Module 8: Equity Recognition and Owner Financing

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Stockholders Equity
Total 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 issuers 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.
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P&Gs Stockholders Equity

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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.

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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.
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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)

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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

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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

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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 companys 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

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Accounting for Stock Options

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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 +$350,000 Tax 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.
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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 of the original amount Only cash dividends affect our evaluation of a companys financial position

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Stock Dividends Issuing Additional Shares to Existing Stockholders

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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

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Foreign Currency Translation Effects on the Balance Sheet

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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

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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 subsidiarys 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).

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Noncontrolling Interest: Income Statement

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Noncontrolling Interest: Balance Sheet

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Analysis and Interpretation of Noncontrolling Interest

The return on equity (ROE) computation is usually performed from the perspective of the parent companys shareholders. Consequently,

the numerator is usually the net income attributable to the parent company shareholders the denominator includes only the equity of the parent companys shareholders (excluding noncontrolling interest equity).

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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.

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Equity Carve Outs: Conocos 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 Conocos balance sheet at $1.75 billion on the date of sale. Conocos 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.

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Global Accounting

Under IFRS, accounting for equity is similar to that under U.S. GAAP. Following are a few terminology differences:

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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.

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