Chapter 10
Liabilities – Continued
&
Shareholders’ Equity
Uncertain Accruals

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Some accruals are more uncertain. Consider a
company facing a lawsuit. Should it record the
possible liability and related expense? The answer
depends on the likelihood of occurrence and the
ability to estimate the obligation.
Specifically, if the obligation is probable and the
amount estimable, then a company will recognize
this obligation, called a contingent liability.
If only one of the criteria is met, the contingent
liability is disclosed in the footnotes.
Accounting for Contingencies
Contingent loss
Probability of
Occurrence
High
Reasonable
Remote
Estimable?
Yes
No
Accounting
Accrue Disclose
Treatment
Disclose
Ignore
Income Tax Expense

Companies maintain two sets of books
1.
2.

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One for reporting to their shareholders
One for reporting to the IRS.
This is perfectly legal as the tax Code is different
from GAAP.
This can result in dramatically different levels of pretax (financial reports to shareholders) and taxable
(reported to the IRS) income.
These differences result in deferred tax liabilities
(book income > taxable income) and deferred tax
assets (book income < taxable income)
Components of Cisco’s Tax
Expense
Cisco’s Deferred Tax Footnote
Pensions

There are generally two types of plans:

Defined contribution plan. This plan has
the company make periodic contributions to an
employee’s account (usually with a third party
trustee like a bank), and many plans require an
employee matching contribution. Following
retirement the employee makes periodic
withdrawals from that account. A taxadvantaged 401(k) account is a typical
example.
Pensions

Defined benefit plan. This plan has the
company make periodic payments to an
employee after retirement. Payments are
usually based on years of service and/or the
employee’s salary. The company may or may
not set aside sufficient funds to make these
payments. As a result, defined benefit plans
can be overfunded or underfunded.
Accounting for Defined
Contribution Plans


From an accounting standpoint, defined
contribution plans offer no particular
problems.
The contribution is recorded as an
expense in the income statement when
paid or accrued.
Accounting for Defined Benefit
Plans


Defined benefit plans are more
problematic due to the fact that the
company retains the pension
investments and the pension obligation
is not satisfied until paid.
Account balances, income and
expenses, therefore, need to be
reported in the company’s financial
statements.
Two Accounting Issues Related to
Pension Investments and Obligations:
Problem # 1


The first of the two primary accounting
issues relates to the appropriate balance
sheet presentation of the pension
investments and obligation.
The pension standard allows companies to
report the net pension liability on their
balance sheet.
Problem # 1 - Continued


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That is, if the pension obligation is greater than
the fair market value of the pension investments,
the underfunded amount is reported on the
balance sheet as a long-term liability.
Conversely, if the pension investments exceed
the company’s obligation, the overfunded
amount is reported as a long-term asset.
The amount reported, however, is not what you
or I would likely consider the true funding status.
Two Accounting Issues Related to
Pension Investments and Obligations:
Problem # 2


The second issue facing the FASB was the
treatment of fluctuations in pension
investments and obligations in the income
statement.
The FASB allows companies to report pension
income based on expected long-term
returns on pension investments (rather than
actual investment returns).
The Balance of the Pension
Liability (PBO) Computation
Accounting for Defined Benefit
Plans



Service cost – the increase in the
pension obligation due to employees
working another year for the employer.
Interest cost – the increase in the
pension obligation due to the accrual of an
additional year of interest.
Benefits paid to employees – the
company’s obligation is reduced as
benefits are paid to employees.
Computation of the Balance of
the Pension Investments
Computation for Pension Expense
Reported in the Income Statement
Footnote Disclosures of
Pensions
Footnote Disclosures of
Pensions
Footnote Disclosures of
Pensions
Expected Return on Pension
Investments


Notice that the computation of pension expense
uses the expected return on pension
investments, not the actual return.
The reason for this is that stock returns are
expected to revert to a long-term average if
currently abnormally high or low. Therefore, this
expected return is a better indicator of the true
cost of the pension.
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
dividends
Security in case of default
No voice in management
Equity
No legal contract
No fixed maturity date
Discretionary
Residual asset interest
Vote - board of
directors
Interest expense
Dividends reduce RE
Reporting and Analyzing Owner
Financing Activities

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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 paidin-capital (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
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.
Some More Jargon
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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.
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-in-capital 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

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Corporation’s own stock that has been issued
and reacquired.
Reasons to reacquire own stock:

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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 contraequity 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:
Retained Earnings

Cumulative net income earned since
inception of company less cumulative
total dividends paid.
Cash Dividends

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
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.
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:
Stock Dividends



Increases every shareholders’ interest
by the same proportion of shares, say
5%.
Have you really received anything?
To record, retained earnings are
reduced and paid-in-capital is
increased.
Stock Split


Each shareholder receives a multiple of
shares previously held.
(As in a stock dividend,) no change in
total shareholders’ equity.
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.
Pfizer’s Statement of Stockholders’
Equity
Stock Options

Is this compensation?
Employee Stock Options



Employee stock options are a form of
compensation.
Given to employees in lieu of cash
payments or salary.
Terms of these plans give employees the
right to purchase a fixed number of
shares of stock in the company at a fixed
price for a pre-determined period of
time.
Up factor:
Down:
1.05
$52.09
0.125
1/1.05
Up prob:
50%
Down:
50%
$49.61
0.25
$47.25
0.50
$45.00
1.00
$47.25
0.375
$45.00
0.50
$42.86
0.50
$42.86
0.375
$40.82
0.25
$38.87
0.125
Outcome
Probability Stock Price
Option Value
(Stock price $45, but not
less than $0)
Probability
x Option
Value
A
12.5%
$52.09
$7.09
$0.89
B
37.5%
$47.25
$2.25
$0.84
C
37.5%
$42.86
$0.00
$0.00
D
12.5%
$38.87
$0.00
$0.00
$1.73
Employee Stock Options

Current GAAP either:


Intrinsic value based method:
 No compensation recorded if option’s exercise price is
equal to or greater than the optioned stock price at the
time both the number of shares optioned and their
exercise price are known.
Fair value based method:
 Expenses fair value of options over their vesting period.
 Vesting means option can be exercised even if employee
leaves the company.
Cisco’s Stock Option “Expense” as
currently footnoted