i.stock award plans - pages persos...

Share-Based Compensation and Earnings per ShareOverview

We’ve discussed a variety of employee compensation plans in prior chapters, including pension and other postretirement benefits in Chapter 17. In this chapter we look at some common forms of compensation in which the amount of the compensation employees receive is tied to the market price of company stock. We will see that these “share-based” compensation plans – stock awards, stock options, and stock appreciation rights - create shareholders’ equity, the topic of the previous chapter and also often affect the way we calculate earnings per share, the topic of the second part of the current chapter. Specifically, we view these as ”potential common shares” along with convertible securities and calculate earnings per share as if they already had been exercised or converted into additional common shares.

LEARNING OBJECTIVESAfter studying this chapter, you should be able to:LO19-1 Explain and implement the accounting for stock award plans.LO19-2 Explain and implement the accounting for stock options.LO19-3 Explain and implement the accounting for employee share purchase plans.LO19-4 Distinguish between a simple and a complex capital structure.LO19-5 Describe what is meant by the weighted average number of common shares.LO19-6 Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split, and the

reacquisition of shares.LO19-7 Describe how preferred dividends affect the determination of EPS.LO19-8 Describe how options, rights, and warrants are incorporated in the calculation of EPS.LO19-9 Describe how convertible securities are incorporated in the calculation of EPS.LO19-10 Determine whether potential common shares are antidilutive.LO19-11 Determine the three components of the proceeds used in the treasury stock method.LO19-12 Explain the way contingently issuable shares are incorporated in the calculation of EPS.LO19-13 Describe the way EPS information should be reported in an income statement.LO19-14 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for share-based compensation and EPS.

Lecture OutlinePart A: Share-Based Compensation

A. Typically, an executive compensation plan is tied to performance in a way that uses compensation to motivate its recipients.

B. Many plans include share-based awards. C. Whichever form such a plan assumes, the accounting objective is to record the fair value

of compensation expense over the periods in which related services are performed. D. This requires:

1. Determining the fair value of the compensation.2. Expensing that compensation over the periods in which participants perform

services.

I. Stock Award Plans (T19-1)A. The compensation is a grant of shares of stock. B. The shares usually are restricted so that benefits are tied to continued employment.

1. Usually shares are subject to forfeiture if employment is terminated within some specified number of years from the date of grant.

2. The employee cannot sell the shares during the restriction period. C. The compensation is simply the market price of the stock at the grant date.

1. Compensation is accrued as expense over the service period for which participants receive the shares.

2. The service period usually is the period from the date of grant to when restrictions are lifted (the vesting date). (T19-2)

D. If restricted stock is forfeited, related entries previously made would simply be reversed.

II. Stock Option Plans (T19-3)A. Allow recipients the option to purchase (a) a specified number of shares of the firm's

stock, (b) at a specified price, (c) during a specified period of time. B. For tax purposes, plans can either qualify as an “incentive stock option plan” under the

Tax Code or be "unqualified plans." Under a qualified incentive plan, the recipient pays no income tax until any shares acquired are subsequently sold. On the other hand, the company gets no tax deduction at all. With a nonqualified plan the employee can’t delay paying income tax, but the employer is permitted to deduct the difference between the exercise price and the market price at the exercise date. (T19-4)

C. The accounting objective is to report the fair value of compensation expense during the period of service for which the compensation is given. (T19-5)

D. Compensation is measured at the grant date, estimated using an option-pricing model that considers the exercise price and expected term of the option, the current market price of the underlying stock and its expected volatility, expected dividends, and the expected risk-free rate of return.

E. When forfeiture estimates change, the cumulative effect on compensation is reflected in current earnings. (T19-6)

F. When options are exercised, cash is debited for the amount received, and stock accounts replace paid-in capital – stock options. (T19-7)

G. If compensation from a stock option depends on meeting a performance target, then whether we record compensation depends on whether or not we feel it’s probable the target will be met. (T19-8)

H. If the target is based on changes in the market rather than on performance, we record compensation as if there were no target.

I. Under U.S. GAAP, a deferred tax asset is created for the cumulative amount of the fair value of the options expensed. Under IFRS, the deferred tax asset isn’t created until the award is “in the money;” that is, has intrinsic value. (T19-9)

J. If recipients gradually become eligible to exercise their options rather than all at once, the plan is said to have “graded vesting.” In such a case, most companies view each vesting group (or tranche) separately, as if it were a separate award. Companies also are allowed to account for the entire award on straight-line basis over the entire vesting period. Either way, the company must recognize at least the amount of the award that has vested by that date.

K. Under IFRS, the straight-line choice is not permitted. Also, there’s no requirement that the company must recognize at least the amount of the award that has vested by each reporting date.

III. Employee Share Purchase Plans (T19-10)A. Employee share purchase plans allow employees to buy company stock under convenient

or favorable terms. B. Most such plans are considered compensatory and require the fair value of any discount

to be recorded as compensation expense.

Part B: Earnings Per Share

I. For analysts and the financial press, earnings per share is the most frequently cited and reported measure of a company’s performance. A. EPS is reported in the income statement of all publicly traded firms. B. In general, EPS is simply earnings available to common shareholders divided by the

weighted average number of common shares outstanding.

II. If a company has no “potential common shares” we consider it to have a simple capital structure. A. For a simple capital structure, a single presentation of basic EPS is sufficient. B. If there are no securities other than common stock and the number of common shares

remained unchanged, basic EPS is simply net income divided by common shares. (T19-11)

III. When the number of shares changes, EPS calculations are based on the weighted average number of shares outstanding during the period.A. New shares issued during a reporting period are time-weighted by the fraction of the

period they were outstanding and then added to the number of shares outstanding for the period. For instance, if 12,000 new shares are sold on October 1, the denominator of the EPS fraction would be increased by: 12,000 x 3/12, or 3,000 shares. (T19-12)

B. On the contrary, an increase in shares due to a stock dividend or stock split is not time-weighted. (T19-13)1. For a stock dividend or stock split, the shares outstanding prior to the stock

distribution are restated to reflect the increase in shares. That is, we simply increase the outstanding shares by the number of new shares.

2. The firm would simply have a larger number of less valuable shares (the same pie is cut into more slices).

3. For example, EPS after a 2 for 1 stock split would be half of what it was before, other things being equal.

4. When reported again in the comparative financial statements, previous years’ EPS are restated for comparability.

C. If common shares are reacquired (as treasury stock or to be retired) those shares are time-weighted for the fraction of the period they were not outstanding. The time-weighted shares then are subtracted from the number of shares in the denominator of the EPS fraction. (T19-14)

IV. Any dividends on preferred stock outstanding are subtracted from reported net income. (T19-15)A. This is because the denominator in the EPS calculation is the weighted average number

of common shares, so the numerator should reflect earnings available to common shareholders.

B. This adjustment is made for cumulative preferred stock whether or not dividends are declared that period. The assumption is that eventually the dividends will be paid if the preferred stock is cumulative.

V. When a company has securities that could potentially dilute (i.e., reduce) earnings per share, it is classified as a complex capital structure. (T19-16)A. These potential common shares include stock options and convertible securities. B. The company reports both basic and diluted earnings per share. C. For diluted EPS, the impact of each potentially dilutive security is reflected by

calculating earnings per share as if the security already had been exercised or converted into additional common shares.

D. Stock options (also stock rights and stock warrants) give their holders the right to exercise their option to purchase common stock, typically at a specified exercise price. The increase in shares would reduce EPS. (T19-17)1. When calculating diluted EPS, we pretend the stock options had been exercised at

the beginning of the period (or at the time the options are issued, if later). 2. We also assume the cash proceeds from the assumed sale were used to buy back (as

treasury stock) as many of those shares as could be acquired at the average market price of the shares during the period.

3. If the options haven’t vested, “proceeds” also include any compensation not yet expensed.

4. If the options are not incentive options, “proceeds” also include any “excess tax benefits.” (T19-18)

5. Restricted stock is potentially dilutive and also is included in diluted EPS by the treasury stock method. (T19-19)

E. For convertible securities, we pretend for the purpose of calculating diluted EPS that the conversion already has occurred. (T19-20)1. To include convertible bonds in the calculation of diluted EPS, we pretend the

conversion occurred at the beginning of the period (or at the time the convertible security is issued, if later). (T19-21)a. The denominator of the EPS fraction is adjusted for the additional common

shares assumed.b. The numerator is increased by the interest (after-tax) that would have been

avoided in the event of conversion. 2. To include convertible preferred stock in the calculation of diluted EPS, we pretend

the conversion occurred at the beginning of the period (or at the time the convertible security is issued, if later). (T19-22)a. The denominator of the EPS fraction is adjusted for the additional common

shares assumed.b. The numerator is not reduced by the preferred dividends because they would

have been avoided in the event of conversion.

VI. If the effect of the assumed conversion or exercise of potential common shares would be to increase, rather than decrease, EPS, we consider them “antidilutive securities.” Antidilutive securities are ignored when calculating both basic and diluted EPS. (T19-23)

VII. Contingently issuable shares also are potential common shares. (T19-24)A. These are considered outstanding in the computation of diluted EPS if the conditions for

their issuance currently are met. B. For instance, if 50,000 shares will be issued next year if the market price of common

shares next year is at least $35 and the market price currently is $36, the 50,000 additional shares would be simply added to the denominator.

VIII. Financial statement disclosures include both basic and diluted EPS for both income from continuing operations and net income. (T19-25)A. Per share amounts also are reported for:

1. Discontinued operations, 2. Extraordinary items, and 3. An accounting change.

B. Disclosures should include a reconciliation of the numerator and denominator used in the computations.

C. IAS No. 33 and U.S. GAAP are similar in most respects. The differences that remain are the result of differences in the application of the treasury stock method, the treatment of contracts that may be settled in shares or cash, and contingently issuable shares. (T19-26)

Decision-Makers’ PerspectiveA. Analysts frequently use EPS data in connection with the price-earnings ratio.

1. The P/E ratio is the market price per share divided by the earnings per share. 2. The P/E ratio measures the decision makers' perception of the “quality” of a

company’s earnings by indicating the price multiple the market is willing to pay for the firm’s earnings.

3. In a way, it represents the market’s expectation of future earnings as indicated by current earnings taking into account analysts’ perceptions of a business’s growth potential, stability, and relative risk.

B. Another measure, the dividend payout ratio, indicates the percentage of earnings that is distributed to shareholders as dividends.

Appendix B. Stock Appreciation Rights (SARs) (T19-27)A. SARs enable an executive to benefit by the amount that the market price of the

company’s stock rises, but without having to buy shares. B. The executive receives the “share appreciation” at exercise that has occurred since the

date of grant. C. Share appreciation is the increase in the market price over a prespecified price (usually

the market price at the date of grant). D. The share appreciation usually is payable in cash but may be payable in shares equal in

value to the share appreciation. 1. The award is considered to be equity if the employer can elect to settle in shares of

stock rather than cash. 2. The award is considered to be a liability if the employee can elect to receive cash

(which usually is the case). 3. When considered debt, the amount of compensation is continually adjusted to

reflect changes in the fair value of the SARs until the SARs expire or are exercised. (T19-28, T19-29)

4. When the award is considered equity fair value is measured at the grant date.

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STOCK AWARD PLANS

Usually, restricted shares are subject to forfeiture if the employee doesn’t remain with the company.

The share value is accrued as compensation expense over the service period for which participants receive the shares, usually from the date of grant to when restrictions are lifted (the vesting date).

T19-1

STOCK AWARD PLANS ILLUSTRATIONUnder its restricted stock award plan, Universal Communications grants 5 million of its $1 par common shares to certain key executives at January 1, 2013. The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of $12 per share. January 1, 2013No entryCalculate total compensation expense: $12 fair value per share

x 5 million shares awarded= $60 million total compensation

The total compensation is allocated to expense over the 4-year service (vesting) period: 2013 - 2016

$60 million ÷ 4 years = $15 million per year

December 31, 2013, 2014, 2015, 2016 ($ in millions)

Compensation expense ($60 million ÷ 4 years).............. 15Paid-in capital – restricted stock......................... 15

December 31, 2016Paid-in capital– restricted stock (5 million sh. at $12).... 60

Common stock (5 million shares at $1 par).................. 5Paid-in capital – excess of par (to balance)............. 55

If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed.

T19-2

STOCK OPTION PLANS

Stock option plans give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified price, (c) during a specified period of time.

The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date).

This requires the use of an option pricing model. The model should take into account the: exercise price of the option expected term of the option current market price of the stock expected dividends expected risk-free rate of return during the term of the

option expected volatility of the stock

T19-3

Tax Implications

For tax purposes, plans can either qualify as an “incentive stock option plan” under the Tax Code or be "unqualified plans."

Among the requirements of a qualified option plan is that the exercise price be equal to the market price at the grant date. Under a qualified incentive plan, the recipient pays no income tax until any shares acquired are subsequently sold. On the other hand, the company gets no tax deduction at all.

With a nonqualified plan the employee can’t delay paying income tax, but the employer is permitted to deduct the difference between the exercise price and the market price at the exercise date.

T19-4

EXPENSING STOCK OPTIONS

At January 1, 2013, Universal Communications grants options that permit key executives to acquire 10 million of the company’s $1 par common shares within the next 8 years, but not before December 31, 2016 (the vesting date). The exercise price is the market price of the shares on the date of grant, $35 per share. The fair value of the options, estimated by an appropriate option-pricing model, is $8 per option.

January 1, 2013No entry

Calculate total compensation expense: $8 estimated fair value per option

x 10 million options granted= $80 million total compensation

The total compensation is allocated to expense over the 4-year service (vesting) period: 2013 - 2016

$80 million ÷ 4 years = $20 million per year

December 31, 2013, 2014, 2015, 2016 ($ in millions)Compensation expense ($80 million ÷ 4 years).............. 20

Paid-in capital – stock options............................ 20

T19-5

ESTIMATED FORFEITURES

If a forfeiture rate of 5% was expected, annual compensation expense would have been $19 million ($76 / 4) instead of $20 million.

During 2015, the third year, Universal revises its estimate of forfeitures from 5% to 10%. The new estimate of total compensation would then be $80 million x 90%, or $72 million.

The expense each year is the current estimate of total compensation that should have been recorded to date less the amount already recorded

2013 ($ in millions)Compensation expense ($80 x 95% x 1/4)................... 19

Paid-in capital –stock options ......................... 19

2014Compensation expense ($80 x 95% x 1/4)................... 19


2015Compensation expense ([$80 x 90% x ¾] – [$19 + 19]). . 16


2016Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16]) 18


T19-6

WHEN OPTIONS ARE EXERCISED

If half the options (five million shares) are exercised on July 11, 2016, when the market price is $50 per share, the following journal entry is made:

July 11, 2016 ($ in millions)Cash ($35 exercise price x 5 million shares)........................ 175Paid-in capital - stock options (1/2 account balance)...... 40

Common stock (5 million shares at $1 par per share)...... 5Paid-in capital – excess of par (to balance)................. 210

If options that have vested expire without being exercised, the following journal entry is made (assuming none of the options were exercised):

($ in millions)Paid-in capital – stock options (account balance) 80

Paid-in capital – expiration of stock options 80

T19-7

PLANS WITH PERFORMANCE OR MARKET CONDITIONS

The way we account for such plans depends on whether the condition is performance-based or market-based.

If compensation from a stock option depends on meeting a performance target, then whether we record compensation depends on whether or not we feel it’s probable the target will be met.

If the initial expectation is that it is not probable that the target will be met, we record no annual compensation expense. If, after two years, the expectation is that it is probable that the target will be met, we record the cumulative effect on compensation in 2015 earnings and record compensation thereafter:

2015Compensation expense ([$80 x ¾] - $0)........... 60

Paid-in capital –stock options ................. 60

2016Compensation expense ([$80 x 4/4] - $60)....... 20

Paid-in capital –stock options ................. 20

Plans with Market Conditions

If the award contains a market condition (e.g., a share option with an exercisability requirement based on the stock price reaching a specified level), then we recognize compensation expense regardless of when, if ever, the market condition is met.

T19-8

Plans with Performance Conditions

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Recognition of Deferred Tax Asset for Stock Options. Under U.S. GAAP, a deferred tax asset is created for the cumulative amount of the fair value of the options expensed. Under IFRS, the deferred tax asset isn’t created until the award is “in the money;” that is, has intrinsic value.

T19-9

EMPLOYEE SHARE PURCHASE PLANS

Permit employees to buy shares directly from their company.

Usually the plan is considered compensatory, and compensation expense is recorded.

Assume an employee buys shares (no par) under an ESPP plan for $850 rather than the current market price of $1,000. The $150 discount is recorded as compensation expense:

Cash (discounted price) 850Compensation expense ($1,000 x 15%) 150

Common stock (market value) 1,000

T19-10

EARNINGS PER SHARE In the most basic setting, earnings per share is simply a

company’s earnings (or loss) divided by the number of shares outstanding.

Sovran Metals Corporation reported net income of $154 million in 2013. (Its tax rate was 40%).

Common stockJanuary 1, 2013 60 million shares outstanding

(in millions, except per share amount)

Basic EPS:net

income $154

= $2.57

60shares

outstanding

T19-11

ISSUANCE OF NEW SHARES

If the number of shares has changed, it’s necessary to find the weighted average of the shares outstanding during the period the earnings were generated. Any new shares issued are time-weighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period.

Sovran Financial Corporation reported net income of $154 million for 2013 (tax rate 40%). Its capital structure included:

Common stockJanuary 1 60 million common shares were outstanding

March 1 12 million new shares were sold

Basic EPS:(amounts in millions, except per share amount)

netincome $154 $154

= = $2.20

60 + 12 (10/12) 70shares new

at Jan. 1 shares

T19-12

STOCK DIVIDENDS AND STOCK SPLITS

The additional shares created by a stock dividend or split are not weighted for the time period they were outstanding. Shares outstanding prior to the stock distribution are retroactively restated to reflect the increase in shares – that is, treated as if the distribution occurred at the beginning of the period.

Sovran Financial Corporation reported net income of $154 million in 2013 (tax rate 40%). Its capital structure included:

Common stockJanuary 1 60 million common shares were outstanding March 1 12 million new shares were sold

June 17 A 10% stock dividend was distributed


netincome $154 $154

= = $2.00

60 (1.10) + 12 (10/12) (1.10) 77shares new

at Jan. 1 shares___ stock dividend ___

adjustment

T19-13

REACQUIRED SHARES 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.


Common stockJanuary 1 60 million common shares were outstanding March 1 12 million new shares were soldJune 17 A 10% stock dividend was distributed

October 1 8 million shares were reacquired as treasury stock


netincome $154 $154

= = $2.05

60 (1.10) + 12 (10/12) (1.10) – 8 (3/12) 75shares new treasury

at Jan. 1 shares shares___ stock dividend ___

adjustment*

* not necessary for the treasury shares since they were reacquired after the stock dividend and thus already reflect the adjustment (that is, the shares repurchased are 8 million “new” shares)

T19-14

EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Preferred dividends are subtracted from net income so that “earnings available to common shareholders” is divided by the weighted average number of common shares.


Common stockJanuary 1 60 million common shares were outstanding March 1 12 million new shares were soldJune 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury

stock Preferred stock, nonconvertible

January 1-December 31 5 million 8%, $10 par, shares


net preferredincome dividends$154 – $4 * $150

= = $2.00



adjustment

* 5,000,000 x $10 x 8%T19-15

COMPLEX CAPITAL STRUCTUREPotential common shares — Securities that, while not being

common stock, may become common stock through their exercise or conversion and, therefore, may “dilute” (reduce) EPS.

Examples: Convertible preferred stock, stock options, rights, or warrants, and contingently issuable securities

Complex capital structure — If potential common shares are outstanding

A firm with a complex capital structure reports two EPS calculations:

Basic EPS ignores the dilutive effect of potential common shares.

Diluted EPS incorporates the dilutive effect of potential common shares. The dilutive effect is included essentially by “pretending” the securities already have been exercised, converted, or otherwise transformed into common shares.

T19-16

OPTIONS, RIGHTS, AND WARRANTSStock options, stock rights, and stock warrants give their holders the right to exercise their option to purchase common stock, usually at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS.

Incentive stock optionsExecutive stock options granted in 2011, exercisable after 2012 for 15 million common shares* at an exercise price of $20 per share. The average market price was $25.

*adjusted for the stock dividend

Basic EPS (amounts in millions, except per share amounts)net preferred

income dividends$154 – $4 $150

= = $2.00



adjustmentDiluted EPS

net preferredincome dividends$154 – $4 $150

____________________________________________________________________ = _____ = $1.9260(1.10) + 12 (10/12) (1.10) – 8 (3/12) + (15 – 12a) 78

shares new treasury exerciseat Jan. 1 shares shares of options

__ stock dividend ___adjustment

a Shares Reacquired for Diluted EPS15 million shares

x $20 (exercise price)$300 million

÷ $25 (average market price)12 million shares reacquired

T19-17

Proceeds for Calculating Reacquired Shares The “proceeds” for the calculation should include:

1. the amount received from the hypothetical exercise of the options ($300 million in our illustration).

2. the total compensation from the award that's not yet expensed. If the fair value of an option had been $4 at the grant date, the total compensation would have been 15 million shares times $4, or $60 million.

In our illustration, the options were fully vested before 2013, so all $60 million already had been expensed. If the options had been only half vested, half the compensation would have been unexpensed and $30 million would have been added to the $300 million proceeds.

3. the "excess tax benefit." We expense the fair value of stock options at the date of grant. If the options were non-qualified options, the corporation receives a tax deduction at exercise equal to the difference between the stock's market value and its exercise price. In our illustration, the options were incentive stock options, hence no tax benefit. Had they been non-qualified options, the proceeds also would have included a $6 million excess tax benefit:

$25 market price during 2013 (& price at hypothetical exercise)(20 ) exercise price$ 5 tax deduction at hypothetical exercise

(4) fair value at grant date (& amount expensed over the vesting period)$ 1 excess tax deduction per option

x 15 million options$15 million excess tax deduction

x 40 % tax rate$ 6 million excess tax benefit

T19-18

Restricted Stock Awards in EPS Calculations Restricted stock awards are included using the treasury stock method.

That is, 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 cash proceeds are zero since executives don’t pay to acquire their shares.

The proceeds for the EPS calculation include the total compensation that’s not yet expensed. For an example, assume total compensation for the award is $60 million ($12 market price per share x 5 million shares). If the stock award vests over four years, it is expensed as $15 million each year for four years. At the end of 2013, the first year, $45 million remains unexpensed, so $45 million would be the assumed proceeds in an EPS calculation. If the market price remains at $12, the $45 million will buy back 3.75 million shares:

No adjustment to the numerator 5 million – 3.75* million = 1.25 million

*Assumed purchase of treasury shares $45 million

÷ $12 (average market price)3.75 million shares

The proceeds would be increased (or decreased) by any tax benefits that would be added to (or deducted from) paid-in capital when the eventual tax deduction differs from the amount expensed. Since that occurs when the stock price at vesting differs from the stock price at the grant date, this component is zero in this example.

T19-19

CONVERTIBLE SECURITIES

For Diluted EPS, conversion into common stock is assumed to have occurred at the beginning of the period (or at the time the convertible security is issued, if that’s later). 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) or preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

T19-20

CONVERTIBLE BONDSCommon stockJanuary 1 60 million common shares were outstanding March 1 12 million new shares were soldJune 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock

[The average market price for 2013 was $25 per share.]

Preferred stock, nonconvertibleJanuary 1-December 31 5 million 8%, $10 par, shares

Executive stock optionsOptions granted in 2011, exercisable for 15 million common shares* at an exercise price of $20 per share

Convertible bonds10%, $300 million face amount issued in 2012, convertible into 12 million common shares*


Basic EPS (amounts in millions, except per share amounts)

$2.00 as before

Diluted EPSnet preferred after-tax

income dividends interest savings$154 – $4 + $30 – (40% x $30) $168

= = $1.87

60(1.10) + 12 (10/12) (1.10) – 8 (3/12) + (15 – 12) + 12 90shares new treasury exercise conversionat Jan. 1 shares shares of options of bonds

___ stock dividend ___adjustment*

T19-21

CONVERTIBLE PREFERRED STOCKAssume the preferred stock is convertible into common shares:

Preferred stock, convertible5 million, 8%, cumulative, $10 par, shares, convertible into 3 million common shares*


Basic EPS (amounts in millions, except per share amounts)net preferred

income dividends$154 – $4 $150

= = 2.0060(1.10) + 12 (10/12)(1.10) – 8 (3/12) 75

shares new treasuryat Jan. 1 shares shares

___ stock dividend ___adjustment

Diluted EPS net preferred after-tax

income dividends interest savings$154 – $4 + $30 – (40% x $30) $172

= = $1.8560 (1.10) + 12 (10/12)(1.10) – 8 (3/12) + (15 – 12) + 12 + 3 93

shares new treasury exercise conv. conversionat Jan. 1 shares shares of options of of preferred

bonds shares___ stock dividend ___

adjustment

T19-22

ANTIDILUTIVE SECURITIES

At times, 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 diluted EPS.

Stock warrantsWarrants granted in 2012, exercisable for 4 million common shares* at an exercise price of $32.50 per share


Calculations:The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive.

The $32.50 exercise price is higher than the market price, $25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

T19-23

CONTINGENTLY ISSUABLE SHARES

At times, contingent shares are 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.

When calculating EPS, contingently issuable shares are considered to be outstanding in the computation of diluted EPS if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period). For example, assume 3 million additional shares will become issuable to certain executives in the following year (2014) if net income that year is $150 million or more. If net income in 2013 was $154 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 3 million additional shares to the denominator of the EPS fraction.

Assumed issuance of contingently issuable shares (diluted EPS):

no adjustment to the numerator

+ 3additional

sharesT19-24

FINANCIAL STATEMENT PRESENTATION

Basic and diluted EPS data are reported on the face of the income statement for all periods presented. Companies without potential common shares present basic EPS only. Disclosure notes should provide additional disclosures including:

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.

Any adjustments to the numerator for preferred dividends. Any potential common shares that weren’t included

because they were antidilutive. Any transactions that occurred after the end of the most

recent period that would materially affect earnings per share.

When the income statement includes one or more items that require separate presentation within the statement, EPS data (both basic and diluted) must also be reported separately for income from continuing operations and net income. Per share amounts for discontinued operations, extraordinary items, and the cumulative effect of an accounting change are disclosed either on the face of the income statement or in the notes to financial statements.

T19-25

INTERNATIONAL FINANCIAL REPORTING STANDARDS

Earnings per Share. FASB ASC 260 – Earnings per Share was issued as part of a joint project with the IASB to eliminate differences between SFAS 128 - Earnings per Share and IAS 33 - Earnings per Share. Now, the denominator for the earnings per share (EPS) calculation is the same under both US GAAP and IFRS. The numerator still can differ because the components of net income often are different under US GAAP and IFRS.

T19-26

STOCK APPRECIATION RIGHTS

When an SAR is considered to be equity (because the employer can elect to settle in shares), the amount of compensation is estimated at the grant date as the fair value of the SARs. This amount is expensed over the service period.

When an SAR is considered to be a liability (because the employee can elect to receive cash upon settlement), the amount of compensation (and related liability) is estimated each period and continually adjusted to reflect changes in the fair value of the SARs until the compensation is finally paid.

The current expense (and adjustment to the liability) is the fraction of the total compensation earned to date by recipients of the SARs (based on the elapsed percentage of the service period), reduced by any amounts expensed in prior periods.

T19-27

STOCK APPRECIATION RIGHTS Universal Communications grants 10 million SARs to key executives at January 1, 2013. Upon exercise, the SARs entitle executives to receive cash or stock equal in value to the excess of the market price at exercise over the share price at the date of grant. The $1 par common shares have a current market price of $10 per share. The SARs vest at the end of 2016 (cannot be exercised until then) and expire at the end of 2015. The fair value of the SARs, estimated by an appropriate option pricing model, is $8 per SAR at January 1, 2013. The fair value re-estimated at December 31, 2013, 2014, 2015, 2016 and 2015, is $8.40, $8, $6, $4.30, and $5, respectively.

January 1, 2013No entry

December 31, 2013 ($ in millions)Compensation expense ($8.40 x 10 million x 1/4) 21

Liability – SAR plan 21

December 31, 2014Compensation expense ([$8 x 10 million x 2/4] – 21) 19


December 31, 2015Compensation expense ([$6 x 10 million x 3/4] – 21 – 19) 5


December 31, 2016Liability – SAR plan 2

Compensation expense ([$4.30 x 10 million x 4/4] –21–19–5) 2

T19-28

STOCK APPRECIATION RIGHTS (CONTINUED)

The liability continues to be adjusted after the service period if the rights haven’t been exercised yet.

December 31, 2015 ($ in millions)Compensation expense ([$5 x 10 million x all] –21–19–5+2) 7

Liability – SAR plan .............................................. 7

It’s necessary to continue to adjust both compensation expense and the liability until the SARs ultimately either are exercised or lapse.

Assume for example that the SARs are exercised on October 11, 2015, when the share price is $14.50, and executives choose to receive the market price appreciation in cash:

October 11, 2015 ($ in millions)Liability – SAR plan.................................................... 5

Compensation expense ([$4.50 x 10 million x all] –50) 5

Liability – SAR plan (balance)...................................... 45Cash......................................................................... 45

T19-29

Suggestions for Class Activities1. Research Activity

Microsoft reported the following in its 2010 annual report:

Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible employees. Compensation expense for the employee stock purchase plan is recognized in accordance with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month intervals at 90% of the fair market value on the last day of each three-month period. Employees may purchase shares having a value not exceeding 15% of their gross compensation during an offering period.

Suggestions:

Have students describe way Microsoft accounts for shares purchased under this plan.

Note:

Since the discount to employees is 15%, the discount is considered to be compensation and that amount is recorded as expense.

2. Research Activity

GAAP requires reporting both basic and diluted EPS, but there is some latitude in how these data are reported within the financial statements.

Suggestions:

Have students locate financial statements of companies with which they are familiar. You may want them to use the Internet where EDGAR at www.sec.gov or specific corporate sites will provide financial statements, seek out hard copy financial statements, or make their own choice in how to locate the reports. Ask them to:

1. Indicate whether EPS data are reported on the income statement for basic, diluted, or both. Are calculations explained in more detail in the footnotes?

2. Indicate whether EPS data are reported for both income from continuing operations and net income.

3. Indicate whether per share amounts also are reported for:1. Discontinued operations.2. Extraordinary items.

4. Locate and explain the reconciliation of the numerator and denominator used in the computations.

http://www.sec.gov/

3. Real World Scenario

Time Warner, Inc. reported first quarter profits from operations of $52 million, or a loss of 5 cents a share.

Suggestions:

Have students consider this statement. Ask them to suggest how it might be true.

Note:

The loss per share is due to the fact that preferred dividends were deducted from earnings before dividing by the weighted average number of shares outstanding.


Analysts attach great significance to earnings announcements. For that reason, companies are particularly eager to meet earnings expectations. This desire has contributed to a relatively recent trend, especially among technology firms, to report pro forma earnings per share.

Suggestions:

Ask students to perform an Internet search for companies that recently reported pro forma EPS. Have them compare those numbers with GAAP EPS and describe the difference. Have them evaluate the value of pro forma reporting of earnings.

Note:

Essentially, pro forma earnings are actual (GAAP) earnings reduced by any expenses the reporting company feels are unusual and should be excluded. Pro forma results of a company always are better than the real results.

When companies report pro forma results, they argue they are trying to help investors by providing numbers that more accurately reflect their normal business activities, because they exclude unusual expenses. Critics have argued otherwise. Due to the purely discretionary nature of pro forma numbers and several infamous instances of abuse, it’s important to determine precisely what expenses are excluded and what the actual GAAP numbers are.


The Motley Fool, in an online article, “Bye-Bye, Stock Options,” said:

Are you a faithful employee of a company that grants you stock options every now and then? If so, find a chair and sit down. I've got some bad news for you. Stock options may soon go the way of the dodo bird and saber-toothed tiger. Media conglomerate Time Warner, for example, recently announced plans to significantly cut back on its options issuance, eliminating them entirely for most employees. Why is this happening?

Suggestions:

Ask students to hypothesize as to “why this is happening.”

Note:

The Financial Accounting Standards Board (FASB) now requires companies to expense stock options. Previously, many firms chose to have their cake and eat it, too – issue options as compensation with no impact on their bottom lines. Now firms are increasingly choosing to do away with options in favor of stock awards or other incentives, at least to some degree, to avoid taking a big hit on their income statements.

6. Professional Skills Development Activities

The following are suggested assignments from the end-of-chapter material that will help your students develop their communication, research, analysis, and judgment skills.

Communication Skills. In addition to Communication Cases 19-2 and 19-8, Judgment Case 19-7 can be adapted to ask students to assume the role of the consultant and write a memo to the client explaining the paradox. Ethics Case 19-3 and Real World Case 19-15 are suitable for student presentation(s). Real World Case 19-6 and Real World Case 19-15 do well as group assignments. Questions 19-6 and 19-19 create good class discussions.

Research Skills. In their professional lives, our graduates will be required to locate and extract relevant information from available resource material to determine the correct accounting practice, perhaps identifying the appropriate authoritative literature to support a decision. Research Cases 19-12 and 19-17 as well as Real World Case 19-9 provide excellent opportunities to help students develop this skill. In addition, Problem 19-8 can be adapted to require students to research the authoritative literature on performance plans.

Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct students to gather, assemble, organize, process, or interpret date to provide options for making business and investment decisions. In addition to Analysis Cases 19-10, 13, 14, and 16, Problem 19-1, Real World Cases 19-4, 9, and 15, and Communication Case 19-2 also provide opportunities to develop analysis skills.

Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require students to critically analyze issues to apply concepts learned to business situations in order to evaluate options for decision-making and provide an appropriate conclusion. In addition to Judgment Case 19-7, Ethics Case 11 also requires students to exercise judgment.

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