ACCT 3621 Intermediate Accounting II

Correct Answer

B. Additional paid-in capital is decreased.

Explanation

When a company acquires and retires its own stock, it reduces its outstanding shares, and the accounting entry typically includes a decrease in Additional Paid-In Capital (APIC). In this case, Winn, Inc. issued stock for $35 per share, which means the APIC was originally recorded as the amount above the par value of $1 per share (i.e., $34 per share). When shares are repurchased for $30 per share, the repurchased stock is removed from both the common stock and APIC accounts. The difference between the original issue price and the repurchase price reduces APIC. This action does not directly affect net income or retained earnings but adjusts the equity section of the balance sheet.

Why other options are wrong

A. 2021 net income is decreased.

This is incorrect because the acquisition and retirement of stock does not directly affect net income. Stock repurchases are recorded in the equity section of the balance sheet, and the transaction does not involve an expense or revenue item that would impact the income statement.

C. 2021 net income is increased.

This is incorrect because the repurchase and retirement of shares does not affect net income. It is an equity transaction, not a revenue or expense transaction, so it does not impact net income.

D. Retained earnings are increased.

This is incorrect because the acquisition and retirement of stock typically results in a decrease in retained earnings if the repurchase price is higher than the stock's par value or original issue price. Retained earnings would only increase if the company repurchased stock at a price lower than the par value or original issue price, which is not the case here.

Correct Answer

B. To reflect the effects of stock dividends and stock splits.

Explanation

Weighted-average shares outstanding must be recalculated to account for changes in the number of shares due to stock dividends and stock splits, which impact earnings per share (EPS). These events change the share count retroactively, and restating the weighted-average ensures accurate comparison and compliance with accounting standards. This recalculation ensures the EPS figure reflects the true impact of changes in capital structure.

Why other options are wrong

A. To adjust for changes in market value of shares

Market value changes do not affect the number of outstanding shares and therefore have no role in the calculation of weighted-average shares. The market value is used in other contexts, such as market capitalization, not in the share count.

C. To account for share buybacks

While share buybacks do affect the number of outstanding shares, the primary purpose of recalculating the weighted-average is to address retroactive events like stock splits and stock dividends, which require adjusting past periods' share counts. Buybacks are reflected when they occur but don't prompt retroactive adjustments.

D. To determine the total equity of the company

Total equity is based on accounting figures such as retained earnings, paid-in capital, and other components of shareholders’ equity. Weighted-average shares are used in per-share calculations, not for determining total equity directly.

Correct Answer

B. Debit to Cash and a credit to Common Stock.

Explanation

When an owner makes an investment by contributing cash into the business in exchange for shares of stock, the transaction is recorded by debiting (increasing) cash and crediting (increasing) common stock. This reflects the receipt of cash and the issuance of stock to the investor. The cash received increases the company's liquidity, and the common stock account represents the ownership interest given to the investor in return for the cash investment.

Why other options are wrong

A. Debit to Common Stock and a credit to Cash.

This is incorrect because the cash account should be debited (increased), not the common stock account. Common stock is credited because it's the account that reflects the issuance of shares to the investor.

C. Debit to Cash and a credit to Retained Earnings.

This is incorrect because retained earnings represent accumulated profits and not capital contributions. When cash is invested, it should be recorded as an increase in common stock, not retained earnings.

D. Debit to Cash and a credit to Stockholder Revenue.

This is incorrect because there is no account called "Stockholder Revenue." Stockholder equity is increased by issuing common stock, not through a revenue account.

Correct Answer

B. It only considers shares that are currently outstanding.

Explanation

Basic earnings per share (EPS) is calculated based on the shares that are currently outstanding, excluding any potential shares that could be issued in the future through options, warrants, or convertible securities. Basic EPS only reflects the earnings allocated to the actual shares in circulation, not those that could potentially be issued if options or convertible securities were exercised or converted.

Why other options are wrong

A. It includes all shares issued by the company.

This is incorrect because basic EPS does not include all shares issued by the company, only those that are outstanding. Shares that are held as treasury stock or those that could be issued in the future (such as convertible securities) are not considered in the basic EPS calculation.

C. It excludes shares that are convertible or options that are not exercised.

This is incorrect because, while basic EPS excludes potential shares that could be issued (like convertible shares or options), this answer does not fully explain why basic EPS does not account for all potential common shares. It is more precise to say that basic EPS only considers shares that are outstanding, not yet converted or exercised.

D. It includes treasury shares in the calculation.

This is incorrect because treasury shares are not included in the calculation of basic EPS. Treasury shares are shares that the company has repurchased and are not considered outstanding. Only shares that are actively held by shareholders are included in the calculation.

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

D. It is calculated using the number of common shares of stock outstanding.

Explanation

Earnings per share (EPS) is calculated by dividing net income by the weighted average number of shares outstanding during a period. The number of shares outstanding is crucial because it affects how much profit is attributed to each share. When shares are bought back as treasury stock or issued, it directly impacts the number of shares outstanding and, therefore, the EPS.

Why other options are wrong

A. Increased net income would cause earnings per share to decrease.

This is incorrect. Increased net income generally leads to an increase in earnings per share, assuming the number of shares outstanding remains the same or does not increase by a greater proportion.

B. Issuance of more common shares would cause earnings per share to increase.

This is incorrect because issuing more shares increases the denominator in the EPS calculation (the number of shares outstanding), which would typically result in a decrease in EPS, not an increase.

C. Purchasing treasury shares would cause earnings per share to decrease.

This is incorrect. Purchasing treasury shares reduces the number of shares outstanding, which increases the EPS, as fewer shares are outstanding to allocate the net income among.

Correct Answer

A. $10 million

Explanation

When stock options are exercised, shareholders' equity increases by the amount the company receives for the options exercised. In this case, the exercise price for the options is $10 per share, and there are 1 million options. The total amount received by the company for these options is 1 million * $10 = $10 million. This amount is added to shareholders' equity. The market price of $20 does not affect the increase in equity for this calculation; it is the exercise price that determines the equity increase.

Why other options are wrong

B. $20 million

This is incorrect because the market price of $20 does not affect the increase in equity from the exercise of stock options. The increase is based on the exercise price of $10 per option, not the market price.

C. $30 million

This is incorrect because, similarly to the previous answer, the increase in equity is based on the exercise price, not the difference between the exercise price and market price. The equity increase will not be the $10 difference between the exercise price and the market price times the number of shares.

D. $40 million

This is incorrect for the same reasons as the others. The total increase in equity is determined by the exercise price, not the market price, and multiplying the market price by the number of options would overstate the increase.

Correct Answer

B. Using an option pricing model such as the Black-Scholes model

Explanation

The fair value of stock options for accounting purposes is typically determined using option pricing models such as the Black-Scholes model or the Binomial model. These models take into account several variables, including the current stock price, the exercise price of the options, the expected life of the options, the volatility of the stock, and the risk-free interest rate. These models provide a theoretical fair value of the options at the grant date, which is then recognized as compensation expense over the vesting period of the options.

Why other options are wrong

A. Based on the market price of the stock on the grant date

This is incorrect because the fair value of stock options is not directly determined by the market price of the stock on the grant date. While the market price is an important variable in the option pricing models, the fair value calculation involves other factors, including volatility and the expected life of the options, which are not captured by the market price alone.

C. By averaging the stock price over the vesting period

This is incorrect because the fair value of stock options is determined at the grant date, not over the vesting period. The stock price at the time of grant is used in the pricing models, but averaging the stock price over the vesting period does not apply to the determination of fair value.

D. Determined by the company's earnings per share

This is incorrect because earnings per share (EPS) is not used to determine the fair value of stock options. EPS is a result of the company's income divided by the weighted average number of shares outstanding, but it does not directly factor into the valuation of stock options for accounting purposes.

Correct Answer

C. Stock split

Explanation

A stock split does not directly affect retained earnings. It is a division of the existing shares into more shares, but the total value of shareholders’ equity remains the same. The number of shares increases, but the par value per share decreases proportionally, leaving the total equity unchanged. Retained earnings are not affected by a stock split, unlike cash or stock dividends, which directly reduce retained earnings.

Why other options are wrong

A. Cash dividend

This is incorrect because a cash dividend directly reduces retained earnings. The company distributes part of its accumulated earnings to shareholders, which lowers the balance in the retained earnings account.

B. Stock dividend

This is incorrect because a stock dividend involves the issuance of additional shares to shareholders. Although no cash is distributed, retained earnings are reduced, as the value of the stock dividend is transferred from retained earnings to common stock or paid-in capital.

D. Property dividend

This is incorrect because a property dividend involves distributing assets other than cash to shareholders. This reduces retained earnings, as the company is distributing part of its accumulated profits in a non-cash form.