Financial Reporting for Owners ’ Equity Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 15 Copyright © 2015 McGraw-Hill Education. All rights reserved.

Financial Reporting for Owners’ Equity

Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 15

Copyright  © 2015 McGraw-Hill Education.  All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education

Learning objectives

1. Why some financing transactions—like debt repurchases—produce reported gains and losses, while others—like stock repurchases—do not.

2. Why companies buy back their stock, and how they do it.

3. Why some preferred stock resembles debt, and how preferred stock is reported on financial statements.

4. How and when retained earnings limits a company’s distributions to common stockholders.

5. How to interpret the balance sheet items that constitute shareholders’ equity.

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Learning objectives:Concluded

6. How to calculate basic EPS and diluted EPS, and whether EPS is a meaningful number.

7. What GAAP says about employee stock options, and why GAAP’s accounting treatment has been so controversial.

8. How and why GAAP understates the true cost of convertible debt and how IFRS guidelines avoid this understatement.

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Overview

Why statement readers must understand the accounting and reporting conventions for owners’ equity:

Appropriate income measurement

Why are bond interest payments an expense, while dividend payments are not an expense?

Linkage to equity valuationHow does a company’s stock options, warrants, and convertible instruments affect EPS?

Legality of corporate distributions to owners

How much cash can be legally distributed to owners as dividends?

Compliance with contract terms and restrictions

How should “hybrid” securities be classified—as debt or equity?

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Appropriate income measurement:Entity and proprietary views of the firm

Entity view of the firm: Proprietary view of the firm:

AssetsLiabilities +

Owners’ equity

• This view focuses on the firm’s total assets because they drive economic performance.

• Capital sources are lumped together.

=Assets – Liabilities

Owners’ equity=

• This view focuses on the firm’s net assets.

• The firm and its owners are inseparable.

• GAAP adopts this view and says that no income or loss can arise from transactions with owners (“insiders”).

• Because creditors are “outsiders”, interest payments are a GAAP expense.

Capital deployed

Capital sources

Net capital deployed

Owners’ capital

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Accounting for common stock:Journal entries

Nahigian Corp. issues 5,000 shares of $1 par common stock at $50 per share. The company records the stock issuance as:

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Several years later, Nahigian buys back 200 shares at a cost of $48 each. The accounting entry is:

Later, Nahigian decides to resell 200 treasury shares at $53 per share:

Accounting for common stock:Balance sheet disclosure

Excerpt from the company’s balance sheet after the stock repurchase but before shares have been resold:

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Shows the dollar amount paid to buy

back shares

Stock repurchases

Why do companies buy back stock?

Share are needed for employee stock options

The stock is undervalued

Distribute surplus cashto owners

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Taxed at capital gain rates rather than ordinary income

rates

Stock repurchases:Magnitude in the U.S.

Figure 15.1The dollar value of stock repurchased each quarter 2005-2012 by U.S. companies in The Standard & Poor’s 500 Index (in $ billions)

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Stock repurchases and earnings management

Rocket Software just completed a successful third quarter with earnings of $220,000 and EPS of $1.00.

The company’s record for quarterly EPS growth is about to be broken because earnings for Q4 are predicted to be only $220,000.

How can Rocket Software increase EPS for Q4?

Some buybacks will also cause earnings to fall

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Compliance with Contract Terms

Owners’ equity is one of the accounting numbers used in contracts with lenders, suppliers, and others.

Here’s an example from National Beverage Corporation:

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Preferred stock:Characteristics

Relative to common stock, it confers on investors certain preferences to dividend payments and the distribution of corporate assets.

Preferred stockholders must be paid their dividends in full before any cash distribution can be made to common shareholders.

If the company is liquidated, preferred stockholders must receive cash or other assets at least equal to the stated (par) value of their shares before any assets are distributed to common shareholders.

Preferred dividends are declared quarterly and can be omitted.

$100 stated value,8% preferred stock

Annual dividend of $8 is not tax deductible to company

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Compliance with contract terms:How preferred stock helps

Why companies issue preferred stock:

1. It’s less risky than debt, which may appeal to financially weak companies.

2. Unlike interest expense, preferred dividends are not tax deductible but that may not matter to companies with a history of operating losses.

3. Preferred stock is treated like equity rather than debt on the financial statements.

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Preferred stock:Mandatorily redeemable preferred stock

Mandatorily redeemable preferred stock would be shown as a balance sheet liability and included with long-term debt. In addition, The FASB’s “liability” treatment requires companies to record as interest expense any dividends on the preferred stock

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Preferred stock:Trust preferred security

Motorola’s TOPrS:

Trust(SPE) • Interest payments

are tax deductible.• “Loan “ shown as

preferred stock.

Investors

Issues mandatorily redeemable preferred stock

1

Company

Loans cash proceeds to company

2

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Legality of Corporate Dividend Distributions

How large a dividend can Delores Corporation distribute to owners?

In some states, they could distribute only up to

the retained earnings amount

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Shareholders’ Equity:Financial Statement Presentation

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Shareholders’ Equity:Financial Statement Presentation

Here’s what Whole Foods has to say about the preferred stock:

The disclosures in Exhibit 15.2 reveal that Whole Foods•Declared preferred stock dividends but did not declare dividends on common stock•Issued 256,000 shares of common stock to employees and incurred $12.8 million in share-based pay expense•Experience $13.7 million in (net) unrealized losses charged to other comprehensive income

In other words, the preferred stock is convertible into common shares at any time holders so desire. It can also be exchanged for other securities or redeemed for cash.

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Shareholders’ Equity:Financial Statement Presentation

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Global Vantage PointFinancial Statement Presentation

Other aspects of IFRS for shareholders’ equity•An IFRS balance sheet often presents shareholders’ equity before liabilities•A statement of changes in shareholders’ equity is required and closely mirrors that required by U.S. GAAP•Most redeemable preferred stock is reported as debt even when redemption is not mandatory as is some preferred stock that is not redeemable

The same as capital stock – par value

for U.S. companies

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Earnings per share:Simple capital structure illustration

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Earnings per share:Simple capital structure illustration

Because additional shares were issued in September, the weighted average number of outstanding shares is computed as follows:

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Suppose Solomon’s 10,000 shares of preferred stock mandatorily convert into 20,000 shares of common stock.

In this situation, basic EPS becomes:

Earnings per share:Mandatorily convertible securities and basic EPS

No preferred dividend adjustment

Presumptive conversion

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A complex capital structure involves securities that are potentially convertible into common stock, or options and warrants that entitle holders to shares of common stock.

Diluted EPS recognizes the “dilutive” potential of these securities:

Earnings per share:Complex capital structure

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Suppose Solomon has also issued $1 million of 5% convertible bonds due in 15 years. Each $1,000 bond is potentially convertible into 10 shares of common stock.

FASB ASC Topic 260, Earnings per share, calls for the “if-converted method” to be used.

In this situation, diluted EPS becomes:

Earnings per share:Complex capital structure illustration

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In addition, Solomon has issued options to buy 20,000 shares of common stock at $100 per share.

GAAP guidelines say the “treasury stock” method must be used. Diluted EPS now becomes:

Earnings per share:Complex capital structure illustration continued

“Net” number of new shares

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Earnings per share:Analytical insights

The “if converted” method:

Assumes that all convertible bonds are exchanged for stock at the beginning of the reporting period.

But conversion is unlikely if the stock price ($75) is substantially below the conversion price ($100).

The resulting diluted EPS figure overstates likely dilution in this case and thus understates EPS.

The “treasury stock” method:

Assumes that proceeds received on exercise of the options ($100 per share) are used to buy back shares at the average market price.

If the average market price is below the exercise price, the options are not dilutive for EPS purposes.

The resulting diluted EPS figure understates likely dilution and overstates diluted EPS.

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Earnings per share:Is EPS a meaningful number?

Which firm performed the best?Company A and Company B report identical basic EPS of $10, but Company B needed twice as much equity capital and 50% more gross assets to attain the $1,000,000 net income. Company A generates more earnings from existing resources – this is, from its equity capital

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Share-based compensation

Companies use stock options:

To help align employees’ interests with the interests of owners.

To attract talented employees while conserving cash.

To take advantage of tax rules that postpone employee taxes.

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Accounting for Share-Based Compensation:Historical perspective

APB Opinion No. 25 was issued in 1972, before option valuation methods were developed.

Options issued with an exercise price equal to or above the stock market price were assumed to have no value.

As option use increased, auditors and others increasingly thought that APB No. 25 was incorrect.

The FASB began to reconsider the approach in 1984.

Case 1: No expense recorded

Option with $20 exercise

price

Share price is $20.01 at grant date.

Case 2: Expense is recorded

Option with $20 exercise

price

Share price is $19.99 at grant date.

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Accounting for Share-Based Compensation:Opposition to the FASB

The FASB’s initial recommendation:

Opposition surfaced in the business community (and in Congress) based on arguments about:

Appropriate income measurement Compliance with contract terms and conditions Legality of corporate distributions to owners Equity valuation

Stock option with $20

exercise price

• Valued at grant date using accepted option pricing model.

• Charge to compensation expense over vesting period.

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Accounting for Share-Based Compensation:The initial compromise—SFAS No. 123

Figure 15.2Employee stock option reporting

alternatives under SFAS No. 123

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Accounting for Share-Based Compensation:SFAS No. 123 illustration

The entry to record compensation expense each year of the vesting period:

The entry to record the exercise of employee stock options:

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Accounting for Share-Based Compensation:The debate rekindled—opponents

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Accounting for Share-Based Compensation:The debate rekindled—proponents

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Convertible debt:Smithfield Foods’ debt offering

Investors paid $1,000 cash for each $1,000 face value 45% convertible debt security issued by the company.

The cash flows—interest and principal discounted present value at 10% were worth only $772.55.

Why were investors willing to pay $227.45 more than the cash flows were worth?

$400 million of convertible

notes paying 4% interest

• Matures in 5 years.• Investors can convert into 44

shares of common stock.

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Convertible debt:Accounting issues

GAAP specifies that convertible bonds must be recorded as debt only, with no value assigned to the option privilege.

So, Smithfield’s entries would be:

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Convertible debt:Accounting issues at conversion

GAAP permits companies to record debt conversions in either of two ways:

1. The Book value method records the newly issued stock at the book value of debt retired.

2. The Market value method records the newly issued shares at their current market value

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Convertible debt:Analytical insights

Estimating the future cash flow implications of convertible debt is difficult.

Recorded interest expense may seriously understate the true cost of debt financing for companies that issue convertible bonds or notes.

The recent appearance of “zero-coupon, zero yield” convertible debt underscores the inherent deficiencies of GAAP.

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Global Vantage Point

Unlike U.S. GAAP, the IFRS guidelines for convertible debt requires the liability and equity components to be separated.

This approach recognized that when a company issues convertible debt it is really issues two distinct types of securities:

Debt that may be in the form of a bond or

a note

An option to convert that debt into shares

of stock

Even though investors pay just one price for the combined

financial instrument

Represents a balance

sheet liability

Shareholders’ equity

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Summary

Aspects of financial reporting for owners’ equity are built on: Technical rules that have evolved over time. Rules that have not evolved despite changing economic and legal

environments. Complicated pronouncements that reflect political compromises.

Stock buybacks don’t produce accounting gains or losses, but they can be used to artificially inflate reported EPS.

Preferred stock that has a mandatory redemption feature looks a lot like debt, so GAAP now requires it to be classified as debt in most cases.

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Summary concluded

Some companies can pay dividends in excess of their retained earnings balance, but their ability to do so depends on state law.

EPS numbers are adjusted for potential dilution from stock options, warrants, and convertible securities.

GAAP now requires companies to record compensation expense when stock options are given to employees.

GAAP can understate interest expense when companies issue traditional convertible debt, but IFRS rules overcome this deficiency.

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