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Share-Based Compensation

and Earnings Per Share


Chapter 19

PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA

Copyright2013byTheMcGrawHillCompanies,Inc.Allrightsreserved.

19-2

Share-Based Compensation
Stock Award Plans
Compensation:
Salary
Stock awards

Restricted stock plans


Usually tied to continuing employment.
Compensation is market price at date of grant.
Compensation expense accrued over service period.

19-3

Stock Option Plans


Stock option plans give employees the option to buy
a specified number of shares of the firm's
stock,
at a specified exercise price,
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).

19-4

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

19-5

Failed Attempt to Require Expensing


Opposition
Opposition to
to aa proposed
proposed FASB
FASB Statement
Statement to
to
recognize
recognize expense
expense for
for certain
certain stock
stock option
option plans
plans
have
have identified
identified three
three objections.
objections.
1.
1. Options
Options with
with no
no intrinsic
intrinsic value
value at
at issue
issue
have
have zero
zero fair
fair value
value and
and should
should not
not give
give
rise
rise to
to expense
expense recognition.
recognition.
2.
2. ItIt is
is impossible
impossible to
to measure
measure the
the fair
fair value
value of
of
compensation
compensation on
on the
the date
date of
of grant.
grant.
3.
3. The
The proposed
proposed standard
standard would
would have
have
unacceptable
unacceptable economic
economic consequences.
consequences.

19-6

Recognizing Fair Value of Options


Accounting
Accounting for
for stock
stock options
options parallels
parallels the
the accounting
accounting
for
for restricted
restricted stock
stock we
we discussed
discussed earlier.
earlier. We
We are
are
required
required to
to estimate
estimate the
the fair
fair value
value of
of stock
stock option
option
on
on the
the grant
grant date.
date.
The FASB requires that compensation expense be
measured using one of several option pricing models
that deal with:
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.

Plans with Performance or Market


Conditions
In some circumstances, compensation from a
stock option plan depends on meeting a
performance target.
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.

19-7

19-8

U. S. GAAP vs. IFRS


There are more similarities than differences in the
treatment of stock options. One major difference is the
treatment of deferred tax assets and when options have
graded vesting.

A deferred tax asset (DTA) is


created for the cumulative
amount of the fair value of the
options the company has
recorded for compensation
expense.
Account for each vesting
amount separately or account
for the entire award on the
straight-line basis over the
entire vesting period.

The deferred tax asset is


not created until the award
is in the money; that is it
has intrinsic value.

Straight-line choice is not


permitted. Companies not
required to recognize the
award that has vested by
each reporting date.

19-9

Plans With Graded-Vesting


Rather than stock option plans vesting on a single date, more plans
awards specify that recipients gradually become eligible to exercise their
options rather than all at once. This is called graded vesting.
Accounting for compensation expense may be handled:

The company may estimate


a single fair value for each
of the options, even though
they vest over different time
periods, using a single
weighted-average expected
life of the options.

The company may use a slightly


more complex method because it
usually results in lower expense.
In this approach, we view each
vesting group separately, as if it
were a separate award. For
example, a company may award
stock options that vest 25% in
the first year, 25% in the second
year, and 50% in the third year.
For accounting purposes we have
three separate awards.

1910

Employee Share Purchase Plans

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:

Cash (100 $8.50)


Compensation expense (100 $1.50)
Common stock (100 $10.00)
Market
Market value
value

850
150
1,000

1911

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.

1912

Basic Earnings Per Share


Simple Capital Structure
(Basic EPS)

Net
Net income
income (after
(after tax)
tax) Preferred
Preferred dividends*
dividends*
Weighted-average
Weighted-average outstanding
outstanding common
common stock
stock

Number of shares outstanding


Number of months outstanding 12
Weighted-average shares outstanding
*Current
*Current periods
periods cumulative
cumulative preferred
preferred stock
stock dividends
dividends (whether
(whether
or
or not
not declared)
declared) and
and noncumulative
noncumulative preferred
preferred stock
stock dividends
dividends
(only
(only ifif declared).
declared).

1913

Issuance of New Shares


Compute the weighted-average number of
shares of common stock outstanding.

1914

Issuance of New Shares


Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting

Annual
Weighting

100,000 + [50,000 (9/12)] + [10,000 (3/12)] = 140,000


Shares
at Jan. 1

New
Shares

New
Shares

1915

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.

1916

Stock Dividends and Stock Splits


Compute the weighted-average number of shares of
common stock outstanding.

1917

Stock Dividends and Stock Splits


Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting

100,000 (2.00) + [50,000 (9/12) 2.00] = 275,000


Shares
at Jan. 1

New
Shares
Stock dividend
adjustment

1918

Stock Dividends and Stock Splits


Retroactive treatment
New shares
issued this period?
Yes
Stock
Stock dividend
dividend or
or split
split is
is
applied
applied retroactively
retroactively in
in
proportion
proportion to
to the
the number
number of
of
shares
shares outstanding
outstanding at
at the
the
time
time of
of the
the dividend
dividend or
or split.
split.

No

Stock
Stock dividend
dividend or
or split
split
is
is treated
treated as
as
outstanding
outstanding from
from the
the
beginning
beginning of
of the
the
period.
period.

1919

Reacquired Shares
If shares were reacquired during the
period, the weighted-average number of
shares is reduced. The number of
reacquired shares is time-weighted for
the fraction of the year they were not
outstanding.

1920

Reacquired Shares
Compute the weighted-average number of shares
of common stock outstanding.

1921

Reacquired Shares
Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting

Annual
Weighting

100,000 + [50,000 (9/12)] [12,000 (8/12)] = 129,500


Shares
at Jan. 1

New
Shares

Subtract the reacquired shares

Treasury
Shares

Earnings Available to
Common Shareholders

1922

1923

Diluted Earnings Per Share


Potential Common
Common Shares

Complex Capital Structure


(dual EPS)

Stock
Stock options,
options, rights,
rights, and
and warrants
warrants

Convertible
Convertible bonds
bonds and
and stock
stock

Contingent
Contingent common
common stock
stock issues
issues

Contingently
issuable
shares

Stock
Options

Convertible
securities

Treasury stock
method

If-converted
method

Dilution/Antidilution Test

May Report Basic and Diluted Earnings Per Share

1924

Options, Rights, and Warrants


The
The treasury stock method
Proceeds
assumes
assumes that
that proceeds
proceeds
from
from the
the exercise
exercise of
of
At
options
options are
are used
used to
to
average
Used to
purchase
purchase treasury
treasury shares.
shares. market
This
This method
method usually
usually
price
results
results in
in aa net
net increase
increase in
in
Purchase
shares
included
in
the
shares included in the
treasury
denominator
of
the
denominator of the
shares
calculation
calculation of
of diluted
diluted
earnings
earnings per
per share.
share.

1925

Options, Rights, and Warrants


1.
2.

Determine new shares from assumed


exercise of stock options.
Compute number of shares repurchased.
Proceeds
Proceeds from
from assumed
assumed exercise
exercise
Average
Average market
market price
price of
of stock
stock

1926

Options, Rights, and Warrants


1.
2.
3.

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)

1927

Options, Rights, and Warrants


When the exercise price exceeds
the market price, the securities are
antidilutive securities and are
excluded from the calculation of
diluted EPS.

1928

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.

1929

Convertible Securities
The assumed conversion of convertible bonds
or preferred stock has two effects on dilutive
earnings per share:
1.
2.

increases the denominator by the number of


common shares issuable upon conversion,
increases the numerator by decreasing aftertax interest expense on convertible bonds
and dividends on convertible preferred stock.

1930

Convertible Securities
Dilutive earnings per share may decrease
or increase after the assumed conversion.

IfIf dilutive
dilutive earnings
earnings per
per share
share decreases,
decreases, the
the
securities
securities are
are dilutive
dilutive and
and are
are assumed
assumed
converted.
converted.
IfIf dilutive
dilutive earnings
earnings per
per share
share increases,
increases, the
the
securities
securities are
are antidilutive
antidilutive and
and are
are not
not
considered
considered converted.
converted.

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.

1931

1932

Additional EPS Issues


Contingently Issuable Shares
Contingent
Contingent shares
shares are
are issuable
issuable in
in the
the
future
future for
for little
little or
or no
no cash
cash consideration
consideration
upon
upon the
the satisfaction
satisfaction of
of certain
certain conditions.
conditions.
Contingently
Contingently issuable
issuable shares
shares are
are
considered
considered to
to be
be outstanding
outstanding in
in the
the
computation
computation of
of EPS
EPS ifif the
the target
target
performance
performance level
level already
already is
is being
being met.
met.

1933

Contingently Issuable Shares


Contingent shares are included in
dilutive EPS if:
Shares
Shares are
are issued
issued
merely
merely due
due to
to passage
passage
of
of time.
time.

Some
Some target
target performance
performance
level
level has
has already
already been
been
met
met and
and is
is expected
expected to
to
continue
continue to
to the
the end
end of
of the
the
contingency
contingency period.
period.

Example:
Example: Additional
Additional shares
shares may
may be
be
issued
issued based
based on
on future
future earnings.
earnings.

1934

Restricted Stock Awards


Restricted stock awards are quickly replacing
stock options as the share-based compensation
plan of choice. Like stock options, the treasury
stock method is used to calculate the number of
shares in the denominator of the EPS equation.
Unlike stock options, employees do not pay to
acquire their shares of stock.
Changes to the EPS Calculation:

1935

Summary

1936

Summary

1937

Financial Statement Presentation


Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income

1938

Appendix 19A Option-Pricing Theory


Intrinsic
Intrinsic value
value is
is the
the benefit
benefit the
the holder
holder of
of an
an
option
option would
would realize
realize by
by exercising
exercising the
the option
option
rather
rather than
than buying
buying the
the underlying
underlying stock
stock directly.
directly.
An
An option
option that
that permits
permits an
an employee
employee to
to buy
buy $25
$25
stock
stock for
for $10,
$10, has
has an
an intrinsic
intrinsic value
value of
of $15.
$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.

1939

Summary
The
The fair
fair value
value of
of an
an option
option is
is (a)
(a) its
its intrinsic
intrinsic value
value plus
plus (b)
(b)
its
its time
time value
value of
of money
money plus
plus (c)
(c) its
its volatility
volatility component.
component.

Appendix 19B - 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
Usually
same
the fairof the SARs.
grant date
asthe
the
fairasvalue

value of a stock option with


similar terms.

This amount is expensed over the service


period.

1940

1941

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.

1942

End of Chapter 19

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