Financial Reporting for Owners ’ Equity Revsine/Collins/Johnson/Mittelstaedt: Chapter 15 Copyright © 2009 by The McGraw-Hill Companies, All Rights Reserved. McGraw-Hill/Irwin

RCJM: Chapter 15 © Learning objectives 1.Why some financing transactions—like debt repurchases— produce reported gains and losses, while others—like stock repurchases—do not. 2.Why companies buy back their stock, and how they do it. 3.Why some preferred stock resembles debt, and how preferred stock gets reported on financial statements. 4.How and when retained earnings limits a company’s distributions to common stockholders. 5.How to calculate basic EPS and diluted EPS, and whether EPS is a meaningful number.

RCJM: Chapter 15 © Learning objectives: Concluded 6.What GAAP says about employee stock options, and why GAAP’s accounting treatment has been so controversial. 7.How and why GAAP understates the true cost of convertible debt and what to do about this understatement. 8.Why employee stock ownership plans (ESOPs) have become popular, and what they mean to statement readers.

RCJM: Chapter 15 © Overview Why statement readers must understand the accounting and reporting conventions for owners’ equity: Appropriate income measurement Compliance with contract terms and restrictions Legality of corporate distributions to owners Linkage to equity valuation Why are bond interest payments an expense, while dividend payments are not an expense? How does a company’s stock options, warrants, and convertible instruments affect EPS? How much cash can be legally distributed to owners as dividends? How should “hybrid” securities be classified— as debt or equity?

RCJM: Chapter 15 © Appropriate income measurement: Entity and proprietary views of the firm  Entity view of the firm:  Proprietary view of the firm: Assets Liabilities + Owners’ equity This view focuses on the firm’s total assets because they drive economic performance. Capital sources are lumped together. = Assets – Liabilities Owners’ equity = 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. Capital deployed Capital sources Net capital deployed Owners’ capital

RCJM: Chapter 15 © Stock repurchases Why do companies buy back stock?How do companies buy back stock? Share are needed for employee stock options The stock is undervalued Distribute surplus cash to owners Open market repurchase Fixed price tender offer Dutch auction tender offer

RCJM: Chapter 15 © 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

RCJM: Chapter 15 © Earnings per share: Simple capital structure illustration

RCJM: Chapter 15 ©  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

RCJM: Chapter 15 © Earnings per share: Analytical insights 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 overstates likely 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.

RCJM: Chapter 15 © 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 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.

RCJM: Chapter 15 © 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: DR Cash $100,000,000 CR Convertible subordinated debentures $100,000,000 DR Interest expense $5,250,000 CR Cash $5,250,000

RCJM: Chapter 15 © 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.

RCJM: Chapter 15 © 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.

RCJM: Chapter 15 © 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 now requires companies to record compensation expense when stock options are given to employees.  GAAP ignores the option value in convertible debt and can understate interest expense, but this too may soon change.