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Published: Wednesday, 08 April 2020 14:02
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STOCKS 101:
Any stock company that is public has to provide financial details of it's business. Comapnies send their investors a lot of reports periodically, which are avilable for anyone to see. Most relevant of these reports are the 4 quarterly reports (known as 10-Q), and one yearly report (known as 10-K). We'll focus on annual report, since quarterly reports are just wastage of time and money.
Reading annual report:
2 types of annual report:
1. annual report to SEC or Form 10-K = large amount of disclosure
2. shareholder annual report = has aggregated financial info (50%) plus sales and marketing material (50%). It's a less detailed version of form 10-K.
We'll look at shareholder annual report. SEC (securities and exchange commision) and FASB (Financial Accounting standards board) regulate much of what appears in report.
SEC was created in 1934 thru securities act of 1934. FASB was created in 1973 for establishing standards of financial accounting and recording. these standard known as GAAP (generally accepted accounting principles). Other organizations as AICPA (american institute of certified public accountants) and ASB (auditing standards board) act as advisors in development of these standards.
ASB also develops GAAS (generally accepted auditing standards) which govern audit of a client company.
Structure of annual report:
1. Financial highlights: generally make a compnay look as good as possible. Do not rely on this.
2. statement of mission or corporate profile: give a sense of firm's direction and purpose
3. chairman's message: it's a letter to shareholders
4. management's discussion and analysis (MD&A): Most imporrtant. SEC requires management to discuss past performance and address 3 important areas: capital resources (debt and equity available for funding capital expenditure), liquidity (ability to pay short term and long term debt) and results of operation (unusual events that may materially affect reported income). It also has forward looking statements
5. Report of management: highlights management responsibility for what appears in the report.
6. Report of independent accountants: outside accounting firm issues independemt auditor's report. It's divided into 3 paragraphs: 1st paragraph identifies the scope (stating that reported info is resposibility of mgmt, and accounting firm is just expressing an opinion on accuracy of staements). 2nd parahraph states that audit was performed in accordance with GAAS. 3rd paragraph is the opinion paragraph. most common is the "unqualified" or "clear" opinion, meaning results are fairly presented. On occasions, "qualified" opinion is rendered which means accounting firm is not in agreement with a specific accounting principle that was chosen by the company. This limitation however doesn't have material impact on performance measure of company. Rarely, auditing accountants will issue an "adverse" opinion, which means that finacial statements don't fairly represent the financial position of company.
Remember that an audit doesn't mean that company's records are 100% accurate because audit is performed using statistical sampling methodoligies, which means only a few samples of accounts and business transactions are examined. It's impossible and cost prohibitive to review all transactions.
6. statement of income: reports financial performance over a period of time.
7. statement of financial position: balance sheet of the company on a particular day.
8. statement of change in stockholder's equity: changes over a period of time
9. statement of cash flow: company's cash inflow and outflow over a period of time.
10. Notes to the financial statement: provides additional clarification.
11. 5-10 yr summary of operating results: this report not covered by auditor's opinion.
12. Investor and Company information: All contact info etc. These identify company's officers (CEO, CFO, VP, etc) and Board of directors (comprising of many current officers and outside individuals). company shareholders appoint many of these board members. BOD reserve the right to approve or reject major startegic initiatives, and also responsible for setting compensation.
A annual report contains income stmt, balance sheet, cashflow stmt and equity stmt. It contains notes to financial stmt aftet this which provide additional info to improve understanding of financial statements. these notes are also audited alongwith financial stmt. There are various notes, some of which are:
1. summary of significant accounting policies.
2.long term debt:
3. income taxes.
4. empoyee stock plans.
5. leases.
6. acquisitions, etc.
corporations follow one of the three strategies:
1. growth: directs financial resources to grow by increasing sales and capital expenditures.
2. stability: lack of change in direction.
3. retrenchment: products are eleiminated, mass layoffs, and there's talk of general business closure.
Different ratios used to measure financial performance of cos.
1. ROA (return on assets): net income/total assets
2. liquidity measure: co ability to meet its current period obligations. cash ratio= available cash/current liabilities.
3. ROE (return on equity): ROA*financial leverage = (income/assets) * (assets/equity) = net_income/(shareholder_equity - preferred stock)
EBITDA (earnings before interest, tax, depreciation and amortization) = it proxies the amount of op cash flow generated from day to day operations. however, SCF gives better idea of cash flow than this, so avoid this.
inventory turnover = measures how quickly inventory is consumed in operations.computed by dividing days in a year by no. of turns. a well run business turns inventory around more times a yr than a poorly run business, so inventory turnover days is lower (ex: 360/10=36 days) for well run business than poorly run business (ex: 360/4=91 days)
accounts receivable turnover = measures how often avg accounts receivable turn over in the form of credit sales. a well run business will turn receivables often to increase cash flow.
emerging issues in financial reporting: gaap and sec guidelines give lot of flexinbility in reporting process, so cos take advantage of that. some of these are:
1. earnings mgmt: revenues are managed sometimes by reporting sales before they are earned
2. managing expenses: cookie jars used to manage expenses big-bath where large non-recurring charges are taken to improve earnings in future also used. off-balance sheet financing also used to manage expenses.
3. pro-forma earnings: it's a recasting of financial info assuming a change in recent business model. it allows mgmt to report hypothetical earnings under a new business model - for ex, effect of a merger or acquisition that occured recently. It should not be relied on.
Statements: Let's now look at 4 most importatnt statements provided in any annual report.
Income statement:
It's record of activity for a month, quarter or a year. some limitations: for Ex., net income ignores when cash receipts for that revenue will be received. thereofore it's differenent from cash flow.
2 sections:
1. operating section: includes revenues and expenses that correspond to the principal operations of the company, i.e. day to day operations. op. revenues and op. expenses lead to op. income/loss.
A. Net sales: Gross sales minus (cost of goods returned, discounts earned by contractors, allowances granted to customers, etc.)
B. Cost of goods sold: recognized only when a merchandise has been sold. Co. can use LIFO, FIFO, weighted avg, etc.
C. Gross profit (gross margin) = A-B.
D. selling and store operating expenses:
I. selling expenses includes employees salary, advertising costs, and other expenses directly related to selling of goods/services.
II. store operating expenses (or occupancy expenses): proportional to no of stores opened. includes rental, depriciation expense, utilities, property tax, etc.
E. Pre opening expenses: in advance of opening new stores, personnal are hired, etc which results in pre opening expenses. These aren't allowed to be capitalized, so these are expensed as they occur, usually in the yr in which new stores open for business.
F. General and Adminstrative expenses: include variety of costs that relate to other than sales operations. For ex. depreciation of co.'s headquarters is included here while depriciation of trianing centre would be a selling expense. Mgmt salaries, utility costs, property taxes are included here.
G. Operating expenses = D+E+F
H. Operating income/loss: C-G (op revenue - op expenses)
2. non-operating section: includes income/expense items and gain/loss items that are routine, but are viewed as peripheral to day-to-day business operations. Ex. are interest earned on investments, interest incurred on borrowings and gain/loss associated with sales of assets.
A. Interest and investment income: co. invests in CD, treasury notes or stocks/bonds of other co. returns in form of dividends, interest, etc is reported. howver banks/financial institutions report this in op. section.
B. Interest expense: associated with interest on notes, bonds, lease or pension obligations.
C. Income Taxes: federal, state and foreign income tax obligations.
income tax expense = federal statutory rate multiplied by co. income before tax + adjustment to include any state/foreign income tax obligations/benefits.
so, effective tax rate may vary from yr to yr. note that co income tax expense is different from income tax paid (which is reported in cash flow stmt).
Sum of op. income/loss and non-op. income/loss is income/loss before income tax expense. Net income is income after subtracting income tax.
Net earnings = op income/loss + non-op income/loss.
net profit margin=net income/loss / net sales.
Basic earnings/share: net income-preferred dividends / weighted avg shares outstanding.
(weighted avg shares outstanding is the avg no. of shares outstansding during the reporting period, and not just the no of shares at the end of period, since co may buy shares at end of period to inflate earnings otherwise)
Diluted earnings/share: same as basic but potentially dilutive shares are included here. dilutive securities may be:
1. convertible bonds or notes
2. convertible preferred stock
3. stock options or warrants
Irregular items: 3 items are reported outside the op and non-op sections.
A. discontinued op.: to qualify as discontinued op., assets, results and activities of business segment must be clearly distinguishable. For ex. assets being sold by co.
B. extraordinary events: unusual and infrequent in occurence. APB opinion 30 says clearly that unusual means high degree of abnormality while infrequent means it should not be reasonably expected to recur in forseeable future. An item such as corporate restructuring charge isn't reported here, but in operating section as FASB considers it as part of normal business.
C. changes in accounting principles: results when a co. switches from one GAAP to another or FASB issues a new accounting announcement. such change requires an adjustment to asset/liability accounts as well as an adjustment to net income or retained earnings. 2 approaches:
1. current approach: this is when income gets affected. cummulative effect is the total income diff between what was reported vs what would have been reported under new rule.
2. retroactive approach: this is when retained earnings are affected. this allows to bypass current yr income, but requires restatement of related prior yr info.
most changes in accounting principles are accounted for under current approach, with cummulative effect of the change reported in current yr income.
CashFlow Statement:
stmt of cash flow (SCF) provides picture of how cash flows in and out of business. 3 types of cash flow captured:
1. net cash provided (used) by op activities: cash that flows into and out of the business from day to day operations, labeled net cash provided by operations.
cash inflow is from
A. sale of goods,
B. interest/divident income on investments
C. service reveneue such as rental income from equip.
while cash outflow is fom
A. purchase of inventory
B. payment of interest/taxes.
C. payment of operating expenses as wages, supplies, maintenance
2 tpes of reporting method for net operating cash flow:
A. indirect method: computation starts with net income, followed by several adjustments resulting in net op cash flow. adjustments are done to remove impact of non-cash charges (such as depreciation/amortization) and accrual based changes to current asset/liability from net income (such as increase in receivables, inventories, accounts payable, income taxes payable, etc). Adjustments:
I. depreciation and amortization: added back to net earnings since no real cash flowed out.
II. Increase (decrease) in receivables: added (subtracted) from net income. this amount can be figured out from balance sheet by seeing how much the recivables decreased/increased, and adding/subtracting the corresponding amount from net income, since this cash wasn't accounted for in the net income section. This may not concile totally with balance sheet because of several minor differences.
III. merchandise inventories: if the balance in merchandise inventory in balance sheet increased, then this amount is subtrated from net income (and vice versa), since that implies that much extra cash was paid to buy it.
IV. accounts payable and accrued expenses: if these increase in the balance sheet, then this amount should be added to SCF since cash associated with this hasn't been paid.
V. income taxes: added/subtracted similar to above.
VI. other: this simply represents the net change of several current asset/liability accounts.
B. direct method: used rarely. reports op cash flow directly associated with day to day operations. It shows cash flow inflow resulting from sale recipits, customers paying on account receivables, and any other cash received. similarly it shows cash outflow resulting from payment to purchase merchandise, tax, interest, etc.
Both direct and indirect method should end up with the same cash amount.
Net cash provided by operations is sum of items I-VI = $X
2. net cash provided (used) in investing activities: measures src and use of cash in selling and purchasing assets.
investing cash inflow would be cash generated by
A. selling land, bldg, equipment.
B. selling stock/bond
C. cash from vendor etc when they repay a loan.
investing cash outflow would be cash given out for
A. purchasing land, bldg, store, etc.
B. purchasing stock/bond of another co.
C. lending of cash to vendor for more than 90 days.
Typical items:
I. capital expenditures: net capital expenditure that was done. None of this capital expense is included in net income part, so all of it is listed here.
II. Acquisitions of business: net amount for purchasing other business is included here
III. proceeds from sale of property/equipment: the net amount is shown here, as it's not included in income section.
IV: purchase/sale of investments: total amounts reported here.
Net cash from investing activities is the sum of items I-IV = $Y
3. net cash provided (used) by financing activities: measures src and use of cash to finance a business.
financing cash inflow is :
A. loan from bank,
B. cash from bond/stock issue
while financing cash outflow is
A. repayment of the loan.
B. cash to pay dividend
C. cash to redeem bond principal or to buy back stocks
Items:
I. issuance (repayment) of Commercial paper obligations: this represents net amount from buying/selling CP.
II. proceeds from long term borrowing: long term debt taken to expand
III. repayments of long term debt: cash is used to pay back part of long term debt and interest.
IV. proceeds from sale of common stock: no. of new stocks issued can be found out from outstanding stock no from equity section in balance sheet. Most of the stocks sold under ESPP to employees.
V. cash dividend paid to stockholders: this amount is also included in the consolidated stmt of stockholder equity and comprehensive income.
VI. minority interest contribution to partnership: if more than 50% of subsidiaries are owned by the co., then cash contributions made by subsidiaries are included here.
Net cash from financing activities is the sum of items I-VI = $Z
Cash and Cash equiv: this is final cash. cash equiv refers to treasury bills, CP, money mkt fund, etc. which have maturity of < 90 days, and can be readily converted to cash = $X+$Y+$Z An extra line is added in SCF to accomodate foreign currency translation adjustment.
Balance Sheet statement:
Comapany's assets (resources) = Liabilities (claims against those resources) + shareholder equity (residual ownership of those assets)
reported as of end of year. Consolidated report means performance of several business combined in one.
capitalization means a particular item bought is recorded as an asset on balance sheet. Each year, the item's partial cost will be allocated to the income statement as depriciation expense. eventually, the item's cost on balance sheet will goto zero.
balance sheet provides info about liquidity and solvency.
1. liquidity: indicates company's ability to meet its current maturing obligations (in next 12 months). We take a ratio of current assets (cash, etc.) and current liabilities and call it liquidity ratio.
2. solvency: indicates company's ability to meet future principal and interest payments on its long term debt. A ratio of total debt to total assets measures this.
ROA (return on assets) = net income / total assets.
ROE (return on equity) = net income / shareholder equity
Account receivable = always reported at their net realizable value (excludes company's estimate of uncollectable amounts). This estimate might be based on aging schedule of accounts receivable.
Assets:
1. "furniture, fixtures and equipment" are recorded on basis of acquisition cost (historical cost). However, they are depreciated, and this captures the cost of using an asset. Remember, that though this reduces the carrying value of assets, it doesn't reflect the fair market value of assets. Estimated asset life should be appropriate.
2. Land is recorded at cost, but is not depriciated. this keeps the carrying value of land the same, as benefits associated with land don't decline with time.
Fair value accounting (mark to market) is used when assets can be liquidated in established markets with identifiable market price. In these cases, investments are recorded at cost but adjusted to fair market value.
Matching revenue and its related expense: Whether asset capitalized or expensed directly, it should try to match the revenue that this asset helped to generate with the expense of genrating the revenue.
Loss contingency: potential obligations that might arise from past events. these detalied in notes to financial statements.
Balance sheet page:
Assets:
Current Assets:
- Cash and cash equivalents: cash in savings/checking accounts, cash invested in short term maturities of 3 months or less (referred to as cash equivalents, and includes high grade commercial paper, money market funds, US govt securities, etc)
- Short term investments (incl current maturities of long term investments): includes stocks/bonds of other companies. These investments are classified according to manamgement's intent, in one of three groups:
A. Trading: mgmt intent to hold for very short period (few weeks to few months). these investments shown on he balance sheet at their current market value, with all unrealized gains and losses (based on changes in market value) reported in income stmt. market value can be determined at the end of reporting period by closing price of share/bond.
B. available for sale (AFS): mgmt intent to hold for more than few weeks or months. They are adjusted to their fair market value, but changes in fair mkt value are reported in shareholder's equity (as part of other comprehensive income), and NOT in income stmt. Logic is that it reduces volatility in earnings since it's supposed to be held for a longer time, and final loss/gain reported in earnings once the investment is liquidated.
C. Held to maturity (HTM): mgmt intent to hold these long term investments till they mature. So, these are carried at cost (no adjustment to fair market value) till they are liquidated.
- long term investments: when a co. invests in another co's debt or equity, it can be short term or long term. If these are intended to be held for more than a yr, these are long term. It can be accounted for under 1. Cost. 2. fair value 3. equity 4. consolidation approach.
Equity method of accounting used (instead of cost or fair value accounting) when company acquires enough voting shares of another company so as to influence mgmt decisions. This requires the investor company to periodically adjust the carrying value of the investment based on its %ownership of the investee company's profits and losses as well as the investee company's dividend distributions. Threshold for application of equity method of accounting is 20% to 50% of company's voting shares. When company's investment is over 50%, the investor company accounts for the investment under consolidation rules, meaning 2 or more companies are reorted as if they were one, even though they are separate legal entities.
- Accounts recivable, net: net represents the amount of cash that it expects to finally collect (difference between gross and net is allowance for bad debts). sales made on credit result in this.
- Merchandise inventories: most illiquid of current assets. Mostly inventories are acquired from other manufactures and then resold (ex. HD), sometimes manufactured and sold by the same company (ex GM). When manufactured and sold by the same company, balance sheet may report 3 inventory accounts: raw materials, work in progress, and finished goods inventory. For reporting purposes, merchandise inventories stated at lower of cost or market (LCM). cost is the purchase price. any losses on inventory write downs are recoginzed in the period it occurred. Different cost-flow assumptions:
1. First in First out (FIFO): let's say 1st purchase of 30 iems cost $11 each, 2nd purchase of 50 items cost $12 each, and final purchase of 20 cost $13 each. if 90 items sold during year, then inventory value of 10 items is $13x10=$130.
2. Last in first Out (LIFO): last items cost 20 at $13, 50 at $12 and 20 at $11. So, inventory value=$11x10=4110.
3. Avg cost: take avg cost by dividing total purchase price by total units, and use that for valuing inventory.
Many companies choose LIFO since during periods of increasing prices, higher costs tranfer to income stmt, creating lower profit and hence lower tax to IRS.
- Property and Equipment: referred as capital expenditures as they provide benefit over more than one period.
Land: includes purchase price, attorney fees, other fees, etc. special assessments levied by govt also included.
Building:
If an existing bldg bought, then purchase price is allocated to land and bldg separately. Any additional expendture to make bldg ready to move in, is also included in the price of bldg. bldg cost is depreciable.
If a new bldg is constructed, then cost of building as well all other fees, permit cost, etc. included in cost.
Furniture, fixtures and equipment: these asset depriciated individually, since they different useful lives.
- leasehold improvement: lease is contract b/w 2 parties that authorizes the use of a specific asset (eg bldg) for an identified period of time. Any money spent on improvement is termed leasehold improvement. and they are written off over the term of the lease or life of the improvement, whichever is shorter. write off of leasehold improvements is termed amortization instead of depreciation. leasehold improvements are intangible assets.
- construction in progress: all such items are reported as assets
- capital leases: 2 categories of leases.
1. operating leases: viewed as temporary rentals, with rental expense reported on income stmt.
2. capital lease: requires rentals that are long term, and approximate the value of the asset being leased. Co. that owns the asset is willing to receive installment payment over the lease term, and provides financing. It is as if lesse had purchased the asset using long term financing, although there is no tranfer of title. So, these leases are treated as a purchase. So, they appear on asset side with a related liability. These assets are depreciated, and are written off oevr the life of the lease. Upon termination of lease agreement, the asset is depriciated completely, and lease liability is fulfilled. At this point, asset transfers back to the lessor, or is sold to the lessee at bargain price.
- notes receivable: It's a written promise to pay a specific amount at some future time. These are generally loans, but can also be conventional sales that allow for extended terms.
Intangible assets: Cost of intangible assets (as patents, copyrights, trademarks, organizational costs[costs icurred in formation of enterprise], goodwill[value over net identifiable assets]) are capitalized and allocated to future periods thru amortization. goodwill has generally been written off over a period of 40 yrs. This writeoff placed a significant drag on earnings for a long time. however recent FASB change requires goodwill to be written down only when its value appears to be permanently impaired. This is because goodwill is supposed to have indefinite life (similar to land).
Liabilities
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Surrent (short term) liabilities
- accounts payable: represents amount owed to other companies. Usually paid within couple of months.
- accrued salaries payable and related expenses: This is because of accrual accounting. accrual accounting requires revenues to be recoginzed when earned and expenses when incurred. Actual receipt of payment with cash is not required to recognize revenues and expenses. When accrual takes place, it is often related to a transaction that does not coincide with the close of the yesr (or quarter), or the exact amount in not yet known (in case of contingent liability). For ex, salary may be paid biweekly, and the end of year may not exactly align with the payment date, so accrued salary recorded for remaining days. Related expenses are payroll taxes or other expenses.
- Sales Taxes payable: Corporations collect sales taxes and pay it to govt periodically. Any amount collected and not remitted to govt is shown as liability.
- other accrued expenses: variety of obligations. For ex, for semi-annual interest payable bonds, interest payment date may not fall at end of fiscal year, so accrual of interest is done from the last interest payment date to the end of yr. Other note obligations, etc may require similar accrual.
- income taxes payable: estimated liability satisfied with periodic payments to several taxing authorities.
- current installments of long term debt: shows current maturaties of long term debt (obligations such as installment notes, commercial paper, mortgages, leases and bonds). Involves principal amount only and not interest payment.
Long term debt (excluding current installment): obligations not payable in coming year. Examples of these are long term capital leases, mortgage obligations, pensions and other retirement benefit obligations. Most of these obligations are comprised of both short term and long term. Even some short term CP are classified as long term because of their roll over status.
Other Long term liabilities: Apart from bonds, employee benefits and pensions are substantial portion of long term liabilities. Generally, employee benefits are not earned until the employee has been with the co. for a no. of years, known as vesting period. cos. accrue employee retirement benefits with passage of time. If they don't fund (set money aside) 100% of accrued pension or other post employment benefits (OPEB), they have to report a future liability for the remaining amount.
OPEB sheet: 3 parts
A. benefit obligations: refers what is to be paid. actuarial present value of employee benefits earned.
B. plan asset's fair value: refers to what is currently put in plan assets to pay for these obligations. These assets are put in trust, invested in stock market, etc, and then redistributed on retirement.
C. Prepaid (accrued) benefit cost: =B-C+some_other_unrecognized gains/losses. It's the pension/OPEB asset/liability reported on balance sheet.
1. Projected benefit obligations (at start of yr): actuarial present value of employee benefits earned using projected salary levels and present yrs of service. $X
2. Service costs (benefits earned during the yr): this yr's service benefits earned. $Y
3. Interest cost on projected benefit obligations: mere passage of time increases projected benefit obligation and pension expense. $Z
4. Actuarial loss(gain): primarily changes in discount rate, change in estimates, etc: $A (positive for loss)
5. Benefits paid: during the current yr. $B (negative for money paid)
4. expected return on plan assets: this expected return reduces volatility on pension and OPEB expenses.
5. net amortization: actuarial adjustments (changes in discount rates, mortality rates, etc) made periodically , thereby inc. or dec. projected benefit obligation. Howver instead of directly adding these losses/gains to obligations, they are amortized over time. A second adjustment is sometimes made which is loss/gain on plan assets, which results from diff b/w expected return and actual return.. To reduce volatility, use of avg expected return is used.
EX:
Projected benefit obligations, Jan 1: $X
Service costs (benefits earned during the yr): $Y
Interest cost on projected benefit obligations:$Z
Actuarial loss(gain), primarily changes in discount rate, etc: $A (positive for loss)
Benefits paid:$B (negative for money paid)
Projected benefit obligations: $X+$Y+$Z+$A-$B
Deferred income taxes:This appears in long term liability section.
deferred income tax liabilities represent future income tax obligations as a result of past events.
deferred income tax assets represent future income tax benefits as a result of past events.
they arise when gaap and tax code result in timing difference in revenue, profit, etc.. these timing differences are temporary. depriciation timing differences are largest contributor of deferred tax liabilities. For ex. if income before depriciation is $X, and depriciation is $Y for tax purpose for 1st year while it's $Z ($Z < $Y usually so that accelerated depriciation results in lower taxes initially) for reporting purpose for 1st year. so, income after dep. for tax = $X-$Y= 80K-25K=55K for book = $X-$Z= 80K-10K=70K so, for yr 1, tax is paid on 55K (lt's say at 30% rate=16.5K), which is lower than if it was paid on $70K (=$21K). So, deferred tax liability is reported=$4.5K. ultimately this vanishes when all depricaition is taken. One example of deferred income tax asset is post retirement benefit expenses. For tax purpose, these expenses are not recognized till they are distributed at retirement. so, taxable income is higher resulting in more tax, so tax asset is realized. Other deferred tax assets are unearned revenue, warranty liabilities, bad debt expense, etc. minority interest:when a co. has ownership interest of between 50% to 100% in another co., 100% of the assets of subsidiary co. are included in asset section of balance sheet. amount represented as minority interest is the amount of assets that the parent co. doesn't own. stockholder's equity: assets are financed both by debt and equity. equity represents the net assets of a corporation. 2 categories of equity: 1. contributed capital: recognized when a co. acquires assets thru sale or exchange of common stock. this goes on in the asset or a reduction in liability. contributed capital consists of: A. common stock: total no of stocks outstanding is multiplied by the par value of stock to give legal capital of firm. legal capital is used as a protective means to prevent co. from distributing dividend in excess of earning and additional paid in capital (so that companies don't just give everything to shareholders). It provides some measure of value to creditors in case of liquidation. Par value and fair value of share are totally unrelated. B. additional paid in capital: represents excess of selling price over par value per share. because stock is sold periodically thru offerings (incl the IPO), selling price varies. Total money that was paid by shareholders in excess of par value is this paid in capital. Authorized common shares: max no. of shares that can be issued by the co. article of incorporation identify this no. and can be exceeded only if the corporate charter is amended. issued common shares: no. of shares sold over time. outstanding common shares: it can be less than or equal to the no. of sharess issued. If it's less, it means the co. reacquired some of the shares thru buyback. reacquired shares are called treasury shares. 2. Earned Capital (retained earnings): represents the accumulated earnings of a co. since its inception, less any dividends paid to the shareholders. At inception, retained earnings are zero, but with passage of time, they get positive. negative retained earnings menas the co. has sustained net losses or paid divivdends in excess of income. retained earnings are a subset of equity (as they add to assets). 3. accumulated other comprehensive income: this is additional component of stockholder equity, and includes gains and losses that have bypassed the income stmt for income smoothing reasons. For many yrs, only net income was reported but now sec requires cos. to report more complete income called comprehensive income.. As increses or decreases occur in other comprehensive income, these are reported not in income stmt but in stmt of change in stock holder equity or in separate stmt of comprehensive income. But any accumulated balance of these unrealized gains/losses is reported under stockholder's equity. These normally include gains/losses on available for sale securities, foreign currency change, etc. Shares purchased for compensation plans: treasury stock is stock repurchased by the issuer. amount here indicates the cost of shares reacquired, at the market price at time of acquisition. On the balance sheet, this amount is deducted from stockholder equity since treasury stock is contra equity account.
Equity statement:
Stockholder's Equity and comprehensive income Statement
It identifies changes in all balance sheet equity accounts over a specified period. It's purpose is similar to cash flow stmt, but rather than measuring change in one balance sheet element (cash), it measures change in all equity accounts.
3 yrs worth of info is reported. also, beginning balance to ending balance is reconciled with retained earnings. FASB requires that significant changes in equity accounts include comprehensive income
stockholder's equity implies net assets of a co. (assets - liabilities). dividend distributions are only reported in 2 places: here and in cash flow stmt.
The report is presented in row/col format.
Rows identify events that cause change in stockholder's equity balance. These events are:
1. shares issued under employee stock purchase and options plans: this increses the number of stocks outstanding. Par value of the stock as well as the additional piad in capital is recorded.
2. tax effect of sale of option shares by employees: exercise of selected stock options (i.e non-qualified options) provides issuing co. with certain tax advantages. however gaap accounting treats tax advantages differently than irs. under gaap, compensation expense related to stocks is measured as below:
expense under GAAP = (shares's mkt price - option price on date options are granted)*no. of options granted.
This expense amount is then allocated to expense over the vesting period.
however, with irs, compensation expense is measured and reported when options are exercised using this formula: (resulting in tax deferred asset)
expense under IRS = (option price - fair mkt value of stock on date options are exercised)*no. of options
so, expense differential between these 2 set of rules results in adjustment to piad in capital. if tax benefit associated with options exercised exceeded the previously reported deferred tax asset, then that amount is added to paid in capital.
3. net earnings: this increases both the retained earnings and total comprehensive income.
4. translation adjustments: foreign currency translation adjustment done to accumulated other comprehensive income.
5. stock compensation expense: granting stock options/units results in compensation expense and is added is the income stmt. however, this may result in addition on the paid in capital also, as explained above.
6. shares purchased for compensation plan (or assets in trust): assets in trust reflect shares set aside for certain stock compensation plans. this is reported in others. A positive value means assets decreased implying some options got cancelled, etc. stocks purchased for buyback are added to treasury stocks, and results in decrease in paid-in capital. note that gain/loss is not recognized on sale/buy of its own stock by cos.
7. cash dividends: this reduce the retained earnings.
8. comprehensive income: it's just a sum of realized and unrealized income.
Columns include:
1. shares issued.
2. amount = par value of shares
3. paid in capital = excess of selling price over par value
4. retained earnings = net income
5. accumulated other comprehensive income: other income
6. other: all other income/loss
7. total stockholder equity = sum of all colums
8. comprehensive income = income from all unusual items included.
