22 Sep Case Study: Statement of Cash Flows Assignment? Read: Revsine: Chapter 16, 20 Read: Chapter 16 – Financial Reporting and Owners’ Equity R
Case Study: Statement of Cash Flows Assignment
- Read: Revsine: Chapter 16, 20
- Read: Chapter 16 – Financial Reporting and Owners' Equity
- Read: Chapter 20 – Statement of Cash Flows
- Watch: Module 7 Presentation
https://canvas.liberty.edu/courses/950718/pages/watch-module-7-presentation?module_item_id=90922885
Financial Reporting for Owners’ Equity
Revsine/Collins/Johnson/Mittelstaedt/Soffer: Chapter 16
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Learning Objectives After studying this chapter, you will understand:
How to account for transactions with shareholders.
Why companies buy back their stock, and how they do it.
How preferred stock balance sheet classification affects equity-based debt covenants.
How retained earnings limits a company’s distributions to common stockholders.
How to interpret the balance sheet items that constitute shareholders’ equity.
What generally accepted accounting principles (G A A P) say about employee stock options, and why the accounting treatment has been controversial.
How G A A P accounts for tax benefits associated with employee stock options.
How G A A P and I F R S account for convertible debt.
How to calculate and interpret basic earnings per share (E P S) and diluted E P S.
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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?
Compliance with contract terms and restrictions
How should “hybrid” securities be classified—as debt or equity?
Legality of corporate distributions to owners
How much cash can be legally distributed to owners as dividends?
Linkage to equity valuation
How does a company’s stock options, warrants, and convertible instruments affect EPS?
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What Constitutes the “Firm”? 1
Under the GAAP view, the firm is the net capital deployed.
Ownership perspective of the firm:
Assets – Liabilities
=
Owners’ equity
Net capital deployed
Owners’ capital
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What Constitutes the “Firm”? 2
Owners are the “insiders” who provide that net capital.
No income or loss can arise from transactions between the firm and its owners because owners are not outsiders.
Banks and bondholders are outsiders—hence, interest costs are expenses.
Shareholders are not outsiders—thus, dividends are a distribution of earnings to owners, not an expense of the company.
As a result, some increases (decreases) in owners’ equity are considered to be income (loss), while other increases (decreases) are not income (loss).
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Accounting for Share Issuances and Repurchases
Terminology:
Shares of common stock are the equity shares that provide the opportunity for purchasers to participate in the company’s future profitability
Par value refers to the nominal value or face value of a security—a dollar amount printed on the face of each stock certificate.
Limited liability makes investing in common stock attractive because although potential gains from ownership are unlimited, the risk of loss is limited to the share purchase price.
Nahigian Corp. issues 5,000 shares of $1 par common stock at $50 per share. The company records the stock issuance as:
| DR Cash | $250,000 | |
| CR Common stock—$1 par value | $ 5,000 | |
| CR Paid-in capital in excess of par | 245,000 |
Difference between issue price and par value
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Accounting for Treasury Stock 1
When a corporation buys back its own shares, the repurchased shares are called treasury stock if the shares are to be held in the corporate treasury for later use.
Later, Nahigian reacquires 200 of these shares at a cost of $48 each.
| DR Treasury stock | $9,600 | |
| CR Cash | $9,600 |
Contra-equity account Treated as a reduction in owners’ equity
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Accounting for Treasury Stock 2
Nahigian Corporation
Owners’ Equity
| Common stock, $1 par value, 5,000 shares issued | $ 5,000 |
| Paid-in capital in excess of par | 245,000 |
| Retained earnings (assumed for illustration) | 700,000 |
| Total paid-in capital and retained earnings | $ 950,000 |
| Less: Treasury stock (at cost) | (9,600) |
| Total owners’ equity | $ 940,400 |
Cost method
The cost of treasury stock is deducted from the other owners’ equity accounts.
The number of issued shares remains at 5,000.
There are 4,800 outstanding shares (5,000 issued less 200 in treasury).
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Accounting for Treasury Stock Transactions 1
Nahigian Corporation
Owners’ Equity
| Common stock, $1 par value, 5,000 shares issued | $ 5,000 |
| Paid-in capital in excess of par | 245,000 |
| Retained earnings (assumed for illustration) | 700,000 |
| Total paid-in capital and retained earnings | $ 950,000 |
| Less: Treasury stock (at cost) | (9,600) |
| Total owners’ equity | $ 940,400 |
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Accounting for Treasury Stock Transactions 2
Several months later, Nahigian decides to resell 100 treasury shares at $53 per share.
| DR Cash | $5,300 | |
| CR Treasury stock | $4,800 | |
| CR Paid-in capital from treasury stock | 500 |
100 shares × ($53 − $48)
The $53 per share selling price is $5 per share higher than the $48 paid to reacquire the shares.
No gain is recognized because the transaction is between the firm and its owners.
Instead, the difference is credited to Paid-in capital from treasury stock.
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Accounting for Treasury Stock Transactions 3.
Later, Nahigian sells the remaining 100 shares of treasury stock for $40 per share.
| DR Cash | $4,000 | |
| DR Retained earnings | 300 | |
| DR Paid-in capital from treasury stock | 500 | |
| CR Treasury stock | $4,800 |
100 shares × ($48 − $40) = $800
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Accounting for Treasury Stock Transactions 4
The $40 per share selling price is $8 per share less than the $48 originally paid to reacquire the treasury shares.
The shares were resold at $800 less than their cost.
The Paid-in capital from treasury stock has a $500 balance (prior to this transaction).
This account cannot carry a negative (debit) balance.
Therefore, to account for the $800 difference:
Paid-in capital from treasury stock is debited for $500, which reduces the account balance to zero.
Retained Earnings is debited for the remaining $300 difference.
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Accounting for Treasury Stock Transactions 5
What if shares are repurchased and permanently retired?
Nahigian reacquires 200 shares at a cost of $48 per share. (Here, the purchase price is less than the original issue price of $50.)
| DR Common stock—$1 par value | $ 200 | |
| DR Paid-in capital in excess of par | 9,400 | |
| CR Cash | $ 9,600 |
Common stock is reduced for the par value of shares retired.
Paid-in capital account is reduced for the “excess” purchase price.
If, instead, Nahigian reacquires the 200 shares at a cost of $56 per share. (The purchase price exceeds the original issue price of $50.)
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Accounting for Treasury Stock Transactions 6
| DR Common stock—$1 par value ($1 × 200) | $ 200 | |
| DR Paid-in capital in excess of par ($49 × 200) | 9,800 | |
| DR Retained earnings ([$56 − $50] × 200) | 1,200 | |
| CR Cash ($56 × 200) | $11,200 |
Original issue price of $50 – Par value of $1
Balances entry
Common stock is reduced for the par value of shares retired.
Paid-in capital account is reduced by the difference between the original issue price and the par value.
Retained earnings is also reduced to balance the entry.
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Why Companies Repurchase Their Common Shares
Firms reacquire their own common stock for many reasons:
Shares are needed for employee stock option redemptions
Management belief that shares are undervalued at prevailing market price
Avoid hostile takeover using company’s own cash surplus to partially finance takeover
Distribute surplus cash to shareholders; taxed to them lower capital gain rates
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Magnitude of Stock Repurchases in the U.S.
Figure 16.1 THE DOLLAR VALUE OF STOCK REPURCHASED EACH QUARTER 2014 to 2018 BY U.S. COMPANIES IN THE STANDARD & POOR’S 500 INDEX (IN BILLIONS)
SOURCE: C. McGrath, “S&P 500 Companies Buy Back $806 Billion in 2018,” Pensions & Investments, March 25, 2019. The Standard & Poor’s 500 Index (S&P 500) is one of the most commonly used benchmarks for the overall U.S. stock market. A team of analysts and economists at Standard & Poor’s chooses 500 stocks for the index based on market size, liquidity, and industry grouping, among other factors.
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Stock Buybacks Motivated by Desire to Boost EPS
Some stock buybacks are motivated solely by a desire to boost EPS.
Rocket Software just completed a successful third quarter with earnings of $220,000 and EPS of $1.00.
This was the ninth consecutive quarter that Rocket Software’s EPS increased by 10% or more.
Fourth quarter earnings are projected to be only $220,000, unchanged from the third quarter.
How can Rocket Software keep its EPS record intact for the fourth quarter?
Management could increase the EPS numerator by finding ways to grow sales revenues or reduce expenses.
Or the company could decrease the EPS denominator by buying back some of its common stock as follows:
| Without Buyback | With Buyback | |
| Projected fourth quarter earnings | $220,000 | $220,000 |
| Common shares outstanding | 220,000 | 200,000 |
| Projected EPS | $ 1.00 | $ 1.00 |
As long as earnings fall by less (in percentage terms) than the buyback percentage reduction in shares outstanding, EPS will indeed go up!
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Equity-based Covenants and Preferred Stock
Owners’ equity is one of the accounting numbers used in many contracts with lenders, suppliers, and others.
Lending agreements usually include covenants that restrict maximum allowable debt-to-equity levels, where equity refers to the book value amount disclosed on the company’s balance sheet.
[A] subsidiary of the Company maintained unsecured revolving credit facilities with banks aggregating $100 million (the “Credit Facilities”). . . . The Credit Facilities requires the subsidiary to maintain certain financial ratios, including debt to net worth and debt to EBITDA (as defined in the Credit Facilities), and contain other restrictions, none of which are expected to have a material effect on our operations or financial position. At April 28, 2018, we were in compliance with all loan covenants.
Source: National Beverage Corp. Annual Report, year ended April 28, 2018, p. 19.
Firms have incentives to use their financial reporting latitude to circumvent these contractual restrictions.
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Characteristics of Preferred Stock 1
Relative to common stock, preferred stock confers certain preferences:
Preferred shareholders must be paid their dividends in full before a cash distribution can be made to common shareholders.
Participating preferred stock entitles its holders to share in profits above the declared dividend along with common shareholders.
Most preferred stock is nonparticipating, meaning that holders are entitled to receive only the stipulated dividends.
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.
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Characteristics of Preferred Stock 2
Preferred stock dividends are not contractual obligations; the board of directors does not have to declare preferred dividends.
$25 stated value,
8% preferred stock
Dividend would be $2 per share ($25 stated value × 8%)
Preferred shares are usually cumulative. If a particular quarter’s preferred dividend is not declared, no dividends on common shares can be paid until all unpaid past and current preferred dividends are paid.
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Compliance with contract terms: How preferred stock helps
Why do companies raise capital through preferred stock rather than using debt, which has tax-deductible interest payments?
It’s less risky than debt because missing a preferred dividend payment will not trigger bankruptcy (unlike missing an interest payment).
Companies with a history of operating losses usually do not pay income taxes and, as a result, debt has no tax advantage.
Preferred stock is treated like equity rather than debt on the financial statements.
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Mandatorily Redeemable Preferred Stock
A company that issues mandatorily redeemable preferred stock is required to retire it (as with debt) at some future date—usually in 5 or 10 years.
Most mandatorily redeemable preferred stock must be reported as a liability (rather than in the owners’ equity) section of the balance sheet.
Companies are also required to record the related preferred stock dividends as interest expense.
As of January 1, 2016, 1,000 shares of Series A preferred stock were authorized, of which 40 shares were issued and outstanding. The dividends are recorded as a component of Interest expense as the Series A preferred stock is treated as a liability for accounting purposes.
Source: Marriott Vacations Worldwide Corporation, Form 10-K for the fiscal year ended January 1, 2016.
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Trust Preferred Security
A new form of mandatorily redeemable preferred stock, called a trust preferred security (T P S), has become popular.
Nondeductible preferred dividends now are deductible interest expense
Similar to the mandatorily redeemable preferred stock, most trust preferred securities are shown on the balance sheet as liabilities.
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Legality of Corporate Dividend Distributions
How large a dividend (cash and/or property) can Delores Corporation distribute to owners?
| Common stock, $1 par value | $ 20,000,000 |
| Paid-in capital in excess of par | 35,000,000 |
| Retained earnings | 43,000,000 |
| Owners’ equity | $ 98,000,000 |
The majority of states have adopted the Revised Model Business Corporation Act as a guide to the legality of dividend distributions.
As long as the fair value of assets exceeds the fair value of liabilities after the distribution, the company is considered to be solvent.
In extreme cases, this means that an asset distribution would be legal even if the book value of net assets is negative after the distribution.
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Stock Dividends and Stock Splits
What happens when a company distributes stock?
Under current U.S. G A A P, stock dividends reduce retained earnings, but stock splits may not.
Small stock distributions (less than 25% of shares outstanding) are required to be recorded as stock dividends.
The market value of the distributed shares is transferred from retained earnings to the par value and paid-in capital accounts.
Distributions that equal or exceed 25% of shares outstanding—commonly called stock splits—can be treated in either of two ways:
Like a true split, which reduces the per share par value and increases the number of shares proportionately.
Like a stock dividend.
Stock dividends and stock splits recorded as stock dividends reduce the company’s future cash dividend-paying ability in states where cash dividends are limited by retained earnings.
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Shareholders’ Equity: Financial Statement Presentation
EXHIBIT 16.2 Marriott Vacations Worldwide Shareholders’ Equity Excerpts
| (in millions except share and per share data) | 2018 | 2017 |
| Preferred stock—$.01 par value; 2,000,000 shares authorized; none issued or outstanding | $ — | $ — |
| Common stock—$.01 par value; 100,000,000 shares authorized; 57,626,462 and 36,861,843 shares issued, respectively | 1 | — |
| Treasury stock—at cost; 11,633,731 and 10,400,547 shares, respectively | (790) | (694) |
| Additional paid-in capital | 3,721 | 1,189 |
| Accumulated other comprehensive income | 6 | 17 |
| Retained earnings | 523 | 529 |
| Total MVW Shareholders’ Equity | $ 3,461 | $ 1,041 |
| Total Liabilities and Equity | $ 9,018 | $ 2,845 |
Source: Marriott Vacations Worldwide Corporation, Form 10-K, December 31, 2018.
Number of outstanding shares = Number of issued shares – Number of treasury shares
Total equity is also called the book value of the firm.
Book value per share = Common equity ÷ Number of common shares outstanding
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Statement of Shareholders’ Equity
Other comprehensive income (OCI) is the change in AOCI.
EXHIBIT 16.3 Marriott Vacations Worldwide Statement of Consolidated Shareholders’ Equity Excerpts
Comprehensive income equals net income plus OCI.
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Global Vantage Point: Equity Presentation
| G A A P | I F R S | |
| Negative balance in retained earnings | Called “retained earnings deficit” | Called “accumulated losses” |
| Called up share value (on IFRS balance sheet) | Somewhat akin to the Capital stock–par value account | Used when investors pay less than the nominal par value (company can later ask for remaining amount by “calling up” shares) |
| Liabilities | Liabilities presented before shareholders’ equity | Shareholders’ equity often presented before liabilities |
| Redeemable preferred stock | Reported as equity unless mandatorily redeemable | Most redeemable preferred stock reported as debt even when redemption is not mandatory, as is some preferred stock that is not redeemable |
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Accounting For Share-based Compensation
Companies use stock options to augment cash compensation for several reasons:
Options help align employees’ interests with the interests of owners (stockholders).
Many “start-up” high-growth companies are “cash starved” and
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