SHARE-BASED COMPENSATION AND EARNINGS PER SHARE

1. Chapter 19 SHARE-BASED COMPENSATION ANDEARNINGS PER SHARE

2. Share-Based Compensation Stock Award Plans Restricted stock plans usually are tied to continued employment of the person receiving the award. The compensation associated with a share of restricted stock (or nonvested 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 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).

4. Expense – The Great Debate Historically, options have been measured at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired. If the market and exercise price are equal on the date of grant, no compensation expense is recognized even if the options provide executives with substantial income.

5. Expense – The Great Debate • Opposition to a proposed FASB Statement have identified three objections. • Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. • It is impossible to measure the fair value of compensation on the date of grant. • Current practices have unacceptable economic consequences.

6. Recognizing Fair Value of Options Accounting for stock options parallels the accounting for restricted stock we discussed earlier. We now are required to estimate the fair value of stock option on the grant date. SFAS 123 (revised) requires the use of an option pricing model that deals with 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. Plans with Performance or Market Conditions In some circumstances, compensation from a stock option plan depends on meeting a performance target. When this is the case, compensation expense depends on whether or not we feel it is probable that the target performance will be met.

8. Employee Share Purchase Plan Permit employees to buy shares directly from their employer. Usually the plan is considered compensatory, and compensation expense is recorded. Employees may buy 100 shares of no par stock for $8.50 per share. The current market price is $10.00. The $1.50 discount is recorded as compensation expense:

9. 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.

10. Net income (after tax) – Preferred dividends* Weighted average outstanding common stock Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding Basic Earnings Per Share *Currentperiod’s cumulative preferred stock dividends (whether or not declared) and noncumulative preferred stock dividends (only if declared). Simple Capital Structure (Basic EPS)

11. Compute the weighted average number of shares of common stock outstanding. Issuance of New Shares

12. Issuance of New Shares Compute the weighted average number of shares of common stock outstanding. 100,000 + [50,000 × (9/12)] + [10,000 × (3/12)] = 140,000 New Shares New Shares Shares at Jan. 1

13. Common shares issued as part of stock dividends and stock splits are treated retroactively as subdivisions of the shares already outstanding at the date of the split or dividend. Stock Dividends and Stock Splits

14. Compute the weighted average number of shares of common stock outstanding. Stock Dividends and Stock Splits

15. Stock Dividends and Stock Splits Compute the weighted-average number of shares of common stock outstanding. 100,000 × (2.00) + [50,000 × (9/12) × 2.00] = 275,000 New Shares Shares at Jan. 1 Stock dividendadjustment

16. Retroactive treatment: Stock Dividends and Stock Splits New shares issued this period? No Yes Stock dividend or split is applied retroactively in proportion to the number of shares outstanding at the time of the dividend or split. Stock dividend or split is treated as outstanding from the beginning of the period.

17. Reacquired Shares The weighted-average number of shares is reduced by the number of reacquired shares, time-weighted for the fraction of the year they were not outstanding.

18. Reacquired Shares Compute the weighted-average number of shares of common stock outstanding.

19. Reacquired Shares Compute the weighted-average number of shares of common stock outstanding. 100,000 + [50,000 × (9/12)] - [12,000 × (8/12)] = 129,500 New Shares Treasury Shares Shares at Jan. 1

20. Net incomeLess: Current period’s cumulative preferred stock dividends (whether or not declared)Less: Noncumulative preferred stock dividends (only if declared)Net income available to common shareholders Earnings Available to Common Shareholders

21. Diluted Earnings Per share Complex Capital Structure (dual EPS) • Potential Common Shares: • Stock options, rights, and warrants • Convertible bonds and stock • Contingent common stock issues StockOptions Convertible securities Contingently issuable shares Treasury stock method If-converted method Dilution/Antidilution Test May Report Basic and Diluted Earnings Per Share

22. Options, Rights, and Warrants The treasury stock method assumes that proceeds from the exercise of options are used to purchase treasury shares. This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share. Proceeds At average market price Used to Purchase treasury shares

23. Proceeds from assumed exercise • Average market price of stock Options, Rights, and Warrants • Determine new shares from assumed exercise of stock options. • Compute number of shares repurchased.

24. Determine new shares from assumed exercise of stock options. Compute shares purchased for the treasury. Compute the incremental shares assumed outstanding. Options, Rights, and Warrants • New shares from assumed exercise (1) • Less: Treasury shares assumed purchased (2) • Net increase in shares outstanding (3)

25. Options, Rights, and Warrants When the exercise price exceeds the market price, the securities are antidilutive.

26. The if-converted methodis used for Convertible debt and equity securities. The method assumes conversion occurs as of the beginning of the period or date of issuance, if later. Convertible Securities

27. The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: increases the denominator by the number of common shares issuable upon conversion, increases the numerator by decreasing after-tax interest expense on convertible bonds, and dividends on convertible preferred stock. Convertible Securities

28. Dilutive earnings per share may decrease or increase after the assumed conversion. Convertible Securities If dilutive earnings per share decreases, the securities are dilutive and are assumed converted. If dilutive earnings per share increases, the securities are antidilutive and are not considered converted.

29. Order of Entry for Multiple Convertible Securities When a company has more than one instances of potential common shares, they are considered for inclusion in dilutive EPS in sequence from the most dilutive to the least dilutive.

30. Additional EPS Issues Contingently Issuable Shares Contingent shares are issuable in the future for little or no cash consideration upon the satisfaction of certain conditions. Contingently issuable shares are considered to be outstanding in the computation of EPS if the target performance level already is being met.

31. Contingently Issuable Shares Contingent shares are included in dilutive EPS if: Shares are issued merely due to passage of time. Some target performance level has already been met and is expected to continue to the end of the contingency period. Example: Additional shares may be issued based on future earnings.

32. Summary

33. Summary

34. Financial Statement Presentation • Report EPS data separately for: • Income from Continuing Operations • Separately Reported Items • Discontinued Operations • Extraordinary Items • Net Income

35. Appendix 19A – Option-Pricing Theory Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. An option that permits an employee to buy $25 stock for $10, has an intrinsic value of $15. Options have a time value because the holder of an option does not have to pay the exercise price until the option is exercised.

36. Summary The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

37. Appendix 19B - Stock Appreciation Rights The SARs are considered to be equity if the employer can elect to settle in shares of stock. The amount of compensation is estimated at the grant date as the fair value of the SARs. This amount is expensed over the service period. Usually the same as the fair value of a stock option with similar terms.

38. Stock Appreciation Rights  The SARs are considered to be a liability if the employee can elect to receive cash upon settlement. In that case, the amount of compensation (and related liability) is estimated each period and continuously adjusted to reflect changes in the fair value of the SARs until the compensation is finally paid. The current expense (and adjustment to the liability) is the fraction of the total compensation earned to date by recipients of the SARs (based on the elapsed percentage of the service period), reduced by any amounts expensed in prior periods.

39. End of Chapter 19