[inviteyou]

After reading the answer solution, I still don’t get it because it seems like you are double counting the equity portion. First you add it to $400,000 to get $500,000 and subtract that from what they owed the creditors of $1,200,000 to get a “gain” of $700,000. But then to answer the question stem you back the $100,000 to the $700,000 to get the stockholders’ equity. Wouldn’t their equity be the $700,000? It looks like I’m missing some piece of the this concept. Does anyone have an explanation for this question from Wiley?

On December 30, 20×4, Hale Corp. paid $400,000 cash and issued 80,000 shares of its $1 par value common stock to its unsecured creditors on a pro rata basis pursuant to a reorganization plan under Chapter 11 of the bankruptcy statutes. Hale owed these unsecured creditors a total of $1,200,000. Hale’s common stock was trading at $1.25 per share on December 30, 20×4.

As a result of this transaction, Hale’s total stockholders’ equity had a net increase of
A. $1,200,000
B. $800,000
C. $100,000
D. $80,000

Answer is B: The market value of the stock issued to the creditors is $100,000 (80,000 × $1.25). The fair value of consideration paid to settle the debt therefore is $500,000 ($400,000 cash + $100,000 of stock). The gain on settling the debt therefore is $700,000 ($1,200,000 − $500,000 total consideration).

The gain increases owners’ equity by way of net income. The issuance of stock is recorded at market value, $100,000. Thus, the total owners’ equity increase is $800,000 ($700,000 + $100,000). Note that this amount is also the difference between the amount of debt retired ($1,200,000) and cash paid ($400,000).

[AusNat]

I'm not 100% sure where you're getting confused, but think about it in terms of balancing the accounting equation – A=L+E. They're asking you to determine the change in equity. You know that both sides of the equation (A and L+E) have to change by the same amount in order to stay in balance.

They give up $400,000 of cash, so assets are reduced by $400,000.
They get rid of $1,200,000 of debt, so liabilities decrease by $1,200,000
Now your equation reads -400,000 = -1,200,000 + E
Solve for E… in order to keep your equation (books) balanced, equity has to increase by $800,000. That makes sense, because it's also the sum of the gain from giving creditors $500,000 worth of consideration to pay off $1,200,000 worth of debt (gain = increase in retained earnings) PLUS the additional stock issued (increase in paid-in capital). What changes equity? Changes in retained earnings and/or changes in paid-in-capital.

[Author]

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