Financial Reporting for Owners’ Equity Revsine/Collins/Johnson: Chapter 15
Learning objectives • Why some financing transactions—like debt repurchases—produce reported gains and losses, while others—like stock repurchases—do not. • Why companies buy back their stock, and how they do it. • Why some preferred stock resembles debt, and how preferred stock gets reported on financial statements. • How and when retained earnings limits a company’s distributions to common stockholders. • How to calculate basic EPS and diluted EPS, and whether EPS is a meaningful number.
Learning objectives:Concluded • What GAAP says about employee stock options, and why GAAP’s accounting treatment has been so controversial. • How and why GAAP understates the true cost of convertible debt and what to do about this understatement.
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?
Entity view of the firm: Proprietary view of the firm: Appropriate income measurement:Entity and proprietary views of the firm Assets Liabilities + Owners’ equity Assets – Liabilities Owners’ equity = = Capital deployed Capital sources Net capital deployed Owners’ capital • This view focuses on the firm’s total assets because they drive economic performance. • Capital sources are lumped together. • This view focuses on the firm’s net assets. • The firm and its owners are inseparable. • GAAP adopts this view and says that no income or loss can arise from transactions with owners (“insiders”). • Because creditors are “outsiders”, interest payments are a GAAP expense.
Several years later, Nahigian buys back 200 shares at a cost of $48 each. The accounting entry is: DRTreasury stock $9,600 CR Cash $9,600 A contra-equity account • Later, Nahigian decides to resell 200 treasury shares at $53 per share: DRCash $10,600 CR Treasury stock $9,600 CR Paid-in capital in excess of par 1,000 Accounting for common stock:Journal entries • Nahigian Corp. issues 5,000 shares of $1 par common stock at $50 per share. The company records the stock issuance as: DRCash $250,000 CR Common stock -$1 par value $5,000 CR Paid-in capital in excess of par 245,000
Accounting for common stock:Balance sheet disclosure • Excerpt from the company’s balance sheet after the stock repurchase but before shares have been resold: Shows the dollar amount paid to buy back shares
Why do companies buy back stock? How do companies buy back stock? Stock repurchases Share are needed for employee stock options Open market repurchase The stock is undervalued Fixed price tender offer Distribute surplus cash to owners Dutch auction tender offer
Stock repurchases:Frequency and magnitude in the U.S. • Number of Stock Repurchases Announced by U.S. Companies from 1980-1999 • Dollar Value of Stock Repurchases Announced by U.S. Companies from 1980-1999
Stock repurchases and earnings management • Rocket Software just completed a successful third quarter with earnings of $220,000 and EPS of $1.00. • The company’s record for quarterly EPS growth is about to be broken because earnings for Q4 are predicted to be only $220,000. • How can Rocket Software increase EPS for Q4? Some buybacks will also cause earnings to fall
Compliance with contract terms • Owners’ equity is one of the accounting numbers used in contracts with lenders, suppliers, and others. • Here’s an example from Sears Roebuck and Company: Allstate Dividends Sears (owns 100% of Allstate)
Preferred stock:Characteristics • Relative to common stock, it confers on investors certain preferences to dividend payments and the distribution of corporate assets. • Preferred stockholders must be paid their dividends in full before any cash distribution can be made to common shareholders. • 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. • Preferred dividends are declared quarterly and can be omitted. $100 stated value, 8% preferred stock Annual dividend of $8 is not tax deductible to company
Preferred stock in the U.S. The Dollar Value of Preferred Stock Issued by U.S. Companies from 1980 to1997
Compliance with contract terms:How preferred stock helps Why companies issue preferred stock: • It’s less risky than debt, which may appeal to financially weak companies. • Unlike interest expense, preferred dividends are not tax deductible but that may not matter to companies with a history of operating losses. • Preferred stock is treated like equityrather than debt on the financial statements.
Mandatorily redeemable preferred:Balance sheet disclosure Outside of “shareholders” equity section
Mandatorily redeemable preferred:FASB now requires a different approach • SFAS No.150 requires “liability” treatment of these securities. • Beginning in 2003, Sealed Air can no longer show its mandatorily redeemable preferred stock in the “mezzanine” section of the balance sheet. • Instead, the securities must be listed along side traditional long-term debt, and the related preferred dividends must be recorded as an interest expense. • Special GAAP rules will apply if the preferred stock is conditionally redeemable.
Preferred stock:Trust preferred stock 1 • Motorola’s TOPrS: Issues mandatorily redeemable preferred stock Investors Trust (SPE) • Interest payments are tax deductible. • “Loan “ shown as preferred stock. Company 2 Loans cash proceeds to company
Legality of corporate dividend distributions • How large a dividend can Delores Corporation distribute to owners?
Dividends at Holiday Corporation Paid out more than just retained earnings Stockholders’ equity becomes negative
Earnings per share:Mandatorily convertible securities and basic EPS • Suppose Solomon’s 10,000 shares of preferred stock mandatorily convert into 20,000 shares of common stock. • In this situation, basic EPS becomes: No preferred dividend adjustment Presumptive conversion
Earnings per share:Complex capital structure • A complex capital structure involves securities that are potentially convertible into common stock, or options and warrants that entitle holders to shares of common stock. • Diluted EPS recognizes the “dilutive” potential of these securities:
Earnings per share:Complex capital structure illustration • Suppose Solomon has also issued $1 million of 5% convertiblebonds due in 15 years. Each $1,000 bond is potentially convertible into 10 shares of common stock. • SFAS No. 128 calls for the “if-converted method” to be used. • In this situation, diluted EPS becomes:
Earnings per share:Complex capital structure illustration continued • In addition, Solomon has issued options to buy 20,000 shares of common stock at $100 per share. They were issued on 2/9/2003 and expire on 2/9/2006. • SFAS No. 128 says the “treasury stock” method must be used. • Diluted EPS now becomes: “Net” number of new shares
The “if converted” method: Assumes that all convertible bonds are exchanged for stock at the beginning of the reporting period. But conversion is unlikely if the stock price ($75) is substantially below the conversion price ($100). The resulting diluted EPS figure overstateslikely dilution in this case and thus understates EPS. The “treasury stock” method: Assumes that proceeds received on exercise of the options ($100 per share) are used to buy back shares at the average market price. If the average market price is below the exercise price, the options are not dilutive for EPS purposes (SFAS No. 128). The resulting diluted EPS figure understates likely dilution and overstates diluted EPS. Earnings per share:Analytical insights
Earnings per share:Is EPS a meaningful number? • Which firm performed the best?
Stock-based compensation Companies use stock options: • To help align employees’ interests with the interests of owners. • To attract talented employees while conserving cash. • To take advantage of tax rules that postpone employee taxes. The Number of U.S. Employees Holding Stock Options
Stock options accounting:Historical perspective • APB Opinion No. 25 was issued in 1972, before option valuation methods were developed. • Options issued with an exercise price equal to or above the stock market price were assumed to have no value. • As option use increased, auditors and others increasingly thought that APB No. 25 was incorrect. • The FASB began to reconsider the approach in 1984. Case 1: No expense recorded Option with $20 exercise price Share price is $20.01 at grant date. Case 2: Expense is recorded Option with $20 exercise price Share price is $19.99 at grant date.
Stock options accounting:Opposition to the FASB • The FASB’s initial recommendation: • Opposition surfaced in the business community (and in Congress) based on arguments about: • Appropriate income measurement • Compliance with contract terms and conditions • Legality of corporate distributions to owners • Equity valuation Stock option with $20 exercise price • Valued at grant date using accepted option pricing model. • Charge to compensation expense over vesting period.
Stock options accounting:The compromise—SFASNo. 123 Employee Stock Option Reporting Alternatives Under SFAS NO. 123
The entry to record the exercise of employee stock options: DRCash (30,000 x $30) $900,000 DR Paid-in capital –stock options ($100,500 x 3 years) 301,500 CR Common stock –par ($20 x 30,000) $600,000 CR Paid-in capital in excess of par 601,500 Stock options accounting:SFASNo. 123 illustration • The entry to record compensation expense each year of the vesting period: DRCompensation expense $100,500 CR Paid-in capital –stock options $100,500
Stock options accounting:Cisco Systems With stock options expensed Without stock options expensed
Convertible debt:VerticalNet’s debt offering • Investors paid $1,000 cash for each $1,000 face value 5.25% convertible debt security issued by the company. • The cash flows—interest and principal discounted present value at 8% were worth only $890.20. • Why were investors willing to pay $109.80 more than the cash flows were worth? $1,000 convertible bond paying 5.25% interest • Matures in 5 years. • Investors can convert into 50 shares of common stock.
Convertible debt:Popularity in the U.S. The Dollar Value of Convertible Debt Issued by U.S. Companies from 1980 to 1997
Convertible debt:Accounting issues • APB Opinion No. 14 governs accounting for convertible debt, and it predates modern option pricing theory. • It says convertible debt must be recorded as debt only, with no value assigned to the option privilege. • So, VerticalNet’s entries would be: DRCash $100,000,000 CR Convertible subordinated debentures $100,000,000 DRInterest expense $5,250,000 CR Cash $5,250,000
2. Market value method DRConvertible subordinated debentures $50,000,000 DR Loss on debt conversion 25,000,000 CR Common stock ($1 par) $2,500,000 CR Paid-in capital in excess of par 72,500,000 Convertible debt:Accounting issues at conversion • APB Opinion no. 14 permits companies to record debt conversions in either of two ways: 1. Book value method DRConvertible subordinated debentures $50,000,000 CR Common stock ($1 par) $2,500,000 CR Paid-in capital in excess of par 47,500,000
Convertible debt:Analytical insights • Estimating the future cash flow implications of convertible debt is difficult. • Recorded interest expense may seriously understate the true cost of debt financing for companies that issue convertible bonds or notes. • The recent appearance of “zero-coupon, zero yield” (or “no no”) convertible debt underscores the inherent deficiencies of APB Opinion No. 14. • GAAP in this area may soon change.
Summary • Aspects of financial reporting for owners’ equity are built on: • Technical rules that have evolved over time. • Rules that have not evolved despite changing economic and legal environments. • Complicated pronouncements that reflect political compromises. • Stock buybacks don’t produce accounting gains or losses, but they can be used to artificially inflate reported EPS. • Preferred stock that has a mandatory redemption feature looks a lot like debt, so GAAP now requires it to be classified as debt in most cases.
Summary concluded • Some companies can pay dividends in excess of their retained earnings balance, but their ability to do so depends on state law. • EPS numbers are adjusted for potential dilution from stock options, warrants, and convertible securities. • GAAP doesn’t yet require companies to record compensation expense when stock options are given to employees—but this could soon change. • GAAP ignores the option value in convertible debt and can understate interest expense, but this too may soon change.