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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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