Ch.16 Convertible Securities

Incentive Stock Options

A stock option that gives an employee the opportunity to buy the employer corporation's stock at a fixed price for a certain period of time, and that offers favorable tax treatment if certain conditions are met. +no gain on exercising the options to the executive for tax purposes Exercise price = $30 Market price at time of exercise= $50 Nontaxable gain 70-30= $40 +Company gets no tax deduction Ex) On selling the stock at 85 -executive has long-term capital gain of 85-30=55

Stock Warrant: Detachable

At issue, detachable warrants are accounted for based on a valuation of what the market price for the security and/ or the detachable warrant will be immediately after issue. +Proportional method: both the security and warrant have determinable market prices. Incremental Method: the market price for only one instrument is determinable.

Example Detachable Warrants:

Cash XX Discount XX Bonds Payable XX Common Stock Warrants XX (Warrants Exercised) Cash XX Common Stock Warrants XX Common Stock XX APIC XX ***If warrants expire, their value is transferred to APIC

Accounting for Stock Options

Compensation Cost = (Market price-exercise price) x # of options **Determined on date of grant ** compensation cost = 0

Restricted stock is less dilutive than stock options, because value to the employee can be achieved with fewer shares.

True

Stock options are usually granted in greater quantity than a comparable RSU grant

True

There is less expense on the Income Statement with RSUs that with stock options

True

Example restricted stock:

Unearned compensation XX Common Stock XX APIC XX Y1: Compensation Expense XX Unearned Compensation XX (FORFEIT) Common Stock XX APIC XX Compensation Expense XX Unearned CompensationXX

Stock Option Example:

Y1 Compensation Expense XX APIC-Stock Options XX (Exercised) Cash XX APIC-Stock Options XX Common Stock XX APIC XX (Forfeited) APIC-Stock Options XX Compensation Expense XX **If the options expire without being exercised the remainder of APIC-Stock options are transferred to APIC **Performance -based stock options plans: exercise price or # of options depends on some future variable

Stock Appreciation Rights (SARs)

choice between stock (equity based) and cash (liability based) +If choice is cash, record a liability until SARs are exercised. +No cash has to be paid in exercising SARs;no cash needed to pay taxes +Executives receive money equal to the difference between the market price and exercising price at date of exercise (share appreciation)

Basic Earnings per Share

net income - preferred dividends / weighted average common shares outstanding +Indicares the income earned for each common share +Preferred stockholder receive preference in dividends payments, therefore the income for each common share is the income leftover after preferred dividends (if preferred stock is cumulative any dividends not paid during the year reduce net income)

With RSUs, no grant of shares is made; rather, the employee is granted units with each until equal in value to share of stock on the grant date

treu

If vesting is performance bases, noshers need to be issued up front with RSUs (as opposed to restricted stock)

true

On vesting, the employee is entitled to shares equal to the current value of the units, or less, typically, the chat equivalent of such shares, which are subject to liability.

true

RSUs have no voting rights but may have divided rights

true

Taxes are vernally due but he employee for restricted stock on vesting

true

The RSUs can be easily canceled if the performance-vesting goal is not met

true

The starting point for grant date fair value for restricted stock is the market price of the stock rather than the use of an option-pricing model

true

Upon vesting, employees own the shares without having to pay an exercise price

true

Vesting for RSUs can occur in increments over the course of the vesting period (graded vesting) or all shares can be delivered at once (cliff vesting)

true

Stock Warrants

+A stock option is a type of warrant +Warrants give the holder the right to acquire shares of stock. -At a specified price. -Within a specified time. +Examples of warrants -Attached to another security (such as a share of stock) -Stock options to employees -Warrants that signify a shareholders preemptive rights (issued to current stockholders b/c they have a right to buy stocks first)

Convertible Debt

+Bondholders have the right to convert each bond into a specified number of shares. +The bond issue may specify the number of shares that the bond converts to. +Otherwise, the bond issue provides a conversion price (stated as a per share dollar amount) +Example: A $1000 convertible bond has a concession price of $10 per share. If the bondholder converts the bond they would receive 100 shares of stock. +Makes the bond issue more attractive to investors

Shareholders

+Capital is invested for undefined time period +Hold a claim to profits without defined limits +Gain from the upside +Only risk what was put in

Debt holder

+Capital is provided over a defined period +Hold claim to only the funds prescribed by the borrowing terms +Do not gain from the upside +Damaged from the downside

Convertible Debt

+If debt is never converted, it is retired using the same method as the retirement of non converted. A gain or loss on retirement is reported in Net Income if the debts is retired prior to maturity. +If convertible debt is outstanding at the end of the year, in addition to reporting basic EPS, dilutive EPS must be considered. +Assume debt is converted as early as possible such that the dilutive shares are outstanding at the beginning of the year (or at issuance if the dilutive security is issued during the year) +Adjust Net Income to reflect the effect of the dilutive security (avoided interest expense upon conversion of debt to common stock and associated increase in income tax expense)

Diluted Earnings per Share

+Indicates the income earned for each potential common share. +Diluted earnings per share is reported to give shareholders a 'worst case' scenario of earnings er share +Any dilutive securities that decrease earnings per share are considered in calculating earnings per share:

Restricted Stock

+Restricted stock transfers shares to employees +The shares cannot be sold or transferred until vesting occurs +Vesting may based on years of service or performance targets +Dividends are paid on restricted stock +Restricted stock will almost always have value; whereas stock options may not +A restricted stock is effectively an option with a zero exercise price. +Restricted stock usually results in less dilution than options; since the company needs to grant fewer shares to provide the same level of compensation (because some stock options may be worthless; whereas restricted stock is not) +On the grant date, a (contra-stockholders equity account) unearned compensation for the fair value of the stock is recognized

Non qualified stock options

+Taxable gain $70-30 =$40 on exercising the options company gets a tax deduction for the $40; the tax deduction was reported in APIC -- Now on I/S +On selling the stock, the executive has a capital gain of $85-70=15

Detachable Warrants

+Warrants represent rights to enable holder to acquire a specific number of common shares at a given price within a certain time period. +Issue Price should be allocated based on relative fair values of bonds and warrants as soon as both elements trade separately

Restricted Stock

+becomes outstanding stock immediately +Shares of stock granted to employees in return of service. Expensed over the service period. +restricted stock compensation is deducted for tax purposes when vested +Held in the employees portfolio exactly as unrestricted stock +The stock cannot be sold by the employee until certain criteria have ben met (performance criteria, time, elapsed, etc.) Once the criteria have been met the stock has vested. +

Noncumulative preferred stock

+equal to cash paid in dividends to preferred shareholders +describes a type of preferred stock that does not pay the stockholder any unpaid or omitted dividends.

Cumulative preferred stock

+equal to the dividend for the current year, paid or not +Preferred stock that includes an option to convert into common stock is called convertible preferred stock +Convertible preferred stock is a potentially dilutive securities because when exercised the number of common shares outstanding increases thereby diluting earnings per share.

Stock Options

+type of warrant granted to employees as part of compensation +Granted to employees in return of service. Expensed over the service period. +The strike price (exercise price) is the price the employee will pay to exercise the option and receive a share of stock. +Expiration date is the date on which the option to purchase a share of stock at the strike price expires.