CHAPTER 16

LECTURE NOTES
DILUTIVE SECURITIES AND EARNINGS PER SHARE
Table of Contents
Page

Issuance of convertible bonds

Conversion of convertible bonds
Preemptive stock rights
Bonds issued with detachable warrants
Stock options
Stock bonus or award plans and restricted stock awards
Employee stock purchase plans
History of incentive stock options
Basic earnings share
Weighted average computation
Disclosure of earnings per share on the income statement
Basic and diluted earnings per share: if converted method for convertible preferred
Antidilution in diluted earnings per share
Basic and diluted earnings per share: if converted method for convertible bonds
Basic and diluted earnings per share: treasury stock method for stock options
Stock option graph
International financial accounting standards
Quiz

2
3
5
7
10
14
16
17
18
19
21
22
23
24
27
29
30
32

Convertible bonds
Ace Company issued $100,000 face value convertible bonds on October 1, 2009. The stated interest rate
was 5%, and the bonds were sold to yield 6%. Each $1,000 bond is convertible into 40 shares of Ace's
$1 par value common on or after October 1, 2012. The bonds pay interest on April 1 and October 1, and
mature on October 1, 2014. How should the convertible bonds be recorded on October 1, 2009?
Market price of the convertible bonds
Market price of the common stock

Convertible bonds tend to sell at a price higher than the market price of the common. For example, assume a
convertible bond was convertible into 50 shares of common and that the market value of the common was $25
per share. The market value of the common is $1,250 per bond (50 shares X $25). The market value of a
convertible bond would likely be higher than $1,250 because investors are willing to pay extra for the option
to convert.

Issuance of convertible bonds

10/1/09

10/1/14

I-------------------------------------------------------------------------------------------------------------------I
$100,000
$2,500 of interest is paid on April and October 1 each year for 5 years
The issue price of a bond is the present value of the maturity amount ($100,000) added to the present
value of the interest annuity ($2,500), both amounts being discounted at the yield rate. $2,500 =
$100,000 X the stated interest rate of 5% for year.
PV using 6% = $2,500(8.53020)* + $100,000(.74409)*
= $95,735
*8.53020 is the present value factor for a 10 rent ordinary annuity at 3%, while .74409 is the present
value of $1 for 10 periods at 3%. Since interest is paid every 6 months, the yield rate of 6% per year
becomes 3% for each year.
2

Accounting question: Should the proceeds from convertible bonds be viewed as all debt or as part debt
and part stockholders equity? The option to convert is imbedded in the convertible bond. When
investors buy convertible bonds, they place a value on the imbedded option. The accounting issue is
how to reliably measure the value of the imbedded option. It is the opinion of the profession that
estimating the value for the imbedded option is too subjective. Therefore, this value is not separated
from the proceeds received from issuing convertible debt.
Value of debt $95,735; Face value of debt $100,000; Discount
on bonds = $100,000 face value minus $95,735 = $4,265
$95,735
Value of imbedded option = $0
The proceeds from the issuance of convertible bonds are accounted for as all debt. The entry below
records the issuance of the convertible bonds on October 1, 2009.
CASH

95,735

DISCOUNT ON BONDS

4,265

BONDS PAYABLE

100,000

Rationale: The Accounting Principles Board (APB) decided that, because the debt and the conversion
feature were inseparable, all the proceeds from convertible debt should be accounted for as debt at the
date of issuance.

Bondholders
or
Stockholders

convert bonds

Company

common stock

Investors are either bondholders or stockholders, not both. This is the inseparability argument.
Therefore, proceeds received from issuing convertible debt are accounted for as 100% debt.

Common stock
(investors are
stockholders if they
convert the bonds into
common stock)

Convertible bonds
(investors are debtors if
they hold the bonds)

Do exercise 16-1 (item 1 only) at this time.

Conversion of convertible bonds
Investors usually convert their convertible bonds into common stock when the common stock price is rising. The
market value of the convertible bonds will increase in tandem with the rise in the market value of the common
stock. When the market value of the common stock decreases, the market value of the convertible bonds will also
decrease in tandem with that of the common stock. However, the decrease in the market value of the convertible
bonds is limited because the bonds pay interest. At a certain point, the market value of the bonds will stabilize due
to the yield rate that investors want from the bonds. Therefore, convertible bonds have unlimited upside potential
and limited downside potential.
Assume the carrying amount for the bonds on October 1, 2012, was $98,142($100,000 minus 1,858 of
unamortized discount) and that $50,000 face value of bonds were converted on that date. Recall that each $1,000
bond is convertible into 40 shares of $1 par value common stock (50 bonds multiplied times 40 common shares
results in 2,000 common shares being exchanged for the bonds).
Carrying value for the bonds converted as of October 1, 2012 is computed as follows:
o
o
o

Face value of bonds converted

Less unamortized discount or plus unamortized premium at the date of
conversion on the bonds converted ($1,858 X 50%)
Carrying value of bonds converted

$50,000
(929)
$49,071
======

There are two methods of accounting for the conversion of convertible bondsthe book value and the
market value methods. The book value method is used more frequently in practice.

Under the book value method, there is no gain or loss reported when convertible bonds are
converted into common stock because the conversion of bonds is not viewed as the
completion of an earnings process. The conversion is an exchange transaction, but the
assumption is that the holders of convertible bonds always intended to be stockholders.
Therefore, being bondholders was a temporary state.
Under the market value method, there is a gain or a loss reported when convertible bonds
are converted because the conversion of bonds is viewed as the completion of an earnings
process. Again, the conversion is an exchange transaction, and the assumption is that the
holders of convertible bonds had to make a separate decision as to whether they wanted to
be bondholders or stockholders. This separate decision represents the completion of an
earnings process if the decision is to convert the bonds into common stock.

Book value method:

BONDS PAYABLE

50,000

DISCOUNT ON BONDS

929

COMMON STOCK ($1 par value X 2,000 shares)

(50 bonds X 40 shares per bond = 2,000 shares)

2,000

ADDITIONAL PAID IN CAPITAL ($50,000 minus $2,929) (plug this amount)

47,071

Under the book value method, the carrying amount of the bonds converted ($49,071) is transferred to
common stock and additional paid in capital. Since common stock is increased for the par value of the shares
issued ($2,000) in the conversion, additional paid in capital is plugged for the difference between the carrying
amount of the bonds converted ($49,071) and the par value of the common stock ($2,000) issued in the
conversion.
Do exercise 16-4 at this time.
Market value method:
Assume the market value of the common stock was $26 per share on the conversion date of October 1, 2012:

Market value of the common stock received by bondholders

as a result of the conversion (2,000 shares X $26 per share)
Carrying amount of the bonds converted
Loss from bond conversion

BONDS PAYABLE

$52,000
( 49,071)
$ 2,929
======
50,000

LOSS ON BOND CONVERSION

2,929

DISCOUNT ON BONDS

929

COMMON STOCK($1 par value X 2,000 shares)

2,000

ADDITIONAL PAID IN CAPITAL($52,000 minus $2,000)

50,000

The loss from bond conversion is reported in the other income and loss section of the income statement.
Since investors usually convert convertible bonds when the market value of the common stock is increasing,
most bond conversions will result in losses being reported if the market value method is used. Because the
book value method does not report gains or losses from bond conversion, selecting the book value method
will increase net income. This is the reason why the book value method is the method of choice.
Common Stock Rights
Rights issued in connection with the preemptive rights of stockholders:

When corporations need cash, one way to raise the cash is to issue more common stock... When unissued
common stock is issued, existing common stockholders usually must be given the right to acquire the
new shares in the same proportion that they own the issued shares. For example, assume a corporation
decided to issue an additional 1,000,000 shares of unissued common stock. Stockholder A, who currently
owns 2% of the issued common shares, must be given rights to acquire 20,000 shares (1,000,000 shares
X 2%) of the new offering. The right to maintain ones ownership percentage is referred to as the

preemptive right of each stockholder.

Preemptive rights are issued by the corporation for no consideration, and the rights expire after a
designated period. The rights permit the holders to acquire unissued common stock at a specified price
per share, referred to as the strike price or the exercise price.

Holders of the rights may exercise them and acquire common stock, or they may choose to sell the rights
to other investors. If the market value of the common stock falls below the exercise price and remains
below the exercise price, the rights will lapse because investors will not act irrationally and acquire
common stock at a price above market value.

In accounting for preemptive stock rights, no entries are made by the corporation when rights are
issued. When rights are issued, the corporation does not record any journal entries because the rights
were issued for no consideration.

When rights are exercised, the corporation records the issuance of common stock and the receipt of cash
equal to the shares issued times the exercise price per share. Until the rights are exercised, disclosure of
the rights is made in the notes to the financial statements.

Example: CRT Company issued rights to acquire 1,000,000 shares of its unissued common stock at a price of $25
per share on February 15, 2011. The rights expire on May 15, 2011. The market value of CRTs $5 par value
common stock was $26 per share on the date the rights were issued. On April 10, 2011, 600,000 rights were
exercised when the market price of CRTs common was $29 per share.
February 15, 2011 journal entry:
No entry is made on the date the rights are issued. There is nothing to record on the issuance date because the
rights were issued for no consideration.
April 10, 2011 journal entry:
CASH (600,000 shares X $25 exercise price)

15,000,000

COMMON STOCK (600,000 shares X $5 par value)

3,000,000

ADDITIONAL PAID IN CAPITAL

12,000,000

DEMONSTRATION OF CONCEPTS: STOCK RIGHTS

A corporation issued rights to its existing
stockholders to purchase unissued shares
of $10 par value common stock for $25 per
share. The rights were issued for no
consideration. Additional paid-in capital will
be credited when the rights are

WHEN RIGHTS ARE EXERCISED, THE FOLLOWING JOURNAL ENTRY IS

MADE:

CASH

25
COMMON STOCK
ADDITIONAL PAID IN CAPITAL

10
15

THERE IS NO JOURNAL ENTRY MADE WHEN THE RIGHTS

ARE ISSUED.
A.

Issued
No

Exercised
Yes

B.
C.
D.

No
Yes
Yes

No
No
Yes

Answer: A

DEMONSTRATION OF CONCEPTS: STOCK RIGHTS

On July 1, 2011, Vail Corp. issued rights to
stockholders to subscribe to additional shares of
its common stock. One right was issued for each
share owned. A stockholder could purchase one
additional share for 10 rights plus $15 cash. The
rights expired on September 30, 2011. On July 1,
2008, the market price of a share with a right
attached was $40, while the market price of one
right alone was $2. Vails stockholders equity on
June 30, 2011, comprised the following:

RETAINED EARNINGS IS NOT AFFECTED BY THE

ISSUANCE OF STOCK RIGHTS. REMEMBER, THERE
IS NO JOURNAL ENTRY MADE WHEN RIGHTS ARE
ISSUED BECAUSE THE RIGHTS ARE ISSUED FOR
NO CONSIDERATION.

Answer: A

Common stock, $25 par value, 4,000

shares issued and outstanding
$100,000
Additional paid-in capital
60,000
Retained earnings
80,000
By what amount should Vails retained earnings
decrease as a result of issuance of the stock rights
on July 1, 2011?
A.
B.
C.
D.

$0
$ 5,000
$ 8,000
$10,000

Bonds Issued with Detachable Warrants

Fay Company issued bonds with a face amount of $200,000. Each $1,000 bond contained 5 detachable stock
warrants to purchase 5 shares of Ray's common stock at $40 per share. Total proceeds from the issue (bonds and
warrants) amounted to $240,000. Immediately after the issuance of the bonds with detachable stock purchase
warrants, the market value of each warrant, selling independently of the bonds, was $40, and the total market
value of the bonds, selling independently of the warrants, was $196,000. At the date the bonds were issued, the
market price of Ray's common stock was $55 per share.
When the bonds and detachable warrants are issued,
one cash amount is received for both the bonds (debt)
and the warrants (stockholders equity). The accounting
problem is to allocate this one cash amount into the
amount received for debt and the amount received for
stock.

After the warrants are detached,

the bonds and the warrants will
each sell independently of each
other. The market values of the
bonds and the warrants will be
used to allocate the cash amount

received into debt and stockholder

equity elements.
W
W
A
A
R
R
R
BONDS
R
A
BONDS
A
N
N
T
T
S
S
Since the warrants are detachable, the proceeds from issuing bonds with detachable warrants should be accounted
for as part debt and part equity. The inseparability argument that was used for convertible bonds does not apply to
bonds issued with detachable warrants because an investor can be both a bondholder and a stockholder at the
same time. In addition, the value for the warrants can be determined using reliable fair values for both the bonds
and the warrants. Therefore, the value for the warrants is not subjective.
Proportional method for allocating the proceeds received from the issuance of debt with detachable warrants:

Formula for amount allocated to debt:

Fair value (FV) of debt without warrants

Debt

Proceeds
from debt
and warrants

$240,000

FV of debt without warrants + FV of warrants

without debt
$196,000
=
$196,000 + $40,000*
* 200 bonds X 5 warrants per bond X $40 per warrant = $40,000
=

$199,322
=======

Journal entry to record issuance of debt with detachable warrants:

CASH

240,000

DISCOUNT ON BONDS ($200,000 face value less $199,322)

678

BONDS PAYABLE

200,000

ADDITIONAL PAID IN CAPITAL-WARRANTS

($240,000 less $199,322)

40,678

Total amount received

for bonds and common stock:
$240,000

Amount allocated to debt $199,322(the $199,322 represents

the present value of the future cash flows related to the bonds)
$200,000 face value of debt $199,322 = $678 bond discount.

Amount allocated to stockholders equity $40,678(this is the

amount that investors paid for the right to become common
stockholders: $240,000 minus $199,322 = $40,678). Note
that this amount is not directly calculated by the formulait
is plugged.
The formula could also have been used to directly determine the amount of the proceeds that came from the
detachable warrants. Note that you would not apply the formula twice to the same transaction since the amount
that is not directly calculated is plugged.

Formula for amount allocated to warrants:

Fair value(FV) of warrants

Warrants =

Proceeds
from debt
and warrants

$240,000

FV of debt without warrants + FV of warrants

without debt
$40,000
Warrants =
$196,000 + $40,000*
* 200 bonds X 5 warrants per bond X $40 per warrant = $40,000
=

$40,678
=======
Do exercises 16-8 and 16-9 at this time.
Incremental method of allocating the amount received from the issuance of bonds with detachable warrants:
Materiality considerations permit using the incremental method instead of the proportional method when
allocating the proceeds from the issuance of bonds with detachable warrants. The incremental method does
not use a formula. It takes one of the market values, for example, the market value of the bonds, and uses it
as the amount that is allocated to debt. The amount allocated to debt is then subtracted from the total amount
to plug in the value for the warrants. In the Fay Company example, the incremental method would produce
the following results if the market value of the bonds was selected as the primary value:
$196,000 from bonds (this is the market value of the bonds
without the warrants) $200,000 face value $196,000 = $4,000 bond
discount.
$240,000 cash received
$ 44,000 from warrants(this amount is plugged: $240,000 less
$196,000 = $44,000)
Journal entry to record the issuance of bonds with detachable warrants:
CASH

240,000

DISCOUNT ON BONDS($200,000 less $196,000)

4,000

BONDS PAYABLE

200,000

ADDITIONAL PAID IN CAPITAL-WARRANTS

44,000

The proportional method should be used when the fair values of the bonds and the warrants are known.
Do exercise 16-8 and CA 16-1 (part an only) at this time.

Employee Stock Options

Stock options are a form of compensation for executives. Instead of giving more salary, the recipients of stock
options are given the opportunity to acquire

a specific number of common shares of the company;

at a designated price per share, known as the exercise price or the strike price;
for a specific time period, known as the exercisable period; and
after they work for a specific period of time, known as the vesting period.

To keep outstanding executives, a company

grants them stock options as a form of salary.
However, the executives have to continue
working for the company before they can
exercise their options, and the options cannot
be sold or transferred.

Corporation has executives

that it wants to keep. It grants
these executives stock
options.

Stock options are difficult to measure (determine a dollar value for) because

they are not transferable(if the recipients of stock options leave the company, their stock options are
terminated);
no cash exchange value is ever established for the option because the options cannot be sold.

Note: stock options are used by corporations to keep valuable employees; however, their importance in new and
emerging companies is critical because these companies usually do not have the cash flow to pay high salaries.
Therefore, valuable employees are granted options to acquire the companys common stock at a fixed price per
share. The hope is that the company will become very successful, and that its earnings and common stock price
will both increase, thus making the stock options valuable.

How do stock options work?

Employees

work and pay the exercise price

common stock is issued

10

Employer

Grant date

Options expire

I-------------------work period--------------------I---------------exercisable period----------------I

Employees work for the right to buy stock. Employees can acquire stock at the exercise price.

Vesting period

GENERALLY ACCEPTED ACCOUNTING PRINCIPLES FOR STOCK OPTIONS

FASB guidance for accounting for stock-based compensation
1.

FASB standards require stock options to be valued at their fair value on the date of grant for public
companies (companies whose stock is traded on national or regional exchanges). The fair value of the
stock options would be determined using an options pricing model-examples, the Black-Scholes
Option Pricing Model or a binominal model.

2.

The following factors are used in determining the estimated fair value of stock options at the
grant dateyou should know that these factors are used to determine an estimate of an options fair
value, but you should not be concerned about using them to calculate a fair value.

The exercise price;

The expected volatility of the common stock;

The market value of the common stock on the grant date;

Expected life of the options;

Risk-free interest rate for the expected term of the options; and

Expected dividends on the common stock.

The amounts are assumed in the example below:

Grant date

Exercise date

--------------------------------------------------------------------------------------------------------------|
Market value on grant date:
Present value of exercise price
Present value of expected dividends
Estimated value of single option

$30
(22)the exercise price is set equal to the market price on the grant
( 3) date to give employees favorable income tax treatment.
$5

11

Number of options granted

Total compensation expense
Vesting period
Expense allocated to each year

10,000
$50,000
4 years
$12,500

Present value the exercise price and expected dividends using the risk free interest rate and subtract both
amounts from the market value of the common stock on the grant date. The difference is the estimated fair
value of an option, before adjusting for expected volatility.
Questions on stock options
On January 1, 2010, Taft Inc. granted stock options that
vest and become exercisable on January 1, 2012, after
employees have worked for two years. Employees may
exercise their options during the period January 1, 2012
through December 31, 2015. Over what time period
should Taft recognize compensation expense for the stock
options granted in 2010?
A.
B.
C.
D.

Compensation expense related to stock options

is allocated over the vesting period2010 and 2011.

In 2010 only.
In 2010 and 2011.
During the period 2010 through 2015.
During the period 2012 through 2015.

Answer: B
On January 2, 2010, Crandle Company, a public company,
granted options to its key executives to purchase 50,000 shares
of its $5 par value common stock at $30 per share. The options
vest and are exercisable beginning on January 1, 2012, after
employees have completed two years of service. The market
value of Crandles common stock was $30 per share on January
2, 2010 and $34 per share on December 31, 2010. The options
are exercisable over the period January 1, 2012 through
December 31, 2014. All the options were exercised in 2013.
Assume the fair value of a single option was $8 on
January 2, 2010.

Number of options
Fair value of an option
Fair value of options on
1/02/10

How much expense should be reported for the options

granted in 2010?
A.
$380,000.
B.
$400,000.
C.
$200,000.
D.
$190,000.

Service period

50,000
$

$400,000
2 years

Compensation expense each year:

$400,000 divided by 2 years =

.
Answer: C

Journal entry (the entry is an adjusting entry) made at the end of both years (2010 and 2011):

12

$200,000

Compensation Expense
Additional Paid in CapitalStock Options

200,000
200,000

Journal entry made when the options were exercised in 2013:

(2) Cash(50,000 shares X $30)
(1) Additional Paid in CapitalStock Options
(3) Common Stock (50,000 shares X $5)
(4) Additional Paid in CapitalExcess Over Par (plug)

1,500,000
400,000
250,000
1,650,000

EMPLOYEES

EMPLOYER
(1) WORK FOR A SPECIFIED PERIOD (VESTING PERIOD) AND
(2) PAY A SPECIFIED PRICE PER SHARE(EXERCISE / STRIKE PRICE)
(3) COMMON STOCK (PAR VALUE) IS ISSUED TO EMPLOYEES
(4) ADDITIONAL PAID IN CAPITAL FOR THE EXCESS OVER PAR VALUE

Note that reporting compensation expense on 12/31/10 and 11 had no effect on total stockholders
equity because total compensation expense of $400,000 is closed to retained earnings and offsets
the increase of $400,000 to additional paid in capitalstock options of $400,000. As a result of the exercise
of the stock options, total stockholders equity increased $1,500,000 (the amount of cash received) and
additional paid in capital increased a net of $1,650,000 ($400,000 from the 12/31/10 and 11 entries and
$1,250,000 from the exercise ($1,650,000 minus $400,000).
Assets

Liabilities

Cash +$1,500,000

Stockholders equity

Common stock + $ 250,000

APIC
+$1,250,000

Expiration of stock options :

If an employee does not exercise stock options, the company should make the following journal entry when
the options expire (assume $100,000 expired because the options were underwater during most of the
exercisable period) :
Additional Paid in Capital-Stock Options
Additional Paid in Capital-Expired Stock Options
Forfeiture of stock options :

13

100,000
100,000

If an employee fails to satisfy the service or vesting requirement because s/he leaves the company, the
cumulative compensation expense recognized to date has to be reversed in the current year (assume that
$50,000 of expense was reported in each of the past 2 years for the employees who left the company):
Additional Paid in Capital-Stock Options
Compensation Expense

100,000
100,000

Additional paid in capital-stock options can be debited in three situations : (1) exercise of stock options, (2)
expiration of stock options, and (3) forfeiture of stock options.
Do exercises 16-10 and 16-12 and problems 16-1 and 16-3 at this time.
Other forms of transactions involving common stock issuances to employees
Stock bonus or award plans
Common shares are issued to executives based upon the accomplishment of some performance criterion, for
example, the growth in the companys earnings from the previous year. Bonus or award plans are not tied to
the market value of the common stock like stock options are. This means that an executive may receive a
stock bonus or award in a particular year even though the companys common stock price may be depressed.
A depressed common stock price makes the exercise of stock options less appealing. Assume an executive
was awarded 5,000 shares of common stock due to a 20% increase in the company's earnings this year. If the
market value of the common stock is $25 per share, then $125,000 of compensation expense would be
recognized. Note that bonus and award plans are 100% compensatory. Assume the par value of the common
stock was $5 per share. The entry to record compensation expense is shown below.
Entry to recognize common stock award:
COMPENSATION EXPENSE (5,000 shares X $25)

125,000

COMMON STOCK (5,000 shares X $5 par value)

25,000

ADDITIONAL PAID IN CAPITAL-EXCESS OVER PAR

100,000

The financial statement effects of the entry are shown belownote that there are no effects on assets and
liabilities.
Assets

Liabilities

Stockholders equity
-Compensation expense -$125,000
(retained earnings)
+Common stock
+$25,000
+Additional paid in
capital-excess over par +$100,000

Restricted stock awards

14

Employees are granted common stock but they cannot dispose of the stock until they complete the vesting period.
If employees do not complete the vesting period, the shares must be given back to the corporation. Assume that a
corporation granted Mary Hines 1,000 shares of restricted common stock on January 1, 2009. The par value of the
common is $2 per share, and the fair value of each share on the grant date was $15. The vesting period is 4 years.
Mary worked for the corporation in 2009 and 2010, but she left the company in 2011.

Journal entries for 2009:

1/1/09
UNEARNED (DEFERRED) COMPENSATION*

15,000

COMMON STOCK

2,000

ADDITIONAL PAID IN CAPITAL-EXCESS OVER PAR

13,000

*Unearned compensation is reported as a contra item in stockholders equity, similar to treasury stock.
The financial statement effects of the entry are shown belownote that there are no effects on assets and
liabilities.
Assets

Liabilities

Stockholders equity
-Unearned Compensation -$15,000
(retained earnings)
+Common stock
+$2,000
+Additional paid in
capital-excess over par +$13,000

12/31/09:
COMPENSATION EXPENSE

3,750

UNEARNED COMPENSATION

3,750

The financial statement effects of the entry are shown below:.

Assets

Liabilities

Stockholders equity
-Compensation expense -$3,750
(retained earnings)
+Unearned compensation+$3,750

12/31/10
COMPENSATION EXPENSE

3,750

15

UNEARNED COMPENSATION

3,750

Journal entry made after Mary leaves the company in 2011, assuming no expense was recognized in 2011:
COMMON STOCK

2,000

ADDITIONAL PAID IN CAPITAL-EXCESS OVER PAR

13,000

COMPENSATION EXPENSE

7,500

UNEARNED COMPENSATION

7,500

The financial statement effects of the entry are shown below.

Assets

Liabilities

Stockholders equity
+Compensation expense +$7,500
(retained earnings)
+Unearned compensation +$7,500
-Common stock
-$2,000
-Additional paid in
capital-excess over par -$13,000

Do exercise 16-13 at this time

Employee stock purchase plans--employees who meet certain eligibility criteria may acquire shares of the
company's common stock at a designated price per share, usually 5% below market value. The FASB restricts
the discount in employee stock purchase plans to 5% in order for the plan to be noncompensatory. These plans
are intended to raise equity capital or to achieve a wider distribution of the companys common stock and are,
therefore, not intended to be compensatory. Assume employees acquired 10,000 common shares at a 5%
discount from the market price of $20 per share. Assume that the par value of the common stock was $5 per
share
The entry to recognize common stock acquired by employees is:
CASH (10,000 shares X $19)

190,000

COMMON STOCK(10,000 shares X $5 par value)

50,000

ADDITIONAL PAID IN CAPITAL-EXCESS OVER PAR

140,000

16

The financial statement effects of the entry are shown below.

Assets

Liabilities

+Cash $190,000
(10,000 shares X $19)

Stockholders equity
+Common stock $50,000
+Additional paid
in capital-excess
over par
$140,000

Do problem 16-4 at this time.

History of Incentive Stock Options

Options originated in the 60s as part of the compensation package of executivessalary,

pension, sick pay, vacation pay, health insurance, life insurance, stock options, restricted
stock awards, stock bonuses and awards, etc.
In the early 70s, the Accounting Principles Board stated that there should be no
compensation expense related to incentive stock options if the exercise price and the market
price of the common stock were equal on the date the stock options were granted. As a result,
corporations did not recognize any compensation expense related to incentive stock options
because corporations structured their options so that the exercise price and the market price
of the common stock were the same on the grant date. To get favorable income tax treatment,
this is the way stock options have to be structured.
In the early 90s, an article in The Wall Street Journal stated that Michael Eisner, then the
CEO of Disney, exercised his stock options and made $66 million. The $66 million was the
difference between the market price and the exercise price of Disney common when Mr.
Eisner exercised his options.
The U.S. House of Representatives member from Michigan, the Honorable Mr. Dingle, read
this article and asked how much expense Disney reported on its income statement as a result
of Mr. Eisner exercising his options. When he found out that it was $0, he immediately
formed a House committee to investigate the accounting for stock options. This led to the
committee putting pressure on the SEC and the FASB to come up with a standard that
required the expensing of employee stock options.
After the FASB worked on the standard for about one year, small emerging companies paid
lobbyists to influence Congress to reverse its position on stock options and to permit $0
expense. Congress then told the SEC and the FASB to stop working on the stock options
standardthat compensation expense related to stock options should not be required.
The FASB passed a standard in 1993 that recommended recognizing compensation expense
for stock options. However, it did not require expensing. Companies had a choiceeither
report $0 expense or report an expense. No companies recognized expense from their stock
options until the early 00s.
As a result of the accounting scandals in the early 00s involving companies such as World
Com and Enron, Congress got involved again with the accounting for stock options. Coca
17

Cola, Boeing, Winn-Dixie, and ABM Property Corp. decided to voluntarily recognize
expense from their stock options.
The FASB then passed a standard in 2004 that required all companies to expense their stock
options using an options pricing model such as the Black-Scholes or the binomial models.
There is harmonization between U.S. GAAP and IFRS on the accounting for stock options.

Analysis and computation of earnings per share

Earnings per share is one of the most used ratios in assessing profitability. How is earnings per share used?
Earnings per share is used to value the common stock of a firm. This is accomplished through the priceearnings multiple. For example, if earnings per share is $2.00, and the current price to earnings multiple for
the company is in the range of 12-15 times earnings per share, the market price of one share of common stock
should be in the range of $24 to $30.
Market value per common share is also predicted by using this same methodology. For example, analysts
predict the firms earnings per share for next year. If analysts agree that the earnings per share for next year
should be in the range of $2.10 to $2.15 per share, then the market value of the common stock during the next
year should be in the range of $25.20 ($2.10 X 12) to $32.25 ($2.15 X 15).
Lets review how this very significant ratio is calculated. Earnings per share is calculated in simple and
complex capital structures. Lets begin by computing earnings per share in a simple capital structure.
Simple capital structure
A capital structure is simple if it does not contain securities that are potentially dilutive. Potentially dilutive
securities include the following securities:

Convertible bonds;
Convertible preferred stock; and
Stock rights, options, and warrants

If potentially dilutive securities are converted or exercised, basic earnings per share may be decreased. The
decrease in basic earnings per share is referred to as dilution.
A simple capital structure contains common stock and no other securities that could dilute basic earnings per share.
Basic earnings per share in a simple capital structure
Net income less preferred dividends*
Basic earnings per share

=
Weighted average of common shares outstanding

18

* Current year preferred dividends are deducted whether declared or not if the preferred stock is cumulative. If the
preferred stock is not cumulative, current year dividends are deducted only if they have been declared.

Garth Inc. reported net income of $250,000 during 2010. The company declared preferred dividends of
$20,000 during 2010. The company started and completed the year with 100,000 shares of common stock
outstanding. Garth did not issue or reacquire any of its common stock during 2010.
$250,000 less $20,000
Basic earnings per share

=
100,000 common shares outstanding
=

$2.30 per share

Weighted average of common shares outstanding

Assume Garth Inc. started 2010 with 100,000 common shares and had the following stock transactions
during 2010:
o
o

On 4/1, 25,000 shares were issued for cash;

On 7/1, 10,000 shares were reacquired and held as treasury stock.

Calculate Garths weighted average number of common shares outstanding for 2010.
Shares outstanding

Fraction of year outstanding

Weighted average

100,000 (from 1/1 to 4/1)

3/12

25,000

125,000 (from 4/1 to 7/1)

3/12

31,250

115,000 (from 7/1 to 12/31)

6/12

57,500

Weighted average of common shares outstanding

113,750
======

Another approach to this computation is shown below.

Shares outstanding

Fraction of year outstanding

Weighted average

100,000 shares

12/12

100,000

25,000 shares

9/12

18,750

(10,000) shares

6/12

( 5,000)

Weighted average of common shares outstanding

113,750
======

Garths basic earnings per share for 2010 would be calculated as follows:

19

$250,000 less $20,000

Basic earnings per share=
113,750 common shares outstanding
=

$2.02 per share

============

Stock dividends and stock splits and the effect on the weighted average of common shares outstanding
Assume Garth Inc. started 2010 with 100,000 common shares and had the following stock transactions
during 2010:
o
o
o

On 4/1, 25,000 shares were issued for cash;

On 7/1, 10,000 shares were reacquired and held as treasury stock;
On 10/1, Garth had a 2 for 1 stock split.

Calculate Garths weighted average number of common shares for 2010.

Shares outstanding

Fraction of year outstanding

100,000 (from 1/1 to 4/1) X2

125,000 (from 4/1 to 7/1) X2
115,000 (from 7/1 to 12/31) X2

Weighted average

3/12
3/12
6/12

50,000
62,500
115,000
227,500
======
Note that a stock split (or a stock dividend) is an adjustment to the shares that were outstanding during 2010.
For EPS purposes, stock splits and stock dividends require restatements of common shares that were
outstanding prior to the split or stock dividend.
Unlike an issuance of shares for cash or the reacquisition of treasury shares for cash, a stock split or a stock
dividend is not weighted from the date of the split or stock dividend.
The same weighted average would have resulted if Garth had declared and issued a 100% stock dividend on
October 1, 2010.
Garths basic earnings per share for 2010 is shown below:
$250,000 less $20,000
Basic earnings per share=
227,500 common shares
=

$1.01 per share

============

20

Garth must also restate prior years earnings per share as a result of its 2 for 1 split in 2010. Assume Garth
originally reported the following amounts for basic earnings per share in 2008 and 2009:
o

2009
$1.90

Basic EPS

2008
$1.50

In 2010, Garth must restate basic EPS for both 2009 and 2008 so that the amounts are consistent with basic
EPS for 2010(note that restatement of EPS is also required for stock dividends):
2010
2009
2008
o

Basic EPS

$1.01

$ .95

$ .75

Disclosure issues for earnings per share

Required to be reported on the face of the income statement for all companies whose
securities are traded on stock exchanges.

Income elements upon which EPS is required to be disclosed:

Income(loss) from continuing operations and

Net income(loss).

Optional EPS disclosureseither on the face of the income statement or in the notes:
o

Income/loss from discontinued operations;

Income before extraordinary item; and

Extraordinary gain/loss

Do exercises 16-15, 16-18, and 16-19 at this time.

21

Basic and diluted earnings per share for a complex capital structure
If a corporation has a complex capital structure, a dual presentation of earnings per share may be necessary. A
complex capital structure is one that contains potentially dilutive securities. Potentially dilutive securities are
securities that, if converted or if exercised, may result in a reduction in basic earnings per share. If there is a
reduction in basic earnings per share, then diluted earnings per share must be disclosed along with basic earnings
per share.
Case I:
ABC Company provided you with the following information for 2010:
1.
2.
3.
4.

Net income
Weighted average shares of common stock outstanding during 2010
Preferred dividends declared
Additional information: The preferred stock is convertible into 20,000 shares
of common stock. The convertible preferred was outstanding during all of
2010. The convertible preferred stock is a potentially dilutive security.

Basic earnings per share

$100,000
100,000
10,000

= Income available to common / weighted average of common shares

Description

Numerator

Net income

$100,000

Preferred dividends

( 10,000)

Weighted average
shares of common
Totals

-----------$ 90,000
========

Denominator

Basic EPS

100,000
------------100,000
=======

$ .90 share
========

Diluted earnings per share:

Diluted EPS
Totals from basic EPS

$ 90,000

100,000

If converted method

22

applied to convertible
preferred stock:

Dividends avoided
Common shares
assumed issued

+ 10,000

----------$100,000
=======

Totals

+ 20,000
-----------120,000
========

$ .83 share
=========

Case I conclusion:
The convertible preferred stock is actually dilutive. Basic earnings per share was decreased from $.90 a share
to $.83 a share. Both basic and diluted earnings per share amounts would be reported on the face of the
income statement, assuming ABCs securities are publicly traded.
Earnings per share on net income for 2010:
Basic earnings per common share on net income

$ .90

Diluted earnings per common share on net income

$ .83

Assume, in case I, that net income was $50,000 instead of $100,000. Compute basic and diluted
earnings per share for 2010.
Basic earnings per share

= Income available to common / weighted average of common shares

Description

Numerator

Net income

$ 50,000

Preferred dividends

( 10,000)

Weighted average
shares of common
Totals

-----------$ 40,000
========

Denominator

Basic EPS

100,000
------------100,000
=======

$ .40 share
========

Diluted earnings per share:

Diluted EPS
Totals from basic EPS

$ 40,000

100,000

If converted method
applied to convertible
preferred stock:

23

Dividends avoided
Common shares
assumed issued

Totals

+ 10,000

----------$ 50,000
=======

+ 20,000
-----------120,000
========

$ .42 share
=========

In the revised case I, diluted earnings per share is higher than basic earnings per share. This means
that the convertible preferred is antidilutive. Only basic earnings per share of $.40 should be reported on
the face of the income statement for 2010.
Case II:
ABC Company provided you with the following information for 2010:
1.
2.
3.
4.

Net income
$100,000
Weighted average shares of common stock outstanding during 2010
100,000
Preferred dividends declared
10,000
Additional information: The preferred is not convertible. However, ABC had convertible
bonds outstanding during all of 2010. The bonds were convertible into 20,000 shares of
common. Interest expense on the bonds for 2010 was $10,000, and the income tax rate
for 2010 was 40%. The convertible bonds are a potentially dilutive security.

Basic earnings per share

Income available to common / weighted average of

common shares

Description

Numerator

Net income

$100,000

Preferred dividends

( 10,000)

Denominator

Weighted average of common

shares
Totals

-----------$ 90,000
========

100,000
----------100,000 =
========

Basic EPS

$ .90 share
========

Diluted earnings per share:

Diluted EPS
Totals from basic EPS
If converted method applied to
convertible bonds:
Interest expense avoided
net of tax: $10,000 ( 1 - .40)
Common shares assumed
issued

$ 90,000

100,000

+6,000
+ 20,000

24

-----------$ 96,000
=======

Totals

----------120,000 = $ .80 share

========
=========

Case II conclusion:
The convertible bonds are actually dilutive. Basic earnings per share decreased from $ .90 a share to
$ .80 a share. As in Case I, both basic and diluted earnings per share would be reported on the face of the
income statement, assuming ABCs securities are publicly traded. Note that the interest avoided computation
is net of tax, whereas the dividends avoided computation for convertible preferred is not net of income tax
because preferred dividends are not an expense.
Case III:
ABC Company provided you with the following information for 2010:
1.
2.
3.
4.

Net income
Weighted average shares of common stock outstanding during 2010
Preferred dividends declared
Additional information: The preferred stock is convertible into 20,000 shares
of common stock. The convertible preferred was outstanding during all of
2010. ABC had convertible also had bonds outstanding during all of 2010.
The bonds were convertible into 20,000 shares of common. Interest expense
on the bonds for 2010 was $10,000, and the income tax rate
for 2010 was 40%.

Basic earnings per share

Income available to common / weighted average of

common shares

Description

Numerator

Net income

$100,000

Preferred dividends

( 10,000)

Denominator

Weighted average of common

shares
Totals

$100,000
100,000
10,000

-----------$ 90,000
========

100,000
----------100,000 =
========

Basic EPS

$ .90 share
========

Diluted earnings per share:

Diluted EPS
Totals from basic EPS
If converted method applied to
convertible bonds:
Interest expense avoided
net of tax: $10,000 ( 1 - .40)
Common shares assumed
issued

$ 90,000

100,000

+6,000
+ 20,000

25

$.80 share

If converted method
applied to convertible
preferred stock:

Dividends avoided
Common shares
assumed issued

+ 10,000

-----------$106,000
=======

Totals

+ 20,000
----------140,000 = $ .76 share
========
=========

Sequential loading of potentially dilutive securities into diluted earnings per share
Rank each potentially dilutive security based on its incremental numerator and denominator effects:

Convertible bonds:
Incremental numerator:
Incremental denominator

Interest expense avoided(net of tax)

= ------------------------------------------Number of common shares issued
upon conversion
=

$6,000 of interest expense

------------------------------------------20,000 common shares

= $.30 per share

Convertible preferred:
Incremental numerator:
Incremental denominator

Preferred dividends avoided

= ------------------------------------------Number of common shares issued
upon conversion
=

$10,000 of dividends
------------------------------------------20,000 common shares

= $.50 per share

Each security is loaded into basic earnings per share, in the order that from lowest incremental
effects to highest incremental effects, until diluted earnings per share stops decreasing.
26

Case III conclusion:

Both the convertible bonds and convertible preferred stock are actually dilutive. Basic earnings per share decreased
from $ .90 a share to $ .76 a share. Both basic and diluted earnings per share would be reported on the face of the
income statement, assuming ABCs securities are publicly traded.
Do exercises 16-24 and 16-25 at this time
Case IV:
1.
2.
3.
4.
5.

Net income for 2010

$100,000
Preferred dividends declared on nonconvertible preferred
10,000
Weighted average shares of common stock outstanding during 2008
100,000
ABC does not have any convertible bonds
ABC had stock options outstanding for 20,000 shares of common at an exercise price of $18
per share. The average market price during 2010 of ABCs common was $30 per share. The ending
market price on December 31, 2010 was $32. The stock options are a potentially dilutive security.
When determining dilution for stock options, disregard the ending market price of the common stock.
Stock options are always dilutive if the average market price is greater than the exercise
price. If the exercise price is greater than the average market price, the stock options are
antidilutive. This means that the treasury stock method would result in higher diluted earnings
per share than basic EPS. In this situation, the assumption that the stock options were exercised
would not be made. Also, a rising common stock price for a company has the effect of decreasing
diluted earnings per share because the larger the spread between the average market price and the
exercise price, the more the dilution in basic earnings per share.
Basic earnings per share

Income available to common / weighted average of

common shares

Description

Numerator

Net income

$100,000

Preferred dividends

( 10,000)

Denominator

Weighted average of common

shares
Totals

-----------$ 90,000
=======

100,000
--------------100,000
=
=========

Diluted earnings per share:

Totals from basic EPS

Basic EPS

$ .90 share
=========
Diluted EPS

$ 90,000

27

100,000

Treasury stock method applied

to stock options:
$30 minus $18
------------------ X 20,000 options =
$30

0
----------$ 90,000
=======

Totals

8,000
/

-----------108,000
========

$ .83 share
=========

Case IV conclusion:
The stock options are dilutive. Basic earnings per share was reduced from $.90 a share to $.83 a share. ABC is
required to report both basic and diluted earnings per share on the face of its income statement, assuming that
ABCs securities are publicly traded.
Comments about the Treasury Stock Method:
The treasury stock method is based upon the following assumptions, using the information from Case III:
a. Assume all options are exercised
as of the first day of the year:

20,000 options X $18 = $360,000. The cash goes to ABC

and 20,000 common shares are assumed to be issued to
employees.

b. Assume all the cash is used to

acquire common stock at the
average market price:

$360,000 / $30 per share(the average market price) = 12,000

shares of common stock reacquired. This stock represents
treasury stock that is assumed to be purchased.

c. Net the effects of (a) and (b):

20,000 shares were issued and 12,000 shares were reacquired.

This leaves 8,000 shares issued for nothing. The 8,000
common shares issued for nothing represents the dilutive
effect.

Employees

Corporation

---------------------------------------------------------------------------------------------- $360,000 cash

20,000 common shares ----------------------------------------------------------------------$360,000 cash ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ 12,000 common shares
in treasury
Net effect of the assumptions: 20,000 shares issued less 12,000 shares in treasury = 8,000 shares of
common stock are outstanding.
Do exercises 16-26 and 16-28 at this time.

28

Stock Option Graph

$
In the money/above water
Market $
Exercise $
Out of the money/below water

Vesting period

Exercisable period

29

Time
Options expire

International Financial Accounting Standards

IFRS and U.S. GAAP are substantially the same in the accounting for stock options and earnings per
share. The minor differences that exist are being worked on, and these should be resolved in the next
year or so.

More substantial differences exist in the accounting for convertible debt and employee stock purchase
plans.

IFRS requires that the proceeds received from the issuance of convertible bonds be allocated into debt
and equity amounts. The process of allocation is referred to as bifurcation. Example: assume a
company issued convertible bonds with a face value of $500,000 for $492,000. IFRS requires that the
present value of the bonds be determined using the market rate of interest. Assume that, using the
market rate of interest, the present value of the bonds is determined to be $471,000. The allocation
below shows how the proceeds of $492,000 are allocated to debt and to equity:

Present value of bonds $471,000

$492,000
Equity component = $492,000 471,000 = $21,000
is plugged
Cash
Discount on Bonds ($500,000 minus 471,000)
Bonds Payable
Share PremiumConversion Equity

492,000
29,000
500,000
21,000

Conversions of convertible bonds are accounted for using the book value method. Assuming all
convertible bonds were converted when the carrying amount of the bonds was $480,000, the entry
below would be made:
Bonds Payable
Share PremiumConversion Equity
Discount on Bonds ($500,000 minus 480,000)

30

500,000
21,000
20,000

Share CapitalOrdinary (par value is assumed)

Share PremiumOrdinary(amount plugged)

50,000
451,000

Employee stock purchase plans are always compensatory. Under U.S. GAAP, these plans were not
compensatory if the discount from the market price of the ordinary shares was no more than 5%.
Assume a companys employees acquired 10,000 ordinary shares at a 5% discount from the market
price of $20 per share, and that the par value of the ordinary shares was $5 per share. The journal
entry to record the employee stock purchase is shown below:
The entry to recognize common stock acquired by employees is:
CASH (10,000 shares X $19)

190,000

COMPENSATION EXPENSE ($20 19 = $1 X 10,000 shares)

10,000

SHARE CAPITAL-ORDINARY(10,000 shares X $5 par value)

SHARE PREMIUM-ORDINARY (plug)

50,000
150,000

The financial statement effects of the entry are shown below.

Assets

Liabilities

+Cash $190,000
(10,000 shares X $19)

Stockholders equity
Share capital-ordinary +$ 50,000
Share premium-ordinary +$150,000
Retained
Earnings
--$ 10,000
(Expense)

31

Quiz 2 Take Home Questions

Spring 2015
Use U.S. GAAP unless otherwise noted.
1. On June 30, 2007, Lomond, Inc. issued $100,000 of 6.5% bonds at a discount. Each $1,000 bond
is convertible into 40 shares of common stock. 10,000 shares of Lomond common stock were
outstanding throughout 2010. None of the bonds were converted during 2010. The following
amounts were reported in Lomonds income statement for the year ended December 31, 2010:
Revenues
Operating expenses
Interest expense on bonds
Income before income tax
Income taxes
Net income

$977,000
920,000
7,000
50,000
15,000
$ 35,000

What is Lomonds diluted earnings per share for 2010?

2.

Ute Co. had the following capital structure during 2009 and 2010:
Preferred stock, $10 par, 4% cumulative, 25,000 shares issued
and outstanding
Common stock, $5 par, 200,000 shares issued and outstanding

$ 250,000
1,000,000

Ute reported net income of $500,000 for the year ended December 31, 2010. Ute paid no preferred
dividends during 2009 and paid $20,000 in preferred dividends during 2010. In its December 31,
2010 income statement, what amount should Ute report as basic earnings per share?
3. Strauch Co. has one class of common stock outstanding and no other securities that are potentially
convertible into common stock. During 2009, 100,000 shares of common stock were outstanding. In
2010, two distributions of additional common shares occurred: On April 1, 20,000 shares of treasury
stock were sold, and on July 1, a 2-for-1 stock split was issued. Net income was $410,000 in 2010 and
$350,000 in 2009. What amounts should Strauch report as basic earnings per share for 2010 and 2009
in its annual report for 2010?
4. On January 1, 2010, Watson Co. had 1,000,000 shares of common stock issued and outstanding.
During 2010, the following transactions occurred that involved the companys common stock:

32

On April 1, 50,000 shares were reacquired as treasury stock.

On July 1, 150,000 shares of unissued common stock were issued for cash.
A 20% stock dividend was declared on October 1 on outstanding shares.

Answer the following questions:

A.
B.

At December 31, 2010, how many shares of common stock are outstanding?
For basic earnings per share computations for 2010, what is the weighted average of common
stock outstanding?
Peters Corp.s capital structure is as follows:
December31
2009
2010
Outstanding shares of stock:
Common
110,000
110,000
Convertible preferred
10,000
10,000

5.

During 2010, Peters paid dividends of $3 per share on its preferred stock and $1 per
share on its common stock. The preferred shares are convertible into 20,000 shares of
common stock. Net income for 2010 was $184,000. Assume the income tax rate is 30%.
Answer the following questions(round up to the nearest cent, i.e. $1.845 = $1.85)
A. What is basic earnings per share for 2010?
B. What is diluted earnings per share for 2010?
C. What earnings per share amount(s) is (are) reported on the 2010 income statement?
6.

Mann, Inc. had 300,000 shares of common stock issued and outstanding at December 31,
2009. On July 1, 2010, an additional 50,000 shares of common stock were issued for
cash. Mann also had stock options to purchase 40,000 shares of common stock at $15 per
share outstanding at the beginning and end of 2010. The average market price of Manns
common stock was $20 during 2010, while the market price on December 31, 2010 was
$24. What is the number of common shares that should be used in computing diluted
earnings per share for the year ended December 31, 2010?

7.

Carlton Inc. issued $1,000,000 face value of bonds on April 1, 2010, for $1,150,000. Each $1,000
bond contained 5 detachable stock purchase warrants that enabled the holder to acquire 5 shares of
Carltons common stock for $50 per share. Immediately after the bonds were issued, the market value
of the bonds selling independently from the warrants was $1,080,000, and the market value of each
warrant selling independently of the bonds was $9. What portion of the $1,150,000 should be credited
to premium on bonds?

8.

Carlton Inc. issued $1,000,000 face value of bonds on April 1, 2010, for $1,150,000. Each $1,000
bond contained 5 detachable stock purchase warrants that enabled the holder to acquire 5 shares of
Carltons common stock for $50 per share. Immediately after the bonds were issued, the market value
of the bonds selling independently from the warrants was $1,100,000. Assuming use of the
incremental method, what portion of the $1,150,000 should be credited to additional paid in capital?

9.

Martz Company has an employee stock purchase plan that allows employees who meet certain
eligibility requirements to acquire the companys common stock at a discount of 5% from its market

33

value. For the month ended December 31, 2010, employees acquired 10,000 shares of the companys
$10 par value common stock under this plan. The average market value of the common during
December was $30 per share. Make the journal entry to record the employee stock purchase.

10. On July 1, 2010, Naples Inc. issued 100,000 rights to its common stockholders for no consideration.
The rights entitled the stockholders to acquire 100,000 shares of Naples unissued $10 par value
common stock for $50 per share. On the date the rights were issued, the market price of the common
stock was $48 per share. On September 1, 2010, 30,000 rights were exercised when the market value
of the common stock was $56 per share. On the date the rights were exercised, what amount should
be credited to additional paid in capital in excess of par value?
11. Which of the following statements is correct?
A.
B.
C.
D.

The objective of issuing rights to existing stockholders to acquire unissued common stock is
to raise equity capital.
For financial reporting purposes, employee stock purchase plans are noncompensatory
(compensation expense is not recognized) when the discount from the market value of the
common stock is equal to or less than 5%.
A and B.
Neither A nor B.

12. The inseparability argument applies to which of the following debt issues?
A.
B.
C.
D.
E.

Convertible bonds.
Debt issued with detachable warrants.
Preferred stock that is subject to mandatory redemption.
A and B.
A, B, and C.

13. Which of the following statements is correct?

A.
B.
C.
D.

Stock options are described as being underwater when the market price of the common
stock is below the strike or exercise price.
Compensation expense for stock options should be recognized during the vesting period.
A and B.
Neither A nor B.

14. Which of the following statements is correct?

A.

If a company reports discontinued operations on its income statement, a company whose

stock is publicly traded is required to report an earnings per share amount on income from
continuing operations.

34

B.
C.
D.

The rationale for not reporting gains and losses on bond conversions is that an exchange
transaction has not taken place.
A and B.
Neither A nor B.

15. Which of the following statements is correct?

A. In accounting for stock based compensation under the fair value method, one of the factors used
to determine fair value is the current prime rate of interest.
B. Comparing the book value method with the market value method of accounting for bond
conversions, the market value method would usually produce a higher net income.
C. A and B.
D. Neither A nor B.
16. Which of the following statements is correct?
A.
B.
C.
D.

The cost principle justifies the use of the incremental method to account for debt issued with
detachable warrants.
When a corporation has a complex capital structure, it must report two earnings per share
amounts on the face of its income statement.
A and B.
Neither A nor B.

17. What is the effect on total stockholders equity from each of the events below?
Stock options
are exercised
A.
B.
C.
D.

Increase
No effect
Increase
Increase

Restricted stock
is awarded
Increase
No effect
Decrease
No effect

18. In determining diluted earnings per share, dividends on nonconvertible cumulative

preferred stock should be
A.
B.
C.
D.

Disregarded.
Added back to net income whether declared or not.
Deducted from net income only if declared.
Deducted from net income whether declared or not.

Use the information below to answer questions 19 and 20.

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Butler Company issued $100,000 of convertible bonds for $95,600 on September 1, 2007. Each $1,000 bond
is convertible into 30 shares of Butlers $5 par value common stock beginning on September 1, 2010. On
September 1, 2010, holders of 50 bonds converted their bonds into the companys common stock. The market
value of the common stock on the day of conversion was $40 per share, and the unamortized discount related
to all of the bonds on the same date was $2,300.
19. On September 1, 2010, make the journal entry to record the conversion, assuming the book value
method is used to record the bond conversion?
20. Assuming the market value method is used to record the bond conversion on September 1, 2010, what
is the amount of loss from bond conversion.
Use the information below to answer questions 21-24.
April Hudson and Jack Jenson are executives who work for Larson Industries. On January 2, 2010, Larson
granted each executive 3,000 shares of the companys $3 par value common stock. On the grant date, the fair
value of Larsons common stock was $35 per share. According to the agreement between the company and
the executives, Ms. Hudson and Mr. Jensen have to work for Larson through 2012 before the common stock
can be sold. Both April Hudson and Jack Jensen worked for Larson during 2010 and 2011. However, a family
matter forced Jack Jensen to resign, effective at the beginning of 2012. April Hudson continued working for
Larson throughout 2012.
21.
22.
23.
24.

On January 2, 2010, what amount is credited to additional paid in capital--excess over par?
Make the journal entry to record compensation expense for 2010?
Make the journal entry to record the return of common stock by Jack Jensen in 2012.
What is compensation expense for 2012 related to April Hudson?

Use the information below to answer questions 25-29.

Mary Jones, Robert Smith, Charlie Hall, and Renee Williams are executives who work for Amsdahl Inc. On
January 2, 2009, Amsdahl granted each executive incentive stock options to acquire 5,000 shares of Amsdahl
$2 par value common stock at $18 per share. The options are exercisable beginning on January 2, 2012, and
expire on December 31, 2013. The market value of Amsdahl common was equal to the exercise price on the
grant date. Using an appropriate options pricing model, the fair value of one option on the grant date was
$4.50. All four executives worked for Amsdahl during 2009. During 2010 and 2011, all executives continued
working for the company except for Renee Williams, who resigned effective January 1, 2010. During 2012,
Mary Jones and Charlie Hall exercised their options when the market value of Amsdahl common was $23 per
share. During 2013, the market value of Amsdahl common fell to $16 per share, and Robert Smith let his
options expire.
25. Make the journal entry to record compensation expense for 2009.
26. What amount should be credited to compensation expense in 2010 as a result of Renee Williams
resignation?
27. What is compensation expense for 2011?
28. What amount should be credited to additional paid in capital--excess over par as a result of the
exercise of the stock options in 2012?
29. Make the journal entry to record the expiration of Robert Smiths options in 2013.
30. On June 30, 2011, Busse Inc. issued convertible bonds with a face value of $500,000 for
$492,500. The present value of the bonds on June 30 was determined to be $477,500. Make the

36

journal entry to record the issuance of the convertible bonds using

a.
U.S. GAAP
b.
IFRS

31. Refer to the previous question. Assume all of the convertible bonds were converted when the carrying
value of the bonds was $486,000 and that the par value of the ordinary shares issued upon conversion
was $60,000. Make the journal entry to record the conversion using IFRS.
32. Martz Company has an employee stock purchase plan that allows employees who meet certain
eligibility requirements to acquire the companys ordinary shares at a discount of 5% from its market
value. For the month ended December 31, 2010, employees acquired 10,000 shares of the companys
$10 par value ordinary shares under this plan. The average market value of the common during
December was $30 per share. Make the journal entry to record the employee stock purchase using
IFRS.
33. Clout Corp. reported net income of $500,000 for 2011. The company had 300,000 weighted average
shares of common stock outstanding during 2011. The company also had the following two
potentially dilutive securities outstanding during 2011: (1) 20,000 shares of convertible preferred
stock upon which a dividend of $50,000 was declared during 2011; the preferred is convertible into
30,000 shares of common and (2) $400,000 face value of convertible bonds that are convertible into
20,000 common shares; interest expense related to the bonds was $25,000 for 2011; the income tax
rate is 35%. For 2011, what was Clouts diluted earnings per share? Round as follows: $1.527 =
$1.53.

37

Accountancy 432/532
Quiz 2 Take Home Answers
Spring 2015
Name:

Aoran Kan

Seat #:

26

1.

2.

3.

2010:

2009:

4.

A.

B.

5.

A.
B.

38

C.
6.
7.

8.

9.

10.

11. B
12. A
13. C
14. C
15. A
16. A
17. A
18. D
19.

20.

39

21.

22.

23.

24.

25.

26.

27.

28.

29.

30.

A.

40

B.

31.

32.

33.

41