978-1259722660 Chapter 19 Lecture Note Part 1

CHAPTER 19

SHARE-BASED COMPENSATION AND EARNINGS PER SHARE

Overview

We’ve discussed a variety of employee compensation plans in prior chapters, including

pension and other postretirement benefits in Chapter 17. In this chapter we look at some common

forms of compensation in which the amount of the compensation employees receive is tied to the

market price of company stock. We will see that these share-based compensation plans—

restricted stock awards, restricted stock units, stock options, and stock appreciation rights—

create shareholders’ equity, the topic of the previous chapter, and which also often affects the

way we calculate earnings per share, the topic of the second part of the current chapter.

Specifically, we view these as potential common shares along with convertible securities, and we

calculate earnings per share as if the securities already had been exercised or converted into

additional common shares.

Learning Objectives

After studying this chapter, you should be able to:

LO19–1 Explain and implement the accounting for restricted stock plans.

LO19–2 Explain and implement the accounting for stock options.

LO19–3 Explain and implement the accounting for employee share purchase plans.

LO19–4 Distinguish between a simple and a complex capital structure.

LO19–5 Describe what is meant by the weighted-average number of common shares.

LO19–6 Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split,

and the reacquisition of shares.

LO19–7 Describe how preferred dividends affect the calculation of EPS.

LO19–8 Describe how options, rights, and warrants are incorporated in the calculation of EPS.

LO19–9 Describe how convertible securities are incorporated in the calculation of EPS.

LO19–10 Determine whether potential common shares are antidilutive.

LO19–11 Describe the two components of the proceeds used in the treasury stock method and how

restricted stock is incorporated in the calculation of EPS.

LO19–12 Explain the way contingently issuable shares are incorporated in the calculation of EPS.

LO19–13 Describe the way EPS information should be reported in an income statement.

LO19–14 Discuss the primary differences between U.S. GAAP and IFRS with respect to

accounting for share-based compensation and earnings per share.

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Lecture Outline

Part A: Share-Based Compensation

I. Overview

A. Typically, an executive compensation plan is tied to performance in a way that uses

compensation to motivate its recipients.

B. Many plans include share-based awards.

C. Whichever form such a plan assumes, the accounting objective is to record the fair value

of compensation expense over the periods in which related services are performed.

D. This requires:

1. Determining the fair value of the compensation.

2. Expensing compensation over the periods in which participants perform services.

II. Restricted Stock Plans

A. The compensation is a grant of shares of stock (restricted stock) or the right to receive

shares of stock (restricted stock units).

B. The shares usually are restricted so that benefits are tied to continued employment.

1. Usually shares are subject to forfeiture if employment is terminated within some

specified number of years from the date of grant.

2. The employee cannot sell the shares during the restriction period.

C. The compensation is simply the market price of the stock at the grant date.

1. Compensation is accrued as expense over the service period for which participants

receive the shares.

2. The service period usually is the period from the date of grant to when restrictions

are lifted (the vesting date).

D. If restricted stock is forfeited, related entries previously made would simply be reversed.

III. Stock Option Plans

A. Allow recipients the option to purchase (a) a specified number of shares of the firm’s

stock, (b) at a specified price, (c) during a specified period of time.

B. For tax purposes, plans can either qualify as an “incentive stock option plan” under the

Tax Code or be “unqualified plans.” Under a qualified incentive plan, the recipient pays

no income tax until any shares acquired are subsequently sold. On the other hand, the

company gets no tax deduction at all. With a nonqualified plan the employee can’t delay

paying income tax, but the employer is permitted to deduct the difference between the

exercise price and the market price at the exercise date.

C. The accounting objective is to report the fair value of compensation expense during the

period of service for which the compensation is given.

D. Compensation is measured at the grant date, estimated using an option-pricing model that

considers the exercise price and expected term of the option, the current market price of

the underlying stock and its expected volatility, expected dividends, and the expected

risk-free rate of return.

E. When forfeiture estimates change, the cumulative effect on compensation is reflected in

current earnings.

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F. When options are exercised, cash is debited for the amount received, and stock accounts

replace paid-in capital—stock options.

G. If compensation from a stock option depends on meeting a performance target, then

whether we record compensation depends on whether or not we feel it’s probable the

target will be met.

H. If the target is based on changes in the market rather than on performance, we record

compensation as if there were no target.

I. Under U.S. GAAP, a deferred tax asset is created for the cumulative amount of the fair

value of the options expensed. Under IFRS, the deferred tax asset isn’t created until the

award is “in the money”; that is, has intrinsic value.

J. If recipients gradually become eligible to exercise their options rather than all at once, the

plan is said to have “graded vesting.” In such a case, most companies view each vesting

group (or tranche) separately, as if it were a separate award. Companies also are allowed

to account for the entire award on straight-line basis over the entire vesting period. Either

way, the company must recognize at least the amount of the award that has vested by that

date.

K. Under IFRS, the straight-line choice is not permitted. Also, there’s no requirement that

the company must recognize at least the amount of the award that has vested by each

reporting date.

IV. Employee Share Purchase Plans

A. Employee share purchase plans allow employees to buy company stock under convenient

or favorable terms.

B. Most such plans are considered compensatory and require the fair value of any discount

to be recorded as compensation expense.

Part B: Earnings Per Share

I. Overview

A. For analysts and the financial press, earnings per share is the most frequently cited and

reported measure of a company’s performance.

1. EPS is reported in the income statement of all publicly traded firms.

2. In general, EPS is simply earnings available to common shareholders divided by the

weighted average number of common shares outstanding.

II. Basic Earnings Per Share

A. Overview

1. If a company has no “potential common shares” we consider it to have a simple

capital structure.

a. For a simple capital structure, a single presentation of basic EPS is sufficient.

b. If there are no securities other than common stock and the number of common

shares remained unchanged, basic EPS is simply net income divided by

common shares.

B. Issuance of New Shares

1. When the number of shares changes, EPS calculations are based on the weighted

average number of shares outstanding during the period.

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2. New shares issued during a reporting period are time-weighted by the fraction of

the period they were outstanding and then added to the number of shares

outstanding for the period. For instance, if 12,000 new shares are sold on October 1,

the denominator of the EPS fraction would be increased by: 12,000 × 3/12, or 3,000

shares.

C. Stock Dividends and Stock Splits

1. On the contrary, an increase in shares due to a stock dividend or stock split is not

time-weighted.

a. For a stock dividend or stock split, the shares outstanding prior to the stock

distribution are restated to reflect the increase in shares. That is, we simply

increase the outstanding shares by the number of new shares.

b. The firm would simply have a larger number of less valuable shares (the same

pie is cut into more slices).

c. For example, EPS after a 2-for-1 stock split would be half of what it was

before, other things being equal.

d. When reported again in the comparative financial statements, previous years’

EPS are restated for comparability.

D. Reacquired Shares

1. If common shares are reacquired (as treasury stock or to be retired) those shares are

time-weighted for the fraction of the period they were not outstanding. The

time-weighted shares then are subtracted from the number of shares in the

denominator of the EPS fraction.

E. Earnings Available to Common Shareholders

1. Any dividends on preferred stock outstanding are subtracted from reported net

income.

a. This is because the denominator in the EPS calculation is the weighted

average number of common shares, so the numerator should reflect earnings

available to common shareholders.

b. This adjustment is made for cumulative preferred stock whether or not

dividends are declared that period. The assumption is that eventually the

dividends will be paid if the preferred stock is cumulative.

III. Diluted Earnings Per Share

A. Potential Common Shares

1. When a company has securities that could potentially dilute (i.e., reduce) earnings

per share, it is classified as a complex capital structure.

a. These potential common shares include stock options and convertible

securities.

b. The company reports both basic and diluted earnings per share.

c. For diluted EPS, the impact of each potentially dilutive security is reflected by

calculating earnings per share as if the security already had been exercised or

converted into additional common shares.

B. Options, Rights, and Warrants

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1. Stock options (also stock rights and stock warrants) give their holders the right to

exercise their option to purchase common stock, typically at a specified exercise

price. The increase in shares would reduce EPS.

a. When calculating diluted EPS, we pretend the stock options had been

exercised at the beginning of the period (or at the time the options are issued,

if later).

b. We also assume the cash proceeds from the assumed sale were used to buy

back (as treasury stock) as many of those shares as could be acquired at the

average market price of the shares during the period.

c. If the options haven’t vested, “proceeds” also include any compensation not

yet expensed.

d. If the options are not incentive options, “proceeds” also include any “excess

tax benefits.”

e. Restricted stock is potentially dilutive and also is included in diluted EPS by

the treasury stock method.

C. Convertible Securities

1. For convertible securities, we pretend for the purpose of calculating diluted EPS

that the conversion already has occurred.

a. To include convertible bonds in the calculation of diluted EPS, we pretend the

conversion occurred at the beginning of the period (or at the time the

convertible security is issued, if later).

i. The denominator of the EPS fraction is adjusted for the additional

common shares assumed.

ii. The numerator is increased by the interest (after-tax) that would have

been avoided in the event of conversion.

b. To include convertible preferred stock in the calculation of diluted EPS, we

pretend the conversion occurred at the beginning of the period (or at the time

the convertible security is issued, if later).

i. The denominator of the EPS fraction is adjusted for the additional

common shares assumed.

ii. The numerator is not reduced by the preferred dividends because they

would have been avoided in the event of conversion.

IV. Antidilutive Securities

A. If the effect of the assumed conversion or exercise of potential common shares would be

to increase, rather than decrease, EPS, we consider them “antidilutive securities.”

Antidilutive securities are ignored when calculating both basic and diluted EPS.

V. Additional EPS Issues

A. Contingently Issuable Shares

1. Contingently issuable shares also are potential common shares.

a. These are considered outstanding in the computation of diluted EPS if the

conditions for their issuance currently are met.

b. For instance, if 50,000 shares will be issued next year if the market price of

common shares next year is at least $35 and the market price currently is $36,

the 50,000 additional shares would be simply added to the denominator.

B. Financial Statement Presentation of Earnings Per Share Data

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1. Financial statement disclosures include both basic and diluted EPS for both income

from continuing operations and net income.

a. Per-share amounts also are reported for discontinued operations.

b. Disclosures should include a reconciliation of the numerator and denominator

used in the computations.

c. IAS No. 33 and U.S. GAAP are similar in most respects. The differences that

remain are the result of differences in the application of the treasury stock

method, the treatment of contracts that may be settled in shares or cash, and

contingently issuable shares.

Decision Makers’ Perspective

A. Analysts frequently use EPS data in connection with the price-earnings ratio.

1. The PE ratio is the market price per share divided by the earnings per share.

2. The PE ratio measures the decision makers’ perception of the “quality” of a

company’s earnings by indicating the price multiple the market is willing to pay for

the firm’s earnings.

3. In a way, it represents the market’s expectation of future earnings as indicated by

current earnings taking into account analysts’ perceptions of a business’s growth

potential, stability, and relative risk.

B. Another measure, the dividend payout ratio, indicates the percentage of earnings that is

distributed to shareholders as dividends.

Appendix 19B: Stock Appreciation Rights (SARs)

A. SARs enable an executive to benefit by the amount that the market price of the

company’s stock rises, but without having to buy shares.

B. The executive receives the “share appreciation” at exercise that has occurred since the

date of grant.

C. Share appreciation is the increase in the market price over a prespecified price (usually

the market price at the date of grant).

D. The share appreciation usually is payable in cash but may be payable in shares equal in

value to the share appreciation.

1. The award is considered to be equity if the employer can elect to settle in shares of

stock rather than cash.

2. The award is considered to be a liability if the employee can elect to receive cash

(which usually is the case).

3. When considered debt, the amount of compensation is continually adjusted to

reflect changes in the fair value of the SARs until the SARs expire or are exercised.

4. When the award is considered equity, fair value is measured at the grant date.

E. Sometimes restricted stock units are payable in cash in which case they are viewed as

liabilities and accounted for like SARs payable in cash.

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PowerPoint Slides

Three PowerPoint presentations of the chapter are available in the Connect Library:

1. With “Concept Checks” useful for classroom presentation, permitting the

instructor to intersperse in the presentation short exercises students can be asked

to solve individually or in small groups before the solution is “revealed” by the

instructor. {These are available only within Instructor Resources.}

2. Without the “Concept Checks” so students don’t have the solutions before being

asked to solve individually or in small groups.

3. Accessible PowerPoint Presentations. Accessibility is becoming even more

important in the education marketplace. Students and instructors with

disabilities use many different assistive technologies, and McGraw-Hill

Education is working to increase compatibility and access that will not only

help those with disabilities achieve better learning outcomes, but also serve the

institutions that are teaching these students. Accessible PowerPoint allows slide

content to be read by a screen reader and provides alternative text descriptions

for any image files used that enrich the learning experience. Accessible

PowerPoint is also designed with high-contrast color palettes and uses texture

when possible, instead of color to denote different aspects of the imagery used

within the slide.

Note: The slides are intended to provide comprehensive coverage of the chapter, but

they can be easily edited to allow instructors to change numbers and content in

illustrations or to delete slides pertaining to topics they choose to omit or

deemphasize. (Using your students’ names for company names in the Concept

Checks or Illustrations can be fun.)

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