• Home
• 2.1 Introduction
• 2.2 SEC Interactive Data
• 2.3 Accessing SEC Data
• 2.4 Additional Information
• 2.5 Touring the 10-K
• 2.6 Primary Statements
• 2.7 M D&A
• 2.8 Item 6 Selected Data
• 2.9 Mini Case Studies
• 2.10 Summary
• A.1 Balance Sheet
• A.2 Income Statement
• A.3 Cash Flow Statement
• A.4 Stockholders' Equity
• A.5 Statement Linkages
• A.6 Common Size Analysis
• 2.11 Questions

A.3 Consolidated Statement of Shareholders’ (or Stockholders’) Equity

The fourth major financial statement, the consolidated statement of shareholders’ equity is the least known among the primary statements.  This statement measures the second concept of income, referred to as “Comprehensive Income.”  Today, however, this statement is gaining increasing importance from the role it plays in fair value accounting and in particular hedge accounting.  Comprehensive Income provides management with additional flexibility for income smoothing resulting from the application of fair value accounting.  This is because fair value accounting creates a set of rules with respect to the recognition and accounting treatment for unrealized gains and losses.  These rules determine which income statement (if any) that these unrealized gains and losses must pass through.  This can have profound implications for the economy because, for example, they can influence a bank’s ability to lend by influencing a bank’s capital tiers. 

But first one needs to know:   What is comprehensive income?

An example of reporting Comprehensive Income is provided below for EBAY:

Other Comprehensive Income contains activities that cause stockholders’ equity to change but do not pass through the accounting net income statement.  To reflect this distinction the stockholders’ equity section of the balance sheet contains two line items titled:  “Accumulated Other Comprehensive Income” and “Retained Earnings.”   These are separate line items because the latter results from the Consolidated Net Income Statement each period and the former results from the Consolidated Statement of Stockholders’ Equity each period.

Combined accumulated retained earnings and accumulated other comprehensive income provide the respective components of comprehensive income that have been retained by the business.   

Other Comprehensive Income (OCI)

OCI provides a rich source of information to a financial analyst because it plays an important role in both fair value and hedge accounting.  For example, bank lending is influenced by capital tiers and tier 1 capital in particular.  Tier 1 capital is defined relative to stockholders’ equity including retained earnings but excluding accumulated other comprehensive income.  As a result, for the banking sector it makes a big difference whether an unrealized loss from fair value accounting passes through the accounting income statement versus whether it passes through OCI.  The former case affects the ability of a bank to lend whereas the latter does not.  It is important therefore, to know what passes through OCI and what does not.

For a large multi-national corporation OCI typically consist of four components:

In addition, to the above four items transfers will occur to the accounting income statement from OCI, whenever the unrealized gains and losses become realized in the current period.

Together these items make up the component Other Comprehensive Income.  A summary of these items is provided next followed by some detailed examples.

Foreign Currency Translations

This item results from SFAS 52 the statement governing Foreign Currency Translations.  Consolidation accounting requires a consolidated foreign subsidiary to have a designated functional currency.  This can be either USD or a foreign currency.  For the foreign currency cases unrealized foreign exchange rate gains and losses pass through OCI whereas if it is USD the unrealized gains and losses pass through the accounting income statement.  For the latter hedge accounting can be further applied to shift these unrealized gains and losses to OCI.

Over time an analyst would expect that these gains and losses would average out because foreign currency fluctuations do not typically exhibit trend behavior over the long run.

Unrealized Gains and Losses

These are unrealized gains and losses for available-for-sale (AFS) on debt and equity securities as governed by SFAS-115.  Classification of a security is based on management’s intent and ability to hold a particular security.

Retirement Related Benefit Plans

These net of tax items recognize the gains and losses and prior service costs or credits that pertain to the current period but are not already recognized under SFAS 87 or related post retirement statements.

Hedge Accounting Adjustments

These items result from SFAS 133 on hedge accounting.  For a cash flow hedge the derivative’s gain or loss is initially reported as a component of other comprehensive income. In addition, for a hedge of the foreign currency exposure of a net investment in a foreign operation, the gain or loss is also reported in other comprehensive income.

To illustrate further the specific items it is useful to provide some examples.

Example 1:  Risk Management and OCI Accounting

Suppose an airline wants to hedge against fuel prices increasing – they can do so by buying a forward contract on fuel.  This fixes the price the company pays at some future point in time (e.g., 3-months, 6-months, 9-months or beyond).  If the spot price goes up the company gains because the gain from the forward contract will approximately offset the loss from paying higher spot prices.  If the spot price goes down the company loses on the forward contract but gains from acquiring the fuel at a lower price.  If this example is designated as a “cash flow hedge” and the company has appropriate support documentation in place, then these unrealized gains and losses pass through OCI not regular income.  They are finally transferred to accounting income only when they are ultimately realized. 

The previous example can have long term implications, up to 30-years.  For example, consider a financial institution (or any corporate for that matter) that enters into an interest rate hedge using a thirty year interest rate swap contract.  How the institution defines the hedge again becomes important because if this hedge is specified as a cash flow hedge the unrealized gains and losses pass through OCI.  If the institution specifies the hedge as a fair value hedge, under hedge accounting the unrealized gains and losses associated with both the hedging instrument and the hedged item are coordinated within the accounting income statement.  This implies that to the extent that the hedge is not perfect the net unrealized gains or losses from a fair value hedge end up in accounting income as opposed to OCI for a cash flow hedge.

The above example, motivates why a consumer of financial statements needs to pay careful attention to the Stockholders’ Equity Statement because it provides rich insight into a company’s risk management practices and unrealized gains and losses are shifting around between the two income statements.

Example 2:  Financial Asset and Liability Classifications

The classification of financial assets and liabilities also has a direct influence upon which income statement (if any) unrealized gains and losses pass through.

Held-to-maturity (Affects Net Income)

Intention is to hold security until maturity and this is carried on the books at amortized cost.  The premium or discount for the bond is amortized over life to accounting income and temporary fluctuations in market value are ignored.

It is noted that equity securities have no defined life and therefore cannot be classified as held-to-maturity.  They will generally end up classified as available-for-sale unless they are held for trading purposes.

Trading Securities (and derivatives) (Affects Net Income)

Financial securities acquired with purposes of selling in near future.  The accounting for these securities is that unrealized gains and losses must be recognized in the Income Statement.  All derivatives are automatically deemed to be trading securities unless they are documented as part of a hedge.

Available-for-Sale (Affects Other Comprehensive Income)

This category catches securities that are not classified as either Held-to-Maturity or Trading.  These are also carried at fair value but their unrealized gains or losses go through Comprehensive Income (via OCI) not the regular Net Income Statement.

Finally, another important implication for financial analysts and other users who are interested in forecasting future Comprehensive Income it is important to note that three of the above four items (foreign currency translations and cash flow hedge accounting) we would expect to average out to zero across time.  That is, have a transitory impact upon comprehensive income, whereas the remaining items (pension accounting and some unrealized gains and losses from available-for-sale securities) may have a relatively more permanent impact upon accumulated other comprehensive income.

Example 3:  Defined Benefit Pension Plans

For old economy stocks this can be significant.  For example the oldest company, that is a current member of the Dow Jones Industrial Index, is DuPont who report their defined benefit pension obligations in millions as follows:

From the above you can see that benefits paid are 1.610 billion for 2011.

 

Under SFAS 158, company “defined benefit” pension plans must recognize the difference between the projected $ benefit obligation and the fair value of the plan’s assets as either an asset or a liability.   Originally pensions were accounted for by recognizing pension expenses when payments were made.  However, this led to large liabilities not being recognized in the financial statements.  SFAS 158 (US GAAP) 2006 improved the financial reporting for defined benefit pension accounting by communicating the funded status of the pension plans transparently in the statements as opposed to relegating this to footnote details.   The reporting net was widened to include liability obligations to pay medical expenses of retired employees and spouses by accruing future benefits as a form of deferred compensation.

 

Defined benefit pension not only creates accounting complexities but also uncertainties and significant potential conflicts of self-interests between the firm and employee.  This is because if a company goes bankrupt there are two choices, reorganize in an attempt to stay in business or liquidate.  The defined benefit pension plan is usually terminated in re-organization and is always terminated in liquidation.  Defined contribution plans that are vested with employees avoid these problems plus are much easier to account for when contributions are made.  As a result, defined contribution plans are the most common form of pension plan today.  Defined contribution plans are absent in the next EBAY comprehensive example as is the norm for tech stocks. 

Comprehensive Example:  EBAY’s Consolidated Statement of Stockholders’ Equity

The above presents part of EBAY’s actual statement.  In the actual statement three years are provided (similar to the Income Statement) but the form of presentation differs because now time is given by rows and categories are provided by column (unlike a traditional income statement).

For EBAY we can first consider an additional subset by scrolling to the bottom as indicated below:

Four aggregated OCI items are circled above.  For EBAY these are expressed in thousands as follows:

First, observe that EBAY is a new economy stock and therefore does not have defined benefit pension plans.  That is, today the typical pension plan is a defined contribution plan which simplifies accounting and protects employees against future restructuring.  So there are no pension related entries in OCI for EBAY.  The other three general categories are all present along with a separate itemization of tax provisions arising from these three categories.

The first category is the change in unrealized gains from investments.  In supporting footnote disclosure EBAY reports its classification for investments.  For example, the “Available-for-Sale” category, which makes up the bulk of the unrealized gain balance, is disclosed as follows:

The second category is change in unrealized gains and losses resulting from cash flow hedges.

Not surprisingly EBAY is a heavy consumer of foreign currency derivatives given their sizeable exposures to foreign exchange risk especially with its PayPal transactions which are processed globally over the web.  However, not all foreign exchange rate fluctuations are hedged as the next category indicates.

The third category is the foreign currency translation adjustment which is negative $280 million.  This arises from accounting for foreign currency and can arise from subsidiaries whose functional currency is not the USD.  EBAY’s foreign currency adjustments have gone against them each year:

EBAY	2009	2010	2011
Foreign currency translation adjustment	-217724	-175605	-280930

Details of EBAY’s foreign exchange exposures are provided in the 10-K.  For example:

Combined, EBAY’s Comprehensive Income for 2011 is:

Comprehensive Income = Net Income + OCI

•      Net Income = 3229387

•      OCI = 56804 + 58289 -280930 -36009 = -201846

•      Comprehensive Income = 3229387 – 201846  = 3027541

This is reported as follows:

Remark:  EBAY has inadvertently labeled “Comprehensive Income” as “Other comprehensive income” in the last line above.  The values provided equal “Comprehensive Income.”

From Consolidated Statement of Stockholders’ Equity to the Balance Sheet

The consolidated statement of Stockholders’ Equity in a 10-K provides the details for the current and previous two years of comprehensive income.  Across periods other comprehensive income is accumulated and the current balance is reported in the stockholders’ equity section of the balance sheet.  Dividends do not affect this accumulated item.  Further fair value accounting will result in OCI containing unrealized gains and losses, but as noted earlier once these gains and losses are realized they are transferred out of OCI to accounting income.  These realized gains and losses ultimately end up in retained earnings and thus can support the stock’s dividend policy.  It is important for users of the financial statements to understand these flows to and from Accumulated Other Comprehensive Income that take place over time.

A summary of the remaining items in the stockholders’ equity section of the balance sheet will be described next.

Stockholders’ Equity:  Balance Sheet

Capital Stock

This item reflects the equity financing decision.  It can include different classes of stocks plus it can also include some rarer items such as ESOP’s.

For IBM depicted above this section is one line:

Common stock, par value $.20 per share, and additional paid-in capital Shares authorized: 4,687,500,000 Shares issued (2011-2,182,469,838; 2010-2,161,800,054)

The above includes a number of terms and summarizes a lot of information as follows:

Common stock:  These are the ordinary voting shareholders and represent the residual equity in the company.  Other types of stock can be issued such as Preferred Stocks but for the IBM example there is no preferred stock.

Par value:  Par value has little significance other than historical and legal significance (lower bound for issuing stock).  When shares are issued, accounting records the par amount for common stock and the remainder is then entered into additional paid-in capital.  However, for reporting purposes it is common to aggregate these two accounts as has IBM have (2011 48129, 2010 45418 in millions)

Shares Authorized:  The number of shares that can be issued (4.687 billion)

Shares Issued:  The number of shares actually issued in the market (2011-2,182,469,838; 2010-2,161,800,054).

However, not all of these shares are currently in the market because IBM can purchase their own stock, which is referred to as Treasury Stock.  We will cover this additional item below.

An example, of a little more complex Capital Stock reporting is Hershey the chocolate company.

The above example contains different classes of common stocks. 

For the case of ALE you can verify the use of ESOP’s:

ESOP’s are a specific Salary package that includes receiving stock as compensation – must be set up as a trust to get IRS ESOP recognition.  It is a rarer line item to find.

Retained Earnings

Accounting income summary is a temporary account that determines accounting net income and is then closed off to retained earnings as part of a permanent balance sheet accounting.  This item reflects the accounting income that has never been paid out as a cash dividend.

Each of the above examples have positive retained earnings. 

Serious investors such as Warren Buffet place a lot of weight on this line item because it implies an opportunity cost.  That is, earnings retained should create additional amounts of shareholder value that are at least equal to what was retained.  Buffet describes these tests as follows in his annual meetings:

Subsequently he appears to have modified this test as follows:

However, regardless of precise implementation details the important and valid point is that when management retain earnings there is an opportunity cost associated with it and good management will meet or beat this implied cost.

Treasury Stock

A public company in the US can purchase its own stock.  This reflects an alternative method for paying dividends to shareholders that is popular with technology stocks.  That is, ignoring taxes investors are indifferent between receiving a cash dividend and receiving a dividend in the form of a capital gain.  In the presence of taxes the advantage swings towards capital gains and so many stocks acquire their own shares as an alternative form of dividend payment. 

In the topic covering the cash flow statement the non US GAAP measure free cash flow was introduced.  Conceptually free cash flow to equity represents the dividend a company could pay (i.e., economic dividend) without affecting the value of the stock.  As a result, when Treasury stock is acquired from free cash flow the per share price is predicted to increase because the number of shares outstanding is reduced, even though the total value remains unchanged.  As a result, the financial test relevant to evaluating Treasury stock acquisitions is whether it is covered by free cash flow to equity.

Accumulated Other Comprehensive Income (AOCI)

Reflects gains and losses not recognized in the income statement but instead pass through the Consolidated Statement of Stockholders’ Equity.  This line item results from the Consolidated Statement of Stockholders’ Equity as discussed in this topic.  The balance sheet accounts separately for the Accumulated Other Comprehensive Income.

Non-Controlling Interests

This item arises from the consolidation process when the company controls less than 100% of a subsidiary.  Formally, this is not part of Stockholders’ Equity and is reported separately after stockholders’ equity.  This is illustrated in the earlier IBM and HSY examples.