator is average stockholders' equity.
The Procter & Gamble Company reported the following information in its 2001 financial statements (USD
millions):
2001
Net earnings $ 2,922
Stockholders' equity, beginning 12,287
Stockholders' equity, ending 12,010

The return on average common stockholders' equity for Procter & Gamble is 24.1 per cent, or USD 2,922/[(USD
12,287 + USD 12,010)/2]. Investors view any increase from year to year as favorable and any decrease as
unfavorable.
Since the stock market is frequently referred to as an economic indicator, the knowledge you now have on
corporate stock issuances should help you relate to stocks traded in the market. Part 3 continues the discussion of
paid-in capital and also discusses treasury stock, retained earnings, and dividends.

An ethical perspective:
Belex corporation

Joe Morrison is the controller for Belex Corporation. He is involved in a discussion with other
members of management concerning how to get rid of some potentially harmful toxic waste
materials that are a by-product of the company's manufacturing process.
There are two alternative methods of disposing of the materials. The first alternative is to bury the
waste in steel drums on a tract of land adjacent to the factory building. There is currently no legal
prohibition against doing this. The cost of disposing of the materials in this way is estimated to be
USD 50,000 per year. The best estimate is that the steel drums would not leak for at least 50 years,
but probably would begin leaking after that time. The second alternative is to seal the materials in

27
 lead drums that would be disposed of at sea by a waste management company. The cost of this
alternative is estimated to be USD 400,000 per year. The federal government has certified this
method as the preferred method of disposal. The best estimate is that the lead drums would never
rupture or leak.
Belex Corporation has seen some tough economic times. The company suffered losses until last
year, when it showed a profit of USD 750,000 as a result of a new manufacturing project. So far, the
waste materials from that project have been accumulating in two large vats on the company's land.
However, these vats are almost full, so soon management must decide how to dispose of the
materials.
One group of managers is arguing in favor of the first alternative because it is legally permissible
and results in annual profits of about USD 700,000. They point out that using the second
alternative would reduce profits to about USD 350,000 per year and cut managers' bonuses in half.
They also claim that some of their competitors are now using the first alternative, and to use the
second alternative would place the company at a serious competitive disadvantage.
Another group of managers argues that the second alternative is the only safe alternative to pursue.
They claim that when the steel drums start leaking they will contaminate the ground water and
could cause serious health problems. When this contamination occurs, the company will lose public
support and may even have to pay for the cleanup. The cost of that cleanup could run into the
millions.

Understanding the learning objectives

• Advantages:
(a) Easy transfer of ownership.
(b) Limited liability.
(c) Continuous existence of the entity.
(d)Easy capital generation.
(e) Professional management.
(f) Separation of owners and entity.
• Disadvantages:
(a) Double taxation.
(b) Government regulation.
(c) Entrenched, inefficient management.
(d)Limited ability to raise creditor capital.
• Par value—an arbitrary amount assigned to each share of a given class of stock and printed on the stock
certificate.
• Stated value—an arbitrary amount assigned by the board of directors to each share of a given class of no-
par stock.
• Market value—the price at which shares of capital stock are bought and sold in the market.

Introduction to Accounting : The Language of Business – Supplemental Textbook 28

 • Book value—the amount per share that each stockholder would receive if the corporation were liquidated
without incurring any further expenses and if assets were sold and liabilities liquidated at their recorded
amounts.
• Liquidation value—the amount a stockholder would receive if a corporation discontinues operations, pays
its liabilities, and distributes the remaining cash among the stockholders.
• Redemption value—the price per share at which a corporation may call in (redeem) its capital stock for
retirement.
• Capital stock authorized—the number of shares of stock that a corporation is entitled to issue as designated
in its charter.
• Capital stock issued—the number of shares of stock that have been sold and issued to stockholders.
• Capital stock outstanding—the number of authorized shares of stock that have been issued and that are still
currently held by stockholders.
• Two basic classes of capital stock:
(a) Common stock—represents the residual equity.
(b) Preferred stock—may be preferred as to dividends and/or assets. Also may be cumulative and/or
callable.
• If the company has paid-in capital in excess of par value, the proper form would be:

Stockholders' equity:
Paid-in capital:
Preferred stock—$100 par value, 6%
cumulative; 1,000 shares
authorized,issued, and outstanding $ 100,000
Common stock—without par value, stated
value, $5; 100,000 shares
authorized,80,000 shares; issued and
outstanding 400,000 $ 500,000
Paid-in capital in excess of par (or stated)value:
From preferred stock issuances $ 5,000
From common stock issuances 20,000 25,000
Total paid-in capital $ 525,000
Retained earnings 200,000
Total stockholders' equity $ 725,000

The following examples illustrate the issuance for cash of: (1) stock with a par value, (2) no-par value stock with
a stated value, and (3) no-par value stock without a stated value.
• Issuance of par value stock for cash—10,000 shares of USD 20 par value common stock issued for USD 22
per share.
Cash (+A) 220,000
Common Stock (+SE) 200,000
Paid-In Capital in Excess of Par Value— 20,000
Common (+SE)

• Issuance of no-par, stated value stock for cash—10,000 shares (no-par value) with USD 20 per share stated
value issued for USD 22 per share.
Cash (+A) 220,000
Common Stock (+SE) 200,000

29
 Paid-In Capital in Excess of Stated Value— 20,000
Common (+SE)

• Issuance of no-par stock without a stated value for cash—10,000 shares (no-par value) issued at USD 22
per share.
Cash (+A) 220,000
Common Stock (+SE) 220,000

• Example: A corporation has 200,000 shares of common stock and 5,000 shares of preferred stock
outstanding. Preferred stock is 6 per cent and cumulative. It is preferred as to dividends and as to assets in
liquidation to the extent of the liquidation value of USD 100 per share, plus any cumulative dividends on the
preferred stock. Dividends for three years are unpaid. Total stockholders' equity is USD 4,100,000.
Calculations are as follows:
Total Per
Share
Total stockholders' equity $4,100,000
Book value of preferred stock (5,000 shares)
Liquidation value (5,000 shares X $100) $ 500,000
Dividends (3 years at $30,000) 90,000 590,000 $ 118.00
Book value of common stock (200,000 shares) $3,510,000 17.55

• The return on average common stockholders' equity equals net income available to common stockholders
divided by average common stockholders' equity.
• The return on average common stockholders' equity is an important measure of the income-producing
ability of the company.
Demonstration problem
Demonstration problem A Violet Company has paid all required preferred dividends through 2004
December 31. Its outstanding stock consists of 10,000 shares of USD 125 par value common stock and 4,000 shares
of 6 per cent, USD 125 par value preferred stock. During five successive years, the company's dividend declarations
were as follows:
2005 $85,000
2006 52,500
2007 7,500
2008 15,000
2009 67,500

Compute the amount of dividends that would have been paid to each class of stock in each of the last five years
assuming the preferred stock is:
a. Cumulative.
b. Noncumulative.
Demonstration problem B Terrier Company has been authorized to issue 100,000 shares of USD 6 par
value common stock and 1,000 shares of 14 per cent, cumulative, preferred stock with a par value of USD 12.
a. Prepare the entries for the following transactions that all took place in June 2009:
• 50,000 shares of common stock are issued for cash at USD 24 per share.
• 750 shares of preferred stock are issued for cash at USD 18 per share.
• 1,000 shares of common stock are issued in exchange for legal services received in the incorporation
process. The fair market value of the legal services is USD 9,000.
b. Prepare the paid-in capital section of Terrier's balance sheet as of 2009 June 30.
Solution to demonstration problem A

Introduction to Accounting : The Language of Business – Supplemental Textbook 30

 VIOLET COMPANY
Assumptions
Year Dividends to a b
2005 Preferred $30,000* $30,000
Common 55,000 55,000
2006 Preferred 30,000 30,000
Common 22,500 22,500
2007 Preferred 7,500 7,500
Common -0- -0-
2008 Preferred 15,000 15,000
Common -0- -0-
2009 Preferred 67,500† 30,000‡
Common -0- 37,500
* 4,000 shares X $125 X 0.06 = $30,000
† $30,000 + $22,500 preferred dividend missed in 2007 + $15,000 preferred
dividend
missed in 2008.
‡Only the basic $30,000 dividend is paid because the stock is
noncumulative.

Solution to demonstration problem B

a. (1) Cash (+A) 1,200,000
Common Stock (+SE) 300,000
Paid-In Capital in Excess of Par Value—Common Stock (+SE) 900,000
To record issuance of 50,000 shares at $24 per share.

31
(2) Cash (+A) 13,500
Preferred Stock (+SE) 9,000
Paid-In Capital in Excess of Par Value—Preferred (+SE) 4,500
To record the issuance of 750 shares for cash, at $18
per share.
(3) Organization Costs (+A) 9,000
Common Stock (+SE) 6,000
Paid-In Capital in Excess of Par Value—Common (+SE) 3,000
To record the issuance of 1,000 shares in exchange for
legal services.

b. TERRIER COMPANY
Partial Balance Sheet
2009 June 30
Paid-in Capital:
Preferred stock—$12 par value, 14% cumulative; $ 9,000
1,000shares authorized; issued and outstanding, 750
shares
Common stock—$6 par value per share; 100,000 shares 306,000 $ 315,000
authorized; issued and outstanding, 51,000 shares
Paid-in capital in excess of par value:
From preferred stock issuances $ 4,500
From common stock issuances 903,000 907,500
Total paid-in capital $1,222,500

Key Terms
Articles of incorporation The application for the corporation's charter.
Board of directors Elected by the stockholders to have primary responsibility for formulating policies for
the corporation. The board also authorizes contracts, declares dividends, establishes executive salaries, and
grants authorization to borrow money.
Book value per share Stockholders' equity per share; the amount per share each stockholder would
receive if the corporation were liquidated without incurring any further expenses and if assets were sold and
liabilities liquidated at their recorded amounts.
Bylaws A set of rules or regulations adopted by the board of directors of a corporation to govern the conduct
of corporate affairs. The bylaws must be in agreement with the laws of the state and the policies and purposes
in the corporate charter.
Callable preferred stock If the stock is nonconvertible, it must be surrendered to the company when the
holder is requested to do so. If the stock is convertible, it may be either surrendered or converted into
common shares when called.
Call premium (on preferred stock) The difference between the amount at which a corporation calls its
preferred stock for redemption and the par value of the stock.
Capital stock Transferable units of ownership in a corporation.
Capital stock authorized The number of shares of stock that a corporation is entitled to issue as
designated in its charter.
Capital stock issued The number of shares of stock that have been sold and issued to stockholders.
Capital stock outstanding The number of shares of authorized stock issued and currently held by
stockholders.
Common stock Shares of stock representing the residual equity in the corporation. If only one class of
stock is issued, it is known as common stock. All other claims rank ahead of common stockholders' claims.
Convertible preferred stock Preferred stock that is convertible into common stock of the issuing
corporation.
Corporate charter The contract between the state and the incorporators of a corporation, and their
successors, granting the corporation its legal existence.
Corporation An entity recognized by law as possessing an existence separate and distinct from its owners;
that is, it is a separate legal entity. A corporation is granted many of the rights, and placed under many of the
obligations, of a natural person. In any given state, all corporations organized under the laws of that state are
domestic corporations; all others are foreign corporations.

32
 Cumulative preferred stock Preferred stock for which the right to receive a basic dividend accumulates if
any dividends have not been paid; unpaid cumulative preferred dividends must be paid before any dividends
can be paid on the common stock.
Discount on capital stock The amount by which the par value of shares issued exceeds their issue price.
The original issuance of shares at a discount is illegal in most states.
Dividend A distribution of assets (usually cash) that represents a withdrawal of earnings by the owners.
Dividend on preferred stock The amount paid to preferred stockholders as a return for the use of their
money; usually a fixed or stated amount expressed in dollars per share or as a percentage of par value per
share.
Dividends in arrears Cumulative unpaid dividends, including quarterly dividends not declared for the
current year.
Domestic corporation See corporation.
Foreign corporation See corporation.
Incorporators Persons seeking to bring a corporation into existence.
Legal capital (stated capital) An amount prescribed by law (usually the par value or stated value of
shares issued) below which a corporation may not reduce stockholders' equity through the declaration of
dividends or other payments to stockholders.
Liquidation value The amount a stockholder will receive if a corporation discontinues operations and
liquidates by selling its assets, paying its liabilities, and distributing the remaining cash among the
stockholders.
Market value The price at which shares of capital stock are bought and sold in the market.
Minutes book The record book in which actions taken at stockholders' and board of directors' meetings are
recorded; the written authorization for many actions taken by corporate officers.
Noncumulative preferred stock Preferred stock on which the right to receive a dividend expires if the
dividend is not declared.
No-par stock Capital stock without par value, to which a stated value may or may not be assigned.
Organization costs Costs of organizing a corporation, such as incorporation fees and legal fees applicable
to incorporation.
Paid-in capital Amount of stockholders' equity that normally results from the cash or other assets invested
by owners; it may also result from services provided for shares of stock and certain other transactions.
Paid-in capital in excess of par (or stated) value—common or preferred Capital contributed to a
corporation in addition to that assigned to the shares issued and recorded in capital stock accounts.
Par value An arbitrary amount assigned to each share of a given class of stock and printed on the stock
certificate.
Preemptive right The right of stockholders to buy additional shares in a proportion equal to the
percentage of shares already owned.
Preferred stock Capital stock that carries certain features or rights not carried by common stock. Preferred
stock may be preferred as to dividends, as to assets, or as to both dividends and assets. Preferred stock may
be callable and/or convertible and may be cumulative or noncumulative.
Proxy A legal document signed by a stockholder, giving another person the authority to vote the
stockholder's shares at a stockholders' meeting.
Redemption value The price per share at which a corporation may call in (or redeem) its capital stock for
retirement.
Retained earnings The part of stockholders' equity resulting from net income, reduced by dividends and
net losses.
Return on average common stockholders' equity A measure of the income-producing ability of the
company. It is the ratio of net income available to common stockholders divided by average common
stockholders' equity.
Shares of stock Units of ownership in a corporation.
Stated value An arbitrary amount assigned by the board of directors to each share of a given class of no-par
stock.
Stock certificate A printed or engraved document serving as evidence that the holder owns a certain
number of shares of capital stock.

Introduction to Accounting : The Language of Business – Supplemental Textbook 33

 Stockholders' ledger Contains a group of subsidiary accounts showing the number of shares of stock
currently held by each stockholder.
Stock preferred as to assets Means that in liquidation, the preferred stockholders are entitled to receive
the par value (or a larger stipulated liquidation value) per share before any assets may be distributed to
common stockholders.
Stock preferred as to dividends Means that the preferred stockholders are entitled to receive a specified
dividend per share before any dividend on common stock is paid.
Stock registrar Typically, a bank that maintains records of the shares outstanding for a company.
Stock-transfer agent Typically, a bank or trust company employed by a corporation to transfer stock
between buyers and sellers.
Stock without par value See no-par stock.
Unissued shares Capital stock authorized but not yet issued.
Self-test
True-false
Indicate whether each of the following statements is true or false.
A person may favor the corporate form of organization for a risky business enterprise primarily because a
corporation's shares can be easily transferred.
In the event of corporate liquidation, stockholders whose stock is preferred as to assets are entitled to receive the
par value of their shares before any amounts are distributed to creditors or common stockholders.
The par value of a share of capital stock is no indication of the market value or book value of the share of stock.
When 10,000 shares of USD 20 par value common stock are issued in payment for a parcel of land with a fair
market value of USD 300,000, the Common Stock account is credited for USD 200,000, and the Paid-In Capital in
Excess of Par Value—Common account is credited for USD 100,000.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following is not an advantage of the corporate form of organization?
a. Continuous existence of the entity.
b. Limited liability of stockholders.
c. Government regulation.
d. Easy transfer of ownership.
An arbitrary amount assigned by the board of directors to each share of a given class of no-par stock is:
a. Quasi-par value.
b. Stated value.
c. Redemption value.
d. Liquidation value.
Preferred stock that has dividends in arrears is:
a. Noncumulative preferred stock.
b. Noncumulative and callable preferred stock.
c. Noncumulative and convertible preferred stock.
d. Cumulative preferred stock.
Quinn Corporation issued 10,000 shares of USD 20 par value common stock at USD 50 per share. The amount
that would be credited to Paid-In Capital in Excess of Par Value—Common is:

34
 a. USD 200,000.
b. USD 300,000.
c. USD 500,000.
d. USD 700,000.
e. None of the above.
You are given the following information: Capital Stock, USD 80,000 (USD 80 par); Paid-In Capital in Excess of
Par Value—Common, USD 200,000; and Retained Earnings, USD 400,000. Assuming only one class of stock, the
book value per share is:
a. USD 680.
b. USD 280.
c. USD 80.
d. USD 400.
e. None of the above.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.

Questions
➢ Cite the major advantages of the corporate form of business organization and indicate why each is
considered an advantage.
➢ What is meant by the statement that corporate income is subject to double taxation? Cite several
other disadvantages of the corporate form of organization.
➢ Why is Organization Expense not a good title for the account that records the costs of organizing a
corporation? Could you justify leaving the balance of an Organization Costs account intact
throughout the life of a corporation?
➢ What are the basic rights associated with a share of capital stock if there is only one class of stock
outstanding?
➢ Explain the purpose or function of: (a) the stockholders' ledger, (b) the minutes book, (c) the stock-
transfer agent, and (d) the stock registrar.
➢ What are the differences between par value stock and stock with no-par value?
➢ Corporate capital stock is seldom issued for less than par value. Give two reasons why this statement
is true.
➢ Explain the terms liquidation value and redemption value.
➢ What are the meanings of the terms stock preferred as to dividends and stock preferred as to assets?
➢ What do the terms cumulative and noncumulative mean in regard to preferred stock?
➢ What are dividends in arrears, and how should they be disclosed in the financial statements?
➢ A corporation has 1,000 shares of 8 per cent, USD 200 par value, cumulative, preferred stock
outstanding. Dividends on this stock have not been declared for three years. Is the corporation
legally liable to its preferred stockholders for these dividends? How should this fact be shown in the
balance sheet, if at all?
➢ Explain why a corporation might issue a preferred stock that is both convertible into common stock
and callable.

Introduction to Accounting : The Language of Business – Supplemental Textbook 35

 ➢ Explain the nature of the account entitled Paid-In Capital in Excess of Par Value. Under what
circumstances is this account credited?
➢ Blake Corporation issued 5,000 shares of USD 100 par value common stock at USD 120 per share.
What is the legal capital of Blake Corporation, and why is the amount of legal capital important?
➢ What is the general approach of the accountant in determining the dollar amount at which to record
the issuance of capital stock for services or property other than cash?
➢ What assumptions are made in determining book value?
➢ Assuming there is no preferred stock outstanding, how can the book value per share of common
stock be determined? Of what significance is the book value per share? What is the relationship of
book value per share to market value per share?
Exercises
Exercise A Winters Corporation has outstanding 1,000 shares of noncumulative preferred stock and 2,000
shares of common stock. The preferred stock is entitled to an annual dividend of USD 100 per share before
dividends are declared on common stock. What are the total dividends received by each class of stock if Winters
Corporation distributes USD 280,000 in dividends in 2010?
Exercise B Zeff Corporation has 2,000 shares outstanding of cumulative preferred stock and 6,000 shares of
common stock. The preferred stock is entitled to an annual dividend of USD 18 per share before dividends are
declared on common stock. No preferred dividends were paid for last year and the current year. What are the total
dividends received by each class of stock if Zeff Corporation distributes USD 108,000 in dividends?
Exercise C Gordon Company issued 10,000 shares of common stock for USD 1,120,000 cash. The common
stock has a par value of USD 100 per share. Give the journal entry for the stock issuance.
Exercise D Thore Company issued 30,000 shares of USD 20 par value common stock for USD 680,000. What
is the journal entry for this transaction? What would the journal entry be if the common stock had no-par or stated
value?
Exercise E Li & Tu, Inc., needed land for a plant site. It issued 100 shares of USD 480 par value common stock
to the incorporators of their corporation in exchange for land, which cost USD 56,000 one year ago. Experienced
appraisers recently valued the land at USD 72,000. What journal entry would be appropriate to record the
acquisition of the land?
Exercise F Smart Corporation owes a trade creditor USD 30,000 on open account which the corporation does
not have sufficient cash to pay. The trade creditor suggests that Smart Corporation issue to him 750 shares of the
USD 24 par value common stock, which is currently selling on the market at USD 40. Present the entry or entries
that should be made on Smart Corporation's books.
Exercise G Why would a law firm ever consider accepting stock of a new corporation having a total par value of
USD 320,000 as payment in full of a USD 480,000 bill for legal services rendered? If such a transaction occurred,
give the journal entry the issuing company would make on its books.
Exercise H The stockholders' equity of Graf Company's balance is as follows:
Stockholders' equity:
Paid-in capital:
Common stock—without par value, $12
stated value; authorized 100,000 shares;
issued and outstanding, 70,000 shares $ 840,000
Paid-in capital in excess of stated value 340,000

36
 Total paid-in capital $1,180,000
Retained earnings 80,000
Total stockholders' equity $1,260,000

Compute the average price at which the 70,000 issued shares of common stock were sold. Compute the book
value per share of common stock.
Problems
Problem A The outstanding capital stock of Robbins Corporation consisted of 3,000 shares of 10 per cent
preferred stock, USD 250 par value, and 30,000 shares of no-par common stock with a stated value of USD 250.
The preferred was issued at USD 412, the common at USD 480 per share. On 2005 January 1, the retained earnings
of the company were USD 250,000. During the succeeding five years, net income was as follows:
2005 $767,500
2006 510,000
2007 48,000
2008 160,000
2009 662,500

No dividends were in arrears as of 2005 January 1, and during the five years 2005-2009, the board of directors
declared dividends in each year equal to net income of the year.
Prepare a schedule showing the dividends declared each year on each class of stock assuming the preferred stock
is:
a. Cumulative.
b. Noncumulative.
Problem B O n 2008 December 27, Glade Company was authorized to issue 250,000 shares of USD 24 par
value common stock. It then completed the following transactions:
2009
Jan. 14 Issued 45,000 shares of common stock at USD 30 per share for cash.
29 Gave the promoters of the corporation 25,000 shares of common stock for their services in organizing the
company. The board of directors valued these services at USD 744,000.
19 Exchanged 50,000 shares of common stock for the following assets at the indicated fair market values:
Land USD 216,000
Building 528,000
Machinery 720,000

a. Prepare general journal entries to record the transactions.

b. Prepare the balance sheet of the company as of 2009 March 1.
Problem C In the corporate charter that it received on 2009 May 1, Norris Company was authorized to issue
15,000 shares of common stock. The company issued 1,000 shares immediately for USD 82 per share, cash.
On July 2, the company issued 100 shares of stock to a lawyer to satisfy a USD 8,400 bill for legal services
rendered in organizing the corporation.
On July 5, the company issued 1,000 shares to the principal promoter of the corporation in exchange for a
patent. Another 200 shares were issued to this same person for costs incurred and services rendered in bringing the
corporation into existence. The market value of the stock was USD 84 per share.
a. Set up T-accounts, and post these transactions. Then prepare a balance sheet for the Norris Company as of
2009 July 5, assuming the authorized stock has a par value of USD 75 per share.

Introduction to Accounting : The Language of Business – Supplemental Textbook 37

 b. Repeat part (a) for the stockholders' equity accounts, and prepare the stockholders' equity section of the July
5 balance sheet assuming the stock authorized has no par value but has a USD 30 per share stated value.
c. Repeat part (a) for the stockholders' equity accounts assuming the stock authorized has neither par nor stated
value. Prepare the stockholders' equity section of the balance sheet.
Problem D On 2009 May 1, Farmington Company received a charter that authorized it to issue:
• 4,000 shares of no-par preferred stock to which a stated value of USD 12 per share is assigned. The stock is
entitled to a cumulative dividend of USD 9.60, convertible into two shares of common stock, callable at USD
208, and entitled to USD 200 per share in liquidation.
• 1,500 shares of USD 400 par value, USD 20 cumulative preferred stock, which is callable at USD 420 and
entitled to USD 412 in liquidation.
• 60,000 shares of no-par common stock to which a stated value of USD 40 is assigned.
May 1 All of the USD 9.60 cumulative preferred was issued at USD 204 per share, cash.
2 All of the USD 20 cumulative preferred was exchanged for merchandise inventory, land, and buildings valued
at USD 128,000, USD 160,000, and USD 425,000, respectively.
3 Cash of USD 15,000 was paid to reimburse promoters for costs incurred for accounting, legal, and printing
services. In addition, 1,000 shares of common stock were issued to the promoters for their services. The value of all
of the services (including those paid in cash) was USD 55,000.
a. Prepare journal entries for these transactions.
b. Assume that retained earnings were USD 200,000. Prepare the stockholders' equity section of the 2009 May
31, balance sheet.
Problem E O n 2008 January 2, the King Company received its charter. It issued all of its authorized 3,000
shares of no-par preferred stock at USD 104 and all of its 12,000 authorized shares of no-par common stock at USD
40 per share. The preferred stock has a stated value of USD 50 per share, is entitled to a basic cumulative dividend
of USD 6 per share, is callable at USD 106 beginning in 2010, and is entitled to USD 100 per share plus cumulative
dividends in the event of liquidation. The common stock has a stated value of USD 10 per share.
On 2009 December 31, the end of the second year of operations, retained earnings were USD 90,000. No
dividends have been declared or paid on either class of stock.
a. Prepare the stockholders' equity section of King Company's 2009 December 31, balance sheet.
b. Compute the book value of each class of stock.
c. If USD 42,000 of dividends were declared as of 2009 December 31, compute the amount paid to each class of
stock.
Problem F The common stock of Lang Corporation is selling on a stock exchange for USD 90 per share. The
stockholders' equity of the corporation at 2009 December 31, consists of:
Stockholders' equity:
Paid-in capital: $ 360,000
Preferred stock—9% cumulative,
$120 par value, $120 liquidation value,
3,000 shares authorized, issued, and outstanding
Common stock—$72 par value, 30,000 shares 2,160,000
authorized, issued
and outstanding
Total paid-in capital $2,520,000
Retained earnings 354,000
Total stockholders' equity $2,874,000

38
 Assume that in liquidation the preferred stock is entitled to par value plus cumulative unpaid dividends.
a. What is the total market value of all of the corporation's common stock?
b. If all dividends have been paid on the preferred stock as of 2009 December 31, what are the book values of the
preferred stock and the common stock?
c. If two years' dividends were due on the preferred stock as of 2009 December 31, what are the book values of
the preferred stock and common stock?
Problem G Haft Corporation has an agreement with each of its 15 preferred and 30 common stockholders that
in the event of the death of a stockholder, it will purchase at book value from the stockholder's estate or heirs the
shares of Haft Corporation stock held by the deceased at the time of death. The book value is to be computed in
accordance with generally accepted accounting principles.
Following is the stockholders' equity section of the Haft Corporation's 2009 December 31, balance sheet.
Stockholders' equity:
Paid-in capital:
Preferred stock—without par value, $50 stated value, $15 $ 150,000
cumulative; 3,000 shares authorized, issued, and outstanding
Common stock—$62.50 par value, 60,000 shares authorized, 3,750,000
issued and outstanding
Paid-in capital in excess of stated value—preferred 840,000
Paid-in capital in excess of par value—common 30,000
Total paid-in capital $4,770,000
Retained earnings 1,800,000
Total stockholders' equity $6,570,000

The preferred stock is cumulative and entitled to USD 300 per share plus cumulative dividends in liquidation.
No dividends have been paid for 1 year.
A stockholder who owned 100 shares of preferred stock and 1,000 shares of common stock died on 2009
December 31. You have been employed by the stockholder's executor to compute the book value of each class of
stock and to determine the price to be paid for the stock held by her late husband.
Prepare a schedule showing the computation of the amount to be paid for the deceased stockholder's preferred
and common stock.
Alternate problems
Alternate problem A On 2005 January 1, the retained earnings of Quigley Company were USD 432,000. Net
income for the succeeding five years was as follows:
2005 $288,000
2006 216,000
2007 4,800
2008 48,000
2009 264,000

The outstanding capital stock of the corporation consisted of 2,000 shares of preferred stock with a par value of
USD 480 per share that pays a dividend of USD 19.20 per year and 8,000 shares of no-par common stock with a
stated value of USD 240 per share. No dividends were in arrears as of 2005 January 1.
Prepare schedules showing how the net income for these five years was distributed to the two classes of stock if
in each of the years the entire current net income was distributed as dividends and the preferred stock was:
a. Cumulative.
b. Noncumulative.
Alternate problem B On 2009 January 1, Cowling Company was authorized to issue 500,000 shares of USD
5 par value common stock. It then completed the following transactions:

Introduction to Accounting : The Language of Business – Supplemental Textbook 39

 2009
Jan. 14 Issued 90,000 shares of common stock at USD 24 per share for cash.
29 Gave the promoters of the corporation 50,000 shares of common stock for their services in organizing the
company. The board of directors valued these services at USD 620,000.
Feb. 19 Exchanged 100,000 shares of common stock for the following assets at the indicated fair market values:
Equipment USD 180,000
Building 440,000
Land 600,000

a. Prepare general journal entries to record the transactions.

b. Prepare the balance sheet of the company as of 2009 March 1.
Alternate problem C On 2009 July 3, Barr Company was authorized to issue 15,000 shares of common stock;
3,000 shares were issued immediately to the incorporators of the company for cash at USD 320 per share. On July
5 of that year, an additional 300 shares were issued to the incorporators for services rendered in organizing the
company. The board valued these services at USD 96,000. On 2009 July 6, legal and printing costs of USD 12,000
were paid. These costs related to securing the corporate charter and the stock certificates.
a. Set up T-accounts and post these transactions. Then prepare the balance sheet of the Barr Company as of the
close of 2009 July 10, assuming the authorized stock has a USD 160 par value.
b. Repeat (a) for the T-accounts involving stockholders' equity, assuming the stock is no-par stock with a USD
240 stated value. Prepare the stockholders' equity section of the balance sheet.
c. Repeat (a) for the T-accounts involving stockholders' equity, assuming the stock is no-par stock with no stated
value. Prepare the stockholders' equity section of the balance sheet.
Alternate problem D Tempo Company received its charter on 2009 April 1, authorizing it to issue: (1) 10,000
shares of USD 400 par value, USD 32 cumulative, convertible preferred stock; (2) 10,000 shares of USD 12
cumulative no-par preferred stock having a stated value of USD 20 per share and a liquidation value of USD 100
per share; and (3) 100,000 shares of no-par common stock without a stated value.
On April 2, incorporators of the corporation acquired 50,000 shares of the common stock for cash at USD 80
per share, and 200 shares were issued to an attorney for services rendered in organizing the corporation. On April
3, the company issued all of its authorized shares of USD 32 convertible preferred stock for land valued at USD
1,600,000 and a building valued at USD 4,800,000. The property was subject to a mortgage of USD 2,400,000. On
April 8, the company issued 5,000 shares of the USD 12 preferred stock in exchange for a patent valued at USD
1,040,000. On April 10, the company issued 1,000 shares of common stock for cash at USD 80 per share.
a. Prepare general journal entries for these transactions.
b. Prepare the stockholders' equity section of the 2009 April 30, balance sheet. Assume retained earnings were
USD 80,000.
c. Assume that each share of the USD 32 convertible preferred stock is convertible into six shares of common
stock and that one-half of the preferred is converted on 2009 September 1. Give the required journal entry.
Alternate problem E Kane Company issued all of its 5,000 shares of authorized preferred stock on 2008
January 1, at USD 100 per share. The preferred stock is no-par stock, has a stated value of USD 5 per share, is
entitled to a cumulative basic preference dividend of USD 6 per share, is callable at USD 110 beginning in 2009,
and is entitled to USD 100 per share in liquidation plus cumulative dividends. On this same date, Kane also issued
10,000 authorized shares of no-par common stock with a USD 10 stated value at USD 50 per share.

40
 On 2009 December 31, the end of its second year of operations, the company's retained earnings amounted to
USD 160,000. No dividends have been declared or paid on either class of stock since the date of issue.
a. Prepare the stockholders' equity section of Kane Company's 2009 December 31, balance sheet.
b. Compute the book value in total and per share of each class of stock as of 2009 December 31.
c. If USD 110,000 of dividends are to be declared as of 2009 December 31, compute the amount payable to each
class of stock.
The stockholders' equity sections from three different corporations' balance sheets follow.
1) Stockholders' equity:
Paid-in capital:

Preferred stock—7% cumulative, $240 par value,500 shares

authorized, issued, and outstanding $ 120,000
Common stock—$48 par value, 10,000 shares authorized,
issued and outstanding 480,000
Total paid-in capital $ 600,000
Retained earnings 422,400
Total stockholders' equity $1,022,400
(All dividends have been paid.)
2) Stockholders' equity:
Paid-in capital:

Preferred stock—6% cumulative, $80 par value,10,000

shares authorized, issued, and outstanding $ 800,000
Common stock—$240 par value, 30,000shares authorized,
issued and outstanding 7,200,000
Total paid-in capital $8,000,000
Retained earnings 88,000
Total stockholders' equity $8,088,000
(The current year's dividends have not been paid.)
3) Stockholders' equity:
Paid-in capital:

Preferred stock—7% cumulative, $480 par value,10,000

shares authorized, issued, and outstanding $ 4,800,000
Common stock—$240 par value, 50,000shares authorized,
issued and outstanding 12,000,000
Total paid-in capital $16,800,000
Retained earnings deficit (1,872,000)
Total stockholders' equity $14,928,000
(Dividends have not been paid for 2 previous years or the current year.)

Compute the book values per share of the preferred and common stock of each corporation assuming that in a
liquidation the preferred stock receives par value plus dividends in arrears.
Alternate problem G Mendell, Inc., is a corporation in which all of the outstanding preferred and common
stock is held by the four Lehman brothers. The brothers have an agreement stating that the remaining brothers will,
upon the death of a brother, purchase from the estate his holdings of stock in the company at book value.
The stockholders' equity section of the balance sheet for the company on 2009 December 31, the date of the
death of James Lehman, shows:
Stockholders' equity:
Paid-in capital:
Preferred stock—6%; $320 par value; $320 liquidation value, $1,280,000
4,000 shares authorized, issued, and outstanding
Paid-in capital in excess of par—preferred 64,000
Common stock—without par value, $16 stated value,
60,000 shares authorized, issued and outstanding 960,000
Paid-in capital in excess of par value—common 960,000
Total paid-in capital $3,264,000
Retained earnings 128,000
Total stockholders' equity $3,392,000

Introduction to Accounting : The Language of Business – Supplemental Textbook 41

 No dividends have been paid for the last year on the preferred stock, which is cumulative. At the time of his
death, James Lehman held 2,000 shares of preferred stock and 10,000 shares of common stock of the company.
a. Compute the book value of the preferred stock.
b. Compute the book value of the common stock.
c. Compute the amount the remaining brothers must pay to the estate of James Lehman for the preferred and
common stock that he held at the time of his death.
Beyond the numbers—Critical thinking
Business decision case A Rudd Company and Clay Company have extremely stable net income amounts of
USD 4,800,000 and USD 3,200,000, respectively. Both companies distribute all their net income as dividends each
year. Rudd Company has 100,000 shares of USD 80 par value, 6 per cent preferred stock, and 500,000 shares of
USD 8 par value common stock outstanding. Clay Company has 50,000 shares of USD 40 par value, 8 per cent
preferred stock, and 400,000 shares of USD 8 par value common stock outstanding. Both preferred stocks are
cumulative.
a. Compute the annual dividend per share of preferred stock and per share of common stock for each company.
b. Based solely on the preceding information, which common stock would you predict to have the higher market
price per share? Why?
c. Which company's stock would you buy? Why?
Business decision case B Jesse Waltrip recently inherited USD 480,000 cash that he wishes to invest in the
common stock of either the West Corporation or the East Corporation. Both corporations have manufactured the
same types of products for five years. The stockholders' equity sections of the two corporations' latest balance
sheets follow:

42
WEST CORPORATION
Stockholders' equity:
Paid-in capital:
Common stock—$125 par value, 30,000 shares
authorized, issued and outstanding $3,750,000
Retained earnings 3,450,000
Total stockholders' equity $7,200,000
EAST CORPORATION
Stockholders' equity:
Paid-in capital:
Preferred stock—8%, $500 par value, cumulative 4,000 shares
authorized, issued and outstanding $2,000,000
Common stock—$125 par value, 40,000 shares authorized,
issued and outstanding 5,000,000 $7,000,000
Retained earnings 560,000
Total stockholders' equity $7,560,000

The West Corporation has paid a cash dividend of USD 6 per share each year since its creation; its common
stock is currently selling for USD 590 per share. The East Corporation's common stock is currently selling for USD
480 per share. The current year's dividend and three prior years' dividends on the preferred stock are in arrears.
The preferred stock has a liquidation value of USD 600 per share.
a. What is the book value per share of the West Corporation common stock and the East Corporation common
stock? Is book value the major determinant of market value of the stock?
b. Based solely on the previous information, which investment would you recommend to Waltrip? Why?
Annual report analysis C Determine the 2003 return on average common stockholders' equity for The
Limited in the Annual report appendix. Explain in writing why this information is important to managers,
investors, and creditors.
Ethics case D Refer to the ethics case concerning Joe Morrison to answer the following questions:
a. Which alternative would benefit the company and its management over the next several years?
b. Which alternative would benefit society?
c. If you were Morrison, which side of the argument would you take?
Group project E In teams of two or three students, examine the annual reports of three companies and
calculate each company's return on common shareholders' equity for the most recent two years. At least two years
are needed to observe any changes. As a team, decide in which of the three companies you would invest. Appoint a
spokesperson for the team to explain to the class which company the team would invest in and why.
Group project F In a team of two or three students, locate the annual reports of three companies that have
preferred stock in their stockholders' equity section. Determine the features of the preferred stock. Analyze the data
in the annual report to determine whether dividends have been paid on the preferred stock each year. Are there
dividends in arrears? Write a report to your instructor summarizing your findings. Also be prepared to make a short
presentation to the class.
Group project G In a group of one or two students, contact state officials and/or consult library resources to
inquire about the incorporation laws in your state. Determine your state laws regarding the issuance of stock at an
amount below par value, how legal capital is determined, and the requirements and government fees for
incorporating a company in your state. Write a report to your instructor summarizing the results of your
investigation and be prepared to make a short presentation to your class.
Using the Internet—A view of the real world
Visit the following website for Macromedia:

43
 http://www.macromedia.com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity. You will
probably go down some "false paths" to get to this financial statement, but you can get there. This experience is all
part of learning to use the Internet. Note the changes that have occurred in the Common Stock, Additional Paid-In
Capital, and Retained Earnings accounts. Check out the notes to the financial statements for further information.
Write a memo to your instructor summarizing your findings.
Visit the following website for Gartner Group:
http://www.gartner.com
Pursue choices on the screen until you locate the consolidated statement of stockholders' equity. You will
probably go down some "false paths" to get to this financial statement, but you can get there. This experience is all
part of learning to use the Internet. Trace the changes that have occurred in the last three years in the Common
Stock account. Check out the notes to the financial statements for further information. Write a memo to your
instructor summarizing your findings.
Answers to self-test
True-false
False. This is not the primary reason a person may prefer the corporate form of business organization in a
situation involving considerable risk. The primary reason is that stockholders can lose only the amount of capital
they have invested in a corporation.
False. The claims of the creditors rank ahead of the claims of the stockholders, even those stockholders whose
stock is preferred as to assets.
True. Par value is simply the amount per share that is credited to the Capital Stock account for each share
issued and is no indication of the market value or the book value of the stock.
True. When capital stock is issued for property or services, the transaction is recorded at the fair market value
of (1) the property or services received or (2) the stock issued, whichever is more clearly evident.
Multiple-choice
c. This feature of corporations is one of the disadvantages of the corporate form of organization.
b. Stated value is an arbitrary amount assigned by the board of directors to each share of capital stock without a
par value.
d . Dividends in arrears are cumulative unpaid dividends. Only cumulative preferred stock has dividends in
arrears.
b. The amount credited to the Paid-In Capital in Excess of Par Value—Common is computed as follows:
10,000 shares X  USD 50− USD 20= USD 300,000
a. The book value of common stock is computed as follows:
Total book value of stockholders' equity
($80,000 + $200,000 + $400,000) $680,000
Total shares ÷1,000
Book value per share $ 680

Introduction to Accounting : The Language of Business – Supplemental Textbook 44

Debt and Equity: Part 3

Learning objectives
After studying this chapter, you should be able to:
• Identify the different sources of paid-in capital and describe how to present them on a balance sheet.
• Account for a cash dividend, a stock dividend, a stock split, and a retained earnings appropriation.
• Account for the acquisition and reissuance of treasury stock.
• Describe the proper accounting treatment of discontinued operations, extraordinary items, and changes in
accounting principle.
• Define prior period adjustments and show their proper presentation in the financial statements.
• Analyze and use the financial results—earnings per share and price-earnings ratio.

The accountant as a financial analyst

The primary purpose of financial reporting is to provide information to investors and creditors. Investors use
financial information in purchasing and selling of stocks, while creditors (such as banks) use financial information
in reviewing the credit-worthiness of companies wishing to obtain loans. In making these types of decisions,
investors and creditors rely on financial analysts to give them accurate assessments of the value and strength of the
company. The role of the financial analysts is to take the financial information reported by a company and translate
that into a rating of company performance. It should therefore be no surprise that a successful financial analyst is
one that has a deep understanding of financial accounting. Who better to analyze the financial statements than the
person who prepared them? Who would have a better understanding of the data and information contained in
financial statements than the accountant? Financial statements are becoming ever more complex and difficult to
interpret by users. Thus, accountants are becoming increasingly important in assisting others to understand and
interpret financial information.
Helping users understand financial information involves such tasks as developing graphs, common-size
statements, and performing horizontal and vertical analysis. Analysis could also involve performing data
comparisons with relevant financial and nonfinancial data. The Altman Z Model is an example of a tool used by
analysts to predict bankruptcy. The model includes such items as retained earnings/total assets and sales/total
assets as variables in the calculation. Based upon this test, Cooper Tire & Rubber Company earned a score of 6.07 in
a recent year. A score below 2.675 was considered an indication of possible bankruptcy. Therefore, analysts
evaluated Cooper as a very healthy company not likely to go bankrupt.
Financial analysts make numerous judgments about the financial condition of companies, as in the example
above. These services are essential to the decisions of investors and creditors. Thus, financial analysts with a strong
accounting background are well compensated for their efforts.
As owners of a corporation, stockholders provide much of the capital for its activities. On the balance sheet, we
show the stockholders' capital investment in the corporation as paid-in capital under stockholders' equity. Also
included in stockholders' equity is the capital accumulated through the retention of corporate earnings (retained
earnings). Paid-in capital is a relatively permanent portion of stockholders' equity; the retained earnings balance is
a relatively temporary portion of corporate capital and is the source of stockholders' dividends.

Introduction to Accounting : The Language of Business – Supplemental Textbook 45

 The preceding chapter discussed the paid-in capital obtained by issuing shares of stock for cash, property, or
services. This chapter describes additional sources of paid-in capital and items affecting retained earnings.

Paid-in (or contributed) capital

As you have learned in the preceding chapter, paid-in capital, or contributed capital, refers to all of the
contributed capital of a corporation, including the capital carried in the capital stock accounts. The general ledger
does not contain an account titled "Paid-In Capital". Instead, paid-in capital is a category, and companies establish
a separate account for each source of paid-in capital.
In Exhibit 9, we summarize several sources of stockholders' equity and list general ledger account titles used to
record increases and decreases in capital from each of these sources. Chapter 12 discussed some of these general
ledger accounts. This chapter discusses other general ledger accounts that record sources of stockholders' equity.
The stockholders' equity section of a balance sheet shows the different sources of the corporation's paid-in
capital because these sources are important information. For example, these additional sources may be from stock
dividends, treasury stock transactions, or donations.
Sources of stockholders' equity Illustrative general ledger account titles
I. Capital paid in (or contributed)
A. For, or assigned to, shares:

1. Issued to the extent of par or stated value or the Common stock

amount received for shares without par or stated value.
2. To be distributed as a stock dividend. 5% preferred stock
3. In addition to par or stated value: Stock dividend distributable – common (preferred)
a. In excess or par. Paid-In capital in Excess of par value – Common
(preferred)
b. In excess of stated value. Paid-In capital in excess of stated value –
Common (preferred)
c. Resulting from declaration of stock dividends. Paid-In capital – Stock Dividends
d. Resulting from reissue of treasury stock at a Paid -In capital – Common (preferred) Treasury
price above its acquisition price. stock transactions
B. Donations (gifts), whether from stockholders or Paid-in Capital - Donations
from others.
II. Capital accumulated by retention of earnings Appropriation per loan agreement
(retained earnings).
A. Appropriated retained earnings. Retained earnings (Unappropriated)

B. Free and unappropriated retained earnings.

Exhibit 5: Sources of stockholders' equity

Paid-in capital—Stock dividends

When it declares a stock dividend, a corporation distributes additional shares of stock (instead of cash) to its
present stockholders. A later section discusses and illustrates how the issuance of a stock dividend results in a
credit to a Paid-In Capital—Stock Dividends account.

Paid-in capital—Treasury stock transactions

Another source of capital is treasury stock transactions. Treasury stock is the corporation's own stock, either
preferred or common, that it has issued and reacquired. It is legally available for reissuance. By reacquiring shares
of its own outstanding capital stock at one price and later reissuing them at a higher price, a corporation can
increase its capital by the difference between the two prices. If the reissue price is less than acquisition cost,
however, corporate capital decreases. We discuss treasury stock transactions at length later in this chapter.

46
 Paid-in capital—Donations
Occasionally, a corporation receives a gift of assets, such as a USD 500,000 building. These donated gifts
increase stockholders' equity and are called donated capital. The entry to record the gift of a USD 500,000
building is a debit to Buildings and a credit to Paid-In Capital—Donations. Accountants would make this entry in
the amount of the USD 500,000 fair market value of the gift when received.

Retained earnings
The retained earnings portion of stockholders' equity typically results from accumulated earnings, reduced by
net losses and dividends. Like paid-in capital, retained earnings is a source of assets received by a corporation.
Paid-in capital is the actual investment by the stockholders; retained earnings is the investment by the stockholders
through earnings not yet withdrawn.
The balance in the corporation's Retained Earnings account is the corporation's net income, less net losses, from
the date the corporation began to the present, less the sum of dividends paid during this period. Net income
increases Retained Earnings, while net losses and dividends decrease Retained Earnings in any given year. Thus,
the balance in Retained Earnings represents the corporation's accumulated net income not distributed to
stockholders.
When the Retained Earnings account has a debit balance, a deficit exists. A company indicates a deficit by
listing retained earnings with a negative amount in the stockholders' equity section of the balance sheet. The firm
need not change the title of the general ledger account even though it contains a debit balance. The most common
credits and debits made to Retained Earnings are for income (or losses) and dividends. Occasionally, accountants
make other entries to the Retained Earnings account. We discuss some of these entries later in the chapter.

Paid-in capital and retained earnings on the balance sheet

The following stockholders' equity section of a balance sheet presents the various sources of capital in proper
form:
Stockholders' equity:
Paid-in capital:
Preferred stock – 6%, $100 par value; authorized, issued, and $400,000
outstanding, 4,000 shares
Common stock – no-par value, $5 stated value; authorized, issued, $2,400,000
and outstanding, 400,000 shares 2,000,000
Paid-in capital -
From preferred stock issuances* $ 40,000
From donations 10,000 50,000
Total paid-in capital $2,450,000
Retained earnings 500,000
Total stockholders' equity $2,950,000
* This label is not the exact account title but is representative of the descriptions used on balance sheets. The exact account title could be used,
but shorter descriptions are often shown.

*This label is not the exact account title but is representative of the descriptions used on balance sheets. The
exact account title could be used, but shorter descriptions are often shown.
In their highly condensed, published balance sheets, companies often omit the details regarding the sources of
the paid-in capital in excess of par or stated value and replace them by a single item, such as:
Paid-in capital in excess of par (or stated) value USD 50,000
Dividends are distributions of earnings by a corporation to its stockholders. Usually the corporation pays
dividends in cash, but it may distribute additional shares of the corporation's own capital stock as dividends.

Introduction to Accounting : The Language of Business – Supplemental Textbook 47

Occasionally, a company pays dividends in merchandise or other assets. Since dividends are the means whereby the
owners of a corporation share in its earnings, accountants charge them against retained earnings.
Before dividends can be paid, the board of directors must declare them so they can be recorded in the
corporation's minutes book. Three dividend dates are significant:
• Date of declaration. The date of declaration indicates when the board of directors approved a motion
declaring that dividends should be paid. The board action creates the liability for dividends payable (or stock
dividends distributable for stock dividends).
• Date of record. The board of directors establishes the date of record; it determines which stockholders
receive dividends. The corporation's records (the stockholders' ledger) determine its stockholders as of the
date of record.
• Date of payment. The date of payment indicates when the corporation will pay dividends to the
stockholders.
To illustrate how these three dates relate to an actual situation, assume the board of directors of the Allen
Corporation declared a cash dividend on 2010 May 5, (date of declaration). The cash dividend declared is USD 1.25
per share to stockholders of record on 2010 July 1, (date of record), payable on 2010 July 10, (date of payment).
Because financial transactions occur on both the date of declaration (a liability is incurred) and on the date of
payment (cash is paid), journal entries record the transactions on both of these dates. No journal entry is required
on the date of record.
Exhibit 6 shows the frequencies of dividend payments made by a sample of representative companies for the
years 1996-99. Note that cash dividends are far more numerous than stock dividends or dividends in kind (paid in
merchandise or other assets).

An accounting perspective:

Uses of technology

After original issuance, investors may trade the stock of a company on secondary markets, such as
the New York Stock Exchange. The company makes no entry on its books for these outside trades
after issuance. Often, a company uses a spreadsheet or database program to note trades between
shareholders. These computer programs can print a report on the date of record. This information
allows a company that declares a dividend to be certain the money or stock goes to the stockholders
who own the stock on the date of record rather than to the stockholders who originally purchased
the stock.

Cash dividends are cash distributions of accumulated earnings by a corporation to its stockholders. To
illustrate the entries for cash dividends, consider the following example. On 2010 January 21, a corporation's board
of directors declared a 2 per cent quarterly cash dividend on USD 100,000 of outstanding preferred stock. This
dividend is one-fourth of the annual dividend on 1,000 shares of USD 100 par value, 8 per cent preferred stock. The
dividend will be paid on 2010 March 1, to stockholders of record on 2010 February 5. An entry is not needed on the
date of record; however, the entries at the declaration and payment dates are as follows:

48
2010
Jan. 21 Retained earnings (-SE) 2,000
Dividends payable (+L) 2,000
Dividends declared: 2% on $100,000 of outstanding preferred stock,
payable 2010 March 1, to stockholders of record on 2010 February 5.

Mar. 1 Dividends payable (-L) 2,000

Cash (-A) 2,000
Paid the dividend declared on 2010 January 21.

Often a cash dividend is stated as so many dollars per share. For instance, the quarterly dividend could have
been stated as USD 2 per share. When they declare a cash dividend, some companies debit a Dividends account
instead of Retained Earnings. (Both methods are acceptable.) The Dividends account is then closed to Retained
Earnings at the end of the fiscal year.
Number of Companies
2006 2005 2004 2003
Cash dividends paid to common stock
shareholders
Per share amount disclosed in retained earnings 213 219 229 239
statements
Per share amount not disclosed in retained earning 157 135 156 164
statements
Total: 370 354 385 403
Cash dividends paid to preferred stock shareholders
Per share amount disclosed in retained earnings 22 22 17 25
statements
Per share amount not disclosed in retained earnings 32 38 48 44
statements
Total: 54 60 65 69
**Dividends paid by pooled companies X X X X
Stock dividends 4 6 4 12
Dividends in kinds 7 10 14 7
Stock purchase rights 1 4 7 9

Exhibit 6: Types of dividends

Once a cash dividend is declared and notice of the dividend is given to stockholders, a company generally cannot
rescind it unless all stockholders agree to such action. 2 Thus, the credit balance in the Dividends Payable account
appears as a current liability on the balance sheet.

An accounting perspective:

Business insight

Fleetwood Enterprises, Inc., is the nation's leading producer of manufactured housing and
recreational vehicles. Often investors believe a company that pays dividends is doing well.
Therefore, companies try to maintain a record of paying dividends, as Fleetwood noted in a 2001
press release.
RIVERSIDE, Calif., Sept. 12 /PRNewswire/—The directors of Fleetwood Enterprises, Inc. (NYSE:
FLE) have declared the company's regular quarterly cash dividend of 19 cents per share of
Common stock, payable 2000 November 8, to shareholders of record 2000 October 6.

2 Stockholders might agree to rescind (cancel) a dividend already declared if the company is in difficult financial
circumstances and needs to retain cash to pay bills or acquire assets to continue operations.

Introduction to Accounting : The Language of Business – Supplemental Textbook 49

 A company that lacks sufficient cash for a cash dividend may declare a stock dividend to satisfy its
shareholders. Note that in the long run it may be more beneficial to the company and the
shareholders to reinvest the capital in the business rather than paying a cash dividend. If so, the
company would be more profitable and the shareholders would be rewarded with a higher stock
price in the future.

Stock dividends are payable in additional shares of the declaring corporation's capital stock. When declaring
stock dividends, companies issue additional shares of the same class of stock as that held by the stockholders.
Corporations usually account for stock dividends by transferring a sum from retained earnings to permanent
paid-in capital. The amount transferred for stock dividends depends on the size of the stock dividend. For stock
dividends, most states permit corporations to debit Retained Earnings or any paid-in capital accounts other than
those representing legal capital. In most circumstances, however, they debit Retained Earnings when a stock
dividend is declared.
Stock dividends have no effect on the total amount of stockholders' equity or on net assets. They merely decrease
retained earnings and increase paid-in capital by an equal amount. Immediately after the distribution of a stock
dividend, each share of similar stock has a lower book value per share. This decrease occurs because more shares
are outstanding with no increase in total stockholders' equity.
Stock dividends do not affect the individual stockholder's percentage of ownership in the corporation. For
example, a stockholder who owns 1,000 shares in a corporation having 100,000 shares of stock outstanding, owns 1
per cent of the outstanding shares. After a 10 per cent stock dividend, the stockholder still owns 1 per cent of the
outstanding shares—1,100 of the 110,000 outstanding shares.
A corporation might declare a stock dividend for several reasons:
• Retained earnings may have become large relative to total stockholders' equity, so the corporation may
desire a larger permanent capitalization.
• The market price of the stock may have risen above a desirable trading range. A stock dividend generally
reduces the per share market value of the company's stock.
• The board of directors of a corporation may wish to have more stockholders (who might then buy its
products) and eventually increase their number by increasing the number of shares outstanding. Some of the
stockholders receiving the stock dividend are likely to sell the shares to other persons.
• Stock dividends may silence stockholders' demands for cash dividends from a corporation that does not
have sufficient cash to pay cash dividends.
The percentage of shares issued determines whether a stock dividend is a small stock dividend or a large stock
dividend. Firms use different accounting treatments for each category.
Recording small stock dividends A stock dividend of less than 20 to 25 per cent of the outstanding shares is
a small stock dividend and has little effect on the market value (quoted market price) of the shares. Thus, the firm
accounts for the dividend at the current market value of the outstanding shares.
Assume a corporation is authorized to issue 20,000 shares of USD 100 par value common stock, of which 8,000
shares are outstanding. Its board of directors declares a 10 per cent stock dividend (800 shares). The quoted market
price of the stock is USD 125 per share immediately before the stock dividend is announced. Since the distribution

50
is less than 20 to 25 per cent of the outstanding shares, the dividend is accounted for at market value. The entry for
the declaration of the stock dividend on 2010 August 10, is:
Aug. 10 Retained earnings (or Stock Dividends) (800shares x $125) (-SE) 100,000
Stock dividend distributable – Common 80,000
(800 shares x $100) (+SE)
Paid-In capital – Stock dividends (+SE) 20,000
To record the declaration of a 10% stock dividend; shares to be
distributed on 2010 September 20, to stockholders of record on 2010
August 31.

This entry records the issuance of the shares:

Sept. 20 Stock dividends distributable – 80,000
Common (-SE)
Common stock (+SE) 80,000
To record the distribution of 800
shares of common stock as
authorized in stock dividends
declared on 2010 August 10.

The stock dividend distributable—common account is a stockholders' equity (paid-in capital) account
credited for the par or stated value of the shares distributable when recording the declaration of a stock dividend.
Since a stock dividend distributable is not to be paid with assets, it is not a liability. When a balance sheet is
prepared between the date the 10 per cent dividend is declared and the date the shares are issued, the proper
statement presentation of the effects of the stock dividend is:
Stockholders' equity:
Paid-in capital:
Common stock - $100 par value; authorized, $800,000
20,000 shares; issued and outstanding, 8,000
shares
Stock dividend distributable on 2010 80,000
September 20, 800 shares at par value
Total par value of shares issued and to be $880,000
issued
Paid-in capital 20,000
Total paid-in capital $900,000
Retained earnings 150,000
Total stockholders' equity $1,050,000

Suppose, on the other hand, that the common stock in the preceding example is no-par stock and has a stated
value of USD 50 per share. The entry to record the declaration of the stock dividend (when the market value is USD
125) is:
Retained earnings (800 shares x $125) (-SE) 100,000
Stock dividends distributable – Common
(800 shares x $50) (+SE) 40,000
Paid-in capital – stock dividends (800 shares 60,000
x $75) (+SE)
To record the declaration of a stock dividend.

The entry to record the issuance of the stock dividend is:

Stock dividend distributable – Common (-SE) 40,000
Common stock (+SE) 40,000
To record the issuance of the stock dividend.

Recording large stock dividends A stock dividend of more than 20 to 25 per cent of the outstanding shares
is a large stock dividend. Since one purpose of a large stock dividend is to reduce the market value of the stock so
the shares can be traded more easily, firms do not use the current market value of the stock in the entry. They
account for such dividends at their par or stated value rather than at their current market value. The laws of the
state of incorporation or the board of directors establish the amounts for stocks without par or stated value.

Introduction to Accounting : The Language of Business – Supplemental Textbook 51

 To illustrate the treatment of a stock dividend of more than 20 to 25 per cent, assume X Corporation has been
authorized to issue 10,000 shares of USD 10 par value common stock, of which 5,000 shares are outstanding. X
Corporation declared a 30 per cent stock dividend (1,500 shares) on 2010 September 20, to be issued on 2010
October 15. The required entries are:

Exhibit 7: Stock dividends

Sept. 20 Retained earnings (or Stock Dividends) (1,500 15,000

shares x $10) (-SE)
Stock dividend distributable – Common (+SE) 15,000
To declare a 30% stock dividend.

Oct. 15 Stock dividend distributable – Common (-SE) 15,000

Common stock (+SE) 15,000
To issue the 30% stock dividend.

Note that although firms account for the small stock dividend at current market value, they account for the 30
per cent stock dividend at par value (1,500 shares X USD 10 = USD 15,000). Because of the differences in
accounting for large and small stock dividends, accountants must determine the relative size of the stock dividend
before making any journal entries.
To see the effect of small and large stock dividends on stockholders' equity, look at Exhibit 7.
A stock split is a distribution of 100 per cent or more of additional shares of the issuing corporation's stock
accompanied by a corresponding reduction in the par value per share. The corporation receives no assets in this
transaction. A stock split causes a large reduction in the market price per share of the outstanding stock. A two-for-
one split doubles the number of shares outstanding, a three-for-one split triples the number of shares, and so on.
The split reduces the par value per share at the same time so that the total dollar amount credited to Common Stock
remains the same. For instance, a two-for-one split halves the par value per share. 3 If the corporation issues 100 per

3 If a corporation reduces the par value of its stock without issuing more shares, say, from USD 100 to USD 60 per
share, then USD 40 per share must be removed from the appropriate capital stock account and credited to Paid-
In Capital Recapitalization. Further discussion of this process, called recapitalization, is beyond the scope of this
text.

52
cent more stock without a reduction in the par value per share, the transaction is a 100 per cent stock dividend
rather than a two-for-one stock split.
The entry to record a stock split depends on the particular circumstances. Usually, firms change only the
number of shares outstanding and the par or stated value in the records. (The number of shares authorized may
also change.) Thus, they would record a two-for-one stock split in which the par value of the shares decreases from
USD 20 to USD 10 as follows:
Common stock - $20 par value (-SE) 100,000
Common stock - $10 par value (+SE) 100,000
To record a two- for-one stock split; 5,000 shares of $20
par value common stock were replaced by 10,000 shares
of $10 par value common stock.

In Exhibit 8, we summarize the effects of stock dividends and stock splits. Stock dividends and stock splits have
no effect on the total amount of stockholders' equity. In addition, stock splits have no effect on the total amount of
paid-in capital or retained earnings. They merely increase the number of shares outstanding and decrease the par
value per share. Stock dividends increase paid-in capital and decrease retained earnings by equal amounts.
Total Common Paid-in Retained Number of Par value
Stockholders' Stock Capital - Earnings Shares Per share
equity common outstanding
Stock
dividends:
Small No effect Increases Increases* Decreases Increases No effect
Large No effect Increases No effect Decreases Increases No effect
Stock splits No effect No effect No effect No effect Increases Decreases

Exhibit 8: Summary of effects of stock dividends and stock splits

The preceding chapter discussed how corporate laws differ regarding the legality of a dividend. State law
establishes the legal or stated capital of a corporation as that portion of the stockholders' equity that must be
maintained intact, unimpaired by dividend declarations or other distributions to stockholders. The legal capital
often equals the par or stated value of the shares issued or a minimum price per share issued.
The objective of these state corporate laws is to protect the corporation's creditors, whose claims have priority
over those of the corporation's stockholders. To illustrate the significance of the legal capital concept, assume a
corporation in severe financial difficulty is about to go out of business. If there were no legal capital restrictions on
dividends, the stockholders of that corporation might pay themselves a cash dividend or have the corporation buy
back their stock, leaving no funds available for the corporation's creditors.
The board of directors of a corporation possesses sole power to declare dividends. The legality of a dividend
generally depends on the amount of retained earnings available for dividends—not on the net income of any one
period. Firms can pay dividends in periods in which they incurred losses, provided retained earnings and the cash
position justify the dividend. And in some states, companies can declare dividends from current earnings despite an
accumulated deficit. The financial advisability of declaring a dividend depends on the cash position of the
corporation.
Normally, dividends are reductions of retained earnings since they are distributions of the corporation's net
income. However, dividends may be distributions of contributed capital. These dividends are called liquidating
dividends.
Accountants debit liquidating dividends to a paid-in capital account. Corporations should disclose to
stockholders the source of any dividends that are not distributions of net income by indicating which paid-in capital

Introduction to Accounting : The Language of Business – Supplemental Textbook 53

account was debited as a result of the dividend. The legality of paying liquidating dividends depends on the source
of the paid-in capital and the laws of the state of incorporation.

An accounting perspective:

Business insight

The Private Securities Litigation Reform Act, passed in 1995, seeks to protect investors against
white-collar crime. Auditors are required by this law to become more aggressive in looking for
fraud in companies they audit. Risk factors that might encourage management to engage in
fraudulent activities include weak internal controls, an aggressive effort to drive up the stock price
by reporting higher earnings, and/or executive bonuses or stock options based on earnings. A
strong company code of ethics and an effective internal control structure can help deter fraud from
occurring.

Retained earnings appropriations

The amount of retained earnings that a corporation may pay as cash dividends may be less than total retained
earnings for several contractual or voluntary reasons. These contractual or voluntary restrictions or limitations on
retained earnings are retained earnings appropriations. For example, a loan contract may state that part of a
corporation's USD 100,000 of retained earnings is not available for cash dividends until the loan is paid. Or a board
of directors may decide to use assets resulting from net income for plant expansion rather than for cash dividends.
An example of a voluntary restriction was General Electric's annual report statement that cash dividends were
limited "to support enhanced productive capability and to provide adequate financial resources for internal and
external growth opportunities".
Companies formally record retained earnings appropriations by transferring amounts from Retained Earnings
to accounts such as "Appropriation for Loan Agreement" or "Retained Earnings Appropriated for Plant Expansion".
Even though some refer to retained earnings appropriations as retained earnings reserves, using the term reserves
is discouraged.
Other reasons for appropriations of retained earnings include pending litigation, debt retirement, and
contingencies in general. Such appropriations do not reduce total retained earnings. They merely disclose to
balance sheet readers that a portion of retained earnings is not available for cash dividends. Thus, recording these
appropriations guarantees that the corporation limits its outflow of cash dividends while repaying a loan,
expanding a plant, or taking on some other costly endeavor. Recording retained earnings appropriations does not
involve the setting aside of cash for the indicated purpose; it merely divides retained earnings into two parts—
appropriated retained earnings and unappropriated retained earnings. The establishment of a separate fund would
require a specific directive from the board of directors. The only entry required to record the appropriation of USD
25,000 of retained earnings to fulfill the provisions in a loan agreement is:
Retained earnings (-SE) 25,000
Appropriation per loan agreement (+SE) 25,000
To record restriction on retained earnings.

54
 When the retained earnings appropriation has served its purpose of restricting dividends and the loan has been
repaid, the board of directors may decide to return the appropriation intact to Retained Earnings. The entry to do
this is:
Appropriation per loan agreement(-SE) 25,000
Retained earnings (+SE) 25,000
To return balance in appropriation per Loan
Agreement account to Retained earnings.

On the balance sheet, retained earnings appropriations appear in the stockholders' equity section as follows:
Stockholders' equity:
Paid-in capital:
Preferred stock – 8%, $50 par value; 500 $25,000
shares authorized; issued and outstanding
Common stock - $5 par value; 10,000 50,000
shares authorized, issued and outstanding
Total paid-in capital $75,000
Retained earnings:
Appropriated:
Per loan agreement $25,000
Unappropriated 20,000
Total retained earnings 45,000
Total stockholders' equity $120,000

Note that a retained earnings appropriation does not reduce either stockholders' equity or total retained
earnings but merely earmarks (restricts) a portion of retained earnings for a specific reason.
The formal practice of recording and reporting retained earnings appropriations is decreasing. Footnote
explanations such as the following are replacing these appropriations:
Note 7. Retained earnings restrictions. According to the provisions in the loan agreement, retained earnings
available for dividends are limited to USD 20,000.
Such footnotes appear after the formal financial statements in "Notes to Financial Statements". The Retained
Earnings account on the balance sheet would be referenced as follows: "Retained Earnings (see note 7)...USD
45,000".
Changes in the composition of retained earnings reveal important information about a corporation to financial
statement users. A separate formal statement—the statement of retained earnings—discloses such changes.

Statement of retained earnings

A statement of retained earnings is a formal statement showing the items causing changes in
unappropriated and appropriated retained earnings during a stated period of time. Changes in unappropriated
retained earnings usually consist of the addition of net income (or deduction of net loss) and the deduction of
dividends and appropriations. Changes in appropriated retained earnings consist of increases or decreases in
appropriations.
Note Ward Corporation's statement of retained earnings in Exhibit 5. The only new appropriation during 2010
was an additional USD 35,000 for plant expansion. Ward added this new USD 35,000 to the USD 25,000
beginning balance in that account and subtracted that amount from unappropriated retained earnings. An
alternative to the statement of retained earnings is the statement of stockholders' equity.
Ward Corporation
Statement of Retained Earnings
For Year Ended 2010 December 31

Introduction to Accounting : The Language of Business – Supplemental Textbook 55

Unappropriated retained earnings:
2010 January 1, balance $180,000
Add: Net income 80,000
$260,000
Less: Dividends $15,000
Appropriation for plant expansion 35,000 50,000
Unappropriated retained earnings, 2010
December 31 $210,000
Appropriated retained earnings:
Appropriation for plant expansion, 2010
January 1, balance $25,000
Add: Increase in 2010 35,000 $ 60,000
Appropriation for contract obligation, 2010 20,000
January 1, balance
Appropriated retained earnings, 2010 $80,000
December 31
Total retained earnings, 2010 December 31 $290,000

Exhibit 9: Statement of retained earnings

Statement of stockholders' equity

Most corporations include four financial statements in their annual reports: a balance sheet, an income
statement, a statement of stockholders' equity (in place of a statement of retained earnings), and a statement of
cash flows. A statement of stockholders' equity is a summary of the transactions affecting the accounts in the
stockholders' equity section of the balance sheet during a stated period. These transactions include activities
affecting both paid-in capital and retained earnings accounts. Thus, the statement of stockholders' equity includes
the information contained in a statement of retained earnings plus some additional information. The columns in
the statement of stockholders' equity reflect the major account titles within the stockholders' equity section: the
types of stock issued and outstanding, paid-in capital in excess of par (or stated) value, retained earnings, and
treasury stock. Each row indicates the effects of major transactions affecting one or more stockholders' equity
accounts.
Look at Exhibit 10, a statement of stockholders' equity. The first row indicates the beginning balances of each
account in the stockholders' equity section. This summary shows that Larkin Corporation issued 10,000 shares of
common stock, declared a 5 per cent stock dividend on common stock, repurchased 1,200 shares of treasury stock,
earned net income of USD 185,000, and paid cash dividends on both its preferred and common stock. After the
transactions' effects are indicated within each row, Larkin added or subtracted each column's components to
determine the ending balance in each stockholders' equity account.

Treasury stock
Treasury stock is the corporation's own capital stock that it has issued and then reacquired; this stock has not
been canceled and is legally available for reissuance. Because it has been issued, we cannot classify treasury stock as
unissued stock.
Recall that when a corporation has additional authorized shares of stock that are to be issued after the date of
original issue, in most states the preemptive right requires offering these additional shares first to existing
stockholders on a pro rata basis. However, firms may reissue treasury stock without violating the preemptive right
provisions of state laws; that is, treasury stock does not have to be offered to current stockholders on a pro rata
basis.
Larkin Corporation
Statement of stockholders' equity
For the Year ended 2010 December 31

56
 $50 par, value, $20 par value Paid-In capital Retained Treasury
6% preferred Common stock In excess of Earnings Stock
stock par value
Balance, 2010 January 1 $250,000 $300,000 $200,000 $500,000 $(42,000)
Issuance of 10,000 shares of 200,000 100,000
common stock
5% stock dividend on common 25,000 27,500 (52,500)
stock, 1,250 shares
Purchase of 1,200 shares of
treasury stock
(48,000)
Net income 185,000
Cash dividends:
Preferred stock (15,000)
Common stock (25,000)
Balance, 2010 December 31 $250,000 $525,000 $327,500 $592,500 $(90,000)

Exhibit 10: Statement of stockholders' equity

A corporation may reacquire its own capital stock as treasury stock to: (1) cancel and retire the stock; (2) reissue
the stock later at a higher price; (3) reduce the shares outstanding and thereby increase earnings per share; or (4)
issue the stock to employees. If the intent of reacquisition is cancellation and retirement, the treasury shares exist
only until they are retired and canceled by a formal reduction of corporate capital.
For dividend or voting purposes, most state laws consider treasury stock as issued but not outstanding, since the
shares are no longer in the possession of stockholders. Also, accountants do not consider treasury shares
outstanding in calculating earnings per share. However, they generally consider treasury shares outstanding for
purposes of determining legal capital, which includes outstanding shares plus treasury shares.
In states that consider treasury stock as part of legal capital, the cost of treasury stock may not exceed the
retained earnings at the date the shares are reacquired. This regulation protects creditors by preventing the
corporation in financial difficulty from using funds to purchase its own stock instead of paying its debts. Thus, if a
corporation is subject to such a law (as is assumed in this text), the retained earnings available for dividends must
exceed the cost of the treasury shares on hand.
When firms reacquire treasury stock, they record the stock at cost as a debit in a stockholders' equity account
called Treasury Stock.4 They credit reissuances to the Treasury Stock account at the cost of acquisition. Thus, the
Treasury Stock account is debited at cost when shares are acquired and credited at cost when these shares are sold.
Any excess of the reissue price over cost represents additional paid-in capital and is credited to Paid-In Capital—
Common (Preferred) Treasury Stock Transactions.
To illustrate, assume that on 2010 February 18, the Hillside Corporation reacquired 100 shares of its
outstanding common stock for USD 55 each. (The company's stockholders' equity consisted solely of common stock
and retained earnings.) On 2010 April 18, the company reissued 30 shares for USD 58 each. The entries to record
these events are:
2010
Feb. 18 Treasury stock – Common (100 shares x $55) (-SE) 5,500
Cash (-A) 5,500
Acquired 100 shares of treasury stock at $55.

Apr. 18 Cash (30 shares x $58) (+A) 1,740

Treasury stock – Common (30 shares x $55) (+SE) 1,650
Paid-In Capital – Common treasury stock 90
transactions (+SE)

4 Another acceptable method of accounting for treasury stock transactions is the par value method. We leave
further discussion of the par value method to intermediate accounting texts.

Introduction to Accounting : The Language of Business – Supplemental Textbook 57

 Reissued 30 shares of treasury stock at $58; cost is
$55 per share.

When the reissue price of subsequent shares is less than the acquisition price, firms debit the difference between
cost and reissue price to Paid-In Capital—Common Treasury Stock Transactions. This account, however, never
develops a debit balance. By definition, no paid-in capital account can have a debit balance. If Hillside reissued an
additional 20 shares at USD 52 per share on 2010 June 12, the entry would be:
June 12 Cash (20 shares x $52) (+A) 1,040
Paid-In Capital – Common treasury stock transactions (-SE) 60
Treasury stock – Common (20 shares x $55) (+SE) 1,100
Reissued 20 shares of treasury stock at $52; cost is $55 per
share.

At this point, the credit balance in the Paid-In Capital—Common Treasury Stock Transactions account would be
USD 30. If the remaining 50 shares are reissued on 2010 July 16, for USD 53 per share, the entry would be:
July 16 Cash (50 shares x $53) (+A) 2,650
Paid-In Capital – Common treasury stock 30
transactions (-SE)
Retained earnings (-SE) 70
Treasury stock – Common (50 shares x $55) 2,750
(+SE)
Reissued 50 shares of treasury stock at $53; cost
is $55 per share.

Notice that Hillside has exhausted the Paid-In Capital—Common Treasury Stock Transactions account credit
balance. If more than USD 30 is debited to that account, it would develop a debit balance. Thus, the remaining USD
70 of the excess of cost over reissue price is a special distribution to the stockholders involved and is debited to the
Retained Earnings account.
Sometimes stockholders donate stock to a corporation. Since donated treasury shares have no cost to the
corporation, accountants make only a memo entry when the shares are received. 5 The only formal entry required is
to debit Cash and credit the Paid-In Capital—Donations account when the stock is reissued. For example, if donated
treasury stock is sold for USD 5,000, the entry would be:
Cash (+A) 5,000
Paid-In capital – Donations (+SE) 5,000
To record the sale of donated
treasury stock.

When treasury stock is held on a balance sheet date, it customarily appears at cost, as a deduction from the sum
of total paid-in capital and retained earnings, as follows:
Hypothetical Corporation
Partial balance sheet
2010 December 31

5 The method illustrated here is called the memo method. Other acceptable methods of accounting for donated
stock are the cost method and par value method. Intermediate accounting texts discuss these latter two
methods.

58
Stockholder's equity:
Paid-In capital:
Preferred stock -8%, $100 par value; 2,000 $200,000
shares authorized, issued, and outstanding
Common stock-$10 par value; authorized, $800,000
100,000 shares; issued, 80,000 shares of which
1,000 are held in the treasury
Stock dividend distributable on common stock on 79,000 879,000
2011 January 15, 7,900 shares
Paid-in capital-
From common stock issuances $40,000
From stock dividends 60,000
From treasury stock transactions 30,000
From donations 50,000 180,000
Total paid-in capital $1,259,000
Retained earnings:
Appropriated:
Per loan agreement $250,000
Unappropriated (restricted to the extent of $150,000
$20,000, the cost of treasury shares held)
Total retained earnings 400,000
Total paid-in capital and retained earnings $1,659,000
Less: Treasury stock, common, 1,000 shares at 20,000
cost
Total stockholders' equity $1,639,000

Exhibit 11: Stockholders' equity section of the balance sheet

Stockholders' equity:
Paid-in capital:
Common stock-$10 par value; authorized and issued, $200,000
20,000 shares, of which 2,000 shares are in the
treasury
Retained earnings (including $22,000 restricted by 80,000
acquisition of treasury stock)
Total paid-in capital and retained earnings $280,000
Less: Treasury stock at cost, 2,000 shares 22,000
Total stockholders' equity $258,000

An accounting perspective:

Business insight

General Mills is a leading producer of ready-to-eat cereals, desserts and baking mixes, snack
products, and dinner and side dish mixes. Popular brand names include Hamburger Helper, Betty
Crocker, and Yoplait. For 2001 and 2000, General Mills reported common stock in the treasury
(treasury stock) of 123,100,000 and 122,900,000 shares, respectively. General Mills deducted the
cost of these shares in the stockholders' equity section of the balance sheet.

To summarize much of what we have discussed in Part 2 and Part 3, we present the stockholders' equity section
of the balance sheet in Exhibit 11. This partial balance sheet shows: (1) the amount of capital assigned to shares
outstanding; (2) the capital contributed for outstanding shares in addition to that assigned to the shares; (3) other
forms of paid-in capital; and (4) retained earnings, appropriated and unappropriated.
Anson Company
Income Statement
For the Year Ended 2010 December 31

Introduction to Accounting : The Language of Business – Supplemental Textbook 59

Net sales $41,000,000
Other revenues 2,250,000
Total revenue $43,250,000
Cost of goods sold $22,000,000
Administrative, selling, and general expenses 12,000,000 34,000,000
Income before federal income taxes $9,250,000
Deduct: Federal income taxes (40%) 3,700,000
Income from continuing operations $5,550,000
Discounted operations:
Loss from operations of discontinued Cosmetics
Division (net of 40% tax effect of $800,000) $(1,200,000)
Loss on disposal of Cosmetics Division (net of 40% (1,500,000)
tax effect of $200,000) (300,000)
Income before extraordinary item and the $4,050,000
cumulative effect of a change in accounting principle
Extraordinary item:
Gain on sale of subsidiary over book value $40,000
Less: Tax effect (40%) 16,000 24,000
Income after extraordinary item $4,074,000
Net income $4,074,000
Earnings per share of common stock:
Income from continuing operations $ 5,550
Discontinued operations (1.500)
Extraordinary item 0.024
Net income $4.074

Exhibit 12: Income statement

Net income inclusions and exclusions

Accounting has long faced the problem of what to include in the net income reported for a period. Should net
income include only the revenues and expenses related to normal operations? Or should it include the results of
discontinued operations and unusual, nonrecurring gains and losses? And further, should the determination of net
income for 2010, for example, include an item that can be clearly associated with a prior year, such as additional
federal income taxes for 2009? Or should such items, including corrections of errors, be carried directly to retained
earnings? How are the effects of making a change in accounting principle to be reported?
APB Opinion No. 9 (December 1966) sought to provide answers to some of these questions. The Opinion
directed that unusual and nonrecurring items having an earnings or loss effect are extraordinary items (reported in
the income statement) or prior period adjustments (reported in the statement of retained earnings). Extraordinary
items are reported separately after net income from regular continuing activities.
In Exhibit 12 and Exhibit 14, we show the reporting of discontinued operations, extraordinary items, and prior
period adjustments. For Exhibit 12 and Exhibit 14, assume that the Anson Company has 1,000,000 shares of
common stock outstanding and the company's earnings are taxed at 40 per cent. Also, assume the following:
• Anson sold its Cosmetics Division on 2010 August 1, at a loss of USD 500,000. The net operating loss of
that division through 2010 July 31, was USD 2,000,000.
• Anson had a taxable gain in 2010 of USD 40,000 from a sale of a subsidiary at an amount greater than
what was on the company's balance sheet (extraordinary item).
• In 2010, Anson discovered that the USD 200,000 cost of land acquired in 2009 had been expensed for both
financial accounting and tax purposes. A prior period adjustment was made in 2010.
Next, we explain the effects of these assumptions in greater detail.
A discontinued operation occurs when a business sells a segment (usually an unprofitable department or
division) to another company or abandons it. When a company discontinues a segment, it shows the relevant

60
information in a special section of the income statement immediately after income from continuing operations and
before extraordinary items. Two items of information appear:
• The income or loss (net of tax effect) from the segment's operations for the portion of the current year
before it was discontinued.
• The gain or loss (net of tax effect) on disposal of the segment.
To illustrate, Anson's sale of its Cosmetics Division on August 1 led to a before-tax loss of USD 500,000. The
after-tax loss was USD 500,000 X 60 per cent = USD 300,000. The operating loss before taxes through July 31 was
USD 2,000,000. The after-tax operating loss for that period was USD 2,000,000 X 60 per cent = USD 1,200,000.
Note this information on the income statement in Exhibit 12.
Prior to 1973, companies reported a gain or loss as an extraordinary item if it was either unusual in nature or
occurred infrequently. As a result, companies were inconsistent in the financial reporting of certain gains and
losses. This inconsistency led to the issuance of APB Opinion No. 30 (September 1973). Opinion No. 30 redefined
extraordinary items as those unusual in nature and occurring infrequently. Note that both conditions must be
met—unusual nature and infrequent occurrence. Accountants determine whether an item is unusual and infrequent
in light of the environment in which the company operates. Examples of extraordinary items include gains or losses
that are the direct result of a major catastrophe (a flood or hurricane where few have occurred before), a
confiscation of property by a foreign government, or a prohibition under a newly enacted law.
Extraordinary items are included in the determination of periodic net income, but are disclosed separately (net
of their tax effects) in the income statement below "Income from continuing operations". As shown in Exhibit 12,
Anson reported the extraordinary items after reporting the loss from discontinued operations.
Gains or losses related to ordinary business activities are not extraordinary items regardless of their size. For
example, material write-downs of uncollectible receivables, obsolete inventories, and intangible assets are not
extraordinary items. However, such items may be separately disclosed as part of income from continuing
operations.
2006 2005 2004 2003
Nature
Debt extinguishments 4 40 70 48
Other* 8 2 8 7
Total Extraordinary Items 12 42 78 55

Number of Companies
Presenting extraordinary items 12 42 78 55
Not presenting extraordinary items 588 588 522 545
Total Companies 600 600 600 600
*For the current year, the nature of
the other items included casualty
losses and gains from asset
disposals.

Exhibit 13: Extraordinary items

In Exhibit 13, note that in a sample of 600 companies for the years 2000-2003, most companies do not report
extraordinary items.
Changes in accounting principle can materially alter a company's reported net income and financial position.
Changes in accounting principle are changes in accounting methods pertaining to such items as inventory.
Such a change includes a change in inventory valuation method from FIFO to LIFO.

Introduction to Accounting : The Language of Business – Supplemental Textbook 61

 According to APB Opinion No. 20, a company should consistently apply the same accounting methods from one
period to another. However, a company may make a change if the newly adopted method is preferable and if the
change is adequately disclosed in the financial statements. In the period in which a company makes a change in
accounting principle, it must disclose on the financial statements the nature of the change, its justification, and its
effect on net income. Also, the company must show on the income statement for the year of the change and the
cumulative effect of the change on prior years' income (net of tax).
According to FASB Statement No. 16, prior period adjustments consist almost entirely of corrections of
errors in previously published financial statements. Corrections of abnormal, nonrecurring errors that may have
been caused by the improper use of an accounting principle or by mathematical mistakes are prior period
adjustments. Normal, recurring corrections and adjustments, which follow inevitably from the use of estimates in
accounting practice, are not treated as prior period adjustments. Also, mistakes corrected in the same year they
occur are not prior period adjustments. To illustrate a prior period adjustment, suppose that Anson purchased land
i n 2009 at a total cost of USD 200,000 and recorded this amount in an expense account instead of in the Land
account. Discovery of the error on 2010 May 1, after publication of the 2009 financial statements, would require a
prior period adjustment. The adjustment would be recorded directly in the Retained Earnings account. Assuming
the error had resulted in an USD 80,000 underpayment of taxes in 2009, the entry to correct the error would be:
May 1 Land (+A) 200,000
Federal income taxes payable (+L) 80,000
Retained earnings (or prior period 120,000
adjustments – Land) (+SE)
To correct an accounting error expensing
land.

An ethical perspective:
Ace chemical company

Ace Chemical Company is a small, privately held manufacturer that has been operating at a profit
for years. The current balance in the Cash account is USD 8 million, and the balance in Retained
Earnings is USD 4 million. The company's plant assets consist of special purpose equipment that
can produce only certain chemicals. The company has long-term debt with a principal balance of
USD 10 million. Its officers (all of whom are stockholders) are concerned about the future prospects
of the company. Many similar firms have been sued by customers and employees claiming that
toxic chemicals produced by the company caused their health problems. No such suits have yet
been filed against Ace, but the officers fully expect them to be filed within the next two years.
The company's stock is not listed on a stock exchange, nor has it recently been traded. The officers
hold 70 per cent of the stock and estimate that their total stockholdings have a current market value
of about USD 8 million (although its value would be much lower if all the facts were known). They
are worried that if suits are filed and the company loses, there will not even be enough remaining
assets to satisfy creditors' claims, and the officers' stock would be worthless. Private legal counsel
has informed the officers that the company is likely to lose any suits that are filed.
One of the officers suggested that they could at least receive something for their stock by having the
company buy half of the shares held by the officers at a total price of USD 4 million. Another officer
asked if such a treasury stock transaction would be legal. The response was that the transaction

62
 would be legal because it did not dip into the present legal capital of the company. Retained
earnings would be reduced to a zero balance, but would not develop a debit balance as a result of
the transaction.

Prior period adjustments do not appear on the income statements but in the current-year financial statements
as adjustments to the opening balance of retained earnings on the statement of retained earnings (Exhibit 14).
Most discontinued operations, extraordinary items, changes in accounting principle, and prior period
adjustments affect the amount of income taxes a corporation must pay. To report the income tax effect, FASB
Statement No. 96 requires reporting all of these items net of their tax effects, as shown in Exhibit 12 and Exhibit
14.6 Net-of-tax effect means that items appear at the dollar amounts remaining after deducting the income tax
effects. Thus, the total effect of a discontinued operation, an extraordinary item, a change in accounting principle,
or a prior period adjustment appears in one place in the appropriate financial statement. The reference to "Income
from continuing operations" on the income statement represents the results of transactions (including income
taxes) that are normal for the business and may be expected to recur. Note that the tax effect of an item may appear
separately, as it does for the gain on voluntary early retirement of deb t in Exhibit 12. Or the company may mention
it parenthetically with only the net amount shown (see loss from discontinued operations and change in accounting
principle in Exhibit 12 and correction of error in Exhibit 14).
Anson Company
Statement of Retained Earnings
For the Year Ended 2010 December 31
Retained earnings, 2010 January 1 $5,000,000
Prior period adjustment:
Correction of error of expensing land (net of tax 120,000
effect of $80,000)
Retained earnings, 2010 January 1, as adjusted $5,120,000
Add: Net income 4,077,600
$9,197,600
Less: Dividends 500,000
Retained earnings, 2010 December 31 $8,687,600

Exhibit 14: Statement of retained earnings

• Income from continuing operations of USD 5,550,000 (Exhibit 12) is more representative of the continuing
earning power of the company than is the net income figure of USD 4,077,600.
• Following income, the special items from continuing operations appear at their actual impact on the
company—that is, net of their tax effect.
• EPS is reported both before (USD 5.550) and after (USD 4.078) the discontinued operations, extraordinary
item, and the cumulative effect of a change in accounting principle (Exhibit 12).
• The correction of the USD 200,000 error adds only USD 120,000 to retained earnings ( Exhibit 14). This
result occurs because the mistake was included in the 2009 tax return and taxes were underpaid by USD
80,000. In the 2010 return, the USD 80,000 of taxes would have to be paid.

6 FASB, Statement of Financial Accounting Standards No. 96, "Accounting for Income Taxes" (Stamford. Conn.,
1987). Copyright © by the Financial Accounting Standards Board, High Ridge Park, Stamford, Connecticut
06905, U.S.A.

Introduction to Accounting : The Language of Business – Supplemental Textbook 63

 Analyzing and using the financial results—Earnings per share and price-earnings ratio
A major item of interest to investors and potential investors is how much a company earned during the current
year, both in total and for each share of stock outstanding. Firms calculate the earnings per share amount only for
the common shares of ownership. They compute earnings per share (EPS) as net income available to common
stockholders divided by the average number of common shares outstanding during that period. Income available
to common stockholders is net income less any dividends on preferred stock. They deduct the regular preferred
dividend on cumulative preferred stock (but not a dividend in arrears) whether or not declared; however, they
deduct only declared dividends on noncumulative preferred stock.
To illustrate, Sun Microsystems, Incorporated, had 3,417,000,000 weighted-average common shares
outstanding with income available to common shareholders of USD 922,590,000 during a recent year. Sun would
compute EPS as follows:
Income available for common stockholders
EPS=
Weighted−average number of common sharesoutstanding
USD 922,590,000
=
3,417,000,000
= USD 0.27 per share
Firms calculate EPS for each major category on the face of the income statement. In other words, they make an
EPS calculation for income from continuing operations, discontinued operations, extraordinary items, changes in
accounting principle, and net income. Note in Exhibit 12 that Anson reports the EPS amounts at the bottom of its
income statement.
The price-earnings ratio (current market price per share of common stock divided by EPS) provides an index
on whether a stock has future high income potential compared to other stocks. Stocks with future high income
potential tend to have a high price-earnings ratio.
In the financial highlights of Kimball International, Incorporated's, recent annual report, the market price at
year-end was USD 16.00. Earnings per share were USD .93 (average of class A & B common stock). Kimball would
compute its price-earnings ratio that day as follows:
Current market price per shareof common stock
Price−earnings ratio=
EPS
USD 16.00
=
USD 0.93
= USD 17.20
This chapter completes the study of stockholders' equity.
Understanding the learning objectives
• Paid-in capital is presented in the stockholders' equity section of the balance sheet. Each source of paid-in
capital is listed separately.
• Sources of paid-in capital are:
(a) Common stock.
(b) Preferred stock.
(c) In excess of par value or stated value (common and preferred).
(d)Stock dividends.
(e) Treasury stock transactions.

64
 (f) Donations.
• Cash dividend of 3 per cent on USD 100,000 of outstanding common stock: declared on July 1 and paid on
September 15.
July 1 Retained earnings (-SE) 3,000
Dividends payable (+L) 3,000

Sept. 15 Dividends payable (-L) 3,000

Cash (-A) 3,000

Ten per cent stock dividend on 10,000 shares of common stock outstanding; par value, USD 100; market value
at declaration, USD 125 per share (declared on January 1 and paid on February 1).
Jan. 1 Retained earnings (1,000 shares x 125,000
$125) (-SE)
Stock dividends distributable –
Common 100,000
(1,000 shares x $100) (+SE)
Paid-in Capital – Stock dividends
(1,000 shares x $25) (+SE) 25,000

Feb. 1 Stock dividend distributable – 100,000

Common (-SE)
Common stock (+SE) 100,000

• Thirty per cent stock dividend on 10,000 shares of common stock outstanding: declared on January 1 and
payable on February 1; par value, USD 100.
Jan. 1 Retained earnings (3,000 shares x 300,000
$100) (-SE)
Stock dividend distributable – 300,000
Common (+SE)
Feb. 1 Stock dividend distributable – 300,000
Common (+SE)
Common stock (-SE) 300,000

• Stock split: 1,000 shares of USD 50 par value common stock replaced by 2,000 shares of USD 25 par value
common stock.
Common stock - $50 par 50,000
value (-SE)
Common stock - $25 par 50,000
value (+SE)

• Retained earnings appropriation: USD 75,000 appropriated for plant expansion.

Retained earnings (-SE) 75,000
Retained earnings appropriated for plant 75,000
expansion (+SE)

• Treasury stock transactions: 100 shares of common stock were reacquired at USD 100 each and reissued
for USD 105 each.
Treasury stock – Common (100 shares x $100) 10,000
Cash 10,000
Cash (100 shares x $105) 10,500
Treasury stock – Common (100 shares x 10,000
$100)
Paid-in Capital – Common treasury stock
transactions 500
(100 shares x $5)

• The income or loss (net of tax effect) from the segment's operations for the portion of the current year
before it was discontinued is reported on the income statement below "Income from continuing operations".
• The gain or loss (net of tax effect) on disposal of the segment is also reported in that same section of the
income statement.

Introduction to Accounting : The Language of Business – Supplemental Textbook 65

 • Extraordinary items are both unusual in nature and infrequent in occurrence. Extraordinary items appear
on the income statement (net-of-tax effect) below "Income from continuing operations".
• In the period in which a change in principle is made, the nature of the change, its justification, and its effect
on net income must be disclosed in the financial statements. Also, the cumulative effect of the change on prior
years' income (net of tax effect) must be shown on the income statement for the year of the change below
"Income from continuing operations".
• Prior period adjustments consist of errors in previously published financial statements. Prior period
adjustments appear (net-of-tax effect) as a correction to the beginning retained earnings balance on the
statement of retained earnings.
• EPS equals the income available to common stockholders divided by the weighted-average number of
common shares outstanding. Income available to common stockholders is net income less any dividends on
preferred stock. EPS provides information on the return of an investment in common stock.
• The price-earnings ratio equals the current market price per share of common stock divided by EPS. The
price-earnings ratio indicates whether a stock has a future high income potential as compared to other stocks.
Demonstration problem
Demonstration problem A Wylie Corporation has outstanding 10,000 shares of USD 150 par value common
stock.
Prepare the entries to record:
a. The declaration of a cash dividend of USD 1.50 per share.
b. The declaration of a stock dividend of 10 per cent at a time when the market value per share is USD 185.
c. The declaration of a stock dividend of 40 per cent at a time when the market value per share is USD 195.
Demonstration problem B Following are selected transactions of Brackett Company:
• The company reacquired 200 shares of its own USD 100 par value common stock, previously issued at USD
105 per share, for USD 20,600.
• Fifty of the treasury shares were reissued at USD 110 per share, cash.
• Seventy of the treasury shares were reissued at USD 95 per share, cash.
• Stockholders of the corporation donated 100 shares of their common stock to the company.
• The 100 shares of treasury stock received by donation were reissued for USD 9,000.
Prepare the necessary journal entries to record these transactions.
Demonstration problem C Selected account balances of Nexis Corporation at 2010 December 31, are:
Common stock (nor par value; 100,000 shares authorized, issued, and
outstanding; stated value of USD 20 per share USD 2,000,000
Retained earnings 570,000
Dividends payable (in cash, declared December 15 on preferred stock) 16,000
Preferred stock (8 per cent, par value USD 200; 1,000 shares
authorized, issued, and outstanding) 200,000
Paid-In capital from donation of plant site 100,000
Paid-in capital in excess of par value – preferred 8,000

Present in good form the stockholders' equity section of the balance sheet.
Solution to demonstration problem
Solution to demonstration problem A
a. Retained earnings (or dividends) (-SE) 15,000
Dividends payable (+L) 15,000

66
 To record declaration of a cash dividend.
b.
Retained earnings (or stock dividends)
(1,000 shares x $185) (-SE) 185,000
Stock dividend distributable – Common
(1,000 shares x $150) (+L) 150,000
Paid-in capital – Stock dividends(+SE) 35,000
To record declaration of a small stock dividend
(10%).
c.
Retained earnings (or stock dividends) (4,000 600,000
shares x $150) (-SE)
Stock dividend distributable – Common (+L) 600,000
To record declaration of a large stock dividend
(40%).

Solution to demonstration problem B

1. Treasury stock (-SE) 20,600
Cash (-A) 20,600
Acquired 200 shares at $20,600 ($103 per
share).

2. Cash (50 shares x $110) (+A) 5,500

Treasury stock – Common (50 shares x 5,150
$103) (+SE)
Paid-in capital – common treasury stock 350
transactions (+SE)
Reissued 50 shares at $110 per share; cost is
$5,150.

3. Cash (70 shares x $95) (+A) 6,650

Paid-in capital – Common treasury stock
transactions 350
(50 shares x $7) (-SE)
Retained earnings (-SE) 210
Treasury stock – common (70 shares x 7,210
$103) (+SE)
Reissued 70 shares at $95 per share; cost is
$7,210.

4. Stockholders donated 100 shares of common stock to the company. (Only memo entry is made.)
5. Cash (+A) 9,000
Paid-in capital – Donations (100 shares 9,000
x $90) (+SE)
Reissued donated shares at $90 per
share.

Solution to demonstration problem C

Nexis Corporation
Partial balance sheet
2010 December 31
Stockholders' equity:
Paid-in capital:
Preferred stock – 8%, par value $200; 1,000 $200,000
shares authorized, issued, and outstanding
Common stock – no par value, stated value of 2,000,000
$20 per share; 100,000 shares authorized,
issued, and outstanding
Paid-in capital from donation of plant site 100,000
Paid-in capital in excess of par value – 8,000
preferred
Total paid-in capital $2,308,0
00
Retained earnings 570,000
Total stockholders' equity $2,878,0
00
Key terms
Cash dividends Cash distributions of accumulated earnings by a corporation to its stockholders.

Introduction to Accounting : The Language of Business – Supplemental Textbook 67

Changes in accounting principle Changes in accounting methods pertaining to such items as inventory.
Contributed capital See paid-in capital.
Date of declaration (of dividends) The date the board of directors takes action in the form of a motion
that dividends be paid.
Date of payment (of dividends) The date of actual payment of a dividend, or issuance of additional
shares for a stock dividend.
Date of record (of dividends) The date of record established by the board that determines the
stockholders who will receive dividends.
Deficit A debit balance in the Retained Earnings account.
Discontinued operation When a segment of a business is sold to another company or is abandoned.
Dividends Distribution of earnings by a corporation to its stockholders.
Dividends (cash) See cash dividends.
Dividends (stock) See stock dividends.
Donated capital Results from donation of assets to the corporation, which increases stockholders' equity.
Earnings per share (EPS) Earnings to the common stockholders on a per share basis, computed as
income available to common stockholders divided by the weighted-average number of common shares
outstanding.
Extraordinary items Items both unusual in nature and infrequent in occurrence; reported in the income
statement net of their tax effects, if any.
Income available to common stockholders Net income less any dividends on preferred stock.
Liquidating dividends Dividends that are a return of contributed capital, not a distribution chargeable to
retained earnings.
Net-of-tax effect Used for discontinued operations, extraordinary items, changes in accounting principle,
and prior period adjustments, whereby items are shown at the dollar amounts remaining after deducting the
effects of such items on income taxes, if any, payable currently.
Paid-in capital All of the contributed capital of a corporation, including that carried in capital stock
accounts. When the words paid-in capital are included in the account title, the account contains capital
contributed in addition to that assigned to the shares issued and recorded in the capital stock accounts.
Paid-In Capital—Common (Preferred) Treasury Stock Transactions The account credited when
treasury stock is reissued for more than its cost; this account is debited to the extent of its credit balance
when such shares are reissued at less than cost.
Price-earnings ratio The current market price per share of common stock divided by EPS.
Prior period adjustments Consist almost entirely of corrections of errors in previously published
financial statements. Prior period adjustments are reported in the statement of retained earnings net of their
tax effects, if any.
Retained earnings That part of stockholders' equity resulting from accumulated earnings; the account to
which the results of corporate activity, including prior period adjustments, are carried and to which
dividends and certain items resulting from capital transactions are charged.
Retained earnings appropriations Contractual or voluntary restrictions or limitations on retained
earnings that reduce the amount of dividends that may be declared.
Statement of retained earnings A formal statement showing the items causing changes in
unappropriated and appropriated retained earnings during a stated period of time.
Statement of stockholders' equity A summary of the transactions affecting the accounts in the
stockholders' equity section of the balance sheet during a stated period of time.
Stock Dividend Distributable—Common account The stockholders' equity (paid-in capital) account
that is credited for the par or stated value of the shares distributable when recording the declaration of a
stock dividend.
Stock dividends Dividends that are payable in additional shares of the declaring corporation's capital
stock.
Stock split A distribution of 100 per cent or more of additional shares of the issuing corporation's stock,
accompanied by a corresponding reduction in the par value per share. The purpose of a stock split is to cause
a large reduction in the market price per share of the outstanding stock.

68
 Treasury stock Shares of capital stock issued and reacquired by the issuing corporation; they have not been
formally canceled and are available for reissuance.
Self-test
True-false
Indicate whether each of the following statements is true or false.
The retained earnings balance of a corporation is part of its paid-in capital.
The purchase of treasury stock does not affect stockholders' equity.
Dividends are expenses since they decrease stockholders' equity.
A stock dividend reduces the retained earnings balance and permanently capitalizes the reduced portion of the
retained earnings.
A retained earnings appropriation reduces the total stockholders' equity shown on the balance sheet.
Heavy frost damage suffered by a Florida citrus grower's orange trees would probably be reported as an
extraordinary item.
Multiple-choice
Select the best answer for each of the following questions.
Which of the following is not included in paid-in capital?
a. Common Stock.
b. Paid-In Capital—Donations.
c. Stock Dividend Distributable.
d. Appropriation per Loan Agreement.
Bevins Company issued 10,000 shares of USD 20 par value common stock at USD 24 per share. Bevins
reacquired 1,000 shares of its own stock at a cost of USD 30 per share. The entry to record the reacquisition is:
a. Premium on Treasury Stock (-SE) 10,000
Treasury stock (-SE) 20,000
Cash (-A) 30,000

b. Premium on Treasury Stock (-SE) 6,000

Treasury stock (-SE) 24,000
Cash (-A) 30,000

c. Treasury Stock (-SE) 30,000

Cash (-A) 30,000

d. Treasury stock (-SE) 20,000

Paid-In Capital – Treasury Stock
Transactions (-SE) 10,000
Cash (-A) 30,000

If the company reissues 500 shares of the treasury stock in (2) for USD 36 per share, the entry is:
a. Cash (+A) 18,000
Treasury Stock (+SE) 15,000
Paid-In Capital – Treasury
Stock Transactions (+SE) 3,000

b. Cash (+A) 18,000

Treasury stock (+SE) 18,000

c. Cash (+A) 18,000

Treasury stock (+SE) 15,000
Retained earnings (+SE) 3,000

d. Cash (+A) 18,000

Treasury stock (+SE) 10,000

Introduction to Accounting : The Language of Business – Supplemental Textbook 69

 Retained earnings (+SE) 8,000

Treasury stock should be shown on the balance sheet as a:

a. Reduction of the corporation's stockholders' equity.
b. Current asset.
c. Current liability.
d. Investment asset.
An individual stockholder is entitled to receive any dividends declared on stock owned, provided the stock is
held on the:
a. Date of declaration.
b. Date of record.
c. Date of payment.
d. Last day of a fiscal year.
ABC Corporation declared the regular quarterly dividend of USD 2 per share. ABC had issued 12,000 shares and
subsequently reacquired 2,000 shares as treasury stock. What would be the total amount of the dividend?
a. USD 24,000.
b. USD 28,000.
c. USD 20,000.
d. USD 4,000.
Which item is not reported as a separate line item below income from continuing operations, net of tax effects,
in the income statement?
a. Extraordinary items.
b. Prior period adjustments.
c. Discontinued operations.
d. Changes in accounting principle.
Now turn to “Answers to self-test” at the end of the chapter to check your answers.

Questions
➢ What are the two main elements of stockholders' equity in a corporation? Explain the difference
between them.
➢ Name several sources of paid-in capital. Would it suffice to maintain one account called Paid-In
Capital for all sources of paid-in capital? Why or why not?
➢ Does accounting for treasury stock resemble accounting for an asset? Is treasury stock an asset? If
not, where is it properly shown on a balance sheet?
➢ What are some possible reasons for a corporation to reacquire its own capital stock as treasury stock?
➢ What is the purpose underlying the statutes that provide for restriction of retained earnings in the
amount of the cost of treasury stock? Are such statutes for the benefit of stockholders, management,
or creditors?
➢ What is the effect of each of the following on the total stockholders' equity of a corporation: (a)
declaration of a cash dividend, (b) payment of a cash dividend already declared, (c) declaration of a
stock dividend, and (d) issuance of a stock dividend already declared?

70
 ➢ The following dates are associated with a cash dividend of USD 80,000: July 15, July 31, and August
15. Identify each of the three dates, and give the journal entry required on each date, if any.
➢ How should a declared but unpaid cash dividend be shown on the balance sheet? How should a
declared but unissued stock dividend be shown?
➢ On May 8, the board of directors of Park Corporation declared a dividend, payable on June 5, to
stockholders of record on May 17. On May 10, James sold his capital stock in Park Corporation
directly to Benton for USD 20,000, endorsing his stock certificate and giving it to Benton. Benton
placed the stock certificate in her safe. On May 30, Benton sent the certificate to the transfer agent of
Park Corporation for transfer. Who received the dividend? Why?
➢ What are the possible reasons for a corporation to declare a stock dividend?
➢ Why is a dividend consisting of the distribution of additional shares of the common stock of the
declaring corporation not considered income to the recipient stockholders?
➢ What is the difference between a small stock dividend and a large stock dividend?
➢ What are liquidating dividends?
➢ What is the purpose of a retained earnings appropriation?
➢ What is a statement of stockholders' equity?
➢ Describe a discontinued operation.
➢ What are extraordinary items? Where and how are they reported?
➢ Give an example of a change in accounting principle. How are the effects of changes in accounting
principle reported?
➢ What are prior period adjustments? Where and how are they reported?
➢ Why are stockholders and potential investors interested in the amount of a corporation's EPS? What
does the EPS amount reveal that total earnings do not.
Exercises
Exercise A The 2009 December 31, trial balance of Yamey Corporation had the following account balances:
Common stock (no-par value; 200,000 shares authorized, issued, and
outstanding; stated value of $20 per share) $4,000,000
Notes payable (12% due 2010 May 1) 500,000
Retained earnings, unappropriated 2,500,000
Dividends payable in cash (declared December 15, on preferred stock)12,000
Appropriation per loan agreement 480,000
Preferred stock (6%, par value $200; 2,000 shares authorized, issued,
and outstanding) 400,000
Paid-In capital in excess of stated value – Common 300,000
Paid-In Capital in Excess of Par Value – Preferred 40,000

Present in proper form the stockholders' equity section of the balance sheet.
Exercise B Fogg Company has issued all of its authorized 5,000 shares of USD 400 par value common stock.
On 2009 February 1, the board of directors declared a dividend of USD 12 per share payable on 2009 March 15, to
stockholders of record on 2009 March 1. Give the necessary journal entries.
Exercise C The stockholders' equity section of Jay Company's balance sheet on 2009 December 31, shows
100,000 shares of authorized and issued USD 20 stated value common stock, of which 9,000 shares are held in the
treasury. On this date, the board of directors declared a cash dividend of USD 2 per share payable on 2010 January
21, to stockholders of record on January 10. Give dated journal entries for these.

Introduction to Accounting : The Language of Business – Supplemental Textbook 71

 Exercise D Kevin Company has outstanding 75,000 shares of common stock without par or stated value, which
were issued at an average price of USD 80 per share, and retained earnings of USD 3,200,000. The current market
price of the common stock is USD 120 per share. Total authorized stock consists of 500,000 shares.
a. Give the required entry to record the declaration of a 10 per cent stock dividend.
b. If, alternatively, the company declared a 30 per cent stock dividend, what additional information would you
need before making a journal entry to record the dividend?
Exercise E Grant Corporation's stockholders' equity consisted of 60,000 authorized shares of USD 30 par
value common stock, of which 30,000 shares had been issued at par, and retained earnings of USD 750,000. The
company then split its stock, two for one, by changing the par value of the old shares and issuing new USD 15 par
shares.
a. Give the required journal entry to record the stock split.
b. Suppose instead that the company declared and later issued a 10 per cent stock dividend. Give the required
journal entries, assuming that the market value on the date of declaration was USD 40 per share.
Exercise F The balance sheet of Willis Company contains the following:
Appropriation per loan agreement USD 900,000
a. Give the journal entry made to create this account.
b. Explain the reason for the appropriation's existence and its manner of presentation in the balance sheet.
Exercise G Kelly Company had outstanding 50,000 shares of USD 20 stated value common stock, all issued at
USD 24 per share, and had retained earnings of USD 800,000. The company reacquired 2,000 shares of its stock
for cash at book value from the widow of a deceased stockholder.
a. Give the entry to record the reacquisition of the stock.
b. Give the entry to record the subsequent reissuance of this stock at USD 50 per share.
c. Give the entry required if the stock is instead reissued at USD 30 per share and there were no prior treasury
stock transactions.
Exercise H Evan Company received 200 shares of its USD 200 stated value common stock on 2009 December
1, as a donation from a stockholder. On 2009 December 15, it reissued the stock for USD 62,400 cash. Give the
journal entry or entries necessary for these transactions.
Exercise I Vista Company has revenues of USD 80 million, expenses of USD 64 million, a tax-deductible
earthquake loss (its first such loss) of USD 4 million, and a tax-deductible loss of USD 6 million resulting from the
voluntary early extinguishment (retirement) of debt. The assumed income tax rate is 40 per cent. The company's
beginning-of-the-year retained earnings were USD 30 million, and a dividend of USD 2 million was declared.
a. Prepare an income statement for the year.
b. Prepare a statement of retained earnings for the year.
Exercise J Conner Company had retained earnings of USD 56,000 as of 2009 January 1. In 2009, Conner
Company had sales of USD 160,000, cost of goods sold of USD 96,000, and other operating expenses, excluding
taxes, of USD 32,000. In 2009, Conner Company discovered that it had, in error, depreciated land over the last
three years resulting in a balance in the accumulated depreciation account of USD 40,000. The assumed tax rate for
Conner Company is 40 per cent. Present in proper form a statement of retained earnings for the year ended 2009
December 31.
Exercise K The following information relates to Perry Corporation for the year ended 2009 December 31:

72
Common stock outstanding 75,000 shares
Income from continuing operations $1,523,200
Loss on discontinued operations (net of
tax) 240,000
Extraordinary gain (net of tax) 144,000

Calculate EPS for the year ended 2009 December 31. Present the information in the same format used in the
corporation's income statement.
Exercise L Dean Company had an average number of shares of common stock outstanding of 200,000 in 2009
and 215,000 in 2010. Net income for these two years was as follows:
2009 $2,208,000
2010 2,304,000

a. Calculate EPS for the years ended 2009 December 31, and 2010.
b. What might the resulting figures tell a stockholder or a potential investor?
Problems
Problem A The bookkeeper of Hart Company has prepared the following incorrect statement of stockholders'
equity for the year ended 2009 December 31:
Stockholders' equity:
Paid-In Capital:
Preferred stock – 6%, cumulative (8,000 $1,003,200
shares)
Common stock – 50,000 shares 2,856,000
Total paid-in capital $3,859,200
Retained earnings 1,636,800
Total stockholders' equity $5,496,000

The authorized stock consists of 12,000 shares of preferred stock with a USD 120 par value and 75,000 shares of
common stock, USD 48 par value. The preferred stock was issued on two occasions: (1) 5,000 shares at par, and (2)
3,000 shares at USD 134.40 per share. The 50,000 shares of common stock were issued at USD 62.40 per share.
Five thousand shares of treasury common stock were reacquired for USD 264,000. The bookkeeper deducted the
cost of the treasury stock from the Common Stock account.
Prepare the correct stockholders' equity section of the balance sheet at 2009 December 31.
Problem B The only stockholders' equity items of Jody Company at 2009 June 30, are:
Stockholders' equity:
Paid-in capital:
Common stock - $200 par value, 10,000 $1,200,000
shares authorized, 6,000 shares issued and
outstanding
Paid-in capital in excess of par value 480,000
Total paid-in capital $1,680,000
Retained earnings 480,000
Total stockholders' equity $2,160,000

On 2009 August 4, a 4 per cent cash dividend was declared, payable on September 3. On November 16, a 10 per
cent stock dividend was declared. The shares were issued on December 1. The market value of the common stock
was USD 360 per share on November 16 and USD 354 per share on December 1.
Prepare journal entries for these dividend transactions.
Problem C Following are selected transactions of White Corporation:
2002
Dec. 31 The board of directors authorized the appropriation of USD 50,000 of retained earnings to provide for
the future acquisition of a new plant site and the construction of a new building. (On the last day of the next six
years, the same action was taken. You need not make entries for these six years.)

Introduction to Accounting : The Language of Business – Supplemental Textbook 73

 2007
Jan. 2 Purchased a new plant site for cash, USD 100,000.
Mar. 29 Entered into a contract for construction of a new building, payment to be made within 30 days following
completion.
2009
Feb. 10 Following final inspection and approval of the new building, Dyer Construction Company was paid in
full, USD 500,000.
Mar. 10 The board of directors authorized release of the retained earnings appropriated for the plant site and
building.
Apr. 2 A 5 per cent stock dividend on the 100,000 shares of USD 50 par value common stock outstanding was
declared. The market price on this date was USD 55 per share.
Prepare journal entries for all of these transactions.
Problem D Following are selected data of Kane Corporation at 2009 December 31:
Net income for the year $512,000
Dividends declared on preferred stock 72,000
Retained earnings appropriated during the year for future plant
expansion 240,000
Dividends declared on common stock 64,000
Retained earnings, January 1, unappropriated 720,000
Directors ordered that the balance in the “Appropriation per loan
agreement”, related to a loan repaid on 2009 March 31, be returned
to unappropriated retained earnings 480,000

Prepare a statement of retained earnings for the year ended 2009 December 31.
Problem E The stockholders' equity of Sayers Company at 2009 January 1, is as follows:
Common stock – no-par value, stated value of
$20; 100,000 shares authorized, 60,000
shares issued $1,200,000
Paid-in capital in excess of stated value 200,000
Appropriation per loan agreement 75,200
Unappropriated retained earnings 424,000
Treasury stock (3,000 shares at cost) (72,000)

During 2009, the following transactions occurred in the order listed:

• Issued 10,000 shares of stock for USD 368,000.
• Declared a 4 per cent stock dividend when the market price was USD 48 per share.
• Sold 1,000 shares of treasury stock for USD 43,200.
• Issued stock certificates for the stock dividend declared in transaction 2.
• Bought 2,000 shares of treasury stock for USD 67,200.
• Increased the appropriation by USD 43,200 per loan agreement.
Prepare journal entries as necessary for these transactions.
Problem F The stockholders' equity of Briar Company on 2008 December 31, consisted of 1,000 authorized,
issued, and outstanding shares of USD 72 cumulative preferred stock, stated value USD 240 per share, which were
originally issued at USD 1,192 per share; 100,000 shares authorized, issued, and outstanding of no-par, USD 160
stated value common stock, which were originally issued at USD 160; and retained earnings of USD 1,120,000.
Following are selected transactions and other data relating to 2009. No previous treasury stock transactions had
occurred.
• The company reacquired 2,000 shares of its common stock at USD 336.

74
 • One thousand of the treasury shares were reissued at USD 288.
• Stockholders donated 1,000 shares of common stock to the company. These shares were immediately
reissued at USD 256 to provide working capital.
• The first quarter's dividend of USD 18 per share was declared and paid on the preferred stock. No other
dividends were declared or paid during 2009.
The company suffered a net loss of USD 224,000 for the year 2009.
a. Prepare journal entries for the preceding numbered transactions.
b. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Problem G The following stockholders' equity section is from Bell Company's 2008 October 31, balance sheet:
Stockholders' equity:
Paid-in capital:
Preferred stock - $60 par value, 6%; 1,000 $ 21,000
shares authorized; 350 shares issued and
outstanding
Common stock - $6 par value; 100,000 240,000
shares authorized; 40,000 shares issued and
outstanding
Paid-in capital from donation of plant site 15,000
Total paid-in capital $276,000
Retained earnings:
Appropriated:
Appropriation for contingencies $ 12,000
Unappropriated 33,300
Total retained earnings 45,300
Total stockholders' equity $321,300

During the ensuing fiscal year, Bell Company entered into the following transactions:
• The appropriation of USD 12,000 of retained earnings had been authorized in October 2008 because of the
likelihood of an unfavorable court decision in a pending lawsuit. The suit was brought by a customer seeking
damages for the company's alleged breach of a contract to supply the customer with certain products at stated
prices in 2007. The suit was concluded on 2009 March 6, with a court order directing the company to pay USD
10,500 in damages. These damages were not deductible in determining the income tax liability. The board
ordered the damages paid and the appropriation closed. The loss does not qualify as an extraordinary item.
• The company acquired 1,000 shares of its own common stock at USD 9 in May 2009. On June 30, it
reissued 500 of these shares at USD 7.20.
• Dividends declared and paid during the year were 6 per cent on preferred stock and 18 cents per share on
common stock. Both dividends were declared on September 1 and paid on 2009 September 30.
For the fiscal year, the company had net income after income taxes of USD 11,400, excluding the loss of the
lawsuit.
a. Prepare journal entries for the preceding numbered transactions.
b. Prepare a statement of retained earnings for the year ended 2009 October 31.
c. Prepare the stockholders' equity section of the 2009 October 31, balance sheet.
Problem H Selected data for Brinks Company for 2009 are given below:
Common stock - $20 par value $2,000,000
Sales, net 1,740,000
Selling and administrative expenses 320,000
Cash dividends declared and paid 120,000
Cost of goods sold 800,000
Depreciation expense 120,000
Interest revenue 20,000

Introduction to Accounting : The Language of Business – Supplemental Textbook 75

Loss on write-down of obsolete inventory 40,000
Retained earnings (as of 2008/12/31) 2,000,000
Operating less on Candy Division up to point of sale in 2009 40,000
Loss on disposal of Candy Division 200,000
Earthquake loss 96,000
Cumulative negative effect on prior years' income of changing from 64,000
straight-line to an accelerated method of computing depreciation.

Assume the applicable federal income tax rate is 40 per cent. All of the items of expense, revenue, and loss are
included in the computation of taxable income. The earthquake loss resulted from the first earthquake experienced
at the company's location. In addition, the company discovered that in 2008 it had erroneously charged to expense
the USD 160,000 cost of a tract of land purchased that year and had made the same error on its tax return for
2008.
a. Prepare an income statement for the year ended 2009 December 31.
b. Prepare a statement of retained earnings for the year ended 2009 December 31.
Alternate problems
Alternate problem A The trial balance of Dex Corporation as of 2009 December 31, contains the following
selected balances:
Notes payable (17%, due 2011 May 1) $4,000,000
Allowance for uncollectible accounts 60,000
Common stock (without par value, $20 stated value; 300,000 shares 6,000,000
authorized, issued, and outstanding)
Retained earnings, unappropriated 500,000
Dividends payable (in cash, declared December 15 on preferred stock) 14,000
Appropriation for pending litigation 600,000
Preferred stock (6%, $200 par value; 3,000 shares authorized, issued,
and outstanding) 600,000
Paid-In Capital – Donations 400,000
Paid-In Capital in Excess of Par Value – Preferred 10,000

Present the stockholders' equity section of the balance sheet as of 2009 December 31.
Alternate problem B The stockholders' equity section of Carson Company's 2008 December 31, balance sheet
follows:
Stockholders' equity:
Paid-In Capital:
Common stock - $120 par value; authorized,
2,000 shares; issued and outstanding, 1,000
shares $120,000
Paid-in capital in excess of par value 6,000
Total paid-in capital $126,000
Retained earnings 48,000
Total stockholders' equity $174,000

On 2009 July 15, the board of directors declared a cash dividend of USD 12 per share, which was paid on 2009
August 1. On 2009 December 1, the board declared a stock dividend of 10 per cent, and the shares were issued on
2009 December 15. Market value of the stock was USD 144 on December 1 and USD 168 on December 15.
Prepare journal entries for these dividend transactions.
Alternate problem C The ledger of Falcone Company includes the following account balances on 2009
September 30:
Appropriation for contingencies $210,000
Appropriation for plant expansion 392,000
Retained earnings, unappropriated 700,000

During October 2009, the company took action to:

• Increase the appropriation for contingencies by USD 60,000.

76
 • Decrease the appropriation for plant expansion by USD 160,000.
• Establish an appropriation per loan agreement, with an annual increase of USD 48,000.
• Declare a cash dividend of USD 140,000.
Prepare the journal entries to record these transactions of Falcone Company.
Alternate problem D Following are selected transactions of Taylor Corporation:
2004
Dec. 31 By action of the board of directors, USD 450,000 of retained earnings was appropriated to provide for
future expansion of the company's main building. (On the last day of each of the next four years, the same action
was taken. You need not make entries for these years.)
2009
Jan. 3 Obtained, at a cost of USD 4,500, a building permit to construct a new wing on the main plant building.
July 30 Paid USD 1,800,000 to Starke Construction Company for completion of the new wing.
Aug. 4 The board of directors authorized the release of the sum appropriated for expansion of the plant building.
4 The board of directors declared a 10 per cent common stock dividend on the 25,000 shares of USD 500 par
value common stock outstanding. The market price on this date was USD 660 per share.
Prepare journal entries to record all of these transactions.
Alternate problem E The following information relates to Dahl Corporation for the year 2009:
Net income for the year $ 1,680,000
Dividends declared on common stock 235,000
Dividends declared on preferred stock 134,000
Retained earnings, January 1, unappropriated 5,040,000
Appropriation for retirement of bonds 672,000
Balance in “Appropriation for possible loss of a lawsuit”, no longer
needed on December 31 because of a favorable court decision, is (by
directors' order) returned to unappropriated retained earnings 840,000

Prepare a statement of retained earnings for the year ended 2009 December 31.
Alternate problem F The stockholders' equity of Acorn Company as of 2008 December 31, consisted of
20,000 shares of authorized, issued, and outstanding USD 50 par value common stock, paid-in capital in excess of
par of USD 240,000, and retained earnings of USD 400,000. Following are selected transactions for 2009:
May 1 Acquired 3,000 shares of its own common stock at USD 100 per share.
June 1 Reissued 500 shares at USD 120.
30 Reissued 700 shares at USD 90.
Oct. 1 Declared a cash dividend of USD 5 per share.
31 Paid the cash dividend declared on October 1.
Net income for the year was USD 80,000. No other transactions affecting retained earnings occurred during the
year.
a. Prepare general journal entries for these transactions.
b. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Alternate problem G The stockholders' equity section of Sager Company's 2008 December 31, balance sheet
follows:
Stockholders' equity:
Paid-In Capital:
Preferred stock - $60 par value, 5%; $150,000
authorized, 5,000 shares; issued and
outstanding, 2,500 shares

Introduction to Accounting : The Language of Business – Supplemental Textbook 77

 Common stock – without par or stated value; 225,000
authorized, 50,000 shares; issued, 25,000
shares of which 500 are held in treasury
Paid-in capital in excess of par – preferred 3,000
Total paid-in capital $378,000
Retained earnings:
Appropriated:
For plant expansion $15,000
Unappropriated (restricted as to dividends to
the extent of $6,000, the cost of the treasury
stock held) 126,000
Total retained earnings 141,000
Total paid-in capital and retained earnings $519,000
Less: Treasury stock, common, at cost (500 6,000
shares)
Total stockholders' equity $513,000

Following are selected transactions that occurred in 2009:

Jan. 13 Cash was received for 550 shares of previously unissued common stock at USD 13.20.
Feb. 4 A plot of land was accepted as payment in full for 500 shares of common stock, and the stock was issued.
Closing market price of the common stock on this date was USD 12 per share.
Mar. 24 All of the treasury stock was reissued at USD 14.40 per share.
June 23 The regular semiannual dividend on the preferred stock was declared.
30 The preferred dividend was paid.
July 3 A 10 per cent stock dividend was declared on the common stock. Market price on this date was USD
16.80.
18 The stock dividend shares were issued.
Oct. 4 The company reacquired 105 shares of its common stock at USD 14.40.
Dec. 18 The regular semiannual dividend on the preferred stock and a USD 0.24 per share dividend on the
common stock were declared.
31 Both dividends were paid.
31 An additional appropriation of retained earnings of USD 3,000 for plant expansion was authorized.
a. Prepare journal entries to record the 2009 transactions.
b. Prepare a statement of retained earnings for the year 2009, assuming net income for the year was USD
25,800.
c. Prepare the stockholders' equity section of the 2009 December 31, balance sheet.
Alternate problem H Selected data of Ace Company for the year ended 2009 December 31, are:
Sales, net $1,000,000
Interest expense 90,000
Cash dividends on common stock 150,000
Selling and administrative expenses 245,000
Cash dividends on preferred stock 70,000
Rent revenue 400,000
Cost of goods sold 650,000
Flood loss (has never occurred before) 200,000
Interest revenue 90,000
Other revenue 150,000
Depreciation and maintenance on rental equipment 270,000
Stock dividend on common stock 300,000
Operating income on Plastics Division up to point of sale in 2009 50,000
Gain on disposal of Plastics Division 25,000
Litigation loss (has never occurred before) 400,000
Cumulative positive effect on prior years' income of changing to a 80,000
different depreciation method

78
 Assume the applicable federal income tax rate is 40 per cent. All of the preceding items of expense, revenue, and
loss are included in the computation of taxable income. The litigation loss resulted from a court award of damages
for patent infringement on a product that the company produced and sold in 2005 and 2006, but was discontinued
in 2006. In addition, the company discovered that in 2005 it had erroneously charged to expense the USD 250,000
cost of a tract of land purchased that year and had made the same error on its tax return for 2008. Retained
earnings as of 2009 January 1, were USD 5,600,000. Assume there were 10,000 shares of common stock and 5,000
shares of preferred stock outstanding for the entire year.
Prepare an income statement and a statement of retained earnings for 2009.
Beyond the numbers—Critical thinking
Business decision case A The stockholders' equity section of the Bates Corporation's balance sheet for 2009
June 30, follows:
Stockholders' equity:
Paid-in Capital:
Common stock - $20 par value; authorized $1,600,000
200,000 shares; issued and outstanding
80,000 shares
Paid-in capital in excess of par value 960,000
Total paid-in capital $2,560,000
Retained earnings 1,520,000
Total stockholders' equity $4,080,000

On 2009 July 1, the corporation's directors declared a 10 per cent stock dividend distributable on August 2 to
stockholders of record on July 16. On 2009 November 1, the directors voted a USD 2.40 per share annual cash
dividend payable on December 2 to stockholders of record on November 16. For four years prior to 2009, the
corporation had paid an annual cash dividend of USD 2.52.
As of 2009 July 1, Bob Jones owned 8,000 shares of Bates Corporation's common stock, which he had
purchased four years earlier. The market value of his stock was USD 48 per share on 2009 July 1, and USD 43.64
per share on 2009 July 16.
a. What amount of cash dividends will Jones receive in 2009? How does this amount differ from the amount of
cash dividends Jones received in the previous four years?
b. Jones has asked you, his CPA, to explain why the price of the stock dropped from USD 48 to USD 43.64 on
2009 July 16. Write a memo to Jones explaining your answer.
c. Do you think Jones is better off as a result of the stock dividend and the USD 2.40 cash dividend than he
would have been if he had just received the USD 2.52 cash dividend? Write a memo to Jones explaining your
answer.
Business decision case B The following journal entries are for Keel Corporation:
1.
Retained earnings 12,000
Reserve for uncollectible accounts 12,000
To record the adjusting entry for
uncollectible accounts.
2.
Retained earnings 48,000
Reserve for depreciation 48,000
To record depreciation expense.
3.
Retained earnings 120,000
Appropriation for plant expansion 120,000
To record retained earnings appropriation.
4.

Introduction to Accounting : The Language of Business – Supplemental Textbook 79

 Retained earnings 8,000
Stock dividend distributable – Common 8,000
To record 10% stock dividend declaration
(100 shares to be distributed - $80 par
value, $120 market value).
5.
Stock dividend distributable – Common 8,000
Common stock 8,000
To record distribution of stock dividend.
6.
Treasury Stock 32,000
Cash 32,000
To record acquisition of 200 shares of $80
par value common stock at $160 per share.
7.
Cash 17,600
Treasury Stock 17,600
To record sale of 100 treasury shares at
$176 per share.
8.
Cash 6,800
Treasury stock 6,800
To record sale of 50 treasury shares at
$136 per share.
9.
Common stock 16,000
Dividends payable 16,000
To record declaration of cash dividend.
10.
Dividends payable 16,000
Cash 16,000
To record payment of cash dividend.

The management of Keel Corporation has asked you, a CPA, to analyze these journal entries and decide whether
each is correct. The explanations are all correct. Wherever a journal entry is incorrect, prepare the journal entry
that should have been made.
Annual report analysis C The following questions are based on the Coca-Cola Company's 2006 annual
report. To view the report, go to the Coca-Cola web site at www.cocacola.com. After you activate the web site, click
on The Coca-Cola Company. Go to investors and a menu will drop down that has financials as an option with
Financial Statements (select this) to its right. Click on Balance Sheet and then open it to find the total cost of
treasury shares. Then go to Selected Financial Data and open it to find the number of common shares outstanding.
a. Based on the information in the balance sheet and the note, determine the number of common shares
outstanding; and the total cost of treasury stock shares on hand at the end of 2006.
b. In writing, discuss what reasons Coca-Cola might have to acquire treasury stock.
c. Find Coca-Cola's basic EPS for 2006 listed in its Income Statement. If the common stock's market price at
2006 December 31, was USD 30, what was the price-earnings ratio?
Ethics case–Writing experience D Based on the ethics case, answer the following questions concerning Ace
Chemical Company in writing:
a. Is this transaction fair to the creditors?
b. Why would the officers not merely declare a USD 4 million cash dividend? Is the proposed treasury stock
transaction fair to the other stockholders?
c. If you were one of the officers, would you feel comfortable in going ahead with this proposed treasury stock
transaction?

80
 Group project E In teams of two to three students, go to the library to find articles evaluating accounting
software packages. Use a periodicals index such as the Accounting and Tax Index or the Business Periodicals Index
to locate these articles. Compare the cost and features of three accounting software packages. As a team, prepare a
memorandum to the manager of a small retail business. Compare and contrast the three accounting software
packages so the manager might decide which package to purchase. In the memorandum, cite the sources used in
gathering the data and properly reference any direct quotes or paraphrasing. The heading of the memorandum
should contain the date, to whom it is written, from whom, and the subject matter.
Group project F With a small group of students, go to the library and locate Statement of Financial
Accounting Standards No. 4, "Reporting Gains and Losses from Extinguishing of Debt", published by the Financial
Accounting Standards Board. Write a report to your instructor giving the highlights of the standard. Why are these
gains and losses treated as extraordinary items? Why did the Board act on this topic? Why did one member of the
Board dissent?
Group project G With one or two other students, locate the annual reports of three companies and study their
statements of stockholders' equity. Determine why the number of common shares outstanding changed (if at all)
during the current year. For instance, the number of outstanding shares may have increased due to new issuances,
exercise of stock options, conversion of preferred stock, exercise of warrants, stock dividends, and other causes. The
number of shares outstanding may have decreased because of repurchases of stock (treasury stock transactions).
Write a report to your instructor presenting your findings. Also be prepared to make a short presentation to your
class.
Using the Internet—A view of the real world
Visit the following website for the General Electric Company:
http://www.ge.com
Pursue choices on the screen until you locate the consolidated statement of changes in stockholders' equity. You
will probably go down some "false paths" to get to this financial statement, but you can get there. This experience is
all part of learning to use the Internet. Trace the changes that have occurred in the last three years in the dividends
and other transactions with stockholders. Check out the notes to the financial statements for further information.
Write a memo to your instructor summarizing your findings.
Visit the following website for 3M:
http://www.3m.com
Pursue choices on the screen until you locate the Financial Section. You will probably go down some "false
paths" to get to this information, but you can get there. This experience is all part of learning to use the Internet.
Trace the changes that have occurred in the stockholders' equity section for the most recent two years. Identify the
causes of the changes. Check out the notes to the financial statements for further information. Write a memo to
your instructor summarizing your findings.
Answers to self-test
True-false
False. The paid-in capital of a corporation only includes capital contributed by stockholders or others. Thus, it
does not include retained earnings.
False. The purchase of treasury stock reduces total stockholders' equity.

Introduction to Accounting : The Language of Business – Supplemental Textbook 81

 False. Dividends are distributions of earnings in the past and are not expenses.
True. A stock dividend permanently capitalizes a portion of retained earnings by decreasing retained earnings
and increasing paid-in capital by an equal amount.
False. The purpose of a retained earnings appropriation is to disclose that a portion of retained earnings is not
available for cash dividends. Thus, such an appropriation does not reduce total stockholders' equity.
False. Such damage occurs too frequently to be considered nonrecurring.
Multiple-choice
d. Appropriation per Loan Agreement is part of retained earnings.
c. When treasury stock is reacquired, the stock is recorded at cost in a debit-balance stockholders' equity
account, Treasury Stock.
a. The excess of the reissue price over the cost of treasury stock is recorded in the Paid-In Capital—Treasury
Stock Transactions account.
a. Treasury stock is customarily shown as a deduction from total stockholders' equity.
b. The date of record determines who is to receive the dividends.
c. The total amount of dividends is computed as follows:
Total Outstanding shares at declaration:
(12,000 – 2,000) shares 10,0000
Dividend per share X USD 2
Total dividend amount USD 20,000

b. Prior period adjustments are shown as adjustments to the opening balance of retained earnings on the
statement of retained earnings.

82
Introduction to Accounting : The Language of Business – Supplemental Textbook 83
 Debt and Equity: Part 4

Learning objectives
After studying this chapter, you should be able to:
• Describe the features of bonds and tell how bonds differ from shares of stock.
• List the advantages and disadvantages of financing with long-term debt and prepare examples showing how
to employ financial leverage.
• Prepare journal entries for bonds issued at face value.
• Explain how interest rates affect bond prices and what causes a bond to sell at a premium or a discount.
• Apply the concept of present value to compute the price of a bond.
• Prepare journal entries for bonds issued at a discount or a premium.
• Prepare journal entries for bond redemptions and bond conversions.
• Describe the ratings used for bonds.
• Analyze and use the financial results—times interest earned ratio.
• Explain future value and present value concepts and make required calculations (Appendix).

The accountant's role in financial institutions

Companies that require funds to maintain existing operations and expand new operations frequently do not
have the necessary cash available within the company. Therefore, these companies are required to obtain long-term
financing from banks and other financial institutions. The operations of financial institutions are unique from those
of the typical manufacturing or service company. As a result, the accounting measurement and disclosure practices
followed by financial institutions can be quite different from those followed in other industries. In addition to the
more traditional careers in accounting (auditing, professional services, financial reporting, cost accounting, and
taxation), accounting majors with interests in finance may pursue a career in financial institutions.
Accountants in this industry commonly deal with issues related to marketable securities, derivatives, hedging,
sale of receivables, foreign currency exchanges, and loan loss provisions and impairments. In addition, accountants
in this area are being called upon to play an increasing role in the strategic operations of the financial institution.
Not only are accountants needed to account for the institution's transactions, but they are being asked to
recommend new opportunities for growth and to advise on financial risk as well. Some of these new areas include
issues related to asset/liability management, interest rate risk, present value measurements, capital structure, and
key ratio analysis.
Accountants also play a key role in one of the most important decisions of a financial institution —the decision of
whether to lend money to a prospective borrower. The decision to lend money hinges on the ability of the
prospective borrower to pay interest and repay debt. Since accountants have been trained in financial statement
preparation and interpretation, accountants are some of the most sought after professionals for understanding the
financial position and risk of a prospective borrower.
In previous chapters, you learned that corporations obtain cash for recurring business operations from stock
issuances, profitable operations, and short-term borrowing (current liabilities). However, when situations arise that

Introduction to Accounting : The Language of Business – Supplemental Textbook 84

require large amounts of cash, such as the purchase of a building, corporations also raise cash from long-term
borrowing, that is, by issuing bonds. The issuing of bonds results in a Bonds Payable account.

Bonds payable
A bond is a long-term debt, or liability, owed by its issuer. Physical evidence of the debt lies in a negotiable
bond certificate. In contrast to long-term notes, which usually mature in 10 years or less, bond maturities often run
for 20 years or more.
Generally, a bond issue consists of a large number of USD 1,000 bonds rather than one large bond. For example,
a company seeking to borrow USD 100,000 would issue one hundred USD 1,000 bonds rather than one USD
100,000 bond. This practice enables investors with less cash to invest to purchase some of the bonds.
Bonds derive their value primarily from two promises made by the borrower to the lender or bondholder. The
borrower promises to pay (1) the face value or principal amount of the bond on a specific maturity date in the
future and (2) periodic interest at a specified rate on face value at stated dates, usually semiannually, until the
maturity date.
Large companies often have numerous long-term notes and bond issues outstanding at any one time. The
various issues generally have different stated interest rates and mature at different points in the future. Companies
present this information in the footnotes to their financial statements. Exhibit 15 shows a portion of the long-term
borrowings footnote from Dow Chemical Company's 2000 annual report. Promissory notes, debenture bonds, and
foreign bonds are shown, with their amounts, maturity dates, and interest rates.
Promissory notes and debentures at 2000 December 31
Millions
2000 1999
6.95%, final maturity 2002 $ 346 $ ---
7.81%, final maturity 2002 ---
7.13%, final maturity 2003
7.00%, final maturity 2005 300 ---
7.70%, final maturity 2006 2,473 2,448
Subtotal $3,267 $3,135

Foreign bonds at 2000 December 31 Millions

2000 1999
4.63%, final maturity 2000, Swiss Fran $-- $ 95
6.38%, final maturity 2001, Japanese Yen 218 244
5.00%, final maturity 2003, Euro 139 151
Subtotal $357 $490

Exhibit 15: Dow chemical company's long-term notes and bonds (in millions)

Comparison with stock

A bond differs from a share of stock in several ways:
• A bond is a debt or liability of the issuer, while a share of stock is a unit of ownership.
• A bond has a maturity date when it must be paid. A share of stock does not mature; stock remains
outstanding indefinitely unless the company decides to retire it.
• Most bonds require stated periodic interest payments by the company. In contrast, dividends to
stockholders are payable only when declared; even preferred dividends need not be paid in a particular period
if the board of directors so decides.
• Bond interest is deductible by the issuer in computing both net income and taxable income, while dividends
are not deductible in either computation.

85
 Selling (issuing) bonds
A company seeking to borrow millions of dollars generally is not able to borrow from a single lender. By selling
(issuing) bonds to the public, the company secures the necessary funds.
Usually companies sell their bond issues through an investment company or a banker called an underwriter.
The underwriter performs many tasks for the bond issuer, such as advertising, selling, and delivering the bonds to
the purchasers. Often the underwriter guarantees the issuer a fixed price for the bonds, expecting to earn a profit by
selling the bonds for more than the fixed price.
When a company sells bonds to the public, many purchasers buy the bonds. Rather than deal with each
purchaser individually, the issuing company appoints a trustee to represent the bondholders. The trustee usually
is a bank or trust company. The main duty of the trustee is to see that the borrower fulfills the provisions of the
bond indenture. A bond indenture is the contract or loan agreement under which the bonds are issued. The
indenture deals with matters such as the interest rate, maturity date and maturity amount, possible restrictions on
dividends, repayment plans, and other provisions relating to the debt. An issuing company that does not adhere to
the bond indenture provisions is in default. Then, the trustee takes action to force the issuer to comply with the
indenture.
Bonds may differ in some respects; they may be secured or unsecured bonds, registered or unregistered (bearer)
bonds, and term or serial bonds. We discuss these differences next.
Certain bond features are matters of legal necessity, such as how a company pays interest and transfers
ownership. Such features usually do not affect the issue price of the bonds. Other features, such as convertibility
into common stock, are sweeteners designed to make the bonds more attractive to potential purchasers. These
sweeteners may increase the issue price of a bond.
Secured bonds A secured bond is a bond for which a company has pledged specific property to ensure its
payment. Mortgage bonds are the most common secured bonds. A mortgage is a legal claim (lien) on specific
property that gives the bondholder the right to possess the pledged property if the company fails to make required
payments.
Unsecured bonds An unsecured bond is a debenture bond, or simply a debenture. A debenture is an
unsecured bond backed only by the general creditworthiness of the issuer, not by a lien on any specific property. A
financially sound company can issue debentures more easily than a company experiencing financial difficulty.
Registered bonds A registered bond is a bond with the owner's name on the bond certificate and in the
register of bond owners kept by the bond issuer or its agent, the registrar. Bonds may be registered as to principal
(or face value of the bond) or as to both principal and interest. Most bonds in our economy are registered as to
principal only. For a bond registered as to both principal and interest, the issuer pays the bond interest by check. To
transfer ownership of registered bonds, the owner endorses the bond and registers it in the new owner's name.
Therefore, owners can easily replace lost or stolen registered bonds.
Unregistered (bearer) bonds An unregistered (bearer) bond is the property of its holder or bearer
because the owner's name does not appear on the bond certificate or in a separate record. Physical delivery of the
bond transfers ownership.
Coupon bonds A coupon bond is a bond not registered as to interest. Coupon bonds carry detachable
coupons for the interest they pay. At the end of each interest period, the owner clips the coupon for the period and
presents it to a stated party, usually a bank, for collection.

Introduction to Accounting : The Language of Business – Supplemental Textbook 86

 Term bonds and serial bonds A term bond matures on the same date as all other bonds in a given bond
issue. Serial bonds in a given bond issue have maturities spread over several dates. For instance, one-fourth of
the bonds may mature on 2011 December 31, another one-fourth on 2012 December 31, and so on.
Callable bonds A callable bond contains a provision that gives the issuer the right to call (buy back) the
bond before its maturity date. The provision is similar to the call provision of some preferred stocks. A company is
likely to exercise this call right when its outstanding bonds bear interest at a much higher rate than the company
would have to pay if it issued new but similar bonds. The exercise of the call provision normally requires the
company to pay the bondholder a call premium of about USD 30 to USD 70 per USD 1,000 bond. A call premium is
the price paid in excess of face value that the issuer of bonds must pay to redeem (call) bonds before their maturity
date.
Convertible bonds A convertible bond is a bond that may be exchanged for shares of stock of the issuing
corporation at the bondholder's option. A convertible bond has a stipulated conversion rate of some number of
shares for each USD 1,000 bond. Although any type of bond may be convertible, issuers add this feature to make
risky debenture bonds more attractive to investors.
Bonds with stock warrants A stock warrant allows the bondholder to purchase shares of common stock at
a fixed price for a stated period. Warrants issued with long-term debt may be nondetachable or detachable. A bond
with nondetachable warrants is virtually the same as a convertible bond; the holder must surrender the bond to
acquire the common stock. Detachable warrants allow bondholders to keep their bonds and still purchase shares of
stock through exercise of the warrants.
Junk bonds Junk bonds are high-interest rate, high-risk bonds. Many junk bonds issued in the 1980s
financed corporate restructurings. These restructurings took the form of management buyouts (called leveraged
buyouts or LBOs), hostile takeovers of companies by outside parties, or friendly takeovers of companies by outside
parties. In the early 1990s, junk bonds lost favor because many issuers defaulted on their interest payments. Some
issuers declared bankruptcy or sought relief from the bondholders by negotiating new debt terms.
Several advantages come from raising cash by issuing bonds rather than stock. First, the current stockholders do
not have to dilute or surrender their control of the company when funds are obtained by borrowing rather than
issuing more shares of stock. Second, it may be less expensive to issue debt rather than additional stock because the
interest payments made to bondholders are tax deductible while dividends are not. Finally, probably the most
important reason to issue bonds is that the use of debt may increase the earnings of stockholders through favorable
financial leverage.
Favorable financial leverage A company has favorable financial leverage when it uses borrowed funds
to increase earnings per share (EPS) of common stock. An increase in EPS usually results from earning a higher
rate of return than the rate of interest paid for the borrowed money. For example, suppose a company borrowed
money at 10 per cent and earned a 15 per cent rate of return. The 5 per cent difference increases earnings.
Exhibit 16 provides a more comprehensive example of favorable financial leverage. The two companies in the
illustration are identical in every respect except in the way they are financed. Company A issued only capital stock,
while Company B issued equal amounts of 10 per cent bonds and capital stock. Both companies have USD
20,000,000 of assets, and both earned USD 4,000,000 of income from operations. If we divide income from
operations by assets (USD 4,000,000/USD 20,000,000), we see that both companies earned 20 per cent on assets

87
employed. Yet B's stockholders fared far better than A's. The ratio of net income to stockholders' equity is 18 per
cent for B, while it is only 12 per cent for A.
Assume that both companies issued their stock at the beginning of 2010 at USD 10 per share. B's USD 1.80 EPS
are 50 per cent greater than A's USD 1.20 EPS. This EPS difference probably would cause B's shares to sell at a
substantially higher market price than A's shares. B's larger EPS would also allow a larger dividend on B's shares.
Company B in Exhibit 16 is employing financial leverage, or trading on the equity. The company is using its
stockholders' equity as a basis for securing funds on which it pays a fixed return. Company B expects to earn more
from the use of such funds than their fixed after-tax cost. As a result, Company B increases its rate of return on
stockholders' equity and EPS.7
Companies A and B Condensed Statements
Balance Sheets
2010 December 31
Company A Company B
Total assets $20,000,000 $20,000,000
Bonds payable, 10% $10,000,000
Stockholders' equity (capital stock) $20,000,000 10,000,000
Total equities $20,000,000 $20,000,000
Income statements
For the year ended 2010 December 31
Income from operations $4,000,000 $4,000,000
Interest expense 1,000,000
Income before federal income taxes $4,000,000 $3,000,000
Deduct: Federal income taxes (40%) 1,600,000 1,200,000
Net income $2,400,000 $1,800,000
Number of common shares outstanding 2,000,000 1,000,000
Earnings per share (EPS) (Net income/Number $1.20 $1.80
of common shares outstanding)
Rate of return on assets employed (Income
from Operations/Total assets; both companies
$4,000,000/$20,000,000) 20% 20%
Rate of return on stockholders' equity (Net
income/Stockholders' equity):
Company A ($2,400,000/$20,000,000) 12%
Company B ($1,800,000/$10,000,000) 18%

Exhibit 16: Favorable financial leverage

Several disadvantages accompany the use of debt financing. First, the borrower has a fixed interest payment that
must be met each period to avoid default. Second, use of debt also reduces a company's ability to withstand a major
loss. For example, assume that instead of having net income, both Company A and Company B in Exhibit 16 sustain
a net loss in 2010 of USD 11,000,000. At the end of 2010, Company A will still have USD 9,000,000 of
stockholders' equity and can continue operations with a chance of recovery. Company B, on the other hand, would
have negative stockholders' equity of USD 1,000,000 and the bondholders could force the company to liquidate if B
could not make interest payments as they came due. The result of sustaining the loss by the two companies is as
follows:
Companies A and B
Partial Balance Sheets
2010 December 31
Company A Company B
Stockholders' equity:
Paid-in capital:
Common stock $20,000,000 $10,000,000
Retained earnings (11,000,000) (11,000,000)
Total stockholders' equity $ 9,000,000 $ (1,000,000)

7 Issuing bonds is only one method of using leverage. Other methods of using financial leverage include issuing
preferred stock or long-term notes.

Introduction to Accounting : The Language of Business – Supplemental Textbook 88

 A third disadvantage of debt financing is that it also causes a company to experience unfavorable financial
leverage when income from operations falls below a certain level. Unfavorable financial leverage results when
the cost of borrowed funds exceeds the revenue they generate; it is the reverse of favorable financial leverage. In the
previous example, if income from operations fell to USD 1,000,000, the rates of return on stockholders' equity
would be 3 per cent for A and zero for B, as shown in this schedule:
Companies A and B
Income Statements
For the year ended 2010 December 31
Company A Company B
Income from operations $1,000,000 $1,000,000
Interest expense 1,000,000
Income before federal income taxes $1,000,000 $ -0-
Deduct: Federal income taxes (40%) 400,000 -0-
Net income 600,000 $ -0-
Rate of return on stockholders' equity:
Company A ($600,000/$20,000,000) 3%
Company B ($0/$10,000,000) 0%

The fourth disadvantage of issuing debt is that loan agreements often require maintaining a certain amount of
working capital (Current assets - Current liabilities) and place limitations on dividends and additional borrowings.
When a company issues bonds, it incurs a long-term liability on which periodic interest payments must be
made, usually twice a year. If interest dates fall on other than balance sheet dates, the company must accrue interest
in the proper periods. The following examples illustrate the accounting for bonds issued at face value on an interest
date and issued at face value between interest dates.
Bonds issued at face value on an interest date Valley Company's accounting year ends on December 31.
On 2010 December 31, Valley issued 10-year, 12 per cent bonds with a USD 100,000 face value, for USD 100,000.
The bonds are dated 2010 December 31, call for semiannual interest payments on June 30 and December 31, and
mature on 2020 December 31. Valley made the required interest and principal payments when due. The entries for
the 10 years are as follows:
On 2010 December 31, the date of issuance, the entry is:
2010
Dec. 31 Cash (+A) 100,000
Bonds payable (+L) 100,000
To record bonds issued at face
value.

On each June 30 and December 31 for 10 years, beginning 2010 June 30 (ending 2020 June 30), the entry
would be:
Each
year
June 30
And Dec.31 Bond Interest Expense ($100,000 x 0.12 x 6,000
½) (-SE)
Cash (-A) 6,000
To record periodic interest payment.

On 2020 December 31, the maturity date, the entry would be:
2020
Dec. 31 Bond interest expense (-SE) 6,000
Bonds payable (-L) 100,000
Cash (-A) 106,000
To record final interest and bond redemption
payment.

89
 Note that Valley does not need adjusting entries because the interest payment date falls on the last day of the
accounting period. The income statement for each of the 10 years 2010-2018 would show Bond Interest Expense of
USD 12,000 (USD 6,000 X 2); the balance sheet at the end of each of the years 2010-2018 would report bonds
payable of USD 100,000 in long-term liabilities. At the end of 2019, Valley would reclassify the bonds as a current
liability because they will be paid within the next year.
The real world is more complicated. For example, assume the Valley bonds were dated 2010 October 31, issued
on that same date, and pay interest each April 30 and October 31. Valley must make an adjusting entry on
December 31 to accrue interest for November and December. That entry would be:
2010
Dec. 31 Bond interest expense ($100,000 x 0.12 x 2,000
2/12) (-SE)
Bond interest payable (+L) 2,000
To accrue two month's interest expense.

The 2011 April 30, entry would be:

2011
Apr. 30 Bond interest expense ($100,000 x 0.12 x 4,000
(4/12)) (-SE)
Bond interest payable (-L) 2,000
Cash (-A) 6,000
To record semiannual interest payment.

The 2011 October 31, entry would be:

2011
Oct. 31 Bond interest expense (-SE) 6,000
Cash (-A) 6,000
To record semiannual interest payment.

Each year Valley would make similar entries for the semiannual payments and the year-end accrued interest.
The firm would report the USD 2,000 Bond Interest Payable as a current liability on the December 31 balance sheet
for each year.
Bonds issued at face value between interest dates Companies do not always issue bonds on the date they
start to bear interest. Regardless of when the bonds are physically issued, interest starts to accrue from the most
recent interest date. Firms report bonds to be selling at a stated price "plus accrued interest". The issuer must pay
holders of the bonds a full six months' interest at each interest date. Thus, investors purchasing bonds after the
bonds begin to accrue interest must pay the seller for the unearned interest accrued since the preceding interest
date. The bondholders are reimbursed for this accrued interest when they receive their first six months' interest
check.
Using the facts for the Valley bonds dated 2010 December 31, suppose Valley issued its bonds on 2011 May 31,
instead of on 2010 December 31. The entry required is:
2011
May 31 Cash (+A) 105,000
Bonds payable (+L) 100,000
Bond interest payable ($100,000 x 0.12 x 5,000
(5/12)) (+L)
To record bonds issued at face value plus
accrued interest.

This entry records the USD 5,000 received for the accrued interest as a debit to Cash and a credit to Bond
Interest Payable.
The entry required on 2011 June 30, when the full six months' interest is paid, is:
2011

Introduction to Accounting : The Language of Business – Supplemental Textbook 90

June 30 Bond Interest Expense ($100,000 x 0.12 x 1,000
(1/12)) (-SE)
Bond interest payable (-L) 5,000
Cash (-A) 6,000
To record bond interest payment.

This entry records USD 1,000 interest expense on the USD 100,000 of bonds that were outstanding for one
month. Valley collected USD 5,000 from the bondholders on May 31 as accrued interest and is now returning it to
them.

Bond prices and interest rates

The price of a bond issue often differs from its face value. The amount a bond sells for above face value is a
premium. The amount a bond sells for below face value is a discount. A difference between face value and issue
price exists whenever the market rate of interest for similar bonds differs from the contract rate of interest on the
bonds. The effective interest rate (also called the yield) is the minimum rate of interest that investors accept on
bonds of a particular risk category. The higher the risk category, the higher the minimum rate of interest that
investors accept. The contract rate of interest is also called the stated, coupon, or nominal rate. Firms state this
rate in the bond indenture, print it on the face of each bond, and use it to determine the amount of cash paid each
interest period. The market rate fluctuates from day to day, responding to factors such as the interest rate the
Federal Reserve Board charges banks to borrow from it; government actions to finance the national debt; and the
supply of, and demand for, money.
Market and contract rates of interest are likely to differ. Issuers must set the contract rate before the bonds are
actually sold to allow time for such activities as printing the bonds. Assume, for instance, that the contract rate for a
bond issue is set at 12 per cent. If the market rate is equal to the contract rate, the bonds will sell at their face value.
However, by the time the bonds are sold, the market rate could be higher or lower than the contract rate. As shown
in Exhibit 17, if the market rate is lower than the contract rate, the bonds will sell for more than their face value.
Thus, if the market rate is 10 per cent and the contract rate is 12 per cent, the bonds will sell at a premium as the
result of investors bidding up their price. However, if the market rate is higher than the contract rate, the bonds will
sell for less than their face value. Thus, if the market rate is 14 per cent and the contract rate is 12 per cent, the
bonds will sell at a discount. Investors are not interested in bonds bearing a contract rate less than the market rate
unless the price is reduced. Selling bonds at a premium or a discount allows the purchasers of the bonds to earn the
market rate of interest on their investment.
Computing long-term bond prices involves finding present values using compound interest. The appendix to
this chapter explains the concepts of future value and present value. If you do not understand the present value
concept, read the appendix before continuing with this section.
Buyers and sellers negotiate a price that yields the going rate of interest for bonds of a particular risk class. The
price investors pay for a given bond issue is equal to the present value of the bonds. To compute present value, we
discount the promised cash flows from the bonds—principal and interest—using the market, or effective, rate. We
use the market rate because the bonds must yield at least this rate or investors are attracted to alternative
investments. The life of the bonds is stated in interest (compounding) periods. The interest rate is the effective rate
per interest period, which is found by dividing the annual rate by the number of times interest is paid per year. For
example, if the annual rate is 12 per cent, the semiannual rate would be 6 per cent.

91
 Issuers usually quote bond prices as percentages of face value—100 means 100 per cent of face value, 97 means
97 per cent of face value, and 103 means 103 per cent of face value. For example, one hundred USD 1,000 face value
bonds issued at 103 have a price of USD 103,000. Regardless of the issue price, at maturity the issuer of the bonds
must pay the investor(s) the face value of the bonds.

Exhibit 17: Bond premiums and discounts

Bonds issued at face value The following example illustrates the specific steps in computing the price of
bonds. Assume Carr Company issues 12 per cent bonds with a USD 100,000 face value to yield 12 per cent. Dated
and issued on 2010 June 30, the bonds call for semiannual interest payments on June 30 and December 31 and
mature on 2013 June 30.8 The bonds would sell at face value because they offer 12 per cent and investors seek 12
per cent. Potential purchasers have no reason to offer a premium or demand a discount. One way to prove the
bonds would be sold at face value is by showing that their present value is USD 100,000:
Cash X Present value =Present
Flow Factor value
Principal of $100,000 due in six interest periods multiplied by
present value factor for 6% from Table A.3 of the Appendix $100,000 X 0.70496 =$70,496
(end of text)
Interest of $6,000 due at the end of six interest periods
multiplied 6,000 X 4.91732 =29,504
by present value factor for 6% from Table A.4 of the
Appendix (end of text)
Total price (present value) $100,000

According to this schedule, investors who seek an effective rate of 6 per cent per six-month period should pay
USD 100,000 for these bonds. Notice that the same number of interest periods and semiannual interest rates occur
in discounting both the principal and interest payments to their present values. The entry to record the sale of these
bonds on 2010 June 30, debits Cash and credits Bonds Payable for USD 100,000.

8 Bonds do not normally mature in such a short time; we use a three-year life for illustrative purposes only.

Introduction to Accounting : The Language of Business – Supplemental Textbook 92

 An accounting perspective:

Business insight

Some persons estimate that Social Security will be broke by the year 2025 unless changes are
made. Therefore, you may want to set aside funds during your working career to provide for
retirement.
Over the last 60 years, the inflation rate has averaged about 3 per cent per year, treasury bills have
averaged a little under 4 per cent per year, corporate bonds have averaged about a little over 5 per
cent per year, and stocks have averaged a little over 10 per cent per year. Using the tables at the
end of the text we can determine how much you would have at age 65 if you invested USD 2,000
each year for 45 years in treasury bills, corporate bonds, or stocks, beginning at age 20.
To do this calculation for treasury bills, for instance, we would first use Table A.2 to determine the
future value of an annuity of USD 2,000 for 30 periods at 4 per cent (USD 2,000 X 56.08494 =
USD 112,170). (We would have used 45 periods, but the table only went up to 30 periods.) Then we
would use Table A.1 to find the value of this lump sum of USD 112,170 for another 15 years at 4 per
cent (USD 112,170 X 1.80094 = USD 202,011). Then we cannot forget that we have another 15
years of USD 2,000 annuity to consider. Thus, we go back to Table A.2 and calculate the future
value of an annuity of USD 2,000 for 15 periods at 4 per cent (USD 2,000 X 20.02359 = USD
40,047). Then we add the USD 202,011 and the USD 40,047 to get the total future value of USD
242,058. (You would have invested USD 2,000 X 45 years = USD 90,000.) Would you be pleased?
Not when you see what you could have had at age 65 if you invested in stocks.
If you had invested in corporate bonds at 5 per cent, you would have USD 319,401. However, if you
had invested in stocks at 10 per cent, you would have USD 1,437,810 at age 65. Can you use the
tables in the back of the text to verify these amounts?

Bonds issued at a discount Assume the USD 100,000, 12 per cent Carr bonds are sold to yield a current
market rate of 14% annual interest, or 7 per cent per semiannual period. Carr computes the present value (selling
price) of the bonds as follows:
Cash X Present =Present value
flow value factor
Principal of $100,000 due in six interest periods multiplied by
present value factor for 7% from Table A.3 of the Appendix $100,00 X0.66634 =$66,634
(end of text) 0
Interest of $6,000 due at the end of six interest periods
multiplied by present 6,000 X4.76654 =28,559
value factor for 7% from Table A.4 of the Appendix (end of
text)
Total price (present value) $95,233

Note that in computing the present value of the bonds, Carr uses the actual USD 6,000 cash interest payment
that will be made each period. The amount of cash the company pays as interest does not depend on the market
interest rate. However, the market rate per semiannual period—7 per cent—does change, and Carr uses this new
rate to find interest factors in the tables.
The journal entry to record issuance of the bonds is:

93
2010
June 30 Cash (+A) 95,233
Discount on bonds payable (-L; Contra- 4,767
account)
Bonds payable (+L) 100,000
To record bonds issued at a discount.

In recording the bond issue, Carr credits Bonds Payable for the face value of the debt. The company debits the
difference between face value and price received to Discount on Bonds Payable, a contra account to Bonds Payable.
Carr reports the bonds payable and discount on bonds payable in the balance sheet as follows:
Long-term liabilities:
Bonds payable, 12%, due 2009 June 30 $100,000
Less: Discount on bonds payable 4,767 $95,233

The USD 95,233 is the carrying value, or net liability, of the bonds. Carrying value is the face value of the bonds
minus any unamortized discount or plus any unamortized premium. The next section discusses unamortized
premium on bonds payable.
Bonds issued at a premium Assume that Carr issued the USD 100,000 face value of 12 per cent bonds to
yield a current market rate of 10 per cent. The bonds would sell at a premium calculated as follows:
Cash X Present value =Present value
Flow Factor
Principal of $100,000 due in six interest periods multiplied by
present $100,000 X 0.74622 =$74,622
value factor for 5% from Table A.3 of the Appendix (end of
text)
Interest of $6,000 due at the end of six interest periods
multiplied by 6,000 X 5.07569 =30,454
present value factor for 5% from Table A.4 of the Appendix
(end of text)
Total price (present value) $105,076

The journal entry to record the issuance of the bonds is:

2010
June 30 Cash (+A) 105,076
Bonds payable (+L) 100,000
Premium on bonds payable (+L) 5,076
To record bonds issued at a
premium.

The carrying value of these bonds at issuance is USD 105,076, consisting of the face value of USD 100,000
and the premium of USD 5,076. The premium is an adjunct account shown on the balance sheet as an addition to
bonds payable as follows:
Long-term liabilities:
Bonds payable, 12%, due 2009 June 30 $100,000
Add: Premium on bonds payable 5,076 $105,076

When a company issues bonds at a premium or discount, the amount of bond interest expense recorded each
period differs from bond interest payments. A discount increases and a premium decreases the amount of interest
expense. For example, if Carr issues bonds with a face value of USD 100,000 for USD 95,233, the total interest cost
of borrowing would be USD 40,767: USD 36,000 (which is six payments of USD 6,000) plus the discount of USD
4,767. If the bonds had been issued at USD 105,076, the total interest cost of borrowing would be USD 30,924: USD
36,000 less the premium of USD 5,076. The USD 4,767 discount or USD 5,076 premium must be allocated or
charged to the six periods that benefit from the use of borrowed money. Two methods are available for amortizing a
discount or premium on bonds—the straight-line method and the effective interest rate method.
The straight-line method records interest expense at a constant amount; the effective interest rate method
records interest expense at a constant rate. APB Opinion No. 21 states that the straight-line method may be used

Introduction to Accounting : The Language of Business – Supplemental Textbook 94

only when it does not differ materially from the effective interest rate method. In many cases, the differences are
not material.

An accounting perspective:

Business insight

US government bonds have traditionally offered a fixed rate of interest. In early 1997, the US
Treasury began offering inflation-indexed bonds. The amount of interest on these bonds is tied to
the officially reported rate of inflation. The bonds pay interest every six months, and the interest is
based on the inflation-adjusted value of the principal. These bonds are designed to protect
purchasers against purchasing power loss due to inflation. At that time, there was some concern by
investors that the government had been considering calculating the official rate of inflation
differently than in the past in such a way that it would lower the annual increase as compared to
the then present method of calculation. This change in calculation, if adopted, would lower the
amount of interest earned on these bonds. However, there were some assurances that for this
purpose the official rate of inflation would be calculated the "old way".

The straight-line method The straight-line method of amortization allocates an equal amount of
discount or premium to each month the bonds are outstanding. The issuer calculates the amount by dividing the
discount or premium by the total number of months from the date of issuance to the maturity date. For example, if
it sells USD 100,000 face value bonds for USD 95,233, Carr would charge the USD 4,767 discount to interest
expense at a rate of USD 132.42 per month (equal to USD 4,767/36). Total discount amortization for six months
would be USD 794.52, computed as follows: USD 132.42 X 6. Interest expense for each six-month period then
would be USD 6,794.52, calculated as follows: USD 6,000 + (USD 132.42 X 6). The entry to record the expense on
2010 December 31, would be:
2010
Dec. 31 Bond interest expense (-SE) 6,794.52
Cash (-A) 6,000.00
Discount on bonds payable ($132.42 x 6) 794.52
(+L)
To record interest payment and discount
amortization.

By the maturity date, all of the discount would have been amortized.
To illustrate the straight-line method applied to a premium, recall that earlier Carr sold its USD 100,000 face
value bonds for USD 105,076. Carr would amortize the USD 5,076 premium on these bonds at a rate of USD 141 per
month, equal to USD 5,076/36. The entry for the first period's semiannual interest expense on bonds sold at a
premium is:
2010
Dec. 31 Bond interest expense (-SE) 5,154
Premium on bonds payable ($141 x 6) (-L) 846
Cash (-A) 6,000
To record interest payable and premium
amortization.

By the maturity date, all of the premium would have been amortized.

95
 The effective interest rate method APB Opinion No. 21 recommends an amortization procedure called the
effective interest rate method, or simply the interest method. Under the interest method, interest expense
for any interest period is equal to the effective (market) rate of interest on the date of issuance times the carrying
value of the bonds at the beginning of that interest period. Using the Carr example of 12 per cent bonds with a face
value of USD 100,000 sold to yield 14 per cent, the carrying value at the beginning of the first interest period is the
selling price of USD 95,233. Carr would record the interest expense for the first semiannual period as follows:
2010
Dec. 31 Bond interest expense ($95,233 x 0.14 x ½) (- 6,666
SE)
Cash ($100,000 x 0.12 x ½) (-A) 6,000
Discount on bonds payable (+L) 666
To record discount amortization and interest
payment.

Note that interest expense is the carrying value times the effective interest rate. The cash payment is the face
value times the contract rate. The discount amortized for the period is the difference between the two amounts.
After the preceding entry, the carrying value of the bonds is USD 95,899, or USD 95,233 + USD 666. Carr
reduced the balance in the Discount on Bonds Payable account by USD 666 to USD 4,101, or USD 4,767 - USD 666.
Assuming the accounting year ends on December 31, the entry to record the payment of interest for the second
semiannual period on 2011 June 30 is:
2011
June 30 Bond interest expense ($95,899 x 0.14 x ½) (- 6,713
SE)
Cash ($100,000 x 0.12 x ½) (-A) 6,000
Discount on bonds payable (+L) 713
To record discount amortization and interest
payment.

Carr can also apply the effective interest rate method to premium amortization. If the Carr bonds had been
issued at USD 105,076 to yield 10 per cent, the premium would be USD 5,076. The firm calculates interest expense
in the same manner as for bonds sold at a discount. However, the entry would differ somewhat, showing a debit to
the premium account. The entry for the first interest period is:
2010
Dec. 31 Bond Interest Expense ($105,076 x 0.10 x ½) (-SE) 5,254
Premium on bonds payable (-L) 746
Cash ($100,000 x 0.12 x ½) (-A) 6,000
To record interest payment and premium amortization.

After the first entry, the carrying value of the bonds is USD 104,330, or USD 105,076 - USD 746. The premium
account now carries a balance of USD 4,330, or USD 5,076 - USD 746. The entry for the second interest period is:
2011
June 30 Bond interest expense ($104,330 x 0.10 x ½) (-SE) 5,216*
Premium on bonds payable (-L) 784
Cash ($100,000 x 0.12 x ½) (-A) 6,000
To record interest payment and premium amortization.
*Rounded down.

Introduction to Accounting : The Language of Business – Supplemental Textbook 96

 Discount and premium amortization schedules A discount amortization schedule (Exhibit 18) and a
premium amortization schedule (Exhibit 19) aid in preparing entries for interest expense. Usually, companies
prepare such schedules when they first issue bonds, often using computer programs designed for this purpose. The
companies then refer to the schedules whenever they make journal entries to record interest. Note that in each
period the amount of interest expense changes; interest expense gets larger when a discount is involved and smaller
when a premium is involved. This fluctuation occurs because the carrying value to which a constant interest rate is
applied changes each interest payment date. With a discount, carrying value increases; with a premium, it
decreases. However, the actual cash paid as interest is always a constant amount determined by multiplying the
bond's face value by the contract rate.
Recall that the issue price was USD 95,233 for the discount situation and USD 105,076 for the premium
situation. The total interest expense of USD 40,767 for the discount situation in Exhibit 18 is equal to USD 36,000
(which is six USD 6,000 payments) plus the USD 4,767 discount. This amount agrees with the earlier computation
of total interest expense. In Exhibit 19, total interest expense in the premium situation is USD 30,924, or USD
36,000 (which is six USD 6,000 payments) less the USD 5,076 premium. In both illustrations, at the maturity date
the carrying value of the bonds is equal to the face value because the discount or premium has been fully amortized.
Adjusting entry for partial period Exhibit 18 and Exhibit 19 also would be helpful if Carr must accrue
interest for a partial period. Instead of a calendar-year accounting period, assume the fiscal year of the bond issuer
ends on August 31. Using the information provided in the premium amortization schedule (Exhibit 19), the
adjusting entry needed on 2010 August 31 is:
2010
Aug. 31 Bond interest expense ($5,254 x (2/6)) 1,751
Premium on bonds payable ($746 x (2/6)) 249
Bond interest payable ($6,000 x (2/6)) 2,000
To record two months' accrued interest.

97
(A) (B) (C) (D) (E)
Interest Bond Interest Cash credit Discount on Carrying value of
Payment Expense Debit ($100,000 x Bonds Payable Bonds Payable
Date (E x 0.14 x ½) 0.12 x ½) Credit (B-C) (previous balance in E+D)
Issued Price $ 95,233
2010/12/31 $6,666 $6,000 $666 95,899
2011/6/30 6,713 6,000 713 96,612
2011/12/31 6,763 6,000 763 97,375
2012/6/30 6,816 6,000 816 98,191
2012/12/31 6,873 6,000 873 99,064
2013/6/30 6,936* 6,000 936 100,000
$40,767 $36,000 $4,767

Exhibit 18: Discount amortization schedule for bonds payable

This entry records interest for two months, July and August, of the six-month interest period ending on 2010
December 31. The first line of Exhibit 19 shows the interest expense and premium amortization for the six months.
Thus, the previous entry records two-sixths (or one-third) of the amounts for this six-month period. Carr would
record the remaining four months' interest when making the first payment on 2010 December 31. That entry reads:
2010
Dec. 31 Bond interest payable (-L) 2,000
Bond interest expense ($5,254 x (4/6)) (-SE) 3,503
Premium on bonds payable ($746 x 4/6) (-L) 497
Cash (-A) 6,000
To record four months' interest expense and semiannual interest
payment.

During the remaining life of the bonds, Carr would make similar entries for August 31 and December 31. The
amounts would differ, however, because Carr uses the interest method of accounting for bond interest. The entry
for each June 30 would be as indicated in Exhibit 19.

Redeeming bonds payable

Bonds may be (1) paid at maturity, (2) called, or (3) purchased in the market and retired. Bonds may also be
retired by being converted into stock. Each action is either a redemption of bonds or the extinguishment of debt. A
company that pays its bonds at maturity would have already amortized any related discount or premium and paid
the last interest payment. The only entry required at maturity would debit Bonds Payable and credit Cash for the
face amount of the bonds as follows:
2013
June 30 Bond payable (-L) 100,000
Cash (-A) 100,000
To pay bonds on maturity date.

(A) (B) (C) (D) (E)

Interest Bond Interest Cash credit Discount on bonds Carrying value of
Payment
Expense Debit ($100,000 x Payable credit Bonds payable
(E x 0.10 x ½) 0.12 x ½) (B- C) (previous balance
in E-D)
Issue Price $105,076
2010/12/31 $ 5,254 $6,000 $ 746 104,330
2011/6/30 5,216* 6,000 784 103,546
2011/12/31 5,177 6,000 823 102,723
2012/6/30 5,136 6,000 864 101,859
2012/12/31 5,093 6,000 907 100,952
2013/6/30 5,048 6,000 952 100,000
$30,924 $36,000 $5,076
*Rounded down.

Exhibit 19: Premium amortization schedule for bonds payable

Introduction to Accounting : The Language of Business – Supplemental Textbook 98

 An issuer may redeem some or all of its outstanding bonds before maturity by calling them. The issuer may also
purchase bonds in the market and retire them. In either case, the accounting is the same. Assume that on 2012
January 1, Carr calls bonds totaling USD 10,000 of the USD 100,000 face value bonds in Exhibit 19 at 103, or USD
10,300. Even though accrued interest would be added to the price, assume that the interest due on this date has
been paid. A look at the last column on the line dated 2011/12/31 in Exhibit 19 reveals that the carrying value of the
bonds is USD 102,723, which consists of Bonds Payable of USD 100,000 and Premium on Bonds Payable of USD
2,723. Since 10 per cent of the bond issue is being redeemed, Carr must remove 10 per cent from each of these two
accounts. The firm incurs a loss for the excess of the price paid for the bonds, USD 10,300, over their carrying
value, USD 10,272. The required entry is:
2012
Jan. 1 Bond payable (-L) 10,000
Premium on bonds payable ($2,723/10) (-L) 272
Loss on bond redemption 9$10,272 - $10,300) 28
(-SE)
Cash (-A) 10,300
To record bonds redeemed.

According to FASB Statement No. 4, gains and losses from voluntary early retirement of bonds are
extraordinary items, if material. We report such gains and losses in the income statement, net of their tax effects, as
described inPart 3. The FASB is currently reconsidering the reporting of these gains and losses as extraordinary
items.
To avoid the burden of redeeming an entire bond issue at one time, companies sometimes issue serial bonds
that mature over several dates. Assume that on 2002 June 30, Jasper Company issued USD 100,000 face value, 12
per cent serial bonds at 100. Interest is payable each year on June 30 and December 31. A total of USD 20,000 of
the bonds mature each year starting on 2010 June 30. Jasper has a calendar-year accounting period. Entries
required for 2010 for interest expense and maturing debt are:
2010
June 30 Bond interest expense ($100,000 x 0.12 x ½) (-SE) 6,000
Cash (-A) 6,000
To record interest payment.

30 Serial bonds payable (-L) 20,000

Cash (-A) 20,000
To record retirement of serial debt.

Dec. 31 Bond interest expense ($80,000 x 0.12 x ½) (-SE) 4,800

Cash (-A) 4,800
To record payment of semiannual interest expense.

Note that Jasper calculates the interest expense for the last six months of 2010 only on the remaining
outstanding debt (USD 100,000 original issue less the USD 20,000 that matured on 2010 June 30). Each year after
the bonds maturing that year are retired, interest expense decreases proportionately. Jasper reports the USD
20,000 amount maturing the next year as a current liability on each year-end balance sheet. The remaining debt is
a long-term liability.
Naturally, bond investors are concerned about the safety of their investments. They fear the company may
default on paying the entire principal at the maturity date. This concern has led to provisions in some bond
indentures that require companies to make periodic payments to a bond redemption fund, often called a
sinking fund. The fund trustee uses these payments to redeem a stated amount of bonds annually and pay the

99
accrued bond interest. The trustee determines which bonds to call and uses the cash deposited in the fund only to
redeem these bonds and pay their accrued interest.
To illustrate, assume Hand Company has 12 per cent coupon bonds outstanding that pay interest on March 31
and September 30 and were issued at face value. The bond indenture requires that Hand pay a trustee USD 53,000
each September 30. The entry for the payment to the trustee is:
Sept. 30 Sinking fund (+A) 53,000
Cash (-A) 53,000
To record payment to trustee of required deposit.

The trustee calls USD 50,000 of bonds, pays for the bonds and accrued interest, and notifies Hand. The trustee
also bills Hand for its fee and expenses incurred of USD 325. Assuming no interest has been recorded on these
bonds for the period ended September 30, the entries are:
Sept.30 Bonds Payable (-L) 50,000
Bond interest expense (-SE) 3,000
Sinking fund (-A) 53,000
To record bond redemption and interest paid by trustee.

30 Sinking fund expense (-SE) 325

Cash (-A) 325
To record trustee fee and expenses.

If a balance exists in the Sinking Fund account at year-end, Hand includes it in a category labeled Investments
or Other Assets on the balance sheet. Hand would describe the USD 50,000 of bonds that must be retired during
the coming year as "Current maturity of long-term debt" and report it as a current liability on the balance sheet.
The existence of a sinking fund does not necessarily mean that the company has created a retained earnings
appropriation entitled "Appropriation for Bonded Indebtedness". A sinking fund usually is contractual (required by
the bond indenture), and an appropriation of retained earnings is simply an announcement by the board of
directors that dividend payments will be limited over the term of the bonds. The former requires cash to be paid in
to a trustee, and the latter restricts retained earnings available for dividends to stockholders. Also, even if the
indenture does not require a sinking fund, the corporation may decide to (1) pay into a sinking fund and not
appropriate retained earnings, (2) appropriate retained earnings and not pay into a sinking fund, (3) do neither, or
(4) do both.
A company may add to the attractiveness of its bonds by giving the bondholders the option to convert the bonds
to shares of the issuer's common stock. In accounting for the conversions of convertible bonds, a company treats
the carrying value of bonds surrendered as the capital contributed for shares issued.
Suppose a company has USD 10,000 face value of bonds outstanding. Each USD 1,000 bond is convertible into
50 shares of the issuer's USD 10 par value common stock. On May 1, when the carrying value of the bonds was USD
9,800, investors presented all of the bonds for conversion. The entry required is:
May 1 Bond payable (-L) 10,000
Discount bonds payable (+L) 200
Common stock ($10,000/$1,000 = 10 bonds;
10 bonds x 50 share x $10 par) (+SE) 5,000
Paid-in capital in excess of par value – common 4,800
(+SE)
To record bonds converted to common stock.

The entry eliminates the USD 9,800 book value of the bonds from the accounts by debiting Bonds Payable for
USD 10,000 and crediting Discount on Bonds Payable for USD 200. It credits Common Stock for the par value of

Introduction to Accounting : The Language of Business – Supplemental Textbook 100

the 500 shares issued (500 shares X USD 10 par). The excess amount (USD 4,800) is credited to Paid-In Capital in
Excess of Par Value—Common.

An accounting perspective:

Business insight

The Securities and Exchange Commission took action to protect the public against abusive
telemarketing calls from sellers of municipal bonds. The residence of any person can only be called
between 8 am and 9 pm, without their prior consent. Callers must clearly disclose the purpose of
the call. Also, a centralized "Do-not-call" list of people who do not wish to receive solicitations must
be maintained and honored.
Source: "SEC Approves Rule Governing Calls From Muni-Bond Sellers to Investors," The Wall
Street Journal, Friday, December 27, 1996, p. A2.

The two leading bond rating services are Moody's Investors Service and Standard & Poor's Corporation. The
bonds are rated as to their riskiness. The ratings used by these services are:
Moody's Standard &
Poor's
Highest quality to upper medium Aaa AAA
Aa AA
A A
Medium to speculative Baa BBB
Ba BB
B B
Poor to lowest quality Caa CCC
Ca CC
C C
In default, value is questionable DDD
DD
D

Normally, Moody's rates junk bonds at Ba or below and Standard & Poor's at BB or below. As a company's
prospects change over time, the ratings of its outstanding bonds change because of the higher or lower probability
that the company can pay the interest and principal on the bonds when due. A severe recession may cause many
companies' bond ratings to decline.
Bond prices appear regularly in certain newspapers. For instance, The Wall Street Journal quoted IBM's bonds
as follows:
Issue Coupon Maturity Yield Price Change
IBM 7˚ 2013 6.6 113 -2

The bonds carry a coupon rate of 7° per cent. The bonds mature in 2013. The current price is USD 113 per
hundred, or USD 1,130.00 for a USD 1,000 bond. The price the preceding day was USD 115, since the change was
-2. The current price yields a return to investors of 6.6 per cent. As the market rate of interest changes from day to
day, the market price of the bonds varies inversely. Thus, if the market rate of interest increases, the market price of
bonds decreases, and vice versa.

101
 An accounting perspective:

Business insight

Companies sometimes invest in the bonds of other companies. According to FASB Statement No.
115 (covered in Chapter 14), investments in these bonds fall into three categories—trading
securities, available-for-sale securities, or held-to-maturity securities. The bonds would be
classified as trading securities if they were acquired principally for the purpose of selling them in
the near future. If the bonds were to be held for a longer period of time, but not until maturity, they
would be classified as available-for-sale securities. Bonds that will be held to maturity are classified
as held-to-maturity securities. All trading securities are current assets. Available-for-sale securities
are either current assets or long-term assets, depending on how long management intends to hold
them. Discounts and premiums on bonds classified as trading and available-for-sale securities are
not amortized because management does not know how long they will be held. Held-to-maturity
securities are long-term assets. Discounts and premiums on bonds classified as held-to-maturity
securities are amortized by the holder of the bonds in the same manner as for the issuer of the
bonds. Further discussion of investments in bonds is reserved for an intermediate accounting
course.

Analyzing and using the financial results—Times interest earned ratio

T he times interest earned ratio (or interest coverage ratio) indicates the ability of a company to meet
required interest payments when due. We calculate the ratio as follows:
Income before interest also taxesIBIT 
Time interest earned ratio=
Interest expense
Income before interest and taxes (IBIT), also called "earnings before interest and taxes (EBIT)", is the
numerator because there would be no income taxes if interest expense is equal to or greater than IBIT. To find IBIT
when the income statement is not complex, take net income and add back interest expense and taxes. However, in
complex situations, when there are discontinued operations, changes in accounting principle, extraordinary items,
interest revenue, and/or other similar items, analysts often use "operating income" to represent IBIT. The higher
the ratio, the more comfortable creditors feel about receiving interest payments in the future.

An ethical perspective:
Rawlings furniture company

The Rawlings brothers inherited 300,000 shares (30 per cent) of the common stock of the Rawlings
Furniture Company from their father, who had founded the company 55 years earlier. One brother
served as president of the company, and the other two brothers served as vice presidents. The
company, which produced a line of fine furniture sold nationwide, earned an average of USD 4
million per year. Located in Jamesville, New York, USA, the company had provided steady

Introduction to Accounting : The Language of Business – Supplemental Textbook 102

 employment for approximately 10 per cent of the city's population. The city had benefited from the
revenues the company attracted to the area and from the generous gifts provided by the father.
The remainder of the common stock was widely held and was traded in the over-the-counter
market. No other stockholder held more than 4 per cent of the stock. The stock had recently traded
at USD 30 per share. The company has USD 10 million of 10 per cent bonds outstanding, which
mature in 15 years.
The brothers enjoyed the money they received from the company, but did not enjoy the work. They
also were frustrated by the fact that they did not own a controlling interest (more than 50 per cent)
of the company. If they had a controlling interest, they could make important decisions without
obtaining the agreement of the other stockholders.
With the assistance of a New York City brokerage house, the brothers decided to pursue a plan that
could increase their wealth. The company would offer to buy back shares of common stock at USD
40 per share. These shares would then be canceled, and the Rawlings brothers would have a
controlling interest. The stock buy-back would be financed by issuing 10-year, 14 per cent, high-
interest junk bonds. The brokerage house had located some financial institutions willing to buy the
bonds. The interest payments on the junk bonds would be USD 3 million per year. The brothers
thought the company could make these payments unless the country entered a recession. If need
be, wage increases could be severely restricted or eliminated and the company's pension plan could
be terminated. If the junk bonds could be paid at maturity, the brothers would own a controlling
interest in what could be an extremely valuable company. If the interest payments could not be met
or if the junk bonds were defaulted at maturity, the company could eventually be forced to
liquidate. The risks are high, but so are the potential rewards. If another buyer entered the picture
at this point and bid an even higher amount for the stock, the brothers could sell their shares and
exit the company. Two of the brothers hoped that another buyer might bid as much as USD 50 per
share so they could sell their shares and pursue other interests. The changes a new buyer might
make are unpredictable at this point.

The times interest earned ratios in a recent year for several companies (described in footnotes to the table) were
as follows:
Earnings before Interest Times Interest
Interest and Expense Earned
Company Taxes (millions) (Millions) Ratio
Ford Mother Companya $19,136 $10,902 1.76
Proctor & Gamble Companyb 6,258 722 8.67
AMR Corporationc 1,754 467 3.76
Dell Computer Corporationd 3,241 47 68.96
Hewlett-Packard Company e
4,882 257 19.00
A
Ford Motor Company is the world's largest producer of trucks and the second largest producer of cars and trucks combined.
B
Proctor and Gamble markets more than 300 brands to nearly five billion customers in over 140 countries.
c
AMR's principal subsidiary is America Airlines.
d
Dell is the world's largest direct computer systems company.
e
Hewlett-Packard Company designs, manufactures, and services products and systems for measurement, computation, and communications.

You can see from these data that a great deal of variability exists in the times interest earned ratios for real
companies. To judge the ability of companies to pay bond interest when due, bondholders would carefully examine
other financial data as well.

103
 Some companies that issued high-interest junk bonds in the 1980s defaulted on their interest payments and had
to declare Chapter 11 bankruptcy or renegotiate payment terms with bondholders in the 1990s. Other companies
with high-interest bonds issued new low-interest bonds and used the proceeds to retire the high-interest bonds.
Chapter 16 discusses the fourth major financial statement—the statement of cash flows, which we mentioned in
Chapter 1. This statement shows the cash inflows and outflows from operating, investing, and financing activities.
Understanding the learning objectives
• A bond is a liability (with a maturity date) that bears interest that is deductible in computing both net
income and taxable income.
• A stock is a unit of ownership on which a dividend is paid only if declared, and dividends are not deductible
in determining net income or taxable income.
• Bonds may be secured or unsecured, registered or unregistered, callable, and/or convertible.
• Advantages include stockholders retaining control of the company, tax deductibility of interest, and
possible creation of favorable financial leverage.
• Disadvantages include having to make a fixed interest payment each period, reduction in a company's
ability to withstand a major loss, possible limitations on dividends and future borrowings, and possible
reduction in earnings per share caused by unfavorable financial leverage.
• If bonds are issued at face value on an interest date, no accrued interest is recorded.
• If bonds are issued between interest dates, accrued interest must be recorded.
• If the market rate is lower than the contract rate, bonds sell for more than their face value, and a premium
is recorded.
• If the market rate is higher than the contract rate, bonds sell for less than their face value, and a discount is
recorded.
• The present value of the principal plus the present value of the interest payments is equal to the price of the
bond.
• The contract rate of interest is used to determine the amount of future cash interest payments.
• The effective rate of interest is used to discount the future payment of principal and of interest back to the
present value.
• When bonds are issued, Cash is debited, and Bonds Payable is credited. For bonds issued at a discount,
Discount on Bonds Payable is also debited. For bonds issued at a premium, Premium on Bonds Payable is also
credited. For bonds issued between interest dates, Bond Interest Payable is also credited.
• Any premium or discount must be amortized over the period the bonds are outstanding.
• Under the effective interest rate method, interest expense for any period is equal to the effective (market)
rate of interest at date of issuance times the carrying value of the bond at the beginning of that interest period.
• Under the straight-line method of amortization, an equal amount of discount or premium is allocated to
each month the bonds are outstanding.
• When bonds are redeemed before they mature, a loss or gain (an extraordinary item, if material) on bond
redemption may occur.
• A bond sinking fund might be required in the bond indenture.

Introduction to Accounting : The Language of Business – Supplemental Textbook 104

 • Bonds may be convertible into shares of stock. The carrying value of the bonds is the capital contributed for
shares of stock issued.
• Bonds are rated as to their riskiness.
• The two leading bond rating services are Moody's Investors Services and Standard & Poor's Corporation.
• Each of these services has its own rating scale. For instance, the highest rating is Aaa (Moody's) and AAA
(Standard & Poor's).
• The times interest earned ratio indicates a company's ability to meet interest payments when due.
• The ratio is equal to income before interest and taxes (IBIT) divided by interest expense.
• The future value of an investment is the amount to which a sum of money invested today will grow in a
stated time period at a specified interest rate.
• Present value is the current worth of a future cash receipt and is the reciprocal of future value. To discount
future receipts is to bring them back to their present values.

Appendix: Future value and present value

Managers apply the concepts of interest, future value, and present value in making business decisions.
Therefore, accountants need to understand these concepts to properly record certain business transactions.

The time value of money

The concept of the time value of money stems from the logical reference for a dollar today rather than a dollar at
any future date. Most individuals prefer having a dollar today rather than at some future date because (1) the risk
exists that the future dollar will never be received; and (2) if the dollar is on hand now, it can be invested, resulting
in an increase in total dollars possessed at that future date.
Most business decisions involve a comparison of cash flows in and out of the company. To be useful in decision
making, such comparisons must be in dollars of the same point in time. That is, the dollars held now must be
accumulated or rolled forward, or future dollars must be discounted or brought back to the present dollar value,
before comparisons are valid. Such comparisons involve future value and present value concepts.

Future value
The future value or worth of any investment is the amount to which a sum of money invested today grows
during a stated period of time at a specified interest rate. The interest involved may be simple interest or compound
interest. Simple interest is interest on principal only. For example, USD 1,000 invested today for two years at 12
per cent simple interest grows to USD 1,240 since interest is USD 120 per year. The principal of USD 1,000, plus 2
X USD 120, is equal to USD 1,240. Compound interest is interest on principal and on interest of prior periods.
For example, USD 1,000 invested for two years at 12 per cent compounded annually grows to USD 1,254.40 as
follows:
Principal or present value $1,000.00
Interest, year 1 = $1,000 x 0.12 = 120.00
Value at end of year 1 $1,120.00
Interest, year 2 = $1,120 x 0.12 = 134.40
Value at end of year 2 (future value) $1,254.40

In Exhibit 20, we graphically portray these computations of future worth and show how USD 1,000 grows to
USD 1,254.40 with a 12 per cent interest rate compounded annually. The effect of compounding is USD 14.40—the

105
interest in the second year that was based on the interest computed for the first year, or USD 120 X 0.12 = USD
14.40.
Interest tables ease the task of computing the future worth to which any invested amount will grow at a given
rate for a stated period. An example is Table A.1 in the Appendix at the end of this text. To use the Appendix tables,
first determine the number of compounding periods involved. A compounding period may be any length of time,
such as a day, a month, a quarter, a half-year, or a year, but normally not more than a year. The number of
compounding periods is equal to the number of years in the life of the investment times the number of
compoundings per year. Five years compounded annually is five periods, five years compounded quarterly is 20
periods, and so on.
Second, determine the interest rate per compounding period. Interest rates are usually quoted in annual terms;
in fact, federal law requires statement of the interest rate in annual terms in some situations. Divide the annual rate
by the number of compounding periods per year to get the proper rate per period. Only with an annual
compounding period will the annual rate be the rate per period. All other cases involve a lower rate. For example, if
the annual rate is 12 per cent and interest is compounded monthly, the rate per period (one month) will be 1 per
cent.
To use the tables, find the number of periods involved in the Period column. Move across the table to the right,
stopping in the column headed by the Interest Rate per Period, which yields a number called a factor. The factor
shows the amount to which an investment of USD 1 will grow for the periods and the rate involved. To compute the
future worth of the investment, multiply the number of dollars in the given situation by this factor. For example,
suppose your parents tell you that they will invest USD 8,000 at 12 per cent for four years and give you the amount
to which this investment grows if you graduate from college in four years. How much will you receive at the end of
four years if the interest rate is 12 per cent compounded annually? How much will you receive if the interest rate is
12 per cent compounded quarterly?
To calculate these amounts, look at the end-of-text Appendix, Table A.1. In the intersection of the 4 period row
and the 12 per cent column, you find the factor 1.57352. Multiplying this factor by USD 8,000 yields USD 12,588.16,
the answer to the first question. To answer the second question, look at the intersection of the 16 period row and
the 3 per cent column. The factor is 1.60471, and the value of your investment is USD 12,837.68. The more frequent
compounding would add USD 12,837.68 - USD 12,588.16 = USD 249.52 to the value of your investment. The
reason for this difference in amounts is that 12 per cent compounded quarterly is a higher rate than 12 per cent
compounded annually.
An annuity is a series of equal cash flows (often called rents) spaced equally in time. The semiannual interest
payments received on a bond investment are a common example of an annuity. Assume that USD 100 will be
received at the end of each of the next three semiannual periods. The interest rate is 6 per cent per semiannual
period. Using Table A.1 in the Appendix, we find the future value of each of the USD 100 receipts as follows:

Introduction to Accounting : The Language of Business – Supplemental Textbook 106

 Exhibit 20: Compound interest and future value

Future value (after three periods) of $100

received at the end of the -
First period: 1.12360 x $100=$112.36
Second period: 1.06000 x 100 = 106.00
Third period: 1.00000 x 100 = 100.00
Total future value $318.36

Such a procedure would become quite tedious if the annuity consisted of many receipts. Fortunately, tables are
available to calculate the total future value directly. See the Appendix, Table A.2. For the annuity just described, you
can identify one single factor by looking at the 3 period row and 6 per cent column. The factor is 3.18360 (the sum
of the three factors shown above), and when multiplied by USD 100, yields USD 318.36, which is the same answer.
In Exhibit 21, we graphically present the future value of an annuity.

Present value
Present value is the current worth of a future cash receipt and is the reciprocal of future value. In future value,
we calculate the future value of a sum of money possessed now. In present value, we calculate the current worth of
rights to future cash receipts possessed now. We discount future receipts by bringing them back to their present
values.
Assume that you have the right to receive USD 1,000 in one year. If the appropriate interest rate is 12 per cent
compounded annually, what is the present value of this USD 1,000 future cash receipt? You know that the present
value is less than USD 1,000 because USD 1,000 due in one year is not worth USD 1,000 today. You also know that
the USD 1,000 due in one year is equal to some amount, P, plus interest on P at 12 per cent for one year. Thus, P +
0.12P = USD 1,000, or 1.12P = USD 1,000. Dividing USD 1,000 by 1.12, you get USD 892.86; this amount is the
present value of your future USD 1,000. If the USD 1,000 was due in two years, you would find its present value by
dividing USD 892.86 by 1.12, which equals USD 797.20. Portrayed graphically, present value looks similar to future
value, except for the direction of the arrows (Exhibit 22).
Table A.3 (end-of-text Appendix) contains present value factors for combinations of a number of periods and
interest rates. We use Table A.3 in the same manner as Table A.1. For example, the present value of USD 1,000 due
in four years at 16 per cent compounded annually is USD 552.29, computed as USD 1,000 X 0.55229. The 0.55229
is the present value factor found in the intersection of the 4 period row and the 16 per cent column.

107
 Exhibit 21: Future value of an annuity

Exhibit 22: Compound interest and present value

As another example, suppose that you wish to have USD 4,000 in three years to pay for a vacation in Europe. If
your investment increases at a 20 per cent rate compounded quarterly, how much should you invest now? To find
the amount, you would use the present value factor found in Table A.3, 12 period row, 5 per cent column. This
factor is 0.55684, which means that an investment of about 55 cents today would grow to USD 1 in 12 periods at 5
per cent per period. To have USD 4,000 at the end of three years, you must invest 4,000 times this factor
(0.55684), or USD 2,227.36.
The semiannual interest payments on a bond are a common example of an annuity. As an example of calculating
the present value of an annuity, assume that USD 100 is received at the end of each of the next three semiannual
periods. The interest rate is 6 per cent per semiannual period. By using Table A.3 (Appendix), you can find the
present value of each of the three USD 100 payments as follows:
Present value of $100 due in:
1 period: 094340 x $100 = $94.34
2 period: 0.89000 x 100 = 89.00
3 period: 0.83962 x 100 = 83.96
Total present value $267.30

Introduction to Accounting : The Language of Business – Supplemental Textbook 108

 Exhibit 23: Present value of an annuity

Such a procedure could become quite tedious if the annuity consisted of a large number of payments.
Fortunately, tables are also available showing the present values of an annuity of USD 1 per period for varying
interest rates and periods. See the end-of-text Appendix, Table A.4. For the annuity just described, you can obtain a
single factor from the table to represent the present value of an annuity of USD 1 per period for three (semiannual)
periods at 6 per cent per (semiannual) period. This factor is 2.67301; it is equal to the sum of the present value
factors for USD 1 due in one period, USD 1 in two periods, and USD 1 in three periods found in the Appendix, Table
A.3. When this factor is multiplied by USD 100, the number of dollars in each payment, it yields the present value
of the annuity, USD 267.30. In Exhibit 23, we graphically present the present value of this annuity and show how to
find the present value of the three USD 100 cash flows by multiplying the USD 100 by a present value of an annuity
factor, 2.67301.
Suppose you won a lottery that awarded you a choice of receiving USD 10,000 at the end of each of the next five
years or USD 35,000 cash today. You believe you can earn interest on invested cash at 15 per cent per year. Which
option should you choose? To answer the question, compute the present value of an annuity of USD 10,000 per
period for five years at 15 per cent. The present value is USD 33,521.60, or USD 10,000 X 3.35216. You should
accept the immediate payment of USD 35,000 since it has the larger present value.
Demonstration problem
Jackson Company issued USD 100,000 face value of 15 per cent, 20-year junk bonds on 2010 April 30. The
bonds are dated 2010 April 30, call for semiannual interest payments on April 30 and October 31, and are issued to
yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule. Enter data in the schedule for only the first two interest periods. Use the
effective interest rate method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
the adjustment needed on 2010 December 31 (assuming Jackson's accounting year ends on that date), and the
second six months' interest expense on 2011 April 30.
Solution to demonstration problem
a.
Price received:
Present value of principal: $100,000 x 0.04603

109
 (see Appendix, Table A.3, 40 period row, 8% column) $ 4,603
Present value of interest: $7,500 x 11.92461
(see Appendix, Table A.4, 40 period row, 8% column) 89,435
Total $94,038

b.
(A) (B) (C) (D) (E)
Interest Bond Cash Credit Discount on Carrying Value
Payment Interest ($100,000 x Bonds Payable of Bonds Payable
Date Expense Debit 0.15 x ½) Credit (previous balance in
(E X 0.16 x ½) (B – C) E + D)
Issued price $94,038
2010/10/31 $7,523 $7,500 $23 94,061
2011/4/30 7,525 7,500 25 94,086

c.
2010
Apr. 30 Cash 94,038
Discount on bonds payable 5,962
Bonds payable 100,000
Issued $100,000 face value of 20-year, 15% bonds to
yield 16%.

Oct. 31 Bond interest expense 7,523

Discount on bonds payable 23
Cash 7,500
Paid semiannual bond interest expense.

Dec. 31 Bond interest expense ($7,525 x (1/3)) 2,508

Discount on bonds payable 8
Bond interest payable ($7,500 x (1/3)) 2,500
To record accrual of two months' interest expense.

2011
Apr. 30 Bond interest payable 2,500
Bond interest expense ($7,525 x (2/3)) 5,017
Discount on bonds payable 17
cash 7,500
Paid semiannual bond interest expense.
Key terms
Annuity A series of equal cash flows spaced in time.
Bearer bond See unregistered bond.
Bond A long-term debt, or liability, owed by its issuer. A bond certificate, a negotiable instrument, is the
formal, physical evidence of the debt owed.
Bond indenture The contract or loan agreement under which bonds are issued.
Bond redemption (or sinking) fund A fund used to bring about the gradual redemption of a bond issue.
Callable bond A bond that gives the issuer the right to call (buy back) the bond before its maturity date.
Call premium The price paid in excess of face value that the issuer of bonds must pay to redeem (call)
bonds before their maturity date.
Carrying value (of bonds) The face value of bonds minus any unamortized discount or plus any
unamortized premium. Sometimes referred to as net liability on the bonds.
Compound interest Interest calculated on the principal and on interest of prior periods.
Contract rate of interest The interest rate printed on the bond certificates and specified on the bond
indenture; also called the stated, coupon, or nominal rate.
Convertible bond A bond that may be exchanged for shares of stock of the issuing corporation at the
bondholders' option.
Coupon bond A bond not registered as to interest; it carries detachable coupons that are to be clipped and
presented for payment of interest due.
Debenture bond An unsecured bond backed only by the general creditworthiness of its issuer.
Discount (on bonds) Amount a bond sells for below its face value.

Introduction to Accounting : The Language of Business – Supplemental Textbook 110

 Effective interest rate method (interest method) A procedure for calculating periodic interest expense
(or revenue) in which the first period's interest is computed by multiplying the carrying value of bonds
payable (bond investments) by the market rate of interest at the issue date. The difference between computed
interest expense (revenue) and the interest paid (received), based on the contract rate times face value, is the
discount or premium amortized for the period. Computations for subsequent periods are based on the
carrying value at the beginning of the period.
Face value Principal amount of a bond.
Favorable financial leverage An increase in EPS and the rate of return on stockholders' equity resulting
from earning a higher rate of return on borrowed funds than the fixed cost of such funds. Unfavorable
financial leverage results when the cost of borrowed funds exceeds the income they generate, resulting in
decreased income to stockholders.
Future value or worth The amount to which a sum of money invested today will grow during a stated
period of time at a specified interest rate.
Interest method See effective interest rate method.
Junk bonds High-interest rate, high-risk bonds; many were issued in the 1980s to finance corporate
restructurings.
Market interest rate The minimum rate of interest investors will accept on bonds of a particular risk
category. Also called effective rate or yield.
Mortgage A legal claim (lien) on specific property that gives the bondholder the right to possess the pledged
property if the company fails to make required payments. A bond secured by a mortgage is called a mortgage
bond.
Premium (on bonds) Amount a bond sells for above its face value.
Present value The current worth of a future cash receipt(s); computed by discounting future receipts at a
stipulated interest rate.
Registered bond A bond with the owner's name on the bond certificate and in the register of bond owners
kept by the bond issuer or its agent, the registrar.
Secured bond A bond for which a company has pledged specific property to ensure its payment.
Serial bonds Bonds in a given bond issue with maturities spread over several dates.
Simple interest Interest on principal only.
Sinking fund See Bond redemption fund.
Stock warrant A right that allows the bondholder to purchase shares of common stock at a fixed price for a
stated period of time. Warrants issued with long-term debt may be detachable or nondetachable.
Straight-line method of amortization A procedure that, when applied to bond discount or premium,
allocates an equal amount of discount or premium to each period in the life of a bond.
Term bond A bond that matures on the same date as all other bonds in a given bond issue.
Times interest earned ratio Income before interest and taxes (IBIT) divided by interest expense. In
complex situations, "operating income" is often used to represent IBIT.
Trading on the equity A company using its stockholders' equity as a basis for securing funds on which it
pays a fixed return.
Trustee Usually a bank or trust company appointed to represent the bondholders and to enforce the
provisions of the bond indenture against the issuer.
Underwriter An investment company or a banker that performs many tasks for the bond issuer in issuing.
bonds; may also guarantee the issuer a fixed price for the bonds.
Unfavorable financial leverage Results when the cost of borrowed funds exceeds the revenue they
generate; it is the reverse of favorable financial leverage.
Unregistered (bearer) bond Ownership transfers by physical delivery.
Unsecured bond A debenture bond, or simply a debenture.
Self-test
True-false
Indicate whether each of the following statements is true or false.
An unsecured bond is called a debenture bond.

111
 Callable bonds may be called at the option of the holder of the bonds.
Favorable financial leverage results when borrowed funds are used to increase earnings per share of common
stock.
If the market rate of interest exceeds the contract rate, the bonds are issued at a discount.
The straight-line method of amortization is the recommended method.
Multiple-choice
Select the best answer for each of the following questions.
Harner Company issued USD 100,000 of 12 per cent bonds on 2010 March 1. The bonds are dated 2010 January
1, and were issued at 96 plus accrued interest. The entry to record the issuance would be:
a.
Cash 98,000
Discount on bonds payable 4,000
Bonds payable 100,000
Bonds interest payable 2,000
b.
Cash 102,000
Bonds payable 100,000
Bond interest payable 2,000
c.
Cash 96,000
Discount on bonds payable 4,000
Bonds payable 100,000

d. None of the above.

If the bonds in the first question had been issued at 104, the entry to record the issuance would have been:
a. Cash 104,000
Bonds payable 100,000
Premium on bonds 4,000
payable

b.
Cash 102,000
Bonds payable 100,000
Bonds interest payable 2,000

c.
Cash 106,000
Bonds payable 100,000
Premium on bonds 4,000
payable
Bonds interest payable 2,000

d. None of the above.

On 2010 January 1, the Alvarez Company issued USD 400,000 face value of 8 per cent, 10-year bonds for cash
of USD 328,298, a price to yield 11 per cent. The bonds pay interest semiannually and mature on 2020 January 1.
Using the effective interest rate method, the bond interest expense for the first six months of 2010 would be:
a. USD 36,113.
b. USD 18,056.
c. USD 32,000.
d. USD 16,000.
If the straight-line amortization method had been used in the previous question, the interest expense for the
first six months would have been:
a. USD 39,170.
b. USD 32,000.

Introduction to Accounting : The Language of Business – Supplemental Textbook 112

 c. USD 18,000.
d. USD 19,585.
Assume a company has net income of USD 100,000, income tax expense of USD 40,000, and interest expense of
USD 20,000. The times interest earned ratio is:
a. 5 times.
b. 7 times.
c. 8 times.
d. 9 times.
Now turn to “Answers to self-test”at the end of the chapter to check your answers.

Questions
➢ What are the advantages of obtaining long-term funds by the issuance of bonds rather than
additional shares of capital stock? What are the disadvantages?
➢ What is a bond indenture? What parties are usually associated with it? Explain why.
➢ Explain what is meant by the terms coupon, callable, convertible, and debenture.
➢ What is meant by the term trading on the equity?
➢ When bonds are issued between interest dates, why should the issuing corporation receive cash equal
to the amount of accrued interest (accrued since the preceding interest date) in addition to the issue
price of the bonds?
➢ Why might it be more accurate to describe a sinking fund as a bond redemption fund?
➢ Indicate how each of the following items should be classified in a balance sheet on 2009 December
31.
➢ Cash balance in a sinking fund.
➢ Accrued interest on bonds payable.
➢ Debenture bonds payable due in 2019.
➢ Premium on bonds payable.
➢ First-mortgage bonds payable, due 2010 July 1.
➢ Discount on bonds payable.
➢ First National Bank—Interest account.
➢ Convertible bonds payable due in 2012.
➢ Why is the effective interest rate method of computing periodic interest expense considered
theoretically preferable to the straight-line method?
➢ Why would an investor whose intent is to hold bonds to maturity pay more for the bonds than their
face value?
➢ Of what use is the times interest earned ratio?

Exercises
Exercise A On 2010 September 30, Domingo's Construction Company issued USD 120,000 face value of 12 per
cent, 10-year bonds dated 2010 August 31, at 100, plus accrued interest. Interest is paid semiannually on February
28 and August 31. Domingo's accounting year ends on December 31. Prepare journal entries to record the issuance
of these bonds, the accrual of interest at year-end, and the payment of the first interest coupon.

113
 Exercise B On 2009 December 31, East Lansing Office Equipment Company issued USD 1,600,000 face value
of 8 per cent, 10-year bonds for cash of USD 1,400,605, a price to yield 10 per cent. The bonds pay interest
semiannually and mature on 2019 December 31.
a. State which is higher, the market rate of interest or the contract rate.
b. Compute the bond interest expense for the first six months of 2010, using the interest method.
c. Show how the USD 1,400,605 price must have been determined.
Exercise C Compute the annual interest expense on the bonds in the previous exercise, assuming the bond
discount is amortized using the straight-line method.
Exercise D After recording the payment of the interest coupon due on 2010 June 30, the accounts of Myrtle
Beach Sailboat, Inc., showed Bonds Payable of USD 300,000 and Premium on Bonds Payable of USD 10,572.
Interest is payable semiannually on June 30 and December 31. The five-year, 12 per cent bonds have a face value of
USD 300,000 and were originally issued to yield 10 per cent. Prepare the journal entry to record the payment of
interest on 2010 December 31. Use the interest method. (Round all amounts to the nearest dollar.)
Exercise E On 2010 June 30 (a semiannual interest payment date), Holiday Rollerblade Company redeemed
all of its USD 400,000 face value of 10 per cent bonds outstanding by calling them at 106. The bonds were
originally issued on 2006 June 30, at 100. Prepare the journal entry to record the payment of the interest and the
redemption of the bonds on 2010 June 30.
Exercise F On 2009 August 31, as part of the provisions of its bond indenture, Caribbean Cruise Line, Inc.,
acquired USD 480,000 of its outstanding bonds on the open market at 96 plus accrued interest. These bonds were
originally issued at face value and carry a 12 per cent interest rate, payable semiannually. The bonds are dated 2002
November 30, and pay semiannual interest on May 31 and November 30. Prepare the journal entries required to
record the accrual of the interest to the acquisition date on the bonds acquired and the acquisition of the bonds.
Exercise G Cleveland Heating Systems, Inc., is required to make a deposit of USD 18,000 plus semiannual
interest expense of USD 540 on 2009 October 31, to the trustee of its sinking fund so that the trustee can redeem
USD 18,000 of the company's bonds on that date. The bonds were issued at 100. Prepare the journal entries
required on October 31 to record the sinking fund deposit, the bond retirement, payment of interest (due on that
date), and payment of trustee expenses, assuming the latter is USD 100.
Exercise H After interest was paid on 2010 September 30, USD 60,000 face value of Miami Video Rentals,
Inc., outstanding bonds were converted into 8,000 shares of the company's USD 5 par value common stock.
Prepare the journal entry to record the conversion, assuming the bonds were issued at 100.
Exercise I A recent annual report of Wal-Mart Corporation showed the following amounts as of the dates
indicated:
Year Ended January 31
2001 2000 1999
Earnings before interest (and taxes) $11,583 $10,162 $8,008
(millions)
Interest expense (millions) 1,467 1,079 838

Calculate the times interest earned ratio for each year and comment on the results.
Exercise J What is the present value of a lump-sum payment of USD 20,000 due in five years if the market
rate of interest is 10 per cent per year (compounded annually) and the present value of USD 1 due in five periods at
10 per cent is 0.62092?

Introduction to Accounting : The Language of Business – Supplemental Textbook 114

 Exercise K What is the present value of a series of semiannual payments of USD 10,000 due at the end of each
six months for the next five years if the market rate of interest is 10 per cent per year and the present value of an
annuity of USD 1 for 10 periods at 5 per cent is 7.72173?
Exercise L Joe Mordino bought a ticket in the Georgia lottery for USD 1, hoping to strike it rich. To his
amazement, he won USD 4,000,000. Payment was to be received in equal amounts at the end of each of the next 20
years. Mordino heard from relatives and friends he had not heard from in years. They all wanted to renew their
relationship with this new millionaire. Federal and state income taxes were going to be about 40 per cent (36 per
cent for federal and 4 per cent for state) on each year's income from the lottery check. The discount rate to use in all
present value calculations is 12 per cent.
a. How much will Mordino actually receive after taxes each year?
b. Is Mordino a multimillionaire according to the present value of his cash inflow after taxes?
c. What is the present value of the net amount the state has to pay out? Remember that the state gets part of the
money back in the form of taxes.
Exercise M After Joe Mordino won USD 4,000,000 in the Georgia lottery, he decided to purchase USD 10,000
of lottery tickets at the end of each year for the next 20 years. He was hoping to hit the lottery again, but he never
did. If the state can earn 12 per cent on ticket revenue received, how much will the annuity of USD 10,000 from
Mordino grow to by the end of 20 years?
Problems
Problem A On 2009 June 1, Economy Auto Parts, Inc., issued USD 180,000 of 10-year, 16 per cent bonds
dated 2009 April 1, at 100. Interest on bonds is payable semiannually on presentation of the appropriate coupon.
All of the bonds are of USD 1,000 denomination. The company's accounting period ends on June 30, with
semiannual statements prepared on December 31 and June 30. The interest payment dates are April 1 and October
1.
All of the first coupons on the bonds are presented to the company's bank and paid on 2009 October 2. All but
two of the second coupons are similarly received and paid on 2010 April 1.
Prepare all necessary journal entries for these transactions through 2010 April 1, including the adjusting entry
needed at 2009 June 30.
Problem B Ecological Water Filtration, Inc., is going to issue USD 400,000 face value of 10 per cent, 15-year
bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2024 June 30.
a. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the
first six months' interest, assuming the bonds are issued at this price. Use the interest method and calculate all
amounts to the nearest dollar.
b. Repeat part (a), assuming investors seek a yield of 12 per cent.
Problem C On 2009 July 1, South Carolina Table Company issued USD 600,000 face value of 10 per cent, 10-
year bonds. The bonds call for semiannual interest payments and mature on 2019 July 1. The company received
cash of USD 531,180, a price that yields 12 per cent.
Assume that the company's fiscal year ends on March 31. Prepare journal entries (to the nearest dollar) to record
the bond interest expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest
method. Calculate all amounts to the nearest dollar.

115
 Problem D Storall Company issued USD 200,000 face value of 16 per cent, 20-year junk bonds on 2010 July 1.
The bonds are dated 2010 July 1, call for semiannual interest payments on July 1 and January 1, and were issued to
yield 12 per cent (6 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 19. Enter data in the schedule for only the first two
interest periods. Use the interest method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming the company's fiscal year ends on that date.
Problem E Kelly Furniture Company issued USD 400,000 face value of 18 per cent, 20-year junk bonds on
2009 October 1. The bonds are dated 2009 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 19. Enter data in the schedule for only the first two
interest periods. Use the interest method and make all calculations to the nearest dollar.
c. Prepare entries to record the issuance of the bonds, the first six months' interest on the bonds, and the
adjustment needed on 2010 June 30, assuming the company's fiscal year ends on that date.
Problem F Houston Clothing Company issued USD 600,000 of 12 per cent serial bonds on 2009 July 1, at face
value. The bonds are dated 2009 July 1; call for semiannual interest payments on July 1 and January 1; and mature
at the rate of USD 120,000 per year, with the first maturity date falling on 2010 July 1. The company's accounting
period ends on September 30.
Prepare journal entries to record the interest payment of 2010 July 1; the maturing of USD 120,000 of bonds on
2010 July 1; and the adjusting entry needed on 2010 September 30. Also, show how the bonds would be presented
in the company's balance sheet for 2010 September 30.
Alternate problems
Alternate problem A On 2009 December 1, New Jersey Waste Management Company issued USD 300,000
of 10-year, 9 per cent bonds dated 2009 July 1, at 100. Interest on the bonds is payable semiannually on July 1 and
January 1. All of the bonds are registered. The company's accounting period ends on March 31. Quarterly financial
statements are prepared.
The company deposits a sum of money sufficient to pay the semiannual interest on the bonds in a special
checking account in First National Bank and draws interest payment checks on this account. The deposit is made
the day before the checks are drawn.
Prepare journal entries to record the issuance of the bonds; the December 31 adjusting entry; the 2010 January
1, interest payment; and the adjusting entry needed on 2010 March 31, to prepare quarterly financial statements.
Alternate problem B Safe Toy Company is seeking to issue USD 800,000 face value of 10 per cent, 20-year
bonds. The bonds are dated 2009 June 30, call for semiannual interest payments, and mature on 2029 June 30.
a. Compute the price investors should offer if they seek a yield of 8 per cent on these bonds. Also, compute the
first six months' interest assuming the bonds are issued at that price. Use the interest method and calculate all
amounts to the nearest dollar.
b. Repeat part (a) assuming investors seek a yield of 12 per cent.

Introduction to Accounting : The Language of Business – Supplemental Textbook 116

 Alternate problem C On 2009 July 1, Tick-Tock Clock Company issued USD 100,000 face value of 8 per cent,
10-year bonds. These bonds call for semiannual interest payments and mature on 2019 July 1. The company
received cash of USD 87,538, a price that yields 10 per cent.
Assume that the company's fiscal year ends on March 31. Prepare journal entries to record the bond interest
expense on 2010 January 1, and the adjustment needed on 2010 March 31, using the interest method. Calculate all
amounts to the nearest dollar.
Alternate problem D Creative Web Page issued USD 600,000 face value of 15 per cent, 20-year bonds on
2010 October 1. The bonds are dated 2010 October 1, call for semiannual interest payments on April 1 and October
1, and are issued to yield 16 per cent (8 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 18. Enter data in the schedule for only the first two
interest periods. Use the interest method.
c. Prepare journal entries to record issuance of the bonds, the first six months' interest expense on the bonds,
and the adjustment needed on 2011 May 31, assuming Creative Web Page's fiscal year ends on that date.
Alternate problem E Goodhew Software Systems, Inc., issued USD 100,000 face value of 10 per cent, 20-year
bonds on 2009 July 1. The bonds are dated 2009 July 1, call for semiannual interest payments on July 1 and
January 1, and are issued to yield 12 per cent (6 per cent per period).
a. Compute the amount received for the bonds.
b. Prepare an amortization schedule similar to that in Exhibit 18. Enter data in the schedule for only the first two
interest periods. Use the interest method and calculate all amounts to the nearest dollar.
c. Prepare entries to record the issuance of the bonds, the first six months' interest on the bonds, and the
adjustment needed on 2010 June 30, assuming Goodhew's fiscal year ends on that date.
Alternate problem F Western Solar Energy Company issued USD 400,000 of 12 per cent bonds on 2009 July
1, at face value. The bonds are dated 2009 July 1, call for semiannual payments on July 1 and January 1, and mature
at the rate of USD 40,000 per year on July 1, beginning in 2010. The company's accounting period ends on
September 30.
a. Prepare journal entries to record the interest expense and payment for the six months ending 2010 July 1; the
maturing of the bonds on 2010 July 1; and the adjusting entries needed on 2010 September 30.
b. Show how the bonds would be presented in the company's balance sheet for 2010 September 30.
Beyond the numbers—Critical thinking
Business decision case A A company is trying to decide whether to invest USD 2 million on plant expansion
and USD 1 million to finance a related increase in inventories and accounts receivable. The USD 3 million
expansion is expected to increase business volume substantially. Profit forecasts indicate that income from
operations will rise from USD 1.6 million to USD 2.4 million. The income tax rate will be about 40 per cent. Net
income last year was USD 918,000. Interest expense on debt now outstanding is USD 70,000 per year. There are
200,000 shares of common stock currently outstanding. The USD 3 million needed can be obtained in two
alternative ways:
• Finance entirely by issuing additional shares of common stock at an expected issue price of USD 75 per
share.

117
 • Finance two-thirds with bonds, one-third with additional stock. The bonds would have a 20-year life, bear
interest at 10 per cent, and sell at face value. The issue price of the stock would be USD 80 per share.
Should the investment be made? If so, explain which financing plan you would recommend. (Hint: Calculate
earnings per share for last year and for future years under each of the alternatives.)
Business decision case B An annual report of a company contained the following paragraph in the notes to
the financial statements:
The 9 7/8 per cent Senior Subordinated Debentures are redeemable at the option of [the company] at 103.635
per cent of the principal amount plus accrued interest if redeemed prior to [a certain date], and at decreasing prices
thereafter. Mandatory sinking fund payments of USD 3,000,000 (which [the company] may increase to USD
6,000,000 annually)...and are intended to retire, at par plus accrued interest, 75 per cent of the issue prior to
maturity.
Answer the following questions:
a. What does the term debentures mean?
b. How much is the call premium initially? Does this premium decrease over time?
c. Under what circumstances might the company want to increase the sinking fund payments?
Business decision case C The Wall Street Journal contained a table showing yield comparisons for groups of
corporate bonds. The following data have been adapted from the table:
Yield Percentage
As of 52-week
4/28 4/27 High Low
Risk category
1-10 year maturities:
High quality 7.08% 6.94% 7.16% 5.32%
Medium quality 7.41 7.26 7.49 5.76
Over 10 year maturities:
High quality 7.91 7.81 8.06 6.93
Medium quality 8.36 8.25 8.49 7.29
High-yield bonds 10.45 10.48 10.53 9.25

Standard & Poor's

ratings were:
High quality AAA to AA
Medium quality A to BBB
High yield BB to C

Prepare written answers to the following questions.

a. In each column of numbers, why do the yield rates increase from top to bottom?
b. For the high quality and medium quality bonds, what could account for the increase in the yield rates from
4/27 to 4/28? Take into consideration possible economic events.
c. Which risk class of bonds was closest to its 52-week high on 4/28? What could have been the cause?
Annual report analysis D Refer to the Annual report appendix and determine the times interest earned ratio
for 2003 for The Limited. Use "operating income" to represent IBIT. Prepare written comments on the results of
your analysis.
Annual report analysis E A recent annual report of Emhart Corporation contained the following paragraph
in its notes to the financial statements:
The 6 3/4 per cent convertible subordinated debentures may be converted into shares of common stock at a
price of USD 26.50 per share at any time prior to maturity. They are redeemable at prices decreasing from 105 per
cent of face amount currently to 100 per cent [at a certain future date].

Introduction to Accounting : The Language of Business – Supplemental Textbook 118

 Answer the following questions:
a. If you held one USD 1,000 bond, how many shares of stock would you receive if you converted the bond into
shares of stock? (Hint: You can use the principal amount of the bond to buy shares of stock at the stated price.)
b. Assume you held one USD 1,000 bond and the bond was called by the company at a price of 105 per cent of
the face amount. If the current market price per share of the stock was USD 29, would you convert the bond into
shares of stock or would you surrender the bond? Explain.
Ethics case – Writing experience F Refer to "An ethical perspective: Rawlings furniture company”. Write
out the answers to the following questions:
a. What motivates the brothers to pursue this new strategy?
b. Are the brothers the only ones assuming the risks?
c. How will workers, the city, the holders of the original bond issue, and the other present stockholders be
affected if the junk bonds are issued and are then defaulted?
d. How might these parties (stakeholders) be affected if a new buyer outbids the management?
e. What ethical considerations are involved?
Group project G In groups of two or three students, write a two-page, double-spaced paper on one of the
following topics:
The Use of Junk Bonds in the 1980s
Why Market Rates of Interest and Prices of Bonds Are Inversely Related
How a Company Can Force Conversion of Callable, Convertible Bonds
How Bond Sinking Funds Work
Do some library research on your topic and properly cite your sources. Make your analysis convincing. Your
paper should be neat, contain no spelling or grammatical errors, and be the result of several drafts. Use a word
processing program to prepare your paper if possible. Your paper should have a cover page with the title and the
authors' names.
Group project H In a small group of students, locate Accounting Principles Board Opinion No. 21 (from a
faculty member or from the library) relating to the amortization of premiums and discounts on bonds. Investigate
why the Board recommended the effective interest rate method over the straight-line method for amortizing bond
premiums and discounts. Which method do you favor and why? Summarize the highlights of the APB Opinion and
your own opinions in a written report to your instructor.
Group project I With one or two other students, locate the annual reports of three companies with bonds
outstanding as part of their long-term debt. You should read the notes to the financial statements to determine the
composition of the long-term debt. Identify the bonds (e.g. debentures, serial), their interest rates, and any other
information pertaining to them. Compare the bonds outstanding for the three companies. Write a report to your
instructor summarizing your findings.
Using the Internet—A view of the real world
Visit the following site for the Eastman Kodak Company:
http://www.kodak.com
By following the instructions on the screen, locate the notes to the financial statements and find the one
pertaining to long-term debt. In your own words, write a short report to your instructor summarizing the types of
long-term debt held by the company and some of the details of the arrangements with lenders.

119
 Visit the following website for Eastman Chemical Company:
http://www.eastman.com
Pursue choices on the screen until you locate the financial information. Then investigate long-term borrowings.
You will probably go down some "false paths" to get to this financial information, but you can get there. This
experience is all part of learning to use the Internet. Check to determine the composition of the long-term
borrowings. Check out the notes to the financial statements for further information. Browse around the site for any
other interesting information concerning the company. Write a memo to your instructor summarizing your
findings.
Answers to self-test
True-false
True. These unsecured bonds are called debenture bonds and are backed only by the general creditworthiness
of the issuer.
False. Callable bonds may be called at the option of the issuer.
True. This statement is the definition of favorable financial leverage. However, unfavorable financial leverage
can result when favorable financial leverage was planned. Unfavorable financial leverage will result if income before
interest and taxes is much lower than anticipated. Then earnings per share for the common stockholders would be
lower than they would have been without the borrowing.
True. Purchasers will not be willing to pay the face amount if the market rate of interest exceeds the contract
rate. By paying less than the face value, purchasers can earn the market rate of interest on the bonds.
False. The effective interest rate method is the recommended method. The straight-line method may be used
only when the results are not materially different from the interest method.
Multiple-choice
a. The discount of USD 4,000 must be recorded. Also, the accrued interest must be recognized (USD 100,000 X
12 per cent X 2/12 = USD 2,000).
c. The premium is USD 4,000, and the accrued interest is USD 2,000. Both must be recognized.
b. The interest is (USD 328,298 X 0.11 X 1/2 ) = USD 18,056.
d. The interest would have been (USD 400,000 X 0.04) + (USD 71,702/20) = USD 19,585.
c. Income before interest and taxes is (USD 100,000 + USD 40,000 + USD 20,000) = USD 160,000. This total
of USD 160,000 divided by interest of USD 20,000 = 8 times.

Introduction to Accounting : The Language of Business – Supplemental Textbook 120

This textbook is part of the the Global Text Project. The textbook has been modified by Business Learning Software,
Inc. and Brigham Young University under the creative commons license
(http://creativecommons.org/licenses/by/3.0/). For more information please see: http://globaltext.terry.uga.edu

Introduction to Accounting : The Language of Business – Supplemental Textbook