Shareholders Equity and

Marketable Securities

GSBA 510:
Financial Accounting
Session 25
Mark Soliman
 Agenda
• Shareholders’ equity – components and common
transactions
– Stock repurchases
– Treasury stock
– Basic and diluted earnings per share
• Marketable Securities
– Accounting for investments in marketable securities
– Comprehensive income
• Dell Computer

Autumn Quarter – Session Mark Soliman 2

15
 Dell’s Liabilities and Equity

Autumn Quarter – Session Mark Soliman 3

15
 Shareholders’ Equity – Components
• Shareholders’ equity is a residual interest,
representing the shareholders’ claim on the assets of
a firm in excess of the higher priority claims of
creditors.
• Changes in shareholders’ equity result from three
types of transactions
– Capital Contributions – firms issue common or preferred
stock to obtain funds to finance various operating and
investing activities.
– Operating Transactions – firms use assets provided by
creditors and owners to generate earnings.
– Distributions – firms distribute assets to shareholders
either in the form of a dividend or the repurchase of
common or preferred stock.

Autumn Quarter – Session Mark Soliman 4

15
 Debt vs. Equity
Stocks can be thought of as a call option on the firm…
 Shareholders’ Equity – Common
Transactions
1 Issue shares for cash.
2 Buy back shares and hold them.
3 Reissue previously reacquired shares.
4 Buy back shares and retire them.
5 Record income for the period.
6 Declare and pay dividends.
7 Declare a small (< 20%) stock dividend.
8 Declare a large (> 20%) stock dividend.
9 Split shares.

Mark Soliman 6
 Stock repurchases

How do companies buy

back stock?
Open market repurchase

Fixed price tender offer

Dutch auction tender offer

Autumn Quarter – Session Mark Soliman 7

15
 Overview
(pecking order theory of finance)
How do firms finance operations/investments?

Internally generated funds Externally generated funds

First Best Option

DEBT EQUITY
Second Best Option Third Best Option

Autumn Quarter – Session Mark Soliman 8

12
 Which does the market prefer?

Autumn Quarter – Session Mark Soliman 9

12
 Actual Returns…

Autumn Quarter – Session Mark Soliman 10

12
 Earnings Per Share (SFAS 128)

• Basic Earnings Per Share (EPS)

– Income available to common shareholders (net

income less preferred dividends) divided by
weighted average number of shares outstanding.

– Ignores the potential dilution due to securities

that could be converted into common stock.

Autumn Quarter – Session Mark Soliman 11

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 Earnings Per Share (SFAS 128)
• Diluted Earnings Per Share
– Securities that are convertible into common stock, or options and
warrants that entitle the holders to obtain common stock under
specified conditions  dilution, .i.e., current shareholders’ owning
a smaller slice of the company.

– Diluted EPS computation recognizes that

• New shares are issued upon conversion – a denominator effect.
• An increase in NI results when the debt interest payments are
eliminated after conversion – a numerator effect.

– Disclosure requirements:
• Both Basic EPS and Diluted EPS need to be reported on the I/S
unless they are the same (up to 2%-3% difference).
• Need to reconcile numerator and denominator effects.

Autumn Quarter – Session Mark Soliman 12

15
 Inter-corporate Investments

Fair Value Equity Method Consolidation

(mostly)

Autumn Quarter – Session Mark Soliman 13

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 “Passive” Investments

Reported at historical
Reported at FV on B/S. cost net of amort. on B/S.
Reported at FV on B/S.
Unrealized gains and Unrealized gains and
Unrealized gains/losses
losses included in NI. losses not recognized.
charged directly to equity
(not included in NI). Amortization and interest
revenue included in NI.

Autumn Quarter – Session Mark Soliman 14

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 Mark-to-market Accounting
• Both Trading and Available for Sale securities
are recorded at FV and use “mark-to-market”
accounting.
• During the financial crisis these rules were
suspended
• Let's go to the cows...

Autumn Quarter – Session Mark Soliman 15

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 Comprehensive Income
• Relatively new disclosure – SFAS 130, issued in 1997.
• A measure of performance that takes into account
gains and losses that impact shareholders directly
rather than through NI, i.e., items that “by-pass” the
I/S and go directly to SE.
• Components of comprehensive income:
– Net Income (from I/S)
– Other comprehensive income
• Unrealized gains and losses on “available-for-sale” securities
• Foreign currency translation adjustments
• Derivatives qualifying as hedges

Autumn Quarter – Session Mark Soliman 16

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 Comprehensive Income
• Components of comprehensive income must be
reported in a primary financial statement, preferably
below NI in the I/S or in a separate Statement of
Comprehensive Income.

• Companies are also allowed to (and most actually do)

report comprehensive income in the Statement of
Shareholders’ Equity.

Autumn Quarter – Session Mark Soliman 17

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 Highlights from Today
• Firms split and repurchase their stock for a number of
reasons.
• Stock splits and repurchases do not generate gains or losses,
but have an impact on EPS.
• Diluted EPS numbers are adjusted for potential dilution from
stock options, warrants, and convertible securities.
• Financial reporting for intercorporate investments depends
on the size of the parent company’s ownership shares.
• When the ownership share is less than 20%, “passive”
investment, fair value (mark-to-market) accounting is used.
• Unrealized gains and losses from passive investments
classified as “available-for-sale” securities by-pass the I/S, but
are reported as a component of comprehensive income.

Autumn Quarter – Session Mark Soliman 18

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 Scenes from the Next Session

• Dell Case

Autumn Quarter – Session Mark Soliman 19

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 Shareholders’ Equity – Common
Transactions
(1) Issue shares for cash

(-) C/S Par (+) (-) C/S APIC (+) (+) Cash (-)
BB BB BB
Par Proceeds Proceeds
Minus par
EB EB EB

Autumn Quarter – Session Mark Soliman 20

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 Shareholders’ Equity – Common
Transactions
(2) Buy back shares and hold them

(+) Treasury Stock (+) Cash (-)

(-)
(Contra Equity Account)
BB BB
Cost to acquire Cost to acquire

EB EB

Autumn Quarter – Session Mark Soliman 21

15
 Shareholders’ Equity – Common
Transactions
(3) Reissue previously reacquired shares

(-) C/S APIC (+) (+) Treasury Stock (+) Cash (-)
(-)
BB BB BB
PLUG  PLUG Cost when Proceeds
acquired

EB EB EB

Autumn Quarter – Session Mark Soliman 22

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 Shareholders’ Equity – Common Transactions
(4) Buy back shares and retire them

(-) C/S Par (+) (-) C/S APIC (+)

BB BB
Par APIC when
issued
EB EB

(-) R/E (+) (+) Cash

(-)
BB BB
PLUG  PLUG Cost to acquire
EB EB

Autumn Quarter – Session Mark Soliman 23

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 Shareholders’ Equity – Common
Transactions
(5) Record NI for the period

(-) R/E (+)

BB
Net Loss  Net Income

EB

Autumn Quarter – Session Mark Soliman 24

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 Shareholders’ Equity – Common
Transactions
(6) Declare and pay dividends

(-) R/E (+) (+) Cash (-)

BB BB
Cash paid Cash paid

EB EB

Autumn Quarter – Session Mark Soliman 25

15
 Shareholders’ Equity – Common
Transactions
(7) Declare and pay a small ( < 20% ) stock dividend

(-) C/S Par (+) (-) C/S APIC (+) (-) R/E (+)
BB BB BB
Par Market Market
minus par

EB EB EB

Autumn Quarter – Session Mark Soliman 26

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 Shareholders’ Equity – Common
Transactions
(8) Declare and pay a large ( > 20% ) stock dividend

(-) C/S Par (+) (-) R/E (+)

BB BB
Par Par

EB EB

Autumn Quarter – Session Mark Soliman 27

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 Shareholders’ Equity – Common
Transactions
(9) Split shares

(-) C/S Par (+) (-) R/E (+)

BB BB
Par Par

EB EB

Autumn Quarter – Session Mark Soliman 28

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 Accounting for common stock:
Journal entries
• XXX Corp. issues 5,000 shares of $1 par common stock at $50 per share.
The company records the stock issuance as:
DR Cash $250,000
CR Common stock -$1 par value $5,000
CR Paid-in capital in excess of par 245,000
 Several years later, XXX buys back 200 shares at a cost of $48 each. The
accounting entry is:
DR Treasury stock $9,600
CR Cash $9,600
A contra-equity account

 Later, XXX decides to resell 200 treasury shares at $53 per share:
DR Cash $10,600
CR Treasury stock $9,600
CR Paid-in capital in excess of par 1,000

Mark Soliman 29
 Accounting for common stock:
Balance sheet disclosure
• Excerpt from the company’s balance sheet after the stock
repurchase but before shares have been resold:

Shows the dollar

amount paid to buy
back shares

Autumn Quarter – Session Mark Soliman 30

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 Stock repurchases and earnings
management
• Rocket Software just completed a successful third quarter with earnings of
$220,000 and EPS of $1.00.

• The company’s record for quarterly EPS growth is about to be broken because
earnings for Q4 are predicted to be only $220,000.

• How can Rocket Software increase EPS for Q4?

Some buybacks will also

cause earnings to fall

Mark Soliman 31
 Earnings per share:
Simple capital structure illustration

Autumn Quarter – Session Mark Soliman 32

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 Earnings per share:
Mandatorily convertible securities and basic EPS
• Suppose Solomon’s 10,000 shares of preferred stock
mandatorily convert into 20,000 shares of common stock.

• In this situation, basic EPS becomes: No preferred dividend

adjustment

Presumptive
conversion

Autumn Quarter – Session Mark Soliman 33

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