CHAPTER 16
Dilutive Securities and Earnings per Share
LEARNING OBJECTIVES
1. Describe the accounting for the issuance, conversion, and retirement of convertible
securities.
2. Contrast the accounting for share warrants and for share warrants issued with other
securities.
CHAPTER REVIEW
1. Chapter 16 examines the issues related to accounting for dilutive securities at date of
issuance and at time of conversion. In addition, the impact of the computation of earnings
Dilutive Securities
2. (L.O. 1) Dilutive securities are defined as securities that are not ordinary shares in form
Convertible Debt
3. In the case of convertible bonds, the conversion feature allows the corporation an
opportunity to obtain equity capital without giving up more ownership control than
necessary. In addition, the conversion feature entices the investor to accept a lower
4. At the settlement date, four situations can result from issuing convertible bonds:
a. If the bonds have not been converted at the maturity date, the issuing company
removes the bond payable from the books when it pays the cash face value, and any
amount originally allocated to equity remains on the books (although it may be
reclassified into a different equity account).
d. If the bonds are repurchased prior to maturity, the same process that was used at
issuance is again used to arrive at the fair value of the bonds. That is, the company
5. When an issuer wishes to induce prompt conversion of its convertible debt to equity
Convertible Preference Shares
6. Convertible preference shares are not compound securities and are accounted for in
the same manner as nonconvertible preference shares at date of issuance. When
Share Warrants
7. (L.O. 2) Share warrants are certificates entitling the holder to acquire shares at a certain
price within a stated period. If warrants are exercised, they become ordinary shares and
8. Debt issued with share warrants is a compound instrument that has a debt and an equity
9. For example, assume that Pontell Corporation issued 1,000, €500 bonds with warrants
attached for par (€500,000). Each bond has one warrant attached. It is estimated that the
bonds would sell for 98 without the warrants. The allocation between the bonds and the
10. When detachable warrants are exercised, Cash is debited for the exercise price and
Share Premium—Share Warrants is debited for the amount assigned to the warrants. The
credit portion of the entry includes Share Capital—Ordinary and Share Premium—
Ordinary. If detachable warrants are never exercised, Share Premium—Share Warrants
Share Rights
11. Share rights are issued to existing shareholders when a corporation’s directors decide to
issue new shares. Each share owned normally entitles the shareholder to one share right.
Share Compensation Plans
12. (L.O. 3) A share option is another form of warrant that arises in share compensation
plans used to pay and motivate employees. This type of warrant gives selected employees
13. In the past, companies have used different methods of recognizing the cost of
compensation under a share option plan. Most recently, the two choices were:
The Fair Value Method
14. Using the fair value method, total compensation expense is computed based on the fair
value of the options expected to vest on the date the options are granted to the employees.
Allocating Compensation Expense
15. In general, compensation expense is recognized in the periods in which the employee
16. To illustrate the accounting for a share option plan, assume that on September 16, 2017,
the shareholders of Jesilow Company approve a plan that grants the company’s three
executives options to purchase 4,000 shares each of the company’s £1 par value ordinary
shares. The options are granted on January 1, 2018, and may be exercised at any time
within the next five years. The option price per share is £30, and the market price of the
shares at the date of grant is £40 per share.
Other Share-Based Compensation Plans
17. Restricted-share plans: Transfer shares to employees, subject to an agreement that the
18. Major advantages of restricted-share plans are:
19. The accounting for restricted shares follows the same general principles as accounting for
20. To illustrate the accounting for restricted-share plans, assume that on January 1, 2018,
Lindsey Company issues 2,000 restricted shares to its President, Amy Carlson. Lindsey’s
shares have a fair value of $12 per share on January 1, 2018. Additional information is as
follows:
a. The service period related to the restricted shares is four years.
Unearned compensation represents the cost of services yet to be performed, which is not
an asset. Thus, the company reports unearned compensation in equity in the statement
Employee Share-Purchase Plans
21. Employee share purchase plans (ESPPs) generally permit all employees to purchase
Debate over Share-Option Accounting
22. The IASB faced considerable opposition when it proposed using the fair value method
(rather than the intrinsic value method) for accounting for share options because its use
Earnings per Share
23. (L.O. 4) Earnings per share (EPS) indicates the income earned by each ordinary share.
EPS is an important statistic for many investors. Due to its importance, EPS must be
Basic Earnings per Share
24. A corporation’s capital structure is simple if it consists only of ordinary shares or includes
no potentially dilutive convertible securities, options, warrants, or other rights that upon
conversion or exercise could in the aggregate dilute earnings per ordinary share. In this
Weighted-Average Number of Shares Outstanding
25. 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 number of outstanding shares and must be weighted by the fraction of the period they
Diluted Earnings per Share
26. (L.O. 5) A capital structure is complex if it includes securities that could have a dilutive
effect on earnings per ordinary share. A complex capital structure requires a dual presen–
Diluted EPS—Convertible Securities
27. The if-converted method is used to measure the dilutive effects of potential conversion
on EPS. The if-converted method for a convertible bond or convertible preference share
assumes (a) the conversion of convertible securities at the beginning of the period (or at
Diluted EPS-Options and Warrants
28. Share options and warrants outstanding are included in diluted earnings per share unless
they are antidilutive. If the exercise price of the option or warrant is lower than the market
Treasury-Share Method
29. The treasury-share method is used in determining the dilutive effect of options and warrants.
This method assumes that the proceeds from the exercise of options and warrants are
used to purchase ordinary shares for the treasury. To illustrate the treasury share
30. For both options and warrants, exercise is not assumed unless the average market price
Contingently Issuable Shares
31. Contingently issuable shares are ordinary shares issuable for little or no cash upon
satisfaction of certain conditions outlined in a contingent share agreement. The basic rule is
Share Appreciation Rights
*32. (L.O. 5) Share appreciation rights are a form of employee compensation that avoids
some of the cash flow problems recipients of nonqualified share option plans face. Under
a share appreciation rights plan, an employee is given the right to receive share
appreciation, which is defined as the excess of the market price of the share at the date
Appendix 16-B
*33. (L.O. 7) Appendix 16-B is a comprehensive illustration of the computations involved in
presenting earnings per share. This appendix is an outstanding demonstration of the
LECTURE OUTLINE
The material in this chapter can be covered in three or four class sessions. Students generally
A. Dilutive Securities: Securities that are not ordinary shares in form but enable their holders
to obtain ordinary shares upon exercise or conversion.
1. (L.O. 1) Accounting for convertible debt: A convertible bond combines the benefits
of a bond with the privilege of exchanging it for shares at the holder’s option.
a. Issuance: accounted for using the “with–and–without” method for valuation
(1) If the bonds have not been converted at the maturity date, the issuing
company removes the bond payable from the books when it pays the cash
face value, and any amount originally allocated to equity remains on the
books (although it may be reclassified into a different equity account).
(2) If the bonds are converted at maturity, the book value of the bond (including
(4) If the bonds are repurchased prior to maturity, the same process that was
used at issuance is again used to arrive at the fair value of the bonds. That is,
2. Accounting for convertible preference shares: Not considered a compound security,
3. (L.O. 2) Accounting for share warrants: entitles holder to acquire shares at a
certain price within a stated period.
a. Normally issued as:
b. Debt issued with warrants: Considered a compound instrument, the with-and–
without method is used to allocate the proceeds between the two components.
4. (L.O. 3) Share compensation plans: Arrangements in which selected employees
are given the option to purchase ordinary shares in the company at a given price over
an extended period of time.
a. The fair value method is used to record compensation expense based on the fair
5. Accounting for share compensation:
a. Allocating Compensation Expense: recognized over the service period (the time
between the grant date and the vesting date).
(1) On Date of grant: no journal entry required.
b. Recording the exercise of options:
Dr. Cash
Dr. Share Premium—Share Options
c. Recording the expiration of options: no adjustment is made to Compensation
Expense
e. Restricted-share plans: transfer shares to employees, subject to an agreement
that the shares cannot be sold, transferred or pledged until vesting occurs.
(1) Vesting is usually based on service being provided over a 3–5 year period.
(2) Advantages of such plans include:
(a) Restricted shares are never completely worthless.
(4) Accounting for restricted shares:
(a) Determine the fair value of the restricted share on the grant date.
Dr. Compensation Expense
Cr. Unearned Compensation
(d) Entry to record forfeiture:
f. Employee share purchase plans: permit all employees to purchase shares at
a discounted price for a short period of time.
g. Disclosure of compensation plans: must disclose information that enables financial
statement users to understand:
(1) The nature and extent of share-based payment arrangements that existed
during the period.
6. Debate over share options: The share option saga illustrates the difficult, contentious
B. Computing Earnings per Share.
1. (L.O. 4) Simple capital structures: companies that have only ordinary shares or no
securities that could dilute earnings per share (EPS) if converted or exercised. In this
case, companies compute basic EPS.
a. EPS =
Net Income–Preference share dividends
Weighted average no. of shares outstanding
(3) Share splits and dividends
(a) If a share dividend/split occurs during the year, treat it as if it occurred at
2. (L.O. 5) Complex capital structures: when a company has convertible securities,
options, warrants, and other rights that upon conversion or exercise could dilute EPS.
a. Requires presentation of both basic and diluted EPS.
c. Convertible securities.
(1) Convertible bonds, use the if-converted method.
(a) Treat conversion as occurring at the beginning of the year, or at issuance
(2) Convertible preference shares.
(3) Use the most advantageous conversion rate available to the holder of the
security.
d. Options and warrants use the treasury-share method and assume:
(1) Exercise at the beginning of the year or issue date, if it issued during the year.
e. Contingent shares are included in the computation of diluted EPS based on the
number of shares that would be issuable as if the end of the period were the end
of the contingency period.
f. Convertibles, options, warrants, and contingently issuable shares are included in
3. Presentation and disclosure.
a. If a company has discontinued operations, EPS is presented for income from
continuing operations, discontinued operations, and net income.
C. (L.O. 6) Accounting for Share-Appreciation Rights.
Share appreciation rights (SARs).
1. Nonqualified share option plans may cause a financial hardship.
2. Incentive plans may require the recipient to borrow money to finance the exercise price, but
no taxes are paid at exercise.
3. Share appreciation rights (SARs) give the recipient the right to receive compensation equal
to the difference between the market price at exercise and a pre-established price (share
4. Share-based equity awards.
a. The recipient receives shares equal to the share price appreciation.
5. Share-based liability awards.
a. The recipient receives cash equal to the share appreciation amount.
b. Accounting for such awards consists of:
(1) Measure the fair value of the award at the grant date and accrue
compensation over the service period.
(4) Allocate this estimated compensation amount over the service period using
the percentage approach.
D. (L.O. 7) Appendix 16-B. Comprehensive EPS Illustration.