Prepared by Gabriela H. Schneider, CMA; Grant MacEwan College INTERMEDIATE ACCOUNTING INTERMEDIATE ACCOUNTING Sixth Canadian Edition KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER, YOUNG, WIECEK

C H A P T E R 18 Dilutive Securities and Earnings Per Share

Learning Objectives 1. Describe the accounting for issuance, conversion, and retirement of convertible securities. 2. Explain the accounting for convertible preferred shares. 3. Contrast the accounting for stock warrants and stock warrants issued with other securities.

Learning Objectives 4. Describe the accounting for stock compensation plans under GAAP. 5. Explain the controversy involving stock compensation plans. 6. Calculate earnings per share in a simple capital structure. 7. Calculate earnings per share in a complex capital structure.

Dilutive Securities and Compensation Plans Convertible debt Convertible preferred shares Stock warrants Stock compensation plans Disclosure Computing Earnings per share Simple capital structure Complex capital structure Dilutive Securities and Earnings Per Share

Dilutive Securities Instrument entitling holder to obtain common shares When exercised cause existing shareholder interest to dilute Ownership interest (percentage) impact Impact on EPS A.k.a. potential common shares

Bonds that are convertible to other forms of securities (e.g. common shares) during a specified period of time Combines the benefits of a bond (interest payments, principal repayment) with the privilege of exchanging the bond for shares at the bondholders option Once the bond is converted, all interest payments and principal are no longer payable Convertible Debt

Issued for two main reasons 1.Corporation can raise equity capital without giving up ownership control 2.It can also achieve equity financing at a lower cost Conversion feature allows the corporation to offer the bond issue at a lower coupon or stated rate Conversion feature provides investor with an opportunity to own equity. This feature generally results in the investor accepting a lower coupon rate than they would with non-convertible debt Convertible Debt

The reporting of convertible debt and the conversion feature result in three issues: 1.Reporting at the time of issuance 2.Reporting at the time of conversion 3.Reporting at the time of retirement Convertible Debt – Accounting Issues

On issue date, part of the proceeds are allocated to liability and part to equity This reflects the nature of the security – since a convertible debt is part liability and part equity The amounts allocated to liability and equity are determined by using either: The Incremental Method The Proportional Method Reporting at the Time of Issuance

The value of the most easily measured component is determined and allocated to that component Debt generally the easier component to value Remainder of the proceeds become the value of the other component The Incremental Method

The Incremental Method - Example Given:  $20,000,000 par value, 10% convertible bonds issued at 99  If the bonds were not convertible, it is estimated they would have been sold at 95  Bond issue costs were $70,000 What portion of the proceeds are allocated to Bond Liability, and what portion to equity?

The Incremental Method - Example Total proceeds for the bond issue ($20,000,000 *.99) = $19,800,000 Fair value of the liability without the conversion option ($20,000,000 *.95) = $19,000,000 Residual allocated to option = $ 800,000 Cash19,800,000 Discount on Bond 1,000,000 Bonds Payable 20,000,000 Contributed Surplus – Stock Options 800,000

When values for both the liability and equity components are known or determinable The Bond Discount (or Premium) becomes a calculated amount under the Proportional Method The Proportional Method

Given: $10,000,000 of 8% convertible debentures due in 20 years issued for $10,800,000 Market value of the company’s common shares (on issue date) $80 per share Present value of bonds at time of issuance was $8,500,000 Corporation believed the difference between the present value and the amount paid was attributable to the conversion feature

Present value (fair value) of the bonds$8,500,000 Fair value of conversion rights (10,800,000 – 8,500,000)$2,300,000 The Proportional Method Cash 10,800,000 Discount on Bonds Payable 1,500,000 Bonds Payable10,000,000 Contributed Surplus 2,300,000 Note that in this case we are clearly given the fair values for both the liability and the conversion feature

Main issue is determining the amount at which to record the securities which are being exchanged Two approaches available Market value approach Gain or loss on conversion can occur Book value approach Gain or loss on conversion does not occur Most common approach Either method acceptable under GAAP Reporting at Time of Conversion

When market price of bonds or shares not known Book Value of the bonds and conversion rights used to record the conversion The basis for this method is that a “swap” or exchange of security has taken place The values were established when the bonds were originally issued and therefore should not be changed, as there was a contract in place Book Value Approach

When the corporation wants to entice or induce the bondholders to convert their bonds into shares Additional consideration – the “sweetener” – offered to the bondholders to convert (cash, common shares, etc.) The inducement is recorded as an expense in the period of conversion Induced Conversion

Treated the same as debt retirement from Chapter 15 Clear any outstanding premiums, discounts, bond issue costs, interest accrued to bondholders The conversion rights account must be reallocated Equity components remains in Contributed Surplus Reporting at the Time of Retirement

Convertible preferred shares are considered equity Convertible debt considered liability and equity At the time of issuance no allocation between debt and equity components Exception is redeemable preferred shares When conversion occurs the book value method is always used Deemed the exchange of one equity for another equity instrument Convertible Preferred Shares

Entitle the (share)holder to acquire shares at a specified price, within a specified period of time Attached to senior securities (bonds, preferred shares) Difference between convertibles and warrants With warrants the holder must pay an amount of money in order to acquire the shares Stock Warrants

Warrants (options to purchase additional shares) occur under three scenarios 1.To make the original security more attractive to the investor 2.To provide evidence of the pre-emptive right to acquire more common shares 3.Used as compensation for executives and employees Stock Warrants

“Rights” are similar to warrants except that rights have a shorter lifespan and are attached only to common shares, in order to purchase more common shares No journal entry required when rights are issued Use either the proportional or incremental method of accounting when dealing with detachable stock warrants If warrants are non-detachable, no allocation to warrants is needed

A form of stock warrant — a stock option Provides the employee with an opportunity to purchase shares at a given price, within a specified period of time Two accounting issues associated with stock compensation plans 1.Determination of compensation expense 2.Periods of allocation for compensation expense amounts Stock Compensation Plans

Stock Options - Important Dates Grant date Options are granted to employee Work start date Vesting date Date that employee can first exercise options Exercise date Employee exercises options Expiration date Unexercised options expire

Compensation Cost Measurement Two available methods 1.Intrinsic Value Method Excess of market price over exercise price at grant date Requires expanded note disclosure –Pro-forma net income and EPS under fair value method 2.Fair Value Method Measured at fair value of the stock options granted Preferred method of measurement Either method acceptable under GAAP, based on newly developed and accepted standard

The Measurement Date Compensation expense is determined as of 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

Options: Allocating Compensation Expense Compensation Expense is determined as of the measurement date 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

Compensation Expense - Example Given: 5 Stock options granted January 1, 2001 Option to purchase:2,000 shares each Option price per share:$60.00 Market price per share:$70.00 (at grant date) Stock option expires:10 years Service period:2 years Intrinsic Value Method: Market value at grant date (5*2,000)*$70 = $700,000 Option price at grant date (5*2,000)*$60 = 600,000 Compensation expense $100,000 Fair Value Method: Expense calculated by applying an option pricing model

Compensation Expense – Example: Journal Entries Intrinsic Value Grant DateNo Entry December 31, 2001 Compensation Expense50,000110,000 Contributed Surplus–Stock Options 50, ,000 (100,000  2 years) // (220,000  2 years) December 31, 2002 Compensation Expense 50,000110,000 Contributed Surplus–Stock Options 50, ,000 Fair Value

EPS - Simple Capital Structure Net Income – Preferred Dividends Weighted Average # of Shares Outstanding If the preferred shares are non-cumulative include only declared dividends If the preferred shares are cumulative include only declared dividends, or if no dividends declared, include only one year’s dividends

Weighted average number of common shares outstanding To find the equivalent number of whole shares outstanding for the year Stock splits and stock dividends require restatement of the outstanding number of shares from the beginning of the year Because there has been no change in the company’s assets, or in the shareholders’ total investment EPS - Simple Capital Structure

A final note ( CICA Handbook, Section 3500 ) If there is a stock split or stock dividend after the year end but before the publication of the financial statements The weighted average number of shares outstanding must be restated This applies to the current year, as well as previous years if comparative statements are issued EPS - Simple Capital Structure

EPS Calculation - Simple Capital Structure Given: January 1:500,000 shares outstanding March 1: Issued 20,000 shares June 1: 50% Stock dividend (60,000 additional shares issued) November 1: Issued 30,000 shares December 31:Ending Balance = 210,000 shares outstanding Determine the weighted average number of shares outstanding.

EPS Calculation - Simple Capital Structure Dates Shares FractionWeighted O/S O/SRestatement of YearShares Jan-Mar 100,000 x 1.50 x 2/12 =25,000 Mar-Jun 120,000 x 1.50 x 3/12 =45,000 Jun-Nov 180,000 x 5/12 =75,000 Nov-Dec 210,000 x 2/12 =35,000 Weighted average shares outstanding 180,000

Complex Capital Structure Complex capital structure: When corporation has convertible securities, options, warrants or other rights, and When converted these could dilute EPS Dilution is the reduction in EPS, if: securities, potentially convertible into common stock, are converted [assumed at beginning of the year] Anti-dilutive securities Securities, when converted, increase EPS Anti-dilutive EPS are not reported, only basic EPS

Requires dual presentation of EPS Basic earnings per share Presented for each separate class of common share Fully diluted earnings per share Only securities that reduce earnings per share (dilutive) are considered Securities that increase earnings per share (anti-dilutive) are ignored EPS - Complex Capital Structure

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)

The If-Converted Method The conversion of the securities into common stock is assumed to occur at the beginning of the year The net income must be adjusted for: Interest (net of tax) on the convertible debt Dividends on the convertible preferred shares The weighted average number of shares is increased by the additional common shares assumed issued (at the beginning of year)

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 to be used to buy back common shares The exercise price per share must be less than the market price per share for dilution to occur

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, =750 Shares (increase in outstanding shares) 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

Earnings per Share: Complex Structures - Summary Dual EPS Presentation Basic EPS Diluted EPS Net Income adjusted for interest (net of tax) and preferred dividends Weighted average number of common shares assuming maximum dilution Dilutive Convertibles Dilutive Options and Warrants Dilutive Contingent Issues

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