Intermediate Accounting III: Equity and Earnings Per Share
Chapter 6. Intermediate Accounting III: Equity and Earnings Per Share
Equity is the ‘true stake of the shareholders’ remaining after all liabilities are repaid. However, its composition is often much more complex than assets or liabilities. Today, we study the sophisticated classification of equity and the distribution of earnings.
1. Equity Structure
Equity is the ‘net assets’ of a firm, calculated as assets minus all liabilities. In accounting, it is strictly classified based on its source as follows:
| Item | Description | Characteristics |
|---|---|---|
| Capital Stock | Par value of paid-in capital | Basis for shareholder proportions |
| Capital Surplus | Amount issued in excess of par | Not for dividends (Capitalizable) |
| Capital Adjustment | Temporary contra accounts | Treasury stock, Discount on stock issuance |
| Accumulated OCI | Unrealized gains/losses | Revaluation surplus, FV appreciation |
| Retained Earnings | Sum of accumulated net income | Source of dividends; solvency indicator |
2. Treasury Stock and Capital Adjustment
When a firm buys back its own shares, it is viewed not as the acquisition of an asset, but as a return of capital.
| Category | Accounting Treatment | Impact |
|---|---|---|
| Acquisition | Capital Adjustment (Contra) | Total Equity Decreases ↓ |
| Disposal | Capital Surplus or Adjustment | Equity Increases or Decreases |
| Retirement | Capital Decrease (Reduction) | Shares Outstanding ↓ EPS Increases ↑ |
3. Earnings Per Share (EPS)
This is the most critical indicator used by investors to judge a firm’s profitability.
| Type | Subjects | Meaning |
|---|---|---|
| Basic EPS | Outstanding common shares | Actual stake of current shareholders |
| Diluted EPS | Includes potential common shares | Worst-case EPS if conversion occurs |
The Trap of EPS: Even if net income does not increase, EPS will rise if the number of shares is reduced through retirement of treasury stock. One must separately analyze the ‘quality of earnings’ behind the numbers.
We have now finished the specific topics of financial accounting. In the next chapter, we will cover the new model for revenue recognition and hybrid financial instruments.
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