1. 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

2. 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
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3. 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.
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4. Convertible Debt: FMV and CV of Debt as Bases
Conversion based
on bonds’ FMV
B.Pay Dr. 1,000
Prem. Dr
Loss [redemp] 120
C/stock
Paid-in Capital ,050 or
Conversion based
on bonds’ C.V.
B.Pay Dr 1,000
Prem Dr
C/Stock
Paid-in-Cap
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5. 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.
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6. 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
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7. 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)
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8. 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.
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9. 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.
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10. 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
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11. 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
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12. Proportional Method: Concluded
Journal entries: Debit Credit
Cash $9,706 Discount (Bonds Payable) $ Bonds Payable $10,000
Cash $ Paid-in (Stock warrants) $ 294
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13. 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, $ $9,700
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14. 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.
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15. Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)
Compensation Plans
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16. 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
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17. 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)
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18. 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
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19. 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.,
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20. 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.
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21. 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.
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22. 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.
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23. 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.
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24. 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
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25. 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
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26. Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)
SFAS 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.
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27. Intermediate Accounting, 10th edn, Chapter 17 (Kieso et al.)
SFAS 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
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28. 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
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29. 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.
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30. 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 ( )
The SARs are held for 3 years and then exercised.
Determine the compensation expense for 2001, 02, and 03.
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31. 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) $ $30,000 / 2 = $15,000
2001 = $ 30,000
Dec 31, 10,000 * ($17-$10) $ 15,000 $ 70,000 - $15,000
2002 = $ 70, = $55,000
Dec 31, 10,000 * ($15-$10) $ 70,000 $ 50,000 - $70,000
2003 = $ 50, = ($20,000)
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32. 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)
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33. 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.
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34. E.P.S BASIC E.P.S: NET INCOME - PREFERRED DIVIDEND
WEIGHT.AVERAGE OUTSTANDING. COMMON SHARES
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35. 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.
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36. 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 = ,000
Total W.Avg.shares ,000
Earnings per Share = $654,000 / 548,000 shares
= $1.19
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37. 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
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38. 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.
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39. 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.
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40. 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)
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41. 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)
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42. 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
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43. 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
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44. Options and Warrants: Treasury Stock Method
Total proceeds from exercise: $10,000
Shares assumed issued upon exercise: 1,000
Assumed reacquisition of shares:
DILUTION: 1, = 750 SHARES (increase in outstanding shares)
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45. 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
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46. 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
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47. COPYRIGHT
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