Two Views of the Firm
Entity View
Assets = Liabilities + Owners’ Equity
Two Views of the Firm
Entity View
Assets = Liabilities + Owners’ Equity
Proprietary View
Assets – Liabilities = Owners’ Equity
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Stock Repurchases
• No gains or losses are recognized
from the sale of a company’s
treasury stock
• Reasons for stock repurchases
– Management believes the shares are
undervalued and wants to boost the price
– Management wants to distribute surplus cash to
owners
– Management needs shares for stock options
Convertible Debt
A bond which, at the buyers
option, may be converted to
common stock at a
predetermined conversion price.
Convertible Debt
• Current GAAP specifies that
convertible debt be recorded as
debt only, with no value assigned
to the conversion feature.
• If the debt is converted the
company may use one of two
methods:
– The book value method
– The market value method
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Earning Per Share
• A critically important ratio
because it is used to calculate
price/earnings ratios.
• This is the only financial ratio
where the FASB mandates how it
is calculated.
• Earning Per Share information
must appear on the face of the
income statement.
Earning Per Share
The calculation of Earnings Per
Share depends upon whether a
firm has a simple capital
structure or a complex capital
structure.
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Simple Capital Structure
• A simple capital structure exists
when a company has no
convertible securities and no
options or warrants outstanding.
• Firms with simple capital
structures calculate only basic
earnings per share.
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Basic Earnings Per Share
Net Income - Preferred Dividends
EPS =
Weighted Average Number of Common
Shares Outstanding
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Complex Capital Structure
A firm has a complex capital
structure when its financing
includes either securities that are
convertible into common stock,
or options and warrants which
entitle holders to obtain common
stock under specified conditions.
Complex Capital Structure
Firms with complex capital
structures have an increased
likelihood that additional
common shares will be issued in
the future. This possible increase
in the number of shares is called
potential dilution.
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Complex Capital Structures
Firms with complex capital
structures must compute both
basic earnings per share and
diluted earnings per share.
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Diluted Earnings Per Share
For convertible securities use the if
converted method.
– Add to the numerator of basic EPS income
adjustments due to dilutive financial
instruments.
– Add to the denominator of basic EPS newly
issuable shares due to dilutive financial
instruments.
Diluted Earnings Per Share
• For Stock Options and warrants
use the treasury stock method.
– Assume the options will be exercised if they are
“in the money.”
– Assume that the firm uses the proceeds of the
exercise to purchase treasury shares at the
average market price for the period.
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Stock-Based Compensation
The FASB allows a choice of
methods.
• Use the APB 25 approach which
rarely recognizes compensation
expense
• Measure the fair value of the
compensation and charge this
amount to expense
Stock-Based Compensation
In the event the ABP approach is
chosen, the company must
disclose pro-forma net income
and earnings per share as if the
fair value method had been used.
Stock-Base Compensation
Fair Value Approach
• Compensation cost (the option
fair value) is measured only once,
the grant date.
• The compensation cost is charged
to expense on a straight-line
basis over the vesting period.
• The offsetting credit is to paid-incapital from stock options.
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