Module 8

1. Module 8 Reporting and Analyzing Owner Financing Activities

2. Reporting and Analyzing Owner Financing Activities • The assets of a company must be financed from one of two sources: • 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.

3. Debt vs. Equity Formal legal contract No legal contract Fixed maturity date No fixed maturity date Fixed periodic payments Discretionary dividends Security in case of default Residual asset interest No voice in management Vote - board of directors Interest expense Dividends reduce RE DebtEquity

4. 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.

5. 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 paid-in-capital component of stockholders’ equity.

6. Components of Paid-in-Capital

7. Stockholders’ Equity Total stockholders’ equity is divided into two major components: • Paid-in-capital –This section is comprised of paid-in-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.

8. Stockholders’ Equity Total stockholders’ equity is divided into two major components: • 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.

9. Types of Stock • There are two often classes of stock: • Common Stock • Preferred Stock

10. Some More Jargon • Authorized, Issued, Outstanding • Market Value • Book Value • Par Value

11. Preferred Stock • Preferred stock generally has some preference, or priority, with respect to common stock.

12. Preferred Stock • Two common preferences are: • 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.

13. 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.

14. 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

15. 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.

16. 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.

17. 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.

18. 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: • Cash increases by $430,000 (10,000 shares x $43) • Common stock increases by the par value of the shares issued (10,000 shares x $0.05 = $500) • Additional paid-in capital increases for the remainder of the purchase price

19. Shareholder Sells Stock to Another Party • No affect on company accounts. • Company notes change of owners and address of owners.

20. 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.

21. 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.

22. 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:

23. 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:

24. Pfizer’s Stock Repurchase Program

25. Pfizer’s Treasury Stock Section of 2003 Balance Sheet

26. Retained Earnings • Cumulative net income earned since inception of company less cumulative total dividends paid.

27. 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.

28. 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.

29. 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:

30. 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:

31. Preferred and Common Dividends (cont’d)

32. Stock Dividends • Increases every shareholders’ interest by the same proportion of shares, say 5%. • Have you really received anything?

33. 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.

34. Accounting for Dividends: Stock Dividends • The following table illustrates the two possibilities:

35. Stock Split • Each shareholder receives a multiple of shares previously held. • (As in a stock dividend,) no change in total shareholders’ equity.

36. 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:

37. 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:

38. 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.

39. 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

40. 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.

41. Comprehensive Income Illustrated • Pfizer reports the following components of comprehensive income in its 2003 10-K:

42. Pfizer’s Statement of Stockholders’ Equity

43. 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.

44. 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.

45. Types of Equity Carve Outs There are three types of Equity Carve Outs: • A Sell-off • A Spin-off • A Split-off

46. 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.

47. A Spin-off • The second form of divestiture is known as a spin-off. • 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.

48. 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: • 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

49. 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:

50. 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: