share-based compensation and earnings per share chapter 19 © 2009 the mcgraw-hill companies, inc

SHARE-BASED SHARE-BASED COMPENSATION ANDCOMPENSATION ANDEARNINGS PER SHAREEARNINGS PER SHARE

Chapter 19

© 2009 The McGraw-Hill Companies, Inc.

McGraw-Hill /Irwin

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Share-Based CompensationShare-Based Compensation

Restricted stock plans Restricted stock plans usually are tied to usually are tied to continued employment of the person continued employment of the person

receiving the award.receiving the award.The compensation associated with a share of The compensation associated with a share of

restricted stock (or nonvested stock) is the restricted stock (or nonvested stock) is the market price at the market price at the grant date grant date of an of an unrestricted share of the same stock. unrestricted share of the same stock.

The amount is accrued as The amount is accrued as compensation compensation expense expense over the service period for which over the service period for which participants receive the shares.participants receive the shares.

Restricted stock plans Restricted stock plans usually are tied to usually are tied to continued employment of the person continued employment of the person

receiving the award.receiving the award.The compensation associated with a share of The compensation associated with a share of

restricted stock (or nonvested stock) is the restricted stock (or nonvested stock) is the market price at the market price at the grant date grant date of an of an unrestricted share of the same stock. unrestricted share of the same stock.

The amount is accrued as The amount is accrued as compensation compensation expense expense over the service period for which over the service period for which participants receive the shares.participants receive the shares.

Stock Award Plans

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Stock Option PlansStock Option Plans

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

The The fair valuefair value is accrued as is accrued as compensation compensation expense over the service periodexpense over the service period for which for which participants receive the options, usually participants receive the options, usually from the date of grant to when the options from the date of grant to when the options become exercisable (the vesting date). become exercisable (the vesting date).

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Expense – The Great DebateExpense – The Great Debate

Historically, options have been measured at Historically, options have been measured at their intrinsic value – the simple difference their intrinsic value – the simple difference

between the market price of the shares and between the market price of the shares and the option price at which they can be the option price at which they can be

acquired. If the market and exercise price acquired. If the market and exercise price are equal on the date of grant, no are equal on the date of grant, no

compensation expense is recognized even compensation expense is recognized even if the options provide executives with if the options provide executives with

substantial income.substantial income.

Historically, options have been measured at Historically, options have been measured at their intrinsic value – the simple difference their intrinsic value – the simple difference

between the market price of the shares and between the market price of the shares and the option price at which they can be the option price at which they can be

acquired. If the market and exercise price acquired. If the market and exercise price are equal on the date of grant, no are equal on the date of grant, no

compensation expense is recognized even compensation expense is recognized even if the options provide executives with if the options provide executives with

substantial income.substantial income.

McGraw-Hill /Irwin

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Expense – The Great DebateExpense – The Great Debate

Opposition to a proposed FASB Statement Opposition to a proposed FASB Statement have identified three objections.have identified three objections.

1.1. Options with no intrinsic value at issue Options with no intrinsic value at issue have zero fair value and should have zero fair value and should notnot give give rise to expense recognition.rise to expense recognition.

2.2. It is impossible to measure the fair value of It is impossible to measure the fair value of compensation on the date of grant.compensation on the date of grant.

3.3. Current practices have unacceptable Current practices have unacceptable economic consequences.economic consequences.

Opposition to a proposed FASB Statement Opposition to a proposed FASB Statement have identified three objections.have identified three objections.

1.1. Options with no intrinsic value at issue Options with no intrinsic value at issue have zero fair value and should have zero fair value and should notnot give give rise to expense recognition.rise to expense recognition.

2.2. It is impossible to measure the fair value of It is impossible to measure the fair value of compensation on the date of grant.compensation on the date of grant.

3.3. Current practices have unacceptable Current practices have unacceptable economic consequences.economic consequences.

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Recognizing Fair Value of OptionsRecognizing Fair Value of OptionsAccounting for stock options parallels the accountingAccounting for stock options parallels the accountingfor restricted stock we discussed earlier. We now arefor restricted stock we discussed earlier. We now are

required to estimate the fair value of stock optionrequired to estimate the fair value of stock optionon the grant date.on the grant date.

Accounting for stock options parallels the accountingAccounting for stock options parallels the accountingfor restricted stock we discussed earlier. We now arefor restricted stock we discussed earlier. We now are

required to estimate the fair value of stock optionrequired to estimate the fair value of stock optionon the grant date.on the grant date.

SFAS 123 (revised) requires the use of an option SFAS 123 (revised) requires the use of an option pricing model that deals with the:pricing model that deals with the:1.1. Exercise price of the option.Exercise price of the option.2. Expected term of the option.2. Expected term of the option.3. Current market price of the stock.3. Current market price of the stock.4. Expected dividends.4. Expected dividends.5. Expected risk-free rate of return.5. Expected risk-free rate of return.6. Expected volatility of the stock.6. Expected volatility of the stock.

McGraw-Hill /Irwin

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Plans with Performance or Market Plans with Performance or Market ConditionsConditions

In some circumstances, compensation from a stock option plan depends on

meeting a performance targetperformance target. When this is the case, compensation expense

depends on whether or not we feel it is probableprobable that the target performance will

be met.

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Employee Share Purchase PlanEmployee Share Purchase Plan 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:

Description Debit Credit

Cash (100 × $8.50) 850

Compensation expense (100 × $1.50) 150

Common stock (100 × $10.00) 1,000

McGraw-Hill /Irwin

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Earnings Per Share (EPS)Earnings Per Share (EPS)

Of the myriad facts and figures Of the myriad facts and figures generated by accountants, the single generated by accountants, the single

accounting number that is reported most accounting number that is reported most frequently in the media and receives by frequently in the media and receives by far the most attention by investors and far the most attention by investors and

creditors is creditors is earnings per shareearnings per share..

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Simple Capital Structure(Basic EPS)

Basic Earnings Per ShareBasic Earnings Per Share

Net income (after tax) – Preferred dividends*Weighted average outstanding common stock Net income (after tax) – Preferred dividends*Weighted average outstanding common stock

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and

noncumulative preferred stock dividends (only if noncumulative preferred stock dividends (only if declared).declared).

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and

noncumulative preferred stock dividends (only if noncumulative preferred stock dividends (only if declared).declared).

Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

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Issuance of New SharesIssuance of New Shares

Date Description No. of Shares1/1 Balance 100,000 4/1 Issued 50,000 10/1 Issued 10,000

Compute the weighted average number of Compute the weighted average number of shares of common stock outstanding.shares of common stock outstanding.

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Issuance of New SharesIssuance of New Shares


100,000100,000 + [50,000 + [50,000 ×× (9/12)] + [10,000 (9/12)] + [10,000 × (3/12)] = × (3/12)] = 140,000140,000SharesShares

at Jan. 1 at Jan. 1NewNew

SharesSharesNewNew

SharesShares

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Stock Dividends and Stock SplitsStock Dividends and Stock Splits

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the retroactively as subdivisions of the shares already outstanding at the date shares already outstanding at the date

of the split or dividend.of the split or dividend.

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the retroactively as subdivisions of the shares already outstanding at the date shares already outstanding at the date

of the split or dividend.of the split or dividend.

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Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Stock dividend(100%) 150,000

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Compute the weighted-average number of Compute the weighted-average number of shares of common stock outstanding.shares of common stock outstanding.

100,000 100,000 × (2.00) + [50,000 × (2.00) + [50,000 × (9/12) × 2.00]× (9/12) × 2.00] = = 275,000275,000SharesShares


SharesShares

Stock dividendStock dividendadjustmentadjustment

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Retroactive treatment:Retroactive treatment:

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the beginning of the

period.period.

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the beginning of the

period.period.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the shares outstanding at the

time of the dividend or split.time of the dividend or split.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the shares outstanding at the

time of the dividend or split.time of the dividend or split.

New sharesNew sharesissued this period?issued this period?

New sharesNew sharesissued this period?issued this period?

YesYes NoNo

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Reacquired SharesReacquired Shares

The weighted-average number of shares The weighted-average number of shares is reduced by the number of reacquired is reduced by the number of reacquired shares, time-weighted for the shares, time-weighted for the fraction of fraction of

the year they were the year they were notnot outstanding. outstanding.

The weighted-average number of shares The weighted-average number of shares is reduced by the number of reacquired is reduced by the number of reacquired shares, time-weighted for the shares, time-weighted for the fraction of fraction of

the year they were the year they were notnot outstanding. outstanding.

McGraw-Hill /Irwin

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Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Repurchased shares 12,000

McGraw-Hill /Irwin

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100,000100,000 + [50,000 + [50,000 ×× (9/12)] - [12,000 (9/12)] - [12,000 × (8/12)] = × (8/12)] = 129,500129,500SharesShares


SharesSharesTreasuryTreasurySharesShares

McGraw-Hill /Irwin

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Earnings Available to Common ShareholdersEarnings Available to Common Shareholders

Net incomeLess: 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

McGraw-Hill /Irwin

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Complex Capital StructureComplex Capital Structure(dual EPS)(dual EPS)

Dilution/Antidilution TestDilution/Antidilution Test

StockStockOptionsOptions

Convertible Convertible securitiessecurities

Treasury stock Treasury stock methodmethod

If-converted If-converted methodmethod

Contingently Contingently issuable issuable sharesshares

Potential Common Shares:Potential Common Shares:•Stock options, rights, and Stock options, rights, and warrants warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock Contingent common stock issues issues

Potential Common Shares:Potential Common Shares:•Stock options, rights, and Stock options, rights, and warrants warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock Contingent common stock issues issues

Diluted Earnings Per shareDiluted Earnings Per share

May Report Basic and Diluted Earnings Per Share

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Options, Rights, and WarrantsOptions, Rights, and Warrants

ProceedsProceeds

Used toUsed to

Purchase Purchase treasury treasury sharesshares

At At average average market market priceprice

The The treasury stock methodtreasury stock method assumes that proceeds assumes that proceeds

from the exercise of from the exercise of options are used to options are used to

purchase treasury shares. purchase treasury shares. This method usually This method usually

results in a net increase in results in a net increase in shares included in the shares included in the

denominator of the denominator of the calculation of diluted calculation of diluted earnings per share.earnings per share.

The The treasury stock methodtreasury stock method assumes that proceeds assumes that proceeds

from the exercise of from the exercise of options are used to options are used to

purchase treasury shares. purchase treasury shares. This method usually This method usually

results in a net increase in results in a net increase in shares included in the shares included in the

denominator of the denominator of the calculation of diluted calculation of diluted earnings per share.earnings per share.

McGraw-Hill /Irwin

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Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Determine new shares from assumed Determine new shares from assumed exercise of stock options.exercise of stock options.

Compute number of shares Compute number of shares repurchased. repurchased.

McGraw-Hill /Irwin

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Determine new shares from assumed Determine new shares from assumed exercise of stock options.exercise of stock options.

Compute shares purchased for the Compute shares purchased for the treasury. treasury.

Compute the incremental shares Compute the incremental shares assumed outstanding.assumed outstanding.

New shares from assumed exercise (1)New shares from assumed exercise (1)

Less: Treasury shares assumed purchasedLess: Treasury shares assumed purchased (2) (2)

Net increase in shares outstanding (3)Net increase in shares outstanding (3)

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When the exercise price When the exercise price exceeds the market exceeds the market

price, the securities are price, the securities are antidilutiveantidilutive..

When the exercise price When the exercise price exceeds the market exceeds the market

price, the securities are price, the securities are antidilutiveantidilutive..

McGraw-Hill /Irwin

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Convertible SecuritiesConvertible Securities

The The if-converted methodif-converted method is used for is used for Convertible debt and equity Convertible debt and equity

securities.securities.The method assumes conversion occurs The method assumes conversion occurs as of the as of the beginningbeginning of the period or date of the period or date

ofof issuance issuance, if later., if later.

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The assumed conversion of convertible bonds The assumed conversion of convertible bonds or preferred stock has two effects on dilutive or preferred stock has two effects on dilutive earnings per share:earnings per share:increases the denominator by the number of increases the denominator by the number of

common shares issuable upon conversion,common shares issuable upon conversion,increases the numerator by decreasing increases the numerator by decreasing after-tax after-tax

interest expenseinterest expense on convertible bonds, and on convertible bonds, and dividends on convertible preferred stock.dividends on convertible preferred stock.

The assumed conversion of convertible bonds The assumed conversion of convertible bonds or preferred stock has two effects on dilutive or preferred stock has two effects on dilutive earnings per share:earnings per share:increases the denominator by the number of increases the denominator by the number of

common shares issuable upon conversion,common shares issuable upon conversion,increases the numerator by decreasing increases the numerator by decreasing after-tax after-tax

interest expenseinterest expense on convertible bonds, and on convertible bonds, and dividends on convertible preferred stock.dividends on convertible preferred stock.

McGraw-Hill /Irwin

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Dilutive earnings per share may decrease or Dilutive earnings per share may decrease or increase after the assumed conversion.increase after the assumed conversion.

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.

McGraw-Hill /Irwin

Order of Entry for Multiple Convertible Order of Entry for Multiple Convertible SecuritiesSecurities

When a company has more than one When a company has more than one instances of potential common shares, instances of potential common shares,

they are considered for inclusion in they are considered for inclusion in dilutive EPS in sequence from the dilutive EPS in sequence from the most most

dilutive to the least dilutivedilutive to the least dilutive..

When a company has more than one When a company has more than one instances of potential common shares, instances of potential common shares,

they are considered for inclusion in they are considered for inclusion in dilutive EPS in sequence from the dilutive EPS in sequence from the most most

dilutive to the least dilutivedilutive to the least dilutive..

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Additional EPS IssuesAdditional EPS Issues

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain conditions. upon the satisfaction of certain conditions. Contingently issuable shares are Contingently issuable shares are

considered to be outstanding in the considered to be outstanding in the computation of EPS if the target computation of EPS if the target

performance level already is being met.performance level already is being met.

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain conditions. upon the satisfaction of certain conditions. Contingently issuable shares are Contingently issuable shares are

considered to be outstanding in the considered to be outstanding in the computation of EPS if the target computation of EPS if the target

performance level already is being met.performance level already is being met.

Contingently Issuable SharesContingently Issuable Shares

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Contingently Issuable SharesContingently Issuable Shares

Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Contingent shares are included in dilutive EPS if:

Contingent shares are included in dilutive EPS if:

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.

McGraw-Hill /Irwin

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SummarySummary

Potential Common Shares Basic EPS Diluted EPS Stock options (or warrants, rights) no yes Convertible securities (bonds, notes, preferred stock) no yes Contingently issuable shares no yes

Dilutive Effect Shown?

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SummarySummary

Potential Common Shares Numerator Denominator

Stock options (or warrants, rights)None

Add incremental shares

Convertible bonds or notes Add after tax interest

Add shares issuable upon

conversion

Convertible preferred Add back dividends declared

Add shares issuable upon

conversion Contingently issuable shares

Conditions being currently met None

Add shares issuable

Conditions not being met None None

Impact

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Slide 34

Financial Statement PresentationFinancial 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

McGraw-Hill /Irwin

Slide 35

Appendix 19A – Option-Pricing TheoryAppendix 19A – Option-Pricing Theory

Intrinsic value Intrinsic value is the benefit the holder of an is the benefit the holder of an option would realize by exercising the option option would realize by exercising the option

rather than buying the underlying stock directly. rather than buying the underlying stock directly. An option that permits an employee to buy $25 An option that permits an employee to buy $25

stock for $10, has an intrinsic value of $15.stock for $10, has an intrinsic value of $15.

Intrinsic value Intrinsic value is the benefit the holder of an is the benefit the holder of an option would realize by exercising the option option would realize by exercising the option

rather than buying the underlying stock directly. rather than buying the underlying stock directly. An option that permits an employee to buy $25 An option that permits an employee to buy $25

stock for $10, has an intrinsic value of $15.stock for $10, has an intrinsic value of $15.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

Options have a time Options have a time value because the value because the

holder of an option does holder of an option does not have to pay the not have to pay the

exercise price until the exercise price until the option is exercised.option is exercised.

McGraw-Hill /Irwin

Slide 36

SummarySummary

The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

The fair value of an option is (a) its intrinsic value plus (b) its time value of money plus (c) its volatility component.

McGraw-Hill /Irwin

Appendix 19B - Stock Appreciation RightsAppendix 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.

This amount is expensed over the service period.

Usually the same as the fair value of a stock option with

similar terms.

McGraw-Hill /Irwin

Stock Appreciation RightsStock 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.

share-based compensation and earnings per share chapter 19 © 2009 the mcgraw-hill companies, inc

Documents

stock options

fair value of stock

share of restricted

nonvested stock

fair value of compensation

firms stock

compensation expense

stock award plans