Chapter 16: Dilutive Securities and Earnings per Share Flashcards
Liabilities vs Equity
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
control number
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
Treasury stock method of calculating dilutive EPS
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
Treasury stock method Average common shares outstanding
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
Calculating interest expense avoided
Interest expense for year
less income tax reduction (tax rate x interest)
= interest expense avoided
Calculating an amount net of tax
Amount x (1-tax rate)
may need to adjust for a partial year
Calculating weighted average shares outstanding for stock dividends / stock splits
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
Calculating weighted average number of shares oustanding
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
Earnings per share: simple capital structure
= 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
How to tell if a security is antidilutive
(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
Reporting EPS with diluted EPS
Net Income (underlined)
EPS (underlined) Basic EPS (double underlined)
Diluted EPS (double underlined)
If-converted method for calculating diluted EPS
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
Calculating diluted EPS
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
Convertible preferred stock and dilutive shares
- 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
EPS presentation on income statement
- 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
EPS disclosures
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
Recording compensation expense under stock appreciation plan
Debit Compensation expense
Credit Liability Under Stock-Appreciation plan
When paid out:
Debit Liability Under Stock-Appreciation Plan
Credit Cash
Percentage approach of allocating compensation expense
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
Recording share based liability awards
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
Share-based liability awards
SARs = liability if, at date of exercise, holder receives a cash payment of the amount of share-price appreciation
Share-based Equity awards
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
Stock-appreciation rights
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
Share appreciation
the excess of market price of the stock at date of exercise over a preestablished price
Incentive stock option plan
No taxes paid at exercise
may need to borrow to finance exercise price (leads to interest expense)
Nonqualified stock option plans
require purchaser to pay income tax on difference between market price and option price
Calculating cumulative preferred stock and EPS
Subtract preferred dividend from net income even if dividend is not declared
Steps for computing diluted EPS
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
Contingent issue agreement
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
Antidilutive securities
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
Disclosure of compensation plans
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
Employee Stock purchase plans
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
Accounting for restricted stock
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
Restricted stock plans
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
Grant date
Date employee receives options to purchase stock
Stock options
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
Dodd-Frank act required disclosures
(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
Dilutive securities
Convertible securities that, upon exercise, may reduce (dilute) earnings per share
also options and warrants
Convertible bonds
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
Induced conversion
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
Convertible preferred stock
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
Diluted EPS: convertible securities
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)
Interest expense net of tax
Total interest expense
Less interest expense *tax rate (tax benefit lost)
= Net interest expense
Dilutive EPS - options and warrants
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)
Dilutive securities
Securities that can be converted to common stock and drive EPS in a downward direction
Reasons for Issuing stock warrants
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
Dilutive Effect
A transaction that reduces earnings per share
Warrants
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
Detachable stock warrant
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
Simple capital structure
only common stock/ no potential dilution of EPS via conversion or exercise of warrants
Reporting earnings per share on income statement
Reported below net income with intermediate components (income from continuing operations, loss or income from discontinued operations) split out if applicable
Earnings per share
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
Nondetachable warrants
No allocation of proceeds - recorded entirely as debt
not 100% faithful representation but would be unreasonably costly to estimate separation
Dilutive Securities
Securities that can be converted to common stock
typical in mergers and compensation plans
on conversion or exercise they reduce EPS
Complex capital structure
Equity includes securities that could have a dilutive effect on EPS
generally need to report both basic and diluted EPS
Options and warrants as dilutive
Exercise price < market price = dilution occurs
Exercise price > market price = antidilutive
only calculate dilutive EPS if dilution occurs
Proportional method of recording stock warrants issued with other securities
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
Recording Exercise of warrants
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)
Recording un-exercised warrants
Debit Paid in capital- stock warrants
Credit paid in capital - expired stock warrants
Becomes equity for current stockholders
Recording rights to subscribe to additional shares
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
Incremental method of valuation of stock warrants issued with other securities
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
Recording stock warrants issued with other securities
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
Recording retirement of convertible debt
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
Recording induced conversion
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
Recording convertible debt at time of issue
Usual debt entries
Bond at face value
Discount or premium
Cash
Nothing recorded as equity
discount or premium then amortized
Recording conversion of bonds into other securities
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
Exercise vs expiration of stock options
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
Fair value method for valuing stock options
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
Intrinsic value method of valuing stock options
NOT GAAP
value = the difference between market price of the stock and the exercise price of the option at the grant date
Recognizing stock compensation
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
Recording conversion of convertible preferred stock
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)
