FRA stubberfield

Review of Financial Reporting & Analysis

• Rose Stubberfield

Our Approach Tonight

• We have only two hours.– Giddy up

• The emphasis is on review.• You should know this material, but not at the depth

you need to understand.• Assume you know how the financial statements

articulate.• Review the balance sheet, then the income

statement … you are on your own for cash flows.

Asset Definition

1. Probable future economic benefit

2. Obtained or controlled by the entity

3. As a result of past transactions

Current vs. Non-Current

- based on year or operating cycle, which ever is longer.

Cash and Cash Equivalents

• Cash, of course.• Equivalents include money market

instruments such as ST CDs, high quality commercial paper, Treasuries, money market funds that mature in three months or less.

Investments in Debt Securities

Three Categories

- Held to Maturity Requires ability and intent

- Available for Sale Cash Management

- Trading Intent to sell in the near term

Accounting for Debt Securities

Accounting & Valuation

- Held to Maturity Interest revenue, gain/loss on sale Reported on balance sheet at amortized cost

- Available for Sale Interest revenue, gain/loss on sale Fair value … with Unrealized Holding G/L to

Comprehensive Income (i.e., equity)

- Trading Interest Revenue, gain/loss on sale Fair value … with Unrealized Holding G/L to Current

Income (i.e., Income Statement, then Retained Earnings)

Investments in Equity Securities

Accounting is based on level of influence

- Minority, Passive (less than 20% ownership) Fair Value Method

- Minority, Active (20% - 50% ownership) Equity Method

- Majority, Active (more than 50% ownership) Consolidation Method

Accounting for Equity Securities

Accounting for Minority, Passive Investments

- Available for Sale Dividend Income, gain/loss on sale to Income

Statement Fair value … with Unrealized Holding G/L to


- Trading Dividend Income, gain/loss on sale to Income

Statement Fair value … with Unrealized Holding G/L to Current

Income (i.e., Income Statement, then Retained Earnings)

Accounting for Equity Securities

Accounting for Minority, Active Investments

Record purchase at cost. Single line acquisitionIf purchase price exceeds proportionate share of investee’s book value, identify fair values of underlying assets & liabilities.

Recognize proportionate share of investee’s income as an increase in the Investment

Recognize proportionate share of investee’s dividends as reduction in Investment

Valuation

Fair Value MethodAnnual AdjustmentTrading – Unrealized Holding G/L in current incomeAvailable for Sale – Unrealized Holding G/L in


Equity MethodAnnual AdjustmentProportional Share of Income = IncomeProportional Share of income less Dividends =

Investment Adjustment

Valuation

The Fair Value Option• Held-to-maturity• Available-for-sale• Equity method

Report unrealized gains and losses through the income statement (not though comprehensive income)

Brand-new and not many takers yet.

Consolidations

Basic Idea: The Parent company along with its Subsidiaries are a single economic unit.

Combine the financial results for Parent & all Subsidiaries, then– Eliminate Intercompany Payables– Eliminate Intercompany Sales– Eliminate double-counting of Investment– Eliminate double-counting of Income

Consolidations – non-controlling Interests

Non-controlling Interest - (aka Minority Interests)

Occurs when the Parent does not own 100% of the subsidiary. The percentage of ownership not controlled by the Parent.

For the Balance Sheet, Non-controlling Interests represent the percent of net assets (assets less liabilities of the subsidiary). Appears between Liabilities & Equities

For the Income Statement, Non-controlling Interest is the percentage of subsidiary income held by the minority shareholders.

Consolidating Foreign Subsidiaries

Companies often have international subsidiaries that must be consolidated with the Parent’s financial statements.

Typically, the subsidiaries accounts are maintained with local currency (and, sometimes, local GAAP). The amounts on the foreign subsidiaries financial statements must be translated in U.S. dollars.

To translate a foreign subsidiary’s financial statements into U.S. dollars, conversion is made with both Historical Exchange Rates (those which existed at the time a transaction occurred) and Current Exchange Rates (Exchange rates which exist as of the balance sheet date)

Consolidating Foreign Subsidiaries

The use of different exchange rates means the resulting financial statements will not balance.

To force the statements to balance, an account called “Translation Adjustment” is used.

Two approaches are used depending on the independence of the subsidiary from the Parent company.

- Self-contained: All-current method (local currency is functional)- Extension of US Parent: Monetary-Nonmonetary method (US dollar is functional currency)

Subsidiaries in countries with hyperinflation (100+%) use the U.S. dollar as the functional currency.

Accounts Receivable

Involves the application of two concepts – Definition of an Asset & Matching

Definition of an asset:- Probable future economic benefit- Obtained or controlled by the entity- As a result of past transactions

What is the cost of extending credit? - Bad debts.

Accounts Receivable

Acct Rec.

Beg. Bal.

End Bal.

Allowance for Bad Debts

Beg. Bal.

End Bal.

Sales

Collections

Write-Offs Write-Offs

Bad DebtExpense

Net Account Receivable

What I can Collect

What I expect to

Collect

Accounts Receivable Example

Year 1Sales $1,500,000

December 31, Year 1Accounts Receivable $175,000Allowance for Bad Debts (10,000)Accounts Receivable, net $165,000

Based on Analysis

Goes to the Balance Sheet


December 31, Year 1Bad Debt Expense $10,000

Allowance for Bad Debts $10,000

This entry applies the two important concepts: - matching expenses with the related revenues - recording the asset at its net realizable value (NRV)


Year 2Sales $5,000,000

Identified and wrote-off as uncollectible $21,500 of accounts receivable.

Allowance for Bad Debts $21,500Accounts Receivable

$21,500

Note, No impact of Net A/R


Year 2

December 31, Year 2Accounts Receivable $330,000Allowance for Bad Debts (25,000)Accounts Receivable, net $305,000

Based on Analysis

Goes to the Balance Sheet


December 31, Year 2Bad Debt Expense $36,500

Allowance for Bad Debts$36,500

Allowance for Bad Debts

10,000 Beg. Balance

25,000 End Balance

Write-Offs 21,500 36,500 Bad Debt Exp.

Inventory – Basic Approach

Beg. Inventory+ Purchases Cost of Goods Available for Sale

Sold

Cost of Goods Sold(Income Statement)

Not Sold

End. Inventory(Balance Sheet)

Inventory – Costing Methods

Beg. Inventory 300 units @ $10 per unitPurchase 100 units @ $12 per unitSale 200 units @ $30 per unitPurchase 600 units @ $14 per unitPurchase 200 units @ $15 per unitSale 600 units @ $30 per unitEnd Inventory 400 units

LIFO – Periodic Cost of Goods Sold $11,400 Ending Inventory $ 4,200

LIFO – Perpetual Cost of Goods Sold $10,800 Ending Inventory $ 4,800

Inventory – Costing Methods

Cost of Goods Sold

FIFO Periodic $ 9,800FIFO Perpetual

9,800

LIFO Periodic $11,400LIFO Perpetual

10,800

W/A Periodic $10,400W/A Perpetual

10,200

Ending Inventory

FIFO Periodic $ 5,800FIFO Perpetual

5,800

LIFO Periodic $ 4,200LIFO Perpetual

4,800

W/A Periodic $ 5,200W/A Perpetual

5,400

Inventory – Valuation (LCM)

• After determining FIFO/LIFO/W-A Ending Inventory, must compare to market valuation.

– Follows the definition of an asset

• Report on the balance sheet, the lower of cost or market. Write-downs of inventory from cost to market are included in cost of goods sold.

– Can establish a reserve account for obsolesce.

Inventory – LIFO Layers

As inventory levels increase, a LIFO layer is added.

Can result in very old costs embedded in inventory.

100 units at $10 per unit




Inventory – LIFO Liquidations

Assume current costs are now $25 per unit.

Delay purchases to “dip” into the LIFO layers …

Instead of CGS at $25 per unit, now it is $20, then $17, then $13 and eventually, $10 per unit





Inventory – LIFO Liquidations

LIFO Liquidations come at a very high cost –taxes!!

LIFO Conformity rule states that if you use LIFO accounting for your tax return, you use it for your financial statements as well.

It costs real money to dip into your LIFO Layers.

Inventory – Comparability

1. BIF + P – CGSF = EIF2. BIL + P – CGSL = EIL3. P = CGSL + EIL – BIL

Substitute 3 into 14. BIF + (CGSL + EIL – BIL) – CGSF = EIF

Rearrange …CGSF = CGSL - [(EIF - EIL) – (BIF - BIL)]

CGSF = CGSL – (LIFO ReserveE – LIFO ReserveB)CGSF = CGSL – Change in LIFO Reserve

Inventory – Comparability

LIFO FIFO

CGS Higher Lower

Income before taxes Lower Higher

Income taxes Lower Higher

Net Income Lower Higher

Cash Flow Higher Lower

Inventory Balance Lower Higher

Assume rising inventory costs and stable orIncreasing inventory levels.

Inventory - Summary

Inventory

Beg. Bal.

End. Bal.

Purchases

Cost of Goods Sold

Obsolescence

Long-Lived Assets – Major Issues

Multi-period assets whose costs are matched to the revenues they help generate.• Smooths the impact on income

Impairment IssuesBased on the definition of an assetGreat opportunities to shift expenses from one

period to another.

Costs Expense

(Asset)Capitalize Allocate

Long-lived Assets

Long-lived Asset Acc. Depreciation

Beg. Bal.

End Bal.

AcquisitionsDisposals

Impairments

Beg. Bal.

End Bal.

Depreciation Expense

Disposals

Impairments

Long-lived Assets – Acquisitions

Acquisition Cost – All the costs necessary to ready the asset for its intended use.

Specialized machinery for a manufacturer.Invoice priceTaxesDelivery chargesSpeeding ticket during deliveryInstallation costs (including repouring floor)Repair work for damage during installationSetup costs (labor and materials)

Long-lived Assets– Depreciation

Depreciation – Allocating the cost of the asset over the period of benefit.

Accounting depreciation ≠ Economic Depreciation

Depreciable amount = Acquisition Cost less Residual Value

Cost - $1,000,000Residual Value - $250,000

Depreciable Amount - $750,000The amount to be expensed over the estimated useful life

of the asset.

Long-lived Assets– Depreciation Methods

Straight-Line: Simple and most pervasive.

Other methods: Sum-of-the-years digits Units of production Declining balance MACRS (tax return only)

Depreciation Expense Book Value

Long-lived Assets– Betterments vs. Repairs

Betterment – Costs incurred after the asset has been placed in service. A betterment extends the asset’s useful life, increases the asset’s productive capacity, or increases the asset’s productive efficiency. Capitalize costs incurred.

Repairs – No increase in economic benefit or increased service potential. Expense costs as incurred.

Long-lived Assets– Disposals & Exchanges

Disposal – Compare the asset’s book value to the value received from the sale. The difference is either a gain or loss.

Exchange – One productive asset (e.g., inventory) for another asset (e.g., equipment).

General rule: The new asset is recorded as the Fair market value (FMV) of the asset exchanged.

Exceptions for exchanges of similar assets or where FMV is not ascertainable.

Long-lived Assets– Change in market Value

Revaluation – Not with U.S. GAAP. However, IFRS and other countries allow revaluation up to market value.

Impairments – Decline in market value of an asset. There are different kinds of tests for different kinds of long-lived assets.

Long-lived Assets– Acquired Intangibles

Acquired Business

Identifiable IntangiblesTangible Assets Other Balance Sheet

Marketing related Contract relatedTechnology relatedCustomer related

• Trademarks• Trade names• Marketing materials• Style guide (unique

color, shape or package design)

• Mastheads• Domain names

• Distributor relationships

• Retailer relationships• Order or production

backlog• Contractual and non-

contractual customer relationships

• Trade secrets, such as secret formulas, processes or recipes

• Patented and un-patented technology

• Computer software• Databases

• Supply contracts• Advertising,

management & service contracts

• Licensing & royalty agreements

• Lease agreements• Construction permits• Franchise agreements• Non-compete

agreements

Goodwill

Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business.

$10 million

$5 million

$3 million

$1 million - Goodwill

- Excess net asset FMV over BV

- Net asset book value

Considerationtransferred

Allocation

$1 million - Identifiable Intangibles

Long-lived Assets– Intangibles Amortization

Depends on the type of intangible asset it is.

•Limited Life intangible assets– Amortize straight-line over estimated economic life.

•Indefinitive Life intangible assets– Assets that the firm intends to maintain for an

unknown period of time.– No amortization.

•Goodwill– No amortization.

Long-lived Assets– Impairments

Property, Plant & Equipment and Limited Life Intangible Assets (Category 1)

Two Step Impairment Test:Step one: Compare future estimated undiscounted cash flows to book value. If cash flows are less than book value, the asset is impaired.Step two: Write the asset down to either fair market value (FMV) or discounted future cash flows & recognize the impairment loss.


Indefinite-Life Intangible Assets (other than Goodwill) (Category 2)

One Step Impairment Test:Step one: Write the asset down to either fair market value (FMV) or discounted future cash flows if below book value.


Goodwill (Category 3)

Two Step Impairment Test:Step one: Compare the fair value of the reporting unit to its book value including goodwill If fair value is below book value, then go to step two.Step two: Determine the implied fair value of goodwill by comparing the fair value of the reporting to the fair value of net identifiable assets. Write goodwill down if needed.


The FASB added a new Step Zero for Intangibles and Goodwill.

– Step zero is an optional, qualitative assessment.

– If determined that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, then no further work required.

Liabilities – Major Issues

Fixed PaymentDates & Amts.

Fixed Payment Amts, Est. Dates

Est. Date& Amount

Advances& UnexecutedAgreements

MutuallyExecutedContracts

ContingentObligations

Note PayableInterest Pay.Bonds Pay.

Accounts Pay.Taxes Pay.

WarrantiesPayable

Rental FeesSubscriptionsInsurance

PurchaseEmploymentCommitments

Pending LawsuitsOff BS Instruments

Recognized as Accounting Liabilities

Generally Not Recognized as Accounting Liability

Liabilities – Basic Definition

1. Probable future economic sacrifice,

2. The obligation belongs to the firm, and

3. Is the result of past transactions.

Parallels the definition of an asset.

Liabilities – Current

• Accounts payable• Wages, salaries, and other payroll items• Short-term notes and Interest payable• Warranties – Matching concept.

• Estimate the warranty liability at the time of sale and record the expense.

• Reduce the liability based on actual costs incurred.

Bonds– Early retirement

Example:

The $100,000 bond is two years from maturing. Originally issued at a market rate of 8%, now trades in the market at 12%.

Journal Entry

Bonds Payable $103,630Cash $ 96,535Gain on early retirement 7,095

Reported in the Income Statement

Contingent Liabilities

When is a liability a liability? If there is uncertainty regarding the outcome of an event (e.g., litigation, possible assessments, expropriation of assets).

Disclosure or Recognize?

Two Criteria for Accruing a Liability:- “Probable”- “Reasonably estimated”

Liabilities – Capital Leases Requirements

Must meet one of the four criteria:1. The lease transfers the ownership to the lessee at the

end of the lease term.

2. The lease contains an option to purchase substantially less than the expected fair market value at the end of the lease term.

3. The lease term is equal to 75% or more of the estimated remaining economic life.

4. At the beginning of the lease term, the present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased asset

Liabilities – Operating Leases

No entry at lease inception - executory contract

Lease Payment Journal EntryRent Expense $ xx

Cash $ xx

No asset nor liability recognized on the balance sheet.

Footnote disclosures are substantial including description and payment schedule.

Liabilities – Capital Leases

At Lease Inception

Leased Asset $ xxLease Liability $ xx

Present value of Minimum Lease

Payments

Second GP

Amortize the leased asset over the life of the lease. Amortization Expense $ xx

Leased Asset $ xx

Lease payments follow Long-Debt GP Interest Expense $ xx Lease Liability $ xx

Cash $ x

Difference

Leases

Managerial considerations

– On Balance sheet or off?• Are investors really fooled?

– Cash flows• Operating leases – Operating cash flows• Capital leases – Investing cash flows• Performance metrics

Pensions – Defined Contribution Plans

Defined Contribution Plans are the dominate pension vehicle.

•Transfers ownership of risks to employees

•Easy accounting:Pension Expense $ XX

Cash $ XX

Pensions – Defined Benefit Plans

Rose in popularity following WWII.

•Employer bear risks of funds market returns

•Conceptual Underpinnings– Matching concept– Record expenses in period of benefit– Record liability

•Management Incentives– Management prefers not to report a liability Cost of Credit Share price impact


Three Concepts

Vested benefits- Legal issue with respect to employee right. If

they leave the firm prior to achieving retirement conditions (e.g., age, years of service).

Accumulated Benefit Obligation (ABO)- Vest & non-vested benefits- Non-vested benefits are estimated- “Actuarial” net present value of benefits earned to

date at today’s pay levels.


Three Concepts

Projected Benefit Obligation (PBO)- PBO equals …

“Actuarial” net present value of benefits earned to date projected at future pay rates

- The real liability conceptually• Best estimate of future payments


Three Elements of Pension Accounting

Record liability for deferred cash flows- Increase for interest recognized over time- Decrease for cash payments

Record asset for invested funds- Recognize earnings on invested funds- Increase cash contributions to fund- Decrease for payments made to retirees

Record expense for “service cost”- NPV of incremental benefit earned for current year services


Violations of FASB Conceptual Framework

Off-set Revenues and ExpensesAnnual pension expense = Net of …

Interest expense Service Cost expense Investment Returns

Off-set Asset & LiabilitiesNet Pension asset or Liability on Balance SheetThe Plan is said to be either “over-funded” or “under-funded”

Pensions – Components of Pension Exp.

1. Service Cost – Increase in PBO because employees have worked another year.

2. Interest Cost – The PBO is the discounted present value of expected benefits to be paid to employees. As the payment date gets closer, interest cost must be recognized (2nd general principle of long-term debt)

3. Expected Return on Plan Assets – The off-sets pension costs and makes pension expense smaller. The expected return is used rather than the actual return to avoid the effects of the stock market’s volatility.

4. Prior Year Service Cost – Adjustments to PBO for additional benefits granted to employees … “sweeteners.”

5. Amortization of Excessive Plan Gains & Losses – Due to changes in Fund earnings experience or PBO assumptions.

Accounting for Dividends

Stock DividendSmall (less than 20 – 25% of outstanding stock)

Retained Earnings $ FMVCommon Stock $ ParAdditional Paid-In Capital

Difference

Large (more than 20 – 25% of outstanding stock)

Retained Earnings $ ParCommon Stock $ Par

Accounting for Dividends

Stock Split

Just like a stock dividend, increases the number of shares outstanding … without impacting Retained Earnings.

No entry is record. Par value and shares outstanding are adjusted to reflect the split.

PhilDrakeCo has 1,000,000 shares of $10 par common stock.Following a 2 for 1 stock split, there are 2,000,000 shares outstanding with a par value of $5.

Treasury Stock

Purchase 10,000 shares of PhilDrakeCo at $11 per share.

Treasury Stock $ 110,000Cash $ 110,000

Reissue Above Cost - $15 per share

Cash $ 150,000Treasury Stock $ 110,000Paid-In Capital – TS 40,000

Reissue Below Cost - $5 per shareCash $ 50,000Paid-In Capital – TS 60,000

Treasury Stock $ 110,000

Contra-Equity

Convertible Securities

Convertible securities (debt and preferred stock) is the underlying security with an option to convert the security into common stock. Terms of conversion are typically fixed (i.e., 50 shares common stock for each $1,000 bond).

For debt, the conversion feature reduces the interest rate due to the investor … lowers cost of borrowing.

When the security is converted, no gain or loss is recognized. Thus, the conversion is done at the convertible security’s book value.

Revenue Recognition

The Securities and Exchange Commission (SEC) has issued authoritative statements in Staff Accounting Bulletin (SAB) 104.

Revenue, generally, is realized or realizable and earned when all of the following criteria are meet:

1. There is persuasive evidence that an arrangement exists,

2. Delivery has occurred or services have been rendered*,

3. The seller’s price to the buyer is fixed or determinable, and

4. Collectability is reasonable assured.

* Risk of loss is transfer or no future performance required

Research & Development

• Companies engage in R&D with the expectation of producing profitable future goods and services. However, there is the risk that these expenditures will have no value for the firm.

• The resulting assets typically have values unrelated to the R&D costs.

• Expensed as incurred. Lacks the probable future economic benefit criteria of an asset.

• Creditors generally do not lend on R&D projects.

Restructuring Activities

Most firms experience some type of restructuring. It is a natural evolution of business.

Restructuring can include employee layoffs, lease terminations, asset write-downs, moving locations, closing operations and other reorganizations.

Following the commitment to a formal plan of restructuring, recognize a liability & expense.

Restructuring Activities

Provides management with a tool for earnings management. The Big Bath Theory.

As the restructuring unfolds, the liability & expense are updated for the new information.

This creates an incentive to front-load expenses.

Strangely, restructuring costs imposed by a merger as expensed as incurred. No liability is established due to past abuses.

Accounting for Income Taxes

GAAPFASB, SEC

Tax lawCongress

Book Income

Taxable Income

≠

Timing differences

Permanentdifferences

A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period.

The basics

A permanent difference results when a revenue (gain) or expense (loss) enters book income but never recognized in taxable income or vise versa.

Temporary Differences

EventBook

IncomeTax

IncomeDef. Tax

AssetDef. Tax Liability

Installment Sales Revenue Today Income Later

Product Warranties Expense Today Deduction Later

Bad Debt Expense Expense Today Deduction Later

Rent Rec’d in Advance Revenue Later Income Today

Depreciation Expense Straight-Line Accelerated

Prepaid Expenses Expense Later Deduction Today

Deferred Tax Liability when Future Taxable Income > Future Book Income

Deferred Tax Asset when Future Taxable Income < Future Book Income

XXXX

XX

Permanent Differences

• Permanent differences will not reverse in the future. Thus, book and tax will never equalize.

• Common permanent differences:– Fines and Penalties– Meals and Entertainment– Political Contributions– Officers Life Insurance– Tax-exempt Interest

• Permanent differences are ignored for financial accounting purposes.

Accounting for Taxes – Mechanics

Income tax expense is the “plug” after determining the tax liability and changes in deferred taxes.

1.Record the tax liability2.Record the changes in the deferred tax accounts3.Plug “Income tax expense.”

Unusual occurrence – Income tax expense when there is a net loss.

Deferred Tax Assets

Deferred tax assets must pass the definition on an asset … “probable future economic benefit”

If there is uncertainty realizing the deferred tax asset (e.g., history of operating losses/profits, unsettled

circumstances, presence of existing contracts or backlog), then a valuation allowance (contra asset) must be establish.

The criteria for the valuation allowance is needed is whether the it is “more likely than not” that the tax benefits will be realized.

Net Operating Losses

The U.S. income Tax code allows firms reporting operating losses to offset those losses against past or future tax payments.

Valuation Allowance

When a valuation allowance is recognized, there is a corresponding increase in the income tax expense.

If it subsequently determined that the deferred tax benefit will be realized, then the entry that established the valuation allowance is reversed. This results in a decrease in income tax expense and an increase in net income. Some analysts call this cookie jar accounting.

Also reveals information about the long-term prospects of a firm’s profitability. General Motors established a $38.6 billion valuation allowance in the 3rd quarter, 2007.

Effective v. Marginal Tax Rates

• Effective Tax Rate (ETR)– Income tax expense divided by pretax book income.– Provides information as to a firm’s tax management.

• Marginal Tax Rate– Income tax for the next dollar of taxable income.– For the U.S. companies, use a marginal federal rate of

35% plus estimated 5% state and local tax rate.

• In conducting incremental analysis and after-tax effects (e.g., interest costs), use the marginal tax rate.

Foreign Currency Transactions

Amerco, a U.S. company, sells goods to a German customer at a price of 1 million Euros (€) when the spot exchange rate is $1.50 per Euro.

If payment were received at the date of sale, Amerco would convert 1 million Euros into $1,500,000.

Instead, Amerco allows the German customer 30 days to pay. At the end of 30 days, the euro had depreciated to $1.45 per Euro and Amerco can convert the 1 million euros into $1,450,000.

How should Amerco account for the $50,000 decrease in value?

Foreign Currency Transactions

Two-transaction perspective:- The export sale- The decision to extend credit

Date of SaleAccounts Receivable $1,500,000

Sales $1,500,000

Date of CollectionForeign Exchange Loss $ 50,000

Accounts Receivable $ 50,000

Cash $1,450,000Accounts Receivable $1,450,000

Goes to Income Stmt

Below the line components

Discontinued Operations & Extraordinary Items- Reported net of tax - Separate EPS calculations

Proctor & Gamble

Earnings Per Share

Very powerful … highly cited, moves markets, motivates people, affects M&As.

The most important single financial number.

Simple Capital Structure – No potential common stock (e.g., NO convertible bonds, convertible preferred stock, stock warrants, stock options)

Earnings Per Share

Complex Capital Structure:Dual Structure- Basic EPS, Diluted EPSFor Diluted EPS calculation include only dilutive securities, exclude antidilutive securities.

Impact of Conversions & Options

The “if converted” method:

• Assumes that all convertible bonds are exchanged for stock at the beginning of the reporting period.

• But conversion is unlikely if the stock price ($75) is substantially below the conversion price ($100).

• The resulting diluted EPS figure overstates likely dilution in this case and thus understates EPS.

The “treasury stock” method:

• Assumes that proceeds received on exercise of the options ($100 per share) are used to buy back shares at the average market price.

• If the average market price is below the exercise price, the options are not dilutive for EPS purposes.

• The resulting diluted EPS figure understates likely dilution and overstates diluted EPS.

Date post:	12-Jun-2015
Category:	Economy & Finance
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Economy & Finance