2. Stock Option Plans
Stock option plans give employees the option
to buy
(a) a specified number of shares of the firm's
stock,
(b) at a specified exercise price,
(c) 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).
3. 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.
4. 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. Current practices have unacceptable
economic consequences.
5. Recognizing Fair Value of Options
Accounting for stock options parallels the accounting
for restricted stock we discussed earlier. We now are
required to estimate the fair value of stock option
on the grant date.
The FASB now 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.
6. 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.
7. Summary
The fair value of an option is (a) its intrinsic value plus (b)
its time value of money plus (c) its volatility component.
All Other Factors Being Equal, If the: The Option Value Will Be:
Exercise price is higher Lower
Term of the option is longer Higher
Market price of the stock is higher Higher
Dividends are higher Lower
Risk-free rate of return is higher Higher
Volatility of the stock is higher Higher
8. 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.
9. U. S. GAAP vs. IFRS
• 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.
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.
• 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.
10. 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
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.
2
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 second year, and
50% the third years. For accounting
purposes we have three separate
awards.
11. 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) 850
Compensation expense (100 × $1.50) 150
Common stock (100 × $10.00) 1,000
Market value
12. 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.
This amount is expensed over the service
period.
Usually the same as the fair
value of a stock option with
similar terms.
13. 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.
14. 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.
15. Simple Capital Structure
(Basic EPS)
Basic Earnings Per Share
Net income (after tax) – Preferred dividends*
Weighted average outstanding common stock
*Current period’s cumulative preferred stock dividends (whether or not
declared) and noncumulative preferred stock dividends (only if declared).
Number of shares outstanding
× Number of months outstanding ÷ 12
Weighted average shares outstanding
16. Issuance of New Shares
Compute the weighted average number of
shares of common stock outstanding.
Date Description No. of Shares
1/1 Balance 100,000
4/1 Issued 50,000
10/1 Issued 10,000
17. Issuance of New Shares
Compute the weighted average number of
shares of common stock outstanding.
100,000 + [50,000 × (9/12)] + [10,000 × (3/12)] = 140,000
Shares
at Jan. 1
New
Shares
New
Shares
Annual
Weighting
Annual
Weighting
18. 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. Stock Dividends and Stock Splits
Compute the weighted average number of shares
of common stock outstanding.
Date Description No. of Shares
1/1 Balance 100,000
4/1 Issued 50,000
5/1 Stock dividend(100%) 150,000
20. Stock Dividends and Stock Splits
Compute the weighted-average number of
shares of common stock outstanding.
100,000 × (2.00) + [50,000 × (9/12) × 2.00] = 275,000
Shares
at Jan. 1
New
Shares
Stock dividend
adjustment
Annual
Weighting
21. Stock Dividends and Stock Splits
Retroactive treatment:
Stock dividend or split
is treated as
outstanding from the
beginning of the
period.
Stock dividend or split is
applied retroactively in
proportion to the number of
shares outstanding at the
time of the dividend or split.
New shares
issued this period?
Yes No
22. 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.
23. Reacquired Shares
Compute the weighted-average number of
shares of common stock outstanding.
Date Description No. of Shares
1/1 Balance 100,000
4/1 Issued 50,000
5/1 Repurchased shares 12,000
24. Reacquired Shares
Compute the weighted-average number of
shares of common stock outstanding.
100,000 + [50,000 × (9/12)] - [12,000 × (8/12)] = 129,500
Shares
at Jan. 1
New
Shares
Treasury
Shares
Annual
Weighting
Annual
Weighting
25. 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
26. Complex Capital Structure
(dual EPS)
Dilution/Antidilution Test
Stock
Options
Convertible
securities
Treasury stock
method
If-converted
method
Contingently
issuable
shares
Potential Common Shares:
•Stock options, rights, and
warrants
•Convertible bonds and stock
•Contingent common stock
issues
Diluted Earnings Per Share
May Report Basic and Diluted Earnings Per Share
27. Options, Rights, and Warrants
Proceeds
Used to
Purchase
treasury
shares
At
average
market
price
The treasury stock method
assumes that proceeds
from the exercise of
options are used to
purchase treasury shares.
This method usually
results in a net increase in
shares included in the
denominator of the
calculation of diluted
earnings per share.
28. Options, Rights, and Warrants
Proceeds from assumed exercise
Average-of-period market price of stock
Determine new shares from assumed
exercise of stock options.
Compute number of shares
repurchased.
29. Options, Rights, and Warrants
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)
30. Options, Rights, and Warrants
When the exercise price
exceeds the market price, the
securities are antidilutive and
are excluded from the
calculation of diluted EPS.
31. 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.
32. Convertible Securities
The assumed conversion of convertible bonds
or preferred stock has two effects on dilutive
earnings per share:
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.
33. 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.
34. 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.
35. Additional EPS Issues
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.
Contingently Issuable Shares
36. Contingently Issuable Shares
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.
Contingent shares are included in
dilutive EPS if:
Example: Additional shares may be
issued based on future earnings.
37. 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 option, employees do not pay to
acquire their shares of stock.
No adjustment to the numerator
Denominator is increased using treasury method
38. Summary
Potential Common Shares Basic EPS Diluted EPS
Stock options (or warrants, rights) no yes
Restricted stock awards no yes
Convertible securities (bonds, notes,
preferred stock) no yes
Contingently issuable shares no yes
Dilutive Effect Shown?
39. Summary
Potential Common Shares Numerator Denominator
Stock options (or warrants, rights) None
Add incremental
shares
Restricted stock award None
Add shares created
by vesting, reduced
by repurchased
shares at the
average stock price
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
Modification to EPS Equation
40. 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
