Concepts, Rules, and Examples

Legal Capital and Capital Stock

Legal capital typically relates to that portion of the stockholders' investment in a corporation that is permanent in nature and represents assets that will continue to be available for the satisfaction of creditor's claims. Traditionally, legal capital was comprised of the aggregate par or stated value of common and preferred shares issued. In recent years, however, many states have eliminated the requirement that corporate shares have a designated par or stated value. Some states have adopted provisions of a model act that completely eliminated the distinction between par value and the amount contributed in excess of par.

Ownership interest in a corporation is made up of common and, optionally, preferred shares. The common shares represent the residual risk-taking ownership of the corporation after the satisfaction of all claims of creditors and senior classes of equity.

Preferred stock.

Preferred shareholders are owners who have certain rights superior to those of common shareholders. These rights will pertain either to the earnings or the assets of the corporation. Preferences as to earnings exist when the preferred shareholders have a stipulated dividend rate (expressed either as a dollar amount or as a percentage of the preferred stock's par or stated value). Preferences as to assets exist when the preferred shares have a stipulated liquidation value. If a corporation were to liquidate, the preferred holders would be paid a specific amount before the common shareholders would have a right to participate in any of the proceeds.

In practice, preferred shares are more likely to have preferences as to earnings than as to assets. Some classes of preferred shares may have both preferential rights. Preferred shares may also have the following features: participation in earnings beyond the stipulated dividend rate; a cumulative feature, affording the preferred shareholders the protection that their dividends in arrears, if any, will be fully satisfied before the common shareholders participate in any earnings distribution; and convertibility or callability by the corporation. Whatever preferences exist must be disclosed adequately in the financial statements, either on the face of the balance sheet or in the notes.

In exchange for the preferences, the preferred shareholders' rights or privileges are limited. For instance, the right to vote may be restricted to common shareholders. The most important right denied to the preferred shareholders, however, is the right to participate without limitation in the earnings of the corporation. Thus, if the corporation has exceedingly large earnings for a particular period, these earnings would tend to accrue to the benefit of the common shareholders. This is true even if the preferred stock is participating (a fairly uncommon feature) because even participating preferred stock usually has some upper limitation placed on its degree of participation.

Occasionally, as discussed in the chapter, several classes of stock will be categorized as common (e.g., Class A common, Class B common, etc.). Since there can be only one class of shares that represents the true residual risk-taking investors in a corporation, it is clear that the other classes, even though described as common shareholders, must in fact have some preferential status. Typically, these preferences relate to voting rights. The rights and responsibilities of each class of shareholder, even if described as common, must be fully disclosed in the financial statements.

Issuance of shares.

The accounting for the sale of shares by a corporation depends on whether the stock has a par or stated value. If there is a par or stated value, the amount of the proceeds representing the aggregate par or stated value is credited to the common or preferred stock account. The aggregate par or stated value is generally defined as legal capital not subject to distribution to shareholders. Proceeds in excess of par or stated value are credited to an additional paid-in capital account. The additional paid-in capital represents the amount in excess of the legal capital that may, under certain defined conditions, be distributed to shareholders. A corporation selling stock below par value credits the capital stock account for the par value and debits an offsetting discount account for the difference between par value and the amount actually received.

If there is a discount on original issue capital stock, it serves to notify the actual and potential creditors of the contingent liability of those investors. As a practical matter, corporations avoided this problem by reducing par values to an arbitrarily low amount. This reduction in par eliminated the chance that shares would be sold for amounts below par. Where corporation laws make no distinction between par value and amounts in excess of par, the entire proceeds from the sale of stock may be credited to the common stock account without distinction between the stock and the additional paid-in capital accounts. The following entries illustrate these concepts:

Facts: A corporation sells 100,000 shares of $5 par common stock for $8 per share cash.

Cash	800,000
Common stock		500,000
Additional paid-in capital		300,000

Facts: A corporation sells 100,000 shares of no-par common stock for $8 per share cash.

Cash	800,000
Common stock		800,000

Preferred stock will often be assigned a par value because in many cases the preferential dividend rate is defined as a percentage of par value (e.g., 10%, $25 par value preferred stock will have a required annual dividend of $2.50). However, the dividend can be stated as a dollar amount per year, thereby obviating the need for par values.

Stock issued for services.

If the shares in a corporation are issued in exchange for services or property rather than for cash, the transaction should be reflected at the fair value of the property or services received. If this information is not readily available, the transaction should be recorded at the fair value of the shares that were issued. Where necessary, appraisals should be obtained to properly reflect the transaction. As a final resort, a valuation by the board of directors of the stock issued can be utilized. Stock issued to employees as compensation for services rendered should be accounted for at the fair value of the services performed, if determinable, or the value of the shares issued.

If shares are given by a major shareholder directly to an employee for services performed for the entity, this exchange should be accounted for as a capital contribution to the company by the major shareholder and as compensation expense incurred by the company. Only when accounted for in this manner will there be conformity with the general principle that all costs incurred by an entity, including compensation, should be reflected in its financial statements.

Issuance of stock units.

In certain instances, common and preferred shares may be issued to investors as a unit (e.g., a unit of one share of preferred and two shares of common can be sold as a package). Where both of the classes of stock are publicly traded, the proceeds from a unit offering should be allocated in proportion to the relative market values of the securities. If only one of the securities is publicly traded, the proceeds should be allocated to the one that is publicly traded based on its known market value. Any excess is allocated to the other. Where the market value of neither security is known, appraisal information might be used. The imputed fair value of one class of security, particularly the preferred shares, can be based on the stipulated dividend rate. In this case, the amount of proceeds remaining after the imputing of a value of the preferred shares would be allocated to the common stock.

The foregoing procedures would also apply if a unit offering were made of an equity and a nonequity security such as convertible debentures.

Stock Subscriptions

Occasionally, particularly in the case of a newly organized corporation, a contract is entered into between the corporation and prospective investors, whereby the latter agree to purchase specified numbers of shares to be paid for over some installment period. These stock subscriptions are not the same as actual stock issuances, and the accounting differs.

The amount of stock subscriptions receivable by a corporation is sometimes treated as an asset on the balance sheet and is categorized as current or noncurrent in accordance with the terms of payment. However, most subscriptions receivable are shown as a reduction of stockholders' equity in the same manner as treasury stock. Since subscribed shares do not have the rights and responsibilities of actual outstanding stock, the credit is made to a stock subscribed account instead of to the capital stock accounts.

If the common stock has par or stated value, the common stock subscribed account is credited for the aggregate par or stated value of the shares subscribed. The excess over this amount is credited to additional paid-in capital. No distinction is made between additional paid-in capital relating to shares already issued and shares subscribed for. This treatment follows from the distinction between legal capital and additional paid-in capital. Where there is no par or stated value, the entire amount of the common stock subscribed is credited to the stock subscribed account.

As the amount due from the prospective shareholders is collected, the stock subscriptions receivable account is credited and the proceeds are debited to the cash account. Actual issuance of the shares, however, must await the complete payment of the stock subscription. Accordingly, the debit to common stock subscribed is not made until the subscribed shares are fully paid for and the stock is issued.

The following journal entries illustrate these concepts:

1. 10,000 shares of $50 par preferred are subscribed at a price of $65 each; a 10% down payment is received.

   Cash	65,000
   Stock subscriptions receivable	585,000
   Preferred stock subscribed		500,000
   Additional paid-in capital		150,000

2. 2,000 shares of no par common shares are subscribed at a price of $85 each, with one-half received in cash.

   Cash	85,000
   Stock subscriptions receivable	85,000
   Common stock subscribed		170,000

3. All preferred subscriptions are paid, and one-half of the remaining common subscriptions are collected in full and subscribed shares are issued.

   Cash [$585,000 + ($85,000 x 0.50)]	627,500
   Stock subscriptions receivable		627,500
   Preferred stock subscribed	500,000
   Preferred stock		500,000
   Common stock subscribed	127,500
   Common stock ($170,000 x 0.75)		127,500

When the company experiences a default by the subscriber, the accounting will follow the provisions of the state in which the corporation is chartered. In some jurisdictions, the subscriber is entitled to a proportionate number of shares based on the amount already paid on the subscriptions, sometimes reduced by the cost incurred by the corporation in selling the remaining defaulted shares to other stockholders. In other jurisdictions, the subscriber forfeits the entire investment on default. In this case the amount already received is credited to an additional paid-in capital account that describes its source.

Additional Paid-in Capital

Additional paid-in capital represents all capital contributed to a corporation other than that defined as par or stated value. Additional paid-in capital can arise from proceeds received from the sale of common and preferred shares in excess of their par or stated values. It can also arise from transactions relating to the following:

1. Sale of shares previously issued and subsequently reacquired by the corporation (treasury stock)

2. Retirement of previously outstanding shares

3. Payment of stock dividends in a manner that justifies the dividend being recorded at the market value of the shares distributed

4. Lapse of stock purchase warrants or the forfeiture of stock subscriptions, if these result in the retaining by the corporation of any partial proceeds received prior to forfeiture

5. Warrants that are detachable from bonds

6. Conversion of convertible bonds

7. Other gains on the company's own stock, such as that which results from certain stock option plans

When the amounts are material, the sources of additional paid-in capital should be described in the financial statements.

Donated Capital

Donated capital should also be adequately disclosed in the financial statements. Donated capital can result from an outright gift to the corporation (e.g., a major shareholder donates land or other assets to the company in a nonreciprocal transfer) or may result when services are provided to the corporation. Under current US GAAP, such nonreciprocal transactions will be recognized as revenue in the period the contribution is received.

In these situations, historical cost is not adequate to reflect properly the substance of the transaction, since the historical cost to the corporation would be zero. Accordingly, these events should be reflected at fair market value. If long-lived assets are donated to the corporation, they should be recorded at their fair value at the date of donation, and the amount so recorded should be depreciated over the normal useful economic life of such assets. If donations are conditional in nature, they should not be reflected formally in the accounts until the appropriate conditions have been satisfied. However, disclosure might still be required in the financial statements of both the assets donated and the conditions required to be met.

Retained Earnings

Legal capital, additional paid-in capital, and donated capital, collectively represent the contributed capital of the corporation. The other major source of capital is retained earnings, which represents the accumulated amount of earnings of the corporation from the date of inception (or from the date of reorganization) less the cumulative amount of distributions made to shareholders and other charges to retained earnings (e.g., from treasury stock transactions). The distributions to shareholders generally take the form of dividend payments, but may take other forms as well, such as the reacquisition of shares for amounts in excess of the original issuance proceeds.

Retained earnings are also affected by action taken by the corporation's board of directors. Appropriation serves disclosure purposes and serves to restrict dividend payments but does nothing to provide any resources for satisfaction of the contingent loss or other underlying purpose for which the appropriation has been made. Any appropriation made from retained earnings must eventually be returned to the retained earnings account. It is not permissible to charge losses against the appropriation account nor to credit any realized gain to that account. The use of appropriated retained earnings has diminished significantly over the years.

An important rule relating to retained earnings is that transactions in a corporation's own stock can result in a reduction of retained earnings (i.e., a deficiency on such transactions can be charged to retained earnings) but cannot result in an increase in retained earnings (any excesses on such transactions are credited to paid-in capital, never to retained earnings).

If a series of operating losses have been incurred or distributions to shareholders in excess of accumulated earnings have been made and if there is a debit balance in retained earnings, the account is generally referred to as accumulated deficit.

Dividends

Dividends are the pro rata distribution of earnings to the owners of the corporation. The amount and the allocation between the preferred and common shareholders is a function of the stipulated preferential dividend rate, the presence or absence of (1) a participation feature, (2) a cumulative feature, and (3) arrearages on the preferred stock, and the wishes of the board of directors. Dividends, even preferred stock dividends where a cumulative feature exists, do not accrue. Dividends become a liability of the corporation only when they are declared by the board of directors.

Traditionally, corporations were not allowed to declare dividends in excess of the amount of retained earnings. Alternatively, a corporation could pay dividends out of retained earnings and additional paid-in capital but could not exceed the total of these categories (i.e., they could not impair legal capital by the payment of dividends). States that have adopted the Model Business Corporation Act grant more latitude to the directors. Corporations can now, in certain jurisdictions, declare and pay dividends in excess of the book amount of retained earnings if the directors conclude that, after the payment of such dividends, the fair value of the corporation's net assets will still be a positive amount. Thus, directors can declare dividends out of unrealized appreciation, which, in certain industries, can be a significant source of dividends beyond the realized and recognized accumulated earnings of the corporation. This action, however, represents a major departure from traditional practice and demands both careful consideration and adequate disclosure.

Three important dividend dates are

1. The declaration date

2. The record date

3. The payment date

The declaration date governs the incurrence of a legal liability by the corporation. The record date refers to that point in time when a determination is made as to which specific registered stockholders will receive dividends and in what amounts. Finally, the payment date relates to the date when the distribution of the dividend takes place. These concepts are illustrated in the following example:

Example of payment of dividends

On May 1, 2003, the directors of River Corp. declare a $.75 per share quarterly dividend on River Corp.'s 650,000 outstanding common shares. The dividend is payable May 25 to holders of record May 15.

May 1	Retained earnings (or Dividends)	487,500
	Dividends payable		487,500
May 15	No entry
May 25	Dividends payable Cash	487,500
	Cash		487,500

If a dividends account is used, it is closed directly to retained earnings at year-end.

Dividends may be made in the form of cash, property, or scrip, which is a form of short-term note payable. Cash dividends are either a given dollar amount per share or a percentage of par or stated value. Property dividends consist of the distribution of any assets other than cash (e.g., inventory or equipment). Finally, scrip dividends are promissory notes due at some time in the future, sometimes bearing interest until final payment is made.

Occasionally, what appear to be disproportionate dividend distributions are paid to some but not all of the owners of closely held corporations. Such transactions need to be analyzed carefully. In some cases these may actually represent compensation paid to the recipients. In other instances, these may be a true dividend paid to all shareholders on a pro rata basis, to which certain shareholders have waived their rights. If the former, the distribution should not be accounted for as a dividend but as compensation or some other expense category and included on the income statement. If the latter, the dividend should be grossed up to reflect payment on a proportional basis to all the shareholders, with an offsetting capital contribution to the company recognized as having been effectively made by those to whom payments were not made.

Property dividends.

If property dividends are declared, the paying corporation may incur a gain or loss. Since the dividend should be reflected at the fair value of the assets distributed, the difference between fair value and book value is recorded at the time the dividend is declared and charged or credited to a loss or gain account.

Scrip dividends.

If a corporation declares a dividend payable in scrip that is interest bearing, the interest is accrued over time as a periodic expense. The interest is not a part of the dividend itself.

Liquidating dividends.

Liquidating dividends are not distributions of earnings, but rather, a return of capital to the investing shareholders. A liquidating dividend is normally recorded by the declarer through charging additional paid-in capital rather than retained earnings. The exact accounting for a liquidating dividend is affected by the laws where the business is incorporated, and these laws vary from state to state.

Stock dividends.

Stock dividends represent neither an actual distribution of the assets of the corporation nor a promise to distribute those assets. For this reason, a stock dividend is not considered a legal liability or a taxable transaction.

Despite the recognition that a stock dividend is not a distribution of earnings, the accounting treatment of relatively insignificant stock dividends (defined as being less than 20 to 25% of the outstanding shares prior to declaration) is consistent with its being a real dividend. Accordingly, retained earnings are debited for the fair market value of the shares to be paid as a dividend, and the capital stock and additional paid-in capital accounts are credited for the appropriate amounts based on the par or stated value of the shares, if any. A stock dividend declared but not yet paid is classified as such in the stockholders' equity section of the balance sheet. Since such a dividend never reduces assets, it cannot be a liability.

The selection of 20 to 25% as the threshold for recognizing a stock dividend as an earnings distribution is arbitrary, but it is based somewhat on the empirical evidence that small stock dividends tend not to result in a reduced market price per share for outstanding shares. In theory, any stock dividend should result in a reduction of the market value of outstanding shares in an inverse relationship to the size of the stock dividend. The aggregate value of the outstanding shares should not change, but the greater number of shares outstanding after the stock dividend should necessitate a lower per share price. As noted, however, the declaration of small stock dividends tends not to have this impact, and this phenomenon supports the accounting treatment.

On the other hand, when stock dividends are larger in magnitude, it is observed that per share market value declines after declaration of the dividend. In such situations it would not be valid to treat the stock dividend as an earnings distribution. Rather, it should be accounted for as a split. The precise treatment depends on the legal requirements of the state of incorporation and on whether the existing par value or stated value is reduced concurrent with the stock split.

If the par value is not reduced for a large stock dividend and if state law requires that earnings be capitalized in an amount equal to the aggregate of the par value of the stock dividend declared, the event should be described as a stock split effected in the form of a dividend, with a charge to retained earnings and a credit to the common stock account for the aggregate par or stated value. When the par or stated value is reduced in recognition of the split and state laws do not require treatment as a dividend, there is no formal entry to record the split but merely a notation that the number of shares outstanding has increased and the per share par or stated value has decreased accordingly.

Treasury Stock

Treasury stock consists of a corporation's own stock that has been issued, subsequently reacquired by the firm, and not yet reissued or canceled. Treasury stock does not reduce the number of shares issued but does reduce the number of shares outstanding, as well as total stockholders' equity. These shares are not eligible to receive cash dividends. Treasury stock is not an asset, although in some circumstances, it may be presented as an asset if adequately disclosed. Reacquired stock that is awaiting delivery to satisfy a liability created by the firm's compensation plan or reacquired stock held in a profit-sharing trust is still considered outstanding and would not be considered treasury stock. In each case, the stock would be presented as an asset with the accompanying footnote disclosure.

Three approaches exist for the treatment of treasury stock: the cost, par value, and constructive retirement methods.

Cost method.

Under the cost method, the gross cost of the shares reacquired is charged to a contra equity account (treasury stock). The equity accounts that were credited for the original share issuance (common stock, paid-in capital in excess of par, etc.) remain intact. When the treasury shares are reissued, proceeds in excess of cost are credited to a paid-in capital account. Any deficiency is charged to retained earnings (unless paid-in capital from previous treasury share transactions exists, in which case the deficiency is charged to that account, with any excess charged to retained earnings). If many treasury stock purchases are made, a cost flow assumption (e.g., FIFO or specific identification) should be adopted to compute excesses and deficiencies on subsequent share reissuances. The advantage of the cost method is that it avoids identifying and accounting for amounts related to the original issuance of the shares, and is therefore the simpler more frequently used method. The cost method is most consistent with the one-transaction concept. This concept takes the view that the classification of stockholders' equity should not be affected simply because the corporation was the middle "person" in an exchange of shares from one stockholder to another. In substance, there is only a transfer of shares between two stockholders. Since the original balances in the equity accounts are left undisturbed, its use is most acceptable when the firm acquires its stock for reasons other than retirement, or when its ultimate disposition has not yet been decided.

Par value method.

Under the second approach, the par value method, the treasury stock account is charged only for the aggregate par (or stated) value of the shares reacquired. Other paid-in capital accounts (excess over par value, etc.) are relieved in proportion to the amounts recognized on the original issuance of the shares. The treasury share acquisition is treated almost as a retirement. However, the common (or preferred) stock account continues at the original amount, thereby preserving the distinction between an actual retirement and a treasury share transaction.

When the treasury shares accounted for by the par value method are subsequently resold, the excess of the sale price over par value is credited to paid-in capital. A reissuance for a price below par value does not create a contingent liability for the purchaser. It is only the original purchaser who risks this obligation to the entity's creditors.

Constructive retirement method.

The constructive retirement method is similar to the par value method except that the aggregate par (or stated) value of the reacquired shares is charged to the stock account rather than to the treasury stock account. This method is superior when (1) it is management's intention not to reissue the shares within a reasonable time period, or (2) the state of incorporation defines reacquired shares as having been retired.

The two-transaction concept is most consistent with the par value and constructive retirement methods. First, the reacquisition of the firm's shares is viewed as constituting a contraction of its capital structure. Second, the reissuance of the shares is the same as issuing new shares. There is little difference between the purchase and subsequent reissuance of treasury shares and the acquisition and retirement of previously issued shares and the issuance of new shares.

Treasury shares originally accounted for by the cost method can subsequently be restated to conform to the constructive retirement method. If shares were acquired with the intention that they would be reissued and it is later determined that such reissuance is unlikely (due for example, to the expiration of stock options without their exercise), it is proper to restate the transaction.

Example of accounting for treasury stock

1. 100 shares ($50 par value) that were sold originally for $60 per share are later reacquired for $70 each.

2. All 100 shares are subsequently resold for a total of $7,500.

To record the acquisition, the entry is

Cost method			Par value method			Constructive retirement method
Treasury stock	7,000		Treasury stock	5,000		Common stock	5,000
Cash		7,000	Additional paid-in capital—common stock	1,000		Additional paid-in capital—common stock	1,000
			Retained earnings	1,000		Retained earnings	1,000
			Cash		7,000	Cash		7,000

To record the resale, the entry is

Cost method			Par value method			Constructive retirement method
Cash	7,500		Cash	7,500		Cash	7,500
Treasury stock		7,000	Treasury stock		5,000	Common stock		5,000
Additional paid-in capital—treasury stock		500	Additional paid-in capital—common stock		2,500	Additional paid-in capital—common stock		2,500

If the shares had been resold for $6,500, the entry is

Cost method			Par value method			Constructive retirement method
Cash	6,500		Cash	6,500		Cash	6,500
[a]Retained earnings	500		Treasury stock		5,000	Common stock		5,000
Treasury stock		7,000	Additional paid-in capital—common stock		1,500	Additional paid-in capital—common stock		1,500
[a]"Additional paid-in capital—treasury stock" or "Additional paid-in capital—retired stock" of that issue would be debited first to the extent it exists.

Alternatively, under the par or constructive retirement methods, any portion of or the entire deficiency on the treasury stock acquisition may be debited to retained earnings without allocation to paid-in capital. Any excesses would always be credited to an "Additional paid-in capital—retired stock" account.

The laws of some states govern the circumstances under which a corporation may acquire treasury stock and they may prescribe the accounting for the stock. For example, a charge to retained earnings may be required in an amount equal to the treasury stock's total cost. In such cases, the accounting according to state law prevails. Also, some states define excess purchase cost of reacquired (i.e., treasury) shares as distributions to shareholders that are no different in nature than dividends. In such cases, the financial statement presentation should adequately disclose the substance of these transactions (e.g., by presenting both dividends and excess reacquisition costs together in the retained earnings statement).

When a firm decides to retire the treasury stock formally, the journal entry is dependent on the method used to account for the stock. Using the original sale and reacquisition data from the illustration above, the following entry would be made:

Cost method			Par value method
Common stock	5,000		Common stock	5,000
Additional paid-in capital—common stock	1,000		Treasury stock		5,000
[a]Retained earnings	1,000
Treasury stock		7,000
[a]"Additional paid-in capital—treasury stock" may be debited to the extent that it exists.

If the constructive retirement method were used to record the treasury stock purchase, no additional entry would be necessary on formal retirement of the shares.

After the entry is made, the pro rata portion of all paid-in capital existing for that issue (i.e., capital stock and additional paid-in capital) will have been eliminated. If stock is purchased for immediate retirement (i.e., not put into the treasury) the entry to record the retirement is the same as that made under the constructive retirement method.

In the case of donated treasury stock, the intentions of management are important. If the shares are to be retired, the capital stock account is debited for the par or stated value of the shares, "Donated capital" is credited for the fair market value, and "Additional paid-in capital—retired stock" is debited or credited for the difference. If the intention of management is to reissue the shares, three methods of accounting are available. The first two methods, cost and par value, are analogous to the aforementioned treasury stock methods except that "Donated capital" is credited at the time of receipt and debited at the time of reissuance. Under the cost method, the current market value of the stock is recorded (an apparent contradiction), whereas under the par value method, the par or stated value is used. Under the last method, only a memorandum entry is made to indicate the number of shares received. No journal entry is made at the time of receipt. At the time of reissuance, the entire proceeds are credited to "Donated capital." The method actually used is generally dependent on the circumstances involving the donation and the preference of the firm.

Other Equity Accounts

There are other adjustments to balance sheet accounts that are accumulated and reflected as separate components of stockholders' equity. Under current US GAAP, these include unrealized gains or losses on available-for-sale portfolios of debt and marketable equity securities, accumulated gain or loss on translation of foreign currency-denominated financial statements, and the net loss not recognized as pension cost.

Stock Options

The matter of accounting for stock options, particularly stock options issued to executives and other employees of a business, ostensibly in compensation for their efforts, has long been very controversial. No current IAS addresses this subject area, but the IASB's share-based payment project appears poised to produce the most comprehensive, fair value driven measurement model of any standard-setting body. This project is discussed in detail in the body of this chapter.

US GAAP currently recommends, but does not require, use of a fair value model to gauge the existence and extent of compensation associated with stock options granted to employees. The IASB project appears to be approaching endorsement of an essentially similar fair value model, but this would be mandatorily used for all employee stock-based compensation arrangements. (FASB is also revisiting this reluctantly, and may well conclude that mandatory use of the fair value approach is warranted.)

Stock Appreciation Rights

Another type of stock-based compensation program gives the employees the opportunity to participate in any increase in value of the company's stock without having to incur the cost of actually purchasing the shares themselves. Such plans are often referred to as phantom stock plans, stock appreciation rights, or variable stock award programs. A wide variety of such plans have been devised in practice. Some provide for the payment of cash to the employees, while others reward participants with shares of the sponsoring company's stock. Often such plans are granted together with compensatory stock option plans as either combination plans or as tandem plans: the former give the employees the rights to both the options and the phantom stock, while the latter require the employees to choose which they will exercise (simultaneously forfeiting the other).

Under US GAAP, compensation cost incurred in connection with stock appreciation rights or other variable awards is determined prospectively until full vesting is achieved, with future increases or decreases in market price resulting in charges or credits to periodic compensation expense. Total compensation cost is allocated ratably (if cliff vesting is provided by the plan) or proportionally (if graded vesting is provided). When an employee forfeits options or rights for which compensation had previously been accrued, the accrual is to be reversed against compensation expense in the period of the forfeiture.

Performance-based stock compensation plans often provide for payment in shares instead of cash. For example, a stock appreciation rights plan may contain a provision that the increase in value will be distributed to the participant in the form of sufficient shares of the sponsor's stock to have an aggregate fair market value equal to the amount of the award. If the plan provides only for payment in shares (a plan that most often is referred to as a phantom stock plan), the offset to the periodic charge for compensation cost should be to paid-in capital accounts. If the award is payable at the participant's choice in either cash or stock, a liability should be accrued, since the sponsor cannot control the means by which the obligation will be settled. If the payment will be made in cash or stock at the option of the company, the offset to compensation should be either to a liability account or to equity accounts, based on the best available information concerning the sponsor's intentions. As these intentions change from one period to another, the amounts should be reclassified as necessary.

Accounting for stock appreciation rights has been altered by the recent standard on stock-based compensation. Furthermore, there are many variations in these plans and thus the precise accounting cannot be stipulated in general terms. Further discussion of this topic is beyond the scope of this book.

Convertible Preferred Stock

The treatment of convertible preferred stock at its issuance is no different from that of nonconvertible preferred. When it is converted, the book value approach is used to account for the conversion. Use of the market value approach would entail a gain or loss for which there is no theoretical justification, since the total amount of contributed capital does not change when the stock is converted. When the preferred stock is converted, the "Preferred stock" and related "Additional paid-in capital—preferred stock" accounts are debited for their original values when purchased, and "Common stock" and "Additional paid-in capital—common stock" (if an excess over par or stated value exists) are credited. If the book value of the preferred stock is less than the total par value of the common stock being issued, retained earnings is charged for the difference. This charge is supported by the rationale that the preferred shareholders are offered an additional return to facilitate their conversion to common stock. Many states require that this excess instead reduce additional paid-in capital from other sources.

Preferred Stock with Mandatory Redemption

A mandatory redemption clause requires the preferred stock to be redeemed (retired) at a specified date(s). This feature is in contrast to callable preferred stock, which is redeemed at the issuing corporation's option. When combined with a cumulative dividend preference, the mandatory redemption feature causes the preferred stock to have the characteristics of debt, especially when the stock is to be redeemed in five to ten years. The dividend payments represent interest, and redemption is the repayment of principal. However, there is one important difference. The dividend payments do not receive the same tax treatment as do interest payments. They are not deductible in determining taxable income.

Despite these debt-like characteristics, this class of preferred stock currently receives no special treatment under GAAP. It is treated as any other stock on issuance, and on redemption, the stock is treated as an ordinary retirement. (It should be noted that this conflicts with the requirements under the international standard, IAS 32, which does demand that a "substance over form" analysis be conducted and that items such as mandatorily redeemable stock be treated as debt. This is one instance, but not the only one, in which the international standards have progressed beyond the US standards.)

For disclosure purposes under US GAAP, the stock is treated as equity and is presented within the stockholders' equity portion of the balance sheet. Disclosure of the amounts and timing of any redemption payments for each of the five years following the balance sheet date is required as footnote disclosure, however.

Book Value Stock Plans

Another type of stock purchase plan, the book value plan, is intended also to be a compensation program for participating employees, although there are important secondary motives in many such plans, such as the desires to generate capital and to tie employees to the employer. Under the terms of typical book value plans, employees (or those attaining some defined level, such as manager) are given the opportunity or, in some cases, they are required to purchase shares in the company, which then must be sold back to the company on termination of employment.

Under US GAAP, if the employees participating in a nonpublic company's book value stock plan have substantive investments in the company that are at risk, the increases in book value during the period of ownership are not to be treated as compensation. However, if the employees are granted options to purchase shares at book value, compensation is to be recognized for value increases, presumably because under the latter scenario the employee has no investment at risk and is only being given an "upside" opportunity. This interpretation is also applicable to book value options granted to employees of publicly held companies.

For accounting purposes, shares issued at book value to employees are simply recorded as a normal stock sale. To the extent that book value exceeds par or stated value, additional paid-in capital accounts may also be credited.

For such plans in publicly owned companies, GAAP states that these plans are performance plans akin to stock appreciation rights, and accordingly, results in compensation expense recognition. This conclusion was reached at least in part due to pressure from the US securities regulators.

Junior Stock

Another category of stock-based compensation program involves junior stock. Typically, such shares are subordinate to normal shares of common stock with respect to voting rights, dividend rate, or other attributes, and are convertible into regular common shares if and when stipulated performance goals are achieved. Like stock appreciation rights, grants of junior stock represent a performance-based program, in contrast to fixed stock options.

An interpretation under US GAAP holds that compensation cost incurred in connection with grants of junior stock is generally to be accrued. However, compensation is to be recognized only when it is deemed to be probable (as that term is defined by the accounting literature dealing with contingencies) that the performance goals will be achieved. It may be that achievement is not deemed probable at the time the junior stock is issued, but it later becomes clear that such achievement is indeed likely. In other circumstances, the ability to convert junior stock to regular stock is dependent on the achievement of more than a single performance goal, and it is not probable that all such goals can be achieved, although some of them are deemed probable of achievement. In both scenarios, full accrual of compensation cost may be delayed until the estimated likelihood of achievement improves.

The rule specifies that the measure of compensation is derived from the comparison of the market price of ordinary common stock with the price to be paid, if any, for the junior stock. Since the junior stock will be convertible to ordinary common stock if the defined performance goals are achieved, the compensation to be received by the employees participating in the plan is linked to the value of unrestricted common shares.

Put Warrant

A detachable put warrant can either be put back to the debt issuer for cash or can be exercised to acquire common stock. US GAAP holds that these instruments should be accounted for in the same manner as mandatorily redeemable preferred stock. The proceeds applicable to the put warrant ordinarily are to be classified as equity. In the case of a warrant with a put price substantially higher than the value assigned to the warrant at issuance, however, the proceeds should be classified as a liability since it is likely that the warrant will be put back to the company.

The original classification should not be changed because of subsequent economic changes in the value of the put. The value assigned to the put warrant at issuance, however, should be adjusted to its highest redemption price, starting with the date of issuance until the earliest date of the warrants. Changes in the redemption price before the earliest put dates are changes in accounting estimates, and changes after the earliest put dates should be recognized in income. If the put is classified as equity, the adjustment should be reported as a charge to retained earnings, and if the put is classified as a liability, the adjustment is reported as interest expense.

Accounting for Stock Issued to Employee Stock Ownership Plans

Increasingly, US corporations have been availing themselves of favorable tax regulations that encourage the establishment of employee stock ownership plans. Employee stock ownership plans (ESOP) are defined contribution employee benefit plans in which shares of the sponsoring entity are given to employees as additional compensation.

In brief, ESOP are created by a sponsoring corporation that either funds the plan directly (unleveraged ESOP) or, as is more often the case, facilitates the borrowing of money either directly from an outside lender (directly leveraged ESOP) or from the employer, who in turn will borrow from an outside lender (indirectly leveraged ESOP). Borrowings from outside lenders may or may not be guaranteed by the sponsor. Since effectively the only source of funds for debt repayment are future contributions by the sponsor, US GAAP requires that the ESOP's debt be considered debt of the sponsor. Depending on the reasons underlying the creation of the ESOP (estate planning by the controlling shareholder, expanding the capital base of the entity, rewarding and motivating the workforce, etc.), the sponsor's shares may be contributed to the plan in annual installments, in a block of shares from the sponsor, or shares from an existing shareholder may be purchased by the plan.

Direct or indirect borrowings by the ESOP must be reported as debt in the sponsor's balance sheet. An offset to a contra equity account, not to an asset, is also reported since the plan represents a commitment (morally, if not always legally) to make future contributions to the plan and not a claim to resources. This results in a "double hit" to the sponsor's balance sheet (i.e., the recording of a liability and the reduction of net stockholders' equity), which is often an unanticipated and unpleasant surprise. This contra equity account was called "unearned compensation" under prior accounting rules but is now referred to as "unearned ESOP shares." If the sponsor lends funds to the ESOP without a "mirror" loan from an outside lender, this loan should not be reported in the employer's balance sheet as debt, although the debit should still be reported as a contra equity account.

As the ESOP services the debt (using contributions made by the sponsor and/or dividends received on sponsor shares held by the plan) the sponsor reflects the reduction of the obligation by reducing the debt and the contra equity account on its balance sheet. Simultaneously, income and thus retained earnings will be affected as the contributions to the plan are reported in the sponsor's current results of operations. Thus, the double hit is eliminated, but net worth continues to reflect the economic fact that compensation costs have been incurred. US GAAP requires that the interest cost component be separated from the remaining compensation expense, that is, that the sponsor's income statement should reflect the true character of the expenses being incurred rather than aggregating the entire amount into a category such as "ESOP contribution."

In a leveraged ESOP, shares held serve as collateral for the debt and are not allocated to employees until the debt is retired. In general, shares must be allocated by the end of the year in which the debt is repaid; however, to satisfy the tax laws, the allocation of shares may take place at a faster pace than retirement of the principal portion of the debt.

The cost of ESOP shares allocated is measured (for purposes of reporting compensation expense in the sponsor's income statements) based on the fair value on the release date, in contrast to the actual historical cost of the shares to the plan. Dividends paid on unallocated shares (i.e., shares held by the ESOP) are reported in the sponsor's income statement as compensation cost and/or as interest expense.

Example of accounting for ESOP transactions

Assume that Intrepid Corp. establishes an ESOP, which then borrows $500,000 from Second Interstate Bank. The ESOP then purchases 50,000 shares of Intrepid no-par shares from the company; none of these shares are allocated to individual participants. The entries would be

Cash	500,000
Bank loan payable		500,000
Unearned ESOP shares (contra equity account)	500,000
Common stock		500,000

The ESOP then borrows an additional $250,000 from the sponsor, Intrepid, and uses the cash to purchase a further 25,000 shares, all of which are allocated to participants.

Compensation	250,000
Common stock		250,000

Intrepid Corp. contributes $50,000 to the plan, which the plan uses to service its bank debt, consisting of $40,000 principal reduction and $10,000 interest cost. The debt reduction causes 4,000 shares to be allocated to participants at a time when the average market value had been $12 per share.

Interest expense	10,000
Bank loan payable	40,000
Cash		50,000
Compensation	48,000
Additional paid-in capital		8,000
Unearned ESOP shares		40,000

Dividends of $0.10 per share are declared (only the ESOP shares are represented in the following entry, but dividends are paid equally on all outstanding shares).

Retained earnings	2,900
Compensation	4,600
Dividends payable		7,500

Note that in all the foregoing illustrations the effect of income taxes is ignored. Since the difference between the cost and fair values of shares committed to be released is analogous to differences in the expense recognized for tax and accounting purposes with regard to stock options, the same treatment should be applied. That is, the tax effect should be reported directly in stockholders' equity rather than in earnings.

Corporate Bankruptcy and Reorganizations

Entities operating under and emerging from protection of the bankruptcy laws.

The going concern assumption is one of the basic postulates underlying generally accepted accounting principles and is responsible for, among other things, the historical cost convention in financial reporting. For entities that have entered bankruptcy proceedings, however, the going concern assumption will no longer be of central importance.

Traditionally, the basic financial statements (balance sheet, income statement, and statement of cash flows) presented by going concerns were seen as less useful for entities undergoing reorganization. Instead, the statement of affairs, reporting assets at estimated realizable values and liabilities at estimated liquidation amounts, was recommended for use by such organizations. In more recent years, use of the statement of affairs has not frequently been encountered in practice. About five years ago, a new standard was promulgated, setting forth certain financial reporting standards for entities undergoing, and emerging from, reorganization under the bankruptcy laws.

Under GAAP, assets are presented at estimated realizable values. Liabilities are set forth at the estimated amounts to be allowed in the balance sheet and liabilities subject to compromise are to be distinguished from those that are not. Furthermore, US GAAP requires that in both statements of income and cash flows, normal transactions be differentiated from those that have occurred as a consequence of the entity's being in reorganization. While certain allocations to the latter category are rather obvious, such as legal and accounting fees incurred, others are less clear. For example, the standard suggests that if the entity in reorganization earns interest income on funds that would normally have been used to settle obligations owed to creditors, such income will be deemed to be income arising as a consequence of the bankruptcy action.

Another interesting aspect of this standard is the accounting to be made for the emergence from reorganization (known as "confirmation of the plan of reorganization"). GAAP now provides for "fresh start" financial reporting in such instances. This accounting is similar to that applied to purchase business combinations, with the total confirmed value of the entity on its emergence from reorganization being analogous to the purchase price in an acquisition. In both cases, this total value is to be allocated to the identifiable assets and liabilities of the entity, with any excess being allocated to goodwill. In the case of entities emerging from bankruptcy, goodwill (reorganization value in excess of amounts allocable to identifiable assets) is measured as the excess of liabilities existing at the plan confirmation date, computed at present value of future amounts to be paid, over the reorganization value of assets. Reorganization value is calculated with reference to a number of factors, including forecasted operating results and cash flows of the new entity.

This standard applies only to entities undergoing formal reorganization under the bankruptcy code. Less formal procedures may still be accounted for under preexisting quasi reorganization accounting procedures.

Quasi Reorganizations

Generally, this procedure is applicable during a period of declining price levels. It is termed "quasi" since the accumulated deficit is eliminated at a lower cost and with less difficulty than a legal reorganization. Under the provisions of US GAAP, the procedures in a quasi reorganization involve

1. Proper authorization from stockholders and creditors where required

2. Revaluation of assets to their current values. All losses are charged to retained earnings, thus increasing any deficit.

3. Elimination of any deficit by charging paid-in capital

   1. Additional paid-in capital to the extent it exists

   2. Capital stock when additional paid-in capital is insufficient. The par value of the stock is reduced, creating the extra additional paid-in capital to which the remaining deficit is charged.

No retained earnings may be created by a reorganization. Any excess created by the reduction of par value is credited to "Paid-in capital from quasi reorganization." Retained earnings must be dated for ten years (less than ten years may be justified under exceptional circumstances) after a quasi reorganization takes place. Disclosure similar to "since quasi reorganization of June 30, 2003" is appropriate.