TUGAS RINGKASAN MATA KULIAH

AKUNTANSI KEUANGAN MENENGAH II

DILUTIVE SECURITIES AND EARNINGS PER SHARE

Disusun oleh:

Adhiyanto Puji Laksono (F0309002/A)

FAKULTAS EKONOMI

UNIVERSITAS SEBELAS MARET

2011

DILUTIVE SECURITIES AND EARNINGS PER SHARE

SECTION 1. DILUTIVE SECURITIES AND COMPENSATION PLANS

DEBT AND EQUITY

Many of the controversies related to the accounting for financial instruments such

as share options, convertible securities, and preference shares relate to whether

companies should report these instruments as a liability or as equity. Declaration of

dividends is at the issuer’s discretion, as is the decision to repurchase the shares.

Similarly, preference shares that are not redeemable do not require the issuer to pay

dividends or repurchase the shares. Thus, non-redeemable ordinary or preference shares

lacks an important characteristic of a liability-an obligation to pay the holder of the

ordinary or preference shares at some point in the future.

CONVERTIBLE DEBT

Convertible bonds can be changed into other corporate securities during some

specified period of time after issuance. A convertible bond combines the benefits of a

bond with the privilege of exchanging it for shares at the holder’s option.

Corporations issue convertibles for two main reasons. One is to raise equity capital

without giving up more ownership control than necessary. A second reason to issue

convertibles is to obtain debt financing at cheaper rates.

Accounting for Convertible Debt

Convertible debt is accounted for as a compound instrument because it contains

both a liability and an equity component. Companies use the ‘with-and-without’ method

to value compound instruments.

To implement the with-and-without approach, companies do the following:

1. Determine the total fair value of the convertible debt with both the liability and

equity component.

2. Determine the liability component by computing the net present value of all

contractual future cash flows discounted at the market rate of interest.

3. The company subtracts the liability component estimated in the second step from

the fair value of the convertible debt to arrive at the equity component.

Accounting at Time of Issuance

To illustrate the accounting for convertible debt, assume that Roche Group (DEU)

issues 2,000 convertible bonds at the beginning of 2011. The bonds have a four-year term

with a stated rate of interest of 6 percent, and are issued at par with a face value of

€1,000 pr bond (the total proceeds received from issuance of the bonds are €2,000,000).

Interest is payable annually at December 31. Each bond is convertible into 250 ordinary

shares with a par value of €1. The market rate of interest on similar non-convertible debt

is 9 percent.

The liability component of the convertible debt is computed as shown below:

Present value of principal: €2,000,000 X .70843 (Table 6-2;n=4, i=9%) €1,416,860

Present value of the interest payments: €120,000 X 3.23972 (Table 6-4; n=4, i=9%)

Present value of the liability component €1,805,606

The equity component of Roche’s convertible debt is then computed as shown

below:

Fair value of convertible debt at date of issuance €2,000,000

Less: Fair value of liability component at date of issuance

Fair value of equity component at date of issuance €194,394

The journal entry to record this transaction is as follows:

Cash 2,000,000

Bonds Payable 1,805,606

Share Premium-Conversation Equity 194,394

The liability component of Roche’s convertible debt issue is recorded as Bonds Payable.

Settlement of Convertible Bonds

1. Repurchase at Maturity. If the bonds are not converted at maturity, Roche makes

the following entry to pay off the convertible debtholders.

Bonds Payable 2,000,000

Cash 2,000,000

2. Conversion at Maturity. If the bonds are converted at maturity, Roche makes the

following entry:

Share Premium-Conversion Equity 194,394

Bonds Payable 2,000,000

Share Capital-Ordinary 500,000

Share Premium-Ordinary 1,694,394

3. Conversion before Maturity. There is no gain or loss on conversion before

maturity: The original amount allocated to equity is transferred to the Share

Premium-Ordinary account.

4. Repurchase before Maturity. Roche determines the fair value of the liability

component of the convertible bonds at December 31, 2012, and then subtracts this

amount from the fair value of the convertible bond issue (including the equity

component) to arrive at the value for the equity. After this allocation is completed:

1. The difference between the consideration allocated to the liability component

and the carrying amount of the liability is recognized as a gain or loss, and

2. The amount of consideration relating to the equity component is recognized

(as a reduction) in equity.

Induced Conversions

Sometimes, the issuer wishes to encourage prompt conversion of its convertible

debt to equity securities in order to reduce interest costs or to improve its debt to equity

ratio. Thus, the issuer may offer some form of additional consideration (such s cash or

ordinary shares), called a ‘sweetener’, to induce conversion. The issuing company reports

the sweetener as an expense of the current period. Its amount is the fair value of the

additional securities or other consideration given.

CONVERTIBLE PREFERENCE SHARES

Convertible preference shares include an option for the holder to convert

preference shares into a fixed number of ordinary shares. Convertible preference shares

are reported as part of equity. When preference shares are converted or repurchased, there

is no gain or loss recognized. The rationale is: A company does not recognize a gain or

loss involving transactions with its existing shareholders.

SHARE WARRANTS

Warrants are certificates entitling the holder to acquire shares at a certain price within

a stated period. This option is similar to the conversion privilege. The issuance of

warrants or options to buy additional shares normally arises under three situations:

1. When issuing different types of securities, such as bonds or preference shares,

companies often include warrants to make the security more attractive-by

providing an “equity kicker”.

2. Upon the issuance of additional ordinary shares, existing shareholders have a

preemptive right to purchase ordinary shares first. Companies may issue warrants

to evidence that right.

3. Companies give warrants, often referred to as share options, to executives and

employees as a form of compensation.

Share Warrants Issued with Other Securities

Warrants issued with other securities are basically long-term options to buy

ordinary shares at a fixed price. Generally, the life of warrants is five years, occasionally

10 years; very occasionally a company may offer perpetual warrants.

Debt issued with share warrants is a compound instrument that has a debt and an

equity component. As a result, the company should use the with-and-without method to

allocate the proceeds between the two components.

Summary Analysis

The IASB indicates that companies should separate the debt and equity

components of securities, such as convertible debt or bonds issued with warrants. We

agree with this position. In both situations, the investor has made a payment to the

company for an equity feature. The only real distinction between them is that the

additional payment made when the equity instrument is formally acquired takes different

forms. Thus, the difference is one of method or form of payment only, t\rather than one

of substance.

Rights to Subscribe to Additional Shares

If the directors of a corporation decide to issue new ordinary shares, the old

shareholders generally have the right to purchase newly issued shares in proportion to

their holdings. This privilege referred to as a share right. Also it may allow them to

purchase shares somewhat below their market value.

Companies make only a memorandum entry when they issue rights to existing

shareholders. Companies make no formal entry at this time because they have not yet

issued shares nor received cash.

Share Compensation Plans

The third form of warrant arises in share compensation plans to pay and motivate

employees. This warrant is a share option, which gives key employees the option to

purchase ordinary shares at a given price over an extended period of time.

A consensus of opinion is that effective compensation programs are ones that do

the following: (1) base compensation on employee and company performance, (2)

motivate employees to high levels of performance, (3) help retain executives and allow

for recruitment of new talent, (4) maximize the employee’s after-tax benefit and

minimize the employer’s after-tax-cost, and (5) use performance criteria over which the

employee has control.

Long-term compensation plans attempt to develop company loyalty among key

employees by giving them “a piece of the action”-that is, an equity interest. These plans

generally referred to as share-based compensation plans, come in many forms.

ACCOUNTING FOR SHARE COMPENSATION

Share-Option Plans

Share-option plans involve two main accounting issues:

1. How to determine compensation expense

2. Over what periods to allocate compensation expense.

Determining Expense

Under the fair value method, companies compute total compensation expense

based on the fair value of the options expected to vest on the date they grant the options

to the employee(s).

Allocating Compensation Expense

In general, a company recognizes compensation expense in the periods in which

its employees perform the services-the service period. The company determines total

compensation cost at grant date and allocates it to the periods benefited by its employees

‘ services.

Restricted Shares

Restricted-share plans transfer shares to employees, subject to an agreement that

the shares cannot be sold, transferred, or pledged until vesting occurs.

Major advantages of restricted-share plans are:

1. Restricted shares never become completely worthless.

2. Restricted shares generally result in less dilution to existing shareholders.

3. Restricted-shares better align the employee incentives with the companies’

incentives.

The accounting for restricted shares follows the same general principles as

accounting for share options at the date of grant.

Employee Share-Purchase Plans

Employee share-purchase plans (ESPPs) generally permit all employees to

purchase shares at a discounted price for a short period of time. These plans are

considered compensatory and should be recorded as expense over the service period.

The IASB indicates that there is no reason to treat broad-based employee share

plans differently from other employee share plans. However, IFRS requires recording

expense for these arrangements.

Disclosure of Compensation Plans

Companies must fully disclose the status of their compensation plans at the end of

the periods presented. Specifically, a company with one or more share-based payment

arrangements must disclose information that enables users of the financial statements to

understand:

1. The nature and extent of share-based payment arrangements that existed during

the period.

2. How the fair value of the goods and services received, or the fair value of the

equity instruments granted during the period, was determined.

3. The effect of share-based payment transaction on the company’s net income (loss)

during the period and on its financial position.

SECTION 2. COMPUTING EARNINGS PER SHARE

The financial press frequently reports earnings per share date. Further,

shareholders and potential investors widely use this data in evaluating the profitability of

a company. Earnings per share indicates the income earned by each ordinary share. Thus,

companies report earnings per share only for ordinary shares. Generally, companies

report earnings per share information below net income in the income statement. When

the income statement contains discontinued operations, companies are required to report

earnings per share from continuing operations and net income on the face of the income

statement.

These disclosures enable the user of the financial statements to compare

performance between different companies in the same reporting period and between

different reporting periods for the same company.

EARNINGS PER SHARE-SIMPLE CAPITAL STRUCTURE

A company’s capital structure is simple if it consists only of ordinary shares or

includes no potential ordinary shares that upon conversion or exercise could dilute

earnings per ordinary share. In this case, a company reports basic earnings per share.

Preference Share Dividends

When a company has both ordinary and preference shares outstanding, it subtracts

the current-year preference share dividend from net income to arrive at income available

to ordinary shareholders.

Earnings per Share

In reporting earnings per share information, a company must calculate income

available to ordinary shareholders. To do so, the company subtracts dividends on

preference shares from income from continuing operations and net income. If a company

declares dividends on preference shares and a net loss occurs, the company adds the

preference dividend to the loss for purpose of computing the loss per share.

If the preference shares are cumulative and the company declares no dividend in

the current year, it subtracts (or adds) an amount equal to the dividend that it should have

declared for the current year only from net income (or to the loss).

Weighted-Average Number of Shares Outstanding

In all computations of earnings per share, the weighted-average number of shares

outstanding during the period constitutes the basis for the per share amounts reported.

Shares issued or purchased during the period affect the amount outstanding. Companies

must weight the shares by the fraction of the period they are outstanding. The rationale

for this approach is to find the equivalent number of whole shares outstanding for the

year.

Share Dividends and Share Splits

When share dividends or share splits occur, companies need to restate the shares

outstanding before the share dividend or split, in order to compute the weighted average

number of shares.

If a share dividend or share split occurs after the end of the year, but before the

financial statements are authorized for issuance, a company must restate the weighted-

average number of shares outstanding for the year.

EARNINGS PER SHARE-COMPLEX CAPITAL STRUCTURE

The EPS discussion to this point applies to basic EPS for a simple capital

structure. One problem with a basic EPS computation is that it fails to recognize the

potential impact of a corporation’s dilutive securities.

Computing diluted EPS is similar to computing basic EPS. The difference is that diluted

EPS includes the effect of all potential dilutive ordinary shares that were outstanding

during the period.

Some securities are antidilutive. Antidilutive securities are securities that upon

conversion or exercise increase earnings per share. Companies with complex capital

structures will not report diluted EPS if the securities in their capital structure are

antidilutive.

Diluted EPS-Convertible Securities

At conversion, companies exchange convertible securities for ordinary shares.

Companies measure the dilutive effects of potential conversion on EPS using the if-

converted method. This method for a convertible bond assumes: (1) the conversion of the

convertible securities at the beginning of the period, and (2) the elimination of related

interest, net of tax.

Other Factors

The conversion rate on a dilutive security may change during the period in which

the security is outstanding. For the diluted EPS computation in such a situation, the

company uses the most dilutive conversion rate available.

Diluted EPS-Options and Warrants

Companies use the treasury-share method to include options and warrants and

their equivalents in EPS computations. The treasury-share method assumes that the

options or warrants are exercised at the beginning of the year, and that the company uses

those proceeds to purchase ordinary shares for the treasury. If the exercise price is lower

than the market price of the shares, then the proceeds from exercise are insufficient to

buy back all the shares. If the exercise price of the option or warrant is lower than the

market price of the shares, dilution occurs. An exercise price of the option or warrant

higher than the market price of the shares reduces ordinary shares. In this case, the

options or warrants are antidilutive because their assumed exercise leads to an increase in

earnings per share.

Contingently Issuable Shares

Contingently issuable ordinary shares are defined as ordinary shares issuable for

little or no cash consideration upon satisfaction of specified conditions in a contingent

share agreement. Companies generally issue these contingent shares based on a measure,

such as attainment of a certain earnings or market price level.

Antidilution Revisited

In computing diluted EPS, a company must consider the aggregate of all dilutive

securities. But first it must determine which potentially dilutive securities are in fact

individually dilutive and which are antidilutive. A company should exclude any security

that is antidilutive, nor can the company use such a security to offset dilutive securities.

Recall that including antidilutive securities in earnings per share computations

increases earnings per share. With options or warrants, whenever the exercise price

exceeds the market price, the security is antidilutive.

Companies should ignore antidilutive securities in all calculations and in

computing diluted earnings per share.

EPS Presentation and Disclosure

A company should present both basic and diluted EPS information as follows:

Earnings per ordinary share

Basic earnings per share

Diluted earnings per share

When the earnings of a period include discontinued operations, a company should

show per share amounts for the following: income from continuing operations,

discontinued operations, and net income. Companies that report a discontinued operation

should present per share amounts for those line items either on the face of the income

statement or in the notes to the financial statements.

The following information should also be disclosed:

1. The amounts used as the numerators in calculating basic and diluted earnings per

share, and a reconciliation of those amounts to net income or loss.

2. The weighted average number of ordinary shares used as the denominator in

calculating basic and diluted earnings per share, and a reconciliation of these

denominators to each other.

3. Instruments (including contingently issuable shares) that could potentially dilute

basic earnings per share in the future but were not include in the calculation of

diluted earnings per share because they are antidilutive for the period(s)

presented.

4. A description of ordinary share transactions or potential ordinary share

transactions that occur after the reporting period and that would have significantly

changed the number of ordinary shares or potential ordinary shares outstanding at

the end of the period if those transactions had occurred before the end of the

reporting period.