Fourth Edition
Peter D. Easton
Mary Lea McAnally
Greg Sommers
MODULE 8
Equity Recognition
and Owner Financing
©Cambridge Business Publishers, 2015
Xiao-Jun Zhang
Learning Objective 1
Describe and illustrate accounting
for contributed capital, including
stock sales and repurchases, and
equity-based compensation.
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Stockholders’ Equity
Total stockholders’ equity is divided into two
components:
1. Contributed capital – proceeds received by the
issuing company from original stock issuances, net
of the amounts paid to repurchase shares of the
issuer’s stock from its investors.
2. Earned capital – Retained earnings and
accumulated other comprehensive income (AOCI).
 In addition, many companies report an equity
account called noncontrolling interest, which
reflects the equity of minority shareholders.
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Components of Paid-in-Capital
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P&G’s Stockholders’ Equity
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Types of Stock
 There are two classes of stock:
1.
2.
Preferred Stock
Common Stock
 Preferred stock preferences:
1. Dividend preference – preferred shareholders
receive dividends on their shares before common
shareholders do.
2. Liquidation preference – preferred shareholders
receive payment in full before common
shareholders in liquidation.
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Preferred Stock Privileges
1. Conversion privileges – a conversion
privilege allows preferred stockholders to
convert their shares into common shares at
a predetermined conversion ratio.
2. Participation feature – allows preferred
shareholders to share ratably with common
stockholders in dividends.
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Dow
Chemical’s
Convertible
Preferred
Stock
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Dow Chemical’s
Convertible Preferred Stock
 Holders of convertible preferred are entitled to an 8.5%
dividend yield (8.5% of the par value).
 Holders of convertible preferred have a preference in
liquidation over common shareholders amounting to
$1,000.
 Each share of convertible preferred is convertible into
24.201 shares of common stock.
 On or after the fifth anniversary of the issuance date, if
the common stock price exceeds $53.72 per share for any
20 trading days in a consecutive 30-day window, Dow
Chemical has the option to convert the preferred series A
into common stock.
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P&G’s
Preferred
Stock
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IBM’s Common Stock
 Par value of $0.20 per share.
 IBM has authorized the issuance of 4,687,500,000 shares.
 To date, IBM’s management has issued (sold) 2,197,561,159
shares of stock.
 IBM has repurchased 1,080,193,483 shares from its shareholders.
 The number of outstanding shares is equal to the issued shares
less treasury shares. There were 1,117,367,676 (2,197,561,159 1,080,193,483) shares outstanding at the end of 2012.
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IBM Market Capitalization
 Market capitalization is equal to
# Shares Outstanding x Market Price per share
 Given
 Outstanding shares of 1,117,367,676
 Market price of $191.55 at end of 2012
 IBM’s market capitalization =
1,117,367,676 X $191.55 = $214,032 million
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P&G’s Common Stock
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Sale of Stock Illustrated
 To illustrate, assume that IBM issues 100,000 shares of
its $0.20 par value common stock at a market price of
$43 cash per share:
1. Cash increases by $4,300,000 (100,000 shares x $43 per share)
2. Common stock increases by the par value of shares sold (100,000
shares x $0.20 par value = $100,000)
3. Additional paid-in capital increases by the $4,280,000 difference
between the issue proceeds and par value ($4,300,000 - $20,000)
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Repurchase of Stock Illustrated
 To illustrate, assume that 3,000 common shares
of IBM previously issued for $43 are repurchased
for $40:
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Repurchase of Stock Illustrated
 Now assume that these 3,000 shares are
subsequently resold for $42 cash per share:
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IBM’s Treasury Stock Section
of 2012 Balance Sheet
 IBM has repurchased 1,080,196,483 shares of
stock.
 The balance in the Treasury Stock account as of
2012 (amount paid for repurchases less amount
received on subsequent sales) is $(123,131)
million.
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Accounting for Stock Options
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IBM’s
Stock
Option
Program
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Cisco’s Stock Option Expense
Cisco’s stock option expense is allocated to




cost of sales,
research and development,
sales and marketing expenses, and
general and administrative expenses.
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Accounting for Restricted Stock
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Learning Objective 2
Explain and illustrate accounting
for earned capital, including
cash dividends, stock dividends,
and comprehensive income.
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IBM’s 2012 Dividends
 Dividend Payout
 Dividend Yield
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Accounting for Dividends:
Cash Dividends
 IBM declares and pays a cash dividend of $10
million:
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Preferred and Common Dividends
 Assume that
 A company has 15,000 shares of $50 par value, 8%
preferred stock outstanding and 50,000 shares of
$5 par value common stock outstanding.
 During its first three years in business, the company
declares $20,000 dividends in the first year,
$260,000 of dividends in the second year, and
$60,000 of dividends in the third year.
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Preferred and Commons Dividends
(continued)
If the preferred stock is cumulative, the total
amount of dividends paid to each class of stock in
each of the three years follows:
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Accounting for Dividends:
Stock Dividends
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Small Stock Dividends Illustrated
 Assume that
 a company has 1 million shares of $5 par common stock
outstanding.
 It declares a small stock dividend of 15% of the outstanding
shares when the market price of the stock is $30 per share.
 This small stock dividend has the following financial
statement effects:
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Large Stock Dividends Illustrated
 Now assume that the company now declares a large
stock dividend of 70% of the outstanding shares when
the market price of the stock is $30 per share ($5 par
value).
 The large stock dividend will have the following effects
on the balance sheet:
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Stock Splits in the Form of
a Stock Dividend – TJX Companies, Inc.
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IBM’s Accumulated
Other Comprehensive Income
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IBM’s Accumulated
Other Comprehensive Income
1. Net unrealized gains (losses) on cash flow hedges, $(90) million. This
$90 million relates to unrealized losses on cash flow hedges (see
appendix to Module 9).
2. Foreign currency translation adjustments, $1,733 million. This is the
cumulative translation adjustment for the net assets of foreign
subsidiaries whose balance sheets are denominated in foreign
currencies (see next slide).
3. Net change retirement-related benefit plans, $(27,406) million. This
amount relates to unrealized losses on pension investments or to
changes in pension-plan assumptions that increase the pension
liability (see Module 10).
4. Net unrealized gains/(losses) on available-for-sale securities, $4
million. Unrealized gains and losses on available-for sale securities are
not reflected in net income. Instead, they are accumulated in AOCI
until the securities are sold (see Module 9).
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Foreign Currency Translation Effects
on the Balance Sheet
 Financial statements prepared according to U.S. GAAP
must be reported in $US.
 This means that financial statements of foreign
subsidiaries must be translated into $US before they are
consolidated with those of the U.S. parent company.
 The amount reflected as an increase (decrease) in equity
is called a foreign currency translation adjustment.
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Noncontrolling Interest
 Noncontrolling interest represents the equity of
noncontrolling (minority) shareholders who only have a
claim on the net assets of one or more of the subsidiaries in
the consolidated entity.
 If the company acquires less than 100% of the subsidiary, it
must include 100% of the subsidiary’s assets, liabilities,
revenues and expenses in its consolidated balance sheet and
income statement, but now there are two groups of
shareholders that have a claim on the net assets and
earnings of the subsidiary company:
 The parent company, and
 The noncontrolling shareholders (those shareholders who
continue to own shares of the subsidiary company).
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Noncontrolling Interest:
Walmart Income Statement
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Noncontrolling Interest:
Walmart Retained Earnings and NCI Equity
 Retained earnings is increased (decreased) by the income (loss)
attributable to the parent’s shareholders and is decreased by the
dividends paid to the parent’s shareholders.
 The equity of the noncontrolling interest is increased (decreased) by the
income (loss) attributable to the noncontrolling shareholders and is
decreased by the dividends paid to the noncontrolling shareholders.
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Noncontrolling Interest:
Walmart Balance Sheet
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Analysis and Interpretation of
Noncontrolling Interest
 The return on equity (ROE) computation is
usually performed from the perspective of the
parent company’s shareholders.
 Consequently,
 the numerator is usually the net income attributable
to the parent company shareholders, and
 the denominator includes only the equity of the
parent company’s shareholders (excluding
noncontrolling interest equity).
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Learning Objective 3
Describe accounting for
equity carve-outs
and convertible debt.
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Equity Carve Outs
 Corporate divestitures have become increasingly
common as companies seek to increase
shareholder value through partial or total
divestiture of operating units.
 In general, these equity carve outs are
motivated by the notion that consolidated
financial statements often obscure the
performance of individual business units, thus
complicating their evaluation by market
analysts.
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Equity Carve Outs:
United Technologies’ Sell-Off
 UTC received $3.4 billion in cash
 The Hamilton Sundstrand Industrial businesses were reported on UTC’s
balance sheet at $1.3 billion on December 13, 2012, the date of sale.
 UTC’s gain on sale equaled the proceeds ($3.4 billion) less the carrying
amount of the business sold ($1.3 billion), or $2.1 billion.
 UTC subtracts the gain on sale in computing net cash flows from
operating activities to remove the gain from net income; cash proceeds
are reported as a cash inflow in the investing section.
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Equity Carve Outs:
Beam, Inc. Spin-Off
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Equity Carve Outs:
Beam, Inc. Spin-Off
 Beam treats the distribution of its Fortune
Brands Home & Security shares as a dividend:
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Equity Carve Outs:
BMY’s Split-Off of Mead Johnson
 The Treasury Stock account on Bristol-Myers’ balance sheet increased (became
more negative) by $6.9 billion (269 million shares x $25.70 per share), which
reduced equity by $6.9 billion.
 This reduction was offset, however, by the recognition of a gain on the
exchange amounting to $7.2 billion after tax.
 This split-off was affected by a tender offer with Bristol-Myers shareholders.
Consequently, it is a non pro rata exchange and is, therefore, valued at market
value with a resulting gain.
 The net effect on equity is minimal, but the income statement reports a
substantial gain for that year.
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Analysis of Equity Carve Outs
 Sell-offs, spin-offs, and split-offs all involve the divestiture of an
operating segment.
 Following an equity carve-out, the parent company loses the cash
flows (positive or negative) of the divested business unit.
 As such, the divestiture should be treated like any other
discontinued operation.
 Any recognized gain or loss from divestiture is treated as a
nonoperating activity.
 The sale price of the divested unit reflects the valuation of future
expected cash flows by the purchaser and is best viewed as a
nonoperating activity.
 Income (and cash flows) of the divested unit up to the date of sale,
however, is part of operations, although discontinued operations
are typically segregated.
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Xilinx’s Convertible Securities
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Xerox’s Convertible Preferred Stock
 Accounting for the conversion of preferred stock is essentially the same
as that for convertible debt: the preferred stock account is removed
from the balance sheet and common stock is issued for the dollar
amount of the preferred.
 A conversion option is valuable and yields a higher price for the
securities than they would otherwise command.
 However, conversion privileges impose a cost on common shareholders.
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Global Accounting
 Under IFRS, accounting for equity is similar to
that under U.S. GAAP. Following are a few
terminology differences:
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Global Accounting
 U.S. GAAP has a more narrow definition of
liabilities than IFRS. Therefore, more items are
classified as liabilities under IFRS.
 For example, some preferred shares are deemed
liabilities under IFRS and equity under GAAP.
 Treasury stock transactions are sometimes
difficult to identify under IFRS because
companies are not required to report a separate
line item for treasury shares on the balance
sheet. Instead treasury share transactions reduce
share capital and share premium.
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The End