The Analysis of the Statement of Shareholders’Equity Chapter 8 The Analysis of the Statement of Shareholders’Equity

The Analysis of the Statement of Shareholders’ Equity Link to Previous Chapter Chapter 7 gave a design for financial statements that readies them for analysis. This Chapter This chapter reformulates the How is the How is dirty - What is hidden statement of surplus income dirty - surplus statement of owners’ equity owners’ equity treated in the income ? according to the design in reformulated reformulation ? Chapter 7. The reformulation to highlight the highlights comprehensive information it income. contains ? Link to Next Chapter Chapters 9 continues the reformulation with the balance sheet and the income statement. For more applications, visit the website Link to Web Page

What you will learn from this Chapter How GAAP statements of shareholders' equity are typically laid out Why reformulation of the statement is necessary What is reported in "other comprehensive income" and where it is reported What "dirty-surplus" items appear in the statement of shareholders' equity How stock options work to compensate employees How stock options and other contingent equity claims result in hidden expenses How management can create (or lose) value for shareholders with share transactions

GAAP Statement of Shareholders’ Equity Opening book value of equity (common and preferred) + Net share transactions with common stockholders + Capital contributions (paid in capital from share issues) - Share repurchases (into treasury stock or against paid-in capital) + Net share transactions with preferred shareholders + Capital contributions (share issues) - Share redemptions + Change in retained earnings + Net income - Common dividends - Preferred dividends + Accumulated other comprehensive income + Change in unearned (deferred) stock compensation Closing book value (common and preferred)

The Governing Accounting Relation Book value, beginning of period + Comprehensive income - Net payout to shareholders = Book value, end of period

Reformulated Statement of Stockholders’ Equity

Reformulation: The Steps Restate beginning and ending balances for items incorrectly included in or excluded from common equity Preferred stock Dividends payable Unearned (deferred) compensation Calculate net transactions with shareholders Cash dividends + share repurchases – share issues Calculate comprehensive income Net income + Other comprehensive income – Preferred dividends

The GAAP Statement: Nike Inc., 2004

Nike: The Reformulated Statement Balances: 2003 2004 Reported $3,990.7 $4,781.7 Dividends payable 36.9 52.6 Unearned compensation 0.6 5.5 Restated balance 4,028.2 4,839.8

The GAAP Statement: Reebok International Ltd., 2004

Reebok: Reformulated Statement Balances: 2003 2004 Reported 1,033.7 1,220.0 Unearned compensation 1.2 5.8 Restated balance 1,034.9 1,225.8

Dirty Surplus Accounting in the US

Most firms choose the last alternative FASB Statement No. 130 Requires the reporting of comprehensive income in one of three ways Within the income statement In separate statement Within the equity statement Most firms choose the last alternative

Ratio Analysis Payout and Retention Ratios

Ratio Analysis (continued) Shareholder Profitability Ratio Growth Ratios

Hidden Dirty Surplus Shareholders lose when shares are issued at less than the market price (e.g. exercise of options) This loss, however, is not recorded as expense. What is the nature of this loss? If options are part of a compensation package, this loss is an employee compensation expense. If from a conversion of a bond, preferred stock or warrants, the loss is a financing expense. What is the amount of the loss? Market price - exercise price. Special case: options granted in the money are recorded as deferred compensation

FASB Statement No. 123R Statement 123R requires an expense to be recognized at option grant date, equal to the value of the option at that date Up to 2006, pro forma net income, including the expense, was reported in footnotes. The expense must now be reported in the income statement. No further expense recorded as the option moves into the money or at exercise date. Firms record a tax benefit (for non-qualified options) at exercise date, and credit this to shareholders’ equity. IFRS2 has a similar requirement.

Measuring the Loss from Exercise of Stock Options: Method 1 (Reebok) Expense is implied from the tax benefit:

Measuring The Loss from Exercise of Stock Options: Method 2 (Reebok) Calculate difference between average stock price and exercise price: Use when tax benefit is not reported, or for incentive options (where there is no tax benefit).

Reebok: Reformulated Statement Shares are issued at market value, and the difference between the market value and after-tax receipts from the shares issued is a loss from exercise of options.

Hidden Losses on Put Options: Dell Computer From the 2002 equity statement (see Chapter 2): The Loss:

The GAAP Statement of Shareholders’ Equity: Dell Computer, 2002

Dell: Reformulated Statement Dell Computer Corporation Reformulated Statement of Shareholders’ Equity Balance, February 2, 2001 $5,696 Transactions with shareholders: Shares issued in stock option exercises (at market) $1,747 Shares repurchased (at market) (1,632) 115 Comprehensive income Comprehensive income reported 1,222 Loss on exercise of employee stock options $1,391 Tax benefit for employee stock options 487 (904) Loss on put options (1,368) (1,050) Other (3) Balance, February 1, 2002 $4,758

Losses on Convertible Securities Loss = Market price of common issued - Book value of convertible surrendered The market value method vs. the book value method - The market value method recognizes losses on conversion - The book value method records the shares at the book value of the convertible securities, with no loss recognized Almost all firms use the book value method.