RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY FINANCIAL ACCOUNTING THEORY AND ANALYSIS: TEXT AND CASES 11TH EDITION RICHARD G. SCHROEDER MYRTLE W. CLARK JACK M. CATHEY 4

CHAPTER 15 EQUITY

Introduction Equity is risk capital No guaranteed return No repayment of the investment The mix of debt and equity is called a company’s capital structure

Theories of Equity Proprietary Entity Fund Commander Enterprise Residual equity

Definition of Equity SFAC No. 6 = residual interest Definition of equity rests on definition of assets and liabilities Assets – liabilities Liabilities vs Equity Liabilities require transfer of resources Equity has no transfer requirement FASB ASC 480-10 Requires that certain obligations that could be satisfied by issuance of equity securities be classified as liabilities

Distinction between Debt and Equity FASB financial instruments project Concerns about how to classify financial instruments in financial statements: Financial instruments that have characteristics of liabilities, but are reported as equity or between liabilities and equity Financial instruments that have characteristics of equity, but are presented between liabilities and equity Financial instruments that have characteristics of both liabilities and equity, but are classified either as liabilities or equity.

Distinction between Debt and Equity SFAS No. 150 (FASB ASC 480). limited its scope to three classes of freestanding financial instruments that embody obligations for the issuer: Manditorily redeemable preferred stock unless the redemption is required to occur only upon liquidation or termination of the issuer, Obligations to repurchase the issuer’s equity shares by transferring assets, and Certain obligations to issue a variable number of shares. The Board determined that financial instruments that fall into all three classes should be classified as liabilities

Reporting Equity Forms of business organization Sole proprietorship Partnership Corporation Most companies are sole proprietorships but the largest amount of business activity is carried out by corporations

Why? Limited liability Continuity Investment liquidity Variety of ownership interests

Components of the Capital Section of a Corporation OTHER COMPREHENSIVE INCOME Paid-In Capital Earned Capital

Paid-in Capital Common stock vs preferred stock Features of preferred stock Conversion Call Cumulative Participating Redemption Paid-in Capital

Stock Options VS Compensatory Noncompensatory When do you measure compensation in a compensatory plan? APB Opinion No. 25

Recording Stock Options under FASB ASC 718 Many accountants believe that the provisions of APB No. 25 result in understated financial statement values That is, the provisions of APB 25 seldom resulted in companies recording compensation expense when stock options were granted Exposure draft SFAS No 123 issued 1995 Encouraged recognition of estimated value of stock options as expense. Recommended, but did not require fair value approach (Black-Scholes) If APB Opinion No. 25 approach was used must show proforma net income and EPS effects

SFAS No. 123R (See FASB ASC 718) Concern of deceptive accounting practices (e.g. Enron, Tyco and WorldCom). Stock options used to avoid paying taxes Requires companies to estimate compensation expense Fair market value Disclose estimated expense on Income Statement Binomial lattice method Opposition to provisions

Stock Warrants Types Valuation The equity-liability question

Retained Earnings Accumulated net profits Have not been distributed as dividends May be divided into appropriated and unappropriated

Other Stockholders’ Equity Issues Stock dividends vs. stock splits Treasury stock Other comprehensive income Quasi reorganizations

Financial Analysis of Stockholders’ Equity Return on common shareholders’ equity (ROCSE) Reports on a company’s performance from the point of view of its common stockholders Based on proprietary theory Borrowing costs are considered expenses rather than a return on investment Net income available to common shareholders Average common stockholders’ equity

Return on Common Stockholders’ Equity

Financial Analysis of Stockholders’ Equity Financial structure ratio (FSR) Proportion of the company’s assets that are being financed by the stockholders Average assets Average common stockholders’ equity

Financial Structure Ratio

International Accounting Standards “Framework for the Preparation of Financial Statements” indicated a preference for the proprietary theory. Also indicated that equity may be sub classified into: Contributed capital Retained earnings Capital maintenance adjustments

IFRS No. 2: Share-Based Payment Specify financial reporting by entity for effects of share-based payment transactions Broader than concept of employee share options Measurement principles and specific requirements for 3 types of share-based payment transactions: Equity-settled share-based payment transactions Cash-settled share-based payment transactions Transactions involving receipt of goods or services

Prepared by Kathryn Yarbrough, MBA End of Chapter 15 Prepared by Kathryn Yarbrough, MBA Copyright © 2014 John Wiley & Sons, Inc.  All rights reserved. Reproduction or translation of this work beyond that permitted in Section 117 of the 1976 United States Copyright Act without the express written consent of the copyright owner is unlawful.  Request for further information should be addressed to the Permissions Department, John Wiley & Sons, Inc.  The purchaser may make back-up copies for his/her own use only and not for distribution or resale.  The Publisher assumes no responsibility for errors, omissions, or damages, caused by the use of these programs or from the use of the information contained herein.