Chapter 09 - The Analysis of the Statement of Shareholders’ Equity
CHAPTER NINE
The Analysis of the Statement of Shareholders’ Equity
Stephen H. Penman
The web page for Chapter Nine runs under the following headings:
What this Chapter is Doing
Comprehensive Income Presentation under GAAP
The Equity Statement and Presentation of Comprehensive Income Under IFRS
Comprehensive Income Presentations from 2012 Onwards
Other Comprehensive Income and Tax Allocation
Noncontrolling Interest in Shareholders’ Equity?
Pensions in Other Comprehensive Income
Cisco Systems and Stock Options
A Firm Reporting Stock Option Compensation in the Income Statement
The Stampede to Report Stock Option Compensation Expense
The IASB and Stock Options
The FASB and Stock Options
Exercise Date Accounting for Employee Stock Options
An Odd Line in the Equity Statement
How Restricted Stock Works
Diluted Earnings per Share: Does it Deal With the Hidden Expense Problem?
Reformulation of VF Corporation’s Statement of Shareholders’ Equity
Reformulation of the Equity Statement: Electronic Data Systems (EDS)
The Equity Footnote
Put Option Contracts and Forward Purchase Agreements: FASB Statement 150
Appropriate Accounting for Contingent Claims on Equity Shares: A Comprehensive Solution
Convertible Securities: The Market Value Method and the Book Value Method
Accelerated Stock Repurchase Programs
The Payout Ratio and the Dividend Yield
History of the Dividend Payout Ratio
The Readers’ Corner
What this Chapter is Doing
The analysis in Chapter 9 has two purposes.
First, it ensures that the earnings that the analyst focuses on are comprehensive earnings.
Second, it ensures that the analyst distinguishes earnings (pertaining to the generation of value) from net dividends (the distribution of value).
The valuation models on Chapters 5 and 6 involve the forecasting of comprehensive earnings. If an analyst misses any component of earnings, value will be lost in her calculation. She must focus on comprehensive earnings. In doing that, she distinguishes the change in equity that is due to comprehensive income and the change that is due to net dividends. The stocks and flows equation, introduced in equation 2.4 in Chapter 2, guides the reformulation to do this.
The book devotes considerable space to this issue. If GAAP accounting for equity were good accounting, the reformulation would be straightforward. Unfortunately that is not so: GAAP fails to distinguish operating and financing components of share transactions, treating all transactions as simply financing transactions. So, for example, a share issue in exercise of employee stock options is treated as a transaction for raising cash for the business rather than payment for compensation netted into a financing transaction. Accordingly, the chapter cleans up the accounting. Read the section, The Eye of the Shareholder at the end of the chapter to get the appropriate perspective.
Comprehensive Income Presentation under GAAP
FASB Statement 130 governs the reporting of comprehensive income. Firms can report “Other Comprehensive Income” in three different ways:
- Within the Equity Statement
- As part of the Income Statement (an add-on to Net Income at the bottom on the statement)
- In a separate Comprehensive Income Statement between the Income Statement and the Equity Statement
Almost all firms choose the first option. A few report under the third option. As a case in point, look at VF Corporation, an apparel manufacturer (including Wrangler and Lee jeans and apparel under the brand names, Riders, Brittania, Rustler, and Timber Creek cotton casuals). Here is VF Corporation’s income statement for the year 2000:
VF CORPORATION
Income Statements
In thousands, except per share amounts December 30, 2000 December 30, 1999
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Net Sales $ 5,747,879 $ 5,551,616
Costs and Operating Expenses
Cost of products sold 3,842,451 3,657,120
Marketing, administrative and general expenses 1,352,024 1,230,009
Other operating expense, net 43,411 11,855
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5,237,886 4,898,984
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Operating Income 509,993 652,632
Other Income (Expense)
Interest income 7,684 8,936
Interest expense (88,716) (71,426)
Miscellaneous, net 2,572 5,434
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(78,460) (57,056)
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Income Before Income Taxes and Cumulative
Effect of Change in Accounting Policy 431,533 595,576
Income Taxes 164,417 229,334
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Income Before Cum Effect of Change in Accounting 267,116 366,242
Cum. Effect on Prior Years of Change in Accounting
for Revenue Recognition, Net of Income Taxes (6,782) --
Net Income $ 260,334 $ 366,242
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Following on for the Income Statement, VF reports a Comprehensive Income Statement:
Consolidated Statements of Comprehensive Income
In thousands Fiscal year ended December 30, 2000 January 1, 2000
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Net Income $ 260,334 $ 366,242
Other Comprehensive Income (Loss)
Foreign currency translation:
Amount arising during year (36,758) (60,180)
Less income tax effect 12,049 21,063
Reclassification to net income
from disposal of subsidiaries 2,030 --
Less income tax effect (711) --
Unrealized gains (losses) on marketable securities:
Amount arising during year (1,176) --
Less income tax effect 431 --
Reclassification to net income for losses realized 1,613 --
Less income tax effect (597) --
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Comprehensive Income $ 237,215 $ 327,125
The Equity Statement and Presentation of Comprehensive Income Under IFRS
Here is the income statement for Siemens, the large German electronics and engineering firm. Following the incomes statement Siemens reports a statement of comprehensive income that begins with net income then adds other comprehensive income to total to comprehensive income:
These two statements are then are posted to the equity statement:
This is a “two statement” presentation, with an income statement separate from a comprehensive income statement. Firms also have the option to combine the two into one statement of comprehensive income.
To view the full annual report for Siemens, go to
Comprehensive Income Presentations from 2012 Onwards
From 2012 onwards, firm in the U.S. will be required to adopt the IFRS presentation, with the choice of the tow-statement or one-statement format. Here is Google’s two-statement format for the first quarter of 2012:
Other Comprehensive Income and Tax Allocation
In reporting other comprehensive income, GAAP requires that amounts must be after tax. That is, taxes must be allocated from the income statement to this part of income. In most cases, the numbers are just reported net of tax. In VF Corporation’s Statement of Comprehensive Income above, the items are reported both gross and net of the taxes that apply to them.
Noncontrolling Interest in Shareholders’ Equity?
Up to 2008, minority interest (as it was then called) was reported above equity in the balance sheet on a line between liabilities and equity. This is the appropriate presentation from the common shareholders’ point of view. However both the FASB and IASB now require minority interests (noncontrolling interest) to be included in shareholders’ equity, as you see in the Siemens’ statement above. Clearly, noncontrolling interest – the equity of non-common shareholders in subsidiary firms – is not the equity of the common shareholders. This is frustrating for the equity analyst, invoking the procedures to deal with the problem in this chapter. Chapters 10 and 14 show how to handle minority interest in financial statement analysis and valuation of the common shareholder’s equity.
Pensions in Other Comprehensive Income
The FASB and IASB now require certain aspects of pension accounting (for defined benefit pension plans) to run through other comprehensive income (FASB Statement No. 158):
- Changes is the funding status of a pension plan due either to (a) unrealized gains and losses on pension assets above those recognized on the balance sheet and (b) revisions of actuarial assumptions for the measurement of the liability are placed in other comprehensive income
- Any recognition of prior service cost is placed in other comprehensive income and then amortized from there to the income statement
Prior service cost is added cost recognized for past service as a result of adoption of a new pension plan or amendment to an existing plan. It is strange to record this in equity: it is a deferred change that should be booked as an asset (like any other deferred charge) and amortized from there. One could take it out of equity and put it the balance sheet in reformulating the equity statement.
Cisco Systems and Stock Options
Some people argue that, because options are not a cash cost, they should not be seen as expenses. John Chambers, the CEO of Cisco, lead the fight against expensing stock options in the early 1990s with this and other arguments. But the argument ignores the point the accounting tracks value (via accruals), not cash. If the accruals are appropriate, they always have cash consequences:
According to a Financial Times report, in the ten years to 2012, Cisco paid out $72 billion on stock repurchases, buying back nearly 3.5 billion shares. But the shares outstanding count changed very little because Cisco also issued shares to employees in exercise of stock options and other stock compensation. It took in about $20 billion from these share issues (at less than market value). The timing of the share repurchases and shares issues were not, of course, precisely to the same date but you can see cash going out: If shares outstanding stays approximately the same, the number of shares issued was approximately the same as that issued, yet Cisco paid $72 billion for the repurchases but received only $20 billion for the shares issued. That is a cash loss of $52 billion. (This is somewhat overstated as the share count did fall somewhat.)
A Firm Reporting Stock Option Compensation in the Income Statement
Prior to 2002, only two US firms – Boeing (the aerospace firm) and Winn Dixie Stores – chose to report stock option compensation in their income statements. All other firms made the choice, permitted under FASB Statement No. 123, to report it in footnotes. FASB Statement 123R now requires income statement presentation (rather than footnote disclosure) for years beginning2006. In advance of this requirement, many firms started expensing options in 2004 using the grant-date accounting required by the FASB.
Boeing’s income statement for 2002 is below. Note the stock option expense (in bold). You will see many move income statements like this as firms adopt sock option expensing. The expense is, of course, the Statement 123 expense, that is, the value of the options granted at grant date, not the loss from exercise.
THE BOEING COMPANY
Income Statements
Dollars in millions) 2002 2001 2000
Year Ended December 31,
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Sales and other operating revenues $ 54,069 $ 58,198 $ 51,321
Cost of products and services 45,499 48,778 43,712
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8,570 9,420 7,609
Income/(loss) from operating investments, net (128) 93 64
General and administrative expense 2,534 2,389 2,335
Research and development expense 1,639 1,936 1,441
In-process research and development expense 557
Gain on dispositions, net 44 21 34
Share-based plans expense 447 378 316
Impact of September 11, 2001, charges/ (2) 935
(recoveries)
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Earnings from operations 3,868 3,896 3,058
Other income/(expense), net 42 318 386
Interest and debt expense (730) (650) (445)
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Earnings before income taxes 3,180 3,564 2,999
Income taxes 861 738 871
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Net earnings before cumulative effect of 2,319 2,826 2,128
accounting change
Cumulative effect of accounting change, net of (1,827) 1
tax
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Net earnings $ 492 $ 2,827 $ 2,128
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After Statement 123R, all companies must report stock compensation expense in the income statement, though it is rarely given a separate line item like here. And, of course, it is grant date expense, not the expense, not the (appropriate) expense from options being exercised.
The Stampede to Report Stock Option Compensation Expense
Following the bursting of the stock market bubble and the realization that many executives and employees got rich from options while shareholders lost, stock compensation accounting came in for much criticism. In response, many firms, beginning with Coca Cola (apparently under the influence of Warren Buffett, a Coke shareholder and board member), began to include the grant date expense in their income statements (as Boeing and Winn Dixie Stores had previously done). .
The IASB and Stock Options
In 2004, the International Accounting Standards Board (IASB) issued IFRS 2 that requires grant date accounting for stock options for firms using international accounting standards.
The FASB and Stock Options
In 2006, the FASB Statement No. 123R was issued (as an amendment to Statement 123) to require expensing grant-date options expense. The statement is similar to IFRS2. Prior to 123R, recording an expense in the income statement was voluntary, although firms had to disclose it in footnotes.
Go to Accounting Clinic IV to see how the FASB/IASB grant-date accounting works.
Exercise Date Accounting for Employee Stock Options
Chapter 9 explains that the grant date expense – measured by the value of the option at that date – is not the cost to shareholders. Rather, the loss is realized at exercise date. Indeed, if the option does not go into the money, it is not exercised, so grant date accounting incorrectly measures an expense.
Accounting Clinic IV, under Course-wide Content on the book’s web site, takes you through exercise date accounting. A key feature, of course, is the recognition of the loss at exercise date. Another feature is the recognition of a contingent liability at grant date that is then marked to market as the option goes into the money.
An Odd Line in the Equity Statement
Grant date accounting requires a firm to recognize the option value at grant date as deferred compensation, which is then amortized though to the income statement over a service period. The journal entry is:
Deferred Compensation Dr XXXX
Stock-based Compensation Cr XXXX
Stock-based Compensations is a credit to owners’ equity. This is indeed odd: the shareholders have an obligation to give up value to the option holders (upon exercise of the option), yet GAAP and IFRS treat this an increase in equity! Clearly it is not. It is a liability. Chapter 9 takes go to some pain to deal with this messy accounting problem.
How Restricted Stock Works
In recent years, firms have been moving away from stock option compensation to issuing restricted stock to employees. With stock subject to less volatility than an option, the employee is more certain of receiving the compensation. So, for example, if an option does not go into the money at vesting, the employee receives nothing with a stock option (she will not exercise), but will have some value in restricted stock. Restricted stock often vests progressively over a vesting period, so the employee does not have to wait until the end of the full vesting period to receive compensation.
Here is how restricted stock works:
The employee receives a stock grant but does not formally own the stock until the end of a vesting periodor, more often, gradually over the vesting period if part of the stock vests each year. (If the employee leaves the firm before vesting, he forfeits the remaining unvested stock.) As vesting the restriction is lifted, the employee pays tax for the remuneration, and can freely trade the stock. As a variation, an employee can opt to pay tax at grant date.
As to the firm, the amount of (deferred) compensation is the market price at the date of the grant of the restricted stock. That deferred compensation is then recognized in the income statement over the vesting period, usually according to the pattern under which the employee vests.
Diluted Earnings per Share: Does it Deal With the Hidden Expense Problem?
It is tempting to think that one can recognize hidden expenses (and the dilution from shares issues) by using diluted earnings per share; that is, capture the effect in the denominator rather than the numerator. This is not the case. Diluted eps divides earnings by shares outstanding as if all convertible securities were converted into common (as might happen in the future). So it divides earnings over both current and future shareholders. However, future shareholders share is future earnings, not current earnings. Further, the loss from the issue of shares at less than market price is incurred by the current shareholders – in selling an interest in the firm to others; it is not a loss to the future shareholders. One must recognize the loss to current shareholders (in basic eps) in selling the firm to new shareholders at less than market value.
Consider the following case: a firm reports a profit so that both basic and diluted eps are positive. However, should the hidden loss be (appropriately) recognized in the numerator, eps would be negative (a loss). Yet in this case diluted eps would be positive.
Diluted eps is an indicator of the possible effect of conversions to common shares on future eps, not a measure of the effect on the current shareholders.
Reformulation of VF Corporation’s Statement of Shareholders’ Equity
The exhibit below gives the 1998 statement of shareholders’ equity for VF Corporation. This statement was prepared before the FASB required identification of other comprehensive income within the equity statement. VF Corporation is an apparel manufacturer, most notably of Wrangler and Lee brand jeans. We will be analyzing VF’s statements in subsequent chapter web pages.
The GAAP statement in the exhibit is for common equity but the firm has redeemable preferred stock also. This company places the preferred stock in the balance sheet separately from the common equity, between liabilities and common shareholders’ equity. This is appropriate from the common owners’ perspective. Preferred dividends are (appropriately) in common owners’ equity, flagged 1 in the exhibit. And three other dirty-surplus items appear in the retained earnings column in addition to the currency translation adjustment in other comprehensive income: a $568 thousand tax benefit on preferred dividends paid to an employee stock ownership plan (ESOP) (flagged 3), a loss on redemption of preferred stocks of $2,763 thousand (flagged 4) and a charge of $37 thousand with respect to grants of common stocks to employees under a restricted stock plan (flagged 5). You notice that not all dirty-surplus items are included in “other comprehensive income” as defined by FASB Statement No. 130. The analyst has to dig deeper.
Preferred dividends are a (dirty-surplus) expense for the common shareholders. Preferred dividends are usually not tax deductible, but both common and preferred dividends are so when paid on shares owned by an ESOP. The tax benefit from preferred dividends is a reduction of the expense of paying preferred dividends -- and a reduction in the cost of remunerating employees -- and so a benefit to common shareholder.