Chapter 19 - Share-Based Compensation and Earnings Per Share
CHAPTER 19
SHARE-BASED COMPENSATION AND EARNINGS PER SHARE
Overview
We’ve discussed a variety of employee compensation plans in prior chapters, including pension
and other postretirement benefits in Chapter 17. In this chapter we look at some common forms
of compensation in which the amount of the compensation employees receive is tied to the
market price of company stock. We will see that these “share-based” compensation plans – stock
awards, stock options, and stock appreciation rights - create shareholders’ equity, the topic of the
previous chapter and also often affect the way we calculate earnings per share, the topic of the
second part of the current chapter. Specifically, we view these as ”potential common shares”
along with convertible securities and calculate earnings per share as if they already had been
exercised or converted into additional common shares.
Learning Objectives
1.
2.
3.
4.
5.
6.
Explain and implement the accounting for stock award plans.
Explain and implement the accounting for stock options.
Explain and implement the accounting for employee share purchase plans.
Distinguish between a simple and a complex capital structure.
Describe what is meant by the weighted average number of common shares.
Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split, and
the reacquisition of shares.
7. Describe how preferred dividends affect the determination of EPS.
8. Describe how options, rights, and warrants are incorporated in the calculation of EPS.
9. Describe how convertible securities are incorporated in the calculation of EPS.
10. Determine whether potential common shares are antidilutive.
11. Determine the three components of the proceeds used in the treasury stock method.
12. Explain the way contingently issuable shares are incorporated in the calculation of EPS.
13. Describe the way EPS information should be reported in an income statement.
14. Discuss the primary differences between U.S. GAAP and IFRS with respect to accounting
for share-based compensation and EPS.
Lecture Outline
Part A: Share-Based Compensation
A.
B.
C.
D.
Typically, an executive compensation plan is tied to performance in a way that uses
compensation to motivate its recipients.
Many plans include share-based awards.
Whichever form such a plan assumes, the accounting objective is to record the fair value
of compensation expense over the periods in which related services are performed.
This requires:
1.
Determining the fair value of the compensation.
2.
Expensing that compensation over the periods in which participants perform
services.
19-1
Chapter 19 - Share-Based Compensation and Earnings Per Share
I.
Stock Award Plans (T19-1)
A. The compensation is a grant of shares of stock.
B. The shares usually are restricted so that benefits are tied to continued employment.
1.
Usually shares are subject to forfeiture if employment is terminated within some
specified number of years from the date of grant.
2.
The employee cannot sell the shares during the restriction period.
C. The compensation is simply the market price of the stock at the grant date.
1.
Compensation is accrued as expense over the service period for which participants
receive the shares.
2.
The service period usually is the period from the date of grant to when restrictions
are lifted (the vesting date). (T19-2)
D. If restricted stock is forfeited, related entries previously made would simply be reversed.
II.
Stock Option Plans (T19-3)
A. Allow recipients the option to purchase (a) a specified number of shares of the firm's
stock, (b) at a specified price, (c) during a specified period of time.
B. For tax purposes, plans can either qualify as an “incentive stock option plan” under the
Tax Code or be "unqualified plans." Under a qualified incentive plan, the recipient pays
no income tax until any shares acquired are subsequently sold. On the other hand, the
company gets no tax deduction at all. With a nonqualified plan the employee can’t delay
paying income tax, but the employer is permitted to deduct the difference between the
exercise price and the market price at the exercise date. (T19-4)
C. The accounting objective is to report the fair value of compensation expense during the
period of service for which the compensation is given. (T19-5)
D. Compensation is measured at the grant date, estimated using an option-pricing model that
considers the exercise price and expected term of the option, the current market price of
the underlying stock and its expected volatility, expected dividends, and the expected
risk-free rate of return.
E. When forfeiture estimates change, the cumulative effect on compensation is reflected in
current earnings. (T19-6)
F. When options are exercised, cash is debited for the amount received, and stock accounts
replace paid-in capital – stock options. (T19-7)
G. If 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. (T19-8)
H. If the target is based on changes in the market rather than on performance, we record
compensation as if there were no target.
I.
Under U.S. GAAP, a deferred tax asset is created for the cumulative amount of the fair
value of the options expensed. Under IFRS, the deferred tax asset isn’t created until the
award is “in the money;” that is, has intrinsic value. (T19-9)
J.
If recipients gradually become eligible to exercise their options rather than all at once, the
plan is said to have “graded vesting.” In such a case, most companies view each vesting
group (or tranche) separately, as if it were a separate award. Companies also are allowed
to account for the entire award on straight-line basis over the entire vesting period. Either
way, the company must recognize at least the amount of the award that has vested by that
date.
19-2
Chapter 19 - Share-Based Compensation and Earnings Per Share
K.
Under IFRS, the straight-line choice is not permitted. Also, there’s no requirement that
the company must recognize at least the amount of the award that has vested by each
reporting date.
III. Employee Share Purchase Plans (T19-10)
A. Employee share purchase plans allow employees to buy company stock under convenient
or favorable terms.
B. Most such plans are considered compensatory and require the fair value of any discount
to be recorded as compensation expense.
Part B: Earnings Per Share
I.
For analysts and the financial press, earnings per share is the most frequently cited and reported
measure of a company’s performance.
A. EPS is reported in the income statement of all publicly traded firms.
B. In general, EPS is simply earnings available to common shareholders divided by the
weighted average number of common shares outstanding.
II.
If a company has no “potential common shares” we consider it to have a simple capital
structure.
A. For a simple capital structure, a single presentation of basic EPS is sufficient.
B. If there are no securities other than common stock and the number of common shares
remained unchanged, basic EPS is simply net income divided by common shares. (T1911)
III. When the number of shares changes, EPS calculations are based on the weighted average
number of shares outstanding during the period.
A. New shares issued during a reporting period are time-weighted by the fraction of the
period they were outstanding and then added to the number of shares outstanding for the
period. For instance, if 12,000 new shares are sold on October 1, the denominator of the
EPS fraction would be increased by: 12,000 x 3/12, or 3,000 shares. (T19-12)
B. On the contrary, an increase in shares due to a stock dividend or stock split is not timeweighted. (T19-13)
1.
For a stock dividend or stock split, the shares outstanding prior to the stock
distribution are restated to reflect the increase in shares. That is, we simply increase
the outstanding shares by the number of new shares.
2.
The firm would simply have a larger number of less valuable shares (the same pie is
cut into more slices).
3.
For example, EPS after a 2 for 1 stock split would be half of what it was before,
other things being equal.
4.
When reported again in the comparative financial statements, previous years’ EPS
are restated for comparability.
C. If common shares are reacquired (as treasury stock or to be retired) those shares are timeweighted for the fraction of the period they were not outstanding. The time-weighted
shares then are subtracted from the number of shares in the denominator of the EPS
fraction. (T19-14)
19-3
Chapter 19 - Share-Based Compensation and Earnings Per Share
IV. Any dividends on preferred stock outstanding are subtracted from reported net income. (T1915)
A. This is because the denominator in the EPS calculation is the weighted average number of
common shares, so the numerator should reflect earnings available to common
shareholders.
B. This adjustment is made for cumulative preferred stock whether or not dividends are
declared that period. The assumption is that eventually the dividends will be paid if the
preferred stock is cumulative.
V.
When a company has securities that could potentially dilute (i.e., reduce) earnings per share, it
is classified as a complex capital structure. (T19-16)
A. These potential common shares include stock options and convertible securities.
B. The company reports both basic and diluted earnings per share.
C. For diluted EPS, the impact of each potentially dilutive security is reflected by calculating
earnings per share as if the security already had been exercised or converted into
additional common shares.
D. Stock options (also stock rights and stock warrants) give their holders the right to exercise
their option to purchase common stock, typically at a specified exercise price. The
increase in shares would reduce EPS. (T19-17)
1.
When calculating diluted EPS, we pretend the stock options had been exercised at
the beginning of the period (or at the time the options are issued, if later).
2.
We also assume the cash proceeds from the assumed sale were used to buy back (as
treasury stock) as many of those shares as could be acquired at the average market
price of the shares during the period.
3.
If the options haven’t vested, “proceeds” also include any compensation not yet
expensed.
4.
If the options are not incentive options, “proceeds” also include any “excess tax
benefits.” (T19-18)
5.
Restricted stock is potentially dilutive and also is included in diluted EPS by the
treasury stock method. (T19-19)
E. For convertible securities, we pretend for the purpose of calculating diluted EPS that the
conversion already has occurred. (T19-20)
1.
To include convertible bonds in the calculation of diluted EPS, we pretend the
conversion occurred at the beginning of the period (or at the time the convertible
security is issued, if later). (T19-21)
a.
The denominator of the EPS fraction is adjusted for the additional common
shares assumed.
b.
The numerator is increased by the interest (after-tax) that would have been
avoided in the event of conversion.
2.
To include convertible preferred stock in the calculation of diluted EPS, we pretend
the conversion occurred at the beginning of the period (or at the time the convertible
security is issued, if later). (T19-22)
a.
The denominator of the EPS fraction is adjusted for the additional common
shares assumed.
b.
The numerator is not reduced by the preferred dividends because they would
have been avoided in the event of conversion.
19-4
Chapter 19 - Share-Based Compensation and Earnings Per Share
VI. If the effect of the assumed conversion or exercise of potential common shares would be to
increase, rather than decrease, EPS, we consider them “antidilutive securities.” Antidilutive
securities are ignored when calculating both basic and diluted EPS. (T19-23)
VII. Contingently issuable shares also are potential common shares. (T19-24)
A. These are considered outstanding in the computation of diluted EPS if the conditions for
their issuance currently are met.
B. For instance, if 50,000 shares will be issued next year if the market price of common
shares next year is at least $35 and the market price currently is $36, the 50,000 additional
shares would be simply added to the denominator.
VIII. Financial statement disclosures include both basic and diluted EPS for both income from
continuing operations and net income. (T19-25)
A.
Per share amounts also are reported for:
1.
Discontinued operations,
2.
Extraordinary items, and
3.
An accounting change.
B.
Disclosures should include a reconciliation of the numerator and denominator used in
the computations.
C.
IAS No. 33 and U.S. GAAP are similar in most respects. The differences that remain
are the result of differences in the application of the treasury stock method, the
treatment of contracts that may be settled in shares or cash, and contingently issuable
shares. (T19-26)
Decision-Makers’ Perspective
A. Analysts frequently use EPS data in connection with the price-earnings ratio.
1.
The P/E ratio is the market price per share divided by the earnings per share.
2.
The P/E ratio measures the decision makers' perception of the “quality” of a
company’s earnings by indicating the price multiple the market is willing to pay for
the firm’s earnings.
3.
In a way, it represents the market’s expectation of future earnings as indicated by
current earnings taking into account analysts’ perceptions of a business’s growth
potential, stability, and relative risk.
B. Another measure, the dividend payout ratio, indicates the percentage of earnings that is
distributed to shareholders as dividends.
Appendix B.
Stock Appreciation Rights (SARs) (T19-27)
A. SARs enable an executive to benefit by the amount that the market price of the
company’s stock rises, but without having to buy shares.
B. The executive receives the “share appreciation” at exercise that has occurred since the
date of grant.
C. Share appreciation is the increase in the market price over a prespecified price (usually
the market price at the date of grant).
D. The share appreciation usually is payable in cash but may be payable in shares equal in
value to the share appreciation.
19-5
Chapter 19 - Share-Based Compensation and Earnings Per Share
1.
2.
The award is considered to be equity if the employer can elect to settle in shares of
stock rather than cash.
The award is considered to be a liability if the employee can elect to receive cash
(which usually is the case).
When considered debt, the amount of compensation is continually adjusted to
reflect changes in the fair value of the SARs until the SARs expire or are exercised.
(T19-28, T19-29)
When the award is considered equity fair value is measured at the grant date.
3.
4.
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19-6
Chapter 19 - Share-Based Compensation and Earnings Per Share
STOCK AWARD PLANS
 Usually, restricted shares are subject to forfeiture if the
employee doesn’t remain with the company.
 The share value is accrued as compensation expense over the
service period for which participants receive the shares,
usually from the date of grant to when restrictions are lifted
(the vesting date).
T19-1
19-7
Chapter 19 - Share-Based Compensation and Earnings Per Share
STOCK AWARD PLANS ILLUSTRATION
Under its restricted stock award plan, Universal Communications
grants 5 million of its $1 par common shares to certain key
executives at January 1, 2011. The shares are subject to forfeiture
if employment is terminated within 4 years. Shares have a current
price of $12 per share.
January 1, 2011
No entry
Calculate total compensation expense:
$12
fair value per share
x 5 million
shares awarded
= $60 million
total compensation
The total compensation is allocated to expense over the 4-year
service (vesting) period: 2011 - 2014
$60 million ÷ 4 years = $15 million per year
December 31, 2011, 2012, 2013, 2014
Compensation expense ($60 million ÷ 4 years) .............
Paid-in capital – restricted stock ........................
December 31, 2014
Paid-in capital– restricted stock (5 million sh. at $12)...
Common stock (5 million shares at $1 par) .................
Paid-in capital – excess of par (to balance) ............
($ in millions)
15
15
60
5
55
 If restricted stock is forfeited because, say, the employee quits
the company, related entries previously made would simply be
reversed.
Illustration 19-1
T19-2
19-8
Chapter 19 - Share-Based Compensation and Earnings Per Share
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 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).
 This requires the use of an option pricing model. The model
should take into account the:
 exercise price of the option
 expected term of the option
 current market price of the stock
 expected dividends
 expected risk-free rate of return during the term of the
option
 expected volatility of the stock
T19-3
19-9
Chapter 19 - Share-Based Compensation and Earnings Per Share
Tax Implications

For tax purposes, plans can either qualify as an “incentive
stock option plan” under the Tax Code or be "unqualified
plans."

Among the requirements of a qualified option plan is that
the exercise price be equal to the market price at the grant
date. Under a qualified incentive plan, the recipient pays no
income tax until any shares acquired are subsequently sold.
On the other hand, the company gets no tax deduction at all.

With a nonqualified plan the employee can’t delay paying
income tax, but the employer is permitted to deduct the
difference between the exercise price and the market price at
the exercise date.
T19-4
19-10
Chapter 19 - Share-Based Compensation and Earnings Per Share
EXPENSING STOCK OPTIONS
At January 1, 2011, Universal Communications grants options
that permit key executives to acquire 10 million of the
company’s $1 par common shares within the next 8 years, but
not before December 31, 2014 (the vesting date). The exercise
price is the market price of the shares on the date of grant, $35
per share. The fair value of the options, estimated by an
appropriate option-pricing model, is $8 per option.
January 1, 2011
No entry
Calculate total compensation expense:
$8
estimated fair value per option
x
10 million
options granted
= $80 million
total compensation
The total compensation is allocated to expense over the 4-year
service (vesting) period: 2011 - 2014
$80 million ÷ 4 years = $20 million per year
December 31, 2011, 2012, 2013, 2014
Compensation expense ($80 million ÷ 4 years) .............
Paid-in capital – stock options ...........................
($ in millions)
20
20
Illustration 19-2
T19-5
19-11
Chapter 19 - Share-Based Compensation and Earnings Per Share
ESTIMATED FORFEITURES
 If a forfeiture rate of 5% was expected, annual compensation
expense would have been $19 million ($76 / 4) instead of
$20 million.
 During 2013, 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
2011
Compensation expense ($80 x 95% x 1/4) ..................
Paid-in capital –stock options ........................
($ in millions)
19
19
2012
Compensation expense ($80 x 95% x 1/4) ..................
Paid-in capital –stock options ........................
19
2013
Compensation expense ([$80 x 90% x ¾] – [$19 + 19])..
Paid-in capital –stock options ........................
16
2014
Compensation expense ([$80 x 90% x 4/4] – [$19 + 19 + 16])
Paid-in capital –stock options ........................
18
19
16
18
Illustration 19-2A
T19-6
19-12
Chapter 19 - Share-Based Compensation and Earnings Per Share
WHEN OPTIONS ARE EXERCISED
If half the options (five million shares) are exercised on July 11,
2014, when the market price is $50 per share, the following journal
entry is made:
July 11, 2014
Cash ($35 exercise price x 5 million shares) .......................
Paid-in capital - stock options (1/2 account balance) ....
Common stock (5 million shares at $1 par per share) .....
Paid-in capital – excess of par (to balance) ...............
($ in millions)
175
40
5
210
If options that have vested expire without being exercised, the
following journal entry is made (assuming none of the options
were exercised):
($ in millions)
Paid-in capital – stock options (account balance)
Paid-in capital – expiration of stock options
80
80
T19-7
19-13
Chapter 19 - Share-Based Compensation and Earnings Per Share
PLANS WITH PERFORMANCE OR
MARKET CONDITIONS
The way we account for such plans depends on whether the condition is
performance-based or market-based.
Plans with Performance Conditions
 If 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. If, after two
years, the expectation is that it is probable that the target will be met,
we record the cumulative effect on compensation in 2013 earnings
and record compensation thereafter:
2013
Compensation expense ([$80 x ¾] - $0) ..........
Paid-in capital –stock options ................
60
2014
Compensation expense ([$80 x 4/4] - $60) ......
Paid-in capital –stock options ................
20
60
20
Plans with Market Conditions
 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 we recognize compensation expense regardless
of when, if ever, the market condition is met.
T19-8
19-14
Chapter 19 - Share-Based Compensation and Earnings Per Share
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Recognition of Deferred Tax Asset for Stock Options. Under
U.S. GAAP, a deferred tax asset is created for the cumulative
amount of the fair value of the options expensed. Under IFRS, the
deferred tax asset isn’t created until the award is “in the money;”
that is, has intrinsic value.
T19-9
19-15
Chapter 19 - Share-Based Compensation and Earnings Per Share
EMPLOYEE SHARE PURCHASE PLANS



Permit employees to buy shares directly from their
company.
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)
850
Compensation expense ($1,000 x 15%) 150
Common stock (market value)
1,000
T19-10
19-16
Chapter 19 - Share-Based Compensation and Earnings Per Share
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 2011. (Its tax rate was 40%).

Common stock
January 1, 2011
60 million shares outstanding
(in millions, except per share amount)
Basic EPS:
net
income
$154
= $2.57
60
shares
outstanding
T19-11
19-17
Chapter 19 - Share-Based Compensation and Earnings Per Share
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 timeweighted 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 2011 (tax rate 40%). Its capital structure included:
Common stock
January 1
60 million common shares were outstanding
 March 1
12 million new shares were sold
Basic EPS:
(amounts in millions, except per share amount)
net
income
$154
$154
=
60
shares
at Jan. 1
+ 12 (10/12)
= $2.20
70
new
shares
T19-12
19-18
Chapter 19 - Share-Based Compensation and Earnings Per Share
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.
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.
Sovran Financial Corporation reported net income of $154
million in 2011 (tax rate 40%). Its capital structure included:
Common stock
January 1
60 million common shares were outstanding
March 1
12 million new shares were sold
 June 17
A 10% stock dividend was distributed
Basic EPS:
(amounts in millions, except per share amount)
net
income
$154
$154
=
60 (1.10)
shares
at Jan. 1
+ 12 (10/12) (1.10)
= $2.00
77
new
shares
___ stock dividend ___
adjustment
T19-13
19-19
Chapter 19 - Share-Based Compensation and Earnings Per Share
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.
Sovran Financial Corporation reported net income of $154
million in 2011 (tax rate 40%). Its capital structure included:
Common stock
January 1
60 million common shares were 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:
(amounts in millions, except per share amount)
net
income
$154
$154
=
60 (1.10) + 12 (10/12) (1.10)
shares
at Jan. 1
new
shares
___ stock dividend ___
adjustment*
– 8 (3/12)
= $2.05
75
treasury
shares
* not necessary for the treasury shares since they were reacquired after the stock dividend and
thus already reflect the adjustment (that is, the shares repurchased are 8 million “new” shares)
T19-14
19-20
Chapter 19 - Share-Based Compensation and Earnings Per Share
EARNINGS AVAILABLE TO COMMON SHAREHOLDERS
 Preferred dividends are subtracted from net income so that
“earnings available to common shareholders” is divided by
the weighted average number of common shares.
Sovran Financial Corporation reported net income of $154
million in 2011 (tax rate 40%). Its capital structure included:
Common stock
January 1
60 million common shares were 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
 Preferred stock, nonconvertible
January 1-December 31
5 million 8%, $10 par, shares
Basic EPS:
(amounts in millions, except per share amount)
net
preferred
income
dividends
$154
– $4 *
$150
=
60 (1.10) + 12 (10/12) (1.10)
shares
at Jan. 1
new
shares
___ stock dividend ___
adjustment
– 8 (3/12)
= $2.00
75
treasury
shares
* 5,000,000 x $10 x 8%
T19-15
19-21
Chapter 19 - Share-Based Compensation and Earnings Per Share
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
potential common shares. The dilutive
included essentially by “pretending” the
already have been exercised, converted, or
transformed into common shares.
effect of
effect is
securities
otherwise
T19-16
19-22
Chapter 19 - Share-Based Compensation and Earnings Per Share
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.

Incentive stock options
Executive stock options granted in 2009, exercisable after 2010 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
(amounts in millions, except per share amounts)
net
preferred
income
dividends
– $4
$154
$150
=
60 (1.10) + 12 (10/12) (1.10)
shares
new
at Jan. 1
shares
___ stock dividend ___
adjustment
= $2.00
– 8 (3/12)
75
treasury
shares
Diluted EPS
net
income
preferred
dividends
$154
– $4
$150
____________________________________________________________________
60 (1.10) + 12 (10/12) (1.10) – 8 (3/12)
shares
at Jan. 1
+ (15 – 12a)
=
_____
= $1.92
78
new
treasury
exercise
shares
shares
of options
__ stock dividend ___
adjustment
a Shares Reacquired for Diluted EPS
15
million shares
x $20
(exercise price)
$300
million
÷ $25
(average market price)
12
million shares reacquired
T19-17
19-23
Chapter 19 - Share-Based Compensation and Earnings Per Share
Proceeds for Calculating Reacquired Shares

The “proceeds” for the calculation should include:
1. the amount received from the hypothetical exercise of the options
($300 million in our illustration).
2. the total compensation from the award that's not yet expensed. If
the fair value of an option had been $4 at the grant date, the total
compensation would have been 15 million shares times $4, or $60
million.
In our illustration, the options were fully vested before 2011, so all
$60 million already had been expensed. If the options had been only
half vested, half the compensation would have been unexpensed and
$30 million would have been added to the $300 million proceeds.
3. the "excess tax benefit." We expense the fair value of stock options at
the date of grant. If the options were non-qualified options, the
corporation receives a tax deduction at exercise equal to the difference
between the stock's market value and its exercise price. In our
illustration, the options were incentive stock options, hence no tax
benefit. Had they been non-qualified options, the proceeds also would
have included a $6 million excess tax benefit:
$25
(20)
$ 5
(4)
$ 1
x 15
$15
x 40%
$ 6
market price during 2011 (& price at hypothetical exercise)
exercise price
tax deduction at hypothetical exercise
fair value at grant date (& amount expensed over the vesting period)
excess tax deduction per option
million options
million excess tax deduction
tax rate
million excess tax benefit
T19-18
19-24
Chapter 19 - Share-Based Compensation and Earnings Per Share
Restricted Stock Awards in EPS Calculations


Restricted stock awards are included using the treasury stock method.
That is, the shares are added to the denominator and then reduced by
the number of shares that can be bought back with the “proceeds” at
the average market price of the company’s stock during the year. The
cash proceeds are zero since executives don’t pay to acquire their
shares.
The proceeds for the EPS calculation include the total compensation
that’s not yet expensed. For an example, assume total compensation
for the award is $60 million ($12 market price per share x 5 million
shares). If the stock award vests over four years, it is expensed as $15
million each year for four years. At the end of 2011, the first year, $45
million remains unexpensed, so $45 million would be the assumed
proceeds in an EPS calculation. If the market price remains at $12, the
$45 million will buy back 3.75 million shares:
No adjustment to the numerator
5 million – 3.75* million = 1.25 million
*Assumed purchase of treasury shares
$45 million
÷ $12 (average market price)
3.75 million shares
 The proceeds would be increased (or decreased) by any tax benefits
that would be added to (or deducted from) paid-in capital when the
eventual tax deduction differs from the amount expensed. Since that
occurs when the stock price at vesting differs from the stock price at
the grant date, this component is zero in this example.
T19-19
19-25
Chapter 19 - Share-Based Compensation and Earnings Per Share
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.
T19-20
19-26
Chapter 19 - Share-Based Compensation and Earnings Per Share
CONVERTIBLE BONDS
Common stock
January 1 60 million common shares were 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
[The average market price for 2011 was $25 per share.]
Preferred stock, nonconvertible
January 1-December 31
5 million 8%, $10 par, shares
Executive stock options
Options granted in 2009, exercisable for 15 million common shares* at an
exercise price of $20 per share

Convertible bonds
10%, $300 million face amount issued in 2010, convertible into 12 million
common shares*
*adjusted for the stock dividend
Basic EPS
(amounts in millions, except per share amounts)
$2.00 as before
Diluted EPS
net
income
preferred
dividends
$154
– $4
after-tax
interest savings
+ $30 – (40% x $30) $168
= $1.87
=
60 (1.10) + 12 (10/12) (1.10) – 8 (3/12) + (15 – 12)
shares
at Jan. 1
new
shares
treasury
shares
+ 12
90
exercise conversion
of options of bonds
___ stock dividend ___
adjustment*
T19-21
19-27
Chapter 19 - Share-Based Compensation and Earnings Per Share
CONVERTIBLE PREFERRED STOCK
Assume the preferred stock is convertible into common shares:

Preferred stock, convertible
5 million, 8%, cumulative, $10 par, shares, convertible into 3 million
common shares*
*adjusted for the stock dividend
Basic EPS
net
income
(amounts in millions, except per share amounts)
preferred
dividends
$154
– $4
$150
=
60 (1.10) + 12 (10/12)(1.10) – 8 (3/12)
shares
at Jan. 1
new
shares
=
2.00
=
$1.85
75
treasury
shares
___ stock dividend ___
adjustment
Diluted EPS
net
income
preferred
dividends
$154
– $4
after-tax
interest savings
+ $30 – (40% x $30)
$172
=
60 (1.10) + 12 (10/12)(1.10) – 8 (3/12) + (15 – 12) + 12
shares
at Jan. 1
new
shares
treasury
shares
exercise
of options
conv.
of
bonds
+3
93
conversion
of preferred
shares
___ stock dividend ___
adjustment
T19-22
19-28
Chapter 19 - Share-Based Compensation and Earnings Per Share
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 diluted EPS.

Stock warrants
Warrants granted in 2010, 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.
T19-23
19-29
Chapter 19 - Share-Based Compensation and Earnings Per Share
CONTINGENTLY ISSUABLE SHARES
 At times, contingent shares are issuable to shareholders of an
acquired company, certain key executives, or others in the
event a certain level of performance is achieved. Contingent
performance may be a desired level of income, a target stock
price, or some other measurable activity level.
 When
calculating EPS, contingently issuable shares are
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 (2012) if net income that year is $150
million or more. If net income in 2011 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 of the EPS fraction.
Assumed issuance of contingently issuable shares (diluted
EPS):
no adjustment to the numerator
+3
additional
shares
T19-24
19-30
Chapter 19 - Share-Based Compensation and Earnings Per Share
FINANCIAL STATEMENT PRESENTATION

Basic and diluted EPS data are reported on the face of the
income statement for all periods presented. Companies
without potential common shares present basic EPS only.
Disclosure notes should provide additional disclosures
including:
 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.
 Any adjustments to the numerator for preferred dividends.
 Any potential common shares that weren’t included
because they were antidilutive.
 Any transactions that occurred after the end of the most
recent period that would materially affect earnings per
share.

When the income statement includes one or more items
that require separate presentation within the statement, EPS
data (both basic and diluted) must also be reported separately
for income from continuing operations and net income. Per
share amounts for discontinued operations, extraordinary
items, and the cumulative effect of an accounting change are
disclosed either on the face of the income statement or in the
notes to financial statements.
T19-25
19-31
Chapter 19 - Share-Based Compensation and Earnings Per Share
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Earnings per Share. FASB ASC 260 – Earnings per Share was
issued as part of a joint project with the IASB to eliminate
differences between SFAS 128 - Earnings per Share and IAS 33 Earnings per Share. Now, the denominator for the earnings per
share (EPS) calculation is the same under both US GAAP and
IFRS. The numerator still can differ because the components of
net income often are different under US GAAP and IFRS.
T19-26
19-32
Chapter 19 - Share-Based Compensation and Earnings Per Share
STOCK APPRECIATION RIGHTS
 When an SAR is considered to be equity (because the
employer can elect to settle in shares), 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.
 When an SAR is considered to be a liability (because the
employee can elect to receive cash upon settlement), the
amount of compensation (and related liability) is estimated
each period and continually 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.
T19-27
19-33
Chapter 19 - Share-Based Compensation and Earnings Per Share
STOCK APPRECIATION RIGHTS
Universal Communications grants 10 million SARs to key executives at January
1, 2011. 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
per share. The SARs vest at the end of 2014 (cannot be exercised until then) and
expire at the end of 2013. The fair value of the SARs, estimated by an
appropriate option pricing model, is $8 per SAR at January 1, 2011. The fair
value re-estimated at December 31, 2011, 2012, 2013, 2014 and 2013, is $8.40,
$8, $6, $4.30, and $5, respectively.
January 1, 2011
No entry
December 31, 2011
Compensation expense ($8.40 x 10 million x 1/4)
Liability – SAR plan
December 31, 2012
Compensation expense ([$8 x 10 million x 2/4] – 21)
Liability – SAR plan
December 31, 2013
Compensation expense ([$6 x 10 million x 3/4] – 21 – 19)
Liability – SAR plan
($ in millions)
21
21
19
19
5
December 31, 2014
Liability – SAR plan
2
Compensation expense ([$4.30 x 10 million x 4/4] –21–19–5)
5
2
T19-28
19-34
Chapter 19 - Share-Based Compensation and Earnings Per Share
STOCK APPRECIATION RIGHTS
(CONTINUED)
The liability continues to be adjusted after the service period if the rights
haven’t been exercised yet.
December 31, 2013
Compensation expense ([$5 x 10 million x all] –21–19–5+2)
Liability – SAR plan ..............................................
($ in millions)
7
7
It’s necessary to continue to adjust both compensation expense and the
liability until the SARs ultimately either are exercised or lapse.
Assume for example that the SARs are exercised on October 11, 2013,
when the share price is $14.50, and executives choose to receive the market
price appreciation in cash:
October 11, 2013
Liability – SAR plan....................................................
Compensation expense ([$4.50 x 10 million x all] –50)
Liability – SAR plan (balance) .....................................
Cash.........................................................................
($ in millions)
5
5
45
45
T19-29
19-35
Chapter 19 - Share-Based Compensation and Earnings Per Share
Suggestions for Class Activities
1.
Research Activity
Microsoft reported the following in its 2008 annual report:
Employee Stock Purchase Plan. We have an employee stock purchase plan for all eligible
employees. Compensation expense for the employee stock purchase plan is recognized in accordance
with SFAS No. 123(R). Shares of our common stock may be purchased by employees at three-month
intervals at 90% of the fair market value on the last day of each three-month period. Employees may
purchase shares having a value not exceeding 15% of their gross compensation during an offering
period.
Suggestions:
Have students describe way Microsoft accounts for shares purchased under this plan.
Note:
Since the discount to employees is 15%, the discount is considered to be compensation and that
amount is recorded as expense.
2.
Research Activity
GAAP requires reporting both basic and diluted EPS, but there is some latitude in how these data are
reported within the financial statements.
Suggestions:
Have students locate financial statements of companies with which they are familiar. You may want
them to use the Internet where EDGAR at http://www.sec.gov/edgar.shtml or specific corporate sites
will provide financial statements, seek out hard copy financial statements, or make their own choice
in how to locate the reports. Ask them to:
1. Indicate whether EPS data are reported on the income statement for basic, diluted, or both.
Are calculations explained in more detail in the footnotes?
2. Indicate whether EPS data are reported for both income from continuing operations and net
income.
3. Indicate whether per share amounts also are reported for:
1.
Discontinued operations.
2.
Extraordinary items.
4. Locate and explain the reconciliation of the numerator and denominator used in the
computations.
19-36
Chapter 19 - Share-Based Compensation and Earnings Per Share
3.
Real World Scenario
Time Warner, Inc. reported first quarter profits from operations of $52 million, or a loss of 5 cents a
share.
Suggestions:
Have students consider this statement. Ask them to suggest how it might be true.
Note:
The loss per share is due to the fact that preferred dividends were deducted from earnings before
dividing by the weighted average number of shares outstanding.
4.
Real World Scenario
Analysts attach great significance to earnings announcements. For that reason, companies are
particularly eager to meet earnings expectations. This desire has contributed to a relatively recent
trend, especially among technology firms, to report pro forma earnings per share.
Suggestions:
Ask students to perform an Internet search for companies that recently reported pro forma EPS.
Have them compare those numbers with GAAP EPS and describe the difference. Have them
evaluate the value of pro forma reporting of earnings.
Note:
Essentially, pro forma earnings are actual (GAAP) earnings reduced by any expenses the reporting
company feels are unusual and should be excluded. Pro forma results of a company always are better
than the real results.
When companies report pro forma results, they argue they are trying to help investors by providing
numbers that more accurately reflect their normal business activities, because they exclude unusual
expenses. Critics have argued otherwise. Due to the purely discretionary nature of pro forma
numbers and several infamous instances of abuse, it’s important to determine precisely what
expenses are excluded and what the actual GAAP numbers are.
19-37
Chapter 19 - Share-Based Compensation and Earnings Per Share
5.
Real World Scenario
The Motley Fool, in an online article, “Bye-Bye, Stock Options,” said:
Are you a faithful employee of a company that grants you stock options every now and then? If
so, find a chair and sit down. I've got some bad news for you. Stock options may soon go the
way of the dodo bird and saber-toothed tiger. Media conglomerate Time Warner, for example,
recently announced plans to significantly cut back on its options issuance, eliminating them
entirely for most employees. Why is this happening?
Suggestions:
Ask students to hypothesize as to “why this is happening.”
Note:
The Financial Accounting Standards Board (FASB) now requires companies to expense stock
options. Previously, many firms chose to have their cake and eat it, too – issue options as
compensation with no impact on their bottom lines. Now firms are increasingly choosing to do away
with options in favor of stock awards or other incentives, at least to some degree, to avoid taking a
big hit on their income statements.
6.
Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis, and judgment skills.
Communication Skills. In addition to Communication Cases 19-2 and 19-8, Judgment Case 19-7
can be adapted to ask students to assume the role of the consultant and write a memo to the
client explaining the paradox. Ethics Case 19-3 and Real World Case 19-15 are suitable for
student presentation(s). Real World Case 19-6 and Real World Case 19-15 do well as group
assignments. Questions 19-6 and 19-19 create good class discussions.
Research Skills. In their professional lives, our graduates will be required to locate and extract
relevant information from available resource material to determine the correct accounting
practice, perhaps identifying the appropriate authoritative literature to support a decision.
Research Cases 19-12 and 19-17 as well as Real World Case 19-9 provide excellent
opportunities to help students develop this skill. In addition, Problem 19-8 can be adapted to
require students to research the authoritative literature on performance plans.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret date to provide options for making
business and investment decisions. In addition to Analysis Cases 19-10, 13, 14, and 16,
Problem 19-1, Real World Cases 19-4, 9, and 15, and Communication Case 19-2 also provide
opportunities to develop analysis skills.
19-38
Chapter 19 - Share-Based Compensation and Earnings Per Share
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
evaluate options for decision-making and provide an appropriate conclusion. In addition to
Judgment Case 19-7, Ethics Case 11 also requires students to exercise judgment.
Assignment Chart
Questions
19-1
19-2
19-3
19-4
19-5
Learning
Objective(s)
1
2
2
2
3, 5
19-6
19-7
19-8
19-9
19-10
19-11
19-12
19-13
19-14
19-15
19-16
19-17
19-18
19-19
19-20
5
5, 6
7
4
8
9
9
10
11
12
9
13
13
A
B
Brief
Exercises
Learning
19-1
19-2
19-3
19-4
19-5
19-6
19-7
19-8
19-9
Objective(s)
1
2
2
2
2
2
2
2
2
Topic
Est. time
(min.)
5
5
5
5
Restricted stock
Stock options
Qualified option plans
Performance and market conditions
EPS for a company with a simple capital
structure
Weighted average number of common shares
Weighted average number of common shares
Preferred dividends when calculating EPS
Distinguish between basic and diluted EPS
Incorporate the dilutive effect of stock options
Convertible securities
Convertible securities
Antidilutive securities
EPS; “proceeds” in the treasury stock method
Contingently issuable shares
Convertible securities actually converted
EPS disclosures
EPS disclosures
Fair value
SARs
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
Est. time
Topic
Restricted stock award
Stock options
Stock options; forfeiture
Stock options; exercise
Stock options; expiration
Performance-based options
Performance-based options
Performance-based options
Options with market-based conditions
19-39
(min.)
5
5
5
5
5
5
5
5
5
Chapter 19 - Share-Based Compensation and Earnings Per Share
19-10
19-11
19-12
19-13
19-14
Exercises
19-1
19-2
19-3
19-4
19-5
19-6
19-7
19-8
19-9
19-10
19-11
19-12
19-13
19-14
19-15
19-16
19-17
19-18
19-19
19-20
19-21
19-22
19-23
19-24
19-25
19-26
19-27
19-28
5, 6
7
8
9
11
EPS; shares issued, shares retired
EPS; nonconvertible preferred shares
EPS; stock options
EPS; convertible preferred shares
EPS; restricted stock award
5
5
5
5
5
Learning
Est. time
Objective(s)
Topic
(min.)
1
Restricted stock award plan
15
1
Restricted stock award plan
15
1
Restricted stock award plan
10
1
Restricted stock award plan; forfeitures
15
anticipated
2
Stock options
15
2
Stock options
20
2
Stock options
20
2
Stock options
20
3
Employee share purchase plan
20
5, 6
Shares issued; stock dividend
10
5, 6
Treasury stock; new shares; stock dividends; two
20
years
5, 6, 7
Stock dividend; nonconvertible preferred stock
10
5, 6, 7
Net loss; nonconvertible preferred stock; shares
10
sold
5, 6, 7
Stock dividend; nonconvertible preferred stock;
10
treasury shares; shares sold
5, 6, 7, 8 Stock dividend; nonconvertible preferred stock;
20
treasury shares; shares sold; stock options
6, 7, 8
Stock dividend; nonconvertible preferred stock;
20
treasury shares; shares sold; stock options
exercised
6, 7, 8, 9 Stock dividend; nonconvertible preferred stock;
treasury shares; shares sold; stock options;
20
convertible bonds
6, 7, 8, 9 Shares issued; stock options
15
7, 9
Convertible preferred stock; convertible bonds
15
11
EPS; restricted stock
15
1, 11
Record restricted stock; effect of EPS
15
6, 12
New shares; contingently issuable shares
15
6, 12
New shares; contingent agreements
15
5-13
Concepts; terminology
20
2
FASB codification research
15
2, 3, 7, 13 FASB codification research
25
B
Stock appreciation rights; settlement in shares
15
B
Stock appreciation rights; cash settlement
25
19-40
Chapter 19 - Share-Based Compensation and Earnings Per Share
CPA/CMA
Exam Questions
Learning
Objective(s)
CPA-1
CPA-2
CPA-3
CPA-4
CPA-5
CPA-6
CPA-7
CMA-1
CMA-2
2
2
6
7
8
9
9
2
2
Topic
Stock options
Stock options
Basic EPS
Basic EPS
Diluted EPS
Diluted EPS
Diluted EPS
Stock awards
Stock awards
19-41
Est. time
(min.)
3
3
3
3
3
3
3
3
3
Chapter 19 - Share-Based Compensation and Earnings Per Share
Problems
19-1
19-2
19-3



19-4
19-5
19-6
19-7
19-8
19-9

19-10
19-11
19-12
19-13

19-14
19-15
19-16
19-17
19-18
19-19

19-20
Learning
Objective(s)
Est. time
(min.)
Topic
Stock options; forfeiture; exercise
2
Stock options; graded vesting
2
Stock options; graded vesting; measurement
2
using a single fair value per option
Stock options; graded vesting; IFRS
2, 14
Steve Job’s restricted stock; tax effects
2
2
Stock option plan; deferred tax effect
recognized
Stock option plan; deferred tax effect of a
2
nonqualifying plan
2
Performance share plan
5, 6, 7, 13
Net loss; stock dividend; nonconvertible
preferred stock; treasury shares; shares sold;
extraordinary loss
4, 5, 6
EPS from statement of retained earnings
4, 5, 6
EPS from Statement of Shareholders’ Equity
4, 5, 6, 7
Nonconvertible preferred stock; treasury
shares; shares sold; stock dividend
4, 5, 6, 7, 8, 10 Nonconvertible preferred stock; treasury
shares; shares sold; stock dividend; options
4, 5, 6, 7, 8, 10, Nonconvertible preferred stock; treasury
11
shares; shares sold; stock dividend; options;
convertible bonds; contingently issuable
shares
7, 9, 10
EPS; convertible preferred stock; convertible
bonds; order of entry
4-10, 13
Antidilution
4, 5, 6, 9
Convertible bonds; treasury shares
4-9
Options; convertible preferred; additional
shares
4-9
Stock options; nonconvertible preferred;
convertible bonds; shares sold
1, 2, 4, 8, 11
Stock options; restricted stock; additional
components for “proceeds” in treasury stock
method
 Star Problems
19-42
25
35
35
35
40
40
40
25
25
20
25
15
20
40
25
25
20
15
25
40
Chapter 19 - Share-Based Compensation and Earnings Per Share
Cases
Real World Case 19-1
Communication Case 19-2
Ethics Case 19-3
Trueblood Accounting
Case 19-4
Real World Case 19-5
Real World Case 19-6
Ethics Case 19-7
Real World Case 19-8
Analysis Case 19-9
Analysis Case 19-10
Judgment Case 19-11
Communication Case 19-12
Real World Case 19-13
Analysis Case 19-14
Research Case 19-15
Analysis Case 19-16
Research Case 19-17
British Airways Case
CPA Simulation 19-1
Learning
Est. time
Objective(s)
Topic
(min.)
1
Restricted stock; Microsoft
25
2
Stock options; basic concepts; prepare a memo
60
2
Stock options
25
1, 2
1, 2, B
3
6
8
Share-based plans
Share-based plans; Cisco
Stock purchase plan; Microsoft
International Network Solutions
Per share data; stock options; antidilutive
securities; Sun Microsystems
4, 5, 6, 7, 8 EPS concepts
5, 6, 7, 8 EPS; AAON, Inc.
4-7, 9
Where are the profits?
9
Dilution
13
Reporting EPS; discontinued operations;
Alberto-Culver Company
13
13
13
13
14
Analyzing financial statements; price-earnings
ratio; dividend payout ratio
Determining and comparing PE ratios; retrieving
stock prices and earnings per share numbers
from the Internet; Microsoft; Intel
Kellogg’s EPS; PE ratio; dividend payout
FASB codification; locate and extract relevant
information and cite authoritative support for a
financial reporting issue; change in
classification of a share-based compensation
instrument
45
45
15
25
25
25
25
40
45
35
30
60
25
60
IFRS; accounting for share-based compensation
30
and earnings per share; British Airways
Judgment; calculating and reporting earnings
per share; analyzing the financial statement
effects; communication; research
19-43