Shareholders’ Equity Analysis

  1. INTRODUCTION

Shareholders’ equity refers to the residual claim on assets attributed to the company’s owners[1].  Equity represents capital directly invested in the company by owners plus retained earnings.  Certain gains, losses, and charges are recorded directly into owner’s equity.

Accounting for shareholders’ equity represents the view of the firm as the sum of the capital employed.  Lenders are considered “outside” providers of capital while owners are considered “inside” providers of capital.  This view of the firm influences the recognition of income under both U.S. GAAP and IFRS.  Particularly, income and expenses are only recognized when a transaction occurs with an “outsider”.  No income or loss is recognized from transactions between the firm and its owners.  For example, dividends and share buybacks are not recognized as transactions that effect income.  In contrast, interest payments are considered expenses, since they are transactions with outsiders.

  1. COMMON STOCK

Holders of a company’s common stock are the legal owners of the business and have a residual interest in the company’s earnings and assets.  The company’s articles of incorporation establish the maximum number of shares which the company may issue, referred to as authorized shares.  The company then raises capital by issuing a certain number of shares.  The company may later decide to repurchase some of its shares.  The outstanding shares are the number of shares issued by the company minus the number of shares which the company has repurchased.  The pro-rata ownership of the company by shareholders is based on the number of outstanding shares.

Contributed (paid-in) capital is the actual financing received from shareholders in return for shares in the company.  Stock issuance contains two components:  par value and additional paid-in capital.  Par value is the amount arbitrarily assigned to the stock by the corporate charter.  Par value is a legal concept with no economic or analytical significance.  Additional paid-in capital is the amount of proceeds in excess of the stated par value.

2.1.  Share Repurchases

Companies may repurchase outstanding shares for a variety of reasons. For example, a company which issues stock options to employees may repurchase shares to offset dilution[2].  A company may also repurchase shares as a means of “returning” excess cash to shareholders by increasing their proportional ownership or because management believes the stock is undervalued.

Shares that have been reacquired by a company are referred to as treasury stock.  The company accounts for repurchased shares as a reduction in shareholders’ equity, debiting treasury stock (a contra-equity account) and crediting cash.

A company can subsequently sell treasury stock.  When a company sells repurchased shares, the company will record the sale by debiting cash, and crediting treasury stock (at cost) and additional paid-in capital (for the difference between the proceeds and the cost).

A company may retire treasury shares when it no longer intends to reissue the shares.  When a company retires treasury stock, the company must reduce the par account by the par value of the shares retired.  Likewise, the company reduces additional paid-in capital in the amount of the “excess” purchase price (the difference between the purchase price and the par amount).

2.2.  Legality of Dividend Distributions

Dividends are distributions of cash, stock, or property to holders of the company’s common or preferred shares.  Dividends are regulated by state corporate law.  Most states follow a model legislation known as the 1984 Revised Model Business Corporation Act.  Regardless of the specifics, state laws regarding dividends are designed to protect creditors by ensuring that only solvent companies distribute dividends.

2.3.  Accounting for Stock Dividends

The accounting for stock dividends depends on whether a stock dividend is considered large or small.  A small stock dividend is a stock dividend equal to or less than 25% of the company’s outstanding shares.  For a small stock dividend, the company reduces retained earnings and increases the capital accounts (par and additional paid-in capital) for an amount equal to the market value of the shares issues.  A large stock dividend is a stock dividend in excess of 25% of the company’s outstanding shares.  The company records a large stock dividend by reducing retained earnings and increasing the par account.  Thus, small stock dividends are valued at market value and large stock dividends are valued at par value.

  1. PREFERRED STOCK

3.1.  General Features of Preferred Stock

Preferred stock is a class of stock which lacks the ownership features (such as voting rights) of common stock but which has priority over common stock in dividend distributions and in liquidation proceeds.  Preferred shares may be considered a fixed-income security rather than an ownership claim, in that the company pays dividends on preferred shares based on a fixed rate of par value.  Unlike typical debt securities, however, companies are not contractually obligated to pay dividends to preferred shareholders.  Some preferred dividends may be cumulative, meaning any dividends missed on the preferred shares must be paid before any dividends are paid to common stock holders.  However, noncumulative (straight) preferred shares do not entitle the holder to any missed preferred dividends.  Also, unlike interest paid on typical debt securities, preferred dividends are not a deductible expense for tax purposes.

Preferred stock may be participating or nonparticipating.  When preferred stock is participating, holders of the preferred stock can receive dividends above the declared dividend and thus “participate” in the company’s operating performance.  Holders of nonparticipating preferred stock, however, are entitled to receive only the stated dividend.

3.2.  Other Types of Preferred Stock

With mandatorily redeemable preferred stock the company is obligated to retire the preferred shares at a future date.  These instruments are accounted for as liabilities – they are shown on the long-term debt section of the balance sheet and the dividends are recorded as interest expense.

Some preferred shares may also have conversion or call features.  When preferred stock is convertible, the preferred holder can convert the preferred shares into common shares at a specified conversion ratio.  When preferred shares are callable, the issuing company can buy back the preferred shares at a call price which is specified when the shares are issued.

Another unique type of preferred stock is a trust preferred security.  With a trust preferred security, the company establishes a special purpose entity (SPE) for the purpose of selling redeemable preferred stock to outside investors.  The company then borrows the proceeds from the preferred stock from the SPE.  The arrangement allows the company to capture the tax benefits of debt, since the interest payments made to the SPE are tax deductible while preferred dividends are not.

  1. CONVERTIBLE SECURITIES

4.1.  General Characteristics

Convertible securities contain an embedded “option” to the holder to exchange the security for the underlying company’s common shares.  Convertible securities are generally bonds or preferred shares.

The conversion price is the price at which the security can be converted into common stock.  The conversion price at the time the security is issued is generally set much higher than the market price.  The conversion ratio is the number of shares into which each security can be converted.  The conversion ratio can be determined by dividing the par value of the convertible security by the stated conversion price.

Certain convertible securities are callable, meaning the issuer can redeem the securities for cash at a specified price before maturity.  However, since the cash value of redemption is generally less than the value of the common stock into which the security can be converted, most holders of the convertibles would rather convert than redeem.

Convertible securities offer a lower interest rate than comparable securities without the conversion feature.  The rate difference is the value of the conversion feature.

4.2.  Financial Reporting for Convertible Securities

Under current U.S. GAAP, convertible securities are recorded in the same manner as their non-convertible counterparts.  Thus, companies recognize no value to the conversion feature.

When the securities are converted into common equity, companies can use one of two methods: the book value method or the market value method.  Under the book value method, the company records the newly issued stock at the book value of the bonds or preferred stock retired through the conversion.  Under the market value method, the company records the newly issued shares at their current market value.  If the market price is greater than the conversion price, the company records the difference as a loss.  If the market price is less than the conversion price, the company records a gain.

4.3.  Convertible Debt with Cash Settlement

Under U.S. GAAP, companies are required to separately recognize the debt and equity components of convertible debt only in instances where the borrower has the right to receive cash in lieu of stock upon conversion.

The initial accounting for such securities requires the company to determine the debt component by discounting the security’s cash flows at a rate that reflects similar debt without the conversion feature.  The company will recognize the equity component of the security as the difference between the cash proceeds of the issue and the calculated debt component.  The company would recognize the debt component in long-term debt (and current liabilities for the portion due within the year) and recognize the equity in a special shareholders’ equity account.

The company would record interest expense for such securities based on the effective interest rate on comparable debt without the conversion feature.  The effective rate method will lead to interest expense which is higher than the cash payment.  The difference is recorded as in increase in the carrying value of the security.

At the time of conversion, the company will recognize the cash settlement by “bifurcating” (splitting into two components).  One component will be for the repurchase of the debt component of the convertible notes and the other component will be for the equity component.  The firm must measure the fair value of the debt by discounting the remaining cash flows of the instrument at the firm’s effective rate (on nonconvertible instruments) at the time of conversion.  If the fair value at conversion is greater than the carrying amount of the convertible security, the firm records a loss for the difference.  If the fair value at conversion is less than the carrying amount of the convertible security, the firm records a gain for the difference.  The equity component of the settlement amount is determined by subtracting the fair value of the debt component (at conversion) from the total settlement amount.  The difference between this settlement amount and the carrying amount of the equity component is accounted for as a decrease to additional paid-in capital.

  1. CAPITAL STRUCTURE AND EARNINGS PER SHARE

The term capital structure refers to the proportions of debt and equity which a company uses to finance its business.  Earnings per share (EPS) refers to the per-share profits accruing to each common share.  Earnings per share (also known as net income per share) is the only per-share amount reported in the company’s financial statements.

5.1.  Simple Capital Structure

A company has a simple capital structure when it has no outstanding securities which can potentially dilute the pro-rata ownership of existing shareholders.  When a company has a simple capital structure, EPS is calculated as:

EPS = (net income – preferred dividends) ÷ weighted average shares outstanding[3].

5.2.  Complex Capital Structure

A company has a complex capital structure when it has issued securities which can later be converted into common shares and thus dilute the ownership of current shareholders.  A company with a complex capital structure must adjust the number of shares to reflect the share dilution.  Dilution generally comes from convertibles securities, employee stock options, and warrants.

EPS which has been adjusted to reflect a potential increase in outstanding shares is referred to as diluted EPS.  The company will calculate diluted EPS by adjusting the numerator in the EPS equation to reflect the impact of instrument conversion on net income[4].  The company will also adjust the number of shares outstanding (denominator in the EPS equation) to reflect potential instrument conversion and potential share issuance from the exercise of stock option grants, net of proceeds received.  The company will make these adjustments using the “if-converted” method for convertible securities and the treasury stock method for employee stock options and warrants.

The if-converted method assumes that conversion of the convertible instruments occurs at the beginning of the reporting period.  This method also assumes that all outstanding convertible securities are converted.  The additional shares issued from assumed conversion are added to the outstanding shares in the EPS equation.

The treasury stock method is used to adjust the number of outstanding shares resulting for dilution from the potential exercise of employee stock options.  This method is also used to adjust outstanding shares for warrants, which are options that are issued to investors directly by the company[5].  This method assumes that any “in-the-money” options (where market price exceeds exercise price) will be exercised at the beginning of the reporting period.  When an employee exercises a stock option, she is purchasing shares from the company at the exercise (strike) price.  Thus, the company will receive proceeds from the exercise of stock options.  The treasury stock method assumes the company will use these proceeds to repurchase shares (at the average market price during the period) in the open market and thus partially offset the dilution.  The treasury stock method adjusts the number of shares outstanding by the difference between the number of shares issued to the option (or warrant) holders under the assumed conversion and the number of share assumed repurchased by the company.

5.3.  Analytical Considerations of Share-Dilution Calculations

The if-converted method tends to overestimate potential share dilution from convertible securities.  This is because the if-converted method assumes that all convertible securities are converted to common equity.  However, holders of convertible securities are likely to only convert when the stock price is above (or close to) the conversion price.

The treasury stock method, in contrast, tends to understate potential dilution.  The treasury stock method assumes an employee will only exercise a stock option when the exercise price is below the average share price for the period (the option is “in-the-money”).  However, exercise may also be likely when the exercise price is slightly above the stock price (i.e., when the option is slightly “out-of-the-money”).

  1. SHARE-BASED COMPENSATION

Recognition of option-based compensation as an expense is a relatively new requirement under U.S. GAAP[6].

6.1.  Accounting at the Time of Grant

The company records as an expense the value of the stock option awards as determined on the grant date (the date the options have been awarded to the employee) using conventional option pricing models, such as the Black-Scholes model or Binomial models.  The company recognizes as expense the value of the option grants on a straight-line basis over the vesting period (the time span between the grant date and the first available exercise date).  The specific entry is for the company to debit compensation expense and credit a special paid-in capital account.  The company would account for any modifications in the award terms by valuing the modifications separately and then recognizing the value ratably over the vesting period.

6.2.  Accounting for Option Exercise

At the time of exercise, the company recognizes the proceeds by debiting cash and the appropriate paid-in capital account (for the cost of the options) and crediting common stock – par and additional paid-in capital (for the sum of the proceeds and the and the option’s cost, minus the par value of the shares).

6.3.  Tax Considerations of Stock Options

Expense recognition of executive stock options awards for tax purposes differs from expense recognition under U.S. GAAP. Generally, firms can deduct the intrinsic value of the options (the share price minus the exercise price) in the year the option is exercised.

The executives receiving such awards must recognize the intrinsic value of the options received as ordinary income in the year the option is exercised.

6.4.  Accounting for Restricted Stock

Restricted stock refers to shares issued to employees as a form of compensation but which can only be sold after some specified period.  The period between the grant date of the stock and the time at which the stock can be sold is the vesting period.

At the time of grant, the company would credit shareholders’ equity (par, and additional paid-in capital) for the fair value at the grant date.  The fair value at the grant date is the stock price at the grant date times the number of shares granted.  The company would also record a corresponding debit to a contra-equity account called deferred compensation.  The initial net result on equity is thus zero.

The firm would recognize the expense on a straight-line basis over the vesting period.  The expense is thus the fair value at the grant date divided by the number of periods in the vesting period.  The firm records this expense by debiting compensation expense and crediting the contra-equity account deferred compensation.  By reducing the contra-equity account, the net impact of the restricted stock on shareholders’ equity is recognized ratably over the vesting period.

  1. IFRS

7.1.  General Presentation of Shareholders’ Equity

The presentation of shareholders’ equity under IFRS mostly mirrors that under U.S. GAAP.  However, there are several differences.

One notable difference is that companies reporting under IFRS standards often present shareholders’ equity before the liabilities section on the balance sheet.  Under U.S. GAAP, liabilities are always presented before the shareholders’ equity section.

Another notable difference is in the presentation of preferred shares.  Under U.S. GAAP, most preferred stock is shown in the shareholders’ equity section of the balance sheet.  However, IFRS has a broader definition of debt, which means that most preferred stock is shown on the balance sheet as a liability.

7.2.  Convertible Debt

Under IFRS, companies must recognize debt and equity components of convertible securities separately[7].  At issuance, firms reporting under IFRS would recognize the debt component as the present value of payments at the effective rate on similar, nonconvertible borrowing and record this component in convertible notes payable.  The firm would recognize the equity component as the difference between the proceeds of issuance and the fair value of the debt component and record this component as an increase in a shareholders’ equity account.

The firm would record the interest expense on the convertible security at the effective borrowing rate at issuance.  Since the effective rate does not reflect the value of the conversion feature and is likely to be higher than the actual rate on the convertible security, the recognized interest expense will be greater than the actual interest payment on the security.  The difference between the interest expense and payment is recognized as an increase in the security’s carrying value.

 

SOURCES

Revsine, Lawrence, Daniel W. Collins, W. Bruce Johnson, H. Fred Mittelstaedt, Leonard C. Soffer.  Financial Reporting & Analysis, 6th ed.  New York:  McGraw-Hill, 2015.

Robinson, Thomas R., Elaine Henry, Wendy L. Pirie, and Michael A. Broihahn.  International  Financial Statement Analysis, 3rd ed.  Hoboken: Wiley, 2015.

 

[1] FASB ASC 505

[2] Dilution is the reduction in each shareholder’s pro-rata ownership claim due to an increase in the number of outstanding shares.  An increase in issued shares due to the exercise of employee stock options is one source of dilution.

[3] Shares are “weighted” by the portion of the year for which a given number of shares were outstanding

[4] Specifically, the company will no longer pay interest or dividends on the conversion of convertible bonds or convertible preferred stock

[5] In contrast with listed options which are created by investors and do not involve the company

[6] Current requirements are found under FASB ASC Topic 718

[7] IAS 32

 

About the Author:

Matthew DePaola is a long-time practitioner of the deep value investing approach. He cofounded Tortuga Capital after having concluded that few institutional money managers follow a true value investing approach. Matthew has broad experience in business finance and asset valuation, and has engineered the leveraged purchase and recapitalization of several small businesses. Matthew has also spent several years as a financial analyst in the residential real estate development field. He earned his MBA from the University of Florida’s Hough Graduate School of Business and holds a BS in Finance from Florida Gulf Coast University.

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