Advanced Financial Reporting Exam 2
Components of the "Proceeds" in the Treasury Stock Method
-The amount, if any, received from the hypothetical exercise of options or vesting of restricted stock (usually zero) -The total compensation from the award that's not yet expensed -The excess tax benefit
Fair value
Compensation now is measured as the _________________ of the stock options at the grant date
Convertible preferred stock
Modification to the Diluted EPS Fractions: Numerator: Do not deduct the dividends that would have been avoided if the preferred stock had been converted Denominator: Add shares that would have been created by the conversion of the preferred stock
Contingently issuable shares: Issuable when specified conditions are met, and those conditions currently are being met
Modification to the Diluted EPS Fractions: Numerator: None Denominator: Add shares that are issuable
Restricted stock
Modification to the Diluted EPS Fractions: Numerator: None Denominator: Add shares that would be creasted by their vesting, reduced by shares repurchased at the average share price
Contigently issuable shares: Issuable when specified conditions are met, and those conditions are not currently being met
Modification to the Diluted EPS Fractions: Numerator: None Denominator: None
Convertible bonds (nor notes)
Modification to the Diluted EPS Fractions: Numerator: Add the interest (after-tax) that would have been avoided if the debt had been converted Denominator: Add shares that would be created by the conversion of the bonds (or notes).
Stock options (or warrants, rights)
Modification to the Diluted EPS Fractions: Numerator: None Denominator: Add the shares that would be created by their exercise, reduced by shares repurchased at the average share price
Vesting period
The recipient benefits by the value of the shares at the end of the ...
1. Restricted Stock Awards 2. Restricted Stock Units
The two primary types of Restricted Stock Plans:
Restricted stock account
These plans are considered to be liabilities payable in cash, the credit portion of the entry as we recognize compensation expense each year is to a liability—_______________________________________________________. And, it's necessary to periodically adjust the liability (and corresponding compensation) based on the change in the stock's fair value until the liability is paid
Objective of Plans with Performance or Market Conditions
To provide employees with additional incentive for managerial achievement
Year the estimate changes
Universal should adjust the cumulative amount of compensation expense recorded to date in the ________________________?
compensation expense
We record that amount as ____________________________________ over the service period for which employees receive the options
Earnings Available to Common Shareholders
When a senior class of shareholders (like preferred shareholders) is entitled to a specified allocation of earnings (like preferred dividends) these amounts are subtracted from earnings before calculating earnings per share
Before, but not after
When a stock distribution occurs during the reporting period, any sales or purchases of shares that occur __________________________________, the distribution are increased by the distribution
Liability
When an RSU is considered to be a ____________, we determine its fair value at the grant date and recognize that amount as compensation expense over the requisite service period consistent with the way we account for restricted stock awards, RSUs, and other share-based compensation
Complex capital structure
When any potential common shares are outstanding
Common stock and paid-in capital—excess of par
When restrictions are lifted, paid-in capital—restricted stock, is replaced by ______________________________________________.
Share-based awards
forms of payment whose value tied to the market price of the company's stock
Stock option plans
give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified price, (c) during a specified period of time
Basic EPS
ignores the dilutive effect of such securities
Diluted EPS
incorporates the dilutive effect of all potential common shares
The "proceeds" include everything the firm will receive from the award
(1) cash, if any, at exercise, (2) services from the recipient (value of award given as compensation), and (3) tax savings.
Criteria for the plan being noncompensatory
(a) All employees can participate (b) Employees have no longer than one month after the price is fixed to decide whether to participate (c) The discount is no greater than 5%
Disclosure notes should provide additional disclosures
-A reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations. -Any adjustments to the numerator for preferred dividends. -Any potential common shares that weren't included because they were antidilutive. -Any transactions that occurred after the end of the most recent period that would materially affect earnings per share.
Earnings Per Share (EPS)
-A way of summarizing the performance of business enterprises in a single number -the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and creditors
Contingently Issuable Shares
-An agreement that specifies additional shares of common stock will be issued, contingent on the occurrence of some future circumstance -are issuable to shareholders of an acquired company, certain key executives, or others in the event a certain level of performance is achieved -Considered to be outstanding in the computation of diluted EPS if the target performance level already is being met
Decision Makers' Perspective
-Analysts should be aware of the possibility of earnings management as a way to increase managers' compensation -If a manager's personal compensation includes company stock, stock options, or other compensation based on the value of the firm's stock, it's not hard to imagine an increased desire to ensure that market expectations are met and that reported earnings have a positive effect on stock prices *One way managers might manipulate numbers is to low-ball the data that go into the option-pricing models
Examples of potential common shares
-Convertible bonds -Convertible preferred stock -Stock options -Contingently issuable securities
Financial Statement Presentation of Earnings Per Share Data
-For all reporting periods presented in the comparative statements -Businesses without potential common shares present basic EPS only
Options, Rights, and Warrants - Diluted Earnings Per Share
-Gives its holders the right to exercise their option to purchase common stock, at a specified exercise price -Dilution resulted from the exercise should be reflected in the calculation of diluted EPS, but not basic EPS -To include the dilutive effect of a security means to calculate EPS as if the potential increase in shares already has occurred
Antidilutive Securities
-If the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease -Ignored when calculating both basic and diluted EPS
The excess tax benefit
-If the options were nonqualified options, the corporation receives a tax deduction at exercise equal to the difference between the stock's market value and its exercise price -the difference times the tax rate is the excess tax benefit -If the options were incentive stock options, no tax benefit is provided
Recognition of compensation expense for performance-based options depends:
-Initially on whether it's probable that the performance target will be met and -Ultimately on whether the performance target actually is met
Assumptions - Diluted Earnings Per Share
-Options (or rights, or warrants) were exercised at the beginning of the reporting period, or when the options were issued if that's later -Cash proceeds from selling the new shares at the exercise price are used to buy back as many shares as possible at the shares' average market price during the year
Employee Share Purchase Plans
-Permit all employees to buy shares directly from their company at favorable terms -Primary intent of these plans is to encourage employee ownership of the company's shares -Loyalty is enhanced among employee shareholders
Restricted Stock Awards and Units (RSUs) in EPS Calculations
-Replacing stock options as the share-based compensation plan of choice -Represents potential common shares and their dilutive effect is included in diluted EPS -The shares are added to the denominator and then reduced by the number of shares that can be bought back with the "proceeds" at the average market price of the company's stock during the year
Increase in shares caused by a stock dividend
-Stock dividend or stock split merely increases the number of shares without affecting the firm's assets. -Larger number of less valuable shares. Same "pie", more slices.
When the buyback (average market) price is higher than the exercise price
-The number of shares assumed repurchased is fewer than the number of shares assumed sold -Shares are sold at the exercise price and repurchased at the market price -Buying back more shares than were sold -Produces a net decrease in the number of shares -EPS would increase, not decrease
Calculation of EPS becomes more demanding
-The number of shares has changed during the reporting period -The earnings available to common shareholders are diminished by dividends to preferred shareholders -We attempt to take into account the impending effect of potential common shares
Terms of RSUs
-The recipient sometimes is given the cash equivalent of the number of shares used to value the RSUs or -The terms might stipulate that either the recipient or the company is allowed to choose whether to settle in stock or cash
Restricted Stock Plans
-These plans are tied to continued employment -Executive compensation sometimes includes a grant of shares of stock or the right to receive shares. Usually, such shares are restricted in such a way as to provide some incentive to the recipient
Actual conversion
-This would cause an actual increase in shares from the date the convertible bonds is converted -These would be time-weighted so the denominator would increase by the fraction -The numerator would be higher because net income actually would be increased by the after-tax interest saved on the bonds
The first component of the proceeds - Additional EPS Issues
-Usually is absent because employees don't pay to acquire their shares -Unvested restricted stock award shares and RSU shares are included in hypothetical EPS calculations -Fully vested shares are distributed and thus outstanding
Increase in shares from selling new shares
-When new shares are sold, both assets and shareholders' equity are increased by an additional investment in the firm by shareholders. -Shareholders' interests in their company's earnings is diluted.
Compensation associated with a share of restricted stock
-is the market price at the grant date of an unrestricted share of the same stock -This amount is accrued as compensation expense over the service period for which participants receive the shares, usually from the date of grant to when restrictions are lifted (the vesting date
1. Basic EPS 2. Diluted EPS
A firm with a complex capital structure reports two EPS calculations:
-To determine the fair value of the compensation and -To expense that compensation over the periods in which participants perform services
Accounting objective for Share-based compensation:
Stock Option Plans with Performance or Market Conditions
An option might not be exercisable until a performance target is met -The way such plans are accounted for depends on whether the condition is: *Performance-based or *Market-based
-Exercise price of the option -Expected term of the option -Current market price of the stock -Expected dividends -Expected risk-free rate of return during the term of the option -Expected volatility of the stock
An option pricing model takes into account several variables, such as:
Assumed conversion
Assume conversion for the period before conversion because they were potentially dilutive during that period
-Actual Conversions -Assumed Conversions
Calculation of diluted EPS: (2)
Actual Conversions
Diluted EPS of convertible bonds converted during the year would be precisely the same as the convertible bonds had been converted at the beginning of the year
Stock Dividends and Stock Splits
Distribution of additional shares to existing shareholders
=Earnings available to common shareholders / Weighted-average number of common shares outstanding
Formula for EPS (Earnings Per Share)
Intrinsic values
Historically, stock option plans have been measured at their ....
Fair value estimate
If previous experience indicates that a material number of the options will be forfeited before they vest (due to employee turnover or violation of other terms of the options), we adjust the _________________________________ made on the grant date to reflect that expectation.
Contingently Issuable Shares - Examples
If shares will be issued at a future date if a certain level of income is achieved and that level of income or more was already reported this year, those additional shares are added to the denominator of the diluted EPS fraction
Plans with Market Conditions
If the award contains a market condition (e.g., a share option with an exercisability requirement based on the stock price reaching a specified level), then no special accounting is required. The fair value estimate of the share option already implicitly reflects market conditions due to the nature of share option pricing models. So, we recognize compensation expense regardless of when, if ever, the market condition is met
The total compensation from the award that's not yet expensed
If the options are fully vested, all the compensation would have been expensed and this second component of the proceeds would be zero; if half vested, half the compensation would have been expensed and the remaining half would be added to the proceeds
Do not record compensation expense
If these criteria for the plan being noncompensatory are met, the sales of new shares are recorded as employees buy shares and ___________________________________________________________
Expense
If these criteria for the plan being noncompensatory are not met, the discount to employees is considered to be compensation, and that amount is recorded as ________________
Options, Warrants, Rights - Antidilutive Securities
In applying the treasury stock method, the number of shares assumed repurchased is fewer than the number of shares assumed sold. This is the case any time the buyback (average market) price is higher than the exercise price. Consequently, there will be a net increase in the number of shares, so earnings per share will decline.
Restricted Stock Units (RSUs)
Is a right to receive a specified number of shares of company stock
Paid-in capital—expiration of stock options
Paid-in capital—stock options becomes _________________________________________________ , when options expire without being exercised
-On the face of the income statement or -In the notes to financial statements
Per share amounts for discontinued operations would be disclosed either: (2)
None
Potential Common Shares Are Reflected in Basic EPS
-Stock options (or warrants, rights) -Restricted stock -Convertible securities (bonds, notes, preferred stock) -Contingently issuable shares
Potential Common Shares Are Reflected in Diluted EPS
Decline in Popularity of Options
Recent years have witnessed a steady shift in the way companies compensate their top executives. In the wake of recent accounting scandals, the image of stock options has been tarnished in the view of many who believe that the potential to garner millions in stock option gains created incentives for executives to boost company stock prices through risky or fraudulent behavior. That image has motivated many firms to move away from stock options in favor of other forms of share-based compensation, particularly restricted stock awards and, increasingly, restricted stock units. Also contributing to the rise of restricted stock is the feeling by many that it better aligns pay with performance. From the executive's perspective, restricted stock is a more certain, though potentially less lucrative, form of compensation.
Potential Common Shares
Securities that are not common stock but might become common stock through their exercise or conversion
stock award plans, stock option plans, stock appreciation rights (SARs), or one of the several similar plans
Share-based compensation plans include :
Stock Option Plans with Performance or Market Conditions
Stock option plans specify a performance condition or a market condition that must be satisfied before employees are allowed the benefits of the award
Vesting requirement
The company distributes the shares after the recipient of RSUs satisfies the .....
Estimated
The fair value is ___________________ by employing a recognized option pricing model
Share-based compensation
The goals are to provide compensation to designated employees, while sometimes providing those employees with a performance incentive
The second component of the proceeds - Additional EPS Issues
The proceeds for the EPS calculation include the total compensation from the unvested restricted stock that's not yet expensed
Benefits to the employees
allow employees to buy shares from their employer without brokerage fees and, perhaps, at a slight discount. Some companies even encourage participation by matching or partially matching employee purchases
The comparability of EPS numbers
is maximized by minimizing the inconsistencies in their calculation from one company to the next
Share-based compensation cost for RSUs
is measured based on the closing fair market value of the Company's common stock on the date of grant. . . . The Company recognizes share-based compensation cost over the award's requisite service period on a straight-line basis.
Weighted average number of shares
is reduced if shares are reacquired during the period -Reacquired either as retired shares or as treasury stock
Change in the nature of the shares
is reflected in a calculation of EPS by increasing the number of shares
The number of reacquired shares
is time-weighted for the fraction of the year they were not outstanding, prior to being subtracted from the number of shares outstanding during the period
Contingent performance
may be a desired level of income, a target stock price, or some other measurable activity level
Basic EPS and diluted EPS
must be reported separately for income from continuing operations and net income when the income statement includes discontinued operations
Restricted Stock Awards
shares actually are awarded in the name of the employee, although the company might retain physical possession of the shares. The employee has all rights of a shareholder, subject to certain restrictions or forfeiture. Ordinarily, the shares are subject to forfeiture by the employee if employment is terminated within some specified number of years from the date of grant. The employee usually is not free to sell the shares during the restriction period and a statement to that effect often is inscribed on the stock certificates. These restrictions give the employee incentive to remain with the company until rights to the shares vest
Disclosure notes
should provide a reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations
Initial estimates of compensation cost as well as subsequent revisions of that estimate
take into account the likelihood of both forfeitures and achieving performance targets
The reason for time-weighting the shares issued
the resources the stock sale provides the company are available for generating income only after the date the shares are sold. So, weighting is necessary to make the shares in the fraction's denominator consistent with the income in its numerator
Intrinsic values
the simple difference between the market price of the shares and the option price at which they can be acquired
