financing decisions

Financing Decisions - 1

FINANCING DECISIONS Creditors and Investors


REPORTING LIABILITIES

Short-term liabilities Long-term Bonds Payable

– Issuance– Accounting for premium or discount

Other liabilities– Long-term Leases

– Contingencies

– Pensions & Postretirement Benefits

– Income taxes

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Definition of a Lease

A lease is a contractual agreement between the lessor (owner of the property) and the lessee (user of the property), giving the lessee the right to use the lessor’s property for a specific period in exchange for stipulated cash payments

Diamond Chapter 13


Economic Advantages of Leasing

For the Lessee: No (or low) down

payment Avoid risks

associated with ownership

–Technological obsolescence

–Physical deterioration–Changing economic conditions

Flexibility

For the Lessor: Increased sales Ongoing business

relationship with the lessee

Residual value retained

Diamond Chapter 13


Lease Types

Capital leases are accounted for as if the lease agreement transfers ownership of the asset to the lessee

– The lease is equivalent to a financed purchase

– An asset and liability must be recorded on lessee’s books

Operating leases are accounted for as rental agreements, with no transfer of effective ownership associated with the lease

– Lease payments are recorded as rent expense by the lessee and rent revenue to the lessor

Diamond Chapter 13


Lease Classification Criteria

1. The lease transfers ownership of the property to the lessee by the end of the lease term

2. The lease contains a bargain purchase option

3. The lease term is equal to 75% or more of the estimated economic life of the leased property

4. The present value of the minimum lease payments equals or exceeds 90% of the fair market value of the property

A lease is classified as a capital lease if any one of the following criteria are met:

Diamond Chapter 13


Accounting for Leases

DATAOn January 1, 2006, Scully Corporation

(lessee) enters into a lease with Porter

Company (lessor) to lease a piece of

equipment for five equal annual year-end

installments of $13,870

• Accounting treatments comparedoperating leasecapital lease

• For illustration purposes only

• Classification is not elective

• Terms of the lease dictate classification

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Accounting for Operating Lease

LesseeNothing is recorded on January 1, 2006Each December 31, record rent expenseNo asset; no liability

LessorContinues to carry as an assetContinues depreciation

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Lessee Accountingfor Capital Leases

Records the equipment as an asset and records an associated liability

– The asset and liability are recorded at the present value of the lease payments using an appropriate rate of interest

Makes annual payments that are divided between interest and principal

Depreciates the asset over a 5-year period

Diamond Chapter 13


Lessee Accountingfor Capital Leases

DateAnnual

Payment

12% Interest

ExpensePrinciple

ReductionLease

Liability01-Jan-06 50,000 31-Dec-06 13,870 6,000 7,870 42,130 31-Dec-07 13,870 5,056 8,814 33,316 31-Dec-08 13,870 3,998 9,872 23,443 31-Dec-09 13,870 2,813 11,057 12,387 31-Dec-10 13,870 1,483 12,387 -

(final interest expense adjusted for rounding)

The interest amount for each year is based on 12% of the balance of the liability at the beginning of the year

Annual depreciation is $10,000 ($50,000 ÷ 5 years)


STOCKHOLDERS’ EQUITY Contributed capital

– Par value issues– Common vs. Preferred stock

Retained earnings– Cash dividends– Stock dividends

Other issues– Stock splits– Treasury stock


Corporations: An Overview

Fewer in number than sole proprietorships and partnerships, yet ...

Generate greatest dollar volume of sales revenues

Largest in terms of total assets and owners’ equity

MISSIONSTATEMENT


Characteristics of a Corporation

Separate legal entity Continuous life/transferability of

ownership Lack of mutual agency Stockholder limited liability Separation of ownership and

management Subject to double-taxation Regulated by government


STOCKHOLDERS’ RIGHTS

Stockholders generally have rights to:

Vote on important matters

Receive dividends Share in net assets

upon liquidation Maintain

proportionate ownership interest in corporation

VOTE TOELECT

DIRECTORS


Owners’ Equity is comprised of 2

elements

Paid-in Capital and Retained Earnings


Paid-in Capital (Contributed

Capital) Total amount

investors have contributed to corporation


1


Retained Earnings Corporation’s

accumulated earnings and losses since its first day of operations

Earnings not distributed back to stockholders in the form of dividends


2


Classes of Stock

PREFERRED Generally fewer

rights of stock ownership

Less risky than common stock

First to receive corporate dividends

Second claim against net assets in event of liquidation

COMMON 4 rights of stock

ownership More risk than

preferred stock Dividends not

guaranteed Residual claims on

net assets upon liquidation


Par Value

Par value - minimum legal capital of the corporation below which Stockholders’ Equity cannot fall

Par value is randomly chosen

Generally very low in amount - $.01, $.10, or $1.00


Treasury Stock

Shares of its own stock which the corporation has reacquired from investors

Similar to unissued stock No dividends paid on

treasury stock Company does not “own”

itself Treasury Stock is a

contra-equity account


1.Use shares for employee compensation– Stock option/bonus plans

2.Reduce number of shares outstanding– Might create increase in market price of

shares

3.Wait until market price of stock rises– Subsequently re-issue shares to increase

total owners’ equity

4.Withdraw shares from secondary market as defense against corporate takeover

TREASURY STOCK


Purchase of Treasury Stock

Reacquiring shares does not reduce total number of shares issued

It does reduce total number of shares outstanding

Also reduces total stockholders’ equity


Ethical Issues and Treasury Stock Transactions

Would it be ethical for a corporation to reacquire its common stock in the week prior to announcing record-breaking financial operating results for the accounting period?


Sale of Treasury Stock

No gain or loss is recognized when corporation re-issues (sells) treasury stock to investors

Sale might be made at price above or below that paid by corporation to reacquire its stock


Retained Earnings

Retained earnings represents investors’ claims against assets acquired through reinvestment of net income

Balance in Retained Earnings account is NOT the same as cash


Retained Earnings

Rather, retained earnings is a claim against all assets of the company

Cash Inventory Plant assets, etc.


Dividends

Distribution, to stockholders, of assets acquired through profitable operations

Board of Directors declares dividends– Retained Earnings balance must be

sufficient to support the declaration

But to pay cash dividends...– Cash balance must be adequate


Dividend Dates

Declaration date

Date of record

Date of Distribution


NONCUMULATIVE Similar in

character to common stock; no claim to previous years’ unpaid dividends

CUMULATIVE Previous years’

dividends owed on preferred stock which haven’t been paid must be paid before common stockholders can receive any dividends

Dividends on Cumulative and Noncumulative Preferred Stock


Stock Dividends

Shares of corporate stock given in lieu of cash dividends

Shareholders receive shares in proportion to their current level of stock ownership

Distribution doesn’t increase or decrease total stockholders’ equity

Nor does it affect total corporation assets


Why issue stock

dividends?


Stock Dividends

Allow corporation to retain cash for re-investment in operations or acquire long-term assets (PP&E) to be used for business activities

Stockholders still receive some form of “distribution” from corporation


Stock Splits Increase in number of

shares authorized, issued, and outstanding

Corresponding proportional decrease in stock’s par value

Stimulates more active trading of stocks with very high market prices


Similarities and Differences Between Stock Dividends and Stock Splits

STOCK SPLITS Increase # shares

owned and outstanding

Doesn’t change total equity or stockholders’ investments

Decreases par value of stock

Doesn’t shift amounts from one account to another

STOCK DIVIDENDS Increase # shares

owned and outstanding

Doesn’t change total equity or stockholders’ investments

Leaves par value unchanged

Shifts amounts from retained earnings to paid-in capital


“ANOTHER CHAPTERCLOSED!”

financing decisions - 1 financing decisions creditors and investors

Documents

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propertya lease

leasea lease

lesseethe lease

lessordiamond chapter

investors financing

minimum lease payments