Chapter 8

The Analysis of the

Statement of
Shareholders’Equity
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

How is the How is dirty- What is hidden

This chapter reformulates the
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.

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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
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)

 The Governing Accounting
Relation

Book value, beginning of period

+ Comprehensive income

- Net payout to shareholders

= Book value, end of period

Reformulated Statement of
Stockholders’ Equity
Opening book value of common equity (CSEt-1)

+ Net transactions with common shareholders

+ Capital contributions (share issues)
- Share repurchases

- Common dividends

+ Comprehensive Income to common shareholders

+ Net income
+ Other comprehensive income

- Preferred dividends

Closing book value of common equity (CSEt)

Note that preferred equity is taken out of the common

shareholders' equity statement (and treated as a
liability).
Reformulation: The Steps

1. Restate beginning and ending balances for

items incorrectly included in or excluded from
common equity
• Preferred stock
• Dividends payable
• Unearned (deferred) compensation

2. Calculate net transactions with shareholders

Cash dividends + share repurchases – share issues

3. Calculate comprehensive income

Net income + Other comprehensive income –

Preferred dividends
The GAAP Statement:
Nike Inc., 2004
Nike: The Reformulated
Statement

Balance, May 31, 2003 $4,028.2

Transaction with Shareholders

Stock issues 308.1

Stock repurchases (416.3)
Common dividends (179.2) (287.4)

Comprehensive Income

Net income reported 945.6

Currency translation gains 27.5
Gains on hedge derivatives 125.9 1099.0

Balance, May 31, 2004 4,839.8

Balances: 2003 2004

Reported $3,990.7 $4,781.7

Dividends payable 36.9 52.6
Unearned compensation 0.6 5.5
Restated balance 4,028.2 4,839.8
The GAAP Statement: Reebok
International Ltd., 2004
Reebok: Reformulated
Statement

Balance, December 31, 2003 $1,034.9

Transaction with Shareholders

Stock issues $62.3

Stock repurchases (88.1)
Common dividends (17.8) (43.6)

Comprehensive income

Net income reported 192.4

Currency translation gains 37.7
Gains on hedge derivatives 4.4 234.5

Balance, December 31, 2004 1,225.8

Balances:
2003 2004
Reported 1,033.7 1,220.0
Unearned compensation 1.2 5.8
Restated balance 1,034.9 1,225.8
Dirty Surplus Accounting in
the US
Operating Income:
• Some income-increasing accounting changes (APB No. 20)
a. change from LIFO valuation of inventory
b. change in long-term contract accounting
c. change to or from full cost accounting in extractive industries
d. a change triggered by a red line in an accounting standard
(e.g. change from cost to equity method for long-term equities)
e. a change made for the first time in conjunction with a IPO
or business combination
• Changes in accounting for contingencies (FASB No. 11)
• Foreign currency transaction gains and losses (FASB No. 52)
• Minimum pension liability adjustment (FASB No. 87)
• Some write-downs of deferred tax valuation allowances (FASB No. 109)
• Tax benefits of loss carry forwards acquired (FASB No. 109)
• Tax benefits of preferred dividends paid to ESOPS (FASB No. 109)
• Unrealized gains and losses on equity securities available for sale (FASB No. 115)

Financing Income or Expenses:

• Preferred Dividends
• Unrealized gains and losses on debt securities available for sale (FASB No. 115)

Operating or Financing Income Items:

• Foreign currency translation gains and losses (FASB No. 52)
• Gains and losses on derivative instruments designated (FASB No. 133)
as cash flow hedges

Balance Sheet Items to be Reclassified:

• Deferred compensation relating to grant of (APB No. 25 and FASB No. 123)
employee stock options and stock
• Dividends payable
• Preferred stock
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

Ratio Analysis

Payout and Retention Ratios

Dividends
Dividend Payout 
Comprehens ive Income

Dividends Stock Repurchase s

Total Payout Ratio 
Comprehens ive Income

Dividends
Dividends - to - Book Value 
BookValueo fCSE  Dividends  Stock Re purchases

Dividends  Stock Re purchses

Total Payout - to - Book Value 
BookValueo fCSE  Dividends  Stock Re purchases

Comprehens ive Income - Dividends

Retention Ratio 
Comprehens ive Income
 1 Dividend Payout Ratio
Ratio Analysis (continued)
Shareholder Profitability Ratio
Comprehens ive Earnings
ROCE t  t
1 CSE t  CSE t 1 
2

Growth Ratios

Transactions with shareholders

Net Investment Rate 
Beginning Book Value of CSE

Change in CSE
Growth Rate of CSE 
Beginning CSE
Comprehensive Income  Net Transactions with Shareholders

Beginning CSE
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
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.

Measuring the Loss from Exercise of
Stock Options: Method 1 (Reebok)

Expense is implied from the tax benefit:

Stock option expense $11,477/0.359 $31,969

Tax benefit at 35.9% (11,477)

Stock option expense, after tax $20,492

Measuring The Loss from Exercise of
Stock Options: Method 2 (Reebok)

Calculate difference between average stock price and

exercise price:

Estimate market value of shares issued 1,751 x $38.00 $66,538

Exercise (issue) price, from equity statement 41,080

Stock option expense, before tax 25,458

Tax benefit at 35.9% 9,139

Stock option expense, after tax $16,319

Use when tax benefit is not reported, or for incentive

options (where there is no tax benefit).
Reebok: Reformulated
Statement
Balance, December 31, 2003 $1,034.9

Transaction with
Shareholders

Stock issues (62.3 + 20.5) $82.8

Stock repurchases (88.1)
Common dividends (17.8) (23.1)

Comprehensive income

Net income reported 192.4

Currency translation gains 37.7
Gains on hedge derivatives 4.4
Loss on employee options (20.5) 214.0

Balance, December 31, 2004 1,225.8

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.
Hidden Losses on Put
Options: Dell Computer
From the 2002 equity statement (see Chapter 2):
Shares Amount

Repurchase of common shares (millions) 68 $3,000

The Loss:
Market price of shares repurchased $24 x 68 million $1,632 million

Amount paid for shares repurchased 3,000

Loss on exercise of put options $1,368 million

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

Dell Computer Corporation

Reformulated Statement of Shareholders’ Equity

Balance, February 2, 2001 $5,696

Transactions with shareholders:

Shares issued in stock option exercises

(at market) $1,747
Shares repurchased (at market) (1,632) 115

Comprehensive income

Comprehensive income reported 1,222

Loss on exercise of employee stock options $1,391
Tax benefit for employee stock options 487 (904)
Loss on put options (1,368) (1,050)

Other (3)

Balance, February 1, 2002 $4,758

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.