1. Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Share-Based Compensation and Earnings Per Share 19

2. 19-2 Learning Objectives Explain and implement the accounting for stock award plans.

3. 19-3 Stock Award Plans Restricted stock award plans usually are tied to continued employment of the person receiving the award. The compensation associated with a share of restricted stock is the market price at the grant date of an unrestricted share of the same stock. The amount is accrued as compensation expense over the service period for which participants receive the shares. Restricted stock award plans usually are tied to continued employment of the person receiving the award. The compensation associated with a share of restricted stock is the market price at the grant date of an unrestricted share of the same stock. The amount is accrued as compensation expense over the service period for which participants receive the shares.

4. 19-4 Stock Award Plans On January 1, 2006, Matrix, Inc. grants 10,000 shares of its $2 par value common stock to its CEO. The shares will be forfeited if the CEO leaves within the next five years. On January 1, the common stock of Matrix is selling for $62 per share. No entry is required on January 1, 2006, but total compensation is calculated at the date of grant as follows: Number of Shares issuable Fair value per share TotalCompensation =× 10,000 × =$62.00$620,000

5. 19-5 Stock Award Plans The total compensation of $620,000 will be recognized over the service period of 5 years. On December 31, 2006, through 2010, we will prepare the following journal entry: $620,000÷5= $124,000 per year

6. 19-6 Stock Award Plans On December 31, 2010, the restrictions are lifted, and the following entry will be made:

7. 19-7 Stock Option Plans In most cases, employees are not awarded shares of stock. Rather they are given an option to buy shares at some time in the future. Options are usually granted 1. for a specified number of shares, 2. at a specified price, 3. during a specified period of time. In most cases, employees are not awarded shares of stock. Rather they are given an option to buy shares at some time in the future. Options are usually granted 1. for a specified number of shares, 2. at a specified price, 3. during a specified period of time.

8. 19-8 Learning Objectives Explain and implement the accounting for stock options.

9. 19-9 Expense – The Great Debate Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired. If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income.

10. 19-10 Expense – The Great Debate Critics to current practice have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences. Critics to current practice have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences.

11. 19-11 Recognizing Fair Value of Options Effective for fiscal years beginning after June 15, 2005, companies now are required to estimate the fair value of stock options on the grant date. Effective for fiscal years beginning after June 15, 2005, companies now are required to estimate the fair value of stock options on the grant date. SFAS 123 (revised) requires the use of an option pricing model that deals with the: 1. Exercise price of the option. 2. Expected term of the option. 3. Current market price of the stock. 4. Expected dividends. 5. Expected risk-free rate of return. 6. Expected volatility of the stock.

12. 19-12 Stock Option Plans  Stock option plans give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified exercise price, (c) during a specified period of time.  The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date).

13. 19-13 Stock Option Plans On January 1, 2006, Matrix, Inc. granted options that permit key executives to acquire 50,000 shares of the company’s $1 par value common stock within the next 5 years, but not before December 31, 2009 (the vesting date). The exercise price is equal to the market price of $24 per share. Using an option pricing model, the fair value of each option if $6. No entry required on January 1, 2006, but total compensation is determined as follows:

14. 19-14 Stock Option Plans On January 1, 2006, Matrix, Inc. granted options that permit key executives to acquire 50,000 shares of the company’s $1 par value common stock within the next 5 years, but not before December 31, 2009 (the vesting date). The exercise price is equal to the market price of $24 per share. Using an option pricing model, the fair value of each option if $4. On December 31, 2006 through 2009 (the vesting date), the following entry will be made:

15. 19-15 Stock Option Plans On June 4, 2010, all the options were exercised and the shares of common stock were issued to the key executives. The following journal entry is required: 50,000 shares × $24 Account balance

16. 19-16 Stock Option Plans Let’s assume that previous experience had indicated that 4% of the options will be forfeited due to employee turnover. We would adjust our entries to recognize compensation expense in 2006 and subsequent years, as follows: ($300,000 × 96%) ÷ 4 years

17. 19-17 Stock Option Plans Assume the market price of the company’s common stock never exceeds $24 per share. The options will not be exercised. On December 31, 2010 the following entry is required to recognize the fact that the options have expired.

18. 19-18 Plans with Performance or Market Conditions performance target probable In some circumstances, compensation from a stock option plan depends on meeting a performance target. When this is the case, compensation expense depends on whether or not we feel it is probable that the target performance will be met.

19. 19-19 Plans with Performance or Market Conditions Recall our previous plan that permits key executives to acquire 50,000 shares of the company’s common stock within the next 5 years, but not before December 31, 2009 (the vesting date). Now assume another condition is that earnings per share exceed $2.50. The exercise price is equal to the market price of $24 per share. Using an option pricing model, the fair value of each option is $6. At December 31, 2006, it was not probable that the earnings per share condition will be met.

20. 19-20 Plans with Performance or Market Conditions At December 31, 2007, management determined that it was probable that the earnings per share condition will be met.

21. 19-21 Learning Objectives Explain and implement the accounting for stock appreciation rights.

22. 19-22 Stock Appreciation Rights The recipient is awarded the share appreciation, which is the amount by which the market price on the exercise date exceeds the option price The employee may receive cash or equity securities in the company.. $ $ $

23. 19-23 Stock Appreciation Rights  The SARs are considered to be equity if the employer can elect to settle in shares of stock.  The amount of compensation is estimated at the grant date as the fair value of the SARs.  This amount is expensed over the service period. Usually the same as the fair value of a stock option with similar terms.

24. 19-24 Stock Appreciation Rights  The SARs are considered to be a liability if the employee can elect to receive cash upon settlement. In that case, the amount of compensation (and related liability) is estimated each period and continuously adjusted to reflect changes in the fair value of the SARs until the compensation is finally paid.  The current expense (and adjustment to the liability) is the fraction of the total compensation earned to date by recipients of the SARs (based on the elapsed percentage of the service period), reduced by any amounts expensed in prior periods.

25. 19-25 Stock Appreciation Rights On January 1, 2006, Matrix, Inc. grants its CEO 20,000 stock appreciation rights that entitle the CEO to receive cash equal to the difference between the market price of the stock and $25 per share. The rights are exercisable anytime over the next 5 years. On January 1, 2006, Matrix, Inc. grants its CEO 20,000 stock appreciation rights that entitle the CEO to receive cash equal to the difference between the market price of the stock and $25 per share. The rights are exercisable anytime over the next 5 years.

26. 19-26 Stock Appreciation Rights No entry is required on January 1, 2006. On December 31, 2006, we calculate the compensation expense as follows: Since the plan covers a five year period, we will recognize one- fifth of the total compensation in 2006.

27. 19-27 Stock Appreciation Rights The journal entry to recognize compensation in 2006 would be: Recognized as a liability because settlement is in cash.

28. 19-28 Stock Appreciation Rights On December 31, 2007, the fair value of one share of Matrix common stock is $32. We calculate the compensation expense as follows: Since the plan covers a five year period, we will recognize two- fifths of the total compensation in 2007.

29. 19-29 Stock Appreciation Rights The journal entry to recognize compensation in 2007 would be: For the two-year period, 2006 and 2007, we have recognized $56,000 in compensation ($20,000 + $36,000)

30. 19-30 Stock Appreciation Rights The stock price changed each year through 2010. Notice how we calculate compensation expense each year.

31. 19-31 Stock Appreciation Rights On December 31, 2010, the CEO of Matrix exercises his stock appreciation rights and is paid the balance in the liability account.

32. 19-32 Learning Objectives Explain and implement the accounting for stock purchase plans.

33. 19-33 Employee Share Purchase Plan  Permit employees to buy shares directly from their employer.  Usually the plan is considered compensatory, and compensation expense is recorded.  Employees may buy 100 shares of no par stock for $8.50 per share. The current market price is $10.00. The $1.50 discount is recorded as compensation expense:

34. 19-34 Learning Objectives Distinguish between a simple and a complex capital structure.

35. 19-35 Earnings Per Share (EPS) Of the myriad facts and figures generated by accountants, the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and creditors is earnings per share.

36. 19-36 Simple Capital Structure (Basic EPS) Basic Earnings Per Share Net income (after tax) – Preferred dividends* Weighted average outstanding common stock Net income (after tax) – Preferred dividends* Weighted average outstanding common stock period’s cumulative preferred stock dividends (whether or not declared) and noncumulative preferred stock dividends (only if declared). *Current period’s cumulative preferred stock dividends (whether or not declared) and noncumulative preferred stock dividends (only if declared). Number of shares outstanding × Number of months outstanding ÷ 12 Weighted average shares outstanding

37. 19-37 Earnings Per Share A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 a. $7.50 b. $7.43 b. $7.43 c. $7.45 c. $7.45 d. $7.38 d. $7.38 A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 a. $7.50 b. $7.43 b. $7.43 c. $7.45 c. $7.45 d. $7.38 d. $7.38

38. 19-38 A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 a. $7.50 b. $7.43 b. $7.43 c. $7.45 c. $7.45 d. $7.38 d. $7.38 A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be a. $7.50 a. $7.50 b. $7.43 b. $7.43 c. $7.45 c. $7.45 d. $7.38 d. $7.38 Earnings Per Share $1,500,000 – (10,000 × 5% × $20 par) 200,000 shares Since dividends were not declared, only the cumulative preferred stock dividends are subtracted. $1,500,000 – (10,000 × 5% × $20 par) 200,000 shares Since dividends were not declared, only the cumulative preferred stock dividends are subtracted.

39. 19-39 Learning Objectives Describe what is meant by the weighted average number of common shares.

40. 19-40 Issuance of New Shares Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding.

41. 19-41 Issuance of New Shares Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding. 100,000 + [50,000 × (9/12)] + [10,000 × (3/12)] = 140,000 Shares at Jan. 1 NewSharesNewShares

42. 19-42 Learning Objectives Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split, and the reacquisition of shares.

43. 19-43 Stock Dividends and Stock Splits Common shares issued as part of stock dividends and stock splits are treated retroactively as subdivisions of the shares already outstanding at the date of the split or dividend.

44. 19-44 Stock Dividends and Stock Splits Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding.

45. 19-45 Stock Dividends and Stock Splits Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding. 100,000 × (2.00) + [50,000 × (9/12) × 2.00] = 275,000 Shares at Jan. 1 NewShares Stock dividend adjustment

46. 19-46 Stock Dividends and Stock Splits Retroactive treatment: Stock dividend or split is treated as outstanding from the beginning of the period. Stock dividend or split is applied retroactively in proportion to the number of shares outstanding at the time of the dividend or split. New shares issued this period? New shares issued this period? Yes No

47. 19-47 Reacquired Shares The weighted average number of shares is reduced by the number of reacquired shares, time-weighted for the fraction of the year they were not outstanding.

48. 19-48 Reacquired Shares Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding.

49. 19-49 Reacquired Shares Compute the weighted average number of shares of common stock outstanding. Compute the weighted average number of shares of common stock outstanding. 100,000 + [50,000 × (9/12)] - [12,000 × (8/12)] = 129,500 Shares at Jan. 1 NewSharesTreasuryShares

50. 19-50 Learning Objectives Describe how preferred dividends affect the calculation of EPS

51. 19-51 Earnings Available to Common Shareholders Net income Less: Current period’s cumulative preferred stock dividends (whether or not declared) Less: Noncumulative preferred stock dividends (only if declared). Net income available to common shareholders

52. 19-52 Complex Capital Structure (dual EPS) Dilution/Antidilution Test Stock Options Convertible securities Treasury stock method If-converted method Contingently issuable shares Potential Common Shares: Stock options, rights, and warrantsStock options, rights, and warrants Convertible bonds and stockConvertible bonds and stock Contingent common stock issuesContingent common stock issues Potential Common Shares: Stock options, rights, and warrantsStock options, rights, and warrants Convertible bonds and stockConvertible bonds and stock Contingent common stock issuesContingent common stock issues Diluted Earnings Per share

53. 19-53 Complex Capital Structure Dual presentation of Earnings Per Share: Basic EPS Diluted EPS

54. 19-54 Learning Objectives Describe how options, rights, and warrants are incorporated in the calculation of EPS.

55. 19-55 Options, Rights, and Warrants Proceeds Used to Purchase treasury shares At average market price The treasury stock method assumes that proceeds from the exercise of options are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share.

56. 19-56 Options, Rights, and Warrants Proceeds from assumed exercise Average market price of stock Proceeds from assumed exercise Average market price of stock  Determine new shares from assumed exercise of stock options.  Compute number of shares repurchased.

57. 19-57 Options, Rights, and Warrants  Determine new shares from assumed exercise of stock options.  Compute shares purchased for the treasury.  Compute the incremental shares assumed outstanding. New shares from assumed exercise (1) Less: Treasury shares assumed purchased (2) Net increase in shares outstanding (3)

58. 19-58 Options, Rights, and Warrants When the exercise price exceeds the market price, the securities are antidilutive.

59. 19-59 Treasury Stock Method Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares

60. 19-60 Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares Treasury Stock Method New shares = 5,000 Treasury shares = 3,125 (5,000 × $50) ÷ $80 Incremental shares = 1,875 (5,000 - 3,125) (5,000 - 3,125) New shares = 5,000 Treasury shares = 3,125 (5,000 × $50) ÷ $80 Incremental shares = 1,875 (5,000 - 3,125) (5,000 - 3,125)

61. 19-61 Learning Objectives Describe how convertible securities are incorporated in the calculation of EPS.

62. 19-62 Convertible Securities The if-converted method is used for Convertible debt and equity securities The if-converted method is used for Convertible debt and equity securities The method assumes conversion occurs as of the beginning of the period or date of issuance, if later.

63. 19-63 Convertible Securities The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share:  Increases the denominator by the number of common shares issuable upon conversion.  Increases the numerator by decreasing after-tax interest expense on convertible bonds, and dividends on convertible preferred stock. The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share:  Increases the denominator by the number of common shares issuable upon conversion.  Increases the numerator by decreasing after-tax interest expense on convertible bonds, and dividends on convertible preferred stock.

64. 19-64 Convertible Securities Dilutive earnings per share may decrease or increase after the assumed conversion. If dilutive earnings per share decreases, the securities are dilutive and are assumed converted. If dilutive earnings per share increases, the securities are antidilutive and are not considered converted.

65. 19-65 If-Converted Method Assume net income (after tax) of $500,000, cumulative convertible preferred stock dividends of $25,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is convertible into 5,000 shares of common stock. Is the convertible preferred stock dilutive? Is the convertible preferred stock dilutive? Assume net income (after tax) of $500,000, cumulative convertible preferred stock dividends of $25,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is convertible into 5,000 shares of common stock. Is the convertible preferred stock dilutive? Is the convertible preferred stock dilutive?

66. 19-66 If-Converted Method = $9.50 EPS EPS without conversion: $500,000 – $25,000 50,000 shares 50,000 shares If the preferred stock is converted, we would not have dividends and the number of shares of common stock would increase by 5,000 shares. There is not a tax effect. = $9.09 EPS DilutiveDilutive EPS after assumed conversion: $500,000 – $0 55,000 shares

67. 19-67 If-Converted Method Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Are the convertible bonds dilutive? Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Assume net income (after tax) of $500,000, convertible bonds with interest expense of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of common stock. Are the convertible bonds dilutive?

68. 19-68 If-Converted Method = $10.00 EPS EPS without conversion: $500,000 $500,000 50,000 shares If the bonds are converted, net income would increase by $35,000 (after taxes) and the number of shares of common stock would increase by 2,000 shares. = $10.29 EPS AntidilutiveAntidilutive EPS after assumed conversion: $535,000 52,000 shares

69. 19-69 Order of Entry for Multiple Convertible Securities When a company has more than one instance of potential common shares, they are considered for inclusion in dilutive EPS in sequence from the most dilutive to the least dilutive.

70. 19-70 Learning Objectives Explain the way contingently issuable shares are incorporated in the calculation of EPS.

71. 19-71 Contingently Issuable Shares Contingent shares are issuable in the future for little or no cash consideration upon the satisfaction of certain conditions. Future

72. 19-72 Contingently Issuable Shares Shares are issued merely due to passage of time. Some target performance level has already been met and is expected to continue to the end of the contingency period. Contingent shares are included in dilutive EPS if: Example: Additional shares may be issued based on future earnings.

73. 19-73 Contingently Issuable Shares Contingent shares are considered outstanding common shares and are included in basic EPS as of the date that all necessary conditions have been satisfied.

74. 19-74 Summary

75. 19-75 Summary

76. 19-76 Earnings Per Share Disclosure Report EPS data separately for: 1.Income from Continuing Operations 2.Separately Reported Items a)Discontinued Operations b)Extraordinary Items 3.Net Income

77. 19-77 Appendix 19 Option-Pricing Theory

78. 19-78 Intrinsic Value Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has an intrinsic value of $15. Options have a time value because the holder of an option does not have to pay the exercise price until the option is exercised.

79. 19-79 Summary The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

80. 19-80 End of Chapter 19