Download The exercise price is equal to the market price of $24 per share

Share-Based
Compensation and
Earnings Per
Share
19
Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Learning Objectives
Explain and implement the accounting for
stock award plans.
19-3
Stock Award Plans
Restricted stock award plans usually are
tied to continued employment of the
person receiving the award.
The compensation associated with a share of
restricted stock is the market price at the
grant date of an unrestricted share of the
same stock.
The amount is accrued as compensation
expense over the service period for which
participants receive the shares.
19-4
Stock Award Plans
On January 1, 2006, Matrix, Inc. grants 10,000 shares
of its $2 par value common stock to its CEO. The
shares will be forfeited if the CEO leaves within the next
five years. On January 1, the common stock of Matrix is
selling for $62 per share.
No entry is required on January 1, 2006, but total
compensation is calculated at the date of grant as follows:
Number of
×
Shares issuable
Fair value
per share
Total
=
Compensation
10,000 × $62.00 = $620,000
19-5
Stock Award Plans
The total compensation of $620,000 will be
recognized over the service period of 5 years.
$620,000 ÷
5
=
$124,000 per year
On December 31, 2006, through 2010, we will
prepare the following journal entry:
GENERAL JOURNAL
Date
Description
Debit
Credit
Dec 31 Compensation expense
124,000
Paid-in capital - restricted stock
124,000
19-6
Stock Award Plans
On December 31, 2010, the restrictions are
lifted, and the following entry will be made:
GENERAL JOURNAL
Date
Description
Dec 31 Paid-in capital - restricted stock
Common stock (10,000 x $2)
Paid-in capital in excess of par
Debit
Credit
620,000
20,000
600,000
19-7
Stock Option Plans
In most cases, employees are not awarded
shares of stock. Rather they are given an
option to buy shares at some time in the
future.
Options are usually granted
1. for a specified number of shares,
2. at a specified price,
3. during a specified period of time.
19-8
Learning Objectives
Explain and implement the accounting for
stock options.
19-9
Expense – The Great Debate
Historically, options have been measured at
their intrinsic value – the simple difference
between the market price of the shares and
the option price at which they can be
acquired. If the market and exercise price
are equal on the date of grant, no
compensation expense is recognized even if
the options provide executives with
substantial income.
19-10
Expense – The Great Debate
Critics to current practice have identified three
objections.
1. Options with no intrinsic value at issue have
zero fair value and should not give rise to
expense recognition.
2. It is impossible to measure the fair value of
compensation on the date of grant.
3. Current practices have unacceptable economic
consequences.
19-11
Recognizing Fair Value of Options
Effective for fiscal years beginning after June 15, 2005,
companies now are required to estimate
the fair value of stock options on the grant date.
SFAS 123 (revised) requires the use of an
option pricing model that deals with the:
1. Exercise price of the option.
2. Expected term of the option.
3. Current market price of the stock.
4. Expected dividends.
5. Expected risk-free rate of return.
6. Expected volatility of the stock.
19-12
Stock Option Plans
Stock option plans give employees the
option to purchase (a) a specified number
of shares of the firm's stock, (b) at a
specified exercise price, (c) during a
specified period of time.
The fair value is accrued as compensation
expense over the service period for which
participants receive the options, usually
from the date of grant to when the options
become exercisable (the vesting date).
19-13
Stock Option Plans
On January 1, 2006, Matrix, Inc. granted options that permit
key executives to acquire 50,000 shares of the company’s
$1 par value common stock within the next 5 years, but not
before December 31, 2009 (the vesting date). The exercise
price is equal to the market price of $24 per share. Using an
option pricing model, the fair value of each option if $6.
No entry required on January 1, 2006, but total compensation is
determined as follows:
Options granted
Fair value per option
Total compensation
50,000
$
6
$ 300,000
19-14
Stock Option Plans
On January 1, 2006, Matrix, Inc. granted options that
permit key executives to acquire 50,000 shares of the
company’s $1 par value common stock within the next
5 years, but not before December 31, 2009 (the vesting
date). The exercise price is equal to the market price
of $24 per share. Using an option pricing model, the
fair value of each option if $4.
On December 31, 2006 through 2009 (the vesting date), the
following entry will be made:
Description
Compensation expense
Paid-in capital - stock options
($300,000 ÷ 4 years = $75,000)
Debit
75,000
Credit
75,000
19-15
Stock Option Plans
On June 4, 2010, all the options were
exercised and the shares of common stock
were issued to the key executives. The
following journal entry is required:
Description
Cash
Paid-in capital - stock options
Common stock
Paid-in capital - excess of par
50,000 shares × $24
Debit
1,200,000
300,000
Credit
50,000
1,450,000
Account balance
19-16
Stock Option Plans
Let’s assume that previous experience had indicated
that 4% of the options will be forfeited due to
employee turnover. We would adjust our entries to
recognize compensation expense in 2006 and
subsequent years, as follows:
Description
Compensation expense
Paid-in capital - stock options
Debit
72,000
($300,000 × 96%) ÷ 4 years
Credit
72,000
19-17
Stock Option Plans
Assume the market price of the company’s
common stock never exceeds $24 per share. The
options will not be exercised. On December 31,
2010 the following entry is required to recognize
the fact that the options have expired.
Description
Paid-in capital - stock options
Paid-in capital - expired stock options
Debit
300,000
Credit
300,000
19-18
Plans with Performance or Market Conditions
In some circumstances, compensation from a
stock option plan depends on meeting a
performance target. When this is the case,
compensation expense depends on whether
or not we feel it is probable that the target
performance will be met.
19-19
Plans with Performance or Market Conditions
Recall our previous plan that permits key executives to
acquire 50,000 shares of the company’s common stock
within the next 5 years, but not before December 31, 2009
(the vesting date). Now assume another condition is that
earnings per share exceed $2.50. The exercise price is equal
to the market price of $24 per share. Using an option pricing
model, the fair value of each option is $6.
At December 31, 2006, it was not probable that the
earnings per share condition will be met.
Description
Debit
Credit
19-20
Plans with Performance or Market Conditions
At December 31, 2007, management
determined that it was probable that the
earnings per share condition will be met.
Options granted
Fair value per option
Total compensation
Number of years
Compensation for 2007
Compensation for 2006
Total compensation
50,000
× $
6
$ 300,000
÷
4
$ 75,000
75,000
$ 150,000
Description
Compensation expense
Paid-in capital - stock options
Debit
150,000
Credit
150,000
19-21
Learning Objectives
Explain and implement the accounting for
stock appreciation rights.
19-22
Stock Appreciation Rights
The recipient is awarded the share
appreciation, which is the amount by
which the market price on the exercise
date exceeds the option price The
employee may receive cash or equity
securities in the company..
$$$
19-23
Stock Appreciation Rights
 The SARs are considered to be equity if the
employer can elect to settle in shares of stock.
 The amount of compensation is estimated at
the grant date as the fair value of the SARs.
Usually the same as the
fair value of a stock option
with similar terms.
 This amount is expensed over the service
period.
19-24
Stock Appreciation Rights
 The SARs are considered to be a liability if the
employee can elect to receive cash upon
settlement. In that case, the amount of
compensation (and related liability) is estimated
each period and continuously adjusted to reflect
changes in the fair value of the SARs until the
compensation is finally paid.
 The current expense (and adjustment to the
liability) is the fraction of the total compensation
earned to date by recipients of the SARs (based
on the elapsed percentage of the service
period), reduced by any amounts expensed in
prior periods.
19-25
Stock Appreciation Rights
On January 1, 2006, Matrix, Inc. grants
its CEO 20,000 stock appreciation
rights that entitle the CEO to receive
cash equal to the difference between
the market price of the stock and $25
per share. The rights are exercisable
anytime over the next 5 years.
19-26
Stock Appreciation Rights
No entry is required on January 1, 2006. On December 31,
2006, we calculate the compensation expense as follows:
Since
Stock
Price at
Excess
Year
12/31
Over $25 Shares
2006
$
30 $
5
20,000 $
2007
32
7
20,000
2008
34
9
20,000
2009
32
7
20,000
the plan
period,
we will
2010covers a five
35 year 10
20,000
Total
100,000
140,000
180,000
140,000
recognize
200,000
fifth of the total compensation in 2006.
Total
$ 100,000
140,000
180,000
140,000
Percent
Liability Current
Accrued
Total
Balance Expense
20%
$ 20,000 $
$ 20,000
40%
56,000
20,000
36,000
60%
108,000
56,000
52,000
80%
112,000
108,000
4,000
one-
19-27
Stock Appreciation Rights
The journal entry to recognize compensation in
2006 would be:
Description
Compensation expense
Liability - SAR plan
Debit
20,000
Credit
20,000
Recognized as a liability because
settlement is in cash.
19-28
Stock Appreciation Rights
On December 31, 2007, the fair value of one share of Matrix
common stock is $32. We calculate the compensation expense
as follows:
Since
Stock
Price at
Excess
Year
12/31
Over $25 Shares
Total
2006
$
30 $
5
20,000 $ 100,000
2007
32
7
20,000
140,000
2008
34
9
20,000
180,000
the plan
five year period,
we will 140,000
recognize
2009 covers a32
7
20,000
2010
35
10
20,000in 2007.
200,000
fifths of the total
compensation
Total
$ 100,000
140,000
180,000
140,000
Percent
Liability Current
Accrued
Total
Balance Expense
20%
$ 20,000 $
$ 20,000
40%
56,000
20,000
36,000
60%
108,000
56,000
52,000
80%
112,000
108,000
4,000
two-
19-29
Stock Appreciation Rights
The journal entry to recognize compensation in
2007 would be:
Description
Compensation expense
Liability - SAR plan
Debit
36,000
Credit
36,000
For the two-year period, 2006 and 2007, we have
recognized $56,000 in compensation
($20,000 + $36,000)
19-30
Stock Appreciation Rights
Year
2006
2007
2008
2009
2010
Stock
Price at
Excess
12/31
Over $25
$
30 $
5
32
7
34
9
32
7
35
10
Notice how we
calculate
compensation
expense each
year.
Shares
20,000
20,000
20,000
20,000
20,000
Total
$ 100,000
$ 140,000
$ 180,000
$ 140,000
$ 200,000
Total
$ 100,000
140,000
180,000
140,000
200,000
Percent
Accrued
20%
40%
60%
80%
100%
Total
$ 20,000
56,000
108,000
112,000
200,000
The stock price
changed each
year through
2010.
Liability Current
Balance Expense
$
$ 20,000
20,000
36,000
56,000
52,000
108,000
4,000
112,000
88,000
19-31
Stock Appreciation Rights
On December 31, 2010, the CEO of Matrix
exercises his stock appreciation rights and is
paid the balance in the liability account.
Description
Liability - SAR plan
Cash
Debit
200,000
Credit
200,000
19-32
Learning Objectives
Explain and implement the accounting for
stock purchase plans.
19-33
Employee Share Purchase Plan
Permit employees to buy shares directly from their
employer.
Usually the plan is considered compensatory, and
compensation expense is recorded.
Employees may buy 100 shares of no par stock for
$8.50 per share. The current market price is $10.00.
The $1.50 discount is recorded as compensation
expense:
Description
Cash (100 × $8.50)
Compensation expense (100 × $1.50)
Common stock (100 × $10.00)
Debit
850
Credit
150
1,000
19-34
Learning Objectives
Distinguish between a simple and a complex
capital structure.
19-35
Earnings Per Share (EPS)
Of the myriad facts and figures generated
by accountants, the single accounting
number that is reported most frequently in
the media and receives by far the most
attention by investors and creditors is
earnings per share.
19-36
Basic Earnings Per Share
*Current period’s cumulative preferred stock
Simple Capital dividends
Structure
(whether or not declared) and
(Basic EPS)
noncumulative preferred stock dividends
(only if declared).
Net income (after tax) – Preferred dividends*
Weighted average outstanding common stock
Number of shares outstanding
× Number of months outstanding ÷ 12
Weighted average shares outstanding
19-37
Earnings Per Share
A company had 200,000 shares of $50 par value
common stock, 10,000 shares of 5%, $20 par value
cumulative preferred stock, and 30,000 shares of 5%,
$10 par value noncumulative preferred stock
outstanding during the year. Net income after taxes
was $1,500,000. No dividends were declared during
the year. EPS would be
a. $7.50
b. $7.43
c. $7.45
d. $7.38
19-38
Earnings Per Share
A company had 200,000 shares of $50 par value
common stock, 10,000 shares of 5%, $20 par value
cumulative preferred stock, and 30,000 shares of 5%,
$10 par value noncumulative preferred stock
outstanding during the year. Net income after taxes
was $1,500,000. No dividends were declared during
the year. EPS would be
a. $7.50
$1,500,000 – (10,000 × 5% × $20 par)
b. $7.43
200,000 shares
c. $7.45
Since dividends were not declared, only
d. $7.38
the cumulative preferred stock dividends
are subtracted.
19-39
Learning Objectives
Describe what is meant by the weighted
average number of common shares.
19-40
Issuance of New Shares
Compute the weighted average number of
shares of common stock outstanding.
Date
1/1
4/1
10/1
Description
Balance
Issued
Issued
No. of Shares
100,000
50,000
10,000
19-41
Issuance of New Shares
Compute the weighted average number of
shares of common stock outstanding.
100,000 + [50,000 × (9/12)] + [10,000 × (3/12)] = 140,000
Shares
at Jan. 1
New
Shares
New
Shares
19-42
Learning Objectives
Differentiate the effect on EPS of the sale of
new shares, a stock dividend or stock split,
and the reacquisition of shares.
19-43
Stock Dividends and Stock Splits
Common shares issued as part of stock
dividends and stock splits are treated
retroactively as subdivisions of the shares
already outstanding at the date of the split
or dividend.
19-44
Stock Dividends and Stock Splits
Compute the weighted average number of shares
of common stock outstanding.
Date
1/1
4/1
5/1
Description
No. of Shares
Balance
100,000
Issued
50,000
Stock dividend(100%)
150,000
19-45
Stock Dividends and Stock Splits
Compute the weighted average number of
shares of common stock outstanding.
100,000 × (2.00) + [50,000 × (9/12) × 2.00] = 275,000
Shares
at Jan. 1
New
Shares
Stock dividend
adjustment
19-46
Stock Dividends and Stock Splits
Retroactive treatment:
New shares
issued this period?
Yes
Stock dividend or split is
applied retroactively in
proportion to the number of
shares outstanding at the time
of the dividend or split.
No
Stock dividend or split
is treated as
outstanding from the
beginning of the period.
19-47
Reacquired Shares
The weighted average number of shares is
reduced by the number of reacquired
shares, time-weighted for the fraction of the
year they were not outstanding.
19-48
Reacquired Shares
Compute the weighted average number of
shares of common stock outstanding.
Date
1/1
4/1
5/1
Description
Balance
Issued
Repurchased shares
No. of Shares
100,000
50,000
12,000
19-49
Reacquired Shares
Compute the weighted average number of
shares of common stock outstanding.
100,000 + [50,000 × (9/12)] - [12,000 × (8/12)] = 129,500
Shares
at Jan. 1
New
Shares
Treasury
Shares
19-50
Learning Objectives
Describe how preferred dividends affect the
calculation of EPS
19-51
Earnings Available to Common Shareholders
Net income
Less: Current period’s cumulative preferred stock dividends
(whether or not declared)
Less: Noncumulative preferred stock dividends (only if
declared).
Net income available to common shareholders
19-52
Diluted Earnings Per share
Complex Capital Structure
(dual EPS)
Potential Common Shares:
•Stock options, rights, and warrants
•Convertible bonds and stock
•Contingent common stock issues
Contingently
issuable
shares
Stock
Options
Convertible
securities
Treasury
stock method
If-converted
method
Dilution/Antidilution Test
19-53
Complex Capital Structure
Dual presentation of Earnings Per Share:
Basic EPS
Diluted EPS
19-54
Learning Objectives
Describe how options, rights, and warrants are
incorporated in the calculation of EPS.
19-55
Options, Rights, and Warrants
The treasury stock method
assumes that proceeds from
the exercise of options are
used to purchase treasury
shares. This method usually
results in a net increase in
shares included in the
denominator of the calculation
of diluted earnings per share.
Proceeds
At
average
market
price
Used to
Purchase
treasury
shares
19-56
Options, Rights, and Warrants
 Determine
new shares from assumed
exercise of stock options.
 Compute number of shares repurchased.
Proceeds from assumed exercise
Average market price of stock
19-57
Options, Rights, and Warrants
 Determine
new shares from assumed
exercise of stock options.
 Compute shares purchased for the treasury.
 Compute the incremental shares assumed
outstanding.
New shares from assumed exercise (1)
Less: Treasury shares assumed purchased (2)
Net increase in shares outstanding (3)
19-58
Options, Rights, and Warrants
When the exercise price
exceeds the market
price, the securities are
antidilutive.
19-59
Treasury Stock Method
Common stock outstanding was 100,000 shares.
Options to purchase 5,000 shares of common stock
were outstanding at the beginning of the year. The
options can be exercised to purchase stock at $50 per
share. The average market price of the stock was $80.
The net increase in the dilutive earnings per share
denominator is
a. 25,000 shares
b. 5,000 shares
c. 3,125 shares
d. 1,875 shares
19-60
Treasury Stock Method
Common stock outstanding was 100,000 shares.
Options to purchase 5,000 shares of common stock
were outstanding at the beginning of the year. The
options can be exercised to purchase stock at $50 per
share. The average market price of the stock was $80.
The net increase in the dilutive earnings per share
denominator is
a. 25,000 shares
b. 5,000 shares
New shares = 5,000
c. 3,125 shares
Treasury shares = 3,125
d. 1,875 shares
(5,000 × $50) ÷ $80
Incremental shares = 1,875
(5,000 - 3,125)
19-61
Learning Objectives
Describe how convertible securities are
incorporated in the calculation of EPS.
19-62
Convertible Securities
The if-converted method is used for
Convertible debt and equity
securities
The method assumes conversion occurs as of
the beginning of the period or date of issuance,
if later.
19-63
Convertible Securities
The assumed conversion of convertible bonds or
preferred stock has two effects on dilutive
earnings per share:
Increases the denominator by the number of common
shares issuable upon conversion.
Increases the numerator by decreasing after-tax
interest expense on convertible bonds, and dividends
on convertible preferred stock.
19-64
Convertible Securities
Dilutive earnings per share may decrease or
increase after the assumed conversion.
If dilutive earnings per share decreases,
the securities are dilutive and are
assumed converted.
If dilutive earnings per share increases,
the securities are antidilutive and are
not considered converted.
19-65
If-Converted Method
Assume net income (after tax) of $500,000,
cumulative convertible preferred stock
dividends of $25,000, common stock
outstanding of 50,000 shares, and a tax
rate of 30%. The convertible preferred
stock is convertible into 5,000 shares of
common stock.
Is the convertible preferred stock dilutive?
19-66
If-Converted Method
EPS without conversion:
$500,000 – $25,000 = $9.50 EPS
50,000 shares
If the preferred stock is converted, we would not have
dividends and the number of shares of common stock would
increase by 5,000 shares. There is not a tax effect.
EPS after assumed conversion:
$500,000 – $0
= $9.09 EPS
55,000 shares
Dilutive
19-67
If-Converted Method
Assume net income (after tax) of $500,000,
convertible bonds with interest expense of
$50,000, common stock outstanding of
50,000 shares, and a tax rate of 30%. The
bonds are convertible into 2,000 shares of
common stock.
Are the convertible bonds dilutive?
19-68
If-Converted Method
EPS without conversion:
$500,000
= $10.00 EPS
50,000 shares
If the bonds are converted, net income would increase by
$35,000 (after taxes) and the number of shares of common
stock would increase by 2,000 shares.
EPS after assumed conversion:
$535,000
52,000
shares
= $10.29 EPS
Antidilutive
19-69
Order of Entry for Multiple Convertible Securities
When a company has more than one
instance of potential common shares,
they are considered for inclusion in
dilutive EPS in sequence from the
most dilutive to the least dilutive.
19-70
Learning Objectives
Explain the way contingently issuable shares
are incorporated in the calculation of EPS.
19-71
Contingently Issuable Shares
Contingent shares are issuable in the
future for little or no cash consideration
upon the satisfaction of certain
conditions.
Future
19-72
Contingently Issuable Shares
Contingent shares are included in
dilutive EPS if:
Shares are issued
merely due to passage
of time.
Some target performance
level has already been
met and is expected to
continue to the end of the
contingency period.
Example: Additional shares may be
issued based on future earnings.
19-73
Contingently Issuable Shares
Contingent shares are considered
outstanding common shares and are
included in basic EPS as of the date that all
necessary conditions have been satisfied.
19-74
Summary
Potential Common Shares
Stock options (or warrants, rights)
Convertible securities (bonds, notes,
preferred stock)
Contingently issuable shares
Dilutive Effect Shown?
Basic EPS
Diluted EPS
no
yes
no
no
yes
yes
19-75
Summary
Impact
Potential Common Shares
Stock options (or warrants, rights)
Convertible bonds or notes
Convertible preferred
Add back
dividends declared
Denominator
Add incremental
shares
Add shares
issuable upon
conversion
Add shares
issuable upon
conversion
None
None
Add shares
issuable
None
Numerator
None
Add after tax
interest
Contingently issuable shares
Conditions being currently met
Conditions not being met
19-76
Earnings Per Share Disclosure
Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income
19-77
Option-Pricing
Theory
Appendix 19
19-78
Intrinsic Value
Intrinsic value is the benefit the holder of an option
would realize by exercising the option rather than
buying the underlying stock directly. An option that
permits an employee to buy $25 stock for $10, has
an intrinsic value of $15.
Options have a time
value because the
holder of an option does
not have to pay the
exercise price until the
option is exercised.
19-79
Summary
The fair value of an option is (a) its intrinsic value plus (b)
its time value of money plus (c) its volatility component.
All Other Factors Being Equal, If the:
Exercise price is higher
Term of the option is longer
Market price of the stock is higher
Dividends are higher
Risk-free rate of return is higher
Volatility of the stock is higher
The Option Value Will Be:
Lower
Higher
Higher
Lower
Higher
Higher
19-80
End of Chapter 19