Chapter 6

Financing Activities

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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
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.
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 firms

discretion.
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.
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.

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
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)
Chapter: 06

Accounting for dividends:

Chapter: 06

Stock Dividends and Stock Splits

Stock Dividends
Small stock dividends (< 2025 %)
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.
Chapter: 06

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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.

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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).

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12

Disclosure for Treasury Stock:

Cost Method
Subtraction from the totality
of shareholders equity

Chapter: 06

Par Method
Cost of treasury stock
would be broken up and
allocated as reductions of
the individual accounts in
owners equity.

13

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.
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Stock Options: Various terms

Grant date
Vesting date
Exercise date
Exercise price
Market price
Compensation Expense

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15

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
Chapter: 06

16

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).

Chapter: 06

17

Stock Options: Accounting

Grant date:

No financial statement effects occur.

Recognition of An increase in compensation expense (a decrease in

compensation net income, which is also a decrease in retained
earnings).
expense:
Exercise:

Transfer of the stock option plus exercise price from

employee to firm.

Expiration:

The capital contributed to the firm by the managers

employment is reclassified as a permanent
contribution to shareholders equity.

Revocation:

Estimates must be revised going forward.

Chapter: 06

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Alternative Share-Based Compensation:

Restricted Stock and RSUs
Eliminates a managers 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.
Chapter: 06

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Restricted Stock and RSUs: Accounting

Restricted Stock

RSUs

Grant date

Issue of common
stock recorded

Recognition of
compensation
expense

Reduces retained earnings and

Reduces deferred compensation a
contra-equity account

Expiration

Restrictions placed
on trading already
issued stock will be
removed
Chapter: 06

No entry

Issue of common
stock recorded

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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.
Chapter: 06

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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.
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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

Chapter: 06

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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

Chapter: 06

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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
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Chapter: 06

25

Criteria for Liability Recognition

Chapter: 06

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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.

Chapter: 06

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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:

Chapter: 06

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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.

Chapter: 06

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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.
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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.

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Accounting for Troubled Debt

Handling of troubled debt:
From debtors 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
Chapter: 06

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Modification of terms (U.S. GAAP)

Total
(undiscounted)
future cash flows

> Book Value

(BV) of Debt

< Book Value

(BV) of Debt

Adjustment to BV

Nil

BV is reduced to
that extent and
gain is recognized

Interest Expense

Recognized at
effective interest
rate

Not recognized

Chapter: 06

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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)

Chapter: 06

34

Accounting for Hybrid Securities

Preferred Stock

U.S.GAAP

IFRS

Mandatorily redeemable

Liability

Liability

Redeemable at firms option

Equity

Equity

Redeemable at holders
option

Mezzanine
section

Liability

Financial
Liability

Debt and equity features

are distinguished and
valued at Fair Value

Convertible Debt
Bonds issued with
detachable warrants
Chapter: 06

Debt and equity features are

distinguished and valued at Fair Value
35

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.
Chapter: 06

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Accounting for Financial Arrangements

Sale of Receivables with recourse

SFAS 140

If selling firm controls

Collateralized loan

If buying firm controls

Sale

Product Financing Arrangements

SFAS 49

Inventory sale commitment

Similar to sale of receivables

Inventory purchase commitment

Liability

Research and Development

Financing Arrangements

SFAS 68

In Joint Venture

Liability

Take-or-Pay or Throughput
Contracts

SFAS 47

Chapter: 06

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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
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38

Choosing the Accounting Method

Conditions for a capital lease:
Extends for at least 75 percent of the assets

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.
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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.
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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

firms financial statements.

determining capital structure weights and debt
costs for the weighted average cost of capital
calculations in entity valuation.
Chapter: 06

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