Chapter 17: Dilutives and Earnings per Share Intermediate Accounting, 10th Edition Kieso, Weygandt, and Warfield Chapter 17: Dilutives and Earnings per Share Prepared by Krishnan Ranganathan, Angelo State University, San Angelo, Texas

Convertible Debt: Accounting Concepts Accounting for convertible debt parallels accounting for straight debt. At conversion, bonds’ basis can be: - either their book value - or their market value Cost of induced conversions is a period expense. Conversion is initiated by security holder. Gain or loss is NOT an extraordinary item 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Convertible Debt: FMV and Carrying value of Debt as Bases Given: One $1,000 bond, issued at $45 premium Each bond is convertible into 10 common shares of $10 par At conversion: Bond’s market value is $1,150 Premium Unamortized is $30 Share’s fair value is $115 per share. Record the conversion based on the bonds’ fair value and their carrying value. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Convertible Debt: FMV and CV of Debt as Bases Conversion based on bonds’ FMV B.Pay Dr. 1,000 Prem. Dr. 30 Loss [redemp] 120 C/stock 100 Paid-in Capital 1,050 or Conversion based on bonds’ C.V. B.Pay Dr 1,000 Prem. Dr 30 C/Stock 100 Paid-in-Cap 930 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

CONVERTIBLE Preferred Stock: Concepts Convertible preferred stock is equity, unless it is redeemable preferred stock. Conversion is an equity transaction: hence, no basis for recognizing gain or loss At conversion, book value of the preferred stock is used. See examples next slide. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Convertible Preferred Stock: Example Given: 10,000 preferred shares, issued at 103: par, $100. One preferred share converts into 3 common shares, (par, $25 each.) All preferred shares are converted into common stock At conversion date, FMV of common stock: $30 per share. Journalize the conversion of preferred shares 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Convertible Preferred Stock: Example Debit Credit Preferred stock $1,000,000 Premium on Pref stock $ 30,000 Common stock $750,000 Common stock: Paid-in $280,000 (Conversion of preferred shares into common shares) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

STOCK WARRANTS: Concepts Stock warrants entitle the holder : to acquire additional shares within a stipulated period at a specified price. These holders have preemptive rights to buy shares in future issues. Stock warrants are also known as stock options. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) STOCK WARRANTS: Types Stock warrants may be: either detachable warrants, or non-detachable warrants If warrants are detachable, value of the warrants is determined by either the proportional method, or the incremental method If warrants are non-detachable, no allocation to warrants is needed. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Bonds with detachable Warrants: Proportional Method Bonds, with a par value of $10,000 and detachable warrants, are offered at par. Bonds’ FMV without the warrants is $9,900 FMV of warrants is $300 Allocate the amount to bonds and the detachable warrants 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Proportional Method: Continued Total proceeds from the bond issue: $10,000 [given] Allocate to Warrants: $300 / $10,200 FMV [times] $10,000 [issue] $294 Allocate to Bonds: $9,900 / $10,200 FMV [times] $10,000 [issue] $9,706 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Proportional Method: Concluded Journal entries: Debit Credit Cash $9,706 Discount (Bonds Payable) $ 294 Bonds Payable $10,000 Cash $ 294 Paid-in (Stock warrants) $ 294 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Warrants: Incremental Method See the previous example Market price of warrants, $300 Market price of bonds without warrants, not determinable Determine the amounts allocated to the bonds and the warrants Total receipt less warrants = bonds $10,000 $300 $9,700 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) STOCK RIGHTS Stock rights give existing shareholders preemptive rights to buy shares. Unlike warrants, rights are of short duration. No journal entries are made, when rights are issued. When stock rights are exercised, corporation usually receives cash. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) Compensation Plans 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

STOCK COMPENSATION PLANS These plans provide employee incentives and may be: Stock option plans: incentive plans [IRS approved], or non-qualified plans Stock appreciation rights Performance plans 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Option Plans: Accounting Issue The important dates are: (see next slide) the grant date of options, the vesting date, and the exercise date of options Corporations recognize compensation expense by: the intrinsic method (APB Opinion No. 25), or the fair value method (SFAS No. 123, recommended) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Options: Important Dates Grant date Options are granted to employee Vesting date Date, employee can first exercise options Exercise date Employee exercises options Expiration date Unexercised options expire Work start date 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Determining Employer’s Compensation Expense Under APB Opinion No. 25, compensation expense is the difference between: the market price of the stock (at grant date), and the exercise price of options (at grant date) Under SFAS No. 123 (recommended), the compensation expense is: the fair value of stock-based compensation (options) paid to employees for their services The FMV of options depends on share price changes, expected dividends , etc., 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

APB No. 25: The Measurement Date Compensation expense is determined as of the MEASUREMENT date (usually the grant date.) Measurement Date is: Grant date, if both the number of shares offered and option price are known. Exercise date, if facts depend on events after grant date. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Options: Allocating Compensation Expense is determined as of the measurement date Compensation Expense and is allocated over the service period > The service period is the period benefited by employee’s service. > It is usually the period between the grant date and the vesting date. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) Illustration Given: Jan 1, 01 (grant date): 10,000 options granted; one option = one share; Par value = $1. Exercise price: $60; Market price (grant date): $70 Options may be exercised at any time within the next ten years. Service period is 2 years (given). The fair value of options is $ 220,000 (given). Determine compensation expense and journalize. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

APB Opinion No. 25 - Illustration Total Compensation Expense (determined at grant date): 10,000 options * [$70 - $60] = $100,000 total expense Annual expense (recognized evenly over service period): $ 100,000 / 2 years = $ 50,000 annual expense. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

APB Opinion No. 25: Granting Options January 01, 2001 (Grant date): No entry December 31, 2001: Compensation expense $ 50,000 Paid-in Capital (Options) $ 50,000 December 31, 2002: Compensation expense $ 50,000 Paid-in Capital (Options) $ 50,000 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

APB Opinion No. 25: Exercising Options Assume that 2,000 options were exercised on June 1, 2004. June 1, 2004: Cash (2,000 * $ 60) $120,000 Paid-in Capital (Options) $ 20,000 Common Stock $ 2,000 Paid-in (Excess) $138,000 Assume that the remaining options were not exercised. January 01, 2011 (Options expiration date) Paid-in Capital (Options) $ 80,000 Paid-in (Expired Options) $ 80,000 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) SFAS 123 - Illustration Total Compensation Expense (determined at grant date): $ 220,000 total expense (given) Annual expense (recognized evenly over service period): $ 220,000 / 2 years = $ 110,000 annual expense. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) SFAS 123 - Entries January 01, 2001 (Grant date): No entry December 31, 2001: Compensation expense $ 110,000 Paid-in Capital (Options) $ 110,000 December 31, 2002: Compensation expense $ 110,000 Paid-in Capital (Options) $ 110,000 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

SFAS 123: Exercising Options Assume that 2,000 options were exercised on June 1, 2004. June 1, 2004: Cash (2,000 * $ 60) $120,000 Paid-in Capital (Options) $ 44,000 Common Stock $ 2,000 Paid-in (Excess) $162,000 Assume that the remaining options were not exercised. January 01, 2011 (Options expiration date) Paid-in Capital (Options) $ 176,000 Paid-in (Expired Options) $ 176,000 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Appreciation Rights [SARs] SARs are designed to mitigate employee’s cash flow problems in non-qualified plans Employee gets a right to receive any appreciation in share value at exercise date equal to market price less a pre-established amount Employee receives cash or stock only for the appreciation. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Appreciation Rights (SARs): Example Given: SAR program is established: January 1, 2001 SAR exercise period: any time next five years Pre-established price per SAR: $10 Number of SARs granted: 10,000 Market prices of the stock: Dec 31, 01: $ 13; Dec 31, 02: $17; Dec 31, 03: $ 15. Service period: 2 years (2001 - 2002) The SARs are held for 3 years and then exercised. Determine the compensation expense for 2001, 02, and 03. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Appreciation Rights (SARs): Example Date Cumulative Compen. Comp.Expense Comp. Expense Expense Recognizable Recognized Recognized for for the service period for prior years the current year Dec 31, 10,000 * ($13-$10) $ -0- $30,000 / 2 = $15,000 2001 = $ 30,000 Dec 31, 10,000 * ($17-$10) $ 15,000 $ 70,000 - $15,000 2002 = $ 70,000 = $55,000 Dec 31, 10,000 * ($15-$10) $ 70,000 $ 50,000 - $70,000 2003 = $ 50,000 = ($20,000) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Appreciation Rights (SARs): Entries Debit Credit Dec 31, 2001 Compensation Expense $15,000 Liability for SARs $15,000 Dec 31, 2002 Compensation Expense $55,000 Liability for SARs $55,000 Dec 31, 2003 Liability for SARs $20,000 Compensation Expense $20,000 Dec 31, 2003 Liability for SARs $50,000 Cash $50,000 (SARs exercised end of the third year) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) EPS - Key Concept EPS is the most important number in the income statement. Dilution of EPS means reduction in EPS. Reduction in EPS results from potential conversion of dilutive securities into common stock. Shareholders want to know the extent of reduction in EPS, if dilution takes place. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

E.P.S BASIC E.P.S: NET INCOME - PREFERRED DIVIDEND ------------------------------------------------------------- WEIGHT.AVERAGE OUTSTANDING. COMMON SHARES 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Basic EPS Computations: Example Given: Jan 1: 500,000 shares outstanding. May 1: Issued 84,000 shares. Sept 1: Reacquired 42,000 shares. Nov 1: Issued 36,000 shares. N.Inc [to common stock]: $654,000. Determine the earnings per share. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Basic EPS Computations: Example Jan 1: 500,000 * 12/12 = 500,000 May: 84,000 * 8/12 = 56,000 Sept 1: 42,000 * 4/12 = (14,000) Nov 1: 36,000 * 2/12 = 6,000 Total W.Avg.shares 548,000 Earnings per Share = $654,000 / 548,000 shares = $1.19 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.) What is “DILUTION?” “DILUTION” is the reduction in E.P.S, if: securities, potentially convertible into common stock, are converted [assumed at beginning of the year]. Two EPS amounts are important: Basic and Diluted 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Stock Dividends and Splits Stock dividends and stock splits require restatement of weighted shares outstanding before the dividend or split. Stock dividends or splits during the year are deemed to have been outstanding since the beginning of the year. Stock dividends or splits after end of the year but before issue of the financials are likewise restated. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Complex Capital Structures Complex structures have convertible securities, options, warrants, or other rights that reduce earnings per share Only securities that reduce earnings per share (dilutive) are considered. Securities that increase earnings per share (antidilutive) are ignored. 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Diluted Earnings per Share: Methods The dilutive effect of convertible securities is measured by the if-converted method The dilutive effect of options and warrants is measured by the treasury stock method For computing dilution, the rate of conversion most advantageous to the security holder is used (maximum dilutive conversion rate) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

The If-Converted Method The conversion of the securities into common stock is assumed to occur at the beginning of the year The related interest effect (net of tax) is removed from net income The weighted average number of shares is increased by the additional common shares assumed issued (at the beginning) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

The Treasury Stock Method Options and warrants (and their equivalents) are included in EPS computations Options and warrants are assumed exercised at the beginning of the year The proceeds from the exercise of options are assumed used to buy back common shares The exercise price per share must be less than the market price per share for dilution to occur 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Options and Warrants: Treasury Stock Method Given: Exercise price of an option : [for one share of stock] $ 10 Market price of one share at Exercise date: $ 40 Options deemed exercised: 1,000 Compute the number of weighted shares for determining diluted earnings per share 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Options and Warrants: Treasury Stock Method Total proceeds from exercise: $10,000 Shares assumed issued upon exercise: 1,000 Assumed reacquisition of shares: 250 DILUTION: 1,000 - 250 = 750 SHARES (increase in outstanding shares) 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Earnings per Share: Simple Capital Structures - Summary Single Presentation of EPS 1 Net Income less Preferred Dividends 2 Weighted Average Number of Common Shares Outstanding 3 EPS = Result in Step 2 Result in Step 3 4 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

Earnings per Share: Complex Structures - Summary Dual EPS Presentation Basic EPS Diluted EPS Dilutive Convertibles Dilutive Options and Warrants Dilutive Contingent Issues Net Income adjusted for interest (net of tax) and preferred dividends ------------------------------------------ Weighted average number of common shares assuming maximum dilution 11/12/2018 Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)

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