Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Share-Based Compensation and Earnings Per Share 19

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.

Share-Based Compensation and

Earnings Per Share

19

19-2

Learning Objectives

Explain and implement the accounting for stock award plans.

19-3

Stock Award Plans

Restricted stock award plans usually are Restricted stock award plans usually are tied to continued employment of the tied to continued employment of the

person receiving the award.person receiving the award.The compensation associated with a share of The compensation associated with a share of

restricted stock is the market price at the restricted stock is the market price at the grant date of an unrestricted share of the grant date of an unrestricted share of the same stock. same stock.

The amount is accrued as compensation The amount is accrued as compensation expense over the service period for which expense over the service period for which participants receive the shares.participants receive the shares.

Restricted stock award plans usually are Restricted stock award plans usually are tied to continued employment of the tied to continued employment of the

person receiving the award.person receiving the award.The compensation associated with a share of The compensation associated with a share of

restricted stock is the market price at the restricted stock is the market price at the grant date of an unrestricted share of the grant date of an unrestricted share of the same stock. same stock.

The amount is accrued as compensation The amount is accrued as compensation expense over the service period for which expense over the service period for which participants receive the shares.participants receive the shares.

19-4

Stock Award Plans

On January 1, 2006, Matrix, Inc. awarded 10,000 On January 1, 2006, Matrix, Inc. awarded 10,000 shares of its $2 par value common stock to its CEO. shares of its $2 par value common stock to its CEO.

The shares will be forfeited if the CEO leaves within the The shares will be forfeited if the CEO leaves within the next five years. On January 1, the common stock of next five years. On January 1, the common stock of

Matrix is selling for $62 per share.Matrix is selling for $62 per share.

No entry is required on January 1, 2006, but total No entry is required on January 1, 2006, but total compensation is calculated at the date of grant as follows:compensation is calculated at the date of grant as follows:

Number ofNumber ofShares issuableShares issuable

Fair valueFair valueper shareper share

TotalTotalCompensationCompensation==××

10,00010,000 ×× ==$62.00$62.00 $620,000$620,000

19-5

Stock Award Plans

The total compensation of $620,000 will be The total compensation of $620,000 will be recognized over the service period of 5 years.recognized over the service period of 5 years.

On December 31, 2006, through 2010, we will On December 31, 2006, through 2010, we will prepare the following journal entry:prepare the following journal entry:

$620,000$620,000 ÷÷ 55 == $124,000 per year$124,000 per year

GENERAL JOURNAL

Date Description Debit Credit

Dec 31 Compensation expense 124,000 Paid-in capital - restricted stock 124,000

19-6

Stock Award Plans

On December 31, 2010, the restrictions are On December 31, 2010, the restrictions are lifted, and the following entry will be made:lifted, and the following entry will be made:

GENERAL JOURNAL


Dec 31 Paid-in capital - restricted stock 620,000 Common stock (10,000 x $2) 20,000 Paid-in capital in excess of par 600,000

19-7

Stock Option Plans

In most cases, employees are In most cases, employees are notnot awarded awarded shares of stock. Rather they are given shares of stock. Rather they are given an option to buy shares at some time in an option to buy shares at some time in

the future.the future.

Options are usually grantedOptions are usually granted

1.1. for a specified number of shares,for a specified number of shares,

2.2. at a specified price,at a specified price,

3.3. during a specified period of time.during a specified period of time.

In most cases, employees are In most cases, employees are notnot awarded awarded shares of stock. Rather they are given shares of stock. Rather they are given an option to buy shares at some time in an option to buy shares at some time in

the future.the future.

Options are usually grantedOptions are usually granted

1.1. for a specified number of shares,for a specified number of shares,

2.2. at a specified price,at a specified price,

3.3. during a specified period of time.during a specified period of time.

19-8

Learning Objectives

Explain and implement the accounting for stock options.

19-9

Expense – The Great Debate

Historically, options have been measured at Historically, options have been measured at their intrinsic value – the simple difference their intrinsic value – the simple difference

between the market price of the shares and between the market price of the shares and the option price at which they can be the option price at which they can be

acquired. If the market and exercise price acquired. If the market and exercise price are equal on the date of grant, no are equal on the date of grant, no

compensation expense is recognized even if compensation expense is recognized even if the options provide executives with the options provide executives with

substantial income.substantial income.

Historically, options have been measured at Historically, options have been measured at their intrinsic value – the simple difference their intrinsic value – the simple difference

between the market price of the shares and between the market price of the shares and the option price at which they can be the option price at which they can be

acquired. If the market and exercise price acquired. If the market and exercise price are equal on the date of grant, no are equal on the date of grant, no

compensation expense is recognized even if compensation expense is recognized even if the options provide executives with the options provide executives with

substantial income.substantial income.

19-10

Expense – The Great Debate

Critics to current practice have identified three Critics to current practice have identified three objections.objections.

1.1. Options with no intrinsic value at issue have Options with no intrinsic value at issue have zero fair value and should zero fair value and should notnot give rise to give rise to expense recognition.expense recognition.

2.2. It is impossible to measure the fair value of It is impossible to measure the fair value of compensation on the date of grant.compensation on the date of grant.

3.3. Current practices have unacceptable economic Current practices have unacceptable economic consequences.consequences.

Critics to current practice have identified three Critics to current practice have identified three objections.objections.

1.1. Options with no intrinsic value at issue have Options with no intrinsic value at issue have zero fair value and should zero fair value and should notnot give rise to give rise to expense recognition.expense recognition.

2.2. It is impossible to measure the fair value of It is impossible to measure the fair value of compensation on the date of grant.compensation on the date of grant.

3.3. Current practices have unacceptable economic Current practices have unacceptable economic consequences.consequences.

19-11

Recognizing Fair Value of Options

Effective for fiscal years beginning after June 15, 2005,Effective for fiscal years beginning after June 15, 2005,companies now are required to estimatecompanies now are required to estimate

the fair value of stock options on the grant date.the fair value of stock options on the grant date.

Effective for fiscal years beginning after June 15, 2005,Effective for fiscal years beginning after June 15, 2005,companies now are required to estimatecompanies now are required to estimate

the fair value of stock options on the grant date.the fair value of stock options on the grant date.

SFAS 123 (revised) requires the use of an SFAS 123 (revised) requires the use of an option pricing model that deals with the:option pricing model that deals with the:1.1. Exercise price of the option.Exercise price of the option.2. Expected term of the option.2. Expected term of the option.3. Current market price of the stock.3. Current market price of the stock.4. Expected dividends.4. Expected dividends.5. Expected risk-free rate of return.5. Expected risk-free rate of return.6. Expected volatility of the stock.6. Expected volatility of the stock.

19-12

Stock Option Plans

On January 1, 2006, Matrix, Inc. grants options to On January 1, 2006, Matrix, Inc. grants options to purchase 100,000 shares of the company’s $1 purchase 100,000 shares of the company’s $1 par value common stock to four key executives. par value common stock to four key executives.

The options may be exercised during the next 10 The options may be exercised during the next 10 years, but not before December 31, 2010. The years, but not before December 31, 2010. The

exercise and market price of the stock on exercise and market price of the stock on January 1 is $57 per share. The fair value of the January 1 is $57 per share. The fair value of the

options, estimated using an options pricing model options, estimated using an options pricing model is $5 per option.is $5 per option.

On January 1, 2006, Matrix, Inc. grants options to On January 1, 2006, Matrix, Inc. grants options to purchase 100,000 shares of the company’s $1 purchase 100,000 shares of the company’s $1 par value common stock to four key executives. par value common stock to four key executives.

The options may be exercised during the next 10 The options may be exercised during the next 10 years, but not before December 31, 2010. The years, but not before December 31, 2010. The

exercise and market price of the stock on exercise and market price of the stock on January 1 is $57 per share. The fair value of the January 1 is $57 per share. The fair value of the

options, estimated using an options pricing model options, estimated using an options pricing model is $5 per option.is $5 per option.

19-13

Stock Option Plans

January 1, 2006: Calculate total January 1, 2006: Calculate total compensation expense.compensation expense.

Shares per executive 100,000 Number of executives 4 Total shares 400,000 Compensation per share 5$ Total compensation 2,000,000$

Shares per executive 100,000 Number of executives 4 Total shares 400,000 Compensation per share 5$ Total compensation 2,000,000$

$2,000,000 $2,000,000 ÷ 5 years (2006 through 2010) = $400,000.÷ 5 years (2006 through 2010) = $400,000.

19-14

Stock Option Plans

The following entry will be made on The following entry will be made on December 31, 2006 through 2010, the December 31, 2006 through 2010, the

service period.service period.

GENERAL JOURNAL


Dec 31 Compensation expense 400,000 Paid-in capital - stock options 400,000

19-15

Stock Option Plans

On May 2, 2011, two executives exercise their On May 2, 2011, two executives exercise their options when the market price of the stock is options when the market price of the stock is

$92 per share. $92 per share. 200,000 shares × $57 per share = $11,400,000200,000 shares × $57 per share = $11,400,000

GENERAL JOURNAL


May 2 Cash 11,400,000Paid-in capital - stock options 1,000,000 Common stock ($1 par) 200,000 Paid in capital in excess of par 12,200,000

19-16

Stock Option Plans

If no options were exercised during the If no options were exercised during the 10-year exercise period, the following entry 10-year exercise period, the following entry

would be made when the options expire:would be made when the options expire:

GENERAL JOURNAL


Dec 31 Paid-in capital - stock options 2,000,000 Paid-in capital - expired options 2,000,000

19-17

Stock Option Plans and Taxes

For incentive plans . . .For incentive plans . . .The recipient pays no tax at the time of The recipient pays no tax at the time of

the grant or when the options are the grant or when the options are exercised.exercised.

Tax is paid on the difference between the Tax is paid on the difference between the market price and exercise price on the market price and exercise price on the date of subsequent sale.date of subsequent sale.

For incentive plans . . .For incentive plans . . .The recipient pays no tax at the time of The recipient pays no tax at the time of

the grant or when the options are the grant or when the options are exercised.exercised.

Tax is paid on the difference between the Tax is paid on the difference between the market price and exercise price on the market price and exercise price on the date of subsequent sale.date of subsequent sale.

19-18

Intrinsic Value of Options

Many companies refuse to recognize the fair value of Many companies refuse to recognize the fair value of options. In this case, the value of options is options. In this case, the value of options is

measured at the grant date in an amount equal to the measured at the grant date in an amount equal to the intrinsic value, which is the difference between the intrinsic value, which is the difference between the market price of the shares and the exercise price at market price of the shares and the exercise price at

which they can be acquired.which they can be acquired.

Many companies refuse to recognize the fair value of Many companies refuse to recognize the fair value of options. In this case, the value of options is options. In this case, the value of options is

measured at the grant date in an amount equal to the measured at the grant date in an amount equal to the intrinsic value, which is the difference between the intrinsic value, which is the difference between the market price of the shares and the exercise price at market price of the shares and the exercise price at

which they can be acquired.which they can be acquired.

Market price at grant date 45.00$ Exercise price at grant date 38.50 Compensation per option 6.50$ Total shares issuable 200,000 Total compensation 1,300,000$

Market price at grant date 45.00$ Exercise price at grant date 38.50 Compensation per option 6.50$ Total shares issuable 200,000 Total compensation 1,300,000$

19-19

Performance Stock Option Plans

In some cases, option plans are structured so In some cases, option plans are structured so that the number of options received and/or the that the number of options received and/or the exercise price per share may be based on the exercise price per share may be based on the

occurrence of some future event.occurrence of some future event.

For example, the CEO may receive options to For example, the CEO may receive options to purchase 100,000 common shares at $10 per purchase 100,000 common shares at $10 per share only if the market price of the company’s share only if the market price of the company’s stock reaches $50 or more per share. This is stock reaches $50 or more per share. This is

known as a variable option plan.known as a variable option plan.

For example, the CEO may receive options to For example, the CEO may receive options to purchase 100,000 common shares at $10 per purchase 100,000 common shares at $10 per share only if the market price of the company’s share only if the market price of the company’s stock reaches $50 or more per share. This is stock reaches $50 or more per share. This is

known as a variable option plan.known as a variable option plan.

19-20

Learning Objectives

Explain and implement the accounting for stock appreciation rights.

19-21

Stock Appreciation Rights

The recipient is awarded the The recipient is awarded the share share appreciationappreciation which is the amount by which is the amount by

which the market price on the exercise which the market price on the exercise date exceeds the option price.date exceeds the option price.

$ $ $$ $ $

19-22


Stock Appreciation Rights Payable in SharesStock Appreciation Rights Payable in Shares

Elective Fair Value ApproachElective Fair Value Approach: The fair value of the SARs : The fair value of the SARs is estimated at the date of grant and accrued to expense is estimated at the date of grant and accrued to expense over the service period.over the service period.

Alternative Intrinsic Value ApproachAlternative Intrinsic Value Approach: The compensation : The compensation may be measured at the end of the accounting period.may be measured at the end of the accounting period. (The FASB’s 2004 Exposure Draft eliminates this approach, except for nonpublic (The FASB’s 2004 Exposure Draft eliminates this approach, except for nonpublic companies and public companies for which fair value estimates are not reasonably companies and public companies for which fair value estimates are not reasonably possible.)possible.)

Stock Appreciation Rights Payable in SharesStock Appreciation Rights Payable in Shares

Elective Fair Value ApproachElective Fair Value Approach: The fair value of the SARs : The fair value of the SARs is estimated at the date of grant and accrued to expense is estimated at the date of grant and accrued to expense over the service period.over the service period.

Alternative Intrinsic Value ApproachAlternative Intrinsic Value Approach: The compensation : The compensation may be measured at the end of the accounting period.may be measured at the end of the accounting period. (The FASB’s 2004 Exposure Draft eliminates this approach, except for nonpublic (The FASB’s 2004 Exposure Draft eliminates this approach, except for nonpublic companies and public companies for which fair value estimates are not reasonably companies and public companies for which fair value estimates are not reasonably possible.)possible.)

19-23


Stock Appreciation Rights Payable in Cash Stock Appreciation Rights Payable in Cash (Liability)(Liability)

The compensation, and related liability, The compensation, and related liability, is estimated each period and is estimated each period and

continually adjusted to reflect changes continually adjusted to reflect changes in the market price of stock until the in the market price of stock until the

compensation is finally paid.compensation is finally paid.

Stock Appreciation Rights Payable in Cash Stock Appreciation Rights Payable in Cash (Liability)(Liability)

The compensation, and related liability, The compensation, and related liability, is estimated each period and is estimated each period and

continually adjusted to reflect changes continually adjusted to reflect changes in the market price of stock until the in the market price of stock until the

compensation is finally paid.compensation is finally paid.

19-24


Let’s see how to account for these SARs.Let’s see how to account for these SARs.

On January 1, 2006, Matrix, Inc. granted 10,000 On January 1, 2006, Matrix, Inc. granted 10,000 stock appreciation rights to 2 key executives. stock appreciation rights to 2 key executives.

Each is to receive cash for the difference between Each is to receive cash for the difference between a base price of $60 per share and the market a base price of $60 per share and the market

value of the stock on December 31 for each of the value of the stock on December 31 for each of the next 3 years. If elected by the executives, the first next 3 years. If elected by the executives, the first payment could be made on December 31, 2006.payment could be made on December 31, 2006.

On January 1, 2006, Matrix, Inc. granted 10,000 On January 1, 2006, Matrix, Inc. granted 10,000 stock appreciation rights to 2 key executives. stock appreciation rights to 2 key executives.

Each is to receive cash for the difference between Each is to receive cash for the difference between a base price of $60 per share and the market a base price of $60 per share and the market

value of the stock on December 31 for each of the value of the stock on December 31 for each of the next 3 years. If elected by the executives, the first next 3 years. If elected by the executives, the first payment could be made on December 31, 2006.payment could be made on December 31, 2006.

19-25

Stock Appreciation RightsOn December 31, 2006, Matrix common shares On December 31, 2006, Matrix common shares

closed at $64.50 per share.closed at $64.50 per share.

Let’s look at the entry to recognize the Let’s look at the entry to recognize the compensation expense for 2006.compensation expense for 2006.

19-26

GENERAL JOURNAL


Dec 31 Compensation expense 30,000 Liability - SAR plan 30,000


$90,000 ÷ 3 years = $30,000$90,000 ÷ 3 years = $30,000

On December 31, 2006, Matrix common shares On December 31, 2006, Matrix common shares closed at $64.50 per share.closed at $64.50 per share.

19-27

Stock Appreciation Rights On December 31, 2007, the stock closed at On December 31, 2007, the stock closed at

$75 per share.$75 per share.

19-28


GENERAL JOURNAL


Dec 31 Compensation expense 180,000 Liability - SAR plan 180,000

On December 31, 2007, the stock closed at On December 31, 2007, the stock closed at $75 per share.$75 per share.

19-29


GENERAL JOURNAL


Dec 31 Liability - SAR plan 210,000 Cash 210,000

On December 31, 2007, the executives On December 31, 2007, the executives exercised their SARs and receive the cash.exercised their SARs and receive the cash.

Liability – SAR plan12/31/06 $ 30,00012/31/07 180,000Balance 210,000

19-30

Learning Objectives

Explain and implement the accounting for stock purchase plans.

19-31

Employee Share Purchase Plans

Broad-based plans offer stock options to all Broad-based plans offer stock options to all employees rather than a select few.employees rather than a select few.

No compensation involved if . . .1.1. All employees meeting employment qualifications All employees meeting employment qualifications

participate.participate.

2.2. Equal offers of stock to all eligible employees.Equal offers of stock to all eligible employees.

3.3. Exercise period is reasonable.Exercise period is reasonable.

4.4. Only modest discount from the market price is Only modest discount from the market price is available.available.

Broad-based plans offer stock options to all Broad-based plans offer stock options to all employees rather than a select few.employees rather than a select few.

No compensation involved if . . .1.1. All employees meeting employment qualifications All employees meeting employment qualifications

participate.participate.

2.2. Equal offers of stock to all eligible employees.Equal offers of stock to all eligible employees.

3.3. Exercise period is reasonable.Exercise period is reasonable.

4.4. Only modest discount from the market price is Only modest discount from the market price is available.available.

19-32

Learning Objectives

Distinguish between a simple and a complex capital structure.

19-33

Earnings Per Share (EPS)

Of the myriad facts and figures generated Of the myriad facts and figures generated by accountants, the single accounting by accountants, the single accounting

number that is reported most frequently in number that is reported most frequently in the media and receives by far the most the media and receives by far the most attention by investors and creditors is attention by investors and creditors is

earnings per share.earnings per share.

19-34

Simple Capital Structure(Basic EPS)

Basic Earnings Per Share

Net income (after tax) – Preferred dividends*Weighted average outstanding common stock Net income (after tax) – Preferred dividends*Weighted average outstanding common stock

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and noncumulative preferred stock dividends noncumulative preferred stock dividends

(only if declared).(only if declared).

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and noncumulative preferred stock dividends noncumulative preferred stock dividends

(only if declared).(only if declared).

Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

19-35

Earnings Per Share

A company had 200,000 shares of $50 par value A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during was $1,500,000. No dividends were declared during the year. EPS would be the year. EPS would be

a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38


a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38

19-36


a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38


a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38

Earnings Per Share

$1,500,000 – (10,000 × 5% × $20 par)$1,500,000 – (10,000 × 5% × $20 par)200,000 shares200,000 shares

Since dividends were Since dividends were notnot declared, only declared, only the the cumulative preferred stockcumulative preferred stock dividends dividends

are subtracted.are subtracted.

$1,500,000 – (10,000 × 5% × $20 par)$1,500,000 – (10,000 × 5% × $20 par)200,000 shares200,000 shares

Since dividends were Since dividends were notnot declared, only declared, only the the cumulative preferred stockcumulative preferred stock dividends dividends

are subtracted.are subtracted.

19-37

Learning Objectives

Describe what is meant by the weighted average number of common shares.

19-38

Issuance of New Shares

Date Description No. of Shares1/1 Balance 100,000 4/1 Issued 50,000 10/1 Issued 10,000

Compute the weighted average number of Compute the weighted average number of shares of common stock outstanding.shares of common stock outstanding.

19-39

Issuance of New Shares


100,000100,000 + [50,000 + [50,000 ×× (9/12)] + [10,000 (9/12)] + [10,000 × (3/12)] = × (3/12)] = 140,000140,000SharesShares

at Jan. 1 at Jan. 1NewNew

SharesSharesNewNew

SharesShares

19-40

Learning Objectives

Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split, and

the reacquisition of shares.

19-41

Stock Dividends and Stock Splits

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the shares retroactively as subdivisions of the shares already outstanding at the date of the split already outstanding at the date of the split

or dividend.or dividend.

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the shares retroactively as subdivisions of the shares already outstanding at the date of the split already outstanding at the date of the split

or dividend.or dividend.

19-42


Compute the weighted average number of shares Compute the weighted average number of shares of common stock outstanding.of common stock outstanding.

Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Stock dividend(100%) 150,000

19-43



100,000 100,000 × (2.00) + [50,000 × (2.00) + [50,000 × (9/12) × 2.00]× (9/12) × 2.00] = = 275,000275,000SharesShares


SharesShares

Stock dividendStock dividendadjustmentadjustment

19-44


Retroactive treatment:Retroactive treatment:

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the period.beginning of the period.

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the period.beginning of the period.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the time shares outstanding at the time

of the dividend or split.of the dividend or split.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the time shares outstanding at the time

of the dividend or split.of the dividend or split.

New sharesNew sharesissued this period?issued this period?

New sharesNew sharesissued this period?issued this period?

YesYes NoNo

19-45

Reacquired Shares

The weighted average number of shares is The weighted average number of shares is reduced by the number of reacquired reduced by the number of reacquired

shares, time-weighted for the shares, time-weighted for the fraction of the fraction of the year they were year they were notnot outstanding outstanding..

The weighted average number of shares is The weighted average number of shares is reduced by the number of reacquired reduced by the number of reacquired

shares, time-weighted for the shares, time-weighted for the fraction of the fraction of the year they were year they were notnot outstanding outstanding..

19-46

Reacquired Shares


Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Repurchased shares 12,000

19-47

Reacquired Shares


100,000100,000 + [50,000 + [50,000 ×× (9/12)] - [12,000 (9/12)] - [12,000 × (8/12)] = × (8/12)] = 129,500129,500SharesShares


SharesSharesTreasuryTreasurySharesShares

19-48

Learning Objectives

Describe how preferred dividends affect the calculation of EPS

19-49

Earnings Available to Common Shareholders

Net incomeLess: Current period’s cumulative preferred stock dividends (whether or not declared)Less: Noncumulative preferred stock dividends (only if

declared).Net income available to common shareholders

19-50

Complex Capital StructureComplex Capital Structure(dual EPS)(dual EPS)

Dilution/Antidilution TestDilution/Antidilution Test

StockStockOptionsOptions

Convertible Convertible securitiessecurities

Treasury Treasury stock methodstock method

If-converted If-converted methodmethod

Contingently Contingently issuable issuable sharesshares

Potential Common Shares:Potential Common Shares:•Stock options, rights, and warrantsStock options, rights, and warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock issuesContingent common stock issues

Potential Common Shares:Potential Common Shares:•Stock options, rights, and warrantsStock options, rights, and warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock issuesContingent common stock issues

Diluted Earnings Per share

19-51

Complex Capital Structure

Dual presentation of Earnings Per Share:Dual presentation of Earnings Per Share:

Basic EPS Basic EPS Diluted EPSDiluted EPS

19-52

Learning Objectives

Describe how options, rights, and warrants are incorporated in the calculation of EPS.

19-53

Options, Rights, and Warrants

ProceedsProceeds

Used toUsed to

Purchase Purchase treasury treasury sharesshares

At At average average market market priceprice

The The treasury stock methodtreasury stock method assumes that proceeds from assumes that proceeds from the exercise of options are the exercise of options are used to purchase treasury used to purchase treasury

shares. This method usually shares. This method usually results in a net increase in results in a net increase in

shares included in the shares included in the denominator of the calculation denominator of the calculation of diluted earnings per share.of diluted earnings per share.

The The treasury stock methodtreasury stock method assumes that proceeds from assumes that proceeds from the exercise of options are the exercise of options are used to purchase treasury used to purchase treasury

shares. This method usually shares. This method usually results in a net increase in results in a net increase in

shares included in the shares included in the denominator of the calculation denominator of the calculation of diluted earnings per share.of diluted earnings per share.

19-54


Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Determine new shares from assumed Determine new shares from assumed exercise of stock options.exercise of stock options.

Compute number of shares repurchased. Compute number of shares repurchased.

19-55


Determine new shares from assumed Determine new shares from assumed exercise of stock options.exercise of stock options.

Compute shares purchased for the treasury. Compute shares purchased for the treasury.

Compute the incremental shares assumed Compute the incremental shares assumed outstanding.outstanding.

New shares from assumed exercise (1)New shares from assumed exercise (1)

Less: Treasury shares assumed purchasedLess: Treasury shares assumed purchased (2) (2)

Net increase in shares outstanding (3)Net increase in shares outstanding (3)

19-56


When the exercise price When the exercise price exceeds the market exceeds the market

price, the securities are price, the securities are antidilutiveantidilutive..

When the exercise price When the exercise price exceeds the market exceeds the market

price, the securities are price, the securities are antidilutiveantidilutive..

19-57

Treasury Stock Method

Common stock outstanding was 100,000 shares. Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. share. The average market price of the stock was $80. The net increase in the dilutive earnings per share The net increase in the dilutive earnings per share denominator isdenominator isa. 25,000 shares a. 25,000 shares b. 5,000 sharesb. 5,000 sharesc. 3,125 sharesc. 3,125 sharesd. 1,875 sharesd. 1,875 shares


19-58



Treasury Stock Method

New shares = 5,000New shares = 5,000Treasury shares = 3,125Treasury shares = 3,125 (5,000 × $50) ÷ $80 (5,000 × $50) ÷ $80Incremental shares = 1,875Incremental shares = 1,875 (5,000 - 3,125)(5,000 - 3,125)

New shares = 5,000New shares = 5,000Treasury shares = 3,125Treasury shares = 3,125 (5,000 × $50) ÷ $80 (5,000 × $50) ÷ $80Incremental shares = 1,875Incremental shares = 1,875 (5,000 - 3,125)(5,000 - 3,125)

19-59

Learning Objectives

Describe how convertible securities are incorporated in the calculation of EPS.

19-60

Convertible Securities

The The if-converted methodif-converted method is used for is used for

Convertible debt and equity Convertible debt and equity securitiessecurities

The method assumes conversion occurs as of The method assumes conversion occurs as of the the beginningbeginning of the period or date of of the period or date of issuance issuance, ,

if later.if later.

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The assumed conversion of convertible bonds or The assumed conversion of convertible bonds or preferred stock has two effects on dilutive preferred stock has two effects on dilutive earnings per share:earnings per share: Increases the denominator by the number of common Increases the denominator by the number of common

shares issuable upon conversion.shares issuable upon conversion. Increases the numerator by decreasing Increases the numerator by decreasing after-tax after-tax

interest expenseinterest expense on convertible bonds, and dividends on convertible bonds, and dividends on convertible preferred stock.on convertible preferred stock.

The assumed conversion of convertible bonds or The assumed conversion of convertible bonds or preferred stock has two effects on dilutive preferred stock has two effects on dilutive earnings per share:earnings per share: Increases the denominator by the number of common Increases the denominator by the number of common

shares issuable upon conversion.shares issuable upon conversion. Increases the numerator by decreasing Increases the numerator by decreasing after-tax after-tax

interest expenseinterest expense on convertible bonds, and dividends on convertible bonds, and dividends on convertible preferred stock.on convertible preferred stock.

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Dilutive earnings per share may decrease or Dilutive earnings per share may decrease or increase after the assumed conversion.increase after the assumed conversion.

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.

19-63

If-Converted Method

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, cumulative convertible preferred stock cumulative convertible preferred stock dividends of $25,000, common stock dividends of $25,000, common stock

outstanding of 50,000 shares, and a tax outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred rate of 30%. The convertible preferred stock is convertible into 5,000 shares of stock is convertible into 5,000 shares of

common stock. common stock.

Is the convertible preferred stock dilutive?Is the convertible preferred stock dilutive?

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, cumulative convertible preferred stock cumulative convertible preferred stock dividends of $25,000, common stock dividends of $25,000, common stock

outstanding of 50,000 shares, and a tax outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred rate of 30%. The convertible preferred stock is convertible into 5,000 shares of stock is convertible into 5,000 shares of


Is the convertible preferred stock dilutive?Is the convertible preferred stock dilutive?

19-64

If-Converted Method

= $9.50 EPS= $9.50 EPSEPS without conversion:EPS without conversion:

$500,000 – $500,000 – $25,000$25,000

50,000 shares50,000 sharesIf the preferred stock is converted, we would not have If the preferred stock is converted, we would not have

dividends and the number of shares of common stock would dividends and the number of shares of common stock would increase by 5,000 shares. There is not a tax effect.increase by 5,000 shares. There is not a tax effect.

= $9.09 EPS= $9.09 EPS DilutiveDilutiveDilutiveDilutive

EPS after assumed conversion:EPS after assumed conversion:$500,000 – $0$500,000 – $055,000 shares55,000 shares

19-65

If-Converted Method

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, convertible bonds with interest expense of convertible bonds with interest expense of

$50,000, common stock outstanding of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of bonds are convertible into 2,000 shares of


Are the convertible bonds dilutive?Are the convertible bonds dilutive?

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, convertible bonds with interest expense of convertible bonds with interest expense of

$50,000, common stock outstanding of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of bonds are convertible into 2,000 shares of


Are the convertible bonds dilutive?Are the convertible bonds dilutive?

19-66

If-Converted Method

= $10.00 EPS= $10.00 EPS

EPS without conversion:EPS without conversion: $500,000$500,000 50,000 shares50,000 shares

If the bonds are converted, net income would increase by If the bonds are converted, net income would increase by $35,000 (after taxes) and the number of shares of common $35,000 (after taxes) and the number of shares of common

stock would increase by 2,000 shares. stock would increase by 2,000 shares.

= $10.29 EPS= $10.29 EPS AntidilutiveAntidilutiveAntidilutiveAntidilutive

EPS after assumed conversion:EPS after assumed conversion:

$535,000$535,00052,000 52,000 sharesshares

19-67

Order of Entry for Multiple Convertible Securities

When a company has more than one When a company has more than one potentially dilutive security, they are potentially dilutive security, they are considered for inclusion in dilutive considered for inclusion in dilutive EPS in sequence from the EPS in sequence from the most most

dilutive to the least dilutivedilutive to the least dilutive..

When a company has more than one When a company has more than one potentially dilutive security, they are potentially dilutive security, they are considered for inclusion in dilutive considered for inclusion in dilutive EPS in sequence from the EPS in sequence from the most most

dilutive to the least dilutivedilutive to the least dilutive..

19-68

Learning Objectives

Explain the way contingently issuable shares are incorporated in the calculation of EPS.

19-69

Contingently Issuable Shares

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain upon the satisfaction of certain conditions.conditions.

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain upon the satisfaction of certain conditions.conditions.

FutureFuture

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Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Contingent shares are included in Contingent shares are included in dilutive EPS if:dilutive EPS if:

Contingent shares are included in Contingent shares are included in dilutive EPS if:dilutive EPS if:

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.

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Contingent shares are considered Contingent shares are considered outstanding common shares and are outstanding common shares and are

included in basic EPS as of the date that all included in basic EPS as of the date that all necessary conditions have been satisfied.necessary conditions have been satisfied.

Contingent shares are considered Contingent shares are considered outstanding common shares and are outstanding common shares and are

included in basic EPS as of the date that all included in basic EPS as of the date that all necessary conditions have been satisfied.necessary conditions have been satisfied.

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Summary

Potential Common Shares Basic EPS Diluted EPS Stock options (or warrants, rights) no yes Convertible securities (bonds, notes, preferred stock) no yes Contingently issuable shares no yes

Dilutive Effect Shown?

19-73

Summary

Potential Common Shares Numerator Denominator

Stock options (or warrants, rights)None

Add incremental shares

Convertible bonds or notes Add after tax interest

Add shares issuable upon

conversion

Convertible preferred Add back dividends declared

Add shares issuable upon

conversion Contingently issuable shares

Conditions being currently met None

Add shares issuable

Conditions not being met None None

Impact

19-74

Earnings Per Share Disclosure

Report EPS data separately for:

1. Income from Continuing Operations

2. Separately Reported Items

a) Discontinued Operations

b) Extraordinary Items

3. Net Income

19-75

Appendix 19

Option-Pricing Theory

19-76

Intrinsic Value

Intrinsic value is the benefit the holder of an option Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than would realize by exercising the option rather than

buying the underlying stock directly. An option that buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has permits an employee to buy $25 stock for $10, has

an intrinsic value of $15.an intrinsic value of $15.

Intrinsic value is the benefit the holder of an option Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than would realize by exercising the option rather than

buying the underlying stock directly. An option that buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has permits an employee to buy $25 stock for $10, has

an intrinsic value of $15.an intrinsic value of $15.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

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Summary

The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

All Other Factors Being Equal, If the: The Option Value Will Be: Exercise price is higher Lower Term of the option is longer Higher Market price of the stock is higher Higher Dividends are higher Lower Risk-free rate of return is higher Higher Volatility of the stock is higher Higher

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End of Chapter 19

Documents

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved. Share-Based Compensation and Earnings Per Share 19