Intermediate Accounting

Intermediate Accounting
*The following presentation covers Chapter 16, containing the slides that accompany your textbook as well as lecture notes by me, Dr. Litt, in order to thoroughly aid in your understanding of the concepts presented. Please be sure you are viewing these under the “Notes Page” view so that you are jointly viewing the slides and my lecture notes to you. This is the equivalent of me lecturing and talking through each slide right with you! *After you’ve studied these slides and your textbook thoroughly, please do the suggested homework problems (see the this week’s Instructions Checklist for these problem numbers) and review their solutions (provided in this week’s Content Folder). *All of this should prepare you for our chat session. So remember to do your part in studying and practicing this material, saving all questions you have for our chat session covering this chapter, and I’ll be sure to clear everything up for your Quiz and Exam covering this material! Prepared by Coby Harmon University of California, Santa Barbara

16 Dilutive Securities and Earnings per Share Intermediate Accounting
14th Edition This chapter will thoroughly examine Dilutive Securities and Earnings per Share, which represent two important topics of accounting and disclosure related to operations and Stockholders’ Equity. Kieso, Weygandt, and Warfield

Learning Objectives Describe the accounting for the issuance, conversion, and retirement of convertible securities. Explain the accounting for convertible preferred stock. Contrast the accounting for stock warrants and for stock warrants issued with other securities. Describe the accounting for stock compensation plans under generally accepted accounting principles. Discuss the controversy involving stock compensation plans. Compute earnings per share in a simple capital structure. Compute earnings per share in a complex capital structure. Above are the learning objectives we will cover in this chapter – once we have completed this presentation, you should be able to do all of these things!

Dilutive Securities and Earnings Per Share
Dilutive Securities and Compensation Plans Computing Earnings Per Share Debt and equity Convertible debt Convertible preferred stock Stock warrants Accounting for compensation Simple capital structure Complex capital structure Here is an overview of all the topics we will be covering related to Dilutive Securities and Earnings per Share over the course of this presentation.

Convertible Securities
Debt and Equity Should companies report these instruments as a liability or equity. Stock Options Convertible Securities Preferred Stock *Many of the securities we are about to examine have characteristics of both equity and debt. We will see that while some should clearly be reported in the equity section (common stock, ordinary preferred stock, stock options), others may be classified as liabilities (mandatorily redeemable preferred stock, convertible debt). We will discuss each of these securities and their accounting treatment so that you have a thorough understanding of this area.

Accounting for Convertible Debt
Bonds which can be changed into other corporate securities are called convertible bonds. Benefit of a Bond (guaranteed interest and principal) + Privilege of Exchanging it for Stock *Convertible debt generally come in the form of Bonds that carry the option to be converted into Shares of Stock after some specified period of time. Therefore, convertible bondholders get the benefit of the bond in that it guarantees them interest and principal repayment at specified points in time, but they have the added benefit of the opportunity to convert the bond into shares of the company’s stock if they decide that this type of security is more desirable in the future. (at the holder’s option) LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

Two main reasons corporations issue convertibles: Desire to raise equity capital without giving up more ownership control than necessary. Obtain common debt financing at cheaper rates. *Companies generally issue convertible bonds: 1 – To be able to raise capital in the future without initially having to give up ownership in the form of stock. 2 – To obtain debt financing at cheaper rates because bondholders are willing to accept lower interest rates in exchange for the option to convert the bonds to stock in the future. LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

At Time of Issuance Convertible bonds recorded as straight debt issue, with any discount or premium amortized over the term of the debt. *The issuance of Convertible Bonds is identical to the issuance of regular bonds (as we studied in Chapter 14) – whereby we put the Cash proceeds on the books, put the Bonds Payable on the books for the face amount, and the difference is put into the Discount or Premium on Bonds Payable account, to be amortized via interest expense each period. LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

BE16-1: Archer issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Journal entry at date of issuance: Cash 3,960,000 Discount on bonds payable 40,000 *This entry is identical to the issuances we practiced in Chapter 14. *The company issues the bonds at 99. which means they are sold for $4,000,000 par value x 0.99 = $3,960,000 (Note: the fact that the bonds would have been sold for less (95) if they hadn’t contained the conversion feature simply tells us that the company was able to issue them at a greater price because bondholders value the conversion option – it does not have any affect on our calculation). *We then put the Bonds Payable on the books for the face amount owed back to bondholders in the future (if they do not convert to stock), which is $4,000,000. *The $40,000 difference is the Discount on Bonds Payable we had to give bondholders because we must be offering a lower stated rate of interest than the market, thus we book this as a contra-liability to be amortized through higher interest expense in the future (remember your bond rules!). Bonds payable 4,000,000 ($4,000,000 x 99% = $3,960,000) LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

At Time of Conversion Companies use the book value method when converting bonds. When the debt holder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion. *If bondholders choose to convert the bonds into stock, the entry is actually quite simple: the company removes the Bonds Payable from its books for the book value at which they are being carried (because they must remove these obligations from the books when bondholders convert them to equity) and the company puts the Stock on its books for this amount (because they must put the shares these bondholders are now receiving onto the books). Let’s look at an example to aid in your understanding… LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

BE16-2: Yuen Corp. has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds are converted on December 31, 2012, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Journal entry at conversion: *In this case, the company’s Convertible Bonds currently have a book value of: 2,000 bonds x $1,000 face value each = $2,000,000 Bonds Payable - Unamortized (remaining) discount = ($30,000) Discount on Bonds Payable = Total Book (or Carrying) Value = $1,970,000 Book Value *The first thing the company must do is remove these bond accounts from the books as the holders of these bonds are converting them into stock – therefore, the company debits Bonds Payable to remove it (because it has a credit balance) and credits the Discount account to remove it (because as a contra-liability it has a debit balance ). Note: if this was a Premium instead, we would have added it to our Bonds Payable to get the carrying value and would have debited it to remove it from the books as it has a credit balance – see textbook example on Page 907). *The company must then put the shares of stock onto the books that these convertible bondholders are now receiving. How many shares are they receiving? 2,000 bonds x 50 shares given per bond = 100,000 shares. *As we did in Chapter 15, we must credit these 100,000 shares onto the books by first allocating the par value per share into the Common Stock account: 100,000 shares x $10 par value per share = $1,000,000 and then allocating the remaining $970,000 of the $1,970,000 book value (calculated above) to Paid-in Capital in Excess of Par (Note: if you had done the entry, this remaining $970,000 would have been the plug entry to make your debits = your credits). *Note that this entry tells the story of Bonds Payable (and all related accounts) being taken off the books and converted into shares of Common Stock. Bonds payable 2,000,000 Discount on bonds payable 30,000 Common stock (2,000 x 50 x $10) 1,000,000 Paid-in capital in excess of par – Common Stock 970,000 LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

Induced Conversion Issuer wishes to encourage prompt conversion. Issuer offers additional consideration, called a “sweetener.” Sweetener is an expense of the period. *Sometimes a company may want to encourage its convertible bondholders to convert their bonds into stock, so they may choose to offer them some amount of cash as an incentive to do so. If the company opts to do this, they must expense this amount of cash in the period it is given to induce conversion. Let’s look at our pervious example, but this time add an induced conversion expense… LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

BE16-2: Yuen Corp. has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. Assume Yuen wanted to reduce its annual interest cost and agreed to pay the bond holders $70,000 to convert. Journal entry at conversion: Bonds payable 2,000,000 Discount on bonds payable 30,000 Same Common stock (2,000 x 50 x $10) 1,000,000 *This is the same example that we previously did together, but here, the company gives an additional $70,000 to bondholders to encourage (or induce) conversion of their bonds to stock. Notice the top entry is the same, but additionally, we must expense this $70,000 as a Debt Conversion Expense and reflect that we paid this $70,000 out of our Cash account. *Note: in the textbook example on Page 908, this induced conversion entry is integrated into the conversion entry as one big entry, but it is identical in effect to doing it in two entries as done in this slide. Also note that in that same textbook example on Page 908, the Bonds Payable are not carried with any Discount or Premium; therefore, only the Bonds Payable account must be removed when taking the bonds off the books. Additional paid-in capital 970,000 Debt conversion expense 70,000 Cash 70,000 LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

Retirement of Convertible Debt Recognized same as retiring debt that is not convertible. Difference between the acquisition price and carrying amount should be reported as gain or loss in the income statement. *Just as we learned with non-convertible debt in Chapter 14, when debt is retired for less of more than its carrying value, a gain or loss is reported on retirement of the debt accordingly. LO 1 Describe the accounting for the issuance, conversion, and retirement of convertible securities.

Convertible Preferred Stock
Convertible preference shares include an option for the holder to convert preference shares into a fixed number of ordinary shares. Convertible preference shares are reported as part of equity. When preference shares are converted or repurchased, there is no gain or loss recognized. *The notion of Convertible Preferred Stock is very similar to the convertible bonds we just examined. These preferred shares are issued with the option for shareholders to convert them into common shares in the future. *When Convertible Preferred Stock is issued, it is put into equity, just as ordinary preferred stock is. And when these shares are converted to Common Stock, just as with convertible bonds, these convertible preferred shares must be removed from the books, and the common shares given to these shareholders must be put onto the books. *Let’s look at an example… LO 2 Explain the accounting for convertible preferred stock.

Convertible Preferred Stock
BE16-3: Gall Inc. issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Journal entry to record conversion: Preferred stock 50,000 *In this case, the preferred stockholders are converting 1,000 of their shares of preferred stock into 2,000 shares of common stock. *We must first remove the Preferred Stock from the books for the amount the shares were initially issued for (their book value). As stated, they have a par value of $50 per share, and they were issued for $60 per share. Since 1,000 of these shares are being converted, we must remove the amount initially put into the Preferred Stock account ($50 par value per share x 1,000 shares = $50,000) and the excess $10 per share ($60 price – $50 par value) initially put into the Paid-in Capital-Preferred Stock account – notice we must remove both of these credit accounts with debits. *We must then credit the Common Stock onto the books that these shareholders are receiving upon conversion. Since they are receiving 2,000 shares of $10 par value common stock, we must put 2,000 x $10 = $20,000 into Common Stock and we must put the remaining $40,000 (the excess) into the Paid-in Capital-Common Stock account. *Note that this entry tells the story of Preferred Stock being taken off the books and converted into shares of Common Stock. *Also note that the textbook shows an example on Page 909 of common stock par value exceeding the book value of preferred shares converted, in which case Retained Earnings or another Paid-in Capital account has to be debited for the difference – do not worry about this very rare case for our course! Focus more on this slide example and homework problems in this area. Paid-in capital – Preferred stock 10,000 Common stock (2,000 x $10 par) 20,000 Paid-in capital – Common stock 40,000 LO 2 Explain the accounting for convertible preferred stock.

Stock Warrants Warrants are certificates entitling the holder to acquire shares at a certain price within a stated period. Normally arises under three situations: To make the security more attractive. Existing stockholders have a preemptive right to purchase common stock first. To executives and employees as a form of compensation. *Stock warrants are certificates issued by the company that entitle holders of these certificates to purchase shares of company stock at a set price within a set period of time. *Companies may issue these certificates: 1 – To make their securities (e.g., stock, bonds) more attractive by attaching these warrants to them, thus providing the purchaser additional value in the form of this locked in future stock purchase price. 2 – To current common stockholders as evidence of their preemptive right to have the first opportunity to purchase additional shares in the future. 3 – To give as additional compensation to employees. LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Stock Warrants Issued with Other Securities
Basically long-term options to buy common stock at a fixed price. Generally life of warrants is five years, occasionally ten years. Proceeds allocated between the two securities. Allocation based on fair market values. Two methods of allocation: (1) proportional method (2) incremental method *Let us first examine the case when stock warrants are issued along with other securities (#1 from previous slide). *When this occurs, we must allocate the proceeds we receive from the issuance of the securities between the securities themselves and the stock warrants issued with them. *As we have seen in previous chapters, there are two methods of allocating these proceeds… LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Proportional Method Determine:
value of the bonds without the warrants, and value of the warrants. The proportional method allocates the proceeds using the proportion of the two amounts, based on fair values. The first method is the Proportional Method – When we know the fair value of both the securities and the stock warrants, we allocate the proceeds based on their relative fair market values. *Let’s look at an example of this method… LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants BE16-4: Margolf Corp. issued 2,000, $1,000 bonds at Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market value of $40. Use the proportional method to record the issuance of the bonds and warrants. *Here, the company is issuing 2,000, $1,000 bonds ($2,000,000 total in bonds) at This means the company is receiving $2,000,000 x 1.01 = $2,020,000. *BUT, with each bond, one stock warrant is also issued. Thus, this $2,020,000 in proceeds must be allocated between the bonds AND the stock warrants. *We are told that the bonds have a market value of 98, which means they have a fair value of $2,000,000 x 0.98 = $1,960,000. Additionally, we are told that the warrants have a market value of $40 each, which means they have a total fair value of 2,000 warrants x $40 fair value per warrants = $80,000. This makes the total fair market value of both the bonds and the warrants = $2,040,000. *So, the bond proportion of total fair value = $1,960,000/2,040,000 = % *And the stock warrant portion of total fair value = $80,000/2,040,000 = % *Since we know both fair values, we then allocate the $2,020,000 accordingly: *Bonds Payable portion = $2,020,000 proceeds x = $1,940,784 *Stock Warrant portion = $2,020,000 proceeds x = $79,216 *Now let’s see how we do the journal entry for this issuance of the bonds and stock warrants… LO 3

Stock Warrants BE16-4: Margolf Corp. issued 2,000, $1,000 bonds at Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market value of $40. Use the proportional method to record the issuance of the bonds and warrants. Cash 2,020,000 Discount on bonds payable 59,216 *We must first debit the $2,020,000 in Cash proceeds we are receiving from the issuance onto our books (see calculation in the notes to the last slide). *We must then allocate these proceeds to both the Bonds Payable and the Stock Warrants as follows: *Also per our calculations from the previous slide, we should allocate $1,940,784 to the Bonds Payable, but remember Bonds Payable are always put onto the books at their face value, which is the 2,000 bonds x $1,000 face value per bond = $2,000,000, and the carrying value is then modified with a Discount of Premium. In this case, we need a Discount to get the carrying value down to the $1,940,784, so we calculate this to be $2,000,000 – 1,940,784 = $59,216. Accordingly, we credit the $2,000,000 in Bonds Payable onto the books and debit the $59,216 Discount on Bonds Payable onto the books as well. *Again as we previously calculated, $79,216 of the proceeds should be allocated to the stock warrants, but into which account? We put it into an account called Paid-in Capital – Stock Warrants to represent the fact that we are setting aside this amount in equity for the holders of the warrants to later purchase stock in our company. Bonds payable 2,000,000 Paid-in capital – Stock warrants 79,216 LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Incremental Method
Where a company cannot determine the fair value of either the warrants or the bonds. Use the security for which fair value can determined. Allocate the remainder of the purchase price to the security for which it does not know fair value. The second method is the Incremental Method – When we only know the fair value of one of the two instruments issued (securities OR stock warrants), we first allocate the proceeds based on the known fair value amount and allocate the remainder to the other. *Let’s look at an example of this method… LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants BE16-5: McCarthy Inc. issued 2,000, $1,000 bonds at Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98. The market price of the warrants, without the bonds, cannot be determined. Use the incremental method to record the issuance of the bonds and warrants. *Here, the company is issuing 2,000, $1,000 bonds ($2,000,000 total in bonds) at This means the company is receiving $2,000,000 x 1.01 = $2,020,000. *BUT, with each bond, one stock warrant is also issued. Thus, this $2,020,000 in proceeds must be allocated between the bonds AND the stock warrants. *We are told that the bonds have a market value of 98, which means they have a fair value of $2,000,000 x 0.98 = $1,960,000. Additionally, we are told that that fair value of the stock warrants is unknown; therefore, we must use the Incremental method to allocate the $2,020,000 in proceeds as follows: *Bonds Payable portion = $1,960,000 (known fair value) *Stock Warrant portion = $2,020,000 proceeds - $1,960,000=$60,000 (remainder) *Now let’s see how we do the journal entry for this issuance of the bonds and stock warrants… LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Cash 2,020,000 Discount on bonds payable 40,000
BE16-5: McCarthy Inc. issued 2,000, $1,000 bonds at Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98. The market price of the warrants, without the bonds, cannot be determined. Use the incremental method to record the issuance of the bonds and warrants. Cash 2,020,000 Discount on bonds payable 40,000 *We must first debit the $2,020,000 in Cash proceeds we are receiving from the issuance onto our books (see calculation in the notes to the last slide). *We must then allocate these proceeds to both the Bonds Payable and the Stock Warrants as follows: *Because we only know the fair value of the bonds, we should allocate the $1,960,000 fair value first to the Bonds Payable, but remember Bonds Payable are always put onto the books at their face value, which is the 2,000 bonds x $1,000 face value per bond = $2,000,000, and the carrying value is then modified with a Discount of Premium. In this case, we need a Discount to get the carrying value down to the $1,960,000, so we calculate this to be $2,000,000 – 1,960,000 = $40,000. Accordingly, we credit the $2,000,000 in Bonds Payable onto the books and debit the $40,000 Discount on Bonds Payable onto the books as well. *We then put the remaining $60,000 of proceeds into Paid-in Capital – Stock Warrants to represent the fact that we are setting aside this amount in equity for the holders of the warrants to later purchase stock in our company. Bonds payable 2,000,000 Paid-in capital – Stock warrants 60,000 LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Conceptual Questions
Detachable warrants involves two securities, a debt security, a warrant to purchase common stock. Nondetachable warrants no allocation of proceeds between the bonds and the warrants, companies record the entire proceeds as debt. *When stock warrants are given with an accompanying debt instrument, as we just saw with the warrants issued with the bonds in the previous example: *They may be Detachable Stock Warrants, which permit the holder to use them separately from the accompanying debt; therefore, as we saw in the previous example, they are accounted for separately from the accompanying debt. *However, when we work with Nondetachable Stock Warrants, which cannot be separated from the accompanying debt, we book the entire amount borrowed as debt as we cannot conceptually separate out the equity component. LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Rights to Subscribe to Additional Shares
Share Rights - existing stockholders have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings. Price is normally less than current market value. Companies make only a memorandum entry. *Now let’s example the case when stock warrants are issued as evidence of current stockholders’ preemptive right (#2 from slide 16-17). *Stock warrants may be issued as evidence of current stockholders’ preemptive right to have the first opportunity to purchase newly-issued shares – if this is the case, the company makes note of this (via a memorandum entry) but does not formally book any actual journal entry. LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants Share Compensation Plans
Share Option - gives key employees option to purchase ordinary shares at a given price over extended period of time. Effective compensation programs are ones that: base compensation on performance motivate employees, help retain executives and recruit new talent, maximize employee’s after-tax benefit, and use performance criteria over which employee has control. *Now let’s examine the third case when stock warrants are issued as additional employee compensation (#3 from slide 16-17). *By offering employees set stock prices on company stock in the future, the company is offering this potential value as additional compensation. *Above are five characteristics of effective compensation plans aimed at maximizing employee performance and thus operational effectiveness. LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Stock Warrants The Major Reporting Issue
FASB guidelines require companies to recognize compensation cost using the fair-value method. Under the fair-value method, companies use acceptable option-pricing models to value the options at the date of grant. *The FASB now requires companies to recognize compensation expense each period an employee earns stock compensation according to the fair value of the related stock options. Note the logic here that during the period the employee works to earn the stock compensation, the company should recognize compensation expense for the fair value of the employee service in order to properly match this expense with the revenue the employee helped generate during the period. *We will now examine the calculations related to accounting for this stock compensation… LO 3 Contrast the accounting for stock warrants and for stock warrants issued with other securities.

Accounting for Stock Compensation
Share Option Plans Two main accounting issues: How to determine compensation expense. Over what periods to allocate compensation expense. *Above are the two central issues that must be considered in appropriately accounting for stock option compensation plans. Let’s discuss them in greater detail and see how the actual calculations work! LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Determining Expense Compensation expense based on the fair value of the options expected to vest on the date the options are granted to the employee(s) (i.e., the grant date). Allocating Compensation Expense Over the periods in which employees perform the service—the service period. *In determining the amount of Compensation Expense to be booked for stock compensation, we use the fair value of the stock options on the date they are granted to employees. We come up with this fair value using an options-pricing model. These fair value amounts will be given to you in the problems we work with! *In allocating this Compensation Expense, as we I previously noted, we should book this expense over the period the employee works to earn the right to use the stock options (referred to as the “service period”). *Let’s look at an example to aid in your understanding of how stock compensation calculations work… LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: On November 1, 2011, the shareholders of Chen Company approve a plan that grants the company’s five executives options to purchase 2,000 shares each of the company’s $1 par value common stock. The company grants the options on January 1, The executives may exercise the options at any time within the next 10 years. The option price per share is $60, and the market price of the shares at the date of grant is $70 per share. Under the fair value method, the company computes total compensation expense by applying an acceptable fair value option-pricing model. The fair value option-pricing model determines Chen’s total compensation expense to be $220,000. *This is the problem we will be referring to when we do the calculations outlined in the following slides. *Notice that the company is granting stock options to employees on January 1, 2012, at which time they must note the fair value of these options in order to book compensation expense over the service period the employees work to benefit the company and earn the options. The company notes this total compensation expense as $220,000, but how should it be recognized? *Let’s see how this works… LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: Assume that the expected period of benefit is two years, starting with the grant date. Chen would record the transactions related to this option contract as follows. Dec. 31, 2012 Compensation Expense 110,000 Paid-in capital – Stock Options 110,000 * *Although this slide states that the “period of benefit” is two years, I prefer the term “service period” as it more directly implies that the employees are working for two years to benefit the company and earn the stock options. *Because the problem states that TOTAL compensation expense for these stock options is $220,000, we must ALLOCATE this amount over the employee SERVICE PERIOD, which is given on this slide as two years. Thus, the company must recognize $220,000/2 years = $110,000 Compensation Expense per year as the employees work each of these two years to earn the stock options, thus requiring the company to expense these options during this period. *The entry each year debits Compensation Expense for the allocated amount and also credits this amount into Paid-in Capital-Stock Options in order to represent the fact that the company is setting aside equity for the employees to later exercise the stock options by purchasing stock in our company. Dec. 31, 2013 Compensation Expense 110,000 Paid-in capital - Stock Options 110,000 * ($220,000 ÷ 2) LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Exercise. If Chen’s executives exercise 2,000 of the 10,000 options (20 percent of the options) on June 1, 2015 (three years and five months after date of grant), the company records the following journal entry. June 1, 2015 Cash (2,000 x $60) 120,000 Paid-in Capital - Stock Options 44,000 Common Stock (2,000 x $1) 2,000 Paid-in Capital in Excess of Par 162,000 *This entry reflects the employees exercising their stock options by purchasing shares of stock at the fixed price set in the options. *The employees must pay $60 per share (as stated in the options), and they are exercising 2,000 shares, for a total debit to Cash of $60 x 2,000 = $120,000, reflecting the increase in cash for the company as a result of these share purchases. *The company must then remove the Paid-in Capital-Stock Options account with a debit for these 2,000 shares as they are no longer stock options when they are exercised as actual shares. They should be removed at the amount they were put into this account. As you saw in the last slide, a total of $220,000 was put into this account for the 10,000 shares granted, which means the per share amount put into the account is $220,000/10,000 = $22/share. Therefore, the amount that should be reversed out of this account when 2,000 shares are exercised is 2,000 shares x $22/share = $44,000. *The company must then put the 2,000 shares issued to these employees on the books as it would for any stock issuance: credit Common Stock for the par value per share (2,000 shares x $1 par value per share = $2,000) and credit Paid-in Capital in Excess of Par for the rest of the proceeds . LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Expiration. If Chen’s executives fail to exercise the remaining stock options before their expiration date, the company records the following at the date of expiration. Jan. 1, 2022 Paid-in Capital - Stock Options 176,000 Paid-in Capital – Expired Stock Options 176,000 * *If employees do not exercise the options, and the options expire, the company must transfer any remaining balance in the Paid-in Capital Stock Options account to an account designated as Paid-in Capital-Expired Stock Options to reflect the fact that these stock options have expired. * ($220,000 x 80%) LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Adjustment. Once the total compensation is measured at the date of grant, can it be changed in future periods? If an employee forfeits a stock option because the employee fails to satisfy a service requirement (e.g., leaves employment), the company should adjust the estimate of compensation expense recorded in the current period (as a change in estimate). *If employees do not work for the entire service period to earn the stock options, the company should decrease Compensation Expense and Paid-in Capital-Stock Options accordingly. LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Restricted Stock Transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs. Major Advantages: Never becomes completely worthless. Generally results in less dilution to existing stockholders. Better aligns employee incentives with company incentives. *Many companies issue Restricted Stock to employees as opposed to Stock Options. Restricted Stock are shares of stock given to employees that cannot be sold by the employees until they have fully earned the shares over a designated service period. *Listed above are some of the primary advantages of Restricted Stock over Stock Options: 1 – Unlike Stock Options that may become totally worthless if the option price is above the stock price, Restricted Stock is never worthless because the shares are actually given to employees. 2 – Because less shares of Restricted Stock are generally issued than Stock Options, less dilution of ownership occurs. 3 – Because Restricted Stock actually makes employees shareholders upon issuance, they better align employee incentives with company incentives as shareholders are interested in long-term objectives of the company. *Let’s go through a Restricted Stock example… LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: On January 1, 2012, Ogden Company issues 1,000 shares of restricted stock to its CEO, Christie DeGeorge. Ogden’s stock has a fair value of $20 per share on January 1, Additional information is as follows. The service period related to the restricted stock is five years. Vesting occurs if DeGeorge stays with the company for a five-year period. The par value of the stock is $1 per share. Ogden makes the following entry on the grant date (January 1, 2012). *Here are the facts for the problem we will now go through. Notice the company is giving its employee shares of stock now with the restriction that they cannot be sold until after a five-year vesting period (thus making it “Restricted Stock”). LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: Ogden makes the following entry on the grant date (January 1, 2012). Unearned compensation 20,000 Common stock (1,000 x $1) 1,000 Paid-in capital in excess of par (1,000 x $19) 19,000 *When the company grants the stock to the employee, it must put the 1,000 shares of $20 fair value stock it issued to the employee on the books as it would for any stock issuance: credit Common Stock for the par value per share (1,000 shares x $1 par value per share = $1,000) and credit Paid-in Capital in Excess of Par for the rest of the fair value per share (1.000 shares x $19 per share = $19,000). *But, since the employee has not actually earned these shares (she must work for the company over the next five years to earn the right to sell them), the company debits an account called Unearned Compensation to reflect the fact that these shares given have not yet been earned. GAAP has us classify this account as a contra-equity account as it is a debit account that is not an asset to the company. Unearned Compensation represents the cost of services yet to be performed, which is not an asset. Unearned Compensation is reported as a component of stockholders’ equity in the balance sheet. LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: Record the journal entry at December 31, 2012, Ogden records compensation expense. Compensation expense 4,000 Unearned compensation 4,000 *Each year that the employee works for the company, a portion of the Unearned Compensation becomes earned compensation, which is reflected by the company booking Compensation Expense to reflect the employee working for the company during the period and thus, vesting in the restricted stock. *The journal entry to reflect the amount earned each year takes the total amount of $20,000 Unearned Compensation and allocates it over the 5 year service period so that $20,000/5 years = $4,000 of Compensation Expense is booked each year (with a debit) and taken out of Unearned Compensation (with a credit) as the employee vests in the shares. Ogden records compensation expense of $4,000 for each of the next four years (2013, 2014, 2015, and 2016). LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Illustration: Assume that DeGeorge leaves on February 3, 2014 (before any expense has been recorded during 2014). The entry to record this forfeiture is as follows Common stock 1,000 Paid-in capital in excess of par - common 19,000 Compensation expense ($4,000 x 2) 8,000 Unearned compensation 12,000 *What happens if the employee leaves before fully vesting in the restricted stock? The company must reverse the restricted shares off its books as these shares are no longer issued to the employee, and the company must also reverse out any Compensation Expense and Unearned Compensation Expense previously booked as the employee never vested and will never vest in the restricted stock. *In this case, the company reverses the shares off the books at the amounts they were initially put onto the books with a debit to Common Stock for the par value per share (1,000 shares x $1 par value per share) and a debit to Paid-in Capital in Excess of Par for the remainder of the fair value amount on the grant date (1,000 shares x $19 per share). *The company must then reverse out any Compensation Expense and Unearned Compensation previously booked. Let’s remember that on the grant date, the company started out with $20,000 in Unearned Compensation, but since that time, for the past two years (2012 and 2013), the company has taken $4,000 out of the account each year to book this amount as Compensation Expense. Thus, the remaining balance in Unearned Compensation as of the beginning of this year (2014) is $20,000 – 4,000 – 4,000 = $12,000, and the total Compensation Expense booked to date is $4, ,000 = $8,000. Therefore, these two amounts must be reversed off when the restricted stock is forfeited with credits as shown above. LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Employee Stock-Purchase Plans Generally permit all employees to purchase stock at a discounted price for a short period of time. Plans are considered compensatory unless they satisfy all three conditions presented below. Substantially all full-time employees may participate on an equitable basis. The discount from market is small. The plan offers no substantive option feature. *Employee Stock-Purchase Plans are put in place by companies to offer discounted prices on company stock. *Notice that in order for a company to offer these plans, they must be offered to substantially all employees, for a relatively low discount, with relatively minor special features – in other words, in order for these plans to not be considered additional compensation to employees, they cannot be exclusive or offer any overly-exceptional benefits. LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Disclosure of Compensation Plans Company with one or more share-based payment arrangements must disclose: Nature and extent of such arrangements. The effect on the income statement of compensation cost. The method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant). The cash flow effects. *Above are the disclosure requirements for companies with stock-based compensation plans. LO 4 Describe the accounting for stock compensation plans under generally accepted accounting principles.

Debate over Stock Option Accounting The FASB faced considerable opposition when it proposed the fair value method for accounting for share options. This is not surprising, given that the fair value method results in greater compensation costs relative to the intrinsic-value model. Transparent financial reporting—including recognition of stock-based expense—should not be criticized because companies will report lower income. If we write standards to achieve some social, economic, or public policy goal, financial reporting loses its credibility. *When the FASB changed its method of accounting for stock options to the fair value method, companies were upset at the notion of the resulting increased compensation expense that would lower net income; however, we cannot lessen the quality and accuracy of financial reporting for the sake of reporting stronger corporate financial results! LO 5 Discuss the controversy involving stock compensation plans.

Computing Earnings Per Share
Earnings per share indicates the income earned by each share of common stock. Companies report earnings per share only for common stock. When the income statement contains intermediate components of income (such as discontinued operations or extraordinary items), companies should disclose earnings per share for each component. Illustration 16-7 *Earnings Per Share (EPS) is one of the most widely-used measures to analyze the performance of a company. *EPS indicates the earnings per share of common stock. This indicates the return companies are earning for its common stockholders. *Companies generally report EPS on the face of the Income Statement with Net Income, and when companies report other intermediate items (as shown above), they break down each component based on its per share implications.

EPS - Simple Capital Structure
Simple Structure--Only common stock; no potentially dilutive securities. Complex Structure--Potentially dilutive securities are present. “Dilutive” means the ability to influence the EPS in a downward direction. *A company has a Simple Structure when it has only common stock (and it may also have preferred stock), but not other potentially-exercisable shares – this means that there are no instruments outstanding that would entitle individuals to claim shares of stock, which would dilute (reduce) EPS. Examples of such instruments are convertible bonds (which can be converted to shares of stock) or stock options (which can be redeemed for shares of stock), which could be used by holders of these instruments to receive shares of stock, thus diluting (reducing) EPS. *A company has a Complex Structure when it does have such instruments that could potentially dilute EPS. LO 6 Compute earnings per share in a simple capital structure.

Preferred Stock Dividends Subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders. Illustration 16-8 *When a company has a simple structure, the EPS calculation is quite simple: The numerator = Net Income – Preferred Dividends: this is because in calculating the return to common stockholders, we start with the amount earned as Net Income and remove any dividend amounts declared for preferred stockholders as these earnings are not available for common stockholders. I also want to note here that if preferred stock is non-cumulative, we only subtract out preferred dividends if they are actually declared, but if preferred stock is cumulative, we subtract out the fixed preferred dividend whether it is declared or not because preferred stockholders are entitled to receive the dividend either way if stock is cumulative. The denominator is the Weighted-Average Number of Common Shares Outstanding, which is a measure of the average number of common shares outstanding for the company throughout the year. We will now see how to calculate this amount… Preferred dividends are subtracted on cumulative preferred stock, whether declared or not. LO 6 Compute earnings per share in a simple capital structure.

Weighted-Average Number of Shares Companies must weight the shares by the fraction of the period they are outstanding. When stock dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split. *We will do an example to better understand Weighted-Average Number of Shares, but just a couple of rules: 1 – We weight shares by the fraction of the year they are outstanding. 2 – When we issue stock dividends or stock splits, we must adjust all share amounts prior to these issuances since these issuances cause stockholders’ equity to be broken into a greater amount of pieces, causing us to have to adjust shares before the issuances to be on this same larger basis. *Let’s look at an example together now… LO 6 Compute earnings per share in a simple capital structure.

Illustration: Franks Inc. has the following changes in its common stock during the period. Illustration 16-9 *Here are the transactions that increased and decreased this company’s number of common shares outstanding for the year. We will use this information to calculate the Weighted-Average Number of Shares Outstanding… Compute the weighted-average number of shares outstanding for Frank Inc. LO 6 Compute earnings per share in a simple capital structure.

Illustration 16-9 Illustration 16-10 *In order to calculate the Weighted-Average Number of Shares Outstanding, we must weight each balance of stock outstanding by the fraction of the year the balance exists. *In the above example, the beginning balance of 90,000 shares is outstanding for 3 months (from Jan 1 to Apr 1) out of the twelve months of the year; therefore, we multiple the 90,000 share balance by 3/12, which equals 22,500. *The company then issues 30,000 more shares, raising the outstanding share balance to 90, ,000 = 120,000 shares, which is the balance for 3 months (Apr 1 to Jul 1), so we multiple the 120,000 share balance by 3/12 to get 30,000. *The company then repurchases 39,000 shares of stock as treasury stock, thus reducing the total number of shares outstanding to 120,000 – 39,000 = 81,000 shares, which is the balance for four months (Jul 1 to Nov 1), so we multiple the 81,000 share balance by 4/12 to get 27,000. *Finally, the company issues another 60,000 shares, raising the outstanding share balance to 81, ,000 = 141,000 shares, which is the balance for the remaining 2 months of the year (Nov 1 to Dec 1), so we multiple the 141,000 share balance by 2/12 to get 23,500. *We then add up all of these weighted share amounts to arrive at the Weighted Average Number of Shares Outstanding. Note: the total sum of all fractions should be 12/12 to ensure you have weighted shares for the entire year. LO 6

EPS - Complex Capital Structure
Complex Capital Structure exists when a business has convertible securities, options, warrants, or other rights that upon conversion or exercise could dilute earnings per share. Company reports both basic and diluted earnings per share. *As previously discussed, a complex capital structure is when a company has instruments outstanding that could cause individuals to come back and claim shares of stock, thus diluting (reducing) the company’s EPS by increasing the denominator with more shares outstanding. LO 7 Compute earnings per share in a complex capital structure.

Diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period. Illustration 16-17 *While this concept may be a little hard to understand at first, it is very important to understand the difference between Basic EPS and Diluted EPS: *Basic EPS is the amount that we calculate, as previously discussed, that incorporates only those shares actually outstanding for the year. *Diluted EPS, on the other hand, starts with Basic EPS but also incorporates shares that could potentially be outstanding as a result of individuals claiming common shares from convertible instruments, stock warrants, and other dilutive securities. *Why does GAAP require companies to disclose this Diluted EPS amount if the additional shares have not actually been issued? Because this is the worst-case scenario for common stockholders if all individuals who could claim common shares do claim their common shares – this way, financial statement users know the most diluted (reduced) EPS could possibly be. *Also note that if financial instruments are anti-dilutive (meaning they increase EPS), they are not reported as these would cause EPS not to be at the worst-case scenario. We will see examples of such instruments as we move through the calculations… Companies will not report diluted EPS if the securities in their capital structure are antidilutive. LO 7 Compute earnings per share in a complex capital structure.

Diluted EPS – Convertible Securities Measure the dilutive effects of potential conversion on EPS using the if-converted method. This method for a convertible bond assumes: the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and the elimination of related interest, net of tax. *When we convert Basic EPS to Diluted EPS, we use an “If-Converted” method for convertible bonds or convertible preferred stock that could be converted into common shares – simply stated, we modify both the numerator and denominator to reflect the effects had these instruments been converted into common shares. *For example, with convertible bonds, the “if-converted” method says what would have happened if the bonds had been converted to common shares at the earliest time possible? *For the numerator, if bondholders had traded in their bonds for common stock at the beginning of the year, the company would not have incurred any interest on the bonds; therefore, we add back after-tax interest to the numerator to reverse out interest expense from net income. *For the denominator, if bondholders had traded in their bonds for common stock at the beginning of the year, the company would have had more common shares outstanding; therefore, we add these shares to the denominator. *Let’s look at an example together… LO 7 Compute earnings per share in a complex capital structure.

E16-22 (Convertible Bonds): In 2012 Buraka Enterprises issued, at par, 75, $1,000, 8% bonds, each convertible into 100 shares of common stock. Buraka had revenues of $17,500 and expenses other than interest and taxes of $8,400 for (Assume that the tax rate is 40%.) Throughout 2013, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed. Instructions (a) Compute diluted earnings per share for 2013. (b) Assume same facts as those for Part (a), except the 75 bonds were issued on September 1, 2013 (rather than in 2012), and none have been converted or redeemed. *Here is an example we will work through together in the next few slides. *Please note that this company has convertible bonds outstanding that entitle the bondholders to trade their bonds in for shares of common stock if they choose to. This means that the company has a complex structure because there are outstanding potentially-exercisable shares. *Let’s look at the calculation of Basic EPS and Diluted EPS based on this information… LO 7 Compute earnings per share in a complex capital structure.

E16-22 (a) Compute diluted earnings per share for 2013. Calculation of Net Income Revenues $17,500 Expenses 8,400 Bond interest expense (75 x $1,000 x 8%) 6,000 Income before taxes 3,100 Income tax expense (40%) 1,240 Net income $ 1,860 *We always start by calculating Basic EPS. *We must first calculate the numerator (Net Income – Preferred Dividends), but in this case, there is no preferred stock, so we will calculate only Net Income as the numerator as follows (and as shown above): Revenues are $17,500, from which we must subtract out the Expenses (other than interest and taxes) of $8,400, and we must then calculate and subtract Interest Expense (75 bonds x $1,000 face value per bond x 8% interest rate on bonds = $6,000). After subtracting all of these expenses, we then take the total before taxes of $3,100 and tax it at 40% to calculate and subtract Income Tax Expense ($3,100 x 0.40 = $1,240), which gives us a final Net Income of $1,860. THIS IS OUR BASIC EPS NUMERATOR! *What about our denominator? In this case, the problem tells us that 2,000 shares were outstanding for the entire year, with no changes in this balance so there is no need to weight the shares as this is already the Weighted-Average Number of Shares Outstanding (think about it: the calculation would be 2,000 shares x 12/12 months outstanding = 2,000 shares!). THIS IS OUR DENOMINATOR! LO 7 Compute earnings per share in a complex capital structure.

EPS - Complex Capital Structure Weighted average shares = 2,000
E16-22 (a) Compute diluted earnings per share for 2013. When calculating Diluted EPS, begin with Basis EPS. Basic EPS Net income = $1,860 = $.93 *For our Basic EPS, we then simply divide the our numerator by our denominator (calculated in the last slide), and we arrive at a Basic EPS of $0.93. Weighted average shares = 2,000 LO 7 Compute earnings per share in a complex capital structure.

E16-22 (a) Compute diluted earnings per share for 2013. When calculating Diluted EPS, begin with Basis EPS. Diluted EPS *Now we use our Basic EPS as the starting point to calculate our Diluted EPS using the “If-converted” method which asks what would have been the effects on EPS if the convertible bonds were converted to common shares at the beginning of the year: *For the numerator, if the bonds had been converted to common shares at the beginning of the year, would the company have incurred any interest expense on the bonds? No! They never would have been outstanding to incur interest. Therefore, we have to reverse out the after-tax interest by adding it back to net income as if the bonds had never been outstanding to incur interest. To calculate after-tax interest, take Interest Expense and multiple by (1 – Tax Rate) as this leaves the interest after it has been taxed: $6,000 interest expense x (1 – 0.40) = $6,000 x 0.60 = $3,600 after-tax interest. When we add this back to the Basic EPS numerator (thus reversing the after-tax interest out of Net Income from which it was initially subtracted), we get $5,460 as shown above. *For the denominator, if the bonds had been converted to common shares at the beginning of the year, how many additional shares would the company have had in its Weighted-Average Number of Shares Outstanding? 75 bonds each convertible into 100 shares of common stock, for a total increase in outstanding shares of 75 bonds x 100 shares each bond = 7,500. When we add these shares to the Basic EPS denominator (thus adding the shares that would have been outstanding if the bonds were converted), we get 9,500 shares. *When we divide the numerator by the denominator, we get a Diluted EPS of $0.57 – notice this is much less than the Basic EPS figure because, again, Diluted EPS gives us the worst-case scenario of EPS for stockholders if all shares that could have been claimed during the year were claimed during the year, thus lessening their share of the earnings. + $1,860 $6,000 ( ) $5,460 = = $.57 + 2,000 7,500 9,500 Basic EPS = .93 Effect on EPS = .48 LO 7 Compute earnings per share in a complex capital structure.

E16-22 (b) Assume bonds were issued on Sept. 1, Calculation of Net Income *Now the problem asks for Basic EPS and Diluted EPS if the bonds were issued on September 1, instead of at the beginning of the year. *Again to calculate Basic EPS, we must start by calculating Net Income. The calculations follow the same logic as part (a), except that now the bonds have only been outstanding as of September 1, therefore, interest expense would only have been incurred for 4 of the 12 months of the year (instead of the whole year), making Interest Expense = 75 bonds x $1,000 face value per bond x 8% x 4/12 = $2,000. The rest of the calculations are identical to part (a). This gives us a Net Income of $4,260, which is the NUMERATOR. *Nothing changes about the Basic EPS DENOMINATOR of 2,000 shares. It is the same logic as part (a). *Therefore, Basic EPS = $4,260/2,000 = $ This will be the starting point for our Diluted EPS calculation to follow… LO 7 Compute earnings per share in a complex capital structure.

E16-22 (b) Assume bonds were issued on Sept. 1, When calculating Diluted EPS, begin with Basis EPS. Diluted EPS *Again, we are using the Basic EPS as the starting point to calculate our Diluted EPS using the “If-converted” method, but this time we ask what would have been the effects on EPS if the convertible bonds were converted to common shares at the earliest point possible, which is no longer at the beginning of the year as they were issued in September: *For the numerator, if the bonds had been converted to common shares when issued in September, the company would have never incurred any interest expense on the bonds. Therefore, again we have to reverse out the after-tax interest by adding it back to net income as if the bonds had never been outstanding to incur interest. But this time, we calculate the after-tax interest to reverse out based on the four months the bonds were outstanding to incur interest: $2,000 interest expense x (1 – 0.40) = $2,000 x 0.60 = $1,200 after-tax interest. When we add this back to the Basic EPS numerator (thus reversing the after-tax interest out of Net Income from which it was initially subtracted), we get $5,460 as shown above. *For the denominator, if the bonds had been converted to common shares when issued in September, how many additional shares would the company have had in its Weighted-Average Number of Shares Outstanding? They are convertible into the same 7,500 shares of common stock, but they only would have been outstanding for the last 4 months out of the 12 months of the year, thus we must weight these 7,500 bonds by 4/12 to give us an increase of 7,500 shares x 4/12 = 2,500 shares weighted outstanding shares. When we add these weighted shares to the Basic EPS denominator, we get 4,500 shares. *When we divide the numerator by the denominator, we get a Diluted EPS of $1.21 – again notice this is much less than the Basic EPS figure because, again, Diluted EPS gives us the worst-case scenario of EPS for stockholders if all shares that could have been claimed during the year were claimed during the year, thus lessening their share of the earnings. + $4,260 $2,000 ( ) $5,460 = = $1.21 + 2,000 7,500 x 4/12 yr. 4,500 Basic EPS = 2.13 Effect on EPS = .48 LO 7 Compute earnings per share in a complex capital structure.

P16-8 (Variation-Convertible Preferred Stock): Prior to 2012, Barkley Company issued 40,000 shares of 6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 5 shares of common stock. Net income for 2012 was $1,200,000. There were 600,000 common shares outstanding during There were no changes during 2012 in the number of common or preferred shares outstanding. Instructions (a) Compute diluted earnings per share for 2012. *When a company has convertible preferred stock (which can be traded in for shares of common stock at the option of the preferred stockholders), we use the same “If-converted” method as with convertible bonds that asks what would have been the effects on EPS if the convertible preferred shares were converted to common shares at the earliest point possible? *Let’s look at the above example of this together… *Notice that the company has 40,000 shares of preferred stock, each share convertible into 5 shares of common stock. Let’s look at our calculation of Basic EPS and how these convertible preferred shares impact Diluted EPS... LO 7 Compute earnings per share in a complex capital structure.

P16-8 (a) Compute diluted earnings per share for 2012. When calculating Diluted EPS, begin with Basis EPS. Basic EPS Net income $1,200,000 – Pfd. Div. $240,000* = $1.60 *Again, we must always start by calculating Basic EPS: *We must first calculate the numerator (Net Income – Preferred Dividends): Net Income is given to us as $1,200,000. What about Preferred Dividends? Remember the rule that if preferred stock is cumulative, we must subtract if from the numerator regardless of if the fixed preferred dividend is declared or not because either way, preferred stockholders are entitled to the fixed dividend in the future (therefore, this amount is not available to common stockholders and thus must be taken out of net income in the numerator). Since the 40,000 preferred shares are 6%, $100 par value stock, the fixed dividend per share is 0.06 x $100 = $6 per share, and since there are 40,000 total preferred shares, the total fixed preferred dividend is $6 per share x 40,000 shares = $240,000. Therefore, our Basic EPS numerator is $1,200,000 – 240,000 = $960,000. *What about our denominator? In this case, it tells us that 600,000 common shares were outstanding for the entire year, with no changes in this balance so there is no need to weight the shares as this is already the Weighted-Average Number of Shares Outstanding (think about it: the calculation would be 600,000 shares x 12/12 months outstanding = 600,000 shares!). *This makes our Basic EPS = $960,000/600,000 = $1.60 Weighted average shares = 600,000 * 40,000 shares x $100 par x 6% = $240,000 dividend LO 7 Compute earnings per share in a complex capital structure.

P16-8 (a) Compute diluted earnings per share for 2012. When calculating Diluted EPS, begin with Basis EPS. Diluted EPS *As with convertible bonds, we use our Basic EPS as the starting point to calculate our Diluted EPS using the “If-converted” method which asks what would have been the effects on EPS if the convertible preferred shares were converted to common shares at the beginning of the year: *For the numerator, if the preferred shares had been converted to common shares at the beginning of the year, would the company have to pay any preferred dividends on these shares? No! They never would have been outstanding to receive the fixed dividend. Therefore, we have to reverse out the $240,000 fixed dividend by adding it back to the numerator as if the preferred shares had never been outstanding. When we add this back to the Basic EPS numerator (thus reversing the fixed dividend out, which was initially subtracted), we get $1,200,000 as shown above. *For the denominator, if the preferred shares had been converted to common shares at the beginning of the year, how many additional shares would the company have had in its Weighted-Average Number of Shares Outstanding? 40,000 preferred shares each convertible into 5 shares of common stock, for a total increase in outstanding shares of 40,000 x 5 = 200,000. When we add these shares to the Basic EPS denominator (thus adding the shares that would have been outstanding if the preferred shares were converted), we get 800,000 shares. *When we divide the numerator by the denominator, we get a Diluted EPS of $1.50 – notice this is less than the Basic EPS figure because, again, Diluted EPS gives us the worst-case scenario of EPS for common stockholders if all shares that could have been claimed during the year were claimed during the year, thus lessening their share of the earnings. + $1,200,000 – $240,000 $240,000 $1,200,000 = = 600,000 200,000* 800,000 + $1.50 Effect on EPS = 1.20 Basic EPS = 1.60 *(40,000 x 5) LO 7 Compute earnings per share in a complex capital structure.

P16-8 (a) Compute diluted earnings per share for 2012 assuming each share of preferred is convertible into 3 shares of common stock. Diluted EPS *In this case, we start with the same Basic EPS as we calculated previously because the facts on the actual shares outstanding are the same – the Diluted EPS is what will change now that the convertible preferred share facts have changed, thus changing the implications if they were converted to common shares (using the “if-converted” method). *With regard to the numerator, the effect is the same as our previous calculation because we must reverse out the fixed preferred dividend as if the shares had been converted to common shares as of the beginning of the year. *With regard to the denominator, now the facts have changed and each preferred share is convertible into 3 shares of common stock; therefore, the effect on the denominator is now 40,000 x 3 = 120,000 additional common shares that would’ve been outstanding if the preferred shares were converted. *Notice that when we do the Diluted EPS calculation based on these new facts, we get $1.67, which is HIGHER than the $1.60 Basic EPS; therefore, this convertible preferred stock is considered anti-dilutive, meaning it increases Basic EPS, which in turn does not show the worst-case EPS scenario for common stockholders; therefore, we do not include these convertible preferred share effects in our Diluted EPS calculation, so in this case, Basic EPS would be the only figure reported. *Also notice that when we calculate the effects on the numerator and denominator above in isolation ($240,000/120,000), we get $ We know this effect is anti-dilutive even before calculating the Diluted EPS because the effect is greater than the Basic EPS, thus forcing upward pressure on Basic EPS as opposed to downward dilutive pressure (as you can see with the other dilutive effects we have seen in the previous problems we have done thus far). + $1,200,000 – $240,000 $240,000 $1,200,000 = = 600,000 120,000* 720,000 + $1.67 Effect on EPS = 2.00 Basic EPS = 1.60 *(40,000 x 3) LO 7 Compute earnings per share in a complex capital structure.

P16-8 (a) Compute diluted earnings per share for 2012 assuming each share of preferred is convertible into 3 shares of common stock. Diluted EPS Basic = Diluted EPS + $1,200,000 – $240,000 $240,000 $1,200,000 = = 600,000 120,000* 720,000 + *This slide just re-iterates what I have just explained: if the effects of the convertible instrument are anti-dilutive (increase Basic EPS), we do not include these effects, thus making Basic EPS = Diluted EPS if there are no other potentially converted dilutive shares, as in this case. Antidilutive $1.67 Effect on EPS = 2.00 Basic EPS = 1.60 *(40,000 x 3) LO 7 Compute earnings per share in a complex capital structure.

Diluted EPS – Options and Warrants Measure the dilutive effects of potential conversion using the treasury-stock method. This method assumes: company exercises the options or warrants at the beginning of the year (or date of issue if later), and that it uses those proceeds to purchase common stock for the treasury. *Other potentially dilutive instruments are Stock Options and Stock Warrants, which may be exercised in exchange for common shares, thus potentially diluting Basic EPS when calculating Diluted EPS. Remember, like with the convertible instruments we have been working with, these instruments were not actually turned into common shares during the year (or they would have been included in Basic EPS, which measures the earnings per actual common share outstanding during the year) – instead, we include them in Diluted EPS which is a hypothetical calculation of just how low EPS could have been if all common shares that could have been issued in exchange for these instruments were issued, thus giving common shareholders the worst-case scenario of how low their stake in the earnings could be if potentially-exercisable shares were/are redeemed. *For Stock Options and Warrants, we use the Treasury-Stock Method, which assumes that the proceeds the company receives from the exercise of stock options or warrants would be used to re-purchase shares of the company’s own stock as treasury stock. The logic here is that companies typically need to re-acquire shares via treasury stock in order to issue them on options or warrants, so we make the assumption that proceeds from options and warrants are used to make such share re-purchases. *Let’s look at an example for a better understanding… LO 7 Compute earnings per share in a complex capital structure.

E16-26 (EPS with Options): Zambrano Company’s net income for 2012 is $40,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2011, each exercisable for one share at $8. None has been exercised, and 10,000 shares of common were outstanding during The average market price of the stock during 2012 was $20. Instructions (a) Compute diluted earnings per share. (b) Assume the 1,000 options were issued on October 1, 2012 (rather than in 2011). The average market price during the last 3 months of 2012 was $20. Again, we must always start by calculating Basic EPS: *We must first calculate the numerator (Net Income – Preferred Dividends), but in this case, there is no preferred stock, so we will the given Net Income of $40,000 is the numerator.. *What about our denominator? In this case, it tells us that 10,000 common shares were outstanding for the entire year, with no changes in this balance so again, there is no need to weight the shares as this is already the Weighted-Average Number of Shares Outstanding (think about it: the calculation would be 10,000 shares x 12/12 months outstanding = 10,000 shares!). *This makes our Basic EPS = $40,000/10,000 = $4.00 *Now let’s look at Diluted EPS for part (a)… LO 7 Compute earnings per share in a complex capital structure.

E16-26 (a) Compute diluted earnings per share for 2012. Treasury-Stock Method Proceeds if shares issued (1,000 x $8) $8,000 Purchase price for treasury shares $20 Shares assumed purchased 400 Shares assumed issued 1,000 Incremental share increase 600 ÷ *Again, we always use our Basic EPS as the starting point to calculate our Diluted EPS, but this time since we are dealing with stock options, we use the treasury stock method which asks what would have been the effects on EPS if the stock option proceeds had been used to purchase treasury stock at the earliest time possible, which in this case is the beginning of the year?: *For the numerator, stock options have no effect, as these transactions have no impact on Net Income or Preferred Dividends, unlike the convertible bonds and preferred stock (recall from Chapter 15). Therefore, the numerator is not affected by stock options or warrants when computing Diluted EPS. *For the denominator, if the proceeds from the options had been used to purchase treasury shares at the beginning of the year, how many treasury shares could have been purchased? Follow the logic of the following computation: each of the 1,000 stock options has an exercise price per share of $8, which means that if these options were exercised, the company would receive cash of 1,000 x $8 = $8,000. Under the treasury stock method, we assume the company uses these proceeds to re-purchase shares of its own stock as treasury stock. But how many treasury shares can the company purchase with these proceeds? With the $8,000 proceeds used to purchase back company shares with an average price of $20 (given in the problem), the company could re-purchase $8,000/$20 = 400 treasury shares. But remember, the denominator must include all the effects of these stock options being exercised and used to re-purchase treasury shares, so upon exercise they would increase common shares by 1,000 as option holders are entitled to this many common shares, but when the company uses the option proceeds to re-purchase 400 treasury shares (as calculated above), this would decrease the number of common shares outstanding; therefore, the overall denominator effect of these options under the treasury stock method is 1,000 – 400 = 600 increase in Weighted-Average Number of Shares Outstanding. LO 7 Compute earnings per share in a complex capital structure.

E16-26 (a) Compute diluted earnings per share for 2012. When calculating Diluted EPS, begin with Basis EPS. Diluted EPS + $40,000 $40,000 = = $3.77 + 10,000 600 10,600 *This slide shows the computation I explained in the previous slide. *Notice that the numerator is the same as Basic EPS, as I explained that stock options have no effect on this, and the denominator takes the 10,000 Basic EPS denominator and adds the 600 common shares we calculated using the treasury stock method in the last slide. *When we divide this numerator by this denominator, we get $3.77 as our Diluted EPS, which is lower than Basic EPS as, again, this calculation incorporated the potentially-dilutive shares and thus showed common stockholders the hypothetical worst-case EPS scenario. Basic EPS = 4.00 Options LO 7 Compute earnings per share in a complex capital structure.

E16-26 (b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2012. Treasury-Stock Method ÷ *Again, we use our Basic EPS as the starting point to calculate our Diluted EPS, and again since we are dealing with stock options, we use the treasury stock method which asks what would have been the effects on EPS if the stock option proceeds had been used to purchase treasury stock at the earliest time possible, which in this case is October 1 when they were issued?: *For the same numerator logic explained in part (a), there is no effect of these options on the numerator. *For the denominator, we use the same logic as part (a) to calculate the 600 share increase, but this time, we must weight these additional common shares by the 3 out of 12 months they could have been outstanding (note: we did not have to do this in part (a) because the common shares could have been outstanding for the entire year as the options were granted in the previous year and thus could have been exercised at the very beginning of the year, and we base the treasury stock method on this earliest point) – but here, when we weight the 600 additional shares by the last three out of twelve months when they could have earliest been exercised, we get 600 x 3/12 = 150 increase in Weighted-Average Number of Shares Outstanding. x LO 7 Compute earnings per share in a complex capital structure.

E16-26 (b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2012. Diluted EPS $40,000 $40,000 = = $3.94 + 10,000 150 10,150 *This slide shows the computation I explained in the previous slide. *Notice that the numerator is the same as Basic EPS, as I explained that stock options have no effect on this, and the denominator takes the 10,000 Basic EPS denominator and adds the 150 common shares we calculated using the treasury stock method in the last slide. *When we divide this numerator by this denominator, we get $3.94 as our Diluted EPS, which is lower than Basic EPS as, again, this calculation incorporated the potentially-dilutive shares and thus showed common stockholders the hypothetical worst-case EPS scenario. Basic EPS = 4.00 Options LO 7 Compute earnings per share in a complex capital structure.

Contingent Issue Agreement Contingent shares are issued as a result of the: passage of time or attainment of a certain earnings or market price level. Antidilution Revisited *Other potentially-dilutive shares may be required in the Diluted EPS calculated when there are Contingent Issue Agreements, which entitle individuals to shares of stock after some passage of time or performance target. If the passage of time or performance condition is met, we include these shares in our Diluted EPS calculation. *Also keep in mind that we do not include in our Diluted EPS calculation any effects that are anti-dilutive, which means they increase Basic EPS as opposed to decreasing it because, again, the inclusion of these would not portray the worst-case EPS scenario to common stockholders. Ignore antidilutive securities in all calculations and in computing diluted earnings per share. LO 7 Compute earnings per share in a complex capital structure.

EPS Presentation and Disclosure A company should show per share amounts for: Income from continuing operations, Income before extraordinary items, and Net income. Per share amounts for a discontinued operation or an extraordinary item should be presented on the face of the income statement or in the notes. *The above information must be disclosed for EPS on the face of the income statement. LO 7 Compute earnings per share in a complex capital structure.

Complex capital structures and dual presentation of EPS require the following additional disclosures in note form. Description of pertinent rights and privileges of the various securities outstanding. A reconciliation of the numerators and denominators of the basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS. The effect given preferred dividends in determining income available to common stockholders in computing basic EPS. Securities that could potentially dilute basic EPS in the future that were excluded in the computation because they would be antidilutive. Effect of conversions subsequent to year-end, but before issuing statements. *Additionally, the above information must be disclosed for EPS in the notes to the financial statements. LO 7 Compute earnings per share in a complex capital structure.

Summary of EPS Computation
Illustration 16-27 *This slide summarizes the Basic EPS calculation we discussed, which is the only calculation necessary when a company does not have any potentially-exercisable common shares outstanding (through convertible bonds, convertible preferred stock, stock options, stock warrants, etc.) to factor into Diluted EPS. LO 7

Summary of EPS Computation
Illustration 16-28 Summary of EPS Computation *This slide summarizes the Basic EPS AND Diluted EPS calculations we discussed, which are both necessary when a company has any potentially-exercisable common shares outstanding (through convertible bonds, convertible preferred stock, stock options, stock warrants, etc.) to factor into Diluted EPS. LO 7

APPENDIX 16A ACCOUNTING FOR STOCK-APPRECIATION RIGHT
You may review this appendix, but we will not be covering it in our course. LO 8 Explain the accounting for share-appreciation rights plans.

Balance Sheet for Comprehensive Illustration
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Balance Sheet for Comprehensive Illustration Illustration 16-B1 *You may look over this very complex, comprehensive EPS example using the detailed rules I just explained and also using the appendix to the textbook that covers this example, but I also believe you will find the suggested homework problems comprehensive in preparing for EPS as covered in our course. *Going through this example may be best to test your EPS knowledge after you have fully studied this chapter, my notes, and done the suggested homework and reviewed the solutions. LO 9 Compute earnings per share in a complex situation.

Balance Sheet for Comprehensive Illustration
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Balance Sheet for Comprehensive Illustration Illustration 16-B1 LO 9 Compute earnings per share in a complex situation.

Computation of Earnings per Share—Simple Capital Structure
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Computation of Earnings per Share—Simple Capital Structure Illustration 16-B2 LO 9 Compute earnings per share in a complex situation.

Diluted Earnings Per Share
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Diluted Earnings Per Share Steps for computing diluted earnings per share: Determine, for each dilutive security, the per share effect assuming exercise/conversion. Rank the results from step 1 from smallest to largest earnings effect per share. Beginning with the earnings per share based upon the weighted-average of ordinary shares outstanding, recalculate earnings per share by adding the smallest per share effects from step 2. Continue this process so long as each recalculated earnings per share is smaller than the previous amount. LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The first step is to determine a per share effect for each potentially dilutive security. Per Share Effect of Options (Treasury-Share Method), Diluted Earnings per Share Illustration 16-B3 LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The first step is to determine a per share effect for each potentially dilutive security. Per Share Effect of 8% Bonds (If-Converted Method), Diluted Earnings per Share Illustration 16-B4 LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The first step is to determine a per share effect for each potentially dilutive security. Per Share Effect of 10% Bonds (If-Converted Method), Diluted Earnings per Share Illustration 16-B5 LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The first step is to determine a per share effect for each potentially dilutive security. Per Share Effect of 10% Convertible Preference Shares (If-Converted Method), Diluted Earnings per Share Illustration 16-B6 LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The first step is to determine a per share effect for each potentially dilutive security. Ranking of per Share Effects (Smallest to Largest), Diluted Earnings per Share Illustration 16-B7 LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The next step is to determine earnings per share giving effect to the ranking Recomputation of EPS Using Incremental Effect of Options Illustration 16-B8 The effect of the options is dilutive. LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The next step is to determine earnings per share giving effect to the ranking Recomputation of EPS Using Incremental Effect of 8% Convertible Bonds Illustration 16-B9 The effect of the 8% convertible bonds is dilutive. LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The next step is to determine earnings per share giving effect to the ranking Recomputation of EPS Using Incremental Effect of 10% Convertible Bonds Illustration 16-B10 The effect of the 10% convertible bonds is dilutive. LO 9 Compute earnings per share in a complex situation.

APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE The next step is to determine earnings per share giving effect to the ranking Recomputation of EPS Using Incremental Effect of 10% Convertible Preference Shares Illustration 16-B11 The effect of the 10% convertible preference shares is NOT dilutive. LO 9 Compute earnings per share in a complex situation.

Finally, Webster Corporation’s disclosure of earnings per
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Finally, Webster Corporation’s disclosure of earnings per share on its income statement. Illustration 16-B12 The effect of the 10% convertible preference shares is NOT dilutive. LO 9 Compute earnings per share in a complex situation.

Assume that Barton Company provides the following information.
APPENDIX 16B COMPREHENSIVE EARNINGS PER SHARE EXAMPLE Illustration 16-B13 Assume that Barton Company provides the following information. Illustration 16-B14 Basic and Diluted EPS LO 9 Compute earnings per share in a complex situation.

RELEVANT FACTS A significant difference between IFRS and GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated into the equity component (the value of the conversion option) of the bond issue and the debt component. Both IFRS and GAAP follow the same model for recognizing stock-based compensation: The fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate. Please look over these differences between GAAP and IFRS. This will help you gain insight into some differences between GAAP and IFRS.

RELEVANT FACTS Related to employee share-purchase plans, under IFRS all employee share-purchase plans are deemed to be compensatory; that is, compensation expense is recorded for the amount of the discount. Under GAAP, these plans are often considered noncompensatory and therefore no compensation is recorded. Certain conditions must exist before a plan can be considered noncompensatory—the most important being that the discount generally cannot exceed 5%. Modification of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modification leads to a reduction, IFRS does not permit the reduction but GAAP does. Please look over these differences between GAAP and IFRS. This will help you gain insight into some differences between GAAP and IFRS

RELEVANT FACTS Although the calculation of basic and diluted earnings per share is similar between IFRS and GAAP, the Boards are working to resolve the few minor differences in EPS reporting. One proposal in the FASB project concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while GAAP gives companies a choice. The FASB project proposes adopting the IFRS approach, thus converging GAAP and IFRS in this regard. Other EPS differences relate to (1) the treasury-stock method and how the proceeds from extinguishment of a liability should be accounted for, and (2) how to compute the weighted average of contingently issuable shares. Please look over these differences between GAAP and IFRS. This will help you gain insight into some differences between GAAP and IFRS

IFRS SELF-TEST QUESTION
All of the following are key similarities between GAAP and IFRS with respect to accounting for dilutive securities and EPS except: the model for recognizing stock-based compensation. the calculation of basic and diluted EPS. the accounting for convertible debt. the accounting for modifications of share options, when the value increases. *The only major difference listed here is the accounting for convertible debt, as GAAP puts such debt exclusively under liabilities, while IFRS separates this convertible debt into liability and equity components based on the fair value of the debt to liabilities and allocating the remainder to equity as the value of the conversion feature.

Which of the following statements is correct? IFRS separates the proceeds of a convertible bond between debt and equity by determining the fair value of the debt component before the equity component. Both IFRS and GAAP assume that when there is choice of settlement of an option for cash or shares, share settlement is assumed. IFRS separates the proceeds of a convertible bond between debt and equity, based on relative fair values. Both GAAP and IFRS separate the proceeds of convertible bonds between debt and equity. *a. is true as explained in the previous slide notes. *b. is false because only IFRS assumes this. GAAP gives companies a choice between both cash or shares. *c. is false because the allocation is done as described in the last slide notes and also as described in a. *d. is false because, as discussed, only IFRS does this.

Under IFRS, convertible bonds: are separated into the bond component and the expense component. are separated into debt and equity components. are separated into their components based on relative fair values. All of the above. *As we have now seen in both previous IFRS examples, b. is correct.

IMPORTANT NOTE!!! Please be sure you have read and studied this presentation’s slides and my notes thoroughly lecturing on each slide before our chat on this chapter (Note: in order to see my notes, please view this presentation in the “Notes Page” view if you have not done so already) – this way you can ask me questions on anything you did not understand based on the lecturing I have provided herein. Also be sure to do the suggested homework problems for this chapter listed in this week’s Instructions Checklist (solutions provided in this week’s Content Folder in Blackboard) so that you may ask about anything you do not understand during our chat to be ready for your Quizzes and Exams!

Intermediate Accounting

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