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CHAPTER 9

SOURCES OF CAPITAL: OWNERS EQUITY


Changes from Eleventh Edition
Updated from Eleventh Edition
Approach
By comparison with Chapter 8, this chapters equity topics are relatively straightforward. I try to
downplay the differences between equity accounting for unincorporated and incorporated businesses. As
a consultant to the former, I urge them to impute market salaries for their employee-owners, so that their
income can be compared with the pretax earnings of incorporated firms.
Cases
Xytech, Inc. provides practice in accounting for various owners equity transactions.
Innovative Engineering Company involves comparison of alternative financing arrangements for a new
company.
UPC, Inc., examines the calculation of earnings per share for annual periods.
Maxim Integrated Products, Inc., provides a platform to discuss accounting for stock options under PAS
123R. This is a new case with this edition.

Problems
Problem 91
a.
(1)

Debt/Equity
Debt/Capitalization
Ratio
Ratio
Including current liabilities....................................................................................................................
Rarely
calculated
$97,920
= 66.7%
this way.
$146,880

(2)

Excluding current liabilities except


$79,560
$79,560
= 35.1%
= 54.2%
current portion of long-term debt...........................................................................................................
$226,440
$146,880

(3)

Excluding all current liabilities..............................................................................................................


$73,440
$73,440
= 50.0%
= 33.3%
$146,880
$220,320

b. These two ratios measure the proportion of funds the company has raised from creditors as opposed
to owners. They indicate how much leverage the firm has in its capital structure. The basic trade-off
a company makes in determining the right ratio (i.e., capital structure) is between the risks inherent
in taking on fixed debt obligations versus the opportunity to increase the shareholders profitability by
having some debt in the capital structure. (A more detailed study of capital structure decisions is
covered in finance courses.)

Accounting: Text and Cases 12e Instructors Manual

Anthony/Hawkins/Merchant

Problem 92
a. Basic earnings per share =

($19,550,000 $3,900,000)
= $7.83
2,000,000 shares

b. Diluted earnings per share =

($19,550,000 $3,900,000)
= $7.45
2,000,000 + (200,000 100,000) *

*Assume 200,000 optional shares issued less assumed 100,000 shared repurchased with option payments
(200,000 shares x $10 per exercised option) at $20 per share.
Problem 93
Weighted average number of shares outstanding during the fiscal year is
(100,000 + 300,000 + 300,000 + 300,000)
= 250,000 shares
4
Problem 94

Total
Johns
Schwartz
Salaries...........................................................................................................................................................................................
$ 55,000
$15,000
$40,000
Interest on capital...........................................................................................................................................................................
12,000
5,000
7,000
Remainder......................................................................................................................................................................................
54,000
27,000
27,000
Total...............................................................................................................................................................................................
$121,000
$47,000
$74,000
Problem 95
December 31, 2006
(a)
No entry (except to show 10,000,000 shares issued and outstanding)
(b)

If retired:
dr. Preferred Stock.........................................................................................................................................................................
1,200,000
Retained Earnings or Paid-In Capital........................................................................................................................................
168,000
cr. Cash.......................................................................................................................................................................................
1,368,000
Or
If not retired:
dr. Treasury Stock..........................................................................................................................................................................
1,368,000
cr. Cash.......................................................................................................................................................................................
1,368,000

January 1, 2007
(a)
dr. Dividends on Preferred Stock...................................................................................................................................................
224,000
cr. Dividends Payable.................................................................................................................................................................
224,000
(b)
dr. Dividends on Common Stock...................................................................................................................................................
1,500,000
cr. Dividends Payable.................................................................................................................................................................
1,500,000

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(c)
No entry. (When this stock dividend is effective, retained earnings is diluted for the fair
value of the additional shares issued, paid-in-capital is credited for a like amount, and
1,000,000 additional shares are listed as issued and outstanding.)
(d)
February 1, 2007
dr. Dividends Payable........................................................................................................................................................
1,724,000
cr. Cash...........................................................................................................................................................................
1,724,000
Problem 9-6
a. 15,000 ( 80,000 - 65,000) common shares issued in 2006.
b.

3,000 sh= = 3, 000 shares =

($300,000 $150,000)
$50 per

Change in preferred stock


Change in paid in capital

150,000
25,000

$175,000
= $58,33 / shares
3,000 shares
c.
d.

e.

Book value (2005) = $1,7 80,000


Book value (2006) = $2,354,000
dr. Treasury stock.....................................................................................................................................................
150,000
cr. Cash.................................................................................................................................................................
150,000
$150,000
= $15 / share
Average price =.........................................................................................................................................................
10,000 shares
Book value (2005) = $1,7 80,000
Book value (2006) = $2,354,000

Problem 97

a. April 15, 2003


No entry
b. April 15, 2003
dr. Cash........................................................................................................................................................................
1,500,000
cr. Common Stock.....................................................................................................................................................
1,500,000
c. December 21, 2003
dr. Retained Earnings...................................................................................................................................................
400,000
cr. Paid-In Capital......................................................................................................................................................
400,000
d. July 1, 2004
dr. Cash........................................................................................................................................................................
900,000
cr. Common Stock.....................................................................................................................................................
900,000
e. November 15, 2004
dr. Treasury Stock........................................................................................................................................................
420,000
cr. Cash......................................................................................................................................................................
420,000
f. December 15, 2004
dr. Cash........................................................................................................................................................................
230,000

Accounting: Text and Cases 12e Instructors Manual

g.
h.

i.
j.

Anthony/Hawkins/Merchant

cr. Treasury Stock..................................................................................................................................................................


210,000
Paid-In Capital....................................................................................................................................................................
20,000
February 1, 2005
No entry
September 15, 2005
dr. Cash.....................................................................................................................................................................................
175,000
Paid-In Capital......................................................................................................................................................................
35,000
cr. Treasury Stock..................................................................................................................................................................
210,000
December 24, 2005
dr. Retained Earnings................................................................................................................................................................
150,000
cr. Dividends Payable.............................................................................................................................................................
150,000
January 24, 2006
dr. Dividends Payable...............................................................................................................................................................
150,000
cr. Cash..................................................................................................................................................................................
150,000

Cases
Case 91: Xytech, Inc.*
Note: This case is unchanged from the Eleventh Edition.
Approach
This case is intended to be a relatively straightforward set of exercises in accounting for capital
transactions, both debt and (primarily) owners equity transactions. The exercises are linked together by
having them be successive transactions for a rapidly growing young company. In class, I simply go
through the transactions in sequence, as shown below.
20x0
A

dr. A&CL..........................................................................................................................................................................
300,000
cr. Able, Capital.............................................................................................................................................................
100,000
Baker, Capital............................................................................................................................................................
100,000
Cabot, Capital............................................................................................................................................................
100,000

b.

dr. A&CL..........................................................................................................................................................................
100,000
cr. Long-Term Debt........................................................................................................................................................
100,000

c.

dr. Able, Capital................................................................................................................................................................


18,000
Baker, Capital..............................................................................................................................................................
18,000
Cabot, Capital..............................................................................................................................................................
18,000
cr. A&CL.......................................................................................................................................................................
54,000

20x1
a.
b.

No impact on invested capital because the loan is a current liability. (The case explicitly states
that the $50,000 was not a loan and not contributed capital.)
The entity is not affected by Bakers selling out to the other two partners, other than to restate
owners equity divided into two equal capital accounts rather than three.

This teaching note was prepared by Robert N. Anthony. Copyright Robert N. Anthony.

2007 McGraw-Hill/Irwin

c.

Chapter 9

dr. A&CL.............................................................................................................................................................
12,000
cr. Able, Capital.................................................................................................................................................
6,000
Cabot Capital................................................................................................................................................
6,000
Invested Capital as of December 31, 19x1

Long-term debt....................................................................................................................................................
$100,000
Owners Equity:

Able, Capital..................................................................................................................................................
129,000
Cabot, Capital.................................................................................................................................................
129,000
Owners Equity..............................................................................................................................................
258,000
Total invested capital...........................................................................................................................................
$358,000
(Check on owners equity total: $300,000 - $54,000 + $12,000 = $258,000.)
It is, of course, correct to refer to Partners Equity rather than Owners Equity at this point; for
pedagogical purposes, I prefer the more generic form.
20x2
a.

Since a capital account was maintained for each partner (as opposed to paid-in-capital and
retained earnings accounts for the firm as a whole,) it is likely that the total owners equity as of
December 31, 19xl, $258,000, was treated as paid-in capital upon incorporation.

dr. Able, Capital...................................................................................................................................................


129,000
Cabot, Capital.................................................................................................................................................
129,000
Cr. Common Stock, $100 par............................................................................................................................
10,000
Additional Paid-In Capital............................................................................................................................
248,000
Strictly speaking, a new entity with its own set of accounts was created; but the effect is the same
as making the above entry and changing the entitys name to Xytech, Inc. Also, if a student treats
the $258,000 as $300,000 paid-in capital and $42,000 accumulated deficit, I regard that as an
acceptable alternative.
b.

dr. A&CL.............................................................................................................................................................
50,000
Cr. Long-Term Debt..........................................................................................................................................
50,000

c.

dr. A&CL.............................................................................................................................................................
26,000
Cr. Retained Earnings........................................................................................................................................
26,000

20x3
a.
b.

dr. A&CL.............................................................................................................................................................
43,000
Cr. Retained Earnings........................................................................................................................................
43,000
Able and Cabot each own 50,000 shares after the stock split. The earnings per share is therefore
$0.43 ($43,000 divided by 100,000 shares). Because of the split, the par value per share is now
only $0.10.

20x4
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Net proceeds were $7.20 per share


dr. A&CL..........................................................................................................................................................................
720,000
Cr. Common Stock, $0.10 par........................................................................................................................................
10,000
Additional Paid-in Capital.........................................................................................................................................
710,000

b.

dr. A&CL..........................................................................................................................................................................
68,000
Cr. Retained Earnings.....................................................................................................................................................
68,000
Invested Capital as of December 31, 20x4

Long-term debt............................................................................................................................................................
150,000
Owners equity:
Common stock, $0.10 par........................................................................................................................................
20,000
Additional paid-in capital.........................................................................................................................................
958,000
Retained earnings.....................................................................................................................................................
137,000
Total.....................................................................................................................................................................
1,115,000
Total invested capital..................................................................................................................................................
$1,265,000
20x5
a.

dr. A&CL..........................................................................................................................................................................
500,000
cr. Bonds Payable...........................................................................................................................................................
500,000
Of the $500,000 asset debit, $475,000 is cash and $25,000 is deferred charges for issuance costs.

b.

dr. Long-Term Debt..........................................................................................................................................................


150,000
cr. A&CL.......................................................................................................................................................................
150,000

c.

dr. A&CL..........................................................................................................................................................................
85,000
cr. Retained Earnings.....................................................................................................................................................
85,000

20x6
a

Able and Cabots sale of shares has no impact on the companys financial statements.

b.

dr. A&CL..........................................................................................................................................................................
111,000
cr. Retained Earnings.....................................................................................................................................................
111,000

c.

dr. Retained Earnings........................................................................................................................................................


30,000
cr. A&CL.......................................................................................................................................................................
30,000
This is the $0.15 per share dividend on the 200,000 outstanding shares.
Invested Capital as of December 31,20x6

Bonds payable...................................................................................................................................................................
500,000
Owners equity:................................................................................................................................................................
Common stock, $0.10 par............................................................................................................................................
20,000
Additional paid-in capital............................................................................................................................................
958,000
Retained earnings........................................................................................................................................................
303,000
Total.........................................................................................................................................................................
1,281,000
Total invested capital........................................................................................................................................................
$1,781,000
20x7

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dr. Treasury Stock................................................................................................................................................


200,000
cr. A&CL...........................................................................................................................................................
200,000

b.

dr. A&CL.............................................................................................................................................................
152,000
cr. Retained Earnings.........................................................................................................................................
152,000

c.

dr. Retained Earnings...........................................................................................................................................


36,000
cr. A&CL...........................................................................................................................................................
36,000
This is the $0.20 per share dividend on the 180,000 outstanding shares. Dividends are not paid on
treasury stock.
Earnings per share = $0.80 ($152,000 divided by 190,000 shares). The 190,000 share divisor is
the weighted-average number of shares outstanding during the year.

20x8
a.

dr. A&CL.............................................................................................................................................................
200,000
cr. Preferred Stock.............................................................................................................................................
200,000

b.

dr. A&CL.............................................................................................................................................................
186,000
cr. Retained Earnings.........................................................................................................................................
186,000

c.

dr. Retained Earnings...........................................................................................................................................


65,000
cr. A&CL...........................................................................................................................................................
65,000
This is the $45,000 dividend on common($0.25 on 180,000 shares) and $20,000 on preferred ($5
on 4,000 shares).
Basic earnings per share: ($186,000 - $20,000 preferred dividend divided by 180,000 shares =
$0.92. Diluted e.p.s. = $186,000 divided by 188,000 shares = $0.99. (If the preferred stock were
all converted into common, the earnings available to common would be $186,000 and 188,000
shares of common would be outstanding. The diluted e.p.s. is antidilutive.

20x9
a.

dr. A&CL.............................................................................................................................................................
252,000
cr. Retained Earnings.........................................................................................................................................
252,000

b.

dr. Retained Earnings...........................................................................................................................................


20,000
cr. A&CL...........................................................................................................................................................
20,000
(Dividend on preferred)

c.

dr. Retained Earnings...........................................................................................................................................


153,000
cr. Common Stock.............................................................................................................................................
153,000
(Value of stock dividend = 180,000 x 0.05 x $17)
Basic EPS = $232,000 divided by 180,000 = $1.29
Diluted EPS = $252,000 divided by 188,000 = $1.34
The diluted EPS is antidiluted.
Invested capital as of December 31, 20x9
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Bonds payable...................................................................................................................................................................
500,000
Owners equity:
Preferred stock............................................................................................................................................................
200,000
Common stock, $0.10 par............................................................................................................................................
20,000
Additional paid-in capital............................................................................................................................................
958,000
Less: Treasury stock....................................................................................................................................................
(47,000)
Retained earnings........................................................................................................................................................
619,000
Total.........................................................................................................................................................................
1,750,000
Total invested capital........................................................................................................................................................
$2,250,000
Debt/Capitalization = $500,000 divided by $2,250,000 = 22 percent.
Case 92: Innovative Engineering Company
Note: This case is unchanged from the Eleventh Edition.
Approach
This fairly brief case is intended to show the effect on income and on capital structure of various
financing alternatives. In order to focus on these relationships, the information is highly simplified.
Students should appreciate this fact and not attempt to complicate the issue by raising such realistic
possibilities as allowing for the growth of earnings through time, the retention of earnings instead of
paying dividends, and so on. If the question of retained earnings arises, it can be answered by stating that
the most straightforward calculation is to assume that dividends equal to net income are paid. Although
this is unrealistic, it is a roughly accurate way of allowing for the expectation of equity investors that their
return will be equal to income, whether this income is immediately paid in dividends or is instead
reinvested and an equivalent return realized later or through capital gains.
Answers to Questions
The calculations are shown in Exhibits A and B. After going through the calculations, I focus on the
results as summarized in Exhibit C. Some of the points implied by these exhibits are given below.
Preferred stock is not a good financing device. From the viewpoint of Innovative, it is more expensive
than debt, not only because of its higher rate (10 percent instead of 8 percent), but also, and more
importantly, because the dividend is not tax deductible. Income is considerably lower than that from an
equivalent amount of debt, and this probably more than offsets the reduced risk of preferred stock as
compared with debt. (The preferred stock would probably contain restrictive provisions that, in the event
of difficulty, would permit Arbor as a preferred stockholder to cause about as much trouble for Innovative
as it would cause if it were a bondholder. For example, in either case Arbor almost certainly would take
control.)
The leverage provided by a heavy proportion of debt is tempting. In the optimistic assumption, the return
is 44 percent, compared with 27 percent of Proposal D with little debt. In the best guess, Proposal A has
significantly more return than D. Offsetting this temptation should be the realization that a high
proportion of debt is risky, as shown by the low return in the pessimistic assumption, and the possibility
that the company could not meet its interest obligations if income fell much below $100,000.
As a venture capital firm, Arbor accepts risks in order to obtain a higher return than would be possible in
safer securities. It therefore will insist on common stock because higher profitability shows up only as a
return on this common stock. At the best guess income estimate, Arbor makes a pretax return of close

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Chapter 9

to 15 percent (which is probably the minimum that it expects from an investment) only under Proposal D.
Moreover, D gives Arbor effective control of Innovative.
EXHIBIT A
Calculations for Innovative
($000)

Proposals
A
B
C
D
Common equity.................................................................................................................................................................
$1,000
$1,000
$1,500
$1,800
Operating income $100,000

Income...............................................................................................................................................................................
100
100
100
100
Aftertax debt......................................................................................................................................................................
58
11
32
16
Preferred dividend.............................................................................................................................................................
_____
90
_____
_____
Available to common.........................................................................................................................................................
42
(1)
68
84
Return on common............................................................................................................................................................
4.2%
(.1%)
4.5%
4.7%
Operating Income $300,000

Income...............................................................................................................................................................................
300
300
300
300
Aftertax debt......................................................................................................................................................................
58
11
32
16
Preferred dividend.............................................................................................................................................................
_____
90
_____
_____
Available to common.........................................................................................................................................................
242
199
268
284
Return on common............................................................................................................................................................
24.2%
19.9%
17.9%
16%
Operating Income $500,000

Income...............................................................................................................................................................................
500
500
500
500
Aftertax debt......................................................................................................................................................................
58
11
32
16
Preferred dividend.............................................................................................................................................................
_____
90
_____
_____
Available to common.........................................................................................................................................................
442
399
468
484
Return on common............................................................................................................................................................
44.2%
39.9%
31.2%
26.9%

Investment

EXHIBIT B
Calculations for Arbor Capital Corporation (Pretax)
($000)
Proposals
A
B
C
D
Debt (8%)..............................................................................................................................................
$1,100
200
600
300
Preferred (10%).....................................................................................................................................
900
Common................................................................................................................................................
100
100
600
900
Operating Income $100,000

Income from:

Debt.......................................................................................................................................................
88
16
48
24
Preferred................................................................................................................................................
90
Common*..............................................................................................................................................
4
___
27
42
Total......................................................................................................................................................
92
106
75
66
Pretax ROI ($1,200)..........................................................................................................................................................
7.7%
8.8%
6.3%
5.5%
Operating Income $300,000
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Anthony/Hawkins/Merchant

Income from:

Debt...................................................................................................................................................................
88
16
48
24
Preferred............................................................................................................................................................
90
Common............................................................................................................................................................
24
20
107
142
Total...................................................................................................................................................................
112
126
155
166
Pretax ROI.....................................................................................................................................................................................
9.3%
10.5%
12.9%
13.8%
Operating Income $500,000
Income from:

Debt...................................................................................................................................................................
88
16
48
24
Preferred............................................................................................................................................................
90
Common............................................................................................................................................................
__44
__40
_187
_242
Total...................................................................................................................................................................
132
146
235
266
Pretax ROI.....................................................................................................................................................................................
11%
12.2%
19.6%
22.2%

*Available to common equity (from Exhibit A) times Arbors percentage share of common equity
ownership.
EXHIBIT C
Summary of Returns
Return on Equity
A
B
C
D
Pessimistic...............................................................................................................................................................................
4.2 %
(.1 %)
4.5 %
4.7 %
Best Guess...............................................................................................................................................................................
24.2 %
19.9 %
17.9 %
16.0 %
Optimistic................................................................................................................................................................................
44.2 %
39.9 %
31.2 %
26.9%

Return to Arbor Capital:


Pessimistic...............................................................................................................................................................................
7.7 %
8.8 %
6.3 %
5.5 %
Best Guess...............................................................................................................................................................................
9.3 %
10.5 %
12.9 %
13.8 %
Optimistic................................................................................................................................................................................
11.0 %
12.2 %
19.6 %
22.2 %
Case 9-3: UPC, Inc.
Note: This case is unchanged from the Eleventh Edition
Approach
The UPC case is an exercise in the computation of earnings per share data. Since the company has a
complex capital structure, the calculations require a good understanding of Statement of Financial
Accounting Standards No. 128, Earnings Per Share. Experience has demonstrated that students have
trouble understanding the Statements measurement rules, even after several readings of the text of this
Statement (or another assigned reading dealing with earnings per share measurement). This is
understandable. Many of the measurement rules are not obvious and in some cases the calculations are
complicated. Recognizing this fact, the objective of the UPC case discussion is to help students through
an illustrative example to gain a clear understanding of this Statements rules and purpose.
Answers to Questions
The cases primary teaching objective can be achieved by simply having students answer in the class the
assigned question. There is no need to go beyond this question, if the instructor requires the students to
explain in turn each calculation in the case, the source of the numbers used in the calculation, the purpose
of the calculation and how each calculation influences the per share amounts.
Once the instructor feels confident that the students have a good grasp of the earning per share

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calculations and the Statements basic rules, students should be encouraged to challenge some of the
Statements assumptions. These might include the treasury stock methods assumption that common stock
would be required with the funds obtained from the assumed exercise of options and warrants. Another
assumption the students might challenge is the if-converted methods assumption that convertible
securities will be converted. This discussion should conclude with the students understanding that
earnings per share calculations include some arbitrary assumptions that may not reflect actual practice,
but nevertheless are better than most of the alternative assumptions; the basic and diluted earnings per
share amounts represent a range of possible earnings per share amounts and it is up to the statement user
to determine where in that range the appropriate figure for the users purpose lies; and for a company with
a complex capital structure, earnings per share that reflects potentially dilutive securities is superior to
basic earnings per share for equity valuation purposes.
Closing Observation
The instructor may want to close the discussion of the UPC case by informing the students that investors
typically use diluted earnings per share data to value equities (rather than basic earnings per share data)
and while investors regard earnings per share as an important statistic, it does not tell the whole story
about a companys performance. To appreciate the significance of per share data, a thorough analysis of
the reporting companys financial reporting policies and practices, financial statement data, business plan
and business environment is required.

Case 9-4: Maxim Integrated Products, Inc.


Note: A new case with the Twelfth Edition
Approach
The case provides a platform to explore accounting, managerial and valuation issues related to accounting
for employee stock options. It is recommended that the instructor begins the class with a discussion of
how stock options work (grant price, exercise price, tax treatment, vesting period, etc.) and how they
differ from common stock (issued, dividends, ownership claim, etc.).
Once the class appears to have an understanding of the financial instrument nature of stock options, the
instructor should spend some time covering the basic accounting entries for employee stock options under
FAS 123 R. For this purpose, the class should assume a value for the option. How this fair value is
determined is discussed later in Question 2.
The basic accounting entries for an option granted (grant date) to acquire a single share of common stock
for $25 (exercise price) with an initial fair value option price of $10 and a 5 year vesting period which is
exercised at the end of year 6 when the companys stock price is $40 are (tax accounting ignored1).

1. At the grant date


No entry
1

Considering tax accounting is not recommended. The accounting is complex and not relevant to the case discussion. The instructor
may wish to point out the tax benefit shown on the statement of cash flows and to briefly describe how it is earned.

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2. Each year during the 5-year vesting period


Dr Compensation expense 2
Cr Paid-in-capital (stock options) 2
3. At the Exercise date
Dr Cash
25
Paid-in-capital (stock option) 10
Cr Common stock or 35
Paid-in-capital
Once the instructor feels students are comfortable with the accounting entries, the class discussion should
move onto covering the seven assigned questions. Since there are so many questions, the instructor must
maintain tight control over the case discussion if the plan is to cover all of the questions.
Question 1
Gifford makes it very clear at the JP Morgan conference that Maxims continued success requires hiring
the best engineers in the world. Stock options are an effective way to attract, motivate and retain such
employees. Stock options should also align these key employees interests with those of the shareholders.
Viewed in this light, stock options are a form of compensation for services rendered.
Question 2
The discussion of assumptions should be intuitive rather than mathematical. This discussion should focus
on Exhibit 4s (Maxims 2005 Stock-Based Compensation Note) weighted average assumptions table. The
impact on the fair value option price of each assumption should be discussed in turn. At the end of this
discussion, the class should have an appreciation of the role of management judgment in the BlackScholes option pricing models determination of the fair value of an option. Possible intuitive
explanations are:
Variable
Expected holding period

Direction
Longer

Risk-free interest rate

Higher

Stock price volatility

Higher

Dividend yield

Higher

Fair Value Impact


Higher there is a greater
chance that the options will be
in the money
Lower present value of any
future payoff is lower because
the payoff is discounted at a
higher discount rate
Higher there is a greater
chance the option will be in
the money
Lower the option holder
does not receive dividends

Question 3
Wall Street is split on how to include the cost of employee stock options in the valuation of equities and
the measurement of company performance. Some analysts include them while others ignore them. Those
that include them in valuation and/or net income tend to believe options are a valuable form of
compensation and/or a contingent-type liability. Those that exclude options tend to focus on their noncash nature, the potential for significant measurement error in their valuation, and the probability that the
granted options may expire worthless.

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2007 McGraw-Hill/Irwin

Chapter 9

Question 4
Finance theory defines free cash flow as the discretionary cash available to the firm. Based on the
proposition that management, in pursuit of maximizing shareholder value should invest in all available
net present value projects, discretionary cash or free cash flow is the excess of cash available after the
investment potential of all available positive net present value projects is exhausted. This is a powerful
idea, but it presents conceptual and managerial issues. For example:
o
o
o
o
o

o
o

Equity value is a function of how managers employ free cash flow, not the amount generated.
Free cash flow may not be a useful valuation metric across industries, companies, and different
times in the economic cycle.
Free cash flow along with cash flow measures in general may not be the best indicator of
future free cash flows. Academic research suggests accrual based net income may be a better
indicator of future cash flows.
Free cash flow can be manipulated by managers with the result that investors are misled.
Free cash flow can be an important consideration in assessing a companys financial flexibility
for such purposes as forecasting corporate performance and financial condition as well as
determining a companys potential as an acquisition candidate, but its significance must be
considered along with the other financial flexibility determinants that enter into this assessment.
Free cash flow stock yields and free cash flow stock multiples have low information value to
investors and, as such, can be dubious stock valuation metrics.
In practice, the concepts, definitions, and measurements of free cash flow employed fall short of
finance theorys definition, which cannot be estimated by investors with reasonable confidence.
As a result, in practice as investors seek a workable alternative, there is considerable confusion
and diversity associated with free cash flow definitions and measurements.

If Gifford believes free cash flow is the appropriate measure of Maxims performance, he should deduct
the current or future cash outflow to buy back shares to avoid shareholder dilution from the employee
exercise of stock options. Each option granted has an inherent probability that a share buyback will be
required.
Question 5
Gifford has a fiduciary responsibility to shareholders. If a significant segment of Wall Street believes
stock options have equity valuation significance, it could be argued Gifford should pay attention to what
GAAP requires.
Question 6
Along with the switch to the requirement to expense employee stock options, many firms changed their
compensation packages for employees below the level of senior management. For these employees,
restricted stock grants and cash bonuses became a more significant component of their compensation.
This trend was the result of the loss of the stock options non-expensing advantage over other forms of
compensation, the negative governance consequences associated with stock options in a number of the
accounting fraud scandals, and the decline in the stock market that left many option grants hopelessly
under water.
Question 7

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Anthony/Hawkins/Merchant

Respondents to the FAS 123 Exposure Draft suggested a number of alternative ways to measure
employee stock option compensation expense.
A variety of views were expressed to support non-recognition. Some argued that an expense should not be
recognized, primarily because the granting of stock options does not result in the occurrence of liability.
Others noted the issuance of a stock option is a capital transaction and as such could not be an expense
since capital transactions do not give rise to expenses. Another non-expense argument rested on the
assertion that the issuance of a stock option was a transaction between the stockholders and employees
and as such should not impact the reporting companys financial statements.
Those supporting recognition proposed several approaches other than the Black-Scholes model to
measure employee stock-option expense. Some of these proposals came as a result of suggesting
measurement dates other than the grant date adopted by the FASB. For example, some proposed the
exercise date. On this date, the gain realized by the employee is known and as such it was argued it is the
appropriate measurement of total compensation received. In addition, it was noted the measurement is
simple and straightforward.
Postscript
Maxim adopted FAS 123R during the quarter ended September 24, 2005. The quarters stock-based
compensation charge was $41.5 million. In contrast, the same quarter for the prior years charge was zero.
The companys stock option tax benefit was now included in the financing section of the statement of
cash flows. Previously, it had been reported as a component of operating cash flow.
The value of Maxims stock options granted under its stock option plans during the three months ended
September 24, 2005 and September 24, 2004 was estimated at the date of grant using the following
weighted average assumptions:
Three Months Ended

Expected option holding period (in years)


Risk-free interest rate
Stock price volatility
Dividend yield

Sept. 24, 2005


4.5
3.9%
28%
1%

Sept. 25, 2004


4.3
2.7%
36%
1%

Maxim included in its Form 10-Q pro forma calculation of net income excluding stock based
compensation expense ($133,228 thousand versus GAAP $105,368 thousand). The company noted this
pro forma presentation is given in part to enhance the understanding of the Companys historical financial
performance and comparability between periods in light of a change in accounting standards particularly
since the Company has not included stock-based compensation as an expense in its financial statements
before and most companies have not yet adopted SFAS 123 (R). In addition, the Company strongly
believes that the pro forma presentation to exclude stock-based compensation is relevant and useful
information that will be widely used by analysts, investors, and other interested parties in the
semiconductor industry. Accordingly, the Company is disclosing this information to permit addition
analysis of the Companys performance2.
Maxim also included a reconciliation of free cash flow to net income in its September 2005 Form 10-Q.
The following table reconciles free cash flow to net income, and it depicts the Maxims free cash flow for
the three months ended September 24, 2005 and September 25, 2004, respectively.
2

Form 10-Q September 24, 2005

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2007 McGraw-Hill/Irwin

Chapter 9

RECONCILIATION OF FREE CASH FLOW TO NET INCOME


For the three months ended
September 24,
2005

September25,
2004

(Amounts in millions)

Net income, as reported


Add adjustments to reconcile net income to net cash provided by operating
activities:
Stock based compensation
Depreciation, amortization, and other
Tax benefit related to stock plans
Accounts receivable
Accounts payable
Inventories
Income taxes payable
Other assets and liabilities

$ 105.4
41.5
20.6
5.6
(20.6)
8.4
(7.8)
19.5
3.5

Total of adjustments
Cash generated by operating activities, as reported
Adjustments:
Capital expenditures
Additional tax benefit related to stock plans
Free cash flow

$ 144.5

$ 174.4

---18.7
23.8
(3.3)
(3.9)
(18.0)
25.5
21.0

70.7

63.8

176.1

208.3

(18.0)
16.3

(66.3)
---- $ 142.0

Management noted in the September 2005 Form 10-Q


Free cash flow is used by management to evaluate, assess, and benchmark the
Companys operating results, and the Company believes that free cash flow is relevant
and useful information that is often widely used by analysts, investors, and other
interested parties in the semiconductor industry. Accordingly, the Company is disclosing
this information to permit a comprehensive and objective analysis of the Companys
operating performance, to provide an additional measure of performance and liquidity,
and to provide additional information with respect to the Companys ability to meet
future share repurchases, dividend payments, and working capital requirements3.

Table of Contents

Form 10-Q September 24, 2005

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Anthony/Hawkins/Merchant

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) MAXIM


INTEGRATED PRODUCTS, INC.
Three Months Ended
(Amounts in thousands)

September 24,
2005

September 25,
2004

Cash flows from operating activities:


Net income

$ 105,368

$ 144,545

Stock based compensation

41,459

Depreciation, amortization and other

20,568

18,685

Tax benefit related to stock based compensation


plans

21,860

23,788

(16,259)

(20,604)

(3,333)

Inventories

(7,736)

(18,033)

Deferred taxes

(9,562)

4,041

(239)

(1,741)

366

8,429

(3,852)

19,528

25,511

(978)

136

All other accrued liabilities

15,777

16,651

Net cash provided by operating activities

176,109

208,266

(17,971)

(66,344)

(238)

(109)

(245,432)

(278,936)

149,000

294,323

(114,641)

(51,066)

Adjustments to reconcile net income to net cash


provided by operating activities:

Excess tax benefit related to stock based


compensation plans
Changes in assets and liabilities:
Accounts receivable

Income tax refund receivable


Other current assets
Accounts payable
Income taxes payable
Deferred income on shipments to
distributors

Cash flows from investing activities:


Additions to property, plant and equipment
Other non-current assets
Purchases of available-for-sale securities
Proceeds from sales/maturities of available-forsale securities
Net cash used in investing activities

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2007 McGraw-Hill/Irwin

Chapter 9

Cash flows from financing activities:


Issuance of common stock

53,620

25,907

Excess tax benefit related to stock based


compensation plans

16,259

Repurchase of common stock

(81,309)

(58,490)

Dividends paid

(32,789)

(25,946)

(44,219)

(58,529)

17,249

98,671

185,551

147,734

$ 202,800

$ 246,405

19,911

18,738

Net cash used in financing activities


Net increase in cash and cash equivalents
Cash and cash equivalents:
Beginning of period
End of period
Supplemental disclosures of cash flow information:
Income tax paid
See accompanying Notes to Condensed Consolidated
Financial Statements.

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