1. Share-Based Compensation and Earnings Per Share19
Chapter 19: Share-Based Compensation and Earnings Per Share

2. Share-Based Awards
 Many compensation plans include one or more types of share-based awards. These include outright awards of shares, stock options, or cash payments tied to the market price of shares.
 Usually, an executive compensation plan is tied to performance in a way that uses compensation to motivate its recipients.
 Regardless of the form such a plan takes, the accounting objective is to record the fair value of the compensation expense over the periods in which related services are performed.

3. Stock Award Plans
Restricted stock award plans usually are tied to continued employment of the person receiving the award.
The compensation associated with a share of restricted 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 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

4. STOCK AWARD PLANS ILLUSTRATION
Universal Communications grants 5 million of its $1 par common shares to certain key executives at January 1, The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of $12 per share.
January 1, 2006
No entry
Calculate total compensation expense:
$12 fair value per share x million shares awarded = $60 million total compensation
The total compensation is allocated to expense over the 4-year service (vesting) period:
$60 million ÷ 4 years = $15 million per year
December 31, 2006, 2007, 2008, 2009 ($ in millions)
Compensation expense ($60 million ÷ 4 years) 15
Paid-in capital – restricted stock

5. STOCK AWARD PLANS ILLUSTRATION
Upon vesting:
($ in millions)
Paid-in capital– restricted stock (5 million sh. at $12) 60
Common stock (5 million shares at $1 par) 5
Paid-in capital – excess of par (to balance) 55
 If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed.

6. 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).

7. Recognizing Fair Value of Options
Estimating fair value requires the use of an option pricing model that incorporates 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.

8. EXPENSING STOCK OPTIONS
At Jan. 1, 2006, Universal grants options to acquire 10 million of the company’s $1 par common shares within the next 8 yrs, but not before Dec. 31, 2009 (the vesting date). The exercise price is the market price on the date of grant, $35 per share The fair value of the options is $8 per option.
January 1, 2006
No entry
Calculate total compensation expense:
$8 estimated fair value per option x million options granted = $80 million total compensation
The total compensation is allocated to expense over the 4-year service (vesting) period:
$80 million ÷ 4 years = $20 million per year
December 31, 2006, 2007, 2008, 2009 ($ in millions)
Compensation expense ($80 million ÷ 4 years) 20
Paid-in capital – stock options 20

9. ESTIMATED FORFEITURES
If a forfeiture rate of 5% was expected, annual compensation expense would have been $19 million ($76 / 4) instead of $20 million.
($ in millions)
Compensation expense ($80 x 95% x 1/4) Paid-in capital –stock options 19
2007
Compensation expense ($80 x 95% x 1/4) Paid-in capital –stock options 19

10. ESTIMATED FORFEITURES
 During 2008, the third year, Universal revises its estimate of forfeitures from 5% to 10%. The new estimate of total compensation would then be $80 million x 90%, or $72 million.
 The expense each year is the current estimate of total compensation that should have been recorded to date less the amount already recorded ($19 million in 2006 and 2007).
($ in millions)
Compensation expense ([$80 x 90% x ¾] – [$ ]) Paid-in capital –stock options
2009
Compensation expense ([$80 x 90% x 4/4] – [$ ]) 18
Paid-in capital –stock options

11. WHEN OPTIONS ARE EXERCISED
If half the options (five million shares) are exercised on July 11, 2009, when the market price is $50 per share:
July 11, ($ in millions)
Cash ($35 exercise price x 5 million shares)
Paid-in capital - stock options (1/2 account balance)
Common stock (5 million shares at $1 par per share) 5
Paid-in capital – excess of par (to balance) 210
If options that have vested expire without being exercised (assuming none of the options were exercised):
($ in millions)
Paid-in capital – stock options (account balance) Paid-in capital – expiration of stock options 80
Irrelevant

12. Plans with Performance Conditions
 Sometimes compensation from a stock option depends on meeting a performance target. Then, whether we record compensation depends on whether or not we feel it’s probable the target will be met.
 If the initial expectation is that it is not probable that the target will be met, we record no annual compensation expense.
 Suppose that after two years it becomes probable that the target will be met. Then, record the cumulative effect on compensation in 2008 earnings:
2008
Compensation expense ([$80 x 3/4] - $0) 60
Paid-in capital –stock options
2009
Compensation expense ([$80 x 4/4] - $60) 20
Paid-in capital –stock options
Also, continue to record compensation thereafter.
3 years’ cumulative compensation

13. Plans with Market Conditions
 Sometimes an award contains a market condition (e.g., an option that can be exercised only if the stock price reaches a specified level).
 In that case, we recognize compensation expense regardless of when, if ever, the market condition is met.

14. Stock Appreciation Rights
The recipient is awarded the share appreciation, which is the amount by which the market price on the exercise date exceeds the option price.
$ $ $
The recipient is awarded the share appreciation, which is the amount by which the market price on the exercise date exceeds the option price. The share appreciation is usually received in the form of cash.

15. STOCK APPRECIATION RIGHTS
 An SAR is considered to be equity if the employer can elect to settle in shares.
 In that case, 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.

16. STOCK APPRECIATION RIGHTS
 An SAR is 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.

17. STOCK APPRECIATION RIGHTS
 Universal Communications grants 10 million SARs to key executives at Jan. 1, Upon exercise, the SARs entitle executives to receive cash or stock equal in value to the excess of the market price at exercise over the share price at the date of grant. The $1 par common shares have a current market price of $10/sh. The SARs vest at the end of 2009 and expire at the end of The fair value of the SARs, estimated by an appropriate option pricing model, is $8 per SAR at Jan. 1, 2006.
January 1, 2006 No entry
The fair value re-estimated at December 31, 2006, is $8.40.
December 31, ($ in millions)
Compensation expense ($8.40 x 10 million x 1/4) 21
Liability – SAR plan
First year of 4-year service (vesting) period

18. STOCK APPRECIATION RIGHTS (continued)
December 31, ($ in millions)
Compensation expense ($8.40 x 10 million x 1/4)
Liability – SAR plan
The fair value re-estimated at December 31, 2007, is $8.
December 31, 2007
Compensation expense ([$8 x 10 million x 2/4] –21) 19
Liability – SAR plan
The fair value re-estimated at December 31, 2008, is $6.
December 31, 2008
Compensation expense ([$6 x 10 million x 3/4] – 21 – 19) Liability – SAR plan
The fair value re-estimated at December 31, 2009, is $4.30.
December 31, 2009
Liability – SAR plan
Compensation expense ([$4.30 x 10 million x 4/4] –21–19–5) 2
If the market price remains $8.40 (not likely), the expense is $21 million in each of the 4 years.
Now, two of the four-year service period has expired.
$21 million was expensed in 2006.

19. STOCK APPRECIATION RIGHTS (continued)
 The liability continues to be adjusted after the service period if the rights haven’t been exercised yet.
The fair value re-estimated at December 31, 2010, is $5.
December 31, ($ in millions)
Compensation expense ([$5 x 10 million x all] –21–19–5+2) 7
Liability – SAR plan
 Assume the SARs are exercised on Oct. 11, 2011, when the share price is $14.50, and executives choose to receive the market price appreciation in cash:
The fair value re-estimated at December 31, 2011, is $4.50.
October 11, ($ in millions)
Liability – SAR plan
Compensation expense ([$4.50 x 10 million x all] –50)
Liability – SAR plan (balance)
Cash
$43 million was expensed during the service period.
Now, the entire service period has expired.

20. EMPLOYEE SHARE PURCHASE PLANS
 Permit employees to buy shares directly from their employer.
 Usually the plan is considered compensatory, and compensation expense is recorded.
 Assume an employee buys shares (no par) under an ESPP plan for $850 rather than the current market price of $1,000. The $150 discount is recorded as compensation expense:
Cash (discounted price)
Compensation expense ($1,000 x 15%) 150
Common stock (market value) 1,000

21. 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.

22. EARNINGS PER SHARE
 In the most basic setting, earnings per share is simply a company’s earnings (or loss) divided by the number of shares outstanding.
Sovran Metals Corporation reported net income of $154 million in (Its tax rate was 40%).
 Common stock
January 1, million shares outstanding
(in millions, except per share amount)

23. ISSUANCE OF NEW SHARES
 If the number of shares has changed, it’s necessary to find the weighted average of the shares outstanding during the period the earnings were generated. 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.
Sovran Financial Corporation reported net income of $154 million for 2006 (tax rate 40%). Its capital structure included:
Common stock
January 1 60 million common shares outstanding
 March 1 12 million new shares were sold
We time-weight the new shares for the fraction of the year they’re outstanding.

24. STOCK DIVIDENDS AND STOCK SPLITS
 The additional shares created by a stock dividend or split are not weighted for the time period they were outstanding.
Common stock
January 1 60 million common shares outstanding
March 1 12 million new shares were sold
 June 17 A 10% stock dividend was distributed
Shares outstanding prior to the stock distribution are retroactively restated to reflect the increase in shares – that is, treated as if the distribution occurred at the beginning of the period.

25. REACQUIRED SHARES
The number of reacquired shares is time-weighted for the fraction of the year they were not outstanding, prior to being subtracted from the number of shares outstanding.
Common stock
January 1 60 million common shares outstanding
March 1 12 million new shares were sold
June 17 A 10% stock dividend was distributed
 October 1 8 million shares were reacquired as treasury stock
Basic EPS:
Stock dividend adjustment not necessary since the treasury shares were reacquired after the stock dividend and thus already reflect the adjustment.

26. EARNINGS AVAILABLE TO COMMON SHAREHOLDERS
Common stock
January million common shares outstanding
March million new shares were sold
June 17 A 10% stock dividend was distributed
October 1 8 million shares reacquired as treasury stock
 Preferred stock, nonconvertible
Jan. 1-Dec million 8%, $10 par, shares
Basic EPS:
Preferred dividends are subtracted from net income so that “earnings available to common shareholders” is divided by the weighted average number of common shares.
5,000,000 x $10 x 8%

27. COMPLEX CAPITAL STRUCTURE
Potential common shares — Securities that, while not being common stock, may become common stock through their exercise or conversion and, therefore, may “dilute” (reduce) EPS.
Examples: Convertible preferred stock, stock options, rights, or warrants, and contingently issuable securities
Complex capital structure — If potential common shares are outstanding
A firm with a complex capital structure reports two EPS calculations:
 Basic EPS ignores the dilutive effect of potential common shares.
 Diluted EPS incorporates the dilutive effect of potential common shares. The dilutive effect is included essentially by “pretending” the securities already have been exercised, converted, or otherwise transformed into common shares.

28. OPTIONS, RIGHTS, AND WARRANTS
Stock options, stock rights, and stock warrants give their holders the right to exercise their option to purchase common stock, usually at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS.
 Executive stock options
Options granted in 2001, exercisable for 15 million common shares* at an exercise price of $20 per share. The average market price was $25.
*adjusted for the stock dividend
Basic EPS is unaffected

29. OPTIONS, RIGHTS, AND WARRANTS (continued)
We assume the $300 million is used to buy back as many shares as possible (12 million) at the average market price.
We assume the options are exercised and 15 million shares are sold.
Assuming the exercise of the options adds 3 million shares to the denominator of diluted EPS.

30. Stock Options a. 25,000 shares b. 5,000 shares c. 3,125 shares
Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at $50 per share. The average market price of the stock was $80. The net increase in the dilutive earnings per share denominator is
a. 25,000 shares
b. 5,000 shares
c. 3,125 shares
d. 1,875 shares
Read through this multiple-choice question carefully and see if you can determine the incremental number of shares that will be included in the denominator of diluted earnings per share as a result of the existence of 5,000 options. Make sure you go through the calculations before moving to the next slide.
New shares = 5,000
Treasury shares = 3, (5,000 × $50) ÷ $80
Incremental shares = 1,875
(5, ,125)

31. CONVERTIBLE SECURITIES
 For Diluted EPS, conversion into common stock is assumed to have occurred at the beginning of the period (or at the time the convertible security is issued, if that’s later). The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion.
 The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

32. Convertible Bonds
 10%, $300 million face amount of bonds issued in 2005, convertible into 12 million common shares (adjusted for the stock dividend)

33. CONVERTIBLE PREFERRED STOCK
In addition to other elements of the capital structure:
 Preferred stock, convertible
10 million, 8%, cumulative, $10 par, shares issued in 1999, convertible into 5 million common shares*
*adjusted for the stock dividend
80 cents per share, or $8 million

34. CONVERTIBLE PREFERRED STOCK (continued)
If we assume the preferred shares have been converted to CS, there would be no preferred dividends to subtract.
Earnings available for CS does not include dividends payable to preferred shareholders.

35. Earnings Per Share
A company had 200,000 shares of $50 par common stock, 10,000 shares of 5%, $20 par cumulative preferred stock, and 30,000 shares of 5%, $10 par noncumulative preferred stock outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. EPS would be
a. $7.50
b. $7.43
c. $7.45
d. $7.38
See if you can calculate basic earnings per share for this company. Don’t go to the next screen until you’ve come up with an answer.
$1,500,000 – (10,000 × 5% × $20 par)
200,000 shares
Since dividends were not declared, only the cumulative preferred stock dividends are subtracted.

36. ANTIDILUTIVE SECURITIES
 At times, the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as “antidilutive” securities. Such securities are ignored when calculating EPS.
 Stock warrants
Warrants granted in 2005, exercisable for 4 million common shares* at an exercise price of $32.50 per share
*adjusted for the stock dividend
Calculations:
The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive.
 The $32.50 exercise price is higher than the market price, $25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

37. CONTINGENTLY ISSUABLE SHARES
 Considered to be outstanding in the computation of diluted EPS if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period).
 For example, assume 3 million additional shares will become issuable to certain executives in the following year (2007) if net income that year is $150 million or more.
 If net income in 2006 was $154 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 3 million additional shares to the denominator.
Assumed issuance of contingently issuable shares (diluted EPS):
no adjustment to the numerator
+ 3 additional shares

38. Order of Entry for Multiple Convertible Securities
When a company has more than one potentially dilutive security, 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.

39. Earnings Per Share Disclosure
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.

40. Option-Pricing Theory
Appendix 19
Appendix 19: Option-Pricing Theory

41. Intrinsic Value
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.

42. 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.

43. End of Chapter 19
End of Chapter 19.