Chapter 10 Liabilities – Continued & Shareholders’ Equity

Uncertain Accruals 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 Accounting Treatment HighReasonableRemote NoYes DiscloseAccrueIgnoreDisclose Estimable?

Income Tax Expense Companies maintain two sets of books 1. One for reporting to their shareholders 2. 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 pre- tax (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 tax- advantaged 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 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

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. It borrows funds 2. 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 DebtEquity Formal legal contractNo legal contract Fixed maturity dateNo fixed maturity date Fixed periodic paymentsDiscretionary dividends Security in case of defaultResidual asset interest No voice in management Vote - board of directors Interest expenseDividends reduce RE

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.

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.

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 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.

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 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. Dividend preference – preferred shareholders receive dividends on their shares before common shareholders do. 2. 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 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.

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.

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 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: 1.05 Down: 1/1.05 Up prob: 50% Down: 50%

OutcomeProbabilityStock Price Option Value (Stock price - $45, but not less than $0) Probability x Option Value A12.5%$52.09$7.09$0.89 B37.5%$47.25$2.25$0.84 C37.5%$42.86$0.00 D12.5%$38.87$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