[Kairos]

The question is as follows:

The following accounts were among those reported on Luna Corp.’s balance sheet at December 31, 20X0:

Investment in trading securities at market, net (cost $80,000) $140,000

Preferred stock, $20 par value, 20,000 shares issued and outstanding $400,000

Additional paid-in capital on preferred stock $30,000

Retained earnings $900,000

On January 20, 20X1, Luna exchanged all of the marketable securities for 5,000 shares of Luna’s preferred stock. Market values at the date of the exchange were $150,000 for the marketable securities and $30 per share for the preferred stock. The 5,000 shares of preferred stock were retired immediately after the exchange. Which of the following journal entries should Luna record in connection with this transaction?

The answer is

Debit

Preferred stock $100,000

Additional paid-in capital on

preferred stock $7,500

Retained earnings $42,500

Credit

Trading securities $140,000

Gain on exchange of securities $10,000

Can anyone tell me where the $100,000 and $7,500 is coming from? Thanks

[Anonymous]

There are two ways of accounting for the re-acquisition of stock – retain the shares as treasury stock, or retire the shares. In this problem, we are retiring. In this case (but treasury stock is different), we want to make as if the stock had never been sold. So we need to debit the accounts at the same rates they were credited at the time of sale.

Based on the balance sheet values, APIC was increased at the rate of $1.50 per stock, because there is $30,000 in APIC & there were 20,000 stocks issued & outstanding.

So when we buy/trade them back, we will credit Preferred Stock @ 5,000 shares x $20 par = $100,000

credit APIC-Preferred Stock @ 5,000 shares x $1.50 par = $7,500

credit Retained Earnings for the balance = (5,000 shares x $30 market) – $107,500 above = $42,500

[Kairos]

Thanks so much for the explanation. It's much clearer now!

[Author]

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