Chapter 15 Outline

Chapter 15 Outline
o Equity= assets + liabilities
o Is the basic risk capital of an enterprise it has no guaranteed return
or a timetable for repayment of the capital investments.
o It can be invested in to long term assets, and exposed to any potential
o Major difference between equity and liability is
 Equity doesn’t have an obligation to transfer future resources
for prior event.
Capital structure
o Mix of debt and equity which is considered by investors and debated
over whether the company debt and equity balance or not.
Theories of Equity:
o Proprietary theory
 Assets- Liabilities= proprietorship
 According to this theory firm is owned specific person or
 Financial reporting is based on the premise that the owner is
the primary focus of the company’s financial statement as he or
she makes the decisions.
o Entity Theory
 Assets= equities
 In this case the owner is the firm.
 The viewpoint suggests that the firm exist as a separate and
distinct entity by the help of its stockholders.
 The financial reporting puts the firm and its interest as a focal
o Fund Theory
 Defined in three Features fund, assets and restriction
 Fund: an area of attention defined by the activities and
 Assets: economic services and potentials
 Restrictions: limitation on the use of assets
o Commander theory
 It focuses on the goals of the manager.
 It is applicable to all types of organizations
o Enterprise theory
 Applies only to large nationally traded companies.
 Treats the organizations as social institutions
 Little impact in the accounting world
o Residual Equity Theory
 Assets – Specific equities = residual equities
 Specific equity holders include creditors and Preferred stock
 Focus on providing the residual owners information regarding
the resource flow so that theory can assess the value of their
Distinction between debt and equity
o Debt to equity ratio:
 It directly related to the risk associated with investing in the
firm's stock.
 If the ratio goes up the risk of investing goes up.
o A financial instrument is equity if:
 It doesn’t impose an obligation on the issuer
 If there is an obligation then it should be determined whether
it must be settled by a transfer of assets (liability) or its and
ownership relationship.
o If it contains components of equity and liability then the issue price
would be allocated between its components based on their relative
fair values.
o If the fair value were not measureable then with and without method
would be used.
o Mandatorily redeemable proffered stock (MRPS) should be reported
as a liability.
Components of equity
o Paid in capital
 Legal capital: the amount of net assets that cant be distributed
to stockholders
 Law vary state to state but legal capital generally constitutes of
par or stated value of outstanding shares
 Additional paid in capital: include amount originally received
for shares of stock in excess of par or stated value
o Special features
 Conversion:
 Included one preferred stock which enables the
stockholder to convert the preferred stock into common
 Call provisions:
 Allow the corporations to reacquire preferred stock at
some predetermined amount.
 A premium is paid in most situations to reacquire the
Cumulative provision
 Gives the preferred stockholder a protection, that if a
preferred stock is reacquired and there is unpaid
dividend then, it would be paid prior to paying any
other dividends.
Participating Provision:
 Allow preferred stockholders to share dividends in
excess of normal returns with common stock holders.
Redemption provision
 Allows the shareholder to exchange the preferred stock
for cash in the future.
 Although there might be a maturity date or a
redemption price set up.
Stock Options
 Shares that are issued in addition to common stock to
fulfill any agreement made with employees or security
Stock Warrants
 Certificates that allow holder to acquire shares at a
certain price within a stated period.
Retained Earnings:
 Represents the accumulated net profits of a corporation
that have not been distributed as dividends.
 Doesn’t mean that cash is available for distribution
Stock split
 A procedure to reduce the price of the stock to attract
 In a stock split each stock holder receive a stated
multiple of stock held e.g. 2 for 1
Treasury Stock
 To reduce capital a company might buy its shares back
on the open market, which are called treasury stocks.
 Buying back stock reduces both assets and equity.
 Company might buy it to increase price or offer it to its
Other comprehensive income
 Items recorded as other comprehensive income arise
from events not connected with issuance of stock or
normal profit related operation.
 Major examples are unrealized gains or losses on
investment in debt and equity securities (Available for
sale securities)
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