Share-Based Compensation and Earnings Per Share

1. Share-Based Compensation and Earnings Per Share Sid Glandon, DBA, CPA Associate Professor of Accounting The University of Texas at El Paso

2. Stock Compensation Plans • Provide employee incentives: • Stock award plans • Stock option plans • Stock appreciation rights • Broad-based (noncompensatory plans)

3. Stock Award Plans • Restricted shares are issued as compensation • Compensation expense is recognized over the vesting period • At the end of the vesting period the normal equity accounts are credited for common stock and additional paid-in capital

4. Stock Award Plans

5. Stock Option Plans • Important dates • Grant date of options • Vesting date • Exercise date of options • Compensation expense recognized by • Fair value method (SFAS 123)

6. Important Dates

7. Example: Fact Pattern • Grant date, January 1, 2001 • 10,000 options granted • One option = one $1 par value share • Exercise price: $60; Market price: $70 • Options exercisable within 10 years • Service period is 2 years • 2,000 options exercised on June 1, 2004 • 8,000 options expired on January 1, 2011 • Using an option pricing model the fair value of options is $220,000

8. Granting Stock Options and Recording Expense

9. Exercise of Stock Options

10. Expiration of Stock Options

11. Stock Appreciation Rights SARs • SARs are designed to mitigate employee cash flow problems in non-qualified plans • Employee gets right to receive any appreciation in share value at exercise date equal to market price • Less pre-established amount • Employee receives cash or stock only for the appreciation

12. Example: Stock Appreciation Rights • Fact Pattern: • SARs program established, January 1, 2001 • Exercise period, over next five years • Pre-established price per SAR $10 • Number of SARs granted, 10,000 • Market prices of stock at December 31, • 2001, $13 • 2002, $17 • 2003, $15 • Service period: 2 years • The SARs are exercised on December 31, 2003

13. Cumulative Compensation Recognizable for Service Period

14. Compensation Expense Related to Stock Appreciation Rights

15. Adjustment to Compensation Expense and Exercise of Stock Appreciation Rights

16. Earnings Per Share (EPS) • Most important number in income statement • Dilution of EPS means reduction in EPS • Potential conversion of dilutive securities into common stock • If dilution takes place extent of reduction must be disclosed

17. Basic EPS

18. Basic EPS • Fact Pattern: • Beginning balance = 800,000 shares • Issued 100,000 shares on April 1 • Reacquired 300,000 shares on July 1 • Net income = $1,700,000 • Preferred dividends = $250,000

19. Weighted-Average common Shares Outstanding

20. Basic Earnings Per Share

21. Stock Dividends and Splits • Restatement of weighted shares outstanding before the dividend or split • Deemed to have been outstanding since the beginning of the year • After year end but before issuance of financial statements require restatement to beginning of year

22. Basic EPS with Stock Dividends • Fact Pattern: • Beginning balance = 800,000 shares • Issued 100,000 shares on April 1 • Reacquired 300,000 shares on July 1 • 25% stock dividend on October 1 • Issue 120,000 shares on November 1 • Net income = $1,500,000 • Preferred dividends = $481,125

23. Weighted-Average Common Shares Outstanding

24. Basic EPS with Stock Dividends

25. Complex Capital Structures • Stock options, rights and warrants • Convertible securities • Convertible bonds • Convertible preferred stock • Only dilutive securities are considered • Antidilutive securities are ignored

26. Dilution • Reduction in EPS if potentially dilutive: • Stock options, rights or warrants • Convertible securities • Assumed exercised or converted at beginning of the year • Two EPS calculations • Basic EPS, and • Diluted EPS

27. Complex Capital Structures: Diluted EPS

28. Methods • Treasury stock method • Options, Rights and Warrants • If converted method • Convertible Securities • Maximum dilutive conversion rate is used in calculating diluted EPS

29. Treasury Stock Method • Options, rights and warrants are included in EPS computations • Assumed exercised at beginning of year • Proceeds from exercise are assumed used to buy back common shares • Exercise price per share must be less than market price per share for dilution

30. Treasury Stock Method • Fact Pattern: • Exercise price = $10 per share • Average market price = $40 per share • 1,000 options outstanding and assumed exercised • Additional shares added to weighted-average common shares outstanding

31. Dilution using the Treasury Stock Method

32. If-Converted Method • Conversion of securities into common stock is assumed to occur at the beginning of the year • Related interest effect (net of tax) and/or convertible preferred dividends are removed from the calculation of income available to common shares • Weighted average number of shares is increased by additional common shares assumed issued at beginning of year

33. If-Converted Method • Fact Pattern: • Net income = $500,000 • Common shares outstanding = 250,000 • $1,000,000 6% convertible bonds • Each $1,000 bond convertible into 25 shares of common stock • Income tax rate = 35%

34. Basic EPA using If-Converted Method

35. Diluted EPS using If-Converted Method

36. Diluted EPS using If-Converted Method

37. Complex Capital Structures • Requires duel presentation • Basic earnings per share • Diluted earnings per share