Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Chapter Eight
LINKS
Link to previous chapter
Chapter 7 laid out a design
for financial statements
that prepares them for
analysis.
The Analysis
of the Statement
of Shareholders’ Equity
This chapter
This chapter reformulates
the statement of owners'
equity according to the
design in Chapter 7. The
reformulation highlights
comprehensive income.
How is the
statement of
owners' equity
reformulated
to highlight the
information it
contains?
How is
dirty-surplus
income treated in
the reformulation?
What is hidden
dirty-surplus
income?
Link to next chapter
Chapter 9 continues the
reformulation with the
balance sheet and the
income statement.
Link to Web page
For more applications of
Chapter 8 content, visit
the text's Web site at
www.mhhe.com/
penman3e.
The statement of shareholders’ equity is usually not considered the most important part of
the financial statements and is often ignored in analysis. In the United States it is not even
required, although if it is not presented, a reconciliation of opening and closing balances of
shareholders’ equity must be displayed in footnotes. However, it is the first statement that
the analyst should examine before going on to the other statements. It is a summary statement, tying together all transactions that affect shareholders’ equity. By analyzing the statement, the analyst ensures that all aspects of the business that affect shareholders’ equity are
included in his analysis to value the equity.
We saw in Part One of the book that when accounting income is used in valuation, it
must be comprehensive income. Otherwise value is lost in the calculation. The accounting
relations in the last chapter hold only if income is comprehensive. We will use these relations as analysis tools in later chapters, but the tools will work only if income is on a comprehensive basis. Unfortunately, earnings reported in most income statements in most
countries is not comprehensive, including earnings reported in statements prepared under
U.S. GAAP and international accounting standards. The analysis of the statement of shareholders’ equity makes the correction.
Value is generated for equity holders through operations, not by equity financing activities. We saw in Chapter 3 that share issues and repurchases at market value do not create
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 263
The Analyst’s Checklist
After reading this chapter you should understand:
After reading this chapter you should be able to:
• How GAAP statements of shareholders’ equity are
typically laid out.
• Reformulate a statement of shareholders’ equity.
• 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 a hidden expense.
• How management can create value for shareholders
with share transactions.
• Distinguish the creation of value from the distribution
of value in the equity statement.
• Calculate the net payout to shareholders.
• Calculate comprehensive income and comprehensive
ROCE from the equity statement.
• Calculate payout and retention ratios.
• Calculate a growth rate for common shareholders’
equity and analyze its components.
• Calculate the expense from exercise of stock options.
• Calculate gains and losses from put options.
• Calculate losses from the conversion of securities into
common stock.
value in efficient capital markets. But share issues are sometimes made in exchange for
goods and services in operations, mostly for employee compensation. Unfortunately, GAAP
accounting sometimes confuses the financing and operating aspects of these transactions,
that is, it confuses the moneys raised for financing with the expenses incurred in operations.
The analysis of the statement of shareholders’ equity sorts out this accounting.
REFORMULATING THE STATEMENT OF OWNERS’ EQUITY
The statement of owners’equity provides the reconciliation of beginning and ending owners’
equity according to the stocks and flows equation introduced in Chapter 2:The change in owners’ equity is explained by comprehensive income for the period plus capital contributions
from share issues, less dividends paid in cash and stock repurchases. The GAAP statement is
often—and unnecessarily—more complicated than this, however, so part of the analysis
involves simplifying it. The ideal statement for a fiscal period has the following form:
Reformulated Statement of Common Shareholders’ Equity
Beginning book value of common equity
+ Net effect of transactions with common shareholders
+ Capital contributions (share issues)
− Share repurchases
− Dividends
= Net cash contribution (negative net dividends)
+ Effect of operations and nonequity financing
+ Net income (from income statement)
+ Other comprehensive income
− Preferred dividends
= Comprehensive income available to common
Closing book value of common equity
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
264 Part Two The Analysis of Financial Statements
Notice three things about this statement:
1. With a view to valuing the common shareholders’ equity, the reformulated statement
excludes preferred equity. From the common shareholders’ point of view, the preferred
equity is an obligation to pay other claimants before themselves, and it is reclassified as
a financial obligation in a reformulated balance sheet.
2. The net addition to common equity from transactions with shareholders—the negative
net dividend—is separated from the addition to shareholders’ equity that arises from
business activities.
3. The total effect of operations and nonequity financing on the common shareholders is
isolated in comprehensive income. This has three components: net income reported in
the income statement, other comprehensive income reported outside the income statement, and preferred dividends. As preferred stock is effectively debt from the common
shareholders’ viewpoint, preferred dividends are an “expense” in calculating comprehensive income, just like interest expense.
Introducing Nike and Reebok
The analysis of financial statements in this and subsequent chapters will be demonstrated
with the 2004 statements of Nike, Inc., and Reebok International Ltd., the sport and leisure
footware companies. You will find it helpful to see a complete analysis of these firms. The
Build Your Own Analysis Product (BYOAP) feature on the book’s Web site, introduced at
the end of the last chapter, carries on the Nike analysis from 1996 through 2004. After covering the material in the book and in that Web module, you will have a complete analysis
history for Nike for a nine-year period, 1996–2004. Take the Nike analysis in the book and
in BYOAP as a model for the analysis of any firm, and use the roadmap in BYOAP to
develop spreadsheets that deliver a concrete analysis and valuation product. You can view
Nike’s full 2004 financial statements in Minicase M2.1 in Chapter 2.
We emphasized in Chapter 1 that the first step in analysis and valuation is “knowing the
business.” Nike and Reebok are no doubt familiar to you: Their logos are visible on the
clothes and shoes that many of us wear, from the greatest sports stars to the smallest of kid
pretenders. The firms are fierce competitors. Boxes 8.1 and 8.2 give some further background on the two companies; however, in practice a much deeper understanding of a firm
is required to carry out a capable analysis.
Reformulation Procedures
Exhibits 8.1 and 8.2 present the GAAP statements of shareholders’ equity for Nike and
Reebok, along with reformulated statements in the form of the template on the previous
page. Reebok’s GAAP statements are in thousands of dollars, but its reformulated statement is in millions of dollars to make the presentation less detailed. Flags to the right of the
GAAP statements indicate which items are transactions with shareholders (T) and which
are components of comprehensive income (CI).
Reformulation follows three steps.
1. Restate beginning and ending balances for the period for items that are not part of common shareholders’ equity:
a. Preferred Stock: Preferred stock is included in shareholders’ equity in the GAAP
statement, but it is a liability for the common shareholders. So reduce the balances by
the amount of preferred stock in those balances (and ignore any preferred stock
transactions during the period in the reformulation). An exception is mandatory
redeemable preferred stock which, under GAAP, is not part of equity but rather is
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Knowing the Business: Nike, Inc.
Incorporated in 1968, Nike (www.nike.com), like Reebok, is
a leading manufacturer and marketer of sport and fashion
footwear. The firm is headquartered in Beaverton, Oregon.
STRATEGY
Nike aims to dominate the $38 billion worldwide market for
athletic footwear and athletic footwear used for casual and
leisure dress. It attempts to accomplish this through extensive
promotion, often using high-profile sports figures and endorsements of sporting events.
OPERATIONS
Nike’s top-selling footwear are basketball, cross-training, running, and children’s shoes, but it also sells tennis, soccer, golf,
baseball, football, bicycling, and other footwear, as well as apparel, brand-name sports equipment, and accessories. It sells
its products through retail outlets in the United States and
around the world and through independent distributors and
licensees. About 47 percent of Nike’s sales in 2004 were in the
United States.
The firm maintains an active research and development
effort to improve its products. Most of its manufacturing facilities are outside the United States, in Asia and South America.
It has approximately 24,700 employees, but much of the manufacturing is through independent contractors.
8.1
The market for footwear is highly competitive, with Reebok
and Adidas being major competitors. Changes in consumer
preferences, changes in technology, and competition are seen
as the main risk factors.
EQUITY FINANCING
Two classes of common shares have equal shares in profits. A
total of 263.1 million shares were outstanding at the end of
fiscal 2004. Nike has a continuing stock repurchase program
and pays dividends. A small number of redeemable preferred
shares are held by an Asian supplier.
The company has an active stock compensation plan for
employees. In fiscal 2004, options on 5,215 thousand shares
were granted and options on 5,526 thousand shares were
exercised at a weighted-average exercise price of $42.67 per
share.
SUMMARY DATA
Basic earnings per share
Diluted earnings per share
Dividends per share
Book value per share
Price per share, end of year
2004
2003
2002
$ 3.59
3.51
0.74
18.17
75.00
$ 1.79
1.77
0.54
16.14
56.00
$ 2.48
2.44
0.48
13.01
55.00
reported on the balance sheet in a “mezzanine” between liabilities and equity. Nike’s
preferred stock is redeemable, so no adjustment is required.
b. Dividends Payable. GAAP requires dividends payable to common shareholders to be
reported as a liability. But shareholders cannot owe dividends to themselves. And dividends payable do not provide debt financing. Common dividends payable are part of
the equity that the common shareholders have in the firm. So instead of reporting them
as liabilities, reclassify them to the balances of shareholders’ equity, as explained in
the notes to Nike’s reformulated statement.
c. Unearned compensation (or deferred compensation). When a firm issues shares at
less than market value, current shareholders incur a loss. Firms grant shares to employees, often at 85 percent of market value, and in doing so they transfer value from
shareholders to employees as compensation. The amount of the compensation is the
difference between the market value of the shares issued and the price paid by employees. Nike issued shares worth $23.2 million during 2004 (listed as “issuance of
shares to employees and others’’) but the employees paid only $15.7 million. The difference, $7.5 million, is compensation that the equity statement recognizes (appropriately) as deferred compensation. The compensation is deferred as it is deemed to
apply to future periods over which the employees work, so it is amortized to the
income statement over a service period; you see the $2.6 million for the amortization
in the current period in the statement. This accounting is appropriate. However, the
classification of the unearned compensation as a contra to equity is not. It is an asset,
like any other deferred charge or, indeed, prepaid wages, and should be classified as
265
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Knowing the Business: Reebok International Ltd. 8.2
Organized in 1979 and incorporated in Massachusetts,
Reebok (www.reebok.com), like Nike, is a leader in the design, manufacturing, and marketing of sport and leisure
footwear.
STRATEGY
Reebok’s strategy is very similar to Nike’s. The firm was primarily focused on the fitness market until 1994, when it
launched a “major strategic effort” to increase its on-field
presence and establish its name as a sports brand. To do this it
entered into promotion arrangements with leading athletes
and endorsed high-profile sporting events. In addition,
Reebok expanded its business beyond footwear to sportsrelated products such as sports and fitness videos, equipment,
and fashion clothing. Like Nike, Reebok aims to be on the
edge of footwear technology.
Reebok’s Rockport Division manufactures the Rockport
brand of comfort footwear. Rockport also develops and markets the Ralph Lauren and Polo brands of footwear.
Virtually all of the company’s products are manufactured
through independent manufacturers, almost all of which are
outside the United States. The company had 9,100 employees
at the end of 2004.
EQUITY FINANCING
Reebok had 59,208 thousand common shares outstanding at
the end of 2004. It has a stock option plan, and in 2004 options on 1,018 thousand shares were granted and options on
1,751 thousand shares were exercised at a weighted-average
exercise price of $23.46 per share.
SUMMARY DATA
OPERATIONS
Reebok manufactures and markets a similar product line to
Nike through its Reebok Division. This division also markets its
Greg Norman apparel. It engages in heavy advertising and promotion and in continuing research and development to enhance products. The Reebok Division also licenses the Reebok
name for such products as athletic gloves, videos, sunglasses,
sport watches, uniforms, school supplies, and infant apparel.
Basic earnings per share
Diluted earnings per share
Dividends per share
Book value per share
Price per share, end of year
2004
2003
2002
$ 3.26
3.05
0.30
20.60
$44.00
$ 2.65
2.43
0.15
17.34
$33.00
$ 2.12
1.97
0.00
14.69
$28.00
such. Increase beginning and ending balances of common equity by the amount of
unearned compensation and ignore any transactions in the account during the period
in the reformulated statement. See the notes to both Nike’s and Reebok’s reformulated statements.
2. Calculate net transactions with shareholders (the net dividend). This calculation nets
dividends and stock repurchases against cash from share issues, as in the exhibits. Dividends must be cash dividends (calculated as follows), and not dividends declared as
dividends payable:
Cash dividends = Dividends reported + Change in dividends payable
For Nike, dividends paid are $194.9 + 36.9 − 52.6 = $179.2 million, which is the number for cash dividends in the cash flow statement. Reebok had no dividends payable.
3. Calculate comprehensive income. Comprehensive income combines net income and
other income reported in the equity statement. Besides net income, the GAAP statement
for both Nike and Reebok reports currency translation gains and gains from the appreciation of certain derivative instruments. U.S. GAAP requires a number for comprehensive income to be reported, so you can see in the GAAP statements that a total is drawn
for comprehensive income. The income reported outside net income is referred to as
other comprehensive income, so comprehensive income is net income plus other comprehensive income (as pointed out in Chapter 2). Note that all items in other comprehensive income are after tax. That is, they are net of any tax that they draw.
266
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 267
EXHIBIT 8.1 GAAP Statement and Reformulated Statement of Common Shareholders’ Equity for Nike, Inc.,
May 31, 2004
The reformulated statement separates transactions with shareholders from comprehensive income (in millions). The flags on
the right of the GAAP statement indicate transactions with shareholders (T) and comprehensive income (CI).
NIKE, INC.
GAAP Statement of Shareholders’ Equity
(in millions, except per share data)
Accumulated
Other
Capital in
Unearned
CompreClass A
Class B
Excess of
Stock
hensive Retained
Shares Amount Shares Amount Stated Value Compensation
Loss
Earnings
Common Stock
Balance at May 31, 2003
97.8
Stock options exercised
Conversion to Class B
common stock
(20.1)
Repurchase of Class B
common stock
Dividends on common stock ($0.74)
Issuance of shares to employees
and others
Amortization of unearned
compensation
$0.2
165.8
5.5
$2.6
(0.1)
20.2
0.1
$589.0
284.9
(6.4)
(7.6)
0.4
23.2
$(0.6)
Balance May 31, 2004
(414.3)(T)
(194.9)(T)
2.6
(1.7)
(0.3)
(2.0)(T)
945.6
945.6(CI)
27.5(CI)
27.5
125.9
153.4
$0.1
185.5
$ 2.7
$887.8
$(5.5)
Reformulated Statement of Common Equity
Comprehensive income
Net income reported
Currency translation gain
Gains on hedging instruments
(406.7)
(194.9)
15.7(T)
$ (86.3)
Note: Footnotes to the 10-K indicate Nike had $52.6 million in dividends payable at the end of 2004 and $36.9 million at the end of 2003.
Balance May 31, 2003
Transactions with shareholders
Stock issues
Stock repurchases
Common dividends paid
3,990.7
284.9(T)
(7.5)
Comprehensive income (Note 13):
Net income
Other comprehensive income
(net of tax benefit of $69.0):
Foreign currency translation
Adjustment for fair value of
hedge derivatives
Comprehensive income
77.6
$3,639.2
2.6
Forfeiture of shares from employees
Balance at May 31, 2004
$(239.7)
$4,028.2
$308.1
(416.3)
(179.2)
945.6
27.5
125.9
(287.4)
1,099.0
$4,839.8
Note: The beginning balance in the reformulated statement is calculated as follows (in millions):
Reported balance
$3,990.7
Dividends payable
36.9
Unearned compensation balance
0.6
$4,028.2
The ending balance is calculated as follows:
Reported balance
$4,781.7
Dividends payable
52.6
Unearned compensation balance
5.5
$4,839.8
Total
945.6
125.9(CI)
1,099.0(CI)
$3,982.9 $4,781.7
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
268 Part Two The Analysis of Financial Statements
EXHIBIT 8.2 GAAP Statement and Reformulated Statement of Common Shareholders’ Equity for Reebok
International Ltd., December 31, 2004
The flags to the right of the GAAP statement indicate transactions with shareholders (T) and comprehensive income (CI).
REEBOK INTERNATIONAL LTD.
GAAP Statement of Equity
(dollar amounts in thousands)
Common Stock Additional
Par
Paid-In Retained
Shares
Value Capital
Earnings
Balance December 31, 2003
101,081
Net income
Foreign currency translation gain
Adjustment for fair value of
derivative investments
Comprehensive income
Issuance of shares to certain
employees
Amortization of unearned
compensation
Shares issued under employee
stock purchase plans
Shares issued upon exercise of
stock options
Acquisition of treasury shares
Income tax reductions relating to
exercise of stock options
Dividends
Balance December 31, 2004
$1,011
$0
$1,796,321
Treasury
Stock
$(740,189)
Accumulated
Other
Unearned
Comprehensive
Compensation
Income
$(1,225)
$(22,208)
192,425
37,691
4,445
149
1
6,315
(5,880)
1
3,351
1,751
(1,264)
18
(13)
41,062
(47,788)
$1,018
$0
$1,985,324
192,425(CI)
37,691(CI)
4,445(CI)
234,561
1,301
3,352(T)
41,080(T)
(88,122)(T)
(40,321)
11,477
(17,839)
101,827
$1,033,710
436(T)
1,301
110
Total
11,477(?)
(17,839)(T)
$(780,510)
$(5,804)
$19,928
$1,219,956
Reformulated Statement of Common Equity (in millions)
Balance December 31, 2003
Transactions with shareholders
Stock issues
Stock repurchases
Common dividends
Comprehensive income
Net income reported
Currency translation gains
Gains on derivatives
Balance December 31, 2004
$1,034.9
$62.3
(88.1)
(17.8)
(43.6)
192.4
37.7
4.4
234.5
1,225.8
Notes: 1. The beginning balance in the reformulated statement is calculated as follows (in millions):
Reported balance
Unearned compensation balance
$1,033.7
1.2
$1,034.9
The endings balance is calculated as follows:
Reported balance
Unearned compensation balance
$1,220.0
5.8
$1,225.8
2. Income tax reductions from the exercise of stock options of $11.5 million have been treated as proceeds from share issues in the reformulated statement.
In reformulating Reebok’s statement, we have added the tax reductions from the exercise
of employee stock options to cash from share issues. Firms often treat the tax deduction
they get when options are exercised as proceeds from share issues and report share issues
net of the tax benefit. Indeed, the $284.9 million that Nike reported as receipts from stock
issues from the exercise of options consisted of $237.7 million received from employees
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 269
exercising the options and $47.2 million for tax benefits. However, this treatment is to be
questioned—as indicated by the (?) flag in Reebok’s equity statement. Deeper issues lurk in
the background. We defer these to the discussion of hidden dirty-surplus expenses below.
You will notice in this reformulation that we have not made any use of the distinction
between stated value (or par value) of shares and additional (or excess) paid-in capital. This
is of no importance for equity analysis; better to know the company’s telephone number
than the par value of its stock. Retained earnings is a mixture of accumulated earnings, dividends, share repurchases, and stock dividends, and it does not bear on the analysis. Conversions of one class of common to another with zero effect do not change the book value
of equity (as with Nike). Nor do stock splits or stock dividends change the book value of
equity; splits change the number of shares but do not change a given shareholder’s claim.
DIRTY-SURPLUS ACCOUNTING
Reporting income items as part of equity rather than in an income statement is known as
dirty-surplus accounting. An equity statement that has no income other than net income
from the income statement is a clean-surplus accounting statement. The terms are pejorative, and appropriately so. Under dirty-surplus accounting the income in the income
statement is not “clean,” it is not complete. “Net” income, as used in GAAP, is really a
misnomer.
Table 8.1 lists the dirty-surplus items you are likely to see in the United States. Income
items are designated as part of operating income or financial income (expense) to categorize them in a reformulated income statement (later). Some of the items you will rarely see.
The three most common are unrealized gains and losses on securities, foreign currency
translation gains and losses, and unrealized gains and losses on certain derivatives.
1. Unrealized gains and losses on securities available for sale. FASB Statement No. 115
distinguishes three types of securities:
• Trading securities
• Securities available for sale
• Securities held to maturity
Trading securities are those held in a portfolio that is actively traded. These securities
are marked to market value in the balance sheet and the unrealized gains and losses from
changes in market value are reported in the income statement. Securities that are not
actively traded but which might be sold before maturity are available for sale. These also
are marked to “fair” market value but the unrealized gains and losses are reported as part
of other comprehensive income. Securities that management intends to hold to maturity
are recorded at cost on the balance sheet, so no unrealized gains and losses are reported.
Realized gains and losses on all types of securities are reported in the income statement
as part of net income. The rules apply to both debt securities and equity securities
involving less than 20 percent ownership interest. Go to Accounting Clinic III.
2. Foreign currency translation gains and losses. The assets and liabilities of majorityowned foreign subsidiaries, measured in the foreign currency, must be consolidated into
the statements of a U.S. parent in U.S. dollars. If the exchange rate changes over the reporting period, the value of the assets and liabilities changes in U.S. dollars. The resulting gain or loss is a translation gain or loss, to be distinguished from gains and losses on
foreign currency transactions. Most transaction gains and losses are reported as part of
net income. Translation gains and losses are part of other comprehensive income.
Translation gains and losses can apply to both the operating and financing assets and
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
270 Part Two The Analysis of Financial Statements
TABLE 8.1
Dirty-Surplus
Accounting: U.S.
GAAP
All dirty-surplus
income items are
reported net of tax.
Operating Income Items
Some income-increasing accounting changes (APB Opinion No. 20):
Change from LIFO valuation of inventory
Change in long-term contract accounting
Change to or from full cost accounting in extractive industries
Change triggered by a red line in an accounting standard (e.g., change from cost to
equity method for long-term equities)
Change made for the first time in conjunction with an IPO or business combination
Changes in accounting for contingencies (FASB Statement No. 11)
Additional minimum pension liability (FASB Statement No. 87)
Tax benefits of loss carryforwards acquired (FASB Statement No. 109)
Tax benefits of dividends paid to ESOPs (FASB Statement No. 109)
Unrealized gains and losses on equity securities available for sale
(FASB Statement No. 115)
Some adjustments of deferred tax valuation allowances
Financing Income (or Expense) Items
Preferred dividends
Unrealized gains and losses on debt securities available for sale (FASB Statement No. 115)
Operating or Financing Income Items
Foreign currency translation gains and losses (FASB Statement No. 52)
Gains and losses on derivative instruments designated as cash-flow hedges
(FASB Statement No. 133)
Balance Sheet Items to Be Reclassified
Deferred compensation relating to grant of employee stock options and stock
(APB Opinion No. 25 and FASB Statement No. 123)
Dividends payable
Note: APB is the Accounting Principles Board, the predecessor body to the Financial Accounting Standards Board (FASB).
liabilities of subsidiaries, so their income can affect operating or financing income as
indicated in Table 8.1.
3. Gains and losses on derivative instruments. FASB Statement No. 133 requires most
derivatives to be marked to fair value on the balance sheet, either as assets or liabilities.
If the instrument hedges an existing asset or liability or a firm commitment by the
company—a so-called fair value hedge—the gain or loss from marking the instrument
to fair value is recorded as part of net income. (Under certain conditions, the gain or loss
is offset in the income statement by the gain or loss on the hedged item.) If the instrument hedges the cash flow from an anticipated future transaction—a so-called cash flow
hedge—the gain or loss is recorded to the equity statement, and then removed from the
equity statement to net income when the hedged transaction affects earnings.1
Comprehensive Income Reporting
For years after 1998, FASB Statement No. 130 requires comprehensive income to be identified in the financial statements. It distinguishes net income from other comprehensive
1
See M. A. Trombley, Accounting for Derivatives and Hedging (New York: McGraw-Hill/Irwin, 2003) for
a primer on the accounting for derivatives.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 271
III
Accounting Clinic
ACCOUNTING FOR MARKETABLE SECURITIES
Further detail on the accounting for securities is covered
in Accounting Clinic III on the book’s Web site. The clinic
covers debt securities held by firms and equity securities
representing less than 20 percent interest in other corporations. The accounting for equity investments of more
than 20 percent is covered in Accounting Clinic V.
income and permits the sum of the two, comprehensive income, to be reported in one of
three ways:
1. Report comprehensive income in the statement of shareholders’ equity by adding net
income to other comprehensive income items reported in the equity statement.
2. Add other comprehensive income to net income in the income statement and close the
total comprehensive income to shareholders’ equity.
3. Present a separate statement of other comprehensive income apart from the income
statement and close it to equity along with net income from the income statement.
Most firms follow the first approach.2 So you now observe dirty-surplus income items
added together into a number called “other comprehensive income” and other comprehensive income and net income added to “total comprehensive income”—all within the equity
statement. This presentation facilitates the task of identifying comprehensive income.
However, it is not, in fact, comprehensive from the common shareholders’ point of view.
First, it omits preferred dividends, and second certain hidden items (which we will identify
toward the end of this chapter) are not included.
RATIO ANALYSIS
What does the reformatted statement of changes in owners’ equity reveal? It gives the
growth in equity over a period. And it distinguishes clearly between the growth in equity
from new investment or disinvestment by the owners and additions to equity from running
the business. Accordingly, the reformulated statement distinguishes the creation of value
from the distribution of value. Indeed both ROCE and growth in equity—the two drivers of
residual earnings—can be identified in the statement. A set of ratios analyzes the statement
to refine this information.
Payout and Retention Ratios
The disinvestment by shareholders is described by payout ratio and retention ratios. The
standard dividend payout ratio is the proportion of income paid out in cash dividends:
Dividend payout =
Dividends
Comprehensive income
A calculation that you commonly see compares dividends to net income rather than
comprehensive income. The dividend payout ratio involves payout in the form of dividends;
2
For an example of the third approach, see the 1998 10-K filing for Pentair, Inc., on the SEC’s EDGAR
Web site. For an example of the second approach, see Chubb Corporation in Minicase M9.2 in Chapter 9.
Also look at the Web page for this chapter.
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total payout is dividends plus share repurchases. Some firms pay no dividends but have
regular stock repurchases. The total payout ratio is
Total payout ratio =
Dividends + Stock repurchases
Comprehensive income
calculated with total dollar amounts rather than per-share amounts. The difference between
this ratio and the dividend payout ratio gives the percentage of earnings paid out as stock
repurchases.
Note that stock dividends and stock splits are not involved. These simply change the
share units, with no effect on the claim of each shareholder. Some splits and stock dividends involve a reclassification from retained earnings to additional paid-in capital, but
again this has no effect on the value of claims.
Although the dividend payout ratio suggests that dividends are paid out of earnings, they
are really paid out of book value, out of assets. So a firm can pay a dividend even if it reports a
loss. Payout, as a proportion of book value, is the rate of disinvestment by shareholders:
Dividends-to-book value =
Total payout-to-book value =
Dividends
Book value of CSE + Dividends
Dividends + Stock repurchases
Book value of CSE + Dividends + Stock repurchases
Usually ending book value of common shareholders’ equity (CSE) is used in the denominator in these calculations (although, with dividends paid out over the year, average CSE is
also appropriate).
Retention ratios focus on earnings retained rather than earnings paid out. The standard
retention ratio involves only cash dividends (but can be modified to incorporate stock
repurchases):
Comprehensive income – Dividends
Retention ratio =
Comprehensive income
= 1 – Dividend payout ratio
Shareholder Profitability
The reformulated statement yields the comprehensive rate of return on common equity,
ROCE, the profitability of the owners’ investment for the period. ROCE is also growth in equity from business activities. For Nike, the 2004 ROCE (using average equity for the year) is
ROCE t =
=
Comprehensive earnings
1 (CSE + CSE
t
t −1 )
2
1
1, 099
= 24.8%
(4, 028 + 4, 840)
2
The ROCE calculated on beginning common equity is 27.3 percent.
Note that the income statement and balance sheet are not needed to calculate ROCE;
rather, they provide the detail to analyze ROCE.
Growth Ratios
The growth in shareholders’ equity is simply the change from beginning to ending balances.
Growth ratios explain this growth as a rate of growth.
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 273
The part of the growth rate resulting from transactions with shareholders is the net
investment rate:
Net transations with shareholders
Net investment rate =
Beginning book value of CSE
Nike’s net investment rate was a negative 7.1 percent because net cash was paid out; shareholders disinvested. The part of the growth rate that comes from business activities is given
by the ROCE on beginning equity, 27.3 percent for Nike. The rate of growth of owners’ equity from both sources—new shareholder financing and business activities—is the growth
rate in common stockholders’ equity:
Growth rate of CSE =
=
Change in CSE
Beginning CSE
Comprehensive income + Net transactions with shareholders
Beginning CSE
Nike’s 2004 growth rate was 20.1 percent.
If ROCE is calculated with beginning CSE in the denominator, then
Growth rate of CSE = ROCE + Net investment rate
For Nike, the growth rate in common equity is 27.3 percent – 7.1 percent = 20.1 percent
(allow for rounding error).
Return on common equity is the focus for the analysis of profitability. Growth in CSE is
the focus for the analysis of growth. Together, the two drive residual earnings and earnings
growth. As a first insight, we see that the growth rate is driven by ROCE and the rate of new
investment.
HIDDEN DIRTY SURPLUS
The distinction between comprehensive income and transactions with shareholders in the
reformulated statement of owners’ equity separates the creation of value from the raising of
funds and the distribution of value to shareholders. The premise is that transactions with
shareholders do not create value. This is so when share transactions are at market value, but
when shares are issued at less than market value, shareholders lose. And the losses do not
appear in GAAP financial statements.
Issue of Shares in Operations
We have seen that when firms grant shares to employees at less than market price, the difference between market price and grant price is treated as (unearned) compensation to employees and ultimately amortized as an expense to the income statement. More frequently,
though, shares are not granted to employees. Rather, stock options are granted and shares
are issued later when the options are exercised.
Four events are involved in a stock option award: the grant of the option, the vesting of
the option, the exercise of the option, and the lapse of the option. At the grant date employees are awarded the right to exercise at an exercise price; the vesting date is the first
date at which they can exercise the option; the exercise date is the date on which they actually exercise at the exercise price; and the lapse date is the date on which the option lapses
should the employee choose not to exercise. Clearly the employee exercises if the stock is
“in the money” at exercise date, that is, if the market price is greater than the exercise price.
If the call option is granted in the money at grant date (with the exercise price set at less
than the market price at grant date), GAAP accounting treats the difference between the
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Measuring the Loss from Exercise
of Stock Options
Stock option loss is the difference between the exercise price
and the market price of the shares at the date of exercise. This
is the amount that shareholders lose by not issuing the shares
at market price. The amount can be calculated in two ways.
METHOD 1
If options are nonqualifying options, the firm receives a tax
deduction for the difference between market price and exercise
price (and the employee is taxed on that difference). As the firm
reports the tax benefit from the exercise of options, (either in
the equity statement, as with Reebok, or the cash flow statement, as with Nike) the amount of the tax deduction—the
stock option expense—can be imputed using the firm’s tax
rate. Reebok’s tax rate, gleaned from the tax footnote to the
financial statements, is 35.9 percent. So, from the tax benefit
of $11,477 thousand reported in the equity statement, the
expense is $11,477/0.359 = $31,969 thousand. As the
expense is a tax deduction, the after-tax option expense is
calculated as follows (in thousands):
Stock option expense
$11,477/0.359
Tax benefit at 35.9%
Stock option expense, after tax
$31,969
(11,477)
$20,492
8.3
METHOD 2
If there is no reported tax benefit to work from, the calculation must estimate the market price at exercise date. Reebok’s
average stock price during 2004 was $38.00. With 1,751
thousand options exercised, the calculation is as follows:
Estimate market value of
shares issued
1,751 × $38.00
Exercise (issue) price, from equity statement
Stock option expense, before tax
Tax benefit at 35.9%
Stock option expense, after tax
$66,538
41,080
25,458
(9,139)
$16,319
This calculation is tentative. If employees exercised above the
$38.00 price (which is likely), the expense would be higher.
Indeed, the Method 2 number is less than the Method 1
number.
Method 2 must be used for incentive options where the
firm does not receive a tax benefit (nor is the employee taxed
until the shares are sold).
market price and exercise price as compensation. Unearned compensation is recorded and
then amortized to the income statement over the vesting period, as in the case of a stock
grant. But most options are granted “at the money,” with exercise price equal to the market
price at grant date. As time elapses and the market price of the stock moves “into the money,”
no compensation expense is recorded. Further, when options are indeed exercised, no compensation expense is recorded. You see in Nike’s and Reebok’s statements of equity that the
amount received on exercise is recorded as issued shares, but, unlike the stock grants, the
expense—the difference between the market price and the issue price—is not recorded.
The appropriate accounting is to record the issue of shares at market price and recognize
the difference between the market price and issue price as compensation expense. In the
absence of this accounting there is a hidden dirty-surplus expense. The expense is not
merely recorded in equity rather than the income statement; it is not recorded at all. But
there has been a distribution of wealth to employees and that distribution has come at the expense of the shareholders: The value of their shares must drop to reflect the dilution of their
equity. GAAP accounting treats this transaction, which is both a financing transaction—
raising cash—and an operational transaction—paying employees—as if it is just a financing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 8.3
calculates Reebok’s loss from the exercise of stock options during 2004.
Some commentators argue that, because options are granted at the money, there is no
expense. Employees—and particularly management, who benefit most—say this adamantly.
But there is no expense only if the options fail to move into the money. They also say that, as
the exercise of options does not involve a cash payment by the firm, there is no expense.
However paying employees with stock options that are exercised substitutes for paying
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 275
them with cash, and recording the expense is recording the cash-equivalent compensation:
The firm is effectively issuing stock to employees at market price and giving them a cash
amount equivalent to the difference between market and exercise prices to help pay for the
stock. From a shareholder’s point of view, it makes no difference whether employees are
paid with cash or with the value of the shares that shareholders have to give up. Recognizing this expense is at the heart of accrual accounting for shareholder value, for accrual accounting looks past cash flows to value flows; it sees a transfer of valuable stock for wages
as no different from cash wages. If you are hesitant in viewing stock compensation as an
expense, think of the case where a firm pays for all its operations—its materials, its advertising, its equipment—with stock options. (Indeed some sports stars have asked to be paid
with stock options for promotions!) If the hidden expenses were not recognized, the income
statement would have only revenues on it and no expenses. Stock options produce revenues
and profits for shareholders if they present an incentive for employees and management.
But GAAP accounting does not match the cost of the options against these revenues and
profits. Value added must be matched with value lost.
With the large growth in stock compensation in the 1990s, the hidden expense has
become quite significant, particularly in the high-tech sector. The Financial Accounting
Standards Board addressed the issue, but in Statement No. 123 came to an unsatisfactory
conclusion. This statement requires unearned compensation to be recognized at grant date
at an amount equal to the value of the option, priced using option-pricing formulas. This
unearned compensation is then amortized to the income statement over a service period,
usually the vesting period. Firms were required to report the effect in footnotes, not the actual statements, but Statement 123R, issued in 2004 for effect in 2006, requires the expense
to be recorded within the statements.3 The international accounting standard on the issue,
IFRS 2, requires similar treatment. This treatment is called grant date accounting. But the
granting of options yields an expense only in recognition of possible exercise. If the option
lapses (because the stock does not go into the money), no expense is incurred. An expense
is realized only if the option is exercised. The difference between the market price and
exercise price at exercise date is the loss to shareholders. Recognizing this expense, as in
Box 8.3, is called exercise date accounting. In 2004, Reebok reported (in footnotes) $9,522
thousand in after-tax stock option expense using grant date accounting. Box 8.3 calculates
an expense of $20,492 thousand from the exercise of options during 2004. Now go to
Accounting Clinic IV.
Significantly, the Internal Revenue Service recognizes that an expense is incurred when
options are exercised and gives the firm a tax deduction for it (if certain conditions are met).
The firm books this tax benefit to equity: You see the entry in Reebok’s equity statement
(Exhibit 8.2), where $11,477 thousand in tax benefits are recorded. So, the accounting recognizes the tax benefit of the expense, increasing equity, but not the associated expense!
This loss from the exercise of options results from options exercised in the current period. However, it does not capture the expected losses to shareholders from stock options in
the future, and it is the expected costs of options with which we are concerned in valuation.
Reebok’s option footnote reported 7,705,184 options outstanding at the end of 2004 at
exercise prices ranging from $7.38 to $48.37 per share. Most of these options are in the
money and are likely to be exercised. In valuing a Reebok share, the investor must consider
the expected loss in value when these options are exercised; if one ignores this loss, one
will overvalue the firm and pay too much for a share.
3
At the time of writing, the application of FASB Statement 123R had been delayed by the SEC until
2006. Firms were also lobbying Congress to override the FASB requirement and the House of
Representatives had indeed passed a bill to do so.
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IV
Accounting Clinic
ACCOUNTING FOR STOCK COMPENSATION
GAAP accounting for stock options in the United States
employs grant-date accounting. The International Accounting Standards Board (IASB) also requires grant-date
accounting. Accounting Clinic IV leads you through grantdate accounting.
Accounting Clinic IV also lays out exercise-date accounting and takes you through the complete accounting
that measures the effects of stock options on shareholders. Unearned compensation costs are recorded at grant
date, and then recognized as expense in the income statement over the period when employee services are given.
Accordingly, the compensation cost is matched against the
revenues that the employees produce. Subsequent to
grant date, further losses are recognized as options go into
the money. Here are the steps to effect sound accrual
accounting for stock options:
1. Recognize the option value at grant date as a contingent liability, along with a deferred (unearned) compensation asset. The two items can be netted on the
balance sheet. The option value at grant date is the
amount recognized with grant-date accounting under
FASB Statement No. 123R. The grant-date value given
to employees is compensation, but it is contingent
upon the options going into the money, so it is a
contingent liability to issue shares. The deferred compensation asset is similar to that which arises from
stock issues to employees at less than market value.
2. Amortize the deferred compensation over an employee
service period, usually the vesting period.
3. Mark the contingent liability to market as options go
into the money to capture the value of the option overhang, and recognize a corresponding unrealized loss
from stock options.
4. Extinguish the liability against the share issue (at market value) at exercise date. If options are not exercised,
extinguish the liability and recognize a windfall gain
from stock options.
Exercise of stock options increases shares outstanding,
so comparing basic EPS with diluted EPS (that anticipates
the share issues) gives some idea of the extent of the problem. But the loss from stock options falls on the current
shareholders, not the future shareholders from the exercise of options, and diluted EPS does not make the distinction. Accounting Clinic IV outlines the calculation of
diluted EPS.
For more on appropriate exercise date accounting, go
to the Web page for this chapter.
We return to the question of how anticipated losses from stock options are incorporated
in valuation in Chapter 13. We will calculate the option overhang, a contingent liability to
issue shares at less than market value, and our valuations will build in this contingent
liability.
Firms use options and warrants for other operating expenses beside wages. See Box 8.4.
Issue of Shares in Financing Activities
Hidden losses occur not only with employee stock options but with the exercise of all contingent equity claims. Call and put options on the firm’s own stock, warrants, rights, convertible bonds, and convertible preferred shares are all contingent equity claims that, if
exercised, require the issue (or repurchase) of shares at a price that is different from market
value. Look at Box 8.5.
Box 8.6 covers the accounting for convertible bonds and convertible preferred stock and
shows how GAAP accounting does not recognize the full cost of financing with these instruments. GAAP accounting is not comprehensive, even though a nominal number, comprehensive income, is reported.
Share Transactions in Inefficient Markets
The maxim that share issues and repurchases at market value do not create value recognizes
that in efficient stock markets, value received equals value surrendered; both sides of the
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Paying for License Rights with Stock
Warrants: Reebok
In 2001, Reebok entered into a 10-year license agreement
with the National Football League (NFL) giving the company
exclusive rights to design, develop, and sell NFL footwear,
apparel, and accessories in exchange for stock warrants valued at $13.6 million. These warrants gave the NFL the right to
purchase up to 1.6 million shares of Reebok’s common stock
at various exercise prices, with an expiration date of 2012.
Reebok recorded an intangible asset (“licenses” below)
and then amortized this asset over 10 years. So its intangible
asset footnote for 2003 reported the following (in thousands):
Amortizable intangible assets:
Licenses
Other intangible assets
Less accumulated amortization
Nonamortizable intangible assets:
Company tradenames and trademarks
$13,600
4,492
$18,092
3,656
$14,436
27,860
$42,296
You see that Reebok recognized the license asset and is amortizing the license cost along with other amortizable intangible
assets. So the license expense is being matched against revenue from NFL branded products in the income statement
over the term of the license. This is appropriate accounting.
However, the issue of the warrants was recorded as a share
issue in the equity statement in 2001, as required by GAAP.
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8.4
But the GAAP accounting is inappropriate. The issue of a
warrant—like the issue of a stock option—is not an issue of
equity but, rather, an obligation for the shareholders to surrender value in the future should the warrants be exercised.
From the shareholders’ point of view a warrant is a (contingent) liability, and appropriate accounting for shareholder
value requires it to be recognized as such. Further, if and when
the warrants are exercised, the difference between the exercise price and the market price of the stock at the time, over
and above the $13.6 million already recognized, is a further
loss to shareholders.
The diligent equity analyst recognizes that GAAP fails to
track the effects of this transaction on shareholder value.
Many of the warrants have an exercise price of $27.06 per
share. At the end of 2004, Reebok’s shares traded at $44.00,
so the warrants were well in the money and likely to be
exercised. The analyst anticipates that there will be a loss of
shareholder value when this happens and builds this into her
valuation. This is the warrant overhang. For now, note that a
rough calculation of the warrant overhang (at the end of
2004) is the amount of value that the shareholders would
have to give up if the warrants were exercised at the end of
2004: The difference between the market price of the share
and the exercise price at the end of 2004 is $44.00 − $27.06 =
$16.94 per warrant. Chapter 13 modifies this calculation to
recognize that the warrants cannot be exercised in 2004, but
rather in 2012, so option value must be added to this rough
calculation.
transaction get what they paid for. In a share repurchase, for example, the firm gives up, and
the seller receives, cash equal to the value of the stock.
But we recognized in Chapter 3 that if stock markets are inefficient, a firm can buy back
shares at less than they are worth and issue shares at more than they are worth. The other
side of the transaction—the shareholder who sells the shares or the new shareholder who
buys—loses value. But the existing shareholders who do not participate in the transaction
gain. These gains (or losses if shareholders lose in the transaction) are not revealed in the
accounts.
Even if stock markets are efficient with respect to publicly available information, a
firm’s management might have private information about the value of their firm’s shares
and issue or repurchase shares at prices that are different from those that will prevail when
the information is subsequently made public. Such transactions also generate value for
existing shareholders. (In the United States there are legal constraints on this practice,
however.)
The active investor who conjectures that the market may be inefficient at times is wary
of share transactions with firms. As with all his trading in the stock market, he tests the
market price against an estimate of intrinsic value. But he is particularly careful in this case
because the firm’s management may have a better feel for intrinsic value than he.
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Hidden Losses and the Accounting for
Put Options Dell Computer Corporation (Dell, Inc.)
In Dell’s statement of shareholders’ equity for the fiscal year
ending February 1, 2002, the following line item appeared
(in millions):
Repurchase of common shares
Shares
Amount
68
$3,000
This line suggests a routine stock repurchase. But further
investigation reveals otherwise. Dividing the $3 billion paid
out by the 68 million shares purchased, the average per-share
purchase price is $44.12. But Dell’s shares did not trade above
$30 during the year, and the average price was $24. Footnotes reveal that Dell was forced to repurchase shares at the
strike price of $44 on put options written to investors. In previous years, Dell had gained from these options as the stock
price continued to rise during the bubble. But with the share
price falling (from a high of $60 in February 2000) as the stock
market bubble burst, Dell was caught as these options went
under water. Using the average price of $24 for 2002 as the
market price when the shares were repurchased, the loss from
the exercise of put options is as follows:
Market price for shares
repurchased
$24 × 68 million
Amount paid for shares repurchased
Loss on exercise of put options
$1,632 million
(3,000)
$1,368 million
(The loss is not tax deductible.) On the 2,670 million shares
outstanding before the repurchase, the loss is $0.51 per share,
a significant amount compared to Dell’s reported EPS of
$0.48. Dell effectively runs two types of businesses, a computer
business earning $0.48 per share in 2002 and a business of
betting on its own stock, earning a loss of $0.51 per share.
The omission of this loss is a concern to the investor, and
the investor must be vigilant. Shareholders lose when share
prices fall, of course, but when the firm has written put options, the shareholder suffers twice; the loss from the price
decline is levered. In 2002, Electronic Data Systems Corporation (EDS) announced that the firm had some accounting
problems and that contract revenue would not be as previously expected. The stock price dropped 70 percent on the
bad news. Later, the firm indicated that the drop in price
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8.5
would trigger the exercise of put options. The price dropped
further.
Put options are sometimes referred to as put warrants.
Firms make similar commitments to buy back stock through
forward share purchase agreements. They disclose the existence of put options and share purchase agreements in footnotes. In buying a stock of Dell in 2002, one must be aware of
the put option overhang, for it might require further repurchases that lose value for shareholders. At the end of fiscal
2002, Dell has a further put option overhang for 51 million
shares to be repurchased at $45 per share. In September
2002, when the shares were trading at $25, the options were
in the money by $20 per share, a total of $1.020 billion, projecting a loss of $0.39 per outstanding share. Analysts were
forecasting $0.80 EPS for fiscal 2003, but that is GAAP earnings. Expected comprehensive earnings was $0.39 less, or
$0.41 per share.
FASB STATEMENT NO. 150
In 2003, the FASB issued Statement 150 to reform the
accounting for these put obligations. Firms are now required
to recognize a liability, measured at fair value, when the contract is written. Subsequently, as the stock price changes, this
liability is measured at the amount of cash that would be required to settle the obligation at the reporting date. This, of
course, is the difference between the exercise price and market price at reporting date. The revaluation of the liability is
booked to the income statement as interest cost. So, the rule
sees a put option contract (appropriately) as a borrowing: The
firm borrows the amount that the contract is worth and then
repays the “loan” in cash or shares. The amount lost on the
contract is the interest cost on the loan. The accounting under
Statement 150 effectively puts the liability for the option overhang on the balance sheet and records losses, as interest, as
the option moves into the money (and so the shareholders
must give up more value). If the option does not go into the
money, a gain is recognized.
Accordingly, Statement 150 brings the hidden expense
into the income statement and also puts a hidden (offbalance-sheet) liability on the balance sheet. Note, however,
that GAAP does not apply the same treatment to call options,
(call) warrants, and other convertible securities. See Box 8.4.
The active investor who understands the intrinsic value of a stock understands when
it might be overvalued or undervalued. And he understands that management might use the
mispricing to advantage. The management might, for example, use overvalued shares
to make acquisitions, to acquire other firms cheaply. Indeed this is a reason why an investor
might buy overvalued shares: He sees that value can be generated by using the shares as
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Accounting for Convertible Securities
Convertible securities are securities, such as bonds and
preferred stock, that can be converted into common shares if
conditions are met. Textbooks propose two methods to record
the conversion of a convertible bond or a convertible preferred stock into common shares:
1. The book value method records the share issue at the book
value of the bond or preferred stock. Common equity is increased and debt or preferred stock is reduced by the same
amount, so no gain or loss is recorded.
2. The market value method records the share issue at the
market value of the shares issued in the conversion. The difference between this market value and the book value of
the security converted is recorded as a loss on conversion.
The book value method is almost exclusively used in
practice. It involves a hidden dirty-surplus loss. The market
value method reports the loss. It accords the treatment of
convertible securities the same treatment as nonconvertible
8.6
securities. On redemption of nonconvertible securities before
maturity, a loss (or gain) is recognized. The only difference
with convertible securities is that shares rather than cash
are used to retire them. In both cases there is a loss to the
existing shareholders.
Convertible bonds carry a lower interest rate than nonconvertible bonds because of the conversion option. GAAP accounting records only this interest expense as the financing
cost, so it looks as if the financing is cheaper. But the full financing cost to shareholders includes any loss on conversion of the
bonds into common shares—and this loss is not recorded.
In the 1990s, financing with convertible preferred stock
became common. Only the dividends on the preferred stock
were recorded as the financing cost, not the loss on conversion. Suppose a convertible preferred stock issue had no dividend rights but, to compensate, set a favorable conversion
price to the buyer of the issue. Under GAAP accounting it
would appear that this financing had no cost.
currency in an acquisition. But this is a tricky business: If investors force up the prices of
shares that are already overpriced, a price bubble can result. The fundamental investor
bases his actions on a good understanding of the firm’s acquisition possibilities and its
acquisition strategy.
As for the management, they can take advantage of share mispricings to create value for
shareholders with share transactions. They can choose to finance new operations with debt
rather than equity if they feel the stock price is “too low.” But they also can choose to exercise their stock options when the price is high—a double whammy for shareholders. They
might also have misguided ideas about stock issues and repurchases. See Box 8.7.
Reformulating the Equity Statement to Incorporate
Hidden Expenses
The reformulated equity statements for Nike and Reebok in Exhibits 8.1 and 8.2 rearrange
items on the face of the GAAP statements but do not identify the hidden dirty-surplus expenses. Exercise E8.8 at the end of the chapter asks you to do that for these two companies.
Here we carry out the complete reformulation for Dell Computer Corporation (Dell, Inc.)
whose put options were discussed in Box 8.5. Exhibit 8.3 reformulates Dell’s 2002 statement of shareholders’ equity given in Exhibit 2.1 in Chapter 2.
The reformulation involves the following adjustments:
1. The “Other” column in Dell’s statement is unearned compensation. As this is a deferred
charge, an asset rather than equity, the opening and closing amounts have been added to
the opening and closing equity:
Restated beginning equity = $5,622 + 74 = $5,696 million
Restated closing equity = $4,694 + 64 = $4,758 million
2. Comprehensive income includes the $1,222 million reported in the GAAP statement,
made up of $1,246 million in net income reported in the income statement and a
279
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Do Share Repurchases Prevent Dilution from
Shares Issued Under Stock Option Programs?
Dell Computer (Dell, Inc.) explains its put option transactions
(examined in Box 8.5) as “part of a share-repurchase program
to manage the dilution resulting from shares issued under employee stock plans.” It is common for firms to explain share
repurchases in this way. The exercise of stock options increases shares outstanding and, as we have seen, dilutes existing shareholders’ value. Buying back shares reduces shares
outstanding. But does it reverse the dilution?
The answer is no. If shares are purchased at fair value,
there is no change in the per-share value of the equity; the
shareholder does not get extra value to compensate for the
loss of value from stock options. Maintaining constant shares
8.7
outstanding with share repurchases only gives the appearance
of reversing the dilution.
During the stock market bubble, employees exercised
options against the shareholders as prices soared. Firms then
repurchased shares “to manage dilution.” But purchasing
shares at bubble prices (above intrinsic value) destroys value
for shareholders. Shareholders lost twice, once with the employee options, and again with the repurchases. As some
firms borrowed to finance the share repurchases, they were
left with large debts that led to significant credit problems as
the bubble burst.
EXHIBIT 8.3 Reformulated Statement of Common Shareholders’ Equity for Dell Computer Corporation (Dell, Inc.)
for Fiscal Year Ending February 1, 2002
This reformulated statement includes hidden dirty-surplus expenses involved in Dell’s share transactions for issuing of shares
in response to employees’ exercising stock options and the repurchase of shares on exercise of put options written by the firm.
DELL COMPUTER CORPORATION (DELL, INC.)
Reformulated Statement of Shareholders’ Equity
Balance, February 2, 2001
$5,696
Transactions with shareholders:
Shares issued in stock option exercises (at market)
Shares repurchased (at market)
Comprehensive income
Comprehensive income reported
Loss on exercise of employee stock options
Tax benefit for employee stock options
Loss on put options
$1,747
(1,632)
115
1,222
$(1,391)
487
(904)
(1,368)
Other
(1,050)
(3)
Balance, February 1, 2002
$4,758
$24 million loss in other comprehensive income. To this is added the loss from exercise
of employee options, calculated from the tax benefit following Method 1 in Box 8.3. The
tax benefit is netted into the share issue—Dell has treated the tax benefit as proceeds
from share issues—so cannot be ascertained from the equity statement. However, the
tax benefit of $487 million is reported in the cash flow statement. So, with a tax rate of
35 percent, the Method 1 calculation runs as follows:
Loss from exercise:$487/0.35
Tax benefit at 35%
After-tax loss
280
$1,391
(487)
904
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 281
The $1,368 million loss from the exercise of put options, calculated in Box 8.5 is also
included deducted in comprehensive income, to yield a comprehensive loss of $1,050
million.
3. The share issues and share repurchases are recorded at their market value, that is, the
cash that would be involved if the transactions were at market value. The market value
of the shares issued for stock option exercises is equal to the exercise price plus the loss
from exercise (which is always the difference between market price and exercise price).
However, the exercise price of $843 million includes the tax benefit, so the $1,747 million number for the share issue is $843 million in the GAAP statement plus the after-tax
loss of $904 million (in point 2 above). Similarly, the market price of the share repurchase is the $3,000 million paid for the repurchase minus the $1,368 million loss representing the difference between the market price and exercise price. The accounting for
both share transactions says that, effectively, Dell traded shares at market value, but then
paid out cash or share equivalent to the counterparty, resulting in a loss of value to
shareholders.
4. The $3 million reduction in equity in the “other” line is not identified by Dell so is
included on its own line here.
The comprehensive loss for 2002 in the reformulation is quite different from the reported comprehensive income. The analyst recognizes that, when wages are paid in stock
(issued below market price) rather than cash, the loss to shareholders must be recorded. She
also recognizes that, in 2002, Dell carried out two lines of business, one trading computers
and associated products and one trading put options on its own stock. The comprehensive
income to both lines of business must be accounted for. Accordingly, the accounting in the
reformulated statement faithfully reports the effects of Dell’s business activities on its
shareholders.4
THE EYE OF THE SHAREHOLDER
We have characterized the financial statements as a lens on the business. For equity analysis, the lens must be focused to the eye of the shareholder. GAAP accounting is inadequate
for equity analysis because it does not have its eye on the shareholder. It does not account
faithfully for the welfare of the shareholder, and nowhere else is this more apparent than
with the accounting in the statement of shareholders’ equity.
GAAP fails to see a sale of shares by current shareholders at less than market value as a
loss. If the shareholders were forced to do so on their own account, they surely would make
a loss. When the firm forces it on them, they also make a loss. GAAP fails to understand
the distinction between cash transactions with shareholders (to raise cash and to pass out
unneeded cash as a matter of financing) and value added (or lost) from operations that can
4
If firms adopt FASB Statement 123R or IFRS 2, they will have recorded the grant date expense for
employee stock options in net income (via unearned compensation amortization charges) by exercise
date. So, recording the full difference between market price and exercise price as a loss at exercise date
would involve some double counting. If this accounting does materialize (see footnote 3 on page 275),
reduce the loss by the amount of grant date expense already recognized in the net income component of
comprehensive income. Unfortunately, this will be quite difficult to trace, so approximations will have to
be made. A rough, but easy, calculation is to reduce the amount of the after-tax loss by the stock
compensation expense recorded for the current year, net of taxes. In this way, there is no double counting on average (errors wash out over time). Under Statement 123R, recorded grant-date expense is not
reversed if options fail to be exercised. The procedure of reducing exercise-date losses by the reported
stock compensation expense captures the implied gain, again on average.
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be embedded in a share issue. It also fails to see that transactions between claimants—
convertible bondholders and common shareholders, for example—can involve losses for
the common shareholders.
In short, GAAP accounting does not honor the property rights of the common shareholder.
This is so despite the fact that financial reports are prepared nominally for the shareholder,
company directors (including the audit committee) have a fiduciary duty to the shareholders,
and management and auditors formally present the financial reports to shareholders at the
annual meeting. GAAP does not honor the shareholders as the owners of the firm. Consequently, the equity analyst must repair the accounting, as we have done in this chapter and
will continue to do as we move to valuation in later chapters.
The Web Connection
Find the following on the Web page for this chapter:
• Further examples of reformulated statements of shareholders’ equity.
• Further discussion of hidden expenses.
• More coverage of footnotes that pertain to the equity
statement.
• More discussion on the appropriate accounting for
contingent claims on equity.
Summary
Misclassifications in the financial statements can lead to erroneous analysis of the financial
statements and to erroneous valuations. Reformatting the statements classifies items correctly. The GAAP statement of equity sometimes comingles the results of operations with
the financing of the operations. This chapter reformulates the statement to distinguish the
creation of value in a firm from the distribution of value to shareholders in net dividends.
The reformulation identifies dirty-surplus items in the statement and yields comprehensive
income and comprehensive ROCE.
Omission in the financial statements is more pernicious than misclassification, and the
chapter sensitizes the analyst to expenses that can arise from exercise of contingent claims
but which are hidden by GAAP accounting. Failure to recognize these expenses in forecasting can lead to overvaluation of firms.
As always, a sense of perspective must be maintained in analyzing the statement of equity. For some firms with few dirty-surplus items and no stock compensation, there is little
to be discovered. For many firms there are just two items—translation gains and losses and
unrealized gains and losses on securities—that appear. And for many firms, the amounts of
these items are small. In the United States, one can sometimes glance at the statement and
dismiss the contents as immaterial. In other countries, the practice of dirty-surplus
accounting is quite extensive. And in the United States, the use of stock options in compensation is widespread.
Key Concepts
call option is a claim that gives the holder
the right, but not the obligation to buy
shares at a particular price (the exercise
price). 276
clean-surplus accounting produces a
statement of shareholders’ equity that
contains only net income (closed from
the income statement) and transactions
with shareholders. 269
contingent equity claim is a claim that
may be converted into common equity if
conditions are met. Examples are call
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 283
options, put options, and convertible
securities. 276
convertible securities are securities (such
as bonds and preferred stock) that can be
converted into common shares if
conditions are met, but which have
additional claims also. 279
dilution (to existing shareholders) occurs
when shares are issued to new shareholders at less than market value. 274
dirty-surplus item is an accounting item
in shareholders’ equity other than
transactions with shareholders or income
closed from the income statement. 269
forward share purchase agreement is an
agreement to buy back shares at a
specified price in the future. 278
hidden dirty-surplus expense is an
expense that arises from the issue of
shares but is not recognized in the
financial statements. 274
incentive options are employee stock
options that are not taxed to the employee
on exercise and are not tax deductible for
the issuing firm. 274
nonqualifying options are employee stock
options that are taxable to the employee
on exercise and tax deductible to the
issuing corporation. 274
option overhang is the value of stock
options unexercised. 276
payout is amounts paid to shareholders.
The term is sometimes used to refer only
to dividends, sometimes to dividends and
stock repurchases. Compare with
retention. 272
put option is a claim that gives the
holder the right, but not the obligation, to
sell shares at a particular price (the
exercise price). 278
redeemable securities are securities (such
as bonds and preferred stocks) that can be
redeemed by the issuer under specified
conditions. 264
retention is paying out less than
100 percent of earnings. Compare with
payout. 272
tax benefit is a tax deduction or credit
given for specified transactions. 275
warrant is similar to a call option but
usually of longer duration. A put
warrant is similar to a put option. 277
The Analyst’s Toolkit
Analysis Tools
Reformulated statements
of common shareholders’
equity
Analysis of dirty-surplus
accounting
Ratio analysis of the equity
statement
Payout analysis
Compensation expense
analysis
Grant-date accounting
Exercise-date accounting
Warrant accounting
Put option accounting
The book value method
The market value method
Page
263
269
271
271
274
275
275
277
278
279
279
Key Measures
Page
Comprehensive income
264
Deferred compensation
265
Diluted earnings per share
276
Foreign currency translation
gains and losses
269
Gains and losses on
derivative instruments
270
Gains and losses on put
options
278
Hidden compensation
expense
274
Net effect of transactions with
shareholders (net dividend) 266
Loss on conversion of a
convertable security
279
Acronyms to Remember
CSE common shareholders’
equity
ESOP employee stock
ownership plan
IFRS International Financial
Reporting Standard
ROCE return on common
shareholders’ equity
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The Analyst’s Toolkit (concluded)
Analysis Tools
Page
Reformulation to incorporate
hidden dirty surplus
expenses
279
Key Measures
Page
Other comprehensive income
Ratios
Dividend payout
Total payout
Dividends-to-book value
Total payout-to-book value
Retention
New investment rate
Comprehensive ROCE
Growth rate of common
shareholders’ equity
Tax benefit on issue of
shares in exercise of
employee stock options
Unrealized gains and losses
on securities available
for sale
Acronyms to Remember
270
271
272
272
272
272
273
272
272
274
269
A Continuing Case: Kimberly-Clark Corporation
A Self-Study Exercise
You are now ready to begin an analysis of Kimberly-Clark’s financial statements with a
view, ultimately, of using the analysis to value KMB’s shares.
As always, we start with the equity statement. This is given in Exhibit 2.2 in the Continuing Case for Chapter 2. The layout is similar to the Nike and Reebok statements in this
chapter. Totals are not given, so first confirm that the beginning and ending balances total
to the amount of shareholders’ equity in the balance sheet. Kimberly-Clark issues shares
when employees exercise stock options and also issues restricted stock to employees. The
firm repurchases stock into treasury—with a very large repurchase of $1.617 billion dollars
in 2004. (It paid a dividend $1.60 per share in 2004, as noted in an earlier installment of the
Continuing Case).
REFORMULATION
Your task is to reformulate this equity statement for 2004 along the lines of the Dell reformulation at the end of this chapter. Go through and mark off the items that are transactions
with shareholders and those that are part of comprehensive income.Then ask yourself if there
are any hidden dirty-surplus expenses. Think about how you should treat the spin-off of
Neenah Paper, Inc. You should note that dividends payable are given in the balance sheet (in
the Chapter 2 installment of the Continuing Case). Kimberly-Clark’s tax rate is 35.6 percent.
RATIO ANALYSIS
State in one or two sentences what the reformulated statement you have drawn up is saying.
Then carry out a ratio analysis that embellishes the story. Why do you think this firm is
paying out so much cash to shareholders?
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BUILD YOUR OWN ANALYSIS ENGINE FOR KMB
You might enter your reformulated equity statement into a spreadsheet. After you have covered the next chapter, you can add the balance sheet and income statement. Then, in subsequent chapters, you can use spreadsheet operations to analyze the statements and derive
valuations from that analysis. The BYOAP feature on the book’s Web site will guide you.
Concept
Questions
C8.1. Why is income in the equity portion of the balance sheet called “dirty-surplus”
income?
C8.2. Why can “value be lost” if an analyst works with reported net income rather than
comprehensive income?
C8.3. Are currency translation gains and losses real gains and losses to shareholders?
Aren’t they just an accounting effect that is necessary to consolidate financial statements prepared in different currencies?
C8.4. Why is it said that amortizations of unearned compensation are treated like an
equity contribution under GAAP (generally accepted accounting principles)?
C8.5. Reebok’s balance sheet for 2004 indicates that there were 59,208 thousand common shares outstanding at the end of 2004. Yet the equity statement in Exhibit 8.2
lists 101,827 thousand shares. Explain the difference. Which number should be
used to calculate per-share numbers?
C8.6. In accounting for the conversion of convertible bonds to common stock, most firms
record the issue of shares at the amount of the book value of the bonds. The issue
of the shares could be recorded at their market value, with the difference between
the market value of the shares and the book value of the bonds recorded as a loss on
the conversion. Which treatment best reflects the effect of the transaction on the
wealth of the existing shareholders?
C8.7. The compensation vice president of General Mills was quoted in The Wall Street
Journal on January 14, 1997, as saying that option programs are “very attractive for
shareholders” because they cut fixed costs and boost profits. So, for General Mills’s
1996 year, selling, general, and administrative expenses, which include compensation, dropped by $222 million, or 9 percent, while pretax earnings from continuing
operations rose by $194 million, or 34 percent. At the same time, the firm was distributing about 3 percent of its stock to employees annually.
What’s wrong with this picture?
C8.8. Before it found the practice to be too expensive, Microsoft (and a number of other
firms) was in the habit of repurchasing some of the shares that it issued each year
as employees exercised stock options. The rationale, according to commentators,
was to avoid the dilution from shares issued to employees.
a. Do share issues from the exercise of employee stock options cause dilution?
b. Do share repurchases reverse dilution?
c. Why would Microsoft feel that repurchasing shares is “too expensive”?
C8.9. Cisco Systems, the networking equipment firm, reported a tax benefit from the exercise of stock options of $537 million in its fiscal 2004 shareholders’ equity statement. Over the previous years, the tax benefits had cut more than 25 percent off the
firm’s tax bills. Commentators saw this tax relief as a major source of value for the
shareholders. Is this correct?
C8.10. In February 1999, Boots, the leading retail chemist in the United Kingdom, announced plans to reform its employee option compensation scheme. In the future,
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it said, the firm will purchase its own shares to provide shares to issue when options
are exercised, and it will charge the difference between the market price and the
issue price for the options against profits. The charge for the first year was expected
to be £63 million ($103 million). What do you think of this scheme?
C8.11. In September 1999, Microsoft agreed to buy Visio Corporation for stock valued at
$1.26 billion. Visio sells a popular line of technical drawing software. At the time,
Microsoft had $14 billion of cash on its balance sheet. Why might Microsoft pay
for the acquisition with its own stock rather than in cash?
Exercises
Drill Exercises
E8.1.
Some Basic Calculations (Easy)
a. A firm listed total shareholders’ equity on its balance sheet at $237 million. Preferred
shareholders’ equity was $32 million. What is the common shareholders’ equity?
b. From the following information, calculate the net dividend to shareholders and comprehensive income (in millions):
Common shareholders’ equity, beginning of period
Common share issues
Common share repurchases
Common dividends
Common shareholders’ equity, beginning of period
$1,081
230
45
36
$1,292
c. A firm reported $62 million of comprehensive income in its statement of shareholders’
equity but $87 million as net income in its income statement. What explains the
difference?
E8.2.
Calculating ROCE from the Statement of Shareholders’ Equity (Easy)
From the following information, calculate the return on common equity for the year 2006
(amounts in millions of dollars). There were no share repurchases.
Common stockholders’ equity, December 31, 2005
Dividends paid to common stockholders
Share issue on December 31, 2006
Common stockholders’ equity, December 31, 2006
E8.3.
174.8
8.3
34.4
226.2
A Simple Reformulation of the Equity Statement (Easy)
From the following information, prepare a reformulated statement of common shareholders’ equity for 2006. Amounts are in millions.
Balance, December 31, 2005
Net income
Foreign currency translation loss
Unrealized gain on debt securities held
Issue of shares
Common dividends
Preferred dividends
Balance, December 31, 2006
$1,206
241
(11)
24
45
(94)
(15)
$1,396
The beginning and end-of-year balances include $200 million of preferred stock.
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 287
E8.4.
Using Accounting Relations that Govern the Equity
Statement (Medium)
The following is a statement of common shareholders’ equity with some numbers missing
(in millions of dollars).
Balance, December 31, 2005
Net income
Common dividends
Preferred dividends
Issue of common stock
Unrealized gain on securities held for sale
Foreign currency translation loss
Balance, December 31, 2006
?
?
(132)
(30)
155
13
(9)
?
a. The market value of the equity was $4,500 million at December 31, 2005, and $5,580
million at December 31, 2006. At both dates the equity traded at a premium of $2,100
million over the book of the common equity. What was net income for 2006?
b. Fill out the missing numbers in the equity statement and reformulate it to identify comprehensive income for the common shareholders for 2006.
E8.5.
Calculating the Loss to Shareholders from the Exercise of Stock
Options (Easy)
In 2001, an employee was granted 305 options on the stock of a firm with an exercise price
of $20 per option. In 2006, after the options had vested and when the stock was trading at
$35 per share, she exercised the options. The firm’s income tax rate is 36 percent. What was
the after-tax cost to shareholders of remunerating this employee with options?
E8.6.
Reformulating an Equity Statement with Employee
Stock Options (Medium)
Reformulate the following statement of shareholder’s equity. The firm’s tax rate is 35%.
Balance, end of fiscal year 2005
Share issues from exercised employee stock options
Repurchase of 24 million shares
Cash dividend
Tax benefit from exercise of employee stock options
Unrealized gain on debt investments
Net income
Balance, end of fiscal year 2006
1,430
810
(720)
(180)
12
50
468
1,870
Applications
E8.7.
A Simple Reformulation: J.C. Penney Company (Easy)
Reformulate the following statement of shareholders’ equity statement for J.C. Penney
Company. Dividends paid consisted of $24 million in preferred dividends and $225 million
in common dividends.
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288 Part Two The Analysis of Financial Statements
J. C. PENNEY COMPANY, INC. AND SUBSIDIARIES
Consolidated Statements of Stockholders’ Equity
Common
Stock
($ in millions)
January 29, 2000
Net loss
Net unrealized change in investments
Currency translation adjustments
Other comprehensive income from
discontinued operations
Total comprehensive (loss)/income
Dividends
Common stock issued
Preferred stock retired
January 27, 2001
3,266
Preferred
Stock
446
Reinvested
Earnings
Accumulated Other
Comprehensive
(Loss)/Income
3,590
(705)
(74)
2
(14)
16
(705)
(249)
4
$2,636
$(70)
28
$3,294
(47)
$399
Total
Stockholders’
Equity
7,228
(705)
2
(14)
16
(701)
(249)
28
(47)
$6,259
Real World Connection
Exercises E2.10 and E3.15 also cover JCPenney
E8.8.
Reformulation of Equity Statements: Nike, Inc. and Reebok
International Ltd. (Easy)
Exhibits 8.1 and 8.2 present statements of shareholders’ equity for Nike and Reebok. The statements are reformulated in those exhibits, but the reformulations there do not include hidden
dirty-surplus items. Modify the reformulated statements to include these items, along the lines
of that for Dell Computer Corporation (Dell, Inc.) at the end of the chapter. For this task, note
that the tax benefit that Nike received from the exercise of employee stock options in 2004—
reported in its cash flow statement—was $47.2 million. Nike’s income tax rate is 37.1 percent
and Reebok’s is 35.9 percent. (The answer to this exercise is given in Exhibit 9.8 in Chapter 9.)
Real World Connection
Nike exercises are E2.13, E6.6, E8.11, E13.16, E14.11, E15.10 and E18.5. Minicases on
Nike are M2.1, M7.1, and M11.2.
E8.9.
Calculating Comprehensive Income to Shareholders:
Intel Corporation (Medium)
The following is adapted from the statement of shareholders’ equity for Intel Corporation
for 2000 (in millions of dollars). Intel faces a 38 percent tax rate.
Balance, December 25, 1999
Net income
Unrealized loss on available-for-sale securities
Issuance of shares through employee stock plans,
net of tax benefit of $887 million
Amortization of unearned compensation
Conversion of subordinated notes to common stock
(market value of stock was $350 million)
Repurchase of common stock
Cash dividends
Issuance of shares for acquisitions
32,535
10,535
(3,596)
1,684
26
207
(3,877)
(470)
278
37,322
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© The McGraw−Hill
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Chapter 8 The Analysis of the Statement of Shareholders’ Equity 289
Calculate comprehensive income to Intel’s shareholders for 2000, being sure to include any
hidden dirty-surplus expenses.
Real World Connection
Exercises E4.12, E9.8, E11.6, and E17.15 also deal with Intel.
E8.10.
Reformulation of an Equity Statement: Dell Computer Corporation
(Dell, Inc.) (Medium)
The following is a condensed version of the statement of shareholders’ equity for Dell
Computer Corporation (Dell Inc.) for fiscal year ending January 31, 2003 (in millions of
dollars):
Balance at February 1, 2002
Net income
Unrealized gain on debt investments
Unrealized loss on derivative instruments
Foreign currency translation gain
Comprehensive income
Shares issued on exercise of options,
including tax benefits of $260
Repurchase of 50 million shares
Balance of January 31, 2003
4,694
2,122
26
(101)
4
2,051
418
(2,290)
4,873
Other information:
1. Dell’s tax rate is 35 percent.
2. The share repurchase occurred when the stock traded at $28 per share.
Prepare a reformulated statement of shareholders’ equity for 2003 for Dell Computer
Corporation (Dell, Inc.). The reformulated statement should identify comprehensive income
and include all hidden items. Dell has unearned compensation in its equity balances, but
ignore this for the purpose of this exercise.
Real World Connection
Exercises E1.4, E2.1, E4.8, E4.9, and E13.14 also deal with Dell. Minicases M10.1 and
M15.1 cover Dell also.
E8.11.
Ratio Analysis for the Equity Statement: Nike and Reebok (Easy)
Using the statements of shareholders’ equity in Exhibits 8.1 and 8.2, carry out a ratio analysis that highlights the information about Nike and Reebok in those statements.
E8.12.
Exercise of Stock Options and the Statement of Shareholders’
Equity: Genentech (Medium)
Genentech’s statement of shareholders’ equity for fiscal 1998 below reports income tax
benefits from employee stock option plans of $17,332 thousand. Genentech has a tax rate
of 37 percent.
a. What is your best estimate of the value loss to shareholders from the exercise of
employee stock options during 1998?
b. What do you think of the accounting treatment of adding the tax benefit to additional
paid-in capital?
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
290 Part Two The Analysis of Financial Statements
GENENTECH, INC.
Consolidated Statements of Stockholders’ Equity (in thousands)
Shares
Special
Special
Additional
Common Common Common Common
Paid-In
Stock
Stock
Stock
Stock
Capital
Balance December 31,
47,607
1997
Comprehensive income
Net income
Net unrealized gain
on securities available
for sale
Comprehensive income
Issuance of stock upon
exercise of options
and warrants
2,460
Issuance of stock under
employee stock plan
427
Income tax benefits
realized from employee
stock option exercises
Balance
50,494
December 31, 1998
76,621
$952
$1,532
$1,463,768
Accumulated
Other
Retained Com-prehensive
Earnings
Income
$511,141
$53,832
181,909
$2,031,225
181,909
5,431
76,621
Total
5,431
187,340
49
86,835
86,884
9
21,055
17,332
21,064
17,332
$1,010
$1,532
$1,588,990
$693,050
$59,263
$2,343,845
Real World Connection
Exercises E2.11 and E3.7 deal with Genentech.
E8.13
Analysis of the Statement of Shareholders’ Equity: Sears, Roebuck and
Company (Hard)
Reformulate the statement of owners’ equity for Sears, Roebuck that follows and identify
comprehensive income. The following footnotes from the annual report will help you:
Discontinued Operations
On Nov. 10, 1994, the Company announced its intention to distribute in a tax-free dividend
to the Company’s common shareholders its 80% ownership interest in The Allstate Corporation. The distribution was approved by shareholders at a special meeting on March 31,
1995. On June 20, 1995, the Company’s Board of Directors approved the distribution to
Sears shareholders in a tax-free dividend. Sears shareholders of record on June 30, 1995,
received, effective June 30, 1995, 0.93 shares of The Allstate Corporation for each Sears
common share owned. This transaction resulted in a noncash dividend to Sears shareholders totaling $8.98 billion.
Preferred Shares
The Series A Mandatorily Exchangeable Preferred Shares [PERCS] were issued in the
form of 28.75 million depository shares having an annual, cumulative dividend of $3.75
per depository share. The Company exchanged the PERCS for common shares on Mar. 20,
1995. Holders of depository shares received 1.24 common shares for each depository
share. The total number of common shares delivered upon exchange was 35.7 million.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 291
Profit Sharing Fund
Most domestic employees are eligible to become members of The Savings and Profits
Sharing Fund of Sears Employees (“the Fund”). The Company contribution is based on 6%
of consolidated income, as defined, for the participating companies. Company contributions are limited to 70% of eligible employee contributions.
The Fund includes an Employee Stock Ownership Plan (“the ESOP”) to prefund a portion of the Company’s anticipated contribution through 2004. The Company loaned the
ESOP $800 million, which it used to purchase 25.9 million of Sears common shares. The
loan is repaid with dividends on ESOP shares and Company contributions.
SEARS, ROEBUCK AND COMPANY
Consolidated Statements of Shareholders’ Equity
1995
(dollars in millions)
8.88% Preferred Shares, First Series
Balance, beginning of year
Issued during year
Balance, end of year
Series A Mandatorily Exchangeable
Preferred Shares (PERCS)
Balance, beginning of year
Issued during year
Exchanged to common shares during year
Balance, end of year
Common Shares
Balance, beginning of year
Conversion of PERCS
Stock options exercised and other changes
Balance, end of year
Capital in Excess of Par Value
Balance, beginning of year
Stock options exercised and other changes
Conversion of PERCS
Balance, end of year
Retained Income
Balance, beginning of year
Net income
Preferred share dividends
Common share dividends
Distribution of The Allstate
Corporation shares
Balance, end of year
Treasury Stock-at-Cost
Balance, beginning of year
Reissued under compensation plans
Balance, end of year
1995
(shares in thousands)
$
325
3,250
$
325
3,250
$ 1,236
7,188
(1,236)
(7,188)
294
27
1
322
392,310
35,673
1,700
429,683
$
$
$ 2,385
40
1,209
$ 3,634
$ 8,918
1,801
(53)
(475)
(7,747)
$ 2,444
$(1,690)
56
$(1,634)
(40,570)
1,375
(39,195)
(Continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
292 Part Two The Analysis of Financial Statements
1995
(dollars in millions)
Minimum Pension Liability
Balance, beginning of year
Minimum liability adjustment during year
Balance, end of year
(285)
$ (285)
Deferred ESOP Expense
Balance, beginning of year
Reductions
Balance, end of year
$ (558)
305
$ (253)
Unrealized Net Capital Gains
Balance, beginning of year
Net increase
Distribution of The Allstate Corporation shares
Balance, end of year
1995
(shares in thousands)
$ 32
1,176
(1,208)
Cumulative Translation Adjustments
Balance, beginning of year
Net unrealized loss during year
Distribution of The Allstate Corporation shares
Balance, end of year
$ (141)
(7)
(20)
$ (168)
Total Common Shareholders’
Equity and Shares Outstanding
Total Shareholders’ Equity
$4,060
$4,385
390,488
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 293
Minicases
M8.1
Discovering Losses to Shareholders
in the Equity Statement: Electronic
Data Systems (EDS)
Electronic Data Systems (EDS) is a technology services company providing information
technology and business process outsourcing services to corporate and government clients
throughout the world. The company offers infrastructure services, such as hosting, workplace (desktop) services, managed storage services, mobile information protection, security
and privacy, and communication services. It also is involved in applications development
and management, and develops enterprise and industry-specific information technology
and outsourcing solutions with clients working with shared services. The Company owns
A.T. Kearney, a value management consultancy. A.T. Kearney operates as a separate
subsidiary of EDS.
The year 2002 was not a good one for EDS shareholders. The stock price fell from $73
in January to $22 in November upon news that revenue from projects would be lower than
expected, both in the current year and subsequent years. But the drop in price was not
entirely due to the revenue news.
The firm’s statement of shareholders’ equity for 2002 is presented below along with
some additional information in footnotes. If you reformulate this statement along the lines
of this chapter you will discover further reasons for the price drop. Indeed, after EDS
revealed the problem, the stock fell further, to $12 in December 2002.
After you have reformulated the equity statement, answer the following questions:
A. Why would EDS sign share purchase agreements?
B. How does FASB Statement 150, introduced after 2002, change the reporting for these
agreements?
Real World Connection
Minicases M9.1 and M11.1 also deal with EDS, as do Exercises E12.10 and E17.11.
ELECTRONIC DATA SYSTEMS CORPORATION
Statement of Shareholders’ Equity
Year Ending December 31, 2002
(in millions of dollars; format modified slightly from 10-K)
Balance 2001
Net income
Currency translation gain
Change in minimum pension liability
Unrealized gain on debt securities
Comprehensive income
Paid-In
Capital
Retained
Earnings
967
7,122
1,116
Other
Comprehensive
Income
Treasury
Stock
Shareholders’
Equity
(560)
(1,083)
6,446
1,116
288
(423)
6
987
288
(423)
6
(Continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
294 Part Two The Analysis of Financial Statements
Paid-In
Capital
Issue of stock for acquisition
Employee stock awards
Issue of stock purchase contracts
Purchase of treasury shares
Common Dividends
Balance 2002
Retained
Earnings
Other
Comprehensive
Income
Treasury
Stock
85
232
(72)
11
(380)
906
(287)
7,951
(689)
(1,146)
Shareholders’
Equity
85
160
11
(380)
(287)
7,022
Additional Information:
1. The issue of stock awards to employees includes issues under stock purchase plans and
issues under stock option plans. With respect to the latter, 0.7 million nonqualifying options were exercised during 2002 at an exercise price of $44.00. A resultant tax benefit
of $5.75 million was netted into the proceeds from the share issues. The firm’s income
tax rate is 35 percent.
2. Proceeds from the issues of purchase contracts were paid by parties signing forward
stock purchase agreements. Stock purchase contracts were also written in 2001, with
EDS recognizing a charge of $118 million to paid-in capital for the right to repurchase
its stock at a set price. In both cases, the parties exercised their purchase rights during
2002.
3. The stock repurchase involved repurchases of 5.4 million shares under the stock repurchase agreements. The stock traded at $20 at the time. The following, from the Financial
Instruments and Risk Management footnote in the 10-K, gives details:
During 2001, the Company initiated a program to manage the future stock issuance
requirements of its employee stock incentive plans (Note 10) by utilizing equity
investment contracts for EDS stock. At December 31, 2001, the Company owned
equity contracts to purchase 539,000 shares of EDS common stock at a weightedaverage price of $70.14. The Company also had put obligations covering 821,000
shares of EDS common stock at a weighted-average price of $70.73. During 2002,
the Company entered into additional equity investment contracts to purchase
2,142,000 shares of EDS common stock at a weighted-average price of $59.74 and
additional put obligations covering 1,938,000 shares of EDS common stock at a
weighted-average price of $60.59. The Company settled all of these contracts in 2002
through a series of purchases of 5.4 million cumulative treasury shares of EDS common stock for $340 million at a weighted-average exercise price of $62.73 per share.
The principal source of funding for these purchases was proceeds from commercial
paper borrowings. Amounts paid upon the purchase of the underlying shares, net of
put premiums received in 2001 and 2002 of $17 million, were recorded as a component of shareholders’ equity. No equity investment contracts issued under this program were outstanding at December 31, 2002.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 295
M8.2
Analysis of the Equity Statement, Hidden
Losses, and Off-Balance-Sheet Liabilities:
Microsoft Corporation
Microsoft has undoubtedly been the most successful software firm ever. Between 1994 and
2000, the firm’s revenues increased from $2.8 billion to $23.0 billion, and its earnings from
$708 million to $9.4 billion. Over the two years, 1998 to 2000, its stock price increased
from $36 per share to almost $120, giving it a trailing P/E ratio of 66 and a market capitalization at the height of the stock market bubble of over half a trillion dollars. By 2005,
Microsoft was trading at $40 per share (on a pre-split basis) with a market capitalization of
$275 billion and a trailing P/E ratio of 25.
Microsoft’s success has been due to a strong product, market positioning, and innovative research and marketing. In terms of the buzzwords of the time, Microsoft has significant “knowledge capital” combined with dominant market positioning and network externalities. These
intangible assets are not on its balance sheet, and accordingly the price-to-book ratio was over
12 in 2000.Yet, to develop and maintain the knowledge base, Microsoft had to attract leading
technical experts with attractive stock option packages, with consequent costs to shareholders. Unfortunately, GAAP accounting did not report this cost of acquiring knowledge, nor did
it report significant off-balance-sheet liabilities to pay for the knowledge. Knowledge liabilities, as well as knowledge assets, were missing from the balance sheet.
This case asks you to uncover the knowledge costs and the associated liabilities and to
deal with other imperfections in the statement of shareholders’ equity.
Microsoft’s income statement for the first nine months of its June 30, 2000, fiscal year
follows, along with its statement of shareholders’ equity at the end of the nine months and
the shareholders’ equity footnote. At the time, Microsoft’s shares were trading at $90 each.
Reformulate the equity statement and then answer the questions that follow.
MICROSOFT CORPORATION
Income Statements
(in millions, except earnings per share)
(Unaudited)
Nine Months Ended
March 31, 2000
Revenue
Operating expenses
Cost of revenue
Research and development
Sales and marketing
General and administrative
Other expenses (income)
Total operating expenses
Operating income
Investment income
Gains on sales
$17,152
2,220
2,735
2,972
825
(13)
8,739
8,413
2,055
156
(Continued)
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
296 Part Two The Analysis of Financial Statements
Nine Months Ended
March 31, 2000
Income before income taxes
Provision for income taxes
10,624
3,612
Net income
Earnings per share:
Basic
Diluted
$ 7,012
$
$
1.35
1.27
Stockholders’ Equity Statement (in millions) (Unaudited)
Nine Months Ended
March 31, 2000
Common stock and paid-in capital
Balance, beginning of period
Common stock issued
Common stock repurchased
Proceeds from sale of put warrants
Stock option income tax benefits
Balance, end of period
$13,844
2,843
(186)
472
4,002
20,975
Retained earnings
Balance, beginning of period
Net income
Net unrealized investment gains
Translation adjustments and other
Comprehensive income
Preferred stock dividends
Common stock repurchased
Balance, end of period
Total stockholders’ equity
13,614
7,012
2,724
166
9,902
(13)
(4,686)
18,817
$39,792
Extract from the footnotes to the financial statements:
Stockholders’ Equity
During the first three quarters of fiscal 2000, the Company repurchased 54.7 million shares
of Microsoft common stock in the open market. In January 2000, the Company announced
the termination of its stock buyback program.
To enhance its stock repurchase program, Microsoft sold put warrants to independent
third parties. These put warrants entitle the holders to sell shares of Microsoft common
stock to the Company on certain dates at specified prices. On March 31, 2000, 163 million
warrants were outstanding with strike prices ranging from $69 to $78 per share. The put
warrants expire between June 2000 and December 2002. The outstanding put warrants
permit a net-share settlement at the Company’s option and do not result in a put warrant
liability on the balance sheet.
During 1996, Microsoft issued 12.5 million shares of 2.75% convertible exchangeable
principal-protected preferred stock. Net proceeds of $980 million were used to repurchase
common shares. The Company’s convertible preferred stock matured on December 15,
1999. Each preferred share was converted into 1.1273 common shares.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
Companies, 2007
8. The Analysis of the
Statement of Shareholders’
Equity
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 297
A. What was the net cash paid out to shareholders during the nine months?
B. What was Microsoft’s comprehensive income for the nine months?
C. Discuss your treatment of the $472 million from “proceeds from sale of put warrants.”
Why would Microsoft sell put warrants? How does GAAP account for put warrants, put
options, and future share purchase agreements?
D. If the put warrants are exercised rather than allowed to lapse, how would GAAP
accounting report the transactions? How would you report the effect on shareholder
value?
E. The equity statement shows that Microsoft repurchased $4.872 billion in common
shares during the nine months. The firm had a policy of repurchasing the amount of
shares that were issued in exercise of employee stock options, to “reverse the dilution,”
as it said. Microsoft discontinued the policy in 2000, as indicated in the shareholders’
equity footnote. Does a repurchase reverse the dilution of shareholders’ equity? Are repurchases at the share prices that prevailed in 2000 advisable from a shareholder’s point
of view?
F. Calculate the loss to shareholders from employees exercising stock options during the
nine months. Microsoft’s combined federal and state statutory tax rate is 37.5 percent.
G. The following is the financing section of Microsoft’s cash flow statement for the nine
months (in millions):
Nine months ending March
Financing
Common stock issued
Common stock repurchased
Put warrant proceeds
Preferred stock dividends
Stock option income tax benefits
Net cash from financing
1999
2000
$1,102
(1,527)
757
(21)
2,238
$2,549
$1,750
(4,872)
472
(13)
4,002
$1,339
Notice that the tax benefits from the exercise of stock options are included as financing
cash flows. Later in 2000, the Emerging Issues Task Force of the Financial Accounting
Standards Board required these tax benefits to be reported in the cash from operations
section of the statement of cash flows. Which is the correct treatment?
H. The income statement reports income taxes of $3,612 million on $10,624 million of income. Yet press reports claimed that Microsoft paid no taxes at the time. Can you see
why? What does the act of paying no taxes on a large income tell you about the quality
of Microsoft’s reported income?
I. Review the shareholders’ equity footnote. What issues arise in the footnote that should
be considered in valuing Microsoft’s shares?
J. Microsoft’s annual report for the year ending May 31, 2000, reported the following in
the stock option footnote:
Stock Option Plans
For various price ranges, weighted-average characteristics of outstanding stock options at
June 30, 2000, were as follows:
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
© The McGraw−Hill
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8. The Analysis of the
Statement of Shareholders’
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298 Part Two The Analysis of Financial Statements
Outstanding Options
Range of
Exercise Prices
Shares
Remaining
Life (Years)
Weighted-Average
Price
$ 0.56–$5.97
5.98–13.62
13.63–29.80
29.81–43.62
43.63–83.28
83.29–119.13
133
104
135
96
198
166
2.1
3.0
3.7
4.5
7.3
8.6
$ 4.57
10.89
14.99
32.08
63.19
89.91
The weighted average Black-Scholes value of options granted under the stock option plans
during 1998, 1999, and 2000 was $11.81, $20.90, and $36.67, respectively. Value was estimated using a weighted-average expected life of 5.3 years in 1998, 5.0 years in 1999, and
6.2 years in 2000, no dividends, volatility of .32 in 1998 and 1999 and .33 in 2000, and riskfree interest rates of 5.7%, 4.9%, and 6.2% in 1998, 1999, and 2000, respectively.
What information does this footnote give you about the off-balance-sheet knowledge
liability for the option overhang? Can you estimate the amount of the liability?
Real World Connection
Minicase M12.1 also deals with Microsoft, as do Exercises E1.6, E4.16, E10.10, and
E17.10.
M8.3
Losses from Put Options:
Household International
Household International is one of the largest U.S. lenders to consumers with poor credit
histories, carrying receivables for auto loans, Mastercard and Visa credit card debt, and a
significant amount of private noncredit card debt. In September 2002 Household issued
18.7 million shares, raising about $400 million. The issue, combined with a decision to sell
$7.5 billion of receivables and deposits, was cheered by analysts concerned about the subprime lender’s liquidity and credit rating. However, closer inspection revealed that Household International might have to use the cash raised for purposes other than bolstering its
reserves.
A footnote in Household’s 10-Q report for the third quarter ending September 30, 2002,
reported the following:
Forward Purchase Agreements
At September 30, 2002, we had agreements to purchase, on a forward basis, approximately
4.9 million shares of our common stock with a weighted-average forward price of $52.99 per
share. The agreements expire at various dates through August 2003. These agreements
may be settled physically or on a net basis either in shares of our common stock or in cash,
depending on the terms of the various agreements, at our option and consequently are
accounted for as permanent equity. Under the terms of the various agreements, expiration
dates accelerate if our stock price reaches certain triggers. Currently, these triggers vary
between the agreements and range between $12 and $16 per share. During the current
quarter, we received approximately 2.1 million shares at an average cost of $55.68 per share
as a result of settlements under these forward contracts.
Penman: Financial
Statement Analysis and
Security Valuation, Third
Edition
II. The Analysis of
Financial Statements
8. The Analysis of the
Statement of Shareholders’
Equity
© The McGraw−Hill
Companies, 2007
Chapter 8 The Analysis of the Statement of Shareholders’ Equity 299
Under a net share settlement, if the price of our common stock falls below the forward
price, we would be required to deliver common shares to the counterparty based upon the
difference between the forward price and the then current stock price. Conversely, if the price
of our common stock rises above the forward price, the counterparty would be required to
deliver to us shares of our common stock based on the price difference. Based upon the
closing price of our common stock of $28.31 at September 30, 2002, we would have been
required to deliver approximately 4.2 million shares of our common stock to net share settle
these contracts at September 30, 2002. If our common stock price had been $1 lower at
September 30, 2002, we would have been required to deliver an additional 332,500 common
shares to net share settle these contracts. If our common stock price had been higher by $1 at
September 30, 2002, we would have been required to deliver a total of 3.9 million shares of
our common stock to net share settle the contracts. These agreements, however, contain
limits on the number of shares to be delivered under a net share settlement, regardless of
the price of our common stock. At September 30, 2002, the maximum number of common
shares we would be required to deliver to net share settle the 4.9 million shares currently
outstanding was 29.8 million shares.
Since the beginning of 2001, Household had been both issuing and repurchasing shares.
The maximum per-share amount received for share issues was $21.72, while the average
amount per-share for repurchases was $53.88, contributing to its liquidity problems.
Discuss the information contained in the footnote. How does GAAP account for these
transactions? What alternative accounting would better reflect the effect on shareholder
value? Does it make a difference to your answers if the settlement is in cash or shares?