After studying this chapter, you should be able to:
Kicking the Habit
Some habits die hard. Take stock options—called by some "the crack cocaine of incentives." Stock options are a form of compensation that gives key employees the choice to purchase stock at a given (usually lower-than-market) price. For many years, U.S. businesses were hooked on these products. Why? The combination of a hot stock market and favorable accounting treatment made stock options the incentive of choice. They were compensation with no expense to the companies that granted them, and they were popular with key employees, so companies granted them with abandon. However, the accounting rules that took effect in 2006 required expensing the fair value of stock options. This new treatment has made it easier for companies to kick this habit.
As shown in the chart on the left, a review of option use for the companies in the S&P 500 indicates a decline in the use of option-based compensation. Fewer companies are granting stock options, following implementation of stock-option expensing. As a spokesperson at Progress Energy commented, "Once you begin expensing options, the attractiveness significantly drops."
In the 1990s, executives with huge option stockpiles had an almost irresistible incentive to do whatever it took to increase the stock price and cash in their options. By reining in options, many companies are taking the first steps toward curbing both out-of-control executive pay and the era of corporate corruption that it spawned.
Some of the ways that companies are curbing option grants include replacing options with shares of restricted stock. As indicated in the table on the right, which shows the fair value by industry sector of restricted stock and option grants, restricted stock is now the plan of choice. Even if the financial sector is excluded, the value of restricted stock exceeds the value of stock-option grants. And in the information technology area (where in the past, stock options were heavily favored), the fair value of restricted stock plans exceeds that for stock options. Some companies are simply reducing option grants, without offering a replacement, while others, like Microsoft and Yahoo, have switched to restricted-stock plans completely.
Is this a good trend? Most believe it is; the requirement to expense stock-based compensation similar to other forms of compensation has changed the focus of compensation plans to rewarding talent and performance without breaking the bank. The positive impact on corporate behavior, while hard to measure, should benefit investors in years to come.
Sources: Adapted from: Louis Lavelle, "Kicking the Stock-Options Habit," BusinessWeekOnline (February 16, 2005). Graphs from Jack T. Ciesielski, "S&P 500 Stock Compensation: Who Needs Options?" The Analyst's Accounting Observer (July 30, 2008).
PREVIEW OF CHAPTER 16
As the opening story indicates, companies are rethinking the use of various forms of stock-based compensation. The purpose of this chapter is to discuss the proper accounting for stock-based compensation. In addition, the chapter examines issues related to other types of financial instruments, such as convertible securities, warrants, and contingent shares, including their effects on reporting earnings per share. The content and organization of the chapter are as follows.
Many of the controversies related to the accounting for financial instruments such as stock options, convertible securities, and preferred stock relate to whether companies should report these instruments as a liability or as equity. For example, companies should classify nonredeemable common shares as equity because the issuer has no obligation to pay dividends or repurchase the stock. Declaration of dividends is at the issuer's discretion, as is the decision to repurchase the stock. Similarly, preferred stock that is not redeemable does not require the issuer to pay dividends or repurchase the stock. Thus, nonredeemable common or preferred stock lacks an important characteristic of a liability—an obligation to pay the holder of the common or preferred stock at some point in the future.
However the classification is not as clear-cut for other financial instruments. For example, in Chapter 15 we discussed the accounting for mandatorily redeemable preferred stock. Companies originally classified this security as part of equity. The SEC then prohibited equity classification, and most companies classified these securities between debt and equity on the balance sheet in a separate section often referred to as the "mezzanine section." The FASB now requires companies to report these types of securities as a liability.[248] [1]
In this chapter, we discuss securities that have characteristics of both debt and equity. For example, a convertible bond has both debt and equity characteristics. Should a company classify this security as debt, as equity, or as part debt and part equity? In addition, how should a company compute earnings per share if it has convertible bonds and other convertible securities in its capital structure? Convertible securities as well as options, warrants, and other securities are often called dilutive securities because upon exercise they may reduce (dilute) earnings per share.
Convertible bonds can be changed into other corporate securities during some specified period of time after issuance. A convertible bond combines the benefits of a bond with the privilege of exchanging it for stock at the holder's option. Investors who purchase it desire the security of a bond holding (guaranteed interest and principal) plus the added option of conversion if the value of the stock appreciates significantly.
Corporations issue convertibles for two main reasons. One is to raise equity capital without giving up more ownership control than necessary. To illustrate, assume a company wants to raise $1 million; its common stock is selling at $45 a share. To raise the $1 million, the company would have to sell 22,222 shares (ignoring issue costs). By selling 1,000 bonds at $1,000 par, each convertible into 20 shares of common stock, the company could raise $1 million by committing only 20,000 shares of its common stock.
A second reason to issue convertibles is to obtain debt financing at cheaper rates. Many companies could issue debt only at high interest rates unless they attach a convertible covenant. The conversion privilege entices the investor to accept a lower interest rate than would normally be the case on a straight debt issue. For example, Amazon.com at one time issued convertible bonds that pay interest at an effective yield of 4.75 percent. This rate was much lower than Amazon.com would have had to pay by issuing straight debt. For this lower interest rate, the investor receives the right to buy Amazon.com's common stock at a fixed price until the bond's maturity.[249]
As indicated earlier, the accounting for convertible debt involves reporting issues at the time of (1) issuance, (2) conversion, and (3) retirement.
The method for recording convertible bonds at the date of issue follows the method used to record straight debt issues. None of the proceeds are recorded as equity. Companies amortize to its maturity date any discount or premium that results from the issuance of convertible bonds. Why this treatment? Because it is difficult to predict when, if at all, conversion will occur. However, the accounting for convertible debt as a straight debt issue is controversial; we discuss it more fully later in the chapter.
If converting bonds into other securities, a company uses the book value method to record the conversion. The book value method records the securities exchanged for the bond at the carrying amount (book value) of the bond.
To illustrate, assume that Hilton, Inc. has a $1,000 bond that is convertible into 10 shares of common stock (par value $10). At the time of conversion, the unamortized premium is $50. Hilton records the conversion of the bonds as follows.
Support for the book value approach is based on the argument that an agreement was established at the date of the issuance either to pay a stated amount of cash at maturity or to issue a stated number of shares of equity securities. Therefore, when the debtholder converts the debt to equity in accordance with the preexisting contract terms, the issuing company recognizes no gain or loss upon conversion.
Sometimes the issuer wishes to encourage prompt conversion of its convertible debt to equity securities in order to reduce interest costs or to improve its debt to equity ratio. Thus, the issuer may offer some form of additional consideration (such as cash or common stock), called a "sweetener," to induce conversion. The issuing company reports the sweetener as an expense of the current period. Its amount is the fair value of the additional securities or other consideration given.
Assume that Helloid, Inc. has outstanding $1,000,000 par value convertible debentures convertible into 100,000 shares of $1 par value common stock. Helloid wishes to reduce its annual interest cost. To do so, Helloid agrees to pay the holders of its convertible debentures an additional $80,000 if they will convert. Assuming conversion occurs, Helloid makes the following entry.
Helloid records the additional $80,000 as an expense of the current period and not as a reduction of equity.
Some argue that the cost of a conversion inducement is a cost of obtaining equity capital. As a result, they contend, companies should recognize the cost of conversion as a cost of (a reduction of) the equity capital acquired, and not as an expense. However, the FASB indicated that when an issuer makes an additional payment to encourage conversion, the payment is for a service (bondholders converting at a given time) and should be reported as an expense. The issuing company does not report this expense as an extraordinary item. [2]
As indicated earlier, the method for recording the issuance of convertible bonds follows that used in recording straight debt issues. Specifically this means that issuing companies should not attribute any portion of the proceeds to the conversion feature, nor should it credit a paid-in capital account.
Although some raise theoretical objections to this approach, to be consistent, companies need to recognize a gain or loss on retiring convertible debt in the same way that they recognize a gain or loss on retiring nonconvertible debt. For this reason, companies should report differences between the cash acquisition price of debt and its carrying amount in current income as a gain or loss.
Convertible preferred stock includes an option for the holder to convert preferred shares into a fixed number of common shares. The major difference between accounting for a convertible bond and convertible preferred stock at the date of issue is their classification: Convertible bonds are considered liabilities, whereas convertible preferreds (unless mandatory redemption exists) are considered part of stockholders' equity.
In addition, when stockholders exercise convertible preferred stock, there is no theoretical justification for recognizing a gain or loss. A company does not recognize a gain or loss when it deals with stockholders in their capacity as business owners. Therefore, companies do not recognize a gain or loss when stockholders exercise convertible preferred stock.
In accounting for the exercise of convertible preferred stock, a company uses the book value method: It debits Preferred Stock, along with any related Paid-in Capital in Excess of Par, and it credits Common Stock and Paid-in Capital in Excess of Par (if an excess exists). The treatment differs when the par value of the common stock issued exceeds the book value of the preferred stock. In that case, the company usually debits Retained Earnings for the difference.
To illustrate, assume Host Enterprises issued 1,000 shares of common stock (par value $2) upon conversion of 1,000 shares of preferred stock (par value $1) that was originally issued for a $200 premium. The entry would be:
The rationale for the debit to Retained Earnings is that Host has offered the preferred stockholders an additional return to facilitate their conversion to common stock. In this example, Host charges the additional return to retained earnings. Many states, however, require that this charge simply reduce additional paid-in capital from other sources.
Financial engineers are always looking for the next innovation in security design to meet the needs of both issuers and investors. 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 −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.
Source: STM Financial Reports. See also Floyd Norris, "Legal but Absurd: They Borrow a Billion and Report a Profit," New York Times (August 8, 2003), p. C1.
Warrants are certificates entitling the holder to acquire shares of stock at a certain price within a stated period. This option is similar to the conversion privilege: Warrants, if exercised, become common stock and usually have a dilutive effect (reduce earnings per share) similar to that of the conversion of convertible securities. However, a substantial difference between convertible securities and stock warrants is that upon exercise of the warrants, the holder has to pay a certain amount of money to obtain the shares.
The issuance of warrants or options to buy additional shares normally arises under three situations:
When issuing different types of securities, such as bonds or preferred stock, companies often include warrants to make the security more attractive—by providing an "equity kicker."
Upon the issuance of additional common stock, existing stockholders have a preemptive right to purchase common stock first. Companies may issue warrants to evidence that right.
Companies give warrants, often referred to as stock options, to executives and employees as a form of compensation.
The problems in accounting for stock warrants are complex and present many difficulties—some of which remain unresolved. The following sections address the accounting for stock warrants in the three situations listed on the previous page.
Warrants issued with other securities are basically long-term options to buy common stock at a fixed price. Generally the life of warrants is five years, occasionally 10 years; very occasionally, a company may offer perpetual warrants.
A warrant works like this: Tenneco, Inc. offered a unit comprising one share of stock and one detachable warrant. As its name implies, the detachable stock warrant can be detached (separated) from the stock and traded as a separate security. The Tenneco warrant in this example is exercisable at $24.25 per share and good for five years. The unit (share of stock plus detachable warrant) sold for 22.75 ($22.75). Since the price of the common stock the day before the sale was 19.88 ($19.88), the difference suggests a price of 2.87 ($2.87) for the warrant.
The investor pays for the warrant in order to receive the right to buy the stock, at a fixed price of $24.25, sometime in the future. It would not be profitable at present for the purchaser to exercise the warrant and buy the stock, because the price of the stock was much below the exercise price.[250] But if, for example, the price of the stock rises to $30, the investor gains $2.88 ($30 – $24.25 – $2.87) on an investment of $2.87, a 100 percent increase! If the price never rises, the investor loses the full $2.87 per warrant.[251]
A company should allocate the proceeds from the sale of debt with detachable stock warrants between the two securities.[252] The profession takes the position that two separable instruments are involved, that is, (1) a bond and (2) a warrant giving the holder the right to purchase common stock at a certain price. Companies can trade detachable warrants separately from the debt. This allows the determination of a market value. The two methods of allocation available are:
At one time AT&T issued bonds with detachable five-year warrants to buy one share of common stock (par value $5) at $25. At the time, a share of AT&T stock was selling for approximately $50. These warrants enabled AT&T to price its bond offering at par with an 8¾ percent yield (quite a bit lower than prevailing rates at that time). To account for the proceeds from this offering, AT&T would place a value on the two securities: (1) the value of the bonds without the warrants, and (2) the value of the warrants. The proportional method then allocates the proceeds using the proportion of the two amounts, based on fair values.
For example, assume that AT&T's bonds (par $1,000) sold for 99 without the warrants soon after their issue. The market value of the warrants at that time was $30. (Prior to sale the warrants will not have a market value.) The allocation relies on an estimate of market value, generally as established by an investment banker, or on the relative market value of the bonds and the warrants soon after the company issues and trades them. The price paid for 10,000, $1,000 bonds with the warrants attached was par, or $10,000,000. Illustration 16-1 shows the proportional allocation of the bond proceeds between the bonds and warrants.
In this situation the bonds sell at a discount. AT&T records the sale as follows.
In addition, AT&T sells warrants that it credits to paid-in capital. It makes the following entry.
AT&T may combine the entries if desired. Here, we show them separately, to indicate that the purchaser of the bond is buying not only a bond, but also a possible future claim on common stock.
Assuming investors exercise all 10,000 warrants (one warrant per one share of stock), AT&T makes the following entry.
What if investors fail to exercise the warrants? In that case, AT&T debits Paid-in Capital—Stock Warrants for $294,118, and credits Paid-in Capital from Expired Warrants for a like amount. The additional paid-in capital reverts to the former stockholders.
In instances where a company cannot determine the fair value of either the warrants or the bonds, it applies the incremental method used in lump-sum security purchases (as explained in Chapter 15, page 747). That is, the company uses the security for which it can determine the fair value. It allocates the remainder of the purchase price to the security for which it does not know the fair value.
For example, assume that the market price of the AT&T warrants is $300,000, but the company cannot determine the market price of the bonds without the warrants. Illustration 16-2 (on page 802) shows the amount allocated to the warrants and the stock in this case.
The question arises whether the allocation of value to the warrants is consistent with the handling of convertible debt, in which companies allocate no value to the conversion privilege. The FASB stated that the features of a convertible security are inseparable in the sense that choices are mutually exclusive: The holder either converts the bonds or redeems them for cash, but cannot do both. No basis, therefore, exists for recognizing the conversion value in the accounts.
The Board, however, indicated that the issuance of bonds with detachable warrants involves two securities, one a debt security, which will remain outstanding until maturity, and the other a warrant to purchase common stock. At the time of issuance, separable instruments exist. The existence of two instruments therefore justifies separate treatment. Nondetachable warrants, however, do not require an allocation of the proceeds between the bonds and the warrants. Similar to the accounting for convertible bonds, companies record the entire proceeds from nondetachable warrants as debt.
Reporting a convertible bond solely as debt is not representationally faithful. However, the cost-benefit constraint is used to justify the failure to allocate between debt and equity.
Many 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 its current exposure draft on this subject, the FASB indicates that companies should separate the debt and equity components of securities such as convertible debt or bonds issued with nondetachable warrants. We agree with this position. In both situations (convertible debt and debt issued with warrants), the investor has made a 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 in regard to accounting for convertible debt, companies will continue to report convertible debt and bonds issued with nondetachable warrants solely as debt.[253]
If the directors of a corporation decide to issue new shares of stock, the old stockholders generally have the right (preemptive privilege) to purchase newly issued shares in proportion to their holdings. This privilege, referred to as a stock right, saves existing stockholders from suffering a dilution of voting rights without their consent. Also, it may allow them to purchase stock somewhat below its market value. Unlike the warrants issued with other securities, the warrants issued for stock rights are of short duration.
The certificate representing the stock right states the number of shares the holder of the right may purchase. Each share of stock owned ordinarily gives the owner one stock right. The certificate also states the price at which the new shares may be purchased. The price is normally less than the current market value of such shares, which gives the rights a value in themselves. From the time they are issued until they expire, holders of stock rights may purchase and sell them like any other security.
Companies make only a memorandum entry when they issue rights to existing stockholders. This entry indicates the number of rights issued to existing stockholders in order to ensure that the company has additional unissued stock registered for issuance in case the rights are exercised. Companies make no formal entry at this time because they have not yet issued stock nor received cash.
If holders exercise the stock rights, a cash payment of some type usually is involved. If the company receives cash equal to the par value, it makes an entry crediting Common Stock at par value. If the company receives cash in excess of par value, it credits Paid-in Capital in Excess of Par. If it receives cash less than par value, a debit to Paid-in Capital in Excess of Par is appropriate.
The third form of warrant arises in stock compensation plans to pay and motivate employees. This warrant is a stock option, which gives key employees the option to purchase common stock at a given price over an extended period of time.
A consensus of opinion is that effective compensation programs are ones that do the following: (1) base compensation on employee and company performance, (2) motivate employees to high levels of performance, (3) help retain executives and allow for recruitment of new talent, (4) maximize the employee's after-tax benefit and minimize the employer's after-tax cost, and (5) use performance criteria over which the employee has control. Straight cash-compensation plans (salary and perhaps a bonus), though important, are oriented to the short run. Many companies recognize that they need a longer-term compensation plan in addition to the cash component.
Long-term compensation plans attempt to develop company loyalty among key employees by giving them "a piece of the action"—that is, an equity interest. These plans, generally referred to as stock-based compensation plans, come in many forms. Essentially, they provide the employee with the opportunity to receive stock if the performance of the company (by whatever measure) is satisfactory. Typical performance measures focus on long-term improvements that are readily measurable and that benefit the company as a whole, such as increases in earnings per share, revenues, stock price, or market share.
As indicated in our opening story, companies are changing the way they use stock-based compensation. Illustration 16-3 (on page 804) indicates that option expense is on the decline and that another form of stock-based compensation, restricted stock, is on the rise. The major reasons for this change are two-fold. Critics often cited the indiscriminate use of stock options as a reason why company executives manipulated accounting numbers in an attempt to achieve higher share price. As a result, many responsible 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.
The data reported in Illustration 16-4 reinforce the point that the design of compensation plans is changing. The study documents recent compensation trends of 68 CEOs of companies in the S&P 500.
Illustration 16-4 shows that cash compensation is increasing. Long-term incentives also are increasing, but the compensation mix is changing. For example, the use of restricted stock jumped 34 percent, but the use of options decreased approximately 19 percent. Yet, stock options remains an important means of compensating these CEOs. As Illustrations 16-3 and 16-4 indicate, stock-based compensation is still a considerable incentive element of employee compensation.
Suppose that, as an employee for Hurdle Inc., you receive options to purchase 10,000 shares of the firm's common stock as part of your compensation. The date you receive the options is referred to as the grant date. The options are good for 10 years. The market price and the exercise price for the stock are both $20 at the grant date. What is the value of the compensation you just received?
Some believe that what you have received has no value. They reason that because the difference between the market price and the exercise price is zero, no compensation results. Others argue these options do have value: If the stock price goes above $20 any time in the next 10 years and you exercise the options, you may earn substantial compensation. For example, if at the end of the fourth year, the market price of the stock is $30 and you exercise your options, you earn $100,000 [10,000 options × ($30 − $20)], ignoring income taxes.
The question for Hurdle is how to report the granting of these options. One approach measures compensation cost by the excess of the market price of the stock over its exercise price at the grant date. This approach is referred to as the intrinsic-value method. It measures what the holder would receive today if the option was immediately exercised. That intrinsic value is the difference between the market price of the stock and the exercise price of the options at the grant date. Using the intrinsic-value method, Hurdle would not recognize any compensation expense related to your options because at the grant date the market price equaled the exercise price. (In the preceding paragraph, those who answered that the options had no value were looking at the question from the intrinsic-value approach.)
The second way to look at the question of how to report the granting of these options bases the cost of employee stock options on the fair value of the stock options granted. Under this fair value method, companies use acceptable option-pricing models to value the options at the date of grant. These models take into account the many factors that determine an option's underlying value.[254]
The FASB guidelines now require that companies recognize compensation cost using the fair value method. [5] The FASB position is that companies should base the accounting for the cost of employee services on the fair value of compensation paid. This amount is presumed to be a measure of the value of the services received. We will discuss more about the politics of GAAP in this area later (see "Debate over Stock-Option Accounting," page 809). Let's first describe the procedures involved.
Stock-option plans involve two main accounting issues:
How to determine compensation expense.
Over what periods to allocate compensation expense.
Under the fair value method, companies compute total compensation 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).[255] Public companies estimate fair value by using an option-pricing model, with some adjustments for the unique factors of employee stock options. No adjustments occur after the grant date in response to subsequent changes in the stock price—either up or down.
In general, a company recognizes compensation expense in the periods in which its employees perform the service—the service period. Unless otherwise specified, the service period is the vesting period—the time between the grant date and the vesting date. Thus, the company determines total compensation cost at the grant date and allocates it to the periods benefited by its employees' services.
An example will help show the accounting for a stock-option plan. Assume that on November 1, 2009, the stockholders of Chen 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, 2010. 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 stock 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 (such as the Black-Scholes option-pricing model). To keep this illustration simple, we assume that the fair value option-pricing model determines Chen's total compensation expense to be $220,000.
Basic Entries. Under the fair value method, a company recognizes the value of the options as an expense in the periods in which the employee performs services. In the case of Chen Company, assume that the expected period of benefit is two years, starting with the grant date. Chen would record the transactions related to this option contract as follows.
As indicated, Chen allocates compensation expense evenly over the two-year service period.
Exercise. If Chen's executives exercise 2,000 of the 10,000 options (20 percent of the options) on June 1, 2013 (three years and five months after date of grant), the company records the following journal entry.
Expiration. If Chen's executives fail to exercise the remaining stock options before their expiration date, the company transfers the balance in the Paid-in Capital—Stock Options account to a more properly titled paid-in capital account, such as Paid-in Capital from Expired Stock Options. Chen records this transaction at the date of expiration as follows.
Adjustment. An unexercised stock option does not nullify the need to record the costs of services received from executives and attributable to the stock option plan. Under GAAP, a company therefore 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). A company records this change in estimate by debiting Paid-in Capital—Stock Options and crediting Compensation Expense for the amount of cumulative compensation expense recorded to date (thus decreasing compensation expense in the period of forfeiture.)
As indicated earlier, many companies are also using restricted stock (or replacing options altogether) 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. These shares are subject to forfeiture if the conditions for vesting are not met.[256]
Major advantages of restricted-stock plans are:
Restricted stock never becomes completely worthless. In contrast, if the stock price does not exceed the exercise price for a stock option, the options are worthless. The restricted stock, however, still has value.
Restricted stock generally results in less dilution to existing stockholders. Restricted-stock awards are usually one-half to one-third the size of stock options. For example, if a company issues stock options on 1,000 shares, an equivalent restricted-stock offering might be 333 to 500 shares. The reason for the difference is that at the end of the vesting period, the restricted stock will have value, whereas the stock options may not. As a result, fewer shares are involved in restricted-stock plans, and therefore less dilution results if the stock price rises.
Restricted stock better aligns the employee incentives with the companies' incentives. The holder of restricted stock is essentially a stockholder and should be more interested in the long-term objectives of the company. In contrast, the recipients of stock options often have a short-run focus which leads to taking risks to hype the stock price for short-term gain to the detriment of the long-term.
The accounting for restricted stock follows the same general principles as accounting for stock options at the date of grant. That is, the company determines the fair value of the restricted stock at the date of grant (usually the fair value of a share of stock) and then expenses that amount over the service period. Subsequent changes in the fair value of the stock are ignored for purposes of computing compensation expense.
Assume that on January 1, 2010, Ogden Company issues 1,000 shares of restricted stock to its CEO, Christie DeGeorge. Ogden's stock has a fair value of $20 per share on January 1, 2010. Additional information is as follows.
The service period related to the restricted stock is five years.
Vesting occurs if DeGeorge stays with the company for a five-year period.
The par value of the stock is $1 per share.
Ogden makes the following entry on the grant date (January 1, 2010).
The credits to Common Stock and Paid-in Capital in Excess of Par indicate that Ogden has issued shares of stock. The debit to Unearned Compensation (often referred to as Deferred Compensation Expense) identifies the total compensation expense the company will recognize over the five-year period. Unearned Compensation represents the cost of services yet to be performed, which is not an asset. Consequently, the company reports Unearned Compensation in stockholders' equity in the balance sheet, as a contra-equity account (similar to the reporting of treasury stock at cost).
At December 31, 2010, Ogden records compensation expense of $4,000 (1,000 shares × $20 × 20%) as follows:
Ogden records compensation expense of $4,000 for each of the next four years (2011, 2012, 2013, and 2014).
What happens if DeGeorge leaves the company before the five years has elapsed? In this situation, DeGeorge forfeits her rights to the stock, and Ogden reverses the compensation expense already recorded.
For example, assume that DeGeorge leaves on February 3, 2012 (before any expense has been recorded during 2012). The entry to record this forfeiture is as follows:
In this situation, Ogden reverses the compensation expense of $8,000 recorded through 2011. In addition, the company debits Common Stock and Paid-in Capital in Excess of Par, reflecting DeGeorge's forfeiture. It credits the balance of Unearned Compensation since none remains when DeGeorge leaves Ogden.
This accounting is similar to accounting for stock options when employees do not fulfill vesting requirements. Recall that once compensation expense is recorded for stock options, it is not reversed. The only exception is if the employee does not fulfill the vesting requirement, by leaving the company early.
In Ogden's restricted-stock plan, vesting never occurred because DeGeorge left the company before she met the service requirement. Because DeGeorge was never vested, she had to forfeit her shares. Therefore, the company must reverse compensation expense recorded to date.[257]
Employee stock-purchase plans (ESPPs) generally permit all employees to purchase stock at a discounted price for a short period of time. The company often uses such plans to secure equity capital or to induce widespread ownership of its common stock among employees. These 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. That is, the discount does not exceed the per share amount of costs avoided by not having to raise cash in a public offering. If the amount of the discount is 5 percent or less, no compensation needs to be recorded.
The plan offers no substantive option feature.
For example, Masthead Company's stock-purchase plan allowed employees who met minimal employment qualifications to purchase its stock at a 5 percent reduction from market price for a short period of time. The reduction from market price is not considered compensatory. Why? Because the per share amount of the costs avoided by not having to raise the cash in a public offering equals 5 percent.
Companies that offer their employees a compensatory ESPP should record the compensation expense over the service life of the employees. It will be difficult for some companies to claim that their ESPPs are non-compensatory (and therefore not record compensation expense) unless they change their discount policy which in the past often was 15 percent. If they change their discount policy to 5 percent, participation in these plans will undoubtedly be lower. As a result, it is likely that some companies will end up dropping these plans.
Companies must fully disclose the status of their compensation plans at the end of the periods presented. To meet these objectives, companies must make extensive disclosures. Specifically, a company with one or more share-based payment arrangements must disclose information that enables users of the financial statements to understand:
The nature and terms of such arrangements that existed during the period and the potential effects of those arrangements on shareholders.
The effect on the income statement of compensation cost arising from share-based payment arrangements.
The 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), during the period.
The cash flow effects resulting from share-based payment arrangements.
Illustration 16-5 (on page 810) presents the type of information disclosed for compensation plans.
The 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. One study documented that, on average, companies in the Standard & Poor's 500 stock index overstated earnings in a recent year by 10 percent through the use of the intrinsic-value method. (See the "What Do the Numbers Mean" box on page 811.) Nevertheless, some companies, such as Coca-Cola, General Electric, Wachovia, Bank One, and The Washington Post, decided to use the fair value method. 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."
Yet many in corporate America resisted the fair value method. Many small high-technology companies have been especially vocal in their opposition, arguing that only through offering stock options can they attract top professional management. They contend that recognizing large amounts of compensation expense under these plans places them at a competitive disadvantage against larger companies that can withstand higher compensation charges. As one high-tech executive stated, "If your goal is to attack fat-cat executive compensation in multi-billion dollar firms, then please do so! But not at the expense of the people who are 'running lean and mean,' trying to build businesses and creating jobs in the process."
The stock-option saga is a classic example of the difficulty the FASB faces in issuing new accounting guidance. Many powerful interests aligned against the Board. Even some who initially appeared to support the Board's actions later reversed themselves. These efforts undermine the authority of the FASB at a time when it is essential that we restore faith in our financial reporting system.
The stock-option controversy involves economic-consequence issues. The FASB believes companies should follow the neutrality concept. Others disagree, noting that factors other than accounting theory should be considered.
Transparent financial reporting—including recognition of stock-based expense—should not be criticized because companies will report lower income. We may not like what the financial statements say, but we are always better off when the statements are representationally faithful to the underlying economic substance of transactions.
By leaving stock-based compensation expense out of income, reported income is biased. Biased reporting not only raises concerns about the credibility of companies' reports, but also of financial reporting in general. Even good companies get tainted by the biased reporting of a few "bad apples." If we write standards to achieve some social, economic, or public policy goal, financial reporting loses its credibility.
Before the change to required expensing of stock options, companies could choose whether to expense stock-based compensation or simply disclose the estimated costs in the notes to the financial statements. 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. And indeed, Merrill Lynch estimated that if all S&P 500 companies were to expense options, reported profits would fall by as much as 10 percent.
Yet, as a small but growing band of big-name companies voluntarily made the switch to expensing, investors for the most part showered them with love. With a few exceptions, the stock prices of the "expensers," from Cinergy to The Washington Post, outpaced the market after they announced the change.
Given the market's general positive reaction to the transparent reporting of stock options, it is puzzling why some companies continued to fight implementation of the expensing rule.
Source: David Stires, "A Little Honesty Goes a Long Way," Fortune (September 2, 2002), p. 186. Reprinted by permission. See also Troy Wolverton, "Foes of Expensing Welcome FASB Delay," TheStreet.com (October 15, 2004).
Companies commonly report per share amounts for the effects of other items, such as a gain or loss on extraordinary items. The financial press also frequently reports earnings per share data. Further, stockholders and potential investors widely use this data in evaluating the profitability of a company. Earnings per share indicates the income earned by each share of common stock. Thus, companies report earnings per share only for common stock. For example, if Oscar Co. has net income of $300,000 and a weighted average of 100,000 shares of common stock outstanding for the year, earnings per share is $3 ($300,000 ÷ 100,000). Because of the importance of earnings per share information, most companies must report this information on the face of the income statement.[258] [6] The exception, due to cost-benefit considerations, is nonpublic companies.[259] Generally, companies report earnings per share information below net income in the income statement. Illustration 16-6 shows Oscar Co.'s income statement presentation of earnings per share.
When the income statement contains intermediate components of income, companies should disclose earnings per share for each component. The presentation in Illustration 16-7 is representative.
These disclosures enable the user of the financial statements to recognize the effects on EPS of income from continuing operations, as distinguished from income or loss from irregular items.[260]
A corporation's capital structure is simple if it consists only of common stock or includes no potential common stock that upon conversion or exercise could dilute earnings per common share. A capital structure is complex if it includes securities that could have a dilutive effect on earnings per common share.
The computation of earnings per share for a simple capital structure involves two items (other than net income)—(1) preferred stock dividends and (2) weighted-average number of shares outstanding.
As we indicated earlier, earnings per share relates to earnings per common share. When a company has both common and preferred stock outstanding, it subtracts the current-year preferred stock dividend from net income to arrive at income available to common stockholders. Illustration 16-8 shows the formula for computing earnings per share.
In reporting earnings per share information, a company must calculate income available to common stockholders. To do so, the company subtracts dividends on preferred stock from each of the intermediate components of income (income from continuing operations and income before extraordinary items) and finally from net income. If a company declares dividends on preferred stock and a net loss occurs, the company adds the preferred dividend to the loss for purposes of computing the loss per share.
If the preferred stock is cumulative and the company declares no dividend in the current year, it subtracts (or adds) an amount equal to the dividend that it should have declared for the current year only from net income (or to the loss). The company should have included dividends in arrears for previous years in the previous years' computations.
In all computations of earnings per share, the weighted-average number of shares outstanding during the period constitutes the basis for the per share amounts reported. Shares issued or purchased during the period affect the amount outstanding. Companies must weight the shares by the fraction of the period they are outstanding. The rationale for this approach is to find the equivalent number of whole shares outstanding for the year.
To illustrate, assume that Franks Inc. has changes in its common stock shares outstanding for the period as shown in Illustration 16-9.
Franks computes the weighted-average number of shares outstanding as follows.
As Illustration 16-10 shows, 90,000 shares were outstanding for three months, which translates to 22,500 whole shares for the entire year. Because Franks issued additional shares on April 1, it must weight these shares for the time outstanding. When the company purchased 39,000 shares on July 1, it reduced the shares outstanding. Therefore, from July 1 to November 1, only 81,000 shares were outstanding, which is equivalent to 27,000 shares. The issuance of 60,000 shares increases shares outstanding for the last two months of the year. Franks then makes a new computation to determine the proper weighted shares outstanding.
When stock dividends or stock splits occur, companies need to restate the shares outstanding before the stock dividend or split, in order to compute the weighted-average number of shares. For example, assume that Vijay Corporation had 100,000 shares outstanding on January 1 and issued a 25 percent stock dividend on June 30. For purposes of computing a weighted-average for the current year, it assumes the additional 25,000 shares outstanding as a result of the stock dividend to be outstanding since the beginning of the year. Thus, the weighted-average for the year for Vijay is 125,000 shares.
Companies restate the issuance of a stock dividend or stock split, but not the issuance or repurchase of stock for cash. Why? Because stock splits and stock dividends do not increase or decrease the net assets of the company. The company merely issues additional shares of stock. Because of the added shares, it must restate the weighted-average shares. Restating allows valid comparisons of earnings per share between periods before and after the stock split or stock dividend. Conversely, the issuance or purchase of stock for cash changes the amount of net assets. As a result, the company either earns more or less in the future as a result of this change in net assets. Stated another way, a stock dividend or split does not change the shareholders' total investment—it only increases (unless it is a reverse stock split) the number of common shares representing this investment.
To illustrate how a stock dividend affects the computation of the weighted-average number of shares outstanding, assume that Sabrina Company has the following changes in its common stock shares during the year.
Sabrina computes the weighted-average number of shares outstanding as follows.
Sabrina must restate the shares outstanding prior to the stock dividend. The company adjusts the shares outstanding from January 1 to June 1 for the stock dividend, so that it now states these shares on the same basis as shares issued subsequent to the stock dividend. Sabrina does not restate shares issued after the stock dividend because they are on the new basis. The stock dividend simply restates existing shares. The same type of treatment applies to a stock split.
If a stock dividend or stock split occurs after the end of the year, but before issuing the financial statements, a company must restate the weighted-average number of shares outstanding for the year (and any other years presented in comparative form). For example, assume that Hendricks Company computes its weighted-average number of shares as 100,000 for the year ended December 31, 2010. On January 15, 2011, before issuing the financial statements, the company splits its stock 3 for 1. In this case, the weighted-average number of shares used in computing earnings per share for 2010 is now 300,000 shares. If providing earnings per share information for 2009 as comparative information, Hendricks must also adjust it for the stock split.
Let's study a comprehensive illustration for a simple capital structure. Darin Corporation has income before extraordinary item of $580,000 and an extraordinary gain, net of tax, of $240,000. In addition, it has declared preferred dividends of $1 per share on 100,000 shares of preferred stock outstanding. Darin also has the following changes in its common stock shares outstanding during 2010.
To compute the earnings per share information, Darin determines the weighted-average number of shares outstanding as follows.
In computing the weighted-average number of shares, the company ignores the shares sold on December 31, 2010, because they have not been outstanding during the year. Darin then divides the weighted-average number of shares into income before extraordinary item and net income to determine earnings per share. It subtracts its preferred dividends of $100,000 from income before extraordinary item ($580,000) to arrive at income before extraordinary item available to common stockholders of $480,000 ($580,000 − $100,000).
Deducting the preferred dividends from the income before extraordinary item also reduces net income without affecting the amount of the extraordinary item. The final amount is referred to as income available to common stockholders, as shown in Illustration 16-15.
Darin must disclose the per share amount for the extraordinary item (net of tax) either on the face of the income statement or in the notes to the financial statements. Illustration 16-16 shows the income and per share information reported on the face of Darin's income statement.
The EPS discussion to this point applies to basic EPS for a simple capital structure. One problem with a basic EPS computation is that it fails to recognize the potential impact of a corporation's dilutive securities. As discussed at the beginning of the chapter, dilutive securities are securities that can be converted to common stock.[261] Upon conversion or exercise by the holder, the dilutive securities reduce (dilute) earnings per share. This adverse effect on EPS can be significant and, more importantly, unexpected unless financial statements call attention to their potential dilutive effect.
As indicated earlier, a complex capital structure exists when a corporation has convertible securities, options, warrants, or other rights that upon conversion or exercise could dilute earnings per share. When a company has a complex capital structure, it generally reports both basic and diluted earnings per share.
Computing diluted EPS is similar to computing basic EPS. The difference is that diluted EPS includes the effect of all potential dilutive common shares that were outstanding during the period. The formula in Illustration 16-17 (on page 817) shows the relationship between basic EPS and diluted EPS.
Some securities are antidilutive. Antidilutive securities are securities that upon conversion or exercise increase earnings per share (or reduce the loss per share). Companies with complex capital structures will not report diluted EPS if the securities in their capital structure are antidilutive. The purpose of presenting both basic and diluted EPS is to inform financial statement users of situations that will likely occur (basic EPS) and also to provide "worst case" dilutive situations (dilutive EPS). If the securities are antidilutive, the likelihood of conversion or exercise is considered remote. Thus, companies that have only antidilutive securities must report only the basic EPS number. We illustrated the computation of basic EPS in the prior section. In the following sections, we address the effects of convertible and other dilutive securities on EPS calculations.
The provisions in U.S. GAAP are substantially the same as those in International Accounting Standard No. 33, "Earnings per Share," issued by the IASB.
At conversion, companies exchange convertible securities for common stock. Companies measure the dilutive effects of potential conversion on EPS using the if-converted method. This method for a convertible bond assumes: (1) the conversion of the convertible securities at the beginning of the period (or at the time of issuance of the security, if issued during the period), and (2) the elimination of related interest, net of tax. Thus the additional shares assumed issued increase the denominator—the weighted-average number of shares outstanding. The amount of interest expense, net of tax associated with those potential common shares, increases the numerator—net income.
As an example, 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 basic earnings per share is therefore $2.10 ($210,000 ÷ 100,000). 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. 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. The tax rate is 40 percent.
As Illustration 16-18 (on page 818) shows, to determine the numerator for diluted earnings per share, Mayfield adds back the interest on the if-converted securities, less the related tax effect. Because the if-converted method assumes conversion as of the beginning of the year, Mayfield assumes that it pays no interest on the convertibles during the year. The interest on the 6 percent convertibles is $60,000 for the year ($1,000,000 × 6%). The increased tax expense is $24,000 ($60,000 × 0.40). The interest added back net of taxes is $36,000 [$60,000 − $24,000, or simply $60,000 × (1 − 0.40)].
Continuing with the information in Illustration 16-18, because Mayfield issues 10 percent convertibles subsequent to the beginning of the year, it weights the shares. In other words, it considers these shares to have been outstanding from April 1 to the end of the year. As a result, the interest adjustment to the numerator for these bonds reflects the interest for only nine months. Thus the interest added back on the 10 percent convertible is $45,000 [$1,000,000 × 10% × 9/12 year × (1 − 0.4)]. The final item in Illustration 16-18 shows the adjusted net income. This amount becomes the numerator for Mayfield's computation of diluted earnings per share.
Mayfield then calculates the weighted-average number of shares outstanding, as shown in Illustration 16-19. This number of shares becomes the denominator for Mayfield's computation of diluted earnings per share.
In its income statement, Mayfield reports basic and diluted earnings per share.[262] Illustration 16-20 shows this dual presentation.
The example above assumed that Mayfield sold its bonds at the face amount. If it instead sold the bonds at a premium or discount, the company must adjust the interest expense each period to account for this occurrence. Therefore, the interest expense reported on the income statement is the amount of interest expense, net of tax, added back to net income. (It is not the interest paid in cash during the period.)
In addition, the conversion rate on a dilutive security may change during the period in which the security is outstanding. For the diluted EPS computation in such a situation, the company uses the most dilutive conversion rate available. For example, assume that a company issued a convertible bond on January 1, 2009, with a conversion rate of 10 common shares for each bond starting January 1, 2011. Beginning January 1, 2014, the conversion rate is 12 common shares for each bond, and beginning January 1, 2018, it is 15 common shares for each bond. In computing diluted EPS in 2009, the company uses the conversion rate of 15 shares to one bond.
A final issue relates to preferred stock. For example, assume that Mayfield's 6 percent convertible debentures were instead 6 percent convertible preferred stock. In that case, Mayfield considers the convertible preferred as potential common shares. Thus, it includes them in its diluted EPS calculations as shares outstanding. 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 stock. The company uses net income as the numerator—it computes no tax effect because preferred dividends generally are not tax-deductible.
A company includes in diluted earnings per share stock options and warrants outstanding (whether or not presently exercisable), unless they are antidilutive. Companies use the treasury-stock method to include options and warrants and their equivalents in EPS computations.
The treasury-stock method assumes that the options or warrants are exercised 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. If the exercise price is lower than the market price of the stock, then the proceeds from exercise are insufficient to buy back all the shares. The company then adds the incremental shares remaining to the weighted-average number of shares outstanding for purposes of computing diluted earnings per share.
For example, if the exercise price of a warrant is $5 and the fair market value of the stock is $15, the treasury-stock method increases the shares outstanding. Exercise of the warrant results in one additional share outstanding, but the $5 received for the one share issued is insufficient to purchase one share in the market at $15. The company needs to exercise three warrants (and issue three additional shares) to produce enough money ($15) to acquire one share in the market. Thus, a net increase of two shares outstanding results.
To see this computation using larger numbers, assume 1,500 options outstanding at an exercise price of $30 for a common share and a common stock market price per share of $50. Through application of the treasury-stock method, the company would have 600 incremental shares outstanding, computed as shown in Illustration 16-21.[263]
Thus, if the exercise price of the option or warrant is lower than the market price of the stock, dilution occurs. An exercise price of the option or warrant higher than the market price of the stock reduces common shares. In this case, the options or warrants are antidilutive because their assumed exercise leads to an increase in earnings per share.
For both options and warrants, exercise is assumed only if the average market price of the stock exceeds the exercise price during the reported period.[264] As a practical matter, a simple average of the weekly or monthly prices is adequate, so long as the prices do not fluctuate significantly.
To illustrate application of the treasury-stock method, assume that Kubitz Industries, Inc. has net income for the period of $220,000. The average number of shares outstanding for the period was 100,000 shares. Hence, basic EPS—ignoring all dilutive securities—is $2.20. The average number of shares related to options outstanding (although not exercisable at this time), at an option price of $20 per share, is 5,000 shares. The average market price of the common stock during the year was $28. Illustration 16-22 shows the computation of EPS using the treasury-stock method.
In business combinations, the acquirer may promise to issue additional shares—referred to as contingent shares—under certain conditions. Sometimes the company issues these contingent shares as a result of the mere passage of time or upon the attainment of a certain earnings or market price level. If this passage of time occurs during the current year, or if the company meets the earnings or market price by the end of the year, the company considers the contingent shares as outstanding for the computation of diluted earnings per share.[265]
For example, assume that Watts Corporation purchased Cardoza Company and agreed to give Cardoza's stockholders 20,000 additional shares in 2013 if Cardoza's net income in 2012 is $90,000. In 2011 Cardoza's net income is $100,000. Because Cardoza has already attained the 2012 stipulated earnings of $90,000, in computing diluted earnings per share for 2011, Watts would include the 20,000 contingent shares in the shares-outstanding computation.
In computing diluted EPS, a company must consider the aggregate of all dilutive securities. But first it must determine which potentially dilutive securities are in fact individually dilutive and which are antidilutive. A company should exclude any security that is antidilutive, nor can the company use such a security to offset dilutive securities.
Recall that including antidilutive securities in earnings per share computations increases earnings per share (or reduces net loss per share). With options or warrants, whenever the exercise price exceeds the market price, the security is antidilutive. Convertible debt is antidilutive if the addition to income of the interest (net of tax) causes a greater percentage increase in income (numerator) than conversion of the bonds causes a percentage increase in common and potentially dilutive shares (denominator). In other words, convertible debt is antidilutive if conversion of the security causes common stock earnings to increase by a greater amount per additional common share than earnings per share was before the conversion.
To illustrate, assume that Martin Corporation has a 6 percent, $1,000,000 debt issue that is convertible into 10,000 common shares. Net income for the year is $210,000, the weighted-average number of common shares outstanding is 100,000 shares, and the tax rate is 40 percent. In this case, assumed conversion of the debt into common stock at the beginning of the year requires the following adjustments of net income and the weighted-average number of shares outstanding.
As a shortcut, Martin can also identify the convertible debt as antidilutive by comparing the EPS resulting from conversion, $3.60 ($36,000 additional earnings × 10,000 additional shares), with EPS before inclusion of the convertible debt, $2.10.
Companies should ignore antidilutive securities in all calculations and in computing diluted earnings per share. This approach is reasonable. The profession's intent was to inform the investor of the possible dilution that might occur in reported earnings per share and not to be concerned with securities that, if converted or exercised, would result in an increase in earnings per share. Appendix 16B to this chapter provides an extended example of how companies consider antidilution in a complex situation with multiple securities.
A company with a complex capital structure would present its EPS information as follows.
When the earnings of a period include irregular items, a company should show per share amounts (where applicable) for the following: income from continuing operations, income before extraordinary items, and net income. Companies that report a discontinued operation or an extraordinary item should present per share amounts for those line items either on the face of the income statement or in the notes to the financial statements. Illustration 16-25 shows a presentation reporting extraordinary items.
A company must show earnings per share amounts for all periods presented. Also, the company should restate all prior period earnings per share amounts presented for stock dividends and stock splits. If it reports diluted EPS data for at least one period, the company should report such data for all periods presented, even if it is the same as basic EPS. When a company restates results of operations of a prior period as a result of an error or a change in accounting principle, it should also restate the earnings per share data shown for the prior periods. Complex capital structures and dual presentation of earnings per share 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.
Illustration 16-26 presents the reconciliation and the related disclosure to meet the requirements of this standard.[266] [7]
Many companies are reporting pro forma EPS numbers along with U.S. 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. Here are some examples.
The SEC has expressed concern that pro forma earnings may be misleading. For example, the SEC cited Trump Hotels & Casino Resorts (DJT) for abuses related to a recent third-quarter pro forma EPS release. It noted that the firm misrepresented its operating results by excluding a material, one-time $81.4 million charge in its pro forma EPS statement and including an undisclosed nonrecurring gain of $17.2 million. The gain enabled DJT to post a profit in the quarter. The SEC emphasized that DJT's pro forma EPS statement deviated from conservative U.S. GAAP reporting. Therefore, it was "fraudulent" because it created a "false and misleading impression" that DJT had actually (1) recorded a profit in the third quarter and (2) exceeded consensus earnings expectations by enhancing its operating fundamentals.
As discussed in Chapter 4, SEC Regulation G now requires companies to provide a clear reconciliation between pro forma and GAAP information. And this applies to EPS measures as well. This reconciliation will be especially important, given the expected spike in pro forma reporting by companies adding back employee stock-option expense.
Sources: See 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).
As you can see, computation of earnings per share is a complex issue. It is a controversial area because many securities, although technically not common stock, have many of its basic characteristics. Indeed, some companies have issued these other securities rather than common stock in order to avoid an adverse dilutive effect on earnings per share. Illustrations 16-27 and 16-28 (on page 824) display the elementary points of calculating earnings per share in a simple capital structure and in a complex capital structure.
The primary iGAAP reporting standards related to financial instruments, including dilutive securities, is IAS 39," Financial Instruments: Recognition and Measurement." The accounting for various forms of stock-based compensation under iGAAP is found in IFRS 2, "Share-Based Payment." This standard was recently amended, resulting in significant convergence between iGAAP and U.S. GAAP in this area. The iGAAP standard addressing accounting and reporting for earnings per share computations is IAS 33, "Earnings per Share."
A significant difference between iGAAP and U.S. GAAP is the accounting for securities with characteristics of debt and equity, such as convertible debt. Under U.S. GAAP, all of the proceeds of convertible debt are recorded as long-term debt. Under iGAAP, convertible bonds are "bifurcated"—separated into the equity component (the value of the conversion option) of the bond issue and the debt component.
Both iGAAP and U.S. 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 iGAAP and U.S. 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. iGAAP requires that share settlement must be used, while U.S. GAAP gives companies a choice. The FASB project proposes adopting the iGAAP approach, thus converging U.S. GAAP and iGAAP in this regard.
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.
As indicated, a significant difference in iGAAP and U.S. GAAP is the accounting for convertible debt. To illustrate, assume Amazon.com issued, at par, $10 million of 10-year convertible bonds with a coupon rate of 4.75%. Amazon makes the following entry to record the issuance under U.S. GAAP.
Under iGAAP, Amazon must "bifurcate" (split out) the equity component—the value of the conversion option—of the bond issue. The equity component can be estimated using option-pricing models. Assume that Amazon estimates the value of the equity option embedded in the bond to be $1,575,000. Under iGAAP, the convertible bond issue is recorded as follows.
Thus, iGAAP records separately the bond issue's debt and equity components. Many believe this provides a more faithful representation of the impact of the bond issue. However, there are concerns about reliability of the models used to estimate the equity component of the bond.
The FASB has been working on a standard that will likely converge to iGAAP 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 U.S. GAAP and iGAAP are similar as to the presentation of EPS, the Boards have been working together to resolve remaining differences related to earnings per share computations.
A major disadvantage of many stock-option plans is that an executive must pay income tax on the difference between the market price of the stock and the option price at the date of exercise. This feature of stock-option plans (those referred to as nonqualified) can be a financial hardship for an executive who wishes to keep the stock (rather than sell it immediately) because he or she would have to pay not only income tax but the option price as well. In another type of plan (an incentive plan), the executive pays no taxes at exercise but may need to borrow to finance the exercise price, which leads to related interest cost.
One solution to this problem was the creation of stock-appreciation rights (SARs). In this type of plan, the 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. The company may pay the share appreciation in cash, shares, or a combination of both.
The major advantage of SARs is that the executive often does not have to make a cash outlay at the date of exercise, but receives a payment for the share appreciation. Unlike shares acquired under a stock-option plan, the company does not issue the shares that constitute the basis for computing the appreciation in a SARs plan. Rather, the company simply awards the executive cash or stock having a market value equivalent to the appreciation. The accounting for stock-appreciation rights depends on whether the company classifies the rights as equity or as a liability.
Companies classify SARs as equity awards if at the date of exercise, the holder receives shares of stock from the company upon exercise. In essence, SARs are essentially equivalent to a stock option. The major difference relates to the form of payment. With the stock option, the holder pays the exercise price and then receives the stock. In an equity SAR, the holder receives shares in an amount equal to the share-price appreciation (the difference between the market price and the pre-established price). The accounting for SARs when they are equity awards follows the accounting used for stock options. 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.
Companies classify SARs as liability awards if at the date of exercise, the holder receives a cash payment. In this case the holder is not receiving additional shares of stock but a cash payment equal to the amount of share-price appreciation. The company's compensation expense therefore changes as the value of the liability changes.
A company uses the following approach to record share-based liability awards:
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 pro-rated 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.
For liability awards, the company estimates the fair value of the SARs, using an option-pricing model. The company then allocates this total estimated compensation cost over the service period, recording expense (or a decrease in expense if fair value declines) in each period. At the end of each period, total compensation expense reported to date should equal the percentage of the total service period that has elapsed, multiplied by the total estimated compensation cost.
For example, assume that the service period is 40 percent complete, and total estimated compensation is $100,000. The company reports cumulative compensation expense to date of $40,000 ($100,000 × .40).
The method of allocating compensation expense is called the percentage approach. In this method, in the first year of, say, a four-year plan, the company charges one-fourth of the estimated cost to date. In the second year, it charges off two-fourths, or 50 percent, of the estimated cost to date, less the amount already recognized in the first year. In the third year, it charges off three-fourths of the estimated cost to date, less the amount recognized previously. In the fourth year it charges off the remaining compensation expense.
A special problem arises when the exercise date is later than the service period. In the previous example, if the stock-appreciation rights were not exercised at the end of four years, in the fifth year the company would have to account for the difference in the market price and the pre-established price. In this case, the company adjusts compensation expense whenever a change in the market price of the stock occurs in subsequent reporting periods, until the rights expire or are exercised, whichever comes first.
Increases or decreases in the fair value of the SAR between the date of grant and the exercise date, therefore, result in a change in the measure of compensation. Some periods will have credits to compensation expense if the fair value decreases from one period to the next. The credit to compensation expense, however, cannot exceed previously recognized compensation expense. In other words, cumulative compensation expense cannot be negative.
Assume that American Hotels, Inc. establishes a stock-appreciation rights plan on January 1, 2010. 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, 2010, is $3, and the service period runs for two years (2010–2011). Illustration 16A-1 indicates the amount of compensation expense to be recorded each period, assuming that the executives hold the SARs for three years, at which time they exercise the rights.
In 2010 American Hotels records compensation expense of $15,000 because 50 percent of the $30,000 total compensation cost estimated at December 31, 2010, is allocable to 2010. In 2011 the fair value increased to $7 per right ($70,000 total). The company recorded additional compensation expense of $55,000 ($70,000 minus $15,000).
The executives held the SARs through 2012, during which time the fair value declined to $5 (and the obligation to the executives equals $50,000). American Hotels recognizes the decrease by recording a $20,000 credit to compensation expense and a debit to Liability under Stock-Appreciation Plan. Note that after the service period ends, since the rights are still outstanding, the company adjusts the rights to market at December 31, 2012. Any such credit to compensation expense cannot exceed previous charges to expense attributable to that plan.
As the company records the compensation expense each period, the corresponding credit is to a liability account, because the company will pay the stock appreciation in cash. American Hotels records compensation expense in the first year as follows.
The company would credit the liability account for $55,000 again in 2011. In 2012, 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.
At December 31, 2012, the executives receive $50,000 (which equals the market price of the shares less the pre-established price). American would remove the liability with the following entry.
Compensation expense can increase or decrease substantially from one period to the next. The reason is that compensation expense is remeasured each year, which can lead to large swings in compensation expense.
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 16A
This appendix illustrates the method of computing dilution when many securities are involved. We present the following section of the balance sheet of Webster Corporation for analysis. Assumptions related to the capital structure follow the balance sheet.
The computation of basic earnings per share for 2010 starts with the amount based upon the weighted-average of common shares outstanding, as shown in Illustration 16B-2.
Note the following points concerning this calculation.
When preferred stock is cumulative, the company subtracts the preferred dividend to arrive at income applicable to common stock, whether the dividend is declared or not.
The company must compute earnings per share of $3 as a starting point, because it is the per share amount that is subject to reduction due to the existence of convertible securities and options.
The steps for computing diluted earnings per share are:
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. That is, rank the results from most dilutive to least dilutive.
Beginning with the earnings per share based upon the weighted-average of common shares outstanding ($3), recalculate earnings per share by adding the smallest per share effects from step 2. If the results from this recalculation are less than $3, proceed to the next smallest per share effect and recalculate earnings per share. Continue this process so long as each recalculated earnings per share is smaller than the previous amount. The process will end either because there are no more securities to test or a particular security maintains or increases earnings per share (is antidilutive).
We'll now apply the three steps to Webster Corporation. (Note that net income and income available to common stockholders are not the same if preferred dividends are declared or cumulative.) Webster Corporation has four securities that could reduce EPS: options, 8 percent convertible bonds, 10 percent convertible bonds, and the convertible preferred stock.
The first step in the computation of diluted earnings per share is to determine a per share effect for each potentially dilutive security. Illustrations 16B-3 through 16B-6 illustrate these computations.
Figure 16B-6. Per Share Effect of 10% Convertible Preferred (If-Converted Method), Diluted Earnings per Share
Illustration 16B-7 shows the ranking of all four potentially dilutive securities.
The next step is to determine earnings per share giving effect to the ranking in Illustration 16B-7. Starting with the earnings per share of $3 computed previously, add the incremental effects of the options to the original calculation, as follows.
Since the recomputed earnings per share is reduced (from $3 to $2.90), the effect of the options is dilutive. Again, we could have anticipated this effect because the average market price ($30) exceeded the option price ($20).
Assuming that Webster converts the 8 percent bonds, recomputed earnings per share is as shown on page 833.
Since the recomputed earnings per share is reduced (from $2.90 to $2.63), the effect of the 8 percent bonds is dilutive.
Next, assuming Webster converts the 10 percent bonds, the company recomputes earnings per share as shown in Illustration 16B-10.
Since the recomputed earnings per share is reduced (from $2.63 to $2.47), the effect of the 10 percent convertible bonds is dilutive.
The final step is the recomputation that includes the 10 percent preferred stock. This is shown in Illustration 16B-11.
Since the recomputed earnings per share is not reduced, the effect of the 10 percent convertible preferred is not dilutive. Diluted earnings per share is $2.47. The per share effects of the preferred are not used in the computation.
Finally, Illustration 16B-12 shows Webster Corporation's disclosure of earnings per share on its income statement.
A company uses income from continuing operations (adjusted for preferred dividends) to determine whether potential common stock is dilutive or antidilutive. Some refer to this measure as the control number. To illustrate, assume that Barton Company provides the following information.
Barton reports basic and dilutive earnings per share as follows.
As Illustration 16B-14 shows, basic earnings per share from continuing operations is higher than the diluted earnings per share from continuing operations. The reason: The diluted earnings per share from continuing operations includes an additional 200,000 shares of potential common stock in its denominator.[267]
Companies use income from continuing operations as the control number because many of them show income from continuing operations (or a similar line item above net income if it appears on the income statement), but report a final net loss due to a loss on discontinued operations. If a company uses final net loss as the control number, basic and diluted earnings per share would be the same because the potential common shares are antidilutive.[268]
SUMMARY OF LEARNING OBJECTIVE FOR APPENDIX 16B
FASB Codification References
FASB ASC 480-10-25. [Predecessor literature: "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity," Statement of Financial Accounting Standards No. 150 (Norwalk Conn.: FASB, 2003), par. 23.]
FASB ASC 470-20-45. [Predecessor literature: "Induced Conversions of Convertible Debt," Statement of Financial Accounting Standards No. 84 (Stamford, Conn.: FASB, 1985).]
FASB ASC 470-20-25-1 to 2. [Predecessor literature: "Accounting for Convertible Debt and Debt Issued with Stock Purchase Warrants," Opinions of the Accounting Principles Board No. 14 (New York, NY: AICPA, 1973).]
FASB ASC 470-20-30. [Predecessor literature: "Accounting for Convertible Debt Instruments that May be Settled in Cash Upon Conversion," FASB Staff Position No. 14-1 (Norwalk, Conn: FASB, 2008).]
FASB ASC 718-10-10. [Predecessor literature: "Accounting for Stock-Based Compensation," Statement of Financial Accounting Standards No. 123 (Norwalk, Conn: FASB, 1995); and "Share-Based Payment," Statement of Financial Accounting Standard No. 123(R) (Norwalk, Conn: FASB, 2004).]
FASB ASC 260-10-45-2. [Predecessor literature: "Earnings per Share," Statement of Financial Accounting Standards No. 128 (Norwalk, Conn: FASB, 1997).]
FASB ASC 260-10-50. [Predecessor literature: "Earnings per Share," Statement of Financial Accounting Standards No. 128, (Norwalk, Conn.: FASB, 1997.)]
Note: All asterisked Questions, Exercises, and Problems relate to material in the appendix to the chapter.
What is meant by a dilutive security?
Briefly explain why corporations issue convertible securities.
Discuss the similarities and the differences between convertible debt and debt issued with stock warrants.
Bridgewater Corp. offered holders of its 1,000 convertible bonds a premium of $160 per bond to induce conversion into shares of its common stock. Upon conversion of all the bonds, Bridgewater Corp. recorded the $160,000 premium as a reduction of paid-in capital. Comment on Bridgewater's treatment of the $160,000 "sweetener."
Explain how the conversion feature of convertible debt has a value (a) to the issuer and (b) to the purchaser.
What are the arguments for giving separate accounting recognition to the conversion feature of debentures?
Four years after issue, debentures with a face value of $1,000,000 and book value of $960,000 are tendered for conversion into 80,000 shares of common stock immediately after an interest payment date. At that time the market price of the debentures is 104, and the common stock is selling at $14 per share (par value $10). The company records the conversion as follows.
Discuss the propriety of this accounting treatment.
On July 1, 2010, Roberts Corporation issued $3,000,000 of 9% bonds payable in 20 years. The bonds include detachable warrants giving the bondholder the right to purchase for $30 one share of $1 par value common stock at any time during the next 10 years. The bonds were sold for $3,000,000. The value of the warrants at the time of issuance was $100,000. Prepare the journal entry to record this transaction.
What are stock rights? How does the issuing company account for them?
Briefly explain the accounting requirements for stock compensation plans under GAAP.
Cordero Corporation has an employee stock-purchase plan which permits all full-time employees to purchase 10 shares of common stock on the third anniversary of their employment and an additional 15 shares on each subsequent anniversary date. The purchase price is set at the market price on the date purchased and no commission is charged. Discuss whether this plan would be considered compensatory.
What date or event does the profession believe should be used in determining the value of a stock option? What arguments support this position?
Over what period of time should compensation cost be allocated?
How is compensation expense computed using the fair value approach?
What are the advantages of using restricted stock to compensate employees?
At December 31, 2010, Reid Company had 600,000 shares of common stock issued and outstanding, 400,000 of which had been issued and outstanding throughout the year and 200,000 of which were issued on October 1, 2010. Net income for 2010 was $2,000,000, and dividends declared on preferred stock were $400,000. Compute Reid's earnings per common share. (Round to the nearest penny.)
What effect do stock dividends or stock splits have on the computation of the weighted-average number of shares outstanding?
Define the following terms.
Basic earnings per share.
Potentially dilutive security.
Diluted earnings per share.
Complex capital structure.
Potential common stock.
What are the computational guidelines for determining whether a convertible security is to be reported as part of diluted earnings per share?
Discuss why options and warrants may be considered potentially dilutive common shares for the computation of diluted earnings per share.
Explain how convertible securities are determined to be potentially dilutive common shares and how those convertible securities that are not considered to be potentially dilutive common shares enter into the determination of earnings per share data.
Explain the treasury-stock method as it applies to options and warrants in computing dilutive earnings per share data.
Earnings per share can affect market prices of common stock. Can market prices affect earnings per share? Explain.
What is meant by the term antidilution? Give an example.
What type of earnings per share presentation is required in a complex capital structure?
* How is antidilution determined when multiple securities are involved?
Coyle Corp. issued $10,000,000 par value 10% convertible bonds at 99. If the bonds had not been convertible, the company's investment banker estimates they would have been sold at 95. Expenses of issuing the bonds were $70,000.
Lambert Company issued $10,000,000 par value 10% bonds at 98. One detachable stock warrant was issued with each $100 par value bond. At the time of issuance, the warrants were selling for $4.
Sepracor, Inc. called its convertible debt in 2010. Assume the following related to the transaction: The 11%, $10,000,000 par value bonds were converted into 1,000,000 shares of $1 par value common stock on July 1, 2010. On July 1, there was $55,000 of unamortized discount applicable to the bonds, and the company paid an additional $75,000 to the bondholders to induce conversion of all the bonds. The company records the conversion using the book value method.
On April 1, 2011, $1,000,000 of these bonds were converted into 30,000 shares of $20 par value common stock. Accrued interest was paid in cash at the time of conversion.
Instructions
Prepare the entry to record the interest expense at October 1, 2010. Assume that accrued interest payable was credited when the bonds were issued. (Round to nearest dollar.)
Prepare the entry(ies) to record the conversion on April 1, 2011. (The book value method is used.) Assume that the entry to record amortization of the bond discount and interest payment has been made.
Instructions
Assuming that the book value method was used, what entry would be made?
Instructions
Prepare the entry to record the original issuance of the convertible debentures.
Prepare the entry to record the exercise of the conversion option, using the book value method. Show supporting computations in good form.
On March 5, 2011, Osygus Corp. called all of the bonds as of April 30 for the principal plus interest through April 30. By April 30 all bondholders had exercised their conversion to common stock as of the interest payment date. Consequently, on April 30, Osygus Corp. paid the semiannual interest and issued shares of common stock for the bonds. The discount is amortized on a straight-line basis. Osygus uses the book value method.
Instructions
Prepare the entry(ies) to record the interest expense and conversion on April 30, 2011. Reversing entries were made on January 1, 2011.
On January 1, 2011, $600,000 of debentures are converted into common stock, which is then selling at $110. An additional $600,000 of debentures are converted on March 31, 2011. The market price of the common stock is then $115. Accrued interest at March 31 will be paid on the next interest date.
Bond premium is amortized on a straight-line basis.
Instructions
Make the necessary journal entries for:
December 31, 2010.
January 1, 2011.
March 31, 2011.
June 30, 2011.
Record the conversions using the book value method.
Instructions
What entry should be made at the time of the issuance of the bonds and warrants?
If the warrants were nondetachable, would the entries be different? Discuss.
Instructions
Prepare in general journal format the entry to record the issuance of the bonds.
(AICPA adapted)
Instructions
Prepare the entry to record the issuance of the bonds and warrants.
Assume the same facts as part (a), except that the warrants had a fair value of $20. Prepare the entry to record the issuance of the bonds and warrants.
All of the options were exercised during the year 2012: 30,000 on January 3 when the market price was $67, and 10,000 on May 1 when the market price was $77 a share.
Instructions
Prepare journal entries relating to the stock-option plan for the years 2010, 2011, and 2012. Assume that the employee performs services equally in 2010 and 2011.
On April 1, 2011, 3,000 options were terminated when the employees resigned from the company. The market value of the common stock was $35 per share on this date.
On March 31, 2012, 12,000 options were exercised when the market value of the common stock was $40 per share.
Instructions
Prepare journal entries to record issuance of the stock options, termination of the stock options, exercise of the stock options, and charges to compensation expense, for the years ended December 31, 2010, 2011, and 2012.
On May 1, 2011, 9,000 options were exercised when the market price of Scooby's stock was $30 per share. The remaining options lapsed in 2013 because executives decided not to exercise their options.
Instructions
Prepare the necessary journal entries related to the stock-option plan for the years 2009 through 2013.
Instructions
Prepare the journal entries to record the restricted stock on January 1, 2010 (the date of grant) and December 31, 2011.
On March 4, 2012, Yaping leaves the company. Prepare the journal entry (if any) to account for this forfeiture.
Instructions
Prepare the journal entries to record the restricted stock on January 1, 2010 (the date of grant) and December 31, 2011.
On July 25, 2014, Tokar leaves the company. Prepare the journal entry (if any) to account for this forfeiture.
Instructions
Compute the weighted-average number of common shares used in computing earnings per common share for 2010 on the 2011 comparative income statement.
Compute the weighted-average number of common shares used in computing earnings per common share for 2011 on the 2011 comparative income statement.
Compute the weighted-average number of common shares to be used in computing earnings per common share for 2011 on the 2012 comparative income statement.
Compute the weighted-average number of common shares to be used in computing earnings per common share for 2012 on the 2012 comparative income statement.
(CMA adapted)
Instructions
Determine the weighted-average number of shares outstanding as of December 31, 2010.
Assume that Chang Corp. earned net income of $3,256,000 during 2010. In addition, it had 100,000 shares of 9%, $100 par nonconvertible, noncumulative preferred stock outstanding for the entire year. Because of liquidity considerations, however, the company did not declare and pay a preferred dividend in 2010. Compute earnings per share for 2010, using the weighted-average number of shares determined in part (a).
Assume the same facts as in part (b), except that the preferred stock was cumulative. Compute earnings per share for 2010.
Assume the same facts as in part (b), except that net income included an extraordinary gain of $864,000 and a loss from discontinued operations of $432,000. Both items are net of applicable income taxes. Compute earnings per share for 2010.
Instructions
What earnings per share data should be reported at the bottom of its income statement, assuming that the casualty loss is extraordinary?
Instructions
Compute earnings per share.
At the end of the current year, Pierson Inc. has outstanding 8,000,000 shares of $10 par common stock and 50,000 shares of 6% preferred.
On April 1 of the current year, Pierson Inc. issued 1,000,000 shares of common stock for $32 per share to help finance the casualty.
Instructions
Compute the earnings per share on common stock for the current year as it should be reported to stockholders.
To acquire the net assets of three smaller companies, Bailey authorized the issuance of an additional 170,000 common shares. The acquisitions took place as shown below.
On May 14, 2010, Bailey realized a $90,000 (before taxes) insurance gain on the expropriation of investments originally purchased in 2000.
On December 31, 2010, Bailey recorded net income of $300,000 before tax and exclusive of the gain.
Instructions
Assuming a 40% tax rate, compute the earnings per share data that should appear on the financial statements of Bailey Industries as of December 31, 2010. Assume that the expropriation is extraordinary.
Net income for 2010 was $2,830,000. No cash dividends were declared or paid during 2010. On February 15, 2011, however, all preferred dividends in arrears were paid, together with a 5% stock dividend on common shares. There were no dividends in arrears prior to 2010.
On April 1, 2010, 450,000 shares of common stock were sold for $10 per share, and on October 1, 2010, 110,000 shares of common stock were purchased for $20 per share and held as treasury stock.
Instructions
Compute earnings per share for 2010. Assume that financial statements for 2010 were issued in March 2011.
Instructions
Compute diluted earnings per share for 2011.
Assume the same facts as those assumed for part (a), except that the 75 bonds were issued on September 1, 2011 (rather than in 2010), and none have been converted or redeemed.
Assume the same facts as assumed for part (a), except that 25 of the 75 bonds were actually converted on July 1, 2011.
On April 1, 2011, the company issued an additional 600,000 shares of stock for cash. All 1,400,000 shares were outstanding on December 31, 2011.
Davenport Inc. also issued $600,000 of 20-year, 8% convertible bonds at par on July 1, 2011. Each $1,000 bond converts to 40 shares of common at any interest date. None of the bonds have been converted to date.
Davenport Inc. is preparing its annual report for the fiscal year ending December 31, 2011. The annual report will show earnings per share figures based upon a reported after-tax net income of $1,540,000. (The tax rate is 40%.)
Instructions
Determine the following for 2011.
The number of shares to be used for calculating:
Basic earnings per share.
Diluted earnings per share.
The earnings figures to be used for calculating:
Basic earnings per share.
Diluted earnings per share.
(CMA adapted)
Instructions
Prepare a schedule to compute both basic and diluted earnings per share.
Discuss how the schedule would differ if the security was convertible preferred stock.
Instructions
Compute diluted earnings per share for 2010.
Compute diluted earnings per share for 2010, assuming the same facts as above, except that $1,000,000 of 6% convertible preferred stock was issued instead of the bonds. Each $100 preferred share is convertible into 5 shares of Lindsey common stock.
Instructions
Compute diluted earnings per share. (Round to the nearest cent.)
Assume the same facts as those assumed for part (a), except that the 1,000 options were issued on October 1, 2010 (rather than in 2009). The average market price during the last 3 months of 2010 was $20.
Instructions
Would the contingent shares have to be considered in Brooks's 2010 earnings per share computations?
Assume the same facts, except that the 10,000 shares are contingent on Donovan's achieving a net income of $130,000 in 2011. Would the contingent shares have to be considered in Brooks's earnings per share computations for 2010?
Instructions
Are the warrants dilutive?
Compute basic earnings per share.
Compute diluted earnings per share.
Instructions
Prepare a schedule that shows the amount of compensation expense allocable to each year affected by the stock-appreciation rights plan.
Prepare the entry at December 31, 2011, to record compensation expense, if any, in 2011.
Prepare the entry on December 31, 2011, assuming that all 120,000 SARs are exercised.
Instructions
Prepare a 5-year (2009–2013) schedule of compensation expense pertaining to the 40,000 SARs granted to president Scott.
Prepare the journal entry for compensation expense in 2009, 2012, and 2013 relative to the 40,000 SARs.
During the current year the following transactions occurred.
The company issued to the stockholders 100,000 rights. Ten rights are needed to buy one share of stock at $32. The rights were void after 30 days. The market price of the stock at this time was $34 per share.
The company sold to the public a $200,000, 10% bond issue at 104. The company also issued with each $100 bond one detachable stock purchase warrant, which provided for the purchase of common stock at $30 per share. Shortly after issuance, similar bonds without warrants were selling at 96 and the warrants at $8.
All but 5,000 of the rights issued in (1) were exercised in 30 days.
At the end of the year, 80% of the warrants in (2) had been exercised, and the remaining were out-standing and in good standing.
During the current year, the company granted stock options for 10,000 shares of common stock to company executives. The company using a fair value option-pricing model determines that each option is worth $10. The option price is $30. The options were to expire at year-end and were considered compensation for the current year.
All but 1,000 shares related to the stock-option plan were exercised by year-end. The expiration resulted because one of the executives failed to fulfill an obligation related to the employment contract.
Instructions
Prepare general journal entries for the current year to record the transactions listed above.
Prepare the stockholders' equity section of the balance sheet at the end of the current year. Assume that retained earnings at the end of the current year is $750,000.
The bonds are convertible after one year into 8 shares of Volker Inc.'s $100 par value common stock for each $1,000 of bonds.
On August 1, 2011, $250,000 of bonds were turned in for conversion into common stock. Interest has been accrued monthly and paid as due. At the time of conversion any accrued interest on bonds being converted is paid in cash.
Instructions
(Round to nearest dollar)
Prepare the journal entries to record the conversion, amortization, and interest in connection with the bonds as of the following dates.
August 1, 2011. (Assume the book value method is used.)
August 31, 2011.
December 31, 2011, including closing entries for end-of-year.
(AICPA adapted)
On January 2, 2010, options to purchase 28,000 shares were granted to president Tom Winter—15,000 for services to be rendered in 2010 and 13,000 for services to be rendered in 2011. Also on that date, options to purchase 14,000 shares were granted to vice president Michelle Bennett—7,000 for services to be rendered in 2010 and 7,000 for services to be rendered in 2011. The market value of the stock was $14 a share on January 2, 2010. The options were exercisable for a period of one year following the year in which the services were rendered. The fair value of the options on the grant date was $4 per option.
In 2011 neither the president nor the vice president exercised their options because the market price of the stock was below the exercise price. The market value of the stock was $8 a share on December 31, 2011, when the options for 2010 services lapsed.
On December 31, 2012, both president Winter and vice president Bennett exercised their options for 13,000 and 7,000 shares, respectively, when the market price was $16 a share.
Instructions
Prepare the necessary journal entries in 2009 when the stock-option plan was adopted, in 2010 when options were granted, in 2011 when options lapsed, and in 2012 when options were exercised.
Instructions
Prepare the journal entry(ies) for the first year of the stock-option plan.
Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700 shares of restricted stock were granted at the beginning of 2010.
Now assume that the market price of Amazon stock on the grant date was $45 per share. Repeat the requirements for (a) and (b).
Amazon would like to implement an employee stock-purchase plan for rank-and-file employees, but it would like to avoid recording expense related to this plan. Which of the following provisions must be in place for the plan to avoid recording compensation expense?
Substantially all employees may participate.
The discount from market is small (less than 5%).
The plan offers no substantive option feature.
There is no preferred stock outstanding.
The following transactions have also occurred at Yaeger.
Options were granted on July 1, 2009, to purchase 200,000 shares at $15 per share. Although no options were exercised during fiscal year 2010, the average price per common share during fiscal year 2010 was $20 per share.
Each bond was issued at face value. The 8% convertible bonds will convert into common stock at 50 shares per $1,000 bond. It is exercisable after 5 years and was issued in 2008.
The preferred stock was issued in 2008.
There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year 2010.
The 1,000,000 shares of common stock were outstanding for the entire 2010 fiscal year.
Net income for fiscal year 2010 was $1,500,000, and the average income tax rate is 40%.
Instructions
For the fiscal year ended June 30, 2010, calculate the following for Fitzgerald Pharmaceutical Industries.
Basic earnings per share.
Diluted earnings per share.
The capital structure of Melton Corporation on June 1, 2009, consisted of 1 million shares of common stock outstanding and 20,000 shares of $50 par value, 6%, cumulative preferred stock. There were no preferred dividends in arrears, and the company had not issued any convertible securities, options, or warrants.
On October 1, 2009, Melton sold an additional 500,000 shares of the common stock at $20 per share. Melton distributed a 20% stock dividend on the common shares outstanding on January 1, 2010. On December 1, 2010, Melton was able to sell an additional 800,000 shares of the common stock at $22 per share. These were the only common stock transactions that occurred during the two fiscal years.
Instructions
Identify whether the capital structure at Melton Corporation is a simple or complex capital structure, and explain why.
Determine the weighted-average number of shares that Melton Corporation would use in calculating earnings per share for the fiscal year ended
May 31, 2010.
May 31, 2011.
Prepare, in good form, a comparative income statement, beginning with income from operations, for Melton Corporation for the fiscal years ended May 31, 2010, and May 31, 2011. This statement will be included in Melton's annual report and should display the appropriate earnings per share presentations.
(CMA adapted)
The company is authorized to issue 8,000,000 shares of $10 par value common stock. As of December 31, 2010, 2,000,000 shares had been issued and were outstanding.
The per share market prices of the common stock on selected dates were as follows.
A total of 700,000 shares of an authorized 1,200,000 shares of convertible preferred stock had been issued on July 1, 2010. The stock was issued at its par value of $25, and it has a cumulative dividend of $3 per share. The stock is convertible into common stock at the rate of one share of convertible preferred for one share of common. The rate of conversion is to be automatically adjusted for stock splits and stock dividends. Dividends are paid quarterly on September 30, December 31, March 31, and June 30.
Thompson Corporation is subject to a 40% income tax rate.
The after-tax net income for the year ended December 31, 2011 was $11,550,000.
The following specific activities took place during 2011.
January 1—A 5% common stock dividend was issued. The dividend had been declared on December 1, 2010, to all stockholders of record on December 29, 2010.
April 1—A total of 400,000 shares of the $3 convertible preferred stock was converted into common stock. The company issued new common stock and retired the preferred stock. This was the only conversion of the preferred stock during 2011.
July 1—A 2-for-1 split of the common stock became effective on this date. The board of directors had authorized the split on June 1.
August 1—A total of 300,000 shares of common stock were issued to acquire a factory building.
November 1—A total of 24,000 shares of common stock were purchased on the open market at $9 per share. These shares were to be held as treasury stock and were still in the treasury as of December 31, 2011.
Common stock cash dividends—Cash dividends to common stockholders were declared and paid as follows.
April 15—$0.30 per share
October 15—$0.20 per share
Preferred stock cash dividends—Cash dividends to preferred stockholders were declared and paid as scheduled.
Instructions
Determine the number of shares used to compute basic earnings per share for the year ended December 31, 2011.
Determine the number of shares used to compute diluted earnings per share for the year ended December 31, 2011.
Compute the adjusted net income to be used as the numerator in the basic earnings per share calculation for the year ended December 31, 2011.
There were no changes during 2010 in the number of common shares, preferred shares, or convertible bonds outstanding. There is no treasury stock. The company also has common stock options (granted in a prior year) to purchase 75,000 shares of common stock at $20 per share.
Instructions
Compute basic earnings per share for 2010.
Compute diluted earnings per share for 2010.
Income from operations before income taxes for Agassi was $1,400,000 and $660,000, respectively, for fiscal years ended May 31, 2011 and 2010. Agassi experienced an extraordinary loss of $400,000 because of an earthquake on March 3, 2011. A 40% combined income tax rate pertains to any and all of Agassi Corporation's profits, gains, and losses.
Agassi's capital structure consists of preferred stock and common stock. The company has not issued any convertible securities or warrants and there are no outstanding stock options.
Agassi issued 40,000 shares of $100 par value, 6% cumulative preferred stock in 2007. All of this stock is outstanding, and no preferred dividends are in arrears.
There were 1,000,000 shares of $1 par common stock outstanding on June 1, 2009. On September 1, 2009, Agassi sold an additional 400,000 shares of the common stock at $17 per share. Agassi distributed a 20% stock dividend on the common shares outstanding on December 1, 2010. These were the only common stock transactions during the past 2 fiscal years.
Instructions
Determine the weighted-average number of common shares that would be used in computing earnings per share on the current comparative income statement for:
The year ended May 31, 2010.
The year ended May 31, 2011.
Starting with income from operations before income taxes, prepare a comparative income statement for the years ended May 31, 2011 and 2010. The statement will be part of Agassi Corporation's annual report to stockholders and should include appropriate earnings per share presentation.
The capital structure of a corporation is the result of its past financing decisions. Furthermore, the earnings per share data presented on a corporation's financial statements is dependent upon the capital structure.
Explain why Agassi Corporation is considered to have a simple capital structure.
Describe how earnings per share data would be presented for a corporation that has a complex capital structure.
(CMA adapted)
CA16-1 (Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.
Instructions
Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.
Discuss the underlying rationale for the differences described in (a)1 above.
Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.
At the start of the year Huish Company issued $18,000,000 of 12% bonds along with warrants to buy 1,200,000 shares of its $10 par value common stock at $18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of $1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding, and the market price was $23 per share. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have been issued at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received.
(AICPA adapted)
In 2010, Gail Devers, the controller of Rouse, reviews year-end estimates of bad debt expense and warranty expense. She calculates the EPS growth at 15%. Kurt Adkins, a member of the executive group, remarks over lunch one day that the estimate of bad debt expense might be decreased, increasing EPS growth to 16.1%. Devers is not sure she should do this because she believes that the current estimate of bad debts is sound. On the other hand, she recognizes that a great deal of subjectivity is involved in the computation.
Instructions
Answer the following questions.
What, if any, is the ethical dilemma for Devers?
Should Devers's knowledge of the compensation plan be a factor that influences her estimate?
How should Devers respond to Adkins's request?
To existing stockholders on a pro rata basis.
To certain key employees under an incentive stock-option plan.
To purchasers of the corporation's bonds.
Instructions
For each of the three examples of how stock warrants are used:
Explain why they are used.
Discuss the significance of the price (or prices) at which the warrants are issued (or granted) in relation to (1) the current market price of the company's stock, and (2) the length of time over which they can be exercised.
Describe the information that should be disclosed in financial statements, or notes thereto, that are prepared when stock warrants are outstanding in the hands of the three groups listed above.
(AICPA adapted)
WASHINGTON, D.C.—February 17, 2005 Congressman David Dreier (R-CA), Chairman of the House Rules Committee, and Congresswoman Anna Eshoo (D-CA) reintroduced legislation today that will preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares.
"Last year, the U.S. House of Representatives overwhelmingly voted for legislation that would have ensured the continued ability of innovative companies to offer stock options to rank-and-file employees," Dreier stated. "Both the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC) continue to ignore our calls to address legitimate concerns about the impact of FASB's new standard on workers' ability to have an ownership stake in the New Economy, and its failure to address the real need of shareholders: accurate and meaningful information about a company's use of stock options."
"In December 2004, FASB issued a stock option expensing standard that will render a huge blow to the 21st century economy," Dreier said. "Their action and the SEC's apparent lack of concern for protecting shareholders, requires us to once again take a firm stand on the side of investors and economic growth. Giving investors the ability to understand how stock options impact the value of their shares is critical. And equally important is preserving the ability of companies to use this innovative tool to attract talented employees."
"Here We Go Again!" by Jack Ciesielski (2/21/2005,
http://www.accountingobserver.com/blog/2005/02/here-we-go-again) On February 17, Congressman David Dreier (R-CA), and Congresswoman Anna Eshoo (D-CA), officially entered Silicon Valley's bid to gum up the launch of honest reporting of stock option compensation: They co-sponsored a bill to "preserve broad-based employee stock option plans and give investors critical information they need to understand how employee stock options impact the value of their shares." You know what "critical information" they mean: stuff like the stock compensation for the top five officers in a company, with a rigged value set as close to zero as possible. Investors crave this kind of information. Other ways the good Congresspersons want to "help" investors: The bill "also requires the SEC to study the effectiveness of those disclosures over three years, during which time, no new accounting standard related to the treatment of stock options could be recognized. Finally, the bill requires the Secretary of Commerce to conduct a study and report to Congress on the impact of broad-based employee stock option plans on expanding employee corporate ownership, skilled worker recruitment and retention, research and innovation, economic growth, and international competitiveness."It's the old "four corners" basketball strategy: stall, stall, stall. In the meantime, hope for regime change at your opponent, the FASB.
Instructions
What are the major recommendations of the stock-based compensation pronouncement?
How do the provisions of GAAP in this area differ from the bill introduced by members of Congress (Dreier and Eshoo), which would require expensing for options issued to only the top five officers in a company? Which approach do you think would result in more useful information? (Focus on comparability.)
The bill in Congress urges the FASB to develop a rule that preserves "the ability of companies to use this innovative tool to attract talented employees." Write a response to these Congress-people explaining the importance of neutrality in financial accounting and reporting.
CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) "Earnings per share" (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a "times earnings" figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.
One of the technical procedures applicable in EPS computations is the "treasury-stock method." Briefly describe the circumstances under which it might be appropriate to apply the treasury-stock method.
Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.
(AICPA adapted)
CA16-6 (EPS Concepts and Effect of Transactions on EPS) Chorkina Corporation, a new audit client of yours, has not reported earnings per share data in its annual reports to stockholders in the past. The treasurer, Beth Botsford, requested that you furnish information about the reporting of earnings per share data in the current year's annual report in accordance with generally accepted accounting principles.
Instructions
Define the term "earnings per share" as it applies to a corporation with a capitalization structure composed of only one class of common stock. Explain how earnings per share should be computed and how the information should be disclosed in the corporation's financial statements.
Discuss the treatment, if any, that should be given to each of the following items in computing earnings per share of common stock for financial statement reporting.
Outstanding preferred stock issued at a premium with a par value liquidation right.
The exercise at a price below market value but above book value of a common stock option issued during the current fiscal year to officers of the corporation.
The replacement of a machine immediately prior to the close of the current fiscal year at a cost 20% above the original cost of the replaced machine. The new machine will perform the same function as the old machine that was sold for its book value.
The declaration of current dividends on cumulative preferred stock.
The acquisition of some of the corporation's outstanding common stock during the current fiscal year. The stock was classified as treasury stock.
A 2-for-1 stock split of common stock during the current fiscal year.
A provision created out of retained earnings for a contingent liability from a possible lawsuit.
Instructions
Write Mr. Dolan a 1–1.5 page letter explaining why the warrants are not included in the calculation. Use the following data to help you explain this situation.
Rhode Corporation earned $228,000 during the period, when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of $25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.
The financial statements of P&G are presented in Appendix 5B or can be accessed at the book's companion website, www.wiley.com/college/kieso.
Instructions
Under P&G's stock-based compensation plan, stock options are granted annually to key managers and directors.
How many options were granted during 2007 under the plan?
How many options were exercisable at June 30, 2007?
How many options were exercised in 2007, and what was the average price of those exercised?
How many years from the grant date do the options expire?
To what accounts are the proceeds from these option exercises credited?
What was the number of outstanding options at June 30, 2007, and at what average exercise price?
What number of diluted weighted-average common shares outstanding was used by P&G in computing earnings per share for 2007, 2006, and 2005? What was P&G's diluted earnings per share in 2007, 2006, and 2005?
What other stock-based compensation plans does P&G have?
Instructions
Go to the book's companion website and use information found there to answer the following questions related to The Coca-Cola Company and PepsiCo, Inc.
What employee stock-option compensation plans are offered by Coca-Cola and PepsiCo?
How many options are outstanding at year-end 2007 for both Coca-Cola and PepsiCo?
How many options were granted by Coca-Cola and PepsiCo to officers and employees during 2007?
What was the average exercise price for Coca-Cola and PepsiCo employees during 2007?
What are the weighted-average number of shares used by Coca-Cola and PepsiCo in 2007, 2006, and 2005 to compute diluted earnings per share?
What was the diluted net income per share for Coca-Cola and PepsiCo for 2007, 2006, and 2005?
Instructions
Briefly discuss how Kellogg's financial statements will be affected by the adoption of the new standard.
Some companies argued that the recognition provisions of the standard are not needed, because the computation of earnings per share takes into account dilutive securities such as stock options. Do you agree? Explain, using the Kellogg disclosure provided above.
Sepracor, Inc., a U.S. drug company, reported the following information. The company prepares its financial statements in accordance with U.S. GAAP.
Analysts attempting to compare Sepracor to international drug companies may face a challenge due to differences in accounting for convertible debt under iGAAP. Under IAS 32, "Financial Instruments," convertible bonds, at issuance, must be classified separately into their debt and equity components based on estimated fair value.
Instructions
Compute the following ratios for Sepracor, Inc. (Assume that year-end balances approximate annual averages.)
Return on assets.
Return on stockholders' equity.
Debt to assets ratio.
Briefly discuss the operating performance and financial position of Sepracor. Industry averages for these ratios in 2007 were: ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis would you make an investment in the company's 5% convertible bonds? Explain.
Assume you want to compare Sepracor to an international company, like Bayer (which prepares its financial statements in accordance with iGAAP). Assuming that the fair value of the equity component of Sepracor's convertible bonds is $150,000, how would you adjust the analysis above to make valid comparisons between Sepracor and Bayer?
Richardson Company is contemplating the establishment of a share-based compensation plan to provide long-run incentives for its top management. However, members of the compensation committee of the board of directors have voiced some concerns about adopting these plans, based on news accounts related to a recent accounting standard in this area. They would like you to conduct some research on this recent standard so they can be better informed about the accounting for these plans.
Instructions
Access the FASB Codification at http://asc.fasb.org/home to conduct research using the Codification Research System to prepare responses to the following items. Provide Codification references for your responses.
Identify the authoritative literature that addresses the accounting for share-based payment compensation plans.
Briefly discuss the objectives for the accounting for stock compensation. What is the role of fair value measurement?
The Richardson Company board is also considering an employee share-purchase plan, but the Board does not want to record expense related to the plan. What criteria must be met to avoid recording expense on an employee stock-purchase plan?
Go to the book's companion website, at www.wiley.com/college/kieso, to find an interactive problem that simulates the computerized CPA exam. The professional simulation for this chapter asks you to address questions related to the accounting for stock options and EPS computations.
[248] The FASB continues to deliberate the accounting for financial instruments with characteristics of both debt and equity. In a "Preliminary Views" document, "Financial Instruments with Characteristics of Equity" (November 30, 2007), the Board proposed a definition of equity that is far more restrictive than current practice. Under the proposed "basic ownership approach," only common stock is classified as equity. All other instruments (such as preferred stock, options, and convertible debt) are classified as liabilities. Instruments classified as liabilities are measured at fair value and changes are reported in income. The Board has proposed the basic ownership approach because it requires a narrow definition of equity. A narrow definition provides fewer opportunities to structure instruments and arrangements to achieve a desired accounting treatment. (See http://www.fasb.org/project/liabeq.shtml.)
[249] As with any investment, a buyer has to be careful. For example, Wherehouse Entertainment Inc., which had 6¼ percent convertibles outstanding, was taken private in a leveraged buyout. As a result, the convertible was suddenly as risky as a junk bond of a highly leveraged company with a coupon of only 6¼ percent. As one holder of the convertibles noted, "What's even worse is that the company will be so loaded down with debt that it probably won't have enough cash flow to make its interest payments. And the convertible debt we hold is subordinated to the rest of Wherehouse's debt." These types of situations have made convertibles less attractive and have led to the introduction of takeover protection covenants in some convertible bond offerings. Or, sometimes convertibles are permitted to be called at par, and therefore the conversion premium may be lost.
[250] Later in this discussion we will show that the value of the warrant is normally determined on the basis of a relative market-value approach because of the difficulty of imputing a warrant value in any other manner.
[251] From the illustration, it is apparent that buying warrants can be an "all or nothing" proposition.
[252] A detachable warrant means that the warrant can sell separately from the bond. GAAP makes a distinction between detachable and nondetachable warrants because companies must sell nondetachable warrants with the security as a complete package. Thus, no allocation is permitted. [3]
[253] A recent FASB Staff Position requires that convertible debt that can be settled in cash should account for the liability and equity components separately. [4] That approach is consistent with the FASB exposure draft. [Proposed Statement of Financial Accounting Standards Accounting for Financial Instruments with Characteristics of Liabilities, Equity, or Both; Summary (FASB, Norwalk, Conn.: October 2000).] Academic research indicates that estimates of the debt and equity components of convertible bonds are subject to considerable measurement error. See Mary Barth, Wayne Landsman, and Richard Rendleman, Jr., "Option Pricing-Based Bond Value Estimates and a Fundamental Components Approach to Account for Corporate Debt," The Accounting Review (January 1998). This and other challenges explain in part the extended time needed to develop new standards in this area.
[254] These factors include the volatility of the underlying stock, the expected life of the options, the risk-free rate during the option life, and expected dividends during the option life.
[255] "To vest" means "to earn the rights to." An employee's award becomes vested at the date that the employee's right to receive or retain shares of stock or cash under the award is no longer contingent on remaining in the service of the employer.
[256] Most companies base vesting on future service for a period of generally three to five years. Vesting may also be conditioned on some performance target such as revenue, net income, cash flows, or some combination of these three factors. The employee also collects dividends on the restricted stock, and these dividends generally must be repaid if forfeiture occurs.
[257] There are numerous variations on restricted-stock plans, including restricted-stock units (for which the shares are issued at the end of the vesting period) and restricted-stock plans with performance targets, such as EPS or stock price growth.
[258] For an article on the usefulness of reported EPS data and the application of the qualitative characteristics of accounting information to EPS data, see Lola W. Dudley, "A Critical Look at EPS," Journal of Accountancy (August 1985), pp. 102–111.
[259] A nonpublic enterprise is an enterprise (1) whose debt or equity securities are not traded in a public market on a foreign or domestic stock exchange or in the over-the-counter market (including securities quoted locally or regionally), or (2) that is not required to file financial statements with the SEC. An enterprise is not considered a nonpublic enterprise when its financial statements are issued in preparation for the sale of any class of securities in a public market.
[260] Companies should present, either on the face of the income statement or in the notes to the financial statements, per share amounts for discontinued operations and extraordinary items.
[261] Issuance of these types of securities is typical in mergers and compensation plans.
[262] Conversion of bonds is dilutive because EPS with conversion ($2.02) is less than basic EPS ($2.10). See Appendix 16B for a comprehensive evaluation of antidilution with multiple securities.
[263] The incremental number of shares may be more simply computed:
[264] Options and warrants have essentially the same assumptions and computational problems, although the warrants may allow or require the tendering of some other security, such as debt, in lieu of cash upon exercise. In such situations, the accounting becomes quite complex and is beyond the scope of this book.
[265] In addition to contingent issuances of stock, other situations that might lead to dilution are the issuance of participating securities and two-class common shares. The reporting of these types of securities in EPS computations is beyond the scope of this book.
[266] Note that GAAP has specific disclosure requirements regarding stock-based compensation plans and earning per share disclosures as well.
[267] A company that does not report a discontinued operation but reports an extraordinary item should use that line item (for example, income before extraordinary items) as the control number.
[268] If a company reports a loss from continuing operations, basic and diluted earnings per share will be the same because potential common stock will be antidilutive, even if the company reports final net income. The FASB believes that comparability of EPS information will be improved by using income from continuing operations as the control number.