Chapter 16

Learning Objectives 1.  Convertible securities: Issuance, conversion, retirement 2.  Convertible preferred stock 3.  Contrast stock warrants with other securities 4.  Stock compensation plans 5.  Controversy involving stock compensation plans 6.  Earnings per share in a simple capital structure 7.  Earnings per share in a complex capital structure 8.  Appendix A: Stock-appreciation rights 9.  Appendix B: Comprehensive EPS example

Dilutive Securities, Earnings per Share

Annual reports: Google, Facebook 1

Preview of Chapter 16

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Learning Objective 1 §  Convertible securities: Issuance, conversion, retirement

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Debt and Equity

Debt and Equity

§  Before finance majors took over Wall Street, life was simple

§  Equity was equity (common stock) §  Cash received when stock sold to public §  No obligation to pay dividends §  No obligation to repurchase shares

§  Equity was equity (common stock) §  Debt was debt (bonds, note pay, loans)

§  Debt was debt (bonds, note pay, loans) §  Borrow principal §  Obligation to pay interest over time §  Obligation to pay principal on maturity date 5

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1

Convertible Securities

Convertible Securities

Convertible stocks Convertible bonds

Convertible Securities

Hybrid Securities Preferred stock

Can be converted into common stock at discretion of holder

Rights

During time window

Beginning July 1, 2025

At specified ratio

One unit converts to 16.125 shares common stock

At specified cost

Exchange may be free, or may require holder to pay flat fee or fee per share

Options Warrants

How to report on financial statements? Impact on earnings per share calculation?

7

Convertible Debt

8

At Time of Issuance

§  Benefits to bond issuer

§  Convertible bonds recorded as if standard debt issue §  Timing and quantity of conversion not predictable, ignore option to convert

§  Lower interest rate on bond §  Less dilution of EPS when bonds issued (EPS declines if converted)

§  Benefits to bond buyer §  Reasonable expectation of receiving stated interest and principal payments §  If stock price rises profit from conversion 9

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Convertible Bonds Issued Brief Exercise 1

#WileyPLUS Brief Exercise 1

Convertible Bonds Issued

§  Issued $4,000,000 par value, 7% convertible bonds at 99 for cash §  If bonds had not included conversion feature, they would have sold for 95

Number of bonds Face value of bonds Issue price Estimated price without conversion feature

Description Debit Credit Cash 3,960,000 Discount on bonds payable 40,000 Bonds payable 4,000,000 Issued bonds at 99 (99% of face value): $4,000,000 × 99% = $3,960,000

4,000 $1,000 99 Ignore

Description Debit Credit Cash (4,000 × $1,000 × 99%) 3,960,000 Discount on bonds payable Plug 40,000 Bonds payable (4,000 × $1,000) 4,000,000 Issued 4,000 convertible bonds, par value $1,000, at 99 11

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2

Debt Conversion Brief Exercise 2

At Time of Conversion §  Debt holder’s option, chooses time §  Issuer uses book value method §  Issuer recognizes no gain or loss

Debt Conversion Number of bonds

2,000

Face value of bonds

$1,000

Unamortized discount

Stock transactions have no income statement effect

Conversion rate

$30,000 1 bond = 50 shares common

Par value common Market price common

$10 Ignore

Issuer records no gain (loss) on debt conversion 13

Debt Conversion Number of bonds

Incentive for Conversion

2,000

Face value of bonds

$1,000

Unamortized discount Conversion rate

§  Issuer offers compensation as incentive for bond holder to convert §  Compensation is expense of period

$30,000 1 bond = 50 shares common

Par value common

$10

Market price common

Ignore

Description Debit Credit Bonds payable (2,000 × $1,000) 2,000,000 Discount on bonds payable 30,000 Common stock (2,000 × 50 × $10) 1,000,000 Plug Paid-in capital in excess of par 970,000 Convert 2,000 bonds, face value $2,000,000, for $10 par stock

15

Conversion, Compensation Brief Exercise 2

Unamortized discount Conversion rate

Same as previous entry

2,000 $1,000 $30,000 1 bond = 50 shares common

Par value common Market price common

16

Description Debit Credit Bonds payable (2,000 × $1,000) 2,000,000 Discount on bonds payable 30,000 Common stock (2,000 × 50 × $10) 1,000,000 Plug Paid-in capital in excess of par 970,000 Convert 2,000 bonds, face value $2,000,000, for $10 par stock

Debt Conversion Number of bonds Face value of bonds

14

$10

Paid bond holders $70,000 to convert

Ignore

Paid bond holders total of $70,000 to convert

17

Description Debit Credit Debt conversion expense 70,000 Cash 70,000 Paid bond holders $70,000 compensation to encourage conversion

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3

Retirement of Convertible Debt

Retirement of Convertible Debt

§  Same as retiring debt not convertible §  Difference between acquisition price, carrying amount reported as gain (loss)

Number of bonds

Debt Retirement 2,000

Face value of bonds

$1,000

Unamortized discount

Does not involve stock, may impact income statement

Amount paid to repurchase bonds

$30,000 $1,900,000

Issuer records gain (loss) on purchase of debt

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Debt Retirement Number of bonds Face value of bonds Unamortized discount Amount paid to repurchase bonds

20

Learning Objective 2

2,000 $1,000

§  Explain accounting for convertible preferred stock

$30,000 $1,900,000

Description Debit Credit Bonds payable (2,000 × $1,000) 2,000,000 Gain on retirement of bonds payable 70,000 Plug Discount on bonds payable 30,000 Cash 1,900,000 Retired bonds, $2,000,000 par value, discount $30,000, paid $1,900,000 21

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Preferred Stock Converted Brief Exercise 3

Convertible Preferred Stock

Conversion of Preferred into Common

§  Holder may convert preferred shares into fixed number of common stock §  Convertible preferred stock reported as part of equity (rarely listed as debt) §  Never a gain (loss) when preferred stock is converted or repurchased

Shares preferred stock ($50 par, issued at $60) Shares common stock ($10 par) FMV common stock at conversion

1,000 2,000 Ignore

Conversion rate: 1 share preferred = 2 shares common

23

Description Debit Credit Preferred stock (1,000 × $50) 50,000 PIC in excess of par – Preferred 10,000 Common stock (2,000 × $10) 20,000 PIC in excess of par – Common 40,000 Plug Convert 1,000 shares preferred stock to 2,000 shares common stock

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Learning Objective 3

Stock Warrants

§  Contrast accounting for stock warrants and for stock warrants issued with other securities

§  Certificates entitling holder to acquire shares at fixed price within stated period §  Life of warrants usually five to ten years §  May be issued separately or with other securities

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26

Stock Warrants Issued with Other Securities

Proportional Method

§  Two methods of allocation

§  Proportional method allocates proceeds using relative fair market values §  Determine

§  Proportional method §  Incremental method

§  Value of securities without warrants §  Value of warrants

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Bonds Issued with Warrants

Bonds, Warrants: Proportional Brief Exercise 4

Number of bonds issued

Par value per bond Bond issue price

101

Detachable warrants per bond

2,000

1

After Bonds Issued

$1,000

FMV bond

101

98

FMV warrant

1

Bonds and warrants trade separately after issuance

Bonds Warrants

After Bonds Issued FMV warrant

$1,000

Bond issue price

Detachable warrants per bond

FMV bond

2,000

Par value per bond

Bonds Issued with Warrants Number of bonds issued

28

98 $40 29

Allocation: Issue price Allocation % Total

$40

Number Amount 2,000 ! $ 1,000 ! 2,000 ! Total Fair Market Value Bonds $2,020,000 96% $1,940,784

Warrants $2,020,000 4% $ 79,216

Price Total 98% = $ 1,960,000 $40 = 80,000 $ 2,040,000

Bond face value Allocated FMV Discount

Percent 96% 4% 100%

$2,000,000 1,940,784 $ 59,21630

5

Number Amount 2,000 ! $ 1,000 ! 2,000 ! Total Fair Market Value

Bonds Warrants

Allocation: Issue price Allocation % Total

Bonds $2,020,000 96% $1,940,784

Warrants $2,020,000 4% $ 79,216

Description Cash (2,000 × $1,000 × 101%) Discount on bonds payable Bonds payable (2,000 × $1,000) Paid-in capital – Stock warrants Issued bonds with stock warrants

Price Total 98% = $ 1,960,000 $40 = 80,000 $ 2,040,000

Bond face value Allocated FMV Discount

Percent 96% 4% 100%

$2,000,000 1,940,784 $ 59,216

Debit 2,020,000 59,216

Incremental Method §  Can determine FMV of either warrants or bonds, but not both §  Allocate first to security with known FMV §  Allocate remainder of issue price to security with unknown FMV

Credit

2,000,000 79,216 31

Bonds Issues with Warrants

Bonds, Warrants: Incremental Brief Exercise 5

Number of bonds issued

$1,000

Bond issue price

FMV bond

1

Number 2,000 ! 2,000 !

Bonds Warrants

98 Unknown

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Allocation: Issue price Bonds Warrants

98

FMV warrant

After Bonds Issued FMV bond

Price Total 98% = $ 1,960,000 = Total Fair Market Value $ 1,960,000 $

Amount 1,000 !

Bonds $2,020,000 1,960,000 $ 60,000

Description Cash (2,000 × $1,000 × 101%) Discount on bonds payable Bonds payable (2,000 × $1,000) Paid-in capital – Stock warrants Issued bonds with stock warrants

Bond face value Allocated FMV Discount

Debit 2,020,000 40,000

1

After Bonds Issued

101

Detachable warrants per bond

101

Detachable warrants per bond

2,000

Par value per bond

Number 2,000 ! 2,000 !

$1,000

Bond issue price

Number of bonds issued

FMV warrant

2,000

Par value per bond

Bonds Issued with Warrants

Bonds Warrants

32

Percent 100% 0% 100%

$2,000,000 1,960,000 $ 40,000

Allocation: Issue price Bonds Warrants

Bonds $2,020,000 1,960,000 $ 60,000

Unknown Price Total 98% = $ 1,960,000 = Total Fair Market Value $ 1,960,000 $

Amount 1,000 !

Bond face value Allocated FMV Discount

Percent 100% 0% 100%

$2,000,000 1,960,000 $ 40,00034

Detachable vs. Non-Detachable Stock Warrants §  Detachable warrants create 2 securities 1.  Debt security 2.  Warrant to purchase common stock

§  May be exercised independently §  Allocate proceeds to two securities

Credit

§  Non-detachable warrants §  May not be exercised independently §  No allocation between bonds and warrants §  Record entire proceeds as debt

2,000,000 60,000 35

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Rights to Subscribe to Additional Shares

Learning Objective 5

§  Existing stockholders have right (preemptive privilege) to purchase new shares in proportion to their holdings

§  Discuss controversy involving stock compensation plans

§  Certificates representing right issued when new stock purchased §  Can be traded on regulated markets

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Stock Option Controversy

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Stock Option Controversy

§  Intrinsic-value model

Stock Option Valuation

§  Compare option cost to FMV on grant date §  Usually resulted in little or no expense §  Commonly used prior to 2005 FASB rule

Number of options

100,000

Stock market price on grant date

$50

Option price

§  Fair value method

Option exercise period

§  Compare option cost to estimate of value using complex model (Black–Scholes) §  Higher expense than intrinsic-value §  Required by FASB starting in 2005

Vesting period

$60 10 years 3 years

Intrinsic-value 39

Stock Option Controversy

Fair value using Black-Sholes model

$0 $2,000,000

40

Stock Option Controversy

§  FASB faced considerable opposition when it proposed fair value method for accounting for share options §  Fair value method results in higher compensation expenses compared to intrinsic-value model

§  Financial reporting should be neutral and representationally faithful §  Transparent financial reporting should not be criticized because companies will report lower income §  If standards written to achieve some social, economic, or public policy goal, financial reporting loses its credibility 41

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Learning Objective 4

Stock Compensation Plans

§  Describe accounting for stock compensation plans under generally accepted accounting principles

§  Employee may purchase common stock at fixed price for defined period of time §  FASB requires fair value method to calculate compensation cost §  Use option-pricing model to determine fair value at date of grant Fair value calculated using complex pricing models Black-Scholes option-pricing model commonly used Fair value ≠ Fair market value 43

Stock Compensation Issues

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Expense: Stock Compensation

§  Two main accounting issues

§  Determining expense

§  How to determine compensation expense §  Over what periods to allocate expense

§  Fair value of options on grant date

§  Allocating compensation expense §  Allocate over periods in which employees perform service (service period) §  Time between grant date and vesting date

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Stock Options Brief Exercise 6

Stock Options Brief Exercise 6

Stock Compensation Number of employees eligible Number of shares per option Par value common stock Option grant date Option vest date Exercise period

46

Stock Compensation 5

Option exercise price per share

2,000

FMV stock on grant date

$1 January 1, 2012

Service period Compensation expense (per options pricing model)

December 31, 2013

Expense per year ($220,000 / 2)

10 years

47

$60 Ignore 2 years $220,000 $110,000

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8

Description No entry No entry Jan 1, 2012: Grant date

Debit

Stock Options Brief Exercise 6

Credit

Stock Compensation Option exercise price per share

Description Debit Credit Compensation Expense 110,000 Paid-in capital – Stock Options 110,000 Dec 31, 2012: AJE to accrue compensation expense for stock options Description Debit Credit Compensation Expense 110,000 Paid-in capital – Stock Options 110,000 Dec 31, 2013: AJE to accrue compensation expense for stock options

$60

Number of shares received

2,000

Portion of options exercised (2K /10K)

20%

Exercise date

49

Stock Options Brief Exercise 6

June 1, 2015

Description Debit Credit Cash (2,000 × $60) 120,000 PIC – Stock Options (20% × $220,000) 44,000 Common stock (2,000 × $1) 2,000 PIC in excess of par 162,000 Plug Jun 1, 2015: 2,000 stock options exercised, 20% of options available

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Stock Options Forfeited

§  Executives fail to exercise remaining stock options before expiration date

§  If an employee forfeits a stock options because employee fails to satisfy a service requirement (leaves company) reverse entries in current period (change in estimate)

Description Debit Credit PIC – Stock Options (80% × $220,000) 176,000 PIC – Expired stock options 176,000 Jan 1, 2022: 8,000 stock options expire, 20% of options available

Description Paid-in capital – Stock Options Compensation Expense Employee forfeits stock options, reverse entries

Debit xxx,xxx

Credit xxx,xxx

51

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Restricted Stock Brief Exercise 7

Restricted Stock

Restricted Stock Compensation

§  Transfer shares of stock to employees, subject to an agreement that shares cannot be sold, transferred, or pledged until vesting occurs §  Share forfeited if employee fails to meet vesting conditions

Shares of restricted stock issued Date restricted stock issued Common stock FMV on issue date Common stock par value

1,000 Jan 1, 2012 $20 $1

Vesting period

5 years

Employee leaves

2 years

Journal Entries Required Record compensation expense 2012, 2013 53

Reverse compensation expense in 2014

54

9

Restricted Stock Brief Exercise 7

Restricted Stock Brief Exercise 7

§  Unearned Compensation

§  Record compensation expense §  $20,000 / 5 = $4,000 per year

§  Cost of services yet to be performed §  Not an asset or liability §  Line item in stockholders’ equity Description Debit Credit Unearned compensation (1,000 × $20) 20,000 Common stock (1,000 × $1) 1,000 Paid-in capital in excess of par 19,000 Jan 1, 2012: Journal entry on grant date, 1,000 shares, FMV $20 share

55

§  In 2014 CEO leaves (served two years) §  No expense recorded in 2014 §  Reverse entries

Debit 4,000

Description Compensation expense Unearned compensation AJE made on Dec 31, 2013

Debit 4,000

Credit 4,000 Credit 4,000 56

Compensation Plan Disclosure §  Nature and extent of plan §  Effect on current share holders §  Effect on income statement §  Method of estimating fair value of goods or services received, or fair value of equity instruments granted §  Cash flow effects

§  Two years of compensation expense §  Balance in unearned compensation §  Entry to issue stock Description Debit Credit Common stock 1,000 Paid-in capital in excess of par 19,000 Compensation exp ($4,000 × 2) 8,000 Unearned compensation 12,000 2014: CEO leaves before vesting, reverse C/S, Comp exp, Unearn Comp

Description Compensation expense Unearned compensation AJE made on Dec 31, 2012

57

Learning Objective 6

58

Earnings Per Share

§  Compute earnings per share in a simple capital structure

§  EPS is net income earned by each share of common stock §  Report EPS only for common stock §  Disclose EPS for each component §  Discontinued operations §  Extraordinary items

59

60

10

Earnings Per Share

Capital Structure §  Simple Structure §  Only common stock §  No potentially dilutive securities

§  Complex Structure §  Potentially dilutive securities

§  Dilutive

61

Potentially Dilutive Securities

§  Security with right to convert into shares of common stock §  May decrease EPS

62

EPS and Preferred Stock

§  Warrants §  Options §  Convertible bonds §  Convertible preferred stock

§  Subtract current year preferred stock dividend from net income §  If cumulative §  Subtract whether declared or not declared §  Do not subtract dividends in arrears

§  If non-cumulative §  Subtract only if declared

63

64

65

66

Weighted-Average Number of Shares §  Companies must weight shares by fraction of period outstanding

11

Weighted-Average Number of Shares §  When stock dividends or share splits occur, adjust number of shares outstanding before share dividend or split to post-split amount §  Adjust for stock dividends or share splits that occur after balance sheet date and before financial statements issued §  Restate prior year shares outstanding for current year stock dividends or splits 67

68

69

70

Comprehensive Example Income before extraordinary item Declared preferred dividends, per share Preferred shares outstanding

$580,000 $1 100,000

Income available to common stock

$480,000

Extraordinary gain, net of tax

$240,000

Learning Objective 7 §  Compute earnings per share in a complex capital structure

71

72

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Diluted EPS

Diluted EPS

§  EPS may be diluted

§  Diluted EPS includes effect of all potentially dilutive securities which had dilutive effect (reduce EPS)

§  Conversion of convertible securities §  Exercise of options, warrants, other rights

§  Report both basic and diluted EPS

73

Anti-Dilutive

74

Dilutive and Anti-Dilutive

§  Some potentially dilutive securities may be anti-dilutive (increase EPS) §  Do not include anti-dilutive securities in diluted EPS calculation

§  EPS is a ratio §  Changing numerator and denominator §  May decrease ratio (dilutive) §  May increase ratio (anti-dilutive)

Cannot predict in advance when security anti-dilutive Must do EPS calculation with and without conversion

75

Anti-Dilutive Example Convertible Debt

76

Diluted EPS

§  If converted §  Shares outstanding increases §  Net income increases because interest expense on debt converted is avoided

77

78

13

Diluted EPS Brief Exercise 22

Diluted EPS: Convertible Securities

2012

§  Assume conversion first day of period

Number of bonds issued (at par)

75

Par value

§  Or time of issuance, if issued during period

$1,000

Stated interest rate

§  Adjust numerator for reduction of interest expense interest, net of tax §  Adjust denominator for increase in shares

8%

Each bond convertible into

100 shares common

No bonds converted 2013 Revenues

$17,500

Expenses (ex interest, tax)

$8,400

Tax rate 79

40%

Common shares outstanding No bonds converted

Diluted EPS Brief Exercise 22

§  When calculating diluted EPS, begin with basic EPS

Revenues

$17,500

Expenses

8,400

Bond interest expense (75 × $1,000 × 8%)

6,000

Income before taxes

3,100

Income tax expense (40%)

1,240

Basic EPS Net income = $1,860

= $0.93

Weighted average shares = 2,000

$ 1,860 81

82

Diluted EPS Brief Exercise 22

Diluted EPS Brief Exercise 22

§  If bonds had been converted

§  If bonds had been converted

§  Avoid $6,000 interest exp Revenues

$17,500

Expenses

8,400

Bond interest expense (none) Income before taxes Income tax expense (40%) Net income

80

Diluted EPS Brief Exercise 22

§  Compute diluted EPS for 2013

Net income

2,000

§  Avoid $6,000 interest exp (calc net of tax) §  Shares outstanding increase by 7,500

0 9,100 3,610

$1,860

+ $6,000 (1 - 0.40)

2,000

+

7,500

$ 5,460

=

$5,460 9,500

= $0.57 Dilutive

83

Basic EPS = 0.93

Effect on EPS = 0.48

84

14

Diluted EPS Brief Exercise 22

Diluted EPS Brief Exercise 22

§  If bonds issued September 1, 2013

§  If bonds issued September 1, 2013

Revenues

$17,500

Expenses

8,400

Bond int exp (75 × $1,000 × 8% × 4/12)

2,000

Income before taxes

7,100

Income tax expense (40%)

2,840

Net income

§  Avoid $2,000 interest exp (calc net of tax) §  Shares o/s increase 2,500 = 7,500 × 4/12 + $2,000 (1 - 0.40)

2,000

+

2,500

=

$5,460 4,500

= $1.21

$ 4,260

Dilutive 85

Diluted EPS WileyPLUS Problem 8

Par value

$100

Stated dividend rate (% of par)

40,000 shares × $100 par × 6% = $240,000 dividend

6%

Net income $1,200,000 – Pfd. Div. $240,000

Net income Common shares outstanding

600,000

No change in preferred stock, common stock

87

Diluted EPS WileyPLUS Problem 8

§  If preferred stock convertible into three shares of common stock §  40,000 shares p/s × 3 shares = 120,000

§  Avoid $240,000 preferred dividend (no tax) §  Shares outstanding increase by 200,000

600,000

Effect on EPS = 1.20

=

$1,200,000 800,000

=

$1.50 Dilutive

88

Diluted EPS WileyPLUS Problem 8

§  If bonds had been converted

+ 200,000

= $1.60

Weighted average shares = 600,000

$1,200,000

+ $240,000

86

5 shares common

2012

$1,200,000 – $240,000

Effect on EPS = 0.48

§  Compute diluted EPS for 2012 §  Begin with basic EPS

40,000

Each share convertible into

Basic EPS = 2.13

Diluted EPS WileyPLUS Problem 8

Prior to 2012 Shares of convertible preferred stock issued

Basic EPS = 1.60

$4,260

89

$1,200,000 – $240,000

+ $240,000

600,000

+ 120,000

Basic EPS = 1.60

Effect on EPS = 2.00

=

$1,200,000 720,000

=

$1.67 Anti-Dilutive

90

15

Diluted EPS WileyPLUS Problem 8

Diluted EPS: Options, Warrants

§  EPS basic = $1.60 §  EPS with dilution = $1.67 §  Dilution not allowed to increase EPS §  Anti-Dilutive: Diluted EPS = Basic EPS $1,200,000 – $240,000

+ $240,000

600,000

+ 120,000

=

720,000

§  Or time of issuance, if issued during period

§  Assume proceeds used to purchase treasury stock

=

$1.67

Effect on EPS = 2.00

Basic EPS = 1.60

$1,200,000

§  Assume exercise first day of period

Anti-Dilutive

91

Diluted EPS: Options, Warrants WileyPLUS Exercise 26

92

Diluted EPS: Options, Warrants WileyPLUS Exercise 26 §  Compute diluted EPS for 2012

2011 Options issued in 2011

1,000

Each option convertible to

Treasury Method: Calc EPS Dilution from Options

1 share common

Exercise price

$8 per share

Proceeds if shares issued (1,000 × $8)

2012 Net income

$40,000

Common stock outstanding Average stock price

10,000 shares $20 per share

$8,000

Purchase price for treasury shares

÷ $20

Shares assumed purchased for treasury

− 400

Shares assumed issued

1,000

Net increase in shares outstanding

600

93

94

Diluted EPS: Options, Warrants WileyPLUS Exercise 26

Diluted EPS: Options, Warrants WileyPLUS Exercise 26

§  Compute diluted EPS for 2012 §  Begin with basic EPS §  Assume options exercised beg of year

§  Compute diluted EPS if 1,000 options were issued on October 1, 2012

$40,000

+

10,000

+

600

=

$40,000 10,600

Treasury Method: Calc EPS Dilution from Options

= $3.77 Dilutive

Basic EPS = 4.00

Options 95

Proceeds if shares issued (1,000 × $8) Purchase price for treasury shares Shares assumed purchased for treasury Shares assumed issued Incremental share increase Weight for 3 months assumed outstanding Net increase in weighted shares outstanding

$8,000 ÷ $20 − 400 1,000 600 × 3/12 150

96

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Diluted EPS: Options, Warrants WileyPLUS Exercise 26

Anti-Dilution Revisited

§  Compute diluted EPS if 1,000 options were issued on October 1, 2012 $40,000

+

10,000

+

150

=

$40,000 10,150

§  Ignore anti-dilutive securities in all calculations and in computing diluted earnings per share

= $3.94 Dilutive

Basic EPS = 4.00

Options

97

98

99

100

Presentation and Disclosure §  Calculate EPS for §  Income from continuing operations §  Income from discontinued operations §  Income before extraordinary items §  Net income

&Learning Objective 8 §  Appendix 16A §  Explain accounting for shareappreciation rights plans Summary of EPS Computation

101

102

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Stock-Appreciation Rights

Stock-Appreciation Rights

§  Employee given compensation equal to increase in stock price §  Share appreciation is excess of market price of stock at date of exercise over a pre-established price

§  Company may pay share appreciation in cash, shares, or combination §  Accounting depends on whether company classifies rights as equity or as liability

103

104

Share-Based Equity Awards

Share-Based Liability Awards

§  Classify SARs as equity if employee receives stock §  Employee receives shares equal to share-price increase (increase in market price over pre-established price) §  On grant date estimate SAR fair value, allocate expense over service period

§  Classify SARs as liability awards if employee receives cash payment §  Employee receives cash equal to shareprice increase (increase in market price over pre-established price) §  On grant date estimate SAR fair value, allocate expense over service period 105

Share-Based Liability Awards

106

Share-Based Liability Awards

§  Re-measure fair value each reporting period until award is settled §  Adjust compensation cost each period for changes in fair value pro-rated for portion of service period completed

§  Once service period is completed, determine compensation expense each subsequent period by reporting full change in market price as an adjustment to compensation expense

107

108

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Stock-Appreciation Rights (SARs) Example

Stock-Appreciation Rights §  10,000 stock-appreciation rights §  Employees receive cash at date of exercise for difference between market price and benchmark price of $10 §  Vesting period two years

§  Fair value of SAR estimated using options pricing model (Black-Scholes) §  Fair value of SARs on December 31 §  2012, $3 §  2013, $7 §  2014, $5

§  2012–2013

§  SARs exercised on December 31, 2014 109

Description Debit Credit Compensation expense 15,000 Liability – stock-appreciation plan 15,000 AJE end of 2012: Record compensation expense at end of first year

110

Description Debit Credit Compensation expense 55,000 Liability – stock-appreciation plan 55,000 AJE end of 2013: Record compensation expense at end of second year 111

Description Debit Credit Liability – stock-appreciation plan 20,000 Compensation expense 20,000 AJE end of 2014: Record compensation expense at end of third year

112

Description Debit Credit Liability – stock-appreciation plan 50,000 Cash 50,000 Dec 31, 21014: Employees paid value of stock appreciation rights 113

114

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Learning Objective 9 §  Appendix 16B §  Compute earnings per share in a complex situation Liability – stockappreciation plan Year 3

20,000

15,000

Year 1

Payout

50,000

55,000

Year 2

0 115

Balance Sheet for Comprehensive Illustration

116

Additional Information for Comprehensive Illustration

117

Essential Calculations

118

Computation of Basic EPS —Simple Capital Structure

§  Basic EPS is starting point §  Cumulative preferred stock §  Subtract preferred div from net income §  Does not matter if pref div declared or not

119

120

20

Diluted Earnings Per Share

Diluted Earnings Per Share

1.  Determine, for each dilutive security, per share effect assuming exercise/ conversion 2.  Rank results from step 1 from smallest to largest earnings effect per share (Most dilutive to least dilutive)

3.  Beginning with basic EPS recalculate earnings per share by adding smallest per share effect from step 2. Continue this process so long as each recalculated earnings per share is smaller than previous amount (Continue as long as dilutive)

121

Step 1: Diluted EPS Calculation

122

Options

§  Four securities could be dilutive

§  Calculate Per Share Effect of Options (Treasury-Share Method)

§  Options §  8% convertible bonds §  10% convertible bonds §  10% convertible preferred stock

§  Step 1: Compute per share effect for each potentially dilutive security 123

8% Convertible Bonds

124

10% Convertible Bonds

§  Calculate Per Share Effect of 8% Bonds (If-Converted Method)

§  Calculate Per Share Effect of 10% Bonds (If-Converted Method)

125

126

21

10% Convertible Preferred Stock

Ranking of EPS Effects

§  Calculate Per Share Effect of 10% Convertible Preference Shares (If-Converted Method)

127

Step 2: Diluted EPS Calculation

128

Add Options

§  Sequentially add each potentially dilutive security, from lowest to highest, until next security no longer dilutive

§  Calculate EPS with options §  Basic EPS, $3.00 §  Add options, $2.90 (dilutive)

129

Add 8% Convertible Bonds

130

Add 10% Convertible Bonds §  Calc EPS w/options, 8% bonds, 10% bonds

§  Calculate EPS with options, 8% bonds §  With options, $2.90 §  Add 8% conv. bonds, $2.63(dilutive)

§  With options, 8% conv. bonds, $2.63 §  Add 10% conv. bonds, $2.47(dilutive)

131

132

22

Add 10% Convertible Preferred Stock

EPS Disclosure

§  Calc EPS w/options, 8% bonds, 10% bonds, pref stock §  With options, 8% conv. bonds, 10% conv. bonds, $2.47

§  Add 10% conv. pref stock, $2.47 (not dilutive)

133

End of Chapter

134

Complex Capital Structures §  Description of pertinent rights and privileges of various securities outstanding §  A reconciliation of numerators and denominators of basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS 136

Complex Capital Structures §  Effect given preferred dividends in determining income available to common stockholders in computing basic EPS §  Securities that could potentially dilute basic EPS in future that were excluded in computation because they would be anti-dilutive §  Effect of conversions subsequent to year-end, but before issuing statements

137

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