CH-19 Share-Based Compensation and Earnings per Share – Intermediate Accounting : Book Guide

Chapter 19 Share-Based Compensation and Earnings per Share 1 Chapter 19 Share-Based Compensation and Earnings per Share QUESTIONS FOR REVIEW OF KEY TOPICS Question 19-1 Restricted stock refers to shares actually awarded in the name of an employee, although the employer might retain physical possession of the shares. Typically, the employee has all rights of a shareholder, but the shares are subject to certain restrictions or forfeiture. Usually the employee is not free to sell the shares during the restriction period. Restricted shares usually are subject to forfeiture by the employee if employment is terminated between the date of grant and a specified vesting date. Restrictions provide the employee incentive to remain with the company. Compensation cost is the fair value of the restricted stock at the grant date and is equal to the market price of unrestricted shares of the same stock. The fair value of shares awarded under a restricted stock award plan is accrued to compensation expense over the service period for which participants receive the shares. This usually is the period from the date of grant to when restrictions are lifted (the vesting date). Question 19-2 The fair value of a stock option is determined by employing a recognized option pricing model. The option pricing model should take into account 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 during the term of the option, and (6) expected volatility of the stock. Question 19-3 The recipient pays no tax at the time of the grant or the exercise of the options under an incentive plan. Instead, the tax on the difference between the option price and the market price at the exercise date is paid on the date any shares acquired are subsequently sold. The employer gets no tax deduction at all. The employee cannot delay paying tax under a nonqualified plan. The tax that could be deferred until the shares are sold under an incentive plan must be paid at the exercise date under a nonqualified plan. On the other hand, the employer is allowed to deduct the difference between the option price and the market price on the exercise date. Thus, a nonqualified plan offers favorable tax treatment to the employer, while an incentive plan offers favorable tax treatment to the employee. 2 Answers to Questions (continued) Question 19-4 The fair value of stock options has two essential components: (1) intrinsic value and (2) time value. “Intrinsic value” is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. For example, an option that allows an employee to buy $13 stock for $8 has an intrinsic value of $5. “Time value” exists so long as time remains before expiration because the market price of the underlying stock may yet rise and create additional intrinsic value. Question 19-5 For performance-based options initial estimates of compensation cost as well as subsequent revisions of that estimate take into account the likelihood of both forfeitures and achieving performance targets. If it is probable that the performance target will be met, we recognize compensation over the vesting period at fair value. If achieving the target is not probable, no compensation is recorded. Probability is reassessed each period. If the award contains a market condition (e.g., a share option with an exercisability requirement based on the stock price reaching a specified level), then no special accounting is required. The fair value estimate of the share option already implicitly reflects market conditions due to the nature of share option pricing models. Thus, we recognize compensation expense regardless of when, if ever, the market condition is met. Question 19-6 The accounting treatment of SARs depends on whether the award is considered an equity instrument or a liability. If the employer can choose to settle in shares rather than cash, the award is considered to be equity. If the employee will receive cash or can choose to receive cash, the award is considered to be a liability. This is the case with the LTV plan. As a result, the amount of compensation and related liability is continually adjusted to reflect changes in the fair value of the SARs until the liability is finally settled. The expense each period is the percentage of the total liability earned to date by recipients of the SARs (based on the elapsed percentage of the service period), minus any amounts expensed in prior periods. Both compensation expense and the liability are adjusted each period until the SARs ultimately either are exercised or lapse. Question 19-7 A firm has a simple capital structure if it has no potential common shares outstanding. These are securities that are not yet common stock, but might become common stock if exercised or converted. Thus, they could potentially dilute (meaning reduce) earnings per share. For a firm with a simple capital structure, EPS is simply earnings available to common shareholders divided by the weighted-average number of common shares outstanding. 3 Answers to Questions (continued) Question 19-8 There is a fundamental difference between the increase in shares caused by stock dividends and stock splits and an increase from selling new shares. When additional shares are sold, both the assets of the firm and shareholders’ equity are increased by an additional investment by owners. On the other hand, stock dividends or stock splits merely increase the number of shares without affecting the firm’s assets. As a consequence, the same “pie” is divided into more pieces resulting in a larger number of less valuable shares. Shares outstanding prior to a stock dividend or stock split are retroactively restated to reflect the increase in shares, as if the distribution occurred at the beginning of the period. On the other hand, any new shares issued are “time- weighted’ by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period. Question 19-9 The weighted-average number of shares for calculating EPS would be 104,500 determined as follows: 100,000 (1.05) – 1,200 (5/12) = 104,500 shares shares stock treasury at Jan. 1 dividend shares adjustment The 1,200 shares retired are weighted by (5/12) to reflect the fact they were not outstanding the last five months of the year. Purchases of shares that occur after a stock dividend or split are not affected by the distribution. Question 19-10 Preferred dividends are deducted from the numerator in the EPS fraction so that “earnings available to common shareholders” will be divided by the weighted-average number of common shares. An exception would be when the preferred stock is noncumulative and no dividends were declared in the reporting period. Another time the deduction is not made is when the preferred stock is convertible and the calculation of EPS assumes the preferred stock has been converted and therefore no dividends are paid. Question 19-11 Basic EPS does not reflect the dilutive effect of potential common shares. On the other hand, diluted EPS incorporates the dilutive effect of all potential common shares, if the effect is not antidilutive. Question 19-12 When calculating diluted EPS, we assume that the shares specified by stock options, warrants, and rights are issued at the exercise price and that the proceeds are used to buy back as treasury stock as many of those shares as could be acquired at the average market price during the reporting period. 4 Answers to Questions (continued) Question 19-13 The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. The numerator is increased by the after-tax interest that would have been avoided if the bonds really had not been outstanding. This effect is reflected in diluted EPS calculations only if the effect is dilutive. Question 19-14 The potentially dilutive effect of convertible preferred stock is reflected in diluted EPS calculations by assuming the preferred stock was converted into common stock, just as is done with convertible bonds. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible preferred stock was issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. Since EPS are calculated as if the preferred shares had been converted into common shares, there would be no dividends on the preferred stock; so, earnings available to common shareholders are increased in the calculation by the dividends that otherwise would have been distributed to preferred shareholders. This is similar to the way after-tax interest would be added back to net income if the securities were convertible bonds. The difference is that dividends have no tax effect to consider. This effect is reflected in diluted EPS calculations only if the effect is dilutive. Question 19-15 The order in which convertible securities are included in the dilutive EPS calculation is determined by comparing the incremental effect of their conversion. They should be included in numerical order, beginning with the lowest incremental effect (that is, the most dilutive). 5 Answers to Questions (concluded) Question 19-16 Contingently issuable shares are considered outstanding in the computation of diluted EPS when they will later be issued upon the mere passage of time or because of conditions that currently are met. If this year’s operating income were $2.2 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 50,000 additional shares to the denominator of the EPS fraction: Contingently issuable shares: no numerator adjustment ——————————— + 50,000 additional shares If conditions specified for issuance are not yet met, the additional shares are ignored in the calculation. This would be the case if this year’s operating income had been $2 million. Question 19-17 The calculation of diluted EPS assumes convertible bonds had been converted at the beginning of the year (unless they actually were issued later). If they actually had been converted, the actual conversion would cause an actual increase in shares at the conversion date. These additional shares would be time-weighted for the remainder of the year. The numerator would be higher because net income actually would be increased by the after-tax interest saved on the bonds for that period. But the calculation also would assume conversion for the period before the actual conversion date because they were potentially dilutive during that period. The shares assumed outstanding would be time-weighted for the fraction of the year before the conversion, and the numerator would be increased by the after-tax interest assumed saved on the bonds for the same period. Question 19-18 EPS data (both basic and diluted for a complex capital structure) must be reported on the face of the income statement for income from continuing operations and net income. Per share numbers for discontinued operations and extraordinary items also should be reported either on the face of the income statement or in related disclosure notes when these components of net income are present. Question 19-19 Disclosure notes should include (a) a summary description of the rights and privileges of the company’s various securities and (b) supplemental EPS data for transactions that occur after the balance sheet date that result in a material change to the number of shares outstanding at the balance sheet date, and (c) a reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations. 6 7 BRIEF EXERCISES Brief Exercise 19-1 $6 fair value per share x 8 million shares granted = $48 million fair value of award The $48 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $16 million each year. Brief Exercise 19-2 $5 fair value per option x 12 million options granted = $60 million fair value of award The $60 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $20 million each year. Brief Exercise 19-3 The company should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes. 2007 Compensation expense ([$60 x 95% x 2/3] – $20) .................. 18 Paid-in capital –stock options .............................................. 18 2008 Compensation expense ([$60 x 95% x 3/3] – $20 – $18) ........ 19 Paid-in capital –stock options .............................................. 19 Note that this approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a 3-year depreciable asset having no estimated residual value. The $60 million depreciable cost would be depreciated straight-line at $20 million over the three-year useful life. If the estimated residual value changes after one year to 5% of cost, the new estimated depreciable cost of $57 would be reduced by the $20 million depreciation recorded the first year, and the remaining $37 million would be depreciated equally, $18.5 million per year, over the remaining two years. 8 Brief Exercise 19-4 ($ in millions) Cash ($17 exercise price x 12 million shares) ...................... 204 Paid-in capital - stock options (account balance) ............ 60 Common stock (12 million shares at $1 par per share) .... 12 Paid-in capital – excess of par (remainder) ................... 252 Note: The market price at exercise is irrelevant. Brief Exercise 19-5 Paid-in capital - stock options (account balance) ............ 60 Paid-in capital – expiration of stock options .......... 60 Brief Exercise 19-6 The estimate of the total compensation would be: 100,000 x $6 = $600,000 options fair estimated expected value total to vest compensation One-third of that amount, or $200,000, will be recorded in each of the three years. Brief Exercise 19-7 The new estimate of the total compensation would change to: 0 x $6 = $0 options fair estimated expected value total to vest compensation In that case, Farmer would reverse the $200,000 expensed in 2006 because no compensation can be recognized for options that don’t vest due to performance targets not being met, and that’s the new expectation. 9 Brief Exercise 19-8 In that case, in 2007, the revised estimate of the total compensation would change to $600,000: 100,000 x $6 = $600,000 options fair estimated expected value total to vest compensation Farmer would reflect the cumulative effect on compensation in 2007 earnings and record compensation thereafter: 2007 Compensation expense ([$600,000 x 2/3] - $0) 400,000 Paid-in capital –stock options .................. 400,000 2008 Compensation expense ([$600,000 x 3/3] - $400,000) 200,000 Paid-in capital –stock options .................. 200,000 Brief Exercise 19-9 If an award contains a market condition such as the stock price reaching a specified level, then no special accounting is required. The fair value estimate of the share option ($6) already implicitly reflects market conditions due to the nature of share option pricing models. So, Farmer recognizes compensation expense regardless of when, if ever, the market condition is met. The estimate of the total compensation would be: 100,000 x $6 = $600,000 options fair estimated expected value total to vest compensation One-third of that amount, or $200,000, will be recorded in each of the three years. 10 Brief Exercise 19-10 (amounts in millions, except per share amount) net Earnings income Per Share $741 $741 ——————————————————————— = —— = $1.30 544 + 36 (10/12) – 6 (8/12) 570 shares new shares at Jan. 1 shares retired Brief Exercise 19-11 (amounts in millions, except per share amount) net preferred income dividends Earnings $426 – $16 $410 Per Share —————————————————— = —— = $.50 820 820 common shares Since the preferred stock is cumulative, the dividends (8% x $200 million = $16 million) are deducted even though no dividends were declared. There are no potential common shares, so a single calculation of EPS is appropriate. 11 Brief Exercise 19-12 24,000 shares – 20,000 shares* = 4,000 shares *Purchase of treasury shares 24,000 shares x $50 (exercise price) $1,200,000 ÷ $60 (average market price) 20,000 shares Brief Exercise 19-13 (amounts in thousands, except per share amounts) Basic EPS net preferred income dividends $1,500 – $60 $1,440 ————————————————— = ——— = $1.80 800 800 shares at Jan. 1 Diluted EPS net income $1,500 $1,500 ———————————————— = ——— = $1.50 800 + 200 1,000 shares conversion* at Jan. 1 of preferred shares • The preferred shares are considered converted when calculating diluted EPS. If converted, there would be no preferred dividends. 12 EXERCISES Exercise 19-1 Requirement 1 $5 fair value per share x 16 million shares granted = $80 million fair value of award Requirement 2 December 31, 2006 ($ in millions) Compensation expense ($80 million ÷ 2 years)... 40 Paid-in capital – restricted stock ................. 40 December 31, 2007 Compensation expense ($80 million ÷ 2 years)... 40 Paid-in capital – restricted stock ................. 40 Paid-in capital – restricted stock ..................... 80 Common stock (16 million shares x $1 par) ..... 16 Paid-in capital – excess of par (remainder) ... 64 13 Exercise 19-2 Requirement 1 $2.50 fair value per share x 12 million shares granted = $30 million fair value of award Requirement 2 no entry Requirement 3 ($ in millions) Compensation expense ($30 million ÷ 3 years)... 10 Paid-in capital – restricted stock ................. 10 Requirement 4 Compensation expense ($30 million ÷ 3 years)... 10 Paid-in capital – restricted stock ................. 10 Requirement 5 Compensation expense ($30 million ÷ 3 years)... 10 Paid-in capital – restricted stock ................. 10 Requirement 6 Paid-in capital – restricted stock ..................... 30 Common stock (12 million shares x $1 par) ..... 12 Paid-in capital – excess of par (remainder) ... 18 14 Exercise 19-3 Requirement 1 $22.50 fair value per share x 4 million shares granted = $90 million fair value of award Requirement 2 no entry Requirement 3 ($ in millions) Compensation expense ($90 million ÷ 3 years)... 30 Paid-in capital – restricted stock ................. 30 Requirement 4 $22.50 fair value per share x 4 million shares granted x 90% 100% – 10% forfeiture rate = $81 million fair value of award 15 Exercise 19-4 Requirement 1 $3 fair value per option x 4 million options granted = $12 million total compensation Requirement 2 no entry Requirement 3 ($ in millions) Compensation expense ($12 million ÷ 2 years)... 6 Paid-in capital – stock options .................... 6 Requirement 4 Compensation expense ($12 million ÷ 2 years)... 6 Paid-in capital – stock options .................... 6 16 Exercise 19-5 Requirement 1 At January 1, 2006, the estimated value of the award is: $3 estimated fair value per option x 25 million options granted = $75 million total compensation Requirement 2 ($ in millions) Compensation expense ($75 million ÷ 3 years)............................. 25.0 Paid-in capital – stock options ............................................. 25.0 Requirement 3 Adams-Menke should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes. 2007 Compensation expense ([$75 x 94% x 2/3] – $25) .................. 22 Paid-in capital –stock options .............................................. 22 2008 Compensation expense ([$75 x 94% x 3/3] – $25 – $22) ........ 23.5 Paid-in capital –stock options .............................................. 23.5 Note that this approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a 3-year depreciable asset having no estimated residual value. The $75 million depreciable cost would be depreciated straight-line at $25 million over the three-year useful life. If the estimated residual value changes after one year to 6% of cost, the new estimated depreciable cost of $70.5 would be reduced by the $25 million depreciation recorded the first year, and the remaining $45.5 million would be depreciated equally, $22.75 million per year, over the remaining two years. 17 Exercise 19-6 Requirement 1 At January 1, 2006, the estimated value of the award is: $1 estimated fair value per option x 40 million options granted = $40 million fair value of award Requirement 2 ($ in millions) Compensation expense ($40 million ÷ 2 years)... 20 Paid-in capital – stock options ................... 20 Requirement 3 Compensation expense ($40 million ÷ 2 years)... 20 Paid-in capital – stock options ................... 20 Requirement 4 Cash ($8 exercise price x 30 million shares)........................ 240 Paid-in capital - stock options (3/4 account balance of $40 million) ................................ 30 Common stock (30 million shares at $1 par per share) .... 30 Paid-in capital – excess of par (remainder) ................... 240 Note: The market price at exercise is irrelevant. Requirement 5 Paid-in capital – stock options ($40 -30 million) ............ 10 Paid-in capital – expiration of stock options .......... 10 18 Exercise 19-7 Requirement 1 At January 1, 2006, the total compensation is measured as: $ 3 fair value per option x 12 million options granted = $36 million intrinsic value of award Requirement 2 December 31, 2006, 2007, 2008 ($ in millions) Compensation expense ($36 million ÷ 3 years)................ 12 Paid-in capital – stock options ................................. 12 Requirement 3 Cash ($11 exercise price x 12 million shares) ...................... 132 Paid-in capital - stock options ($12 million x 3 years) ..... 36 Common stock (12 million shares at $1 par per share) ... 12 Paid-in capital – excess of par (to balance) ................... 156 Note: The market price at exercise is irrelevant. 19 Exercise 19-8 Requirement 1 The SARs are considered to be equity because IE will settle in shares of IE stock at exercise January 1, 2006 No entry Calculate total compensation expense: $ 3 estimated fair value per SAR x 24 million SARs granted = $72 million total compensation The total compensation is allocated to expense over the 4-year service (vesting) period: 2006 – 2009 $72 million ÷ 4 years = $18 million per year Requirement 2 December 31, 2006, 2007, 2008, 2009 ($ in millions) Compensation expense ($72 million ÷ 4 years) 18 Paid-in capital – SAR plan 18 Requirement 3 The total compensation is measured once – at the grant date – and is not re- measured subsequently. Requirement 4 June 6, 2011 Paid-in capital – SAR plan (account balance) 72 Common stock ($1 par x 24 million shares) 24 Paid-in capital – in excess of par (to balance) 48 20 Exercise 19-9 Requirement 1 The SARs are considered to be a liability because employees can elect to receive cash at exercise. January 1, 2006 No entry Requirement 2 December 31, 2006 ($ in millions) Compensation expense ($4 x 24 million x 1/4) 24 Liability – SAR plan 24 December 31, 2007 Compensation expense ([$3 x 24 million x 2/4] - 24) 12 Liability – SAR plan 12 December 31, 2008 Compensation expense ([$4 x 24 million x 3/4] – 24 – 12) 36 Liability – SAR plan 36 December 31, 2009 Liability – SAR plan 12 Compensation expense ([$2.50 x 24 million x 4/4] –24 –12 –36) 12 Requirement 3 December 31, 2010 Compensation expense ([$3 x 24 million x all] –24 –12 –36 +12) 12 Liability – SAR plan 12 Requirement 4 June 6, 2011 Compensation expense ([($50-46) x 24 million x all] –24–12–36+12–12) 24 Liability – SAR plan 24 Liability – SAR plan (account balance) 96 Cash 96 21 Exercise 19-10 Cash ($12 x 50,000 x 85%) 510,000 Compensation expense ($12 x 50,000 x 15%) 90,000 Common stock ($1 x 50,000) 50,000 Paid-in capital - in excess of par ($11 x 50,000) 550,000 Exercise 19-11 (amounts in thousands, except per share amount) net Earnings income Per Share $655 $655 ———————————————————————— = —— = $.64 900(1.05) + 60 (8/12) (1.05) + 72 (7/12) 1,029 shares new new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment 22 Exercise 19-12 (amounts in thousands, except per share amount) net preferred Earnings income dividends Per Share $2,000 – $50 $1,950 ————————————————— = ———— = $1.95 800 (1.25) 1,000 shares stock dividend at Jan. 1 adjustment Exercise 19-13 (amounts in thousands, except per share amount) net preferred Net Loss loss dividends Per Share – $114 – $761 - $190 —————————————————————— = —— = ($.50) 373 + 12 (7/12) 380 shares new at Jan. 1 shares 19.5% x $800* = $76 *8,000 shares x $100 par = $800,000 23 Exercise 19-14 1. EPS in 2006 (amounts in thousands, except per share amount) net Earnings income Per Share $400 $400 —————————————————————————— –––– = $2.00 202 - 6 (10/12) + 6 (2/12) + 24 (1/12) 200 shares treasury treasury shares new at Jan. 1 shares sold shares 2. EPS in 2007 (amounts in thousands, except per share amount) net Earnings income Per Share $400 $400 —————————————————————————— –––– = $.88 (202 - 6 + 6 + 24) x (2.00) 452 shares stock dividend at Jan. 1 adjustment 3. 2006 EPS in the 2007 comparative financial statements (amounts in thousands, except per share amount) net Earnings income Per Share $400 $400 —————————————————————————— –––– = $1.00 200 x (2.00) 400 weighted-average shares stock dividend as previously calculated adjustment 24 Exercise 19-15 (amounts in millions, except per share amount) net preferred Earnings income dividends Per Share $150 – $271 $123 —————————————————————— = ——— = $.65 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) 190 shares treasury new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment 19% x $300 = $27 25 Exercise 19-16 (amounts in millions, except per share amount) Basic EPS net preferred income dividends $150 – $27 $123 —————————————————————————— = —— = $.65 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) 190 shares treasury new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment Diluted EPS net preferred income dividends $150 – $27 $123 —————————————————————————— = —— = $.63 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + (30 – 24*) 196 shares treasury new assumed exercise at Jan. 1 shares shares of options ↑___ stock dividend ___↑ adjustment *Purchase of treasury stock 30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares 26 Exercise 19-17 (amounts in millions, except per share amount) Basic EPS net preferred income dividends $150 – $27 $123 —————————————————————————— = —— = $.62 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + 30(4/12) 200 shares treasury new actual exercise at Jan. 1 shares shares of options ↑___ stock dividend ___↑ adjustment Diluted EPS net preferred income dividends $150 – $27 $123 ———————————————————————————— = —— = $.60 200 (1.05) – 24(10/12) (1.05) + 4(3/12) + (30 – 24*)(8/12) + 30(4/12) 204 shares treasury new assumed exercise actual exercise at Jan. 1 shares shares of options of options ↑___ stock dividend ___↑ adjustment *Purchase of treasury stock 30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares 27 Exercise 19-18 (amounts in millions, except per share amount) Basic EPS net preferred income dividends $150 – $27 $123 ———————————————————————————— = — = $.65 200(1.05) – 24 (10/12) (1.05) + 4 (3/12) 190 shares treasury new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment Diluted EPS net preferred after-tax income dividends interest savings $150 – $27 + $5* – 40% ($5*) $126 ———————————————————————————— = — = $.62 200 (1.05) – 24 (10/12) (1.05) + 4 (3/12) + (30 – 24**) + 6 202 shares treasury new exercise conversion at Jan. 1 shares shares of options of bonds ↑___ stock dividend ___↑ adjustment *8% x $62.5 million = $5 million interest **Purchase of treasury stock 30 million shares x $56 (exercise price) $1,680 million ÷ $70 (average market price) 24 million shares 28 Exercise 19-19 (amounts in thousands, except per share amounts) Basic EPS net preferred income dividends $500 – 60* $440 ——————————————————————— = ——— = $4.40 100 100 shares at Jan. 1 Diluted EPS net preferred preferred after-tax income dividends dividends interest savings $500 – 60* +60* + $100** – 40% ($100) $560 ——————————————————————————— = —— = $3.46 100 +32 + 30 162 shares conversion conversion at Jan. 1 of preferred of bonds stock * 12,000 shares x $5 ** $1,000,000 x 10% 29 Exercise 19-20 (amounts in thousands, except per share amount) Basic EPS net income $720 $720 ———————————————————— = —— = $8.47 80 + 15 (4/12) 85 shares new at Jan. 1 shares Diluted EPS net income $720 $720 —————————————————————— = —— = $8.09 80 + 15 (4/12) + (24 – 20)* 89 shares new exercise at Jan. 1 shares of warrants *Purchase of treasury shares 24,000 shares x $37.50 (exercise price) $900,000 ÷ $45 (average market price) 20,000 shares 30 Exercise 19-21 (amounts in millions, except per share amounts) Basic EPS net income $148 $148 —————————————————————————— = ——— = $3.89 35 + 4 (9/12) 38 shares new at Jan. 1 shares Diluted EPS net income $148 $148 —————————————————————————— = ——— = $3.79 35 + 4 (9/12) + 1 39 shares new additional at Jan. 1 shares shares Because the conditions are met for issuing 1 million shares, those shares are assumed issued for diluted EPS. Conditions for the other 1 million shares are not yet met, so as they are ignored. 31 Exercise 19-22 (amounts in thousands, except per share amounts) Basic EPS net income $2,000 $2,000 —————————————————————————— = ——— = $2.96 600 + 100 (9/12) 675 shares new at Jan. 1 shares Diluted EPS net income $2,000 $2,000 —————————————————————————— = ——— = $2.74 600 + 100 (9/12) + 4 x 10 + 15 730 shares new contingent contingent at Jan. 1 shares shares* shares** * Because the conditions currently are met (i.e., market price exceeds $48) for issuing 10,000 shares in each of the next 4 years, those shares are assumed issued for diluted EPS. ** The condition for the other 15,000 shares also is met (the controller is employed), so those shares are assumed issued for diluted EPS. 32 Exercise 19-23 List A List B __e_ 1. Subtract preferred dividends. a. Options exercised. __m_ 2. Time-weighted by 5/12. b. Simple capital structure. __a_ 3. Time-weighted shares assumed issued c. Basic EPS. plus time-weighted-actual shares. d. Convertible preferred stock. __i_ 4. Midyear event treated as if e. Earnings available to common it occurred at the beginning of the shareholders. reporting period. f. Antidilutive. __l_ 5. Preferred dividends do not reduce g. Increased marketability. earnings. h. Extraordinary items. __b_ 6. Single EPS presentation. i. Stock dividend. __g_ 7. Stock split. j. Add after-tax interest to numerator. __d_ 8. Potentially dilutive security. k. Diluted EPS. __f_ 9. Exercise price exceeds market price. l. Noncumulative, undeclared __c_10. No dilution assumed. preferred dividends. __j_ 11. Convertible bonds. m. Common shares retired in August. _n_ 12. Contingently issuable shares. n. Include in diluted EPS when _k_ 13. Maximum potential dilution. conditions for issuance are met. _h_ 14. Shown between per share amounts for net income and for income from continuing operations. Exercise 19-24 1. d. A noncompensatory plan is defined as one in which substantially all full- time employees participate, the stock available to each employee is equal or is based on salary, the option exercise period is reasonable, and the discount from market is not greater than reasonable in an offer to shareholders or others. Noncompensatory plans do not provide for the achievement of certain performance criteria. 2. b. A compensatory stock option plan involves the issuance of stock in whole or in part for employee services. The compensation cost should be 33 recognized as an expense of one or more periods in which the employee performed services. 34 PROBLEMS Problem 19-1 Requirement 1 The measurement date is always is the date of grant. Requirement 2 $ 6 estimated fair value per option x 20 million options granted = $120 million fair value of award The total compensation is to be allocated to expense over the 3-year service (vesting) period: 2006 - 2008 $120 million ÷ 3 years = $40 million per year Requirement 3 Ensor should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes. 2007 Compensation expense ([$120 x 90% x 2/3] – $40) ................ 32 Paid-in capital –stock options .............................................. 32 2008 Compensation expense ([$120 x 90% x 3/3] – $40 – $32) ...... 36 Paid-in capital –stock options .............................................. 36 35 Problem 19-1 (concluded) Requirement 4 This approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a 3-year depreciable asset having no estimated residual value for $120 million. The $120 million depreciable cost would be depreciated straight-line at $40 million over the three-year useful life. If the estimated residual value changes after one year to 10% of cost, the new estimated depreciable cost of $108 would be reduced by the $40 million depreciation recorded the first year, and the remaining $68 million would be depreciated equally, $34 million per year, over the remaining two years. Requirement 5 Cash ($15 x 80% = $12 exercise price x 18 million shares) ... 216 Paid-in capital - stock options (account balance of $108 million) 108 Common stock (2 million shares at $1 par per share) ..... 18 Paid-in capital – excess of par (remainder) ................... 306 Note: The market price at exercise is irrelevant. 36 Problem 19-2 Requirement 1 At January 1, 2006, the estimated value of the award is: $2 estimated fair value per option x 40 million options granted = $80 million total compensation Requirement 2 ($ in millions) Compensation expense ($80 million ÷ 2 years)... 40 Paid-in capital – stock options .................... 40 Deferred tax asset ($40 million x 40%) .............. 16 Tax expense ............................................... 16 Note: Since the plan does not qualify as an incentive plan, Walters will deduct the difference between the exercise price and the market price at the exercise date. Recall from Chapter 16 that this creates a temporary difference between accounting income (for which compensation expense is recorded currently) and taxable income (for which the tax deduction is taken later upon the exercise of the options). Under FASB 123(r), we assume the temporary difference is the cumulative amount expensed for the options, $40 million at this point. So, the deferred tax benefit is 40% x $40 million. Requirement 3 Compensation expense ($80 million ÷ 2 years)... 40 Paid-in capital – stock options .................... 40 Deferred tax asset ($40 million x 40%) .............. 16 Tax expense ............................................... 16 37 Problem 19-2 (concluded) Requirement 4 ($ in millions) Cash ($8 exercise price x 40 million shares)......................... 320 Paid-in capital - stock options (account balance) ............. 80 Common stock (40 million shares at $1 par per share) ..... 40 Paid-in capital – excess of par (to balance) .................... 360 Income taxes payable ([$12 - 8] x 40 million shares x 40%) 64 Deferred tax asset (2 years x $16 million) ..................... 32 Paid-in capital - tax effect of stock options (remainder) 32 Requirement 5 Compensation expense ($80 million ÷ 2 years)................ 40 Paid-in capital – stock options ................................. 40 No deferred tax asset is recorded because an incentive plan does not provide the employer a tax deduction. Requirement 6 Cash ($8 exercise price x 40 million shares)........................ 320 Paid-in capital - stock options (account balance) ............ 80 Common stock (40 million shares at $1 par per share) .... 40 Paid-in capital – excess of par (to balance) ................... 360 No tax effect because an incentive plan does not provide the employer a tax deduction. 38 Problem 19-3 Requirement 1 At January 1, 2006, the total compensation is measured as: $ 6 fair value per option x 6 million options granted = $36 million fair value of award Requirement 2 Dec. 31, 2006, 2007, 2008 ($ in millions) Compensation expense ($36 million ÷ 3 years)... 12.0 Paid-in capital – stock options .................... 12.0 Deferred tax asset ($12 million x 40%) .............. 4.8 Tax expense ............................................... 4.8 Note: Since the plan does not qualify as an incentive plan, JBL will deduct the difference between the exercise price and the market price at the exercise date. Recall from Chapter 16 that this creates a temporary difference between accounting income (for which compensation expense is recorded currently) and taxable income (for which the tax deduction is taken later upon the exercise of the options). Under FASB 123, we assume the temporary difference is the cumulative amount expensed for the options, $12 million, $24 million, and $36 million at Dec. 31, 2006, 2007, and 2008, respectively. So, the deferred tax benefit is 40% of that amount each year. Requirement 3 August 21, 2010 ($ in millions) Cash ($22 exercise price x 6 million shares)................................... 132.0 Paid-in capital - stock options (account balance) ....................... 36.0 Common stock (6 million shares at $1 par per share) ................ 6.0 Paid-in capital – excess of par (to balance) ............................... 162.0 Income taxes payable ([$27 - 22] x 6 million shares x 40%) ......... 12.0 Paid-in capital - tax effect of stock options (remainder) .......... 2.4 Deferred tax asset (3 years x $4.8 million) ......... .................... 14.4 39 Problem 19-4 Requirement 1 No entry until the end of the reporting period, but compensation must be estimated at the grant date: 1 million x $12 = $12 million options fair estimated expected value total to vest compensation Requirement 2 December 31, 2006, 2007, 2008, 2009 ($ in millions) Compensation expense ($12 million x ¼) ...... 3 Paid-in capital – stock options .................... 3 Requirement 3 If, after two years, LCI estimates that it is not probable that the performance goals will be met, then the new estimate of the total compensation would change to: 0 x $12 = $0 options fair estimated expected value total to vest compensation In that case, LCI would reverse the $6 million expensed in 2006-2007 because no compensation can be recognized for options that don’t vest due to performance targets not being met, and that’s the new expectation. December 31, 2008 ($ in millions) Paid-in capital – stock options ........................ 6 Compensation expense .............................. 6 December 31, 2009 No entry 40 Problem 19-5 1. Net loss per share for the year ended December 31, 2006: (amounts in millions, except per share amount) net preferred Net Loss loss dividends Per Share – $140 – $1601 - $300 —————————————————————————— = ——— = ($.49) 600 (1.05) – 30 (8/12) (1.05) + 12 (4/12) 613 shares treasury new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment 2. Per share amount of income or loss from continuing operations for the year ended December 31, 2006: (amounts in millions, except per share amount) Income from Continuing operating preferred Operations income dividends Per Share $2602 – $1601 $100 ————————————————————————— = ——— = $.16 600(1.05) – 30 (8/12) (1.05) + 12 (4/12) 613 shares treasury new at Jan. 1 shares shares ↑___ stock dividend ___↑ adjustment 1 20 million shares x $100 x 8% = $160 million 2 $400 – $140 = $260 million 41 Problem 19-5 (concluded) 3. 2006 and 2005 comparative income statements: (amounts in millions, except per share amount) 2006 2005 Earnings (Loss) Per Common Share: Income (loss) from operations before extraordinary items $ .16 $.71 Extraordinary loss from litigation settlement (.65) — Net income (loss) ($ .49) $.71 Note: The weighted-average number of common shares in 2005 should be adjusted for the stock dividend in 2006 for the purpose of reporting 2005 EPS in subsequent years for comparative purposes: net Earnings income Per Share $450 $450 ——————————— = ——— = $.71 600 (1.05) 630 shares stock dividend at Jan. 1 adjustment 42 Problem 19-6 2004 net Net Loss loss Per Share – $160,500 —————————— = ($.09) 1,855,000 shares 2005 net Earnings income Per Share $2,240,900 $2,240,900 ————————————————— = ——————— = $1.23 1,855,000 – 110,000 (3/12) 1,827,500 shares retired at Jan. 1 shares 2006 net Earnings income Per Share $3,308,700 $3,308,700 ————————————————— = ——————— = $1.86 1,745,000* x (1.02)** 1,779,900 shares stock dividend at Jan. 1 adjustment * 1,855,000 – 110,000 = 1,745,000 shares ** This is a 2% stock dividend: 34,900 ÷ 1,745,000 = 2%. Alternatively, the additional 34,900 shares could be simply added to the 1,745,000 initial shares outstanding. 43 Problem 19-7 (amounts in millions, except per share amount) 2004 net preferred Earnings income dividends Per Share $290 – $1 $289 ————————————————— = ——— = $4.86 55 + 9 (6/12) 59.5 shares new at Jan. 1 shares 2005 net preferred Earnings income dividends Per Share $380 – $1 $379 ————————————————— = ——— = $4.14 64 (1.50) – 4 (9/12) (1.50) 91.5 shares retired at Jan. 1 shares ↑___ stock split ___↑ adjustment 2006 net preferred Earnings income dividends Per Share $412 – $2 $410 ————————————————— = ——— = $4.10 90 (1.10) + 3 (4/12) 100 shares stock dividend new at Jan. 1 adjustment shares 44 Problem 19-8 (amounts in thousands, except per share amount) net preferred Earnings income dividends Per Share $2,100 – $75 $2,025 ————————————————————————— = ——— = $3.00 600 (1.04) + 60 (10/12) (1.04) – 2 (6/12) 675 shares new shares at Jan. 1 shares retired ↑___ stock dividend ___↑ adjustment 45 Problem 19-9 The options issued in 2004 are not considered when calculating 2006 EPS because the exercise price ($33) is not less than the 2006 average market price of $32 (although they would have been considered when calculating 2004 or 2005 EPS if the average price those years had been more than $33). The options issued in 2006 do not affect the calculation of 2006 EPS because they were issued at December 31. Options are assumed exercised at the beginning of the year or when granted, whichever is later — when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2005 are considered exercised for 8,000 shares when calculating 2006 EPS because the exercise price ($24) is less than the 2006 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 shares x $24 (exercise price) $192,000 ÷ $32 (average market price) 6,000 shares 46 Problem 19-9 (concluded) (amounts in thousands, except per share amount) Basic EPS net preferred income dividends $2,100 – $75 $2,025 —————————————————————————— = —— = $3.00 600(1.04) + 60 (10/12) (1.04) – 2 (6/12) 675 shares new shares at Jan. 1 shares retired ↑___ stock dividend ___↑ adjustment Diluted EPS net preferred income dividends $2,100 – $75 $2,025 —————————————————————————— = —— = $2.99 600(1.04) + 60 (10/12) (1.04) – 2 (6/12) + (8 – 6) 677 shares new shares exercise at Jan. 1 shares retired of options ↑___ stock dividend ___↑ adjustment 47 Problem 19-10 The options issued in 2004 are not considered when calculating 2006 EPS because the exercise price ($33) is not less than the 2006 average market price of $32 (although they would have been considered when calculating 2004 or 2005 EPS if the average price those years had been more than $33). The options issued in 2006 do not affect the calculation of 2006 EPS because they were issued at December 31. Options are assumed exercised at the beginning of the year or when granted, whichever is later — when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2005 are considered exercised for 8,000 shares when calculating 2006 EPS because the exercise price ($24) is less than the 2006 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 shares x $24 (exercise price) $192,000 ÷ $32 (average market price) 6,000 shares 48 Problem 19-10 (concluded) (amounts in thousands, except per share amounts) Basic EPS net preferred income dividends $2,100 – $75 $2,025 ——————————————————————————— = —— = $3.00 600(1.04) + 60 (10/12) (1.04) – 2 (6/12) 675 shares new shares at Jan. 1 shares retired ↑___ stock dividend ___↑ adjustment Diluted EPS net preferred after-tax income dividends interest savings $2,100 – $75 + $80 – 40%($80) $2,073 ———————————————————————————— = — = $2.86 600(1.04) + 60(10/12) (1.04) – 2 (6/12) + (8 – 6) + 23* + 24** 724 shares new shares exercise contingent conversion at Jan. 1 shares retired of options shares of bonds ↑___ stock dividend ___↑ adjustment * The contingently issuable shares are considered issued when calculating diluted EPS because the condition for issuance (Merrill net income > $500,000) currently is being met. ** The bonds are considered converted when calculating diluted EPS: 800 bonds x 30 shares = 24,000 shares upon conversion. Interest = $800,000 x 10% = $80,000. 49 Problem 19-11 Requirement 1 (amounts in thousands, except per share amount) Basic EPS: preferred net income dividends $150 – $77 $73 ———————————————— = ——— = $1.83 40 40 weighted-average shares With conversion of preferred stock (Diluted EPS): net income $150 $150 ———————————————— = ——— = $2.50 40 + 20 60 weighted-average conversion shares of preferred shares Since the assumed conversion of the convertible preferred stock causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS. 50 Problem 19-11 (concluded) Requirement 2 Basic EPS: net income $150 ————————— = $3.75 40 weighted-average shares With conversion of bonds: after-tax net income interest savings $150 + $40 – 40% ($40) $174 ———————————————— = ——— = $3.87 40 + 5 45 weighted-average conversion shares of bonds Since the assumed conversion of the convertible bonds causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS. Requirement 3 Since the exercise price is less than average market price, the options are not antidilutive and therefore assumed exercised when calculating diluted EPS. Requirement 4 Since the exercise price is higher than the average market price, the warrants are antidilutive and therefore ignored when calculating diluted EPS. Requirement 5 The 5,000 shares are added to the denominator when calculating diluted EPS since 2006 net income is higher than the conditional amount. Since only the denominator is increased, the effect is not antidilutive. 51 Problem 19-12 (amounts in millions, except per share amounts) Basic EPS net income $560 $560 —————————————————————— = —— = $1.44 400 – 30 (4/12) 390 shares new at Jan. 1 shares Diluted EPS net after-tax* income interest savings $560 + $30 – 40% ($30) $578 —————————————————————— = —— = $1.36 400 – 30 (4/12) + 36 426 shares new conversion at Jan. 1 shares of bonds *Interest on the bonds = $300 million x 10% = $30 million. If the bonds were not outstanding, interest expense would have been $30 million lower, and tax expense would have been 40% x $30 million, or $12 million higher, a net after- tax savings of $18 million. 52 Problem 19-13 (amounts in thousands, except per share amounts) Basic EPS net preferred income dividends $650 – $40* $610 —————————————————————————————————— = ——— = $1.37 440 + 16 (3/12) 444 shares new at Jan. 1 shares Diluted EPS net preferred preferred income dividends dividends $650 – $40* + 40* $650 ————————————————————————————————— = ——— = $1.33 440 + 16 (3/12) + (20 – 15**) + 40 489 shares new exercise conversion at Jan. 1 shares of options of preferred shares * 4,000 shares x $100 par x 10% = $40,000 **Assumed purchase of treasury shares 20,000 shares x $30 (exercise price) $600,000 ÷ $40 (average market price) 15,000 shares 53 Problem 19-14 (amounts in millions, except per share amounts) Basic EPS net preferred income dividends $1,476 – $60* $1,416 ——————————————————————————————————————— = ——— = $2.27 600 + 72 (4/12) 624 shares new at Jan. 1 shares Diluted EPS net preferred after-tax income dividends Interest savings $1,476 – $60* + $160 - 40% ($160) $1,512 ——————————————————————————————————————— = ——— = $2.09 600 + 72 (4/12) + (60 – 40)** + 80 724 shares new exercise conversion at Jan. 1 shares of options of bonds *Preferred dividends: 6% x $50 x 20 million shares = $60 million **Computation of Treasury Shares: 60 million shares x $12 exercise price $720 million proceeds ÷ $18 average share price 40 million treasury shares 54 Real World Case 19-1 Requirement 1 The shares are restricted in such a way as to provide some incentive to the recipient. Dell’s restricted stock award plans are tied to continued employment. The shares are subject to forfeiture by the employee if employment is terminated within seven years from the date of grant. These restrictions give the employee incentive to remain with the company until rights to the shares vest. Requirement 2 2002 grant $24 fair value per share x 2.1 million shares granted = $50.4 million fair value of award / 7 years service period $ 7.2 million annual compensation expense 2003 grant $25 fair value per share x 0.3 million shares granted = $7.5 million fair value of award / 7 years service period $ 1.1 million annual compensation expense 2004 grant $28 fair value per share x 0.6 million shares granted = $16.8 million fair value of award / 7 years service period $ 2.4 million annual compensation expense 2004 expense $ 7.2 million 2002 grant 1.1 million 2003 grant 2.4 million 2004 grant $10.7 million 2004 compensation expense CASES 55 Communication Case 19-2 Suggested Grading Concepts and Grading Scheme: Content (80% ) 30 Measurement of compensation. Compensation cost should be measured at the date of grant. Fair value of the stock options. Estimated by employing a recognized option pricing model. Value per option times number of options. Can be adjusted for estimated forfeiture rate. No entry on grant date. 25 Determination of compensation expense. Expensed over the period of service for which the options are given, 2006 - 2008. Debit compensation expense. Credit paid-in capital – stock options. Not adjusted when the price of the underlying stock changes. 15 Effect of forfeiture before vesting. Reduce compensation expense in forfeiture period for the cumulative effect of the revised estimate. Revise compensation expense for remaining service period. 10 Effect of forfeiture after vesting. Paid-in capital - stock options becomes Paid-in capital - expiration of stock options. Compensation expense of previous periods cannot be reversed for vested options. Bonus (5) Option pricing model considers: Exercise price of the option. Expected term of the option. Current market price of the stock. Expected dividends. Expected risk-free rate of return. Expected volatility of the stock. 80-85 points 56 Case 19-2 (concluded) Writing (20%) 5 Terminology and tone appropriate to the audience of controller. 6 Organization permits ease of understanding. introduction that states purpose. paragraphs separate main points. 9 English. word selection. spelling. grammar. 20 points 57 Ethics Case 19-3 Discussion should include these elements: Facts: The choice of method will affect earnings. FIFO will increase reported net income. FIFO will cause an increase in taxes paid. Company managers stand to benefit from the change. The auditor risks negative consequences if the change is challenged. Ethical Dilemma: Is the auditor’s obligation to challenge the questionable change in methods greater than the obligation to the financial interests of the CPA firm and its client? Who is affected? You, the auditor Managers CPA firm (lost fees? reputation? legal action?) Shareholders Potential shareholders [From research performed in this area, it is not clear that accounting changes that increase earnings without any real economic (cash flow) effect will have the desired effect of increasing share price. In fact, the preponderance of such research indicates that the market “sees through” cosmetic accounting changes. Nevertheless, there is plenty of evidence, at least anecdotal, that managers attempt to fool the market. Some efforts to manage earnings may not be an attempt to affect share prices, but to avoid violating terms of contracts based on earnings or related balance sheet items. Some may be to favorably affect terms of compensation agreements.] The employees The creditors 58 Real World Case 19-4 Requirement 1 Whether an incentive plan is a stock option plan, a stock award plan, a stock appreciation rights (SARs) plan, or one of the various similar plans, the intention is to provide compensation to designated employees, while at the same time providing those employees with some sort of performance incentive. Likewise, our reporting objectives in accounting for these plans are the same for each: (1) to determine the fair value of the compensation and (2) to expense that compensation over the periods in which participants perform services. Requirement 2 The $29 million GE reported as share-based expense in the third quarter of 2004 is that period’s portion of the value of options granted in 2004 and prior years. Each reporting period, GE determines the value of the options granted that period and expenses that compensation over the periods in which participants perform services, usually the vesting period for the options. So, for instance, if options granted in 2002 had a value of $40 million and a 4-year vesting period, $10 million / 4 quarters = $2.5 million of that amount would be part of the $29 million expensed in the third quarter of 2004. 59 Judgment Case 19-5 Although net income declined during the period, a combination of events caused EPS to increase in spite of declining profits. Specifically, retiring the preferred shares increased earnings available to common shareholders; retiring common shares and retiring convertible debt each decreased the weighted-average number of common shares. The following calculations show the effect of these events: (amounts in millions, except per share amount) 2004 net preferred Basic income dividends EPS $145 – $16* $129 ——————————————————— = —— = $2.15 60 60 shares at Jan. 1 net preferred after-tax Diluted income dividends interest savings EPS $145 – $16* + $5 – 40% ($5) $132 ——————————————————— = —— = $1.91 60 + 9 69 shares conversion at Jan. 1 of bonds * 8% x [$10 x 20 million] = $16 60 Case 19-5 (concluded) 2005 net preferred Basic income dividends EPS $134 – $12‡ $122 ——————————————————— = —— = $2.44 60 – 12 (10/12) 50 shares retired at Jan. 1 shares net preferred after-tax Diluted income dividends interest savings EPS $134 – $12‡ + $5 – 40% ($5) $125 ——————————————————— = —— = $2.12 60 – 12 (10/12) + 9 59 shares retired conversion at Jan. 1 shares of bonds 2006 net Basic income EPS $95 $95 ——————————————————— = —— = $2.50 48± – 12 (10/12) 38 shares retired at Jan. 1 shares net Diluted income EPS $95 $95 ——————————————————— = —— = $2.50 48 – 12 (10/12) 38 shares retired at Jan. 1 shares ‡ $16 – (6/12 x 8% x [$10 x 20 million x 1/2]): calculation reflects the retirement of half the shares on July 1 ± 60 - 12 61 Communication Case 19-6 Suggested Grading Concepts and Grading Scheme: Content (80% ) 60 Convertible securities are included in the computation. Of diluted earnings per share. By assuming they were converted, the “if- converted” method, as it’s called. The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion. The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided. 20 Antidilutive securities. Antidilutive means EPS increases rather than decreases. Ignored when calculating earnings per share. Bonus (4) Provides detail regarding the tax effect calculation for convertible bonds. Interest on bonds is tax deductible. Tax expense will increase by the tax rate times interest. 80-84 points Writing (20%) 5 Terminology and tone appropriate to the audience of division managers. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points 62 Real World Case 19-7 Requirement 1 The disclosure note refers to adjustments for “stock options and other.” Other potential common shares might include convertible securities and contingently issuable shares. Stock options give their holders the right to to purchase common stock at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS, but not basic EPS. To include the dilutive effect of a security means to calculate EPS as if the potential increase in shares already has occurred (even though it hasn’t yet). So, for stock options, we “pretend” the options have been exercised. In fact, we assume the options were exercised at the beginning of the reporting period, or when the options were issued if that’s later. We then assume the cash proceeds from selling the new shares at the exercise price are used to buy back as many shares as possible at the shares’ average market price during the year. Similarly, we would assume convertible securities had been converted into shares. This means adding the new shares to the denominator and increasing the numerator by the after-tax effect of the convertible security not being outstanding. When an agreement specifies that additional shares of common stock will be issued, contingent upon the occurrence of some future circumstance, perhaps issuable to shareholders of an acquired company, certain key executives, or others in the event a certain level of performance is achieved. Contingent performance may be a desired level of income, a target stock price, or some other measurable activity level. When calculating EPS, contingently issuable shares are considered to be outstanding in the computation of diluted EPS if shares are to be issued merely as a result of time passing, or if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period). For example, if shares will be issued at a future date if a certain level of income is achieved and that level of income or more was already earned this year, those additional shares are simply added to the denominator of the diluted EPS fraction. The shares should be included in both basic and diluted EPS if all conditions have actually been met so that there is no circumstance under which those shares would not be issued. In essence, these are no longer contingent shares. 63 Case 19-7 (concluded) Requirement 2 Sometimes, the effect of the exercise of options would be to increase, rather than decrease, EPS. These we refer to as “antidilutive” securities. Such options are ignored when calculating both basic and diluted EPS. For example, when we adjust shares for the effect of the options being exercised, we apply what’s called the “treasury stock” method. The number of shares assumed repurchased is fewer than the number of shares assumed sold any time the buy-back (average market) price is higher than the exercise price. In those cases, there will be a net increase in the number of shares so earnings per share will decline. This was the case for Clorox’s options referred to in the note. On the other hand, if the exercise price is higher than the market price, to assume shares are sold at the exercise price and repurchased at the market price would mean buying back more shares than were sold. This would produce a net decrease in the number of shares. EPS would increase, not decrease, if we were to assume the exercise of stock options. These would have an antidilutive effect and would not be considered exercised. For that matter, a rational investor would not exercise options at an exercise price higher than the current market price anyway. We don’t include them because the intent of reporting diluted EPS is to report the extent to which EPS would be diluted, or reduced, if the potential common shares actually had become shares. Requirement 3 Here is the presentation of basic and diluted earnings per share for 2004, 2003, and 2002 that Clorox reports in its 2004 annual report. Net Income Per Common Share 2004 2003 2002 Basic: Continuing operations $2.58* $2.36 $1.54 Discontinued operations 0.01** (0.10) (0.15) $2.59 $2.26 $1.39 Diluted: Continuing operations $2.55‡ $2.33 $1.52 Discontinued operations 0.01± (0.10) (0.15) $2.56 $2.23 $1.37 * $546,000/211,683 = $2.58 ** $3,000/211,683 = $0.01 ‡ $546,000/214,371= $2.55 ± $3,000/214,371= $0.01 64 Analysis Case 19-8 Requirement 1 In its simplest form, earnings per share is merely a firm’s net income divided by the number of shares outstanding throughout the year. Earnings per share = Income available to common shareholders Weighted-average shares outstanding = $487 181 = $2.69 Requirement 2 Price-earnings ratio = Market price per share Earnings per share = $47.00 $2.69 = 17.5 The ratio is a measure of the market's perception of the “quality” of a company’s earnings. It indicates the price multiple the capital market is willing to pay for the company’s earnings. In a way, this ratio reflects the market’s perceptions of the company’s growth potential, stability, and relative risk in that the ratio relates these performance measures with the external judgment of the marketplace concerning the value of the firm. The calculation indicates that IGF’s share price represents $17.50 for every dollar of earnings. In that regard, it measures the “quality” of earnings in the sense that it represents the market’s expectation of future earnings as indicated by current earnings. We should be aware, though, that a ratio might be low, not because earnings expectations are low, but because of abnormally elevated current earnings, or, the ratio might be high, not because earnings expectations are high, but because the company’s current earnings are temporarily depressed. 65 Case 19-8 (concluded) Requirement 3 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. To calculate the ratio for IGF with the information provided, we must estimate dividends from analysis of the retained earnings account: Retained Earnings 2,428 487 Net income Dividends ? 2,730 Dividends apparently were $185,000,000. Dividends per share, then, would be $185 / 181 = $1.02 Dividend payout ratio = Cash dividends per share Earnings per share = $1.02 $2.69 = 37.9% IGF paid cash dividends of $1.02 cents per share during the most recent year, almost 38% of earnings. The ratio provides an indication of the firm’s reinvestment strategy. If the payout ratio is low, it suggests that the company retains a large portion of earnings for reinvestment for purposes such as new facilities and current operations. Sometimes, though, the ratio just reflects managerial strategy regarding the mix of internal versus external financing. Investors who, for tax or other reasons, prefer current income over market price appreciation, or vice versa, are particularly interested in this ratio. 66 Ethics Case 19-9 Discussion should include these elements. Effect of share repurchase on EPS. Reducing the number of shares will increase earnings per share. That impact will be lessened, though, the closer to the end of the year the shares are bought due to the way the share reduction is “time-weighted” for the fraction of the year they are not outstanding. Ethical Dilemma: Apparently, a more productive use for available funds will be offered by Barber. How does a less-than-optimal use of company funds compare with the perceived need to maintain a record of increasing reported EPS? Who is affected? Mashburn Lane Managers under the bonus plan Shareholders Potential shareholders Employees Creditors 67 Integrating Case 19-10 Requirement 1 The 949 million options outstanding will not affect basic EPS. Only shares actually issued upon the exercise of options affect that calculation. However, diluted EPS will reflect the potential dilution from the assumed exercise of those options. Specifically, that calculation assumes the outstanding options had been exercised at the beginning of the year, or when the options were issued for those granted during the current period. The assumed proceeds from the exercise would be assumed to be used to buy back as many of the 949 million shares as could be purchased at the average market price of the shares. Requirement 2 If there were no actual changes in shares, and no potential common shares other than options, we could explain the difference as follows: 949 million shares assumed issued upon the exercise of the options at the beginning of the period (91 million) difference in shares used in diluted and basic EPS calculations (10,894 million – 10,803 million) 858 million shares assumed repurchased at the average market price per share Note: The restrictive assumptions were made for convenience. Microsoft’s dilutive potential common shares were due primarily to stock options, but partly also to other potential common shares. Also, Microsoft’s shares actually did change in fiscal 2004 as a result of common stock repurchases and the actual exercise of options. Also, the options outstanding changed during the year as follows: Balance, June 30, 2003 1,549 Granted 2 Exercised (198) Transferred under transfer program (345) Canceled (59) Balance, June 30, 2004 949 68 Research Case 19-11 The results students report will vary somewhat depending on the dates and times quotes were accessed. It is unlikely, though, that their relative comparisons or conclusions will differ. The PE ratio is the market price per share divided by the earning per share. It measures the market's perception of the “quality” of a company’s earnings by indicating the price multiple the capital market is willing to pay for the company’s earnings. The ratio reflects the information provided by all financial information in that the market price reflects analysts’ perceptions of the company’s growth potential, stability, and relative risk. The price-earnings ratio relates these performance measures with the external judgment of the marketplace concerning the value of the firm. The ratio measures the “quality” of earnings in the sense that it represents the market’s expectation of future earnings as indicated by current earnings. Caution is called for in comparing price-earnings ratios. Historically, the ratio for both companies has been relatively high, reflecting growth expectations. 69 Analysis Case 19-12 Requirement 1 The price-earnings ratio is simply the market price per share divided by the earnings per share. For Kellogg, the ratio is: $44.66 ÷ $2.14 = 20.9 It purports to measure the market's perception of the “quality” of a company’s earnings by indicating the price multiple the securities market is willing to pay for the company’s earnings. The P/E ratio reflects analysts’ perceptions of the company’s growth potential, stability, and relative risk by relating these performance measures with the external judgment of the marketplace in regard to the value of the company. Care is needed when evaluating price-earnings ratios. Like other ratios, it is best evaluated in context of P/E ratios of earlier periods and other, similar companies. For example, the P/E ratio of General Mills, Kellogg’s prime competitor was 18.9 at the same time. Neither is high relative to the average P/E ratio for all companies at the time, which was 20.2. Requirement 2 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. The ratio is calculated by dividing dividends per common share by the earnings per share. For Kellogg’s most recent 12 months, the ratio is: ($.2525 x 4) ÷ ($2.14) = 47% Relative to the average company, this payout percentage is quite high. It slightly higher than General Mills, Kellogg’s prime competitor. General Mills’ payout ratio was 44% at the same time. Historically, both companies and the industry in general have relatively high dividend payouts. This ratio provides an indication of a firm’s reinvestment strategy. A low payout percentage suggests that a company is retaining a large portion of earnings for reinvestment in new projects. Low ratios often are found in growth industries. High payouts, like those of General Mills and Kellogg, often are found in mature industries. Sometimes, the ratio is just an indication of management strategy related to the mix of internal 70 versus external financing. A high ratio is preferred by investors who, for tax or other reasons, prefer current income to market price appreciation. 71 Analysis Case 19-13 Requirement 1 When calculating basic earnings per share, the numerator in the computation is the earnings available to common shareholders. This will be net income reduced by dividends payable to preferred shareholders. Since the preferred stock is cumulative we subtract preferred dividends even if not declared. Because unpaid dividends accumulate to be paid in a future year when (if) dividends are subsequently declared, the presumption is that, although the year’s dividend preference isn’t distributed this year, it eventually will be paid. Requirement 2 When calculating basic earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during 2006. Thus, the 8 million shares outstanding at January l, 2006, plus a portion of the shares sold will result in the weighted-average number of shares outstanding for calculating basic EPS. The 3 million common shares issued during 2006 must be included in computing the weighted-average number of shares outstanding. The 3 million shares will be weighted one-third because they were outstanding only for the four months of 2006. The 1 million common shares issued upon the exercise of stock options must be included in computing the weighted-average number of shares outstanding. The 1 million shares will be weighted one-half because they were outstanding only for the six months of 2006. Requirement 3 When calculating diluted earnings per share, the numerator in the computation is the earnings available to common shareholders. Proactive will not reduce net income by dividends payable to preferred shareholders because it will treat the convertible preferred stock as if the preferred shares were converted and 4 million common shares were outstanding, unless including these shares in the denominator would increase earnings per share (be antidilutive). This means that it would not reduce the numerator for the preferred dividends as it would do if the preferred shares were assumed outstanding, as in calculating basic EPS. 72 Case 19-13 (continued) Requirement 4 When calculating diluted earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during the reporting period. But since potential common shares exist in a complex capital structure, as in this situation, the calculation of the denominator becomes more involved. We begin by determining the weighted-average of the number of common shares outstanding during 2006, the 8 million shares outstanding at January l, 2006, plus a portion of the shares sold. The 3 million common shares issued during 2006 must be included in computing the weighted-average number of shares outstanding. The 3 million shares will be weighted one-third because they were outstanding only for the four months of 2006. The 1 million common shares issued upon the exercise of stock options must be included in computing the weighted-average number of shares outstanding. The 1 million shares will be weighted one-half because they were outstanding only for the six months of 2006. For diluted EPS, two adjustments are needed to the denominator. First, we treat the convertible preferred stock as if the preferred shares were converted and 4 million additional common shares were outstanding, unless including these shares in the denominator would increase earnings per share (be antidilutive). As noted in requirement 2, this means also that we would not reduce the numerator for the preferred dividends as we would do if the preferred shares were assumed still outstanding. Second, we treat the stock options outstanding under the employee stock option plan as having been exercised. The number of common shares represented by the options outstanding should be computed by application of the treasury stock method. By this method, earnings per share is computed as if the options were exercised at the beginning of the period (or at time of issue, if later) and as if the cash received were used to purchase common stock at the average market price during the period. The weighted-average number of shares outstanding for 2006 includes (a) the 1 million shares represented by the 1 million options outstanding for the full year, plus (b) a time-weighted proportion of the 1 million exercised in 2006, and (c) a time-weighted proportion of the 1.5 million granted during 2006. We cannot determine the weighted-average number of options outstanding from the data provided because no exercise or grant dates were given. The 1 million shares issued when the options were exercised during 2006 must be included in the computation of the weighted-average number of shares outstanding from the date exercised to the year-end. Again, we cannot determine this number because the exercise dates were not given. 73 Case 19-13 (concluded) Note that the options outstanding for only part of the reporting period are included in the denominator on a time-weighted basis. For the 1.5 million options granted during the year, the denominator would include the appropriate incremental shares x the appropriate time-weighting fraction. Likewise, for the options exercised during the year, the weighted average shares should include (a) the appropriate incremental shares x the appropriate time-weighting fraction for the period prior to actual exercise and (b) the appropriate actual shares issued x the appropriate time-weighting fraction for the period after the exercise. 74 Real World Case 19-14 Requirement 1 The note indicates that “diluted net loss per common share is computed using the weighted average number of common and dilutive common equivalent shares outstanding during the period.” Securities like stock options or convertible bonds, while not being common stock, may become common stock through their exercise or conversion. As a result, they may dilute (reduce) earnings per share and therefore are called “potential common shares.” Diluted EPS incorporates the dilutive effect of all potential common shares. Requirement 2 In fiscal 2004, Sun would have added 30 million potential common shares to the “basic weighted average shares outstanding to compute the diluted weighted average shares outstanding” for its 603 million stock options. To include the dilutive effect of a security means to calculate EPS as if the potential increase in shares already has occurred, even though it hasn’t yet. Therefore, for its stock options Sun “pretends” the options have been exercised. Specifically, it assumed the options were exercised at the beginning of the reporting period, or when the options were issued if that’s later. Sun assumed the cash proceeds from selling the new shares at the exercise price were used to buy back as many shares as possible at the shares’ average market price during the year. The net difference, shares issued (603 million) minus shares repurchased, was 30 million shares, so the shares assumed repurchased must have been 573 million. Requirement 3 In fiscal 2004, Sun does not include dilutive potential common shares from employee stock options. The reason is stated in the disclosure note: “due to our net loss, …. their inclusion would have been anti-dilutive. If Sun had included the 30 million dilutive potential common shares from employee stock options, the loss per share would have declined from ($.118) to ($.117), ($388) / [3,277 + 30]. Whenever a company reports a net loss, as Sun did, it reports a loss per share. In that situation, stock options that otherwise are dilutive will be antidilutive. The loss per share declines. This represents an increase in performance – not a dilution of performance. The options would be considered antidilutive, then, and not included in the calculation of the net loss per share. 75 Real World Case 19-15 Requirement 1 Meg’s questions imply that she thinks you will get cash dividends of 26 cents a share. Earnings per share, though, is a way to summarize the performance of business enterprises into a single number. It is simply earnings expressed on a per share basis. It does not imply anything about cash dividends. Whether some, all, or none of the earnings are distributed depends on the company’s reinvestment strategy. A dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. Requirement 2 The press release says, “Earnings per share for the prior-year period have been adjusted to reflect the company's three-for-two stock split distributed in May 2004.” When calculating earnings per share, shares outstanding prior to a stock split (or stock dividend) are retroactively restated to reflect the increase in shares (50% in this instance). That is, it is treated as if the May split occurred at the beginning of the year. When reported again for comparison purposes in the comparative income statements, the year earlier figure also would be restated to reflect the 3-for-2 stock split. Otherwise we would be comparing apples and oranges. Requirement 3 The press release indicates that Sonic may repurchase up to $60 million of its stock. If the number of shares changes, it’s necessary to find the weighted average of the shares outstanding during the period the earnings were generated. If shares are reacquired during a period (either retired or as treasury stock), Sonic will reduce the weighted-average number of shares. The company time-weights the number of reacquired shares for the fraction of the year they were not outstanding, prior to subtracting from the number of shares outstanding during the period. Requirement 4 Yes, it is. If we don’t take into account the dilutive effect of the share increase we might mislead investors and creditors. So, in addition to basic EPS, we also calculate diluted EPS to include the dilutive effect of options and other potential common shares. This means to calculate EPS as if the potential increase in shares already has occurred (even though it hasn’t yet). For Sonic’s stock options, the calculation assumes the options were exercised at the beginning of the reporting period. Then the cash proceeds from selling the new 76 shares are used to buy back as many shares as possible at the shares’ average market price during the year. Solution Manual for Intermediate Accounting David J. Spiceland, James F. Sepe, Lawrence A. Tomassini 9780072994025, 9780072524482