Chapter 8 The Analysis of !

he Sr£ltemem ofShareholders' Equity 257

After reading this chapter you should understand: After reading this chapter you should be able to:
How statements of shareholders' equity are typically Reformulate a statement ofshareholders' equity.
laid out. Distinguish the creation of value from the distribution
Why reformulation ofthestatement isnecessary. ofvalue intheequity statement.
What is reported in "other comprehensive income" Calculate the netpayout to shareholders.
andwhere it is reported. Calculate comprehensive income and comprehensive
What "dirty·surplus" items appear inthe statement of ROCE from theequity statement.
shareholders' equity. Calculate payout andretention ratios.
LINKS How stock options work to compensate employees. Calculate a growth rate for common shareholders'
I Link to previouschapter
Chapter 7 laidouta design
, Equity How stock options and other contingent equity claims
result ina hidden expense.
equity and analyze its components.
Calculate the expense from exercise of stock options.
forfinancial statements
How management can create value (and losses) for Calculate gains andlosses from putoptions.
thatprepares them for shareholders with share transactions. Calculate losses from the conversion of securities into
analysis. How accounting hides losses from share transactions. common stock.

This chapter
and IFRS accounting sometimes confuses the financing and operating aspects of these
Thischapterreformulates
thestatement of owners' transactions; thatis,itconfuses themoneys raisedforfinancing withtheexpenses incurred in
equityaccording to the Whatis hidden operations. The analysis of the statement of shareholders' equitysorts out this accounting.
design inChapter 7. The dirty-surplus
reformulation highlights income?
comprehensive income. REFORMULATING THE STATEMENT OF OWNERS' EQUITY
The statement of owners'equityprovides the reconciliation of beginning andendingown-
ers' equityaccording to thestocksandflows equation introduced in Chapter 2: The change
Link to next chapter
in owners'equityis explained by comprehensive income for the periodplus capital contri-
Chapter 9 continues the butions from share issues, lessdividends paid in cash and stockrepurchases. The GAAP
reformulation withthe The statement of shareholders' equityis usually notconsidered the mostimportant part of
statement isoften-and unnecessarily-more complicated thanthis,however, so partof the
balance sheetandthe the financial statements and is oftenignoredin analysis. However, it is the first statement
income statement. analysis involves simplifying it. The idealstatement for a fiscal periodhas the following
that the analyst shouldexamine beforegoingon to the other statements. It is a summary
form:
statement, tyingtogether all transactions that affectshareholders' equity. By analyzing the
statement, the analystensures that all aspects of the business thataffectshareholders' eq-
uityare included in his analysis to value the equity. Reformulated Statement of Common Shareholders' Equity
Link to Webpage
Wesaw in Part One of the book that whenaccounting income is used in valuation, it Beginning bookvalue ofcommon equity
Formoreapplications of must be comprehensive income. Otherwise valueis lostin the calculation. The accounting + Net effect oftransactions with common shareholders
Chapter 8 content, visit + Capital contributions (share issues)
thetext's Websiteat relations in the last chapterholdonlyif income is comprehensive. We will use theserela-
www.mhhe.coml tionsas analysis tools in laterchapters, butthe toolswill workonlyif income is on a com- - Share repurchases
penmance. - Dividends
prehensive basis. Unfortunately, earnings reported in most income statements in most Net cash contribution (negative netdividends)
countries is not comprehensive, including earnings reported in statements prepared under
+Effect ofoperations and nonequity financing
U.S. GAAP and international accounting standards. The analysis of thestatement of share- + Net income (from income statement)
holders'equity makesthe correction. + Other comprehensive income
Value is generated for equityholders through operations, not byequityfinancing activi- - Preferred dividends
ties.Wesaw in Cbapter 3 that share issuesand repurchases at marketvaluedo not create _ Comprehensive income available tocommon
value in efficient capitalmarkets. But share issues are sometimes made in exchange for Closing bookvalue ofcommon equity
goodsandservices inoperations, mostly foremployee compensation. Unfortunately, GAAP
258 P?rt Two The Analysis ofFinancial Statement!
Notice threethings aboutthisstatement:
1. With a view to valuing the common shareholders' equity, the reformulated statement
excludes preferred equity. Fromthecommon shareholders' pointof view, thepreferred
equityis an obligation to pay otherclaimants beforethemselves, and it is treated as a
liability. So the beginning and ending balances refer only to common shareholders'
equity.
2. The net addition to common equityfrom transactions withshareholders-the negative
net dividend-is separated from the addition to shareholders' equity that arisesfrom
business activities.
3. The total effectof operations and nonequity financing on the common shareholders is
isolated in comprehensive income. This has three components: net income reported in
the income statement, othercomprehensive income reported outside the income state-
ment, and preferred dividends. As preferred stockis effectively debtfromthe common
shareholders' viewpoint, preferred dividends are an "expense" in calculating compre-
hensive income, just likeinterest expense.
Introducing Nike
The analysis of financial statements in thisand subsequent chapters will be demonstrated
with the 2008statements of Nike,Inc.,the sport and leisure footware company. You will
findit helpful to see a complete analysis of this firm. The BuildYour OwnAnalysis Prod-
uct (BYOAP) feature on thebook's Web site,introduced at the endofthelastchapter, takes
the Nike analysis backto earlier years. Aftercovering the material in the bookandin that
Web module, you will have a complete analysis history for Nike for a 10-year period,
1999-2008. Take the Nile analysis in thebookandin BYOAP as a model for theanalysis
of anyfum, andusethe roadmap in BYOAP to develop spreadsheets thatdeliver a concrete
analysis andvaluation product. You canviewNike'sfull2008financial statements in Mini-
caseM2.1 in Chapter 2.
Weemphasized in Chapter1 thatthefirststepin analysis and valuation is "knowing the
business." Nikeis no doubtfamiliar to you: Its logois visible on theclothes andshoes that
manyof us wear, from the greatest sports stars to the smallest of kid pretenders. Box 8.1
gives somefurtherbackground on the company; however, in practice a muchdeeper un-
derstanding of a firm is required tocarryouta capable analysis. Fora start,checktheBusi-
nessSection(Item I) of the firms IO~K reporton EDGAR.
Reformulation Procedures
Exhibit 8.1 presents the GAAP statement of shareholders' equity forNike,alongwith re-
formulated statements in the form of thetemplate on theprevious page.Flagsto the right
of the GAAP statement indicate whichitems are transactions with shareholders (f) and
whicharecomponents of comprehensive income (Cl).
Reformulation follows threesteps.
1. Restate beginning andending balances for theperiodfor items thatare notpart of com-
monshareholders' equity:
a. Preferred Stock: Preferred stock is included in shareholders' equity in the GAAP
statement, but it is a liability for the common shareholders. So reduce the balances
by the amount of preferred stock in thosebalances (and ignore any preferred stock
transactions during the period in the reformulation). An exception is mandatory
redeemablepreferred stock which, underGAAP, is notpart of equitybut ratheris
Incorporated in1968, Nike (www.nike.com)isaleadingman- The market for footwear ishighly competitive, with Puma
ufacturer and marketer ofsport and fashion footwear. The firm and Adidas being major competitors. Changes inconsumer
is headquartered inBeaverton, Oregon. preferences, changes in technology, and competition areseen
asthemain risk factors.
STRATEGY
Nike aims to dominate the worldwide market for athletic EQUITY FINANCING
footwear and athletic footwear used for casual and leisure Two cesses ofcommon shares have equal shares in profits. A
dress. It attempts to accomplish this through extensive pro- total of491.1 million shares were outstanding at theendof
motion, often using high-profile sports figures and endorse- fiscal 2008. Nike has a continuing stock repurchase program
ments ofsporting events. and pays dividends. Asmall number of redeemable preferred
shares areheld byanAsian supplier.
OPERATIONS The company has an active stock compensation plan for
Nike's top-se'linc footwear are basketball, training, running, employees. In fiscal 2008, options on6.9million shares were
and children's shoes, but it also sells tennis, soccer, golf, granted and options on9.1 million shares were exercised at a
baseball, football, bicycling, and other footwear, as wei! as weighted-average exercise price of$33.45 pershare.
apparel, brand-name sports equipment, and accessories. It
sells its products through retail outlets in the United States SUMMARY DATA
and around theworld and through independent distributors
and licensees. About 43 percent of Nike's sales in 2008 were 2008 2007 2006
intheUnited States. Basic earning, per share $ 3.80 $ 2.96 $ 2.69
The firm maintains an active research and development Diluted earnings per share 3.74 2.93 2.64
effort to improve itsproducts. Most ofits manufacturing facil- Dividends per share 0.88 0.71 0.59
ities areoutside theUnited States, inAsia andSouth America. Book value per share 15.93 14.00 i2.2B
Ithas approximately 32,500 employees, butmuch oftheman- Price per share, end ofyear 57.20 55.60 40.00
ufacturing is through independent contractors.
reported on thebalance sheet in a "mezzanine" between liabilities andequity. Nike's
preferred stockis redeemable, so noadjustment is required.
b. Dividends Payable. GAAP requires dividends payable to common shareholders to be
reported asa liability. Butshareholders cannot owe dividends to themselves. Anddiv-
idends payable do notprovide debtfinancing. Common dividends payable arepart of
theequitythatthecommon shareholders have inthefirm. Soinstead ofreporting them
as liabilities, reclassify themto thebalances of shareholders' equity, as explained in
thenotesto Nike's reformulated statement in Exhibit 8.1.
c. Under FASB Statement 123R, applied forthe first time in 2007, and under thesimi-
lar international accounting standard, IFRS 2, firms mustbookthe grant-date value
of stock options granted to employees as deferred compensation, with the cone-
spending creditgoing to shareholders' equity ($141 million in Nike's 2008 state-
ment). While the option grantis indeed compensation to theemployee. the creditto
shareholders' equityis clearly wrong: It looks as if an expense increased sharehold-
ers' equity in the firm. Rather, stockoptions are (contingent) liabilities to theshare-
holders: The shareholders are liable to loseequity-not add to theirequity-if the
options go intothe money and employees are issued shares, on exercise of the op-
tions, at lessthan market price.Wewillaccommodate this"bad"accounting later in
thischapter, butforthemoment taketheoffending $141 million out ofthestatement
and adjustthe closing balance of shareholders' equityaccordingly. See the note to
Nike's reformulated statement.
259
260 PartTwo TheATlIJ1)'s.is of Financial S=entl Chapter 8 The Analysis 0/tile StatemC7\t ofShareholden' Eqllir) 251

Reformulated Statement of Common Equity

EXHIBIT 8.1 GAAPStatementand Reformulated Statement of Common Shareholders'Equity for Nike,Inc"
May31,2008 Balanceat May31, 2007 $7,118.3
Thereformulated statement separates transactions withshareholders from comprehensive income. Theflags on therightof the Transactionswith shareholders
GAAP statementindicate transactions withshareholders (T) andcomprehensive income (Cl). Stockissued for stockoptions $372.2
Stock issued to employees (net) 35.8
NIKE,!NC. Stockrepurchased 0,248.0)
Cash dividends (412.8) (1,252.8)
GAAP Statement of Shareholders' Equity
(inmillions, except pershare data) Comprehensive income
Netincome reported 1,883.4
CommonStock Accumulated Nettranslation gainsand losses 165.6
Capital in
Other Net hedging gainsand losses (91.6)
ClassA ClassB Comprehensive Retained
Excess of Prior earnings restatements (25.7) 1,931.8
Shares Amount Shares Amount Stated Value Income(Loss) Earnings Total Balanceat May31, 2008 7,797.3
Balanceat May31, 2007 117.5 $0.1 384.1 S2.7 $1,960.0 $177.4 $4,885.2 $7,025.4
Note: Thebeginning b~\anec in therefOlmol,te<l Sl,temenl isc:I!""I,te<l :IS follows:
Stock options exercised 9.1 372.2 372.2 m Repol1e<lo,J,,,,,::e 57,025.4
Dividends p:ty:lbie ----'ll1.
Conversion to Class Bcommon 57.1183
stock (20.8) 20.8 Theendiogbalance iSC<llcul,ted as follows:
Reported b:lI= S7.825.4
Repurchase of Class Bcommon Dividend~ p;ly.lble 112.9
stock (20.5) (12.3) (1,235.7) (l,248.0){T) Siod-b.,.,d com~eM'ltion (141.0)
$7,797.3
Dividends on common stock
($0.875per share) (432.8) (432.8) (T)

Issuance of sharesto employees 1.0 39.2 39.2 {T}

Stock-based compensation: 2. Calculate net transactions with shareholders (the net dividend). This calculation nets
(Notes 1 and 10): 141.0 141.0 dividends andstockrepurchases againstcashfromshareissues, as in the exhibits. Div-
Forfeiture of sharesfromemployees (O.l) (2.3) (1.1) (3.4)(T) idends must be cash dividends (calculated as follows), and not dividends declared as
Comprehensive income (Note 13): dividends payable:
Netincome 1,883.4 1.883.4(0)
Othercomprehensive income:
Cashdividends = Dividends reported + Change in dividends payable
Foreign currency translation and With dividends payable of $92.9 million and $112.9 million at the end of 2007 and
other (net of taxexpenseof
$101.5) 211.9 211.9(0) 2008,respectively, Nike'scashdividends paid are $432.8 + 92.9 ~ 112.9 = $412.8 mil-
Realized foreign currency lion,which is the number for cashdividends in the cashflow statement.
translation gaindue to 3. Calculate comprehensive income. Comprehensive income combines net income and
divestiture (Note 15) (45.3) (45.3)(CI)
otherincome reported in the equitystatement. Besides net income, the GAAP statement
Netlosson cashflowhedges
(net of tax benefitof $67.7) (175.8) (175.S) (CI) for Nikereportscurrencytranslation gains and lossesand gainsand losseson hedging
Netlosson net investment instruments, You cansee in the GAAP statementthata totalis drawn forcomprehensive
hedges(net of tax benefit income aftertheseitems.But comprehensive income also includes the twoitemsunder
of $25.1) (43.5) (43.5)(CI) thistotalfor the adjustments to prioryears' income forchanges in accounting methods:
Redassifkaticn to net income of Theseare changes to shareholders' equityfrom (measuring) business income. The in-
previously deferred losses come reported outside net income is referred to as other comprehensive income, so
relatedto hedgederivatives
(net of tax benefitof $49.5) 127.7 127.7(CI) comprehensive income is net income plus other comprehensive income. Note that all
items in othercomprehensive income are after tax.That is, theyare reported net of any
Comprehensive income 74.0 1,883.4 1,957.4
tax thattheydraw.
Adoption of FIN 48 (Notes 1 and 8) (15.6) (15.6)(O)
Adoption of E1TF 06·2 Sabbaticals
You willnotice in this reformulation that we have not made any use of the distinction
(net of tax benefitof $6.2) between statedvalue(orpar value) of shares andadditional (orexcess) paid-incapital. This
(Note1) (10.1) (10.1)(0) is of no importance for equityanalysis; better to know the company's telephone number
Balanceat May 31. 2008 96.8 $0.1 394.3 $2.7 $2,497.8 $251.4 $5,073.3 $7,825.3 thantheparvalueof its stock.Retained earnings is a mixture ofaccumulated earnings, div-
idends, sharerepurchases, and stockdividends, and it doesnot bear on the analysis. Con-
Note: Footr.o:es 10the IO·K indicMe Nikeh:>d S112.9:nillionindividends P"Y"ble ,t the endof2008 :u>d $92.9mimon,t Ibeeodof2007. versions of one class of common to anotherwith zeroeffect do notchangethe bookvalue
of equity (as with Nike). Nor do stock splits or stockdividends change the bookvalueof
equity; splitschangethe number of sharesbut do not change a given shareholder's claim.
262 Part Two The AMJ)'sis ofFinancial Statements
DIRTY-SURPLUS ACCOUNTING
Reporting income itemsas part of equityratherthan in an income statement is known as
dirty-surplus accounting. An equity statement that has no income otherthan net income
from theincome statement is a clean-surplusaccountingstatement. Thetermsarepejora-
tive, and appropriately so. Under dirty-surplus accounting, the income in the income
statement is not "clean:' it is not complete. "Net" income or profit, as usedunder GAAP
andinternational accounting standards, is really a misnomer.
Table g.j Iists the dirty-surplus items youarelikely toseein theUnited States. Income
items are designated as part of operating income or financial income (expense) to catego-
rizethemina reformulated income statement (later). Some oftheitemsyouwillrarelysee.
The three most Common are unrealized gains and losses on securities, foreign currency
translation gainsand losses, and unrealized gainsandlosses on certainderivatives.
I. Unrealized gains and losses On securities available for sale. FASB Statement No. 115
distinguishes threetypes of securities:
• Trading securities
• Securities available for sale
• Securities heldto maturity
Trading securitiesare thoseheld in a portfolio that is actively traded. Thesesecurities
are marked to marketvalue in the balance sheet and the unrealized gains and losses
from changes in marketvalueare reported in the income statement. Securities that are
not actively traded but which might be sold before maturity are available for sale.
These also are marked to "fair" marketvaluebut the unrealized gainsand losses are
reported as part of othercomprehensive income. Securities that management intends
to hold to maturity are recorded at cost on the balancesheet, so no unrealized gains
and losses are reported. Realized gains and losses on all types of securities are
reportedin the income statement as part of net income. The rules applyto both debt
securities and equitysecurities involving less than20 percent ownership interest. Go
to Accounting ClinicIII.
2. Foreign currency translation gains and losses. The assets and liabilities of majority-
owned foreign subsidiaries, measured in theforeign currency, mustbeconsolidated into
the statements of a U.S. parent in U.S. collars. If theexchange ratechanges overthere-
portingperiod, the value of theassetsandliabilities changes in u.s. dollars. Theresult-
inggainor lossis a translation gainor loss, to bedistinguished from gains andlosseson
foreign currency transactions. Mosttransaction gainsandlossesare reported as part of
net income. Translation gains and losses are part of other comprehensive income.
Translation gains and lossescan applyto both theoperating and financing assetsand
liabilities of subsidiaries, so their income can affect operating or financing income as
indicated in Table 8.1.
3. Gains and losses on derivative instruments. FASB Statement No. 133requires most
derivatives to be marked to fair valueon the balance sheet, eitheras assetsor liabili-
ties. If the instrument hedgesan existing assetorliabilityor a firm conunitment bythe
company-s-a so-called fair value hedge-the gain or loss from marking the instru-
ment to fair value is recorded as part of net income. (Undercertain conditions, the
gain or loss is offsetin the income statement by the gain or loss on the hedgeditem.)
If the instrument hedges the cash flow from an anticipated future transaction-a
so-called cashflow hedge-the gain or loss is recorded to the equitystatement, and
Chapter 8 Th~ AnCl/Y.lb of(he Slalemenc ofShar~ho!Jer; Eq:lilj 263
TABLE 8.1 OperatingIncome Items
Dirty-Surplus
Accounting: U.S. Changes inaccounting forcontingencies (FASB Statement No. 11)
Additional minimum pension liability (FASB Statement No. 87)
GAAP
Tax benefits of loss carryforwards acquired (FASB Statement No. 109)
Alldirty-surplus
income items are Tax benefits of dividends p~id to ESOPs (FASB Statement No. 109)
reported netof tax. Unrealized gains andlosses onequity securities available forsale
(FASB Statement No. 115)
Some adjustments of deferred taxvaluation allowances (FASB Statement No. 109)
Change infunding statusof pension pians (FASB Statement No. 158)
Financing Income (or Expense) Items
Preferred dividends
Unrealized gains andJesses ondebtsecurities available forsale (FASB Statement No. 115)
Operatingor Financing Income Items
Foreign currency translation gains andlosses (FASB Statement No. 52)
Gains andlosses on derivative instruments designated as cash-flow hedges
(FASB Statement No. 133)
Restatements of prior years' income due to a change inaccounting principles (FASB
Statement No.1 54)
Balance Sheet Itemsto BeReclassified
Credits to shareholders' equity forstock compensation expense (FASB Statement No. 123R)
Dividends payable
then removed from the equity statement to net income when the hedgedtransaction
affectsearnings. 1
Comprehensive Income Reporting under u.s. GAAP and IFRS
FASB Statement No. 130requires comprehensive income to be identified in the financial
statements. It distinguishes net income from othercomprehensive income and permits the
sumof the two, comprehensive income, to be reported in oneof threeways:
I. Report comprehensive income in the statement of shareholders' equityby adding net
income to othercomprehensive income items reported in theequitystatement.
2. Addothercomprehensive income to net income in the income statement, andclosethe
total comprehensive income to shareholders' equity.
3. Present a separate statement of other comprehensive income apart from the income
statement, andcloseit to equity alongwithnet income from theincome statement.
1 SeeM. A. Trombley, Accounting for Derivatives andHedging (New York: McGraw-Hill/lrwin, 2003) for
a primer onthe accounting forderivatives. fi5 these hedging gains and losses will be matched against
realized gains andlosses on the hedged items insubsequent income statements. theyare more appropri-
ately classified asdeferred income ordeferred charges inthe liability andasset sections ofthebalance
sheet. Weleave themintheequity statement hereto maintain thereported number forcomprehensive
income. But notethat theyrepresent income that islikely to be reversed insubsequent periods when the
corresponding gains and losses on thehedged items are recognized on termination ofthe hedge.
264 Part Two TheAna1)"lil ojFilUlncia.1 Srar.emenl.l
Chapter 8 TheAnalylis ofdle Sra.rement ofS!w.rcno1ders' Eq"ir)' 265

'~il'l total payoutis dividends plusshare repurchases. Some firms pay no dividends but have
Accounting Clinic ~~ regular stock repurchases. The total payout ratio is

. Dividends + Stock repurchases

ACCOUNTING FOR MARKETABLE SECURITIES representing lessthan 20 percent interest in other corpo- TotaI payout ratro -
rations. The accounting for equity investments of more Comprehensive income
Further detail on the accounting for securities is covered
in Accounting Clinic 1I! on the book's Website.Theclinic than 20 percent iscovered inAccounting Clinic V.
calculated with totaldollaramounts rather than per-share amounts. Thedifference between
covers debt securities held by firms and equity securities
this ratio andthe dividend payout ratiogives the percentage of earnings paidout as stock
repurchases.
Note that stock dividends and stock splits are not involved. These simply change the
Most firms follow the first approach/ So you now observe dirty-surplus income items share units, withno effect on the claim of each shareholder. Some splitsand stock divi-
added together intoa number called"othercomprehensive income" andothercomprehen- dends involve a reclassification from retained earnings to additional paid-in capital, but
siveincome andnetincome added to "totalcomprehensive income"-all within theequity again thishasno effect on the value of claims.
statement. This presentation facilitates the task of identifying comprehensive income.
Although thedividend payout ratiosuggests thatdividends are paidoutofearnings, they
However, it is not, in fact, comprehensive from the common shareholders' pointof view. arereally paidoutofbookvalue, outofassets. Soa firm canpaya dividend even ifitreports a
First, it omits preferred dividends, and, second, certain hidden items(which wewill iden- loss. Payout, asaproportion ofbook value, istherateofdisinvestment byshareholders:
tifytoward theend of thischapter) arenot included.
Other comprehensive income under lFRSconsists ofitems similartothose intheUnited Dividends
Dividends-to-book value
States, withthe addition of actuarial gainsandlosses onpension assets andassetrevalua- Book value of CSE + Dividends
tiongainsand losses. Up to 2009, firms could electto report othercomprehensive income
ina statement of recognized income expense, outside ofboththe income statement andthe Dividends + Stock repurchases
Totalpayout-to-book value
equity statement. UnderlAS 1(Revised 2007), effective from 2009 on,thisseparate state- Bookvalue ofCSE + Dividends + Stock repurchases
mentdisappears. Finnswillchoose to reporta single statement of comprehensive income
Usually ending bookvalue of common shareholders' equity (CSE) is usedin the denomi-
or twostatements, a statement of operations anda statement of comprehensive income. The
natorinthese calculations (although, withdividends paidoutovertheyear, average CSEis
revised lAS 1 will not permit comprehensive income to be displayed in the statement of
alsoappropriate).
changes in shareholders' equity (asis permitted under GAAP).
Retentionratios focus On earnings retained rather than earnings paidout.Thestandard
retention ratio involves only cash dividends (but Can be modified to incorporate stock
RATIO ANALYSIS repurchases):
. . Comprehensive income - Dividends
What does the reformatted statement of changes in owners' equity reveal? It gives the Retennon rano -
Comprehensive income
growth in equity overa period. Andit distinguishes clearly between the growth in equity
fromnewinvestment or disinvestment by the owners andadditions to equity from running = 1- Dividend payoutratio
the business. Accordingly, the reformulated statement distinguishes the creation of value
from thedistribution of value. Indeed, bothreturn oncommon equity(ROCE) andgrowth Shareholder Profitability
in equity-the twodrivers ofresidual earnings-ean be identified inthestatement. A setof The reformulated statement yields the comprehensive rate of return on common equity,
ratios analyzes the statement to refine this information. ROCE, theprofitability oftheowners' investment fortheperiod. ROCE isalsogrowth ineq-
uityfrom business activities. ForNike, the2008 ROCE (using average equity fortheyear) is
Payoutand Retention Ratios
Thedisinvestment byshareholders isdescribed bypayout andretention ratios. Thestandard Comprehensive earnings
ROCE,
dividend payout ratio is theproportion of income paidoutin cashdividends: Yz (CSE, + CSEr-l)
Dividends 1,931.8 25.9%
Dividend payout = -=--~-"'=~'--­ 1, (7,118.3 +7,797.3)
Comprehensive income
A calculation that you commonly see compares dividends to net income rather than TheROCE calculated on beginning common equity is 27.1 percent.
comprehensive income. Thedividend payout ratio involves payout in theform of dividends; Notethat the income statement and balance sheetare not needed to calculate ROCE;
rather, theyprovide the detail to analyze ROCE.

2 For anexample ofthe third approach, seethe 2005 lO-K filing forMaytag Corporation, ontheSEC's Growth Ratios
EDGAR Web site. For anexample ofthesecond approach, seeChubb Corporation inMinicase M9.Z in Thegrowth inshareholders' equity issimply thechange from beginning toending balances.
Chapter 9. Also look at the Web page supplement forthischapter. Growth ratios explain thisgrowth as a rateof growth.
266 Part Two TheAnalysis of Financial Smtcmenrs
The part of the growth rate resulting from transactions with shareholders is the net
investment rate:
.
Net mvestment rate == _N~'e~t_tr~an_S7a_ti~o~ns_,~v_it_h~s~ha~r~e~ho::l:,d::ers:c
Beginning bookvalue of CSE
Nike'snetinvestment ratewasa negative 17.6 percent because netcashwaspaidout;share-
holders disinvested. Thepart ofthe growth ratethatcomes from business activities is given
by theROCE on beginning equity, 27.1 percent forNike. The rateof growth of owners'eq-
uity from bothsources-new shareholder financing and business activities-is the growth
rate in common stockholders' equity:
-,C-,ha"nc£ge"i"n-,C,::SE=,
Growth rate 0 fCSE ==:::.
Beginning CSE
Comprehensive income + Nettransactions withshareholders
Beginning CSE
Nike's 2008growth ratewas9.5 percent.
IfROCEis calculated withbeginning CSEin thedenominator, then
Growth rateofCSE = ROCE + Net investment rate
ForNike, the growth rate in common equityis 27.1 percent - 17.6 percent = 9.5 percent.
HIDDEN DIRTY SURPLUS
The distinction between comprehensive income and transactions withshareholders in the
reformulated statement ofowners'equity separates thecreation ofvalue from theraising of
funds and the distribution of valueto shareholders. The premise is that transactions with
shareholders do notcreatevalue. Thisisso when sharetransactions areat market value, but
when sharesare issued at lessthanmarket value, shareholders lose. Andthe losses do not
appearin GAAP financial statements.
Issue of Shares in Operations
When firms grant shares to employees at less than market price, the difference between
market priceand issuepriceis treated as (deferred) compensation to employees and ulti-
mately amortized as an expense to the income statement. This is appropriate accounting,
for thediscount from market value is compensation to employees anda lossofshareholder
value. Morefrequently, though, shares are not granted to employees. Rather, stockoptions
are granted and shares are issued later when the options are exercised. Unfortunately,
GAAP and IFRS accounting do a poorjob of reporting the effects of stock options on
shareholder value.
Fourevents areinvolved in a stockoption award: the grantofthe option, thevesting of
the option,the exercise of the option, and the lapseof the option. At the grantdate, em-
ployees are awarded the rightto exercise at an exercise price; the vesting date is the first
date at whichtheycan exercise the option; theexercise date is the dateon which theyac-
tuallyexercise at the exercise price; and the lapsedate is the date on which the option
lapsesshouldthe employee choosenot to exercise. Clearly the employee exercises if the
stock is "in the money" at exercise date, that is, if the market price is greaterthan the
exercise price.
If thecalloption is granted in themoney at grantdate(with theexercise pricesetat less
than the market priceat grant date), accounting treats the difference between the market
price and exercise priceas compensation. Unearned compensation is recorded and then
METHOD 2
If there isnoreported tax benefit to work from, thecalcula-
tion must estimate the market price at exercise date. Nike's
average stock price during 2008 was $62.00. With 9.1 million
options exercised. thecalculation isasfollows:
Estimate market value of
shares issued 9.1 x $62 $564.2
Exercise (issue) price, from equity statement
(less tax benefit of.$63) 309.2
Stock option 1055, before tax 255.0
Tax benefit at 36.4% 92.8
Stock option 1055.after tax S162.2
This calculation is tentative. If employees exercised below the
$62 price, theexpense would be lower. Indeed. theMethod 2
number is higher than the Method 1 number.
Method 2must beused for incentive options, where the
Stock option loss $173.1
Tax benefit at 36.4% (63.0)
firm does notreceive a tax benefit (nor isthe employee taxed
Stock option loss, after tax $110.1
until theshares aresold).
amortized to the income statement overthe vesting period, as in thecaseof a stockgrantat
less than market price. However, most options are granted "at the money," with exercise
price equal tothemarket priceatgrantdate.As time elapses andthemarket priceofthestock
moves "intothemoney," noadditional compensation expense isrecorded. Further, when op-
tionsareindeed exercised, nocompensation expense isrecorded. You seeinNike's statement
of equity thatthe amount received on exercise is recorded as issued shares, but,unlike the
stockgrants, the expense-the difference between the market price and the issue price-
is notrecorded.
Theappropriate accounting isto record the issue ofsharesat market price andrecognize
the difference between the market priceand issuepriceas compensation expense. In the
absence of this accounting there is a hidden dirty-surplus expense. The expense is not
merely recorded in equity ratherthan the income statement; it is not recorded at alL But
there hasbeen a distribution ofwealth 10 employees andthatdistribution hascome attheex-
pense of theshareholders: Thevalue of theirsharesmustdropto reflect thedilutionof their
equity. GAAP accounting treats this transaction, which is botha financing transaction-
raising cash-and an operational transaction-paying employees-as if it is just a financ-
ing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 8.2
calculates Nike's lossfrom theexercise of stockoptions during 2008.
Some commentators argue that, because options are granted at the money, there is no
expense. Employees-andparticularly management, who benefit most-say thisadamantly.
Butthere isnoexpense onlyiftheoptions faiito move intothemoney. Theyalsosaythat,as
the exercise of options does not involve a cash payment by the firm, there is no expense.
However, paying employees with stock options that are exercised substitutes for paying
267
268 Part Two TheAnaJ)'sis of Financial Starements
themwithcash,and recording the expense is recording the cash-equivalent compensation:
The firm is effectively issuing stockto employees at market priceand givingthema cash
amount equivalent to the difference between market and exercise pricesto help payfor the
stock. From a shareholder's point of view, it makes no difference whether employees are
paid withcashor with thevalueof the sharesthatshareholders haveto giveup. Recogniz-
ingthis expense is at the heartof accrual accounting for shareholder value,for accrual ac-
counting lookspast cashflows to valueflows; it seesan award of valuable stockforwages
as no different from cash wages. If youare hesitant in viewing stock compensation as an
expense, thinkof the casewherea firm paysforaU its operations-s-its materials, its adver-
tising,its equipment-with stockoptions. (Indeed somesportsstars have asked to be paid
withstockoptions forpromotions') Ifthe hidden expenses were notrecognized, the income
statement would haveonlyrevenues on it andno expenses. Stockoptions produce revenues
and profits for shareholders if they present an incentive for employees and management.
But GAAP accounting does not match the cost of the options againsttheserevenues and
profits. Value addedmustbe matched withvaluelost.
With the large growthin stockcompensation in the 1990s, the hiddenexpense became
quitesignificant, particularly in the high-tech sector. The Financial Accounting Standards
Boardaddressed the issue, but in Statement No. 123R cameto an unsatisfactory conclu-
sion.This statement requires unearned compensation to be recognized at grant date at an
amount equal to the valueof the option, priced usingoption-pricing formulas. The credit
goes to shareholders' equity, incorrectly as we haveseen with Nike.The unearned corn-
pensation is thenamortized to the income statement overa serviceperiod, usually thevest-
ing period.' The international accounting standard on the issue, IFRS 2, requires similar
treatment. Thistreatment iscalledgrant dateaccounting. Butthegranting of options yields
an expense only in recognition of possible exercise. If the option lapses(because the stock
does notgo intothe money), no expense is incurred, but the accounting maintains the ex-
pense. An expense is realized onlyif the option is exercised. The difference between the
marketpriceandexercise priceat exercise date isthe lossto shareholders. Recognizing this
expense, as in Box8.2, is calledexercise dateaccounting. In 2008,Nikereported (in foot-
notes) $127.0 million in before-tax stock option expense using grant date accounting.
Box8.2 calculates an expense of $J73.1 million, beforetax, from the exercise of options
during2008. Nowgo to Accounting ClinicIV.
Significantly, the Internal Revenue Service recognizes thatan expense is incurred when
options areexercised andgives the finn a taxdeduction forit (ifcertainconditions are met).
The firm booksthistax benefit to equity, oftenas an addition to theproceeds fromtheshare
issue. So the $372.2 million that Nike received from the exercise of stock options (in
Exhibit 8.1)represents $309.2million received fromthe shareissueplus$63million in tax
benefits. So,the accounting recognizes the taxbenefit of theexpense, increasing equity, but
not the associated expense!
You can see that stock optionaccounting underthe presentaccounting standards is a
bit of a mess.Wecould correct the accounting by recognizing the appropriate loss from
exercise of options($173.1 million,beforetax, for Nikein Box8.2) but, as Nikehasrec-
ognized an expense from grant-date accounting (SI27.0 million), we would be double
counting to some extent. We could unravel the GAAP accounting and apply the appro-
priate accounting outlined in the box introducing Accounting Clinic IV, but that is a
difficult task.
3 Prior to2006. noexpense was recognized atall. Rather, theexpense was reported ill footnotes.
Chapter 8 TheAu.alysil of rhe Statemenr ofShareholders' Equiry 269
Accounting Clinic .~ .
ACCOUNTING FOR STOCK COMPENSATION balance sheet The option value at grant date is the
GAAP accounting for stock options intheUnited States em- amount recognized with grant-date accounting under
ploys grant-date accounting. The International Accounting FAS8 Statement No. 123R. The grant-date value given
toemployees iscompensation, butitiscontingent upon
Standards Board {lASB} also requires grant-date accounting
the options going into the money, so it is a contingent
under IFRS2. Accounting Clinic IV leads you through grant-
dateaccounting. liability to issue shares. The deferred compensation
Accounting Clinic IV also lays out exercise-date ac- asset issimilar to thatwhich arises from stock issues to
counting andtakes you through thecomplete accounting employees at less than market value.
that measures the effects of stock options on sharehold- 2. Amortize thedeferred compensation over anemployee
ers. Unearned compensation costs are recorded at grant service period, usually thevesting period.
date, andthen recognized as expense intheincome state- 3-. Mark the contingent liability to market as options go
ment over the period when employee services aregiven. into themoney to capture thevalue oftheoption over-
Accordingly, thecompensation cost is matched against the hang, and recognize a corresponding unrealized loss
revenues that the employees produce. Subsequent to from stock options.
grant date, further losses arerecognized asoptions gointo 4. Extinguish the liability against the share issue (at mar-
the money. Here are the steps to effect sound accrual ketvalue) at exercise date. If options arenotexercised,
accounting for stock options: extinguish the liability and recognize a windfall gain
from stock options.
1. Recognize the option value at grant dateas a contin-
gent liability, along with a deferred (unearned) com- For more on appropriate exercise dateaccounting, go
pensation asset. The twoitems can be netted on the also to theWeb page for this chapter.
Withan eyeon the future, we canfinesse the problem. Thelossfrom exercise of options
in the currentperiodis a legitimate lossthatshouldbe reported. But when an investor buys
a stock, he is concerned about how he could lose from these instruments in the future.
Accordingly, valuation focuses on the expected lossesfrom future exercise of options. This
expected lossis referred to as the option overhang.Itcan be estimated as the lossincurred
if outstanding options were exercised at the currentmarket price.At the endof2008, Nike
had36.6million options outstanding witha weighted-average exercise priceofS40.l4. The
closingmarket pricefor its sharesat fiscal yearend was$67.20. So the optionoverhang is
estimated as follows (in millions):
Market price of shares to be issued foroptions 36.6 x $67.20= $2,460
Exercise price 36.6 x $40.14= 1,490
991
Tax benefit (at 36.4%) .2§1
Contingent liability (option overhang) 630
This drag on the value of the shares amounts to S1.28 per share (with 491.1 million
shares outstanding). Note that the liabilityfor the expected loss is reduced by the ex-
pectedtax benefit on exercise. The measure of the option overhang here is a floorvalua-
tion; it shouldalso include optionvaluefor the possibilityit mightincrease. Wereturnto
the complete treatment in Chapter 13 when we formally buildcontingent claims intoeq-
uity valuation.
Firmsuseoptions andwarrants forotheroperating expenses besidewages. SeeBox8.3.
In 2001, Reebok, Nike's rival. entered into a 10-year license But the GAAP accounting is inappropriate. The issue of a
agreement with the National Football league(NFL) giving the warrant-like the issue of a stock option-is not an issue of
company exclusive rights to design, develop, and sell NFL equity but, rather, an obligation for the shareholders to sur-
footwear, apparel, andaccessories inexchange forstock war- render value in the future should the warrants be exercised.
rants valued at $13.6 million. These warrants gave theNFL the From the shareholders' point of view a warrant isa (contin-
right to purchase up to 1.6million shares of Peebok's common gent) liability, and appropriate accounting for shareholder
stock etvarous exercise prices, with anexpiration dateof2012. value requires itto be recognized assuch. Further, ifandwhen
Reebok recorded an intangible asset Cfkenses" below) the warrants are exercised, the difference between the exer-
andthen amortized this asset over 10years. So itsintangible cise price andthe market price of the stock at the time, over
assetfootnote for2003 reported the following (in thousands): and above the $13.6 million already recognized, is a further
loss to shareholders.
Amortizable intangible assets: The diligent equity analyst recognizes that GAAP fails to
licenses $13,600 track the effects of this transaction on shareholder value.
Other intangible assets 4,492 Many of the warrants have an exercise price of $27.06 per
$18,092 share. Atthe endof2004, Reebok's shares traded at $44.00,
Less accumulated amortization 3,656 so the warrants were well in the money and likely to be
$14,436 exercised. The analyst anticipates that therewill be a loss of
ncnamoruzebte intangible assets:
shareholder value when thishappens and builds thisintoher
Company tredenemes andtrademarks
valuation. This is the warrant overhang. For now, note that
a rough calculation of the warrant overhang (at the end of
2004) is the amount of value that the shareholders would
You seethat Reebok recognized the license assetandisamor- have to give up ifthe warrants wereexercised at the endof
tizing the license costalong withotheramortizable intangible 2004: The difference between the market price of the share
assets. Sothe license expense is being matched against rev- andtheexercise price at theendof 2004is$44.00 - $27.06 =
enue from NFL branded products in the income statement $16.94 perwarrant. Chapter 13 modifies thiscalculation to
over the term of the license. This is appropriate accounting. recognize that the warrants cannot be exercised in 2004, but
However, the issue ofthewarrants wasrecorded asa share rather in 2012, so option value must be added to thisrough
issue in the equity statement in 2001, as required byGAAP. calculation.
Issue of Shares in Financing Activities
Hidden lossesoccur notonly with employee stockoptions but with the exerciseof all con-
tingent equity claims. Call and put options on the firm'sown stock, warrants, rights,con-
vertible bonds, and convertible preferred shares are all contingent equity claims that, if
exercised, requirethe issue(or repurchase) of sharesat a pricethat is differentfrom market
value. Look at Box 8.4.
Box 8.5 coversthe accounting for convertible bondsand convertible preferredstock and
shows how GAAPand IFRS accounting do not recognizethe full cost of financing with
these instruments. The accounting is not comprehensive, even though a nominal number,
comprehensive income, is reported.
Handling Diluted Earnings per Share
Firms report two earnings-per-share numbers, basic EPS and diluted EPS. Basic EPS
is simply earningsavailable to common(after preferred dividends) dividedby the number
of outstanding shares. Diluted EPS is an "as if" number that estimates what earnings
per share would be if holders of contingent equity claims like stock options, warrants,
convertibledebt, and convertible preferred shares were to exercisetheir option to convert
270
In Dell's statement of shareholders' equity for the fiscal year
ending February 1, 2002, the following line item appeared
(in millions):
Shares Amount
Repurchase ofcommon shares 68 $3,000
This line suggests a routine stock repurchase. But further
investigation reveals otherwise. Dividing the $3 billion paid
out bythe 68 million shares purchased, the average per-share
purchase price is$44.12. But Dell's shares didnottradeabove
$30 during the year, and the average price was $24. Foot-
notes reveal that Dell wasforced to repurchase shares at the
strike price of $44on put optionswritten to investors. In pre-
vious years, Dell had gained from theseoptions as the stock
price continued to rise during the bubble. But with the share
price falling (from a high of $58in2000) as the stock. market
bubble burst, Dell was caught as these options went under
water. Using the average price of $24for2002 asthe market
price when the shares were repurchased, the loss from the
exercise of putoptions isasfollows:
Market price for shares
repurchased $24 x 68 million $1 632 million
Amount paid for shares repurchased (3 0001
Loss on exercse ofputoptions $1,368 million
(The loss isnot taxdeductible.) This loss should be reported as
partof comprehensive income, butit was not. Onthe 2,670
million shares outstanding before the repurchase, the loss is
$0.51 per share, a significant amount compared to Dell's
reported EPS of $0.48. Dell effectively ran two types of busi-
nesses, a computer business earning $0.48 pershare in 2002
and a business of betting on itsownstock, earning a loss of
$0.51pershare.
The omission of thisloss isa concern to the investor, and
the investor must be vigilant. Shareholders lose when share
prices fal!, of course, but when the firm haswritten put op-
tions, the shareholder suffers twice; the loss from the price
decline islevered. In 2002, Electronic Data Systems Corpora-
tion (EOS) announced that the firm had some accounting
problems and that contract revenue would not be as previ-
ously expected. The stock price dropped 70 percent on the
bad news. later, the firm indicated that the drop in price
would trigger the exercise of put options. The price dropped
further.
Putoptions are sometimes referred to as put warrants.
Firms make similar commitments to buyback. stock through
forward share purchase agreements. They disclose the
existence of put options and share purchase agreements in
footnotes. In buying a stock of Dell in 2002, one must be
aware of the putoption overhang, foritmight require further
repurchases that lose value forshareholders. Atthe endoffis-
cal2002, Dell hasa further putoption overhang for51 million
shares to be repurchased at $45 per share. In September
2002, when the shares were trading at $25, the options were
inthe money by$20pershare, a totalof $1.020 billion, pro-
jecting a loss of $0.39 peroutstanding share. Analysts were
forecasting $0.80 EPS forfiscal 2003,but that is GAAP earn-
ings. Expected comprehensive earnings was $0.39 less, or
$0.41 pershare.
FASB STATEMENT NO. 1S0
In 2003, the FASB issued Statement 150 to reform the
accounting for these putobligations. Firms arenowrequired
to recognize a liability, measured at fair value, whenthe con-
tractiswritten. Subsequently, as the stock price changes, this
liability is measured at the amount of cash that would be re-
quired to settle the obligation at the reporting date.This, of
course, isthe difference between the exercise price and mar-
ket price at reporting date.The revaluation of the liability is
booked to the income statement as interest cost. So, the rule
seesa putoption contract (appropriately) asa borrowing: The
firm borrows the amount that the contract isworth andthen
repays the "loan" incash or shares. The amount lost on the
contract isthe interest coston the loan. The accounting under
Statement 150effectively putsthe liability fortheoption over-
hang on the balance sheet and records losses, as interest,
as the option moves intothe money (and sothe shareholders
mustgive up more value). If the option doesnot go intothe
money, a gain isrecognized.
Accordingly, Statement 150 brings the hidden expense
into the income statement and also puts a hidden (off-
balance-sheet) liability on the balance sheet.Note, however,
that GAAP does not apply the same treatment to call
options, (call) warrants, andotherconvertible securities. See
Box 8.3.
271
 Convertible securities are securities, such as bonds and
preferred stock, thatcan beconverted into common shares if
conditions aremet Textbooks propose twomethods to record
the conversion of a convertible bond or a convertible pre-
ferred stock into common shares:
i_The bookvalue method records theshare issue atthebook
value of thebond or preferred stock. Common equity isin-
creased anddebtor preferred stock isreduced bythesame
emount. sono gain or loss isrecorded.
2. Tne market value method records the share issue at the
market value of theshares issued in theconversion. The dif-
financing cost toshareholders includes any loss onconversion of
the bonds into common shares-andthis loss is notrecorded.
In the 1990s, financing with convertible preferred stock
Dell, Jne., explains its put option transactions (examined in outstanding with share repurchases only gives theappearance
became common. Only the dividends on the preferred
Box 8.4) as "pert of a share-repurchase program to manage of reversing thedilution.
stock were recorded asthefinancing cost, nottheloss oncon-
theollution resulting from shares issued under employee stock During the stock market bubble, employees exercised
version. Suppose a convertible preferred stock issue had no
plans. ~ Itis common forfirms to explain share repurchases in options against the shareholders as prices soared. Firms then
dividend rights but, to compensate, setafavorable conversion
this way. The exercise of stock options increases shares out- repurchased shares "to manage dilution. ~ But purchasing
price to the buyer of the issue. Under GAAP accounting it
standing and, as we have seen, dilutes existing shareholders' shares at bubble prices (above intrinsic value) destroys value
would appear thatthis financing hadnocost.
value. Buying back shares reduces shares outstanding. But for shareholders. Shareholders lost twice, once with the em-
In September 2008, in themidst ofthecredit crisis onWall
does itreverse thedilution? ployee options, andagain with therepurchases. Assome firms
Street, Goldman Sachs invited Warren Buffett, the legendary
The answer is no. If shares are purchased at fair value, borrowed to finance the share repurchases, they were left
fundamental investor, to contribute much-needed equity

I ference between thismarket value andthe bookvalue of
capital tothefirm. Buffett seemingly gota very good deal. For
the security converted isrecorded as a loss on conversion.
a $5 billion cash infusion, he received perpetual preferred eq-
The book value method is almost exclusively used in uity shares carrying a 10percent dividend (redeemable byGold-
practice. It involves a hidden dirty-surplus loss. The market man Sachs) plus warrants to buy 43.5million common shares
value method reports the loss. It accords the treatment of at $115 pershare (for a total ofanother $5 billion}. The $115
convertible securities the same treatment as nonconvertible conversion price was setat the current share price, a three-
securities. On redemption of nonconvertib!e securities before year low for Goldman. The stock price rose to $135 within
maturity, a loss (or gain) is recognized. The only difference three days, putting Mr. Buffett's warrants well into themoney.
with convertible securities is that shares rather than cash It remains to be seen at what price Mr. Buffett exercises.
are used to retire them. In both cases there isa loss to the But any difference between theexercise price andthemarket
existing shareholders. price at that point will be a loss for shareholders. GAAP
Convertible bonds carry a lower interest rate than roncon- accounting will not, however; record that loss. At a stock
vertible bonds because of the conversion option. GAAP price of $135 per share, the prospective loss-the warrant
accounting records only this interest expense as the financ- overbanq-was $20 pershare, or a total of $870 million for
ing cost, so it looks asifthefinancing ischeaper. But thefull the 43.5 million shares.
those claimsto common shares; ratherthanshares outstanding, the denominator is shares
outstanding plusshares that would be outstanding shouldconversion takeplace. (Account-
ingClinicIV givesmoredetail.)
Handle the diluted EPS numberwith care. Whilediluted EPS gives an indication of
likely dilution to the common shareholders, it is not a numberto be used in valuingthe
common shareholders'equity.lt commingles the Current shareholders' claimon earnings
withthose of possiblefuture shareholders. The claimsof current and futureshareholders
are quite different. Both will share in future earnings should options be exercised, but
only current shareholders share in current earnings. Further, they share future earnings
! differently. When claims are converted to common equity, the loss will fall on current
there is no change inthe per-share value of the equity; the with large debts thatled to significant credit problems as the
shareholder does notget extra value to compensate for the bubble burst.
loss ofvalue from stock options. Maintaining constant shares
transaction get whattheypaidfor. Ina sharerepurchase, forexample, thefirm gives up,and
thesellerreceives, cashequalto the valueof the stock.
Butwerecognized in Chapter 3 that if stockmarkets are inefficient, a firmcan buyback
shares at less thantheyare worth and issuesharesat morethantheyare worth. The other
side of the transaction-the shareholder whosells the sharesor the new shareholder who
buys-loses value. But the existing shareholders whodo not participate in the transaction
gain.Thesegains(or lossesif shareholders lose in the transaction) are not revealed in the
accounts.
Even if stock markets are efficient with respect to publicly available information, a
fum's management mighthave private information about the valueof their firm's shares
and issue or repurchase shares at pricesthatare different fromthosethat willprevail when
the information is subsequently made public. Such transactions also generate value for
existing shareholders. (In the United States there are legal constraints on this practice,
however.)
The active investor whoconjectures that the marketmay be inefficient at timesis wary
of share transactions with firms. As with all his trading in the stock market, he tests the
marketpriceagainstan estimate of intrinsic value. Buthe isparticularly careful in thiscase
because the firm's management mayhavea betterfeel for intrinsic valuethan he.
The active investor who understands the intrinsic value of a stock understands when
it mightbe overvalued or undervalued. Andhe understands that management mightusethe
mispricing to advantage. The management might, for example, use overvalued shares
to make acquisitions, to acquire otherfirms cheaply. Indeed thisis a reason why an investor

Ii shareholders. while the Dew shareholders will gain as current shareholders effectively
sell the firm to newshareholders at less than marketprice.The twoearnings claimsmust
be differentiated and the diluted EPS does not do this. With a focus on valuingthe cur-
rent outstanding shares, one must focus on basic EPS,adjustedof course for the failure
II of the accounting to recordlosses(to currentshareholders) whenclaimsare converted to
II common equity.
I shareholders withsharetransactions. Theycan chooseto finance newoperations withdebt
Share Transactions in Inefficient Markets
Themaxim thatshareISSUes andrepurchases atmarket valuedo notcreatevaluerecognizes
that in efficient stock markets. value received equalsvalue surrendered; bothsides of the
might buy overvalued shares; He sees that valuecan be generated by usingthe shares as
currency in an acquisition. But this is a trickybusiness: If investors force up the pricesof
shares that are already overpriced, a price bubble can result. The fundamental investor
bases his actions on a good understanding of the firm's acquisition possibilities and its
acquisition strategy.
As forthe management, theycantakeadvantage of sharemispricings to createvalue for
ratherthanequity if theyfeel thestockpriceis "too low." But theyalsocan choose to exer-
cise theirstockoptions whenthe price is high-a double whammy for shareholders. They
mightalsohave misguided ideasaboutstock issuesand repurchases. See Box8.6.

272 273
 Chapter 8 The AlUllYlis of1M Stmement ofShareholders' Equity 275

This chapterhas identified quality lapses in GAAP and IFRS accounting. Withan eyeon the shareholder, the analyst needsto
maintain a watchon the following. Theissues ariseboth in GAAP and IFRS accounting.
Accounting Item Quality Problem
Dividends payable GAAP treats dividends payable asa liability. Rather, itispartofshareholders' equity. Shareholders have
a daim to thesedividends that have been declared butnotpaid. They do notowethemto others.
Unrealized gains and losses Unrealized gains and losses on available-for-sale debtandequity securities are reported as
onsecurities part ofother comprehensive income intheequity statement rather thanintheincome statement Thus,
thefull performance ofaninvestment portfolio isnotreported intheincome statement. Worse, asfirms
report realized gains andtosses intheincome statement, they can"cherry pick" gains into theincome
statement (and earnings pershare) byselling securities thathave appreciated invalue while holding those
onwhich they have experienced losses andreporting those unrealized losses intheequity statement.
would make a loss. When thefum forces it onthem, they alsomake a loss. Theaccounting
fails to understand the distinction between cash transactions withshareholders (to raise
cashandtopassoutunneeded cashas a matter of financing) andvalue added (orlost) from
operations that can be embedded in a share issue. It also fails to see that transactions
between claimants-convertible bondholders and conunon shareholders, for example-
caninvolve losses forthecommon shareholders.
In short,GAAP and IFRS accounting does nothonortheproperty rightsof thecom-
monshareholder. Thisis so despite thefactthatfinancial reports areprepared nominally
for theshareholder, company directors (including theauditcommittee) havea fiduciary
duty to the shareholders, and management and auditors formally present the financial
reports to shareholders at the annual meeting. The accounting doesnothonortheshare-
holders as the owners of the firm. Consequently, the equity analyst mustrepairthe ac-
counting, as wehavedoneinthischapterandwill continue to doaswemove tovaluation
in laterchapters.

Translation gains andlosses
Preferred dividends
Stock compensation credits
to equity
Grant-date stockoption
accounting
Again orloss results from holding assets and liabilities inforeign currencies whenexchange rate
change isnotrecognized in theincome statement(The effect isbooked to equity inthe equity state-
ment, bypassing the income statement)
Preferred dividends are treatedas a distribution of equity ratherthan a costto (common)
shareholders.
GAAP recognizes deferred compensation fromgrantof stock options as a creditto equity,
as ifshareholders' equity increases bycompensating employees. This isa liability-togive
upvalueon the exercise of options-not an increase inequity.
GAAP recognizes stockoptioncompensation at option grantdate. However, the expense
(to the shareholder) isincurred at exercise date asshares areissued for lessthan market price. If
grantedoptionsare not exercised, GAAP overstates wages'expense. If options are exercised,
ACCOUNTING QUALITY WATCH
k; we proceed with thefinancial statement analysis in Part Two ofthebook, wewill address
accounting issues asthey arise. Thetextwill provide anoutline of how therelevant accounting
works-as wedidformarketable securities andemployee stock options inthischapter-and
referyou to Accounting Clinics on the book's Web site for further elaboration-as wedid
with Accounting Clinics III andIVon marketable securities andstock compensation in this
chapter.
Oneneeds to understand how the accounting works, but onealso needs to understand
when theaccounting doesnotwork fortheequity analyst. When do accounting quality is-
sues frustrate theanalyst? Some of these quality issues arise just because of practical diffi-

IIi Accounting forwarrants

GAAP typically understates wages'expense.
GAAP does not reportthe loss to shareholders whenwarrants and (call and put)options
culties in accounting measurement. Others arise because theaccounting standard setters do
notget it right, as wehave seen in this chapter. Andyetothers arise because firms usethe
license available within GAAP to manipulate theaccounting.
and options on the firm's stockareexercised and sharesare issued or repurchased at prices differing
from market price. Box8.7starts ourAccounting QualityWatch. It liststhe accounting quality issues we
have encountered inthischapter. We willaddto thislistas we proceed so that, when wego
I Accounting for convertible GAAP converts theseclaims to equity at theirbookvalue. Thus, no loss is recognized
bondsand preferred stock on the conversion.
specifically into theanalysis of accounting quality in Chapter 17,wewillhave considerable
background.
Omitted borrowing costs As losses are not recognized on conversion of nonequity financing instruments (like convertible
bonds) intoequity, borrowing costsare understated.
:" ,~-(,~ .~: ;~;~.,~ - ,'-~ -i: '". ;,,,,-,,,-,~ '~: ~:;::~~
Omitted (off-balance-sheet) Outstanding obligations to issue shares at lessthen market price are not recognized on the
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Find the following on the Web pagefor thischapter: More on GAAP and IFRS accounting for convertible
THE EYE OF THE SHAREHOLDER securities.
Accounting for the equitystatement and comprehen-
siveincome underIFRS. More discussion on the appropriate accounting for
We have characterized thefinancial statements as a lenson thebusiness. Forequity analy-
contingentclaims on equity.
sis,the lens must be focused to theeye of theshareholder. GAAP andIFRS accounting is Further examples of reformulated statements of share-
holders' equity. Adiscussion of accelerated stock repurchase programs
inadequate forequity analysis because it does not have its eyeon the shareholder. It does
(that alsoinvolve dirty-surplus accounting).
notaccount faithfully forthe welfare of theshareholder, andnowhere elseis thismore ap- Further discussion of hidden expenses.
The Readers' Cornerexplores the issues raised in this
parent than with theaccounting in thestatement of shareholders' equity. More coverage of footnotesthat pertain to the equity
chapter.
GAAP and IFRS fail to seea saleof shares by current shareholders at less thanmarket statement.
value as a loss. If theshareholders were forced to do so on their own account, they surely

274
276 Part Two TheAnalysis of Fillancial Sta.lrmenlS Chapter 8 TheAnal)'sis of the Sta.temem ofShareholders' Equity 277

Misclassifications in thefinancial statements canleadto erroneous analysis ofthe financial put option is a claimthatgivesthe retentionispaying out lessthan 100 percent
Summary
statements and to erroneous valuations. Reformatting the statements classifies itemscor- holderthe right, but notthe obligation, to ofearnings. Compare with payout. 265
rectly. TheGAAP statement ofequitysometimes commingles theresults of operations with sellsharesat a particular price(the tax benefit is a tax deduction or credit
the financing of the operations. This chapter reformulates thestatement to distinguish the exercise price). 271 given for specified transactions. 268
creation of valuein a finn from the distribution of valueto shareholders in net dividends. redeemablesecurities are securities (such warrant is similarto a call option but
Thereformulation identifies dirty-surplus itemsin thestatement andyields comprehensive as bondsand preferred stocks) that can be usually of longerduration. A put
income and comprehensive ROCE. redeemed by the issuerunderspecified warrant is similarto a put option. 270
Omission in the financial statements is more pernicious than misclassification, and the conditions. 258
chaptersensitizes the analyst to expenses (hatcan arisefromexercise of contingent claims
but whichare hidden by GAAP and IFRS accounting. Failure to recognize theseexpenses
in forecasting can leadto overvaluation of firms.
As always, a senseof perspective mustbe maintained in analyzing thestatement of eq-
. uity Forsomefirms withfewdirty-surplus itemsandno stockcompensation, thereis little
to be discovered. Formanyfirms therearejust twoitems-translation gainsand lossesand
unrealized gainsand losseson securities-that appear. Andformanyfirms, the amounts of
these itemsaresmall.In the UnitedStates,onecan sometimes glanceat thestatement and
dismiss the itemsas immaterial. In othercountries, the practice of dirty-surplus accounting AnalysisTools Page Key Measures Page Acronyms to Remember
is quite extensive. And in the United States, the use of stock options in compensation is
widespread. Reformulated statements Comprehensive income 257 CSE common shareholders'
of common shareholders' Neteffect of transactions with equity
equity 257 shareholders (netdividend) 261 EPS earnings pershare
Analysis of dirty-surplus Other comprehensive income 258 IFRS International Financial
accounting 262 Foreign currency translation Reporting Standard
Ratio analysis of the equity gains and losses 262 RaCE return on common
statement 264 Gains and losses on shareholders' equity
Payout analysis 264 derivative instruments 262
Key Concepts call option is a claimthatgivesthe holder incomeclosed from the income Compensation expense Basic earnings pershare 270
the right,butnotthe obligation, to buy statement. 262 analysis 266 Diluted earnings pershare 270
sharesat a particular price(theexercise forward share purchase agreement is an Grant-date accounting 268 Hidden compensation
price). 266 agreement to buybackshares at a Exercise-date accounting 268 expense 267
clean-surplus accountingproduces a specified price in the future. 271 Warrant accounting 270 Option overhang 269
statement ofshareholders' equitythat hidden dirty-surplus expenseis an Put option accounting 271 lossesonwarrants 270
containsonlynet income (closedfrom expense thatarisesfromthe issueof The book value method 272 Gains and losses on put
the income statement) and transactions shares but is notrecognized in the The market value method 272 options 271
with shareholders. 262 financial statements. 267 losson conversion of a
contingent equity claim is a claimthat incentiveoptions are employee stock convertabfe security 272
may be converted into common equity if Ratios
options thatare nottaxedto the employee
Dividend payout 264
conditions aremet. Examples are call on exercise andare not tax deductible for Total payout 265
options, put options,and convertible the issuingfirm. 267 Dividends-to-book value 265
securities. 270 nonqualifyingoptions areemployee stock Total payout-to-book value 265
convertiblesecuritiesare securities (such options thatare taxable to the employee Retention 265
as bondsandpreferred stock)thatcanbe on exercise and tax deductible to the New investment rate 266
converted intocommon sharesif issuingcorporation. 267 Comprehensive ROCE 265
conditions are met,butwhich have option overhang is the valueof stock Growth rateof common
additional claims also. 272 options unexercised. 269 shareholders' equity 265
dilution (to existing shareholders) occurs payout is amounts paidto shareholders. Tax benefit on issue of shares
whenshares are issuedto newshare- Theterm is sometimes usedto referonly inexercise of employee
holders at lessthanmarketvaIue. 267 stock options 267
to dividends, sometimes to dividends and
Unrealized gains and losses on
dirty-surplus item is an accounting item stockrepurchases. Compare with securities available forsale 262
in shareholders'equity other than retention. 265
transactionswith shareholders or