1. Equity Recognition and Owner Financing
Module 8
Equity Recognition and Owner Financing
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2. Examine stock as a financing source and explain its various features.1
Examine stock as a financing source and explain its various features.
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3. J&J’s Stockholders’ Equity
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4. J&J’s Stockholders’ Equity Accounts
Preferred stock
Johnson & Johnson is authorized to issue up to 2,000,000 preferred shares, but to date has not issued any—the balance is $0.
Common stock
Par value. The par value of its common stock (as stated in its charter) is $1 per share.
Authorized shares. It can issue up to 4,320,000,000 shares without further shareholder approval.
Issued shares. To date, it has sold (issued) 3,119,843,000 shares at the $1 par value and thus, the common stock account has a balance of $3,120 million.
Accumulated Other Comprehensive Income (AOCI)
This account reflects the cumulative total of changes to stockholders’ equity other than from transactions with owners and transactions reflected in net income.
This account can be a positive or negative amount.
Retained earnings
The cumulative sum of net income recorded since its inception less all of the dividends the company has ever paid out to shareholders.
Treasury stock
The treasury stock balance is a cumulative amount that reflects open-market repurchases and subsequent resale of its shares.
On January 3, 2016, the company held 364,681,000 shares for which it paid $22,684 million.
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5. Book Value per Share
A measure commonly used by analysts and the financial press is book value per share.
This is the equity (net book value) of the company that is available to common shareholders and is defined as:
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6. Statement of Stockholders’ Equity
The statement of stockholders’ equity reconciles the beginning and ending balances of the stockholders’ equity accounts.
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7. Preferred Stock
Preferred Stock is a multi-use security with a number of desirable features.
In addition to usual dividend and liquidation preferences, preferred stock has two other common features.
Yield. Preferred stock can be structured to provide investors with a dividend yield that is similar to an interest rate on a bond.
Conversion privileges. Preferred stock can contain an option that allows investors to convert their preferred shares into common shares at a pre-determined number of common shares per preferred share.
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8. Convertible Preferred Stock — Dow Chemical —
Dow’s convertible preferred stock
Pays a dividend of 8.5% of par value, or $340 million ($4,000 million x 8.5%), and
The preferred shares are convertible into common shares at a pre-determined conversion ratio of common shares for each preferred share.
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9. J&J’s Common Stock
Johnson & Johnson has one class of common stock that has the following attributes.
A par value of $1.00 per share.
Par value is an arbitrary amount set when the company was formed and has no relation to, or impact on, the stock’s market value. Generally, par value is only used to allocate proceeds from stock issuances between the two contributed capital accounts on the balance sheet: common stock and additional paid-in capital.
4,320,000,000 shares of stock have been authorized for issuance.
The company cannot issue (sell) more shares than have been authorized. If more shares are needed, say for an acquisition, the stockholders must vote to authorize more shares.
To date, JNJ has issued (sold) 3,119,843,000 shares of common.
The number of issued shares is a cumulative amount. Year-over-year changes in the number of issued shares represent the number of shares of stock issued in the current year.
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10. J&J’s Common Stock continued
To date, JNJ has repurchased 364,681,000 shares from its stockholders at a cumulative cost of $22,684 million.
These shares are currently held in the company’s treasury, hence the name treasury stock. These shares neither have voting rights nor do they receive dividends.
Number of outstanding shares is equal to the issued shares less treasury shares.
There were 2,755,162,000 (3,119,843, ,681,000) shares outstanding at the end of 2015.
Number of outstanding common shares multiplied by the market price per share yields the market capitalization (or market cap) for the company. As of December 31, 2015, JNJ’s market capitalization was $283 billion (2,755,162,000 shares outstanding 3 $ per share).
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11. Noncontrolling Interest
Many companies report an additional equity account called noncontrolling interest.
This account arises when the company controls a subsidiary but does not own all of the subsidiary’s stock. That is, the company owns > 50% of the stock, but less than 100%.
The noncontrolling interest is the portion of the subsidiary’s stock NOT owned by the company.
The noncontrolling interest account increases with any additional investment made by the noncontrolling shareholders and by their share of the subsidiary’s net income whose common stock they own.
The account decreases by any dividends paid to the noncontrolling shareholders and by share of any net losses of the subsidiary.
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12. Analyze stock issuances and repurchases.2
Analyze stock issuances and repurchases.
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13. Stock Issuance
Companies issue stock to obtain cash and other assets for use in their business.
Stock issuances increase assets (cash) by the issue proceeds.
Equity increases by the same amount, which is reflected in contributed capital accounts.
If the stock has a par value, the common stock account increases by the number of shares sold multiplied by its par value.
The additional paid-in capital account increases by the remainder.
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14. Stock Issuance Financial Effects
Assume that JNJ issues 1,000 shares with
A $1.00 par value common stock,
At a market price of $100 cash per share.
This stock issuance has the following financial statement effects.
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15. Stock Repurchase Financial Effects
Assume that
200 common shares of JNJ previously issued for $100 are repurchased for $90 cash per share.
This repurchase has the following financial statement effects.
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16. Reissuing Treasury Stock
Assume that
These 200 shares of treasury stock are subsequently resold for $95 cash per share.
This resale of treasury stock has the following financial statement effects.
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17. Treasury Stock Disclosures and Interpretation
The treasury stock section of JNJ’s balance sheet is reproduced below.
JNJ repurchased a cumulative total of 364,681,000 shares of common stock for $22,684 million, an average repurchase price of $62.20 per share.
These shares, while legally owned by JNJ, have no voting rights and receive no dividends.
Treasury shares can be reissued should JNJ need to raise capital or acquire another entity.
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18. 3
Interpret stock-based compensation, including restricted stock and options.
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19. Stock-Based Compensation
Companies use a range of stock-based compensation plans that share the following features.
Create incentives for employees to think and act like shareholders.
The amount of the stock award is often tied to corporate performance targets including sales, income, and stock price.
Stock-based compensation plans motivate employees to work hard and make decisions that improve company performance.
Encourage employee retention and longevity.
With most plans, employees earn the right to own or purchase shares over time. The period of time over which ownership rights are earned is called the vesting period.
During this vesting period, employees have greater incentive to stay with the company.
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20. Types of Stock-Based Compensation Plans
The following stock-based compensation plans are widely in use today and companies often maintain more than one of these plans at the same time.
Restricted stock. Shares are issued to the employee but the employee is not free to sell the shares during a restriction period.
Restricted stock units (RSUs). Employee is awarded the right to receive a specified number of shares (or cash equivalent) after a vesting period.
Unlike restricted stock, shares are not issued to the employee until after the restriction period, at which time the employee has all of the rights of a shareholder (but not during the vesting period).
Stock option plans. Employees are given the right to purchase shares at a fixed (strike) price for a specified period of time.
Stock appreciation rights (SARs). Employees are paid in cash or stock for the increase in share price, but do not purchase shares of stock.
Employee share purchase plans. Employees are permitted to purchase shares directly from the company at a discounted price, typically a set percentage (such as 85%) of the prevailing market price.
Most stock-based compensation plans contain forfeiture provisions—if the employee is terminated for cause or, leaves the company before the rights to receive shares are vested, the award is forfeited.
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21. Analysis of Stock-Based Compensation Plans
There are two analysis issues relating to stock-based compensation plans:
Expense Recognition. When shares or options are awarded to employees, companies estimate the fair value of the award and recognize the fair value as compensation expense in the income statement over the period in which the employee provides service.
Potential Dilution. Dilution relates to the number of common shares outstanding that have a claim against the company’s earnings or net assets.
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22. Accounting for Stock-Based Compensation
Regardless of the type of stock-based compensation plan, there are common accounting steps.
When the award is granted to employees, the company estimates the fair value of the award.
The fair value of the award is recorded as an expense in the income statement, ratably over the vesting period.
When the shares are issued, common stock and additional paid-in capital increase in the same manner as for cash-based stock issuances, as described above.
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23. Reporting Stock-Based Compensation
Stock-based compensation expense is included on the income statement but rarely reported as a separate line item.
Cost of goods sold (for employees in R&D and manufacturing) or
Selling general and administrative expense (for employees in selling and administration and executive roles).
We can determine the amount of the expense from the statement of cash flows.
Because stock-based compensation expense is a non- cash expense, companies add back this expense in the statement of cash flow.
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24. Is Stock-Based Compensation a Cash Expense?
The stock-based compensation add-back might lead some to conclude that this form of compensation is cash free.
However, a real cash cost occurs when the company buys new treasury shares in the open market to offset the dilution created by the share award to the employees.
To accurately evaluate and forecast operating cash flow, analysts must either include stock-based compensation expense or recognize the related treasury-stock purchase as an operating cash outflow.
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25. Footnote Disclosures for Stock-Based Compensation
Footnotes describe two facets of a company’s stock-based compensation:
Plan Activity
Number of shares granted to employees during the year.
Number of shares issued during the year to satisfy awards that vested.
Any shares forfeited—when employees leave the company or fail to exercise options within the specified time period.
Fair Value and Expense
Fair value of the stock-based compensation awards.
How fair value is determined.
Restricted stock awards are valued using the share price on the date of the award.
Stock option plans are valued using option pricing models (Black-Scholes model and the bilateral model.
The expense on the income statement.
Value of the shares issued to employees over and above the price the employee paid for shares (this difference is called the intrinsic value).
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26. Analyze cash dividends and their financial effects.4
Analyze cash dividends and their financial effects.
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27. Dividend Payout and Yield
Dividend Payout The dividend payout ratio measures the proportion of the company’s earnings that is paid out as dividend—it is defined as:
Dividend Yield Dividend yield is tied to the current market value of the company’s stock and is defined as:
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28. Cash Dividends Financial Effects
Cash dividends reduce both cash and retained earnings by the amount of the cash dividends paid.
To illustrate, assume that JNJ declares and pays cash dividends in the amount of $10 million.
The financial statement effects of this cash dividend payment are as follows.
Dividend payments do not affect net income. They directly reduce retained earnings and bypass the income statement.
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29. Cumulative Dividends in Arrears
Dividends on preferred stock have priority over those on common stock, including unpaid prior years’ preferred dividends (called dividends in arrears) when preferred stock is cumulative.
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30. Analyze stock splits and stock dividends and their financial effects.5
Analyze stock splits and stock dividends and their financial effects.
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31. Stock Split
A stock split happens when a company issues additional common shares to its existing stockholders.
Stock splits are usually prompted by the company’s desire to reduce its stock price in order to improve marketability of the shares.
A stock split is not a monetary transaction and, as such, there are no financial statement effects.
However, companies must disclose the number of shares outstanding for all periods presented in the financial statements.
Additionally, companies must reduce the par value of the stock proportionally and historical financial statements presented in the current 10-K must be adjusted likewise.
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32. Stock Dividend
Companies can also declare a stock dividend where shares of stock are distributed to shareholders instead of cash.
To account for a stock dividend, the company reduces retained earnings (just as for cash dividends) and increases contributed capital accounts.
Cash and the stock’s par value per share are both unaffected by a stock dividend.
Many companies declare a stock dividend, rather than a stock split, to avoid the reduction of the par value that is required in a stock split.
This event is typically described as a stock split effected in the form of a stock dividend.
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33. Large and Small Stock Dividends
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34. Interpret accumulated other comprehensive income and its components.6
Interpret accumulated other comprehensive income and its components.
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35. Components of AOCI Foreign currency translation adjustments.
Foreign subsidiaries often maintain their financial statements in foreign currencies and these statements are translated into $US before the subsidiaries’ financial statements are included in the company’s 10-K.
The strengthening and weakening of the $US vis-à-vis foreign currencies results in decreases and increases in the $US-value of subsidiaries’ assets and liabilities.
These unrealized gains or losses in the $US value of foreign subsidiaries’ assets and liabilities are included in AOCI.
Gains and losses on marketable securities.
Investments in certain types of marketable securities are reported at fair value on the asset side of a company’s balance sheet.
If the fair value differs from the securities’ cost, there are unrealized gains and losses on these securities included in AOCI. (The accounting rules for marketable securities are changing as we explain in another module. Under the new rules, changes in the fair value of marketable securities are reflected in current income and not in AOCI).
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36. Components of AOCI continued
Employee benefit plans.
Unrealized gains and losses on some pension investments and pension liabilities are reported in AOCI.
Gains and losses on derivatives and hedges.
Unrealized gains and losses on certain financial securities (derivatives) that companies purchase to hedge exposures to interest rate, foreign exchange rate, and commodity price risks are included in AOCI.
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37. J&J’s AOCI
Following is the reconciliation of beginning and ending balances in AOCI for Johnson & Johnson.
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38. Comprehensive Income
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39. JNJ’s Statement of Comprehensive Income
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40. Analyze convertible securities and their financial effects.7
Analyze convertible securities and their financial effects.
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41. Convertible Securities
When common stock is issued, the company receives proceeds equal to the market price of the stock multiplied by the number of shares sold.
Companies can increase the cash proceeds by including provisions in the preferred stock and bonds agreements that make the securities more desirable.
One such provision is a conversion option that allows the holder of those securities to convert them into common stock at a pre-set price.
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42. Convertible Securities Disclosures and Interpretation
Xilinx reported convertible notes (similar to bonds) in its K.
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43. Convertible Securities Financial Effects
Assume that the Xilinx bonds are reported at their face amount of $600 million and that all of the bonds are subsequently converted into 20,243,460 shares ([$600 million/$1,000] x shares) of common stock with a par value of $0.01 per share.
The financial statement effects of the conversion are as follows (in $000s).
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44. Interpret earnings per share.8
Interpret earnings per share.
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45. Basic and Diluted EPS
A common metric reported in the financial press is earnings per share (EPS).
Two EPS statistics
Basic EPS. Basic EPS is computed as:
Subtracting preferred stock dividends, in the numerator, yields the income available for dividend payments to common shareholders.
The denominator is the average number of common shares outstanding during the year.
Diluted EPS
Diluted EPS reflects the impact of additional shares that would be issued if all stock options and convertible securities are converted into common shares at the beginning of the year.
Diluted EPS never exceeds basic EPS.
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46. Basic and Diluted EPS Computations
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47. J&J’s EPS
JNJ reports the following table of basic and diluted EPS for 2015.
The denominator in diluted earnings per share calculation presumes the most-extreme case: at the beginning of the year, all employees exercise their right to purchase common shares and all convertible debt holders convert their notes to common shares.
JNJ uses the treasury-stock method to determine the dilutive effect of stock options.
The method assumes that all options are exercised (141.5 million shares) and that the company uses the proceeds to repurchase shares on the open market at the current stock price (102.6 million shares).
The 38.9 million share increase is the net of the shares issued to option holders less the new treasury shares (141.5 million million).
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