Transcript Module 8 – Equity Recognition and Owner Financing

FINANCIAL STATEMENT
ANALYSIS & VALUATION
Third Edition
Peter D.
Easton
©Cambridge Business Publishers, 2013
Mary Lea
McAnally
Gregory A.
Sommers
Xiao-Jun
Zhang
Module 8:
Equity Recognition
and Owner Financing
©Cambridge Business Publishers, 2013
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
issuer’s stock from its investors.
2. Earned capital - Retained earnings and
accumulated other comprehensive income (AOCI).
In addition, many companies report an equity account
called noncontrolling interest, which reflects the equity of
minority shareholders.
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Components of Paid-in-Capital
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P&G’s Stockholders’ Equity
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Types of Stock
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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.
2. Participation feature – allows preferred
shareholders to share ratably with common
stockholders in dividends.
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Fortune Brands’
Convertible Preferred Stock
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Fortune Brands’
Convertible Preferred Stock
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Holders of convertible preferred are entitled to $2.67 dividends
per share.
Each share of convertible preferred stock is entitled to 3/10 of
a vote per share.
Holders of convertible preferred have a preference in liquidation
over common shareholders amounting to $30.50.
Each share of convertible preferred is convertible into 6.601
shares of common stock.
Fortune Brands has an option to redeem each share at a price of
$30.50; upon redemption, the preferred shareholder will receive
that cash amount and will surrender that share to the company.
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P&G’s
Preferred
Stock
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Aon’s Common Stock
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Par value of $1 per share.
Aon has authorized the issuance of 750 million shares.
To date, Aon’s management has issued (sold) 385.9 million
shares of stock.
Aon has repurchased 53.6 million shares from its
shareholders.
The number of outstanding shares is equal to the issued
shares less treasury shares. There were 332.3 million (385.9
million – 53.6 million) shares outstanding at the end of 2010.
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P&G’s Common Stock
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Sale of Stock Illustrated
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To illustrate, assume that AON issues 100,000 shares of
its $1 par value common stock at a market price of $43
cash per share:
1. Cash increases by $4,300,000 (100,000 shares @ $43 per share)
2. Common stock increases by the par value of shares sold (100,000 shares
@ $1 par value = $100,000)
3. Additional paid-in capital increases by the $4,200,000 difference between
the issue proceeds and par value ($4,300,000 - $100,000)
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Repurchase of Stock Illustrated
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To illustrate, assume that 3,000 common shares
of AON previously issued for $43 are
repurchased for $40:
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Repurchase of Stock Illustrated
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Now assume that these 3,000 shares are
subsequently resold for $42 cash per share:
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Aon’s Treasury Stock Section
of 2010 Balance Sheet
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Accounting for Stock Options
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Aon’s
Stock
Option
Program
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Cisco’s Stock Option Expense
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Accounting for Restricted Stock
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Accounting for Dividends:
Cash Dividends
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Aon declares and pays a cash dividend of $10
million:
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Preferred and Common Dividends
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Assume that a company has 15,000 shares of $50 par
value, 8% preferred stock outstanding and 50,000
shares of $5 par value common stock outstanding.
During its first three years in business, the company
declares $20,000 dividends in the first year, $260,000
of dividends in the second year, and $60,000 of
dividends in the third year.
If the preferred stock is cumulative, the total amount
of dividends paid to each class of stock in each of the
three years follows:
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Preferred and Common Dividends
(continued)
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Accounting for Dividends:
Stock Dividends
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Small Stock Dividends Illustrated
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Assume that a company has 1 million shares of $5 par
common stock outstanding. It then declares a small
stock dividend of 15% of the outstanding shares when
the market price of the stock is $30 per share. This
small stock dividend has the following financial
statement effects:
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Large Stock Dividends Illustrated
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To illustrate the effect of a large stock dividend,
assume that the company now declares a large stock
dividend of 70% of the outstanding shares when the
market price of the stock is $30 per share ($5 par
value). The large stock dividend will have the following
effects on the balance sheet:
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Stock Splits in the Form of a
Stock Dividend – John Deere
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Aon’s Accumulated
Other Comprehensive Income
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Foreign Currency Translation Effects
on the Balance Sheet
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Noncontrolling Interest
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Noncontrolling interest represents the equity of
noncontrolling (minority) shareholders who only have a
claim on the net assets of one or more of the subsidiaries in
the consolidated entity.
If the company acquires less than 100% of the subsidiary, it
must include 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:
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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
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The return on equity (ROE) computation is
usually performed from the perspective of the
parent company’s shareholders.
Consequently,
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the numerator is usually the net income
attributable to the parent company shareholders
and
the denominator includes only the equity of the
parent company’s shareholders (excluding
noncontrolling interest equity).
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Equity Carve Outs
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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: Conoco’s Sell-Off
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Conoco received $4.6 billion in cash, which it reported as a component of
cash flows from investing activities in its statement of cash flows.
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.
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Equity Carve Outs:
Altria’s Spin-Off of Kraft
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Equity Carve Outs:
Altria’s Spin-Off of Kraft
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Equity Carve Outs:
BMY’s Split-off of Mead Johnson
 The Treasury Stock account on Bristol-Myers’ balance sheet increased (became more
negative) by $6.9 billion (269 million shares x $25.70 per share), which reduced equity
by $6.9 billion.
 This reduction was offset, however, by the recognition of a gain on the exchange
amounting to $7.2 billion after tax.
 This split-off was affected by a tender offer with Bristol-Myers shareholders.
Consequently, it is a non pro rata exchange and is, therefore, valued at market value
with a resulting gain.
 The net effect on equity is minimal, but the income statement reports a substantial
gain for that year.
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Xilinx’s Convertible Securities
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Xerox’s Convertible Preferred Stock
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Global Accounting
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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
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U.S. GAAP has a more narrow definition of liabilities
than IFRS. Therefore, more items are classified as
liabilities under IFRS.
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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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End Module 8
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