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552 f553
Equity Financing EOC Chapter 11
Equity Financing


Preferred stock (8%, $60 par, noncumulative, 16,000 shares authorized,
8,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $480,000
Common stock ($10 par, 120,000 shares authorized,
80,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800,000
Paid-in capital in excess of par, preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 252,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330,000

1. Journalize the following 2003 transactions:
Required:
a. Issued 2,000 preferred shares at $70 per share.
b. Reacquired 1,000 common shares for the treasury at $13 per share.
c. Declared and paid a $2-per-share dividend on common stock in addition to paying
the required preferred dividends. (Note: Debit Retained Earnings directly.)
d. Reissued 600 treasury shares at $14 per share.
e. Reissued the remaining treasury shares at $12 per share.
f. Earnings for the year were $92,000, including $200,000 of revenues and $108,000
of expenses.
2. Prepare the stockholders equity section of the balance sheet for the company at Decem-
ber 31, 2003.


PROBLEM 11-3 RECORDING STOCKHOLDERS EQUITY TRANSACTIONS
Zina Corporation was organized during 2002. At the end of 2002, the stockholders equity sec-
tion of the balance sheet appeared as follows:
Contributed capital:
Preferred stock (8%, $40 par, 10,000 shares authorized,
5,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . ............... $200,000
Common stock ($20 par, 30,000 shares authorized, 12,000 issued,
10,000 outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............... 240,000
Paid-in capital in excess of par, preferred stock. . . . . . . . . . . . . . . ............... 50,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............... $490,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............... 110,000
Total contributed capital plus retained earnings . . . . . . . . . . . . . . ............... $600,000
Less treasury stock (2,000 shares at cost of $25 per share) . . . . . . ............... (50,000)
Total stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ............... $550,000

During 2003, the following transactions occurred in the order given:
a. Issued 1,000 shares of common stock at $24 per share.
b. Reissued 1,000 shares of treasury stock at $27 per share.
c. Reissued 500 shares of treasury stock at $20 per share.
Record the transactions.
Required:


PROBLEM 11-4 STOCK TRANSACTIONS AND STOCKHOLDERS EQUITY
SECTION
The balance sheet for Lakeland Corporation as of December 31, 2002, is as follows:
Assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $750,000
Liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $410,000
Stockholders equity:
Preferred stock, convertible (5%, $20 par) . . . . . ................... $ 50,000
Common stock ($10 par). . . . . . . . . . . . . . . . . . ................... 150,000
Paid-in capital in excess of par, common stock. ................... 30,000
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . ................... 116,000
$346,000
Less treasury stock, common (500 shares at cost). . . . . . . . . . . . . . . . . . (6,000) 340,000
Total liabilities and stockholders equity . . . . . . . . . . . . . . . . . . . . . . . $750,000
553
f554 Equity Financing
Part 3 EOC Investing and Financing Activities


During 2003, the following transactions were completed in the order given:
a. The company reacquired 750 shares of outstanding common stock at $7 per share.
b. The company reacquired 150 shares of common stock in settlement of an account receiv-
able of $1,500.
c. Semiannual cash dividends of 75 cents per share on common stock and 50 cents per
share on preferred stock were declared and paid.
d. Each share of preferred stock is convertible into three shares of common stock. Five hun-
dred shares of preferred stock were converted into common stock. (HINT: Shares are
converted at par values, and any excess reduces Retained Earnings.)
e. The 900 shares of common treasury stock acquired during 2003 were sold at $13. The
remaining treasury shares were exchanged for a machine with a fair market value of
$6,300.
f. The company issued 3,000 shares of common stock in exchange for land appraised at
$39,000.
g. Semiannual cash dividends of 75 cents per share on common stock and 50 cents per
share on preferred stock were declared and paid.
h. Closed net income of $35,000 to Retained Earnings, which included $135,000 of rev-
enues and $100,000 of expenses.
i. Closed dividends accounts to Retained Earnings.

1. Give the necessary journal entries to record the transactions listed.
Required:
2. Prepare the stockholders equity section of the balance sheet as of December 31, 2003.


PROBLEM 11-5 STOCKHOLDERS EQUITY, DIVIDENDS, AND TREASURY STOCK
The stockholders equity section of Nielsen Corporation s December 31, 2002, balance sheet is
as follows:
Stockholders equity:
Preferred stock (10%, $50 par, 10,000 shares authorized,
1,000 shares issued and outstanding) . . . . . . . . . . . . . . ...................... $ 50,000
Common stock ($15 par, 100,000 shares authorized,
5,000 shares issued and outstanding) . . . . . . . . . . . . . . ...................... 75,000
Paid-in capital in excess of par, preferred stock . . . . . . . . ...................... 2,000
Paid-in capital in excess of par, common stock . . . . . . . . ...................... 25,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . ...................... $152,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...................... 102,000
Total stockholders equity. . . . . . . . . . . . . . . . . . . . . . . ...................... $254,000

During 2003, Nielsen Corporation had the following transactions affecting stockholders
equity:
Jan. 20 Paid a cash dividend of $2 per share on common stock. The dividend was declared
on December 15, 2002.
Aug. 15 Reacquired 1,000 shares of common stock at $20 per share.
Sept. 30 Reissued 500 shares of treasury stock at $21 per share.
Oct. 15 Declared and paid cash dividends of $3 per share on the common stock.
Nov. 1 Reissued 200 shares of treasury stock at $18 per share.
Dec. 15 Declared and paid the 10% preferred cash dividend.
Dec. 31 Closed net income of $40,000 to Retained Earnings. (Revenues were $260,000;
expenses were $220,000.) Also closed the dividends accounts to Retained Earn-
ings.
1. Journalize the transactions.
Required:
2. Prepare the stockholders equity section of Nielsen Corporation s December 31, 2003,
balance sheet.
3. Interpretive Question: What is the effect on earnings per share when a company pur-
chases treasury stock?
554 f555
Equity Financing EOC Chapter 11
Equity Financing



PROBLEM 11-6 DIVIDEND CALCULATIONS
Salty Corporation was organized in January 2000 and issued shares of preferred and common
stock as shown. As of December 31, 2003, there have been no changes in outstanding stock.
Preferred stock (8%, $10 par, 20,000 shares issued and outstanding) . . . . . . . . . . . . . . $200,000
Common stock ($40 par, 10,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . 400,000

Required: For each of the following independent situations, compute the amount of dividends that would
be paid for each class of stock in 2002 and 2003. Assume that total dividends of $10,000 and
$80,000 are paid in 2002 and 2003, respectively.
1. Preferred stock is noncumulative.
2. Preferred stock is cumulative, and no dividends are in arrears in 2002.
3. Preferred stock is cumulative, and no dividends have been paid during 2000 and 2001.

PROBLEM 11-7 DIVIDEND CALCULATIONS
Rasmussen Corporation had authorization for 40,000 shares of 6% preferred stock, par value
$10 per share, and 8,000 shares of common stock, par value $100 per share, all of which are is-
sued and outstanding. During the years beginning in 2002, Rasmussen Corporation maintained
a policy of paying out 50% of net income in cash dividends. One-half the net income for the
three years beginning in 2002 was $16,000, $160,000, and $128,000. There are no dividends
in arrears for years prior to 2002.
Required: Compute the amount of dividends paid to each class of stock for each year under the following
separate cases:
1. Preferred stock is noncumulative.
2. Preferred stock is cumulative.
3. Interpretive Question: Why is it important that a common stockholder know about the
dividend privileges of the preferred stock?

PROBLEM 11-8 DIVIDEND PAYOUT RATIO
The following numbers are for three different companies:

A B C

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 50 $ 200 $ 400
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 800 3,500
Cash dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 0 500
Paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 2,500 2,000
Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 300 1,400
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 10,000 4,000
Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 500 800


Required: 1. For each company, compute the dividend payout ratio.
2. Interpretive Question: Which of the three companies is most likely to be a high-growth
Internet company? Which is most likely to be an old, stable company? Explain.

PROBLEM 11-9 PREPARING THE STOCKHOLDERS EQUITY SECTION AND
RECORDING DIVIDENDS
In 2001, Lee Ann Adams and some college friends organized The Candy Jar, a gourmet candy
company. In 2001, The Candy Jar issued 150,000 of the 300,000 authorized shares of com-
mon stock, par value $15, for $3,000,000 and all the 50,000 authorized shares of 10%, $20
par, cumulative preferred stock for $1,100,000. Combined earnings for 2001, 2002, 2003, and
2004 amounted to $1,250,000. Dividends paid in the four years were as follows: 2001
$100,000; 2002 $300,000; 2003 $0; 2004 $150,000.
Required: 1. Prepare the stockholders equity section of the balance sheet as of December 31, 2004,
for The Candy Jar.
2. Prepare the journal entry that would be necessary to record the dividends paid in 2004.
555
f556 Equity Financing
Part 3 EOC Investing and Financing Activities



PROBLEM 11-10 STOCKHOLDERS EQUITY CALCULATIONS
A computer virus destroyed important financial information pertaining to Denton Company s
stockholders equity section. Your expertise is needed to compute the missing account balances.
The only information you can recover from the computer s backup system is as follows:
a. During 2003, 8,000 shares of common stock with a par value of $10 were issued when
the market price per share was $22.
b. Cash dividends of $30,000 were paid to preferred shareholders.
c. Denton Company acquired 4,000 shares of common stock at $15 to hold as treasury
stock.
d. Denton Company reissued 3,000 shares of treasury stock for $18.


December 31, 2002 December 31, 2003

Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000 $ 2,000
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 ?
Paid-in capital in excess of par,
preferred stock . . . . . . . . . . . . . . . . . . . . . . . 750 750
Paid-in capital in excess of par,
common stock . . . . . . . . . . . . . . . . . . . . . . . 1,750 ?
Paid-in capital, treasury stock . . . . . . . . . . . . . . 0 ?
Retained earnings . . . . . . . . . . . . . . . . . . . . . . 4,500 5,250
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . 0 (15,000)
Total stockholders equity. . . . . . . . . . . . . . . . . 15,000 ?



1. Calculate the account balances for the following accounts:
Required:
a. Common Stock
b. Paid-In Capital in Excess of Par, Common Stock
c. Paid-In Capital, Treasury Stock
d. Stockholders Equity
2. How much net income did Denton Company report for 2003?


PROBLEM 11-11 STOCK CALCULATIONS AND THE STOCKHOLDERS EQUITY
SECTION
The following account balances appear on the books of World Corporation as of December 31,
2003:
Preferred stock (7%, $40 par, 70,000 shares authorized,
50,000 shares issued and outstanding). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,000,000
Common stock ($3 par, 500,000 shares authorized,
300,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900,000
Paid-in capital in excess of par, preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310,000
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 490,000
Net income for 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 130,000
Dividends paid during 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000
Retained earnings, January 1, 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,360,000

Required: 1. If the preferred stock is selling at $45 per share, what is the maximum amount of cash
that World Corporation can obtain by issuing additional preferred stock given the pre-
sent number of authorized shares?
2. If common stock is selling for $12 per share, what is the maximum amount of cash that
can be obtained by issuing additional common stock given the present number of autho-
rized shares?
3. Given the account balances at December 31, 2003, and ignoring parts (1) and (2), pre-
pare, in good form, the stockholders equity section of the balance sheet.
556 f557
Equity Financing EOC Chapter 11
Equity Financing



PROBLEM 11-12 UNIFYING CONCEPTS: STOCK TRANSACTIONS AND THE
STOCKHOLDERS EQUITY SECTION
Richard Corporation was founded on January 1, 2003, and entered into the following stock
transactions during 2003.
a. Received authorization for 100,000 shares of $20 par-value common stock, 50,000 shares
of 6% preferred stock with a par value of $5, and 50,000 shares of no-par common
stock.
b. Issued 25,000 shares of the $20 par-value common stock at $24 per share.
c. Issued 10,000 shares of the preferred stock at $8 per share.
d. Issued 5,000 shares of the no-par common stock at $22 per share.
e. Reacquired 1,000 shares of the $20 par-value common stock at $25 per share.
f. Reacquired 500 shares of the no-par common stock at $20 per share.
g. Reissued 250 of the 1,000 reacquired shares of $20 par-value common stock at $23 per share.
h. Reissued all the 500 reacquired shares of no-par common stock at $23 per share.
i. Closed the $14,000 net income to Retained Earnings. Revenues and expenses for the year
were $90,000 and $76,000, respectively.
Required: 1. Prepare journal entries to record the 2003 transactions in Richard Corporation s books.
2. Prepare the stockholders equity section of Richard Corporation s balance sheet at De-
cember 31, 2003. Assume that the transactions represent all the events involving equity
accounts during 2003.

PROBLEM 11-13 UNIFYING CONCEPTS: STOCK TRANSACTIONS, THE
STOCKHOLDERS EQUITY SECTION, AND THE STATEMENT OF
STOCKHOLDERS EQUITY
The condensed balance sheet of IBC Corporation at December 31, 2002, is shown below.

IBC Corporation
Balance Sheet
December 31, 2002

Assets
Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400,000
All other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,042,000
$1,442,000

Liabilities and Stockholders Equity
Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 164,000
Long-term liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230,000
$ 394,000
Contributed capital:
Common stock ($10 par, 100,000 shares authorized,
80,000 shares outstanding). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800,000
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168,000
$1,048,000
$1,442,000


During 2003, the following transactions affected stockholders equity:
Feb. 15 Purchased 2,000 shares of IBC outstanding common stock at $15 per share.
May 21 Sold 1,200 of the shares purchased on February 15 at $19 per share.
Sept. 15 Issued 8,000 shares of previously unissued common stock at $21 per share.
Dec. 21 Sold the remaining 800 shares of treasury stock at $22 per share.
Dec. 31 Closed net income of $85,360 to Retained Earnings. Revenues were $185,360; ex-
penses were $100,000.
557
f558 Equity Financing
Part 3 EOC Investing and Financing Activities


1. Prepare the journal entries to record the 2003 transactions.
Required:
2. Prepare the stockholders equity section of the balance sheet at December 31, 2003.
3. Prepare a statement of stockholders equity for the year ended December 31, 2003.

PROBLEM 11-14 UNIFYING CONCEPTS: STOCKHOLDERS EQUITY
Icon Corporation was organized during 2001. At the end of 2002, the equity section of its bal-
ance sheet appeared as follows:
Contributed capital:
Preferred stock (6%, $20 par, 10,000 shares authorized,
5,000 shares issued and outstanding) . . . . . . . . . . . . ....................... $100,000
Common stock ($10 par, 50,000 shares authorized,
11,000 shares issued, 10,000 outstanding) . . . . . . . . . ....................... 110,000
Paid-in capital in excess of par, preferred stock . . . . . . ....................... 20,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . ....................... $230,000
Retained earnings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....................... 100,000
Total contributed capital plus retained earnings . . . . ....................... $330,000
Less treasury stock (1,000 shares of common at cost). . ....................... (12,000)
Total stockholders equity . . . . . . . . . . . . . . . . . . . . . ....................... $318,000

During 2003, the following stockholders equity transactions occurred (in chronological se-
quence):
a. Issued 500 shares of common stock at $13 per share.
b. Reissued 500 shares of treasury stock at $13 per share.
c. Issued 1,000 shares of preferred stock at $25 per share.
d. Reissued 500 shares of treasury stock at $10 per share.
e. Declared a dividend large enough to meet the current-dividend preference of the pre-
ferred stock and to pay the common stockholders $2 per share. Dividends are recorded
directly in the retained earnings account.
f. Closed net income of $65,000 to Retained Earnings. Revenues were $400,000; expenses
were $335,000.
Required: 1. Journalize the transactions.
2. Prepare the stockholders equity section of the balance sheet at December 31, 2003.

PROBLEM 11-15 COMPREHENSIVE INCOME
The following information relates to Pecos Yo Company:
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,000
Cost of goods sold. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000
Other operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,500
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400
Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000

In addition, the following events occurred during the year:
a. Pecos Yo Company has an investment portfolio for long-term investment purposes. That
portfolio decreased in value by $7,000 during the year.
b. Pecos Yo Company owns a substantial amount of land. During the year, the land in-
creased in value by $11,000.
c. Pecos Yo Company has several foreign subsidiaries. The currencies in the countries where
those subsidiaries are located declined in value (relative to the U.S. dollar) during the
year. Accordingly, the computed value of the equity of those subsidiaries, in U.S. dollars,
decreased by $5,000.
Required: 1. Compute Pecos Yo s comprehensive income for the year.
2. Interpretive Question: Is comprehensive income a good measure of the change in a
company s value during the year?
558 f559
Equity Financing EOC Chapter 11
Equity Financing



PROBLEM 11-16 STOCKHOLDERS EQUITY SECTION WITH SELECTED OTHER
INFORMATION
The stockholders equity section of Glory Company s balance sheet was as follows as of De-
cember 31, 2003, and December 31, 2002:


Glory Company
Stockholders Equity Sections of Balance Sheet
December 31, 2003 and 2002
(in millions)
2003 2002

Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21.4 $ 21.4
Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48.4 43.2
Paid-in capital, various types . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22.6 15.3
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51.8 41.2
Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $144.2 $121.1
Accumulated foreign currency translation
adjustments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.4 57.3
Net unrealized gains (losses) on investments in certain
debt and equity securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (46.4) (8.8)
Total stockholders equity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $119.2 $169.6



Required: Based on the stockholders equity section for Glory Company, answer the following ques-
tions:
1. Do you believe Glory Company made a profit during the year 2003? Assuming that only
net income and dividends changed the retained earnings balance from 2002 to 2003, by
how much did net income exceed dividends?
2. What was the total amount of money raised during 2003 from the selling of stock? (As-
sume that only the selling of stock affected the contributed capital accounts.)
3. Did the market value of Glory Company s securities that affect the equity section in-
crease or decrease in 2003? By how much?
4. Interpretive Question: The board of directors believes it should fire the current manage-
ment of the company because total stockholders equity decreased substantially. Do you
agree? Why or why not?




PROBLEM 11-17 RECORDING STOCKHOLDERS EQUITY TRANSACTIONS
The stockholders equity section of Hathaway Corporation s December 31, 2002, balance sheet
is as follows:

Stockholders Equity
Contributed capital:
Preferred stock (5%, $25 par, 2,000 shares issued and outstanding) . .............. $ 50,000
Common stock ($30 par, 10,000 shares issued and outstanding) . . . .............. 300,000
Paid-in capital in excess of par, preferred stock . . . . . . . . . . . . . . . . .............. 10,000
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . .............. 100,000
Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............. $460,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............. 340,000
Total stockholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............. $800,000
559
f560 Equity Financing
Part 3 EOC Investing and Financing Activities


During 2003, Hathaway Corporation had the following transactions:
Feb. 1 Paid a cash dividend of $3 per share on common stock. The dividend was declared
December 31, 2002.
Mar. 15 Declared and issued a 19% common stock dividend. The market price of the stock
on this date was $40 per share.
June 1 Reacquired 3,000 shares of common stock at $35 per share.
Sept. 1 Reissued 500 shares of treasury stock at $40 per share.
Nov. 15 Reissued 500 shares of treasury stock at $32 per share.
Required: Record the transactions.

PROBLEM 11-18 DIVIDEND TRANSACTIONS AND CALCULATIONS
As of December 31, 2002, First Corporation has 200,000 shares of $10 par-value common stock
authorized, with 100,000 of these shares issued and outstanding.
Required: 1. Prepare journal entries to record the following 2003 transactions:
Jan. 1 Received authorization for 200,000 shares of 7%, cumulative preferred stock with a
par value of $10.
Jan. 2 Issued 10,000 shares of the preferred stock at $15 per share.
June 1 Reacquired 40% of the common stock outstanding for $18 per share.
June 2 Declared a cash dividend of $10,000. The date of record is June 15.
June 30 Paid the previously declared cash dividend of $10,000.
2. Determine the proper allocation to preferred and common stockholders of a $100,000
cash dividend declared on December 31, 2003. (This dividend is in addition to the June
2 dividend.)
3. Interpretive Question: Why didn t the preferred stockholders receive their current-
dividend preference of $7,000 in part (2)?

PROBLEM 11-19 RECORDING DIVIDEND TRANSACTIONS AND REPORTING
STOCKHOLDERS EQUITY
Murtry, Inc., reported the following stockholders equity balances in its June 30, 2002, balance
sheet:
Preferred stock (6%, $100 par, cumulative; 20,000 shares authorized,
6,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 600,000
Common stock ($20 par; 250,000 shares authorized,
60,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200,000
Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 950,000

Required: 1. The following stockholders equity transactions occurred (in the order presented) during
the fiscal year ending June 30, 2003. Prepare the necessary journal entries to record the
transactions.
a. Murtry declared and issued a 5% dividend on common stock; the market value of
the stock was $30 per share on the date of the dividend.
b. A 50% stock dividend on common stock was declared and issued when the stock
was trading at a market price of $40 per share.
c. A cash dividend was declared at the end of the fiscal year. The common stockholders
will receive 50 cents per share after the current and cumulative preference on the
preferred stock is satisfied. Preferred stock dividends are one year in arrears.
2. Assuming Murtry s net income for the year ended June 30, 2003, is $310,000, prepare
the stockholders equity section of the June 30, 2003, balance sheet and a statement of
stockholders equity for the 2002 2003 fiscal year.
3. Interpretive Question: What is the effect on earnings per share when a company has a
stock dividend or stock split?
560 f561
Equity Financing EOC Chapter 11
Equity Financing



PROBLEM 11-20 STATEMENT OF RETAINED EARNINGS AND STOCKHOLDERS
EQUITY
The following balances appear in the accounts of Iron Corporation as of December 31, 2003:
Retained earnings, January 1, 2003. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $128,000
Prior-period adjustment (tax adjustment for 2001). . . . . . . . . . . . . . . . . . . . . . . . . . . . (57,000)
Net income for 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Preferred stock (7%, $12 par, 20,000 shares authorized,
5,000 shares issued and outstanding) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000
Common stock ($5 par, 100,000 shares authorized,
16,000 shares issued, 200 held as treasury stock) . . . . . . . . . . . . . . . . . . . . . . . . . . 80,000
Paid-in capital in excess of par, preferred stock. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13,400
Paid-in capital in excess of par, common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42,800
Treasury stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600
Cash dividends (declared during 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

1. Prepare the statement of retained earnings for Iron Corporation as of December 31,
Required:
2003.
2. Prepare the stockholders equity section of Iron Corporation s balance sheet as of Decem-
ber 31, 2003.

PROBLEM 11-21 STATEMENT OF RETAINED EARNINGS
Marsh Corporation records show the following at December 31, 2003:
Extraordinary loss (net of tax). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(50,000)
Cash dividends declared during 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000
Stock dividends issued during 2003 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000
January 1, 2003, retained earnings balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690,000
Prior-period adjustment (net of tax) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (36,000)
Net income before extraordinary items and taxes (assume a 40% tax rate) . . . . . . . . . 160,000

Prepare a 2003 statement of retained earnings.
Required:

PROBLEM 11-22 ACCOUNTING FOR A PROPRIETORSHIP
On January 1, 2003, Pat Larsen decided to open the Donut Shop. Pat deposited $40,000 of
her own money in a company bank account and obtained a $30,000 loan from a local bank.
During its first year of operation, the shop had net income of $84,000, which included $150,000
of revenues and $66,000 of expenses. Pat withdrew a lump sum of $48,000 from the business
that year to cover personal living expenses.
1. Prepare journal entries to record:
Required:
a. Pat s original contribution to the firm.
b. The bank loan.
c. Pat s withdrawal for her living expenses.
d. Any closing entries required at year-end.
2. Prepare a statement of owner s capital for 2003.
3. Interpretive Question: How would the accounting for the transactions in part (1) be
different if Pat s business were a corporation?

PROBLEM 11-23 PARTNERSHIP ACCOUNTING
On January 1, 2003, Reed and Bailey established a partnership to sell fruit.
a. Reed invested $42,000 cash in the partnership, and Bailey invested $20,000 cash and a
building valued at $25,000.
b. Reed invested another $6,000 cash. Bailey donated a truck valued at $7,000.
c. Reed withdrew $11,000 cash, and Bailey withdrew $6,300 cash.
d. A fire destroyed half of the building donated by Bailey. There was no insurance on the
building. The partners share profits and losses equally.
561
f562 Equity Financing
Part 3 CEO Investing and Financing Activities


e. Reed and Bailey agree to admit a third partner on March 1 of the next year. This part-
ner, Kiefer, promises to invest $50,000 cash.
1. Journalize the transactions.
Required:
2. Journalize the closing entries. Assume revenues totaled $50,000 and expenses totaled
$31,000.
3. Compute each partner s capital balance at the end of 2003.
4. Interpretive Question: What is the relationship between the amount of capital con-
tributed by each owner and the way profits are to be allocated?




competency enhancement opportunities




LLL
LLLL




Analyzing Real Company Information The Debate
International Case Cumulative Spreadsheet Project
Ethics Case Internet Search
Writing Assignment




The following additional assignments provide opportunities for students to de-
velop critical thinking, ethical perspectives, oral and written communication
skills, experience with electronic research, and teamwork through group and
business activities.
L




ANALYZING REAL COMPANY INFORMATION
Analyzing 11-1 (Microsoft)
The 1999 annual report for MICROSOFT is included in Appendix A. Microsoft s
stockholders equity statements provide details of equity transactions of the
company during the 1999 fiscal year. Locate the statements and consider the
following questions:
1. What was the major reason that stockholders equity increased for the year?
2. How much did common stockholders receive in dividends during the year?
How much did preferred stockholders receive?
3. Did Microsoft issue more shares than it repurchased during the year or vice
versa? How can you tell? (HINT: You should look in the notes to the state-
ments to answer this question.)
Analyzing 11-2 (Wal-Mart Stores, Inc.)
WAL-MART has a simple, straightforward statement of shareholders equity.
That statement for the years 1998 and 1999 is reproduced on the top of the
next page.
562 f563
Equity Financing CEO Chapter 11
Equity Financing




Consolidated Statements of Shareholders Equity
Other
Capital in Accumulated
(Amounts in millions Number Common Excess of Retained Comprehensive
except per share data) of Shares Stock Par Value Earnings Income Total

Balance January 31, 1998 2,241 $224 $585 $18,167 $(473) $18,503
Net income 4,430 4,430
Cash dividends ($0.16 per share) (693) (693)
Foreign currency translation adjustment (36) (36)
Purchase of company stock (21) (2) (37) (1,163) (1,202)
Two-for-one stock split 2,224 223 (223)
Other 4 110 110
Balance January 31, 1999 4,448 445 435 20,741 (509) 21,112
Net income 5,377 5,377
Cash dividends ($0.20 per share) (890) (890)
Foreign currency translation adjustment 54 54
Purchase of company stock (2) (2) (99) (101)
Other 11 1 281 282
Balance January 31, 2000 4,457 $446 $714 $25,129 $(455) $25,834


1. Based on the dividends paid during each year, how many shares of stock
were outstanding when the dividends were paid?
2. Why isn t the number of shares receiving dividends exactly the same as
the number of shares outstanding on January 31 of each year as indicated
in the statement?
3. Estimate Wal-Mart s dividend payout ratio for each year. (HINT: You will
need to estimate an earnings-per-share figure given the available data.)
L




INTERNATIONAL CASE
The EMI Group
The shareholders equity section of the balance sheet of THE EMI GROUP, a
company based in the United Kingdom, is reproduced below. Review this in-
formation and answer the questions below.

Balance Sheets
at 31 March 1999
Group
Pro Forma
1999 1998
£m £m

Capital and reserves
Called-up share capital 110.2 110.1
Share premium reserve 441.2 439.0
Capital redemption reserve 495.8 495.8
Other reserves 636.9 786.3
Profit and loss reserve (including goodwill previously written off) 710.5 529.3
Equity shareholders funds 2,394.6 2,360.5
563
f564 Equity Financing
Part 3 CEO Investing and Financing Activities




1. What do you think the term called-up share capital means?
2. What does the term profit and loss reserve mean?
3. In the United Kingdom, goodwill has historically not been recorded as an
asset. Instead, it has frequently been recorded as a contra-equity account.
As of March 31, 1997, The EMI Group reported a goodwill contra-equity
amount of 524.7 million pounds. Assuming that The EMI Group paid cash
of 524.7 million pounds for the goodwill it purchased, provide the journal
entry that would have been made at the time. How does this journal entry
differ from the one that would have been made had EMI been a U.S.-based
company? [Note: Since 1997, The EMI Group has changed its accounting
for goodwill; EMI now uses the same approach used in the United States.]
L




ETHICS CASE
Buying Your Own Shares Back
You are the chief financial officer for Esoteric, Inc., a company whose stock is
publicly traded. The stock market has recently experienced an overall down-
turn, and the price of your company s stock has decreased by about 15%. This
significantly affects the compensation of the executives of your company as
their bonuses are based on the company s stock price. The bonus plan rewards
company executives who take actions to increase the value of the company to
shareholders. The reasoning is that if management increases the value of the
company to shareholders, management should be rewarded.
As you consider ways to increase the value of the company, when the mar-
ket itself is slumping, the following idea pops into your head: We will buy back
our own stock. That will cause the remaining outstanding stock to increase in
value, which is good for those individuals holding that stock. And it will also
result in you and the other corporate executives receiving sizable bonuses.
Do you think this plan of action to increase stock price was what the de-
signers of the compensation plan had in mind when they linked executive
bonuses to company stock price? Does buying back the company s own stock
add value to the company as a whole? Should the compensation plan prohibit
activities like buying stock back? Consider these issues and be prepared to dis-
cuss them.
L




WRITING ASSIGNMENT
Stock Splits Versus Stock Dividends
In this chapter, you learned that we account for stock dividends differently than
we account for stock splits. For stock dividends, the accounting also varies, de-
pending on the size of the dividend. Prepare a two-page memo summarizing
the following points:
1. To an investor who holds stock in a company, what is the difference be-
tween a small stock dividend, a large stock dividend, and a stock split?
2. To the accountant who must account for business transactions, what is the
difference between a small stock dividend, a large stock dividend, and a
stock split?
3. If you held stock in a company that was contemplating the declaration of
a stock dividend or a stock split, which would you prefer?
564 f565
Equity Financing CEO Chapter 11
Equity Financing




L
THE DEBATE
Microsoft Should Share the Wealth!
Turn to MICROSOFT s annual report in Appendix A and notice its cash balance.
As of June 30, 1999, the company had over $17 billion in cash and short-term in-
vestments. It is likely that the company has a lot more cash on hand now. Should
Microsoft use some of that cash to pay a dividend to its common shareholders?
Divide your group into two teams.
The first team represents the position that Bill Knows Best Don t Pay a
Dividend. Prepare a two-minute presentation outlining the reasons why
Microsoft s no-dividend policy is appropriate.
The second team represents the position that A Dividend Should Be Paid.
Prepare a two-minute presentation outlining reasons why Microsoft should
use some of its stockpile of cash to reward common shareholders who
have never received a dividend.
L




CUMULATIVE SPREADSHEET PROJECT
This spreadsheet assignment is a continuation of the spreadsheet assignments
given in earlier chapters. If you completed those spreadsheets, you have a head
start on this one.
1. Handyman wishes to prepare a forecasted balance sheet and income state-
ment for 2004. Use the original financial statement numbers for 2003 [given
in part (1) of the Cumulative Spreadsheet Project assignment in Chapter 2]
as the basis for the forecast, along with the following additional information:
a. Sales in 2004 are expected to increase by 40% over 2003 sales of $700.
b. Cash will increase at the same rate as sales.
c. The forecasted amount of accounts receivable in 2004 is determined
using the forecasted value for the average collection period. For sim-
plicity, do the computations using the end-of-period accounts receiv-
able balance instead of the average balance. The average collection pe-
riod for 2004 is expected to be 14.08 days.
d. The forecasted amount of inventory in 2004 is determined using the
forecasted value for the number of days sales in inventory (computed
using the end-of-period inventory balance). The number of days sales
in inventory for 2004 is expected to be 107.6 days.
e. The forecasted amount of accounts payable in 2004 is determined us-
ing the forecasted value for the number of days purchases in accounts
payable (computed using the end-of-period accounts payable balance).
The number of days purchases in accounts payable for 2004 is ex-
pected to be 48.34 days.
f. The $160 in operating expenses reported in 2003 breaks down as fol-
lows: $5 depreciation expense, $155 other operating expenses.
g. New long-term debt will be acquired (or repaid) in an amount sufficient
to make Handyman s debt ratio (total liabilities divided by total assets)
in 2004 exactly equal to 0.80.
h. No cash dividends will be paid in 2004.
i. New short-term loans payable will be acquired in an amount sufficient
to make Handyman s current ratio in 2004 exactly equal to 2.0.
j. The forecasted amount of property, plant, and equipment (PP&E) in
2004 is determined using the forecasted value for the fixed asset
turnover ratio. For simplicity, compute the fixed asset turnover ratio us-
ing the end-of-period gross PP&E balance. The fixed asset turnover ra-
tio for 2004 is expected to be 3.518 times.
565
f566 Equity Financing
Part 3 CEO Investing and Financing Activities




k. In computing depreciation expense for 2004, use straight-line depreci-
ation and assume a 30-year useful life with no residual value. Gross
PP&E acquired during the year is depreciated for only half the year. In
other words, depreciation expense for 2004 is the sum of two parts: (1)
a full year of depreciation on the beginning balance in PP&E, assum-
ing a 30-year life and no residual value and (2) a half-year of depreci-
ation on any new PP&E acquired during the year, based on the change
in the gross PP&E balance.
Assume an interest rate on short-term loans payable of 6.0% and on
l.
long-term debt of 8.0%. Only a half-year s interest is charged on loans
taken out during the year. For example, if short-term loans payable at
the end of 2004 are $15 and given that short-term loans payable at the
end of 2003 were $10, total short-term interest expense for 2004 would
1/ )].
be $0.75 [($10 .06) ($5 .06 2

Note: These statements were constructed as part of the spreadsheet assign-
ment in Chapter 10; you can use that spreadsheet as a starting point if you
have completed that assignment.
For this exercise, add the following additional assumptions:
In addition to preparing forecasted financial statements for 2004, Handy-
man also wishes to prepare forecasted financial statements for 2005. All
assumptions applicable to 2004 are also assumed to be applicable to 2005.
Sales in 2005 are expected to be 40% higher than sales in 2004.
Clearly state any additional assumptions that you make.
2. For each forecasted year, 2004 and 2005, state whether Handyman is ex-
pected to issue new shares of stock or to repurchase shares of stock.
3. Repeat (2), with the following changes in assumptions:
a. The debt ratio in 2004 and 2005 is exactly equal to 0.70.
b. The debt ratio in 2004 and 2005 is exactly equal to 0.95.
4. Comment on how it is possible for a company to have negative paid-in
capital.
L




INTERNET SEARCH
Dow Jones & Company
We began this chapter with a look at the history of DOW JONES & COMPANY.
Let s continue our examination of this company using its Internet site. Access
Dow Jones site at http://dowjones.com. Sometimes Web addresses change,
so if this address doesn t work, access the Web site for this book (http://
albrecht.swcollege.com) for an updated link to Dow Jones & Company.
Once you have gained access to the company s Web site, answer the fol-
lowing questions:
1. What business publications is the company responsible for? What other
services does the company provide?
2. Locate the company s most recent annual report. Which of the company s
business segments is the most profitable as measured by operating income
as a percentage of revenues?
3. Did the company pay a dividend in the most recent year? If so, how much
per share? Compute the company s dividend payout ratio.
4. Review the note disclosure relating to the company s executive incentive
plan (employee stock compensation plans). What is the objective of this plan?
Investments in
Debt and Equity
Securities

chapter



12
f12
learning objectives After studying this chapter, you should be able to:


1 Understand why companies 4 Account for changes in the 6 Account for securities using
invest in other companies. value of securities. the equity method.

2 Understand the different
classifications for securities.

3 Account for the purchase,
recognition of revenue, and
5 Account for held-to-maturity
sale of trading and available-
securities.
for-sale securities.
568 chapter f12
Investments In Debt And Equity Securities


Warren Buffett, who has been called “the nual return over its life from 1956 to 1969.
world™s greatest investor,” has lived most Buffett also began purchasing shares in a
of his life not far from the house in which small textile manufacturer called BERK-
he grew up in Omaha, Nebraska.1 He at- SHIRE HATHAWAY. His first 2,000 shares
tended the Wharton School at the Univer- of Berkshire Hathaway stock cost $7.50 per
sity of Pennsylvania (but dropped out be- share (plus $0.10 per share in commis-
cause he thought he wasn™t learning sions). Buffett transformed Berkshire Hath-
anything); received a bachelor™s degree away from a textile manufacturer into a
from the University of Nebraska; applied for holding company that invests in the stock
admission to do graduate work at Harvard of other companies. A selection of the
but was rejected; and instead earned a mas- companies controlled by Berkshire Hath-
ter™s degree in economics at Columbia. away, along with some of Berkshire Hath-
Buffett began his professional career away™s major investments, is shown in Ex-
as a stock trader and eventually created an hibit 12-1.
investment fund called the Buffett Part- How has Berkshire Hathaway™s stock
setting the stage
nership, which earned a 32% average an- performed under Warren Buffett™s leader-



Berkshire Hathaway™s Operations and Investments
exhibit 12-1



Companies Owned by Berkshire Hathaway*

Industry

GEICO Property and casualty insurance
FlightSafety International Aviation training
See's Candies Candy
Kirby Vacuum cleaners
Nebraska Furniture Mart, R.C. Willey, Home furnishings
Star Furniture, and Jordan's Furniture
The Buffalo News Newspaper publishing
Dexter Shoe Company, H.H. Brown Shoe Company, Shoes
and Lowell Shoe, Inc.
Helzberg Diamond Shops and Borsheim's Retail jewelry stores
International Dairy Queen Fast food and dairy desserts
Orange Julius Blended fruit drinks

Companies in Which Berkshire Hathaway Has Invested*

Ownership
CO K E Percentage

American Express Company 11.3%
The Coca-Cola Company 8.1%
M&T Bank 6.5%
Freddie Mac 8.6%
The Gillette Company 9.0%
The Washington Post Company 18.3%
Wells Fargo & Company 3.6%

*This information is as of the end of 1999.


1 Janet Lowe, Warren Buffett Speaks: Wit and Wisdom from the World™s Greatest Investor (New York: John Wi-
ley & Sons, 1997).
569
f570 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities


ship? Well, on October 23, 2000, the com- don™t feel sorry for Mr. Buffett. He was smart
pany™s stock closed at $58,600 per share! enough to purchase a large number of Berk-
How has Warren Buffett done personally? shire Hathaway shares when the price was
He receives a salary of only $100,000 per low. With a personal worth of approxi-
year (making him the lowest paid CEO mately $25.6 billion, he ranks fourth on the
list of the world™s richest people.2
among the nation™s top 200 companies). But




In this chapter we focus on why companies invest in other companies and how to account for those
investments. When a company purchases the debt or equity securities of another company, several ac-
counting issues are raised: how to account for the initial purchase, how to account for the receipt of
dividends or interest, how to account for any subsequent changes in value of the security, and how to
account for the security if it is sold or matures. The remainder of this chapter focuses on each of these
issues. First, we examine how securities are classified and the different accounting implications of these
classifications. We then introduce proper accounting for the purchase, receipt of revenue, sale, and val-
uation of securities. In the expanded material section of the chapter, we review the computations and
accounting for a bond premium or discount from the point of view of the purchaser (we focused on
the seller™s perspective in Chapter 10). We also introduce the equity method of accounting and dis-
cuss when its application is appropriate. Exhibit 12-2 highlights the financial statement accounts that
will be discussed in this chapter.


1 WHY COMPANIES INVEST IN OTHER
COMPANIES
Understand why companies
invest in other companies.
Companies invest in the debt and equity securities of other companies for a variety of reasons. A
major reason is to earn a return on their excess cash. Most businesses are cyclical or seasonal; that
is, their cash inflows and outflows vary significantly throughout the year. At certain times (par-
ticularly when inventories are being purchased), a company™s cash supply is low. At other times
(usually during or shortly after heavy selling seasons), there is excess cash on hand. A typical cash
flow pattern for a retail firm is illustrated in Exhibit 12-3. The time line shows that the company
has insufficient cash for inventory buildup for the Christmas rush, followed by large amounts of
accounts receivable (from credit sales), and then an excess of cash immediately after Christmas.
When a company needs cash to meet current obligations, funds can be obtained through
such means as borrowing from financial institutions or selling (factoring) accounts receivable or
other assets. During those periods of time when excess cash exists, firms usually prefer to invest
that money and earn a return. One possibility is to place the money in a bank and earn a fixed
return. Most firms, however, are not satisfied with the low interest rates offered by financial in-
stitutions and have turned to other investment alternatives. Investing in the stocks (equity) and
bonds (debt) of other companies allows a firm to earn a higher rate of return by accepting a
higher degree of risk. BERKSHIRE HATHAWAY is perhaps the most famous example of a
company whose sole purpose is to invest in the debt and equity securities of other companies.
Firms also invest in other companies for reasons other than to earn a return. The desire to
ensure a supply of raw materials, to influence the board of directors, or to diversify its product
offerings are additional reasons for a company to invest in other companies. For example, THE
COCA-COLA COMPANY owns 40% of COCA-COLA ENTERPRISES and 37% of COCA-
COLA AMATIL LTD. These two companies bottle many of Coke™s products, and The Coca-
Cola Company maintains a significant ownership percentage to ensure that the bottling facilities
remain available. As indicated in Exhibit 12-1, Berkshire Hathaway owns a number of compa-
nies outright and has significant investments in other companies. These investments allow Berk-
shire Hathaway to significantly influence or even control the operating decisions of the investees.

2 If you have never had the pleasure of reading one of Warren Buffett™s “Chairman™s Letter to the Sharehold-
ers,” you should take the opportunity now. No one writes a funnier, more insightful letter than Mr. Buffett. The
company™s Internet address is http://www.berkshirehathaway.com.
570 f571
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities



Financial Statement Items Covered in This Chapter
exhibit 12-2



Statement of
Balance Sheet Cash Flows
Current assets
Operating activities
Investments
Purchase of trading securities
Sale of trading securities
Long-term investments
Investing activities
Stockholders™ equity
Purchase of debt and
Unrealized increase/decrease
equity securities other than
in value of securities
trading securities
Sale of debt and equity
securities other than
trading securities




Income
Statement
Other revenues and expenses
Gains and losses on sales
of securities
Unrealized gains and losses
on securities
Interest revenue




A Cash Flow Pattern
exhibit 12-3

Beginning End
of year Midyear of year
Excess cash
(used for Actual cash
short-term on hand
investments)
Average
cash needs



Insufficient cash
(relieved by
short-term
borrowing)
571
f572 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities


COCA-COLA COMPANY
owns significant stakes in
companies that bottle its
products. Such invest-
ments allow Coca-Cola to
ensure that its bottling fa-
cilities remain available
and that its soft-drink
products consistently
meet the company™s qual-
ity standards.




Rather than investing in the research and development required to develop a product or an
area of expertise, many companies find it cheaper to purchase all or part of another company
that has already expended the effort and the time to develop the desired prod-
Can you think of addi- uct or know-how. As an example, to complement its existing software, NOV-
ELL (a computer company specializing in networking) purchased WordPerfect
tional reasons why companies would pur-
and Quattro Pro, word-processing and spreadsheet software packages, respec-
chase interests in other companies?
tively. This purchase then allowed Novell to assemble a menu of software pack-
ages to compete with MICROSOFT™s Word, Excel, PowerPoint, and Access software packages.
Novell™s attempt to compete with Microsoft failed, however, and the company eventually sold
WordPerfect to COREL.



to summarize
Companies invest in other companies for a variety of reasons. In most cases,
the objective is to earn a return on the investment, either through the receipt
of interest or dividends, or through an increase in the value of the investment.
A firm may also invest in other companies so that it will be able to influence
their operating decisions. In some cases, companies find it cheaper to buy an-
other company to gain access to its assets than to expend the resources nec-
essary to develop the assets on their own.




2 CLASSIFYING A SECURITY
Understand the different
Two general types of securities are purchased by companies”debt securities and equity securi-
classifications for securities.
ties. Debt securities are financial instruments that carry with them the promise of interest pay-
debt securities Financial in-
ments and the repayment of the principal amount. Bonds are the most common type of debt
struments issued by a com-
security. Debt securities are issued by companies when the need for cash arises. These securities
pany that carry with them a
are often traded on public exchanges such as the New York Bond Exchange. Investors often pre-
promise of interest pay-
fer debt securities to equity securities because of the certainty of the income stream (interest)
ments and the repayment
of principal.
572 f573
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities


and the relative safety (low risk) of debt as an investment. Investors in corporate debt securities
have priority over investors in equity securities, both for the yearly interest payments and for
the return of principal if the issuing corporation gets into financial difficulty. Bonds issued by
corporations are the most common type of debt securities (recall from Chapter 10 that bonds
are typically issued in multiples of $1,000). Once the bonds are issued, ownership of the entire
bond issuance, or just a portion, can change hands frequently.
equity securities (stock)
Shares of ownership in a Unlike bonds, equity securities (or stock), which are also traded on public exchanges,
corporation that can change
represent actual ownership interest in a corporation. The owner of equity securities is allowed
significantly in value and
to vote on such corporate matters as executive compensation policies, who will serve on the
that provide for a return to
board of directors of the corporation, and who will be the outside auditor. In addition to vot-
investors in the form of div-
ing, the owner of stock often receives a return on that investment in the form of a dividend.
idends.
A second type of return often accumulates to the stockholder as well”appreciation in stock
price. Many investors invest in a company not for the dividend but for the potential increase
in stock price. High-tech companies typically do not pay dividends, instead electing to funnel
their profits back into the company. Investors know that their return in high-tech companies
net work
will come in the form of an increased stock price, not a dividend. With the potential for in-
Do you follow the stock
creased stock price also comes a risk”the stock price could fall. Holders of debt securities, bar-
price of individual compa-
ring extreme financial difficulties by the issuer, will always receive the face amount of the bond
nies? How can you get a
upon maturity. Equity holders do not have that same promise. Stock can greatly increase in
company™s stock price his-
tory? You can find the cur-
value or become worthless.
rent stock price for any
As mentioned earlier, investors can purchase both debt and equity securities with different
company that is publicly
goals in mind. Some may purchase to receive interest or dividend payments or to realize quick
traded on the major stock
exchanges at http://finance.
gains on price changes, while others may invest for more long-term reasons. Accounting standard-
yahoo.com. At what price is
setters have developed different methods of accounting for investments depending on the in-
BERKSHIRE HATHAWAY
tentions of the holder of the security. Exhibit 12-4 outlines the major classifications of debt and
(trading symbol BRKa) cur-
rently trading?
equity securities.

Held-to-Maturity Securities
If an investor purchases a debt security with the intent of holding the security until it matures,
it is classified as a held-to-maturity security and is accounted for using techniques similar to
held-to-maturity security A
debt security purchased by those discussed in Chapter 10 for the bond issuer. The investor and the issuer record the same
an investor with the intent amounts but in a different way. With bond liabilities, the face value of the bonds is recorded in
of holding the security until
Bonds Payable, and a separate contra account is maintained for any discount or premium. Amor-
it matures.
tization of the discount or premium is then recorded in these contra accounts. With bond in-
vestments, the actual amount paid for the bonds (the cost of the asset), not the face value, is
originally debited to the investment account. The amortization of any bond premium or discount



Classifications of Debt and Equity Securities
exhibit 12-4


Investments




Equity
Debt




Available Equity
Held to
Trading
for Sale Method
Maturity
573
f574 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities


is then recorded directly in the investment account. Thus, if you recall the accounting for
fyi
Bonds Payable as presented in Chapter 10, you already know most of the accounting for
Equity securities cannot be a bond investment that is expected to be held to maturity. The procedures relating to
classified as held-to-maturity amortizing premiums and discounts for the investors are discussed in the expanded ma-
securities. terial section of this chapter. Note that equity securities cannot be classified as held-to-
maturity securities; equity securities typically do not mature.3

Equity Method Securities
In the case of equity securities, accounting standard-setters have determined that if securities
are held with the objective of significantly influencing the operations of the investee, then the
securities should be accounted for using the equity method. The equity method records
equity method A method
used to account for an in- changes in the value of the investment as the net assets of the investee change. The assump-
vestment in the stock of an-
tion underlying the equity method is that if the investor can influence the operating decisions
other company when signif-
of the investee, then any change in the net assets of the investee should be reflected on the
icant influence can be
books of the investor. In determining what constitutes significant influence, the Accounting
imposed (presumed to exist
Principles Board suggests that, unless evidence exists to the contrary, ownership of at least
when 20 to 50% of the out-
standing voting stock is 20% of the outstanding common stock of a company, but less than 50%, indicates the exis-
owned).
tence of significant influence. Because accounting for a security using the equity method can
get complicated, details of the equity method are presented in the expanded material section
of this chapter. If ownership exceeds 50%, then a controlling interest is assumed, and the ac-
counting becomes far more complex. The FASB is examining the issue of control and
fyi has suggested that companies look beyond ownership percentage and examine other fac-
tors that may indicate control.4 Two factors the FASB has highlighted are (1) owner-
Debt securities cannot be classi-
ship of a large minority voting interest (approximately 40%) with no other group own-
fied as equity method securities.
ing a significant interest and (2) a company™s domination of the process for electing the
investee™s board of directors. In cases where it is determined that control exists, the par-
ent company (the acquiring company) and the subsidiary company (the acquired company)
are required to combine their financial statements into one set of statements as if they were
one economic entity. Such combined statements are called consolidated financial statements.
consolidated financial
statements Statements that The preparation of consolidated financial statements is covered in advanced accounting
report the combined oper- courses.
ating results, financial posi-
tion, and cash flows of two
Trading and Available-for-Sale Securities
or more legally separate
but affiliated companies as
In those instances where securities are not being held to maturity (in the case of debt) or to
if they were one economic
control or significantly influence an investee (in the case of equity), the Financial Accounting
entity.
Standards Board has developed two other classes of securities”trading and available-for-sale.
Trading securities are those debt and equity securities held with the intent of selling the se-
trading securities Debt and
equity securities purchased curities should the need for cash arise or to realize gains arising from short-term changes in
with the intent of selling
price. These types of securities are purchased simply to earn a return on excess cash. Available-
them should the need for
for-sale securities are publicly traded securities that are classified as neither held-to-maturity
cash arise or to realize
nor trading (in the case of debt securities). In the case of equity securities, they represent se-
short-term gains.
curities that are not classified as trading securities or accounted for using the equity method.
available-for-sale securities
Debt and equity securities
Why the Different Classifications?
not classified as trading,
held-to-maturity, or equity
Why are there different classifications for debt and equity securities? Why not simply classify all
method securities.
securities as “investments”? The reason for the distinction lies in the different treatments of ac-
counting for changes in market value. In the case of securities classified as held-to-maturity,
changes in the securities™ value between the date of purchase and the maturity date do not


3 There are exceptions to this rule, as in the case of “mandatorily redeemable preferred stock,” but the ac-
counting for these types of securities is beyond the scope of this text.
4 Exposure Draft: Consolidated Financial Statements: Purpose and Policy (Stamford: Financial Accounting Stan-
dards Board, 1999).
574 f575
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities


affect the amount to be received at maturity. That amount is fixed on the day the bonds are is-
sued. Thus, temporary changes in the value of securities classified as held-to-maturity are not
recognized on the investor™s books. Similar reasoning applies to securities accounted for under
the equity method. These securities are purchased, not with the intent of selling them in the fu-
ture, but instead to be able to exercise influence over a corporation. Again, temporary changes
in the value of these securities are not recognized on the investor™s books.
Trading securities are purchased with the intent of earning a return”through interest or
dividends and through short-term resale of the securities. Firms are required to recognize these
two types of returns on the income statement. For example, assume that XYZ Company pur-
chases 100 shares of ABC, Inc. stock for $5 per share. During the year, ABC pays a $1 divi-
dend per share, and the value of the stock increases to $7 per share. XYZ will recognize, as in-
come, $100 in dividend income as well as $200 in unrealized market gains. While the $100 in
dividends was actually received, the $200 gain was not. The securities would have to have been
sold in order to actually receive the $200 increase in value. Recognizing this gain, even though
it was not realized through an arm™s-length transaction, represents a major departure from the
historical cost principle that has guided accounting for centuries. In 1994, the FASB determined
that because the fair market value of many debt and equity securities can be objectively deter-
mined (via market quotes) and they can easily be sold (one phone call to a broker), it would be
appropriate to include any unrealized gains or losses on changes in value of trading securities on
the income statement.
Changes in the value of securities classified as available-for-sale are recorded on the
fyi balance sheet. However, no gain or loss is realized on the income statement. Instead, an
adjustment is made directly to a stockholders™ equity account”Unrealized Increase/
Many companies avoid the is-
Decrease in Value of Available-for-Sale Securities Equity. The obvious question is “Why
sue of what to include on the
aren™t changes in the value of these securities reflected on the income statement?” The an-
income statement by classify-
swer lies in the intent behind holding the securities. Trading securities will probably be
ing all their investment securi-
sold sooner rather than later. We cannot make that same assumption with available-for-
ties as being available-for-sale.
sale securities. We are less certain they will be sold. Because of this uncertainty as to when
Berkshire Hathaway and MI-
the change in value will actually be realized, the FASB elected to go around the income
CROSOFT are examples of statement in reporting changes in value relating to available-for-sale securities. Whatever
companies that use this classi- the classification used, companies disclose their classification in the notes to the financial
statements. For example, BERKSHIRE HATHAWAY provides the following note dis-
fication scheme.
closure relating to its investments:


Berkshire™s management determines the appropriate classifications of in-
vestments at the time of acquisition and re-evaluates the classifications
at each balance sheet date. Investments may be classified as held for
trading, held to maturity, or, when neither of those classifications is ap-
propriate, as available-for-sale. Berkshire™s investments in fixed matu-
rity and equity securities are classified as available-for-sale. Available-
for-sale securities are stated at fair value with unrealized gains or losses,
net of taxes and minority interest, reported as a separate component in
shareholders™ equity. Realized gains and losses, which arise when avail-
able-for-sale investments are sold (as determined on a specific identifi-
cation basis) or other than temporarily impaired, are included in the
Consolidated Statements of Earnings.


As you can see, Berkshire Hathaway classifies every security as available-for-sale and is very spe-
cific as to what this classification means for the financial statements: current values go on the
balance sheet, with unrealized gains and losses disclosed in stockholders™ equity, while realized
gains and losses are reported on the income statement.
Exhibit 12-5 summarizes the classification and disclosure issues relating to investments in
debt and equity securities.
575
f576 Part 3 Investments In Debt And Equity Securities
Investing and Financing Activities



business environment essay


Following the Stock Market Stocks are dend; (5) the yield percentage in relation to the pur-
sold in a variety of markets in the same chase price; (6) the price-earnings (PE) ratio; (7) the
way that bonds are sold. Original is- volume of sales for that day; (8) the high, low, and
sues of stocks are usually sold by an closing prices for that day; and (9) the net change
investment banking group, referred to from the closing price of the previous day™s trading.
as the underwriters. After stocks are To illustrate how to read the quotation, the infor-
originally sold, they are traded in the mation for BERKSHIRE HATHAWAY class A common
marketplace, either on the New York stock is as follows: The 52-week high was $66,900,
Stock Exchange, the American Stock and the low was $40,800. Berkshire does not pay a
Exchange, regional market exchanges, dividend. Thus, the dividend amount and dividend
or the over-the-counter market. A selected portion yield are blank. The current price is 47 times the an-
of stocks traded on the New York Stock Exchange nual earnings. A total of 90 (the z indicates that the
on Monday, October 23, 2000, is listed here as they 90 is actual number of shares sold) shares were
were reported in The Wall Street Journal on Tues- traded on Monday, October 23, 2000, with the high
day, October 24, 2000. The quotations show the fol- price for the day being $59,200 and the low price be-
lowing information for each stock: (1) 52-week high ing $58,600. The stock closed for the day at $58,600,
and low; (2) the name of the company; (3) the trad- which was $800 lower than the close on Friday, Oc-
ing symbol for that company; (4) the current divi- tober 20, 2000.




Classification and Disclosure of Securities
exhibit 12-5


Reporting of
Temporary
Classification Types of Changes in
of Securities Securities Disclosed at Fair Value

Trading Debt and equity Fair value Income statement
Available-for-sale Debt and equity Fair value Stockholders™ equity
Held-to-maturity Debt Amortized cost Not recognized
Equity method Equity Cost adjusted for Not recognized
changes in net
assets of investee




to summarize
Securities are classified depending upon the intent of management. If man-
agement™s intent is to hold the investment until maturity (debt) or to influence
the decisions of an investee (equity), then the held-to-maturity (debt) and eq-
576 f577
Investments In Debt And Equity Securities Chapter 12
Investments in Debt and Equity Securities




NEW YORK STOCK EXCHANGE
COMPOSITE TRANSACTIONS
Quotations as of 5 p.m. Eastern Time
Monday, October 23, 2000
52 Weeks Yld Vol Net
Hi Lo Stock Sym Div % PE 100s Hi Lo Close Chg
p
3931 2706 2919 2375 2469 544
Bemis BMS .96 3.9 10 10189
6425 1225 4725 4438 4525 113
BenchmkElec BHE ... 92 774
5094 3538 3581 3581 3581 013
Benetton BNG 3.78e 10.6 ... 3
450 144 225 206 213
BentonOG BNO ... dd 458 ...
1219 450 913 875 925 019
BergnBruns BBC .04 .4 5 11056
1794 775 1425 1394 1425 013
BergenCapTr TOPrS 1.95 13.9 ... 153
6690025 4080025 5920025 5860000 5860025 80013
BerkHathwy A BRKA ... 47 z90
221925 135125 195325 192300 192825 2813
BerkHathwy B BRKB ... ... z6160
p
1994 1213 1756 1725 1725 025
BerryPete A BRY .40 2.3 12 55
8888 3925 4444 4050 4388 375
BestBuy BBY ... 25 52393
931 225 244 225 238 013
BethStl BS ... dd 7107
5150 3075 3050 2813 2863 225
BethStl pf 5.00 17.5 ... 98
2613 1463 1494 1338 1338 150
BethStl pfB 2.50 18.7 ... 208
638 250 438 413 431 006
BeverlyEnt BEV ... dd 2166
p
4150 1175 4150 3975 4150 156
BndlyWest BDY .08 .2 35 4888
3850 1581 1825 1763 1763 019
Biomatrx BXM ... 27 682
4350 1272 3969 3825 3906 006
s Biovail g BVF g ... ... 4270
7925 3925 7338 7106 7225 131
n Biovail pf 1.76e 2.4 ... 55
13450 2319 12025 11644 12025 325
Biovail wt ... ... 5



Source: The Wall Street Journal, October, 24, 2000.




uity method (equity) classifications are appropriate. If the securities are being
held for other reasons, then management may classify them as either trading
or available-for-sale. The importance of the classification becomes apparent
when accounting for changes in value.


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