1. The Analysis of the Statement of Shareholders’Equity
Chapter 8
The Analysis of the Statement of Shareholders’Equity

2. The Analysis of the Statement of Shareholders’ Equity
Link to Previous Chapter
Chapter 7 gave a design for
financial statements that
readies them for analysis.
This Chapter
This chapter reformulates the
How is the
How is dirty -
What is hidden
statement of
surplus income
dirty -
surplus
statement of owners’ equity
owners’ equity
treated in the
income ?
according to the design in
reformulated
reformulation ?
Chapter 7. The reformulation
to highlight the
highlights comprehensive
information it
income.
contains ?
Link to Next Chapter
Chapters 9 continues the
reformulation with the balance
sheet and the income
statement.
For more applications,
visit the website
Link to Web Page

3. What you will learn from this Chapter
How GAAP statements of shareholders' equity
are typically laid out
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 hidden expenses
How management can create (or lose) value for
shareholders with share transactions

4. GAAP Statement of Shareholders’ Equity
Opening book value of equity (common and preferred)
+ Net share transactions with common stockholders
+ Capital contributions (paid in capital from share issues)
- Share repurchases (into treasury stock or against paid-in capital)
+ Net share transactions with preferred shareholders
+ Capital contributions (share issues)
- Share redemptions
+ Change in retained earnings
+ Net income
- Common dividends
- Preferred dividends
+ Accumulated other comprehensive income
+ Change in unearned (deferred) stock compensation
Closing book value (common and preferred)

5. The Governing Accounting Relation
Book value, beginning of period
+ Comprehensive income
- Net payout to shareholders
= Book value, end of period

6. Reformulated Statement of Stockholders’ Equity

7. Reformulation: The Steps
Restate beginning and ending balances for items incorrectly included in or excluded from common equity
Preferred stock
Dividends payable
Unearned (deferred) compensation
Calculate net transactions with shareholders
Cash dividends + share repurchases – share issues
Calculate comprehensive income
Net income + Other comprehensive income –
Preferred dividends

8. The GAAP Statement: Nike Inc., 2004

9. Nike: The Reformulated Statement
Balances:
Reported $3, $4,781.7
Dividends payable
Unearned compensation
Restated balance 4, ,839.8

10. The GAAP Statement: Reebok International Ltd., 2004

11. Reebok: Reformulated Statement
Balances:
Reported 1, ,220.0
Unearned compensation
Restated balance 1, ,225.8

12. Dirty Surplus Accounting in the US

13. Most firms choose the last alternative
FASB Statement No. 130
Requires the reporting of comprehensive income
in one of three ways
Within the income statement
In separate statement
Within the equity statement
Most firms choose the last alternative

14. Ratio Analysis
Payout and Retention Ratios

15. Ratio Analysis (continued)
Shareholder Profitability Ratio
Growth Ratios

16. Hidden Dirty Surplus
Shareholders lose when shares are issued at less than the market price (e.g. exercise of options)
This loss, however, is not recorded as expense.
What is the nature of this loss? If options are part of a compensation package, this loss is an employee compensation expense. If from a conversion of a bond, preferred stock or warrants, the loss is a financing expense.
What is the amount of the loss? Market price - exercise price.
Special case: options granted in the money are recorded as deferred compensation

17. FASB Statement No. 123R
Statement 123R requires an expense to be recognized at option grant date, equal to the value of the option at that date
Up to 2006, pro forma net income, including the expense, was reported in footnotes. The expense must now be reported in the income statement.
No further expense recorded as the option moves into the money or at exercise date.
Firms record a tax benefit (for non-qualified options) at exercise date, and credit this to shareholders’ equity.
IFRS2 has a similar requirement.

18. Measuring the Loss from Exercise of Stock Options: Method 1 (Reebok)
Expense is implied from the tax benefit:

19. Measuring The Loss from Exercise of Stock Options: Method 2 (Reebok)
Calculate difference between average stock price and exercise price:
Use when tax benefit is not reported, or for incentive options (where there is no tax benefit).

20. Reebok: Reformulated Statement
Shares are issued at market value, and the difference between the market value and after-tax receipts from the shares issued is a loss from exercise of options.

21. Hidden Losses on Put Options: Dell Computer
From the 2002 equity statement (see Chapter 2):
The Loss:

22. The GAAP Statement of Shareholders’ Equity: Dell Computer, 2002

23. Dell: Reformulated Statement
Dell Computer Corporation
Reformulated Statement of Shareholders’ Equity
Balance, February 2, $5,696
Transactions with shareholders:
Shares issued in stock option exercises
(at market) $1,747
Shares repurchased (at market) (1,632)
Comprehensive income
Comprehensive income reported ,222
Loss on exercise of employee stock options $1,391
Tax benefit for employee stock options (904)
Loss on put options (1,368) (1,050)
Other (3)
Balance, February 1, $4,758

24. Losses on Convertible Securities
Loss = Market price of common issued -
Book value of convertible surrendered
The market value method vs. the book value
method
- The market value method recognizes losses on
conversion
- The book value method records the shares at
the book value of the convertible securities,
with no loss recognized
Almost all firms use the book value method.