Financing Decisions - 1
FINANCING DECISIONS
Creditors and Investors
Financing Decisions - 2
REPORTING LIABILITIES
 Short-term liabilities
 Long-term Bonds Payable
– Issuance
– Accounting for premium or discount
 Other liabilities
– Long-term Leases
– Contingencies
– Pensions & Postretirement Benefits
– Income taxes
Financing Decisions - 3
Definition of a Lease
A lease is a contractual agreement
between the lessor (owner of the
property) and the lessee (user of the
property), giving the lessee the right
to use the lessor’s property for a
specific period in exchange for
stipulated cash payments
Diamond Chapter 13
Financing Decisions - 4
Economic Advantages of Leasing
 For the Lessor:
 For the Lessee:
 No (or low) down
payment
 Avoid risks
associated with
ownership
– Technological
obsolescence
– Physical deterioration
–Changing economic
conditions
 Increased sales
 Ongoing business
relationship with the
lessee
 Residual value
retained
 Flexibility
Diamond Chapter 13
Financing Decisions - 5
Lease Types
Capital leases are accounted for as if the
lease agreement transfers ownership of the
asset to the lessee
– The lease is equivalent to a financed purchase
– An asset and liability must be recorded on
lessee’s books
Operating leases are accounted for as rental
agreements, with no transfer of effective
ownership associated with the lease
– Lease payments are recorded as rent expense
by the lessee and rent revenue to the lessor
Diamond Chapter 13
Financing Decisions - 6
Lease Classification Criteria
A lease is classified as a capital lease if any one
of the following criteria are met:
1.
The lease transfers ownership of the property
to the lessee by the end of the lease term
2.
3.
The lease contains a bargain purchase option
The lease term is equal to 75% or more of the
estimated economic life of the leased property
The present value of the minimum lease
payments equals or exceeds 90% of the fair
market value of the property
4.
Diamond Chapter 13
Financing Decisions - 7
Accounting for Leases
DATA
On January 1, 2006, Scully
Corporation (lessee)
enters into a lease with
Porter Company (lessor)
to lease a piece of
equipment for five equal
annual year-end
installments of $13,870
• Accounting treatments
compared
operating lease
capital lease
• For illustration purposes only
• Classification is not elective
• Terms of the lease dictate
classification
Diamond Chapter 13
Financing Decisions - 8
Accounting for Operating Lease
Lessee
Nothing is recorded on January 1, 2006
Each December 31, record rent expense
No asset; no liability
Lessor
Continues to carry as an asset
Continues depreciation
Diamond Chapter 13
Financing Decisions - 9
Lessee Accounting
for Capital Leases
 Records the equipment as an asset and
records an associated liability
– The asset and liability are recorded at the
present value of the lease payments using an
appropriate rate of interest
 Makes annual payments that are divided
between interest and principal
 Depreciates the asset over a 5-year period
Diamond Chapter 13
Financing Decisions - 10
Lessee Accounting
for Capital Leases
12%
Annual
Interest Principle
Lease
Date
Payment Expense Reduction Liability
01-Jan-06
50,000
31-Dec-06
13,870
6,000
7,870
42,130
31-Dec-07
13,870
5,056
8,814
33,316
31-Dec-08
13,870
3,998
9,872
23,443
31-Dec-09
13,870
2,813
11,057
12,387
31-Dec-10
13,870
1,483
12,387
(final interest expense adjusted for rounding)
 The interest amount for each year is based on 12% of the
balance of the liability at the beginning of the year
 Annual depreciation is $10,000 ($50,000 ÷ 5 years)
Diamond Chapter 13
Financing Decisions - 11
STOCKHOLDERS’ EQUITY
 Contributed capital
– Par value issues
– Common vs. Preferred stock
 Retained earnings
– Cash dividends
– Stock dividends
 Other issues
– Stock splits
– Treasury stock
Financing Decisions - 12
Corporations: An Overview
 Fewer in number than
sole proprietorships
and partnerships, yet
...
 Generate greatest
dollar volume of sales
revenues
 Largest in terms of
total assets and
owners’ equity
MISSION
STATEMENT
Financing Decisions - 13
Characteristics of a Corporation
 Separate legal entity
 Continuous life/transferability of
ownership
 Lack of mutual agency
 Stockholder limited liability
 Separation of ownership and
management
 Subject to double-taxation
 Regulated by government
Financing Decisions - 14
STOCKHOLDERS’ RIGHTS
Stockholders generally
have rights to:
 Vote on important
matters
 Receive dividends
 Share in net assets
upon liquidation
 Maintain proportionate
ownership interest in
corporation
VOTE TO
ELECT
DIRECTORS
Financing Decisions - 15
Paid-in Capital and Retained
Earnings
Owners’ Equity is
comprised of 2
elements
Financing Decisions - 16
Paid-in Capital and Retained
Earnings
1
Paid-in Capital
(Contributed
Capital)
 Total amount
investors have
contributed to
corporation
Financing Decisions - 17
Paid-in Capital and Retained
Earnings
2
Retained
Earnings
 Corporation’s
accumulated
earnings and losses
since its first day of
operations
 Earnings not
distributed back to
stockholders in the
form of dividends
Financing Decisions - 18
Classes of Stock




PREFERRED
Generally fewer
rights of stock
ownership
Less risky than
common stock
First to receive
corporate dividends
Second claim against
net assets in event of
liquidation




COMMON
4 rights of stock
ownership
More risk than
preferred stock
Dividends not
guaranteed
Residual claims on
net assets upon
liquidation
Financing Decisions - 19
Par Value
 Par value - minimum
legal capital of the
corporation below
which Stockholders’
Equity cannot fall
 Par value is
randomly chosen
 Generally very low in
amount - $.01, $.10,
or $1.00
Financing Decisions - 20
Treasury Stock
 Shares of its own stock
which the corporation has
reacquired from investors
 Similar to unissued stock
 No dividends paid on
treasury stock
 Company does not “own”
itself
 Treasury Stock is a contraequity account
Financing Decisions - 21
TREASURY STOCK
1. Use shares for employee
compensation
– Stock option/bonus plans
2. Reduce number of shares outstanding
– Might create increase in market price of
shares
3. Wait until market price of stock rises
– Subsequently re-issue shares to increase
total owners’ equity
4. Withdraw shares from secondary
market as defense against corporate
takeover
Financing Decisions - 22
Purchase of Treasury Stock
 Reacquiring shares does not
reduce total number of shares
issued
 It does reduce total number of
shares outstanding
 Also reduces total stockholders’
equity
Financing Decisions - 23
Ethical Issues and Treasury Stock
Transactions
Would it be ethical for
a corporation to
reacquire its common
stock in the week
prior to announcing
record-breaking
financial operating
results for the
accounting period?
Financing Decisions - 24
Sale of Treasury Stock
 No gain or loss is
recognized when
corporation re-issues
(sells) treasury stock to
investors
 Sale might be made at
price above or below that
paid by corporation to
reacquire its stock
Financing Decisions - 25
Retained Earnings
 Retained earnings
represents investors’
claims against assets
acquired through
reinvestment of net
income
 Balance in Retained
Earnings account is
NOT the same as
cash
Financing Decisions - 26
Retained Earnings
 Rather, retained
earnings is a claim
against all assets
of the company
 Cash
 Inventory
 Plant assets, etc.
Financing Decisions - 27
Dividends
 Distribution, to stockholders, of assets
acquired through profitable operations
 Board of Directors declares dividends
– Retained Earnings balance must be
sufficient to support the declaration
 But to pay cash dividends...
– Cash balance must be adequate
Financing Decisions - 28
Dividend Dates
 Declaration date
 Date of record
 Date of Distribution
Financing Decisions - 29
Dividends on Cumulative and
Noncumulative Preferred Stock
CUMULATIVE
 Previous years’
dividends owed
on preferred
stock which
haven’t been paid
must be paid
before common
stockholders can
receive any
dividends
NONCUMULATIVE
 Similar in
character to
common stock; no
claim to previous
years’ unpaid
dividends
Financing Decisions - 30
Stock Dividends
 Shares of corporate stock given in lieu
of cash dividends
 Shareholders receive shares in
proportion to their current level of stock
ownership
 Distribution doesn’t increase or
decrease total stockholders’ equity
 Nor does it affect total corporation
assets
Financing Decisions - 31
Why issue
stock
dividends?
Financing Decisions - 32
Stock Dividends
 Allow corporation to
retain cash for reinvestment in
operations or acquire
long-term assets
(PP&E) to be used
for business
activities
 Stockholders still
receive some form of
“distribution” from
corporation
Financing Decisions - 33
Stock Splits
 Increase in number
of shares authorized,
issued, and
outstanding
 Corresponding
proportional
decrease in stock’s
par value
 Stimulates more
active trading of
stocks with very high
market prices
Financing Decisions - 34
Similarities and Differences Between Stock
Dividends and Stock Splits




STOCK DIVIDENDS
Increase # shares
owned and
outstanding
Doesn’t change total
equity or stockholders’
investments
Leaves par value
unchanged
Shifts amounts from
retained earnings to
paid-in capital




STOCK SPLITS
Increase # shares
owned and
outstanding
Doesn’t change total
equity or stockholders’
investments
Decreases par value of
stock
Doesn’t shift amounts
from one account to
another
Financing Decisions - 35
“ANOTHER
CHAPTER
CLOSED!”