Chapter 16: Dilutive Securities and Earnings per Share

Question 1

Liabilities vs Equity

Answer 1

Liabilities - include an obligation to pay the liability holder at some future point. measured at fair value with changes reported in income

differentiating liabilities vs equity is a current FASB project

Question 2

control number

Answer 2

Income from continued operations used to determine if a potential common stock is dilutive or antidilutive

Instead of using final net loss as basic EPS numerator

Question 3

Treasury stock method of calculating dilutive EPS

Answer 3

Used for options, warrants and equivalents

• assumes that options/warrants are exercised at the beginning of the year or date of issue
• assumes the company uses the proceeds to purchase common stock for treasury

Shares issue upon exercise of warrant/option
less treasury shares purchasable with proceeds (market price - option price / market price x number of options = number of treasury shares)
= incremental shares oustanding

Question 4

Treasury stock method Average common shares outstanding

Answer 4

average number of shares related to options outstanding x option price per share
= proceeds upon exercise of options

Proceeds / average market price of common stock = treasury shares that could be repurchased

Excess number of shares under option over treasury shares repurchased = potential common incremental shares + average number of common shares outstanding

Question 5

Calculating interest expense avoided

Answer 5

Interest expense for year
less income tax reduction (tax rate x interest)
= interest expense avoided

Question 6

Calculating an amount net of tax

Answer 6

Amount x (1-tax rate)

may need to adjust for a partial year

Question 7

Calculating weighted average shares outstanding for stock dividends / stock splits

Answer 7

Must restate shares outstanding prior to the dividend/ split as if the shares were in place all year

no change to total investment

so if 25% dividend declared then multiply outstanding shares from earlier periods by 1.25
3 to 1 split = multiply by 3

if occurs after year end buy before statements are issued then must restate all of the previous year

Question 8

Calculating weighted average number of shares oustanding

Answer 8

outstanding shares weighted by fraction of period outstanding to get equivalent whole shares for the year

shares purchased by company reduce total shares outstanding

Period (shares outstanding x fraction of the year) = weighted shares
sum all weighted shares for total shares

Question 9

Earnings per share: simple capital structure

Answer 9

= net income - preferred dividends / weighted average common shares outstanding

EPS = income available to common stockholders

if net loss:
= net loss + preferred dividends / weighted average common shares outstanding (WACSO)

if cumulative preferred stock but no declared dividends subtract amount of preferred dividends that would be for the current year only as any dividends in arrears would have been in previous year’s computations

Question 10

How to tell if a security is antidilutive

Answer 10

(if antidilutive should be excluded from diluted EPS)

If conversion of security will increase EPS then security is antidilutive

Occurs with:

• options and warrants where exercise price is greater than market price
• convertible debt where increase from addition of net of tax interest to income is greater than percentage increase in common shares from conversion

easiest just to check the math

Question 11

Reporting EPS with diluted EPS

Answer 11

Net Income (underlined)

EPS (underlined)
Basic EPS (double underlined) 

Diluted EPS (double underlined)

Question 12

If-converted method for calculating diluted EPS

Answer 12

Assumes:

• conversion at the time of issue or the beginning of the period
• elimination of related interest expense, net of tax

if sold at premium or discount must adjust

net income may or may not increase depending on interest effect/tax effect (numerator)
weighted average shares increases (denominator)

must consider portion of the year

Question 13

Calculating diluted EPS

Answer 13

Basic EPS
less impact of convertibles
less impact of options, warrants, and other dilutive securities

if conversion rate changes over the year must calculate the most dilutive option

Question 14

Convertible preferred stock and dilutive shares

Answer 14

• convertible preferred stock = potential common shares, included in diluted EPS
• do NOT subtract preferred dividends in the numerator (since if there is no preferred stock there will be no preferred dividends)

No tax effect because preferred dividends are not generally taxable

Question 15

EPS presentation on income statement

Answer 15

• list both basic EPS and Diluted EPS
• split into continuing ops and discontinued ops when applicable
• show EPS for all periods presented
• if show diluted EPS for one period must show for all
• must restate if statments are restated

Question 16

EPS disclosures

Answer 16

Required for complex capital structures/ dual presentation
Must disclose:
- pertinent rights and privileges for securities
- reconciliation of basic and dilutive EPS calculation
- income and share amounts from all activities that affect EPS
- effect of any preferred dividends
- potential future dilutive securities not currently included
- effects of conversions after year end but before statements are released

Question 17

Recording compensation expense under stock appreciation plan

Answer 17

Debit Compensation expense
Credit Liability Under Stock-Appreciation plan

When paid out:
Debit Liability Under Stock-Appreciation Plan
Credit Cash

Question 18

Percentage approach of allocating compensation expense

Answer 18

every period charges total percent of service period served to date less amounts already charged

adjusted for change in market price if change in prices occurs in subsequent periods or until rights expired or exercised

cumulative expense cannot be negative

Question 19

Recording share based liability awards

Answer 19

1) Measure fair value at grant date and accrue compensation over the service period
2) re-measure fair value each reporting period until award is settled. Adjust compensation prorated for portion of service period completed.
3) when service period completed compensation expense in subsequent periods = full change in market price

Question 20

Share-based liability awards

Answer 20

SARs = liability if, at date of exercise, holder receives a cash payment of the amount of share-price appreciation

Question 21

Share-based Equity awards

Answer 21

SARs = equity if, at date of exercise, the holder receives stock

creates equivalent stock option

shares received = share price appreciation

follows accounting for stock options
- compensation expense recorded over service period

Question 22

Stock-appreciation rights

Answer 22

SARs
Right to receive compensation equal to share appreciation
- may be paid in cash, shares, or a combination
- no cash outlay required to receive payment
- shares not actually issued
- accounting depends on how company classifies rights - as liability or equity

Question 23

Share appreciation

Answer 23

the excess of market price of the stock at date of exercise over a preestablished price

Question 24

Incentive stock option plan

Answer 24

No taxes paid at exercise

may need to borrow to finance exercise price (leads to interest expense)

Question 25

Nonqualified stock option plans

Answer 25

require purchaser to pay income tax on difference between market price and option price

Question 26

Calculating cumulative preferred stock and EPS

Answer 26

Subtract preferred dividend from net income even if dividend is not declared

Question 27

Steps for computing diluted EPS

Answer 27

1) for each dilutive security determine the per share effect of exercise or conversion
2) rank results from smallest to largest effect
3) as long as earnings per share total is less than simple EPS, starting with smallest per share effect add dilutive securities to EPS

Question 28

Contingent issue agreement

Answer 28

shares to be issued upon certain conditions in a business combination (passage of time, market price level)

if contingency is within current year then company considers contingent shares outstanding for basic and diluted EPS

Question 29

Antidilutive securities

Answer 29

Upon conversion EPS in increased (or loss per share is decrease)

NOT reported in financial statements

• likelihood of conversion/exercise considered remote
• basic EPS = likely situation, Dilutive EPS = worst case

Question 30

Disclosure of compensation plans

Answer 30

Must disclose status of compensation plans

If have share based payment arrangements:

• nature and terms of arrangements existing during period
• potential affects on shareholders
• effect on the income statement of this compensation cost
• method of estimating fair value
• cash flow from share-based payment arrangements

Question 31

Employee Stock purchase plans

Answer 31

ESPP

Permit all employees to purchase stock at a discounted price for a short period of time

COMPENSATORY unless ALL of the below are true:

• all full time employees are eligible on an equitable basis
• discount from market price is small, does not exceed per share costs avoided by lack of public offering (5% or less)
• no substantive option feature

Expense recorded over service life of employee

Question 32

Accounting for restricted stock

Answer 32

Similar to accounting for stock options

• determine fair value at date of grant
• expenses fair value over service period

Debit Unearned Compensation (deferred compensation expense, not liability)
Credit common stock (shares @ par)
Credit PIC common stock

then over service period:
Debit Compensation Expense
Credit unearned compensation

if forfeited then entries reversed as long as not vested

Question 33

Restricted stock plans

Answer 33

Transfer shares of stock to employees subject to an agreement that shares cannot be sold, transferred or pledged until vesting occurs. Shares are forfeited if conditions not met.

Advantages

• restricted stock never becomes worthless
• results in less dilution to existing stockholders
• better aligns employee incentives with company incentives when employees are stockholders

Question 34

Grant date

Answer 34

Date employee receives options to purchase stock

Question 35

Stock options

Answer 35

a form of compensation that gives key employees the choice to purchase shares at a given (usually lower than market) price

• opportunity to receive stock if company performance is satisfactory

new accounting rules in 2005 require expensing of the fair value of stock options when granted

Question 36

Dodd-Frank act required disclosures

Answer 36

(2010) “Pay Ratio rule”

SEC requires companies to disclose:

• median of the annual total compensation of all employees in the company except the CEO
• annual total compensation of the CEO
• ratio of above amounts

Question 37

Dilutive securities

Answer 37

Convertible securities that, upon exercise, may reduce (dilute) earnings per share

also options and warrants

Question 38

Convertible bonds

Answer 38

can be changed into other corporate securities during some specified period after the bond’s issuance
- benefits of a bond (guaranteed interest and principle) + option of conversion to stock (if stock value rises)

conversion privilege may entice investor to accept lower than usual interest rate

considered a liability

Question 39

Induced conversion

Answer 39

Issuer offers additional consideration (cash, common stock) to encourage prompt conversion of debt to equity

Additional consideration = “sweetener” is recorded as an expense of the current period for the fair value of the consideration

Question 40

Convertible preferred stock

Answer 40

Includes an option for the holder to convert preferred shares to a fixed number of common shares

convertible preferred stock = equity

no gain or loss on conversion

Question 41

Diluted EPS: convertible securities

Answer 41

If converted method

• find effect on net income (elimination of interest net of tax or elimination of preferred dividends)
• find effect on weighted average common shares outstanding
• assumes conversion at the beginning of the period or as soon as the security was issued)

(Always find basic eps first to determine if security is dilutive or antidilutive)

Question 42

Interest expense net of tax

Answer 42

Total interest expense
Less interest expense *tax rate (tax benefit lost)
= Net interest expense

Question 43

Dilutive EPS - options and warrants

Answer 43

Treasury stock method

• calculate net income from exercise of option/warrant
• figure out how many treasury shares could be bought at market price with that income
• new shares outstanding less treasury shares purchased = net effect on weighted average shares outstanding
• no effect on net income
• assumes exercises at the beginning of the period or as soon as option issued
• remember to weight for partial periods

(Always find basic eps first to determine if security is dilutive or antidilutive)

Question 44

Dilutive securities

Answer 44

Securities that can be converted to common stock and drive EPS in a downward direction

Question 45

Reasons for Issuing stock warrants

Answer 45

1) Provide an “equity kicker” when issuing certain types of securities
2) as evidence of preemptive right of stockholders
3) as stock options to executives and employees

Question 46

Dilutive Effect

Answer 46

A transaction that reduces earnings per share

Question 47

Warrants

Answer 47

Certificates entitling the holder to acquire shares of stock at a certain price in a certain period

if exercised: become common stock and generally have a dilutive effect (reducing EPS)

Still must pay for shares

A long term option on common stock at a fixed price

Question 48

Detachable stock warrant

Answer 48

Can be detached from the stock and traded as a separate security

Price = price paid for unit (stock and warrant) less market price of common stock
- proceeds allocated between the two securities

not profitable to exercise the warrant unless the stock price increases

Question 49

Simple capital structure

Answer 49

only common stock/ no potential dilution of EPS via conversion or exercise of warrants

Question 50

Reporting earnings per share on income statement

Answer 50

Reported below net income with intermediate components (income from continuing operations, loss or income from discontinued operations) split out if applicable

Question 51

Earnings per share

Answer 51

Earnings per share for common stock ONLY

Public companies MUST report on income statement

Must split out continuing and discontinued ops

Discontinued operations shown net of tax

fails to recognize the impact of dilutive securities

Question 52

Nondetachable warrants

Answer 52

No allocation of proceeds - recorded entirely as debt

not 100% faithful representation but would be unreasonably costly to estimate separation

Question 53

Dilutive Securities

Answer 53

Securities that can be converted to common stock

typical in mergers and compensation plans

on conversion or exercise they reduce EPS

Question 54

Complex capital structure

Answer 54

Equity includes securities that could have a dilutive effect on EPS

generally need to report both basic and diluted EPS

Question 55

Options and warrants as dilutive

Answer 55

Exercise price < market price = dilution occurs
Exercise price > market price = antidilutive

only calculate dilutive EPS if dilution occurs

Question 56

Proportional method of recording stock warrants issued with other securities

Answer 56

Record values of bonds (liability) and warrants (equity) separately

allocates via proportions based on fair value -percentage of aggregate fair value applied to the sales price

Bonds
Debit Cash
Debit Discount or Credit Premium
Credit Bonds Payable (face value)

Warrants
Debit Cash
Credit PIC Stock warrants (don’t recognize common stock until warrants exercised)

can combine

Question 57

Recording Exercise of warrants

Answer 57

Debit Cash (price on warrant x shares)
Debit PIC- stock warrants (full or relative amount of original PIC amount)
Credit common stock (# stocks x par/ stated value)
Credit PIC- common stock (remaining)

Question 58

Recording un-exercised warrants

Answer 58

Debit Paid in capital- stock warrants
Credit paid in capital - expired stock warrants

Becomes equity for current stockholders

Question 59

Recording rights to subscribe to additional shares

Answer 59

Preemptive privilege / stock right
- usually a short duration warrant to purchase stock below market price

Memorandum entry made when issued (# of rights issued)

No formal entry until exercised then just usual:

Debit Cash
Credit stock
Credit PIC if any

Question 60

Incremental method of valuation of stock warrants issued with other securities

Answer 60

If cannot determine fair value of warrant or of bonds then use the same incremental method as for lump sum securities

• record whichever part for which fair value can be determined at that fair value
• apply remainder of price to other security

Question 61

Recording stock warrants issued with other securities

Answer 61

Allocate the proceeds from the sale between the two securities

• if actively traded as separate investments then can determine fair value

Two methods for recording:

• proportional
• incremental

Question 62

Recording retirement of convertible debt

Answer 62

Recognize a gain or loss on retirement exactly as for non-convertible debt

Difference between cash acquisition price of debt and carrying amount = current income gain or loss

Question 63

Recording induced conversion

Answer 63

Debit Debt Conversion expense
Debit Bond payable (face value)
Debit Discount or credit premium on bond
Credit Common stock (at par value)
Credit PIC - common stock (plug)
Credit cash received

Question 64

Recording convertible debt at time of issue

Answer 64

Usual debt entries

Bond at face value
Discount or premium
Cash

Nothing recorded as equity

discount or premium then amortized

Question 65

Recording conversion of bonds into other securities

Answer 65

Book value method
- records securities exchanged for the bond at the book value of the bond

Debit Bonds Payable
Debit premium or credit discount (for any unamoritized amount)
Credit common stock
Credit PIC Common-stock

No gain or loss recorded on conversion

Question 66

Exercise vs expiration of stock options

Answer 66

Exercise:
Debit Cash
Debit PIC - stock options
        Credit Common stock (at par)
        Credit PIC - common stock

Expiration
Debit PIC - stock options
Credit PIC- expired stock options

Question 67

Fair value method for valuing stock options

Answer 67

GAAP
Stock options valued at fair base based on acceptable option-pricing models taking multiple factors into account

generally results in higher compensation costs than intrinsic value

Used to compute compensation expense. Not readjusted later as stock price changes

Question 68

Intrinsic value method of valuing stock options

Answer 68

NOT GAAP

value = the difference between market price of the stock and the exercise price of the option at the grant date

Question 69

Recognizing stock compensation

Answer 69

Expense amount determined using fair value method

Service period in which expense recognized = vesting period (period between grant date and vesting date) = expected period of benefit

• Expense over expected period of benefit
• no entry at date of grant

Debit Compensation Expense
Credit PIC- stock options
(split equally over periods in period of benefit)

if employee fails to satisfy service requirement for vesting then journal entry is reversed

Question 70

Recording conversion of convertible preferred stock

Answer 70

Book value method

Debit Preferred Stock (at par)
Debit PIC- preferred stock (proportion of any related)
Credit Common stock
Credit PIC- common stock (plug)

Or, if par value of common stock greater than the book value of the preferred stock then debit the difference to retained earnings

(this debit to retained earnings is basically an additional return offered to preferred stockholders to facilitate conversion to common stock. some states require that instead of reducing retained earnings PIC from other sources should be reduced instead)