Module 8

Reporting and Analyzing Owner Financing Activities

Reporting and Analyzing Owner Financing Activities The assets of a company must be financed

from one of two sources: 1. It borrows funds

2. It obtains capital from its shareholders.

On average, companies obtain about half of their capital from borrowed sources and the other half from shareholder investment.

Debt vs. EquityDebt Equity

Formal legal contract No legal contract

Fixed maturity date No fixed maturity date

Fixed periodic payments Discretionary dividends

Security in case of default Residual asset interest

No voice in management Vote - board of directors

Interest expense Dividends reduce RE

Reporting and Analyzing Owner Financing Activities

Stockholders’ equity is accounted for at historical cost, just like assets and liabilities.

When a company sells stock to the investing public, it records the receipt of cash and the increase in stockholders’ equity, representing increased investment in the company by the shareholders.

Reporting and Analyzing Owner Financing Activities There is an important difference between the

accounting for stockholders’ equity and the accounting for transactions involving assets and liabilities: there is never any gain or loss recorded on the purchase and sale of stock or the payment of dividends.

Instead, these “gains” and “losses” are reflected in increases (decreases) in the paid-in-capital component of stockholders’ equity.

Components of Paid-in-Capital

Stockholders’ Equity

Total stockholders’ equity is divided into two major components:

1. Paid-in-capital –This section is comprised of paid-in-capital (preferred stock and common stock), and additional paid-in-capital. Both of these accounts are generically referred to as paid-in-capital.

Treasury stock – This account represents the amounts paid to repurchase shares of stock from investors, net of the proceeds from the resale of those shares.

Stockholders’ Equity

Total stockholders’ equity is divided into two major components:

2. Earned capital – The retained earnings account represents the cumulative profits of the company that have not yet been paid out to shareholders in the form of dividends. Accumulated other comprehensive income (OCI) includes a number of changes to stockholders’ equity that have not impacted earnings and are, therefore, not reflected in the retained earnings account.

Types of Stock

There are two often classes of stock:

1. Common Stock

2. Preferred Stock

Some More Jargon

Authorized, Issued, Outstanding Market Value Book Value Par Value

Preferred Stock

Preferred stock generally has some preference, or priority, with respect to common stock.

Preferred Stock

Two common preferences are:1. Dividend preference – preferred shareholders

receive dividends on their shares before common shareholders do.

2. Liquidation preference – in the event of the failure of the company, preferred shareholders will receive payment in full before common shareholders. This liquidation preference makes preferred shares less risky to own in the event of business failure than common shares.

Types of Preferred Stock Cumulative preferred: dividends in arrears

and current year’s dividends must be paid before common dividends can be paid.

Convertible preferred: convertible into a specified number of shares of common.

Accounting for Stock Transactions: Sale of Stock From an accounting standpoint, cash increases by the

number of shares sold multiplied by the market price of the stock on the date of sale.

Equity also increases by the same amount, and this increase is reflected in the paid-in-capital accounts.

Assuming that common stock is issued, the common stock account increases by the number of shares sold multiplied by the par value and the additional paid-in-capital account increases for the remainder.

Sale of Stock Illustrated

To illustrate, assume that Pfizer issues 10,000 shares of $0.05 par value common stock at a market price of $43 per share. The sale of stock has the following effects on the balance sheet:

1. Cash increases by $430,000 (10,000 shares x $43)

2. Common stock increases by the par value of the shares issued (10,000 shares x $0.05 = $500)

3. Additional paid-in capital increases for the remainder of the purchase price

Shareholder Sells Stock to Another Party

No affect on company accounts.

Company notes change of owners and address of owners.

Treasury Stock

Corporation’s own stock that has been issued and reacquired.

Reasons to reacquire own stock: Limited investment opportunities. To increase stock price. To increase EPS. To issue stock bonus to employees. To prevent hostile takeover.

Accounting for Stock Transactions: Repurchase of Stock When common stock is repurchased, both

assets (cash) and stockholders’ equity decrease by the purchase price.

The reduction in stockholders’ equity is accomplished by increasing a contra-equity account called treasury stock.

Repurchase of Stock Illustrated To illustrate, assume that 3,000 of the shares issued

above for $43 are subsequently repurchased for $40. The repurchase will have the following effects on the balance sheet:

Repurchase of Stock Illustrated Now assume that these 3,000 shares are subsequently

resold for $42. The resale of the treasury stock has the following effects on the balance sheet:

Retained Earnings

Cumulative net income earned since inception of company less cumulative total dividends paid.

Cash Dividends

Why pay dividends? At declaration (vote of the BOD): decrease

RE and increase Dividends Payable. At date of record, figure out who is entitled to

the dividend, no entry. At payment, reduce Dividends payable and

reduce Cash.

Dividends

Companies pay dividends out of retained profits. Dividends are usually paid in cash on a quarterly basis.

Stock analysts closely monitor the payment of dividends.

It is generally perceived that the level of dividend payments is related to long-term expected core earnings.

As a result, dividend increases are usually accompanied by stock price increases, and companies rarely reduce their dividends unless absolutely necessary.

Dividend reductions are, understandably, greeted with significant stock price declines.

Accounting for Dividends: Cash Dividends The accounting for cash dividends is straightforward. Both

cash and retained earnings are reduced by the amount of the cash dividends paid.

In 2003, Pfizer paid $4.771 billion of cash dividends on its common shares The payment of these dividends had the following effects on its financial statements:

Stock Dividends

Increases every shareholders’ interest by the same proportion of shares, say 5%.

Have you really received anything?

Accounting for Dividends: Stock Dividends Although most dividends are paid in cash,

dividends can also be paid in the form of the company’s stock.

In this case, retained earnings are reduced and paid-in-capital is increased.

In addition, the amount by which retained earnings are reduced depends on the proportion of the outstanding shares distributed.

Stock Split

Each shareholder receives a multiple of shares previously held.

(As in a stock dividend,) no change in total shareholders’ equity.

Comprehensive Income

Comprehensive Income includes all recognized changes in equity that occur during a period except those resulting from investments by owners and distributions to owners.

Thus, included in comprehensive income but excluded from net income are foreign currency adjustments, unrealized changes in the fair value of available-for-sale securities, minimum pension liability adjustments, and changes in the market values of certain derivative investments.

Pfizer’s Statement of Stockholders’ Equity