Conducted by: Mr. Koy Chumnith

Share-Based Compensationand Earnings Per Share

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McGraw-Hill/Irwin 2011, Royal University of Law and Economics

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Share-Based Compensation

Compensation:•Salary•Stock awards

Stock Award Plans

Restricted stock plans•Usually tied to continuing employment,•Compensation is market price at date of grant,•Compensation expense accrued over service period.

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Stock Option PlansStock option plansStock option plans give employees the option to give employees the option to

buy buy (a)(a) a specified a specified numbernumber of shares of the firm's of shares of the firm's

stock, stock, (b)(b) at a specified at a specified exercise priceexercise price,,(c)(c) during a specified during a 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 from participants receive the options, usually from the date of grant to when the options become the date of grant to when the options become exercisable (the vesting date). exercisable (the vesting date).

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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.

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.

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Failed Attempt to Require ExpensingOpposition to a proposed FASB Statement to Opposition to a proposed FASB Statement to recognize expense for certain stock option plans recognize expense for certain stock option plans 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 to Opposition to a proposed FASB Statement to recognize expense for certain stock option plans recognize expense for certain stock option plans 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 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.

The FASB now requires that compensation The FASB now requires that compensation expense be measured using one of several option expense be measured using one of several option pricing models that deal with:pricing models that deal with: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.

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Plans with Performance or Market Conditions

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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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.

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Plans With Graded-VestingRather 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:

1The 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.

2The 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.

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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) 850Compensation expense (100 × $1.50) 150

Common stock (100 × $10.00) 1,000

Market valueMarket value

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

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

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

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

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Issuance of New Shares

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

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

at Jan. 1 at Jan. 1NewNew

SharesSharesNewNew

SharesShares

AnnualAnnualWeightingWeighting

AnnualAnnualWeightingWeighting

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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.

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.

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Stock Dividends and Stock Splits Compute the weighted average number of shares Compute the weighted average number of shares

of common stock outstanding.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

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Stock Dividends and Stock Splits Compute the weighted-average number of Compute the weighted-average number of

shares of common stock outstanding.shares of common stock outstanding.

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

at Jan. 1 at Jan. 1NewNew

SharesShares

Stock dividendStock dividendadjustmentadjustment

AnnualAnnualWeightingWeighting

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Stock Dividends and Stock Splits

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 Shares

If shares were reacquired during the If shares were reacquired during the period, the weighted-average number of period, the weighted-average number of

shares is reduced. The number of shares is reduced. The number of reacquired shares is time-weighted for reacquired shares is time-weighted for the the fraction of the year they were fraction of the year they were notnot

outstandingoutstanding..

If shares were reacquired during the If shares were reacquired during the period, the weighted-average number of period, the weighted-average number of

shares is reduced. The number of shares is reduced. The number of reacquired shares is time-weighted for reacquired shares is time-weighted for the the fraction of the year they were fraction of the year they were notnot

outstandingoutstanding..

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Reacquired Shares

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

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Reacquired Shares

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

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

at Jan. 1 at Jan. 1NewNew

SharesSharesTreasuryTreasurySharesShares

AnnualAnnualWeightingWeighting

AnnualAnnualWeightingWeighting

˗̶7

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Earnings Available toCommon 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

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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 Share

May Report Basic and Diluted Earnings Per Share

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Options, 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.

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Options, Rights, and Warrants

Proceeds from assumed exerciseProceeds from assumed exercise

Average-of-periodAverage-of-period market price of stock market price of stock

Proceeds from assumed exerciseProceeds from assumed exercise

Average-of-periodAverage-of-period 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.

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Options, Rights, and Warrants

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)

Less: Treasury shares assumed purchased (2)

Net increase in shares outstanding (3)

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Options, Rights, and Warrants

When the exercise price When the exercise price exceeds the market price, the exceeds the market price, the securities are securities are antidilutive antidilutive and and

are excluded from the are excluded from the calculation of diluted EPScalculation of diluted EPS..

When the exercise price When the exercise price exceeds the market price, the exceeds the market price, the securities are securities are antidilutive antidilutive and and

are excluded from the are excluded from the calculation of diluted EPScalculation of diluted EPS..

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Convertible 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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Convertible Securities

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.

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Convertible Securities

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.

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Order of Entry for Multiple Convertible Securities

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

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Restricted Stock Awards

Restricted stock awards are quickly replacing Restricted stock awards are quickly replacing stock options as the share-based compensation stock options as the share-based compensation plan of choice. Like stock options, the treasury plan of choice. Like stock options, the treasury stock method is used to calculate the number of stock method is used to calculate the number of shares in the denominator of the EPS equation. shares in the denominator of the EPS equation. Unlike stock option, employees do not pay to Unlike stock option, employees do not pay to acquire their shares of stock.acquire their shares of stock.

No adjustment to the numeratorDenominator is increased using treasury method

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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?

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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

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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

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Appendix 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.

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SummaryThe 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.

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

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

similar terms.similar terms.

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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.

End of Chapter 19