AC392 Chapter 15 Concepts

No JE included

dilutive securites

-securities that aren’t c/s yet, but holders can obtain c/s with exercise or conversion
-when converted, co must issue new shares

examples of dilutive securities

-conv bonds
-conv p/s

-warrants

-contingent shares

convertible bonds

-co: needs $, giving up less control today, raise equity capital on a delay, gets equity w/o having to sell at a discount
-investor: safety net w/ potential profit, takes a lower rate bc if co does well, conversion worth way more (cheaper loans)

accounting rules for convertible bonds

-date of issuance: ignore conversion, record like a normal loan/straight debt

-investor paid for bond & right to convert, still record all proceeds as debt (treat as standard loan until converted)

accounting rules for convertible bonds (a-e)

a) issuance: same as any other bond
b) interest dates: same as any other bond
c) conversion: book value approach (current carrying BV)
d) if retired for cash instead of convtd, convsn recorded same as retirement of other bonds
e) induced convsns: additional consideration given to induce convsn recognized as exp for current pd

convertible p/s

-essentially an internal trade
-recorded normally —→ nonconv p/s
-unless a “mandatory redemtion” considered as part of SE
-no gains or losses, just moving $ btwn two equity accts
-take value currently on books for p/s and slide over to c/s

convertible p/s JE

1) clear the old: debit (remove) p/s & PIC-p/s
2) create the new: credit (add) new c/s @ par value
3) the “plug”: usually $ leftover, credit PIC-c/s
* if PV of c/s higher than total BV of old p/s co has to “pay” for the difference
- debit RE (dipping into a “savings acct”)

stock warrants

-warrant: right to buy shares at a fixed (exercise) price for a certain amt of time
-conv bond becomes the stock, warrant lets you buy the stock while keeping your bond

benefits of stock warrants

-creating a “sweetener”
1) investor: if price goes up, the “coupon” is valuable; can sell it to someone else for cash
2) company (discount): cheaper debt, lower int rate on bond; when investors exercise warrants, have to pay co cash for new shares

issuance of stock warrant usually arises when

a) equity “kicker” to make another security more attractive
b) preemptive right of existing shareholders
c) compensation to executives & employees
- proceeds of non-detachable stock warrant = debt; proceeds allocated btwn
two securities —→ traded separately from debt, made on basis of warrants FV @ date of issuance

issuing stock warrants - proportional method

-used when both value of bonds (w/o warrants) & value of warrants alone are known
-allocate sales price of bonds btwn bonds & warrants based on FV

exercising detachable stock warrants

-when detachable warrants are exercised:
—→ cash debited for exercise price and PIC - Stock Warrants
—→ credit c/s and PIC Excess of Par
-when DW are never exercised:

—→ debit PIC - Stock Warrants
—→ credit PIC - Expired Stock Warrants

Issuing Stock Warrants - Incremental Method

-used when FV of warrants or bonds is not determinable
-security of known FV used, the rest is allocated to the other security

stock rights

-preemptive right; issued to existing stockholders when a corp’s directors decide to issue stock
-allows owners to buy new shares before gen. public (often @ discount)

JE for stock rights

-at issuance: memorandum entry only; no formal JE required bc no assets have been moved yet
-at exercise: record as normal stock issuance (cash vs. c/s)

stock compensation plans: stock options

-specific type of warrant given to employees
-The Right: employees can buy co stock at a set price (ex: exercise price)
-The Goal: if stock price goes up, employee buys it at the lower set price & makes immediate profit

Fair Value Method (Stock Options)

-co’s used to be able to choose how they record the cost, now required to do FV method
-The Concept: the co must estimate what the option is worth on the day its given to an employee
-Calculation Example: Black-Scholes model
-Non-employees: same rule applies if co gives options to consultants/vendors instead of cash

Grant Date

the day a co gives the option to an employee

Vesting Date

the day the employee actually owns the option and can use it
—→ if they quit before this date, they lose the options

Service Period

the time between the grant date and vesting date; when the employee “earns” the bonus

Accounting for Stock Options

-Goal: spread cost of the bonus over yrs the employee works to earn it
-Step 1 - Grant Date: no JE because employee hasnt worked for it yet; just note total value expected to pay out over time
-Step 2 - During Svc Pd: recognize compensation expense evenly (straight-line) over the yrs

Restricted Stock Compensation Plans

-a “loyalty bonus” when co gives you actual shares of stock with essentially a “lock” on them
—→can see them in your acct, but can’t touch them until you’ve been w/ the co long enough

Restricted Stock

-The Transfer: gives you actual shares on day 1
-Restriction: cannot sell, transfer, or use until you vest (work there long enough)
-Forfeiture: if you quit or get fired before vesting date, you forfeit the shares back to the co

Advantages of Restricted Stock

1) Never worthless: always has value unless the co goes to 0; has value even if stock options don’t
2) Less dilution: each share is more valuable, co gives out fewer shares to provide same lvl of compensation (fewer new shares = less dilution for current owners)
3) Better Alignment: since employees own actual shares, they want stock price to rise as much as regular shareholders do

Accounting Rules for Retired Stock

-same general principles as stock options
-Step 1 - Grant Date: FV of stock on the day its granted (usually current mkt price)
-Step 2 - During Svc Pd: allocate the underearned compensation value as an expense over the years until vesting

Employee Stock Purchase Plans (ESPP)

-permit all employees to purchase stock at discounted price for a short pd of time
-”company-wide discount code”
-employee gets benefits & employer doesnt have to record an expense

(ESPP) Compensation Expense is not Reported if:

a) most full-time employees can participate fairly;
b) discount from the mkt is small; and
c) the plan offers no independent option feature

Disclosure of Compensation Plans

Companies must disclose:
a) nature/terms of plan & potential effects on shareholders
b) IncStmt effects of compensation costs from share-based plans
c) method used to estimate FV of goods/svcs received or FV of equity instruments granted
d) cash flow effects from the plans

Debate Over Stock-Option Accounting

-FASB faced backlash when proposing FV method instead of intrinsic value method bc it results in higher compensation exp recorded
—→ why co’s rely more on restricted-stock plans

Earnings Per Share (EPS)

-reported directly on the income statement, right below net income
-if co has any special sections (like Income from Cont. Operations) they must show a separate EPS for that part too

Simple Capital Structure (EPS)

-if co only has c/s
-no convertibles, warrants, or options that could dilute value

Preferred Dividend Rules (EPS)

-Goal: income available to common stockholders
-Cumulative Stock: even if co doesnt pay dividends this yr, still subtract current year amount from net income
-Arrears: not included
-Net Loss: PrefDivs make loss bigger —→ add div amt to loss

Weighted-Avg Shares Rules (EPS)

-Issued/Brought Back: weighed by how many months it was active/”alive”
-Stock Splits/Divs: retroactive, treat as if they happened on the Jan 1st no matter what

Complex Capital Structure (EPS)

-if co has potentially dilutive securities
1) Basic EPS: shares actually outstanding (real number)
2) Diluted EPS: based on “worst-case scenario” (what if everyone converted bonds and warrants into stock?)

Antidilutive Rules (EPS)

-co never reports Diluted EPS if the extra securities would increase EPS

Diluted EPS - Convertible Securities

-Start of Year Assumption: pretend conversion happened on Jan 1st
-New Issue: if actually issued halfway through the year, pretend it was issued on the same date (issue date)
-Best Case for Holder: always assume investor uses the most advantageous conversion rate (gives them the most shares)

Convertible Bonds (DEPS - CS)

1) Numerator: Increases bc co no longer has to pay back int on these bonds
—→ only add back IntExp, net of tax
2) Denominator: Increases bc there is more common shares

Convertible Preferred Stock (DEPS - CS)

1) Numerator: stop subtracting PrefDivs
—→ no tax adjustment bc divs arent tax-deductible
2) Denominator: increases by number of new common shares

Diluted EPS - Options & Warrants

-Buyback Assumption: when employee exercises an option, they give the co cash
-Treasury Stock method assumes co uses that cash to buy back its own shares from the market (T/S)

Dilutive - Included (DEPS-OW)

-Exercise Price < Mkt Price
-employee pays back small amt, can only buy back a few shares (more new shares than # bought back)

Antidilutive - Ignored (DEPS - OW)

-Ex Price > Mkt Price
-employee paying more than stock is worth
-DO NOT include in DEPS calculation

Calculation of DEPS-OW

1) Assume exercise: calc how many new shares are issued
2) Assume buyback: cash received (shares X ex price) / avg mkt price for year = # of shares bought back by co
3) Net Increase: subtract bought back shares from issued shares (add final # to denominator)
*** Options/Warrants never change numerator

Contingent Issue Agreement

-shares that will be issued only if a specific condition is met
-only include in DEPS if the goal has been met by the end of the year

Conditions to Include DEPS

a) if shares are guaranteed to be issued
b) if shares are issued only if the company hits a certain profit or stock price
—→ met by yr-end: include in DEPS
—→ not met: ignore

Presentation and Disclosure

a) EPS presented for income from cont. operations, discont. operations, and net income
b) reported for all periods presented
c) prior EPS is restated for any prior pd adjustments
d) additional EPS disclosure is required in note form for co’s with complex capital structures & dual presentation of EPS

Stock-Appreciation Rights

-form of employee compensation that avoids cash flow problems that recipients of nonqualified stock option plans face
-employee given right to receive share appreciation

Share Appreciation

-excess of mkt price of stock @ date of exercise divided by pre established price
-can be received in cash, shares of stock, or combo of both

Compensation Cost (SAR)

-difference btwn current mkt price of stock & option price X # of stock-appreciation rights
-measurement date = date of exercise