OCW041: Additional Topics in Stockholders’ Equity

Other Comprehensive Income

Accumulated Other Comprehensive Income (AOCI) is all the changes in equity other than transactions from owners and distributions to owners.

Learning Objectives

Summarize the purpose of the comprehensive income section on the financial statement

Key Takeaways

Key Points

  • Other comprehensive income is comprised of several gains and losses that are not disclosed in the income statement and which relate to available for sale securities, foreign currency translation, derivatives, pension plans, and revaluation of assets.
  • The AOCI balance is presented as a line item in the stockholder ‘s equity section of the balance sheet.
  • The individual components of AOCI can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Key Terms

  • hedge: Contract or arrangement reducing one’s exposure to risk (for example, the risk of price movements or interest rate movements).
  • IFRS: International Financial Reporting Standards; designed as a common global language for business affairs so that company accounts are understandable and comparable across international boundaries.

Definition of Other Comprehensive Income

Other comprehensive income, disclosed in the stockholder’s equity section, is the total non-owner change in equity for a reporting period or all the changes in equity other than transactions from owners and distributions to owners. Most changes to equity, such as revenues and expenses, appear in the income statement. A few gains and losses are not shown in the income statement since they are not closed to retained earnings. They are disclosed in the shareholder equity section of the balance sheet known as “accumulated other comprehensive income”.

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Stakeholders that use financial statements.: Other comprehensive income can be reported in its own statement of comprehensive income or in a separate section within the income statement.

Components of Other Comprehensive Income

Other comprehensive income is comprised of the following items:

  • Unrealized gains and losses on available for sale securities (debt and equity)
  • Gains and losses on the effective portion of derivatives held as cash flow hedges
  • Gains and losses resulting from the translation of the financial statements of foreign subsidiaries from the foreign currency to the reporting currency
  • Actuarial gains and losses on recognized defined benefit pension plans (minimum pension liability adjustments)
  • Changes in the revaluation surplus account (this account records changes between the market and book value of fixed assets on the balance sheet)

The accumulated other comprehensive income balance is presented as a line item in the stockholder’s equity section of the balance sheet. The individual components of the balance can be presented in a separate statement of comprehensive income or a separate section for comprehensive income within the income statement.

Other Comprehensive Income and IFRS

All items of income and expense recognized in a period must be included in profit or loss unless a standard or an interpretation requires otherwise. Some IFRSs (international financial reporting standards) require or permit that some components be excluded from the income statement and instead be included in other comprehensive income.

Convertible Stock

A convertible security, such as convertible preferred stock, is any security that can be converted into another.

Learning Objectives

Explain why a company would offer convertible stocks

Key Takeaways

Key Points

  • Convertible preferred stock has an embedded option that allows the stock to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.
  • The conversion feature in convertible stock adds an option of acquiring common shares, which has certain advantages, such as voting rights and unlimited access to company earnings.
  • Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

Key Terms

  • liquidation: The selling of the assets of a business as part of the process of dissolving it.
  • par value: The amount or value listed on a bill, note, stamp, etc.; the stated value or amount.

Definition of Convertible Securities

This refers to any security that can be converted into another security. Convertible securities can include bonds that pay interest or preferred stocks that pay dividends. This type of stock has an embedded option that allows it to be converted into a specified number of shares of common stock at a predetermined price; usually at a premium over the stock’s market price.

The conversion can also be based on the occurrence of certain conditions, such as the stock’s market price appreciating to a predetermined level, or the requirement that the conversion take place by a certain date. The conversion is exercised at the security holder’s discretion. The shareholder can also sell the original security and use the conversion feature as a favorable selling point.

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Allied Paper Corp. Common Stock Certificate: A public company’s preferred stock is designated as convertible if it can be exchanged for common stock.

Convertible Preferred Stock

Preferred stock (also called preferred shares ) is an equity security with properties of both an equity and a debt instrument, and is generally considered a hybrid. Preferred shares rank higher to common stock during earnings distributions, such as dividends; however, they are subordinate to bonds in terms of their claim to company assets in the event of a business liquidation. Unlike common stock, preferred shares usually have no voting rights. The shares may also be cumulative or non-cumulative. A cumulative preferred stock accumulates unpaid prior period dividends into the future, while a non-cumulative preferred loses rights to any dividends not paid in prior periods. The conversion feature adds an option of acquiring common shares, which has certain advantages, such as voting rights.

Convertible Stock and Stockholder ‘s Equity

Accounting principles require the reporting of convertible preferred stock in the same manner as non-convertible preferreds. Preferred stock is reported in the stockholder’s equity section as the number of shares outstanding, multiplied by the stock’s market price. The result is divided between the value of the shares that fall under “common stock – par value” and the excess value over par is reported as “common stock – additional paid-in-capital”. The value of the conversion feature is not reported due to the uncertainty of when the conversion may occur, if at all.

Stock Warrants

A stock warrant entitles the holder to buy the underlying stock of the issuer at a fixed exercise price until the expiration date.

Learning Objectives

Summarize why a company would issue a stock warrant

Key Takeaways

Key Points

  • Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer.
  • Stock warrants have several features that should be evaluated: premium, expiration date, leverage, and restrictions on exercise option.
  • No matter the type of warrant, all are reported in the stockholder ‘s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of shares the warrant provides.

Key Terms

  • yield: The current return as a percentage of the price of a stock or bond.
  • exercise price: The fixed price at which the owner of an option can purchase (in the case of a call) or sell (in the case of a put) the underlying security or commodity.
  • contributed capital: Refers to capital contributed to a corporation by investors through purchase of stock from the corporation (primary market) (not through purchase of stock in the open market from other stockholders (secondary market)). It includes share capital (i.e. capital stock) as well as additional paid-in capital.

Definition of Stock Warrants

A stock warrant is similar to a stock option in that it entitles the holder to buy the underlying stock of the issuing company at a fixed exercise price until the expiration date. Stock warrants, like options, are discretionary and it is not mandatory for the warrant holder to acquire the underlying stock. Warrants are frequently attached to bonds or preferred stock as an added bonus for the buyer. They benefit the warrant issuer by allowing the company to pay lower interest rates or dividends. They can be used to enhance the yield of the bond and make them more attractive to potential buyers. Warrants can also be used in private equity deals.

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Sears Roebuck & Co. Bond Certificate: Public companies can offer company bonds for sale with stock warrants attached.

Stock Warrant Features

Since warrants are typically attached to other securities, in certain cases it is possible to detach them and sell them independently of the bond or stock. In the case of warrants issued with preferred stocks, stockholders may need to detach and sell the warrant before they can receive dividend payments. Therefore, it is sometimes beneficial to detach and sell a warrant as soon as possible. Stock warrants have several features that can make them more or less attractive investments:

  • Premium (the extra amount paid for the shares when exercising the warrant as compared to the market price paid when acquiring the stock through the open market)
  • Leverage ( risk exposure to the underlying shares acquired through the warrant as compared to the risk exposure of shares purchased in the open market)
  • Expiration Date (the date the warrant expires; the longer the time frame involved until expiration the greater the opportunities for stock price appreciation, which increases the price of the stock warrant until its value diminishes to zero on the expiration date)
  • Restrictions on Exercise (American-style warrants must be exercised before the expiration date and European-style warrants can only be exercised on the expiration date.

Stock Warrants and Stockholder’s Equity

There are many types of stock warrants — equity, callable, putable, covered, basket, index, wedding, detachable, and naked warrants. No matter the type of warrant, all are reported in the stockholder’s equity section of the balance sheet as a line item under contributed capital. They are valued at their exercise price multiplied by the specified number of common shares the warrant provides.

Calculating Diluted Earnings per Share

Diluted earnings per share (EPS) takes the basic EPS formula and accounts for the effect of dilutive shares on earnings.

Learning Objectives

Explain why a company would calculate diluted earning per share for its stock

Key Takeaways

Key Points

  • Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator ( weighted average number of common shares outstanding), which decreases the value of earnings per share.
  • Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.
  • Basic EPS, based on net income and reported on the face of the income statement, is followed by diluted earnings per share, also reported on the income statement.

Key Terms

  • dilutive: Describing something that dilutes or causes dilution (reduces value).
  • weighted average: An arithmetic mean of values biased according to agreed weightings.

Diluted Earnings Per Share

Definition

Diluted Earnings Per Share (diluted EPS) is a company’s earnings per share (EPS) calculated using fully diluted common shares outstanding (i.e. which includes the impact of instruments such as stock option grants and convertible bonds). Fully diluted common shares consider securities with features that will increase the number of common shares outstanding and reduce (dilute) earnings per share. Diluted EPS indicates a “worst case” scenario, one in which everyone who could have received stock did so without purchasing shares directly for the full market value.

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Earnings per share shows the amount of income applicable to each share of common stock.: Diluted earnings per share includes shares of common stock from dilutive securities, such as convertible debt or stock options, in its calculation.

Calculation

The basic earnings per share formula involves taking the income available for common shareholders (net income minus preferred stock dividends), divided by the weighted average number of common shares outstanding. Dilutive common shares from dilutive instruments, such as stock options or stock warrants, are added to the basic equation’s denominator (weighted average number of shares outstanding), which decreases the ending result of earnings per share. So, basic earnings per share tends to have a higher value than diluted earnings per share. Diluted earnings per share is the most conservative per share earnings number because the equation takes into account the largest number of common shares that could be outstanding.

Disclosure

Public companies calculate and disclose EPS for each major category on the face of the income statement. In other words, they make an EPS calculation for income from continuing operations, discontinued operations, extraordinary items, changes in accounting principle, and net income. Basic EPS, based on net income, is followed by diluted earnings per share and and both figures are reported on the income statement.


Source: Accounting