CHAPTER 15

EQUITY

Introduction

Equity is risk capitalno guaranteed return

no repayment of the investment

The mix of debt and equity is called a company’s capital structure

Theories of Equity

Proprietary

Entity

Fund

Commander

Enterprise

Residual equity

Distinction between Debt and Equity

FASB financial instruments projectConcerns about how to classify financial instruments in financial statements:

1. Financial instruments that have characteristics of liabilities, but are reported as equity or between liabilities and equity

2. Financial instruments that have characteristics of equity, but are presented between liabilities and equity

3. Financial instruments that have characteristics of both liabilities and equity, but are classified either as liabilities or equity.

Distinction between Debt and Equity

SFAS No. 150. limited its scope to three classes of freestanding financial instruments that embody obligations for the issuer:

1. Manditorily redeemable preferred stock unless the redemption is required to occur only upon liquidation or termination of the issuer,

2. Obligations to repurchase the issuer’s equity shares by transferring assets, and

3. Certain obligations to issue a variable number of shares.

The Board determined that financial instruments that fall into all three classes should be classified as liabilities

Definition of Equity

SFAC = residual interest

Definition of equity rests on definition of assets and liabilities

Recording Equity

Forms of business organizationSole proprietorship

Partnership

Corporation

Most companies are sole proprietorships but the largest amount of business activity is carried out by corporations

Why?

Limited liability

Continuity

Investment liquidity

Variety of ownership interests

Components of the Capital Section of a Corporation

Paid-In Capital

Unrealized Capital

Earned Capital

Paid-in Capital

Common stock vs preferred stock

Features of preferred stockConversion

Call

Cumulative

Participating

Redemption

Paid-in Capital

Stock Options

When do you measure compensation in a compensatory

plan?

Compensatory

Noncompensatory

SFAS No. 123

Many accountants believe that the provisions of APB No. 25 result in understated financial statement valuesExposure draftSubsequently SFAS No 123 was issued

Recommends, but does not require fair value approach (Black-Scholes)

If APB Opinion No. 25 approach is used must show proforma net income and EPS effects

Stock Warrants

Types

Valuation

The equity-liability question

Other Stockholders’ Equity Issues

Stock dividends vs. stock splits

Treasury stock

Other comprehensive income

Quasi reorganizations

Financial Analysis of Stockholders’ Equity

Return on common shareholders’ equity (ROCSE)

reports on a company’s performance from the point of view of its common stockholders

Based on proprietary theory borrowing costs are considered expenses rather than a return on investment

Net income available to common shareholders

Average common stockholders’ equity

Financial Analysis of Stockholders’ Equity

Common stock earnings leverage ratio (CSELR) proportion of net operating profit after taxes that belongs to the common stockholders

Net income available to common stockholdersNet operating profit after taxes

Financial structure ratio (FSR) proportion of the company’s assets that are being financed by the stockholders

Average assets Average common stockholders’ equity

International Accounting Standards

“Framework for the Preparation of Financial Statements” indicated a preference for the proprietary theory.

Also indicated that equity may be sub classified into:

Contributed capital

Retained earnings

Capital maintenance adjustments

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Prepared by Richard Schroeder, DBAKathryn Yarbrough, MBA