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CPA FAR – STUDY UNIT 14

Equity
Core Concepts

1. Classes of Equity
a. A corporation’s authorized, issued, and outstanding stock is reported as contributed capital
(paid-in capital). It consists of (1) the stated capital (par or stated value) of outstanding
common and preferred stock and (2) additional paid-in capital (paid-in capital in excess of
par value) from those sources. Other classes of equity are (1) retained earnings (increased
by net income, decreased by net loss and dividends, and adjusted for error corrections and
retrospective application of changes in accounting principle), (2) treasury stock (the entity’s
own stock issued and repurchased), and (3) accumulated other comprehensive income
(certain exclusions from net income).
2. Issuance of Stock
a. The par value assigned by the issuer is legal capital.
b. Cash is debited, a stock account is credited for total par value, and additional paid-in capital
is credited for the difference.
c. Direct costs of issuance reduce the proceeds and additional paid-in capital.
d. When stock is issued for property received or services rendered, the transaction is recorded
at the more determinable of the fair values of the stock issued or the property or services
received.
e. When convertible preferred stock is converted, related amounts are removed from the
books and replaced with amounts related to the new security using the book value method.
f. The proceeds of the combined issuance of different securities are allocated based on their
relative fair values of the securities.
3. Stock Warrants and Stock Rights
a. A warrant represents a right to purchase shares at a specified price within a specified
period. A preemptive right is a right to purchase a pro rata amount of a new issuance.
b. In a rights offering, each shareholder is issued an option to buy a certain number of shares
at a fixed price. When rights are issued for no consideration, the issuer makes only a
memorandum entry.
4. Treasury Stock -- Acquisition
a. Under the cost method, the entry is a debit to treasury stock and a credit to cash. Under
the par-value method, the acquisition is a constructive retirement. All related amounts are
removed from the books.
b. Treasury stock is not an asset. It is reported as a contra-equity account.
5. Treasury Stock -- Reissue
a. If the price exceeds cost, the excess is credited to a paid-in capital account.
b. If the price is less than cost, the difference is debited to a paid-in capital or retained earnings
under the cost method. Any remaining deficiency is debited to retained earnings.
c. If the price is less than cost, the difference is credited to a paid-in capital account under the
par-value method.
6. Retirement of Stock
a. A retirement of treasury stock does not change the number of shares authorized.
Furthermore, transactions in an entity’s own stock, whether issuances, acquisitions,
reissuances, or retirements, do not result in gain or loss.
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2 CPA FAR – Study Unit 14

7. Cash Dividends
a. Dividends are paid on outstanding shares only, not on treasury stock.
b. Unlike interest on debt, dividends on preferred stock are not a legal obligation until declared.
However, common shareholders may not receive a dividend unless the current preferred
dividend has been paid.
c. If preferred stock is cumulative, common shareholders may not receive a dividend until all
preferred dividends in arrears have been paid.
8. Property Dividends and Liquidating Dividends
a. A dividend of tangible property (1) requires the property to be remeasured to fair value and
any gain or loss on the remeasurement is recognized in the income statement and (2) the
property then is distributed as a dividend at its fair value.
b. Dividends in excess of retained earnings are liquidating dividends.
9. Stock Dividends and Stock Splits
a. In a stock dividend, a portion of retained earnings is capitalized.
1) An issuance of shares of less than 20% to 25% of the outstanding common shares
usually should be recognized as a stock dividend. Retained earnings is debited for
the market price of shares issued, common stock is credited for the par value issued,
and additional paid-in capital is credited for the difference.
2) An issuance of more than 20% to 25% of the outstanding common shares (25% or
more for public entities) is a stock split in the form of a dividend. Retained earnings is
debited and common stock is credited for the par value of stock issued.
b. In a stock split, no journal entry is made other than a memorandum entry. The par or stated
value of the shares is reduced.

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