Diluted Securities
complex capital structure
A capital structure that includes securities that could have a dilutive effect on earnings per common share.
Earnings per share
A distilled and important income figure, calculated as net income minus preferred dividends (income available to common stockholders), divided by the weighted-average number of shares outstanding. Companies must disclose earnings per share on the face of the income statement.
Percentage approach
A method of allocating compensation expense over the service period. At the end of each period, total compensation expense reported to date should equal the percentage of the total service period that has elapsed, multiplied by the total estimated compensation cost.
Stock-appreciation rights (SARs)
A plan in which the company gives an executive the right to receive compensation equal to the share appreciation.
Detachable stock warrents
A warrant (option to buy common stock at a fixed price) that can be "detached" from the related security (a bond) and traded as a separate security for a specified period of time. To account for detachable stock warrants, companies separate debt issued with detachable warrants into debt and equity components, using either the proportional method or the incremental method.
Convertible bonds
Bond that permits its holder to exchange it for ("convert it to") other corporate securities (typically common stock) for a specified period of time after issuance. The sale of a convertible bond is recorded like a straight-debt issue; upon conversion, the company records the securities exchanged for the bond at the carrying amount (book value) of the bond. The company amortizes, either at its maturity or upon conversion, any discount or premium that results from the issuance of the bond.
Describe the accounting for stock compensation plans.
Companies must use the fair value approach to account for stock-based compensation. Under this approach, a company computes total compensation expense based on the fair value of the options that it expects to vest on the grant date. Companies recognize compensation expense in the periods in which the employee performs the services. Restricted-stock plans follow the same general accounting principles as those for stock options. Companies estimate total compensation cost at the grant date based on the fair value of the restricted stock; they expense that cost over the service period. If vesting does not occur, companies reverse the compensation expense.
Service period
For stock options, the period in which employees perform services, typically represented by the time between the grant date and the vesting date. A company generally determines total compensation cost of the options at the grant date and allocates it as an expense in the periods in which employees perform the services.
Stock option
Gives key employees the option to purchase common stock at a given price over an extended period of time.
Warrents
Long-term options, issued with other securities, to buy common stock at a fixed price for a specified period of time (generally 5 years, occasionally 10). Companies account for debt issued with nondetachable warrants as straight debt. To account for detachable stock warrants, companies separate debt issued with detachable warrants into debt and equity components, using either the proportional method or the incremental method.
Intrinsic-value method
Method for reporting the granting of stock options. It measures compensation cost as what the holder of the stock option would receive today if the option was immediately exercised. The intrinsic value is the difference between the market price of the stock and the exercise price of the options at the grant date. Use of this approach for most stock-based compensation plans is not allowed under GAAP, which generally requires the fair value method.
Treasury-stock method
Method of measuring the dilutive effects on EPS of stock options and warrants outstanding. This method assumes that a company exercises the options or warrants and uses those proceeds to purchase common stock for the treasury at the average price of common shares during the period. If such purchases result in dilution (assuming the market price of the stock is above the exercise price), the company reports potential common shares in its diluted EPS.
Restricted-stock plans
Restricted-stock plans transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs.
Dilutive securities
Securities that can be converted to common stock. Upon conversion or exercise by the holder, the dilutive securities reduce (dilute) earnings per share. Companies with dilutive securities report both basic EPS and diluted EPS in their income statements.
antidilutive securities
Securities, which upon conversion or exercise, increase earnings per share (or reduce the loss per share). Companies with complex capital structures will not report diluted EPS if the securities in their capital structure are antidilutive; they will report only the basic EPS number.
Contrast the accounting for stock warrants and for stock warrants issued with other securities.
Stock warrants: Companies should allocate the proceeds from the sale of debt with detachable warrants between the two securities. Warrants that are detachable can be traded separately from the debt, and therefore companies can determine their fair value. Two methods of allocation are available: the proportional method and the incremental method. Nondetachable warrants do not require an allocation of the proceeds between the bonds and the warrants; companies record the entire proceeds as debt. Stock rights: No entry is required when a company issues rights to existing stockholders. The company needs only to make a memorandum entry to indicate the number of rights issued to existing stockholders and to ensure that the company has additional unissued stock registered for issuance in case the stockholders exercise the rights.
fair value method
The amount at which a company can exchange a financial instrument in a current transaction between willing parties. Companies account for expense related to stock options and restricted stock at fair value.
Grant date
The date at which a company grants stock options to employees. Public companies estimate the options' fair value as of that date, using an option-pricing model and any adjustments needed for unique factors. No adjustments occur after the grant date in response to subsequent changes (up or down) in the stock price.
weighted-average number of shares outstanding
The denominator used in an earnings per share calculation. Companies weight the shares of stock issued or purchased during a period by the fraction of the period they are outstanding, to determine the equivalent number of whole shares outstanding for the year.
diluted EPS
The earnings per share for a complex capital structure. Diluted EPS begins with the basic EPS computation but includes the effect of all potential dilutive common shares outstanding during the period. It is computed as income available to common stockholders divided by weighted-average number of shares outstanding, plus the impact of convertibles, options, warrants, and other dilutive securities.
Basic EPS
The earnings per share for a simple capital structure. A company with a complex capital structure reports both basic EPS and diluted EPS amounts on the face of its income statement.
Share appreciation
The excess of the market price of the stock at the date of exercise over a pre-established price.
Control number
The measure the company uses, that is, income from continuing operations (adjusted for preferred dividends), to determine whether potential common stock is dilutive or antidilutive.
Describe the accounting for the issuance, conversion, and retirement of convertible securities.
The method for recording convertible bonds at the date of issuance follows that used to record straight debt issues. Companies amortize any discount or premium that results from the issuance of convertible bonds, assuming the bonds will be held to maturity. If companies convert bonds into other securities, the principal accounting problem is to determine the amount at which to record the securities exchanged for the bonds. The book value method is considered GAAP. The retirement of convertible debt is considered a debt retirement, and the difference between the carrying amount of the retired convertible debt and the cash paid should result in a gain or loss.
income available to common stockholders
The numerator used in a basic earnings per share calculation when a company has both common and preferred stock outstanding. Computed as net income minus preferred dividends.
Induced conversion
The offer of additional consideration, to prompt conversion of convertible debt to equity securities.
stock-based compensation plans
These plans provide the employee with the opportunity to receive stock if the performance of the company is satisfactory.
Stock right
Upon the issue of new stock, the old stockholders generally have the right to purchase newly issued shares in proportion to their holdings, to avoid a dilution of voting rights.
Proportional method
Used to account for the proceeds of an issue of detachable warrants, by allocating the proceeds based on the proportion of the following two amounts: (1) the value of the bonds without the warrants, and (2) the value of the warrants.
Incremental method
When a company cannot determine the fair value of either the warrants or the bonds, the company uses the security for which it can determine the fair value, and allocates the remainder of the purchase price to the security for which it does not know the fair value.
Explain the accounting for convertible preferred stock.
When convertible preferred stock is converted, a company uses the book value method. It debits Preferred Stock, along with any related Paid-in Capital in Excess of Par—Preferred Stock, and credits Common Stock and Paid-in Capital in Excess of Par—Common Stock (if an excess exists).
Discuss the controversy involving stock compensation plans.
When first proposed, there was considerable opposition to the recognition provisions contained in the fair value approach. The reason: that approach could result in substantial, previously unrecognized compensation expense. Corporate America, particularly the high-technology sector, vocally opposed the proposed standard. They believed that the standard would place them at a competitive disadvantage with larger companies that can withstand higher compensation charges. Offsetting such opposition is the need for greater transparency in financial reporting, on which our capital markets depend.
Compute earnings per share in a simple capital structure
company has both common and preferred stock outstanding, it subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders. The formula for computing earnings per share is net income less preferred stock dividends, divided by the weighted-average number of shares outstanding.
Compute earnings per share in a complex capital structure.
complex capital structure requires a dual presentationof earnings per share, each with equal prominence on the face of the income statement. These two presentations are referred to as basic earnings per share and diluted earnings per share. Basic earnings per share relies on the number of weighted-average common shares outstanding (i.e., equivalent to EPS for a simple capital structure). Diluted earnings per share indicates the dilution of earnings per share that will occur if all potential issuances of common stock that would reduce earnings per share takes place. Companies with complex capital structures should exclude antidilutive securities when computing earnings per share.
Convertible preferred stock
convertible preferred stock Preferred stock that allows stockholders, at their option, to exchange preferred shares for shares of common stock at a predetermined ratio. The convertible preferred stockholder not only enjoys a preferred claim on dividends but also has the option of converting into a common stockholder with unlimited participation in earnings.
If-converted method
if-converted method Method of measuring the dilutive effects of potential conversion on EPS, for companies with securities convertible into common stock. For a convertible bond, this method assumes the conversion of the convertible securities at the beginning of the period and the elimination of related interest, net of tax. The additional shares assumed issued increase the weighted-average number of shares outstanding (the denominator), and the amount of interest expense increases net income (numerator).
Simple capital structure
simple capital structure Capital structure that consists only of common stock and other securities (preferred stock, bonds, warrants) that are not dilutive. A company has a simple capital structure if does not include potential common stock that upon conversion or exercise could dilute earnings per share.
