1. · 1 CORPORATE FINANCIAL REPORTING 2 16 - Dilutive Securities & E.P.S Dilutive Securities and EPS

2. · 2 D ILUTIVE S ECURITIES Dilutive securities are: convertible debt & convertible preferred stock, stock warrants & stock options, & “contingent” shares.

3. · 3 D ILUTIVE S ECURITIES Convertible Debt Our company issues 100,000 6% bonds (each with a face value of $1,000) for $100,400,000. Each bond is convertible into 40 shares of our $1 par common stock. Our investment banking firm believes that, had the bonds not been convertible the bonds would have been issued for their face value.

4. · 4 D ILUTIVE S ECURITIES Convertible Preferred Stock Our company issues 1,000,000 shares of 6% preferred stock (each with a par value of $100) for $100,400,000. Each share is convertible into 40 shares of our $1 par common stock. Our investment banking firm believes that, had the stock not been convertible, the stock would have been issued for its face value.

5. · 5 D ILUTIVE S ECURITIES Stock Warrants Stock warrants are usually issued in conjunction with other financial instruments but can be issued to existing shareholders for “free”. They entitle the warrant holder to buy common stock at a (usually) bargain price.

6. · 6 D ILUTIVE S ECURITIES Stock Warrants Our company issues 100,000 6% bonds (each with a face value of $1,000) for $100,500,000. Each bond has an attached warrant allowing the holder of the warrant to purchase 10 shares of our $1 par common stock for $5/share. Immediately after issue, the warrants are traded in the market for $4.

7. · 7 D ILUTIVE S ECURITIES Share Based Payment Plans [FAS 123R (ASC 718) / IFRS 2] There are several kinds of stock compensation plans: Stock appreciation rights plans Stock option plans Restricted stock plans Employee stock purchase plans

8. · 8 D ILUTIVE S ECURITIES Stock Appreciation Right Plans 1/08 12/08 12/09 12/10 12/11 12/12 12/13 12/14 MP=$8 $9 $10 $9 $11 $12 $15 $14 Stock appreciation SAR’s SAR’s SAR’s rights granted for vest exercised expire 1,000 shares How do SARs work? What journal entries should the company make? The income tax rate for the company is 40% for all years. IRS says SAR tax compensation expense = cash paid the year SARs are exercised.

9. · 9 D ILUTIVE S ECURITIES Stock Options Different perspectives: tax treatment of stock options & financial reporting of stock options

10. Stock Option Plans Tax Reporting 1/07 12/09 12/11 12/14 12/17 Stock options stock employee optionsemployee granted for options exercises - expire sells the 1,000 shares vest pays $10 shares exercise price=mp=$10(mp=$18) for $30 On how much gain is the employee taxed? How much expense may the employer report? The answers? It depends on the type of plan: INCENTIVE STOCK OPTION or NONQUALIFIED STOCK OPTION · 10

11. Stock Option Plans - Tax Reporting Gain for the EMPLOYEE 1/07 12/09 12/11 12/14 12/17 Stock options stock employee optionsemployee granted for options exercises - expire sells the 1,000 shares vest pays $10 shares exercise price=mp=$10(mp=$18) for $30 ISO NQSO at grant -- -- at exercise -- $ 8 income at stock sale $20 income $12 income · 11

12. Stock Option Plans - Tax Reporting Expense for the EMPLOYER 1/07 12/09 12/11 12/14 12/17 Stock options stock employee optionsemployee granted for options exercises - expire sells the 1,000 shares vest pays $10 shares exercise price=mp=$10(mp=$18) for $30 ISO NQSO at grant -- -- at exercise -- ($ 8) at stock sale -- -- · 12

13. · 13 Stock Option Plans Financial Reporting In general there are two types of stock option plans for financial reporting: Noncompensatory – designed to raise capital and encourage employee ownership (no compensation expense). Compensatory – result in compensation expense.

14. · 14 D ILUTIVE S ECURITIES Compensatory Stock Option Plan (&NQSO) 1/07 12/07 12/08 12/09 12/10 12/11 12/12 12/13 xx MP= 8 9 10 9 11 12 15 14 Stock options stock stock granted for options options 1,000 shares vest expire exercise price = $8 par value of c/s = $1 A person with 100 options quits the company. A person with 850 options exercises them. A person with 50 options forgets to exercise them. The income tax rate for the company is 40% for all years.

15. · 15 D ILUTIVE S ECURITIES Restricted Stock Plans 1/07 12/07 12/08 12/09 12/10 12/11 12/12 12/13 MP= 8 9 10 9 11 12 15 14 1000 shares Restricted of Restricted Stock vests Stock granted How does Restricted Stock work? What journal entries should the company make? The tax rate for the company is 40% for all years.

16. · 16 D ILUTIVE S ECURITIES QUESTIONS BEFORE WE MOVE ON TO EARNINGS PER SHARE?

17. · 17 E ARNINGS P ER S HARE FASB says corporations fall into one of two categories: ◊ corporations with a simple capital structure and ◊ corporations with a complex capital structure. (FAS 128 & IAS 33)

18. · 18 E ARNINGS P ER S HARE Simple Capital Structure A corporation has a simple capital structure if it has no dilutive securities - that is it only has common stock and NO: convertible debt or convertible preferred stock, stock warrants or stock options, or contingent shares.

19. · 19 E ARNINGS P ER S HARE Simple Capital Structure A corporation with a simple capital structure calculates one eps (called “basic earnings per share”) like this: net income - pref. stock dividends declared* weighted avg. no. of shares of common stock**

20. · 20 E ARNINGS P ER S HARE Complex Capital Structure A corporation has a complex capital structure if it has dilutive securities - that is it has common stock, AND convert. debt/convert pref. stock, stock warrants/options, or contingent shares.

21. · 21 E ARNINGS P ER S HARE Complex Capital Structure A corporation with a complex capital structure calculates TWO eps: ◊ basic eps (exactly like a corporation with a simple capital structure) ◊ diluted eps which assumes that the dilutive securities did become common stock.

22. · 22 E ARNINGS P ER S HARE Complex Capital Structure This is why I think the FASB requires two eps. Suppose in 2013 Company A has the following: ◊ net income of $100,000 ◊ 10,000 shares of convertible P/S that are convertible into 20,000 shares of common stock ◊ 20,000 shares of common stock

23. · 23 E ARNINGS P ER S HARE Complex Capital Structure And in 2014, the following happened: ◊ net income $100,000 ◊ on 1/1/14 the preferred stock all converted into 20,000 shares of common stock ◊ common stock outstanding all year was now 40,000 shares

24. · 24 D ILUTED EPS Convertible Preferred Stock Treatment In the denominator, assume the convertible P/S converts to common stock at the beginning of the year*. IF that had happened, the P/S would not have been paid dividends, so add back (to income available to common stockholders) in the numerator the dividends declared on the convertible P/S.

25. · 25 D ILUTED EPS Convertible Preferred Stock Example ◊ 2013 net income: $100,000 ◊ P/S declared $1,000 dividends ◊ P/S is convertible into 5,000 shares of common ◊ C/S outstanding all year: 10,000 shares

26. · 26 D ILUTED EPS Convertible Bonds Example 2013 Income Statement: Revenue $ xxxxxx Expense ( xxxxx) Int. expense( 10,000) all on bonds Inc. bef. tax 100,000 Inc. tax (30%) ( 30,000) Net income $70,000 The company has 200,000 shares of common stock and also has bonds convertible into 100,000 shares of common stock.

27. · 27 D ILUTED EPS Stock Options Example ◊ 2013 net income: $9,000 ◊ C/S outstanding all year: 1,000 shares ◊ stock options for 100 shares of common stock outstanding all year. ◊ option price $5/share. ◊ C/S average price in 2010: $8/share.

28. · 28 D ILUTED EPS Contingent shares Example 2011 NI: $10,000 outstanding: 10,000 shares of common stock In 2012, we tell management if NI > $20,000 before 2015, they get 500 shares free (it is a one time offer) 2012 NI: $18,000 2013 NI: $22,000

29. · 29 E ARNINGS P ER S HARE When making assumptions for diluted eps calculation, you can never increase eps: NI : $100,000 P/S: 10,000 shares, convertible into 4,000 shares of common P/S declared $5,000 of dividends C/S: 100,000 shares

30. · 30 E ARNINGS P ER S HARE Average No. of Common Shares This can be tedious in the real world. The idea is to calculate the weighted average number of shares of common stock outstanding during the year - but remember you do NOT weight shares for stock dividends or stock splits in the year they happened.

31. · 31 E ARNINGS P ER S HARE Calculating Avg. No. of Common Shares 2012: (our first year of business) NI : $360,000 1/1: 80,000 shares outstanding 7/1: 20,000 shares issued for cash 2013: NI : $500,000 1/1: 100,000 shares outstanding 7/1: 30,000 shares issued for cash 8/1: 2 for 1 stock split 12/1: bought 1,000 shares as T/S