Earnings per share

and dilutive securities

CHAPTER 16
Suggested homework practice
Exercises
◦ E7
◦ E10
◦ E18
◦ E25
◦ E26

Problem
◦ P1 part 4(exercising warrants)
 Suggested homework problems for Chapter 16
Quiz 1 has 10 questions these HW problems cover all the material for that quiz
1. JE| exercising employee stock options
2. JE| issuing warrant
3. JE| exercising warrant
4. Compensation expense timing or amount for stock options
5. Diluted EPS calculation/convertible preferred
6. Diluted EPS calculation/convertible bond
7. Basic EPS calculation/preferred dividends
8. Weighted average number of shares calculation/stock splits
9. CPA exam question on above topics
10. CPA exam question on above topics
Convertible Preferred Stock: Concepts
Convertible preferred stock is equity on the B/S, unless it is redeemable preferred stock.
◦ If it is redeemable then it is debt.

Conversion is an equity transaction: No gains or losses are recognized.

If converted, valuation is based on the book value of the preferred stock.

◦ No gain or loss
Conversion of Preferred: Example
Suppose the firm had 1,000 shares of $100 par value preferred stock outstanding and $50,000 of
APIC – Preferred stock. Each share is convertible into 5 shares of $5 par common. On June 1st
400 shares of preferred stock are converted. What is the JE?
Stock Warrants: Concepts
Stock warrants are also known as stock options.
◦ A warrant/option is like a coupon (product, price, expiration date)
◦ The holder is entitled to acquire additional common stock (product) within a
stipulated period (expiation date) at a specified price.

Stock warrants are issued by the company they are redeemed for stock. (the company
issues stock for the warrant + cash)

Warrants typically have a dilutive effect on EPS.

◦ New shares issued, # shares goes up and earnings per share goes down
Stock Warrants Issued with Other Securities
Stock warrants may be:
detachable
non-detachable

If warrants are detachable, value of the warrants is determined by:

Either the proportional method
Or the incremental method.

If warrants are non-detachable, no allocation to warrants is made.

All the value is attributed to the bond
Proportional Method: Example
Example:
o Bonds, with a par value of $10,000 and detachable warrants, are sold at 10,100.
o Bonds’ FMV without the warrants is $9,800.
o FMV of warrants is $400.

Allocate the $10,100 to bonds and the detachable warrants.

Total Value is
Proportional Method: Example
Total proceeds from
the bond issue:
$10,100 [given]
Allocate to Bonds:
$9,800/$10,200 FMV
X $9,704
$10,100 [issue]
Allocate to Warrants:
$400/$10,200 FMV
[times]
$10,100 [issue]
$396
$10,000 - 9,704 = 296
Discount on Bond Payable
Proportional Method: Example
Journal entries:
Incremental Method: Example
Example:
o Bonds, with a par value of $10,000 and detachable warrants, are sold at 10,100.
o Market price of warrants, $300.
o Market price of bonds without warrants, not determinable.

Determine the amounts allocated to the bonds and the warrants

Total receipt less warrants = bonds

 Incremental Method: Example
Journal entries:
Issue bond with warrant – incremental method
On January 1st 2017, Bubba’s Bait Shop issues 500, $1,000 8% bonds for $499,000. Each
bond has one detachable warrant. Bonds trade at 99 without warrants. The price of the
warrants is unknown but the strike price is $30. Bubba’s stock price is $33 per share and
the par value is $1 per share.
o What is the journal entry to record the issuance of the bonds/warrants?
o What do we know?

Figure out the rest

Bubba’s Bait Shop
What is the journal entry to record the issuance of the bonds/warrants?
Stock Rights
o Stock rights give existing shareholders preemptive rights to buy shares.
o Unlike warrants, rights are of short duration.
o No journal entries are made, when rights are issued.

o When stock rights are exercised, corporation usually receives cash.

o JE same as any other issuance of stock.

Issue and redeem stock rights
o On January 2nd 2017 Bubba’s bait shop grants 5,000 stock rights to existing stockholders. Each right
grants the right to purchase 1 share of $1 par common stock for $32 and the stock price is 33. The
rights expire on January 15th.
o What is the journal entry for this transaction on January 2nd?

o On January 14th when the stock is trading for $34 per share, 1,000 of the stock rights are exercised.
What is the Journal entry to record this transaction?
Stock Compensation Plans
These plans provide employee incentives and may be:
1. Stock option plans:
2. Stock appreciation rights
3. Performance plans
Stock Option Plans: Accounting Issues
What is the value of the compensation?
When, if at all, should it be recognized?
◦ the fair value method
 Stock Options: Important Dates
Grant Vesting Exercise Expiration
date date date date

Options Employee Employee

granted to exercises Unexercised
can take options
employee keep option options
expire
if they leave
Measure
Expense here the company Recognize
Exercisable Expense here

Vesting
Measuring Compensation Expense
Fair value method (required method):
Compensation expense is:
o the fair value of the options on grant date that are expected to vest.

o option pricing models may be used to determine fair value.

Options: Allocating Compensation Expense
is determined as of the
grant date
Compensation Expense
and is allocated over
the service period

> The compensation expense is calculated using the fair value method.

> The service period is the period benefited by employee’s service.

The service period is usually the period between the grant date
and the vesting date.
Y Corp. Example - this problem has 6 parts
1. Company issues 100,000 stock holders rights. 10 rights needed to buy one share of stock.
Rights entitle holders to buy shares at $32 within 30 days.
◦ No entry needed

2. Issue $200,000 bond for $205,000 with 2,000 detachable warrants.

Bonds trade at 96 without warrants and warrants trade at $8 each.
Strike price on warrants is $30 and Par value of the stock is $1
What portion of the value belongs to bonds/warrants?
Y Corp. Example

Carrying value of the bond =

Y Corp. Example
3. 90,000 stock rights exercised {10 rights per share} (This comes from #1)
How much cash?

4. 80% warrants exercised and 20% expired

Value of warrants?

Number of shares?
Y Corp. Example
Cash received from exercised warrants?

Par value of stock issued?

Journal entry?
Y Corp. Example
5. On December 31st 2017 the firm grants options to purchase 5,000 shares of common stock. On that
date the shares are trading for $31 per share and the strike price of the options is $30 per share. The
options vest over the next calendar year.
On date of grant the options are worth $10 each.

Journal entry on December 31st to record grant of options.

None

Journal entry on December 31st 2018 (after 1 year) to record compensation expense related to the
options
Y Corp. Example
6. In 2019, 4,000 options are exercised and 1,000 expire
How much cash is paid?

How much common stock is issued?

Value of options exercised?

Y Corp. Example
What do we do about the 1,000 options that expire
Two possibilities
◦ Options expire out of the money (No reason to exercise them)

◦ Options expire because they do not vest (employee not allowed to exercise them)
Z Corp. Example
2016 Firm adopts employee stock option plan: JE
◦ No entry needed
January 2, 2017 Options Granted for services rendered in 2017 and 2018.
◦ 42,000 options granted – 22,000 for 2017 and 20,000 for 2018
The first 22,000 options expire in 2018 and the second expire in 2019.
◦ Each option has a fair value of $3 and a strike price of $8
◦

December 31, 2017 record compensation expense for the year

◦
Z Corp. Example
2018 No one exercised their options and 22,000 options expire unused because the stock
price is too low. {no reason to exercise them}

20,000 options vest over 2018. Recognize compensation expense December 31st , 2018
◦ 20,000 * $3 per option = $60,000
Z Corp. Example
On December 31st , 2019 20,000 options exercised
How much Cash?

Value of Options

Par value of newly issued stock?

Each share has $5 par
Earnings Per Share: Concepts
o EPS is often the focus of investors.

o Dilution of EPS means reduction in EPS.

o Reduction in EPS results from conversion of other securities into common stock.

o Shareholders want to know the extent of reduction in EPS, if dilution takes place.
EPS
EPS measures entity performance over the reporting period.
Disclosure requirements
◦ Basic EPS in all situations
◦ Diluted EPS when capital structure includes potentially dilutive securities
◦ Must be presented on face of the income statement for both

◦ Income from continuing operations

◦ Net Income
Relation between Basic and Diluted EPS
Basic EPS Calculations
Basic EPS:

Net income — Preferred dividends

Weighted average common shares outstanding
Numerator specifics
For EPS from continuing operations
◦ Net income from continuing operations = Net income – any net income (or + any net loss) from
discontinued operations.
◦ Subtract preferred dividends as detailed above.
Basic EPS numerical example
In 2017, Grace Slick Inc. reports net income of $1,000,000 and has 1,000,000
shares of common stock outstanding for the entire year. The firm reports a
200,000 loss from discontinued operations and pays a 100,000 preferred
dividend that was declared the previous year. What will the firm report for basic
EPS in 2017
Basic EPS numerical example
In 2017, Jefferson Airplane Inc. reports net income of $1,000,000 and has 1,000,000 shares of
common stock outstanding for the entire year. The firm reports a 200,000 income from
discontinued operations. The firm has $500,000 par 6% cumulative preferred stock but no
preferred divided was declared or paid in 2017. This was the third year the firm did not pay a
preferred dividend. What will the firm report for basic EPS in 2017
Basic EPS numerical example
In 2017 3rd quarter, Jefferson Starship Inc. reports net income of $250,000 and has 1,000,000
shares of common stock outstanding for the entire quarter. The firm declares a 50,000
preferred dividend in the third quarter that is paid in the forth quarter. What will the firm report
for basic EPS from continuing operations in 2017 3rd quarter?
Weighted average number of shares outstanding
Weight shares by the faction of the period they were outstanding
B company had 120,000 shares outstanding at beginning of year. On May 1 the firm issued an
additional 45,000 shares. On July 1st the company purchase 10,000 treasury shares. These treasury
shares were reissued on October 1st. What is the weighted average number of shares outstanding for
the year?
Dates Shares Fraction Shares x Fraction
1/1–5/1 120,000 4/12 40,000
5/1–7/1 165,000 2/12 27,500
7/1–10/1 155,000 3/12 38,750
10/1–12/31 165,000 3/12 41,250
Weighted average number of shares outstanding 147,500
Stock dividends and stock splits
When stock dividend or stock spit occurs firm restates shares outstanding before the stock split or
dividend.
Example
Date Share Changes Shares Outstanding
1/1 Beginning Balance 1,000
4/1 Issues 200 shares for cash 1,200
6/1 3 for 1 stock split 3,600
10/1 400 shares repurchased 3,200

Calculate weighted average # shares outstanding for the year

Weighted # shares outstanding
Dates Shares Restatement Months Weighted shares

1/1-4/1 1,000 3 3/12 750

4/1-6/1 1,200 3 2/12 600
6/1-10/1 3,600 - 4/12 1,200
10/1-12/31 3,200 - 3/12 800
Weighted average number of shares outstanding
Diluted earnings per share
What do we do about potential shares
◦ Employee stock options/Warrants
◦ Convertible bonds/Convertible Preferred
Basic Earnings per share ignores them

Diluted earnings per share treats them as converted

Dilutive effect of convertible securities is measured by the if converted method.

The dilutive effect of options/warrants is measured by the treasury stock method.

How to calculate dilution - convertibles
Convertibles {if converted method.}
◦ Denominator (shares) is increased by the new shares that would be created if converted

◦ Numerator (Income) is increased by the after tax interest that would be saved if converted

◦ Example interest = $100, tax rate = 35%

◦ Pretax income increases by $100. Tax expense increases by $35. Net income increases by
100 – 35 = $65
◦ In general the numerator effect is interest x (1- tax rate)

◦ The Numerator adjustment for preferred stock is preferred dividends

If converted example 1 - preferred
JJ company has 1,000 shares of common stock, 200 shares of $10 par 5%
preferred stock and $400 of net income. Each share of preferred is
convertible into 20 shares of common

Basic EPS
◦ Numerator

◦ Denominator

◦ Basic EPS?
If converted example 1 - preferred
If preferred stock is converted then 2 effects
◦ More shares of common (200 shares preferred X 20)
◦ No preferred dividends ($100)

Diluted EPS
◦ Numerator

◦ Denominator

◦ Diluted EPS?
If converted example 1 - Bonds
JJ company has 1,000 shares of common stock, 200, $1000 5% convertible
bonds. The firm has $14,000 of net income and a 40% tax rate. Each bond is
convertible into 50 shares of common stock

Basic EPS
◦ Numerator

◦ Denominator

◦ Basic EPS?
If converted example 1 - Bonds
If the bonds were converted at beginning of the year
◦ New shares issued
◦ No interest paid to bond holders
Basic EPS
◦ Numerator/ What would change in net income be?
Less interest expense/more taxable income
More tax expense
Higher NI
◦ Denominator/what would change in shares be?
200 bonds

◦ Diluted EPS?
How to calculate dilution – Treasury stock method
Options and Warrants
◦ Denominator (shares) is increased by the new shares that would be created
◦ Denominator (shares) is decreased by the number of shares that can be repurchased
with the strike price.

Example – Treasury stock method

◦ 10 options outstanding with strike price = $30 and fair value of shares = $50 per
share.
◦ Proceeds = 10 shares x $30 = $300.
◦ Shares repurchased = $300/$50 per share= 6 shares.
◦ Increase to denominator = 10 – 6 = 4 shares.
Treasury Stock method Example - Options
JJ company has 1,000 shares of common stock, employee stock options to purchase 200 shares
of common stock for $25 per share. The firm earns $400 of net income. Common shares sale for
$40 per share on the open market
Basic EPS
◦ Numerator Denominator
◦ Basic EPS?

Diluted EPS
◦ Number of new shares issued if options exercised
◦ Proceeds from strike price
◦ Number of shares repurchased
◦ Net new shares
◦ Diluted EPS
Is the security dilutive?
Divide numerator effect by denominator effect.
If this ratio is less than basic EPS the security is dilutive
Example suppose tax rate is 40%
Suppose X company has Basic EPS of $2.00 per share
The firms also has convertible bonds with a face value of 1,000,000 and an interest rate of 5%.

a. If these 1,000 bonds can be converted into 50 shares each

1,000,000 x 5% (1-.4) / 50,000 = 0.60
0.60 < $2.00 so the security is dilutive

b. If these 1,000 bonds can be converted into 10 shares each

1,000,000 x 5% (1-.4) / 10,000 = 3.00
3.00 > $2.00 so the security is anti-dilutive
Is the security dilutive?
◦ Using the same example to prove the ratio method works
◦ Income = 2,000,000
◦ Weighted average shares outstanding =1,000,000
◦ Basic EPS = $2.00

a. dilutive: Income increases by 30,000 denominator increases by 50,000

Diluted EPS = [2,000,000 + 30,000]/[1,000,000 + 50,000] = 1.93
Dilutive and included in calculation of diluted EPS

b. anti-dilutive: Income increases by 30,000 denominator increases by 10,000. If we used this security is would increase EPS.
Diluted EPS = [2,000,000 + 30,000]/[1,000,000 + 10,000] = 2.01
The securities are anti-dilutive so it is not used for diluted EPS
 Diluted EPS example from text book
H has net income = 360,000 and 100,000 average shares outstanding. Common stock sold at an
average market price of $15 during the period. Also outstanding were 15,000 warrants that
could be exercised to purchase one share of common stock at $10.
a. Are the warrants dilutive?

b. Compute basic EPS

c. Compute diluted EPS

1. How many new shares?
2. How much cash will we get? 15,000 x 10 =
3. How many shares can we buy for $150,000?
4. EPS =
Compressive example –
diluted EPS some securities anti-dilutive
V company has
◦ $1,200,000 of net income; 40% income tax rate
◦ 30,000 shares of $100 par value 6% preferred shares
◦ Each Preferred share is convertible into 3 shares of common stock
◦ The par value of common stock outstanding is $6,000,000 and the par value of each share is $10

Calculate Basic EPS

Income available to common
Weighted average # shares outstanding
Compressive example –
diluted EPS some securities anti-dilutive
Three Securities Options, Bonds, Convertible preferred
Options
◦ 50,000 options; 20 strike price; 25 average price
◦ In the money?
50,000 x $20 strike price = $1,000,000 proceeds
$1,000,000/ $25 average price = 40,000 shares repurchased

◦ 50,000 – 40,000 = 10,000 net shares; no numerator effect

◦ Ratio 0/10,000 = 0 < 1.70 : Dilutive
Compressive example –
diluted EPS some securities anti-dilutive
Three Securities Options, Bonds, Convertible preferred
◦ Bond: 2,000, $1,000 8% bonds convertible into 40 shares of common stock each.
How much interest will be avoided if they are converted at beginning of the
year?

◦ Denominator effect
◦ Ratio =
Compressive example –
diluted EPS some securities anti-dilutive
Three Securities Options, Bonds, Convertible preferred
◦ Preferred: 30,000, $100 par 6% convertible into 3 shares of common stock each.
How much will income available to common go up if these are converted?

Denominator effect

Ratio =
Compressive example –
diluted EPS some securities anti-dilutive
Diluted EPS
NumeratorDenominator Dilutive?
Basic 1,020,000 600,000
Options 0 10,000
Convertible bonds 96,000 80,000
Preferred 180,000 90,000
Basic EPS
Basic EPS

Diluted EPS
◦ Numerator 1,200,000 – 180,000
◦ Denominator 600,000
What if dilative securities are not outstanding the whole year?
If potentially dilative securities are not outstanding for the entire year, then numerator and
denominator effects are time weighted.
◦

◦ Actual conversion takes place, then newly issued shares will be outstanding from their date of
issuance and will be included in calculation the numerator effect and denominator affect for
time before conversion took place will be calculated.