SHARE-BASED COMPENSATION AND EARNINGS PER SHARE Chapter 19 SHARE-BASED COMPENSATION AND EARNINGS PER SHARE Chapter 19: Share-based compensation and earning per share © 2009 The McGraw-Hill Companies, Inc.

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. Executive compensation sometimes includes a grant of shares of stock. Usually, such shares are restricted in such a way as to provide some incentive to the recipient. Stock award plans are usually granted to employees to encourage them not to leave the company. The amount of compensation involved in the plan is determined at the date of grant and is based on the market value per share of the stock award. The compensation is amortized over the service period we expect to receive from the employee. 76

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). In the typical stock option plan, an employee is given the right to purchase a specified number of common shares, at a specified exercise price, during a set period of time. The fair value of the stock options is accrued as compensation expense over the service period.

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. Historically, options have been measured at their intrinsic value. The intrinsic value is the simple difference between the market price of the shares and the option price at which they can be acquired. If on the date of grant, the market price and exercise price are equal, no compensation expense is recognized. This is true even if the executives received substantial income from the stock options.

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. The FASB proposed a new standard that would have required companies to measure options at their fair values at the time they are granted and to expense that amount over the appropriate service period. Opposition to a proposed FASB Statement for stock options identify three major objections. First, options with no intrinsic value at date of the issue have zero fair value and should not give rise to expense recognition. Second it is impossible to measure the fair value of the compensation expense at the date of grant. Third, the current accounting practices have unacceptable economic consequences.

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. Effective for fiscal years beginning after June 5, 2005, companies now are required to estimate the fair value of stock options on the grant date. They contend that the variables needed to estimate the value of the stock options using an option pricing model, are well-known and relatively easy to apply.

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. Some stock option plans are structured so that compensation is received only when certain performance or market conditions are met. For example, the options may be exercised only if earnings per share exceed $2. If it is not probable that the condition will be met, no compensation is recognized. If it is probable that the condition will be meet compensation must be recognized. In some cases this means that we will have a cumulative amount of compensation to recognize. That is compensation for the current period plus an adjustment for the periods when we did not recognize compensation. Let’s use are previous stock option plan from Matrix and add a performance condition.

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: Part I An employee stock purchase plan permits employees to buy shares of the company’s common stock directly from the company. There is usually an element of compensation measured by the difference between the value fair of the stock purchased and the discounted purchased price that employees may receive. Part II To record the compensation associated with this share purchase plan, we would debit Cash for the total amount received, $850, debit Compensation Expense for $150 (100 shares times the discount of $1.50 per share), and credit Common Stock for $1,000 (100 shares times the current market price of $10 per share).

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. Earnings per share is perhaps the most widely viewed ratio generated by accountants.

Basic Earnings Per Share *Current period’s cumulative preferred stock dividends (whether or not declared) and noncumulative preferred stock dividends (only if declared). Simple Capital Structure (Basic EPS) Net income (after tax) – Preferred dividends* Weighted average outstanding common stock Number of shares outstanding × Number of months outstanding ÷ 12 Weighted average shares outstanding Part I A simple capital structure requires that we disclose only basic earnings per share. Basic earnings per share is to defined as net income after taxes, minus certain preferred dividends, divided by the weighted average number of common shares outstanding. Part II Current period’s cumulative preferred stock dividends will be subtracted, whether declared or not. Noncumulative preferred stock dividends will only be subtracted if they have been declared. The weighted average number of common shares outstanding is determined by taking the number of shares outstanding times the number of months that those shares have been outstanding, divided by 12.

Issuance of New Shares Compute the weighted average number of shares of common stock outstanding. Here is as simple example that we will use to calculate weighted average number of common shares outstanding. The company has the beginning balance of 100,000 shares outstanding, and they issued additional shares of common stock two times during the year. See if you can calculate the weighted average common shares outstanding before you move on to the next slide.

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 Shares at Jan. 1 New Shares New Shares The beginning balance of shares has been outstanding all year, so we weight the hundred thousand shares times, 12 twelfths. The first issue of common shares, took place on April 1st. The 50,000 shares have been outstanding 9 twelfths of the year. The last issue of common stock took place on October 1. The shares have been outstanding for 3 twelfths of the year. Finally we sum the weighted shares to get a total weighted average common shares outstanding for the year of 140,000.

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. Common shares that are issued as part of a stock dividend or stock split are treated retroactively. They may be viewed as subdivisions of the shares already outstanding at the date of the split or dividend.

Stock Dividends and Stock Splits Compute the weighted average number of shares of common stock outstanding. This example shows you how to handle stock dividends. Stock splits enter the calculation of weighted-average shares outstanding in the same manner as stock dividends. Notice that on May 1, the company issued a 100% stock dividend. Let’s see how we would calculate weighted average common shares outstanding, given this new fact.

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 Shares at Jan. 1 New Shares Stock dividend adjustment The beginning balance is weighted for the entire year and adjusted for the 100% stock dividend issued on May 1st. The stock issue on April 1, is weighted for 9 twelfths of the year, and adjusted for the 100% stock dividend. Under our new set of facts, the weighted-average common shares outstanding would be 275,000.

Stock Dividends and Stock Splits Retroactive treatment: New shares issued this period? Yes No 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. If we issue shares during the period, in the form of a stock dividend or stock split, we treat those shares retroactively for the portion of the year that the original shares were outstanding. If the stock split had been issued prior to the current year, we would adjust the weighted-average common shares outstanding, as if the split had taken place at the beginning of the year.

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. When we reacquire common shares, the weighted-average number of shares is reduced for the weighted shares reacquired for the fraction of the year the shares were not outstanding.

Reacquired Shares Compute the weighted-average number of shares of common stock outstanding. Once again, we have expanded our original example. In this example, the company repurchased 12,000 of its own common shares. Let’s see how we will treat these repurchased shares.

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 Shares at Jan. 1 New Shares Treasury Shares You can see that the weighting of the original 100,000 shares for the entire year, and the 50,000 shares issued on April the first are weighted for nine 12th of the year. The reacquired shares are not outstanding from May 1 through December 31 or eight months, so they are weighted as a negative amount for eight 12th of the year. In this example we have 129,500 weighted-average common shares outstanding.

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 As we have discussed before, the numerator of the earnings per share equation is equal to net income less dividends on cumulative preferred stock, less dividends on noncumulative preferred stock, only if they have been declared. Net income minus preferred dividends is referred to as net income available to common shareholders.

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 Stock Options Convertible securities Contingently issuable shares Treasury stock method If-converted method To this point, we have discussed the calculation of basic earnings per share. Now, we will begin our discussion of diluted earnings per share. We will only report diluted earnings per share if the company is determined to have a complex capital structure. A company is said to have a complex capital structure, if, in addition to common stock, it has convertible securities (debt or preferred), or stock options, rights, or warrants. In the next several slides, we will look at the calculation of diluted earnings per share in detail. Dilution/Antidilution Test May Report Basic and Diluted Earnings Per Share

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 Whenever a company has options, rights, or warrants we use the treasury stock method to determine the impact of those securities on diluted earnings per share. Under the treasury stock method we assume that any proceeds received from the exercise of the option, right, or warrant is used to purchase treasury shares at the average market price per share. The effective of this treatment is to determine an incremental number of shares that will appear in the denominator of the diluted earnings per share equation. Purchase treasury shares

Options, Rights, and Warrants Determine new shares from assumed exercise of stock options. Compute number of shares repurchased. Proceeds from assumed exercise Average market price of stock First we determined the new shares from the assumed conversion of the stock options, rights, or warrants. Then we compute the shares purchased using the proceeds received to purchase shares of treasury stock at the average market price of the stock.

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. The incremental shares will be the difference between the new shares assumed issued minus the treasury shares assumed to be repurchased with the proceeds. New shares from assumed exercise (1) Less: Treasury shares assumed purchased (2) Net increase in shares outstanding (3)

Options, Rights, and Warrants When the exercise price exceeds the market price, the securities are antidilutive. If the exercise price of the option, right, or warrant is higher than the market price, the securities are said to be antidilutive, and are excluded from the calculation of diluted earnings per share.

Convertible 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. When a company has convertible securities and is calculating earnings per share, it uses the if converted method to determine the impact of those securities upon earnings per share. If the convertible shares have been outstanding in prior years, we will assume conversion as of the beginning of the current period. If the convertible securities have been issued during the current period, we will assume conversion at this later date.

Convertible Securities 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. If the company has convertible securities, there is an impact on both the numerator and denominator of the equation. First, the denominator is increased by the number of common shares issuable upon conversion. Second, the numerator is the increased by removing the after-tax interest expense associated with the convertible debt, or increased by removing the preferred dividends.

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. Dilutive earnings per share may increase or decrease as a result of the assumed conversion. If diluted earnings per share decreases, the securities are in fact dilutive and are assumed converted. If the diluted earnings per share increases, the securities are antidilutive and are not considered in the calculation of diluted earnings per share. If dilutive earnings per share increases, the securities are antidilutive and are not considered converted.

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. When a company has more than one potentially dilutive security, they are considered for inclusion in diluted earnings per share, starting with the most dilutive and working to the least dilutive.

Contingently Issuable Shares 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. Contingently issuable shares are issuable in the future, for little or no cash, upon the satisfaction of some specified condition. 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 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. Contingently issuable shares are included in diluted earnings per share, if they are issuable merely due to the passage of time, or if they’re based upon some target performance level and that target performance level has already been met. Perhaps the most common example of contingently issuable shares is shares that are issued upon reaching some future earnings level. Example: Additional shares may be issued based on future earnings.

Summary Here is a short summary of the treatment of stock options, convertible securities, and contingently issuable shares on basic and diluted earnings per share.

Summary This is a more detailed summary of the impact of the options, convertible bonds, convertible preferred and contingently issuable shares on the numerator and denominator of the earnings per share equation.

Financial Statement Presentation Report EPS data separately for: Income from Continuing Operations Separately Reported Items Discontinued Operations Extraordinary Items Net Income Companies must disclose per share amounts for (1) income before any separately reported items, (2) each separately reported item, and (3) net income.

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. Part I Intrinsic value is the benefit a 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. Part II Options have a time value because the holder of the option does not have to pay the exercise price until the option is exercised.

Summary The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component. The fair value of an option is its intrinsic value, plus it’s time value of money, plus its volatility component. This table shows the impact of various option pricing factors on the value of the option itself.

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. Stock appreciation rights, or SARs, are consider equity if the employer can elect to settle the rights in shares of the company’s stock. The amount of compensation expense is estimated at the date of grant as the fair market value of the SARs. The estimated amount is expensed over the service period.

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. Part I In some cases, the employee may elect to receive cash upon settlement of the SARs plan. In this case the SARs represent a liability. The amount of compensation expense is estimated each accounting period and continuously updated to reflect changes in the fair vale of the SARs. Part II The current compensation expense is a fraction of the total compensation earned to date by the recipients of the SARs reduced by the amounts expensed in pervious periods.

End of Chapter 19 End of Chapter 19. © 2008 The McGraw-Hill Companies, Inc.