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Chapter 6. Financing Activities. Equity Financing. Book value of shareholders’ equity: The amount of shareholders’ equity reported in the balance sheet. Is the investment base for equity/net assets used in profitability analysis, risk analysis and residual income-based equity valuation.

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Chapter 6

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Chapter 6

Chapter 6

Financing Activities


Equity financing

Chapter: 06

Equity Financing

Book value of shareholders’ equity:

The amount of shareholders’ equity reported in the balance sheet.

Is the investment base for equity/net assets used in profitability analysis, risk analysis and residual income-based equity valuation.

Shareholders’ equity is affected by:

Investments by shareholders

Distributions to shareholders

Profitable operating and investing activities


Investments by shareholders common equity issuance

Chapter: 06

Investments by Shareholders: Common Equity Issuance

Measurement: Fair value of what the corporation initially receives.

Accounting: The fair value received is split between two contributed capital accounts:

Common stock (par value) and

Additional paid-in capital (amount of fair value received that exceeds par value).

Common shareholders bear both residual upside and downside risk, sometimes limited by contracts as under a SPE.


Investments by shareholders preferred stock issuance

Chapter: 06

Investments by Shareholders: Preferred Stock Issuance

Measurement: Fair Value

Accounting: The fair value received is split between two contributed capital accounts:

Preferred stock (par value) and

Additional paid-in capital (amount of fair value received that exceeds par value).

Convertible into common shares or callable at scheduled dates or at the firm’s discretion.


Other terms

Chapter: 06

Other Terms

Subscription Agreement:

A strategy to market shares in initial public offerings.

Is an agreement whereby the companies agree to issue shares in the future and potential buyers agree to pay for the shares in the future.

Results in subscription receivable to the extent cash is not collected when subscription agreement is reached.


Other terms contd

Chapter: 06

Other Terms (Contd.)

Reporting requirements under SEC and IFRS (IAS 1):

As common equity: Fair value of subscribed shares.

As contra-equity: Fair value of the subscriptions receivable.


Distributions to shareholders dividends

Chapter: 06

Distributions to Shareholders: Dividends

Are simply a transfer (usually of cash) to shareholders of a portion of what they really own, namely, net assets of the firm.

The declaration of dividends is formalized by three important dates:

Date of declaration

Date of record

Date of payment


Types of dividends

Chapter: 06

Types of dividends

Dividends are paid in the form of:

Cash

Scrip dividends (dividends with an interest-bearing promise to pay dividends)

Property dividends

Stock dividends

Liquidating dividends (where payments to shareholders exceed the retained earnings balance)


Accounting for dividends

Chapter: 06

Accounting for dividends:


Stock dividends and stock splits

Chapter: 06

Stock Dividends and Stock Splits

Stock Dividends

Small stock dividends (< 20–25 %)

Large stock dividends

Stock Split

Are distributions =>100 %

Accounting:

Depends on appropriate state law.

Accounting rule: Total par value after the stock split = Total par value before the split.


Distributions to shareholders share repurchases

Chapter: 06

Distributions to Shareholders: Share Repurchases

Purpose:

To service the possible exercise of options.

To shift the mix of debt and equity financing.

To signal to investors that corporate management believes the stock is undervalued.

To tackle a takeover attempt.

Treasury Stock: stock repurchased for reissue at a later date.


Accounting for treasury stock

Chapter: 06

Accounting for Treasury Stock

Cost Method

Accounting:

At Repurchase: Cash disbursement and increase in treasury stock account.

At Subsequent Issue: If reissue price ≠ cost of treasury stock, increase (or decrease) additional paid-in capital.

Par Value Method (rarely used).


Disclosure for treasury stock

Chapter: 06

Disclosure for Treasury Stock:


Equity issued as compensation stock options

Chapter: 06

Equity Issued as Compensation: Stock Options

Stock Options:

The right, or option, given by firms to employees.

To acquire shares of common stock.

At a fixed price (the market price of the stock at the time the firm grants the stock option).

Exercised at a later time if the stock price increases above the stock option exercise price.

A part of a sign-on or retention package.

No use of cash.


Stock options various terms

Chapter: 06

Stock Options: Various terms

Grant date

Vesting date

Exercise date

Exercise price

Market price

Compensation Expense


Stock options fair value method and required disclosures

Chapter: 06

Stock Options: Fair Value Method and Required Disclosures

Various Pronouncements and Methods of Pricing:

Opinion No. 25 (1972): intrinsic value method

Statements No.123 and No.123 (Revised 2004): fair value method

Disclosure requirements as per Statement No.123 (Revised 2004):

Stock option grants

Effect on total compensation expense

Methodology (model) used for valuation

Key assumptions for estimating the value


Stock option elements cash flows

Chapter: 06

Stock Option: Elements & Cash Flows

Elements of (theoretical) value of a stock option:

Benefit element and

Time-value element

Option events create two cash flows on exercise of an option:

Receipt of cash from employee.

Tax savings (tax deduction as per a recent FASB rule).


Stock options accounting

Chapter: 06

Stock Options: Accounting


Alternative share based compensation restricted stock and rsus

Chapter: 06

Alternative Share-Based Compensation:Restricted Stock and RSUs

Eliminates a manager’s need to pay the exercise price.

Types:

Restricted Stock:

Shares of stock rather than options are given which cannot be traded until the vesting period is completed.

Restricted Stock Units (RSU):

Non-tradable rights for a number of shares of stock given once the vesting period is completed.


Restricted stock and rsus accounting

Chapter: 06

Restricted Stock and RSUs: Accounting


Alternative share based compensation cash settled share based plans

Chapter: 06

Alternative Share-Based Compensation:Cash-Settled Share-Based Plans

Are compensation plans that provide cash compensation to employees based on share-price appreciation.

Often called stock appreciation rights plans

Accounting for estimated cash payments:

An increase in an operating liability and

A corresponding increase in compensation expense.


Earned capital

Chapter: 06

Earned Capital

Net Income and Retained Earnings

Accumulated Other Comprehensive Income

E.g. unrealized fair value gains or losses on securities deemed available for sale, unrealized foreign currency gain or loss.

Reserves

E.g. account titled reserve for contingencies.


Summary and interpretation of equity

Chapter: 06

Summary and Interpretation of Equity

Market-to-Book Ratio = Market Price per Share/Book Value per Share

Generally, Market-to-Book Ratio >1 because book value is less than market value due to

Conservatism of accounting

Non accounting for future growth opportunities


Debt financing

Chapter: 06

Debt Financing:

Critical for understanding the profitability and risk of the firm.

Reporting for debt involves:

Principles of Liability Recognition

involves a probable future sacrifice of economic benefits.

a present obligation.

transaction or event has already occurred.

Principles of Liability Valuation

Application of Criteria for Liability Recognition


Principles of liability valuation

Chapter: 06

Principles of Liability Valuation

Valuation for liabilities:

Requiring future cash payments

Requiring future delivery of goods or services

Representing cash advances from customers

Disclosure of the fair values of financial instrument as per U.S. GAAP and optionally under FASB Statement No.159 or IASB IAS 39


Criteria for liability recognition

Chapter: 06

Criteria for Liability Recognition


Financing with long term debt

Chapter: 06

Financing with Long-Term Debt

In the form of:

Notes payable (primarily to banks and other financial institutions).

Bonds payable (to any type of bondholder, including open-market debt investors).

Leases (entered into with property owners, equipment dealers, or finance companies)

Is evidenced by a bond indenture, promissory note, or lease agreement.


Cash flows of long term debt

Chapter: 06

Cash Flows of Long-Term Debt

Net Cash Flow = Cash Inflow At Issue – Total Cash Interest – Cash Outflow at Retirement Date

Terms:

Coupon Rate or Stated Rate

Cash Interest

Effective Interest (Yield, Yield-to-maturity, Rate of return) – calculated by solving for i in:


Financial reporting of long term debt

Chapter: 06

Financial Reporting of Long-Term Debt

Balance sheet:

Maturity period >1 year: Long-Term Debt: At the present value of future cash flows.

Maturity period <= 1 year, Current Liability

Impacts current ratio drastically

To reduce the impact,

Sinking fund in liquid assets is set up to pay debt.

Entering into a refinance agreement.


Financial reporting of long term debt pronouncements

Chapter: 06

Financial Reporting of Long-Term Debt: Pronouncements

Reporting under FASB(SFAS 159) and IASB(IAS 39):

Financial Liabilities and Financial Assets: Option to value at fair value (SFAS No. 157)

Instead of amortized cost

Interest Expense of such Financial Instruments: If nothing mentioned Effective Interest Rate Method applied generally.


Reducing debt early retirement

Chapter: 06

Reducing Debt: Early Retirement

Method of Reducing Debt

Methods to retire early

Accounting:

Income statement:

Realized Gain or Loss: The difference between the amounts used to extinguish the debt and the book value of the debt.

Cash Flows from financing activities: Cash flows used to reduce debt.


Accounting for troubled debt

Chapter: 06

Accounting for Troubled Debt

Handling of troubled debt:

From debtor’s perspective

Settlement in cash or by issue of capital stock

A gain on debt settlement: the difference between the book value of the debt settled (principal plus any accrued interest) and the fair market value of the non-cash asset or cash transferred to retire the debt.

Modification of terms

Accounting

Is conservative

Ignores the present value in restructuring model


Modification of terms u s gaap

Chapter: 06

Modification of terms (U.S. GAAP)


Additional issues hybrid securities i e compound financing instruments

Chapter: 06

Additional Issues: Hybrid Securities (i.e., compound financing instruments)

Securities have both debt and equity characteristics.

Methods of recording conversion under U.S.GAAP & IFRS.

Book Value Method

Market Value Method (rarely used)


Accounting for hybrid securities

Chapter: 06

Accounting for Hybrid Securities


Off balance sheet financing arrangements

Chapter: 06

Off-Balance-Sheet Financing Arrangements

Either or combination of approaches:

Sale of an existing asset or sale-leaseback.

Use of another entity (uncontrolled entity) to obtain financing.

Ways to avoid consolidation:

Joint venture

SPE/ VIE

Financial reporting does not recognized mutually unexecuted contracts as liabilities they are mere promises.


Accounting for financial arrangements

Chapter: 06

Accounting for Financial Arrangements


Leases

Chapter: 06

Leases

Benefits to Lessees:

Ability to shift the tax benefits

Flexibility to change capacity

Ability to reduce the risk of technological obsolescence.

Ability to finance the “acquisition” of an asset.

Accounting Methods

Operating Lease Method

Capital Lease Method


Choosing the accounting method

Chapter: 06

Choosing the Accounting Method

Conditions for a capital lease:

Extends for at least 75 percent of the asset’s total expected economic life.

Transfers ownership to the lessee.

The “bargain purchase” option will be used.

The present value of the contractual minimum lease payments equals or exceeds 90 percent of the fair market value of the asset at the time of signing.


Converting operating leases to capital leases

Chapter: 06

Converting Operating Leases to Capital Leases

By Analyst

To avoid understating the short-term liquidity or long-term solvency risk of the firm.

For various firms’ cross-sectional comparisons.

If the purpose appears to be financing rather than acquisition.

Provides a more conservative measure of liabilities.

Balance sheet restatements are more significant than income statement restatements.


Impact of accounting for operating leases as capital leases

Chapter: 06

Impact of Accounting for Operating Leases as Capital Leases

Though individually impact is relatively small, cumulatively can be significant.

Thus, important for analyst:

assessing the risk and accounting quality of a firm’s financial statements.

determining capital structure weights and debt costs for the weighted average cost of capital calculations in entity valuation.


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