McGraw-Hill /Irwin© 2009 The McGraw-Hill Companies, Inc. SHARE-BASED COMPENSATION AND EARNINGS PER SHARE Chapter 19

Slide Share-Based Compensation 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. 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. Stock Award Plans

19-3 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).

Slide 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.

Slide Expense – The Great Debate Opposition to a proposed FASB Statement have identified three objections. Opposition to a proposed FASB Statement have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences. Opposition to a proposed FASB Statement have identified three objections. Opposition to a proposed FASB Statement have identified three objections. 1.Options with no intrinsic value at issue have zero fair value and should not give rise to expense recognition. 2.It is impossible to measure the fair value of compensation on the date of grant. 3.Current practices have unacceptable economic consequences.

Slide 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. 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.

Slide Plans with Performance or Market Conditions performance target probable 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.

19-8 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 $ The $1.50 discount is recorded as compensation expense:

Slide 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.

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

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

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

Slide Stock Dividends and Stock Splits 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.

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

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

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

Slide 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.

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

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

Slide Earnings Available to Common Shareholders Net income Less: 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

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

Slide Options, Rights, and Warrants Proceeds Used to Purchase treasury shares At average market price 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.

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

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

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

Slide Convertible Securities The if-converted method is used for Convertible debt and equity securities. 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 of issuance, if later.

Slide Convertible Securities The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: 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. The assumed conversion of convertible bonds or preferred stock has two effects on dilutive earnings per share: 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.

Slide Convertible Securities Dilutive earnings per share may decrease or increase after the assumed conversion. 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.

19-29 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.

Slide Additional EPS Issues 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. Contingently Issuable Shares

Slide Contingently Issuable Shares 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. Contingent shares are included in dilutive EPS if: Example: Additional shares may be issued based on future earnings.

Slide Summary

Slide Summary

Slide Financial Statement Presentation Report EPS data separately for: 1.Income from Continuing Operations 2.Separately Reported Items a)Discontinued Operations b)Extraordinary Items 3.Net Income