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 = residual interest Definition of equity rests on definition of assets and liabilities

Distinction between Debt and Equity FASB financial instruments project Concerns about how to classify financial instruments in financial statements: 1. Financial instruments that have characteristics of liabilities, but are reported as equity or between liabilities and equity 2. Financial instruments that have characteristics of equity, but are presented between liabilities and equity 3. 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 limited its scope to three classes of freestanding financial instruments that embody obligations for the issuer: 1. Manditorily redeemable preferred stock unless the redemption is required to occur only upon liquidation or termination of the issuer, 2. Obligations to repurchase the issuer’s equity shares by transferring assets, and 3. 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

Recording 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 Paid-In Capital Unrealized 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 When do you measure compensation in a compensatory plan? Compensatory Noncompensatory

SFAS No. 123 Many accountants believe that the provisions of APB No. 25 result in understated financial statement values Exposure draft SFAS No 123 issued 1995  Encouraged recognition of estimated value of stock options as expense. Recommends, but does not require fair value approach (Black-Scholes) If APB Opinion No. 25 approach is used must show proforma net income and EPS effects

SFAS No. 123R Concern of deceptive accounting practices  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

Stock Warrants Types Valuation The equity-liability question

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

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