Deferred Taxes Along with long-term liabilities, the analyst may encounter another

Deferred Taxes Along with long-term liabilities, the analyst may encounter another

account, deferred taxes. Deferred taxes are taxes that will have to be

FOUNDATIONS

paid to the federal and state governments based on accounting income, but are not due yet. Deferred taxes arise when different methods of accounting are used for financial statements and for tax purposes. These differences are temporary and are the result of different timing of reve- nue or expense recognition for financial statement reporting and tax purposes. The deferred tax liability arises when the actual tax liability is less than the tax liability shown for financial reporting purposes (mean- ing that the firm will be paying the difference in the future), whereas the deferred tax asset, mentioned earlier, arises when the actual tax liability is greater than the tax liability shown for reporting purposes.

EQUITY Equity is the owner’s interest in the company. For a corporation, owner-

ship is represented by common stock and preferred stock. Shareholders’ equity is also referred to as the book value of equity, since this is the value of equity according to the records in the accounting books.

The value of the ownership interest of preferred stock is represented in financial statements as its par value, which is also the dollar value on which dividends are figured. For example, if you own a share of pre- ferred stock that has a $100 par value and a 9% dividend rate, you receive $9 in dividends each year. Further, your ownership share of the company is $100. Preferred shareholders’ equity is the product of the number of preferred shares outstanding and the par value of the stock; it is shown that way on the balance sheet.

The remainder of the equity belongs to the common shareholders. It consists of three parts: common stock outstanding (listed at par or at stated value), additional paid-in capital, and retained earnings. The par value of common stock is an arbitrary figure; it has no relation to market value or to dividends paid on common stock. Some stock has no par value, but may have an arbitrary value, or stated value, per share. None- theless, the total par value or stated value of all outstanding common shares is usually entitled “capital stock” or “common stock.” Then, to inject reality into the equity part of the balance sheet, an entry called additional paid-in capital is added; this is the amount received by the corporation for its common stock in excess of the par or stated value. If

a firm sold 10,000 shares of $1 par value common stock at $40 a share, its equity accounts would show:

Common stock, $1 par value

Additional paid-in capital

Financial Statements

In Exhibit 6.1, Fictitious’ common stock represents the stock’s par value and the amount paid in excess of par value is recorded as addi- tional paid-in capital. Some corporations eliminate this arbitrary divi- sion of accounts and instead report the entire amount paid for the common stock as capital stock or common stock.

If some of the stock is bought back by the firm, the amount it pays for its own stock is recorded as treasury stock. Because these shares are not owned by shareholders, common shareholders’ equity is reduced by the cost of the treasury stock.

There are actually four different labels that can be applied to the number of shares of a corporation on a balance sheet:

■ The number of shares authorized by the shareholders. ■ The number of shares issued and sold by the corporation, which can

be less than the number of shares authorized. ■ The number of shares currently outstanding, which can be less than the number of shares issued if the corporation has bought back (repur- chased) some of its issued stock.

■ The number of shares of treasury stock, which is stock that the com- pany has repurchased.

The outstanding stock is reported in the stock accounts, and adjust- ments must be made for any treasury stock. In the case of Fictitious Corporation, shown in Exhibit 6.1, in 2003 there were 2 million autho- rized shares, 1.5 million issued shares, and (since there was no treasury stock) 1.5 million shares outstanding.

As another example, consider the numbers of shares for the Walt Disney Company. For the fiscal year ended September 30, 2001, Disney had 3.6 billion shares authorized, 2.1 billion shares issued, and 2.019 billion shares outstanding.

The number of shares actually issued by Disney is well below the number of shares the company is authorized to issue; as of the end of 2001, Disney could issue 3.6 − 2.1 = 1.5 billion common shares without shareholder approval.

The bulk of the equity interest in a company is in its retained earn- ings. Retained earnings is the accumulated net income of the company, less any dividends that have not been paid, over the life of the corpora- tion. Retained earnings are not strictly cash and any correspondence to cash is coincidental. Any cash generated by the firm that has not been paid out in dividends has been reinvested in the firm’s assets—to finance accounts receivable, inventories, equipment, and so forth.

The book value of equity—the sum total of retained earnings, com- mon stock, and (if applicable) preferred stock—represents the equity

FOUNDATIONS

interest of the corporation’s owners, stated in terms of historical costs. However, historical costs often bear little resemblance to the value of equity stated in terms of market values. Consider the case of several companies at the end of their fiscal 2001 year:

Book Value of Equity Market Value of Equity Company

in Millions (in Millions)

117,224 General Electric

17,847 Wal-Mart Stores

267,091 Source: Book values of equity are drawn from the company’s 2001 annual report.

Market value, as of the end of the company’s fiscal year-end, is from Yahoo! Finance, biz.yahoo.com.

In most cases, the market value of equity exceeds the company’s book value by a wide margin, as typified by Coca-Cola, General Elec- tric, and Wal-Mart. Yet there are cases in which the book value of equity is negative (as illustrated by Amazon), which bears no relation to the company’s market value of equity. And in other, relatively uncom- mon cases such as Sprint, the market value of equity is close to the com- pany’s book value.