Chapter 15 Outline Equity 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 risks 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 group. 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 point. o Fund Theory Defined in three Features fund, assets and restriction Fund: an area of attention defined by the activities and operations 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 holders. Focus on providing the residual owners information regarding the resource flow so that theory can assess the value of their claim. 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 stock Call provisions: Allow the corporations to reacquire preferred stock at some predetermined amount. A premium is paid in most situations to reacquire the stock. 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 holders. 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 investors. 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 employees. 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)