Module 8
Reporting and
Analyzing Owner
Financing Activities
Reporting and Analyzing Owner
Financing Activities

The assets of a company must be financed
from one of two sources:
1.
2.

It borrows funds
It obtains capital from its shareholders.
On average, companies obtain about half of
their capital from borrowed sources and the
other half from shareholder investment.
Debt vs. Equity
Debt
Formal legal contract
Fixed maturity date
Fixed periodic payments
Security in case of default
No voice in management
Interest expense
Equity
No legal contract
No fixed maturity date
Discretionary dividends
Residual asset interest
Vote - board of directors
Dividends reduce RE
Reporting and Analyzing Owner
Financing Activities


Stockholders’ equity is accounted for at
historical cost, just like assets and liabilities.
When a company sells stock to the investing
public, it records the receipt of cash and the
increase in stockholders’ equity, representing
increased investment in the company by the
shareholders.
Reporting and Analyzing Owner
Financing Activities


There is an important difference between the
accounting for stockholders’ equity and the
accounting for transactions involving assets
and liabilities: there is never any gain or
loss recorded on the purchase and sale of
stock or the payment of dividends.
Instead, these “gains” and “losses” are
reflected in increases (decreases) in the paidin-capital component of stockholders’ equity.
Components of Paid-in-Capital
Stockholders’ Equity
Total stockholders’ equity is divided into two
major components:
1.
Paid-in-capital –This section is comprised of paid-incapital (preferred stock and common stock), and
additional paid-in-capital. Both of these accounts are
generically referred to as paid-in-capital.
Treasury stock – This account represents the amounts
paid to repurchase shares of stock from investors, net of
the proceeds from the resale of those shares.
Stockholders’ Equity
Total stockholders’ equity is divided into two major
components:
2.
Earned capital – The retained earnings account
represents the cumulative profits of the company
that have not yet been paid out to shareholders in
the form of dividends. Accumulated other
comprehensive income (OCI) includes a number of
changes to stockholders’ equity that have not
impacted earnings and are, therefore, not reflected
in the retained earnings account.
Types of Stock
There are two often classes of
stock:

1.
2.
Common Stock
Preferred Stock
Some More Jargon




Authorized, Issued, Outstanding
Market Value
Book Value
Par Value
Preferred Stock

Preferred stock generally has some
preference, or priority, with respect to
common stock.
Preferred Stock

Two common preferences are:
1.
2.
Dividend preference – preferred shareholders
receive dividends on their shares before
common shareholders do.
Liquidation preference – in the event of the
failure of the company, preferred shareholders
will receive payment in full before common
shareholders. This liquidation preference makes
preferred shares less risky to own in the event of
business failure than common shares.
Types of Preferred Stock

Cumulative preferred: dividends in arrears
and current year’s dividends must be paid
before common dividends can be paid.

Convertible preferred: convertible into a
specified number of shares of common.
Common Stock




Residual interest in net assets after all
creditors and preferred shareholders.
Par or stated value usually a nominal
(meaningless) amount.
Common shareholders’ equity = Paid in
capital + retained earnings.
Paid in capital = Common stock at par (or
stated value) + paid in capital in excess of
par
Pfizer’s Common Stock


Pfizer common stock has a par value of $0.05 per share. The
par value is an arbitrary amount set by the company
organizers at the time of formation. Its impact rests mainly
in specifying the allocation of proceeds from stock
issuances between common stock and additional paid-in
capital accounts on the balance sheet.
Pfizer has authorized the issuance of 12 million shares. As
of 2003, 8.702 million shares are issued. Initially, the number
of shares ‘outstanding’ equals those issued. Any shares
subsequently repurchased as treasury stock are deducted
from issued shared to derive outstanding shares.
Accounting for Stock Transactions: Sale
of Stock


The sale of stock, whether common or
preferred, results in an increase in assets
and corresponding increase in
stockholders’ equity.
By the sale of stock, the company is
raising cash for use in its business. The
company is growing.
Accounting for Stock Transactions: Sale
of Stock



From an accounting standpoint, cash increases by the
number of shares sold multiplied by the market price
of the stock on the date of sale.
Equity also increases by the same amount, and this
increase is reflected in the paid-in-capital accounts.
Assuming that common stock is issued, the common
stock account increases by the number of shares sold
multiplied by the par value and the additional paid-incapital account increases for the remainder.
Sale of Stock Illustrated

To illustrate, assume that Pfizer issues 10,000 shares of
$0.05 par value common stock at a market price of $43
per share. The sale of stock has the following effects on
the balance sheet:
1. Cash increases by $430,000 (10,000 shares x $43)
2. Common stock increases by the par value of the shares issued (10,000
shares x $0.05 = $500)
3. Additional paid-in capital increases for the remainder of the purchase price
Shareholder Sells Stock to Another
Party

No affect on company accounts.

Company notes change of owners and
address of owners.
Treasury Stock

Corporation’s own stock that has been issued
and reacquired.

Reasons to reacquire own stock:





Limited investment opportunities.
To increase stock price.
To increase EPS.
To issue stock bonus to employees.
To prevent hostile takeover.
Accounting for Stock Transactions:
Repurchase of Stock


When common stock is repurchased, both
assets (cash) and stockholders’ equity
decrease by the purchase price.
The reduction in stockholders’ equity is
accomplished by increasing a contra-equity
account called treasury stock.
Repurchase of Stock Illustrated

To illustrate, assume that 3,000 of the shares issued
above for $43 are subsequently repurchased for
$40. The repurchase will have the following effects
on the balance sheet:
Repurchase of Stock Illustrated

Now assume that these 3,000 shares are
subsequently resold for $42. The resale of the
treasury stock has the following effects on the
balance sheet:
Pfizer’s Stock Repurchase Program
Pfizer’s Treasury Stock Section of 2003
Balance Sheet
Retained Earnings

Cumulative net income earned since
inception of company less cumulative total
dividends paid.
Cash Dividends




Why pay dividends?
At declaration (vote of the BOD): decrease
RE and increase Dividends Payable.
At date of record, figure out who is entitled to
the dividend, no entry.
At payment, reduce Dividends payable and
reduce Cash.
Dividends





Companies pay dividends out of retained profits.
Dividends are usually paid in cash on a quarterly
basis.
Stock analysts closely monitor the payment of
dividends.
It is generally perceived that the level of dividend
payments is related to long-term expected core
earnings.
As a result, dividend increases are usually
accompanied by stock price increases, and
companies rarely reduce their dividends unless
absolutely necessary.
Dividend reductions are, understandably, greeted
with significant stock price declines.
Accounting for Dividends: Cash
Dividends


The accounting for cash dividends is straightforward. Both
cash and retained earnings are reduced by the amount of the
cash dividends paid.
In 2003, Pfizer paid $4.771 billion of cash dividends on its
common shares The payment of these dividends had the
following effects on its financial statements:
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.
If the preferred stock is cumulative, the total amount
of dividends paid to each class of stock in each of
the three years follows:
Preferred and Common Dividends
(cont’d)
Stock Dividends

Increases every shareholders’ interest by the
same proportion of shares, say 5%.

Have you really received anything?
Accounting for Dividends: Stock
Dividends



Although most dividends are paid in cash,
dividends can also be paid in the form of the
company’s stock.
In this case, retained earnings are reduced
and paid-in-capital is increased.
In addition, the amount by which retained
earnings are reduced depends on the
proportion of the outstanding shares
distributed.
Accounting for Dividends: Stock
Dividends

The following table illustrates the two possibilities:
Stock Split

Each shareholder receives a multiple of
shares previously held.

(As in a stock dividend,) no change in total
shareholders’ equity.
Small Stock Dividends Illustrated

Assume that a company has 1 million shares of $5 par
common stock outstanding. It then 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:
Large Stock Dividends Illustrated

To illustrate the effect of a large stock dividend, 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. The large stock dividend will have the following
effects on the balance sheet:
Book Value per Share


Book value is frequently used in assessing
merger terms, and analysis of companies
composed of mainly liquid assets (finance,
investment, insurance, and banking
institutions) relies extensively on book values.
Book value per share is the per share
amount resulting from a company’s
liquidation at amounts reported on its balance
sheet.
Book Value


Book value is conventional terminology
referring to net asset value—that is, total
assets reduced by claims against them.
The book value of common stock is equal to
the total assets less liabilities and claims of
securities senior to common stock (such as
preferred stock) at amounts reported on the
balance sheet
Comprehensive Income


Comprehensive Income includes all recognized
changes in equity that occur during a period except
those resulting from investments by owners and
distributions to owners.
Thus, included in comprehensive income but
excluded from net income are foreign currency
adjustments, unrealized changes in the fair value of
available-for-sale securities, minimum pension
liability adjustments, and changes in the market
values of certain derivative investments.
Comprehensive Income Illustrated

Pfizer reports the following components of
comprehensive income in its 2003 10-K:
Pfizer’s Statement of Stockholders’ Equity
Pfizer’s Statement of Stockholders’ Equity




Pfizer’s statement of stockholders’ equity reveals the
following key transactions for 2003:
Pfizer’s stockholders’ equity increased by $5.98 billion
from net income and other comprehensive income.
Pfizer issued 6,019 million preferred shares with a total
par (stated) value of $242 million as part of Pharmacia’s
acquisition in 2003. It also issued 1.817 million common
shares, which increased paid-in capital by 55.493 billion
(0.019 billion+ 55.402 billion).
Pfizer’s stockholders’ equity decreased by $4,771 million
($4,764 million + $7 million) from dividend payments to
preferred and common stock.
Paid-in capital increased by 1.532 billion from issuance of
shares for the exercise of employee stock options, and
decreased by $13.037 billion from stock repurchases.
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.
Types of Equity Carve Outs
There are three types of Equity Carve Outs:
1.
A Sell-off
2.
A Spin-off
3.
A Split-off
A Sell-Off




The simplest form of divestiture is the outright sale of the
business, a sell-off.
In this case, the company sells its equity interest to an unrelated
party.
When a company sells the stock that it owns, it accounts for this
sale in the same manner as the sale of any other asset: The
excess of the cash received over the carrying amount of the
investment is recorded as a gain or loss on the sale.
The amount reported as “Investment in sub” is the carrying
amount of the investment as reported under the equity method of
accounting for inter-company investments.
A Spin-off



The second form of divestiture is known as a spinoff.
In this case, the company is distributing the
subsidiary shares that it owns as a dividend to its
shareholders who will, then, own shares in the
subsidiary directly rather than through the parent
company.
In recording this dividend, retained earnings are
reduced by the book value of the equity method
investment and the investment account is removed
from the balance sheet.
A Split-off

The dollar amount at which the treasury stock is recorded,
however, depends on how the distribution is affected. There are
two possibilities:
1.
Pro-rata distribution. In a pro-rata distribution, the shares are
distributed to stockholders on a pro-rata basis, that is, a shareholder
owning 10% of the outstanding stock of the parent company would
receive 10% of the shared of the subsidiary distributed. In this case, the
treasury stock account is recorded as the book value of the investment
in the subsidiary.
Non pro-rata distribution. In a non pro-rata distribution (e.g., a tender
offer in which stockholders can accept or reject the distribution), the
treasury stock account is recorded at the market value of the shares of
the subsidiary to be distributed. And since the investment account can
only be reduced for its carrying amount, a gain or loss on the
distribution is recorded in the income statement for the difference
2.
Convertible Securities



Convertible securities are debt and equity securities that
provide the holder with an option to convert those securities
into other securities.
Convertible debentures, for example, are debt securities that
give the holder the option to convert the debt into common
stock at a pre-determined conversion price.
Preferred stock can also contain a conversion privilege.
Pfizer provides an example of the latter in its description of
the Parmacia acquisition:
Convertible Securities Illustrated

Assume that convertible bonds with a face value of
$1,000 and an unamortized premium of $100 at the
conversion date are converted into 20 shares of $10
par value common stock. The financial statement
effects of this conversion follow: