Share-Based Awards

1. Share-Based Awards Many compensation plans include one or more types of share-based awards. These include outright awards of shares, stock options, or cash payments tied to the market price of shares. Usually, an executive compensation plan is tied to performance in a way that uses compensation to motivate its recipients. Regardless of the form such a plan takes, the accounting objective is to record the fair value of the compensation expense over the periods in which related services are performed.

2. Stock Award Plans Restricted stock award plans usually are tied to continued employment of the person receiving the award. • The compensation associated with a share of restricted stock is the market price at the grant date of an unrestricted share of the same stock. • The amount is accrued as compensation expense over the service period for which participants receive the shares.

3. STOCK AWARD PLANS ILLUSTRATION Universal Communications grants 5 million of its $1 par common shares to certain key executives at January 1, 2009. The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of $12 per share. January 1, 2009 No entry Calculate total compensation expense: $12 fair value per share x 5 million shares awarded = $60 million total compensation The total compensation is allocated to expense over the 4-year service (vesting) period: 2009 - 2012 $60 million ÷ 4 years = $15 million per year December 31, 2009, 2010, 2011, 2012($ in millions) Compensation expense ($60 million ÷ 4 years) 15 Paid-in capital – restricted stock 15

4. STOCK AWARD PLANS ILLUSTRATION Upon vesting: ($ in millions) Paid-in capital– restricted stock (5 million sh. at $12) 60 Common stock (5 million shares at $1 par) 5 Paid-in capital – excess of par (to balance) 55  If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed.

5. STOCK OPTION PLANS  Stock option plans give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified exercise price, (c) during a specified period of time. The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date).

6. Recognizing Fair Value of Options Estimating fair value requires the use of anoption pricing modelthat incorporates the:1.Exercise price of the option.2. Expected term of the option.3. Current market price of the stock.4. Expected dividends.5. Expected risk-free rate of return.6. Expected volatility of the stock.

7. EXPENSING STOCK OPTIONS At Jan. 1, 2009, Universal grants options to acquire 10 million of the company’s $1 par common shares within the next 8 yrs, but not before Dec. 31, 2012 (the vesting date). The exercise price is the market price on the date of grant, $35 per share The fair value of the options is $8 per option. January 1, 2009 No entry Calculate total compensation expense: $8 estimated fair value per option x 10 million options granted = $80 million total compensation The total compensation is allocated to expense over the 4-year service (vesting) period: 2009 - 2012 $80 million ÷ 4 years = $20 million per year December 31, 2009, 2010, 2011, 2012($ in millions) Compensation expense ($80 million ÷ 4 years) 20 Paid-in capital – stock options 20

8. ESTIMATED FORFEITURES If a forfeiture rate of 5% was expected, annual compensation expense would have been $19 million ($76 / 4) instead of $20 million. 2009 ($ in millions) Compensation expense ($80 x 95% x 1/4) 19 Paid-in capital –stock options 19 2010 Compensation expense ($80 x 95% x 1/4) 19Paid-in capital –stock options 19

9. ESTIMATED FORFEITURES  During 2011, the third year, Universal revises its estimate of forfeitures from 5% to 10%. The new estimate of total compensation would then be $80 million x 90%, or $72 million.  The expense each year is the current estimate of total compensation that should have been recorded to date less the amount already recorded ($19 million in 2009 and 2010). 2011($ in millions) Compensation expense ([$80 x 90% x ¾] – [$19 + 19]) 16 Paid-in capital –stock options 16 2012 Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16]) 18 Paid-in capital –stock options 18

10. WHEN OPTIONS ARE EXERCISED If half the options (five million shares) are exercised on July 11, 2012, when the market price is $50 per share: July 11, 2012($ in millions) Cash ($35 exercise price x 5 million shares) 175 Paid-in capital - stock options (1/2 account balance) 40 Common stock (5 million shares at $1 par per share) 5 Paid-in capital – excess of par (to balance) 210 If options that have vested expire without being exercised (assuming none of the options were exercised): ($ in millions) Paid-in capital – stock options (account balance) 80Paid-in capital – expiration of stock options 80 Irrelevant

11. Plans with Performance Conditions Sometimes 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. If the initial expectation is that it is not probable that the target will be met, we record no annual compensation expense.  Suppose that in the third year it becomes probable that the target will be met. Then, record the cumulative effect on compensation in 2011 earnings: 2011 Compensation expense ([$80 x 3/4] - $0) 60 Paid-in capital –stock options 60 2012 Compensation expense ([$80 x 4/4] - $60) 20 Paid-in capital –stock options 20 Also, continue to record compensation thereafter. 3 years’ cumulative compensation

12. Plans with Market Conditions  Sometimes an award contains a market condition (e.g., an option that can be exercised only if the stock price reaches a specified level).  In that case, we recognize compensation expense regardless of when, if ever, the market condition is met.

13. EMPLOYEE SHARE PURCHASE PLANS Permit employees to buy shares directly from their employer. Usually the plan is considered compensatory, and compensation expense is recorded. Assume an employee buys shares (no par) under an ESPP plan for $850 rather than the current market price of $1,000. The $150 discount is recorded as compensation expense: Cash (discounted price) 850 Compensation expense ($1,000 x 15%) 150 Common stock (market value) 1,000

14. Earnings Per Share (EPS) Of the myriad facts and figures generated by accountants, the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and creditors is earnings per share.

15. EARNINGS PER SHARE In the most basic setting, earnings per share is simply a company’s earnings (or loss) divided by the number of shares outstanding. Sovran Metals Corporation reported net income of $154 million in 2009. (Its tax rate was 40%).  Common stock January 1, 2009 60 million sharesoutstanding (in millions, except per share amount)

16. ISSUANCE OF NEW SHARES If the number of shares has changed, it’s necessary to find the weighted average of the shares outstanding during the period the earnings were generated. Any new shares issued are time-weighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period. Sovran Financial Corporation reported net income of $154 million for 2009 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding  March 1 12 million new shares were sold We time-weight the new shares for the fraction of the year they’re outstanding.

17. STOCK DIVIDENDS AND STOCK SPLITS  The additional shares created by a stock dividend or split are not weighted for the time period they were outstanding. Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold  June 17 A 10% stock dividend was distributed Shares outstanding prior to the stock distribution are retroactively restated to reflect the increase in shares – that is, treated as if the distribution occurred at the beginning of the period.

18. REACQUIRED SHARES The number of reacquired shares is time-weighted for the fraction of the year they were not outstanding, prior to being subtracted from the number of shares outstanding. Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed  October 1 8 million shares were reacquired as treasury stock Basic EPS: Stock dividend adjustment not necessary since the treasury shares were reacquired after the stock dividend and thus already reflect the adjustment.

19. EARNINGS AVAILABLE TO COMMON SHAREHOLDERS Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed October 1 8 million shares reacquired as treasury stock Preferred stock, nonconvertible Jan. 1-Dec. 31 5 million 8%, $10 par, shares Basic EPS: Preferred dividends are subtracted from net income so that “earnings available to common shareholders” is divided by the weighted average number of common shares. 5,000,000 x $10 x 8%

20. COMPLEX CAPITAL STRUCTURE Potential common shares — Securities that, while not being common stock, may become common stock through their exercise or conversion and, therefore, may “dilute” (reduce) EPS. Examples: Convertible preferred stock, stock options, rights, or warrants, and contingently issuable securities Complex capital structure — If potential common shares are outstanding A firm with a complex capital structure reports two EPS calculations: BasicEPS ignores the dilutive effect of potential common shares. DilutedEPS incorporates the dilutive effect of potential common shares. The dilutive effect is included essentially by “pretending” the securities already have been exercised, converted, or otherwise transformed into common shares.

21. OPTIONS, RIGHTS, AND WARRANTS Stock options, stock rights, and stock warrants give their holders the right to exercise their option to purchase common stock, usually at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS. Incentive stock options Executive stock options granted in 2007, exercisable after 2008 for 15 million common shares* at an exercise price of $20 per share. The average market price was $25. *adjusted for the stock dividend Basic EPS is unaffected

22. OPTIONS, RIGHTS, AND WARRANTS (continued) We assume the $300 million is used to buy back as many shares as possible (12 million) at the average market price. We assume the options are exercised and 15 million shares are sold. Assuming the exercise of the options adds 3 million shares to the denominator of diluted EPS.

23. Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares b. 5,000 shares c. 3,125 shares d. 1,875 shares Stock Options New shares = 5,000 Treasury shares = 3,125 (5,000 × $50) ÷ $80 Incremental shares = 1,875 (5,000 - 3,125)

24. Proceeds for Calculating Reacquired Shares The “proceeds” for the calculation should include: 1. amount received from the hypothetical exercise of the options ($300M). 2. total compensation that's not yet expensed. If the FV of an option had been $4, total compensation would have been 15M shares times $4, or $60M. In our illustration, the options were fully vested, so all $60M already had been expensed. Hence, this component of the proceeds is zero. If the options had been only half vested, half the compensation would have been unexpensed and $30M would have been added to the $300M proceeds. 3. the "excess tax benefit." We expense the fair value of stock options at the date of grant. If the options had been non-qualified options, the corporation receives a tax deduction at exercise equal to the difference between the stock's market value and its exercise price. Our options were incentive stock options, hence zero tax benefit. If non-qualified options, proceeds would have included a $6M excess tax benefit: $25 average market price during 2009 (& price at hypothetical exercise) (20) exercise price $ 5 tax deduction at hypothetical exercise (4) fair value at grant date (& amount expensed over the vesting period) $ 1 excess tax deduction per option x 15 million options $15 million excess tax deduction x 40% tax rate $ 6 million excess tax benefit 15M sh. x $20 exercise price = $300M

25. Restricted Stock in EPS Calculations Restricted stock awards are included in EPS using the treasury stock method. Shares are added to the denominator and then reduced by the number of shares that can be bought back with the “proceeds” at the average market price of the company’s stock. The cash proceeds are zero since executives don’t pay to acquire shares.  The proceeds include the compensation that’s not yet expensed. Assume total compensation for a restricted stock award is $60M ($12 per share x 5M shares). If the stock vests over 4 years, it’s expensed as $15M each yr for 4 yrs. At the end of 2009, $45M remains unexpensed, so $45M would be the assumed proceeds. If the market price remains at $12, the $45M will buy back 3.75M shares: No adjustment to the numerator 5 million – 3.75* million = 1.25 million *Assumed purchase of treasury shares $45 million ÷ $12 (average market price) 3.75 million shares The $45M proceeds would include any excesstax benefits if the eventual tax deduction differs from the amount expensed. That occurs when the stock price at vesting (now in our hypothetical vesting) differs from the price at grant, so this component is zero in this example.

26. CONVERTIBLE SECURITIES For Diluted EPS, conversion into common stock is assumed to have occurred at the beginning of the period (or at the time the convertible security is issued, if that’s later). The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion.  The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

27. Convertible Bonds 10%, $300 million face amount of bonds issued in 2005, convertible into 12 million common shares (adjusted for the stock dividend)

28. CONVERTIBLE PREFERRED STOCK Now assume the preferred stock is convertible into common stock:  Preferred stock, convertible 5 million, 8%, cumulative, $10 par, shares, convertible into 3 million common shares* *adjusted for the stock dividend 80 cents per share, or $4 million

29. CONVERTIBLE PREFERRED STOCK (continued) If we assume the preferred shares have been converted to CS, there would be no preferred dividends to subtract. Earnings available for CS does not include dividends payable to preferred shareholders.

30. A company had 200,000 shares of $.50 par common stock, 10,000 shares of 5%, $20 par cumulative preferred stock, and 30,000 shares of 5%, $10 par preferred stock convertible into 10,000 common shares. Net income after taxes was $1,500,000. No dividends were declared during the year. Diluted EPS would be a. $7.14 b. $7.07 c. $6.67 d. $7.00 Earnings Per Share $1,500,000 – (10,000 × 5% × $20 par) 200,000 + 10,000 shares Even though dividends were notdeclared, the cumulative preferred stock dividends are subtracted.

31. ANTIDILUTIVE SECURITIES At times, the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as “antidilutive” securities. Such securities are ignored when calculating EPS.  Stock warrants Warrants granted in 2008, exercisable for 4 million common shares* at an exercise price of $32.50 per share *adjusted for the stock dividend Calculations: The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive. The $32.50 exercise price is higher than the market price, $25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

32. CONTINGENTLY ISSUABLE SHARES Considered to be outstanding in the computation of diluted EPS if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period). For example, assume 3 million additional shares will become issuable to certain executives in the following year (2010) if net income that year is $150 million or more. If net income in 2009 was $154 million, the additional shares would beconsidered outstanding in the computation of diluted EPS by simply adding 3 million additional shares to the denominator. Assumed issuance of contingently issuable shares (diluted EPS): no adjustment to the numerator + 3 additional shares

33. Order of Entry for Multiple Convertible Securities When a company has more than one potentially dilutive security, they are considered for inclusion in dilutive EPS in sequence from the most dilutive to the least dilutive.

34. Earnings Per Share Disclosure • Report EPS data separately for: • Income from Continuing Operations • Separately Reported Items • Discontinued Operations • Extraordinary Items • Net Income