Understanding Disclosures in Notes
Eli Lilly and Company provided the following information in the notes (excerpts) to its 1997 financial statements:
Note 8: Stock Plans
Stock options and performance awards have been granted to officers and other executive and key employees. Stock options are granted at exercise prices equal to the fair market value of the company’s stock at the dates of grant. Generally, options vest 100 percent after three years from the grant date and have a term of 10 years. In October 1995, the company issued its second grant under the Global Shares program. Essentially all employees were given an option to buy 400 shares of the company’s common stock at a price equal to the fair market value of the company’s stock at the date of grant. Options to purchase approximately 10.3 million shares were granted as part of the program. Individual grants generally become exercisable on or after the third anniversary of the grant date and have a term of 10 years.
The company has elected to follow Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees” and related interpretations in accounting for its stock options. Under APB No. 25, because the exercise price of the company’s employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. Total compensation expense for stock based awards reflected in income on a pretax basis was $242.1 million, $164.2 million, and $93.1 million in 1997, 1996, and 1995, respectively. However, SFAS No. 123, “Accounting for Stock Based Compensation,” requires presentation of pro forma information as if the company had accounted for its employee stock options granted subsequent to December 31, 1994, under the fair value method of that statement. For purposes of pro forma disclosure, the estimated fair value of the options is amortized to expense over the vesting period. Under the fair value method, the company’s net income (loss) and earnings (loss) per share would have been as follows:
|
1997 |
1996 |
1995 |
|
|
Net income (loss) |
$(424.2) |
$1,496.5 |
$2,285.3 |
|
Earnings (loss) per share—diluted |
$ (0.39) |
$ 1.34 |
$ 1.98 |
Because SFAS No. 123 is applicable only to options granted subsequent to December 31, 1994, and the options have a three year vesting period, the pro forma effect will not be fully reflected until 1998.
Note 9: Shareholders’ Equity
On September 15, 1997, the company’s board of directors declared a two for one stock split to be effected in the form of a 100 percent stock dividend payable to shareholders of record at the close of business on September 24, 1997. The outstanding and weighted average number of shares of common stock and per share data in these financial statements have been adjusted to reflect the impact of the stock split for all periods presented. The company now has 1,111,521,927 issued shares of common stock without par value, including 554,331,485 shares issued October 15, 1997, as a result of the stock split. Treasury shares held by the company were not split. The company has an Employee Stock Ownership Plan (ESOP) as a funding vehicle for the existing employee savings plan. The ESOP used the proceeds of a loan from the company to purchase shares of common stock from the treasury.
In 1991, the ESOP issued $200 million of third party debt, repayment of which was guaranteed by the company (see Note 7). The proceeds were used to purchase shares of the company’s common stock on the open market. Shares of common stock held by the ESOP will be allocated to participating employees annually through 2006 as part of the company’s savings plan contribution. The fair value of shares allocated each period is recognized as compensation expense. Under the terms of the company’s Shareholder Rights plan, all shareholders of common stock received for each share owned a preferred stock purchase right entitling them to purchase from the company one four hundredth of a share of Series A Participating Preferred Stock at an exercise price of $40.63.
The rights are not exercisable until after the date on which the company’s right to redeem has expired. The company may redeem the rights for $.00125 per right up to and including the tenth business day after the date of a public announcement that a person (the “Acquiring Person”) has acquired ownership of stock having 20 percent or more of the company’s general voting power (the “Stock Acquisition Date”). The plan provides that, if the company is acquired in a business combination transaction at any time after a stock acquisition date, generally each holder of a right will be entitled to purchase at the exercise price a number of the acquiring company’s shares having a market value of twice the exercise price. The plan also provides that, in the event of certain other business combinations, certain self dealing transactions or the acquisition by a person of stock having 25 percent or more of the company’s general voting power, generally each holder of a right will be entitled to purchase at the exercise price a number of shares of the company’s common stock having a market value of twice the exercise price. Any rights beneficially owned by an acquiring person shall not be entitled to the benefit of the adjustments with respect to the number of shares described above. The rights will expire on July 28, 1998 unless redeemed earlier by the company.
Required
a Review Lilly’s notes. Identify any unusual terms.
b. Reconstruct each of the transactions described by Lilly. Use the accounting equation to summarize these transactions.
c. Indicate how each of these transactions may affect Lilly’s (a) EPS and (b) ROE.
d. Discuss the possible impact of Lilly’s preferred rights issue.
e. Discuss the implications of Lilly’s stock option plan.
f. Identify whether Lilly’s disclosures are favorable or unfavorable for existing shareholders. Are they advantageous for future shareholders? Why?