ACCT 3621 Intermediate Accounting II

Correct Answer

B. Decrease the cumulative compensation expense

Explanation

When stock options are forfeited—usually due to employees leaving the company before vesting—the company must adjust previously recorded compensation expense downward. This is because the forfeited options will no longer vest, and thus no compensation cost should be recognized for them. The total cumulative expense should reflect only the portion of options expected to vest.

Why other options are wrong

A. Increase the cumulative compensation expense

This is incorrect because forfeitures reduce the amount of compensation expense that should be recognized. Recognizing more expense for options that won’t vest would be a misrepresentation of the actual compensation cost.

C. No effect on cumulative compensation expense

This is inaccurate because accounting standards require that compensation expense be recognized only for options expected to vest. When options are forfeited, it directly impacts that estimate and thus reduces the cumulative expense.

D. Record a new expense for the forfeiture

This is incorrect because forfeitures do not create a new type of expense. Instead, they reduce the originally estimated compensation expense related to unvested options.

Correct Answer

A. It decreases the number of shares outstanding, potentially increasing EPS.

Explanation

When a company purchases its own stock and holds it as treasury stock, the number of shares outstanding decreases. This reduction in outstanding shares can increase the basic earnings per share (EPS), as the company's net income is now distributed over a smaller number of shares. Basic EPS is calculated by dividing net income by the weighted average shares outstanding, so a decrease in outstanding shares results in a higher EPS, assuming net income remains the same. This principle is related to the concept of capital structure, specifically the impact of treasury stock transactions on the total number of shares outstanding.

Why other options are wrong

B. It has no effect on EPS.

This is incorrect because purchasing treasury stock does affect EPS by reducing the number of shares outstanding, which can lead to an increase in EPS.

C. It increases the number of shares outstanding, decreasing EPS.

This is incorrect because purchasing treasury stock actually decreases the number of shares outstanding, not increases them. A reduction in shares outstanding can increase EPS, not decrease it.

D. It only affects retained earnings.

This is incorrect because while purchasing treasury stock does reduce retained earnings, it also directly impacts the number of shares outstanding, which in turn can affect EPS. Therefore, it affects more than just retained earnings.

Correct Answer

A) It reflects the difference between the exercise price and par value.

Explanation

When stock options are exercised, employees or option holders purchase the company’s stock at the exercise price, which is often different from the par value of the stock. The credit to paid-in capital—excess of par represents the amount above the par value that the company received for the stock issued. This is necessary to ensure that the stock is properly accounted for in terms of both the par value and any additional value received above the par. This entry reflects the difference between the amount the company receives (the exercise price) and the nominal par value of the stock.

Why other options are wrong

B) It represents the total market value of the shares issued.

This is incorrect because the credit to paid-in capital—excess of par does not reflect the market value of the shares, but the difference between the exercise price and the par value.

C) It is used to record the company's retained earnings.

This is incorrect because the credit to paid-in capital—excess of par does not affect retained earnings. Instead, it affects the paid-in capital section of equity.

D) It indicates the total liabilities incurred by the company.

This is incorrect because the credit to paid-in capital—excess of par does not indicate liabilities. It reflects equity transactions related to stock issuance.

Correct Answer

B. They can potentially increase the number of shares outstanding.

Explanation

Stock options can complicate the calculation of diluted earnings per share (EPS) because if the options are exercised, they result in an increase in the number of shares outstanding. Diluted EPS accounts for the potential dilution of earnings by considering not only the actual shares outstanding but also any potentially dilutive securities, such as stock options. When stock options are exercised, they increase the total number of shares outstanding, which dilutes the earnings allocated to each share. The impact of this dilution is factored into the diluted EPS calculation, making it more complex.

Why other options are wrong

A. They increase the net income.

This is incorrect because the issuance of stock options does not directly increase net income. Stock options may lead to compensation expense but do not inherently increase net income.

C. They decrease the total equity.

This is incorrect because the issuance of stock options does not necessarily decrease total equity. In fact, if options are exercised, they could increase equity by raising capital for the company.

D. They have no effect on earnings per share.

This is incorrect because stock options can affect earnings per share, particularly diluted EPS, by potentially increasing the number of shares outstanding.

Correct Answer

C. Relative market values

Explanation

When a company sells multiple securities for a single price and the total selling price differs from the sum of the market prices, the method used to allocate the cash received is based on relative market values. The cash is allocated among the securities in proportion to their respective market values at the time of the sale. This ensures that the allocation is fair and reflects the relative worth of each security.

Why other options are wrong

A. Par amounts

Allocating based on par values is not appropriate for securities that have market values different from their par values. Par value is generally an arbitrary value assigned to stock, and it does not reflect the true economic value of the securities. Using par values would distort the allocation.

B. Relative book values

Relative book values could be used in certain situations, but they are not the standard method for allocating cash received from the sale of multiple securities. The relative market value method is preferred because it reflects the actual current market prices of the securities at the time of sale.

D. The earnings per share

Earnings per share (EPS) is a financial metric used to calculate the profitability of a company on a per-share basis and is not used in allocating cash when selling multiple securities. This option is unrelated to the allocation process for securities sold for a single 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

C. It will potentially increase diluted earnings per share

Explanation

When stock options are granted to employees, the company must account for the potential dilution of its earnings per share (EPS) in the future if the options are exercised. If the stock price increases significantly after the options are granted, it may encourage employees to exercise the options. This can result in an increase in the number of shares outstanding, which may potentially lead to a decrease in the company's earnings per share (EPS). However, this would be accounted for in the calculation of diluted EPS, which considers the potential dilution effect of outstanding stock options.

Why other options are wrong

A. It will decrease additional paid-in capital

This is incorrect because an increase in stock price would generally lead to more proceeds from the exercise of stock options, which would increase additional paid-in capital, not decrease it.

B. It will increase the company's liabilities

This is incorrect because stock options are equity-based compensation, not liabilities. The exercise of stock options would not result in an increase in liabilities unless the company had a cash-settled stock option plan, which is not indicated in the question.

D. It will have no effect on the financial statements

This is incorrect because the increase in stock price can have an effect on both the number of options exercised and the potential impact on diluted EPS. Therefore, it will not have any effect on the financial statements.

Correct Answer

B. Reduces total shareholders' equity

Explanation

Treasury stock represents shares that a company has repurchased from the open market. These shares are recorded as a contra-equity account, meaning they reduce the total shareholders' equity on the balance sheet. They do not represent an asset, nor do they affect liabilities directly. The reduction in equity reflects the use of resources to repurchase the stock.

Why other options are wrong

A. Increases total shareholders' equity

This is incorrect because treasury stock is a reduction from shareholders' equity. It does not increase ownership value; instead, it reduces the company's total equity due to the repurchase.

C. Has no effect on total shareholders' equity

This option is wrong because treasury stock is reported as a deduction from equity. Ignoring its impact would misstate the company’s financial position.

D. Increases total liabilities

This is not accurate because repurchasing stock does not create a liability. It’s simply a reclassification within the equity section, where resources used to buy back stock reduce equity rather than increase obligations.

Correct Answer

A. The market price reflects current investor sentiment and demand for the stock.

Explanation

The market price of an unrestricted share is used to determine the compensation for restricted stock units (RSUs) because it reflects the current value of the stock as determined by the market. This price incorporates investor sentiment, supply and demand, and market expectations for the company's future performance. The market price provides a more accurate and real-time measure of the stock's value than the book value, which is based on historical accounting data and does not fully reflect current market conditions or future growth potential.

Why other options are wrong

B. The book value is always higher than the market price.

This is incorrect because the book value does not always exceed the market price. The market price can be higher or lower than the book value depending on factors such as company performance, market conditions, and investor expectations.

C. The market price is irrelevant to the compensation calculation.

This is incorrect because the market price is highly relevant to the compensation calculation for RSUs. The value of RSUs is directly tied to the market price of the stock, which determines how much the employee will receive upon vesting.

D. The book value does not account for future growth potential.

This is correct in part but irrelevant to the reason RSUs are valued using the market price. While it's true that the book value does not account for future growth potential, the primary reason for using the market price is that it reflects the current, real-time value of the stock, incorporating all market factors, including growth expectations.