19 share-based compensation n eps

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2012 The McGraw-Hill Companies, Inc.

Share-Based Compensation andEarnings per Share

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Share-Based Awards

Many compensation plans include one or moretypes of share-based awards. These includeoutright awards of shares, stock options, or cashpayments tied to the market price of shares.

Usually, an executive compensation plan is tied toperformance in a way that uses compensation tomotivate its recipients.

Regardless of the form such a plan takes, theaccounting objective is to record the fair value ofthe compensation expense over the periods inwhich related services are performed.


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Stock Award Plans

Restricted stock award plans usuallyare tied to continued employment of

the person receiving the award.

The compensation associated with ashare of restricted stock is the marketprice at the grant date of anunrestricted share of the same stock.

The amount is accrued ascompensation expense over the serviceperiod for which participants receive

the shares.


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STOCK AWARD PLANS

ILLUSTRATION

Universal Communications grants 5 million of its $1 par commonshares to certain key executives at January 1, 2011. Theshares are subject to forfeiture if employment is terminatedwithin 4 years. Shares have a current price of$12 per share.

January 1, 2011

No entryCalculate 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-yearservice (vesting) period: 2011 - 2014$60 million 4 years = $15 million per year

December 31, 2011, 2012, 2013, 2014 ($ in millions)Compensation expense ($60 million 4 years) 15

Paid-in capital restricted stock 15


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STOCK AWARD PLANS

ILLUSTRATION

Upon vesting:($ in millions)

Paid-in capital restricted stock (5 million sh. at $12) 60

Common stock (5 million shares at $1 par) 5

Paid-in capital excess of par (to balance) 55

If restricted stock is forfeited because, say, the employee quitsthe company, related entries previously made would simply bereversed.


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STOCK OPTION PLANS

Stock option plans give employees theoption to purchase (a) a specified numberof shares of the firm's stock, (b) at aspecified exercise price, (c) during aspecified period of time.

The fair value is accrued as compensation

expense over the service period for whichparticipants receive the options, usuallyfrom the date of grant to when the optionsbecome exercisable (the vesting date).


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Recognizing Fair Value of Options

Estimating fair value requires the use of anoption pricing modelthat incorporates the: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.


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2012 The McGraw-Hill Companies, Inc.

CHANGING VALUE OF

STOCK OPTIONS
http://www.dilbert.com/strips/comic/2000-09-30/


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EXPENSING STOCK OPTIONS

At Jan. 1, 2011, Universal grants options to acquire 10 million ofthe companys $1 par common shares within the next 8 yrs, butnot before Dec. 31, 2014 (the vesting date). The exercise priceis the market price on the date of grant, $35 per share The fairvalue of the options is $8 per option.January 1, 2011

No entryCalculate total compensation expense:

$8 estimated fair value per optionx 10 million options granted= $80 million total compensation

The total compensation is allocated to expense over the 4-yearservice (vesting) period: 2011 - 2014$80 million 4 years = $20 million per year

December 31, 2011, 2012, 2013, 2014 ($ in millions)Compensation expense ($80 million 4 years) 20

Paid-in capital stock options 20


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ESTIMATED FORFEITURES

If a forfeiture rate of 5% was expected, annualcompensation expense would have been $19million ($76/ 4) instead of $20 million.

2011 ($ in millions)

Compensation expense ($80 x 95% x 1/4) 19Paid-in capital stock options 19

2012

Compensation expense ($80 x 95% x 1/4) 19Paid-in capital stock options 19


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ESTIMATED FORFEITURES

During 2013, the third year, Universal revises its estimate offorfeitures from 5% to 10%. The new estimate of totalcompensation 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 theamount already recorded ($19 million in 2011 and 2012).

2013 ($ in millions)

Compensation expense ([$80 x 90% x ] [$19 + 19]) 16Paid-in capital stock options 16

2014Compensation expense ([$80 x 90% x 4/4] [$19 + 19 + 16]) 18

Paid-in capital stock options 18


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WHEN OPTIONS ARE

EXERCISED

If half the options (five million shares) are exercised on July11, 2014, when the market price is $50 per share:

July 11, 2014 ($ in millions)

Cash ($35 exercise price x 5 million shares) 175

Paid-in capital - stock options (1/2 account balance) 40

Common stock (5 million shares at $1 par per share) 5

Paid-in capital excess of par (to balance) 210

If options that have vested expire without being exercised(assuming none of the options were exercised):

($ in millions)

Paid-in capital stock options (account balance) 80Paid-in capital expiration of stock options 80

Irrelevant

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EMPLOYEE SHARE PURCHASE

PLANS

Permit employees to buy shares directly from theiremployer.

Usually the plan is considered compensatory, andcompensation expense is recorded.

Assume an employee buys shares (no par) under anESPP plan for $850 rather than the current marketprice of $1,000. The $150 discount is recorded ascompensation expense:

Cash (discounted price) 850

Compensation expense ($1,000 x 15%) 150

Common stock (market value) 1,000

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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.

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EARNINGS PER SHARE

In the most basic setting, earnings per share is simply acompanys earnings (or loss) divided by the number of sharesoutstanding.Sovran Metals Corporation reported net income of $154 millionin 2011. (Its tax rate was 40%).

Common stockJanuary 1, 2011 60 million sharesoutstanding

(in millions, except per share amount)Basic EPS:

netincome

$154= $2.57

60shares

outstanding

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ISSUANCE OF NEW SHARES

If the number of shares has changed, its necessary to find theweighted average of the shares outstanding during the period theearnings were generated. Any new shares issued are time-weightedby the fraction of the period they were outstanding and then added tothe 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 stockJanuary 1 60 million common shares outstanding

March 1 12 million new shares were soldBasic EPS:

netincome

$154 $154= = $2.20

60 + 12 (10/12) 70

shares newat Jan. 1 shares

We time-weight the new shares for the

fraction of the year theyre outstanding.

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STOCK DIVIDENDS AND STOCK SPLITS

The additional shares created by a stock dividend or split arenotweighted for the time period they were outstanding.

Common stock

January 1 60 million common shares outstanding

March 1 12 million new shares were sold June 17 A 10% stock dividend was distributed

Shares outstanding prior to the stock distribution are retroactivelyrestatedto reflect the increase in shares that is, treated as if the

distribution occurred at the beginning of the period.

Basic EPS:(amounts in millions, except per share amount)

netincome

$154 $154= = $2.00

60 (1.10) + 12 (10/12) (1.10) 77shares new

at Jan. 1 shares

___ stock dividend ___adjustment

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REACQUIRED SHARES

Common stock

January 1 60 million common shares 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 stockBasic EPS:

The number of reacquired shares is time-weighted for the fraction of the year they werenot outstanding, prior to being subtracted from

the number of shares outstanding.

netincome

$154 $154= = $2.05

60 (1.10) + 12 (10/12) (1.10) 8 (3/12) 75shares new treasury

at Jan. 1 shares shares___ stock dividend ___

adjustment

Stock dividend adjustmentnot necessary since thetreasury shares were

reacquired after the stockdividend and thus already

reflect the adjustment.

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EARNINGS AVAILABLE TO

COMMON SHAREHOLDERS

net preferredincome dividends

$154

$4 $150= = $2.00


at Jan. 1 shares shares


Common stockJanuary 1 60 million common shares outstandingMarch 1 12 million new shares were soldJune 17 A 10% stock dividend was distributedOctober 1 8 million shares reacquired as treasury stock Preferred stock, nonconvertible

Jan. 1-Dec. 31 5 million 8%, $10 par, sharesBasic EPS:

5,000,000 x $10 x 8%

Preferred dividends are subtracted from net income sothat earnings available to common shareholders isdivided by the weighted average number of common

shares.

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COMPLEX CAPITAL STRUCTURE

Potential common shares Securities that, while not beingcommon stock, may become common stock through theirexercise 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 areoutstanding

A firm with a complex capital structure reports two EPS

calculations:BasicEPS ignores the dilutive effect of potential common

shares.

DilutedEPS incorporates the dilutive effect of potentialcommon shares. The dilutive effect is included essentially bypretending the securities already have been exercised,converted, or otherwise transformed into common shares.

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OPTIONS, RIGHTS, AND WARRANTS

Basic EPS (amounts in millions, except per share amounts)net preferred

income dividends

$154

$4 $150= = $2.00




Stock options, stock rights, and stock warrants give their holders theright to exercise their option to purchase common stock, usually at aspecified exercise price. The dilution that would result from theirexercise should be reflected in the calculation of diluted EPS.

Incentive stock optionsExecutive stock options granted in 2009, exercisable after 2010 for 15

million common shares* at an exercise price of $20 per share. Theaverage market price was $25.

*adjusted for the stock dividend

Basic EPS is unaffected

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Diluted EPSnet preferred

income dividends

$154 $4 $150

____________________________________________________________________ = _____ = $1.9260 (1.10) + 12 (10/12) (1.10)8 (3/12) + (1512) 78

shares new treasury exerciseat Jan. 1 shares shares of options

__ stock dividend ___adjustment

Shares Reacquired for Diluted EPS15 million shares

x $20 (exercise price)$300 million

$25 (average market price)12 million shares reacquired

OPTIONS, RIGHTS, AND WARRANTS

(continued)

We assume the options areexercised and 15 million

shares are sold.

We assume the $300 million is usedto buy back as many shares as

possible (12 million) at the averagemarket price.

Assuming the exercise ofthe options adds 3 millionshares to the denominator

of diluted EPS.

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Stock Options

Common stock outstanding was 100,000shares. Options to purchase 5,000 sharesof common stock were outstanding at the

beginning of the year. The options can beexercised to purchase stock at $50 pershare. The average market price of thestock was $80. The net increase in the

dilutive earnings per share denominator isa. 25,000 sharesb. 5,000 sharesc. 3,125 sharesd. 1,875 shares

New shares = 5,000Treasury shares = 3,125

(5,000 $50) $80Incremental shares = 1,875

(5,000 - 3,125)

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CONVERTIBLE SECURITIES

For Diluted EPS, conversion into common stock isassumed to have occurred at the beginning of theperiod (or at the time the convertible security isissued, if thats later). The denominatorof the

EPS fraction is increased by the additionalcommon shares that would have been issuedupon conversion.

The numeratoris increased by the interest(after-tax) orpreferred dividends that would have beenavoided if the convertible securities had not beenoutstanding due to having been converted.

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Convertible Bonds

Basic EPS (amounts in millions, except per share amounts)

$2.00 as before

Diluted EPSnet preferred after-tax

income dividends interestsavings

$154 $4 + $30 - (40% x $30) $168

= = $1.87

60 (1.10) + 12 (10/12) (1.10)8 (3/12) + (1512) + 12 90

shares new treasury exercise conversionat Jan. 1 shares shares of options of bonds

___ stock dividend ___adjustment*

10%, $300 million face amount of bonds issued in2005, convertible into 12 million common shares(adjusted for the stock dividend)

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CONVERTIBLE PREFERRED

STOCK

Now assume the preferred stock isconvertible into common stock:

Preferred stock, convertible5 million, 8%, cumulative, $10 par,shares, convertible into 3 million common

shares**adjusted for the stock dividend

80 cents per share,

or $4 million

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CONVERTIBLE PREFERRED

STOCK(continued)Basic EPS (amounts in millions, except per share amounts)

net preferredincome dividends

$154 $4 $150= = $2.00

60 (1.10)+ 12 (10/12)(1.10)8 (3/12) 75shares new treasury



Diluted EPSnet preferred after-tax

income dividends interest savings$154 $4 + $30 - (40% x $30) $172

= = $1.85

60 (1.10) + 12 (10/12)(1.10)8 (3/12) + (1512) + 12 + 3 93shares new treasury exercise conv. conversion

at Jan. 1 shares shares of options of of preferred

bonds shares


Earnings available for CSdoes not include dividends

payable to preferredshareholders.

If we assume thepreferred shares havebeen converted to CS,

there would be no

preferred dividends tosubtract.

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Earnings Per Share

A company had 200,000 shares of $.50 parcommon stock, 10,000 shares of 5%, $20 parcumulative preferred stock, and 30,000

shares of 5%, $10 par preferred stockconvertible into 10,000 common shares. Netincome after taxes was $1,500,000. Nodividends were declared during the year.Diluted EPS would be

a. $7.14b. $7.07

c. $7.10

d. $7.00

$1,500,000 (10,000 5% $20 par)200,000 + 10,000 shares

Even though dividends were notdeclared, the cumulative preferred stock

dividends are subtracted.

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ANTIDILUTIVE SECURITIES

At times, the effect of the conversion or exercise of potentialcommon shares would be to increase, rather than decrease,EPS. These we refer to as antidilutive securities. Suchsecurities are ignored when calculating EPS.

Stock warrantsWarrants granted in 2010, exercisable for 4 million commonshares* at an exercise price of $32.50 per share

*adjusted for the stock dividend

Calculations:

The calculations of both basic and diluted EPS are unaffectedby the warrants because the effect of exercising the warrantswould be antidilutive.

The $32.50 exercise price is higher than the market price, $25,so to assume shares are sold at the exercise price andrepurchased at the market price would mean reacquiring moreshares than were sold.

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CONTINGENTLY ISSUABLE SHARES

Considered to be outstanding in the computation ofdilutedEPSif some target performance level already is being met(assumed to remain at existing levels until the end of thecontingency period).

For example, assume 3 million additional shares will becomeissuable 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 beconsidered outstanding in the computation of dilutedEPS by simply adding 3 million additional shares to thedenominator.

Assumed issuance of contingently issuable shares (diluted EPS):

no adjustment to the numerator

+ 3additional

shares

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Earnings Per Share Disclosure

Report EPS data separately for:

1. Income from Continuing Operations

2. Separately Reported Items

a) Discontinued Operations

b) Extraordinary Items

3. Net Income

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End of Chapter 19

19 share-based compensation n eps

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