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Chapter 6

Chapter 6. Financing Activities. Equity Financing. Book value of shareholders’ equity: The amount of shareholders’ equity reported in the balance sheet. Is the investment base for equity/net assets used in profitability analysis, risk analysis and residual income-based equity valuation.

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Chapter 6

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  1. Chapter 6 Financing Activities

  2. Chapter: 06 Equity Financing Book value of shareholders’ equity: The amount of shareholders’ equity reported in the balance sheet. Is the investment base for equity/net assets used in profitability analysis, risk analysis and residual income-based equity valuation. Shareholders’ equity is affected by: Investments by shareholders Distributions to shareholders Profitable operating and investing activities

  3. Chapter: 06 Investments by Shareholders: Common Equity Issuance Measurement: Fair value of what the corporation initially receives. Accounting: The fair value received is split between two contributed capital accounts: Common stock (par value) and Additional paid-in capital (amount of fair value received that exceeds par value). Common shareholders bear both residual upside and downside risk, sometimes limited by contracts as under a SPE.

  4. Chapter: 06 Investments by Shareholders: Preferred Stock Issuance Measurement: Fair Value Accounting: The fair value received is split between two contributed capital accounts: Preferred stock (par value) and Additional paid-in capital (amount of fair value received that exceeds par value). Convertible into common shares or callable at scheduled dates or at the firm’s discretion.

  5. Chapter: 06 Other Terms Subscription Agreement: A strategy to market shares in initial public offerings. Is an agreement whereby the companies agree to issue shares in the future and potential buyers agree to pay for the shares in the future. Results in subscription receivable to the extent cash is not collected when subscription agreement is reached.

  6. Chapter: 06 Other Terms (Contd.) Reporting requirements under SEC and IFRS (IAS 1): As common equity: Fair value of subscribed shares. As contra-equity: Fair value of the subscriptions receivable.

  7. Chapter: 06 Distributions to Shareholders: Dividends Are simply a transfer (usually of cash) to shareholders of a portion of what they really own, namely, net assets of the firm. The declaration of dividends is formalized by three important dates: Date of declaration Date of record Date of payment

  8. Chapter: 06 Types of dividends Dividends are paid in the form of: Cash Scrip dividends (dividends with an interest-bearing promise to pay dividends) Property dividends Stock dividends Liquidating dividends (where payments to shareholders exceed the retained earnings balance)

  9. Chapter: 06 Accounting for dividends:

  10. Chapter: 06 Stock Dividends and Stock Splits Stock Dividends Small stock dividends (< 20–25 %) Large stock dividends Stock Split Are distributions =>100 % Accounting: Depends on appropriate state law. Accounting rule: Total par value after the stock split = Total par value before the split.

  11. Chapter: 06 Distributions to Shareholders: Share Repurchases Purpose: To service the possible exercise of options. To shift the mix of debt and equity financing. To signal to investors that corporate management believes the stock is undervalued. To tackle a takeover attempt. Treasury Stock: stock repurchased for reissue at a later date.

  12. Chapter: 06 Accounting for Treasury Stock Cost Method Accounting: At Repurchase: Cash disbursement and increase in treasury stock account. At Subsequent Issue: If reissue price ≠ cost of treasury stock, increase (or decrease) additional paid-in capital. Par Value Method (rarely used).

  13. Chapter: 06 Disclosure for Treasury Stock:

  14. Chapter: 06 Equity Issued as Compensation: Stock Options Stock Options: The right, or option, given by firms to employees. To acquire shares of common stock. At a fixed price (the market price of the stock at the time the firm grants the stock option). Exercised at a later time if the stock price increases above the stock option exercise price. A part of a sign-on or retention package. No use of cash.

  15. Chapter: 06 Stock Options: Various terms Grant date Vesting date Exercise date Exercise price Market price Compensation Expense

  16. Chapter: 06 Stock Options: Fair Value Method and Required Disclosures Various Pronouncements and Methods of Pricing: Opinion No. 25 (1972): intrinsic value method Statements No.123 and No.123 (Revised 2004): fair value method Disclosure requirements as per Statement No.123 (Revised 2004): Stock option grants Effect on total compensation expense Methodology (model) used for valuation Key assumptions for estimating the value

  17. Chapter: 06 Stock Option: Elements & Cash Flows Elements of (theoretical) value of a stock option: Benefit element and Time-value element Option events create two cash flows on exercise of an option: Receipt of cash from employee. Tax savings (tax deduction as per a recent FASB rule).

  18. Chapter: 06 Stock Options: Accounting

  19. Chapter: 06 Alternative Share-Based Compensation:Restricted Stock and RSUs Eliminates a manager’s need to pay the exercise price. Types: Restricted Stock: Shares of stock rather than options are given which cannot be traded until the vesting period is completed. Restricted Stock Units (RSU): Non-tradable rights for a number of shares of stock given once the vesting period is completed.

  20. Chapter: 06 Restricted Stock and RSUs: Accounting

  21. Chapter: 06 Alternative Share-Based Compensation:Cash-Settled Share-Based Plans Are compensation plans that provide cash compensation to employees based on share-price appreciation. Often called stock appreciation rights plans Accounting for estimated cash payments: An increase in an operating liability and A corresponding increase in compensation expense.

  22. Chapter: 06 Earned Capital Net Income and Retained Earnings Accumulated Other Comprehensive Income E.g. unrealized fair value gains or losses on securities deemed available for sale, unrealized foreign currency gain or loss. Reserves E.g. account titled reserve for contingencies.

  23. Chapter: 06 Summary and Interpretation of Equity Market-to-Book Ratio = Market Price per Share/Book Value per Share Generally, Market-to-Book Ratio >1 because book value is less than market value due to Conservatism of accounting Non accounting for future growth opportunities

  24. Chapter: 06 Debt Financing: Critical for understanding the profitability and risk of the firm. Reporting for debt involves: Principles of Liability Recognition involves a probable future sacrifice of economic benefits. a present obligation. transaction or event has already occurred. Principles of Liability Valuation Application of Criteria for Liability Recognition

  25. Chapter: 06 Principles of Liability Valuation Valuation for liabilities: Requiring future cash payments Requiring future delivery of goods or services Representing cash advances from customers Disclosure of the fair values of financial instrument as per U.S. GAAP and optionally under FASB Statement No.159 or IASB IAS 39

  26. Chapter: 06 Criteria for Liability Recognition

  27. Chapter: 06 Financing with Long-Term Debt In the form of: Notes payable (primarily to banks and other financial institutions). Bonds payable (to any type of bondholder, including open-market debt investors). Leases (entered into with property owners, equipment dealers, or finance companies) Is evidenced by a bond indenture, promissory note, or lease agreement.

  28. Chapter: 06 Cash Flows of Long-Term Debt Net Cash Flow = Cash Inflow At Issue – Total Cash Interest – Cash Outflow at Retirement Date Terms: Coupon Rate or Stated Rate Cash Interest Effective Interest (Yield, Yield-to-maturity, Rate of return) – calculated by solving for i in:

  29. Chapter: 06 Financial Reporting of Long-Term Debt Balance sheet: Maturity period >1 year: Long-Term Debt: At the present value of future cash flows. Maturity period <= 1 year, Current Liability Impacts current ratio drastically To reduce the impact, Sinking fund in liquid assets is set up to pay debt. Entering into a refinance agreement.

  30. Chapter: 06 Financial Reporting of Long-Term Debt: Pronouncements Reporting under FASB(SFAS 159) and IASB(IAS 39): Financial Liabilities and Financial Assets: Option to value at fair value (SFAS No. 157) Instead of amortized cost Interest Expense of such Financial Instruments: If nothing mentioned Effective Interest Rate Method applied generally.

  31. Chapter: 06 Reducing Debt: Early Retirement Method of Reducing Debt Methods to retire early Accounting: Income statement: Realized Gain or Loss: The difference between the amounts used to extinguish the debt and the book value of the debt. Cash Flows from financing activities: Cash flows used to reduce debt.

  32. Chapter: 06 Accounting for Troubled Debt Handling of troubled debt: From debtor’s perspective Settlement in cash or by issue of capital stock A gain on debt settlement: the difference between the book value of the debt settled (principal plus any accrued interest) and the fair market value of the non-cash asset or cash transferred to retire the debt. Modification of terms Accounting Is conservative Ignores the present value in restructuring model

  33. Chapter: 06 Modification of terms (U.S. GAAP)

  34. Chapter: 06 Additional Issues: Hybrid Securities (i.e., compound financing instruments) Securities have both debt and equity characteristics. Methods of recording conversion under U.S.GAAP & IFRS. Book Value Method Market Value Method (rarely used)

  35. Chapter: 06 Accounting for Hybrid Securities

  36. Chapter: 06 Off-Balance-Sheet Financing Arrangements Either or combination of approaches: Sale of an existing asset or sale-leaseback. Use of another entity (uncontrolled entity) to obtain financing. Ways to avoid consolidation: Joint venture SPE/ VIE Financial reporting does not recognized mutually unexecuted contracts as liabilities they are mere promises.

  37. Chapter: 06 Accounting for Financial Arrangements

  38. Chapter: 06 Leases Benefits to Lessees: Ability to shift the tax benefits Flexibility to change capacity Ability to reduce the risk of technological obsolescence. Ability to finance the “acquisition” of an asset. Accounting Methods Operating Lease Method Capital Lease Method

  39. Chapter: 06 Choosing the Accounting Method Conditions for a capital lease: Extends for at least 75 percent of the asset’s total expected economic life. Transfers ownership to the lessee. The “bargain purchase” option will be used. The present value of the contractual minimum lease payments equals or exceeds 90 percent of the fair market value of the asset at the time of signing.

  40. Chapter: 06 Converting Operating Leases to Capital Leases By Analyst To avoid understating the short-term liquidity or long-term solvency risk of the firm. For various firms’ cross-sectional comparisons. If the purpose appears to be financing rather than acquisition. Provides a more conservative measure of liabilities. Balance sheet restatements are more significant than income statement restatements.

  41. Chapter: 06 Impact of Accounting for Operating Leases as Capital Leases Though individually impact is relatively small, cumulatively can be significant. Thus, important for analyst: assessing the risk and accounting quality of a firm’s financial statements. determining capital structure weights and debt costs for the weighted average cost of capital calculations in entity valuation.

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