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Accounting for Lawyers Final > Module 6: Stockholders' Equity > Flashcards

Module 6: Stockholders' Equity Flashcards

1
Q

SE = ______ - ______

A 
SE = A - L
SE = "net assets" = BV
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2
Q

GAAP value of SE = ______

FMV of SE = ______

A

GAAP value of SE = stockholder’s equity = net assets = BV = GAAP value of SE

FMV of SE = market cap = # of shares x stock price

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3
Q

market cap = ______ x ______

A

market cap = # of shares x stock price

market cap = FMV of SE

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4
Q

Are the BV and FMV usually more pronounced on the liabilities side or on the asset side?

A

asset side

most assets are recorded at BV, not FMV and some assets aren’t recorded at all so for most companies market cap exceeds BV

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5
Q

The Dow: equation?

A

(total market cap of the 30 companies in the Dow) / (total # of shares of each company when it joined the Dow) = average of the stock price of 30 bellweather companies (AmEx, Coca Cola, Visa, etc.)

Note: adjustments such as stock splits must be made

Note: market cap = # of shares x stock price

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6
Q

stock splits

A

increases # of shares and decreases price/share, does NOT change market cap

Note: stock splits are one of the most important adjustments that must be made in calculating the Dow, if we didn’t make adjustments, the Dow would decrease every time a company split its stock

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7
Q

How do we record common stock?

A

DR cash XX / CR common stock XX / CR additional paid-in capital (APIC) XX

amount that gets recorded to the common stock account is the only amount of the stock’s par value
amount that gets recorded in

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8
Q

What are other broader market indices aside from the Dow?

A
  • NASDAQ: stock exchange on which 3,200 stocks of mainly high-tech (mostly US) cos. are traded
  • S & P 500: composite of 500 large corps (mostly US)
  • Russell 3000: composite of the 3,000 largest companies traded in the US
  • Russell 2000: composite of the smallest 2,000 companies in the Russell 3000
  • Wilshire 5000: index that tracks just about all publicly-traded stocks in the US
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9
Q

Common stock is only the amount of the stock’s ________

A

par value

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10
Q

APIC

A

amount of the issue price in excess of par value

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11
Q

What was the original intent of APIC?

A

represented extent to which an investor was legally liable, so if a corp didn’t pay its liabilities, investors who had not paid in at least par value were still on the hook for the excess of par value over the stock’s issue price

Note: corps played games, set low amounts so Model Bus. Corp. Act eliminated par value concept but not everyone has adopted the MBCA so the concept still survives

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12
Q

What does par value of the preferred stock represent?

A

(1) redemption value of the stock and (2) base on which dividends are paid

Note: unlike common stock, par value of preferred stock does NOT represent the amount for which an investor is legally liable

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13
Q

When to trigger a poison pill?

A

When a hostile party (someone who wants to buy the company who doesn’t have the approval of T’s board) buys > a pre-set % of stock.

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14
Q

poison pill

A

All of the other shareholders get to buy the preferred stock (with the super voting rights) at a cheap price, which has the effect of significantly diluting the hostile shareholder’s voting power, making it prohibitively expensive for the hostile raider to gain control of the company

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15
Q

treasury stock

A

contra equity account against SE (debit balance), stock that a company has issued but then bought back

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16
Q

When company buys back its stock, it records: ?

A

DR treasury stock XX / CR cash XX

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17
Q

Can treasury stock be reissued?

A

Yes—likely at a different price, these gains and losses are recorded to APIC (not net income)

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18
Q

Why do companies buy back their stock?

A

It’s a way of returning $$ to its shareholders, much like paying dividends

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19
Q

Advantages of dividends over treasury stock?

A

shareholders like the security of a steady, recurring payment

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20
Q

Advantages of stock buybacks (treasury stock) over dividends?

A
  • allow a one-time return of cash to shareholders without creating expectations of future payouts (like an increased dividend would)
  • allow companies to increase EPS without having to increase earnings
  • provide companies with stock to use in employee stock option plans
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21
Q

dividend irrelevance theory

A

in terms of maximization of wealth, shareholders should be indifferent among dividends, stock buybacks, or whether dividends or buybacks are done at all

this theory doesn’t really work bc shareholders be like: “show me the $$$!”

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22
Q

How much to pay in dividends (or alternatively, how much stock to buy back)?

A

look to payout ratio (dividends/NI)

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23
Q

Payout ratio:

A

% of a company’s earnings that it pays out in dividends (dividends/NI)

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24
Q

Compared to companies in mature industries, do companies in growth industries tend to have high or low payout ratios?

A
  • Companies in mature industries (e.g., consumer goods) → tend to have high payout ratios
  • Companies in growth industries (e.g., high-tech) → tend to have low payout ratios
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25
Q

many states have laws restricting the payment of dividends (or the buyback of stock) to protect creditors: Maine, S. Dakota, and W. Virginia limit dividends to ____________

Delaware limits dividends to ____________

A

Maine, S. Dakota, and W. Virginia limit dividends to earned surplus

Delaware: limits dividends to total surplus (earned surplus + capital surplus)

Other states limits dividends based on accounting measures

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26
Q

Reasons why Delaware is the incorporation state of choice for corporate America

A
  • limits dividends to total surplus (earned surplus + capital surplus)
  • efficient court system, pro-business statutes
  • well-developed precedent

Note: 60% of largest 500 corps and 50% of corps traded on NYSE incorporated in Delaware

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27
Q

Benefits of transactions pertaining to Sub stock (outright sales of Sub’s stock, spinoffs, splitoffs, tracking stock)

A
  • Provide an enhanced ability to focus on core competencies
  • Investors with pure plays in P & S: invest only in S without investing at all in P (or vice versa)—mitigated by reqs of segment reporting, requiring separate FN disclosure info for each segment that’s at least 10% of the company (in terms of revenues, total assets, or profits)
  • Enhance financial analyses of companies: easier to analyze a company in one industry than to analyze a big conglomerate that’s engaged in many industries
28
Q

When disposing of (selling) Sub’s stock, Parent:

A
  1. Reduces BV of “Inv in S” by the BV of the stock sold
  2. Determines gain or loss on the sale (sales price – BV of the stock sold)
  3. After the sale, uses the appropriate accounting method for the % of stock owned AFTER the sale
29
Q

When a corp owned by another corp does an IPO, it’s called a _________

A

carveout

30
Q

S issues shares to the public (none of which are bought by P) ≈ P’s % ownership of S went down kind of like a sale, so record gains and losses:

A

DR inv in S XX / CR gain on sale XX or DR loss on sale XX / CR inv in S XX

How could “Inv in S” possibly increase in such a sale? Bc P now has a smaller % of a bigger pie

31
Q

S’s “adjusted equity” in a carveout = _________ + _________

A

P’s “Inv in S” account before carveout + S’s proceeds from stock sale

32
Q

If P owned less than 100% of S’s stock prior to the carveout, in determining P’s new share of S’s adjusted equity you would have to extrapolate the amount that would’ve been in P’s “Inv in S” account if P did own 100% of S prior to the stock sale by:

A

amount in P’s “Inv in S” account / % owned by P prior to the carveout

33
Q

If P owned > 50% of S prior to carveout…?

A

consolidate P and S’s financial statements to reflect one economic entity

two approaches:

  • I/S approach: DR Inv in S XX / CR gain on sale XX or DR loss on sale XX / CR Inv in S XX
  • APIC approach: DR Inv in S XX / CR APIC XX or DR APIC XX / CR Inv in S XX
34
Q

In an equity carveout, has FASB endorsed the APIC approach or the I/S approach?

A

FASB has endorsed the APIC approach

35
Q

In an equity carveout, P companies may use the I/S approach if what certain criteria are met?

A
  • Stock issuance is via a public offering (not private placement)—price of the stock sold in a public offering is a more reliable indicator of the true value
  • Stock issuance is not part of a broader recapitalization that’ll involve other capital transactions (ex. spinoff)
36
Q

spinoff

A

dividend to P’s shareholders of stock in S

37
Q

In a ________, P gives its remaining S stock to its shareholders so P won’t actually realize the gain/loss implied by the price obtained in the IPO of Sub’s stock so P can’t record it

A

spinoff

38
Q

dividend of shares in S is recorded as: ?

A

DR dividend XX / CR Inv in S XX

39
Q

How can P reduce ownership in S?

A
  • just plain sell S’s stock outright
  • do an equity carveout of S
  • spinoff S’s stock to P’s shareholders
40
Q

In a spinoff, if FMV of S’s stock

A

P must mark down the “Inv in S” account and then record the dividend

41
Q

Are spinoffs usually taxable?

A

Yes - spinoffs are taxable by default but if certain tax rules are met, spinoffs are tax-free

Since spinoffs are actually just dividends to P’s shareholders, the FMV of the stock given to P’s shareholders is taxable to P’s shareholders (regardless of whether P itself had a gain or loss on the spinoff)

42
Q

When are spinoffs tax-free so that P is not taxed on any gain and P’s shareholders aren’t taxed?

A

To be tax-free (this shows why carveouts are usually limited to

43
Q

Morris Trust transactions

A

(1) P agrees to sell S to B, just like before; (2) but, instead of actually selling S directly to B, P and B agree on the following: P spins off S in a tax-free spinoff → B buys S directly from P’s shareholders

Note: P will’ve already had its shareholders vote to approve of this sale prior to the spinoff, so the spinoff is just one step in a pre-arranged sale

This avoided tax for both P and P’s shareholders (sale can be structured so P shareholders-now S’s shareholders, receive B’s stock not cash so that similar to like-kind exchanges, save taxes for P’s shareholders

Rules changed so that if S is spinoff and then acquired within 2 years of the spinoff, P is retroactively taxed (but P’s shareholders aren’t

44
Q

How can retroactive taxation be avoided in a Morris Trust transaction?

A

Retroactive taxation can be avoided if you can prove that at the time of spinoff, no intent to sell S in the 2 years prior to spinoff OR even if there was intent to sell S, S is the Buyer (instead of being the Target)

45
Q

If Buyer buys the Sub’s stock by paying cash to the Sub’s shareholders, after the deal how much of B’s stock is owned by Sub’s shareholders? B’s shareholders?

A

Sub’s shareholders: 0

B’s shareholders: 100%

46
Q

If Buyer buys Sub’s stock by paying B’s stock to the Sub’s shareholders, after the deal how much of B’s stock is owned by Sub’s shareholders? B’s shareholders?

A

Sub’s shareholders: some

B’s shareholders: some

How much each of B’s stock that each of the sets of shareholders own is based on the relative market caps of the two companies (e.g., 2 companies have same market cap → Sub’s shareholders own? 50% / B’s shareholders? 50%)

Parent can still spinoff S and have it be acquired (in a legal sense), as long as the S shareholders end up owning more than 50% of the legal Buyer’s stock

47
Q

reverse Morris Trust transaction

A

merger partner merges with the distributing parent or spun-off Sub immediately after the spin-off and tax-free transaction

48
Q

Steps of a reverse Morris Trust transaction

A
  1. P still agrees to sell to B
  2. To consummate the sale, P spins off S
  3. S still combines with B
  4. Legal B’s Board & management still effectively control the combined company
  5. But, S shareholders end up owning > 50% of the combined company

RMT transaction is tax-free bc immediately after the transaction, historic stockholders of the distributing parent own > 50% of the stock by vote and value of the combined

RMT is only practical if the merger partner is appx ≤ the spun-off Sub

49
Q

When is a reverse Morris Trust practical?

A

RMT is only practical if the merger partner is appx ≤ the spun-off Sub

50
Q

In a spinoff, do P shareholders own S stock in the same or different ratio in which they own P stock? What about in a splitoff?

A

In a spinoff, P shareholders own S stock in the same ratio in which they own P stock.

In a splitoff, the ownership ratio of P and S changes.

This is bc the shareholders who got stock in S must give back some of their stock in P.

51
Q

What are 2 main motivations for splitoffs?

A

(1) stock buyback that doesn’t require cash outlay on the part of the parent corporation
(2) personality conflicts (for small corps. In which the shareholders have had a falling out, this is a way of splitting up the company among the shareholders)

52
Q

splitoff

A

a stock buyback using S stock instead of cash

53
Q

spinoff vs splitoff

A

spinoff: dividend to P’s shareholders of stock in S
splitoff: a stock buyback using S stock instead of cash

54
Q

Like spinoffs, splitoffs are taxable by default, and tax-free if…?

A

reqs of Sec. 355 are met:

  • there must be a business (non-tax) purpose
  • P must own at least 80% of S before splitoff
  • as part of the split off P must distribute at least 80% of S

Note: splitoffs are not typically done if the reqs of Sec. 355 aren’t met

55
Q

tracking stock

A

P issues stock based on the performance of a specific business unit within the company and not of the company as a whole

56
Q

economic impact of tracking stock

A

Economically, issuance of tracking stock is equivalent to P doing an outright sale of S’s stock.

57
Q

legal impact of tracking stock

A

Legally, P still legally owns S’s stock → allows for continued benefits of joint ownership of S by P (i.e. synergies).

58
Q

risks of tracking stock

A

conflict of interests between the shareholders of the tracking stock and the shareholders of the regular stock

Note: presents issues w/r/t Board of Director’s fiduciary responsibilities

59
Q

What do S and P each record when tracking stock occurs?

A

S itself doesn’t record anything and P records: DR cash XX / CR common stock XX / CR APIC XX

No GAAP income or taxable income resulting from the issuance of tracking stock

60
Q

Since tracking stock is just P stock, the issuance of tracking stock doesn’t necessitate the filing of separate financial statements for S. But, where will P break out earnings between the different shares (i.e. the tracking stock and other stock)?

A

P’s I/S will break out earnings between the different share (i.e. the tracking stock and other stock)

61
Q

stock options give the holder the right to buy stock at ____________

A

stock options give the holder the right to buy stock at a fixed price (“exercise price” or “strike” price)

62
Q

How do employee stock options increase stock price?

A

Considered incentive compensation so employees will work hard, think creatively, add value to the company → increasing the stock price

63
Q

What are fixed/exercise prices set equal to in employee stock options?

A

Exercise price is often set equal to the stock price on the day the options are given; if the stock price increases enough, the options will be in the money

64
Q

backdating stock options

A

scandal where options actually being awarded on the date but with exercise prices based on stock prices of an earlier date

65
Q

Is there GAAP income or taxable income from the issuance of tracking stock?

A

No, the issuance of tracking stock is just the issuance of regular stock.

66
Q

Backdating stock options in the money is not illegal, but as a result of GAAP, tax, and legal failings, regulatory investigations at 180+ companies have been sparked and many execs have been fired because options that were in the money:

A
  • Weren’t being recorded as GAAP expense
  • Weren’t being taxed to employees
  • Issuing options that are in the money may mislead investors, who assume the options will be issued at the money or out of the money
67
Q

In reviewing a client’s internal control, CPAs find good internal control through:

A
  • Adequate separation of duties: Sarbanes-Oxley law reqs auditor to give opinion on company’s internal control
  • Separation of control of company’s assets from the accounting (don’t let cashier do bookkeeping)
  • Separation of authorization of company’s transactions from control of assets (person who authorizes payment of a bill shouldn’t also be writing the check)
  • Separation of operational responsibility from the accounting (keep records at home office bc ppl at the plant might have incentive to change #’s)
  • Separation of info technology duties/access from user depts: don’t let sales agent enter in customer order online (might override system to allow more of credit sale than what customer is authorized for)
  • Proper authorization of transactions
  • Proper documentation
  • Physical control over assets and records (use of fireproof safes, safety deposit box, lock inventory storeroom)
  • Performance of independent checks (e.g., someone preps bank reconciliations and someone else reviews)

Accounting for Lawyers Final (4 decks)

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