Questions for Review of Key Topics

Chapter 19 Share-Based Compensation and Earnings Per Share

Questions for Review of Key Topics

Question 19-1

Restricted stock refers to shares actually awarded in the name of an employee, although the employer might retain physical possession of the shares. Typically, the employee has all rights of a shareholder, but the shares are subject to certain restrictions or forfeiture. Usually the employee is not free to sell the shares during the restriction period. Restricted shares usually are subject to forfeiture by the employee if employment is terminated between the date of grant and a specified vesting date. Restrictions provide the employee incentive to remain with the company.

Compensation cost is the fair value of the restricted stock at the grant date and is equal to the market price of unrestricted shares of the same stock. The fair value of shares awarded under a restricted stock award plan is accrued to compensation expense over the service period for which participants receive the shares. This usually is the period from the date of grant to when restrictions are lifted (the vesting date).

Question 19-2

The fair value of a stock option is determined by employing a recognized option pricing model. The option pricing model should take into account 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 during the term of the option, and (6) expected volatility of the stock.

Question 19-3

The recipient pays no tax at the time of the grant or the exercise of the options under an incentive plan. Instead, the tax on the difference between the option price and the market price at the exercise date is paid on the date any shares acquired are subsequently sold. The employer gets no tax deduction at all.

The employee cannot delay paying tax under a nonqualified plan. The tax that could be deferred until the shares are sold under an incentive plan must be paid at the exercise date under a nonqualified plan. On the other hand, the employer is allowed to deduct the difference between the option price and the market price on the exercise date. Thus, a nonqualified plan offers favorable tax treatment to the employer, while an incentive plan offers favorable tax treatment to the employee.

Answers to Questions (continued)

Question 19-4

For performance-based options initial estimates of compensation cost as well as subsequent revisions of that estimate take into account the likelihood of both forfeitures and achieving performance targets. If it is probable that the performance target will be met, we recognize compensation over the vesting period at fair value. If achieving the target is not probable, no compensation is recorded. Probability is reassessed each period.

If the award contains a market condition (e.g., a share option with an exercisability requirement based on the stock price reaching a specified level), then no special accounting is required. The fair value estimate of the share option already implicitly reflects market conditions due to the nature of share option pricing models. Thus, we recognize compensation expense regardless of when, if ever, the market condition is met.

Question 19-5

A firm has a simple capital structure if it has no potential common shares outstanding. These are securities that are not yet common stock, but might become common stock if exercised or converted. Thus, they could potentially dilute (meaning reduce) earnings per share.

For a firm with a simple capital structure, EPS is simply earnings available to common shareholders divided by the weighted-average number of common shares outstanding.

Question 19-6

There is a fundamental difference between the increase in shares caused by stock dividends and stock splits and an increase from selling new shares. When additional shares are sold, both the assets of the firm and shareholders’ equity are increased by an additional investment by owners. On the other hand, stock dividends or stock splits merely increase the number of shares without affecting the firm’s assets. As a consequence, the same “pie” is divided into more pieces resulting in a larger number of less valuable shares. Shares outstanding prior to a stock dividend or stock split are retroactively restated to reflect the increase in shares, as if the distribution occurred at the beginning of the period. On the other hand, 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.

Answers to Questions (continued)

Question 19-7

The weighted-average number of shares for calculating EPS would be 104,500 determined as follows:

100,000 (1.05) – 1,200 (5/12) = 104,500 shares
shares stock treasury
at Jan. 1 dividend shares
adjustment

The 1,200 shares retired are weighted by (5/12) to reflect the fact they were not outstanding the last five months of the year. Purchases of shares that occur after a stock dividend or split are not affected by the distribution.

Question 19-8

Preferred dividends are deducted from the numerator in the EPS fraction so that “earnings available to common shareholders” will be divided by the weighted-average number of common shares. An exception would be when the preferred stock is noncumulative and no dividends were declared in the reporting period. Another time the deduction is not made is when the preferred stock is convertible and the calculation of EPS assumes the preferred stock has been converted and therefore no dividends are paid.

Question 19-9

Basic EPS does not reflect the dilutive effect of potential common shares. On the other hand, diluted EPS incorporates the dilutive effect of all potential common shares, if the effect is not antidilutive.

Question 19-10

When calculating diluted EPS, we assume that the shares specified by stock options, warrants, and rights are issued at the exercise price and that the hypothetical proceeds are used to buy back as treasury stock as many of those shares as could be acquired at the average market price.

Question 19-11

The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. The numerator is increased by the after-tax interest that would have been avoided if the bonds really had not been outstanding. This effect is reflected in diluted EPS calculations only if the effect is dilutive.

Answers to Questions (continued)

Question 19-12

The potentially dilutive effect of convertible preferred stock is reflected in diluted EPS calculations by assuming the preferred stock was converted into common stock, just as is done with convertible bonds. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible preferred stock was issued, if later.

When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. Since EPS are calculated as if the preferred shares had been converted into common shares, there would be no dividends on the preferred stock; so, earnings available to common shareholders arenot decreased by the dividends that otherwise would have been distributed to preferred shareholders. This is similar in concept to after-tax interest being added back to net income if the securities were convertible bonds because in each situation, if there are hypothetically no dividends or no interest to be paid, then net income would reflect earnings hypothetically available to only common shareholders. This effect is reflected in diluted EPS calculations only if the effect is dilutive.

Question 19-13

The order in which convertible securities are included in the dilutive EPS calculation is determined by comparing the incremental effect of their conversion. They should be included in numerical order, beginning with the lowest incremental effect (that is, the most dilutive).

Question 19-14

For the treasury stock method, “proceeds” include (1) the amount, if any, received from the hypothetical exercise of options or vesting of restricted stock, (2) the total compensation from the award that's not yet expensed, and (3) the difference between the eventual tax benefit and the amount recognized in expense.

Answers to Questions (continued)

Question 19-15

Contingently issuable shares areconsidered outstanding in the computation of diluted EPS when they will later be issued upon the mere passage of time or because of conditions that currently are met. If this year’s operating income were $2.2 million, the additional shares would beconsidered outstanding in the computation of diluted EPS by simply adding 50,000 additional shares to the denominator of the EPS fraction:

Contingently issuable shares:

no numerator adjustment
———————————
+ 50,000
additional
shares

If conditions specified for issuance are not yet met, the additional shares are ignored in the calculation. This would be the case if this year’s operating income had been $2 million.

Question 19-16

The calculation of diluted EPS assumes convertible bonds had been converted at the beginning of the year (unless they actually were issued later). If they actually had been converted, the actual conversion would cause an actual increase in shares at the conversion date. These additional shares would be time-weighted for the remainder of the year. The numerator would be higher because net income actually would be increased by the after-tax interest saved on the bonds for that period. But the calculation also would assume conversion for the period before the actual conversion date because they were potentially dilutive during that period. The shares assumed outstanding would be time-weighted for the fraction of the year before the conversion, and the numerator would be increased by the after-tax interest assumed saved on the bonds for the same period.

Question 19-17

EPS data (both basic and diluted for a complex capital structure) must be reported on the face of the income statement for income from continuing operations and net income. Per share numbers for discontinued operations and extraordinary items also should be reported either on the face of the income statement or in related disclosure notes when these components of net income are present.

Question 19-18

Disclosure notes should include (a) a summary description of the rights and privileges of the company’s various securities and (b) supplemental EPS data for transactions that occur after the balance sheet date that result in a material change to the number of shares outstanding at the balance sheet date, and (c) a reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations.

Answers to Questions (concluded)

Question 19-19

The fair value of stock options has two essential components: (1) intrinsic value and (2) time value. “Intrinsic value” is the benefit the holder of an option would realize by exercising the option rather than buying the underlying stock directly. For example, an option that allows an employee to buy $13 stock for $8 has an intrinsic value of $5. “Time value” exists so long as time remains before expiration because the market price of the underlying stock may yet rise and create additional intrinsic value.

Question 19-20

The accounting treatment of SARs depends on whether the award is considered an equity instrument or a liability. If the employer can choose to settle in shares rather than cash, the award is considered to be equity. If the employee will receive cash or can choose to receive cash, the award is considered to be a liability. This is the case with the LTV plan. As a result, the amount of compensation and related liability is continually adjusted to reflect changes in the fair value of the SARs until the liability is finally settled. The expense each period is the percentage of the total liability earned to date by recipients of the SARs (based on the elapsed percentage of the service period), minus any amounts expensed in prior periods. Both compensation expense and the liability are adjusted each period until the SARs ultimately either are exercised or lapse.

BRIEF EXERCISES

Brief Exercise 19-1

$6 fair value per share
x 8 million shares granted
= $48 million fair value of award

The $48 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $16 million each year.

Brief Exercise 19-2

$5 fair value per option
x 12 million options granted
= $60 million fair value of award

The $60 million total compensation is expensed equally over the three-year vesting period, reducing earnings by $20 million each year.

Brief Exercise 19-3

The company should adjust the cumulative amount of compensation expense recorded to date in the year the estimate changes.

Compensation expense ([$60 x 95% x 2/3] – $20)............. 18
Paid-in capital –stock options ........................................ 18

Compensation expense ([$60 x 95% x 3/3] – $20 – $18)... 19
Paid-in capital –stock options ........................................ 19

Note that this approach is contrary to the usual way companies account for changes in estimates. For instance, assume a company acquires a 3-year depreciable asset having no estimated residual value. The $60 million depreciable cost would be depreciated straight-line at $20 million over the three-year useful life. If the estimated residual value changes after one year to 5% of cost, the new estimated depreciable cost of $57 would be reduced by the $20 million depreciation recorded the first year, and the remaining $37 million would be depreciated equally, $18.5 million per year, over the remaining two years.

Brief Exercise 19-4

($ in millions)

Cash ($17 exercise price x 12 million shares)..................... 204
Paid-in capital - stock options (account balance)......... 60
Common stock (12 million shares at $1 par per share)... 12
Paid-in capital – excess of par (remainder)................ 252

Note: The market price at exercise is irrelevant.

Brief Exercise 19-5

Paid-in capital - stock options (account balance)......... 60
Paid-in capital – expiration of stock options ..... 60

Brief Exercise 19-6

The estimate of the total compensation would be:

100,000 x $6 = $600,000
options fair estimated

expected value total

to vest compensation

One-third of that amount, or $200,000, will be recorded in each of the three years.

Brief Exercise 19-7

The new estimate of the total compensation would change to:

0 x $6 = $0
options fair estimated

expected value total

to vest compensation

In that case, Farmer would reverse the $200,000 expensed in 2011 because no compensation can be recognized for options that don’t vest due to performance targets not being met, and that’s the new expectation.

Brief Exercise 19-8

In that case, in 2012, the revised estimate of the total compensation would change to $600,000:

100,000 x $6 = $600,000
options fair estimated

expected value total

to vest compensation

Farmer would reflect the cumulative effect on compensation in 2012 earnings and record compensation thereafter:

Compensation expense ([$600,000 x 2/3] - $0) 400,000

Paid-in capital –stock options ............. 400,000

Compensation expense ([$600,000 x 3/3] - $400,000) 200,000

Paid-in capital –stock options ............. 200,000

Brief Exercise 19-9

If an award contains a market condition such as the stock price reaching a specified level, then no special accounting is required. The fair value estimate of the share option ($6) already implicitly reflects market conditions due to the nature of share option pricing models. So, Farmer recognizes compensation expense regardless of when, if ever, the market condition is met. The estimate of the total compensation would be:

100,000 x $6 = $600,000
options fair estimated

expected value total

to vest compensation

One-third of that amount, or $200,000, will be recorded in each of the three years.

Date: 2016-01-14; view: 972