Chapter 15: Dilutive Securities and Earnings Per Share

What are dilutive securities and what are some examples?

Financial instruments that have the potential to increase the number of common shares outstanding. E.g., convertible bonds, convertible preferred stock, stock options and other employee compensation plans, and warrants.

What are convertible bonds and how do you account for them?

Bonds that permit bondholder to convert bonds to shares of common stock. This is an option, which means bondholders may not exercise this option. The accounting for convertible bonds involves reporting issues at the time of issuance, conversion, and retirement.

From the issuer’s perspective, why convertible bonds?

Compared with equity: this raises money without giving up more ownership control.

Compared with conventional bond: interest is typically lower. 

From lender’s perspective: Why investors buy such a bond at a lower interest than a non-convertible bond?

Upside potential: choice to convert to equity (when the stock price is high)

What method should you use when doing bond conversion?

Use the book value method: No gain or loss is recognized by the issuer/borrower when the debtholder converts the debt to equity.

Convertible preferred stock may be changed into ____________ during a specified period of time after issuance. Advantage to issuer: dividend rate is lower. Existing owners are able to raise capital ($) and retain control (preferred stockholders usually can’t vote). Advantage to investor: security of assured dividend with upside potential (option to convert P/S to C/S)

common stock

______________ may be used to buy common stock at a pre-determined (i.e., strike) price. Often used in stock-based compensation.

Stock options

What is a stock warrant and why is it used?

Certificates entitling the holder to acquire shares of stock at a certain price within a stated period. It’s often used as a “sweetener” when selling bonds or preferred stock. It’s basically long-term options to buy common stock at a fixed price.

What does retirement mean for convertible debt and how do you calculate the gain or loss?

Retirement means paying off the debt. Gain or loss is recognized the same way as retiring debt that is not convertible. The difference between the cash acquisition price and carrying amount should be reported as gain or loss in the income statement.

Recently, many companies use stock-based compensation to pay their executives and sometimes rank-and-file employees. What are some typical stock-based compensations?

Stock options, restricted stock award (RSAs) or restricted stock units (RSUs), and employee stock purchase plans.

How do stock options work?

• Fair value method is used

• Gives employee the right to buy employer firm’s common stock at specified price (“exercise price”)

• Not exercisable under end of the vesting period

• Options can be exercised any time after the vesting period but before expiration.

What’s an example of a stock warrant?

Selling a conventional bond bundled with a stock warrant. To some extent, this is similar to a convertible bond where an investor earns interest while being able to tap “upside potential” of the issuer. Difference: upon exercise of the warrants, there is an exchange of cash.

Sometimes Warrants are nondetachable. What’s the difference between detachable and nondetachable?

Detachable warrants involves two securities, a debt security and a warrant to purchase common stock. Nondetachable do not require an allocation of proceeds between the bonds and the warrants. Companies record the entire proceeds as debt.

What are weighted average common shares?

Issuance and repurchase of common shares. Weighted by the fraction of the year newly issued shares are outstanding OR fraction of the year repurchased shares are not outstanding. E.g.,: Shares issued on May 31 receive a weight of 7/12 (outstanding June-December)

Stock dividends and stock splits may also change the number of shares outstanding. Companies need to restate the shares outstanding before the stock dividend or split.

When would you use the if-converted method and what does it assume?

Measure the dilutive effects of potential conversion on EPS using the if-converted method. This method for a convertible bond assumes the conversion at the beginning of the period (or at the time of issuance of the security, if issued during the period), and the elimination of related interest, net of tax.

What is recognized when a convertible debt is retired?

Either a gain or a loss

Under the fair-value method of recording stock options, companies will report a lower/higher compensation cost relative to the intrinsic value method.

higher