Chapter 13, Problem 13SP

1)

To determine

Introduction:

Classes of shares:

• Shares provide partial ownership or a “share” of a corporation. There are two primary classes of shares − Equity Shares and Preference Shares.

• Equity shares are the class of shares which carry voting rights and equity share holders are the true owners of the company as in the event of dissolution, equity shareholders get last preference in clearing the amounts invested and there is no guarantee of profits will be debited by dividend on an annual basis.
• Preference shares are the class of shares which do not carry voting rights and in the event of dissolution, preference shareholders get first preference in clearing the amounts invested and there is usually guarantee of profits will be debited by dividend on an annual basis. Convertible Preference shares are preference shares that carry the option to be converted into equity shares after certain duration.
Journal Entries

• Journal entries are the first step in recording financial transactions and preparation of financial statements.

• These represent the impact of the financial transaction and demonstrate the effect on the accounts impacted in the form of debits and credits.

• Assets and expenses have debit balances and Liabilities and Incomes have credit balances and according to the business transaction, the accounts are appropriately debited will be credited by credited to reflect the effect of business transactions and events.

To Prepare:

Journal entries to record issuance of stock

Answer to Problem 13SP

Solution:

Alternative	Particulars	Debit ($)	Credit ($)
(A)	Bank	$86,000
	Paid in Capital - Common Stock		$86,000
	(Being common stock issued for $86,000)
(B)	Bank	$86,000
	Paid in Capital − 7% Preferred Stock		$86,000
	(Being 860 preferred shares with par value of $100 of 7% preferred stock issued)
(C)	Bank	$86,000
	7% Notes Payable		$86,000
	(Being Notes Payable Issued with 7% interest payable for 10 years)

Explanation of Solution

• Assets and Expenses have debit balances and must be debited in order to increase their balance and credited in order to decrease their balance.

• Liabilities and Incomes have credit balances and must be debited in order to decrease their balance and credited in order to increase their balance.

• When a company decides to issue shares, it can do so at par, at a premium or at a discount. If the issue price equals the par value, the shares are said to be issued at par.

• If the issue price is less than the par value, the shares are said to be issued at a discount. If the issue price exceeds the par value, the shares are said to be issued at a premium

• In case of alternative A Bank will be debited by $86,000 and Paid in Capital - Common Stock will be debited by $86,000 since common stock was issued for $86,000. It is assumed stock is issued at par. After issuance of such stock the total equity share capital of the company will be $215,000 ($129,000 already invested + $86,000 fresh investment)

• In case of alternative B Bank will be debited by $86,000 and Paid in Capital − 7% Preferred Stock will be credited by $86,000 since 860 preferred shares with par value of $100 of 7% preferred stock were issued.

• In case of alternative C Bank will be debited by $86,000 and 7% Notes Payable will be credited by $86,000 since Notes Payable were Issued with 7% interest payable for 10 years.

• Bank is an asset and must be debited to indicate increase in balances. Paid in Capital - Common Stock − Common Stock, Paid in Capital − 7% Preferred Stock and Notes Payable are liabilities and must be credited to indicate increase in balances.

Conclusion

Hence the transactions have been journalized.

2)

To determine

Introduction:

Classes of shares:

• Shares provide partial ownership or a “share” of a corporation. There are two primary classes of shares − Equity Shares and Preference Shares.

• Equity shares are the class of shares which carry voting rights and equity share holders are the true owners of the company as in the event of dissolution, equity shareholders get last preference in clearing the amounts invested and there is no guarantee of profits / dividend on an annual basis.
• Preference shares are the class of shares which do not carry voting rights and in the event of dissolution, preference shareholders get first preference in clearing the amounts invested and there is usually guarantee of profits / dividend on an annual basis. Convertible Preference shares are preference shares that carry the option to be converted into equity shares after certain duration.

Notes Payable:

• Notes Payable is long term negotiable instruments of debt issued by corporate entities to secure funds from the public. These funds are used to either fund long term capital expenditure or similar long term investment opportunities.

• Notes Payable represents steady income for the investor in the form of periodic interest payments by the entity issuing the bond. Notes Payable are issued at par, at premium or at a discount.

To Determine:

Pros and Cons of Each Alternative

Answer to Problem 13SP

Solution:

Alternative A: Issue of Equity Shares:

Pros:

1. Benefit of issue of Equity shares is that out of all the three alternatives they are the least expensive source of funds.

Cons:

2. Issue of Equity shares leads to dilution of ownership

Alternative B: Issue of Preference Shares:

Pros:

1. Benefit of issue of preferred shares is that they ensure there is no dilution of ownership.

Cons:

2. Issue of preferred shares is expensive as preference dividend is payable. In the given scenario 7% preference dividend is payable.

Alternative C: Issue of Notes Payable

Pros:

1. Benefit of issue of notes payable is that they ensure there is no dilution of ownership.

Cons:

2. Issue of notes payable is expensive as interest on notes is payable. In the given scenario 10% interest is payable.

Explanation of Solution

• Issue of equity shares entails dilution of ownership. However if the cost of additional funds is to be considered, then equity shares are the least expensive of all three alternatives.

• Preferred stock would ensure there is no dilution of true ownership since, there is no voting rights with issue of preferred stock. However preference dividend is payable on an annual basis.

• Notes Payable would ensure there is no dilution of true ownership since there they are recorded as long term debt. However interest is payable on an annual basis.

Conclusion

Hence pros and cons of each alternative are listed.

3)

To determine

Introduction:

Classes of shares:

• Shares provide partial ownership or a “share” of a corporation. There are two primary classes of shares − Equity Shares and Preference Shares.

• Equity shares are the class of shares which carry voting rights and equity share holders are the true owners of the company as in the event of dissolution, equity shareholders get last preference in clearing the amounts invested and there is no guarantee of profits / dividend on an annual basis.
• Preference shares are the class of shares which do not carry voting rights and in the event of dissolution, preference shareholders get first preference in clearing the amounts invested and there is usually guarantee of profits / dividend on an annual basis. Convertible Preference shares are preference shares that carry the option to be converted into equity shares after certain duration.

To Determine:

Which class of shares should be issued

Answer to Problem 13SP

Solution:

The company should initially issue preference shares as it would ensure there is no dilution of ownership.

Explanation of Solution

• Preference shares are a class of shares which do not carry voting rights. Preference shareholders get first preference in clearing the amounts invested and there is usually guarantee of profits / dividend on an annual basis.

• When an organization is in its initial stages, it should opt for issue of preference shares since preference shareholders need to be paid only preference dividend and they do not have any voting rights.

• Since Santana anticipates healthy profits as well as an ability to sell franchises in the future, there is sufficient Bank flow, and hence, in order to ensure there is no dilution of equity, the company should initially issue preference shares.

• They may also issue convertible preference shares if the intention is to dilute equity and reduce fixed costs in the form of preference dividend. Convertible Preference shares are preference shares that carry the option to be converted into equity shares after certain duration.

Conclusion

Hence it has been explained, why the company should issue preference shares initially.