Chapter 4 (Unit 3 Pt 2) Dilutive Securities and Earnings per Share

Question 1

Define the two measures of EPS.

Answer 1

1. Basic EPS (BEPS)
   Computed on common shares outstanding and net income.
2. Diluted EPS (DEPS)
   “As if” calculation. Includes the assumed conversion of potential common stock (PCS). PCS includes stock options and other securities that could become common stock in the future.

Question 2

What is the formula for Basic EPS?

Answer 2

Net Income - Preferred Stock Dividends / Weighted average shares of common outstanding

Question 3

What is the formula for Diluted EPS?

Answer 3

Net Income - Preferred Stock Dividends +/- Adjust to NI for assumed conversion of PCS /
Weighted average shares of common outstanding + Shares from assumed conversion of PCS

Question 4

When is a company required to report BEPS?

Answer 4

All public companies are required to report BEPS.

Question 5

When is a company required to report DEPS?

Answer 5

DEPS is required if the firm has dilutive PCS (complex capital structure).

Question 6

Where is BEPS and DEPS reported on the financial statements?

Answer 6

BEPS and DEPS are shown on the face of the Income Statement for:
- Income from Continuing Operations (IFCO)
-Net Income (NI)

Question 7

If an entity reports Discontinued Operations, where must they present the BEPS and DEPS?

Answer 7

An entity that reports Discontinued Operations may present BEPS and DEPS for Discontinued Operations on the face of the income statement or in the footnotes to the financial statements.

Question 8

When calculating the BEPS Numerator, how are cumulative preferred stocks handled vs noncumulative preferred stock?

Answer 8

Cumulative Preferred Stock - deduct one full year of dividends regardless of amount declared or paid. (Cumulative preferred dividend is a contractual obligation whether it was declared or paid)

Noncumulative Preferred Stock - deduct dividends declared in the current year.

Question 9

There are 1,000 shares of 7%, $100 preferred stock outstanding. For the current year, what amount of preferred dividends is subtracted in calculating BEPS when the preferred stock is cumulative, and there are two years’ dividends in arrears, and $4,000 of dividends were paid?

Answer 9

For Culumative Preferred Stock - deduct one full year of dividends regardless of amount declared or paid.

1,000 shares x $100 par x 7% = $7,000

Question 10

There are 1,000 shares of 7%, $100 preferred stock outstanding. For the current year, what amount of preferred dividends is subtracted in calculating BEPS when the preferred stock is noncumulative, $2,000 of dividends were declared in the current year, and $3,200 of dividends were paid?

Answer 10

For Noncumulative Preferred Stock - deduct dividends declared in the current year.

$2,000

Question 11

Calculate the weighted average shares outstanding:

Jan 1: 1,000 common shares outstanding

Oct 1: Issue 600 shares

Nov 4: Split stock 2-for-1

Dec 1: Acquire 120 shares for treasury

Dec 9: Issude 40% stock dividend

Answer 11

Jan 1: 1,000 x 12/12 = 1,000

Oct 1: 600 x 3/12 = 150

Nov 4: (1,000 + 150) x 2 = 2,300

Dec 1: -120 x 1/12 = -10

Dec 9: [(1,000 + 150) x 2 - 10] x 1.4 = 3,206

Weighted averages shares outstanding = 3,206

Question 12

A company had 400,000 shares of common stock issued and outstanding on January 1, year 1 and had the following equity transactions for year 1:

April 1: Issued 200,00 new shares for cash
July 1: Issued new shares as result of 3-for-1 stock split
October 1: Purchased 300,000 shares treasury stock for cash

What should the company use as the denominator for the calculation of basic earnings per share for year ended December 31, year 1?

Answer 12

1,575,000

Question 13

In regards to Compensation Expense, what is the difference between Noncompensatory Stock Purchase Plans and Compensatory Stock Purchase Plans?

Answer 13

Noncompensatory
Compensation Expense = amount paid by employer

Compensatory
Compensation Expense - amount paid by employer plus discount

Question 14

What is the journal entry to record stock issuance from a Noncompensatory Stock Purchase Plan?

Answer 14

D: Compensation Expense (paid by employer)
D: Cash (paid by employee)
C: Common Stock (par value)
C: APIC (share price - par)

Question 15

What is the journal entry to record stock issuance from a Compensatory Stock Purchase Plan?

Answer 15

D: Compensation Expense (paid by employer + discount)
D: Cash (paid by employee)
C: Common Stock (par value)
C: APIC (plug)

Question 16

What is the compensation expense for a Stock Option Plan and how is it adjusted for forfeitures? How is the compensation expense recognized?

Answer 16

Compensation Expense = FV of option at grant date (NOT FV of stock)

Adjusted for forfeitures either by:
-estimate of future forfeitures OR
-as they occur

Total compensation expense is amortized SL as compensation expense over the service period.

Question 17

Define Stock Options

Answer 17

Stock options give the holder the right (not the obligation) to purchase a share of stock at a set price (strike price) by a certain date.

Question 18

Define Stock Option Forfeiture

Answer 18

Options that are not exercised. This is usually because the employee leaves.

Question 19

On Jan 1, 20x4 several managers were granted options to purchase 100,000, $2 par common stock for $10 during the two-year period 1/1/x7 - 12/31/x8.

• The market price of the stock on grant date = $10.
• The service period is 3 years: 1/1/x4 - 12/31/x6.
• The manager must work the entire service period for the option to vest.
• The options expire 12/31/x8.
• The fair value of one option is $3 based on an option pricing model.

a) What is the compensation expense for the 3 year period assuming no forfeiture?

b) What is the journal entry for compensation expense at the end of 20x4, x5, and x6?

c) What is the compensation expense for the 3 year period assuming in 20x5 that 3,000 options are forfeited? What is the 20x6 compensation expense?

Answer 19

a) [($3 x 100,000 options)/3] = $100,000 a year

b) Entry on December 21, 20x4, x5, and x6:
D: Compensation Expense 100,000
C: APIC - stock options 100,000

c) 3,000 x $3 = $9,000
Revised total compensation expense: $300,000 - $9,000 = $291,000
Expense to be recognized in 20x5: [$291,000(2/3] - $100,000 (for 20x4) = $94,000
Double check: $100,000 + $94,000 = $194,000 (2/3 of $291,000)

20x6 compensation expense: $291,000(1/3) = $97,000

Question 20

On Jan 1, 20x4 several managers were granted options to purchase 100,000, $2 par common stock for $10 during the two-year period 1/1/x7 - 12/31/x8.

• The market price of the stock on grant date = $10.
• The service period is 3 years: 1/1/x4 - 12/31/x6.
• The manager must work the entire service period for the option to vest.
• The options expire 12/31/x8.
• The fair value of one option is $3 based on an option pricing model.

a) What is the compensation expense for the 3 year period assuming forfeitures are estimated to be 3% per year?

b) What is the journal entry for compensation expense at the end of 20x4, x5, and x6?

c) Assume the predicted forfeitures were accurate. What is the journal entry when the options are exercised?

d) Ignoring scenario c, assume in 20x5 the forfeiture rate is doubled to 6%. What amount of compensation expense is recognized in that year? What would be the compensation expense in 20x6?

Answer 20

a) [($3 x 100,000 options)(1 - 0.03)^3] = $273,802 OR
$273,802/3 = $91,267 per year

b) Entry on December 31, 20x4, x5, and x6:
D: Compensation Expense 91,267
C: APIC-stock options 91,267

c)
D: Cash (91,267 x $10) 912,670
D: APIC - stock options 273,802 (remove 91,267/year from comp exp)
C: Common Stock (91,267 x $2) 182,534
C: APIC - Common Stock 1,003,938 (plug)

d) Revised total compensation expense:
$300,000(1.06)^3 = $249,175

Expense to be recognized in 20x5:
[(2/3$249,175 - $91,267 (for 20x4)] = $74,850

Double check: $91,267 + $74,850 = $166,117 (2/3 of $249,175)

Compensation Expense in 20x6 = $249,175(1/3) = $83,058

Question 21

What scenario would cause stock options to expire? How is it handled in the books?

Answer 21

Options expire if the stock price fails to rise above the option exercise price.

No retroactive adjustment for expiration.

The compensation expense remains but APIC - stock options is transferred to APIC - expired stock options.

Question 22

What are Performance (Variable) Plans? How are they handled in the books?

Answer 22

Requires a performance target to be met before vesting.

A performance plan is called variable because all terms are not known at grant date.

Targets could be sales growth, minimum return on certain assets, etc.

Adjustments in the expected number of shares to be issued is handled the same way as changes in forfeitures. The change is applied to the current period such that total compensation expense through the current year reflects the revised rate.

Question 23

What scenario would cause a Performance Plan to expire? How is that handled in the books?

Answer 23

If no options vest because the minimum incentive level is not met, reverse the previously recognized expense.

Question 24

On April 1, 2014, Clayton Company issued 500 $1,000 bonds at 104. Each bond was issued with one detachable stock warrant. Shortly after issuance, the bonds were selling at 97, but the fair value of the warrants cannot be determined.

a) Prepare the entry to record the issuance of the bonds and warrants. (Incremental method)

b) Assume the same facts as part a, except that the warrants had a fair value of $65. Prepare the entry to record the issuance of the bonds and warrants. (Proportional method)

Answer 24

a)
D: Cash 520,000 (500 x $1,000 x 1.04)
D: Discount on Bonds Payable 15,000 ($500,000 - [$500,000 x 0.97])
C: Bonds Payable 500,000 (500 x $1,000)
C: APIC - Stock Warrants 35,000 ($520,000 - [$500,000 x 0.97])

b)
D: Cash 520,000 (500 x $1,000 x 1.04)
D: Discount on Bonds Payable 12,656 ($500,000 - $487,344)
C: Bonds Payable 500,000 (500 x $1,000)
C: APIC - Stock Warrants 32,656 ([32,500 / 517,500] x 520,000)

Question 25

On Sept 1, 2014, Herbert Corporation sold at 106 (plus accrued interest) 4,000 of its 9%, 10 year, $1,000 face value, nonconvertible bonds with detachable stock warrants. Each bond carried two detachable warrants. Each warrant was for one share of common stock at a specified option price of $18 per share. Shortly after issuance, the warrants were quoted on the market for $5 each. No fair value can be determined for the Herbert Corporation bonds. Interest is payable on December 1 and June 1. The bond issue costs of $35,000 were incurred.

Prepare the entry to record the issuance of the bonds.

Answer 25

Face value of the bonds = $4,000,000

Lump-sum receipt = 4,000 x $1,000 x 1.06 = 4,240,000
Total number of detachable warrants = 4,000 x 2 = 8,000
Allocated to the warrants = 8,000 x $5 = 40,000
Balance allocated to the bonds = 4,240,000 - 40,000 = 4,200,000
Annual Interest = $4,000,000 x 9% = 360,000
Accrued Interest = 360,000 x 3/12 = 90,000

D: Cash 4,295,000 (4,240,000 + accrued interest 90,000)
D: Unamortized Bond Issue Costs 35,000 (stated in question)
C: Bonds Payable 4,000,000 (face value)
C: Premium on Bonds Payable 200,000 (4,200,000 - 4,000,000) premium
because allocated value is higher than face value
C: APIC - Stock Warrants 40,000 (8,000 x 5)
C: Interest Expense 90,000 (360,000 x 3/12)

Question 26

How is fair value determined for Restricted Stock?

Answer 26

The fair value of the restricted stock is determined at the date of grant.

Then, the fair value is expensed over the service period.

(Same as stock options)

Question 27

Define Restricted Stock.

Answer 27

Like stock options, restricted stock is used to compensate employees.

Restricted-stock plans transfer shares of stock to employees, subject to an agreement that the shares cannot be sold, transferred, or pledged until vesting occurs.

Question 28

How does Restricted Stock differ from Stock Options?

Answer 28

Restricted stock never becomes completely worthless. It has value even when the stock price does not exceed the exercise price.

Generally results in less dilution to existing stockholders. This is because these stocks are usually one-half to one-third in size of the stock option and have value at the end of the vesting period. As a result, less dilution results if the stock price rises.

Better aligns the employee incentives with the companies’ incentives.

Question 29

How do subsequent changes in the fair value of Restricted Stock affect the computing of compensation expense?

Answer 29

Subsequent changes in fair value are ignored for purposes of computing compensation expense.

Question 30

What must the company do if Restricted Stock vesting does not occur?

Answer 30

The company reverses the compensation expense.

Question 31

Alice Company issues 6,000 shares of restricted stock to its CFO, Andrea Gates, on January 1, 2014. The stock has a fair value of $80,000 on this date. The service period related to this restricted stock is 5 years. Vesting occurs if Gates stays with the company until December 31, 2018. The par value of the stock is $10. At December 31, 2014, the fair value of the stock is $65,000.

a) Prepare the journal entries to record the restricted stock on January 1, 2014 (the date of grant), and December 31, 2015.

b) On July 25, 2018, Gates leaves the company. Prepare the journal entry (if any) to account for this forfeiture.

Answer 31

a)
01/01/2014
D: Unearned Compensation 80,000 (fv of stock; total comp exp the company will recognize over the 5 year period)
C: Common Stock 60,000 (6,000 shares x $10 par value)
C: APIC - Common Stock 20,000 (plug)

12/31/15
D: Compensation Expense 16,000 (20% of 80,000; $80,000/5 years)
C: Unearned Compensation 16,000 (removing/recognizing)

b)
07/25/2018
D: Common Stock 60,000 (reverse original entry)
D: APIC - Common Stock 20,000 (reverse original entry)
C: Compensation Expense 64,000 (16,000 x 4 years)
C: Unearned Compensation 16,000 (plug)

Question 32

On November 1, 2014, Olympic Company adopted a stock-option plan that granted options to key executives to purchase $4,500 shares of the company’s $14 par value common stock. The options were granted on January 2, 2015 and were exercisable 2 years after the date of grant if the grantee was still an employee of the company. The options expired 6 years from date of grant. The option price was set at $40, and the fair value option-pricing model determines the total compensation expense to be $720,000.

All of the options were exercised during the year 2017: 40,875 on January 3 when the market price was $67, and 13,625 on May 1 when the market price was $78 a share.

Prepare journal entries relating to the stock option plan for the years 2015, 2016, and 2017. Assume that the employee performs services equally in 2015 and 2016.

01/02/15
12/31/15
12/31/16
01/03/17
05/01/17

Answer 32

01/02/15 (day of grant)
No entry unless stock is vested immediately which is not common.

12/31/15
D: Compensation Expense 360,000 (720,000/2; fair value recognized equally during the service years)
C: APIC - Stock Options 360,000

12/31/16
D: Compensation Expense 360,000 (720,000/2; fair value recognized equally during the service years)
C: APIC - Stock Options 360,000

01/03/17 (first-time options are exercised)
D: Cash 1,635,000 (40,875 x $40 option price)
D: APIC - Stock Options 540,000 (40,875/54,500=75%; 720,000 x 0.75= 540,000)
C: Common Stock 572,250 (40,875x14 PV)
C: APIC - Common Stock 1,602,750 (plug)

05/01/17 (second-time options are exercised)
D: Cash 545,000 (13,625 x $40 option price)
D: APIC - Stock Options 180,000 (13,625/54,500=25%; 720,000 x 0.25 = 180,000)
C: Common Stock 190,750 (13,625 x 14PV)
C: APIC - Common Stock 534,250 (plug)

Question 33

Sheffield Corporation had 2017 net income of $1,066,000. During 2017, Sheffield paid a dividend of $2 per share on 36,350 shares of preferred stock. During 2017, Sheffield had outstanding 301,000 shares of common stock.

Compute Sheffield’s 2017 earnings per share.

Answer 33

(1,066,000 - 72,700) / 301,000 = 3.3

Question 34

In 2019, Chartres Inc., issued for $105 per share, 60,000 shares of $100 par value convertible preferred stock. One share of preferred stock can be converted into three shares of Chatre’s $25 par value common stock at the option of the preferred stockholder. In April 2020, all of the preferred stock was converted into common stock. The market value of the common stock at the date of the conversation was $30 per share.

What total amount should be credited to additional paid-in capital from common stock as a result of the conversation of the preferred stock into common stock?

Answer 34

D: Preferred Stock 6,000,000 (60,000 shares x $100 PV)
D: APIC - PS 300,000 [60,000 x (105/share - 100/share)]
C: Common Stock 4,500,000 (60,000 x 3 = 180,000 CS x 25 PV)
C: APIC - CS 1,800,000 (plug)

Answer = 1,800,000

Question 35

What are cnvertible bonds usually converted into?

Answer 35

In order to obtain financing at lower rates, corporations will issue convertible bonds so the purchaser may convert its debt into common stock (or ownership interest) of the corporation.

Question 36

When a bond issuer offers some form of additional consideration (a “sweetener”) to induce conversion, how is the sweetener accounted for?

Answer 36

An Expense. To eliminate required principal and interest payments on debt, it is in the interest of the corporation to induce its convertible bond holders to exercise the conversion option. This inducement is most commonly in the form of cash or additional common stock. This inducement is an expense of the current period, with an amount equal to the fair value of the additional securities or other consideration given.

Question 37

During the conversion of preferred stock into common, how should any excess of the par value of the common shares issued over the carrying amount of the preferred being converted be treated?

Answer 37

It should be treated as a direct reduction of retained earnings to balance the entry.

Question 38

When the cash proceeds from a bond issued with detachable stock warrants exceed the sum of the par value of the bonds and the fair value of the warrants, to which account should the excess be credited?

Answer 38

Premium on bonds payable

When bonds with detachable warrants are issued, two securities are created. However, until the warrants are exercised, they are reported on the balance sheet in the stockholders’ equity section at the value of the cash attributed to the warrants. Therefore, any difference in proceeds and the face value of the bond will be reported as either a premium or discount on the bond payable and amortized over the life of the bond.

Question 39

When is the treasury stock method used vs. the if-converted method?

Answer 39

The treasury stock method is only used to calculate the shares related to stock options and warrants. Convertible securities (bonds and stock) use the if-converted method.