CHAPTER
16
Dilutive Securities
and
Earnings
per
Share
……..…………………………………………………………...
Convertible Bonds
 exchanged for stock at the bond
holder’s option
 increases the value of the bond
 a “sweetener” might be offered to
induce conversion
ACCOUNTING FOR CONVERTIBLE DEBT
At Time of Issuance
 recorded like a straight debt issue
 no value allocated to conversion privilege
 FASB considers the privilege inseparable
from the bond
Cash
106,000
Bonds Payable
Premium on Bonds Payable
100,000
6,000
At Time of Conversion
 stock is recorded at book value of the
converted bonds
Bonds Payable
100,000
Premium Bond Pay
6,000
1,000
5,000
Induced Conversions
 record the “sweetener” as an expense
Debt Conversion Expense
Bonds Payable
Premium on Bonds Payable
Common Stock
Paid-in Cap – excess of par
Cash
7,000
100,000
5,000
This is the same whether or
not there is a sweetener.
20,000
85,000
7,000
Retirement of Convertible Debt
 recorded like a straight debt retirement
Clear-out the balances of
bonds and premium.
Not an extraordinary item
CONVERTIBLE PREFERRED STOCK
 at conversion, common stock is recorded
at book value of the converted preferred
Preferred Stock
250,000
Add. Paid-in Capital
40,000
STOCK WARRANTS
 options to buy shares of stock at a
certain price
 warrants are issued

with bonds or preferred stock as an
“added bonus”

to common stockholders with a
preemptive right

to executives and employees
Warrants Issued with Other Securities
Example
Sold 500 $1,000 bonds for $505,000. Included with
each bond is a 5-year warrant to buy 1 share of
common for $25.
Incremental Method
Assume the market value of each warrant is $30 and
the market value of the bonds (alone) is unknown.
Proportional Method
Assume the market value of each warrant is $30 and
the market value of each bond is $990.
Mkt Value
Bonds
$495,000
Warrants
15,000
Book Value
STOCK COMPENSATION PLANS
Effective Compensation
 motivate performance

compensation tied to performance

performance over which employee
has control

short- and long-term performance
 retain and recruit executives
Stock options are very
attractive to managers.
Stock price is thought to be
better that Sales or other
accounting measures.
The Expected Value of a Share of Stock
Possible
Stock Values
Probability
$80
$90
$100
$110
$120
10%
20%
40%
20%
10%
Expected value
$ 8
18
40
22
12
$100
What is the value of an option to buy 1
share of stock at $100?
The Value of a Stock Option
Possible
Stock Values
Probability
Value of Option
to buy at $100
$80
$90
$100
$110
$120
10%
20%
40%
20%
10%
$0
$0
$0
$10
$20
Expected value
An option to buy has value.
$0
0
0
2
2
$4
The Value of Volatility
Possible
Stock Values
Probability
Value of Option
to buy at $100
$60
$80
$100
$120
$140
10%
20%
40%
20%
10%
$0
$0
$0
$20
$40
Expected value
$0
0
0
4
4
$8
Accounting for Stock Compensation
 Valuation

intrinsic value method: excess of market
price over exercise price

fair value method: estimated value of
options expected to vest

value generally measured at grant date

FASB now requires fair value method
 Allocation of expense

expense recognized in the service period

generally service period = vesting period
Exercise 16-10 (Modified)
Columbo Company adopted a stock option plan: options
to buy 30,000 shares of $10 par common stock at $40.
Options were exercisable 2 years after grant date. Value
of options was $450,000.
November 1, 2007 Plan adopted
no entry
January 2, 2008 Options granted
no entry
2-year service period
beginning on the
grant date.
December 31, 2008 (first year of service period completed)
December 31, 2009 (second year of service completed)
January 3, 2010 20,000 options were exercised
January 2, 2014 10,000 options expired
DISCLOSURE OF COMPENSATION PLANS
 number and weighted average fair value
of options

granted

exercised

forfeited

outstanding
 average remaining life of options
outstanding
EARNINGS PER SHARE – SIMPLE
EPS
=
Net Income - Preferred Dividends
Weighted Average Shares Outstanding
Current year preferred dividend
or
Dividend that should have been declared
if the preferred stock is cumulative
Weighted Average Shares Outstanding
Dates
Outstanding
Shares
Outstanding
1/1 – 4/1
4/1 – 7/1
7/1 –11/1
11/1 – 12/31
90,000
120,000
81,000
141,000
Fraction
of Year
New stock issued
Stock repurchased
Weighted Average with Stock Dividend or Split
1/1
3/1
8/1
10/1
Beginning balance
Issued 30,000 shares
2 for 1 stock split
Purchsd 20,000 shares
Dates
Outstnd
1/1 – 3/1
3/1 – 10/1
10/1 – 12/31
Shares
Outstnd
Rstmt
# Shares
80,000
110,000
220,000
200,000
Fraction
of Year
EARNINGS PER SHARE – COMPLEX
 Dilutive securities have an adverse effect
on EPS

convertible securities

options or warrants
 Firms must report both Basic EPS and
Dilutive EPS
Convertible Securities: If-Converted Method
1/1
Beginning balance: 200,000 shares common
5/1
Issued $500,000, 8% bonds for $535,530
(effective interest = 7%) convertible into
24,000 shares common
Net Income (net of 40% tax): $350,000
Net Income
Add: Bond interest (net of tax)
$535,530 x 7% x 8/12
Less: 40% tax
Adjusted net income
$350,000
$24,991
9,997
14,994
$364,994
1/1
Beginning balance: 200,000 shares common
5/1
Issued $500,000, 8% bonds for $535,530
(effective interest = 7%) convertible into
24,000 shares common
Net Income (net of 40% tax): $350,000
Dates
Outstanding
Shares Out
if Converted
1/1 – 5/1
5/1 – 12/31
Basic EPS
=
Diluted EPS =
Fraction
of Year
Antidilutive Convertible Securities
Outstanding for the year:
500,000 shares common
$1,000,000, 10% bonds issued at par
convertible into 50,000 shares common
Net Income (net of 30% tax): $600,000
Bond interest (net of tax)
$1,000,000 x 10% x (1 - .30)
Basic EPS
“Diluted” EPS
$70,000
=
=
Any security that increases EPS should be excluded.
Options and Warrants: Treasury Stock Method
 Options and warrants are dilutive if the
exercise price is lower than the market price.
 Increases the potential shares outstanding.
 No effect on net income.
Potential
=
Add. Shares
=
Basic EPS
Diluted EPS
Market Price - Option Price
Market Price
$50 - $30
$50
=
=
x
1,500
x # of Options
=
600
EPS Presentation
Exercise 16-18
STOCK OPTIONS - OTHER STUFF
APB Opinion #25
 Old approach that some firms follow.
Incentive Stock Options
Nonqualified Options

Tax advantages to
employee

Tax advantages to firm

option price = market
price on grant date

option price is usually
less than market price

no compensation
expense

compensation expense =
mkt price - option price
Stock Appreciation Rights
 right to receive compensation equal to the market
price over a pre-established price
 at the end of each year of the service period

estimate total SAR compensation
(market price - pre-established price) x # of rights

multiply by % compensation accrued

bring cumulative compensation up to date
Estimate of total
compensation will change
from year to year.
This might mean recording
negative compensation in
some years.