Financial Accounting: In an Economic Context

THE ECONOMIC CONSEQUENCES ASSOCIATED WITH ACCOUNTING FOR SHAREHOLDERS' EQUITY

The economic consequences associated with accounting for shareholders' equity arise in part from the effects of financial ratios (e.g., return on equity) that include the dollar amount of shareholders' equity or its components. Such ratios affect a company's stock prices, credit rating, and any debt covenants that restrict additional borrowings, the payment of dividends, or the repurchase of outstanding equity shares (i.e., treasury stock purchases). We argued in Appendix 5A that return on equity (net income divided by shareholders' equity) is the most important indicator of whether management is creating value for the shareholders. Indeed, the ROE model is designed to explain why return on equity increases or decreases. Four of Dun & Bradstreet's fourteen key business ratios explicitly use the dollar value of shareholders' equity (net worth) in their calculations: (1) current liabilities/net worth, (2) total liabilities/net worth, (3) fixed assets/net worth, and (4) return on net worth. Dun & Bradstreet uses the values of these ratios to determine a company's credit rating, which in turn can affect the terms (e.g., market price, interest rate, security, restrictive covenants) of the company's debt issuances.

Many companies “manage” their debt/equity ratios to maintain or improve their credit ratings. In general, as a company's debt/equity ratio increases, its credit ratings fall. When American Stores, ...