Chapter 16 Intermediate Accounting: Vocabulary

__ can be changed into other corporate securities during some specified period of time after issuance. A __ combines the benefits of a bond with the privilege of exchanging it for stock at the holder's option. Investors who purchase it desire the security of a bond holding (guaranteed interest and principal) plus the added option of conversion if the value of the stock appreciates significantly.

Convertible bonds, convertible bond

__ includes an option for the holder to convert preferred shares into a fixed number of common shares. The major difference between accounting for a convertible bond and convertible preferred stock at the date of issue is their classification. Convertible bonds are considered liabilities, whereas convertible preferreds (unless mandatory redemption exists) are considered part of stockholders' equity. In addition, when stockholders exercise convertible preferred stock, there is no theoretical justification for recognizing a gain or loss. A company does not recognize a gain or loss when it deals with stockholders in their capacity as business owners. Therefore, companies do not recognize a gain or loss when stockholders exercise convertible preferred stock.

Convertible preferred stock

__ indicates the income earned by each share of common stock. Thus, companies report earnings per share only for common stock. For example, if Oscar Co. has net income of $300,000 and a weighted average of 100,000 shares of common stock outstanding for the year, earnings per share is $3 ($300,000 4 100,000).

Earnings per share

Many companies also use restricted stock (in some cases, replacing options altogether) to compensate employees. __ transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs. Similar to stock options, these shares are subject to forfeiture if the conditions for vesting are not met.

Restricted-stock plans

__ are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. This option is similar to the conversion privilege in a convertible bond. __, if exercised, become common stock and usually have a dilutive effect (reduce earnings per share) similar to that of the conversion of convertible securities. However, a substantial difference between convertible securities and stock warrants is that upon exercise of the warrants, the holder has to pay a certain amount of money to obtain the shares.

Warrants, Warrants

The EPS discussion to this point applies to __ for a simple capital structure. One problem with a basic EPS computation is that it fails to recognize the potential impact of a corporation's _. As discussed at the beginning of the chapter, dilutive securities are securities that can be converted to common stock.15 Upon conversion or exercise by the holder, the dilutive securities reduce (dilute) earnings per share. This adverse effect on EPS can be significant and, more importantly, unexpected unless financial statements call attention to their potential dilutive effect. Basic EPS=(net income-Preferred dividends)/Weighted-average number of shares outstanding

basic EPS, dilutive securities

A company uses income from continuing operations (adjusted for preferred dividends) to determine whether potential common stock is dilutive or antidilutive. Some refer to this measure as the __.

control number

Warrants issued with other securities are basically long-term options to buy common stock at a fixed price. Generally the life of warrants is five years, occasionally 10 years; very occasionally, a company may offer perpetual warrants. A warrant works like this. Tenneco, Inc. offered a unit comprising one share of stock and one detachable warrant. As its name implies, the __ can be detached (separated) from the stock and traded as a separate security. The Tenneco warrant in this example is exercisable at $24.25 per share and good for five years. The unit (share of stock plus detachable warrant) sold for 22.75 ($22.75). Since the price of the common stock the day before the sale was 19.88 ($19.88), the difference suggests a price of 2.87 ($2.87) for the warrant. The investor pays for the warrant in order to receive the right to buy the stock, at a fixed price of $24.25, sometime in the future. It would not be profitable at present for the purchaser to exercise the warrant and buy the stock, because the price of the stock was much below the exercise price. But if, for example, the price of the stock rises to $30, the investor gains $2.88 ($30 2 $24.25 2 $2.87) on an investment of $2.87, a 100 percent increase! If the price never rises, the investor loses the full $2.87 per warrant.

detachable stock warrant

Computing __ is similar to computing basic EPS. The difference is that diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period. Diluted EPS=([net income-Preferred dividends]/Weighted-average number of shares outstanding) - impact of convertibles- impact of options, warrants, and other securities

diluted EPS

Convertible securities as well as options, warrants, and other securities are often called __ because upon exercise they may reduce (dilute) earnings per share.

dilutive securities

Under the __, companies use acceptable option-pricing models to value the options at the date of grant. These models take into account the many factors that determine an option's underlying value.7

fair value method

Suppose that as an employee for Hurdle Inc., you receive options to purchase 10,000 shares of the firm's common stock as part of your compensation. The date you receive the options is referred to as the __. The options are good for 10 years. The market price and the exercise price for the stock are both $20 at the grant date. What is the value of the compensation you just received? Some believe that what you have received has no value. They reason that because the difference between the market price and the exercise price is zero, no compensation results. Others argue these options do have value. If the stock price goes above $20 any time in the next 10 years and you exercise the options, you may earn substantial compensation. For example, if at the end of the fourth year, the market price of the stock is $30 and you exercise your options, you earn $100,000 [10,000 options 3 ($30 2 $20)], ignoring income taxes. The question for Hurdle is how to report the granting of these options. One approach measures compensation cost by the excess of the market price of the stock over its exercise price at the grant date. This approach is referred to as the __ It measures what the holder would receive today if the option was immediately exercised. That intrinsic value is the difference between the market price of the stock and the exercise price of the options at the grant date.

grant date, intrinsic-value method.

At conversion, companies exchange convertible securities for common stock. Companies measure the dilutive effects of potential conversion on EPS using the __. This method for a convertible bond assumes (1) the conversion of the convertible securities at the beginning of the period (or at the time of issuance of the security, if issued during the period), and (2) the elimination of related interest, net of tax. Thus, the additional shares assumed issued increase the denominator—the weighted-average number of shares outstanding. The amount of interest expense, net of tax associated with those potential common shares, increases the numerator—net income.

if-converted method

As we indicated earlier, earnings per share relates to earnings per common share. When a company has both common and preferred stock outstanding, it subtracts the current year preferred stock dividend from net income to arrive at __. Earnings per Share= (Net Income - Preferred Dividends)/ Weighted-Average Number of Shares Outstanding

income available to common stockholders

In instances where a company cannot determine the fair value of either the warrants or the bonds, it applies the __ used in lump-sum security purchases (as explained in Chapter 15, page 827). That is, the company uses the security for which it can determine the fair value. It allocates the remainder of the purchase price to the security for which it does not know the fair value.

incremental method

Sometimes the issuer wishes to encourage prompt conversion of its convertible debt to equity securities in order to reduce interest costs or to improve its debt to equity ratio. Thus, the issuer may offer some form of additional consideration (such as cash or common stock), called a "sweetener," to __. The issuing company reports the sweetener as an expense of the current period. Its amount is the fair value of the additional securities or other consideration given.

induce conversion

The method of allocating compensation expense is called the __. In this method, in the first year of, say, a four-year plan, the company charges onefourth of the estimated cost to date. In the second year, it charges off two-fourths, or 50 percent, of the estimated cost to date, less the amount already recognized in the first year. In the third year, it charges off three-fourths of the estimated cost to date, less the amount recognized previously. In the fourth year, it charges off the remaining compensation expense. A special problem arises when the exercise date is later than the service period. In the previous example, if the stock-appreciation rights were not exercised at the end of four years, in the fifth year the company would have to account for the difference in the market price and the pre-established price. In this case, the company adjusts compensation expense whenever a change in the market price of the stock occurs in subsequent reporting periods, until the rights expire or are exercised, whichever comes first.

percentage approach

At one time, AT&T issued bonds with detachable five-year warrants to buy one share of common stock (par value $5) at $25. At the time, a share of AT&T stock was selling for approximately $50. These warrants enabled AT&T to price its bond offering at par with an 8¾ percent yield (quite a bit lower than prevailing rates at that time). To account for the proceeds from this offering, AT&T would place a value on the two securities: (1) the value of the bonds without the warrants, and (2) the value of the warrants. The __ then allocates the proceeds using the proportion of the two amounts, based on fair values.

proportional method

A corporation's capital structure is __ if it consists only of common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. A capital structure is __ if it includes securities that could have a dilutive effect on earnings per common share. The computation of earnings per share for a simple capital structure involves two items (other than net income)—(1) preferred stock dividends and (2) weighted-average number of shares outstanding.

simple, complex

The third form of warrant arises in stock compensation plans to pay and motivate employees. This warrant is a __, which gives key employees the option to purchase common stock at a given price over an extended period of time.

stock option

If the directors of a corporation decide to issue new shares of stock, the old stockholders generally have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings. This privilege, referred to as a __, saves existing stockholders from suffering a dilution of voting rights without their consent. Also, it may allow them to purchase stock somewhat below its fair value. Unlike the warrants issued with other securities, the warrants issued for stock rights are of short duration.

stock right

With the creation of __, the company gives an executive the right to receive compensation equal to the share appreciation. __ is the excess of the market price of the stock at the date of exercise over a pre-established price. The company may pay the share appreciation in cash, shares, or a combination of both. The major advantage of SARs is that the executive often does not have to make a cash outlay at the date of exercise, but receives a payment for the share appreciation. Unlike shares acquired under a stock-option plan, the company does not issue the shares that constitute the basis for computing the appreciation in a SARs plan. Rather, the company simply awards the executive cash or stock having a fair value equivalent to the appreciation. The accounting for stock-appreciation rights depends on whether the company classifies the rights as equity or as a liability.

stock-appreciation rights (SARs), Share appreciation

Long-term compensation plans attempt to develop company loyalty among key employees by giving them "a piece of the action"—that is, an equity interest. These plans, generally referred to as __, come in many forms. Essentially, they provide the employee with the opportunity to receive stock if the performance of the company (by whatever measure) is satisfactory. Typical performance measures focus on long-term improvements that are readily measurable and that benefit the company as a whole, such as increases in earnings per share, revenues, stock price, or market share.

stock-based compensation plans

A company includes in diluted earnings per share stock options and warrants outstanding (whether or not presently exercisable), unless they are antidilutive. Companies use the __ to include options and warrants and their equivalents in EPS computations. The treasury-stock method assumes that the options or warrants are exercised at the beginning of the year (or date of issue if later), and that the company uses those proceeds to purchase common stock for the treasury. If the exercise price is lower than the market price of the stock, then the proceeds from exercise are insufficient to buy back all the shares. The company then adds the incremental shares remaining to the weighted average number of shares outstanding for purposes of computing diluted earnings per share.

treasury-stock method

In all computations of earnings per share, the __ during the period constitutes the basis for the per share amounts reported. Shares issued or purchased during the period affect the amount outstanding. Companies must weight the shares by the fraction of the period they are outstanding. The rationale for this approach is to find the equivalent number of whole shares outstanding for the year.

weighted-average number of shares outstanding