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Share-Based Compensation and Earnings Per Share

Sid Glandon, DBA, CPAAssociate Professor of AccountingThe University of Texas at El Paso

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Stock Compensation Plans Provide employee incentives:

Stock award plans Stock option plans Stock appreciation rights Broad-based (noncompensatory

plans)

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Stock Award Plans Restricted shares are issued as

compensation Compensation expense is

recognized over the vesting period At the end of the vesting period

the normal equity accounts are credited for common stock and additional paid-in capital

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Stock Award PlansAccount Debit Credit

Compensation expense XXX Paid-in capital, restricted stock XXXTo record the annual allocation to compensation expense under the stock award plan

Account Debit CreditPaid-in capital, restricted stock XXX Common stock XXX Paid-in capital, excess of par XXXTo record the vesting of stock under the stock award plan

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Stock Option Plans Important dates

Grant date of options Vesting date Exercise date of options

Compensation expense recognized by Fair value method (SFAS 123)

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Important Dates

Work Start Date

Grant Date Exercise Date

Vesting Date

Expiration Date

Options are granted to employee

Date employee can first exercise options

Employee exercises options

Unexercised Options expire

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Example: Fact Pattern Grant date, January 1, 2001 10,000 options granted One option = one $1 par value share Exercise price: $60; Market price: $70 Options exercisable within 10 years Service period is 2 years 2,000 options exercised on June 1, 2004 8,000 options expired on January 1, 2011 Using an option pricing model the fair value of

options is $220,000

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Granting Stock Options and Recording Expense

Date Account Debit Credit1/1/01 No entry at grant date

12/31/01 Compensation expense $110,000 Paid-in capital, stock options $110,000To record the allocation of compensation related to the stock options

12/31/02 Compensation expense $110,000 Paid-in capital, stock options $110,000To record the allocation of compensation related to the stock options

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Exercise of Stock OptionsDate Account Debit Credit

6/1/04 Cash $120,000Paid-in capital, stock options 44,000 Common stock $2,000 Paid-in capital, excess of par 162,000To record the exercise of 2,000 options at $60 per share

Analysis of paid-in capital, options:Original compensation expense $220,000Number of options 10,000Compensation per option 22Options exercised 2,000Reduction of paid-in capital, options $44,000

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Expiration of Stock Options

Date Account Debit Credit1/1/11 Paid-in capital, stock options $176,000

Paid-in capital, expired options $176,000To record the expiration of 8,000 stock options

Analysis of paid-in capital, options:Original compensation expense $220,000Number of options 10,000Compensation per option 22Options expired 8,000Reduction of paid-in capital, options $176,000

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Stock Appreciation Rights SARs

SARs are designed to mitigate employee cash flow problems in non-qualified plans

Employee gets right to receive any appreciation in share value at exercise date equal to market price Less pre-established amount

Employee receives cash or stock only for the appreciation

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Example: Stock Appreciation Rights Fact Pattern:

SARs program established, January 1, 2001 Exercise period, over next five years

Pre-established price per SAR $10 Number of SARs granted, 10,000

Market prices of stock at December 31, 2001, $13 2002, $17 2003, $15

Service period: 2 years The SARs are exercised on December 31, 2003

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Cumulative Compensation Recognizable for Service Period

2001 2002 2003Market value of stock $13 $17 $15SAR specified price 10 10 10 Difference 3 7 5Number of SARs shares granted 10,000 10,000 10,000Total compensation expense 30,000 70,000 50,000Percentage of service completed 50% 100% 100%Accumulated compensation expense 15,000 70,000 50,000Recognized in prior years 0 15,000 70,000Current year compensation expense $15,000 $55,000 ($20,000)

December 31,

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Compensation Expense Related to Stock Appreciation Rights

Date Account Debit Credit1/1/01 No entry at grant date

12/31/01 Compensation expense 15,000 Liability for SARs 15,000

12/31/02 Compensation expense 55,000 Liability for SARs 55,000

To record compensation expense associated with stock appreciation rights granted in 2001

To record compensation expense associated with stock appreciation rights granted in 2001

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Adjustment to Compensation Expense and Exercise of Stock Appreciation Rights

Date Account Debit Credit12/31/03 Liability for SARs 20,000

Compensation expense 20,000

12/31/03 Liability for SARs 50,000 Cash 50,000To record the exercise of SARS at December 31, 2003

To record and adjustment to compensation expense associated with stock appreciation rights granted in 2001

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Earnings Per Share (EPS) Most important number in income

statement Dilution of EPS means reduction in

EPS Potential conversion of dilutive

securities into common stock If dilution takes place extent of

reduction must be disclosed

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Basic EPS

Net Income less Preferred DividendsWeighted Average Outstanding Common Shares

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Basic EPS Fact Pattern:

Beginning balance = 800,000 shares Issued 100,000 shares on April 1 Reacquired 300,000 shares on July 1 Net income = $1,700,000 Preferred dividends = $250,000

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Weighted-Average common Shares Outstanding

Description Dates SharesFraction of

YearWeighted Average

Beginning balance 1/1/04 800,000 3/12 200,000 Issued shares 4/1/04 100,000Adjusted balance 900,000 3/12 225,000 Reacquired shares 7/1/04 (300,000)Adjusted balance 600,000 6/12 300,000

Weighted-average common shares outstanding 725,000

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Basic Earnings Per Share

Net income $1,700,000Less: preferred dividends 250,000Income available for common shareholders $1,450,000Divided by weighted-average shares 725,000 Earnings per share $2.00

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Stock Dividends and Splits Restatement of weighted shares

outstanding before the dividend or split

Deemed to have been outstanding since the beginning of the year

After year end but before issuance of financial statements require restatement to beginning of year

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Basic EPS with Stock Dividends

Fact Pattern: Beginning balance = 800,000 shares Issued 100,000 shares on April 1 Reacquired 300,000 shares on July 1 25% stock dividend on October 1 Issue 120,000 shares on November 1 Net income = $1,500,000 Preferred dividends = $481,125

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Weighted-Average Common Shares Outstanding

Description Dates Shares RestateRestated Shares

Fraction of Year

Weighted Average

Beginning balance 1/1/04 800,000 1.25 1,000,000 3/12 250,000 Issued shares 4/1/04 100,000Adjusted balance 900,000 1.25 1,125,000 3/12 281,250 Reacquired shares 7/1/04 (300,000)Adjusted balance 600,000 1.25 750,000 3/12 187,500 25% stock dividend 10/1/04 150,000Adjusted balance 750,000 750,000 1/12 62,500 Issued shares 11/1/04 120,000Adjusted balance 870,000 870,000 2/12 145,000

Weighted-average common shares outstanding 926,250

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Basic EPS with Stock Dividends

Net income $1,500,000Less: preferred dividends 481,125Income available for common shareholders $1,018,875Divided by weighted-average shares 926,250 Earnings per share $1.10

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Complex Capital Structures

Stock options, rights and warrants Convertible securities

Convertible bonds Convertible preferred stock

Only dilutive securities are considered

Antidilutive securities are ignored

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Dilution Reduction in EPS if potentially

dilutive: Stock options, rights or warrants Convertible securities

Assumed exercised or converted at beginning of the year

Two EPS calculations Basic EPS, and Diluted EPS

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Complex Capital Structures: Diluted EPS

Net Income less Preferred Dividends plus Bond Interest Expense (net of tax) and/or Convertible Preferred DividendsWeighted Average Number of Common Shares Outstanding

Assuming Maximum Dilution

Diluted EPS =

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Methods Treasury stock method

Options, Rights and Warrants If converted method

Convertible Securities Maximum dilutive conversion rate

is used in calculating diluted EPS

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Treasury Stock Method Options, rights and warrants are

included in EPS computations Assumed exercised at beginning of year Proceeds from exercise are assumed

used to buy back common shares Exercise price per share must be less

than market price per share for dilution

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Treasury Stock Method

• Fact Pattern:• Exercise price = $10 per share• Average market price = $40 per

share• 1,000 options outstanding and

assumed exercised• Additional shares added to weighted-

average common shares outstanding

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Dilution using the Treasury Stock Method

Shares assumed issued 1,000Proceeds assumed from options: Exercise price $10 Number of optionns outstanding 1,000 Assumed proceeds $10,000Assumed number of shares purchased: Assumed proceeds $10,000 Divided by average market price 40 Assumed number of shares purchased 250 Dilution (increase in outstanding shares) 750

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If-Converted Method Conversion of securities into common

stock is assumed to occur at the beginning of the year

Related interest effect (net of tax) and/or convertible preferred dividends are removed from the calculation of income available to common shares

Weighted average number of shares is increased by additional common shares assumed issued at beginning of year

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If-Converted Method Fact Pattern:

Net income = $500,000 Common shares outstanding =

250,000 $1,000,000 6% convertible bonds Each $1,000 bond convertible into 25

shares of common stock Income tax rate = 35%

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Basic EPA using If-Converted Method

Net income $500,000Common shares outstanding 250,000 Basic EPS $2.00

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Diluted EPS using If-Converted MethodAdjustment to net income available to commonNet income $500,000Face amount of bonds $1,000,000Stated interest rate 6%Interest expense 60,000Less: tax affect 21,000 Interest expense net of tax 39,000Adjusted net income $539,000

Adjustment to common shares outstandingCommon shares outstanding 250,000Shares assumed to be issued: Number of $1,000 bonds 1,000 Conversion ratio 25 Shares assumed to be issued 25,000Adjusted common shares outstanding 275,000

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Diluted EPS using If-Converted Method

Adjusted net income $539,000Adjusted common shares outstanding 275,000 Diluted EPS $1.96

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Complex Capital Structures Requires duel presentation

Basic earnings per share Diluted earnings per share