Contingent Liability on Financial Statement Gaap - Excel by lyg10301

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									Financial Statement Analysis (Spring 2004)
Solution to Exercise M8.1 in the Penman textbook.

Statement of Stockholders' Equity, as originally presented:
                                                                                              Nine Months
                                                                                                    Ended
                                                                                                31-Mar-00
Common Stock and Paid-in Capital:
 Balance, beginning of period                                                                        13844
 Common stock issued                                                                                  2843
 Common stock repurchased                                                                             -186
 Proceeds from sale of put warrants                                                                    472
 Stock option income tax benefits                                                                     4002
 Balance, end of period                                                                              20975
Retained earnings:
 Balance, beginning of period                                                                        13614
 Net income                                                                            7012
 Net unrealized investment gains                                                       2724
 Translation adjustments and other                                                      166
   Comprehensive income                                                                               9902
 Preferred stock dividends                                                                             -13
 Common stock repurchased                                                                            -4686
 Balance, end of period                                                                              18817
Total stockholders' equity                                                                           39792

                                                                                              Nine Months
                                                                                                    Ended
Reformulated Stockholders' Equity Statement:                                                    31-Mar-00
Common stockholders' equity, beginning of period (=B_beg):                                          27458
Earnings available to common shareholders (=E):
 Net income                                                                            7012
 Net unrealized investment gains                                                       2724
 Translation adjustments and other                                                      166

 Preferred dividends                                                                    -13
   Income available to common shareholders                                                            9889
New investment from (distributions to) shareholders (=-d):
 Common stock issued                                                                   2843
 Proceeds from sale of put warrants                                                     472
 Tax benefit from stock option exercise                                                4002
 Common stock repurchased                                                             -4872
   New investment from (net distributions to) shareholders (=-d):                                     2445
Common stockholders' equity, beginning of period (=B_end):                                           39792

Note that the above reformulation does not change the company's beginning and ending common stockholders' equity.
Based on the analysis below and on additional analysis, we would ideally reformulate the income statement to include:
 1. Expense related to stock option plans and an associated deferred tax benefit.
 2. Gains and losses related to put warrant transactions.
 3. Losses related to the conversion of the preferred stock.
If the income statement was reformulated to include the above three items, then the reformulated stockholders' equity
statement would:
 1. Not include the tax benefit from the stock option exercise because it would have already been allocated to the period
    when the employee performed the services and when the related compensation expense was recorded
    (i.e., over the period between the option grant date and the date when the options became exercisable).
    See the discussion of stock options under G and J below.
 2. Then the increase in common stockholders' equity due to the conversion of the preferred stock would be recorded
      at the market value of the common stock issued. See I below for further explanation.
 3. Then the proceeds from the sale of put warrants would not appear in the stockholders' equity statement. Instead, these
      proceeds would create a financial obligation which becomes income if the put warrants lapse or offsets losses if the
      put warrants are exercised. Gains and losses would be recorded on the income statement as the market value of the
      warrants changes over the time between the sale of the warrants and the time that they either lapse
      or are exercised. See C below for further explanation.

A.
 Net cash paid out to shareholders:
   Common stock repurchased                                                                           4872
   Common stock issued                                                                 2843
   Less portion due to conversion of pref. to com. stk. (estimated)                   -1093
     Net proceeds on issue of common stock (given in the cash flow statement)                         1750
     Net cash paid out to shareholders                                                                3122
                                                                                                                                 This answer corresponds to the following criticisms of GAAP:
     When the convertible preferred stock was originally issued, the company would have recorded it at a                          1. Proceeds from the sale of put warrants should be accounted for as unearned financing income
      book value equal to the proceeds estimated above at $1,093 (according to the footnote, the net proceeds were $980              (i.e., a financing liability). If the warrants expire because the stock price increases, then
      which probably means underwriting expenses amounted to $113). At the time of conversion to common,                             the income is recognized. If the stock price goes down and the options are exercised, then
      Microsoft would have used the book value method recording the common stock issued at the $1,093 book value                     the unearned income is offset against a loss equal to the difference between the market price
      of the preferred stock retired. Better accounting is described under I below. In any case, the $1,093 is a non-cash            at the time of exercise and the exercise price. The analyst needs to be aware of the "put
      portion of the increase in common stockholders' equity due to stock issues in the 9 months ending 3/31/2000.                   warrant overhang" when valuing the firm's stock, where the overhang represents off-balance

B.                                                                                                                                    sheet financing equal to the difference between the exercise price and the market price at the
     Net income (as reported)                                                          7012                                           valuation date times the number of warrants outstanding.
     Other comprehensive income (as reported):                                                                                     2. The tax benefit from stock option exercise should be recorded as operating income and offset
       Unrealized gains on available for sale securities investments                   2724                                           against the loss associated with the difference between the option price and the market price
       Translation gains                                                                166                                           of the stock at the exercise date. Ideally, both the expense and related tax benefit would be recorded
      Reported comprehensive income                                                    9902                                           over the period between the grant date and the date the options became exercisable. In that case,
      Less preferred stock dividends                                                    -13                                           no expense or tax would be recorded at the time of the exercise.
      Earnings available to common shareholders (as reported)                          9889                                     The analyst should be aware of the "option overhang"
                                                                                                                                      and the stock-based compensation component of the company's total compensation expense
      Reformulated earnings available to shareholders should consider the following additional adjustments:                           when valuing the firm's stock. Stock-based compensation expense should be projected as
      1. Gains or losses on changes in the value of put warrants outstanding during the period.                                       a reduction of forecasted operating income, offset by the projected tax benefit; and the
         See C below for further description.                                                                                         option overhang should be evaluated as off-balance sheet financing equal to the difference
      2. Stock-based compensation expense net of related tax benefits. See G and J below for further description.                     between the option price and market price times the options outstanding at the valuation date.

C.
     For the sake of maintaining the recorded stockholders' equity beginning and ending balances, we did
     not remove the put options from stockholders' equity. However, better (than GAAP) accounting would
     record the proceeds as a financial obligation (like deferred income but a financing item),
     and the analyst should deduct the market value of the warrant overhang in valuing the equity of
     the firm. According to GAAP, the company records the proceeds at the issue date as an increase in cash and
     stockholders' equity, makes no entry if the warrants lapse and, if the
     warrants are exercised, simply records a reduction in cash and stockholders' equity
     in equal amounts. Why would Microsoft sell the warrants? Presumably, Microsoft is betting
     on it's stock price increasing. Other companies might use put options as a way of borrowing
     money and keeping the debt off the balance sheet -- if the stock price declines substantially this
     becomes a very expensive way to have borrowed money!

     Consider the following example:
       A company sells 100 put warrants for $10 each. Each warrants entitles the holder to sell 1
          share of the company's stock back to the company for $80, the current market price.
       By the end of the year, the company's stock price has fallen and the estimated market value of the warrants is $1,500.
       At the end of year 2 the market price of the company's stock is only $30 per share and the warrants are all exercised.

                                                                                            CSE
                                                                    Financial Contributed       Retained
     Accounting treatment under current GAAP:             Cash      obligation  Capital         Earnings
          At issue date                                   1000                      1000
          At the end of year 1 -- no entry
          At the end of year 2                            -8000                    -8000
      Better accounting treatment:
           At issue date                                  1000        1000
           At the end of year 1                                        500                        -500     loss recorded on reformulated income statement
           At the end of year 2                          -8000        -1500        -3000         -3500     loss recorded on reformulated income statement
        Note that the total loss recorded over the two years equals the difference between the exercise price and market
        value of the company's stock at the time of exercise, offset by the cash received by the company at the original issue
          date.

D.
      As described in (C) above, if the warrants are exercised, the company simply records a reduction
      in cash and stockholders' equity (creating dirty surplus). A better approach (clean surplus) is described above.
      In any case, the analyst should account for the effects of outstanding put options on shareholder
      value by marking the liability to market and deducting it from the value of the enterprise at the
      valuatioin date.

E.
      Dilution is caused by outstanding "in the money" options, warrants and other contingent claims.
      Repurchasing shares at current market values might increase reported EPS, but it does not counteract
      the economic effect of outstanding "in the money" claims or the exercise of those claims. A
      company should only repurchase its own shares if: (a) the company believes the shares are undervalued; or
      (b) the company has excess cash (or financial assets) and deems the repurchase of shares a better
      mechanism (e.g., for tax purposes) for distributing the money to shareholders than through the payment of dividends.
      With hindsight, share repurchases at the peak of the bubble (in March 2000) looks like a bad idea,
      but repurchasing shares at current market value has no economic effect on shareholders holding on to their shares.
      The important point is that repurchasing shares at any point in time at current market values
      for the cosmetic benefit of increasing EPS without increasing earnings does nothing for shareholders.

F.
      Tax benefit from stock option exercise                                                                         4002
      Marginal (statutory) tax rate                                                                               37.50%
      Difference between market price and option exercise price at exercise date                                    10672
      Tax benefit from stock option exercise                                                                         4002
      Net loss to shareholders as a result of the options                                                            6670
      However, keep in mind that investors holding shares from the time of the grant to the time of exercise of
      these options also gained, and, if the options did their job, those gains were due to the incentives provided
      by granting the options as a form of compensation. In other words, the option plan worked. The
      only problem is that the income statement recorded the benefits but did not record the full compensation cost.
      Ideally, the compensation cost net of the tax benefit ($6,670) would be recorded on the
      income statement over the period between the option grant date and the date the options became exercisable
     (i.e., matched to the periods when related revenues were being recognized).

G.
     The new treatment is correct. The only cash effects of the options are: (a) the tax benefit which offsets a
     non-cash operating expense (described in F above), and (b) the financing cash inflow equal to the
     exercise price times the number of options exercised. If the non-cash operating expense were properly
     recorded on the income statement, then it would be added back in the section of the cash flow statement
     that reconciles operating income to cash from operations (i.e., as part of the change in net operating assets).

     An example illustrating the ideal accounting follows:
     Facts: Assume that at the beginning of 2001, options to buy 1000 shares are granted to employees.
            The option exercise price (and market price at the grant date) is $10 per option, and the
            Black-Scholes option pricing model value is $4 per option. The options become exercisable in two years.
            The Black-Scholes value increases to $6 per option by the end of 2001, and the options are exercised
            at the end of 2002 when the market price has risen to $18 per share.

                                                                               Increase (Decrease)
                                                                OA                    FO                 CSE
                                                                  Deferred        Financial Contributed Retained
                                                           Cash   Expense         Obligation     Capital     Earnings
At the grant date                                                  4000              4000
At the end of the first year                                       2000              2000
   "                                                               -3000                                      -3000 an operating expense
At the end of the second year                                      2000              2000
   "                                                               -5000                                      -5000 an operating expense
   "                                                      10000                     -8000        18000

In class, we extended the above example to demonstrate accounting for tax effects of the options as follows
(assume 40% tax rate):
                                                                         Increase (Decrease)
                                                      OA                        OL             FO                CSE
                                                   Deferred Deferred         Income        Financial Contributed Retained
                                          Cash     Expense tax asset tax payable Obligation               Capital Earnings
At the grant date                                     4000                                    4000
At the end of the first year                          2000                                    2000
   "                                                 -3000                                                           -3000            an operating expense
   "                                                             1200                                                 1200            tax benefit
At the end of the second year                         2000                                    2000
   "                                                 -5000                                                           -5000            an operating expense
   "                                                             2000                                                 2000            tax benefit
   "                                     10000                                                -8000        18000
   "                                                            -3200         -3200

H.
      The tax benefit from the employee stock options is not recorded on the income statement. If it was recorded, then
      tax expense would have been $3,612-4,002= -390 (i.e., a net tax benefit of $390). Failure to record the
      expense and related tax benefit on the income statement detracts from the quality of the company's reported earnings.
      If a firm is paying low taxes on a high income, it means: (1) the firm is getting certain tax credits (for R&D, for example),
     or (2), it has tax deductions not recognized as expenses on the income statement (or revenue recognized on the income
     statement and not recognized for taxes). If the difference is for reason (2), there is a concern about the quality
     of the firm's accounting earnings: i.e., is the firm recognizing the correct revenues and expenses?

I.
      The analyst should consider the off-balance sheet financing, and subtract the market values of the obligations associated with
      the outstanding put options, stock options and convertible preferred stock from the enterprise value when valuing the common
      stock of the firm. As of 3/31/2000, the put options had exercise prices between $69 and $78, and, given the $90 market price
      of the company's stock at 3/31/2000, the warrants were out of the money. Still, they would have some value and that value
      must be considered as off-balance sheet financing in valuing the firm. As time passed, these options became very much
      "in the money", as Microsoft's stock plumeted to $44 per share in September 2002. Many of these warrants were exercised,
      and in accord with GAAP (and dirty surplus), Microsoft did not record a loss. See Box 8.4 in the chapter and C above for
      better than GAAP accounting.

      The convertible preferred stock results in a loss to shareholders, if converted, but the contingent liability for this loss
      is not recorded, nor is the actual loss recorded on conversion. So, when the preferreds were converted in 1999, the equity
      statement showed a substitution of common stock for preferred stock at the book value of the preferred stock (by the
      book value method), but no loss (that would have been recognized under the market value method). In 1999, Microsoft’s
      shares traded at an average price of $88. With 14.091 million common shares issued (12.5 x 1.1273), common
      stock worth $1,240 million was issued. As the carrying value of the preferred stock was about $1,093 (see A above), the
      loss in conversion was about $147 million (unrecorded).

J.
      Refer to http://www.numa.com/derivs/ref/calculat/calculat.htm (referenced on the research tips and links segment
      of the course webpages), and estimate the option overhang liability as follows:

                               Weighted
                               average                    Black-
                               exercise Remaining         Scholes                 Estimated
                                price      life            Value      Shares     total value
                           4.57       2.1          75.972        133      $ 10,104
                          10.89        3           70.908        104         7,374
                          14.99       3.7          68.009        135         9,181
                          32.08       4.5          56.079        96          5,384
                          63.19       7.3          45.495        198         9,008
                          89.91       8.6          40.781        166         6,770
Estimated total option overhang obligation                                $ 47,821

Information needed for calculations (in addition to the above): June 30, 2000 stock price=$80; dividend yield = 0%;
risk free interest rate=6.2% in 2000; volatility=33% in 2000.

								
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