ACF 101 102 Introductory Financial Accounting Introductory Financial

ACF 101 -102 Introductory Financial Accounting Introductory Financial Statement Analysis LECTURE 14

Learning Outcome Understand the accounting concepts and conventions present in accepted accounting principles and their application in financial statements analysis. Appraise financial performance and the position of an organisation through the calculation and review of a number of basic ratios and various methods of analysis.

Topics Stockholders equity Ethical nature of accounting practice GAAP IAS

Describe the rights of shareholders.

Stockholders (owners of the company) are entitled to a. vote. b. share in corporate profits. c. share residually in corporate assets upon liquidation. d. acquire more shares of subsequent issues of stock.

Corporations hold annual meetings of shareholders to vote on important matters (election to the board of directors, employee bonus plans, choosing outside auditors, etc. ).

Preemptive rights are the rights to acquire a pro-rata amount of any new issues of capital stock.

Present shareholders are allowed to purchase additional shares directly from the corporation, before the shares can be sold to the general public.

The shareholders are able to maintain their percentage of the ownership

Limited liability is a right of common shareholders, which means that creditors of the corporation have claims only on the assets owned by the corporation, not on the assets of the owners of the corporation. Only in the special case of professional corporations do shareholders have unlimited liability.

Account for common stock, including payment of dividends.

The total number of shares that may be issued is known as the authorized shares. When the company receives cash in exchange for stock certificates, the shares become issued shares.

Shares that are issued and held by the stockholders are called outstanding shares. Treasury stocks are shares reacquired by the company by purchasing them from shareholders. These shares are issued but not outstanding.

Cash Dividends 1. Dividends are proportional distributions of assets to shareholders to satisfy their claims arising from the generation of net income. Distributions of assets other than cash are infrequent. Usually, U. S. firms pay dividends quarterly. 2. The declaration date is the date on which the board formally announces that it will pay a dividend.

Shareholder Rights Corporations - authorized per state laws Stockholders’ rights ◦ Vote on some issues and board of director members ◦ Directly vote ◦ Grant others the right to vote for you (Proxy) ◦ Share in corporate profits (dividends) ◦ Share in any assets left at liquidation (after paying of claims by debt holders) 15 of 31

Shareholder Rights Stockholders’ rights - continued ◦ Acquire more shares of subsequently issued stock (preemptive rights allow current stockholders to retain the same proportion of ownership) ◦ Limited liability ◦ Creditors have claims only on the corporation’s assets ◦ Stockholders’ personal assets are not at risk 16 of 31

Common Stock Articles of incorporation ◦ Approved by the state where the Corp. is chartered ◦ Detail number/types of shares that can be issued Number of Shares are described as ◦ Authorized – total shares that can be issued ◦ Issued - shares sold to stockholders ◦ Outstanding—shares still held by the stockholders after repurchasing some shares (treasury stock) Par Value (stated value) ◦ Old way of stating the minimum value of each stock ◦ Basically meaningless today but still used in accounting 17 of 31

Common Stock Issue common stock ◦ Par value = $. 01 ◦ Issue 1 M shares, each share is bought for $50 Cash 50, 000 Common stock at par 10, 000 Additional paid-in capital * 49, 990, 000 • Amount above par value. If state does not require usage of par value, credit the common stock account for $50 million Issue preferred stock – Same as above only change the account names 18 of 31

Common Stock Dividends – one of two things investors seek ◦ Cash - proportional distributions of income to shareholders. To pay cash dividends a corporation must have: ◦ Cash (uncommitted to current/future needs) ◦ Retained earnings (state laws often limit the amount of dividends payable to the amount of unrestricted retained earnings) ◦ Bond covenants that allow dividends ◦ Stock (later) ◦ Declared by the board of directors - not automatic ◦ 19 of 31

Common Stock Dividends - continued ◦ Three important dates associated with dividends: ◦ Date of declaration ◦ Date when board announced the dividends ◦ E. g. , Sept. 26; $20, 000 (must have it available) ◦ Date of record ◦ If own the stock on this day, receive dividends ◦ E. g. , Oct. 15 ◦ Date of payment ◦ Date the company makes payment ◦ E. g. , Nov. 10 20 of 31

Common Stock Dividends - continued ◦ Sept. 26 – Date of declaration Retained Earnings * Dividends Payable 20, 000 ◦ Some will debit a “Dividends” account which is then closed directly to Retained Earnings at year-end ◦ Oct 15 – Date of record – no entry ◦ Nov 10 – Date of payment Dividends Payable Cash 21 of 31 20, 000

Preferred Stock Special features of preferred - Dividends ◦ Stated as X% times par value or $Y per share ◦ Paid to preferred before common ◦ Cumulative - If dividends aren’t declared, they accumulate (Dividend arrearages or Dividends in Arrears) and must be paid before common stockholders can receive dividends ◦ Amount is typically a fixed amount that is lower than noncumulative share dividend rate ◦ Participating – can receive dividends above the fixed amount if a good year and declared 22 of 31

Preferred Stock Special features of preferred - Liquidation ◦ Liquidation preference ◦ Must pay off all debts first (least risky) ◦ Whatever is left goes to preferred (moderate risk), then to common stockholders (most risky) ◦ Liquidation value (often the same as par value) plus any dividends in arrears) must be paid to preferred before distributions to common stockholders 23 of 31

Preferred Stock Special features of preferred - Life ◦ Can be indefinite like common ◦ Callable preferred stock gives the company the right to redeem the stock at a certain call price ◦ Convertible preferred stock gives the owner the option to exchange preferred for common shares • Special features of preferred – Other things ◦ ◦ 24 of 31 Vote - typically none Other – practically anything the company wants and investors are willing to purchase

Preferred Stock Feature Contract Common None Duration Indefinite Control Elect Board Dir. Return None specified Maybe Dividends Stockholders’ Equity Appreciation Risk in Liquidation 25 of 31 Unlimited Last in line Preferred Moderate length Sometime Indefinite Callable Usually none Debt Lengthy/specific Dividends Cumulative Participating Stockholders’ Equity Interest Hardly any unless convertible Before common None unless convertible Definite Callable Through covenants Tax deductable Income Statement Before Stockholders

Preferred Stock Options ◦ Rights given to others (usually employees) to buy a specified number of shares at a specific price for a specific period of time. ◦ Idea is to align employees’ interests with those of the company, i. e. , to enhance shareholders’ wealth ◦ A form of compensation other than $ ◦ ◦ 26 of 31 Grant - Options announced to the employee Vest – Employee worked the requisite time; can buy Exercise – Employee buys the stock Expire – Right to purchase ends (e. g. , 5 years)

Preferred Stock Options Example ◦ 30, 000 shares of previously granted options became vested allowing holders to buy the stock at $50/share ◦ When vested, a share’s value was estimated at $7 Compensation expense, stock options Additional paid-in capital (30, 000 × $7) 210, 000 ◦ 5 years later employees exercise all options because the market price of a share has risen to $60 Cash (30, 000 shares × $50) 1, 500, 000 Common Stock ($. 01 par value × 30, 000) 300 Additional paid-in capital 1, 499, 700 27 of 31

Preferred Stock Restricted stock – various constraints not found in normal stock such as ◦ ◦ Employees cannot sell the stock until it vests While holding, receive dividends Often sold back to the Co. at the going market price Restricted stock has value whereas stock options “under water” (market price lower than purchase price) makes the options worthless Compensation expense, restricted stock XXX Common Stock (at par value) YYY Additional paid-in capital ZZZ 28 of 31

Stock Splits – Issue additional shares for each share currently owned ◦ 2 for 1: Get 2 new in exchange for 1 old, or get 1 more new share for each old share owned (now own 2) Why split? ◦ Since give away no assets or change liabilities, total equity remains unchanged ◦ For a 2 for 1 split ◦ Number of shares outstanding doubles ◦ Market value for each share decreases 50% thus making it more affordable to more investors 29 of 31

Stock Splits Key to understanding splits (e. g. , 2 for 1) Common stock account = # shares times its par value $200, 000 = 1, 000 × $0. 20 2 for 1 - par value doesn’t change $400, 000 = 2, 000 × Additional Paid in Capital Common Stock 2 for 1 - par value does change $200, 000 = 2, 000 × $. 10 No entry – Par value change explained in footnotes 30 of 31 $0. 20 200, 000

Stock Dividends Stock dividends ◦ Paid in the company’s own shares of common stock ◦ No change in par value ◦ Essentially transfers claims from Retained Earnings to Common Stock, i. e. , Owners’ Equity total does not change ◦ Recording depends upon whether the stock dividend is large or small ◦ Large > 20% new shares measured at par value ◦ Small < 20% new shares measured at market value 31 of 31

Stock Dividends Example - 100% new shares issued; par = $10; market value = $150 per share; 100, 000 shares now outstanding Large – measured at par value Retained earnings (100, 000 × $10) 1, 000 Common stock 1, 000 • Small – measured at market value Retained Earnings (100, 000 × 20% × $150) 300, 000 Common Stock (100, 000 × 20% × $10) 20, 000 Additional Paid in Capital 280, 000 32 of 31

Stock Dividends Cash dividends related to stocks that split ◦ Normally cut the dividend proportionally so the same total dollar amount is paid, i. e. , stockholder does not get any more than before (half as much for twice the shares) ◦ But can also leave it at its old rate or announce a new rate which obviously benefits the stockholder Why use splits and dividends? - Whatever the motivation, it affects the future, not present Fractional Shares - If entitled to 4. 8 shares, get 4 shares plus market value of. 8 shares in cash 33 of 31

Repurchase of Shares Companies repurchase shares because they: ◦ ◦ Want to retire the stock Think the stock is undervalued by the market Need shares to distribute in a stock option plan Want to return cash to shareholders without creating expectations for permanent increases in dividends (shareholders decide whether to sell their shares) ◦ Want to change ratio calculations ◦ EPS increases ◦ Debt to equity increases - leverage 34 of 31

Repurchase of Shares Retire ◦ Originally issued the shares at $50 per share ◦ Purchase 5, 000 shares ($10 par value) at $150 for a total of $750, 000 cash. Common stock (5, 000 × $10) * 50, 000 Additional paid-in capital (5, 000 × $40) * 200, 000 Retained earnings (difference) 500, 000 Cash (5, 000 × $150) 750, 000 * Undoes entry when shares were initially sold 35 of 31

Treasury Stock – buy back for subsequent reissue ◦ Need shares for employee stock options or bonuses Treasury stock (5, 000 shares × $150) 750, 000 Cash 750, 000 ◦ Treasury stock is a contra stockholder equity account—not an asset, i. e. , reduces total and average owners’ equity accounts, thus improving ratios based on that/those amount, i. e. , ROE ◦ Shares are not entitled to vote or receive dividends ◦ Never impacts the income statement or its accounts 36 of 31

Treasury Stock Reissue 5000 shares at $180/share (above $150) Cash (5000 shares × $180) 900, 000 Treasury stock (original cost) 750, 000 Additional paid-in Capital 150, 000 Reissue 5000 shares at $120/share (below $150) Cash (5000 shares × $120) 600, 000 Additional paid-in Capital Treasury stock (original cost) 150, 000 750, 000 - Additional paid-in capital can decline to $0. Beyond that, debt entry would be to Retained Earnings 37 of 31

Other Issuances of Common Stock Noncash exchanges and conversion Asset (buy an asset, e. g. building) Liability (pay it off or convert it by issuing stock) Preferred Stock (if convertible) Additional Paid in Capital-preferred zz Common Stock Additional Paid in Capital 38 of 31 WW xx yy AA BB

Other Issuances of Common Stock State laws or contractual obligations often restrict retained earnings (and assets) for the protection of creditors ◦ Dividends cannot be paid out to the point that retained earnings becomes less than the cost of treasury stock ◦ Companies can disclose restrictions by ◦ Footnotes ◦ Line item on the balance sheet called restricted or appropriated retained earnings 39 of 31

Other Issuances of Common Stock Other items can appear in stockholders’ equity: ◦ Accumulated Other Comprehensive Income (Loss), which can arise from: ◦ ◦ Foreign currency translation adjustments Unrealized investment gains/losses (Chapter 12) Certain pension liability adjustments Other events affecting Owners Equity the FASB felt should not be reported in net income ◦ Deferred Compensation Agreements where there is an obligation to deliver shares in the future 40 of 31

Stockholders’ Equity Ratios Return on (common) Equity (ROE) measures a company’s profitability based on the common stockholders’ investment ROE = Net income – Preferred dividends Average common equity * * Beginning owners’ equity Less beginning preferred equity + Ending owners’ equity Less ending preferred equity 41 of 31 2

Stockholders’ Equity Ratios Book value per share = Total stockholders’ equity Market value per share – daily quoted pricevalue of preferred stock of common stock – Book Average common equity ◦ A market value well the book value may indicate unrecorded or appreciated Book value to above = Market value per share common assets such as R&D, patents developed in house, etc. Market value Book value per share of common ◦ Or overpricing in the market 42 of 31