Kế toán tài chính - Dilutive securities and earnings per share

PREVIEW OF CHAPTER 16Intermediate Accounting16th EditionKieso ● Weygandt ● Warfield Describe the accounting for the issuance, conversion, and retirement of convertible securities.Contrast the accounting for stock warrants and for stock warrants issued with other securities.LEARNING OBJECTIVESDescribe the accounting and reporting for stock compensation plans.Compute basic earnings per share.Compute diluted earnings per share.After studying this chapter, you should be able to:Dilutive Securities and Earnings per Share16LO 1DILUTIVE SECURITIESStock OptionsConvertible SecuritiesPreferred StockShould companies report these financial instruments as a liability or equity?LO 1Debt and Equity(at the holder’s option)Benefit of a Bond (guaranteed interest and principal)Privilege of Exchanging it for StockConvertible bonds can be changed into other corporate securities during some specified period of time after issuance.+LO 1Accounting for Convertible DebtDILUTIVE SECURITIESTo raise equity capital without giving up more ownership control than necessary.Obtain debt financing at cheaper rates.Two main reasons corporations issue convertibles:Accounting for Convertible DebtLO 1The accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement.At Time of IssuanceAccounting for Convertible DebtRecording convertible bonds follows the method used to record straight debt issues, with any discount or premium amortized over the term of the debt.LO 1Illustration: Miller Corporation issued $4,000,000 par value, 7% convertible bonds at 99 for cash. If the bonds had not included the conversion feature, they would have sold for 95. Record the entry at date of issuance. ($4,000,000 x 99% = $3,960,000)Accounting for Convertible DebtLO 1Issue Price =Cash 3,960,000Discount on Bonds Payable 40,000 Bonds Payable 4,000,000Accounting for Convertible DebtCompanies use the book value method when converting bonds.When the debtholder converts the debt to equity, the issuing company recognizes no gain or loss upon conversion.LO 1At Time of ConversionIllustration: Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. The bonds are converted on December 31, 2017, when the unamortized discount is $30,000 and the market price of the stock is $21 per share. Prepare the entry to record the conversion of the bonds.Accounting for Convertible DebtLO 1Bonds Payable 2,000,000 Discount on Bonds Payable 30,000 Common Stock (2,000 x 50 x $10) 1,000,000 Paid-in Capital in Excess of Par—Common 970,000Issuer wishes to encourage prompt conversion.Issuer offers additional consideration, called a “sweetener.”Sweetener is an expense of the current period.Accounting for Convertible DebtInduced ConversionLO 1Bonds Payable 2,000,000 Discount on Bonds Payable 30,000 Common Stock (2,000 x 50 x $10) 1,000,000 Paid-in Capital in Excess of Par—Common 970,000Illustration: Moore Corporation has outstanding 2,000, $1,000 bonds, each convertible into 50 shares of $10 par value common stock. Assume Moore wanted to reduce its annual interest cost and agreed to pay the bondholders $70,000 to convert. Accounting for Convertible DebtSameLO 1Debt Conversion Expense 70,000 Cash 70,000Recognized same as retiring debt that is not convertible.Difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement.Accounting for Convertible DebtRetirement of Convertible DebtLO 1Convertible preferred stock includes an option for the holder to convert preferred shares into a fixed number of common shares.Classified as part of stockholders’ equity, unless mandatory redemption exists.No theoretical justification for recognizing a gain or loss when exercised.DILUTIVE SECURITIESLO 1Convertible Preferred StockIllustration: Gall Inc. issued 2,000 shares of $10 par value common stock upon conversion of 1,000 shares of $50 par value preferred stock. The preferred stock was originally issued at $60 per share. The common stock is trading at $26 per share at the time of conversion. Prepare the entry to record the conversion.Convertible Preferred StockLO 1Preferred Stock 50,000Paid-in Capital in Excess of Par—Preferred 10,000 Common Stock (2,000 x $10) 20,000 Paid-in Capital in Excess of Par—Common 40,000LO 1What do Tesla Motors Inc., Twitter Inc., AOL Inc., Red Hat Inc., and Priceline Group Inc. all have in common? They are part of the wave of U.S. companies who have raised capital in the convertible bond market. And quite a wave it is. As indicated in the chart below, U.S. companies recently issued over $40 billion of convertible bonds.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? HOW LOW CAN YOU GO?(continued)These bonds are popular with issuing companies and investors. As we have discussed, companies like them because they allow them to raise money at rates lower than those on ordinary bonds. Investors like them because, at a time of low interest rates, they can book extra profit if the issuer’s stock price rises. However, LO 1depending on the features of the bond and the stock value, some unusual results may be observed. Consider the convertible bonds issued by STMicroelectronics (STM). STM’s 10-year bonds have a zero coupon and are convertible into STM common stock at an exercise price of $33.43. When issued, the bonds sold at an effective yield of minus 0.05 percent. That’s right—a negative yield. How could this happen? When STM issued the bonds, investors thought the options to convert were so valuable that they were willing to take zero interest payments and invest an amount in excess of the maturity value of the bonds. In essence, the investors are paying interest to STM, and STM records interest revenue. Why would investors do this? If the stock price rises, as many thought it would for STM and many tech companies at this time, these bond investors could convert and get a big gain in the stock. Investors did get some additional protection in the deal: They can redeem the $1,000 bonds after three years and receive $975 (and after five and seven years, for lower amounts) if it looks like the bonds will never convert. In the end, STM has issued bonds with a significant equity component. And because the entire bond issue is classified as debt, STM records negative interest expense.Sources: STM Financial Reports. See also Floyd Norris, “Legal but Absurd: They Borrow a Billion and Report a Profit,” The New York Times (August 8, 2003), p. C1; and M. Cherney, “Convertible Bonds Take Off in Low-Yield Era,” Wall Street Journal (October 5, 2014).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? HOW LOW CAN YOU GO?Describe the accounting for the issuance, conversion, and retirement of convertible securities.Contrast the accounting for stock warrants and for stock warrants issued with other securities.LEARNING OBJECTIVESDescribe the accounting and reporting for stock compensation plans.Compute basic earnings per share.Compute diluted earnings per share.After studying this chapter, you should be able to:Dilutive Securities and Earnings per Share16LO 2STOCK WARRANTSWarrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. Normally arises under three situations:To make the security more attractive.Existing stockholders have a preemptive right to purchase common stock first.To executives and employees as a form of compensation.LO 2Stock Warrants Issued with Other SecuritiesBasically long-term options to buy common stock at a fixed price. Generally life of warrants is five years, occasionally ten years.Proceeds allocated between the two securities.Allocation based on fair market values. Two methods of allocation: (1) proportional method (2) incremental methodLO 2STOCK WARRANTSProportional MethodDetermine:value of the bonds without the warrants, andvalue of the warrants.The proportional method allocates the proceeds using the proportion of the two amounts, based on fair values.LO 2STOCK WARRANTSIllustration: Margolf Corp. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98, and the warrants had a market value of $40. Use the proportional method to record the issuance of the bonds and warrants.LO 2Proportional MethodLO 2Cash 2,020,000Discount on Bonds Payable 59,216 Bonds Payable 2,000,000 Paid-in Capital – Stock Warrants 79,216 Proportional MethodLO 2Illustration: Assume each warrant can be exercised to buy one share of common stock ($5 par value) of Margolf Inc. for $30 per share. If investors exercise all 2,000 warrants (one warrant per one share of stock), Margolf Inc. makes the following entry. Cash (2,000 x $30) 60,000Paid-in Capital – Stock Warrants 79,216 Common Stock (2,000 x $5) 10,000 Paid-in Capital in Excess of Par—Common Stock 129,216Proportional MethodIncremental MethodWhere a company cannot determine the fair value of either the warrants or the bonds. Use the security for which fair value can determined. Allocate the remainder of the purchase price to the security for which it does not know fair value.LO 2STOCK WARRANTSIllustration: McCarthy Inc. issued 2,000, $1,000 bonds at 101. Each bond was issued with one detachable stock warrant. After issuance, the bonds were selling in the market at 98. Market price of the warrants, without the bonds, cannot be determined. Use the incremental method to record issuance of the bonds and warrants. LO 2Incremental MethodLO 2Cash 2,020,000Discount on Bonds Payable 40,000 Bonds Payable 2,000,000 Paid-in Capital – Stock Warrants 60,000Incremental MethodDetachable warrants involves two securities, a debt security, a warrant to purchase common stock.Nondetachable warrants do not require an allocation of proceeds between the bonds and the warrants, companies record the entire proceeds as debt.Conceptual QuestionsLO 2STOCK WARRANTSRights to Subscribe to Additional SharesStock Right - existing stockholders have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings.Price is normally less than current price of the shares.Companies make only a memorandum entry.LO 2STOCK WARRANTSMany argue that the conversion feature of a convertible bond is not significantly different in nature from the call represented by a warrant. The question is whether, although the legal forms differ, sufficient similarities of substance exist to support the same accounting treatment. Some contend that inseparability per se is an insufficient basis for restricting allocation between identifiable components of a transaction.Examples of allocation between assets of value in a single transaction do exist, such as allocation of values in basket purchases and separation of principal and interest in capitalizing long-term leases. Critics of the current accounting for convertibles say that to deny recognition of value to the conversion feature merely looks to the form of the instrument and does not deal with the substance of the transaction. In an exposure draft on this subject (project now inactive), the FASB indicates that companies should separate the debt and equity components of securities such as convertible debt or bonds issued with nondetachable warrants (see footnotes 1 and 6). We agree with this position. In both situations (convertible debt and debt issued with warrants, whether detachable or not), the investor has made aWHAT’S YOUR PRINCIPLEEVOLVING ISSUE IS THAT ALL DEBT?LO 2(continued)payment to the company for an equity feature—the right to acquire an equity instrument in the future. The only real distinction between them is that the additional payment made when the equity instrument is formally acquired takes different forms. The warrant holder pays additional cash to the issuing company; the convertible debt holder pays for stock by forgoing the receipt of interest from conversion date until maturity date and by forgoing the receipt of the maturity value itself. Thus, the difference is one of method or form of payment only, rather than one of substance. However, until the profession officially reverses its stand with respect to accounting for convertible debt, companies will continue to report convertible debt and bonds issued with nondetachable warrants solely as debt.WHAT’S YOUR PRINCIPLEEVOLVING ISSUE IS THAT ALL DEBT?LO 2Describe the accounting for the issuance, conversion, and retirement of convertible securities.Contrast the accounting for stock warrants and for stock warrants issued with other securities.LEARNING OBJECTIVESDescribe the accounting and reporting for stock compensation plans.Compute basic earnings per share.Compute diluted earnings per share.After studying this chapter, you should be able to:Dilutive Securities and Earnings per Share16LO 3Stock Option - gives key employees option to purchase common stock at a given price over extended period of time.Effective compensation programs are ones that: Base compensation on performance.Motivate employees.Help retain executives and recruit new talent.Maximize employee’s after-tax benefit.Use performance criteria over which employee has control. LO 3STOCK COMPENSATION PLANSIllustration 16-3 indicates that option expense is a much smaller element of compensation relative to restricted stock at companies such as Ford and Wal-Mart Stores, Inc.LO 3ILLUSTRATION 16-32014 Company Equity Grants ($ in millions)STOCK COMPENSATION PLANSMany companies decided to cut back on the issuance of options, both to avoid such accounting manipulations and to head off investor doubts. In addition, GAAP now results in companies recording a higher expense when stock options are granted. Measurement—Stock Compensation GAAP requires companies to recognize compensation cost using the fair-value method.Under the fair-value method, companies use acceptable option-pricing models to value the options at the date of grant.STOCK COMPENSATION PLANSLO 3The FASB faced considerable opposition when it proposed the fair value method for accounting for stock options. This is not surprising, given that the fair value method results in greater compensation costs relative to the intrinsic-value model. Merrill Lynch estimated that if all S&P 500 companies were to expense options, reported profits would fall by as much as 10 percent. Nevertheless, some companies, such as Coca-Cola, General Electric, Wachovia, and Bank One, decided to use the fair value method. You might think investors would punish companies that decided to expense stock options. After all, most of corporate America has been battling for years to avoid having to expense them, worried that accounting for those perks would destroy earnings. Yet, for this small band of big-name companies that voluntarily made the switch to expensing, investors for the most part showered them with love. As shown in the following table, with a few exceptions, the stock prices of the “expensers,” from Cinergy to The Washington Post, outpaced the market after they announced the change. WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WHAT’S THE DEBATE ABOUT?(continued)LO 3WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WHAT’S THE DEBATE ABOUT?(continued)LO 3So what’s the fuss? As the CFO of Coca-Cola stated, “There is no doubt that stock options are compensation. If they weren’t, none of us would want them.” It is puzzling why some companies continued to fight implementation of the expensing rule. Indeed, the market’s general positive reaction to the expensing of stock options provides a good case study supporting the value that investors place on transparent accounting and earnings. Sources: David Stires, “A Little Honesty Goes a Long Way,” Fortune (September 2, 2002), p. 186; and Troy Wolverton, “Foes of Expensing Welcome FASB Delay,” TheStreet.com (October 15, 2004).WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? WHAT’S THE DEBATE ABOUT?LO 3Two main accounting issues:How to determine compensation expense. Over what periods to allocate compensation expense.Recognition—Stock Compensation LO 3STOCK COMPENSATION PLANSDetermining ExpenseCompensation expense based on the fair value of the options expected to vest on the date they grant the options to the employee(s) (i.e., the grant date).Allocating Compensation ExpenseRecognizes compensation expense in the periods in which its employees perform the service—the service period.Recognition—Stock Compensation LO 3Illustration: On November 1, 2016, the stockholders of Searle Company approve a plan that grants the company’s five executives options to purchase 2,000 shares each of the company’s $1 par value common stock. The company grants the options on January 1, 2017. The executives may exercise the options at any time within the next 10 years. The option price per share is $60, and the market price of the shares at the date of grant is $70 per share. Under the fair value method, the company computes total compensation expense by applying an acceptable fair value option-pricing model. The fair value option-pricing model determines Searle’s total compensation expense to be $220,000.LO 3Recognition—Stock Compensation Basic Entries. Assume that the expected period of benefit is two years, starting with the grant date. Searle would record the transactions related to this option contract as follows.Compensation Expense 110,000 Paid-in Capital – Stock Options 110,000Dec. 31, 2017($220,000 ÷ 2)**Compensation Expense 110,000 Paid-in Capital - Stock Options 110,000Dec. 31, 2018LO 3Recognition—Stock Compensation Exercise. If Searle’s executives exercise 2,000 of the 10,000 options (20 percent of the options) on June 1, 2020 (three years and five months after date of grant), the company records the following journal entry.Cash (2,000 x $60) 120,000Paid-in Capital - Stock Options 44,000 Common Stock (2,000 x $1) 2,000 Paid-in Capital in Excess of Par - Common 162,000June 1, 2020LO 3Recognition—Stock Compensation Expiration. If Searle’s executives fail to exercise the remaining stock options before their expiration date, the company records the following at the date of expiration.Paid-in Capital - Stock Options 176,000 Paid-in Capital – Expired Stock Options 176,000Jan. 1, 2027($220,000 x 80%)**LO 3Recognition—Stock Compensation Adjustment. A company does not adjust compensation expense upon expiration of the options.However, if an employee forfeits a stock option because the employee fails to satisfy a service requirement (e.g., leaves employment), the company should adjust the estimate of compensation expense recorded in the current period (as a change in estimate).LO 3Recognition—Stock Compensation Restricted StockRestricted-stock plans transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs.Major Advantages:Never becomes completely worthless.Generally results in less dilution to existing stockholders.Better aligns employee incentives with company incentives.LO 3STOCK COMPENSATION PLANSIllustration: On January 1, 2017, Skidmore Company issues 1,000 shares of restricted stock to its CEO, Rail Stalker. Skidmore’s stock has a fair value of $20 per share on January 1, 2017. Additional information is as follows.The service period related to the restricted stock is five years.Vesting occurs if Stalker stays with the company for a five-year period.The par value of the stock is $1 per share.Skidmore makes the following entry on the grant date (January 1, 2017).Restricted Stock ExampleLO 3Unearned Compensation 20,000 Common Stock (1,000 x $1) 1,000 Paid-in Capital in Excess of Par (1,000 x $19) 19,000Unearned Compensation represents the cost of services yet to be performed, which is not an asset. Unearned Compensation is reported as a component of stockholders’ equity in the balance sheet.Illustration: Skidmore makes the following entry on the grant date (January 1, 2017).LO 3Restricted Stock ExampleCompensation Expense 4,000 Unearned Compensation 4,000Skidmore records compensation expense of $4,000 for each of the next four years (2018, 2019, 2020, and 2021).Illustration: Record the journal entry at December 31, 2017, Skidmore records compensation expense.LO 3Restricted Stock ExampleCommon Stock 1,000Paid-in Capital in Excess of Par - Common 19,000 Compensation Expense ($4,000 x 2) 8,000 Unearned Compensation 12,000Illustration: Assume that Stalker leaves on February 3, 2019 (before any expense has been recorded during 2019). The entry to record this forfeiture is as followsLO 3Restricted Stock ExampleEmployee Stock-Purchase Plans Generally permit all employees to purchase stock at a discounted price for a short period of time. Plans are considered compensatory unless they satisfy all three conditions presented below.Substantially all full-time employees may participate on an equitable basis.The discount from market is small. The plan offers no substantive option feature.LO 3STOCK COMPENSATION PLANSDisclosure of Compensation PlansCompany with one or more share-based payment arrangements must disclose:Nature and extent of such arrangements.Effect on the income statement of compensation cost.Method of estimating the fair value of the goods or services received, or the fair value of the equity instruments granted (or offered to grant). Cash flow effects.LO 3STOCK COMPENSATION PLANSDescribe the accounting for the issuance, conversion, and retirement of convertible securities.Contrast the accounting for stock warrants and for stock warrants issued with other securities.LEARNING OBJECTIVESDescribe the accounting and reporting for stock compensation plans.Compute basic earnings per share.Compute diluted earnings per share.After studying this chapter, you should be able to:Dilutive Securities and Earnings per Share16LO 4LO 4Earnings per share indicates the income earned by each share of common stock.Companies report earnings per share only for common stock.When the income statement contains intermediate components, such as discontinued operations, companies should disclose earnings per share for each component.BASIC EARNINGS PER SHAREILLUSTRATION 16-7 Income Statement Presentation of EPSILLUSTRATION 16-8 Income Statement Presentation of EPS ComponentsSimple Structure--Common stock; no potentially dilutive securities.Complex Structure--Includes securities that could dilute earnings per common share.“Dilutive” means the ability to influence the EPS in a downward direction.LO 4Earnings per Share—Simple Capital StructureBASIC EARNINGS PER SHAREPreferred Stock DividendsSubtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders.Preferred dividends are subtracted on cumulative preferred stock, whether declared or not. LO 4BASIC EARNINGS PER SHAREILLUSTRATION 16-9 Formula for Computing Earnings per ShareWeighted-Average Number of Shares OutstandingCompanies must weight the shares by the fraction of the period they are outstanding.When stock dividends or share splits occur, companies need to restate the shares outstanding before the share dividend or split.LO 4BASIC EARNINGS PER SHAREIllustration: Zachsmith Inc. has the following changes in its common stock during the period.Compute the weighted-average number of shares outstanding for Zachsmith Inc.Weighted-Average Shares OutstandingLO 4ILLUSTRATION 16-10Shares Outstanding, Ending BalanceLO 4ILLUSTRATION 16-10Weighted-Average Shares OutstandingILLUSTRATION 16-11Weighted-Average Number of Shares OutstandingIllustration: Bergman Company has the following changes in its common stock during the period.Compute the weighted-average number of shares outstanding for Bergman Company.Weighted-Average Shares OutstandingLO 4ILLUSTRATION 16-12Shares Outstanding, Ending Balance— Bergman CompanyLO 4ILLUSTRATION 16-12Weighted-Average Shares OutstandingILLUSTRATION 16-13Weighted-Average Number of Shares Outstanding— Stock Issue and Stock DividendDescribe the accounting for the issuance, conversion, and retirement of convertible securities.Contrast the accounting for stock warrants and for stock warrants issued with other securities.LEARNING OBJECTIVESDescribe the accounting and reporting for stock compensation plans.Compute basic earnings per share.Compute diluted earnings per share.After studying this chapter, you should be able to:Dilutive Securities and Earnings per Share16LO 5Complex Capital Structure exists when a business hasconvertible securities, options, warrants, or other rights that upon conversion or exercise could dilute earnings per share. DILUTED EARNINGS PER SHARE LO 5Company generally reports both basic and diluted earnings per share.Diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period.Companies will not report diluted EPS if the securities in their capital structure are antidilutive.LO 5DILUTED EARNINGS PER SHARE ILLUSTRATION 16-18Relationship between Basic and Diluted EPSDiluted EPS — Convertible SecuritiesMeasure the dilutive effects of potential conversion on EPS using the if-converted method.This method for a convertible bond assumes: the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and the elimination of related interest, net of tax.LO 5DILUTED EARNINGS PER SHARE Illustration: Mayfield Corporation has net income of $210,000 for the year and a weighted-average number of common shares outstanding during the period of 100,000 shares. The company has two convertible debenture bond issues outstanding. One is a 6 percent issue sold at 100 (total $1,000,000) in a prior year and convertible into 20,000 common shares. Interest expense on the 6 percent convertibles is $60,000. The other is a 10 percent issue sold at 100 (total $1,000,000) on April 1 of the current year and convertible into 32,000 common shares. Interest expense on the 10 percent convertible bond is $75,000. The tax rate is 40 percent.Example — If-Converted Method LO 5Net income = $210,000Weighted-average shares = 100,000=$2.10Calculate basic earnings per share.LO 5Example — If-Converted Method Mayfield calculates the weighted-average number of shares outstanding, as follows.Calculate diluted earnings per share.LO 5Example — If-Converted Method ILLUSTRATION 16-20Computation of Weighted-Average Number of SharesWhen calculating Diluted EPS, begin with basic EPS.$210,000100,000=+$60,000 x (1 - .40)20,000Basic EPS = $2.10Effect on EPS = $1.80+++$100,000 x (1 - .40) x 9/1224,000Effect on EPS = $1.875Diluted EPS = $2.026% Debentures10% DebenturesBasic EPSLO 5Example — If-Converted Method Other FactorsThe conversion rate on a dilutive security may change during the period in which the security is outstanding. In this situation, the company uses the most dilutive conversion rate available.For Convertible Preferred Stock the company does not subtract preferred dividends from net income in computing the numerator. Why not? Because for purposes of computing EPS, it assumes conversion of the convertible preferreds to outstanding common shares.LO 5Example — If-Converted Method Illustration: In 2016, Chirac Enterprises issued, at par, 60, $1,000, 8% bonds, each convertible into 100 shares of common stock. Chirac had revenues of $17,500 and expenses other than interest and taxes of $8,400 for 2017. (Assume that the tax rate is 40%.) Throughout 2017, 2,000 shares of common stock were outstanding; none of the bonds was converted or redeemed.Instructions(a) Compute diluted earnings per share for 2017.(b) Assume same facts as those for Part (a), except the 60 bonds were issued on September 1, 2017 (rather than in 2016), and none have been converted or redeemed.LO 5Example — If-Converted Method (a) Compute diluted earnings per share for 2017.Calculation of Net IncomeRevenues $17,500Expenses 8,400Bond interest expense (60 x $1,000 x 8%) 4,800Income before taxes 4,300Income tax expense (40%) 1,740Net income $ 2,580LO 5Example — If-Converted Method When calculating Diluted EPS, begin with basic EPS.Net income = $2,580Weighted average shares = 2,000=$1.29Basic EPSLO 5(a) Compute diluted earnings per share for 2017.Example — If-Converted Method $2,5802,000=$.68Diluted EPS+$4,800 (1 - .40)6,000Basic EPS = $1.29$5,4608,000=Effect on EPS = $.48+LO 5(a) Compute diluted earnings per share for 2017.When calculating Diluted EPS, begin with basic EPS.Example — If-Converted Method (b) Assume bonds were issued on Sept. 1, 2017 .LO 5Calculation of Net IncomeExample — If-Converted Method $4,5002,000=$1.37Diluted EPS$1,600 (1 - .40)6,000 x 4/12 yr.$5,4604,000=Effect on EPS = $.48Basic EPS = $2.25++LO 5(b) Assume bonds were issued on Sept. 1, 2017 .When calculating Diluted EPS, begin with basic EPS.Example — If-Converted Method Illustration: Prior to 2017, Barkley Company issued 40,000 shares of 6% convertible, cumulative preferred stock, $100 par value. Each share is convertible into 5 shares of common stock. Net income for 2017 was $1,200,000. There were 600,000 common shares outstanding during 2017. There were no changes during 2017 in the number of common or preferred shares outstanding.Instructions(a) Compute diluted earnings per share for 2017.LO 5Example — If-Converted Method (a) Compute diluted earnings per share for 2017.When calculating Diluted EPS, begin with basic EPS.Net income $1,200,000 – Pfd. Div. $240,000 *Weighted average shares = 600,000=$1.60Basic EPS* 40,000 shares x $100 par x 6% = $240,000 dividendLO 5Example — If-Converted Method 600,000=$1.50Diluted EPS$240,000Basic EPS = $1.60=Effect on EPS = $1.20$1,200,000 – $240,000200,000*$1,200,000800,000*(40,000 x 5)++(a) Compute diluted earnings per share for 2017.When calculating Diluted EPS, begin with basic EPS.LO 5Example — If-Converted Method 600,000=$1.67Diluted EPS$240,000Basic EPS = $1.60=(a) Compute diluted earnings per share for 2017 assuming each share of preferred is convertible into 3 shares of common stock. $1,200,000 – $240,000120,000*$1,200,000720,000*(40,000 x 3)++LO 5Effect on EPS = $2.00Example — If-Converted Method 600,000=$1.67Diluted EPS$240,000Basic EPS = $1.60=Effect on EPS = $2.00$1,200,000 – $240,000120,000*$1,200,000720,000*(40,000 x 3)AntidilutiveBasic = Diluted EPS++(a) Compute diluted earnings per share for 2017 assuming each share of preferred is convertible into 3 shares of common stock. LO 5Example — If-Converted Method Diluted EPS – Options and WarrantsMeasure the dilutive effects of potential conversion using the treasury-stock method.This method assumes: the exercise the options or warrants at the beginning of the year (or date of issue if later), and that the company uses those proceeds to purchase common stock for the treasury.LO 5DILUTED EARNINGS PER SHARE Illustration: Zambrano Company’s net income for 2017 is $40,000. The only potentially dilutive securities outstanding were 1,000 options issued during 2016, each exercisable for one share at $8. None has been exercised, and 10,000 shares of common were outstanding during 2017. The average market price of the stock during 2017 was $20.Instructions(a) Compute diluted earnings per share. (b) Assume the 1,000 options were issued on October 1, 2017 (rather than in 2016). The average market price during the last 3 months of 2017 was $20.LO 5Example — Treasury-Stock Method Proceeds if shares issued (1,000 x $8) $8,000Purchase price for treasury shares $20Shares assumed purchased 400Shares assumed issued 1,000Incremental share increase 600(a) Compute diluted earnings per share for 2017.Treasury-Stock Method÷LO 5Example — Treasury-Stock Method When calculating Diluted EPS, begin with basic EPS.$40,00010,000=$3.77Diluted EPS+600Basic EPS = $4.00$40,00010,600=Options+LO 5(a) Compute diluted earnings per share for 2017.Example — Treasury-Stock Method Treasury-Stock Method÷(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2017.xLO 5Example — Treasury-Stock Method $40,00010,000=$3.94Diluted EPS150Basic EPS = $4.00$40,00010,150=Options+LO 5(b) Compute diluted earnings per share assuming the 1,000 options were issued on October 1, 2017.Example — Treasury-Stock Method Contingent Issue AgreementContingent shares are issued as a result of thepassage of time condition or upon attainment of a certain earnings or market price level.Antidilution RevisitedIgnore antidilutive securities in all calculations and in computing diluted earnings per share.LO 5DILUTED EARNINGS PER SHARE EPS Presentation and DisclosureA company should show per share amounts for: Income from continuing operations, Income before extraordinary items, and Net income.Per share amounts for a discontinued operation or an extraordinary item should be presented on the face of the income statement or in the notes.LO 5DILUTED EARNINGS PER SHARE Complex capital structures and dual presentation of EPS require the following additional disclosures in note form.Description of pertinent rights and privileges of the various securities outstanding.A reconciliation of the numerators and denominators of the basic and diluted per share computations, including individual income and share amount effects of all securities that affect EPS.The effect given preferred dividends in determining income available to common stockholders in computing basic EPS.Securities that could potentially dilute basic EPS in the future that were excluded in the computation because they would be antidilutive.Effect of conversions subsequent to year-end, but before issuing statements.LO 5EPS Presentation and DisclosureMany companies are reporting pro forma EPS numbers along with GAAP-based EPS numbers in the financial information provided to investors. Pro forma earnings generally exceed GAAP earnings because the pro forma numbers exclude such items as restructuring charges, impairments of assets, R&D expenditures, and stock compensation expense. In some industries such as high-tech, the major item excluded is stock compensation expense.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? PRO FORMA EPS CONFUSION(continued)LO 5Google is a classic example. As indicated by one analyst, Google paid out huge, share-laden compensation packages totaling more than $300 million recently to three key executives. Only a small amount of this compensation will be reported in the non-GAAP income measures.Another case of possibly misleading pro forma reporting is social gaming company Zynga. It recently reported so much stock-compensation expense ($600 million) that it overwhelmed its operating profit; these expenses took operating profit negative to the tune of $406 million. The accounting? Zynga “window dressed” the expense by encouraging Wall Street analysts to use a non-GAAP pro forma accounting figure—“adjusted earnings before interest, taxes, depreciation and amortization”—that ignores the stock compensation. LinkedIn and Groupon also use non-GAAP metrics that exclude stock compensation. LinkedIn’s $30 million stock compensation expense roughly halved its operating profit, while Groupon’s $94 million took operating profit $203 million into the red. Wall Street analysts tend to go along with the accounting hocus-pocus, as it allows them to justify higher valuations for stocks. Investors should remember, however, that employee equity awards are real costs. As discussed in Chapter 4, SEC Regulation G requires companies to provide a clear reconciliation between pro forma and GAAP information. And this applies to EPS measures as well. This reconciliation is especially important, given the spike in pro forma reporting by companies adding back employee stock-option expense.WHAT’S YOUR PRINCIPLEWHAT DO THE NUMBERS MEAN? PRO FORMA EPS CONFUSIONLO 5Sources: M. Moran, A. J. Cohen, and K. Shaustyuk, “Stock Option Expensing: The Battle Has Been Won; Now Comes the Aftermath,” Portfolio Strategy/Accounting, Goldman Sachs (March 17, 2005); R. Winkler, “Stock and Awe at Facebook and Zynga,” Wall Street Journal (February 16, 2012); and A. Bary, “How Much Do Silicon Valley Firms Really Earn?” Barrons (June 27, 2015).ILLUSTRATION 16-28 Calculating EPS, Simple Capital Structure Summary of EPS Computation LO 5Earnings per ShareLO 5ILLUSTRATION 16-29 Calculating EPS, Complex Capital Structure Stock-Appreciation Rights (SARs):Company gives an executive the right to receive compensation equal to the share appreciation. Share appreciation is the excess of the market price of the stock at the date of exercise over a pre-established price. Company may pay the share appreciation in cash, shares, or a combination of both.Accounting for stock-appreciation rights depends on whether the company classifies the rights as equity or as a liability.LO 6 Explain the accounting for stock-appreciation rights plans.ACCOUNTING FOR STOCK-APPRECIATION RIGHTSAPPENDIX 16ASARS — SHARE-BASED EQUITY AWARDSCompanies classify SARs as equity awards if at the date of exercise, the holder receives shares of stock from the company upon exercise. Holder receives shares in an amount equal to the share-price appreciation (the difference between the market price and the pre-established price). At the date of grant, the company determines a fair value for the SAR and then allocates this amount to compensation expense over the service period of the employees.ACCOUNTING FOR STOCK-APPRECIATION RIGHTSLO 6APPENDIX 16ASARS — SHARE-BASED LIABILITY AWARDSCompanies classify SARs as liability awards if at the date of exercise, the holder receives a cash payment. To record share-based liability:Measure the fair value of the award at the grant date and accrue compensation over the service period.Remeasure the fair value each reporting period, until the award is settled; adjust the compensation cost each period for changes in fair value prorated for the portion of the service period completed.Once the service period is completed, determine compensation expense each subsequent period by reporting the full change in market price as an adjustment to compensation expense.ACCOUNTING FOR STOCK-APPRECIATION RIGHTSLO 6APPENDIX 16AIllustration: American Hotels, Inc. establishes a stock-appreciation rights plan on January 1, 2017. The plan entitles executives to receive cash at the date of exercise for the difference between the market price of the stock and the pre-established price of $10 on 10,000 SARs. The fair value of the SARs on December 31, 2017, is $3, and the service period runs for two years (2017–2018).Illustration 16A-1 indicates the amount of compensation expense to be recorded each period.ACCOUNTING FOR STOCK-APPRECIATION RIGHTSLO 6APPENDIX 16AAmerican Hotels records compensation expense in the first year as follows.Compensation Expense 15,000 Liability under Stock-Appreciation Plan 15,000ACCOUNTING FOR STOCK-APPRECIATION RIGHTSLO 6APPENDIX 16AILLUSTRATION 16A-1Compensation Expense, Stock-Appreciation RightsIn 2019, when it records negative compensation expense, American would debit the account for $20,000. The entry to record the negative compensation expense is as follows.Liability under Stock-Appreciation Plan 20,000 Compensation Expense 20,000At December 31, 2019, the executives receive $50,000. American would remove the liability with the following entry.Liability under Stock-Appreciation Plan 50,000 Cash 50,000ACCOUNTING FOR STOCK-APPRECIATION RIGHTSLO 6APPENDIX 16ALO 7 Compute earnings per share in a complex situation.COMPREHENSIVE EARNINGS PER SHARE EXAMPLEAPPENDIX 16BILLUSTRATION 16B-1Balance Sheet for Comprehensive IllustrationIllustration 16-B1COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-1Balance Sheet for Comprehensive IllustrationComputation of Earnings per Share—Simple Capital StructureCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-2Computation of Earnings per Share—Simple Capital StructureDILUTED EARNINGS PER SHARESteps for computing diluted earnings per share:Determine, for each dilutive security, the per share effect assuming exercise/conversion.Rank the results from step 1 from smallest to largest earnings effect per share. Beginning with the earnings per share based upon the weighted-average of common stock outstanding, recalculate earnings per share by adding the smallest per share effects from step 2. Continue this process so long as each recalculated earnings per share is smaller than the previous amount. COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BThe first step is to determine a per share effect for each potentially dilutive security.Per Share Effect of Options (Treasury-Share Method), Diluted Earnings per ShareCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-3The first step is to determine a per share effect for each potentially dilutive security.Per Share Effect of 8% Bonds (If-Converted Method), Diluted Earnings per ShareCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-4The first step is to determine a per share effect for each potentially dilutive security.Per Share Effect of 10% Bonds (If-Converted Method), Diluted Earnings per ShareCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-5The first step is to determine a per share effect for each potentially dilutive security.Per Share Effect of 10% Convertible preferred stocks (If-Converted Method), Diluted Earnings per ShareCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-6The first step is to determine a per share effect for each potentially dilutive security.Ranking of per Share Effects (Smallest to Largest), Diluted Earnings per ShareCOMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-7The next step is to determine earnings per share giving effect to the ranking.Recomputation of EPS Using Incremental Effect of OptionsThe effect of the options is dilutive.COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BILLUSTRATION 16B-8The next step is to determine earnings per share giving effect to the ranking.Recomputation of EPS Using Incremental Effect of 8% Convertible BondsILLUSTRATION 16-B9The effect of the 8% convertible bonds is dilutive.COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BThe next step is to determine earnings per share giving effect to the ranking.Recomputation of EPS Using Incremental Effect of 10% Convertible BondsILLUSTRATION 16-B10The effect of the 10% convertible bonds is dilutive.COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BThe next step is to determine earnings per share giving effect to the rankingRecomputation of EPS Using Incremental Effect of 10% Convertible preferredILLUSTRATION 16-B11The effect of the 10% convertible preferred stocks is NOT dilutive.COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BFinally, Webster Corporation’s disclosure of earnings pershare on its income statement.ILLUSTRATION 16-B12COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7APPENDIX 16BAssume that Barton Company provides the following information.Basic and Diluted EPSILLUSTRATION 16-B14COMPREHENSIVE EARNINGS PER SHARE EXAMPLELO 7ILLUSTRATION 16-B13APPENDIX 16BLO 8 Compare the accounting for dilutive securities and earnings per share under GAAP and IFRS.RELEVANT FACTS - SimilaritiesIFRS and GAAP follow the same model for recognizing stock-based compensation: The fair value of shares and options awarded to employees is recognized over the period to which the employees’ services relate.Although the calculation of basic and diluted earnings per share is similar between IFRS and GAAP, the Boards are working to resolve the few minor differences in EPS reporting. One proposal in the FASB project concerns contracts that can be settled in either cash or shares. IFRS requires that share settlement must be used, while GAAP gives companies a choice. The FASB project proposes adopting the IFRS approach, thus converging GAAP and IFRS in this regard.RELEVANT FACTS - DifferencesA significant difference between IFRS and GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under IFRS, convertible bonds are “bifurcated”—separated into the equity component (the value of the conversion option) of the bond issue and the debt component. Related to employee share-purchase plans, under IFRS, all employee share-purchase plans are deemed to be compensatory; that is, compensation expense is recorded for the amount of the discount. Under GAAP, these plans are often considered noncompensatory and therefore no compensation is recorded. Certain conditions must exist before a plan can be considered noncompensatory—the most important being that the discount generally cannot exceed 5 percent.LO 8RELEVANT FACTS - DifferencesModification of a share option results in the recognition of any incremental fair value under both IFRS and GAAP. However, if the modification leads to a reduction, IFRS does not permit the reduction but GAAP does. Other EPS differences relate to (1) the treasury-stock method and how the proceeds from extinguishment of a liability should be accounted for, and (2) how to compute the weighted average of contingently issuable shares.LO 8ON THE HORIZONThe FASB has been working on a standard that will likely converge to IFRS in the accounting for convertible debt. Similar to the FASB, the IASB is examining the classification of hybrid securities; the IASB is seeking comment on a discussion document similar to the FASB Preliminary Views document, “Financial Instruments with Characteristics of Equity.” It is hoped that the Boards will develop a converged standard in this area. While GAAP and IFRS are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations.LO 8All of the following are key similarities between GAAP and IFRS with respect to accounting for dilutive securities and EPS except:the model for recognizing stock-based compensation.the calculation of basic and diluted EPS.the accounting for convertible debt.the accounting for modifications of share options, when the value increases.IFRS SELF-TEST QUESTIONLO 8Which of the following statements is correct?IFRS separates the proceeds of a convertible bond between debt and equity by determining the fair value of the debt component before the equity component.Both IFRS and GAAP assume that when there is choice of settlement of an option for cash or shares, share settlement is assumed.IFRS separates the proceeds of a convertible bond between debt and equity, based on relative fair values.Both GAAP and IFRS separate the proceeds of convertible bonds between debt and equity.IFRS SELF-TEST QUESTIONLO 8Under IFRS, convertible bonds:are separated into the bond component and the expense component.are separated into debt and equity components.are separated into their components based on relative fair values.All of the above.IFRS SELF-TEST QUESTIONLO 8“Copyright © 2016 John Wiley & Sons, Inc. 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