Dilutive Securities

1
CHAPTER 16
Dilutive Securities and Earnings per Share
.....
Convertible Bonds

• exchanged for stock at the bond holders option
• increases the value of the bond
• a sweetener might be offered to induce
  conversion

2
At Time of Issuance

• recorded like a straight debt issue
• no value allocated to conversion privilege
• FASB considers the privilege inseparable from the
  bond

Cash 106,000 Bonds Payable 100,000 Premium
on Bonds Payable 6,000
3
At Time of Conversion

• stock is recorded at book value of the converted
  bonds

4
Induced Conversions

• record the sweetener as an expense

Debt Conversion Expense 7,000 Bonds
Payable 100,000 Premium on Bonds
Payable 5,000 Common Stock 20,000 Paid-in Cap
excess of par 85,000 Cash 7,000
This is the same whether or not there is a
sweetener.
5
Retirement of Convertible Debt

• recorded like a straight debt retirement

Clear-out the balances of bonds and premium.
Not an extraordinary item
6

• at conversion, common stock is recorded at book
  value of the converted preferred

7

• options to buy shares of stock at a certain price
• warrants are issued
• with bonds or preferred stock as an added bonus
• to common stockholders with a preemptive right
• to executives and employees

8
Warrants Issued with Other Securities
Example Sold 500 1,000 bonds for 505,000.
Included with each bond is a 5-year warrant to
buy 1 share of common for 25.
Incremental Method
Assume the market value of each warrant is 30
and the market value of the bonds (alone) is
unknown.
9
Proportional Method
Assume the market value of each warrant is 30
and the market value of each bond is 990.
Mkt Value Book Value Bonds 495,000 Warrants 15
,000
10
Effective Compensation

• motivate performance
• compensation tied to performance
• performance over which employee has control
• short- and long-term performance
• retain and recruit executives

Stock price is thought to be better that Sales or
other accounting measures.
Stock options are very attractive to managers.
11
The Expected Value of a Share of Stock
8 18 40 22 12 Expected
value 100
Possible Stock Values Probability 80 10 90
20 100 40 110 20 120 10
What is the value of an option to buy 1 share of
stock at 100?
12
The Value of a Stock Option
Possible Value of Option Stock
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.
13
The Value of Volatility
Possible Value of Option Stock
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
14
Accounting for Stock Compensation

• Valuation
• intrinsic value method excess of market price
  over exercise price
• fair value method estimated value of options
  expected to vest
• value generally measured at grant date
• FASB now requires fair value method
• Allocation of expense
• expense recognized in the service period
• generally service period vesting period

15
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
2-year service period beginning on the grant date.
January 2, 2008 Options granted
no entry
16
December 31, 2008 (first year of service period
completed)
December 31, 2009 (second year of service
completed)
17
January 3, 2010 20,000 options were exercised
January 2, 2014 10,000 options expired
18

• number and weighted average fair value of options
• granted
• exercised
• forfeited
• outstanding
• average remaining life of options outstanding

19

EPS
Current year preferred dividend or Dividend that
should have been declared if the preferred stock
is cumulative
20
Weighted Average Shares Outstanding
1/1 4/1 90,000 4/1 7/1 120,000 7/1
11/1 81,000 11/1 12/31 141,000
Dates Shares Fraction Outstanding Outstanding of
Year
New stock issued
Stock repurchased
21
Weighted Average with Stock Dividend or Split
Shares 1/1 Beginning balance 80,000 3/1 Issued
30,000 shares 110,000 8/1 2 for 1 stock
split 220,000 10/1 Purchsd 20,000 shares 200,000
1/1 3/1 3/1 10/1 10/1 12/31
Dates Shares Fraction Outstnd Outstnd Rstmt of
Year
22

• Dilutive securities have an adverse effect on EPS
• convertible securities
• options or warrants
• Firms must report both Basic EPS and Dilutive EPS

23
Convertible Securities If-Converted Method
1/1 Beginning balance 200,000 shares
common 5/1 Issued 500,000, 8 bonds for 535,530
(effective interest 7) convertible into 24,000
shares common Net Income (net of 40 tax)
350,000
Net Income 350,000 Add Bond interest (net of
tax) 535,530 x 7 x 8/12 24,991 Less 40
tax 9,997 14,994 Adjusted net
income 364,994
24
1/1 Beginning balance 200,000 shares
common 5/1 Issued 500,000, 8 bonds for 535,530
(effective interest 7) convertible into 24,000
shares common Net Income (net of 40 tax)
350,000
1/1 5/1 5/1 12/31
Dates Shares Out Fraction Outstanding if
Converted of Year
Basic EPS Diluted EPS
25
Antidilutive Convertible Securities
Outstanding for the year 500,000 shares
common 1,000,000, 10 bonds issued at par
convertible into 50,000 shares common Net Income
(net of 30 tax) 600,000
Bond interest (net of tax) 1,000,000 x 10 x (1
- .30) 70,000
Basic EPS Diluted EPS
Any security that increases EPS should be
excluded.
26
Options and Warrants Treasury Stock Method

• Options and warrants are dilutive if the exercise
  price is lower than the market price.
• Increases the potential shares outstanding.
• No effect on net income.

Potential Add. Shares

x of Options
600
Basic EPS Diluted EPS
27
EPS Presentation
Exercise 16-18
28
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

29
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

This might mean recording negative compensation
in some years.
Estimate of total compensation will change from
year to year.