Valuation Tutor Lesson: Understanding the Consolidated Statement of Stockholders’ Equity

Overview

Stockholders’ Equity (or ‘Owners Equity”) is the difference between a firm’s assets and liabilities.  Stockholders’ equity (or simply equity) is further broken down into components, and this statement tells you how the components changed, i.e. what was responsible for the changes in the equity. In this lesson, we will work through the components with a large company; small companies sometimes merge this statement into their balance sheet. 

One source of a change in the equity is net income after tax.  But there are other items that change the value of the equity that do not pass through the income statement, such as unrealized gains from marketable securities.  These other transactions can be classified into two sub-sets:

Set A:  Transactions involving stockholders’ such as payment of dividends, purchases and issues of common stock.

Set B:  Transactions not involving stockholders or income summary but still impact stockholders’ equity.  This set of transactions is referred to as “Other Comprehensive Income” (OCI).

The concept of comprehensive income captures these other sources of changes in equity.  It is separated into two parts:

Comprehensive Income = Net Income after Tax + Other Comprehensive Income

Net Income After Tax (NIAT) results from combining the revenues and gains less expenses and losses over the accounting period into a temporary account referred to as the “Income Summary Account” which forms the basis of the disclosed Income Statement.  This temporary account is then closed off at the end of each period by transferring its balance to the stockholders’ equity account typically under the heading “retained earnings.”  

Other Comprehensive Income (OCI) has become increasingly important because of the holdings of financial assets by large public companies.  For example, Apple (AAPL) has approximately USD$100 billion of financial securities on their balance sheet today! 

Accounting for these securities falls into three types:

For Trading

Available-for-Sales

Held to Maturity

If a security is not classified as either the first or third then it is automatically deemed to be Available-for-Sale.  In this case any unrealized gains and/or losses must pass through Other Comprehensive Income in the Stockholders’ Equity Statement.  Given the growing importance of financial securities on the Balance Sheets of large firms this becomes a useful source of information and increasingly so after the financial crisis of 2008.

Consolidated Statement of Stockholders’ Equity:  Overview of the Parts

Barebones, this statement consists of four major categories:

Capital Stock --- This category reflects the equity financing decision, different classes of equity stocks, and can also include more esoteric items such as ESOP’s (see below)

Accumulated Other Comprehensive Income (AOCI) --- Described above in terms of transactions (other than Accounting Income transactions) that impact stockholders’ equity without stockholders’ being involved in the transaction.

Retained Earnings ---- Results from Accounting Income and Dividend payments

Treasury Stock --- in the US a company can trade its own stock.

Example: IBM

The above plot from Valuation Tutor depicts the four major components that make up IBM’s “Total Stockholders’ Equity” (the last item in the chart).  Capital Stock and Retained Earnings are both positive and Treasury Stock and Other Comprehensive Income are both negative for IBM.  Overall, Stockholders’ Equity is a net positive – a good sign!

The supporting numbers are depicted next:

As an aside, the term Non-controlling Interests above is a product of the consolidation process and this term replaces the older “Minority Interest” term that used to appear in the statements.  These arise from entities that are part of the consolidated “IBM Entity” that IBM management have control over the economic resources of the entity but hold less than 100% of equity ownership in the entity.

Consider now the four basic categories.

Capital Stock

Common stock, par value  $.20 per share and additional paid-in capital Shares authorized: 4,687,500,000 Shares issued (2010 - 2,161,800,054; 2009 - 2,127,016,668)

Common stock is stock issued for ordinary voting shareholders and common stockholders have the residual equity claims in the company.  Other types of stock will appear in this section for some firms.  The most common being Preferred Stocks.  These stocks have a preferred claim to dividend payments in the sense they rank ahead of common stockholders for dividends but they rank behind all debt-holders.  Preferred stock do not have a residual equity claim on the company which is an important part of a common stock’s capital gain.

The term Par value has little significance other than historical and legal significance.  It is a lower bound for issuing stock which is why it is usually set at some low amount.   When shares are issued, formally accounting records the par-amount in common stock and the remainder in additional paid-in capital.  However, external reporting often combines the two as is the case above for IBM.

Finally, in the label description it is common to provide additional information regarding the number of shares management is authorized to issue:  Shares Authorized.  For IBM this is 4.687 billion.  Shares Issued is the number of shares that have been actually issued in the market which for IBM is 0.933 billion in 2011.  However, it is noted that this is not the number of shares outstanding in the market.  This last number needs to be computed by subtracting away the number of Treasury stock from the number of issued stock.

Another less common form of equity stock is an ESOP (Employee Stock Ownership Plan).  This is a specific type of salary package in the US that includes receiving stock as compensation.  To qualify as being an ESOP it must be formally set up as a trust to get IRS recognition.  It is this latter feature that makes ESOP’s a rarer line item.  However, an example of one is provided below:

Treasury Stock

As discussed earlier this is stock that management has repurchased from the company’s owned issued stock.  It is a common way of paying a dividend alternative to a cash dividend.  That is, stockholders’ receive the dividend in the form of a capital gain if the company systematically reduces its issued stock by applying free cash flows to Treasury stock acquisitions.

Retained Earnings

This is the cumulative amount of net income that has been retained by the firm and not paid out as a cash dividend.  That is, at the end of each accounting period the Income Summary temporary account is closed off to the Retained Earnings permanent account.  Cash dividends can be paid out of the retained earnings account regardless of whether the company generated a positive net income for the current period or not.

Using Retained Earnings to Evaluate a Company

The investor Warren Buffet has a very interesting test that he applies to Retained Earnings.  He asks: over some period of time (e.g., 5- or 10-years), has the stock price appreciation exceeded the retained earnings?  In other words, if the company retained $1 of earnings, did the market value of the stock increase by more than $1?  If so, the company is producing value with the retained earnings.  This test gets to the heart of the retained earnings decision because it recognizes there is an opportunity cost to common shareholders when a company retains earnings.  This opportunity cost is met if the increase shareholder value over some reasonable period of time exceeds retained earnings.

Accumulated Other Comprehensive Income

This, like retained earnings, is a cumulative number but instead it results from the Consolidated Statement of Stockholders’ Equity as Other Comprehensive Income (OCI).  At the beginning of this lesson we provided a general overview of this line item.  In practice it consists of five types of sub components:

i. Foreign currency translations resulting from fluctuations in exchange rates that impact the financial statements.  This provides insight into a firm’s overall exposure to foreign currency risk.

ii. Unrealized gains and losses resulting from hedge accounting.  The unrealized gain and loss from a derivative contract that is part of a cash flow hedge passes through Other Comprehensive Income (OCI) and not the regular income statement.  The hedge accounting treatment of derivatives is a special case because otherwise all derivatives are automatically deemed as  “For Trading” under US GAAP and under this classification any unrealized losses and gains must pass through ordinary income.  From an accounting perspective the essence of hedge accounting reporting is to protect the regular accounting income statement from the fluctuations that are hedged by shifting these adjustments to the Balance Sheet and the Statement of Stockholders’ Equity via OCI.

iii. Unrealized gains and losses resulting from fair value accounting.  For any financial security (asset or liability) that is deemed to be “Available-for-Sale,” the unrealized gains and losses must be disclosed via OCI as opposed to passing them through Accounting Income.

iv. Additional defined benefit pension liabilities.  This is an important category for the typical “old economy” stock.  This category arises because pension plans can be either “Defined Benefits” or “Defined Contribution.”   Defined Contribution has easy accounting implications (Debit Pension Expense and Credit Cash or Payables) and are the most common form of pension plans today.  However, defined benefit pension plans were popular in the past and many old economy stocks have enormous obligations arising from such plans.  This area of accounting is complex, and requires actuarial estimation of the liabilities.  Changes in the liabilities relative to their underlying funding can have both regular income statement implications and OCI implications.  US GAAP has certain 10% corridor tests that protects the regular income statement from fluctuations within the corridor and exposes it to fluctuations outside of the corridor.  As a result, both the Statement of Stockholders’ Equity and the Accounting Income Statement are affected.  However, the changes in these liabilities if under-funded (or assets if over-funded) must first pass through Other Comprehensive Income and then additional corridor tests may kick in second.  Pension accounting is a major driver of IBM’s Accumulated Other Comprehensive Income balance.

v. The fifth category is only applicable to International Accounting Standards (IAS) and this category arises from the revaluation of fixed assets but revaluations that are not the result of some prior impairment test.  In fair value accounting under both US GAAP and IAS fixed assets are now subject to impairment tests.  That is, a fixed asset is impaired if there is a decline in their fair value and this impairment is written off to the regular accounting income statement.  Under IAS but not US GAAP previously impaired write-downs can be recovered but again this also passes through the regular income statement.  However, for the case of IAS fair value accounting permits upward revaluations under specific circumstances and conditions.  For example, upward revisions (that are not recovering previous impairments) are not available for distribution to ordinary shareholders.  If there is an upward revaluation then the gain flows through Other Comprehensive Income as opposed to regular income.

So OCI provides an analyst with rich insight into a company’s risk management practices, pension practices, available-for-sale security value fluctuations, exposures to foreign currency fluctuation risk and for IAS reporting firms upwards revisions in fair value. 

To see how the above works we will consider IBM.

Consolidated Statement of Stockholders’ Equity:  IBM Example

The formal statement covers the past three years and selected parts are displayed in the following example:

Important Observations

First, you have (or will) learn in the lesson on the Cash Flow Statement that this statement is designed performing a reconciliation of the closing balance of Cash and Marketable Securities with its opening balance organized by operating, investing and financing activities.  Similarly, the Stockholders’ Equity statement performs a reconciliation of the opening and closing balance of the Stockholders’ Equity section of the Balance Sheet organized around the major sub categories of the Stockholders’ Equity section (Capital Stock, Other Comprehensive Income, Retained Earnings/Dividends and Treasury Stock).

Second, this statement reports Comprehensive Income in the form of Net Income plus Other Comprehensive Income. 

For Other Comprehensive Income, IBM has first reported their net unrealized gains/losses from cash flow hedges.  The reported gain of $385 million has served to offset the underlying hedged item’s loss.

IBM has then reported its exposure to foreign currency translations which equaled a favorable $643 million for IBM.

As an analyst note for these first two line items one would expect that over time these items wash out over time because these fluctuations in the hedged item and foreign currency translations should not systematically favor or hurt IBM’s core activities over time.   As a result, when forecasting future comprehensive income these items can be ignored.

The next items, under the header Retirement-related benefit plans, arise from Defined Benefit pension accounting.  These items include prior service credits/costs and net losses/gains and amortizations.  US GAAP permit a “corridor” for pension accounting fluctuations.  Under the Corridor Method, a portion of the gains or losses is recognized in earnings when the cumulative amounts of these gains or losses exceed 10% of the benefit obligation, or assets, if larger (“the corridor”).  For IBM amortization of resulted in $808 million being expenses through their net income statement.

 

Finally, for IBM unrealized gains and losses from available-for-sale securities were $51 million gains, small relative to the pension accounting implications.

 

Summing up, the above has resulted in aggregate Other Comprehensive Income being a gain of $87 million which relative to Accounting Income is small for IBM.  However, this will not always be the case especially when Defined Benefit Pension Accounting is involved.

The final set of reconciliations involves capital accounts, Treasury Stock adjustments and cash dividend payments.

 

 

Conclusions

The Consolidated Statement of Stockholders’ Equity is a technically demanding statement.  However, wading through the technicalities is worth it because it reveals a rich collection of information relevant to understanding a firm’s risk management policies, their exposures to important sources of risk, the impact of fair value accounting on this and other major statements, as well as their exposure to defined benefit pension accounting.