● Checkpoint Questions 4 and 5 on
page 201 (Solutions on page 210)
● Quick Study 5-5 to 5-7 on pages 220-221
(Solutions)
Example 9-1
Note that if cash dividends are debited directly to the Retained earnings account (instead of being debited to the Cash dividends declared account), there is no need to close the Cash dividends declared account.
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Exercise 16-1 solution
1 This account is a contra equity account; it is not a liability.
2 Share dividends are recorded using the market/fair value on the date of declaration.
3 Notice that no assets are being distributed to the shareholders as a result of a share dividend, unlike a cash dividend where cash, an asset, is distributed to shareholders.
Analysis component:
The market price of Delware’s shares decreased as a result of the 5% share dividend because given that the number of shares issued and outstanding increased with no additional asset investment by shareholders, the value will decrease per share (assuming no changes other than the share dividend). Since the share price is recovering after the declaration of the share dividend (as evidenced by the market price increase from January 20 to January 30 of $13.50 to $14.25), it can be assumed that shareholders have a positive future outlook for this company.
Exercise 16-2 solution
Analysis component:
The market price of Stingray’s shares decreased by about 2/3 as a result of the 3:1 share split because although the number of shares tripled, no new assets were contributed by the shareholders as a result of the share split. If the number of shares triples with no assets contributed, it is logical that the market value per share would decrease by a ratio equivalent to the increase in the number of shares.
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Analysis
A reasonable approach to this case is to start by identifying the facts and the operational issues. The facts are clearly stated in the case. It is important to recognize, however, the conflict between the managers’ fiduciary responsibility to the
shareholders and their apparent desire to increase their personal wealth through the share option plan. If the information about the new contract can be kept private until after the option plan is approved and the options are priced, the managers will stand to make much more money when they eventually exercise those options. The officer’s suggestion that annual meetings are only about the company’s past activities is misleading because shareholders are being asked to vote on the three-year stock option plan for managers. Moreover, the general point of annual meetings is to provide an opportunity for the board to be accountable to shareholders.
This case raises both legal and moral issues. It is against the law to mislead the capital markets by distributing false
information or by withholding relevant information. The managers’ decision to withhold the news is objectionable because of the share option plan. The financial vice-president should impress upon the officers and directors that withholding
information about the contract would be unethical.
Some economists and philosophers argue that rules against insider trading don’t work and that markets would be more efficient if there were no prohibitions of insider trading. So while there would not be a level playing field for investors (insider investors would know far more than investors on the outside), the market would respond more quickly and efficiently to new information and the rest of the market would learn the information quickly. Moreover, these critics claim that with no rules against insider trading, other investors (outsiders) would factor in their relative lack of knowledge in making investment decisions by hiring more knowledgeable investment experts, for example.
It is important to realize that the argument about which type of market arrangements would be more efficient — one with restrictions on insider trading and one with no restrictions — is a theoretical one. It is
not an argument that under our current arrangements (which strongly restrict insider trading), it is acceptable to act in violation of the securities regulations and to take advantage of “uninformed” investors, who trust that investments will generally be made on the basis of publicly available knowledge.
You can rightly argue that rules against insider trading should be weakened or even abolished. But it is definitely wrong to engage in insider trading in a market that has rules against it. This is to take unfair advantage of others. This is like driving on the left-hand side of the road in Canada and justifying this by claiming that it is required to drive on that side in Japan. In other words, it is one thing to argue about whether one set of rules is more desirable than another, but quite another to act on that belief when the general rule in place is the opposite.
For human interactions (including economic interactions) to work well, we have to agree on certain ground rules and trust that they are in place. Once the ground rules are in place (whether these permit or forbid insider trading), it is unfair to act as if those rules do not exist. Moreover, to act in such an unfair way undermines the trust that makes productive human interactions possible.
The ethical bottom line in this case is then crystal clear. The managers are acting unethically in withholding this information from the shareholders, and they are undermining the trust that is essential to capital markets.