Share-Based Compensation and Earnings Per Share

1. Share-Based Compensationand Earnings Per Share Chapter 19

2. Share-Based Compensation Stock Award Plans • Compensation: • Salary • Stock awards • Restricted stock plans • Usually tied to continuing employment. • Compensation is market price at date of grant. • Compensation expense accrued over service period.

3. Stock Option Plans Stock option plans give employees the option to buy • a specified number of shares of the firm's stock, • at a specified exercise price, • 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. Failed Attempt to Require Expensing • Opposition to a proposed FASB Statement to recognize expense for certain stock option plans have identified three objections. • Options with no intrinsic value at issue have zero fair value and should notgive rise to expense recognition. • It is impossible to measure the fair value of compensation on the date of grant. • The proposed standard would have unacceptable economic consequences.

6. Recognizing Fair Value of Options Accounting for stock options parallels the accounting for restricted stock we discussed earlier. We are required to estimate the fair value of stock option on the grant date. The FASB requires that compensation expense be measured using one of several option pricing models that deal with: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. U. S. GAAP vs. IFRS There are more similarities than differences in the treatment of stock options. One major difference is the treatment of deferred tax assets and when options have graded vesting. • A deferred tax asset (DTA) is created for the cumulative amount of the fair value of the options the company has recorded for compensation expense. • Account for each vesting amount separately or account for the entire award on the straight-line basis over the entire vesting period. • The deferred tax asset is not created until the award is “in the money;” that is it has intrinsic value. • Straight-line choice is not permitted. Companies not required to recognize the award that has vested by each reporting date.

9. Plans With Graded-Vesting Rather than stock option plans vesting on a single date, more plans awards specify that recipients gradually become eligible to exercise their options rather than all at once. This is called “graded vesting.” Accounting for compensation expense may be handled: 1 The company may estimate a single fair value for each of the options, even though they vest over different time periods, using a single weighted-average expected life of the options. 2 The company may use a slightly more complex method because it usually results in lower expense. In this approach, we view each vesting group separately, as if it were a separate award. For example, a company may award stock options that vest 25% in the first year, 25% in the second year, and 50% in the third year. For accounting purposes we have three separate awards.

10. 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: Employee Share Purchase Plans Cash (100 × $8.50) 850 Compensation expense (100 × $1.50) 150 Common stock (100 × $10.00) 1,000 Market value

11. 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.

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

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

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

15. 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

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

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

18. Stock Dividends and Stock Splits Retroactive treatment 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.

19. Reacquired Shares If shares were reacquired during the period, the weighted-average number of shares is reduced. The number of reacquired shares is time-weighted for the fraction of the year they were not outstanding.

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

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

22. 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 toCommon Shareholders

23. 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

24. 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

25. Proceeds from assumed exercise Averagemarket price of stock Options, Rights, and Warrants Determine new shares from assumed exercise of stock options. Compute number of shares repurchased.

26. 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)

27. Options, Rights, and Warrants When the exercise price exceeds the market price, the securities are antidilutive securitiesand are excluded from the calculation of diluted EPS.

28. The if-converted method is used for convertible debt and equity securities. The method assumes conversion occurs as of the beginning of the period or date ofissuance, if later. Convertible Securities

29. 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

30. Dilutive earnings per share may decrease or increase after the assumed conversion. Convertible Securities If dilutive earnings per share decreases,the securities are dilutiveand are assumedconverted. If dilutive earnings per share increases,the securities are antidilutiveand are not considered converted.

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

32. 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.

33. 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.

34. Restricted Stock Awards Restricted stock awards are quickly replacing stock options as the share-based compensation plan of choice. Like stock options, the treasury stock method is used to calculate the number of shares in the denominator of the EPS equation. Unlike stock options, employees do not pay to acquire their shares of stock. Changes to the EPS Calculation: No adjustment to the numerator Denominator is increased using treasury method

35. Summary

36. Summary

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

38. 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.

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

40. 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. Appendix 19B - Stock Appreciation Rights Usually the same as the fair value of a stock option with similar terms.

41. 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. Stock Appreciation Rights

42. End of Chapter 19