Share-Based Compensation
and Earnings Per Share
Chapter 19
PowerPoint Authors:
Susan Coomer Galbreath, Ph.D., CPA
Charles W. Caldwell, D.B.A., CMA
Jon A. Booker, Ph.D., CPA, CIA
Cynthia J. Rooney, Ph.D., CPA
Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.
19-2
Share-Based Compensation
Stock Award Plans
Compensation:
 Salary
 Stock awards
Restricted stock plans
 Usually tied to continuing employment.
 Compensation is market price at date of grant.
 Compensation expense accrued over service period.
19-3
Stock Option Plans
Stock option plans give employees the option to buy
 a specified number of shares of the firm's stock,
 at a specified exercise price,
 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).
19-4
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.
19-5
Failed Attempt to Require Expensing
Opposition to a proposed FASB Statement to
recognize expense for certain stock option plans
have identified three objections.
1. Options with no intrinsic value at issue
have zero fair value and should not give
rise to expense recognition.
2. It is impossible to measure the fair value of
compensation on the date of grant.
3. The proposed standard would have
unacceptable economic consequences.
19-6
Recognizing Fair Value of Options
Accounting for stock options parallels the accounting
for restricted stock we discussed earlier. We are
required to estimate the fair value of stock option
on the grant date.
The FASB requires that compensation expense be
measured using one of several option pricing models
that deal with:
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.
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.
19-7
19-8
U. S. GAAP vs. IFRS
There are more similarities than differences in the
treatment of stock options. One major difference is the
treatment of deferred tax assets and when options have
graded vesting.


A deferred tax asset (DTA) is
created for the cumulative amount
of the fair value of the options the
company has recorded for
compensation expense.
Account for each vesting amount
separately or account for the
entire award on the straight-line
basis over the entire vesting
period.


The deferred tax asset is not
created until the award is “in the
money;” that is it has intrinsic
value.
Straight-line choice is not
permitted. Companies not
required to recognize the award
that has vested by each reporting
date.
19-9
Plans With Graded-Vesting
Rather than stock option plans vesting on a single date, more plans
awards specify that recipients gradually become eligible to exercise their
options rather than all at once. This is called “graded vesting.”
Accounting for compensation expense may be handled:
1
2
The company may estimate a single
fair value for each of the options,
even though they vest over
different time periods, using a single
weighted-average expected life of
the options.
The company may use a slightly more
complex method because it usually
results in lower expense. In this approach,
we view each vesting group separately, as
if it were a separate award. For example,
a company may award stock options that
vest 25% in the first year, 25% in the
second year, and 50% in the third year.
For accounting purposes we have three
separate awards.
19-10
Employee Share Purchase Plans



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:
Cash (100 × $8.50)
Compensation expense (100 × $1.50)
Common stock (100 × $10.00)
Market value
850
150
1,000
19-11
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.
19-12
Basic Earnings Per Share
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
*Current period’s cumulative preferred stock dividends (whether
or not declared) and noncumulative preferred stock dividends
(only if declared).
19-13
Issuance of New Shares
Compute the weighted-average number of shares of
common stock outstanding.
Date
1/1
4/1
10/1
Description
Balance
Issued
Issued
No. of Shares
100,000
50,000
10,000
19-14
Issuance of New Shares
Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting
Annual
Weighting
100,000 + [50,000 × (9/12)] + [10,000 × (3/12)] = 140,000
Shares
at Jan. 1
New
Shares
New
Shares
19-15
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.
19-16
Stock Dividends and Stock Splits
Compute the weighted-average number of shares of
common stock outstanding.
Date
1/1
4/1
5/1
Description
No. of Shares
Balance
100,000
Issued
50,000
Stock dividend (100%)
150,000
19-17
Stock Dividends and Stock Splits
Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting
100,000 × (2.00) + [50,000 × (9/12) × 2.00] = 275,000
Shares
at Jan. 1
New
Shares
Stock dividend
adjustment
19-18
Stock Dividends and Stock Splits
Retroactive treatment
New shares
issued this period?
Yes
Stock dividend or split is
applied retroactively in
proportion to the number of
shares outstanding at the
time of the dividend or split.
No
Stock dividend or split
is treated as
outstanding from the
beginning of the
period.
19-19
Reacquired Shares
If shares were reacquired during the
period, the weighted-average number of
shares is reduced. The number of
reacquired shares is time-weighted for
the fraction of the year they were not
outstanding.
19-20
Reacquired Shares
Compute the weighted-average number of shares
of common stock outstanding.
Date
1/1
4/1
5/1
Description
Balance
Issued
Repurchased shares
No. of Shares
100,000
50,000
12,000
19-21
Reacquired Shares
Compute the weighted-average number of
shares of common stock outstanding.
Annual
Weighting
Annual
Weighting
100,000 + [50,000 × (9/12)]  [12,000 × (8/12)] = 129,500
Shares
at Jan. 1
New
Shares
Subtract the reacquired shares
Treasury
Shares
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
19-22
19-23
Diluted Earnings Per Share
Potential Common Shares
Stock options, rights, and warrants
 Convertible bonds and stock
 Contingent common stock issues
Complex Capital Structure
(dual EPS)

Contingently
issuable
shares
Stock
Options
Convertible
securities
Treasury stock
method
If-converted
method
Dilution/Antidilution Test
May Report Basic and Diluted Earnings Per Share
19-24
Options, Rights, and Warrants
The treasury stock method
Proceeds
assumes that proceeds
from the exercise of
At
options are used to
Used to
average
purchase treasury shares. market
This method usually
price
results in a net increase in
Purchase
shares included in the
treasury
denominator of the
shares
calculation of diluted
earnings per share.
19-25
Options, Rights, and Warrants
Determine new shares from assumed
exercise of stock options.
2. Compute number of shares repurchased.
1.
Proceeds from assumed exercise
Average market price of stock
19-26
Options, Rights, and Warrants
1.
2.
3.
Determine new shares from assumed
exercise of stock options.
Compute shares purchased for the treasury.
Compute the incremental shares assumed
outstanding.
New shares from assumed exercise (1)
Less: Treasury shares assumed purchased (2)
Net increase in shares outstanding (3)
19-27
Options, Rights, and Warrants
When the exercise price exceeds
the market price, the securities are
antidilutive securities and are
excluded from the calculation of
diluted EPS.
19-28
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.
19-29
Convertible Securities
The assumed conversion of convertible bonds or
preferred stock has two effects on dilutive earnings per
share:
1.
2.
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.
19-30
Convertible Securities
Dilutive earnings per share may decrease or
increase after the assumed conversion.
If dilutive earnings per share decreases, the
securities are dilutive and are assumed
converted.
If dilutive earnings per share increases, the
securities are antidilutive and are not
considered converted.
Order of Entry for Multiple Convertible
Securities
When a company has more than one instance of
potential common shares, they are considered for
inclusion in dilutive EPS in sequence from the
most dilutive to the least dilutive.
19-31
19-32
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.
19-33
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.
Example: Additional shares may be
issued based on future earnings.
19-34
Restricted Stock Awards
Restricted stock awards are quickly replacing
stock options as the share-based compensation
plan of choice. Like stock options, the treasury
stock method is used to calculate the number of
shares in the denominator of the EPS equation.
Unlike stock options, employees do not pay to
acquire their shares of stock.
Changes to the EPS Calculation:
No adjustment to the numerator
Denominator is increased using treasury method
19-35
Summary
19-36
Summary
19-37
Financial Statement Presentation
Report EPS data separately for:
1. Income from Continuing Operations
2. Separately Reported Items
a) Discontinued Operations
b) Extraordinary Items
3. Net Income
19-38
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.
19-39
Summary
The fair value of an option is (a) its intrinsic value plus (b)
its time value of money plus (c) its volatility component.
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.
Usually the same as the fair
value of a stock option with
similar terms.

This amount is expensed over the service period.
19-40
19-41
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.
19-42
End of Chapter 19