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.
2.
3.
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. limited its scope to three classes of
freestanding financial instruments that embody
obligations for the issuer:

1.
2.
3.

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
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
Compensatory
Noncompensatory
When do you measure compensation in a
compensatory plan?
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
ROCSE
60.0%
51.8%
56.7%
50.0%
40.0%
30.0%
20.0%
11.7%
11.3%
10.0%
0.0%
2004
Hershey
2005
Tootsie
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
FSR
4.00
3.76
3.06
3.00
2.00
1.37
1.33
1.00
0.00
2004
Hershey
2005
Tootsie
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
Prepared by
Kathryn Yarbrough, MBA
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