Managerial Accounting Managerial Accounting Week 3 Notes David B Hamm

Document Sample
Managerial Accounting Managerial Accounting Week 3 Notes David B Hamm Powered By Docstoc
					Managerial Accounting
Week 3 Notes David B. Hamm MBA, CPA
June 2002
Updated November 2003

Owners’ Equity (overview)




Owner’s equity represents capital contributions and retained business earnings due to owners of a firm, or Assets – Liabilities = Owners Equity For an unincorporated firm (proprietorship or partnership), a capital account is maintained in the name of each owner
 

Contributions & net income increase the account Withdrawals & net losses decrease the account

Owners’ Equity--Corporate


For a corporate entity, owners’ equity is divided into two parts:




Paid in Capital—what owners contribute (to purchase stock & other contributions) Retained Earnings—portion of net earnings retained by the business after dividends, if any, are paid.

Paid in Capital


Common stock—basic ownership right of a corporation
 



may vote in stockholders’ meetings residual rights to all assets after liabilities and other obligations are paid Bears greatest risk of loss in case of business failure, but ―limited liability‖ restricts loss to amounts invested

Paid in Capital (continued)


Preferred stock—also an ownership right but with some characteristics of long term debt also






Priority claim to dividends (before common shareholders)—‖cumulative‖ right Priority claim to assets in liquidation (again, before common shareholders) But generally no voting rights or rights to assets beyond call value of preferred stock

Paid in Capital (continued)


Additional Paid in Capital:






Excess over par—any premium over ―par‖ paid on new issues of stock (preferred or common) Stock values are always recorded at ―par‖ if a par value is identified—some states require a par value or ―stated value‖ to be assigned in corporate charter If ―no-par‖ then stock is recorded at whatever price sold to original purchasers

Stock Terminology



 

Authorized—by corp. charter Issued—sold to original purchasers Outstanding—still held by stockholders Treasury—shares repurchased by corp. and not yet retired
   

For later deposit to pension plans, 401(k)’s For gifts or to satisfy corp. obligations Risks of self-dealing—‖insider trading‖ Shown as a reduction in total shareholder equity

M & A’s, LBO’s






Merger—combination of two or more corporations into a new entity (old stock is redeemed for new stock) Acquisition—one corp. may buy up stock of another, which becomes a corp. subsidiary Leveraged buyout—popular in the 1980’s to avoid unfriendly takeovers—issuance of new debt to redeem publicly held stock and take a firm ―private.‖

Retained Earnings & Dividends






Retained earnings will increase by corp. income or decrease by corp. losses IRS expects earnings to be distributed as dividends to shareholders unless ―appropriated‖ for future business purpose (new investment, debt reduction, etc.) Dividends may be in cash, stock, assets

Dividends (continued)




Cash dividends—declared by Board as an amount per share (becomes a corporate obligation only on date of declaration) Stock dividends—issues of new shares to outstanding shareholders proportionate to their interest




Transfers retained earnings to paid in capital— capitalizing retained earnings Dividend recorded at market value of stock— record new shares at par and balance to paid in capital excess over par

Stock Splits






A stock split occurs when corp. issues new shares (2 for 1, etc.) proportionate to ownership of existing shares in order to reduce market price of stock An equal reduction is made to par or stated value of the stock Memorandum entry only on books, as no ―funds‖ change hands

Earnings Per Share








Reported at end of Income Statement, it is a tie-in between net income and outstanding common stock per balance sheet EPS = net income / No. common shares (basic formula) Number of shares outstanding is weighted by period outstanding if this changes during the accounting year Treasury stock or other stock not outstanding is not calculated in EPS

Earnings Per Share (continued)




―Fully diluted‖ EPS—in addition to basic EPS, EPS is re-calculated to increase shares outstanding by ―potential shares‖ such as stock options, convertible debt, etc., if executed. Dilution is required reporting if it would reduce EPS by 3% or more (―worst case‖)

The Statement of Cash Flows




―New‖ statement (required only since 1988)—some advisors ignore because they were not trained in its use But when understood, the cash flow statement is perhaps the most valuable of all the financial statements for obtaining a true picture of firm operations and future potential

Statement of Cash Flows (cont.)


Format of the cash flow statement:








Cash flows from operating activities—is the firm generating cash from its primary business activities? Or losing cash? Cash flows from investing activities—is the firm investing for the future, or selling off assets? Cash flows from financing activities—is the firm reducing debt, or adding new debt? Selling more stock? Is it paying dividends? Repurchasing its own stock? (Why?) Reconciliation to cash balance per balance sheet

Statement of Cash Flows (cont.)


―Direct‖ vs. ―Indirect‖ method for reporting operating cash flows—see overhead illustrations (results should be identical in either method)

Pause to review Exhibit 9-9 on pgs 333-334

Leverage (Overview)


If a corporation wishes to finance a new investment, should it issue new debt or issue new stock?
 



Equity issues need not be ―repaid‖ But, new stock ties up owners’ resources, may dilute ownership levels & EPS Also, interest expense (business) is tax-deductible, thus IRS ―covers‖ part of the cost of financing



Leverage is the use of debt financing to gain business advantage (OPM—other peoples’ money)

Leverage (continued)


Financial leverage = difference between return on investment and interest paid




If ROI on borrowed money > interest paid, leverage is positive If ROI on borrowed money < interest paid, leverage is negative

For our purposes, ROI = net income from an investment divided by amount invested. A more detailed ROI analysis will come in Finance module

Leverage (continued)




If a firm can earn a return on borrowed funds greater than its interest cost, the positive leverage ―multiplies‖ earnings and EPS. Use of leverage is recommended. But if it can not, the negative leverage becomes a negative multiplier. Leverage should be avoided.

Leverage (class illustration)

Pause for class work on leverage illustration

Leverage problem (solution)
12% return No leverage
EBIT Less Interest $120,000 0 Inc before taxes $120,000 40% leverage $120,000 40,000 $ 80,000

Taxes (25%) Net Income ROI ROE EPS

30,000 $ 90,000 12% 9% $9.00

20,000 $ 60,000 12% 10% $10.00

Leverage solution (cont.)
7% return
EBIT Less Interest Taxes (25%) Net Income ROI

No leverage
$ 70,000 0 17,500 $ 52,500 7%

40% leverage
$ 70,000 40,000 $ 30,000 7,500 $ 22,500 7%

Inc before taxes $ 70,000

ROE EPS

5.25% $5.25

3.75% $3.75