IA Ch. 16 Dilutive Securities and EPS

Basic Earnings Per Share Formula

(net income - preferred dividends) / weighted average common shares outstanding Subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders preferred dividends are subtracted when preferred stock is cumulative, whether declared or not.

nondetachable warrants

-Do not require an allocation of proceeds between the bonds and the warrants -Companies record the entire proceeds as debt (book value method)

If converted with preferred stock

-subtract dividend to get to Net income to common shareholders -Use net income amount from before preferred stock dividends

Two methods of warrant proceeds allocation:

1)proportional method - use when you know the fair value of both securities 2)incremental method - use when you know the fair value of only one security

Effective compensation programs are ones that:

1. Base compensation on performance. 2. Motivate employees. 3. Help retain executives and recruit new talent. 4. Maximize employee's after-tax benefit. 5. Use performance criteria over which employee has control.

Stock compensation plains - Two main accounting issues:

1. How to determine compensation expense. 2. Over what periods to allocate compensation expense.

Company with one or more share-based payment arrangements must disclose:

1. Nature and extent of such arrangements. 2. Effect on the income statement of compensation cost. 3. Method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant). 4. Cash flow effects.

Plans are considered compensatory unless they satisfy all three conditions presented below:

1. Substantially all full-time employees may participate on an equitable basis. 2. The discount from market is small. 3. The plan offers no substantive option feature.

warrants normally arise under three situations:

1. To make the security more attractive. 2. To employees as a form of compensation - (aka stock options) 3. Existing stockholders have a preemptive right to purchase common stock first.

If-converted method for convertible bonds assumes:

1. the conversion 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 (you have to take tax out for calculation)

Treasury stock method assumes:

1. the exercise the options or warrants at the beginning of the year (or date of issue if later), and 2. that the company uses those proceeds to purchase common stock for the treasury.

Complex capital structures and dual presentation of EPS require the following additional disclosures in note form.

1.Description of pertinent rights and privileges of the various securities outstanding. 2.A reconciliation of the numerators and denominators of the basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS. 3.The effect given preferred dividends in determining income available to common stockholders in computing basic EPS. 4.Securities that could potentially dilute basic EPS in the future that were excluded in the computation because they would be antidilutive. 5.Effect of conversions subsequent to year-end, but before issuing statements.

On January 1, 2020, Ogden Company issues 1,000 shares of restricted stock to its CEO, Christie DeGeorge. Ogden's stock has a fair value of $20 per share on January 1, 2020. Additional information is as follows. 1.The service period related to the restricted stock is five years. 2.Vesting occurs if DeGeorge stays with the company for a five-year period. 3.The par value of the stock is $1 per share.

1/1/20 Dr. unearned compensation expense 20,000 Cr. CS 1000 Cr. PIC-CS 19000 12/31/20 Dr. Compensation expense 4000 Cr. unearned compensation expense 4000

On November 1, 2019, the stockholders of Chen Company approve a plan that grants the company's five executives options to purchase 2,000 shares each of the company's $1 par value common stock. The company grants the options on January 1, 2020. The options vest over two years and the option holders may exercise the options at any time within the next 10 years. The option price per share ("strike price") and the market price of the stock at the date of grant is $70 per share. The company computes total compensation expense by applying an acceptable fair value option-pricing model (Black-Scholes). Assume that the fair value option-pricing model determines Chen's total compensation expense to be $220,000. What is the journal entry for compensation expense?

12/31/20 Dr. Compensation Expense 110k (220k/2) Cr. PIC - stock options 110k 12/31/21 Dr. Compensation Expense 110k (220k/2) Cr. PIC - stock options 110k

If Chen's executives exercise 2,000 of the 10,000 options (20 percent of the options) on June 1, 2023 (three years and five months after date of grant), the company records the following journal entry.

6/1/23 Dr. Cash 140; (2000 * $70) Dr. PIC-stock options 44k (.2 * 220k) Cr. CS 2000 (2000 * $1) Cr. PIC in excess of par-CS 182k

EPS Presentation and Disclosure

A company should show per share amounts for: •Income from continuing operations, •Income before extraordinary items, and •Net income. Per share amounts for a discontinued operation or an extraordinary item should be presented on the face of the income statement or in the notes.

Zambrano Company's net income for 2020 is $40,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2019, each exercisable for one share at $8. None has been exercised, and 10,000 shares of common were outstanding during 2020. The average market price of the stock during 2020 was $20. Instructions a.Compute diluted earnings per share. b.Assume the 1,000 options were issued on October 1, 2020 (rather than in 2019). The average market price during the last 3 months of 2020 was $20.

A) Proceeds if shares issued: (1,000 × $8) $8,000 Purchase price for treasury shares. ÷ $20 Shares assumed purchased =400 Shares assumed issued 1,000 Incremental share increase = 600 Diluted EPS = 40,000 / (10,000 + 600) = $3.77 B) 600 * (3/12) = 150 Diluted EPS = 40,000/ (10,000+150) = $3.94

Prior to 2020, Barkley Company issued 40,000 shares of 6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 5 shares of common stock. Net income for 2020 was $1,200,000. There were 600,000 common shares outstanding during 2020. There were no changes during 2020 in the number of common or preferred shares outstanding. Compute Basic EPS Compute Diluted EPS

Basic EPS = (1,200,000 - 240,000)/600,000 = $1.6 Diluted EPS = (1,200,000 - 240,000 + 240,000)/(600,000 + 200,000) = $1.5

Mayfield Corporation has net income of $210,000 for the year and a weighted-average number of common shares outstanding during the period of 100,000 shares. The company has two convertible debenture bond issues outstanding. One is a 6 percent issue sold at 100 (total $1,000,000) in a prior year and convertible into 30,000 common shares. The other is a 10 percent issue sold at 100 (total $1,000,000) on April 1 of the current year and convertible into 36,000 common shares. The tax rate is 20 percent.

Basic EPS= 210,000/100,000 = $2.1 6% issue: (60,000 * .80)/30,000 = $1.6 --> DILUTIVE, included in EPS calculation 10% issue: (100,000 * .80 * 9/12)/(36,000 * 9/12) = $2.22 --> ANTIDILUTIVE, excluded from calculation Diluted EPS = (210k + 48k)/(100k + 30k) = $1.98

when computing Diluted EPS, do not subtract preferred dividends from net income in computing the numerator. Why?

Because for purposes of computing EPS, it assumes conversion of the convertible preferred to outstanding common shares, and therefore there are no preferred dividends to deduct from net income. Still subtract them for Basic EPS though!

Eisler Corporation issued 2,000 $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market price of $40. Use the proportional method to record the issuance of the bonds and warrants.

Bond = 96.1% Warrant = 3.9% Dr. Cash 2,020,000 Dr. Discount on BP 59216 Cr. B/P 2,000,000 Cr. PIC warrants 79216

Convertible bonds

Bonds that can be converted into common stock at the bondholder's option can be changed into other corporate securities during some specified period of time after issuance. Benefit of a bond (guaranteed interest and principal) + Privilege of Exchanging it for Stock (at the holder's option)

Weighted-Average Number of Shares Outstanding

Companies must weight the shares by the fraction of the period they are outstanding (i.e. if 100,000 shares are outstanding beginning on April 1, than 75,000 are considered outstanding for the full year - 100,000 x 9/12 months) When stock dividends or stock splits occur, companies need to restate the shares outstanding before the stock dividend or split, in order to compute the weighted-average number of shares. (EVEN PRIOR YEARS) - we double the amount of outstanding shares and then also double the amount of shares issued or repurchased and add to the prior years doubled shares •Companies restate the issuance of a stock dividend or stock split, but not the issuance or repurchase of stock for cash

Simple structure

Company only has common stock; no potentially dilutive securities. (Public companies invariably have dilutive securities)

What happens if options are cancelled before they vest or expire?

Compensation expense is adjusted in the current period for options that do not vest because the employee fails to satisfy a service requirement (e.g., leaves employment). This is considered as a change in estimate. Dr. PIC-stock options Cr. compensation expense •When vested options expire - compensation expense is not adjusted (e.g. employees fail to exercise option during option life, perhaps because options are "not in the money")

Complex Capital Structure exists when a business has

Complex Capital Structure exists when a business has •convertible securities, •options, warrants, or other rights that upon conversion or exercise could dilute earnings per share. Report both basic and diluted earnings per share, even when the result is the same.

If converted bonds affects weighted shares

Compute additional shares added

Diluted EPS Contingent Issue Agreement

Contingent shares are issued as a result of the 1. passage of time condition or 2. upon attainment of a certain earnings or market price level.

Hilton, Inc. has a $1,000 bond that is convertible into 10 shares of common stock (par value $10). At the time of conversion, the unamortized premium is $50. How does Hilton records the conversion of the bonds?

Dr. B/P 1000 Dr. Premium on BP 50 Cr. CS 100 Cr. PIC in excess of par -CS 950

Assume that DeGeorge leaves on February 3, 2022 (before any expense has been recorded during 2022). The entry to record this forfeiture is as follows.

Dr. CS 1000 Dr. PIC-CS 19000 Cr. compensation expense 8000 Cr. unearned compensation expense 12000

Assume investors exercise all 10,000 warrants

Dr. Cash Dr. PIC- stock warrants 294,118 Cr. CS Cr. PIC-CS

Hoosier Company issued $20,000,000 par value 10% bonds at 98. One detachable stock purchase warrant was issued with each $100 par value bond. At the time of issuance, the warrants were selling for $4.

Dr. Cash 19,600,000 Dr. Discount on BP 1,200,000 Cr. BP 20,000,000 Cr. PIC - stock warrants 800,000

Archer Inc. issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Prepare the journal entry to record the issuance of the bonds.

Dr. Cash 3,960,000 Dr. Discount on BP 40k Cr. BP 4,000,0000

Assume that AT&T's bonds (par $1,000) sold for 99 without the warrants soon after their issue. The market price of the warrants at that time was $30. (Prior to sale the warrants will not have a fair value.) The price paid for 10,000, $1,000 bonds with the warrants attached was par, or $10,000,000. The following illustration shows the proportional allocation of the bond proceeds between the bonds and warrants.

Dr. Cash 9,705,882 Dr. discount on BP 294,118 Cr. BP 10,000,000

Helloid, Inc. has outstanding $1,000,000 par value convertible debentures convertible into 100,000 shares of $1 par value common stock. Helloid wishes to reduce its annual interest cost. To do so, Helloid agrees to pay the holders of its convertible debentures an additional $80,000 if they will convert. Assuming conversion occurs, Helloid makes the following entry.

Dr. Debt conversion expense Dr. BP 1,000,000 Cr. CS 100,000 Cr. PIC in excess of par-CS 900,000 Cr. Cash 80,000

If investors fail to exercise warrants

Dr. PIC-stock warrants 294,118 Cr. PIC-expired stock warrants 294,118

Host Enterprises issued 1,000 shares of common stock (par value $2) upon conversion of 1,000 shares of preferred stock (par value $1) that was originally issued for a $200 premium.

Dr. PS 1000 Dr. PIC in excess of par - PS 200 Dr. RE 800 Cr. CS

Gall Inc. issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Prepare the entry to record the conversion.

Dr. Preferred Stock 50,000 Dr. Paid-in Capital in Excess of Par-Preferred 10,000 Cr. Common Stock (2,000 x $10) 20,000 Cr. Paid-in Capital in Excess of Par-Common 40,000

Diluted EPS

EPS = [(net income-preferred dividends)/weighted average number of shares outstanding] - impact of convertibles - impact of options, warrants, and other dilutive securities

Basic Earnings Per Share

Earnings per share indicates the income earned by each share of common stock. Companies report earnings per share only for common stock.

Determining Compensation Expense

GAAP requires companies to recognize compensation cost using the fair-value method. Under the fair-value method, companies use acceptable option-pricing models to value the options at the date of grant. -Black-Scholes method -Monte Carlo method •Compensation expense based on the fair value of the options expected to vest on the date the options are granted to the employee(s) (i.e., the grant date).

If the conversion rate on a dilutive security changes in which the security is outstanding

In this situation, the company uses the most dilutive conversion rate available.

Complex structure

Includes securities that could dilute earnings per common share.

Induced conversion

Issuer offers additional consideration, called a "sweetener. to encourage prompt conversion of debt to CS Sweetener is an expense of the current period.

If-converted method

Method of measuring the dilutive effects of potential conversion on EPS, for companies with securities convertible into common stock. The additional shares assumed issued increase the weighted-average number of shares outstanding (the denominator), and the amount of interest expense increases net income (the numerator). For a convertible bond, this method assumes: 1. The conversion at the beginning of the period (or at the time of issuance of the security, if issues during the period), and 2. the elimination of related interest, net of tax Use for both convertible debt and for convertible preferred stock

Weighted avg. number of shares

Net income/net income per share

Assume the 1,000 options were outstanding and vested at January 1, 2019. The option price is $8 per share and average market price during 2019 was $20 per share. Assume net income of $40,000 and 10,000 weighted average common shares outstanding:

Proceeds if shares issued: (1,000 × $8) $8,000 Purchase price for treasury shares. ÷ $20 Shares assumed purchased =400 Shares assumed issued 1,000 Incremental share increase = 600 Diluted EPS = 40,000 / (10,000 + 600) = $3.77

Restricted Stock

Restricted-stock plans transfer shares of stock to employees, subject to an agreement that shares cannot be sold, transferred, or pledged until vesting occurs. •Generally granted at a price equal to market price on date of grant •Fair value is equal to the excess of market price over the purchase price or "exercise price" on date of grant. As such, no need to use option pricing model (i.e. black-scholes) •Generally vest pro rata (straight line), but alternatively can vest at end of vesting period ("cliff vest") Compensation expense is the difference between exercise price of restricted stock and FV on the date of grant expensed over vesting period

Treasury Stock Method

The Treasury Stock Method assumes that the proceeds from the exercise of warrants, options or restricted stock are used to buy common shares on the open market. The exercised shares, net of the assumed shares purchased on the open market, are added to the denominator. There is no change to the numerator. Shares are assumed converted for all periods when: a)The shares are vested. b)The shares are dilutive.

"Dilutive"

The ability to influence the PS in a downward direction

If Chen's executives fail to exercise the remaining stock options before their expiration date:

The company transfers the balance in the Paid-in Capital—Stock Options account to a more properly titled paid-in capital account, such as Paid-in Capital—Expired Stock Options (memo entry only) Dr. PIC - stock options 176k (220k * 80%) Cr. PIC - expired stock options 176k

What method is used for options and warrants?

Treasury stock method

I/S Presentation of EPS Components

When the income statement contains intermediate components, such as discontinued operations, companies should disclose earnings per share for each component. Earnings per share: Income from continuing operations $4.00 Loss from discontinued operations, net of tax 0/60 = Net income $3.40

Venzuela Company's net income for 2017 is $50,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2016, each exercisable for one share at $6. None has been exercised, and 10,000 shares of common were outstanding during 2017. The average market price of Venzuela's stock during 2017 was $20. (a) Compute diluted earnings per share. (b) Assume the same facts as those assumed for part (a), except that the 1,000 options were issued on October 1, 2017 (rather than in 2016). The average market price during the last 3 months of 2017 was $20.

a) Diluted earnings per share = (Total income - preferred dividends) /( outstanding shares + diluted shares) Amount paid towards shares = Options issued * Exercise price per share = 1,000 * 6 = $ 6,000 Value of options = Amount paid towards shares / Current market price = $ 6,000 /$ 20 = 300 Diluted shares = Options issued - value of options = 1000 - 300 = 700 So Diluted Earnings per share = ( 50,000) / ( 10,000 +700) = $ 4.67 per share. b) Calculation of diluted shares 700 (same as above ) Weighted average for the period holding i.e, 3 months = 700 *3/12 = 175 shares increased during the period. Diluted EPS = 50,000 /(10,000 +175) = $ 4.91 per share

How do you know when options, warrants, etc. are dilutive?

a) When the average market price is greater than the option exercise price b) When basic earnings per share are positive

Companies will not report diluted EPS if the securities in their capital structure are ______

antidilutive

Stock warrants

certificates entitling the holder to acquire shares of stock at a certain price within a stated period.

Employee Stock-Purchase Plans Generally permit all employees to purchase stock at a _______ for a short period of time.

discounted price

Accounting for Convertible bonds (At Time of Issuance)

follows the method used to record straight debt issues, with any discount or premium amortized over the term of the debt. IFRS requires that the issuer of convertible debt record the liability and equity components separately. Dr. Cash Dr. Discount on BP Cr. Bonds payable

Black-Scholes method

generally used for options for which vesting requirement is only continued employment

Monte Carlo method

generally used for options that include performance metrics

Stock option

gives key employees option to purchase common stock at a given price over extended period of time.

Method for convertible securities

if-converted method

Convertible Preferred Stock

includes an option for the holder to convert preferred shares into a fixed number of common shares. •Classified as part of stockholders' equity, unless mandatory redemption exists. •No theoretical justification for recognizing a gain or loss when exercised. Company uses the book value method.

If converted bonds affects earnings to common shareholders...

interest from bond is added back to NI after tax

Detachable warrants

involves two securities. 1) debt security. 2) warrant to purchase common stock. Basically long-term options to buy common stock at a fixed price. •Proceeds allocated between the two securities. •Allocation based on fair market values.

Remove preferred stock from net income when calculating EPS if:

preferred stock is cumulative (100,000 * $100 * 9%)

If par value of CS > par value of preferred stock, that difference comes from

retained earnings

Accounting for Convertible bonds (At Time of Conversion)

use the book value method when converting bonds. When the debt-holder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion.

Compensation is recorded over the _______ starting on the _______

vesting period; grant date

When calculating net income for EPS, given revenues and expenses not including interest and tax expense

you have to deduct the bond interest expense and then once you get net income before taxes, you have to deduct tax expense to get net income

Allocating Compensation Expense

•Compensation expense is recognized in the periods in which employees perform the service - the "service period" (aka vesting period).

Restricted stock in practice

•In practice compensation expense is recorded over the vesting period by debiting compensation expense and crediting paid-in-capital. •When shares are issued - common stock is credited and PIC is debited for par value of shares issued.

Retirement of convertible bonds

•Recognized same as retiring debt that is not convertible. •Difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement. •Remember if converted, no gain or loss is recorded other than cost of "sweetener."