ACCT 3621 Intermediate Accounting II

Correct Answer

C. It impacts both the income statement and equity section of the balance sheet.

Explanation

Share-based compensation, such as stock options or restricted stock units, is considered a form of employee compensation and is expensed on the income statement, reducing net income. Simultaneously, it also affects the equity section of the balance sheet, typically increasing additional paid-in capital as the company records the value of the shares granted. This accounting treatment ensures that the financial statements reflect the cost of compensating employees with equity.

Why other options are wrong

A. It only affects the cash flow statement

This is incorrect because share-based compensation is a non-cash expense. It affects the operating section of the cash flow statement through the reconciliation of net income but does not "only" affect this statement. Its primary impact is on the income statement and balance sheet.

B. It increases liabilities and decreases equity

This is a misunderstanding of the transaction. Share-based compensation does not create a liability unless it's cash-settled. Equity-settled compensation increases equity, specifically in the form of contributed capital. There is no increase in liabilities in standard share-based arrangements.

D. It has no effect on financial statements

This is clearly incorrect. Share-based compensation must be recognized as an expense, and omitting it would result in materially misstated financial statements. It affects earnings and must be disclosed and reported accordingly.

Correct Answer

A. Total shares issued - treasury shares

Explanation

The number of shares outstanding for calculating basic earnings per share (EPS) is determined by subtracting treasury shares (shares repurchased by the company) from the total shares issued. This gives the number of shares that are currently held by shareholders and are eligible for earnings distribution.

Why other options are wrong

B. Total shares issued + treasury shares

This is incorrect because treasury shares should be subtracted from the total shares issued, not added. Treasury shares are not considered outstanding, as they are held by the company and are not available for distribution to shareholders.

C. Total shares outstanding - preferred shares

This is incorrect because the number of shares outstanding is not directly related to preferred shares in the context of calculating basic EPS. Preferred shares are subtracted only when calculating diluted EPS or adjusting net income for preferred dividends.

D. Total shares outstanding + treasury shares

This is incorrect because the correct calculation of shares outstanding involves subtracting treasury shares from the total shares issued, not adding them back.

Correct Answer

A. To maintain a proportional ownership interest in the corporation

Explanation

The primary purpose of the preemptive right is to allow shareholders to maintain their proportional ownership interest in the corporation when new shares are issued. This right gives existing shareholders the first opportunity to purchase additional shares before the company offers them to other investors, thus preventing dilution of their ownership stake in the company.

Why other options are wrong

B. To influence corporate policy through voting

While shareholders do have voting rights, the preemptive right is specifically related to the ability to maintain ownership by purchasing additional shares, not about influencing corporate policy through voting.

C. To ensure a minimum dividend payout

The preemptive right does not guarantee a minimum dividend payout. It is concerned with maintaining ownership proportions when new shares are issued, not with guaranteeing dividends.

D. To receive priority in asset distribution during liquidation

The preemptive right does not provide priority in asset distribution during liquidation. Priority in liquidation is typically determined by the seniority of the claims (e.g., creditors, preferred shareholders). The preemptive right is specifically about maintaining ownership interest, not liquidation preferences.

Correct Answer

C. The total compensation cost is determined by multiplying the number of shares by the market price on the grant date.

Explanation

For restricted stock units (RSUs), the total compensation cost is calculated based on the fair market value of the shares on the grant date, as this is the value of the compensation being provided to the employees. RSUs are typically granted at the current market price, and the total compensation cost is determined by multiplying the number of RSUs granted by the market price at the time of the grant. This compensation is then recognized as an expense over the vesting period of the RSUs.

Why other options are wrong

A. The market price does not affect the total compensation cost.

This is incorrect because the market price directly affects the total compensation cost. The value of the RSUs at the time of grant is based on the market price, and this determines the expense that will be recognized over time.

B. The total compensation cost is calculated based on the par value of the shares.

This is incorrect because the total compensation cost for RSUs is based on the market value of the shares, not their par value. Par value is an arbitrary value assigned to shares and does not reflect the true value of the compensation being provided.

D. The market price only affects the dividends paid on the shares.

This is incorrect because the market price affects both the total compensation cost of RSUs and any potential dividends, not just dividends. The compensation cost is calculated from the market price on the grant date, regardless of the dividends.

Correct Answer

B. Total shareholders' equity would decrease by $50,000.

Explanation

When a company repurchases its own stock, it reduces its cash balance (an asset) and increases treasury stock (a contra-equity account), which leads to a decrease in total shareholders' equity. In this case, repurchasing 1,000 shares at $50 per share results in a $50,000 reduction in equity. There are no changes to liabilities or retained earnings that offset this, so the total shareholders' equity decreases by that amount.

Why other options are wrong

A. Total shareholders' equity would increase by $50,000.

This is incorrect because buying back shares is not an income-generating activity. It uses up company resources and reduces equity, rather than increasing it. An increase in shareholders' equity would typically result from profits or issuing new shares, not from repurchasing them.

C. Total shareholders' equity would remain unchanged.

This is incorrect because treasury stock reduces equity. Although the transaction affects both cash and equity accounts, the net effect is a decrease in total shareholders’ equity. Repurchases are recorded as negative amounts in the equity section of the balance sheet.

D. Total shareholders' equity would decrease by $1,000.

This is incorrect because it underestimates the impact of the transaction. The repurchase of 1,000 shares at $50 each equals a $50,000 reduction, not $1,000. This suggests a misunderstanding of either the number of shares or the repurchase price.

Correct Answer

C. Basic earnings per share may increase or decrease depending on the number of shares issued versus repurchased

Explanation

The effect on basic earnings per share (EPS) depends on the net change in the number of shares outstanding after both issuing new shares and repurchasing treasury stock. If more shares are issued than repurchased, the total number of shares outstanding increases, likely causing a decrease in EPS. If more treasury stock is repurchased than shares issued, the number of shares outstanding decreases, which could increase EPS.

Why other options are wrong

A. Basic earnings per share will definitely increase

This is incorrect because repurchasing treasury stock typically reduces the number of shares outstanding, which could increase EPS only if the number of shares issued is smaller than the number repurchased. However, if more shares are issued, the increase in outstanding shares could decrease EPS.

B. Basic earnings per share will definitely decrease

This is incorrect because the effect on EPS depends on the balance between the number of shares issued and repurchased. If more treasury stock is repurchased than new shares are issued, EPS could increase, not decrease.

D. Basic earnings per share will remain unchanged

This is incorrect because issuing new shares and repurchasing treasury stock usually affects the number of shares outstanding, which in turn affects basic EPS. It is unlikely that these two actions will exactly cancel each other out, leaving EPS unchanged.

Correct Answer

B. Record one-third of the total fair value of the options as an expense each year for three years.

Explanation

When stock options are granted to employees with a vesting period, the company must recognize the compensation expense over the vesting period. In this case, with a three-year vesting period, the company would recognize one-third of the total fair value of the stock options as an expense each year over the three years. This approach aligns with the accrual accounting method, where expenses are matched with the period in which they are incurred, ensuring that the compensation expense is spread over the entire vesting period.

Why other options are wrong

A. Record the total fair value of the options as an expense in the first year only.

This is incorrect because the expense should be spread evenly over the vesting period, not recorded all at once in the first year.

C. Record the total fair value of the options as an expense at the end of the vesting period.

This is incorrect because the expense must be recognized over the entire vesting period, not in a lump sum at the end. The company needs to allocate the expense annually to reflect the service provided by employees during the vesting period.

D. Record the fair value of the options only when they are exercised.

This is incorrect because the expense is recognized when the options are granted and vested, not when they are exercised. The company must account for the expense over the vesting period, regardless of when the options are eventually exercised.

Correct Answer

A) To provide transparency to investors and stakeholders

Explanation

Publicly traded corporations are required to report earnings per share (EPS) as it provides critical financial information that allows investors and stakeholders to assess the company's profitability and performance relative to its share count. This transparency helps shareholders make informed decisions about buying, holding, or selling shares. Private companies, which do not have publicly traded shares, are not subject to the same reporting requirements and do not have the same need for widespread investor transparency.

Why other options are wrong

B) To comply with tax regulations

This is incorrect because the requirement to report EPS is not primarily driven by tax regulations but rather by financial reporting standards set by bodies such as the SEC (Securities and Exchange Commission).

C) To enhance company reputation

This is incorrect because while reporting EPS may indirectly contribute to reputation, the primary reason for this requirement is to provide investors with financial transparency, not to boost the company's image.

D) To reduce accounting costs

This is incorrect because reporting EPS does not reduce accounting costs. In fact, it requires additional analysis and disclosure, which may increase costs for companies.

Correct Answer

C. EPS will decrease due to higher expenses

Explanation

When a company revises its estimate of share-based compensation expense upward, the total compensation expense increases. This increase in expenses reduces the company's net income for the reporting period, leading to a decrease in earnings per share (EPS). Since EPS is calculated by dividing net income by the weighted average number of shares outstanding, any increase in expenses (which reduces net income) will lower the EPS.

Why other options are wrong

A. EPS will increase due to lower expenses

This is incorrect because revising the share-based compensation expense upward increases the expenses, not reduces them. Therefore, EPS will not increase due to lower expenses.

B. EPS will remain unchanged as it does not affect net income

This is incorrect because an upward revision in compensation expense directly affects net income, which in turn affects EPS. Therefore, EPS will not remain unchanged.

D. EPS will increase due to additional revenue

This is incorrect because revising the share-based compensation expense does not generate additional revenue. Instead, it increases expenses, which leads to a reduction in net income and consequently decreases EPS.