Chapter 17 Dilutive Securities and Earnings Per Share LECTURE OUTLINE The material in this chapter can be covered in three or four class sessions. Students generally have not been exposed to the types of dilutive securities discussed in this chapter nor are they aware of the complex rules governing the calculation of EPS. A. Dilutive Securities: Securities which are not common stock in form but enable their holders to obtain common stock upon exercise or conversion. Illustration 17-1 provides a numerical example of convertible bonds at date of issue and at date of conversion. Conversion is shown using both the market value and book value approaches. 1. Accounting for convertible debt: A convertible bond combines the benefits of a bond with the privilege of exchanging it for stock at the holder's option. a. Issuance: recorded the same as issuance of any other bond. b. Interest dates: recorded the same as any other bond. c. Conversion recorded using either market value or book value approach. (1) Market value approach: Use market value of stock, if determinable. Otherwise, use market value of bonds. Less-common approach (b) Any gain or loss on conversion is treated as an ordinary item. (2) Book value approach: Use book value of bonds. No gain or loss recognized. d. If retired for cash, instead of converted, recorded the same as any other bond.
e. Induced conversions: Additional consideration given to induce conversion should be recognized as an expense of the current period. (1) The conversion inducement is recorded as an expense of the current period. f. Retirement of convertible debt: treat as any other debt retirement. Any gain or loss is recognized as extraordinary. 2. Accounting for convertible preferred stock: Handled at issuance and conversion in the same manner as convertible debt, but only the book value method should be used. Illustration 17-2 provides a numerical example of convertible preferred stock at date of issue and at date of conversion. a. Exception: If the par value of the common stock exceeds the preferred stock's book value, the difference is debited to Retained Earnings. 3. Accounting for stock warrants: entitles holder to acquire shares of stock at a certain price within a stated periods. a. Normally issued as: (1) an "equity kicker" to make another security more attractive. (2) a pre-emptive right to purchase additional shares given to existing shareholders. (3) compensation to executives and employees. b. Detachable stock warrants: can be traded separately, and therefore, have a market value. (1) Proportional method: use when value of bonds without the warrants and the value of the warrants are both known. Allocate the sale price of the bonds between the bonds and the warrants based on their respective market values.
(2) Incrimental method: use when only the value of the bonds without the warrants or the value of the warrants is known. Subtract the market value of the known security from the sale price of the bonds to determine the value of the other security. Illustration 17-3 provides a numerical example of the proporational and incremental methods. (3) Warrants not exercised: transfer the carrying value from the PIC-Stock Warrants account to the PIC-from Expired Warrants account. c. Nondetachable stock warrants: record the entire proceeds as debt. d. Stock warrants representing stock rights to existing shareholders do not require any journal entry at the issuance date. 4. Stock compensation plans: Arrangements where selected employees are given the option to purchase common stock in the company at a given price over an extended period of time. a. The major accounting issue: what is the value of the compensation received? (1) Under the intrinsic value method: compensation expense = market price of the stock exercise price of the options at the measurement date (usually the grant date). (2) Under the fair value method: compensation expense = fair value of the stock options expected to vest at the grant date based on an acceptable option pricing model (such as the Black-Scholes model). Vesting occurs on the date the employee's right to receive or retain the shares is no longer contingent on remaining in the service of the employer. (b) Stock options issued to non-employees for goods or services must be recognized using this method.
(3) Under SFAS No. 123, FASB encourges, but does not require, the use of the fair value method. Most companies use the intrinsic value method because it results in a lower compensation expense amount. b. Allocating Compensation Expense: recognized over the service period (the time between the grant date and the vesting date). (1) On Date of grant: no journal entry required (2) Allocate amount of compensation expense evenly over the service period under both methods. Dr. Compensation Expense Cr. Paid in Capital Stock Options c. Recording the exercise of options: the same accounts are affected under both methods. (1) Dr. Cash Paid in Capital Stock Options Cr. Common Stock Paid in Capital in Excess of Par d. Recording the expiration of options: no adjustment is made to Compensation Expense (1) Dr. Paid in Capital Stock Options Cr. Paid in Capital Expired Stock Options e. Recording the forfeiture of options: occurs if the employee leaves the company before the vesting date. (1) Dr. Paid in Capital Stock Options Cr. Compensation Expense f. Types of plans: Several different types of plans exist and are used to compensate executives (Appendix 17A discusses these plans further):
(1) Incentive or nonqualified stock option plans. (2) Stock appreciation rights: a device used to ease the cash burdens on an executive that a stock option plan may impose. Compensation expense is the amount by which the market value of the shares exceeds the value specified. Changes in the market value result in a change in the measure of compensation. (3) Performance-type plans: stock issued to executive if performance criteria are met. (4) Noncompensatory plans: stock issued by employer either to obtain equity capital or to induce widespread ownership among the employees. Must meet all of the following characteristics: (b) (c) Substantially all full-time employees may participate on an equitable basis. The discount from market price is small. The plan offers no substantive option feature. 5. Disclosure of compensation plans a. For each type of plan a company offers, it must disclose: (1) the number of shares under option (2) the options exercised and forfeited (3) the weighted average options prices for these categories (4) the weighted average fair value of options granted during the year (5) the average remaining contractual life of the options outstanding (6) the method and significant assumptions used to estimate the fair values of the stock options b. If the company uses the intrinsic value method it must still disclose the following, as if the fair value method had been used: (1) pro-forma net income (2) pro-forma earnings per share (if presented)
6. Debate over stock options: the chronology of events related to SFAS No. 123 shows the impact that social, economic, and public policy goals can have on the development of accounting standards. B. Computing Earnings Per Share. Illustration 17-4 presents a conceptual overview of the EPS computations. 1. Simple capital structures: companies that have only common stock or no securities that could dilute earnings per share (EPS) if converted or exercised. a. EPS = Net Income Preferred stock dividends Weighted average no. of shares outstanding (1) EPS is calculated for each component of income; income from continuing operations, income before extraordinary items or changes in accounting principle, and net income. (2) Preferred stock dividends are the current year's dividend only. If none declared, then calculate an amount equal to what the current dividend would have been. (b) Don't include dividends in arrears. (c) If a net loss occurs, add the preferred dividend. (3) Weighted average shares outstanding = No. of shares outstanding fraction of the year outstanding If a stock dividend/split occurs during the year, treat it as if it occurred at the beginning of the year.
Illustration 17-5 demonstrates how to calculate the weighted average number of common shares outstanding. Illustration 17-6 indicates the elementary points in calculating the basic EPS. 2. Complex capital structures: when a company has convertible securities, options, warrants, and other rights that upon conversion or exercise could dilute EPS. a. Requires both basic and diluted EPS. b. Diluted EPS = Net income Preferred dividend Weighted ave. no. of shares outstanding Impact of convertible securities Impact of options, warrants, and other dilutive securities c. Convertible securities (1) If convertible bonds, use the if-converted method. Treat conversion as occurring at the beginning of the year, or at issuance date, if it occurred during the year. (b) Eliminate related interest expense, net of tax. (2) If convertible preferred stock Eliminate preferred dividend from numerator. (b) Increase weighted average number of shares outstanding in denominator.
(3) Use the most advantageous conversion rate available to the holder of the security. d. Options and warrants use the treasury stock method and assume: (1) Exercise at the beginning of the year or issue date, if it occurs during the year. (2) Proceeds are used to purchase common stock for treasury stock. (3) If exercise price < market price of stock, dilution occurs. (4) If exercise price > market price, securities are antidilative and can be ignored in the diluted EPS calculation. e. Contingent shares are included in the computation of the diluted EPS. Illustration 17-7 provides an overview of the EPS calculations in a complex capital structure. 3. Presentation and disclosure. a. EPS is presented for income from continuing operations, income before extraordinary items or change in accounting principle, and net income. b. Reported for all periods presented c. Prior period EPS is restated for any prior period adjustments. d. Footnotes are required for diluted EPS.
C. Appendix 17A Stock Options Additional Complications 1. Stock option plans a. Incentive stock option plans (1) There is no compensation expense because the market price and the option price must be equal on the grant date. (2) Provides a tax advantage to the employee. The difference between the market price and option price is not taxable until the shares are sold. (b) The difference is taxable at either the capital gains rate or ordinary income tax rates, depending on how long the stock is held. b. Nonqualified (nonstatutory) stock option plans (1) Compensation expense equals the difference between the market price and option price at the date of grant (measurement date). Allocated over the periods benefitted. (2) Provides no tax advantage to the employee The difference between the market price and option price is taxable at the time the stock is purchased, at ordinary tax rates. 2. Stock appreciation rights (SARs) a. Employees receive cash, or stock or combination of both in an amount equal to the difference between the market price on the exercise date and pre-established option price.
b. Compensation expense (1) Measurement date is the exercise date under APB Opinion No. 25 (2) Estimated total compensation cost = (current market price option price) No. of SARs outstanding (3) Use the percentage approach to allocate compensation expense Cumulative Compensation expense = % of total service period elapsed Estimated total compensation cost (b) Current compensation expense = Cumulative conpensation expense prior periods' expense (4) If exercise date occurs after service period, adjust compensation expense downward for changes in market price. Cumulative compensation expense cannot be negative. (5) If company uses SFAS No. 123 guidelines, total compensation expense is recognized on grant date. Subsequent changes in market price are ignored. (b) Total compensation expense may be lower.
3. Performance-type plans a. Employees receive common stock or cash if specific performance criteria are met during the performance period (3 5 years). (1) Increases in return on assets or equity, growth in sales, growth in EPS, or a combination of these. b. Measurement date = exercise date c. Compensation expense is determined using the percentage approach is with SARs. D. Appendix 17B Comprehensive EPS Illustration.