INTERMEDIATE
ACCOUNTING
Chapter 15
Contributed Capital
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What Information Does Shareholders’ Equity Provide?
(Slide 1 of 2)
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Equity is the residual interest in the assets of a company
that remains after deducting its liabilities.
The balance sheet accounting for financing activities by
common equity shareholders typically involves:
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Contributed capital accounts, such as common equity at par and
additional paid-in capital
Earned capital accounts, such as retained earnings and
accumulated other comprehensive income
Contributed Capital is the section of shareholders’ equity
in which a corporation records the results of all its stock
transactions in capital stock accounts and additional paidin capital accounts.
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What Information Does Shareholders’ Equity Provide?
(Slide 2 of 2)
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Retained Earnings is an account in shareholders’ equity where any
net income that has been reinvested in the corporation and not paid
out to shareholders as dividends is reported.
Accumulated Other Comprehensive Income is an account in
shareholders’ equity where a corporation reports any increase or
decrease in shareholders’ equity as a result of other comprehensive
income.
A company’s equity changes:
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As it earns net income
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As it declares dividends
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As transactions between the company and its owners occur
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As other comprehensive income transactions occur
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How Are Corporations Organized?
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Shareholders (or stockholders) are owners of a corporation.
The primary advantage of the corporate form is the ability to
raise large amounts of capital by issuing shares of stock.
Limited legal liability is a concept in which owners bear no
personal liability for the corporation’s debts and risk; they risk
only their capital investment.
Corporations generally pay more taxes than other
organization forms because of:
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Higher tax rates than other forms
Owners are subject to double taxation
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How Are Corporations Classified?
(Slide 1 of 2)
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Privately held corporations are any corporations not
owned by the government.
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Open corporations (often called publicly traded
corporations) are corporations whose stock can be
purchased by any individual on a stock exchange.
Closed corporations (often called privately held
corporations) are corporations that do not allow the sale
of stock to the general public. For example, the candy
company Mars, Inc.
Public corporations are corporations owned or
operated by governmental units.
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How Are Corporations Classified?
(Slide 2 of 2)
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Domestic corporations are companies doing business in
the state in which it is incorporated.
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Starbucks, which is incorporated in the State of Washington, is
a domestic company with respect to Washington.
Walmart is a domestic corporation with regard to the State of
Arkansas.
Foreign corporations are companies that are operated in
a state other than the one in which it is incorporated.
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Starbucks is a foreign corporation with regard to the State of
North Carolina.
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How Are Corporations Formed?
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In the United States, a corporation is a legal entity of a
particular state.
An approved application for incorporation becomes a
corporation’s articles of incorporation (or corporate charter).
For a corporation to perform its functions, the state gives it
various rights and powers. These include the right to:
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Enter into contracts
Hold, buy, and sell property
Sue and be sued
Continue indefinitely
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How is the Capital Structure of a Corporation
Defined?
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A stock certificate is a serially numbered document that
indicates the number of shares owned and the par value
(if any).
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Because stock certificates are easily transferred from one
investor to another, state laws require that each corporation
keep appropriate records of its shareholders.
A transfer agent (such as a bank) handles the issuance of
stock certificates.
A registrar is a person who maintains the shareholder
records.
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Capital Stock and Shareholders’ Rights
(Slide 1 of 2)
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Capital stock refers to the shares of stock issued by the
corporation and owned by its shareholders.
Each shareholder has various rights.
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Right to a dividend when it is declared
Right to elect directors and to establish corporate policies
(voting right)
Right (called a preemptive right) to maintain a proportionate
interest in the ownership of the corporation by purchasing a
proportionate (pro rata) share of additional capital stock if
more stock is issued
Right to share in the distribution of the assets of the
corporation if it is liquidated
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Capital Stock and Shareholders’ Rights
(Slide 2 of 2)
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Common stock is capital stock that carries all of the
rights of ownership.
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Some corporations issue more than one class of common
stock such as Class A and Class B common stock.
In this case, usually one type of common stock has
greater voting rights than the other to maintain control
over the corporate activities.
Preferred stock is not granted all of the common stock’s
rights, but receives in exchange certain other privileges.
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Basic Terminology
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Authorized capital stock is the number of shares of capital stock (both
preferred and common) that a corporation may issue as stated in the
corporate charter.
Issued capital stock is the number of shares of capital stock that a
corporation has issued to its shareholders as of a specific date.
Outstanding capital stock is the number of shares of capital stock that a
corporation issued to stockholders and that are being held by
shareholders as of a specific date.
Treasury stock is the number of shares of issued capital stock reacquired
from shareholders, but not retired.
Subscribed capital stock is the number of shares of capital stock that a
corporation will issue upon completion of an installment purchase contract
with an investor.
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Legal Capital
(Slide 1 of 2)
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To protect the corporation’s creditors, state laws
have established the concept of legal capital as the
amount of stockholders’ equity that the corporation
cannot distribute to shareholders.
The definition of legal capital varies among states.
 Most states designate that the par value of all its
issued stock is the legal capital.
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Legal Capital
(Slide 2 of 2)
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The par value of a corporation’s capital stock (either common or
preferred) is a designated dollar amount per share that is
established in the articles of incorporation and is printed on each
stock certificate.
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The par value of a stock has no relation to its market value.
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Stock rarely sells initially for less than its par value, because it is illegal to
do so in most states.
No-par capital stock is stock that does not carry a par value. When
a corporation issues no-par stock, some states require that the
corporation designate the entire proceeds received as legal capital.
Stated value per share of no-par stock, when multiplied by the
number of shares issued, generally determines the amount of the
corporation’s legal capital.
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Additional Paid-in Capital
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State law requires the corporation to record the par or
stated value.
Additional paid-in capital is the excess value received
(the difference between the exchange price and the par
or stated value) in each type of stock transaction.
While most companies use the term Additional Paid-in
Capital, you may also see the terms:
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Capital in Excess of Par (or Stated) Value
Paid-in Capital in Excess of Par (or Stated) Value
Additional Capital
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Stock Issuance Costs
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A corporation may incur miscellaneous costs that arise
from issuing its capital stock.
Legal fees
 Accounting fees
 Stock certificate fees
 Underwriter’s fees
 Promotional fees
 Postage
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When these costs are incurred at the initial issuance of
stock at the time of incorporation, they are considered
an organization expense.
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Stock Subscriptions
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Investors sometimes agree to purchase capital stock
from a corporation and pay at a later date.
This creates a legally-binding subscription contract between
the corporation and the future shareholders.
 This contract requires the investor to buy a certain number
of shares at an agreed-upon price, with payment spread
over a specified time period.
 The contract often requires a down payment and may
require the investor to issue the company a promissory note.
 The contract will also set forth what will happen if the
investor is not able to pay and defaults.
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Nonmonetary Issuance of Stock
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A nonmonetary exchange is any type of transaction in which
a corporation issues capital stock for assets other than cash,
or for services performed.
The general rule is to record the exchange at the fair value
of the stock issued or the asset received, whichever can be
measured with greater representational faithfulness.
Stock may be closely held and not actively traded. The fair
value of the assets received may provide a more
representationally faithful value of the transaction.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock Splits
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To reduce the market price of a corporation’s stock so that
it falls within a desired “trading range” of most investors,
a corporation may authorize a stock split.
A stock split is proportionally decreases in market price
and par value per share of stock and increases the
number of shares issued.
A stock split also results in a proportional increase in the
number of shares authorized.
A reverse split increases the par value per share and
proportionally decreases the number of shares issued.
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Stock Warrants
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Stock warrants represent the right to purchase
additional shares of common stock at an established
price, usually referred to as the exercise price.
Exercise price (or strike price) is the price at which
the holder of an option or warrant has the right to
buy or sell the common stock.
Detachable warrants are warrants that can be
separated from the other security and traded
independently.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do Companies Account for
Noncompensatory Share Purchase Plans?
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A noncompensatory share purchase plan enables employees to
buy shares of stock, usually at a discount.
Three criteria for share purchase plan to be noncompensatory:
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All employees who meet limited employment qualifications may participate
in the plan on an equal basis.
The discount from the market price does not exceed the per-share amount of
stock issuance costs avoided by not issuing the stock to the public.
The plan has no option features other than the following:
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Employees are allowed a short time (no longer than 31 days) from the date the
purchase price is set to decide whether to enroll in the plan
The purchase price is based solely on the market price of the stock on the
purchase date, and employees are permitted to cancel their participation
before the purchase date and obtain a refund of any amounts previously paid.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What Are Share-Based Compensation Plans?
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A share-based compensation plan is a compensation
arrangement in which employees receive share options, shares of
stock, or cash payments based on the change in stock price
instead of cash bonus.
A compensatory share option plan is an arrangement intended
to provide additional compensation by rewarding employees
shares in the company or cash bonuses tied to changes in the
company’s stock price.
Restricted share awards and appreciation rights are
arrangements intended to provide additional compensation by
awarding employees shares in the company or cash bonuses tied
to changes in the company’s stock price.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Overview of Compensatory Share Option
Plans
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In developing a compensatory share option plan, a
company’s objective is to better align the company’s goals
with those of management and its owners.
The grant date is the date on which the company provides
the share options to the employees.
The intrinsic value method is a method whereby a
corporation measures the total options-based
compensation cost for each employee as follows:
Total Options-Based
Compensation Cost
Number of
=
Share Options
×
Market Price of
Exercise Price of
the Stock on
‒ the Share Option
Date of Grant
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How Do We Account for Compensatory Share
Option Plans? (Slide 1 of 2)
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Option pricing models are used to estimate the fair value of
the option.
The option pricing model that a corporation uses must take into
account the following variables as of the grant date:
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Exercise price
Expected life of the option
Current market price of the underlying common stock
Expected volatility of the stock price
Expected dividends on the stock
Risk-free interest rate for the expected term of the option
An option’s value is determined at the grant date as follows:
Option Value (Fair Value) = Current Stock Price ‒ Present Value of Exercise Price
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for Compensatory Share
Option Plans? (Slide 2 of 2)
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The cost recognized by a company for its share-based
compensation plan is the total fair value of the share options that
actually become vested.
Vested occurs when an employee has fulfilled the service
requirement and has ownership of the share options.
If the corporation expects that a significant number of employees
will forfeit their options, then it records the compensation expense
each year based on an estimate of the number of options
expected to vest. The estimated total compensation cost is
determined at the grant date as follows:
Estimated Total
Compensation Cost
=
Fair Value
per Option
×
Estimate of the Number of Share
Options Expected to Vest
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Performance-Based Option Plans
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Performance-based share option plans (or variable-term
share option plans) are plans in which one or more terms are
not fixed at the grant date. These plans are set up so that the
terms will vary depending on how well the selected employees
perform during the service period.
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Restricted Share Plan
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Because some employees who qualify to buy shares of stock
in a compensatory plan have a cash-flow problem,
corporations have developed share-based plans involving
restricted shares.
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A restricted share plan is a plan in which employees are
granted actual shares of stock.
While the employee becomes an actual shareholder on the date
of the grant, the company maintains physical possession of the
shares, restricting the employee’s ability to sell the shares until
the employee reaches certain goals.
These restrictive shares are referred to as noninvested shares.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Share Appreciation Rights
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Share appreciation rights (SARs) are rights granted to selected
employees that enable them to receive cash, shares, or a
combination of both equal to the excess of the market value over
a stated price of the corporation’s stock on the date of exercise.
A company accounts for a SARs plan using the fair value method.
 For SARs the fair value can only be determined on the date the
rights are exercised.
To record the compensation expense for the SARs plan, an
estimate of the total compensation cost is made at the end of
each year based on the fair value of the SARs at that time.
Adjustments are made after each service period has expired.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What Characteristics are Associated with
Preferred Stock?
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Various preferred stock characteristics may be specified
in preferred stock contract:
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Preference as to dividends
Accumulation of dividends
Participation in excess dividends
Convertibility to common stock
Attachment of stock warrants
Callability by the corporation
Mandatory redemption at a future maturity date
Preference to assets upon liquidation of the corporation
Lack of voting rights
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Cumulative Preferred Stock
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Noncumulative preferred stock is stock carrying the provision
that the holder will never be paid a dividend in a particular
year if dividends are not declared in that year.
Cumulative preferred stock is stock carrying the provision
that, if a corporation fails to declare a dividend on cumulative
preferred stock at the stated rate on the usual dividend date,
the amount become dividends in arrears.
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Dividends in arrears accumulate from period to period.
Dividends in arrears are not liabilities.
A corporation cannot pay common shareholders any dividends until
it has paid the preferred dividends in arrears.
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Participating Preferred Stock
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Participating preferred stock is stock carrying the
provision that preferred shareholders share with the
common shareholders in any additional dividends.
Participating preferred stock may be either fully or
partially participating.
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Fully participating preferred shareholders are
shareholders who share equally with the common
shareholders in any extra dividends.
Partially participating preferred shareholders are
shareholders who share in extra dividends, but the
participation is limited to a fixed rate or amount per share.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Convertible Preferred Stock
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Convertible preferred stock is stock with a provision that
allows shareholders, at their option and under specified
conditions, to convert the shares of preferred stock into
another security of the corporation.
Accounting for the conversion of preferred to common stock
is very straightforward because the book value method is
used.
The conversion of preferred to common stock changes the
components of shareholders’ equity, but does not affect the
corporation’s total shareholders’ equity.
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Preferred Stock with Stock Warrants
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A corporation may also attach warrants to preferred stock to
enhance their attractiveness.
These warrants represent rights that allow the holder to
purchase additional shares of common stock at a specified
price over some future period.
Because these warrants are detachable from the preferred
stock, they usually begin trading on the stock market at some
market price.
The investor in detachable preferred stock has dual rights:
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Right to dividends that will be paid on the preferred stock
Right to the market value appreciation of the common stock that may
be purchased as a result of the warrants
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Callable Preferred Stock
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Callable preferred stock is stock that may be retired
(recalled) under specified conditions by a corporation
at its discretion.
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Redeemable Preferred Stock
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In contrast to convertible preferred stock and callable
preferred stock, some preferred stock is redeemable.
Redeemable preferred stock is stock that may either be
subject to mandatory redemption at a specified future
maturity date for a specified price or redeemable at the
option of the holder.
Redeemable preferred stock has a key characteristic of a
liability because of the obligation of a cash outflow in the
future that the company has no ability to prevent.
Preferred stock that is redeemable at the option of the holder
is not reported as a liability. It is reported in shareholders’
equity.
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Preference in Liquidation
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If a corporation is liquidated, the preferred stock contract
usually allows the preferred shareholders liquidation
preference over the common shareholders (but secondary to
creditors).
The preference is typically expressed as a percentage of (or
equal to) the par value.
It also frequently requires the payment of dividends in arrears.
A corporation discloses this information either parenthetically in
its shareholders’ equity section or in the notes accompanying its
financial statements.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What is Treasury Stock and How is it Accounted For?
(Slide 1 of 3)
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Treasury stock is a corporation’s own capital stock that (1) has
been fully paid for by the shareholders, (2) has been legally
issued, (3) reacquired by the corporation, and (4) is being held
by the corporation for future issuance.
A corporation may acquire treasury stock to:
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Use for share option, bonus, and employee purchase plans
Use in the conversion of convertible preferred stock or bonds
Use excess cash
Use in acquiring other companies
Signal to the capital market that the company managers believe
the shares are underpriced
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What is Treasury Stock and How is it Accounted For?
(Slide 2 of 3)
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Reduce the number of shares held by hostile shareholders and
thereby reduce the likelihood of being acquired by another
company
Use for the issuance of a stock dividend
Treasury stock is not an asset.
To ensure that treasury stock is handled in the best interest of
the shareholders, states have passed laws regulating
corporate activities as follows:
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A corporation must acquire treasury stock for some legitimate
corporate purpose.
Treasury stock does not vote, has no preemptive rights, ordinarily
cannot participate in dividends or liquidation.
Treasury stock does not participate in stock splits.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
What is Treasury Stock and How is it Accounted For?
(Slide 3 of 3)
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The acquisition of treasury stock does not formally reduce a
corporation’s legal capital.
Treasury stock transactions may reduce retained earnings but may
never increase retained earnings.
If the treasury shares are not retired, the corporation may
reissue the treasury stock at a price above or below the
acquisition price or the par value.
A corporation may account for treasury stock transactions by
either the cost method or the par (stated) value method. The cost
method is used by the vast majority of companies that hold
treasury stock.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.