FINANCIAL ACCOUNTING
THEORY AND ANALYSIS:
TEXT AND CASES
11TH EDITION
RICHARD G. SCHROEDER
MYRTLE W. CLARK
JACK M. CATHEY
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:


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 (FASB ASC 480). 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
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
Paid-In Capital COMPREHENSIVE
INCOME
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?
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).


Requires companies to estimate compensation
expense




Stock options used to avoid paying taxes
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
ROCSE
69.9%
70.0%
60.0%
50.0%
40.0%
30.0%
20.0%
10.0%
0.0%
69.4%
8.0%
2010
Hershey
6.6%
2011
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
5.00
4.68
4.80
4.00
3.00
2.00
1.29
1.29
1.00
0.00
2010
Hershey
2011
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
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:
1.
2.
3.
Equity-settled share-based payment transactions
Cash-settled share-based payment transactions
Transactions involving receipt of goods or services
End of Chapter 15
Prepared by Kathryn Yarbrough, MBA
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