Items that constitute shareholders’ equity usually do not have a marked effect on income determination and, as a consequence, do not seriously impact analysis of income. The more relevant information for analysis relates to the composition of capital accounts and to their applicable restrictions. Composition of equity is important because of provisions that can affect residual rights of common shares and, accordingly, the rights, risks, an returns of equity investors. Such provisions include dividend participation rights, conversion rights, and a variety of options and conditions that characterize complex securities frequently issued under merger agreements most of which dilute common equity. It is important that we reconstruct and explain changes in these capital accounts
Retained Earnings
Retained earnings are the earned capital of a company. The retained earnings account reflects the accumulation of undistributed earnings (net income) of a company since its inception. This contrasts with the capital stock and additional paid-in capital accounts that constitute capital contributed by shareholders. Retained earnings are the primary source of dividend distributions to shareholders. While some states permit distributions to shareholders from additional paid-in capital, these distributions representvcapital (not earnings) distributions.
Cash and Stock Dividends
A cash dividend is a distribution of cash to shareholders. It is the most common form of dividend and, once declared, is a liability of a company. Another form of dividend is the dividend in kind, or property dividend. These dividends are payable in the assets of a company, in goods, or in the stock of another corporation. Such dividends are valued at the market value of the assets distributed.
A stock dividend is a distribution of a company’s own shares to shareholders on a pro rata basis. It represents, in effect, a permanent capitalization of earnings. Shareholders receive additional shares in return for reallocation of retained earnings to capital accounts. Accounting for small (or ordinary) stock dividends, typically less than 20% to 25% of shares outstanding, requires the stock dividend be valued at its market value on the date of declaration. Large stock dividends (or “split-ups effected in the form of a dividend”), typically exceeding 25% of shares outstanding, require that the stock dividend be valued at the par value of shares issued. We must not be misled into attaching substantive value to stock dividends. Companies sometimes encourage such inferences for their own selfinterestsas shown here:
Retained Earnings
Retained earnings are the earned capital of a company. The retained earnings account reflects the accumulation of undistributed earnings (net income) of a company since its inception. This contrasts with the capital stock and additional paid-in capital accounts that constitute capital contributed by shareholders. Retained earnings are the primary source of dividend distributions to shareholders. While some states permit distributions to shareholders from additional paid-in capital, these distributions representvcapital (not earnings) distributions.
Cash and Stock Dividends
A cash dividend is a distribution of cash to shareholders. It is the most common form of dividend and, once declared, is a liability of a company. Another form of dividend is the dividend in kind, or property dividend. These dividends are payable in the assets of a company, in goods, or in the stock of another corporation. Such dividends are valued at the market value of the assets distributed.
A stock dividend is a distribution of a company’s own shares to shareholders on a pro rata basis. It represents, in effect, a permanent capitalization of earnings. Shareholders receive additional shares in return for reallocation of retained earnings to capital accounts. Accounting for small (or ordinary) stock dividends, typically less than 20% to 25% of shares outstanding, requires the stock dividend be valued at its market value on the date of declaration. Large stock dividends (or “split-ups effected in the form of a dividend”), typically exceeding 25% of shares outstanding, require that the stock dividend be valued at the par value of shares issued. We must not be misled into attaching substantive value to stock dividends. Companies sometimes encourage such inferences for their own selfinterestsas shown here:
Spin-Offs and Split-Offs
Companies often divest subsidiaries, either in an outright sale or as a distribution to shareholders. The sale of a subsidiary is accounted for just like the sale of any other asset: a gain (loss) on the sale is recognized for the difference between the consideration received and the book value of the subsidiary investment. Distributions of subsidiary stock to shareholders can take one of two forms:
Spin-off, the distribution of subsidiary stock to shareholders as a dividend; assets (investment in subsidiary) are reduced, as are retained earnings Split-off, the exchange of subsidiary stock owned by the company for shares in the company owned by the shareholders; assets (investment in subsidiary) are reduced and the stock received from the shareholders is treated as treasury stock.
If these transactions affect shareholders on a pro rata basis (equally), the investment in the subsidiary is distributed at book value. For non-pro rata distributions, the investment is first written up to market value, resulting in a gain on the distribution, and the market value of the investment is distributed to shareholders. To illustrate, AT&T split off the Wireless subsidiary as a separate company via an exchange of the wireless subsidiary stock owned by AT&T for shares in AT&T owned by its shareholders. Since the exchange was a non-pro rata distribution, the shares were written up to market value prior to the exchange, resulting in a gain of $13.5 billion as reported below:
Companies often divest subsidiaries, either in an outright sale or as a distribution to shareholders. The sale of a subsidiary is accounted for just like the sale of any other asset: a gain (loss) on the sale is recognized for the difference between the consideration received and the book value of the subsidiary investment. Distributions of subsidiary stock to shareholders can take one of two forms:
Spin-off, the distribution of subsidiary stock to shareholders as a dividend; assets (investment in subsidiary) are reduced, as are retained earnings Split-off, the exchange of subsidiary stock owned by the company for shares in the company owned by the shareholders; assets (investment in subsidiary) are reduced and the stock received from the shareholders is treated as treasury stock.
If these transactions affect shareholders on a pro rata basis (equally), the investment in the subsidiary is distributed at book value. For non-pro rata distributions, the investment is first written up to market value, resulting in a gain on the distribution, and the market value of the investment is distributed to shareholders. To illustrate, AT&T split off the Wireless subsidiary as a separate company via an exchange of the wireless subsidiary stock owned by AT&T for shares in AT&T owned by its shareholders. Since the exchange was a non-pro rata distribution, the shares were written up to market value prior to the exchange, resulting in a gain of $13.5 billion as reported below:
AT&T next spun off its Broadband subsidiary in connection with its acquisition by Comcast. The spin-off was effected as a non-pro rata distribution to shareholders and, consequently, was recorded at fair market value, resulting in a gain of $1.3 billion as reported here:
In both of these cases, the transactions with AT&T shareholders were non-pro rata, meaning that different groups of AT&T shareholders were treated differently. Had these transactions been effected on a pro rata basis (all shareholders receiving their pro rata share of the distribution), the subsidiary stock would have been distributed at book value and no gain would have been recognized. Our analysis must be cognizant of these noncash, transitory gains when evaluating income.
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