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Theory of Financial Accounting II > Chapter 16: Dilutive Securities and Earnings per Share > Flashcards

Chapter 16: Dilutive Securities and Earnings per Share Flashcards

1
Q

Liabilities vs Equity

A

Liabilities - include an obligation to pay the liability holder at some future point. measured at fair value with changes reported in income

differentiating liabilities vs equity is a current FASB project

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2
Q

control number

A

Income from continued operations used to determine if a potential common stock is dilutive or antidilutive

Instead of using final net loss as basic EPS numerator

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3
Q

Treasury stock method of calculating dilutive EPS

A

Used for options, warrants and equivalents

  • assumes that options/warrants are exercised at the beginning of the year or date of issue
  • assumes the company uses the proceeds to purchase common stock for treasury

Shares issue upon exercise of warrant/option
less treasury shares purchasable with proceeds (market price - option price / market price x number of options = number of treasury shares)
= incremental shares oustanding

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4
Q

Treasury stock method Average common shares outstanding

A

average number of shares related to options outstanding x option price per share
= proceeds upon exercise of options

Proceeds / average market price of common stock = treasury shares that could be repurchased

Excess number of shares under option over treasury shares repurchased = potential common incremental shares + average number of common shares outstanding

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5
Q

Calculating interest expense avoided

A

Interest expense for year
less income tax reduction (tax rate x interest)
= interest expense avoided

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6
Q

Calculating an amount net of tax

A

Amount x (1-tax rate)

may need to adjust for a partial year

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7
Q

Calculating weighted average shares outstanding for stock dividends / stock splits

A

Must restate shares outstanding prior to the dividend/ split as if the shares were in place all year

no change to total investment

so if 25% dividend declared then multiply outstanding shares from earlier periods by 1.25
3 to 1 split = multiply by 3

if occurs after year end buy before statements are issued then must restate all of the previous year

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8
Q

Calculating weighted average number of shares oustanding

A

outstanding shares weighted by fraction of period outstanding to get equivalent whole shares for the year

shares purchased by company reduce total shares outstanding

Period (shares outstanding x fraction of the year) = weighted shares
sum all weighted shares for total shares

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9
Q

Earnings per share: simple capital structure

A

= net income - preferred dividends / weighted average common shares outstanding

EPS = income available to common stockholders

if net loss:
= net loss + preferred dividends / weighted average common shares outstanding (WACSO)

if cumulative preferred stock but no declared dividends subtract amount of preferred dividends that would be for the current year only as any dividends in arrears would have been in previous year’s computations

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10
Q

How to tell if a security is antidilutive

A

(if antidilutive should be excluded from diluted EPS)

If conversion of security will increase EPS then security is antidilutive

Occurs with:

  • options and warrants where exercise price is greater than market price
  • convertible debt where increase from addition of net of tax interest to income is greater than percentage increase in common shares from conversion

easiest just to check the math

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11
Q

Reporting EPS with diluted EPS

A

Net Income (underlined)

EPS (underlined)
Basic EPS (double underlined)

Diluted EPS (double underlined)

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12
Q

If-converted method for calculating diluted EPS

A

Assumes:

  • conversion at the time of issue or the beginning of the period
  • elimination of related interest expense, net of tax

if sold at premium or discount must adjust

net income may or may not increase depending on interest effect/tax effect (numerator)
weighted average shares increases (denominator)

must consider portion of the year

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13
Q

Calculating diluted EPS

A

Basic EPS
less impact of convertibles
less impact of options, warrants, and other dilutive securities

if conversion rate changes over the year must calculate the most dilutive option

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14
Q

Convertible preferred stock and dilutive shares

A
  • convertible preferred stock = potential common shares, included in diluted EPS
  • do NOT subtract preferred dividends in the numerator (since if there is no preferred stock there will be no preferred dividends)

No tax effect because preferred dividends are not generally taxable

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15
Q

EPS presentation on income statement

A
  • list both basic EPS and Diluted EPS
  • split into continuing ops and discontinued ops when applicable
  • show EPS for all periods presented
  • if show diluted EPS for one period must show for all
  • must restate if statments are restated
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16
Q

EPS disclosures

A

Required for complex capital structures/ dual presentation
Must disclose:
- pertinent rights and privileges for securities
- reconciliation of basic and dilutive EPS calculation
- income and share amounts from all activities that affect EPS
- effect of any preferred dividends
- potential future dilutive securities not currently included
- effects of conversions after year end but before statements are released

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17
Q

Recording compensation expense under stock appreciation plan

A

Debit Compensation expense
Credit Liability Under Stock-Appreciation plan

When paid out:
Debit Liability Under Stock-Appreciation Plan
Credit Cash

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18
Q

Percentage approach of allocating compensation expense

A

every period charges total percent of service period served to date less amounts already charged

adjusted for change in market price if change in prices occurs in subsequent periods or until rights expired or exercised

cumulative expense cannot be negative

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19
Q

Recording share based liability awards

A

1) Measure fair value at grant date and accrue compensation over the service period
2) re-measure fair value each reporting period until award is settled. Adjust compensation prorated for portion of service period completed.
3) when service period completed compensation expense in subsequent periods = full change in market price

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20
Q

Share-based liability awards

A

SARs = liability if, at date of exercise, holder receives a cash payment of the amount of share-price appreciation

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21
Q

Share-based Equity awards

A

SARs = equity if, at date of exercise, the holder receives stock

creates equivalent stock option

shares received = share price appreciation

follows accounting for stock options
- compensation expense recorded over service period

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22
Q

Stock-appreciation rights

A

SARs
Right to receive compensation equal to share appreciation
- may be paid in cash, shares, or a combination
- no cash outlay required to receive payment
- shares not actually issued
- accounting depends on how company classifies rights - as liability or equity

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23
Q

Share appreciation

A

the excess of market price of the stock at date of exercise over a preestablished price

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24
Q

Incentive stock option plan

A

No taxes paid at exercise

may need to borrow to finance exercise price (leads to interest expense)

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25
Q

Nonqualified stock option plans

A

require purchaser to pay income tax on difference between market price and option price

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26
Q

Calculating cumulative preferred stock and EPS

A

Subtract preferred dividend from net income even if dividend is not declared

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27
Q

Steps for computing diluted EPS

A

1) for each dilutive security determine the per share effect of exercise or conversion
2) rank results from smallest to largest effect
3) as long as earnings per share total is less than simple EPS, starting with smallest per share effect add dilutive securities to EPS

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28
Q

Contingent issue agreement

A

shares to be issued upon certain conditions in a business combination (passage of time, market price level)

if contingency is within current year then company considers contingent shares outstanding for basic and diluted EPS

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29
Q

Antidilutive securities

A

Upon conversion EPS in increased (or loss per share is decrease)

NOT reported in financial statements

  • likelihood of conversion/exercise considered remote
  • basic EPS = likely situation, Dilutive EPS = worst case
30
Q

Disclosure of compensation plans

A

Must disclose status of compensation plans

If have share based payment arrangements:

  • nature and terms of arrangements existing during period
  • potential affects on shareholders
  • effect on the income statement of this compensation cost
  • method of estimating fair value
  • cash flow from share-based payment arrangements
31
Q

Employee Stock purchase plans

A

ESPP

Permit all employees to purchase stock at a discounted price for a short period of time

COMPENSATORY unless ALL of the below are true:

  • all full time employees are eligible on an equitable basis
  • discount from market price is small, does not exceed per share costs avoided by lack of public offering (5% or less)
  • no substantive option feature

Expense recorded over service life of employee

32
Q

Accounting for restricted stock

A

Similar to accounting for stock options

  • determine fair value at date of grant
  • expenses fair value over service period

Debit Unearned Compensation (deferred compensation expense, not liability)
Credit common stock (shares @ par)
Credit PIC common stock

then over service period:
Debit Compensation Expense
Credit unearned compensation

if forfeited then entries reversed as long as not vested

33
Q

Restricted stock plans

A

Transfer shares of stock to employees subject to an agreement that shares cannot be sold, transferred or pledged until vesting occurs. Shares are forfeited if conditions not met.

Advantages

  • restricted stock never becomes worthless
  • results in less dilution to existing stockholders
  • better aligns employee incentives with company incentives when employees are stockholders
34
Q

Grant date

A

Date employee receives options to purchase stock

35
Q

Stock options

A

a form of compensation that gives key employees the choice to purchase shares at a given (usually lower than market) price

  • opportunity to receive stock if company performance is satisfactory

new accounting rules in 2005 require expensing of the fair value of stock options when granted

36
Q

Dodd-Frank act required disclosures

A

(2010) “Pay Ratio rule”

SEC requires companies to disclose:

  • median of the annual total compensation of all employees in the company except the CEO
  • annual total compensation of the CEO
  • ratio of above amounts
37
Q

Dilutive securities

A

Convertible securities that, upon exercise, may reduce (dilute) earnings per share

also options and warrants

38
Q

Convertible bonds

A

can be changed into other corporate securities during some specified period after the bond’s issuance
- benefits of a bond (guaranteed interest and principle) + option of conversion to stock (if stock value rises)

conversion privilege may entice investor to accept lower than usual interest rate

considered a liability

39
Q

Induced conversion

A

Issuer offers additional consideration (cash, common stock) to encourage prompt conversion of debt to equity

Additional consideration = “sweetener” is recorded as an expense of the current period for the fair value of the consideration

40
Q

Convertible preferred stock

A

Includes an option for the holder to convert preferred shares to a fixed number of common shares

convertible preferred stock = equity

no gain or loss on conversion

41
Q

Diluted EPS: convertible securities

A

If converted method

  • find effect on net income (elimination of interest net of tax or elimination of preferred dividends)
  • find effect on weighted average common shares outstanding
  • assumes conversion at the beginning of the period or as soon as the security was issued)

(Always find basic eps first to determine if security is dilutive or antidilutive)

42
Q

Interest expense net of tax

A

Total interest expense
Less interest expense *tax rate (tax benefit lost)
= Net interest expense

43
Q

Dilutive EPS - options and warrants

A

Treasury stock method

  • calculate net income from exercise of option/warrant
  • figure out how many treasury shares could be bought at market price with that income
  • new shares outstanding less treasury shares purchased = net effect on weighted average shares outstanding
  • no effect on net income
  • assumes exercises at the beginning of the period or as soon as option issued
  • remember to weight for partial periods

(Always find basic eps first to determine if security is dilutive or antidilutive)

44
Q

Dilutive securities

A

Securities that can be converted to common stock and drive EPS in a downward direction

45
Q

Reasons for Issuing stock warrants

A

1) Provide an “equity kicker” when issuing certain types of securities
2) as evidence of preemptive right of stockholders
3) as stock options to executives and employees

46
Q

Dilutive Effect

A

A transaction that reduces earnings per share

47
Q

Warrants

A

Certificates entitling the holder to acquire shares of stock at a certain price in a certain period

if exercised: become common stock and generally have a dilutive effect (reducing EPS)

Still must pay for shares

A long term option on common stock at a fixed price

48
Q

Detachable stock warrant

A

Can be detached from the stock and traded as a separate security

Price = price paid for unit (stock and warrant) less market price of common stock
- proceeds allocated between the two securities

not profitable to exercise the warrant unless the stock price increases

49
Q

Simple capital structure

A

only common stock/ no potential dilution of EPS via conversion or exercise of warrants

50
Q

Reporting earnings per share on income statement

A

Reported below net income with intermediate components (income from continuing operations, loss or income from discontinued operations) split out if applicable

51
Q

Earnings per share

A

Earnings per share for common stock ONLY

Public companies MUST report on income statement

Must split out continuing and discontinued ops

Discontinued operations shown net of tax

fails to recognize the impact of dilutive securities

52
Q

Nondetachable warrants

A

No allocation of proceeds - recorded entirely as debt

not 100% faithful representation but would be unreasonably costly to estimate separation

53
Q

Dilutive Securities

A

Securities that can be converted to common stock

typical in mergers and compensation plans

on conversion or exercise they reduce EPS

54
Q

Complex capital structure

A

Equity includes securities that could have a dilutive effect on EPS

generally need to report both basic and diluted EPS

55
Q

Options and warrants as dilutive

A

Exercise price < market price = dilution occurs
Exercise price > market price = antidilutive

only calculate dilutive EPS if dilution occurs

56
Q

Proportional method of recording stock warrants issued with other securities

A

Record values of bonds (liability) and warrants (equity) separately

allocates via proportions based on fair value -percentage of aggregate fair value applied to the sales price

Bonds
Debit Cash
Debit Discount or Credit Premium
Credit Bonds Payable (face value)

Warrants
Debit Cash
Credit PIC Stock warrants (don’t recognize common stock until warrants exercised)

can combine

57
Q

Recording Exercise of warrants

A

Debit Cash (price on warrant x shares)
Debit PIC- stock warrants (full or relative amount of original PIC amount)
Credit common stock (# stocks x par/ stated value)
Credit PIC- common stock (remaining)

58
Q

Recording un-exercised warrants

A

Debit Paid in capital- stock warrants
Credit paid in capital - expired stock warrants

Becomes equity for current stockholders

59
Q

Recording rights to subscribe to additional shares

A

Preemptive privilege / stock right
- usually a short duration warrant to purchase stock below market price

Memorandum entry made when issued (# of rights issued)

No formal entry until exercised then just usual:

Debit Cash
Credit stock
Credit PIC if any

60
Q

Incremental method of valuation of stock warrants issued with other securities

A

If cannot determine fair value of warrant or of bonds then use the same incremental method as for lump sum securities

  • record whichever part for which fair value can be determined at that fair value
  • apply remainder of price to other security
61
Q

Recording stock warrants issued with other securities

A

Allocate the proceeds from the sale between the two securities

  • if actively traded as separate investments then can determine fair value

Two methods for recording:

  • proportional
  • incremental
62
Q

Recording retirement of convertible debt

A

Recognize a gain or loss on retirement exactly as for non-convertible debt

Difference between cash acquisition price of debt and carrying amount = current income gain or loss

63
Q

Recording induced conversion

A

Debit Debt Conversion expense
Debit Bond payable (face value)
Debit Discount or credit premium on bond
Credit Common stock (at par value)
Credit PIC - common stock (plug)
Credit cash received

64
Q

Recording convertible debt at time of issue

A

Usual debt entries

Bond at face value
Discount or premium
Cash

Nothing recorded as equity

discount or premium then amortized

65
Q

Recording conversion of bonds into other securities

A

Book value method
- records securities exchanged for the bond at the book value of the bond

Debit Bonds Payable
Debit premium or credit discount (for any unamoritized amount)
Credit common stock
Credit PIC Common-stock

No gain or loss recorded on conversion

66
Q

Exercise vs expiration of stock options

A 
Exercise:
Debit Cash
Debit PIC - stock options
        Credit Common stock (at par)
        Credit PIC - common stock

Expiration
Debit PIC - stock options
Credit PIC- expired stock options

67
Q

Fair value method for valuing stock options

A

GAAP
Stock options valued at fair base based on acceptable option-pricing models taking multiple factors into account

generally results in higher compensation costs than intrinsic value

Used to compute compensation expense. Not readjusted later as stock price changes

68
Q

Intrinsic value method of valuing stock options

A

NOT GAAP

value = the difference between market price of the stock and the exercise price of the option at the grant date

69
Q

Recognizing stock compensation

A

Expense amount determined using fair value method

Service period in which expense recognized = vesting period (period between grant date and vesting date) = expected period of benefit

  • Expense over expected period of benefit
  • no entry at date of grant

Debit Compensation Expense
Credit PIC- stock options
(split equally over periods in period of benefit)

if employee fails to satisfy service requirement for vesting then journal entry is reversed

70
Q

Recording conversion of convertible preferred stock

A

Book value method

Debit Preferred Stock (at par)
Debit PIC- preferred stock (proportion of any related)
Credit Common stock
Credit PIC- common stock (plug)

Or, if par value of common stock greater than the book value of the preferred stock then debit the difference to retained earnings

(this debit to retained earnings is basically an additional return offered to preferred stockholders to facilitate conversion to common stock. some states require that instead of reducing retained earnings PIC from other sources should be reduced instead)

Theory of Financial Accounting II (8 decks)

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