True/False Questions

 

1. The current FASB standard requires using intrinsic value accounting for employee stock options.

 

Answer: False      Learning Objective: 2          Level of Learning: 1

 

2. Current year stock dividends and splits require retroactive restatement of EPS for all prior years presented in comparative financial statements.

 

Answer: True      Learning Objective: 7          Level of Learning: 1

 

3. Compensation expense must be adjusted during the service period to reflect changes in the fair value of options caused by changes in the market price of the underlying shares.

 

Answer: False      Learning Objective: 2          Level of Learning: 2

 

4. Stock options will be dilutive and included in the calculation of dilutive EPS if the exercise price is greater than the average market value of the stock.

 

Answer: False      Learning Objective: 9          Level of Learning: 2

 

5. Dilutive convertible bonds affect both the numerator and the denominator in computing diluted EPS.

 

Answer: True      Learning Objective: 10          Level of Learning: 1

 

6. If previous experience indicates that a material number of stock options will be forfeited before they vest, the fair value estimate of the options on the grant date should be adjusted to reflect that expectation.

 

Answer: True      Learning Objective: 2          Level of Learning: 1

 

7. Except for tax considerations the potentially dilutive effect of convertible preferred stock is handled in EPS calculations in much the same way as convertible debt.

 

Answer: True      Learning Objective: 10          Level of Learning: 1

 

8. No time weighting of contingently issuable shares is required when computing basic EPS.

 

Answer: True      Learning Objective: 11          Level of Learning: 1

 

9. If a company’s capital structure includes convertible bonds, diluted EPS might be reduced even if the bonds are not actually converted during the year.

 

Answer: True      Learning Objective: 10          Level of Learning: 2

 

10. If a company reports an extraordinary gain, EPS must be disclosed on the face of the income statement for both income from ordinary continuing operations and net income.

 

Answer: True      Learning Objective: 12          Level of Learning: 1

 

 

Matching Pair Questions

 

Use the following to answer questions 11-15:

 

11-15.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Complex capital structure
2. Contingently issuable shares
3. Convertible bonds
4. Convertible preferred stock dividends
5. Diluted EPS
6. If converted method
7. Price-earnings ratio
8. Simple capital structure
9. Stock dividends and splits
10. Treasury stock method

Phrases:

11. ____ Add after-tax interest to EPS numerator.
12. ____ Applies to both convertible debt and convertible equity securities.
13. ____ Approximation of EPS assuming potential common shares became common stock.
14. ____ Assumption used for options, rights, and warrants.
15. ____ Dual presentation of EPS does not apply.

 

Answer: 11-C; 12-F; 13-E; 14-J; 15-H

 

Use the following to answer questions 16-20:

 

16-20.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Contingently issuable shares
2. Convertible bonds
3. Convertible preferred stock dividends
4. Diluted EPS
5. If converted method
6. Price-earnings ratio
7. Stock dividends and splits
8. Times interest earned multiple
9. Treasury stock method
10. Undeclared preferred dividends

Phrases:

16. ____ Expresses the market value of a stock as a multiple of EPS.
17. ____ Factored into EPS if the stock is cumulative.
18. ____ Handled retroactively in computing current and prior years’ EPS.
19. ____ Omitted from the EPS numerator under the if converted approach.
20. ____ Included in diluted EPS when performance criterion is met.

 

Answer: 16-F; 17-J; 18-G; 19-C; 20-A

 

 

Use the following to answer questions 21-25:

 

21-25.   Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Antidilutive security
2. Basic EPS
3. Convertible bonds
4. Dividend payout ratio
5. Earnings available to common shareholders
6. Issuance of new shares
7. Multiple convertible securities
8. Options, rights, and warrants
9. Preferred dividends
10. Preferred dividends

Phrases:

21. ____ Need to be ranked high to low in terms of dilutive effect.
22. ____ No dilution considered.
23. ____ Tends to be low for growth companies.
24. ____ The numerator in the EPS formula.
25. ____ The treasury stock method is used.

 

Answer: 21-G; 22-B; 23-D; 24-E; 25-H

 

Use the following to answer questions 26-30:

 

26-30.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Antidilutive security
2. Basic EPS
3. Convertible bonds
4. Contingently issuable shares
5. Earnings available to common shareholders
6. Issuance of new shares
7. Multiple convertible securities
8. Options, rights, and warrants
9. Preferred dividends
10. Reacquired shares

Phrases:

26. ____ Potentially dilutive debt.
27. ____ Time-weighted decrease in the basic EPS denominator.
28. ____ Time-weighted increase in the basic EPS denominator.
29. ____ Decrease in the EPS numerator.
30. ____ Does not affect and is not affected by EPS calculations.

 

Answer: 26-C; 27-J; 28-F; 29-I; 30-A

 

 

Use the following to answer questions 31-35:

 

31-35.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Bonuses
2. Expired options
3. Grant date
4. Option exercise date
5. Option exercise price
6. Performance condition plans
7. Stock option
8. SARs
9. Stock volatility
10. Vesting period

Phrases:

31. ____ A right to buy shares of stock in the future.
32. ____ Shares given for achieving financial goals.
33. ____ Benefit period over which stock option compensation expense is spread.
34. ____ Paid-in capital effectively renamed under the fair value approach.
35. ____ Expensed as compensation in the period earned.

 

Answer: 31-G; 32-F; 33-J; 34-B; 35-A

 

Use the following to answer questions 36-40:

 

36-40.  Listed below are ten terms followed by a list of phrases that describe or characterize five of the terms. Match each phrase with the correct term by placing the letter designating the best term in the space provided by the phrase.

 

Terms:

1. Bonuses
2. Expired options
3. Grant date
4. Option exercise date
5. Option exercise price
6. Performance condition plans
7. Stock option
8. SARs
9. Stock volatility
10. Vesting period

Phrases:

36. ____ Require(s) liability recognition if the employee can elect to receive cash or stock.
37. ____ Date on or after which employees can buy stock with options.
38. ____ Date on which options are awarded.
39. ____ An important factor in option pricing models.
40. ____The amount paid to convert the option into stock.

 

Answer: 36-H; 37-D; 38-C; 39-I; 40-E

 

 

 

Multiple Choice Questions

 

41. The single accounting number in the annual report that receives the most attention by investors is:
42. A) Total revenue.
43. B) Book value per share.
44. C) Equity per share.
45. D) Earnings per share.

 

Answer: D      Learning Objective: 12          Level of Learning: 1

 

42. A primary goal of earnings per share determination is:
43. A)
44. B)
45. C)
46. D)

 

Answer: B      Learning Objective: 12          Level of Learning: 1

 

43. ABC declared and paid cash dividends in January of the current year to its common shareholders. The dividend:
44. A) Will be added to the numerator of the earnings per share fraction for the current year.
45. B) Will be added to the denominator of the earnings per share fraction for the current year.
46. C) Will be subtracted from the numerator of the earnings per share fraction for the current year.
47. D) Has no effect on the earnings per share for the coming year.

 

Answer: D      Learning Objective: 5          Level of Learning: 2

 

44. The reporting of earnings per share is required only for:
45. A) Private companies.
46. B) Companies with complex capital structures.
47. C) Publicly traded corporations.
48. D) Medium-sized and large corporations.

 

Answer: C      Learning Objective: 12          Level of Learning: 1

 

45. When a company’s only potential common shares are convertible bonds:
46. A) Diluted EPS will be greater if the bonds are actually converted than if they are not converted.
47. B) Diluted EPS will be smaller if the bonds are actually converted than if the bonds are not converted.
48. C) Diluted EPS will be the same whether or not the bonds are converted.
49. D) The effect of conversion on diluted EPS cannot be determined without additional information.

 

Answer: C      Learning Objective: 6          Level of Learning: 2

 

 

 

46. If convertible bonds were issued at a discount, when computing diluted EPS, the amortization of the bond discount:
47. A) Will have no effect.
48. B) Will decrease the numerator.
49. C) Will increase the numerator.
50. D) May increase or decrease the numerator, depending on the amortization method used.

 

Answer: C      Learning Objective: 10          Level of Learning: 2

 

47. XYZ paid $10,000 in dividends in January of the current year to its preferred shareholders. The preferred stock is nonconvertible and noncumulative. The dividend:
48. A) Will be added to the denominator of the earnings per share fraction for the current year.
49. B) Will be added to the numerator of the earnings per share fraction for the current year.
50. C) Will be subtracted from the numerator of the earnings per share fraction for the current year.
51. D) May not affect earnings per share depending on the declaration date.

 

Answer: D      Learning Objective: 10          Level of Learning: 2

 

48. When computing earnings per share, noncumulative preferred dividends not declared should be:
49. A)
50. B) Deducted from earnings for the year.
51. C) Added to earnings for the year.
52. D) Deducted, net of tax effect, from earnings for the year.

 

Answer: A      Learning Objective: 8          Level of Learning: 1

 

49. When computing earnings per share, cumulative preferred dividends not declared should be:
50. A) Deducted from earnings for the year.
51. B) Deducted, net of tax effect, from earnings for the year.
52. C) Added to earnings for the year.
53. D)

 

Answer: A      Learning Objective: 8          Level of Learning: 1

 

50. Basic earnings per share is computed using:
51. A) The actual number of common shares outstanding at the end of the year.
52. B) A weighted-average of preferred and common shares.
53. C) The number of common shares outstanding plus common stock equivalents.
54. D) Weighted-average common shares outstanding for the year.

 

Answer: D      Learning Objective: 6          Level of Learning: 1

 

51. Which of the following is a correct statement concerning earnings per share?
52. A) Earnings per share can never be a negative number.
53. B) Earnings per share must be reported for all corporations.
54. C) If a company has an extraordinary loss, at least two EPS amounts must be reported.
55. D) Reported earnings per share is the result of dividing weighted-average shares by net income.

 

Answer: C      Learning Objective: 12          Level of Learning: 1

 

 

52. When a company’s income statement includes an extraordinary gain, the company should report per share information on:

	Net Income	Extraordinary Gain
A)	Yes	No
B)	Yes	Yes
C)	No	No
D)	No	Yes

 

Answer: B      Learning Objective: 12          Level of Learning: 1

 

53. When a company’s income statement includes discontinued operations and a gain on the sale of machinery, the company should report per share information on:

	Net income	Discontinued operations	Gain on sale of machinery
A)	Yes	No	No
B)	Yes	Yes	No
C)	Yes	No	Yes
D)	Yes	Yes	Yes

 

Answer: B      Learning Objective: 12          Level of Learning: 1

 

54. The result of a stock split is:
55. A) A larger number of more valuable shares.
56. B) An increase in corporate assets.
57. C) An increase in shareholders’ equity.
58. D) A larger number of less valuable shares.

 

Answer: D      Learning Objective: 7          Level of Learning: 1

 

55. When computing diluted earnings per share, which of the following will be omitted from the calculation?
56. A) Dividends paid on common stock.
57. B) The weighted average common shares.
58. C) The effect of stock splits.
59. D) The number of common shares represented by stock purchase warrants.

 

Answer: A      Learning Objective: 6          Level of Learning: 1

 

56. When computing diluted earnings per share, stock options:
57. A) Are included if they are antidilutive.
58. B) Should be ignored.
59. C) Are included if they are dilutive.
60. D) Increase the numerator while not affecting the denominator.

 

Answer: C      Learning Objective: 9          Level of Learning: 2

 

57. Basic and diluted earnings per share data are required to be reported:
58. A) In footnotes to the financial statements.
59. B) Only if they add to the relevance of the income statement.
60. C) In the summary section of the annual report.
61. D) On the face of the income statement.

 

Answer: D      Learning Objective: 12          Level of Learning: 2

 

 

58. Which of the following will require a recalculation of weighted-average shares outstanding for all years presented?
59. A) Stock dividends and stock splits.
60. B) Stock dividends but not stock splits.
61. C) Stock splits but not stock dividends.
62. D) Stock rights.

 

Answer: A      Learning Objective: 9          Level of Learning: 2

 

59. All other things equal, what is the effect on earnings per share when a corporation acquires shares of its own stock on the open market?
60. A)
61. B) No effect if the shares are held as treasury shares.
62. C) Increase only if the shares are considered to be retired.
63. D)

 

Answer: D      Learning Objective: 7          Level of Learning: 2

 

60. If a stock dividend were distributed, when calculating the current year’s EPS, the shares distributed are treated as having been issued:
61. A) At the end of the year.
62. B) At the beginning of the year.
63. C) On the declaration date.
64. D) On the date of distribution.

 

Answer: B      Learning Objective: 7          Level of Learning: 2

 

61. If a stock split occurred, when calculating the current year’s EPS, the shares are treated as issued:
62. A) At the end of the year.
63. B) On the first day of the next fiscal year.
64. C) At the beginning of the year.
65. D) On the date of distribution.

 

Answer: C      Learning Objective: 7          Level of Learning: 1

 

62. The adjustment to the weighted-average shares for retired shares is the same as for issuing new shares except:
63. A) The shares are deducted rather than added.
64. B) The shares are added rather than deducted.
65. C) The shares are treated as being acquired at the end of the year.
66. D) The shares are treated as being acquired at the beginning of the year.

 

Answer: A      Learning Objective: 6          Level of Learning: 2

 

 

63. Preferred dividends are subtracted from earnings when computing earnings per share whether or not the dividends are declared or paid if the preferred stock is:
64. A)
65. B)
66. C)
67. D)

 

Answer: D      Learning Objective: 8          Level of Learning: 2

 

64. Preferred dividends would not be subtracted from earnings when computing earnings per share in a year when the dividends are not declared if the preferred stock is:
65. A)
66. B)
67. C)
68. D)

 

Answer: A      Learning Objective: 8          Level of Learning: 2

 

65. How many types of potential common shares must a corporation have in order to be said to have a complex capital structure?
66. A)
67. B)
68. C) 1.
69. D)

 

Answer: C      Learning Objective: 5          Level of Learning: 1

 

66. Which of the following is not a potential common stock?
67. A) Convertible preferred stock.
68. B) Convertible bonds.
69. C) Stock rights.
70. D) Participating preferred stock.

 

Answer: D      Learning Objective: 5          Level of Learning: 1

 

67. Basic earnings per share ignores:
68. A) All potential common shares.
69. B) Some potential common shares, but not others.
70. C) Dividends declared on noncumulative preferred stock.
71. D) Stock splits.

 

Answer: A      Learning Objective: 5          Level of Learning: 1

 

68. Stock options, rights, and warrants are different from convertible securities in that they:
69. A) Typically increase cash upon exercise.
70. B) Usually reduce total assets upon exercise.
71. C) Often reduce liabilities upon exercise.
72. D) Normally increase retained earnings upon exercise.

 

Answer: A      Learning Objective: 9          Level of Learning: 1

 

 

 

69. Stock options do not affect the calculation of:
70. A) Diluted EPS.
71. B) Weighted-average common shares.
72. C) The denominator in the diluted EPS fraction.
73. D) Basic EPS.

 

Answer: D      Learning Objective: 9          Level of Learning: 2

 

70. The calculation of diluted earnings per share assumes that stock options were exercised and that the proceeds were used to:
71. A) Buy common stock as an investment.
72. B) Retire preferred stock.
73. C) Buy treasury stock.
74. D) Increase net income.

 

Answer: C      Learning Objective: 9          Level of Learning: 2

 

71. The calculation of diluted earnings per share assumes that stock options were exercised and that the proceeds were used to buy treasury stock at:
72. A) The end-of-year market price.
73. B) The average market price during the period.
74. C) The purchase price stated on the options.
75. D) The stock’s par value.

 

Answer: B      Learning Objective: 9          Level of Learning: 1

 

72. When we assume conversion of convertible bonds, the numerator is increased by:
73. A) The amount of after-tax interest.
74. B) The gross amount of interest.
75. C) The weighted-average interest.
76. D) The amount of cash paid during the current year for interest.

 

Answer: A      Learning Objective: 10          Level of Learning: 1

 

73. When we take into account the dilutive effect of stock options, rights, and warrants in the calculation of EPS, the method used is called the:
74. A) Optional method.
75. B) If converted method.
76. C) Dilution method.
77. D) Treasury stock method.

 

Answer: D      Learning Objective: 9          Level of Learning: 1

 

74. When we take into account the dilutive effect of convertible securities in the calculation of EPS, the method used is called the:
75. A) Treasury stock method.
76. B) If converted method.
77. C) Optional method.
78. D) Dilution method.

 

Answer: B      Learning Objective: 10          Level of Learning: 1

 

 

 

75. Nonconvertible bonds affect the calculation of:
76. A) Basic earnings per share.
77. B) Diluted earnings per share.
78. C) Both A and C.
79. D) None of the above is correct.

 

Answer: D      Learning Objective: 5          Level of Learning: 2

 

76. A simple capital structure might include:
77. A) Stock rights.
78. B) Convertible bonds.
79. C) Nonconvertible preferred stock.
80. D) Stock purchase warrants.

 

Answer: C      Learning Objective: 5          Level of Learning: 1

 

77. In computing diluted earnings per share, the treasury stock method is used for:
78. A) Stock warrants.
79. B) Stock splits.
80. C) Reverse stock splits.
81. D) Convertible preferred stock.

 

Answer: A      Learning Objective: 9          Level of Learning: 1

 

78. When several types of potential common shares exist, the one that enters the computation of diluted EPS first is the one with the:
79. A) Highest incremental effect.
80. B) Higher numerator.
81. C) Median incremental effect.
82. D) Lowest incremental effect.

 

Answer: D      Learning Objective: 5          Level of Learning: 1

 

79. Contingently issuable shares may be included in:
80. A) Basic EPS.
81. B) Diluted EPS.
82. C) Both A and C.
83. D) None of the above is correct.

 

Answer: B      Learning Objective: 11          Level of Learning: 1

 

80. Which of the following results in increasing basic earnings per share?
81. A) Paying more than carrying value to retire outstanding bonds.
82. B) Issuing cumulative preferred stock.
83. C) Purchasing treasury stock.
84. D) All of the above decrease basic earnings per share.

 

Answer: C      Learning Objective: 5          Level of Learning: 1

 

 

 

81. The most important accounting objective for executive stock options is:
82. A) Measuring and reporting the amount of compensation expense during the service period.
83. B) Measuring their fair value for balance sheet purposes.
84. C) To disclose increases or decreases in the stock options held at the end of each accounting period.
85. D) None of the above is correct.

 

Answer: A      Learning Objective: 2          Level of Learning: 1

 

82. Executive stock options should report as compensation expense:
83. A) Using the intrinsic value method.
84. B) Using the fair value method.
85. C) Using either the fair value method or the intrinsic value method.
86. D) Only on rare occasions.

 

Answer: B      Learning Objective: 2          Level of Learning: 1

 

83. Which of the following statements is true regarding SARS payable in cash?
84. A) Any change in estimated total compensation is recorded as a prior adjustment.
85. B) The total amount of compensation is not known for certain until the date the SAR is exercised.
86. C) The liability is adjusted only to reflect each additional year of service.
87. D) None of the above is correct.

 

Answer: B      Learning Objective: 3          Level of Learning: 2

 

84. The compensation associated with a share of restricted stock under a stock award plan is:
85. A) The market price of a share of similar fixed income securities.
86. B) The market price of an unrestricted share of the same stock.
87. C) The book value of an unrestricted share of the same stock.
88. D) The book value of a share of similar stock.

 

Answer: B      Learning Objective: 1          Level of Learning: 1

 

85. If restricted stock is forfeited because an employee leaves the company, the appropriate accounting procedure is to:
86. A) Reverse related entries made previously.
87. B) Do nothing.
88. C) Prepare correcting entries.
89. D) Record an income item.

 

Answer: A      Learning Objective: 2          Level of Learning: 2

 

86. Under the fair value approach for recognizing compensation under a stock option plan, unanticipated forfeitures are treated as:
87. A) A change in accounting principle.
88. B) A loss.
89. C) An income item.
90. D) A change in estimate.

 

Answer: D      Learning Objective: 2          Level of Learning: 2

 

 

 

Use the following to answer questions 87-88:

 

During 2006, Falwell Inc. had 500,000 shares of common stock and 50,000 shares of 6% cumulative preferred stock outstanding.  The preferred stock has a par value of $100 per share. Falwell did not declare or pay any dividends during 2006.

 

Falwell’s net income for the year ended December 31, 2006, was $2.5 million. The income tax rate is 40%. Falwell granted 10,000 stock options to its executives on January 1 of this year. Each option gives its holder the right to buy 20 shares of common stock at an exercise price of $29 per share. The market price of the common stock averaged $30 per share during 2006, and the price on 12/31/06 was $33.

 

87. What is Falwell’s basic earnings per share for 2006, rounded to the nearest cent?
88. A) $3.14
89. B) $4.40
90. C) $5.00
91. D) None of the above is correct.

 

Answer: B      Learning Objective: 9          Level of Learning: 3

Rationale:

net                       preferred
income                    dividends
$2,500,000    —  (50,000 x $100 x 6%)                $2,200,000

——————————————————­­  =    ———————       = $4.40/share

500,000                                              500,000 shares
common shares

88. What is Falwell’s diluted earnings per share for 2006, rounded to the nearest cent?
89. A) $3.14
90. B) $4.90
91. C) $4.34
92. D) Cannot determine from the given information.

 

Answer: C      Learning Objective: 9          Level of Learning: 3

Rationale:

The computation (in $ 000’s) is as follows:

net                       preferred
income                    dividends
$2,500,000    —  (50,000 x $100 x 6%)                $2,200,000

——————————————————­­  =    ———————       = $4.34/share

500,000      +              6,667 *                         506,667 shares

common shares      net shares added from

on 1/1/06                    conversion of options

*10,000 options x 20 shares/option = 200,000 shares;

Proceeds = 200,000 x $29 = $5,800,000

$5,800,000 / $30 per share = 193,333 shares of treasury stock

Net shares added = 200,000 — 193,444 = 6,667

 

 

 

Use the following to answer questions 89-90:

 

During 2006, Angel Corporation had 900,000 shares of common stock and 50,000 shares of 6% preferred stock outstanding.  The preferred stock does not have cumulative or convertible features. Angel declared and paid cash dividends of $300,000 and $150,000 to common and preferred shareholders, respectively, during 2006.

 

On January 1, 2005, Angel issued $2,000,000 of convertible 5% bonds at face value. Each $1,000 bond is convertible into 5 common shares.

 

Angel’s net income for the year ended December 31, 2006, was $6 million. The income tax rate is 20%.

 

89. What is Angel’s basic earnings per share for 2006, rounded to the nearest cent?
90. A) $5.29
91. B) $5.57
92. C) $6.50
93. D) None of the above is correct.

 

Answer: C      Learning Objective: 5          Level of Learning: 3

Rationale: The basic EPS is $6.50.

The computation is as follows:

net                       preferred
income                    dividends
$6,000,000      —        150,000                              $5,850,000

——————————————————­­  =    ———————       = $6.50/share

900,000                                            900,000 shares
common shares

90. What will Angel report as diluted earnings per share for 2006, rounded to the nearest cent?
91. A) $6.43
92. B) $6.25
93. C) $6.22
94. D) None of the above is correct.

 

Answer: D      Learning Objective: 10          Level of Learning: 3

Rationale:

net             preferred                   after-tax
income          dividends          interest savings
$6,000,000    —     150,000         +      $80,000*                          $5,930,000

—————————————————————  =       ———————  = $6.52/share**

900,000                   +         (2,000 x 5)                                     910,000 shares
shares                                  conversion
at Jan. 1                                  of bonds

 

* (2,000,000 x 5%) = $100,000 in interest; $100,000 x 20% = $20,000 in tax savings

 

So after-tax interest cost = $80,000.

 

**Because, this increases EPS, it is antidilutive.  Only $6.50 basic EPS will be reported.

 

 

Use the following to answer questions 91-93:

 

Wilson Inc. developed a business strategy that used stock options as a major compensation incentive for is top executives. On 1/1/05, 20 million options were granted, each giving the executive owning them the right to acquire five $1 par value common shares. The exercise price is the market price on the grant date—$10 per share. Options vest on 1/1/07.  They cannot be exercised before that date and will expire on 12/31/10. The fair value of the 20 million options, estimated by an appropriate option pricing model, is $40 per option.

 

91. Wilson’s compensation expense in 2005 for these stock options was:
92. A) $0
93. B) $200 million
94. C) $800 million
95. D) None of the above is correct.

 

Answer: B      Learning Objective: 2          Level of Learning: 3

Rationale:

The computation is as follows:

Estimated value of the options at January 1, 2005:

$40 estimated fair value/option
x 20 million options granted
                        = $800 million fair value of options

 

Fair value is spread over four years of vesting period at $200 million/year.

 

92. On March 1, 2009, when the market price of Wilson’s stock was $14 per share, 3 million of the options were exercised.  The journal entry to record this would include:
93. A) A debit to paid-in capital – stock options for $42 million.
94. B) A credit to paid-in capital (excess of par) for $285 million
95. C) A credit to common stock for $75 million
96. D) All of the above are correct.

 

Answer: B      Learning Objective: 2          Level of Learning: 3

Rationale:

The computation is as follows:

Cash: 3 million options x 5 shares/option x $10/share = $150 million

Paid-in Capital — stock options: 3 million options x $40/option) = $120 million

Common stock: 15 million shares x $1 par/share = $15 million

Paid-in capital in excess of par (to balance) = $285 million

 

93. Assume that all compensation expense from the stock options granted by Wilson has already been recorded.  Further assume that 200,000 options expire without being exercised in 2010? The journal entry to record this would include:
94. A) Debit to paid-in capital — stock options for $8 million.
95. B) A debit to common stock for $5 million.
96. C) A debit to paid-in capital — expiration of stock options for $8 million.
97. D) None of the above is correct.

 

Answer: A      Learning Objective: 2          Level of Learning: 3

Rationale: This is 200,000 options that had been recorded by credits to paid-in capital — stock options for $8 million, i.e., 200,000 options x $40 option.  This is reversed at expiration.

 

Use the following to answer questions 94-95:

 

Pastore Inc. granted options for one million shares of its $1 par common stock at the beginning of the current year. The exercise price is $35 per share, which was also the market value of the stock on the grant date. The fair value of the options was estimated at $8 per option.

 

94. What would be the total compensation indicated by these options?
95. A) $3 million.
96. B) $27 million.
97. C) $ 8 million.
98. D) $35 million.

 

Answer: C      Learning Objective: 2          Level of Learning: 3

Rationale: 1,000,000 x $8 = $8,000,000

 

95. If the options have a vesting period of five years, what would be the balance in «Paid-in Capital-Stock Options» three years after the grant date?
96. A) A credit of $4.8 million.
97. B) A credit of $16.2 million.
98. C) A debit of $4.8 million.
99. D) A debit of $16.2 million.

 

Answer: A      Learning Objective: 2          Level of Learning: 3

Rationale: 1,000,000 x $8 x 3/5 = $4,800,000

 

Use the following to answer questions 96-99:

 

Wall Drugs offered an incentive stock option plan to its employees. On January 1, 2006, options were granted for sixty thousand $1 par common shares. The exercise price equals the $5 market price of the common stock on the grant date. The options cannot be exercised before January 1, 2009, and expire December 31, 2010. Each option has a fair value of $1 based on an option pricing model.

 

96. What is the total compensation cost for this plan?
97. A) $0.
98. B) $60,000.
99. C) $240,000.
100. D) $300,000.

 

Answer: B      Learning Objective: 2          Level of Learning: 3

Rationale: 60,000 x $1 = $60,000

 

97. Which is the correct entry to record compensation expense for the year 2006?

A)	Compensation expense	12,000
	Paid-in capital-stock options		12,000
B)	Compensation expense	20,000
	Common stock		20,000
C)	Compensation expense	20,000
	Paid-in capital-stock options		20,000
D)	Compensation expense	80,000
	Paid-in capital-stock options		80,000

 

Answer: C      Learning Objective: 2          Level of Learning: 3

Rationale: (60,000 x $1)/3 = $20,000

 

 

98. Which is the correct entry to record the exercise of 90% the options on April 15, 2009, when the market price of the stock was $8?

A)	Cash	270,000
	Paid-in capital-stock options	54,000
	Common stock		60,000
	Paid-in capital—excess of par		264,000
B)	Cash	378,000
	Paid-in capital-stock options	54,000
	Common stock		54,000
	Paid-in capital—excess of par		378,000
C)	Cash	270,000
	Paid-in capital-stock options	54,000
	Compensation expense	108,000
	Common stock		54,000
	Paid-in capital—excess of par		378,000
D)	Cash	270,000
	Paid-in capital-stock options	54,000
	Common stock		54,000
	Paid-in capital—excess of par		270,000

 

Answer: D      Learning Objective: 2          Level of Learning: 3

Rationale:

Cash (60,000 x 90% x $5)	270,000
Paid-in-capital – stock options
($60,000 x 90%)	54,000
Common stock (60,000 x 90% x $1)		54,000
Paid-in-capital-excess of par		270,000

 

99. What is the entry to record the expiration of 10% of the options on December 31, 20010?

A)	Paid-in capital-stock options	6,000
	Paid-in capital—expiration to stock options		6,000
B)	Paid-in capital-stock options	6,000
	Retained earnings		6,000
C)	Paid-in capital-stock options	6,000
	Compensation expense		6,000
D)	Stock options receivable	30,000
	Common stock		6,000
	Paid-in capital—excess of par		27,000

 

Answer: A      Learning Objective: 2          Level of Learning: 3

Rationale:

60,000 x $1 x 10% = $6,000

When unexercised options expire, the paid-in capital is renamed.

 

 

100. On December 31, 2005, Albacore Company had 300,000 shares of common stock issued and outstanding. Albacore issued a 10% stock dividend on June 30, 2006. On September 30, 2006, 12,000 shares of common stock were reacquired as treasury stock. What is the appropriate number of shares to be used in the basic earnings per share computation for 2006?
101. A) 303,000.
102. B) 342,000.
103. C) 312,000.
104. D) 327,000.

 

Answer: D      Learning Objective: 2          Level of Learning: 3

Rationale: (300,000 x 1.10) (12,000 x 3/12) = 327,000

 

101. On December 31, 2005, Beta Company had 300,000 shares of common stock issued and outstanding. Beta issued a 5% stock dividend on June 30, 2006. On September 30, 2006, 40,000 shares of common stock were reacquired as treasury stock. What is the appropriate number of shares to be used in the basic earnings per share computation for 2006?
102. A) 315,000.
103. B) 307,500.
104. C) 305,000.
105. D) 267,500.

 

Answer: C      Learning Objective: 7          Level of Learning: 3

Rationale: (300,000 x 1.05) (40,000 x 3/12) = 305,000

 

102. On December 31, 2005, the Bennett Company had 100,000 shares of common stock issued and outstanding. On July 1, 2006, the company sold 20,000 additional shares for cash. Bennett’s net income for the year ended December 31, 2006 was $650,000. During 2006, Bennett declared and paid $89,000 in cash dividends on its nonconvertible preferred stock. What is the 2006 basic earnings per share?
103. A) $5.91.
104. B) $5.61.
105. C) $5.10.
106. D) None of the above is correct.

 

Answer: C      Learning Objective: 7          Level of Learning: 3

Rationale:

 

 

 

103. On December 31, 2005, the Frisbee Company had 250,000 shares of common stock issued and outstanding. On March 31, 2006, the company sold 50,000 additional shares for cash. Frisbee’s net income for the year ended December 31, 2006 was $700,000. During 2006, Frisbee declared and paid $80,000 in cash dividends on its nonconvertible preferred stock. What is the 2006 basic earnings per share?
104. A) $2.16.
105. B) $3.50.
106. C) $3.10.
107. D) $2.80.

 

Answer: A      Learning Objective: 6          Level of Learning: 3

Rationale:

 

 

104. Flyaway Travel Company reported net income for 2006 in the amount of $90,000. During 2006, Flyaway declared and paid $2,125 in cash dividends on its nonconvertible preferred stock. Flyaway also paid $10,000 cash dividends on its common stock. Flyaway had 40,000 common shares outstanding from January 1 until 10,000 new shares were sold for cash on April 1, 2006. What is the 2006 basic earnings per share?
105. A) $1.85.
106. B) $1.64.
107. C) $1.76.
108. D) None of the above is correct

 

Answer: A      Learning Objective: 6          Level of Learning: 3

Rationale:

 

 

105. Getaway Travel Company reported net income for 2006 in the amount of $50,000. During 2006, Getaway declared and paid $2,000 in cash dividends on its nonconvertible preferred stock. Getaway also paid $10,000 cash dividends on its common stock. Getaway had 40,000 common shares outstanding from January 1 until 10,000 new shares were sold for cash on July 1, 2006. A 2-for-1 stock split was granted on July 5, 2006. What is the 2006 basic earnings per share?
106. A) $.42.
107. B) $.47.
108. C) $.53.
109. D) $.56.

 

Answer: C      Learning Objective: 7          Level of Learning: 3

Rationale:

 

 

 

106. Baldwin Company had 40,000 shares of common stock outstanding on January 1, 2006. On April 1, 2006 the company issued 20,000 shares of common stock. The company had outstanding stock options for 10,000 shares exercisable at $10 that had not been exercised by its executives. The end-of-year market price of common stock was $11 while the average price for the year was $12. What number of shares of stock should be used in computing diluted earnings per share?
107. A) 65,000.
108. B) 56,667.
109. C) 55,000.
110. D) 61,667.

 

Answer: B      Learning Objective: 9          Level of Learning: 3

Rationale:

40,000 + (20,000 x 9/12) + (10,000 8,333*) = 56,667

*(10,000 x $10)/$12 = 8,333

 

107. Blue Cab Company had 50,000 shares of common stock outstanding on January 1, 2006. On April 1, 2006, the company issued 20,000 shares of common stock. The company had outstanding stock options for 5,000 shares exercisable at $10 that had not been exercised by its executives. The end-of-year market price of common stock was $11 while the average price for the year was $12. The company reported net income in the amount of $269,915 for 2006. What is the diluted earnings per share?
108. A) $3.60.
109. B) $4.10.
110. C) $4.50.
111. D) $3.81.

 

Answer: B      Learning Objective: 9          Level of Learning: 3

Rationale:

 

*(5,000 x $10)/$12 = 4,167 from option, plus 50,000 + (20,000 x 9/12).

 

108. Purple Cab Company had 50,000 shares of common stock outstanding on January 1, 2006. On April 1, 2006, the company issued 20,000 shares of common stock. The company had outstanding stock options for 5,000 shares exercisable at $10 that had not been exercised by its executives. The end-of-year market price of common stock was $11 while the average price for the year was $12. The company reported net income in the amount of $269,915 for 2006. What is the basic earnings per share?
109. A) $4.10.
110. B) $3.86.
111. C) $3.60.
112. D) $4.15.

 

Answer: D      Learning Objective: 9          Level of Learning: 3

Rationale: $269,915 / (50,000 + (20,000 x 9/12)) = $4.15

 

 

109. Burnet Company had 30,000 shares of common stock outstanding on January 1, 2006. On April 1, 2006, the company issued 15,000 shares of common stock. The company had outstanding stock options for 5,000 shares exercisable at $10 that had not been exercised by its executives. The end-of-year market price of common stock was $8 while the average for the year was $9. The company reported net income in the amount of $189,374 for 2006. What is the effect of the options?
110. A) The options are antidilutive.
111. B) The options will dilute EPS by $.09 per share.
112. C) The options will dilute EPS by $.33 per share.
113. D) The options will dilute EPS by $.17 per share.

 

Answer: A      Learning Objective: 9          Level of Learning: 3

Rationale: Market price is less than exercise price, so the options are ignored when computing EPS.

 

110. At December 31, 2006, Hansen Corporation had 50,000 shares of common stock and 5,000 shares of 6%, $100 par cumulative preferred stock outstanding. No dividends were declared or paid in 2006. Net income was reported as $200,000. What is basic EPS?
111. A) $4.00.
112. B) $3.40.
113. C) $3.64.
114. D) $4.02.

 

Answer: B      Learning Objective: 8          Level of Learning: 3

Rationale:

 

 

Use the following to answer questions 111-112:

 

Rudyard Corporation had 100,000 shares of common stock and 10,000 shares of 8%, $100 par convertible preferred stock outstanding during the year. Net income for the year was $400,000 and dividends were paid to both common and preferred shareholders. Rudyard’s effective tax rate is 40%. Each share of preferred stock is convertible into 5 shares of common.

 

111. What is Rudyard’s basic EPS?
112. A) $2.13.
113. B) $4.80.
114. C) $4.00.
115. D) $3.20.

 

Answer: D      Learning Objective: 8          Level of Learning: 3

Rationale:

 

 

 

112. What is Rudyard’s diluted EPS?
113. A) $2.13
114. B) $2.67
115. C) $3.20
116. D) $4.80

 

Answer: B      Learning Objective: 10          Level of Learning: 3

Rationale:

 

 

113. Dulce Corporation had 200,000 shares of common stock outstanding during the current year. At the beginning of the year, options for 10,000 shares of common stock were granted with an exercise price of $20. The average market price of the common stock during the year was $25. Net income was $4 million. What is diluted EPS?
114. A) $20.00.
115. B) $19.80.
116. C) $19.23.
117. D) $18.18.

 

Answer: B      Learning Objective: 9          Level of Learning: 3

Rationale:

 

 

*(10,000 x $20)/$25 = 8,000

 

114. Cracker Company had 2 million shares of common stock outstanding all through 2005. On April 1, 2006, an additional 100,000 shares were sold and issued. On September 30, 2006, Cracker declared a 2-for-1 stock split. Net income in 2006 and 2005 was $10 million and $8 million, respectively. On the 2006, comparative financial statements, EPS would be reported as follows:

	2006 EPS	2005 EPS
A)	$2.41	$2.00
B)	$2.41	$4.00
C)	$4.82	$4.00
D)	$4.82	$2.00

 

Answer: A      Learning Objective: 7          Level of Learning: 3

Rationale:

2005: $8,000,000/(2,000,000 x 2) = $2.00

2006: $10,000,000/[(2,000,000 x 2) + (100,000 x 9/12 x 2) = $2.41

 

 

115. Dublin Inc. had the following common stock record during the current calendar year:

 

Outstanding — beginning of year	2,000,000
Additional shares issued 6/30	100,000
Additional shares issued 9/30	100,000

 

A 10% stock dividend was paid on December 1. What is the number of shares to be used in computing basic EPS?

1. A) 2,075,000.
2. B) 2,282,500.
3. C) 2,475,000.
4. D) 2,620,000.

 

Answer: B      Learning Objective: 7          Level of Learning: 3

Rationale: [2,000,000 + (100,000 x 6/12) + (100,000 x 3/12)] x 1.10 = 2,282,500

 

116. During the current year, East Corporation had 2 million shares of common stock outstanding. Two thousand, $1,000, 8% convertible bonds were issued at face amount at the beginning of the year. East reported income before tax of $3 million and net income of $1.8 million for the year. Each bond is convertible into ten shares of common stock. What is diluted EPS?
117. A) $.90.
118. B) $.95.
119. C) $.89.
120. D) $.94.

 

Answer: D      Learning Objective: 10          Level of Learning: 3

Rationale:

 

 

*($3-$1.8)/$3 = 40%

 

117. Morrison Corporation had the following common stock record during the current calendar year:

 

Outstanding — January 1	2,000,000
Additional shares issued 3/31	100,000
Distributed a 10% stock dividend on 6/30
Additional shares issued 9/30	100,000

 

What is the number of shares to be used in computing basic EPS?

1. A) 2,000,000.
2. B) 2,200,000.
3. C) 2,307,500.
4. D) 2,310,000.

 

Answer: C      Learning Objective: 7          Level of Learning: 3

Rationale: ($2,000,000 x 1.10) + (100,000 x 9/12 x 1.10) + (100,000 x 3/12) = 2,307,500

 

 

118. Gear Corporation had the following common stock record during the current calendar year:

 

Outstanding — January 1	5,000,000
Additional shares issued 3/31	100,000
Distributed a 10% stock dividend on 6/30
Shares reacquired 9/30	100,000

 

What is the number of shares to be used in computing basic EPS?

1. A) 5,500,000.
2. B) 5,557,500.
3. C) 5,555,000.
4. D) 5,050,000.

 

Answer: B      Learning Objective: 7          Level of Learning: 3

Rationale: (5,000,000 x 1.10) + (100,000 x 9/12 x 1.10) — (100,000 x 3/12) = 5,557,500

 

119. During the current year, High Corporation had 3 million shares of common stock outstanding. Five thousand, $1,000, 6% convertible bonds were issued at face amount at the beginning of the year. High reported income before tax of $4 million and net income of $2.4 million for the year. Each bond is convertible into ten shares of common. What is diluted EPS?
120. A) $.85.
121. B) $.86.
122. C) $.80.
123. D) $.79.

 

Answer: A      Learning Objective: 10          Level of Learning: 3

Rationale:

 

*($4-$2.4)/$4 = 40%

 

120. Ignatius Corporation had 7 million shares of common stock outstanding during the current calendar year. It issued ten thousand, $1,000, convertible bonds on January 1. On June 30, Ignatius issued 100,000 shares of $100 par 6% cumulative preferred stock. Dividends are declared and paid semiannually. The bonds were issued at face amount and pay interest quarterly at an annual rate of 10%. Each bond is convertible into 50 shares of common stock. Ignatius has an effective tax rate of 40%. Ignatius would report the following EPS data on its net income of $20 million.

	Basic EPS	Diluted EPS
A)	$2.77	$2.67
B)	$2.81	$2.71
C)	$2.85	$2.67
D)	$2.81	$2.68

 

Answer: B      Learning Objective: 10          Level of Learning: 3

Rationale:

 

Diluted EPS: [$20,000,000 — $300,000 + (1,000,000 x .6)]/7,000,000 + (10,000 x 50) = $2.71

 

 

121. Jet Corporation had 8 million shares of common stock outstanding during the current calendar year. On July 1, Jet issued ten thousand, $1,000 face value, convertible bonds. The bonds were issued at face amount and pay interest quarterly for 20 years. They have a stated rate of 12%. Each bond is convertible into 50 shares of common stock. Jet had income before tax of $30 million and a net income of $18 million. Jet would report the following EPS data:

	Basic EPS	Diluted EPS
A)	$2.25	$2.23
B)	$2.25	n/a — antidilutive
C)	$2.25	$2.16
D)	$2.25	$2.12

 

Answer: A      Learning Objective: 10          Level of Learning: 3

Rationale:

 

 

 

*($30 $18)/$30 = 40%

 

 

Problems

 

122. Cartel Products Inc. offers a restricted stock award plan to its vice presidents. On January 1, 2006, the corporation granted 12 million of its $1 par common shares, subject to forfeiture if employment is terminated within 2 years. The common shares have a market value of $6 per share on the date the award is granted.

 

Required:

• Assume that no shares are forfeited. Determine the total compensation cost pertaining to the restricted shares.
• Prepare the appropriate journal entries related to the restricted stock through December 31, 2007.

 

Answer:

($ in millions)
1.	$6 x 12 shares = $72
2.)	December 31, 2006
	Compensation expense ($72/2)	36
	Paid-in capital-restricted stock		36
	December 31, 2007
	Compensation expense ($72/2)	36
	Paid-in capital-restricted stock		36
	Paid-in capital-restricted stock	72
	Common stock (12 x $1)		12
	Paid-in capital-excess of par		60

 

Learning Objective: 2          Level of Learning: 3

 

 

123. Steverino Inc. offers a restricted stock award plan to its vice presidents. On January 1, 2006, the corporation granted 10 million of its $5 par common shares, subject to forfeiture if employment is terminated within 2 years. The common shares have a market value of $10 per share on the date the award is granted.

 

Required:

• Assume that no shares are forfeited. Determine the total compensation cost pertaining to the restricted shares.
• Prepare the appropriate journal entries related to the restricted stock through December 31, 2007.

 

Answer:

($ in millions)
(1.)	$10 x 10 shares = $100
(2.)	December 31, 2006
	Compensation expense ($100/2)	50
	Paid-in capital-restricted stock		50
	December 31, 2007
	Compensation expense ($100/2)	50
	Paid-in capital-restricted stock		50
	Paid-in capital-restricted stock	100
	Common stock (10 x $5)		50
	Paid-in capital-excess of par		50

 

Learning Objective: 1          Level of Learning: 3

 

124. On January 1, 2006, Jeans-R-Us Company awarded 15 million of its $1 par common shares to key personnel, subject to forfeiture if employment is terminated within 3 years. On the date of the grant, the stock had a market price of $3 per share.

 

Required:

• Determine the total compensation cost pertaining to the restricted shares.
• Prepare the appropriate journal entry to record the award on January 1, 2006.
• Prepare the appropriate journal entry to record compensation expense on December 31, 2006.

 

Answer:

($ in millions)

(1.)  $3 x 15 shares = $45

 

(2.)  NO ENTRY

 

(3.)	Compensation expense ($45/3)	15
	Paid-in capital-restricted stock		15

 

Learning Objective: 1          Level of Learning: 3

 

 

125. On January 1, 2006, Jeans-R-Us Company awarded 15 million of its $1 par common shares to key personnel, subject to forfeiture if employment is terminated within 3 years. On the date of the grant, the stock had a market price of $3 per share.

 

Required:

• Determine the total compensation cost pertaining to the restricted shares.
• Prepare the appropriate journal entry to record the award on January 1, 2006.
• Prepare the appropriate journal entry to record compensation expense on December 31, 2006.
• Prepare the appropriate journal entry to record compensation expense on December 31, 2007.
• Prepare the appropriate journal entry to record compensation expense on December 31, 2008.
• Prepare the appropriate journal entry to record the lifting of restrictions on December 31, 2008.

 

Answer:

($ in millions)

(1.)  $3 x 15 shares = $45

 

(2.)  NO ENTRY

 

(3.)	Compensation expense ($45M/3)	15
	Paid-in capital-restricted stock		15
(4.)	Compensation expense ($45M/3)	15
	Paid-in capital-restricted stock		15
(5.)	Compensation expense ($45M/3)	15
	Paid-in capital-restricted stock		15
(6.)	Paid-in capital-restricted stock	45
	Common stock		15
	Paid-in capital-excess of par		30

 

Learning Objective: 1          Level of Learning: 3

 

126. Hammerstein Corporation offers a variety of share-based compensation plans to employees. Under its restricted stock award plan, the company, on January 1, 2006, granted 2 million of its $1 par common shares to various division managers. The shares are subject to forfeiture if employment is terminated within 4 years. The common shares have a market price of $20 per share on the award date.

 

Required:

• Determine the total compensation cost from these restricted shares.
• Prepare the appropriate journal entry to record the award on January 1, 2006.
• Prepare the appropriate journal entry to record compensation expense on December 31, 2006.
• Suppose a 15% forfeiture rate was expected prior to vesting. Determine the total compensation cost, assuming the company follows the fair value approach and chooses to anticipate forfeitures at the grant date.

 

 

Answer:

($ in millions)

(1.) $20 x 2 shares = $40

 

(2.)  No Entry

 

(3.)	Compensation expense ($40/4 yrs)	10
	Paid-in capital restricted stock		10

 

(4.)  $20 x 2 shares x 85% = $34

 

Learning Objective: 1          Level of Learning: 3

 

127. Olde Corporation provides an executive stock option plan. Under the plan, the company granted options on January 1, 2006, that permit executives to acquire 2 million of the company’s $1 par value common shares within the next five years, but not before December 31, 2007 (the vesting date). The exercise price is the market price of the shares on the date of the grant, $14 per share. The fair value of the options, estimated by an appropriate option pricing model, is $2 per option. No forfeitures are anticipated. Ignore taxes.

 

Required:

• Determine the total compensation cost pertaining to the options, assuming the fair value approach has been selected.
• Prepare the appropriate journal entry to record the award of the options on January 1, 2006.
• Prepare the journal entry to record compensation expense on December 31, 2006.
• Prepare the journal entry to record compensation expense on December 31, 2007.

 

Answer:

($ in millions)

(1.)   $2 x 2 shares = $4

(2.)   NO ENTRY

 

(3.)	Compensation expense ($4/2yrs.)	2
	Paid-in capital stock options		2
(4.)	Compensation expense ($4/2yrs.)	2
	Paid-in capital stock options		2

 

Learning Objective: 2          Level of Learning: 3

 

 

128. The Burford Corporation provides an executive stock option plan. Under the plan, the company granted options on January 1, 2006, that permit executives to acquire 12 million of the company’s $1 par value common shares within the next five years, but not before December 31, 2009 (the vesting date). The exercise price is the market price of the shares on the date of the grant, $14 per share. The fair value of the options, estimated by an appropriate model, is $3 per option. No forfeitures are anticipated. Ignore taxes.

 

Required:

• Determine the total compensation cost pertaining to the options, assuming Burford chooses to follow the FASB’s accounting approach for fixed compensation plans. Show calculations.
• Prepare the appropriate journal entry (if any) to record the award of options on January 1, 2006.
• Prepare the appropriate journal entry (if any) to record compensation expense on December 31, 2006.

 

Answer:

Requirement 1

12 million	number of options
x $3	fair value
$ 36 million	total compensation

 

Requirement 2

no entry

 

Requirement 3

	($ in millions)
Compensation expense ($36 million ÷ 4 years)	9
Paid-in capital — stock options		9

 

Learning Objective: 2          Level of Learning: 3

 

129. Burns Company reported $752.4 million in net income in 2006. On January 1, 2006, the company had 400 million shares of common stock outstanding. On March 1, 2006, 24 million new shares of common stock were sold for cash. On June 1, 2006, the company’s common stock split 2 for 1. On July 1, 2006, 8 million shares were reacquired as treasury stock.

 

Required:

            Compute Burns’ basic earnings per share for the year ended December 31, 2006.

 

Answer:

(400M x 2)+ (24M x 10/12 x 2)) — (8M x 6/12) = 836,000,000 weighted-average shares

 

$752.4 million/836 million = $.90 EPS

 

Learning Objective: 7          Level of Learning: 3

 

 

130. Sugarland Industries reported a net income of $750,750 on December 31, 2006. At the beginning of the year, the company had 500,000 common shares outstanding. On April 1, the company sold 27,000 shares for cash. On August 31, the company issued 48,000 additional shares as part of a merger.

 

Required:

            Compute Sugarland’s net income that would produce a basic EPS of $2.00 per share for 2006.

 

Answer:

500,000 + (27,000 x 9/12) + (48,000 x 4/12) = 536,250 weighted-average shares

 

X/536,250 = $2.00 EPS

X = $1,072,500

 

Learning Objective: 6          Level of Learning: 3

 

131. Nagy Industries reported a net income of $619,369 on December 31, 2006. At the beginning of the year, the company had 500,000 common shares outstanding. On April 1, the company sold 27,000 shares for cash. On August 31, the company issued 48,000 additional shares as part of a merger. On December 1, 2006, the company declared and issued a 10% stock dividend.

 

Required:

            Compute Nagy’s net income that would produce a basic EPS of $2.00 per share for 2006.

 

Answer:

(500,000 x 1.10) + (27,000 x 9/12 x 1.10) + (48,000 x 4/12 x 1.10) = 589,875 weighted-average shares

 

X/589,875 = $2.00 EPS

X = $1,179,750

 

Learning Objective: 6          Level of Learning: 3

 

132. Rice Inc. had 420 million shares of common stock and 1 million shares of 6%, $200 par, cumulative preferred stock outstanding at the end of 2005 and 2006. No dividends were declared or paid on either class of stock in either year. Net income for 2006 was $398.4 million. The company’s tax rate is 30%.

 

Required:

            Compute basic earnings per share for the year ended December 31, 2006.

 

(in millions except per share amount)

 

Answer:

[$398.4 — (6% x $200 x 1)]/420 = $.92 EPS

Preferred dividends in arrears for 2005 were included in the 2005 EPS.

 

Learning Objective: 8          Level of Learning: 3

 

 

133. Kramer Inc. had 95 million shares of common stock, 1 million shares of 6%, $100 par, cumulative preferred stock, and 1 million shares of 8%, $100 par, noncumulative preferred stock outstanding at the end of 2005 and 2006. No dividends were declared or paid on common stock in either year. In 2006, a $3 million dividend was paid on the 6% preferred stock and a $4 million dividend was paid on the 8% preferred stock. Net income for 2006 was $300 million. The company’s tax rate is 30%.

 

Required:

            Compute basic earnings per share for the year ended December 31, 2003.

 

(in millions except per share amount)

 

Answer: [$300 — (6% x $100 x 1) — $4] / 95 = $3.05 EPS

 

Learning Objective: 5          Level of Learning: 3

 

134. Capital Consulting Company had 400,000 shares of common stock outstanding on December 31, 2006. On that date, there were also 5,000 shares of, $100 par, 6% noncumulative preferred stock outstanding. On March 1, 2006, the company’s common stock split 3-for-1. On December 15, 2006, a preferred dividend was declared and paid in the amount of $25,000. Net income for 2006 was $3,000,000.

 

Required:

            Compute basic earnings per share for the year ended December 31, 2006.

 

Answer: ($3,000,000 — $25,000) / (400,000 x 3) = $2.48 EPS

 

Learning Objective: 5          Level of Learning: 3

 

135. Parsley Corporation had 250,000 shares of common stock and 5,000 shares of 8%, $100 par, preferred stock outstanding on December 31, 2005. The preferred stock is cumulative, nonconvertible preferred stock. On June 1, 2006, Parsley sold 36,000 shares of common stock for cash. No cash dividends were declared for 2006. Parsley reported a net loss of $320,000 for the year ended December 31, 2003.

Required:

            Calculate Parsley’s loss per share for the year ended December 31, 2006.

 

Answer:

[$ -320,000 — (8% x $100 x 5,000)]/[250,000 + (36,000 x 7/12)] =

$1.33 Loss Per Share

 

Learning Objective: 5          Level of Learning: 3

 

 

136. On January 1, 2006, Algerian Delivery had 100,000 shares of common stock outstanding. The following transactions occurred during 2006:

 

March 1:	Reacquired 3,000 shares, accounted for as treasury stock.
September 30:	Sold all the treasury shares.
December 1:	Sold 12,000 new shares for cash.
December 31:	Reported a net income of $297,750.

 

Required:

            Calculate Algerian Delivery’s basic earnings per share for the year ended December 31, 2006.

 

Answer:

$297,750 /[(100,000 — (3,000 x 10/12) + (3,000 x 3/12) + (12,000 x 1/12)] = $3.00 EPS

 

Learning Objective: 7          Level of Learning: 3

 

137. On January 1, 2006, Shamu Corporation had 100,000 shares of common stock outstanding.  The following transactions occurred during 2006:

 

March 1:	Reacquired 3,000 shares, accounted for as treasury stock.
September 30:	Sold all the treasury shares.
December 1:	Sold 12,000 new shares for cash.
December 31:	Reported a net income of $198,500.

 

The following transactions occurred during 2007:

 

January 10:           Declared and issued a 25% stock dividend.

December 31:       Reported a net income of $268,800.

 

Required:

            Calculate Shamu’s basic earnings per share for both years for presentation in comparative financial statements that will be prepared at the end of 2006.

 

Answer:

2006 EPS*

2006:

2007:

 

 

*Since comparative financial statements are being reported in 2007, EPS for 2006 must be recalculated to reflect the stock dividend.

 

Learning Objective: 7          Level of Learning: 3

 

 

138. On December 31, 2005, Belair Corporation had 100,000 shares of common stock outstanding and 30,000 shares of 7%, $50 par, cumulative preferred stock outstanding.  On February 28, 2006, Belair purchased 24,000 shares of common stock on the open market as treasury stock paying $20 per share.  On June 30, 2006, Belair declared and issued a 2-for-1 stock split on common stock. Belair sold 6,000 treasury shares on September 30, 2006, for $15 per share.  Net income for 2006 was $180,905.

 

Required:

            Compute Belair’s basic earnings per share for 2006.

 

Answer:

$180,905 – (30,000 x $50 x 7%) / (100,000 x 2) – (24,000 x 2 x 10/12) + (6,000 x 3/12)

= $0.47

 

Learning Objective: 7          Level of Learning: 3

 

139. On December 31, 2005, Brisbane Company had 100,000 shares of common stock outstanding and 30,000 shares of 7%, $50 par, cumulative preferred stock outstanding.  On February 28, 2006, Brisbane purchased 24,000 shares of common stock on the open market as treasury stock paying $40 per share. Brisbane sold 6,000 treasury shares on September 30, 2006, for $45 per share.  Net income for 2006 was $180,905. Also outstanding during the year were stock options giving key personnel the option to buy 50,000 common shares at $40. During 2006, the average market price of the common shares was $50 with a closing price of $51 on December 31, 2006.

 

Required:

            Compute Brisbane’s basic and diluted earnings per share for 2006.

 

Answer:

Basic EPS

[$180,905 — (7% x $50 x 30,000)]/[(100,000 — (24,000 x 10/12 ) + (6,000 x 3/12] = $.93 EPS

 

Diluted EPS

[$180,905 — (7% x $50 x 30,000)]/[(100,000 — (24,000 x 10/12) + (6,000 x 3/12) + (50,000 — 40,000*)] = $.83 EPS

 

*(50,000 x $40)/$50 = 40,000

 

Learning Objective: 7          Level of Learning: 3

 

 

140. On December 31, 2005, Jackson Company had 100,000 shares of common stock outstanding and 30,000 shares of 7%, $50 par, cumulative preferred stock outstanding. On February 28, 2006, Jackson purchased 24,000 shares of common stock on the open market as treasury stock $35 per share. Jackson sold 6,000 treasury shares on September 30, 2006, for $37 per share. Net income for 2006 was $180,905. Also outstanding during the year were stock options giving key personnel the option to buy 50,000 common shares at $40.  During 2006, the average market price of the common shares was $38 with a closing price of $39 on December 31, 2006.

 

Required:

            Compute Jackson’s basic and diluted earnings per share for 2006.

 

Answer:

Basic EPS

[$180,905 — (7% x $50 x 30,000]/[100,000 — (24,000 x 10/12) + (6,000 x 3/12] = $.93 EPS

 

Diluted EPS

Since the exercise price is greater than the average price on the open market, the stock options are antidilutive. Therefore, only basic EPS is presented. The existence of the options is disclosed in the footnotes.

 

Learning Objective: 9          Level of Learning: 3

 

141. On December 31, 2005, Jackson Company had 100,000 shares of common stock outstanding and 30,000 shares of 7%, $50 par, cumulative preferred stock outstanding. On February 28, 2006, Jackson purchased 24,000 shares of common stock on the open market as treasury stock paying $45 per share. Jackson sold 6,000 of the treasury shares on September 30, 2006, for $47 per share. Net income for 2006 was $180,905. Also outstanding at December 31, 2005, were stock options giving key personnel the option to buy 50,000 common shares at $40. These stock options were exercised on November 1, 2006. During 2006, the average market price of the common shares was $50 with a closing price of $51 on December 31, 2006.

 

Required:

            Compute Jackson’s basic and diluted earnings per share for 2006.

 

Answer:

Basic EPS

[$180,905 — (7% x $50 x 30,000]/[100,000  — (24,000 x 10/12) + (6,000 x 3/12) + (50,000 x 2/12)] =  $.84 EPS

 

Diluted EPS

[$180,905 — (7% x $50 x 30,000)]/[(100,000 — (24,000 x 10/12) + (6,000 x 3/12) + ({50,000 — 40,000*} x 10/12) + (50,000 x 2/12)] = $.77EPS

 

*(50,000 x $40)/$50 = 40,000

 

Learning Objective: 9          Level of Learning: 3

 

 

142. On December 31, 2005, Heffner Company had 100,000 shares of common stock outstanding and 30,000 shares of 7%, $100 par, cumulative preferred stock outstanding. On February 28, 2006, Heffner purchased 24,000 shares of common stock on the open market as treasury stock paying $45 per share. Heffner sold 6,000 of the treasury shares on September 30, 2006, for $47 per share. Net income for 2006 was $540,000. The income tax rate is 40%. Also outstanding at December 31, 2005, were stock options giving key personnel the option to buy 50,000 common shares at $40. During 2006, the average market price of the common shares was $50 with a closing price of $51 on December 31, 2006. Five thousand 6% bonds were issued at par on January 1, 2006. Each $1,000 bond is convertible into 125 shares of common stock. None of the bonds had been converted by December 31, 2006 and no stock options were exercised during the year.

 

   Required:

            Compute basic and diluted earnings per share for Heffner Company for 2006.

 

Answer:

Basic EPS

[$540,000 — (7% x $100 x 30,000)]/[(100,000 — (24,000 x 10/12) + (6,000 x 3/12) = $4.05 EPS

 

Diluted EPS

[$540,000 — (7% x $100 x 30,000) + ((5,000 x $1,000 x 6% x 60%)]/

[(100,000 — (24,000 x 10/12) + (6,000 x 3/12) + (50,000 — 40,000*)

+ (5,000 x 125) = $0.71 EPS

 

*(50,000 x $40)/$50 = 40,000

 

Learning Objective: 9          Level of Learning: 3

 

143. Stock options for 100,000 shares of common stock at an exercise price of $50 were outstanding for the entire year. The average market price of the stock was $56 and the end-of-year price was $55.

 

Required:

            By how many shares will the assumed exercise of these options increase the weighted-average number of shares outstanding when calculating diluted earnings per share?

 

Answer:

100,000 — [(100,000 x $50 / $56)] = 10,714 shares

 

Learning Objective: 9          Level of Learning: 3

 

 

144. Stock options for 60,000 shares of common stock at an exercise price of $50 were outstanding at the beginning of 2006. The average market price of the stock was $56 and the end-of-year price was $55.

 

Required:

            If these options are exercised on March 1 of the current year, by how many shares will the options increase the weighted-average number of shares outstanding when calculating diluted earnings per share?

 

Answer:

[(60,000 – 53,571*) x 2/12)] + (60,000 x 10/12) = 51,072 shares

 

**(60,000 x $50/$56) = 53,571

 

Learning Objective: 9          Level of Learning: 3

 

145. XYZ Company had 200,000 shares of common stock outstanding on December 31, 2005. On July 1, 2006, XYZ issued an additional 50,000 shares for cash. On January 1, 2006, XYZ issued 20,000 shares of convertible preferred stock. The preferred stock had a par value of $100 per share and paid a 5% dividend. Each share of preferred stock is convertible into 8 shares of common. During 2006, XYZ paid the regular annual dividend on the preferred and common stock. Net income for the year was $300,000.

 

Required:

            Calculate XYZ’s basic and diluted earnings per share for 2006.

 

Answer:

Basic

[$300,000 — ($100 x 5% x 20,000)]/[(200,000 + (50,000 x 6/12)] = $.89 EPS

 

Diluted

$300,000 /[(200,000 + (50,000 x 6/12) + (20,000 x 8)] = $.78 EPS

 

Learning Objective: 7          Level of Learning: 3

 

        

\

146. Paul Company had 100,000 shares of common stock outstanding on January 1, 20063. On September 30, 2006, Iceland sold 48,000 shares of common stock for cash. Paul also had 10,000 shares of convertible preferred stock outstanding throughout 2006. The preferred stock is $100 par, 6%, and is convertible into 3 shares of common for each share of preferred. Paul also had 500, 8%, convertible bonds outstanding throughout 2006. Each $1,000 bond is convertible into 30 shares of common stock. The bonds sold originally at par. Reported net income for 2006 was $300,000 with a 40% tax rate. The regular common and preferred dividends were paid in 2006.

            Required:

            Compute basic and diluted earnings per share for 2006.

 

 

Answer:

Basic

[$300,000 — (6% x $100 x 10,000)]/[(100,000 + (48,000 x 3/12)] = $2.14 EPS

 

Diluted

[$300,000 + ($500,000 x 8% x 60%*)]/[(100,000 + (48,000 x 3/12) + (10,000 x 3) +

(500 x 30)) = $2.06 EPS

 

*1- 40% = 60%

 

Learning Objective: 10          Level of Learning: 3

 

147. Woolery, Inc. had 50,000 shares of common stock outstanding at January 1, 2006. On March 31, 2006, an additional 12,000 shares were sold for cash. Woolery also had $4,000,000 of 6% convertible bonds outstanding throughout the year. The bonds are convertible into 40,000 shares of common stock. Net income for the year was $350,000. The tax rate is 35%.

 

Required: Compute basic and diluted earnings per share for the year ended December 31, 2006.

 

Answer:

Basic

$350,000 /[(50,000 + (12,000 x 9/12)] = $5.93 per share

 

Diluted

[$350,000 + ($4M x 6% x 65%)]/[(50,000 + (12,000 x 9/12) + 40,000)] = $5.11 per share

 

Learning Objective: 10          Level of Learning: 3

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

148. On December 31, 2005, Merlin Company had outstanding 400,000 shares of common stock and 40,000 shares of 8% cumulative preferred stock (par $10). On February 28, 2006, Merlin issued an additional 36,000 shares of common stock. On September 1, 2006, 9,000 shares were retired. At year-end, there were executive stock options outstanding for 30,000 shares of common stock (adjusted for the stock dividend). The exercise price was $18. The market price of the common stock during the year had averaged $20. Also outstanding were $1,000,000 face amount of 10% convertible bonds issued in 2003 and convertible into 50,000 common shares (adjusted for the stock dividend). Net income was $900,000. The tax rate for the year was 40%. A 10% stock dividend was declared and distributed on July 1, 2006.

 

Required:

            Compute basis and diluted EPS for the year ended December 31, 2006.

Answer:

Basic EPS = ($ in 000s, except per share amount)

 

 

 

Diluted EPS

 

 

 

Shares Reacquired for Diluted EPS

 

	30	thousand shares
x	$  18	(exercise price)
	$540	thousand
÷	$  20	(average market price)
	27	thousand shares reacquired

 

Learning Objective: 9          Level of Learning: 3

 

149. During 2006, Quattro entered into the following transactions relating to shareholders’ equity.  The corporation was authorized to issue 20 million common shares, $1 par per share.

 

Net income for 2006 was $110 million.

Jan. 2:	Issued 10 million common shares for cash.
Jan. 3:	Entered an agreement with the company president to issue up to 2 million additional shares of common stock in 2006 based on the earnings of Quattro in 2006.  If net income exceeds $100 million, the president will receive 1 million shares; 2 million shares if net income exceeds $120 million.

 

Required:

            Compute basic and diluted EPS for 2006.

 

Answer:

(amounts in millions, except per share amounts)

Basic EPS

 

 

 

Diluted EPS

 

 

 

Because the conditions are met for issuing 1 million shares, those shares are assumed issued for diluted EPS.  Conditions for the other 1 million shares are not yet met, so they are ignored.

 

Learning Objective: 11          Level of Learning: 3

 

 

Essay

 

Instructions:

 

The following answers point out the key phrases that should appear in students’ answers.  They are not intended to be examples of complete student responses. It might be helpful to provide detailed instructions to students on how brief or in-depth you want their answers to be.

 

150. Compare the concepts of basic and diluted earnings per share.

 

Answer: Basic earnings per share is simply the current year’s net income (or loss) minus preferred stock dividends if any, (the numerator), divided by the weighted-average common shares outstanding for the year (the denominator). The diluted earnings per share computation also includes the dilutive effects of potential common shares in the denominator of the fraction providing the maximum possible dilution if all potential common shares are converted into common stock.

 

Learning Objective: 12          Level of Learning: 2

 

151. How is a complex capital structure different from a simple capital structure?

 

Answer: A complex capital structure is one that includes convertible securities and/or rights, options, or warrants that would have a potential dilutive effect on earnings per share if converted or exercised. In a simple capital structure, the company only has common stock or common stock along with nonconvertible preferred stock as the only securities outstanding with no potential common shares.

 

Learning Objective: 5          Level of Learning: 1

 

152. Why are earnings per share figures for prior years adjusted for stock splits and stock dividends when data from prior years is presented in comparative financial statements?

 

Answer: When a company has a stock split or issues a stock dividend, the number of shares of common stock outstanding is increased with no increase in the resources of the corporation. If one is to compare the earnings per share figure of the current period with that of any periods shown for comparative purposes, then the stock split or stock dividend must be reflected in the EPS data for all years presented in the comparative statements.

 

Learning Objective: 7          Level of Learning: 2

 

153. What is the treasury stock method of accounting for stock options, warrants, and rights?

 

Answer: The treasury stock method is a way of determining the extent of dilution of earnings per share due to stock options, stock rights, and stock purchase warrants. Under the treasury stock method, options, rights, and warrants are treated as if they were exercised at the beginning of the year. The funds that would come into the firm from the assumed exercise of options, rights, and warrants are assumed to be used to reacquire shares of common stock (treasury stock) at the average market price of the stock for the year.

 

Learning Objective: 9          Level of Learning: 1

 

 

154. What is meant by dilution of earnings per share?

 

Answer: Dilution refers to the effect that convertible securities and rights such as options, stock rights, and stock purchase warrants could have on basic earnings per share if these securities were exchanged for common stock. If the exercise of the security would reduce earnings per share to a level below basic earnings per share, then the effect on EPS is dilutive. Dilution can only occur in a firm with a complex capital structure.

 

Learning Objective: 10          Level of Learning: 1

 

155. What is the «if converted method»?

 

Answer: The «if converted method» is used to assume conversion of any convertible preferred stock or convertible bonds outstanding at year-end into common stock. By assuming conversion of preferred stock, the numerator of the basic earnings per share computation is increased by the preferred dividends while the denominator is increased by the number of shares of common stock represented by the convertible preferred stock. By assuming conversion of convertible bonds, the numerator of the basic earnings per share computation is increased by the current year’s bond interest (net of tax) while the denominator is increased by the number of common shares represented by the convertible bonds.

 

Learning Objective: 10          Level of Learning: 1

 

156. Why are preferred dividends deducted from net income when calculating EPS?

 

Answer: Preferred dividends are deducted from the numerator in the EPS fraction so that «earnings available to common shareholders» can be divided by the weighted-average common shares outstanding. This is done because preferred shareholders normally receive dividends before common shareholders are entitled to receive any distribution from the company. This is one of the preferences that make preferred stock attractive to certain investors.

 

Learning Objective: 8          Level of Learning: 2

 

157. When the income statement includes separately reported items such as discontinued operations or extraordinary items, which amounts require per share presentation?

 

Answer: EPS data (basic and diluted) must be presented on the face of the income statement for net income. EPS for these «below the line items» would be reported either on the face of the income statement or through footnote disclosure.

 

Learning Objective: 12          Level of Learning: 1

 

158. What is an antidilutive security?

 

Answer: An antidilutive security is one whose terms permit it to be converted into common stock, but if it were converted, EPS would increase rather than decrease. If a loss is reported for the year, it would decrease rather than increase the loss per share. If a convertible security or right to stock is antidilutive, it is ignored in the EPS computations. Although ignored in the calculation of EPS, such securities must still be disclosed in the footnotes.

 

Learning Objective: 10          Level of Learning: 2

 

159. Magnetek, Inc. supplies digital power-electronic products used in information technology and industrial, communications, consumer and other markets. In its 2001 Annual Report to Shareholders, Magnetek, Inc. disclosed the following footnote about its EPS:

 

«The consolidated financial statements are presented in accordance with SFAS No. 128, «Earnings Per Share.» Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per common share incorporate the incremental shares issuable upon the assumed exercise of stock options and upon the assumed conversion of the Company’s Convertible Notes in fiscal 2001 as if conversion to common shares had occurred at the beginning of the fiscal year. Earnings have also been adjusted for interest expense on the Convertible Notes in fiscal 2001.»

 

Explain why Magnetek mentioned the adjustment in the last sentence of the footnote.

 

Answer: In determining its diluted EPS, Magnetek assumed conversion of its notes into common stock.  In this hypothetical case, the notes would disappear, as would the interest cost on them.  Thus, by assuming conversion, the diluted EPS denominator is increased and, correspondingly, the interest expense is eliminated from net income in the numerator.

 

Learning Objective: 10          Level of Learning: 2

 

Use the following to answer questions 160-161:

 

In its 2004 Annual Report to shareholders, Comfort Stores disclosed the following footnote about its EPS:

 

NOTE 9 — EARNINGS PER SHARE:

 

The following represents the reconciliation from basic earnings per share to diluted earnings per share. Options to purchase 8.3 million and 9.7 million shares of common stock were outstanding at May 31, 2004 and May 31, 2003, respectively, but were not included in the computation of diluted earnings per share because the options’ exercise prices were greater than the average market price of the common shares and, therefore, the effect would be antidilutive. No such antidilutive options were outstanding at May 31, 2002.

 

	YEAR ENDED MAY 31,
	2004	2003	2002
	(IN MILLIONS,
Determination of shares:	EXCEPT PER SHARE DATA)
Average common shares outstanding…………………….	270.0	275.7	283.3
Assumed conversion of dilutive stock options and
awards…………………………………………………………	3.3	3.7	5.0
Diluted average common shares outstanding…………….	273.3	279.4	288.3
Basic earnings per common share…………………………..	$ 2.18	$ 2.10	$ 1.59
Diluted earnings per common share………………………..	$ 2.16	$ 2.07	$ 1.57

 

160. How are outstanding stock options and awards taken into account in computing diluted EPS for Comfort Stores?

 

Answer: We assume, hypothetically, that the options have been exercised and then treasury shares were repurchased with the proceeds at the average market price during the period.

 

Learning Objective: 9          Level of Learning: 2

 

 

161. At the end of 2004, what is the maximum number of shares that could possibly be issued if all stock options and awards are exercised?  Explain why Comfort Stores used only 3.3 million in its computation for 2004.

 

Answer: A total of 11.6 million shares is the maximum.  As the footnote indicates, 8.3 of these were not included because the exercise prices were higher than the average market price during the year.  If they were exercised, there would be more shares bought back than the assumed number issued.  This would decrease the denominator and, therefore, be antidilutive.

 

Learning Objective: 9          Level of Learning: 2

 

162. Reacting to opposition to the FASB’s “Share-Based Payment” Exposure Draft, Senator Carl Levin stated, “Stock options are the 800-pound gorilla that has yet to be caged by corporate reform.”  In reference to a bill that would thwart the FASB’s position, Senator John McCain said, “This legislation blocking stock option expensing not only undermines FASB’s independence, but undermines the effort to restore confidence in our financial markets as well.”  Discuss what these two senators meant by their statements.

 

Answer: The rest of Senator Levin’s statement explains the first, namely “Corporate scandals have shown how current U.S. accounting rules are fueling stock option abuses linked to deceptive accounting, excessive executive pay, and nonpayment of taxes by profitable corporations. Honest accounting of stock options would strengthen the accuracy of U.S. financial statements and help restore investor confidence in our financial markets.”  Senator McCain’s comment on the FASB’s independence was in reference to the purpose of having an independent standard setting body in the private sector, something that would be undermined by congressional intervention.  The rest of his statement reinforced what Senator Levin indicated about the need for financial reporting improvements to overcome investor skepticism after highly publicized corporate reporting scandals.

 

Learning Objective: 2          Level of Learning: 2

 

163. What is restricted stock? Describe how compensation expense is determined and recorded for a restricted stock plan.

 

Answer: Restricted stock refers to shares actually awarded in the name of an employee, although the employer might retain possession of the shares. Typically, the shares must be forfeited if employment is terminated within a specified number of years. Usually, the employee is not free to sell the shares during the restriction period. Restrictions provide an incentive for the employee to stay with the company. Compensation expense is the fair value of the awarded shares on the date of the award. The compensation expense is accrued over the service period required under the restriction.

 

Learning Objective: 1          Level of Learning: 2

 

 

164. The tax code differentiates between qualified and nonqualified incentive plans. What are the major differences in tax treatment between the two?

 

Answer:

Under a qualified plan, the recipient pays no tax at the time of the grant or exercise of the options. The tax on the difference between the option price and the market price at the exercise date is paid on the date any shares acquired are subsequently sold. The employer gets no tax deduction at all.

 

Under a nonqualified plan, the employee cannot delay paying tax. On the other hand, the employer is allowed to deduct the difference between the option price and the market price on the date of exercise.

 

Learning Objective: 2          Level of Learning: 1

 

165. What is the advantage of a stock appreciation right over stock options?

 

Answer: With stock appreciation rights, employees can benefit from increased value of a company’s shares without having to buy the stock.

 

Learning Objective: 3          Level of Learning: 1