Module 8

©Cambridge Business Publishers, 2013

Module 8:

Equity Recognition and Owner Financing


Stockholders’ EquityTotal stockholders’ equity is divided into two components:

1.Contributed capital - proceeds received by the issuing company from original stock issuances, net of the amounts paid to repurchase shares of the issuer’s stock from its investors.

2.Earned capital - Retained earnings and accumulated other comprehensive income.In addition, many companies report an equity account called noncontrolling interest, which reflects the equity of minority shareholders.


P&G’s Stockholders’ Equity


Types of Stock There are two classes of stock:

1. Preferred Stock 2. Common Stock

Preferred stock preferences:1. Dividend preference – preferred

shareholders receive dividends on their shares before common shareholders do.

2. Liquidation preference –preferred shareholders receive payment in full before common shareholders in liquidation.


Preferred Stock Privileges

1.Conversion privileges – a conversion privilege allows preferred stockholders to convert their shares into common shares at a predetermined conversion ratio. (important for new companies)

2.Participation feature – allows preferred shareholders to share ratably with common stockholders in dividends.


Analysis of Preferred Stock

Analysts generally treat preferred stock as a form of long-term debt because it has a fixed dividend rate that is effectively an interest rate.

Preferred stock with greater equity characteristics are treated as equity, e.g., stock with dividend participation and convertible preferred that is “in the money” (likely to be converted)


Characteristics of Common Stock

Normally voting, but some classes do not vote

Dividends are at the discretion of management

Lowest level of preference if corporation is liquidated; therefore, the first to suffer loss of principal


Restricted Stock Restricted stock is given to

employees as compensation with restrictions on when it can be sold. The quantity is generally based on performance and/or continued employment

The increase in equity is recognized as the employee earns the shares


Stock Options Most stock options are used for

management compensation, but they may be issued in other instances such as in exchange for a purchase

The initial value of stock options is measured based on options pricing models, e.g., Black-Scholes and binomial models

Valuations of stock options are typically at amounts that are less than the ultimate value of the company’s cost of issuing the options, i.e., the FMV of the options when they are issued less any cash received.

Management can manipulate the valuations


Accounting for Stock Options


Tax Benefit of the Options

If the 100,000 shares have a market value of $46 each at the exercise date, the company is allowed a total tax expense of $2,000,000 [($46-$26) x 100,000] reducing income tax payable by $700,000. Only $350,000 of reduction in tax payable was recorded previously so an additional adjustment is required as follows:

APIC +$350,000Tax Payable -$350,000 Note that the total reduction to taxes

payable is $700,000 but only $1,000,000 of expense was reported in the financial statements.


Dividends & Stock Splits Cash dividends reduce Retained

Earnings Stock dividends simply reclassify

Retained Earnings as Paid-in-Capital

Stock Splits reduce the Par Value of all shares proportionally, e.g., a 4 for 1 split reduces the par value of all shares to ¼ of the original amount

Only cash dividends affect our evaluation of a company’s financial position


Stock Dividends – Issuing

Additional Shares to Existing Stockholders


Accumulated Other Comprehensive Income

These items represent cumulative changes in equity related to operations that were not reported on the income statement as revenues or expenses. Unrealized changes in the value of certain

derivatives Foreign currency translation adjustments

to balance sheet accounts Unrealized changes in the value of

postretirement benefit obligations(pension obligation)

Unrealized changes in the value of certain investments in securities


Foreign Currency Translation Effects on the Balance Sheet


Analysis of Accumulated Other Comprehensive Income

The primary issue in evaluating these equity balances is whether the corresponding assets and liabilities have been valued correctly. The Postretirement Benefit

Obligation is the most likely to be severely understated because current accounting practice delays recognition of losses. This account is also subject to easy manipulation by management.

Another important issue to evaluate is the timing of the future recognition of the gains and losses that are included in the equity balance


Minority (Noncontrolling) Interest

Noncontrolling interest represents the equity of minority shareholders who only have a claim on the net assets of a subsidiary in the consolidated entity.

If a company acquires less than 100% of the subsidiary, it includes 100% of the subsidiary’s assets, liabilities, revenues and expenses in its consolidated balance sheet and income statement, but now there are two groups of shareholders that have a claim on the net assets and earnings of the subsidiary company: The parent company, and The noncontrolling shareholders (those

shareholders who continue to own shares of the subsidiary company).


Noncontrolling Interest: Income Statement


Noncontrolling Interest: Balance Sheet


Analysis and Interpretation of Noncontrolling Interest

The return on equity (ROE) computation is usually performed from the perspective of the parent company’s shareholders.

Consequently, the numerator is usually the net

income attributable to the parent company shareholders

the denominator includes only the equity of the parent company’s shareholders (excluding noncontrolling interest equity).


Equity Carve Outs Corporate divestitures have become

increasingly common as companies seek to increase shareholder value through partial or total divestiture of operating units.

In general, these equity carve outs are motivated by the notion that consolidated financial statements often obscure the performance of individual business units, thus complicating their evaluation by market analysts.


Equity Carve Outs: Conoco’s Sell-Off

Conoco received $4.6 billion in cash, which it reported as a component of cash flows from investing activities in its SCF.

The Syncrude joint venture was reported on Conoco’s balance sheet at $1.75 billion on the date of sale.

Conoco’s gain on sale equaled the proceeds ($4.6 billion) less the carrying amount of the business sold ($1.75 billion), or $2.85 billion which Conoco rounds to $2.9 billion in the footnote referenced above.

Conoco subtracts the gain on sale in computing net cash flows from operating activities to remove the gain from net income; cash proceeds are reported as a cash inflow in the investing section.


Global Accounting Under IFRS, accounting for equity

is similar to that under U.S. GAAP. Following are a few terminology differences:


Global Accounting U.S. GAAP has a more narrow definition of

liabilities than IFRS. Therefore, more items are classified as liabilities under IFRS. For example, some preferred shares

are deemed liabilities under IFRS and equity under GAAP.

Treasury stock transactions are sometimes difficult to identify under IFRS because companies are not required to report a separate line item for treasury shares on the balance sheet. Instead treasury share transactions reduce share capital and share premium.

Module 8

Documents

cambridge

equity carve

parent companys

balance sheet

preferred

income statement

comprehensive

common shareholders