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.
Pages to are hidden for
"Contingent Liability on Financial Statement Gaap - Excel"Please download to view full document