Intermediate Accounting - Chapter 16 4/17/2017 CHAPTER 16 Dilutive Securities and Earnings per Share ……..…………………………………………………………... Convertible Bonds exchanged for stock at the bond holder’s 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 106,000 Bonds Payable 100,000 Premium on Bonds Payable 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

This is the same whether or not there is a sweetener. Induced Conversions record the “sweetener” as an expense Debt Conversion Expense 7,000 Bonds Payable 100,000 Premium on Bonds Payable 5,000 Common Stock 20,000 Paid-in Cap – excess of par 85,000 Cash 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 Book Value Bonds $495,000 Warrants 15,000

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.

What is the value of an option to buy 1 share of stock at $100? The Expected Value of a Share of Stock Possible Stock Values Probability $80 10% $90 20% $100 40% $110 20% $120 10% $ 8 18 40 22 12 Expected value $100 What is the value of an option to buy 1 share of stock at $100?

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

The Value of Volatility Possible Value of Option Stock Values Probability to buy at $100 $60 10% $80 20% $100 40% $120 20% $140 10% $0 $ 0 $0 0 $20 4 $40 4 Expected value $ 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 Allocation of expense expense recognized in the service period generally service period = vesting period

2-year service period beginning on the grant date. 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 2-year service period beginning on the grant date. January 2, 2008 Options granted no entry

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 Net Income - Preferred Dividends Weighted Average Shares Outstanding EPS = Current year preferred dividend or Dividend that should have been declared if the preferred stock is cumulative

Weighted Average Shares Outstanding 1/1 – 4/1 90,000 4/1 – 7/1 120,000 7/1 –11/1 81,000 11/1 – 12/31 141,000 Dates Shares Fraction Outstanding Outstanding of Year New stock issued Stock repurchased

Weighted Average with Stock Dividend or Split # Shares 1/1 Beginning balance 80,000 3/1 Issued 30,000 shares 110,000 8/1 2 for 1 stock split 220,000 10/1 Purchsd 20,000 shares 200,000 Dates Shares Fraction Outstnd Outstnd Rstmt of Year 1/1 – 3/1 3/1 – 10/1 10/1 – 12/31

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 $350,000 Add: Bond interest (net of tax) $535,530 x 7% x 8/12 $24,991 Less: 40% tax 9,997 14,994 Adjusted net income $364,994

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 Dates Shares Out Fraction Outstanding if Converted of Year 1/1 – 5/1 5/1 – 12/31 Basic EPS = Diluted EPS =

Any security that increases EPS should be excluded. 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. Market Price - Option Price Market Price Potential Add. Shares = x # of Options $50 - $30 $50 = x 1,500 = 600 Basic EPS = Diluted EPS =

EPS Presentation Exercise 16-18

Old approach that some firms follow. STOCK OPTIONS - OTHER STUFF APB Opinion #25 Old approach that some firms follow. Incentive Stock Options Nonqualified Options Tax advantages to employee Tax advantages to firm option price = market price on grant date option price is usually less than market price no compensation expense 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.