MANAGEMENT DECISIONS AND FINANCIAL ACCOUNTING REPORTS Baginski & Hassell

Chapter 5

FINANCING DECISIONS (Reducing Outstanding Equity and Debt) Topics –Identify conditions leading to reduction of equity financing –Identify methods of equity reduction –Review of Statement of Owners’ Equity –Identify conditions leading to reduction of debt financing –Identify methods of debt reduction

Reasons for Reducing Equity Financing Available free cash flow is used to pay dividends Corporation desires to shift the mix of debt and equity financing Stock buy-backs can be used as a signal of higher future earnings expectations Repuchase to support stock price

Methods of Equity Reduction Liquidating dividends Retire common stock Purchase treasury stock

Liquidating Dividends Normally, regular dividends are limited to the amount of free and unappropriated retained earnings. –Regular dividends are considered a return on capital. “Dividend distributions” that are greater than the free and unappropriated retained earnings are designated as a liquidating dividends. –Liquidating dividends are considered a return of capital. –What is the debit after retained earnings hits zero?

Retire Common Stock When common stock shares are acquired and retired … –The par value and original premium over par value are written off. –Any “economic gain/loss” is credited/charged directly to the premium account, if any, in the stockholders’ equity section. –The shares revert to the status of unissued.

The following two slides indicate the “before & after” balance sheet of Beneish Co. that acquired and retired (cancelled) 10,000 shares of its common stock (for $56 per share.)

Retire Common Stock Example Stockholders’ Equity [before] Common stock, $10 par; 10,000,000 shares authorized; 500,000 shares issued and outstanding$ 5,000,000 Additional paid-in capital25,000,000 Retained earnings42,000,000 Total stockholders’ equity$72,000,000 Note: The average price per share received by Beneish = $60 ($30,000,000 in common stock and additional paid-in capital  500,000 shares)

Acquire and Retire Common Stock: Stockholders’ Equity Results Stockholders’ Equity [after] Common stock, $10 par; 10,000,000 shares authorized; 490,000 shares issued and outstanding$ 4,900,000 Additional paid-in capital24,540,000 Retained earnings42,000,000 Total stockholders’ equity$71,440,000 Note: Both cash and total stockholders’ equity decrease by $560,000 (10,000 shares × $56).

SUPP0RTING COMPUTATIONS: Beneish realizes $40,000 “economic gain” on combination of two transactions, issuing stock and retiring stock: –Originally received 10,000 shares × $60 (average price) = $600,000 –Repurchase price was $560,000 –Economic gain = $40,000

–Common stock decreases $100,000: 10,000 shares × $10 par –Additional [original] paid in capital in excess of par decreases by $500,000: 10,000 shares × $50 premium in original issuance –Additional paid-in capital from retirement of stock increases by the $40,000 “economic gain” If a net “economic loss” had resulted, the loss would be charged either to additional paid-in capital, if any, or to retained earnings, likely dependent on state law.

Purchase of Treasury Stock Treasury Stock: A corporation’s own stock which has been reacquired, but not retired, with the intent of holding it temporarily and reissuing it later. –Two methods of accounting for treasury stock: cost method (predominant) and par method (not illustrated here) Treasury stock is contra-equity and is reported as such in the balance sheet. (Not an asset!)

The following two slides indicate the “before & after” balance sheet of Shane Co. that acquired 50,000 shares of treasury stock for $40 per share (presumably in the open market).

Treasury Stock Example (Cost Method) Stockholders’ Equity [before] Common stock, $5 par; 10,000,000 shares authorized; 1,000,000 shares issued and outstanding$ 5,000,000 Additional paid-in capital30,000,000 Retained earnings42,000,000 Total stockholders’ equity$77,000,000 Note: Average price per share = $35 ($35,000,000 in common stock and additional paid-in capital  1,000,000 shares)

Stockholders’ Equity [after] Common stock, $5 par, 10,000,000 shares authorized; 1,000,000 shares issued, 950,000 shares outstanding$ 5,000,000 Additional paid-in capital30,000,000 Retained earnings42,000,000 77,000,000 Less Treasury Stock (50,000 shares at cost)– 2,000,000 Total stockholders’ equity$75,000,000 Note: The difference between the number of shares issued (1,000,000) and outstanding (950,000) is the number of shares of treasury stock.

REISSUE SHARES: Assume Shane reissued 20,000 of the 50,000 treasury shares (which were acquired at $40 per share) at $42 per share.

Results: Shane realizes a $40,000 “economic gain:” 20,000 shares × ($42 reissue price - $40 repurchase price). The “economic gain” increases additional paid-in capital because no “outsiders” were involved. Both cash and stockholders’ equity increase by $840,000 (20,000 shares × $42).

Reissue Shares: Stockholders’ Equity Results Stockholders’ Equity Common stock, $5 par; 10,000,000 shares authorized; 1,000,000 shares issued; 970,000 shares outstanding$ 5,000,000 Additional paid-in capital30,040,000 Retained earnings42,000,000 $77,040,000 Treasury Stock (30,000 shares at cost)- 1,200,000 Total stockholders’ equity$75,840,000

Statement of Owners’ Equity The Statement of Owners’ Equity reconciles the beginning balances to the ending balances of each component of stockholders’ equity. It is an analysis (not a schedule). A template for the a corporate statement is as follows:

Statement of Stockholders’ Equity Common Stock Additional Paid-in Capital Retained Earnings Accumulated Other Comprehensive Income* Treasury Stock Balance Jan 1 …… Balance Dec 31 * Topic covered in future chapters with discussions of transactions that affect accumulated other comprehensive income

Items appearing in the Statement of Stockholders’ Equity covered in Chapters 2-5 include: –Net income –Issue common stock –Dividends (cash, property, stock, liquidating) –Stock splits –Treasury stock transactions –Retirement of common stock

Reasons for Reducing Debt Financing Market conditions favor “refunding existing debt” –If interest rates fall substantially, firms are able to issue debt at current market rates and repurchase and retire high interest rate debt issued previously. Strategic planning results in reallocating debt and equity financing (e.g., to reach a target ratio of debt to equity).

Methods of Debt Reduction Normal payments Early extinguishment of debt –Call or open market purchase Conversion into common stock Troubled debt –Settlements –Modifications of terms

Early Extinguishment of Debt FASB Statement #145 (2002) –Previously all early extinguishment were accounted for as extraordinary items –Most early debt extinguishments result from risk-management decisions –Don’t meet the “unusual and infrequent” test –Pre-2002 extinguishments will continue to be shown as extraordinary in comparative financial statements

Early Extinguishment of Debt: Example Liu Co.: Trial balance excepts on July 1, as of the opening of business: Bond payable, face value$5,000,000 Unamortized premium on bond payable250,000 Accrued interest payable, July 175,000 Unamortized bond issue costs40,000 On July 1, Liu repurchases debt for $5.1 million (including accrued interest to date).

Gain computation: Bonds payable$5,000,000 Bonds payable premium250,000 Interest payable75,000 Unamortized bond issue costs(40,000) Net book value of debt prior to settlement $5,285,000 Repurchase price5,100,000 Gain$ 185,000

Troubled Debt: Settlement Assume here that settlement only occurs if debtor has an economic gain and creditor an economic loss (the typical scenario). Usually, debt is settled by either transferring assets to the lender and/or issuing stock to the lender. If assets are to be transferred –they must first be written up/down to FMV, resulting in an ordinary gain/loss on revaluation –excess of the carrying value of the debt over FMV of assets given or stock issued is an ordinary gain on debt settlement

Troubled Debt: Settlement Example Mufasa Co. owed First National Bank a $5,000,000 note payable plus accrued interest of $90,000. In complete settlement of the debt, Mufasa... –transferred to First National Bank land with a book value of $750,000 (FMV = $1,200,000), and –issued to First National Bank 700,000 shares of $1 par common (FMV = $5 per share).

SOLUTION Mufasa would write up the land by $450,000 (up to FMV) and recognize a gain on revaluation. Mufasa would record a $390,000 gain on the debt settlement Debt owed$5,090,000 FMV of land1,200,000 FMV of stock3,500,0004,700, ,000

Troubled Debt: Modification of Terms The accounting depends on comparison of the pre-modification debt carrying value and the total future cash flows under the modified debt agreement: –Pre-modification carrying value < total future cash flows New effective interest rate is computed using new future cash flows Debtor records no gain (because the net interest rate still calculates as positive)

–Pre-modification carrying value > total future cash flows Debtor records gain on restructuring equal to the excess of pre-modification carrying value over total future cash flows New effective interest rate = 0 or calculates to a negative A “negative” rate calculation would simply mean that the principal amount is to be adjusted and a 0% rate used in the bookkeeping.

Troubled Debt: Modification of Terms Example, Situation 1 Situation 1: On January 1, 2004, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, First National agrees to restructure the note as follows: Principal reduced to $4,500,000 due December 31, 2008; accrued interest of $90,000 waived; stated interest rate reduced to 6% to be paid annually on December 31 of each year.

Pre-modification carrying value = $5,090,000 (total payoff needed) Total of future cash payments as modified = $5,850,000 ($4,500, interest payments of $270,000) The “real” interest rate remains positive (although interest cost is reduced); thus, no gain recognition.

RESULT: Mufasa records no gain because future cash flows $5,850,000 > pre-modification carrying value $5,090,000 New effective interest rate of 3.13% must be computed: n = 5 present value = $5,090,000 future value = $4,500,000 interest payment (ordinary annuity) = $270,000 i = ? = 3.13%

Troubled Debt: Modification of Terms Example, Situation 2 Situation 2. On January 1, 2004, the Mufasa Co. owed First National $5,000,000 plus accrued interest of $90,000 on a 7.2%, $5,000,000 note payable due December 31, First National agrees to restructure the note as follows: principal reduced to $4,000,000 due December 31, 2008; accrued interest of $90,000 waived; stated interest rate reduced to 4% to be paid annually on December 31 of each year.

Pre-modification carrying value = $5,090,000 (total payoff needed) Total of future cash payments as modified = $4,800,000 ($4,000, interest payments of $160,000) The “real” interest rate is negative (principal reduced so much that interest rate is below zero); thus, a gain on restructuring is recognized.

Result: Mufasa records an extraordinary gain because $4,800,000 < $5,090,000 New effective interest rate = 0% n = 5 present value = $4,800,000 (after modification) future value = $4,000,000 interest payment (ordinary annuity) = $160,000 i = ? = 0% The note’s carrying value is reduced from $5,090,000 to $4,800,000 and all future payments are principal Gain = $5,090,000 – $4,800,000 = $290,000

End of Chapter 5