Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
CHAPTER 15
FINANCIAL REPORTING FOR OWNERS’ EQUITY
CHAPTER OVERVIEW
Statement readers must understand accounting procedures and reporting conventions for owner’s
equity for the following reasons: (1) Appropriate income measurement; (2) Compliance with contract
terms and restrictions; (3) Legality of corporate distributions to owners; (4) Linkage to equity valuation.
Many aspects of financial reporting for owners’ equity transactions are built on technical rules and
procedures that have evolved over time. Other aspects of owners’ equity accounting have not changed
despite changing economic and legal environments. Still other aspects of owners’ equity accounting
involve complicated pronouncements that reflect political compromises. Financial statement readers must
recognize these influences and avoid unwarranted inferences based on the reported figures.
Stock buybacks don’t produce accounting gains and losses, but they can be used to artificially inflate a
company’s reported EPS. Preferred stock that has a mandatory redemption feature looks a lot like debt,
so GAAP now requires it to be classified as debt in most cases.
Some companies can pay dividends in excess of their retained earnings balance, but their ability to do
so depends on state law. EPS numbers are adjusted for potential dilution from stock options, warrants,
and convertible securities.
GAAP now requires companies to record compensation expense when stock options are given to
employees, but GAAP ignores the option value in convertible debt. GAAP can understate interest
expense when companies issue convertible debt, but new GAAP rules may soon correct this problem.
IFRS rules already do so.
While some rules for owners’ equity accounting may seem arbitrary – and therefore insignificant –
these financial statement items have a profound impact on lending agreements, regulation, and the cost of
equity capital. Furthermore, managers have strong incentives to use the financial reporting latitude to
achieve various economic goals.
CHAPTER OUTLINE
I. APPROPRIATE INCOME MEASUREMENT
A. What Constitutes the “Firm”?
1. Prevailing GAAP is based on a different perspective—called the “ownership” perspective
of the firm—which looks at the basic accounting equation from the viewpoint of owners’
equity and differentiates between capital provided by stockholders and capital provided by
creditors.
a. Under this perspective, net capital deployed (assets minus liabilities) equals owners’
capital (owners’ equity).
b. The prevalence of the “ownership” view in GAAP greatly influences income
measurement.
i. To illustrate why, consider the basic accounting principle that
income can be earned (or expenses incurred) only through
transactions between the firm and “outsiders” and not “insiders.”
ii. Under the “ownership” view, the “firm” and its owners are the same.
iii. Consequently, no income (or loss) can arise from transactions between the firm
and its owners because owners are not “outsiders.”
iv. This perspective explains why interest payments to banks or bondholders
(outsiders) are expenses that reduce income while dividend payments to
common and preferred stockholders (insiders) are not expenses.
2. One way corporations raise capital is selling equity shares to Called common stock, these
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
shares provide the opportunity for purchasers to participation the company’s future profitability.
1. In addition to conveying ownership rights, common stock has limited liability.
a. So long as each share is sold for an amount in excess of an arbitrary per share dollar
amount—called par value—a shareholder’s potential future loss is limited to the
original purchase price of the common share.
b. Limited liability makes investing in common stock attractive because potential gains
from ownership are unlimited but downside risk of loss is limited to the share
purchase price.
4. The difference between the issue price of common stock and its par value is credited to a
separate owners’ equity account called “Paid–in capital in excess of par”—sometimes also
called “Additional paid-in capital.”
4. When a corporation buys back its own shares, the repurchased shares are called
treasury shares because they are held in the corporate treasury for later use.
1. The reason stock repurchases do not involve accounting gains and losses is that they are
transactions between the company and its owners.
2. Treasury stock is treated as a contra-equity account on the balance sheet; it is not
considered a corporate asset.
3. Reselling the shares at a share price higher (lower) than the share price to reacquire them
does not result in income (expense); the difference is added to (subtracted from) the
“Paid-in capital in excess of par” account.
D. Why Companies Repurchase their Stock:
1. A company may need a supply of shares to have available for employee stock options.
2. Management may conclude the company’s shares are undervalued at the existing market
price and that the best use of corporate funds is to invest in the firm’s own shares.
3. The corporation may want to signal to investors that “insiders” have confidence in the
value of the share price.
4. Management may want to distribute surplus cash to shareholders rather than keeping it
inside the company.
a. Stock repurchases have one other advantage—shareholders who take the cash are
taxed at capital gain rates.
5. Some stock buybacks are motivated solely by a desire to boost EPS which can be used to
camouflage business slowdowns.
6. It’s always good to look behind the numbers when it comes to stock buybacks.
II. COMPLIANCE WITH CONTRACT TERMS
A. Owners’ equity is one of the accounting numbers used in many contracts and analysts must
fully understand how owners’ equity is reported to determine a firm’s compliance with its
contractual terms. Firms have incentives to use their financial reporting latitude to circumvent
contractual restrictions. Some financial experts suggest that the popularity of certain equity
instruments like preferred stock can be explained by their potential use in avoiding various
contractual constraints.
1. Preferred stockholders must be paid their dividends in full before any cash distribution
can be made to common shareholders.
2. If the company is liquidated, preferred stockholders must receive cash or other assets at
least equal to the stated value of their shares before any assets are distributed to common
shareholders.
a. The stated value of preferred stock is typically $100 per share.
b. The dividend is often expressed as a percentage of the stated value.
c. Unlike bond interest expense, preferred stock dividends are not a contractual
obligation that could precipitate bankruptcy proceedings if unpaid, and they are not a
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
deductible expense for tax purposes.
3. Preferred shares are usually cumulative, meaning that if, for any reason, a particular
quarter’s preferred dividend is not declared, then no dividends on common shares can be
paid until all unpaid past and current preferred dividends are paid.
B. Corporations who issue preferred stock do so because of one or more of the following:
1. Financially weak corporations consider preferred stock to be less risky than debt since
missing a preferred dividend payment, unlike missing an interest payment, will not
precipitate bankruptcy.
2. Companies with a history of operating losses usually don’t pay income taxes because
of their operating loss carryforwards, so preferred stock becomes more attractive
since debt, in this case, no longer has a tax advantage.
3. Preferred stock offer tax advantages to corporate investors since 70% to 80% of the
dividends corporations receive from their stock investments can be tax free (Ch. 13).
4. Preferred stock is treated as equity rather than debt on financial statements, so
companies precluded from issuing additional debt because of covenant restrictions
can issue preferred stock instead and still not dilute the ownership claims of common
stockholders.
C. The distinction between preferred stock and debt is often murky since preferred stock (like
debt) is usually nonvoting and so preferred shareholders often have no direct control over
the affairs of the company.
1. The distinction between debt and preferred stock has been further blurred as
companies began issuing mandatorily redeemable preferred stock.
a. Although called preferred stock, these financial instruments require the issuing
company to retire them (just like debt) at some future date, commonly five or ten
years.
b. This kind of preferred stock represents what many consider debt that is
“disguised” as equity.
2. The SEC does not consider mandatorily redeemable preferred stock to be equity and
prohibits firms issuing such securities from including them under the caption
“Owners’ Equity” on the balance sheet. U.S. GAAP requires liability treatment for
most mandatorily redeemable preferred stock.
a. This meant that amounts for redeemable preferred stock could no longer be
combined with true owners’ equity items like nonredeemable preferred stock and
common stock in financial statements filed with the SEC.
b. Redeemable preferred stock was previously shown on a separate line between
liabilities and shareholders equity (the so-called mezzanine section of the
balance sheet).
i. This classification may not capture the real economic characteristics of
these securities.
ii. If mandatorily redeemable preferred shares are convertible into common
stock at the option of the investor, it is possible that preferred shares with this
convertibility feature may never be redeemed by the company, making their
presentation status as nonequity arguable.
3. Beginning 2003, the FASB required mandatorily redeemable preferred shares to be
reported as a balance sheet liability and included alongside long-term debt.
Associated interest expense (dividends in essence) is also reported. SEC rules further
require companies to differentiate clearly between common stock and any type of
preferred stock, whether redeemable or not.
4. Trust preferred security, a new form of mandatorily redeemable preferred stock, has
become popular. A special purpose entity is established that then sells redeemable
preferred stock to investors. The company then borrows money from the created entity
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
with terms identical to those of the preferred stock and gains the tax advantage
associated with the debt.
5. The trust pays dividends and instead of interest and a final payment at the end called a
mandatory redemption payment instead of a principal payment.
6. Most trust preferred securities are now shown as balance sheet liabilities.
7. Finally, U.S. GAAP requires companies to disclose the dollar amount of preferred
stock redemption requirements for each of the five years following the balance sheet
date.
III. LEGALITY OF CORPORATE DISTRIBUTIONS
A. State laws, which vary from state to state, govern corporate distributions to shareholders.
1. The intent of these laws is to prohibit companies from distributing “excessive” assets to
owners and thereby making themselves insolvent—that is, incapable of repaying creditor
claims.
2. These laws were designed to protect creditors by ensuring that only solvent companies
distribute cash to owners.
B. Existing GAAP disclosure rules focus attention on the source of owners’ equity –
contributed capital versus earned capital, but ignore the capacity of the corporation for
making legally permitted asset distributions to stockholders.
C. Many states have now adopted the 1984 Revised Model Business Corporation Act as a guide
to the legality of distributions.
1. Under this act the firm is considered to be solvent as long as the fair value of assets
exceeds the fair value of liabilities after the distribution.
2. In extreme cases, this means that an asset distribution would be legal even if the book
value of net assets is negative after the distribution. This means that the book value of
owners’ equity may not give an accurate picture of potentially legal distributions in states
that have adopted the 1984 Act.
3. To ascertain potential cash distributions, analysts need to know two things:
a. The distribution law in the state of the firm incorporation
b. Fair value information if state law permits distributions based on excess fair
value of net assets. This is difficult to ascertain since GAAP does not disclosure
of this information.
4. If a company distributes stock instead of cash, GAAP requires that stock dividends reduce
retained earnings, but stock splits may not.
5. United States is the only country that records stock dividends at market value. Other
countries use the par value or the book value.
IV. SHAREHOLDERS’ EQUITY: FINANCIAL STATEMENT PRESENTATION
1. Most companies report capital contribution amounts (Common Stock at par) separately
from Paid-in capital in excess of par.
2. Retained earnings are also reported separately. Some companies disclose restricted
retained earnings separately from unrestricted retained earnings. Others show the
restriction on retained earnings in notes to the financial statements.
3. Balance sheet amounts reflect end-of-period amounts and so analysts and investors
may find the statement of shareholders’ equity to be more informative.
IV. GLOBAL VANTAGE POINT
A. The balance sheet presentation of shareholders’ equity under IFRS closely mirrors that used by
U.S. GAAP firms even though the terminology may differ. Other notable aspects of IFRS for
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
shareholders’ equity are:
1. An IFRS balance sheet often presents shareholders’ equity before liabilities
2. A statement of changes in shareholders’ equity is required – format is similar to U.S.
GAAP
3. Most redeemable preferred stock is reported as debt even when redemption is not
mandatory, as is some preferred stock that is not redeemable.
V. EARNINGS PER SHARE
In valuing a company, analysts prefer to focus on the value of individual common shares. It
allows them to know how much the company’s total earnings accrue to each share (EPS). This
is reported on the income statement. Computing for EPS depends on the company’s capital
structure.
A. A simple capital structure exists when a company has no convertible securities (either
convertible debt or convertible preferred stock) and no options or warrants outstanding.
1. Basic EPS =
2. The weighted average number of common shares outstanding must be calculated to
account for shares issued and/or repurchased during the year.
3. Both FASB and IASB agreed that mandatorily convertible securities should also be included
in the computation of basic EPS as soon as conversion becomes obligatory.
B. A firm has a complex capital structure when its financing includes either securities that are
convertible into common stock, or options and warrants which entitle holders to obtain common
stock under specified conditions.
1. These financial instruments increase the likelihood that additional common shares will be
issued in the future.
2. This possible increase in the number of shares is called potential dilution.
3. Anti-dilutive Securities, upon conversion or exercise, have the effect of increasing EPS. Such
securities are ignored when calculating basic or diluted EPS.
4. U.S. GAAP requires companies with complex capital structures to compute another
measure called diluted earnings per share.
5. The computation of diluted EPS requires that certain assumptions be made for:
a. The new shares are issued upon conversion (a denominator effect).
b. The after-tax net income increases following the elimination of debt interest
payments after conversion (a numerator effect).
5. Assumptions must also be made for options or warrants when computing diluted EPS.
a. When holders of options or warrants exercise them, they receive common shares.
b. At the same time, the company receives cash in an amount representing the
exercised options or warrants.
c. In computing diluted EPS, it is assumed that this cash is used to acquire outstanding
common shares in the market.
Income Adjustments Net
Income – Preferred Dividends + due to Dilutive
6. Diluted EPS = Financial Instruments
__________________________________________________
Net income – Preferred dividends
Weighted average number of common shares outstanding
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
Newly Issuable Shares
Weighted Average Number of + Due to Dilutive
Common Shares Outstanding Financial Instruments
7. The “if–converted” method is used when convertible securities exist.
a. It is presumed that the convertible debentures were converted into new common
shares on the first day of the reporting period, so the additional shares issued on
the conversion are added back in the diluted EPS denominator.
b. No interest would have been paid on the debentures if converted on the first day
of the reporting period, so the after-tax effect of interest payments on the debt is
added back in the diluted EPS numerator.
8. The treasury stock method is used when options and warrants exist.
a. Stock options are dilutive when they are “in the money,” i.e., when the average
market price during the period exceeds the option price.
b. Using the treasury stock method, it is assumed that the proceeds to the company
from presumptive exercise of the options are used to repurchase previously
issued common shares at the average market price.
c. With “in the money” options, the shares presumed issued exceed the shares
presumed acquired with the option cash proceeds.
i. This relationship holds since the average market price during the periods
exceeds the option price for “in the money” options.
ii. The excess of the shares presumed issued over the shares presumed
acquired is added to the diluted EPS denominator.
Teaching Tip: Employee stock options and nonvested stock are not included in the calculation of
basic EPS (even though nonvested shares are legally outstanding).
How employee stock options affect diluted EPS is dependent on the vesting provision.
Awards that are subject to time-related vesting provisions are treated similar to options under the
treasury stock method. In this case, nonvested stock options and partially paid subscriptions will
be dilutive when the average price of the common stock during the period exceeds the exercise
price of the options.
Plans that are subject to performance-based vesting provisions or any additional vesting
criteria other than continued service or time-related vesting are treated as contingently issuable
shares. Contingently issuable shares should be included in basic EPS as of the date that all
necessary conditions have been satisfied. However, to calculate diluted EPS, once all of the
necessary conditions have been satisfied, those shares should be included in the denominator of
the diluted EPS calculation as of the beginning of the interim period.
Prior to the end of the contingency period (i.e., before the necessary conditions have been
satisfied), the number of contingently liable shares to be included in diluted EPS should be based
on the number of shares, if any, that would be issuable under the terms of the arrangement if the
end of the reporting period were the end of the contingency period, assuming that the result would
be dilutive. These contingently issuable shares should then be included in the denominator of
diluted EPS as of the beginning of the period, or as of the inception date of the contingent stock
arrangement, if later.
9. Analytical insights:
1. Estimating the future cash flow implications of convertible debt is difficult. Conversion
(thus EPS dilution) is unlikely when a company’s stock price is substantially below the
conversion price.
2. The if–converted method for computing EPS dilution ignores the fact that bondholders are
unwilling to convert their debt certificates into shares when the share price is below the
conversion price. It assumes conversion at the beginning of the reporting period. This yields a
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
diluted EPS figure that is conservative.
3. The treasury stock method understates potential earnings dilution (overstates diluted EPS)
when the average market price is below the exercise price. No adjustment is made in that
case.
10. Is Earnings per Share a Meaningful Number?
1. Since management can use their accounting discretion to distort reported earnings, EPS
can be a misleading financial performance measure.
2. Stock repurchases can be used to distort the EPS denominator making reported EPS a
potentially misleading measure.
3. EPS ignores the amount of capital required to generate the reported earnings.
4. The narrow focus of reported EPS ratio clouds comparison between companies as well as
year-to-year EPS changes for a single company.
VI. GLOBAL VANTAGE POINT
A. Although the GAAP guidelines on earnings per share have much in common with IFR
requirements, a few differences remain.
1. Application of the treasury stock method
2. Treatment of contingently issuable shares
3. Details that pertain to contracts that can be settled in cash or shares
VII. ACCOUNTING FOR SHARE-BASED COMPENSATION
A. Many U.S. companies compensate managers and other salaried employees with a combination
of cash and stock options—options to purchase equity shares in the company.
1. A typical employee stock option gives the employee the right to purchase a specified
number of common shares at a specified price over some specified time–period.
2. The specified price—called the exercise price—is usually equal to or higher than the
market price of the underlying shares at the time the options are issued but not always.
3. When the exercise price exceeds the current share price, the stock option is “out of the
money.”
4. The time between the grant date and the first available exercise date is called the vesting
period.
B. Companies use stock options to augment cash compensation for several reasons.
1. Options help align employees’ interests with those of owners (stockholders) since
employees with stock options have a strong incentive to make decisions that ultimately
cause the share price to exceed the option exercise price.
2. Many “start–up” high growth companies are “cash–starved” and cannot afford to pay
competitive cash salaries, so stock options provide a way to attract talented employees
while conserving cash.
3. So long as the exercise price is equal to or greater than the stock price when the option is
issued, this compensation is not taxable to the employee until the option is exercised.
B. Historical Perspective:
1. Prior to 1995, APB Opinion No. 25 governed accounting for stock-based compensation but
offered no mechanism for establishing the value of stock options granted as compensation
to employees. If the exercise price was equal to or higher than the market price, they were
considered to have no intrinsic value for compensation expense purposes.
2. During the 1980s, U.S. companies increasingly adopted employee compensation packages
designed to link employee pay to company performance. FASB begain reconsidering the
accounting for stock options in 1984.
3. Strong and widespread opposition to FASB argued that FASB’s proposal would result in
expenses being recognized on the income statement when stock options were granted. The
Financial Reporting and Analysis 6e Financial Reporting for Owner’s Equity
arguments went along the following themes:
a. Appropriate income measurement.
b. Compliance with contract terms and restrictions.
c. Legality of corporate distributions to owners.
d. Linkage to equity valuation.
4. Opposition to the FASB:
1. Opponents said that treating stock options as an expense would violate the
appropriate income measurement since stock options do not involve a cash outflow.
Cash would, instead flow in when the stock options were exercised. FASB supporters
argued that cash was not the issue.
2. Compliance with contract terms and conditions ~ opposition group said treating
stock options as an expense would create this jeopardy since the reported expense
would reduce the earnings number used in certain financial ratios.
3. In 1993, U.S. Congress limited the tax deductibility of executive compensation to $1m
per employee.
4. While the legality of corporate distributions to owners was never at issue regarding
executive compensation, the issue of whether large executive salaries were proper did
5. Opponents also argued based on equity valuation in the sense that a simple “price–
earnings multiple” relationship exists between reported earnings and common stock
values. They argued that stock option grants would increase compensation expense
and lower earnings, and therefore lower stock price.
6. Faced with heavy involvement in Congress that would result in FASB’s loss of its
independence, FASB abandoned its efforts and implemented a compromise treatment.
7. The Initial Compromise – SFAS No. 123: The widespread, powerful opposition to
recognizing stock-based compensation as an expense caused the FASB to allow a
choice of accounting methods. Companies could continue using the intrinsic value
approach under which compensation expense was rarely recognized or alternatively,
they could measure the fair value of the stock option at the grant date and charge this
amount to expense.
1. Firms adopting the fair value method for measuring the compensation cost in the financial
statements are issued the following guidelines.
a. The fair value of a stock option is measured using standard option-pricing models,
with adjustments for the unique factors of the option.
b. The FASB encouraged companies to adopt the fair value approach.
c. Implementing the fair value approach requires that we estimate the expected life of the
options—meaning we must forecast when the options are likely to be exercised by
employees.
d. The fair value of an equity share option is measured on the grant date based on
“the observable market price of an option with the same or similar terms and
conditions, if one is available…. [If an observable market price is not available, the
equity share option fair value] shall be estimated using a valuation technique such
as an option pricing model… that takes into account, at a minimum, all of the
following: the exercise price of the option; the expected term of the option…; the
current price of the underlying share; the expected volatility of the price of the
underlying share for the expected term of the option…; the expected dividends on
the underlying share…; [and] the risk–free interest rate(s) for the expected term of
the option. (FASB ASC 718, various paragraphs).
e. According to GAAP, observable market price is the starting point for determining
the fair value of employee stock options. Problem – a market price is rarely
available since employee stock options are not traded on an organized exchange.
Absent a market price, GAAP allows the use of an options pricing model like the