CHAPTER

16

Dilutive Securities and Earnings per Share .....

Convertible Bonds
exchanged for stock at the bond holders option
increases the value of the bond a sweetener might be offered to induce conversion

ACCOUNTING FOR CONVERTIBLE DEBT

At Time of Issuance
recorded like a straight debt issue
no value allocated to conversion privilege FASB considers the privilege inseparable from the bond Cash Bonds Payable Premium on Bonds Payable 106,000 100,000 6,000

At Time of Conversion
stock is recorded at book value of the converted bonds Bonds Payable 100,000 Premium Bond Pay 6,000 1,000 5,000

Induced Conversions
record the sweetener as an expense Debt Conversion Expense Bonds Payable Premium on Bonds Payable Common Stock Paid-in Cap excess of par Cash 7,000 100,000 5,000

20,000 85,000 7,000

This is the same whether or not there is a sweetener.

Retirement of Convertible Debt

recorded like a straight debt retirement

Clear-out the balances of bonds and premium.

Not an extraordinary item

CONVERTIBLE PREFERRED STOCK

at conversion, common stock is recorded at book value of the converted preferred Preferred Stock 250,000 Add. Paid-in Capital 40,000

STOCK WARRANTS
options to buy shares of stock at a certain price warrants are issued

with bonds or preferred stock as an added bonus to common stockholders with a preemptive right to executives and employees

Warrants Issued with Other Securities

Example Sold 500 $1,000 bonds for $505,000. Included with each bond is a 5-year warrant to buy 1 share of common for $25. Incremental Method Assume the market value of each warrant is $30 and the market value of the bonds (alone) is unknown.

Proportional Method
Assume the market value of each warrant is $30 and the market value of each bond is $990. Mkt Value Bonds $495,000 Warrants 15,000 Book Value

STOCK COMPENSATION PLANS

Effective Compensation
motivate performance

compensation tied to performance performance over which employee has control short- and long-term performance

retain and recruit executives Stock price is thought to be better that Sales or other accounting measures.

Stock options are very attractive to managers.

The Expected Value of a Share of Stock

Possible Stock Values $80 $90 $100 $110 $120 Probability 10% 20% 40% 20% 10% Expected value $ 8 18 40 22 12 $100

What is the value of an option to buy 1 share of stock at $100?

The Value of a Stock Option

Possible Stock Values $80 $90 $100 $110 $120 Probability 10% 20% 40% 20% 10% Value of Option to buy at $100 $0 $0 $0 $10 $20 Expected value An option to buy has value. $0 0 0 2 2 $4

The Value of Volatility

Possible Stock Values $60 $80 $100 $120 $140 Probability 10% 20% 40% 20% 10% Value of Option to buy at $100 $0 $0 $0 $20 $40 Expected value $0 0 0 4 4 $8

Accounting for Stock Compensation

Valuation

intrinsic value method: excess of market price over exercise price fair value method: estimated value of options expected to vest value generally measured at grant date FASB now requires fair value method expense recognized in the service period generally service period = vesting period

Allocation of expense

Exercise 16-10 (Modified)

Columbo Company adopted a stock option plan: options to buy 30,000 shares of $10 par common stock at $40. Options were exercisable 2 years after grant date. Value of options was $450,000. November 1, 2007 Plan adopted no entry January 2, 2008 Options granted no entry 2-year service period beginning on the grant date.

December 31, 2008 (first year of service period completed)

December 31, 2009 (second year of service completed)

January 3, 2010 20,000 options were exercised

January 2, 2014 10,000 options expired

DISCLOSURE OF COMPENSATION PLANS

number and weighted average fair value of options

granted exercised forfeited outstanding

average remaining life of options outstanding

EARNINGS PER SHARE SIMPLE

EPS

Net Income - Preferred Dividends Weighted Average Shares Outstanding

Current year preferred dividend or Dividend that should have been declared if the preferred stock is cumulative

Weighted Average Shares Outstanding

Dates Outstanding 1/1 4/1 4/1 7/1 7/1 11/1 11/1 12/31 Shares Outstanding 90,000 120,000 81,000 141,000 Fraction of Year

New stock issued

Stock repurchased

Weighted Average with Stock Dividend or Split

1/1 3/1 8/1 10/1 Dates Outstnd 1/1 3/1 3/1 10/1 10/1 12/31 Beginning balance Issued 30,000 shares 2 for 1 stock split Purchsd 20,000 shares Shares Outstnd # Shares 80,000 110,000 220,000 200,000 Fraction of Year

Rstmt

EARNINGS PER SHARE COMPLEX

Dilutive securities have an adverse effect on EPS

convertible securities

options or warrants

Firms must report both Basic EPS and Dilutive EPS

Convertible Securities: If-Converted Method

1/1 Beginning balance: 200,000 shares common

5/1

Issued $500,000, 8% bonds for $535,530 (effective interest = 7%) convertible into 24,000 shares common

Net Income (net of 40% tax): $350,000 Net Income Add: Bond interest (net of tax) $535,530 x 7% x 8/12 Less: 40% tax Adjusted net income $350,000 $24,991 9,997

14,994 $364,994

1/1
5/1

Beginning balance: 200,000 shares common

Issued $500,000, 8% bonds for $535,530 (effective interest = 7%) convertible into 24,000 shares common

Net Income (net of 40% tax): $350,000

Dates Outstanding 1/1 5/1 5/1 12/31 Shares Out if Converted Fraction of Year

Basic EPS = Diluted EPS =

Antidilutive Convertible Securities

Outstanding for the year: 500,000 shares common $1,000,000, 10% bonds issued at par convertible into 50,000 shares common Net Income (net of 30% tax): $600,000 Bond interest (net of tax) $1,000,000 x 10% x (1 - .30)

$70,000

Basic EPS Diluted EPS

= =

Any security that increases EPS should be excluded.

Options and Warrants: Treasury Stock Method

Options and warrants are dilutive if the exercise price is lower than the market price. Increases the potential shares outstanding. No effect on net income. Potential = Add. Shares = Basic EPS Diluted EPS

Market Price - Option Price

Market Price $50 - $30 $50 = = x 1,500

x # of Options

600

EPS Presentation
Exercise 16-18

STOCK OPTIONS - OTHER STUFF

APB Opinion #25
Old approach that some firms follow.
Incentive Stock Options

Nonqualified Options

Tax advantages to employee

option price = market price on grant date no compensation expense

Tax advantages to firm

option price is usually less than market price compensation expense = mkt price - option price

Stock Appreciation Rights

right to receive compensation equal to the market price over a pre-established price

at the end of each year of the service period

estimate total SAR compensation (market price - pre-established price) x # of rights

multiply by % compensation accrued

bring cumulative compensation up to date This might mean recording negative compensation in some years.

Estimate of total compensation will change from year to year.