The Analysis of the Statement of Shareholders’ Equity

RUNNING WITH NIKEThe analysis of financial statements will be demonstrated with the 2010 statements of Nike, Inc. You will see a complete analysis of this firm as we proceed. The Build Your Own Analysis Product (BYOAP) feature on the book’s Web site takes the Nike analysis back to earlier years. After covering the material in the book and in that Web module, you will have a complete analysis history for Nike for a 15-year period, 1996–2010. Take the Nike analysis in the book and in BYOAP as a model for the analysis of any firm, and use BYOAP to develop spreadsheets that deliver a concrete analysis and valuation product.

The first step in analysis and valuation is “knowing the business.” For a start, check the Business Section (Item 1) of the firm’s 10-K report on EDGAR.

REFORMULATION PROCEDURESExhibit 9.1 presents the GAAP statement of shareholders’ equity for Nike, along with reformulated statements in the form of the template. Reformulation follows three steps.

1. Restate beginning and ending balances for the period for items that are not part of common shareholders’ 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 those balances (and ignore any preferred stock transactions during the period in the reformulation). An exception is mandatory redeemable preferred stock which, under GAAP, is not part of equity but rather is reported on the balance sheet in a “mezzanine” between liabilities and equity. Nike’s preferred stock is redeemable, so no adjustment is required.b. Noncontrolling Interests. Both GAAP and IFRS report noncontrolling interests (also called minority interests) within the equity statement. These minority interests in subsidies are clearly not common shareholder interests, so must be deducted from opening and closing balances.

c. Dividends Payable. GAAP requires dividends payable to common shareholders to be reported as a liability. But shareholders cannot owe dividends to themselves. And div- idends payable do not provide debt financing. Common dividends payable are part of the equity that the common shareholders have in the firm. So instead of reporting them as liabilities, reclassify them to the balances of shareholders’ equity, as calculated in the notes to Nike’s reformulated statement in Exhibit 9.1.2. Calculate net transactions with shareholders (the net dividend). This calculation nets dividends and stock repurchases against cash from share issues, as in the exhibit. Dividends must be cash dividends (calculated as follows), and not dividends declared as dividends payable: Cash dividends = Dividends reported − Change in dividends payable

With dividends payable of $121.4 million and $130.7 million at the end of 2009 and 2010, respectively, Nike’s cash dividends paid are $514.8 − 130.7 + 121.4 = $505.5 mil- lion, which is the number for cash dividends in the cash flow statement.

3. Calculate comprehensive income. Comprehensive income combines net income and other income reported in the equity statement. Besides net income, the GAAP statement for Nike reports currency translation gains and losses and gains and losses on hedging instruments. You can see in the GAAP statement that a total is drawn for comprehensive income after these items. The income reported outside net income is referred to as other comprehensive income, so comprehensive income is net income plus other comprehensive income. Note that all items in other comprehensive income are after tax. That is, they are reported net of any tax that they draw. Be careful to exclude any income that goes to the noncontrolling interests.You will notice that there is a line at the bottom of the reformulated statement— $159.0 million for stock-based compensation—that falls outside of both transactions with shareholders and comprehensive income. When firms issue stock options, GAAP and IFRS (correctly) require the value of the options to be booked as compensation, and this goes into the income statement as wages expense. But, oddly, shareholders’ equity is credited for the same amount, effectively canceling the expense in the net income that has also been added to shareholders’ equity. This is clearly wrong. It implies that incurring wages expense has no effect on shareholders’ equity. Stock options are (contingent) liabilities for shareholders, not equity; shareholders will lose equity if the

options are exercised with shares issued for less than market price. So increasing equity by $159 million is perverse. The accounting around stock options is a mess that we will clean up in this chapter. For the moment, leave the $159 million for stock-based compensation stranded in the reformulated statement as a plug.

You will notice in this reformulation that we have not made any use of the distinction between stated value (or par value) of shares and additional (or excess) paid-in capital. This is of no importance for equity analysis; better to know the company’s telephone number than the par value of its stock. Retained earnings is a mixture of accumulated earnings, dividends, share repurchases, and stock dividends already identified in the reformation, so does not bear on the analysis. Conversions of one class of common to another with zero effect do not change the book value of equity (as with Nike). Indeed, different classes of common stock can be ignored, provided they share in earnings equally. So can stock splits and stock dividends; splits change the number of shares but do not change a given shareholder’s claim.

COMPREHENSIVE INCOME REPORTING UNDER U.S. GAAP AND IFRSFASB Statement No. 130 requires comprehensive income to be identified in the financial statements. It distinguishes net income from other comprehensive income and permits the sum of the two, comprehensive income, to be reported in one of three ways:

1. Report comprehensive income in the statement of shareholders’ equity by adding net income to other comprehensive income items reported in the equity statement.

2. Add other comprehensive income to net income in the income statement, and close the total comprehensive income to shareholders’ equity.

3. Present a separate statement of other comprehensive income apart from the income statement, and close it to equity along with net income from the income statement.

Most firms follow the first approach, as with Nike. So you now observe dirty-surplus in- come items added together into a number called “other comprehensive income” and other comprehensive income and net income added to “total comprehensive income”—all within the equity statement. This presentation facilitates the task of identifying comprehensive income. However, it is not, in fact, comprehensive from the common shareholders’ point of view. First, it omits preferred dividends, and, second, certain hidden items are not included.

Other comprehensive income under IFRS consists of items similar to those in the United States, with the addition of actuarial gains and losses on pension assets and asset revaluation gains and losses. Under IAS 1 (Revised 2007) firms choose to report a single statement of comprehensive income or two statements, a statement of operations and a statement of comprehensive income. Comprehensive income cannot be displayed in the statement of changes in shareholders’ equity (as is permitted under GAAP).

In June 2011 (at the time of writing of this edition of the book), the FASB decided to conform to the IFRS presentation, effective for U.S. GAAP for fiscal years ending after December 15, 2012. Nike must now choose to present the comprehensive income portion of its equity statement in Exhibit 9.1 as an add-

on to its income statement or in a separate statement following the income statement. Under the first option, comprehensive income becomes the bottom line in the income statement, with this total closed to the equity statement. Under the second option, net income is the bottom line of the income statement (as at present) but also the top line of the separate comprehensive income statement which, with other comprehensive income added, totals to comprehensive income (which is then closed to the equity statement). However, our reformulated statement will be exactly the same. Examples of IFRS presentation and the new GAAP presentation are on the Web page for this chapter.Note that GAAP and IFRS sometimes use different terminology. Stocks are shares under IFRS, common stock is share capital, and additional paid-in capital is called share premium (but the accounting for these items is identical).

PAYOUT AND RETENTION RATIOSThe disinvestment by shareholders is described by payout and retention ratios. The standard dividend payout ratio is the proportion of income paid out in cash dividends:

A calculation that you commonly see compares dividends to net income rather than comprehensive income. The dividend payout ratio involves payout in the form of dividends, but total payout is dividends plus share repurchases. Some firms pay no dividends but have regular stock repurchases. The total payout ratio is

calculated with total dollar amounts rather than per-share amounts. The difference between this ratio and the dividend payout ratio gives the percentage of earnings paid out as stock repurchases.

Note that stock dividends and stock splits are not involved. These simply change the share units, with no effect on the claim of each shareholder. Some splits and stock divi- dends involve a reclassification from retained earnings to additional paid-in capital, but again this has no effect on the value of claims.

Although the dividend payout ratio suggests that dividends are paid out of earnings, they are really paid out of book value, out of assets. So a firm can pay a dividend even if it reports a loss. Payout, as a proportion of book value, is the rate of disinvestment by shareholders:

Usually ending book value of common shareholders’ equity (CSE) is used in the denominator in these calculations (although, with dividends paid out over the year, average CSE is also appropriate).

Retention ratios focus on earnings retained rather than earnings paid out. The standard retention ratio involves only cash dividends (but can be modified to incorporate stock repurchases):

SHAREHOLDER PROFITABILITYThe reformulated statement yields the comprehensive rate of return on common equity, ROCE, the profitability of the owners’ investment for the period. ROCE is also the growth rate in equity from business activities. For Nike, the 2010 ROCE (using average equity for the year) is

The ROCE calculated on beginning common equity is 19.9 percent. Note that the income statement and balance sheet are not needed to calculate ROCE; rather, they provide the detail to analyze ROCE.

GROWTH RATIOSThe growth in shareholders’ equity is simply the change from beginning to ending balances. Growth ratios explain this growth as a rate of growth.The part of the growth rate resulting from transactions with shareholders is the net investment rate:

Nike’s net investment rate was a negative 9.6 percent because net cash was paid out; shareholders disinvested. The part of the growth rate that comes from business activities is given by the ROCE on beginning equity, 19.9 percent for Nike. The rate of growth of owners’ equity from both sources—new shareholder financing and business activities—is the growth rate in common stockholders’ equity:

Nike’s 2008 growth rate was 10.3 percent.

If ROCE is calculated with beginning CSE in the denominator, then

Growth rate of CSE = ROCE + Net investment rate

For Nike, the growth rate in common equity is 19.9 percent – 9.6 percent = 10.3 percent.

ISSUE OF SHARES IN OPERATIONSWhen firms grant shares to employees at less than market price, the difference between market price and issue price is treated under GAAP and IFRS as (deferred) compensation to employees and ultimately amortized as an expense to the income statement. This is appropriate accounting, for the discount from market value is compensation to employees and a loss of shareholder value. More frequently, though, shares are not granted to employees. Rather, stock options are granted and shares are issued later when

the options are exercised. Unfortunately, GAAP and IFRS accounting do a poor job of reporting the effects of stock options on shareholder value.Four events are involved in a stock option award: the grant of the option, the vesting of the option, the exercise of the option, and the lapse of the option. At the grant date, employees are awarded the right to exercise at an exercise price; the vesting date is the first date at which they can exercise the option; the exercise date is the date on which they actually exercise at the exercise price; and the lapse date is the date on which the option lapses should the employee choose not to exercise. Clearly the employee exercises if the stock is “in the money” at exercise date, that is, if the market price is greater than the exercise price.

If the call option is granted in the money at grant date (with the exercise price set at less than the market price at grant date), accounting treats the difference between the market price and exercise price as compensation. That compensation is then recognized in the income statement over the vesting period, as in the case of a stock grant at less than market price. However, most options are granted “at the money,” with exercise price equal to the market price at grant date. As time elapses and the market price of the stock moves “into the money,” no additional compensation expense is recorded. Further, when options are indeed exercised, no compensation expense is recorded. You see on the first line in Nike’s statement of equity that the amount received on exercise is recorded as issued shares, but, unlike the stock grants, the expense—the difference between the market price and the issue price— is not recorded.The appropriate accounting is to record the issue of shares at market price and recognize the difference between the market price and issue price as an expense. In the absence of this accounting there is a hidden dirty-surplus expense. The expense is not merely recorded in equity rather than the income statement; it is not recorded at all. But there has been a distri- bution of wealth to employees and that distribution has come at the expense of the share- holders: The value of their shares must drop to reflect the dilution of their equity. GAAP ac- counting treats this transaction, which is both a financing transaction—raising cash—and an operational transaction—paying employees—as if it is just a financing transaction. This hidden dirty-surplus accounting creates a hidden expense. Box 9.1 calculates Nike’s loss from the exercise of stock options during 2010.

Some commentators argue that, because options are granted at the money, there is no expense. Employees—and particularly management, who benefit most—say this adamantly.But there is no expense only if the options fail to move into the money. They also say that, 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 them with cash, and recording the expense is recording the cash-equivalent compensation: The firm is effectively issuing stock to employees at market price and giving them a cash amount equivalent to the difference between market and exercise prices to help pay for the stock. From a shareholder’s point of view, it makes no difference whether employees are paid with cash or with the value of the shares that shareholders have to give up; the shareholders are simply paying employees with their own paper rather than with cash. Recognizing this expense is at the heart of accrual accounting for shareholder value, for accrual accounting looks past cash flows to value flows; it sees an award of valuable stock for wages as no different from cash wages. If you are hesitant in viewing stock compensation as an expense, think of the case where a firm pays for all its operations—its materials, its advertising, its equipment—with stock options. (Indeed some sports stars have asked to be paid with stock options for promotions!) If the hidden expenses were not recognized, the income statement would have only revenues on it and no expenses. Stock options produce revenues and profits for shareholders if they provide an incentive for employees and management. But GAAP accounting does not match the cost of the options against these revenues and profits. Value added must be matched with value lost.

With the large growth in stock compensation in the 1990s, the hidden expense became quite significant, particularly in the high-tech sector. The Financial Accounting Standards Board addressed the issue, but in writing Statement No. 123R came to an unsatisfactory conclusion. This statement requires compensation to be recognized at grant date at an amount equal to the value of the option, priced using option-pricing formulas. The compensationis then recognized in the income statement over a service period, usually the vesting period. The credit goes to shareholders’ equity, incorrectly as we have seen with Nike. The international accounting standard on the issue, IFRS 2, requires similar treatment. This treatment is called grant date accounting. But the granting of options yields an expense only in recognition of possible exercise. If the option lapses (because the stock does not go into the money), no expense

is incurred, but the accounting maintains the expense. An expense is realized only if the option is exercised. The difference between the market price and exercise price at exercise date is the loss to shareholders. Recognizing this expense, as in Box 9.1, is called exercise date accounting. In 2010, Nike reported $159 million in before-tax stock option expense using grant date accounting. Box 9.1 calculates an expense of $161.1 million, be- fore tax, from the exercise of options during 2010. Now go to Accounting Clinic IV.Significantly, the Internal Revenue Service recognizes that an expense is incurred when options are exercised and gives the firm a tax deduction for it (if certain conditions are met). The firm books this tax benefit to equity, often as an addition to the proceeds from the share issue. So the $379.6 million that Nike received from the exercise of stock options (in Exhibit 9.1) represents $321.1 million received from the share issue plus $58.5 million in tax benefits. So, the accounting recognizes the tax benefit of the expense, increasing equity, but not the associated expense!

Exhibit 9.2 presents a reformulated statement of shareholders’ equity for Nike that reports the loss from the exercise of stock options as part of comprehensive income. As GAAP records an expense based on grant date accounting, we have to be careful not to double count. So you see in the reformulated statement that the after-tax loss on exercise of stock options, $102.6 million, has been reduced by the $159 million that hasbeen recognized under grant-date accounting. That, of course, gets rid of the $159 million embarrassing “plug” in the reformulated statement in Exhibit 9.1. The difference between market price and exercise price, $161.1 million has been added to share issues to report them as if they were issued at market value (and thus add no value). Now the reformulated statement records transactions with shareholders at market value with any loss from issuing shares at less than market value appropriately recognized in comprehensive income. It’s all a bit messy to handle, but that’s what poor GAAP accounting leaves us with. The difference between the grant date and exercise date expenses can be quite large if options go well into the money after grant date.

The loss from exercise of options in the current period is a legitimate loss that should be 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 losses from future exercise of options. This expected loss is referred to as the option overhang. It can be estimated as the loss incurred if outstanding options were exercised at the current market price. At the end of 2010, Nike had 36.0 million options outstanding with a weighted- average exercise price of $46.60. The closing market price for its shares at fiscal year end was $72.38. So the option overhang is estimated as follows (in millions):

This drag on the value of the shares amounts to $1.22 per share (with 484 million shares outstanding). Note that the liability for the expected loss is reduced by the expected tax benefit on exercise. The measure of the option overhang here is a floor valuation; it should also include option value for the possibility it might increase.

Firms use options and warrants for other operating expenses beside wages. See Box 9.2.

Accounting ClinicACCOUNTING FOR STOCK COMPENSATIONGAAP accounting for stock options in the United States employs grant-date accounting. The International Accounting Standards Board (IASB) also requires grant date accounting under IFRS 2.

Accounting Clinic IV leads you through grant- date accounting. Accounting Clinic IV also lays out exercise date accounting and takes you through the complete accounting that measures the effects of stock options on shareholders. Unearned compensation costs are recorded at grant date, and then recognized as expense in the income state- ment over the period when employee services are given. Accordingly, the compensation cost is matched against the revenues that the employees produce. Subsequent to grant date,

further losses are recognized as options go into the money. Here are the steps to effect sound accrual accounting for stock options:

1. Recognize the option value at grant date as a contingent liability, along with a deferred (unearned) compensation asset. The two items can be netted on thebalance sheet. The option value at grant date is the amount recognized with grant-date accounting under FASB Statement No. 123R. The grant-date value given to employees is compensation, but it is contingent upon the options going into the money, so it is a contingent liability to issue shares. The deferred compensation asset is similar to that which arises from stock issues to employees at less than market value.

2. Amortize the deferred compensation over an employee service period, usually the vesting period.

3. Mark the contingent liability to market as options go into the money to capture the value of the option overhang, and recognize a corresponding unrealized loss from stock options.

4. Extinguish the liability against the share issue (at market value) at exercise date. If options are not exercised, extinguish the liability and recognize a windfall gain from stock options.

For more on appropriate exercise date accounting, go also to the Web page for this chapter.