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CHAPTER 16

Dilutive Securitiesand Earnings per Share.....

exchanged for stock at the bond

holders option

increases the value of the bond

a sweetener might be offered to

induce conversion

Convertible Bonds

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ACCOUNTING FOR CONVERTIBLE DEBT

Cash 106,000

Bonds Payable 100,000Premium on Bonds Payable 6,000

At Time of Issuance

recorded like a straight debt issue

no value allocated to conversion privilege

FASB considers the privilege inseparablefrom the bond

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At Time of Conversion

stock is recorded at book valueof theconverted bonds

Bonds Payable

100,000

Premium Bond Pay

6,0001,000

5,000

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Debt Conversion Expense 7,000Bonds Payable 100,000

Premium on Bonds Payable 5,000Common Stock 20,000Paid-in Capexcess of par 85,000Cash 7,000

Induced Conversions

record the sweetener as an expense

This is the same whether ornot there is a sweetener.

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Retirement of Convertible Debt

recorded like a straight debt retirement

Clear-out the balances ofbonds and premium.

Not an extraordinary item

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CONVERTIBLE PREFERRED STOCK

at conversion, common stock is recordedat book valueof the converted preferred

Preferred Stock

250,000

Add. Paid-in Capital

40,000

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STOCK WARRANTS

options to buy shares of stock at acertain price

warrants are issued

with bonds or preferred stock as anadded bonus

to common stockholders with a

preemptive right

to executives and employees

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Warrants Issued with Other Securities

Incremental Method

ExampleSold 500 $1,000 bonds for $505,000. Included witheach bond is a 5-year warrant to buy 1 share ofcommon for $25.

Assume the market value of each warrant is $30 andthe market value of the bonds (alone) is unknown.

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Proportional Method

Mkt Value Book Value

Bonds $495,000Warrants 15,000

Assume the market value of each warrant is $30 andthe market value of each bond is $990.

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STOCK COMPENSATION PLANS

Effective Compensation motivate performance

compensation tied to performance

performance over which employeehas control

short- and long-term performance

retain and recruit executives

Stock price is thought to bebetter that Sales or other

accounting measures.Stock options are veryattractive to managers.

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The Expected Value of a Share of Stock

PossibleStock Values Probability

$80 10%$90 20%

$100 40%$110 20%$120 10%

$ 818

402212

Expected value $100

What is the value of an option to buy 1share of stock at $100?

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The Value of a Stock Option

Possible Value of OptionStock Values Probability to buy at $100

$80 10%$90 20%

$100 40%$110 20%$120 10%

$0 $ 0$0 0

$0 0$10 2$20 2

Expected value $ 4

An option to buy has value.

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The Value of Volatility

Possible Value of OptionStock Values Probability to buy at $100

$60 10%$80 20%

$100 40%$120 20%$140 10%

$0 $ 0$0 0

$0 0$20 4$40 4

Expected value $ 8

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Accounting for Stock Compensation

Valuation intrinsic value method: excess of market

price over exercise price

fair value method: estimated value of

options expected to vest

value generally measured at grant date

FASB now requiresfair value method

Allocation of expense

expense recognized in the service period

generally service period = vesting period

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Exercise 16-10 (Modified)

Columbo Company adopted a stock option plan: options

to buy 30,000 shares of $10 par common stock at $40.Options were exercisable 2 years after grant date. Value

of options was $450,000.

November 1, 2007 Plan adopted

no entry

January 2, 2008 Options grantedno entry

2-year service periodbeginning on the

grant date.

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December 31, 2008 (first year of service period completed)

December 31, 2009 (second year of service completed)

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January 3, 2010 20,000 options were exercised

January 2, 2014 10,000 options expired

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DISCLOSURE OF COMPENSATION PLANS

number and weighted average fair valueof options

granted

exercised

forfeited

outstanding

average remaining life of options

outstanding

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EARNINGS PER SHARESIMPLE

EPS

Net Income - Preferred Dividends

Weighted Average Shares Outstanding=

Current year preferred dividendor

Dividend that should have been declaredif the preferred stock is cumulative

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1/14/1 90,0004/17/1 120,000

7/111/1 81,00011/112/31 141,000

Weighted Average Shares Outstanding

Dates Shares FractionOutstanding Outstanding of Year

New stock issued

Stock repurchased

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1/13/13/110/1

10/112/31

Weighted Average with Stock Dividend or Split

Dates Shares FractionOutstnd Outstnd Rstmt of Year

# Shares1/1 Beginning balance 80,0003/1 Issued 30,000 shares 110,0008/1 2 for 1 stock split 220,00010/1 Purchsd 20,000 shares 200,000

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Convertible Securities: If-Converted Method

1/1 Beginning balance: 200,000 shares common

5/1 Issued $500,000, 8% bonds for $535,530(effective interest = 7%) convertible into24,000 shares common

Net Income (net of 40% tax): $350,000

Net Income $350,000Add: Bond interest (net of tax)

$535,530 x 7% x 8/12 $24,991Less: 40% tax 9,997 14,994

Adjusted net income $364,994

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1/15/15/112/31

Dates Shares Out FractionOutstanding if Converted of Year

1/1 Beginning balance: 200,000 shares common

5/1 Issued $500,000, 8% bonds for $535,530

(effective interest = 7%) convertible into24,000 shares common

Net Income (net of 40% tax): $350,000

Basic EPS =

Diluted EPS =

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Antidilutive Convertible Securities

Outstanding for the year:500,000 shares common

$1,000,000, 10% bonds issued at parconvertible into 50,000 shares common

Net Income (net of 30% tax): $600,000

Bond interest (net of tax)$1,000,000 x 10% x (1 - .30) $70,000

Basic EPS =

Diluted EPS =

Any security that increases EPS should be excluded.

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Options and Warrants: Treasury Stock Method

Options and warrants are dilutive if theexercise price is lower than the market price.

Increases the potential shares outstanding.

No effect on net income.

PotentialAdd. Shares

Market Price - Option Price

Market Price= x # of Options

$50 - $30$50

= x 1,500 = 600

Basic EPS =

Diluted EPS =

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EPS Presentation

Exercise 16-18

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STOCK OPTIONS - OTHER STUFF

APB Opinion #25

Old approach that some firms follow.

Incentive Stock Options Nonqualified Options

Tax advantages to

employee

Tax advantages to firm

option price = market

price on grant date

option price is usually

less than market price

no compensation

expense

compensation expense =

mkt price - option price

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Stock Appreciation Rights

right to receive compensation equal to the market

price over a pre-established price

at the end of each year of the service period

estimate total SAR compensation

(market price - pre-established price) x # of rights multiply by % compensation accrued

bring cumulative compensation up to date

Estimate of totalcompensation will change

from year to year

This might mean recordingnegative compensation in

some years.