978-0324651140 Chapter 14 Lecture Note

14-1 Notes

CHAPTER 14

SHAREHOLDERS’ EQUITY: CAPITAL CONTRIBUTIONS,

DISTRIBUTIONS, AND EARNINGS

I. Learning Objectives

1. Understand the different priority claims of common and preferred

shareholders on the assets of a firm and the disclosure of those claims in

the shareholders’ equity section of the balance sheet.

2. Understand the accounting for the issuance of common and preferred stock,

particularly shares issued under various option arrangements.

3. Understand the accounting for (a) cash, property, and stock dividends, and

(b) stock splits and reverse stock splits.

4. Understand the accounting for the acquisition and reissue of treasury stock.

5. Understand why the format for reporting income matters, and master the

concept that different kinds of income require different formats

6. Understand the distinction between net income (or profit) and

comprehensive income.

7. Understand the required adjustments for errors and accounting changes.

8. Develop the skills to interpret disclosures about changes in shareholders’

equity accounts.

II. Organization of Class Sessions

We often find that we do not have sufficient class time to do justice to this

chapter. We always have our students read the chapter, even if we do not

assign any chapter-end questions, exercises and problems. The three primary

topics in this chapter are (1) accounting for various securities with an option

element (for example, convertible securities, stock options, stock warrants), (2)

accounting for treasury shares, and (3) reporting different kinds of income.

Previous chapters introduced issues in accounting for the issuance of capital

stock and dividends.

Notes 14-2

III. Lecture Outline

1. Understand the different priority claims of common and preferred

shareholders on the assets of a firm and the disclosure of those

claims in the shareholders’ equity section of the balance sheet.

We begin by placing the following diagram on an overhead screen:

Total

Shareholders‘

Equity Retained Earnings

Treasury Stock

Preferred Stock

Common Stock

Par Value

Additional Paid-in Capital

Par Value

Additional Paid-in Capital

We ask: What is the purpose of separating preferred stock from

common stock? Preferred shareholders have a separable, senior claim on

the assets of the firm relative to the common shareholders. Next ask: What

is the purpose of separating capital stock accounts from retained earnings?

This distinction indicates the amounts contributed by shareholders for the

firm’s capital stock and amounts earned and retained from using those

capital contributions to generate earnings. This latter distinction is of

questionable usefulness for two reasons. First, the common shareholders

generally have a full claim on assets represented by retained earnings.

Second, firms engage in transactions (for example, stock dividends, certain

treasury stock purchases and sales) that result in transfers of amounts from

retained earnings to common stock accounts.

Next ask: Why separate treasury stock from the capital stock and

retained earnings accounts? Firms often purchase their own shares with

14-3 Notes

the intention of reissuing them soon thereafter for some purpose (for

example, issuance under stock option plan to employees, issuance in a

corporate acquisition). (Modern finance teaches that share repurchases

have beneficial effects when one compares them to dividends.) Reporting

treasury shares separately permits the financial statement user to observe

the activity in treasury shares. The alternative to this separate

presentation is to reduce the capital stock and retained earnings accounts

for the acquisition cost of treasury shares and increase these accounts at

the time the shares are reissued. This method of disclosure buries treasury

stock activity in these other shareholders’ equity accounts.

Finally, ask: Why are the distinctions discussed above more difficult to

make in recent years as a result of the issuance of various securities with

options or rights attached to them? The options or rights usually attach to

another security (for example, debt, preferred stock) and give them common

stock attributes. The accountant generally does not separate the issue price

of these securities into amounts related to their debt or preferred stock

attributes and amounts related to their common stock attributes. Also,

firms issue options or warrants giving their holder the right to acquire

common stock. Accountants historically have not recognized such options in

the accounts unless the firm receives cash at the time of their issuance.

2. Understand the accounting for the issuance of common and

preferred stock, particularly shares issued under various option

arrangements.

We begin by asking: Why do accountants distinguish between the par

(or stated) value of Common stock and amounts received in excess of par or

stated value? This distinction has legal significance in states that require

firms to issue shares for an amount at least equal to their par or stated

value. The distinction also has significance for preferred stock since the

dividend rate is usually based on the par value. The distinction has,

however, virtually no economic significance. Firms usually issue common

stock for more than par or stated value. (Problem 14.28, and 14.29).

Moreover, the firms may issue capital stock (preferred or common) for cash

or for noncash assets. Some issuances of common stock result from various

option arrangements.

We spend most of the available class time on this chapter discussing

various forms of options. We begin by asking: What benefit does a firm

derive by giving options to others (for example, employees, bondholders,

preferred shareholders) to purchase shares of the firm’s common stock for

less than the market price at the time the holders exercise their options?

Firms can obtain employees’ services or issue securities for a lower cash

Notes 14-4

cost than if the options were not included. The lower cost is an illusion

because the option must have a cost. The accounting issue is whether to

account for the cost of the option element. Accounting has historically not

separately accounted for the cost of the option because of difficulties in

measuring its amount. Recent advances in the valuation of options in

finance make this measurement process less difficult and, in part,

underlies the FASB’s move to fair value accounting for stock options.

(Questions 14.9, 14.10, 14.11, Exercises 14.15, 14.16, 14.17, 14.20, and

14.21, and Problems 14.33 and 14.34)

3. Understand the accounting for (a) cash, property, and stock

dividends, and (b) stock splits and reverse stock splits.

Previous chapters discussed the accounting for cash dividends. We

raise the question: What factors should a firm consider in deciding on the

amount of cash dividend to distribute? This is a question for finance

courses, but we introduce the concepts here. One issue is the financial

ability to pay a dividend. Does the firm have sufficient cash to pay a

dividend? Does it need to conserve cash for future investment? Another

issue is the legal ability to pay a dividend. Is the firm restricted by state

laws or by debt covenants from paying a dividend? A third issue is the

dividend history of the firm. The stock market often reacts negatively to a

decrease in or omission of a regular cash dividend.

Next ask: How frequently do you suspect that firms pay property

dividends? Publicly-traded firms seldom distribute property dividends

because they are not feasible with a large number of dispersed

shareholders. Some retailing and consumer goods firms distribute coupons

permitting shareholders to purchase the firm’s products for less than their

full price. Whether such coupons represent cash or property dividends is

unclear. Smaller, privately-held firms issue property dividends somewhat

more frequently than publicly-traded firms. The dividends may take the

form of transportation, lodging, country club, or similar services or

automobiles, other plant assets, or inventory that the firm no longer needs

in its operations.

Then, ask: Why do some firms issue stock dividends? Students need

to see that the total resources available to the firm do not change as a

result of a stock dividend (that is, assets do not increase). Thus, the total

market value of the firm should not change. Because the number of shares

outstanding increases, the market price should decrease in proportion to

the stock dividend. Shareholders should not rejoice upon receiving a stock

dividend. (Question 14.8 and Exercises 14.22 and 14.23).

14-5 Notes

Later ask: Why do firms execute Stock Splits? Explain to students

that these resembles stock dividends. The firm issues additional shares of

stock to shareholders in proportion to their existing holdings. This does

not imply an increase in common stock. Firms typically reduce the par

value of the common stock in proportion to the additional number of shares

issued. Also, students could be questioned on the journal entry required on

the method suggested above. As an alternative way for accounting stock

splits, ask students if the Additional Paid in capital or retained earnings is

affected if at all the firm accounts the stock splits by not reducing the par

value.

Finally question the students, what a reverse stock split would be?

Later explain them that the reverse stock split simply cancels the

outstanding shares or increase the par value of the stock and

correspondingly reduce the number of shares outstanding. Consider the

Example 13 provided in the text to explain this concept of reverse split.

4. Understand the accounting for the acquisition and reissue of

treasury stock.

We begin by asking: Why do firms repurchase their own shares to use

in stock option plans or for corporate acquisitions instead of simply issuing

new shares for these purposes? The answer relates to the concept of

dilution. One form of dilution is voting interest dilution. Issuing new

shares means that the proportionate interest of each shareholder gets

reduced. Repurchasing shares and then using them in an option

arrangement means that the same total number of shares is outstanding

after completion of the transaction as before. Another form of dilution is

market value dilution. Firms typically issue shares under option plans for

an amount less than the market price at the time of the option’s exercise.

The total market value of the firm increases by the amount of the cash

received but the market price per share for all shares decreases because of

the issue of shares for less than the market value. Firms often purchase

their own shares on the market at a price approximately equal to the

option price at the time of issuing the options. They then reissue these

treasury shares at the option price. Except for the time value of cash

flows, this series of transactions should leave the resources available to the

firm, the total market value of the firm’s shares, and the market price per

share the same after exercise of the options as before granting them. Such

actions represent an attempt to mitigate the dilutive effect of stock options

on stock prices. We next ask: Why does GAAP not allow firms to report

the change in market prices of treasury stock between the date purchased

and the date sold as a gain or loss in measuring net income? Accounting

standard setters were concerned that firms might take advantage of their

Notes 14-6

knowledge of the firm and its prospects and trade in their own securities to

the detriment of some shareholders.

U.S. GAAP provided three approaches to the accounting for treasury

shares: (1) The cost method. (2) The par value method. (3) The constructive

retirement method. Under each of these methods, the firms are required to

reduce shareholders’ equity for the acquisition cost of the shares and report

no gain or loss on treasury share transactions. (Question 14.9 and

Exercises 14.24, and 14.25,)

5. Understand why the format for reporting income matters and

master the concept that different kinds of income require different

formats.

We begin by placing Exhibit 14.4 from the text on an overhead screen.

We review the three sections of the income statement required by GAAP:

continuing operations, discontinued operations, and extraordinary items.

We then pose the following to the class: The placement of items within the

income statement is simply a matter of geography. Because each of the

items is a component of earnings, why does it matter where they appear

within the income statement? We want students to think of the income

statement as both a report on what has happened in the past (therefore

explaining the inclusion of all three categories of items in the income

statement) and as information for helping to project future earnings. It is

for this second purpose that GAAP requires the three categories of income

items. To project future earnings the analyst focuses on earnings from

continuing operations.

Next, we place Figure 14.2 on an overhead screen. We pose the

following: Projected future earnings should include items that are

recurring and from primary operating activities (upper left cell). What is

the rationale for including recurring income items that are peripheral to

primary operating activities (lower left cell)? We want to get students to

understand that the recurring characteristic dominates their peripheral

characteristic if the objective is to project future earnings.

Next, we pose the following: Why separate earnings from primary

activities and earnings from peripheral activities, since both are recurring?

This question moves from one use of the income statement, to assist the

analyst in projecting future earnings, to another use, comparing the

profitability of firms in the same industry. Firms within an industry do

similar core things in creating and selling a product. Management directs

most of its time and energy to doing these core activities successfully. The

analyst is interested in how well firms do these similar things when

14-7 Notes

comparing their performance. Generating wealth from the activities only

peripherally related to the core activities, although recurring, is not why

the firm chooses to be in the particular industry.

Finally, we pose the following: Earnings from primary operating

activities show revenues and expenses as gross amounts, whereas earnings

from peripheral activities appear as net amounts. What is the rationale

for the different degrees of aggregation? This question is an extension of

that in the previous paragraph. Firms within an industry combine similar

inputs (material, labor) to create similar outputs (goods or services). To

evaluate how well firms manage this process, separate information on the

inputs and outputs is needed. Because management spends much less

time and energy on peripheral activities, the analyst is not as interested in

how inputs relate to outputs. The analyst is primarily interested that the

firm is not continually realizing losses from peripheral activities. Thus,

reporting earnings from peripheral activities as net amounts is sufficient.

6. Understand the distinction between net income (or profit) and

comprehensive income.

We pose the following question: On what basis does GAAP distinguish

income items that appear in one of the four categories of income addressed

above (continuing, discontinued, extraordinary, changes in accounting

principles) and other comprehensive income, which together comprise

comprehensive income. The chapter will get students to respond that the

distinction is one of realization items in each of the four categories result

from completed transactions and items in other comprehensive income

require a future event, like a sale, for realization. Although this response

is accurate for most items, it does not apply to all. Gains and losses from

changes in the market value of marketable equity securities are unrealized

prior to their sale, consistent with the general principle of their inclusion

in other comprehensive income. Losses from inventory obsolescence and

fixed and intangible asset impairments are not realized but are included in

income from continuing or discontinued operations. The only rationale

that we can see for the different treatment of these unrealized gains and

losses is conservatism. Inventory writedowns and asset impairments

negatively affect income. Conservatism argues for recognition of losses as

soon as they become evident. Changes in the market values of marketable

equity securities and financial instruments can be either gains or losses.

GAAP appears more reluctant to include unrealized gains in income.

We next review the three disclosure formats for other comprehensive

income: (1) in a combined statement of income and other comprehensive

income, (2) in a separate statement of other comprehensive income, and (3)

Notes 14-8

part of a statement analyzing changes in shareholders’ equity. We pose

the question: Why do most firms likely choose the third method of

disclosure? Firms lobbied the FASB to keep unrealized gains and losses

out of income, because their amounts were unpredictable and could lead to

wide fluctuations in income. Disclosing items of other comprehensive

income under the first two disclosure formats makes them appear as part

of income. Disclosing them in an analysis of changes in shareholders’

equity accounts makes them appear as part of balance sheet accounts.

7. Understand the required adjustments for errors and accounting

changes.

This topic could be started with questioning the students on the types

of errors usually faced by an account in a firm. Later explain them that the

U.S. GAAP and IFRS require the firms to account for correction of errors if

material, by restating net income of prior periods and adjusting the

beginning balance in Retained Earnings for the current period. And in case

of an accounting change, it is required to recalculate prior period’s income

under the new accounting principle.

8. Develop the skills to interpret disclosures about changes in

shareholders’ equity accounts.

We use either Problem 14.35, 14.36, 14.37, or 14.38 to get students to

work backwards from disclosures about shareholders’ equity to the

underlying transactions. An alternative suggestion would be to use the

Exhibit 14.6 provided in the text and advice the students to come up with

their interpretations on the Statement of Changes in Shareholders’ Equity

for Citigroup over the 3 years.

14-9 Notes

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