Equity on the FAR Test of the CPA Exam
The financial accounting and reporting (FAR) test of the CPA exam tests your knowledge of equity. Normally, when companies pay dividends to shareholders, they do so in cash. However, businesses can use other assets as property dividends. Whether cash is paid or some other asset is distributed, the transaction reduces the equity section of the balance sheet.
For example, suppose a company owns land at a cost of $100,000. The firm wants to pay a property dividend to a large shareholder. The company declares a dividend on March 27. This declaration date is the date on which the board of directors announces the next dividend payment.
Now assume that the land has a fair market value of $150,000 on the declaration date. When the property dividend is paid, the firm makes this journal entry:
Debit property dividend $150,000
Credit gain on disposition of property $50,000, land $100,000
This entry treats the land as if it were sold at fair market value. The debit to property dividend reduces equity for the fair market value of the land. Land is credited for its carrying amount ($100,000). Because land doesn’t depreciate, the land’s carrying value (cost less accumulated depreciation) is the same as original cost.
The difference between the carrying amount and fair value is a $50,000 gain. You know it’s a gain because you need a credit entry to make total debits equal credits.
Stock appreciation rights (SARs) are a method to reward valuable employees for staying with your firm. The reward is the increase in the market price of the company’s stock. A firm starts out by setting an exercise price, the stock price that’s subtracted from the market price to determine the value of the SAR. For example, suppose that the exercise price is $20.
One SAR allows the holder to receive the difference between the market price and the exercise price in cash. In this example, assume 10,000 rights are issued on December 31, Year 1.
To earn the benefit from exercising the SARs, the employee must complete a service period. Say the service period is 2 years. That means that the worker can exercise the SARs and receive cash starting on December 31, Year 3.
Suppose that the market price of the stock on December 31, Year 2, is $40. A typical FAR test questions will ask you to calculate the compensation expense and the liability for the SARs plan for Year 2. Here are the steps to answer the questions:
Compute the difference between the market price of the stock and the exercise price per share.
As of December 31, Year 2, the calculation is $40 – $20 = $20. Twenty dollars is the value of one right.
Multiply the value of one right by the number of rights issued.
That amount is $20 x 10,000 = $200,000. The $200,000 is total estimated compensation expense.
To compute the compensation expense, divide the total estimated compensation expense by the service period.
That calculation is $200,000 / 2 years = $100,000 per year of service. At the end of Year 2, 1 year of the service period has passed. The company should debit compensation expense $100,000 and credit liability for SARs $100,000.
When the service period ends on December 31, Year 3, an employee can exercise the SARs. Note that the market price of the stock may have changed, so the amount of compensation expense and liability may be adjusted. When the value of a right is paid to the worker, the firm debits (reduces) liability for SARs and credits cash.