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CHAPTER 16

Dilutive Securities and Earnings Per Share


ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics

Questions

Problems

Concepts
for Analysis

1, 2, 3, 4, 5,
6, 7, 22, 23,
24, 25

1, 2

Convertible debt

2.

Convertible preferred
stock.

3.

Warrants.

2, 3, 8, 9

4, 5

7, 8, 9, 28

1, 3

4.

Stock compensation
plans; restricted stock.

10, 11, 12,


13, 14, 15

6, 7, 8

10, 11, 12,


13, 14

1, 3, 4

2, 4

5.

Earnings per share


Simple capital
structure.

18, 24

9, 15

17, 18, 19,


20, 21

6.

EPSDetermining
potentially dilutive
securities.

19, 20, 21

12, 13, 14

22, 23, 27

5, 6

7.

EPSTreasury stock
method.

22, 23

28

5, 6

8.

EPSWeightedaverage computation.

16, 17

10, 11

9.

EPSGeneral
objectives.

24, 25

9, 15

EPSComprehensive
calculations.

25, 26

11.

EPSContingent
shares.

*12.

Stock appreciation
rights.

1, 2, 3

Exercises

1.

10.

1, 2, 3, 4,
5, 6, 7

Brief
Exercises

24, 25

15, 16, 17,


18, 19, 20,
21

5, 6, 7,
8, 9
5, 6

22, 23, 24,


25, 26,
27, 28

5, 7, 8, 9

27
16

29, 30

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16-1

*This material is dealt with in an Appendix to the chapter.

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ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)


Learning Objectives

Brief
Exercises

Exercises

Problems

1, 2, 3,
4, 5, 6

1, 2

1. Describe the accounting for the issuance,


conversion, and retirement of convertible
securities.

1, 2

2. Explain the accounting for convertible


preferred stock.

3. Contrast the accounting for stock warrants and


for stock warrants issued with other securities.

4, 5

1, 7, 8, 9

4. Describe the accounting for stock compensation


plans.

6, 7, 8

10, 11, 12,


13, 14

1, 3, 4

6. Compute earnings per share in a simple


capital structure.

9, 10,
11, 15

15, 16, 17, 18,


19, 20, 21

6, 9

7. Compute earnings per share in a complex


capital structure.

12, 13, 14

22, 23, 24, 25,


26, 27, 28

5, 7, 8

16

29, 30

5. Discuss the controversy involving stock


compensation plans.

*8. Explain the accounting for stock-appreciation


rights plans.
*9. Compute earnings per share in a complex
situation.
*10. Compare the accounting for dilutive securities
and earnings per share for IFRS and GAAP.

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ASSIGNMENT CHARACTERISTICS TABLE

Issuance and conversion of bonds.


Conversion of bonds.
Conversion of bonds.
Conversion of bonds.
Conversion of bonds.
Conversion of bonds.
Issuance of bonds with warrants.
Issuance of bonds with detachable warrants.
Issuance of bonds with stock warrants.
Issuance and exercise of stock options.
Issuance, exercise, and termination of stock options.
Issuance, exercise, and termination of stock options.
Accounting for restricted stock.
Accounting for restricted stock.
Weighted-average number of shares.
EPS: Simple capital structure.
EPS: Simple capital structure.
EPS: Simple capital structure.
EPS: Simple capital structure.
EPS: Simple capital structure.
EPS: Simple capital structure.
EPS with convertible bonds, various situations.
EPS with convertible bonds.
EPS with convertible bonds and preferred stock.
EPS with convertible bonds and preferred stock.
EPS with options, various situations.
EPS with contingent issuance agreement.
EPS with warrants.
Stock-appreciation rights.
Stock-appreciation rights.

Simple
Simple
Simple
Moderate
Simple
Moderate
Simple
Simple
Moderate
Moderate
Moderate
Moderate
Simple
Simple
Moderate
Simple
Simple
Simple
Simple
Simple
Simple
Complex
Moderate
Moderate
Moderate
Moderate
Simple
Moderate
Moderate
Moderate

Time
(mi
nut
es)
1520
1520
1015
1520
1020
2535
1015
1015
1520
1525
1525
1525
1015
1015
1525
1015
1015
1015
2025
1015
1015
2025
1520
2025
1015
2025
1015
1520
1525
1525

P16-1
P16-2
P16-3
P16-4
P16-5
P16-6
P16-7
P16-8
P16-9

Entries for various dilutive securities.


Entries for conversion, amortization, and interest of bonds.
Stock option plan.
Stock-based compensation.
EPS with complex capital structure.
Basic EPS: Two-year presentation.
Computation of basic and diluted EPS.
Computation of basic and diluted EPS.
EPS with stock dividend and extraordinary items.

Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Moderate
Complex

3540
4550
3035
2530
3035
3035
3545
2535
3040

CA16-1
CA16-2
CA16-3
CA16-4
CA16-5

Warrants issued with bonds and convertible bonds.


Ethical issuescompensation plan.
Stock warrantsvarious types.
Stock compensation plans.
EPS: Preferred dividends, options, and convertible debt.

Moderate
Simple
Moderate
Moderate
Moderate

2025
1520
1520
2535
2535

Ite
m
E16-1
E16-2
E16-3
E16-4
E16-5
E16-6
E16-7
E16-8
E16-9
E16-10
E16-11
E16-12
E16-13
E16-14
E16-15
E16-16
E16-17
E16-18
E16-19
E16-20
E16-21
E16-22
E16-23
E16-24
E16-25
E16-26
E16-27
E16-28
*E16-29
*E16-30

16-4

Description

Level of
Difficul
ty

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CA16-6

EPS, antidilution.

Moderate

2535

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LEARNING OBJECTIVES
1. Describe the accounting for the issuance, conversion, and retirement of convertible
securities.
2. Explain the accounting for convertible preferred stock.
3. Contrast the accounting for stock warrants and for stock warrants issued with other
securities.
4. Describe the accounting for stock compensation plans.
5. Discuss the controversy involving stock compensation plans.
6. Compute earnings per share in a simple capital structure.
7. Compute earnings per share in a complex capital structure.
*8. Explain the accounting for stock-appreciation rights plans.
*9. Compute earnings per share in a complex situation.
*10. Compare the accounting for dilutive securities and earnings per share for IFRS and
GAAP.
*This material is covered in an Appendix to the chapter.

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CHAPTER REVIEW
1. Chapter 16 examines the issues related to accounting for dilutive securities at date of
issuance and at time of conversion. The impact of the computation of earnings per share
is presented. The significance attached to the earnings per share figure by stockholders
and potential investors has caused the accounting profession to direct a great deal of
attention to the calculation and presentation of earnings per share.
Dilutive Securities
2. (L.O. 1)Dilutive securities are defined as securities that are not common stock in form,
but enable their holders to obtain common stock upon exercise or conversion. The most
notable examples include convertible bonds, convertible preferred stocks, warrants, and
contingent shares.
Convertible Bonds
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. The conversion feature entices the investor to accept a lower interest rate
than he or she would normally accept on a straight debt issue. Accounting for
convertible bonds on the date of issuance follows the procedures used to account for
straight debt issues.
4. If bonds are converted into other securities, the issue price of the stock is based upon the
book value of the bonds. No gain or loss is recorded as the issue price of the stock
is recorded at the book value of the bonds.
5. Assume that Irvine Corporation has convertible bonds with a book value of $3,200
($3,000 plus $200 unamortized premium) convertible into 120 shares of common stock
($10 par value) with a current fair value of $35 per share. The journal entry to be made is
as follows:
Bonds Payable............................................................
Premium on Bonds Payable.......................................
Common Stock (120 $10)..................................
Paid-in Capital in Excess of Par............................

3,000
200
1,200

2,000

6. When an issuer wishes to induce prompt conversion of its convertible debt to equity
securities, the issuer may offer some form of additional consideration (sweetener). The
sweetener should be reported as an expense in the current period at an amount equal to
the fair value of the additional consideration given.
7. Convertible debt that is retired without exercise of the conversion feature should be
accounted for as though it were a straight debt issue. Any difference between the cash
acquisition price of the debt and its carrying amount should be reflected currently in
income as a gain or loss.

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16-8

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Convertible Preferred Stock


8. (L.O. 2)Convertible preferred stock is accounted for in the same manner as nonconvertible preferred stock at date of issuance. When conversion takes place, the book
value method is used. Preferred Stock, along with any related Paid-in Capital in Excess of
Par, is debited; Common Stock and Paid-in Capital in Excess of Par (if an excess exists)
are credited. If the par value of the common stock issued exceeds the book value of the
preferred stock, Retained Earnings is debited for the difference.
Stock Warrants
9. (L.O. 3)Stock warrants are certificates entitling the holder to acquire shares of stock at
a certain price within a stated period. Warrants are potentially dilutive. When stock
warrants are exercised, the holder must pay a specified amount of money to obtain the
shares. If stock warrants are attached to debt, the debt remains after the warrants are
exercised.
10. The issuance normally arises under one of three situations:
a.
An equity kicker to make another security move attractive.
b.
A pre-emptive right of existing shareholders.
c.
Compensation to executives and employees.
11. When detachable stock warrants are attached to debt, the proceeds from the sale is
allocated between the two securities. This treatment is based on the fact that the stock
warrants can be traded separately from the debt. Allocation of the proceeds between the
two securities is normally made on the basis of the warrants fair values at the date of
issuance. The amount allocated to the warrants is credited to Paid-in CapitalStock
Warrants. The two methods of allocation available are (a) the proportional method and
(b) the incremental method.
Issuing Stock WarrantsProportional Method
12. To value the warrants under the proportional method, a value must be placed on the
bonds without the warrants and then on the warrants.
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 and the value of the warrants in the market is
$25,000. The allocation between the bonds and the warrants would be made as follows:
Fair value of bonds
(without warrants) ($500,000 .98)..........................................
Fair value of warrants...................................................................
Aggregate fair value.....................................................................
Allocated to bonds:

$490,000
$515,000

$490,000
25,000
$515,000

$500,000 = $475,728

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16-9

Allocated to warrants:

$25,000
$515,000

$500,000 = $ 24,272

The journal entry for the issuance of the bonds is:


Cash (1,000 $500)................................................
Discount on Bonds Payable.....................................
Bonds Payable....................................................
Paid-in CapitalStock Warrants........................

500,000
24,272

500,000
24,272

Exercising Detachable Stock Warrants


13. When detachable warrants are exercised, Cash is debited for the exercise price and Paidin CapitalStock Warrants is debited for the amount assigned to the warrants. The credit
portion of the entry includes Common Stock and Paid-in Capital in Excess of Par. If
detachable warrants are never exercised, Paid-in CapitalStock Warrants is debited and
Paid-in Capital Expired Stock Warrants is credited.
14. Example: If all the warrants described in paragraph 12 are exercised for $15 cash and one
warrant, the holder will receive one share of $5 par value common stock per warrant for
each of the 1,000 warrants, the journal entry to record the transaction is the following:
Cash (1,000 $15)...................................................
Paid-in CapitalStock Warrants..............................
Common Stock (1,000 $5)...............................
Paid-in Capital in Excess of Par..........................

15,000
24,272

5,000
34,272

Issuing Stock WarrantsIncremental Method


15. Where the fair value of either the warrants or the bonds is not determinable, the incremental
method may be used. That is, the security for which the fair value is determinable is used
and the remainder of the purchase price is allocated to the security for which the fair value
is not known.
Stock Rights
16. Stock rights are issued to existing stockholders when a corporations directors decide to
issue new shares of stock. Each share owned normally entitles the stockholders to one
stock right. This privilege allows each stockholder the right to maintain his or her percentage
ownership in the corporation. Only a memorandum entry is required when rights are
issued to existing stockholders.

16-10

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Stock Compensation Plans


17. A stock option is another form of warrant that arises in stock compensation plans used to
pay and motivate employees. This type of warrant gives selected employees the option to
purchase common stock at a given price over an extended period of time. The FASB has
recently issued a new standard on stock options and other types of compensation plans
that are listed on the stock market.
18. In the past, the FASB gave companies a choice in the method of recognizing the cost of
compensation under a stock option plan. The two choices were:
a. the fair value method, and
b. the intrinsic value method.
The FASB now requires the use of the fair value method.
Fair Value Method of Recording Compensation Expense
19. 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.
Fair value for public companies is estimated using an option-pricing model, with some
adjustments for the unique factors of employee stock options. No adjustments are made
after the grant date in response to subsequent changes in the stock price.
Allocating Compensation Expense
20. (L.O. 4) In general, compensation expense is recognized in the periods in which the
employee performs the service the service period. Unless otherwise specified, the
service period is the vesting period the time between the date of grant and the vesting
date.
21. To illustrate the accounting for a stock-option plan, assume that on September 16, 2014,
the stockholders of Jesilow Company approve a plan that grants the companys three
executives options to purchase 4,000 shares each of the companys $1 par value common
stock. The options are granted on January 1, 2015, and may be exercised at any time within
the following five years. The option price per share is $30, and the market price of the
stock at the date of grant is $40 per share.
Using the fair value method, total compensation expense is computed by applying an
acceptable fair value option-pricing model. Assume that the fair value option-pricing model
determines total compensation expense to be $180,000.
Assuming the expected period of benefit is 3 years (starting with the grant date), the
journal entries for each of the next three years are as follows:
Compensation Expense ($170,000 3)..................
Paid-in CapitalStock Options...........................

60,000

60,000

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16-11

If all of the options are exercised on July 1, 2019, the journal entry is as follows:
Cash (12,000 $30)................................................
Paid-in CapitalStock Options................................
Common Stock (12,000 $1).............................
Paid-in Capital in Excess of Par..........................

360,000
180,000

12,000
528,000

Restricted Stock Compensation Plans


22. Restricted stock plans transfer shares of stock to employees, subject to an agreement
that the shares cannot be sold, transferred or pledged until vesting occurs. These shares
are subject to forfeiture if the conditions for vesting are not met. Major advantages of
restricted-stock plans are:
a. Restricted stock never becomes completely worthless.
b. Restricted stock generally results in less dilution to existing stockholders.
c. Restricted stock better aligns the employee incentives with the companies incentives.
23. Accounting for restricted stock follows the same general principles as accounting for stock
options at the date of grant. That is, the company determines the fair value of the
restricted stock at the date of grant and then allocates that amount as an expense over
the service period.
24. To illustrate the accounting for restricted-stock plans, assume that on January 1, 2014,
Lindsey Company issues 2,000 shares of restricted stock to its President, Amy Carlson.
Lindseys stock has a fair value of $12 per share on January 1, 2014. Additional information
is as follows:
a. The service period related to the restricted stock is four years.
b. Vesting occurs if Carlson stays with the company for a four-year period.
c. The par value of the stock is $1 per share.
Lindsey makes the following entry on the grant date (January 1, 2014):
Unearned Compensation............................................
Common Stock (2,000 $1).................................
Paid-in Capital in Excess of Par (2,000 $11).....

24,000

2,000
22,000

Unearned Compensation represents the cost of services yet to be performed, which is not
an asset. The company reports unearned compensation in stockholders equity in the
balance sheet as a contra-equity account. For the year ended December 31, 2014,
Lindsey recognizes compensation expense of $6,000 (2,000 shares $12 25%) and
the same amount for each of the following three years.

16-12

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Employee Stock-Purchase Plans


25. Employee stock purchase plans (ESPPs) permit all employees to purchase stock at a
discounted price for a short period of time. Compensation expense is not reported if:
a. Substantially all full-time employees may participate on an equitable basis;
b. The discount from market is small; and
c. The plan offers no substantive option feature.
Disclosure of Compensation Plans
26. Disclosure of compensation plans.Companies must disclose information that enables
financial statement users to understand:
a. The nature and terms of the plan and its potential effects on shareholders.
b. The income statement effects of compensation costs from share-based plans.
c. The method used to estimate the fair value of goods or services received, or the fair
value of the equity instruments granted.
d. The cash flow effects from such plans.
Debate over Stock-Option Accounting
27. (L.O. 5) The FASB faced considerable opposition when it proposed using the fair value
method (rather than the intrinsic value method) for accounting for stock options because
its use generally results in recording a greater amount of compensation expense than the
intrinsic value method. Its a classic example of the pressure facing the FASB in issuing
new accounting guidance in an effort to make financial reporting more transparent.
Earnings Per Share
28. (L.O. 6)Earnings per share indicates the income earned by each share of common
stock. Generally, earnings per share information is reported below net income in the income
statement. When the income statement contains intermediate components of income
(e.g., income from continuing operations), earnings per share is disclosed for each
component.
Simple Capital Structure
29. (L.O. 7)A corporations capital structure is simple if it consists only of common stock or
includes no potentially dilutive convertible securities, options, warrants, or other rights that
upon conversion or exercise could in the aggregate dilute earnings per common share.
The formula for computing earnings per share is as follows:

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16-13

Net Income - Preferred Dividends


Weighted-Average Number of Shares Outstanding

Earnings per Share

Preferred Stock Dividend


30. Current year preferred stock dividends are subtracted from net income to arrive at the net
income available for common shareholders. If the preferred stock is cumulative and the
dividend is not declared in the current year, an amount equal to the dividend that should
have been declared for the current year should be subtracted from net income or added to
the net loss.
Weighted-Average Number of Shares Outstanding
31. 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
are outstanding. When stock dividends or stock splits occur during the period,
computation of the weighted-average number of shares requires the assumption that the
shares have been outstanding since the beginning of the period. If a stock dividend or
stock split occurs after the end of the year, but before the financial statements are issued,
the weighted-average number of shares outstanding for the year (and any other years
presented in comparative form) must be restated as if they were outstanding since the
beginning of the year.
Complex Capital Structure
32. (L.O. 8)A capital structure is complex if it includes securities that could have a dilutive
effect on earnings per common share. A complex capital structure requires a dual presentation of earnings per share, each with equal prominence on the face of the income
statement. The dual presentation consists of basic EPS and diluted EPS. Companies
with complex capital structures do report diluted EPS if the securities in their capital
structure are antidilutive (increase EPS).
Diluted EPSConvertible Securities
33. 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 preferred stock
assumes (a) the conversion of convertible securities at the beginning of the period (or at
the time of the issuance of the security, if issued during the period) and (2) the elimination
of related interest, net of tax, or preferred dividends. The denominator is increased by the
additional shares assumed converted and the numerator is increased by the amount of
interest expense, net of tax, or decreased by the preferred dividend associated with the
potential common shares.

16-14

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Diluted EPSOptions and Warrants


34. Stock 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
price of the stock, dilution occurs. If the exercise price of the option or warrant is higher
than the market price of the stock, common shares are reduced. In this case, the options
or warrants are antidilutive because their assumed exercise leads to an increase in
earnings per share.
Treasury-Stock Method
35. The treasury-stock 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 common stock for the treasury.
To illustrate the treasury-stock method, assume 2,000 options are outstanding with an
exercise price of $25 per common share. If the market price of the common stock is $60
per share, computation of the incremental shares using the treasury-stock method is:
Proceeds from exercise of 2,000 options (2,000 $25)...............
Shares issued upon exercise of options.......................................
Treasury shares purchasable with proceeds ($50,000/$60).........
Incremental shares outstanding (potential common shares)........

$50,000
2,000
(833)
1,167

Contingent Issue Agreement


36. Contingent shares are a promise to issue additional shares. If this passage-of-time
condition occurs during the current year, or if the company meets the earnings or market
price by the end of the year, the company considers the contingent shares as
outstanding for the computation of diluted earnings per share.
37. For both options and warrants, exercise is not assumed unless the average market price
of the stock is above the exercise price during the period being reported. As a practical
matter, a simple average of the weekly or monthly prices is adequate, so long as the prices
do not fluctuate significantly.
Presentation and Disclosure

38. When the earnings of a period include irregular items, a company should show per share
amounts (where applicable) for the following: income from continuing operations, income
before extraordinary items, and net income. Companies that report a discontinued
operation or an extraordinary item should present per share amounts for those line
items either on the face of the income statement or in the notes to the financial
statements.

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16-15

39. Complex capital structures and dual presentation of earnings per share require additional
disclosure in note form.

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Stock-Appreciation Rights
*40. Stock-appreciation rights are a form of employee compensation that avoids some of the
cash flow problems recipients of nonqualified stock option plans face. Under a stockappreciation rights plan, an employee is given the right to receive share appreciation,
which is defined as the excess of the market price of the stock at the date of exercise over
a pre-established price. This share appreciation may be received in cash, shares of stock,
or a combination of both. Compensation cost for the plan at any interim period is the
difference between the current market price of the stock and the option price multiplied by
the number of stock-appreciation rights. The measurement date is the date of exercise.
Comprehensive EPS Example
*41. (L.O. 9)Appendix 16-B contains a comprehensive illustration of the computations
involved in calculating and presenting earnings per share.

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LECTURE OUTLINE
The material in this chapter can be covered in three or four class sessions. Students generally
have not been exposed to the types of dilutive securities discussed in this chapter, nor are they
aware of the complex rules governing the calculation of EPS.
A. Dilutive Securities:Securities are not common stock in form, but enable their holders to
obtain common stock upon exercise or conversion.
TEACHING TIP

Illustration 16-1 provides a numerical example of convertible bonds at date of issue and at
date of 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 stock at the holders option.
a.

Issuance:recorded the same as issuance of any other bond.

b.

Interest dates:recorded the same as any other bond.

c.

Conversion is recorded using the book value approach.


Under this approach, the book value of bonds payable is removed from the
accounts and is replaced by the common stock issued. No gain or loss is
recognized.

d.

If retired for cash, instead of converted, conversion is recorded the same as the
retirement of any other bond.

e.

Induced conversions:Additional consideration given to induce conversion should


be recognized as an expense of the current period.
(1) The conversion inducement (sweetener) is recorded as an expense in the
current period.

2.

16-18

(L.O. 2)Convertible preferred stock.


a.

Convertible preferred stock includes an option for the holder to convert preferred
shares into a fixed number of common shares.

b.

Convertible preferreds (unless mandatory redemption exists) are considered part


of stockholders equity.

c.

No gain or loss is recognized upon conversion.

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TEACHING TIP

Illustration 16-2 provides a numerical example of convertible preferred stock at date of issue
and at date of conversion.
3.

(L.O. 3)Stock warrants entitle the holder to acquire shares of stock at a price within a
stated period.
a.

Normally issued as:


(1) An equity kicker to make another security more attractive.
(2) A pre-emptive right to purchase additional shares given to existing shareholders.
(3) Compensation to executives and employees.

b.

Detachable stock warrants can be traded separately, and therefore, have a fair
value.
(1) Proportional method isused when both the value of bonds without the
warrants and the value of the warrants alone are known.
(a) Allocate the sale price of the bonds between the bonds and the warrants
based on their respective fair values.
(2) Incremental method isused when only the value of the bonds without the
warrants or the value of the warrants is known, but not both.
(a) Subtract the fair value of the known security from the sale price of the
bonds to determine the value of the other security.
TEACHING TIP

Illustration 16-3 provides a numerical example of stock warrants issued with debt securities
using both the proportional and incremental methods.
(3) Warrants not exercisedtransfer the carrying value of the warrants from the
PICStock Warrants account to the PICExpired Stock Warrants account.
c.

The proceeds from issuing nondetachable stock warrants is recognized entirely


as debt.

d.

Stock warrants representing stock rights to existing shareholders require no


journal entry at the issuance date.

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16-19

4.

Stock compensation plans arearrangements in which key employees are given the
option to purchase common stock in the company (a form of warrant) 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
value of the stock options expected to vest on the date of grant using an
acceptable option-pricing model (such as the Black-Scholes model).
(1) Vesting occurs on the date the employees right to receive or retain the shares
is no longer contingent on remaining in the service of the employer.
(2) Stock options issued to non-employees for goods or services are also recognized using this method.

5.

(L.O. 4)Accounting for stock compensation.


a.

Allocating Compensation Expense.Compensation expense is recognized over


the service period (the time between the date of grant and the vesting date).
(1) On date of grant: no journal entry required.
(2) At end of service period adjustment:
(a) Compute total compensation expense using an acceptable fair value
option-pricing model.
(b) Allocate the amount of compensation expense evenly over the service
period.
Dr. Compensation Expense
Cr. Paid-in CapitalStock Options

b.

Exercise of options.
Dr. Cash
Dr. Paid-in CapitalStock Options
Cr. Common Stock
Cr. Paid-in Capital in Excess of ParCommon Stock

c.

Expiration of options.No adjustment is made to Compensation Expense.


Dr. Paid-in CapitalStock Options
Cr. Paid-in CapitalExpired Stock Options

d.

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Forfeiture of options.This occurs if the employee leaves the company before the
vesting date (recorded as a change in estimated compensation expense).

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Dr. Paid-in CapitalStock Options


Cr. Compensation Expense
6.

Restricted-stock planstransfer shares of stock to employees, subject to an


agreement that the shares cannot be sold, transferred, or pledged until vesting
occurs.
a.

Advantages of such plans include:


(1) Restricted stock never becomes completely worthless.
(2) Restricted stock generally results in less dilution to existing stockholders.
(3) Restricted stock better aligns employee incentives with company
incentives.

b.

Accounting for restricted stock.


(1) Determine the fair value of the restricted stock on the grant date.
(2) Entry on grant date:
Dr. Unearned Compensation
Cr. Common Stock
Cr. Paid-in Capital in Excess of Par
(a) Unearned compensation is a contra-equity account.
(3) Entry to record compensation expense:
Dr. Compensation Expense
Cr. Unearned Compensation
(4) Entry to record forfeiture:
Dr. Common Stock
Dr. Paid-in Capital in Excess of ParCommon Stock
Cr. Compensation Expense (for total amount previously recorded)
Cr. Unearned Compensation

7.

Employee stock-purchase planspermit all employees to purchase stock at


a discounted price for a short period of time.
a.

Considered compensatory and compensation is not reported unless all 3


conditions are satisfied:
(1)

Substantially all full-time employees may participate on an equitable basis.

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16-21

8.

(2)

The discount from market is small.

(3)

The plan offers no substantive option feature.

Disclosure of compensation plans. Companies must disclose information that


enables financial statement users to understand:
a.

The nature and terms of the plan and its potential effects on shareholders.

b.

The income statement effects of compensation costs from share-based plans.

c.

The method used to estimate the fair value of goods or services received, or
the fair value of the equity instruments granted.

d.

The cash flow effects from such plans.

B. (L.O. 5)Debate over stock options.The stock option saga illustrates the difcult,
contentious nature of standard setting and shows the impact that social, economic, and
public policy goals can have on the development of accounting standards.
C. Computing Earnings Per Share.
TEACHING TIP

Illustration 16-4 presents a conceptual overview of EPS computations.


1. (L.O. 6)Simple capital structures exist whencompanies have only common stock,
or have no securities that could potentially dilute earnings per share (EPS) if converted
or exercised.
a.
EPS

Net Income - Preferred Dividends


Weighted-Average Number of Shares Outstanding

(1) EPS is calculated for each component of income: income from continuing
operations, income before extraordinary items, and net income.
(2) Current year preferred stock dividends are subtracted from net income.

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(a)

If the preferred stock is cumulative and no dividends are declared, then


the dividend subtracted is equal to the amount of the current dividend
that would have been paid.

(b)

Dividends in arrears are not included.

(c)

If a net loss occurs, the preferred dividend is added to the net loss.

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(3)

Weighted-Average Shares
Outstanding

Number of Shares
Outstanding

Fraction of Year
Outstanding

(a)

Shares issued or purchased during the period are weighted by the


fraction of the period they are outstanding.

(b)

If a stock dividend/split occurs during the year, it is treated as if it


occurred at the beginning of the year.

(c)

If a stock dividend/split occurs after year end, but before the financial
statements are issued, the weighted-average number of shares is
adjusted as if it occurred at the beginning of the year.
TEACHING TIP

Illustration 16-5 demonstrates how to calculate the weighted-average number of common


shares outstanding.

TEACHING TIP

Illustration 16-6 provides an overview of calculating EPS with a complex capital structure.
2. (L.O. 7)Complex capital structuresexist 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 on the face of the income
statement.

b.
Diluted EPS =

c.

Net Income Preferred


Dividends
Number of Weighted
Average Shares

Impact of
Convertible
Securities

Impact of Options,
Warrants, and
Other Dilutive
Securities

Convertible securities.
(1)

Convertible bonds.
(a)

The if-converted method is applied. The conversion is treated as if it


occurred at the beginning of the year, or at its issuance date if it was

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16-23

issued during the year. The weighted-average number of shares


outstanding in the denominator is increased.
(b)

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Related interest expense, net of tax, is eliminated from the numerator.

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(2)

(3)

d.

Convertible preferred stock.


(a)

Preferred dividends are eliminated from the numerator.

(b)

The weighted-average number of shares outstanding is increased in


the denominator.

The most advantageous conversion rate available to the holder of the


security is used.

Options and warrants use the treasury stock method and assume:
(1) The exercise occurs at the beginning of the year or issue date, if it issued
during the year.
(2) Proceeds are used to purchase common stock for treasury stock at the
average market price for common stock during the year.
(3) If exercise price < market price of stock, dilution occurs.
(4) If exercise price > market price, securities are antidilutive and can be ignored
in the diluted EPS calculation.

e.

Contingent shares are included in the computation of diluted EPS.

f.

Convertibles, options, warrants, and contingently issuable shares are included in


diluted EPS only if they are dilutive (reduce EPS). Antidilutive securities are
ignored for purposes of computing EPS.

3. Presentation and disclosure.


a.

EPS is presented for income from continuing operations, discontinued operations,


extraordinary items, income before extraordinary items, and net income.

b.

Reported for all periods presented.

c.

Prior period EPS is restated for any prior period adjustments.

d.

Additional EPS disclosure is required in note form for companies with complex
capital structures and dual presentation of EPS.

*D. (L.O. 8)Accounting for Stock-Appreciation Rights.


1.

Stock appreciation rights (SARs).


a.

Stock appreciation rights (SARs) gives the recipient the right to receive compensation
equal to the difference between the market price at exercise over a pre-established

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price (share appreciation).


(1) Recipient does not buy the shares.
(2) Recipient receives cash, shares, or a combination of both equal to the appreciation amount.
(3) Compared to nonqualified stock option plans and incentive plans, which both
require cash payments on the exercise date, the executive experiences no cash
outflows.
b.

Share-based equity awards.


(1) The recipient receives shares of stock equal to the share price appreciation.
(2) Accounting for such awards follows that used for stock options.

c.

Share-based liability awards.


(1) The recipient receives cash equal to the share appreciation amount.
(2) Accounting for such awards consists of:
(a)

Estimating the fair value of the award using an option-pricing model on


the grant date.

(b)

Allocating this estimated compensation amount over the service period


using the percentage approach.

(c)

If the exercise date occurs after the service period elapses, adjust the
compensation expense for changes in market price.

(d)

Cumulative compensation expense cannot be negative.

E. (L.O. 9)Appendix 16-B.Comprehensive EPS Illustration.

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*F IFRS Insights
1. The primary IFRS related to financial instruments, including dilutive securities, is IAS
39, Financial Instruments: Recognition and Measurement. The accounting for various
forms of stock-based compensation under IFRS is found in IFRS 2, Share-Based
Payment. This standard was recently amended, resulting in significant convergence
between IFRS and GAAP in this area. The IFRS addressing accounting and reporting
for earnings per share computations is IAS 33, Earnings per Share.
2. Similarities.
a.

IFRS and GAAP follow the same model for recognizing stock-based compensation:
The fair value of shares and options awarded to employees is recognized over the
period to which the employees services relate.

b.

Although the calculation of basic and diluted earnings per share is similar between
IFRS and GAAP, the Boards are working to resolve the few minor differences in
EPS reporting. One proposal in the FASB project concerns contracts that can be
settled in either cash or shares. IFRS requires that share settlement must be used,
while GAAP gives companies a choice. The FASB project proposes adopting the
IFRS approach, thus converging GAAP and IFRS in this regard.

3. Differences.
a.

A significant difference between IFRS and GAAP is the accounting for securities
with characteristics of debt and equity, such as convertible debt. Under GAAP, all of
the proceeds of convertible debt are recorded as long-term debt. Under IFRS,
convertible bonds are bifurcatedseparated into the equity component (the value
of the conversion option) of the bond issue and the debt component.

b.

Related to employee share-purchase plans, under IFRS, all employee sharepurchase plans are deemed to be compensatory; that is, compensation expense is
recorded for the amount of the discount. Under GAAP, these plans are often
considered noncompensatory and therefore no compensation is recorded. Certain
conditions must exist before a plan can be considered noncompensatorythe most
important being that the discount generally cannot exceed 5 percent.

c.

Modification of a share option results in the recognition of any incremental fair value
under both IFRS and GAAP. However, if the modification leads to a reduction, IFRS
does not permit the reduction but GAAP does.

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d.

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Other EPS differences relate to (1) the treasury-stock method and how the
proceeds from extinguishment of a liability should be accounted for, and (2) how to
compute the weighted average of contingently issuable shares.

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ILLUSTRATION 16-1
ACCOUNTING FOR CONVERTIBLE DEBT

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16-29

ILLUSTRATION 16-2
ACCOUNTING FOR CONVERTIBLE SECURITIES

16-30

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ILLUSTRATION 16-3
STOCK WARRANTS ISSUED WITH DEBT SECURITIES

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ILLUSTRATION 16-4
EARNINGS PER SHARE OVERVIEW

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ILLUSTRATION 16-5
WEIGHTED-AVERAGE NUMBER OF COMMON
SHARES OUTSTANDING COMPUTATION

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16-33

16-34

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ILLUSTRATION 16-6
CALCULATING EPS WITH A COMPLEX CAPITAL STRUCTURE

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16-35

16-36

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