Chapter 19: Share-Based Compensation and Earnings Per Share

Financial Statement Presentation of Earnings Per Share Data

• Basic EPS and diluted EPS must be reported separately for income from continuing operations and net income when the income statement includes discontinued operations • Per share amounts for discontinued operations would be disclosed either: ¤ On the face of the income statement or ¤ In the notes to financial statements • For all reporting periods presented in the comparative statements • Businesses without potential common shares present basic EPS only • Disclosure notes should provide additional disclosures including: 1. 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 2. Any adjustments to the numerator for preferred dividends 3. Any potential common shares that weren't included because they were antidilutive 4. Any transactions that occurred after the end of the most recent period that would materially affect earnings per share

Stock Appreciation Rights (SARs)

• Enable an employee to benefit by the amount that the market price of the company's stock rises without having to buy shares • Employees are awarded the share appreciation • Share appreciation ¤ The amount by which the market price on the exercise date exceeds a prespecified price (usually the market price at the date of grant) • Usually payable in cash or the recipient has the choice between cash and shares • Example: If the share price rises from $35 to $50, the employee receives $15 cash for each SAR held

Convertible Securities

• Securities that can be converted into (exchanged for) shares of stock at the option of the holder of the security. Thus convertible securities are potentially dilutive. • The potentially dilutive effect of convertible securities is reflected in diluted EPS calculations by pretending they were converted. • Assuming conversion: ¤ The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion ¤ The numerator is increased by the interest (after-tax) on bonds or other debt or the preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted

Stock Appreciation Rights (SARs): Is it debt or is it equity?

• The accounting treatment depends on whether the award is considered an equity instrument or a liability\ • If the employer can elect to settle in shares of stock rather than cash, the award is considered to be equity • If the employee will receive cash or can elect to receive cash, the award is considered to be a liability

Stock Appreciation Rights (SARs): SARs payable in shares (equity)

• The fair value of the SARs is estimated at the grant date and we accrue that compensation to expense over the service period • The cash settlement of an equity award is treated like the repurchase of an equity instrument • The total compensation is not revised for subsequent changes in the price of the underlying stock

Effect of Variables on an Option's Fair Value

• All Factors Being Equal, If the: 1. Exercise price is higher, then Option Value Will Be Lower 2. Term of the option is longer, then Option Value Will Be Higher 3. Market price of the stock is higher, then Option Value Will Be Higher 4. Dividends are higher, then Option Value Will Be Lower 5. Risk-free rate of return is higher, then Option Value Will Be Higher 6. Volatility of the stock is higher, then Option Value Will Be Higher

Stock Dividends and Stock Splits

• A stock dividend or a stock split is a distribution of additional shares to existing shareholders. • It changes the number of shares is reflected in a calculation of EPS by increasing the denominator. • But there's an important and fundamental difference between the increase in shares caused by a stock dividend and an increase 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. • On the other hand, a stock dividend or stock split merely increases the number of shares without affecting the firm's assets. In effect, the same pie is divided into more pieces. The result is a larger number of less valuable shares.

Recognizing Fair Value of Stock Option Plans

• Compensation is measured as the fair value of the stock options at the grant date • Compensation expense is recorded over the service period for which employees receive the options • The fair value is estimated by employing a recognized option pricing model • An option pricing model takes into account several variables, such as: 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 during the term of the option 6. Expected volatility of the stock

Antidilutive Securities: Convertible Securities

• Convertible Securities are difficult to determine whether the effect of conversion of convertible securities would be dilutive or antidilutive because the assumed conversion affects both the numerator and the denominator of the EPS fraction • Alternative way to determine whether convertible securities are dilutive and should be included in a diluted EPS calculation: 1. If Incremental effect of conversion is greater than Basic EPS then it is antidilutive 2. If Incremental effect of conversion is less than Basic EPS then it is dilutive

Additional EPS Issues: Components of the "Proceeds" in the Treasury Stock Method

• First Component: The amount, if any, received from the hypothetical exercise of options • 2nd Component: Vesting of restricted stock (usually zero) ¤ The total compensation from the award that's not yet expensed ¤ Example: 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

Reacquired Shares

• If shares were reacquired during the period (either retired or as treasury stock), the weighted-average number of shares is reduced. • 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. • When a stock distribution occurs during the reporting period, any sales or purchases of shares that occur before the distribution are increased by the distribution. But the stock distribution does not increase the number of shares sold or purchased, if any, after the distribution.

Diluted Earnings Per Share: Options, Rights, and Warrants

• Options, Rights, and Warrants are similar in regards because they give holders the right to exercise their option to purchase common stock, at a specified exercise price • Dilution resulting from the possible 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 • Assumptions: ¤ 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

Share-Based Compensation

• Share-based awards are forms of payment whose value is tied to the market price of the company's stock • Share-based compensation plans include stock award plans, stock option plans, stock appreciation rights (SARs), or one of several similar plans • The goals are to provide compensation to designated employees, while sometimes providing those employees with a performance incentive • Accounting objective: ¤ To determine the fair value of the compensation ¤ To expense that compensation over the periods in which participants perform services

Restricted Stock Units (RSUs) Payable in Cash

• Sometimes the recipient is given the cash equivalent of shares instead of the shares • If the employee will receive cash, or can elect to receive cash, the award is considered to be a liability and accounted for the same as an SAR payable in cash • Its fair value is determined at the grant date and that amount is recognized as compensation expense over the requisite service period • The liability is periodically adjusted based on the change in the stock's fair value until the liability is paid

Earnings Available to Common Shareholders

• The numerator represent earnings available to common shareholders. • When preferred shareholders are entitled to a specified allocation of earnings (preferred dividends) these amounts are subtracted from earnings before calculating earnings per share • We subtract dividends on cumulative preferred stock, even if not declared this period, the presumption being that the dividends eventually will be paid.

Convertible Preferred Stock

• The potentially dilutive effect of convertible preferred stock is reflected in EPS calculations in much the same way as convertible debt. EPS is calculated as if conversion already had occurred. • Effect on EPS calculation: ¤ Shares are added to the denominator of the EPS fraction ¤ The preferred dividends in the numerator are not subtracted because those dividends would have been avoided if the preferred stock had been converted

Antidilutive Securities: Order of Entry for Multiple Convertible Securities

• A convertible security might seem to be dilutive when looked at individually but may be antidilutive when included in combination with other convertible securities • The earnings per incremental share is used to determine the sequence of including securities' effects • The securities are included in reverse order, beginning with the lowest incremental effect (that is, most dilutive), followed by the next lowest

Contingently Issuable Shares

• An agreement that specifies additional shares of common stock will be issued, contingent on the occurrence of some future circumstance • Contingent shares can be issuable to shareholders of an acquired company, certain key executives, or others in the event a certain level of performance is achieved ¤ Contingent performance may be a desired level of income, a target stock price, or some other measurable activity level • Considered to be outstanding in the computation of diluted EPS if the target performance level already is being met • Example: 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

Decision Makers' Perspective on Earnings Management

• 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. • Investors and creditors, though, should be alert to indications of attempts to artificially manipulate income and realize that the likelihood of earnings management is probably higher for companies with generous share-based compensation plans.

Basic Earnings Per Share

• Basic EPS = Earnings available to common shareholders ÷ Weighted-average number of common shares outstanding • Calculation of EPS becomes more demanding when: ¤ The number of shares has changed during the reporting period ¤ The earnings available to common shareholders are diminished by dividends to preferred shareholders ¤ Take into account the impending effect of potential common shares

Stock Option Plans: Plans with Cliff or Graded Vesting

• Cliff vesting: The stock option plans that vest (become exercisable) on one single date • Graded vesting" Recipients gradually become eligible to exercise their options rather than all at once

Actual Conversions

• Diluted EPS of convertible bonds that were converted during the year would be precisely the same as if not converted • Calculation of diluted EPS: 1. Actual conversion: ¤ This would cause an actual increase in shares from the date the convertible bonds are 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 2. Assumed conversion: ¤ Assume conversion for the period before conversion because they were potentially dilutive during that period

Reconciliation of Basic EPS Computations to Diluted EPS Computations

• 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

Earnings Per Share

• Earnings Per Share (EPS) is a way of summarizing the performance of business enterprises in a single number. • The comparability of EPS numbers is maximized by minimizing the inconsistencies in their calculation from one company to the next. • 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 (EPS). • The reasons for the considerable attention paid to earnings per share certainly include the desire to find a way to summarize the performance of business enterprises into a single number.

Antidilutive Securities

• If the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities. • Such securities are ignored when calculating both basic and diluted EPS. • Options, Warrants, Rights: ¤ When the exercise price is higher than the buyback (average market) price, this causes: 1. The number of shares assumed repurchased is fewer than the number of shares assumed sold 2. Shares are sold at the exercise price and repurchased at the market price 3. Buying back more shares than were sold 4. Produces a net decrease in the number of shares 5. EPS would increase, not decrease

Stock Option Plans with Market Conditions

• If the target is based on changes in the market rather than on performance, compensation is recorded as if there were no target • Compensation expense is recognized regardless of when the market condition is met

Restricted Stock Awards

• In a restricted stock award, 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. • 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.

Decline in Popularity of Stock Option Options

• 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.

Restricted Stock Units (RSUs)

• Is a right to receive a specified number of shares of company stock • The company distributes the shares after the recipient of RSUs satisfies the vesting requirement • The recipient benefits by the value of the shares at the end of the vesting period • Terms of RSUs vary ¤ The recipient sometimes is given the cash equivalent of the number of shares used to value the RSUs ¤ The terms might stipulate that either the recipient or the company is allowed to choose whether to settle in stock or cash • RSU is considered to be a liability when the employee receive cash or can elect to receive cash. • The fair value amount at the grant date is then recognize as compensation expense over the requisite service period the same way as restricted stock awards, RSUs, and other share-based compensation.

Option-Pricing Theory

• Option values have two essential components: 1. Intrinsic Value 2. Time Value 1. Intrinsic Value • The benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly • An option that has an exercise price equal to or exceeding the market price of the underlying stock has zero intrinsic value 2. Time Value • Options also have a time value due to the fact that: ¤ The holder of an option does not have to pay the exercise price until the option is exercised ¤ The market price of the underlying stock may yet rise and create additional intrinsic value • The longer the time until expiration, other things being equal, the greater the time value • Time value can be subdivided into two components: (1) the effects of time value of money and (2) volatility value. • Volatility Value ¤ One popular option pricing model is the Black-Scholes model which assumes a log-normal distribution o This assumption posits that the stock price is as likely to fall by half as it is to double and that large price movements are less likely than small price movements ¤ The higher a stock's volatility, the higher the probability of large increases or decreases in market price

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 Benefits to the employees: • Employees benefits by being able to buy shares from their employer without brokerage fees and at a slight discount • The accounting is basically a sale of new shares to employees or having no compensation expense as long as: (a) substantially 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% (or can be justified as reasonable). • 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 expense

Diluted Earnings Per Share: Potential Common Shares

• Potential Common Shares are Securities that are not common stock but might become common stock through their exercise or conversion. They may dilute (reduce) earnings per share • A firm is said to have a complex capital structure if potential common shares are outstanding. • Examples of potential common shares: 1. Convertible bonds 2. Convertible preferred stock 3. Stock options 4. Contingently issuable securities • A firm with a complex capital structure reports two EPS calculations. 1. Basic EPS that ignores the dilutive effect of such securities 2. Diluted EPS that incorporates the dilutive effect of all potential common shares.

Stock Option Plans with Performance Conditions

• 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 • The target could be divisional revenue, earnings per share, sales growth, or rate of return on assets.

Additional EPS Issues: Restricted Stock Awards and Units (RSUs) in EPS Calculations

• Restricted stock awards and restricted stock units (RSUs) are quickly replacing stock options as the share-based compensation plan of choice. • Like stock options, they represent 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. • The first component of the proceeds: ¤ 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 already distributed and outstanding • The second component of the proceeds: ¤ The proceeds for the EPS calculation include the total compensation from the unvested restricted stock that's not yet expensed

Stock Option Plans: Plans with Performance or Market Conditions

• Stock option (and other share-based) plans often specify a performance condition or a market condition that must be satisfied before employees are allowed the benefits of the award. • The objective is to provide employees with additional incentive for managerial achievement. • An option might not be exercisable until a performance-base or market-based target is met. This is will change the behavior on how it is accounted for.

Stock Option Plans

• Stock option plans give employees the option to purchase 1. A specified number of shares of the firm's stock 2. At a specified exercise price 3. During a specified period of time • Historically, options were measured at their intrinsic values ¤ Intrinsic value = Market price of the shares - Option price at which they can be acquired

Stock Appreciation Rights (SARs): SARs payable in cash (liability)

• The fair value of the SARs is estimated and that amount is recognized as compensation expense over the requisite service period • The fair value is periodically re-estimated in order to continually adjust the liability (and corresponding compensation) until it is paid • The periodic expense is the fraction of the total compensation earned to date by recipients of the SARs reduced by any amounts expensed in prior periods

Restricted Stock Plans

• These plans usually are tied to continued employment • The two primary types of restricted stock plans 1. Restricted Stock Awards 2. Restricted Stock Units