Day Enhancement 8
Stockholders Equity
and
Investment Securities
Group Exercise: Board of
Directors Meeting
Security
Original
Purchase
Cost
Selling Price
During the
Year
Market Value
at Year End
A
$10,000
$17,000
n/a
B
10,000
2,000
n/a
C
10,000
n/a
$23,000
D
10,000
n/a
1,000
Preliminary net income computations (without considering the
impact of the investment securities) indicate that net income for
the year is $150,000.
Analysts have forecast earnings of $123,000 for the company.
Bonus if net income exceeds $125,000.
For each security, trading or available for sale?
Group Exercise: Meeting of
Board of DirectorsSolution
Securities
The gain and the loss are REALIZED
Included in net income for both trading and AFS
$150,000 income + $7,000 gain on A - $8,000
loss on B = $149,000
Security
A and B
C
Unrealized gain of $13,000
Already high net income for the year
Perhaps better to save the gain for a future year
Classify security C as AFS
Group Exercise: Meeting of
Board of DirectorsSolution
Security
D
Unrealized loss of $9,000
Even with this loss, income still exceeds both
analysts forecasts and the bonus threshold
Classify Security D as trading
If
C is AFS and D is trading, net income is
computed as follows:
$149,000 - $9,000 unrealized loss on D (trading
security) = $140,000
Group Exercise: Meeting of
Board of DirectorsSolution
To
prevent this type of strategic accounting,
companies are required to designate
securities as trading or AFS when they are
acquired.
Q
In-Class Quiz
1. Company B purchased four investment securities on January 1. Two of the securities were sold
during the year; the other two remain in the companys portfolio at year end. Information about the
four securities is given in the following table.
`Security
i
ii
iii
iv
Original
Purchase Cost
$10,000
10,000
10,000
10,000
Selling Price
During the Year
$7,000
2,000
n/a
n/a
Market Value
at Year End
n/a
n/a
$3,000
21,000
Preliminary net income computations (without considering the impact of the investment securities)
indicate that net income for the year is $150,000. Analysts have forecast net income of $145,000
for the company. Assume that the board of directors has complete freedom in classifying these
securities AND that the members of the board of directors are not bothered by ethical concerns.
a.
b.
c.
d.
e.
f.
Which ONE of the following sets of decisions will cause Company B to meet the analyst forecast
level of net income of $145,000?
Classify (i) , (ii), (iii), and (iv) as available for sale and none as trading.
Classify (i) , (ii), (iii), and (iv) as trading and none as available for sale.
Classify (i) and (ii) as available for sale and (iii) and (iv) as trading.
Classify (i) and (ii) as trading and (iii) and (iv) as available for sale.
Classify (i) and (iii) as available for sale and (ii) and (iv) as trading.
Classify (ii) and (iv) as available for sale and (i) and (iii) as trading.
Five Measures of Income
Sales
- Cost of Goods Sold
= Gross Profit
- Other Operating Expenses, Gains, and Losses
= Operating Income
- Interest Expense
+/- Miscellaneous revenues, expenses, gains, and losses
= Income Before Taxes
- Income Tax Expense
= Income from Continuing Operations
+/- Income from Discontinued Operations
+/- Extraordinary Items
= Net Income
+/- Unrealized gains and losses not included in Net Inc.
= Comprehensive Income
What investors want to know!
Sales
- Cost of Goods Sold
= Gross Profit
- Other Operating Expenses, Gains, and Losses
= Operating Income
- Interest Expense
+/- Miscellaneous revenues, expenses, gains, and losses
= Income Before Taxes
- Income Tax Expense
= Income from Continuing Operations
+/- Income from Discontinued Operations
+/- Extraordinary Items
= Net Income
+/- Unrealized gains and losses not included in Net Inc.
= Comprehensive Income
Below the Line Items
Sales
- Cost of Goods Sold
= Gross Profit
- Other Operating Expenses, Gains, and Losses
= Operating Income
- Interest Expense
+/- Miscellaneous revenues, expenses, gains, and losses
= Income Before Taxes
- Income Tax Expense
= Income from Continuing Operations
+/- Income from Discontinued Operations
+/- Extraordinary Items
= Net Income
+/- Unrealized gains and losses not included in Net Inc.
= Comprehensive Income
Comprehensive Income Items
Sales
- Cost of Goods Sold
= Gross Profit
- Other Operating Expenses, Gains, and Losses
= Operating Income
- Interest Expense
+/- Miscellaneous revenues, expenses, gains, and losses
= Income Before Taxes
- Income Tax Expense
= Income from Continuing Operations
+/- Income from Discontinued Operations
+/- Extraordinary Items
= Net Income
+/- Unrealized gains and losses not included in Net Inc.
= Comprehensive Income
Specific Items Affecting
Comprehensive Income
Sales
- Cost of Goods Sold
= Gross Profit
- Other Operating Expenses, Gains, and Losses
= Operating Income
- Interest Expense
+/- Miscellaneous revenues, expenses, gains, and losses
= Income Before Taxes
- Income Tax Expense
= Income from Continuing Operations
+/- Income from Discontinued Operations
+/- Extraordinary Items
= Net Income
+/- Unrealized gains and losses on AFS securities
+/- Increases or decreases in foreign subsidiaries
= Comprehensive Income
Comprehensive Income
Comprehensive income reflects the overall change in a
companys wealth during the period.
Comprehensive Income =
Net income
Plus other comprehensive income
Other Comprehensive Income Items
Changes in the value of available-for-sale investment
securities.
Changes in the US dollar value of foreign subsidiaries
due to exchange rate changes
Excluded
from income
because not
related
to business
operations!
But in comprehensive
income because they
do affect fair values of
assets and liabilities!
Group Exercise IIValuation
Last years net income (no extraordinary items)
Shares outstanding
P/E Ratio for industry
Beginning of year stock price
Income from continuing operations
+ Income from discontinued operations
Net income
+ Unrealized gain on available-for-sale securities
Comprehensive income
$10,000
10,000 shares
20
$20
$12,000
3,000
$15,000
5,000
$20,000
The income from discontinued operations reflects the amount of
income generated by certain operations this year; those same
operations have been discontinued and will not generate any
income or loss for the Company in future years.
What is your estimate of Han Companys stock price per share
as of the end of this year?
Group Exercise IIValuation
Beginning value of the company
(10,000 shares x $20 per share)
Total Value
$200,000
Per Share
$20.00
Group Exercise IIValuation
Beginning value of the company
(10,000 shares x $20 per share)
One-time increase in value because income from
discontinued operations
Total Value
$200,000
Per Share
$20.00
3,000
0.30
Group Exercise IIValuation
Beginning value of the company
(10,000 shares x $20 per share)
One-time increase in value because income from
discontinued operations
One-time increase in value because of increase
in value of AFS security portfolio
Total Value
$200,000
Per Share
$20.00
3,000
0.30
5,000
0.50
Group Exercise IIValuation
Beginning value of the company
Total Value
(10,000 shares x $20 per share)
$200,000
One-time increase in value because income from
discontinued operations
3,000
One-time increase in value because of increase
in value of AFS security portfolio
5,000
Increase in value because of increase in income from
continuing operations.
$2,000 increase x 20 PE ratio
This increase is more than just
the $2,000 because it
is expected to continue into the future
40,000
Per Exercise Share
$20.00
0.30
0.50
4.00
Group IIValuation
Beginning value of the company
Total Value
(10,000 shares x $20 per share)
$200,000
One-time increase in value because income from
discontinued operations
3,000
One-time increase in value because of increase
in value of AFS security portfolio
5,000
Increase in value because of increase in income from
continuing operations.
$2,000 increase x 20 PE ratio
This increase is more than just
the $2,000 because it
is expected to continue into the future
40,000
Ending value
$248,000
Per Share
$20.00
0.30
0.50
4.00
$24.80
Just an estimate; understanding the intuition is important!
Q
In-Class Quiz
2. Last year, Company C reported net income of $20,000 and had 10,000 shares
outstanding. Other companies in the same industry have P/E ratios of
approximately 15. Last year there were no below the line items, and there was
also no other comprehensive income. At the beginning of this year, Company
C had a stock price per share of $30. During this year, Company C reported the
following.
Income from continuing operations
+ Loss from discontinued operations
Net income
- Unrealized decrease from foreign currency adjustment
Comprehensive income
$22,000
(3,000)
$19,000
(5,000)
$14,000
The loss from discontinued operations is a one-time decrease in the value of
the company from profitable operations that occurred this year but that will not
be repeated in future years.
What is your estimate of Company Cs stock price per share as of the end
of this year?
Valuing Bonds Held as
Investment Securities
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond Rating
Bond 1
15
AA
Bond 2
6
BBB
Bond 3
3
AAA
Bond 4
18
BB
Bond 5
9
A
Estimate the Fair Value of
Bond #1
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond 1
15
Bond Rating
AA
Look at the AA bond rating column
The 15-year term of Bond 1 is exactly halfway between 100.29 and 91.49.
(100.29 + 91.49)/2 = 95.89
Estimated price of Bond 1 = $1,000 x 95.89% = $958.90
Estimate the Fair Value of
Bond #2
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond 2
6
Bond Rating
BBB
Look at the BBB bond rating column
The 6-year term of Bond 2 is 20% (1year/5 years) from 100.17 to 98.54.
(100.17 98.54)*0.20 = 0.326; 100.17 0.326 = 99.844
Estimated price of Bond 2 = $1,000 x 99.844% = $998.44
Estimate the Fair Value of
Bond #3
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond 3
3
Bond Rating
AAA
Look at the AAA bond rating column
The 3-year term of Bond 3 is 33% (1year/3 years) from 103.85 to 103.66.
(103.85 103.66)*0.33= 0.0627; 103.85 0.0627 = 103.7873
Estimated price of Bond 3 = $1,000 x 103.7873% = $1,037.87
Estimate the Fair Value of
Bond #4
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond 4
18
Bond Rating
BB
Look at the BB bond rating column
The 18-year term of Bond 4 is 80% (8year/10years) from 91.98 to 82.06.
(91.98 82.06)*0.80= 7.936; 91.98 7.936 = 84.044
Estimated price of Bond 4 = $1,000 x 84.044% = $840.44
Estimate the Fair Value of
Bond #5
Bond Prices (% of par)
Bond Ratings
Term (in years)
AAA
AA
A
BBB
BB
2
103.85
103.56
102.71
102.37
100.29
5
103.66
102.53
101.45
100.17
98.50
10
101.64
100.29
99.56
98.54
91.98
20
95.66
91.49
90.00
89.31
82.06
Term
Bond 5
9
Bond Rating
A
Look at the A bond rating column
The 9-year term of Bond 5 is 80% (4year/5years) from 101.45 to 99.56.
(101.45 99.56)*0.80= 1.512; 101.45 1.512 = 99.938
Estimated price of Bond 5 = $1,000 x 99.938% = $999.38
Q
In-Class Quiz
3. Below is a bond pricing matrix.
Bond Prices (% of par)
Bond Ratings
------------------------------------------------------Term
AAA
AA
A
2 years
104
103
102
5 years
103
102
101
10 years
101
100
99
20 years
96
91
90
BBB
101
100
98
89
Company H owns a bond with a 13-year term and a AA rating. What is the fair value of this $1,000
bond?
a.
b.
c.
d.
e.
$973
$937
$955
$923
$977
The Fair Value Option
Under the provisions of SFAS No. 159, a company has the option
to report, at each balance sheet date, any or all of its financial
assets and liabilities at their fair values on the balance sheet date.
Why did the FASB give companies this financial reporting
flexibility?
The objective is to improve financial reporting by providing
entities with the opportunity to mitigate volatility in reported
earnings caused by measuring related assets and liabilities
differently without having to apply complex hedge accounting
provisions.
Example A
1.
2.
One asset, a bond (called Bond B)
One liability, one of its own bonds (called Bond X)
Both bonds have the same terms: $1,000 face value, 30-year life, 8% coupon
rate, and single interest payments made at the end of each year.
On their issuance dates, both bonds were associated with a market interest rate
of 8%.
Prepare a balance sheet for the company as of the issuance date of investment Bond
B and the companys own Bond Payable X.
On the very next day, the market interest rate with respect to Bond B had risen to
11% and the market interest rate with respect to Bond Payable X had also risen to
11%. Prepare the companys balance sheet.
Solution A
1.
Both bonds were issued when the market interest rate of 8% was
equal to the coupon rate, so the bonds were issued at par of
$1,000.
Assets
Bond B
Liabilities and Equity
$1,000
Bond X Payable
$1,000
Equity
$0
Solution A
The increase in the market rate of interest changes the value of
the bonds:
Asset: N=30, I=11%, PMT=$80, FV=$1,000; PV=$739
Liability: N=30, I=11%, PMT=$80, FV=$1,000; PV=$739
2.
Assets
Bond B
Liabilities and Equity
$739
Bond X Payable
$739
Without the Fair Value Option:
Equity
$0
Liabilities and Equity
$739
Bond X Payable
$1,000
Assets
Bond B
Q
In-Class Quiz
4.
A company has:
one asset, a bond (called Bond B)
one liability, one of its own bonds (called Bond X)
Both bonds have the same terms:
$1,000 face value, 30-year life, 8% coupon rate, and single interest payments made at the end of each year.
On their issuance dates, both bonds had a market interest rate of 8%, so both were issued at par ($1,000). The
company has determined to account for both the bond asset and the bond liability using the fair value option.
On the day after the issuance of both bonds,
the market interest rate for Bond B (the purchased bond) rose to 13%
the market interest rate for Bond X (the issued bond) rose to 11%.
Which ONE of the following will appear on the companys simplified balance sheet?
a.
b.
c.
d.
e.
Equity subtraction of $375
Equity addition of $261
Equity subtraction of $375
Equity subtraction of $364
Equity subtraction of $114
The End
The