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19

2012 The McGraw-Hill Companies, Inc.

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Share-Based Awards
Many compensation plans include one or more types of share-based awards. These include outright awards of shares, stock options, or cash payments tied to the market price of shares.

Usually, an executive compensation plan is tied to performance in a way that uses compensation to motivate its recipients. Regardless of the form such a plan takes, the accounting objective is to record the fair value of the compensation expense over the periods in which related services are performed.

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Stock Award Plans

Restricted stock award plans usually are tied to continued employment of the person receiving the award.
The compensation associated with a

share of restricted stock is the market price at the grant date of an unrestricted share of the same stock. The amount is accrued as compensation expense over the service period for which participants receive the shares.

STOCK AWARD PLANS ILLUSTRATION

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Universal Communications grants 5 million of its \$1 par common shares to certain key executives at January 1, 2011. The shares are subject to forfeiture if employment is terminated within 4 years. Shares have a current price of \$12 per share. January 1, 2011 No entry Calculate total compensation expense: \$12 fair value per share x 5 million shares awarded = \$60 million total compensation The total compensation is allocated to expense over the 4-year service (vesting) period: 2011 - 2014 \$60 million 4 years = \$15 million per year December 31, 2011, 2012, 2013, 2014 Compensation expense (\$60 million 4 years) Paid-in capital restricted stock
(\$ in millions)

15

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STOCK AWARD PLANS ILLUSTRATION

Upon vesting:
(\$ in millions)

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Paid-in capital restricted stock (5 million sh. at \$12) Common stock (5 million shares at \$1 par) Paid-in capital excess of par (to balance)

60 5 55

If restricted stock is forfeited because, say, the employee quits the company, related entries previously made would simply be reversed.

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STOCK OPTION PLANS

Stock option plans give employees the option to purchase (a) a specified number of shares of the firm's stock, (b) at a specified exercise price, (c) during a specified period of time. The fair value is accrued as compensation expense over the service period for which participants receive the options, usually from the date of grant to when the options become exercisable (the vesting date).

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Recognizing Fair Value of Options

Estimating fair value requires the use of an option pricing model that incorporates the:
1. Exercise price of the option. 2. Expected term of the option. 3. Current market price of the stock. 4. Expected dividends. 5. Expected risk-free rate of return. 6. Expected volatility of the stock.

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EXPENSING STOCK OPTIONS

At Jan. 1, 2011, Universal grants options to acquire 10 million of the companys \$1 par common shares within the next 8 yrs, but not before Dec. 31, 2014 (the vesting date). The exercise price is the market price on the date of grant, \$35 per share The fair value of the options is \$8 per option. January 1, 2011 No entry Calculate total compensation expense: \$8 estimated fair value per option x 10 million options granted = \$80 million total compensation The total compensation is allocated to expense over the 4-year service (vesting) period: 2011 - 2014 \$80 million 4 years = \$20 million per year December 31, 2011, 2012, 2013, 2014 Compensation expense (\$80 million 4 years) Paid-in capital stock options
(\$ in millions)

20

20

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ESTIMATED FORFEITURES
If a forfeiture rate of 5% was expected, annual
compensation expense would have been \$19 million (\$76 / 4) instead of \$20 million.

2011 Compensation expense (\$80 x 95% x 1/4) Paid-in capital stock options
2012 Compensation expense (\$80 x 95% x 1/4) Paid-in capital stock options

(\$ in millions)

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ESTIMATED FORFEITURES
During 2013, the third year, Universal revises its estimate of forfeitures from 5% to 10%. The new estimate of total compensation would then be \$80 million x 90%, or \$72 million. The expense each year is the current estimate of total compensation that should have been recorded to date less the amount already recorded (\$19 million in 2011 and 2012). 2013 Compensation expense ([\$80 x 90% x ] [\$19 + 19]) Paid-in capital stock options
(\$ in millions)

16

16

2014 Compensation expense ([\$80 x 90% x 4/4] [\$19 + 19 + 16]) 18 Paid-in capital stock options 18

WHEN OPTIONS ARE EXERCISED

If half the options (five million shares) are exercised on July 11, 2014, when the market price is \$50 per share: Irrelevant July 11, 2014 (\$ in millions) Cash (\$35 exercise price x 5 million shares) 175 Paid-in capital - stock options (1/2 account balance) 40 Common stock (5 million shares at \$1 par per share) 5 Paid-in capital excess of par (to balance) 210 If options that have vested expire without being exercised (assuming none of the options were exercised):
(\$ in millions)

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Paid-in capital stock options (account balance) Paid-in capital expiration of stock options

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EMPLOYEE SHARE PURCHASE PLANS

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Permit employees to buy shares directly from their employer. Usually the plan is considered compensatory, and compensation expense is recorded. Assume an employee buys shares (no par) under an ESPP plan for \$850 rather than the current market price of \$1,000. The \$150 discount is recorded as compensation expense: Cash (discounted price) Compensation expense (\$1,000 x 15%) Common stock (market value) 850 150 1,000

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Earnings Per Share (EPS)

Of the myriad facts and figures generated by accountants, the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and creditors is earnings per share.

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EARNINGS PER SHARE

In the most basic setting, earnings per share is simply a companys earnings (or loss) divided by the number of shares outstanding. Sovran Metals Corporation reported net income of \$154 million in 2011. (Its tax rate was 40%). Common stock January 1, 2011 60 million shares outstanding

Basic EPS:
net income

(in millions, except per share amount)

\$154 = \$2.57 60
shares outstanding

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ISSUANCE OF NEW SHARES

If the number of shares has changed, its necessary to find the weighted average of the shares outstanding during the period the earnings were generated. Any new shares issued are time-weighted by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period. Sovran Financial Corporation reported net income of \$154 million for 2011 (tax rate 40%). Its capital structure included: Common stock January 1 60 million common shares outstanding March 1 12 million new shares were sold

Basic EPS:
net income

We time-weight the new shares for the fraction of the year theyre outstanding.

\$154 = 60
shares at Jan. 1

\$154 = \$2.20 70

+ 12 (10/12)
new shares

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STOCK DIVIDENDS AND STOCK SPLITS

The additional shares created by a stock dividend or split are not weighted for the time period they were outstanding.
Common stock prior to the stock distribution are retroactively Shares outstanding January 1 reflect 60 million common outstanding restated to the increase in shares that is, treated as if the occurred the beginning of the period. Marchdistribution 1 12 million newat shares were sold June 17 A 10% stock dividend was distributed

Basic EPS:
(amounts in millions, except per share amount) net income

\$154 = 60 (1.10)
shares at Jan. 1

\$154 = \$2.00 77

+ 12 (10/12) (1.10)

new shares ___ stock dividend ___ adjustment

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REACQUIRED SHARES
The number of reacquired shares is timeCommon stock weighted for the fraction of the year they were January 1 60 million common shares outstanding not outstanding, prior to being subtracted from March 1 12 million newthe shares were sold number of shares outstanding. June 17 A 10% stock dividend was distributed October 1 8 million shares were reacquired as treasury stock Basic EPS: net income

\$154 = 60 (1.10) + 12 (10/12) (1.10)

shares at Jan. 1 new shares ___ stock dividend ___ adjustment

\$154 = \$2.05 75
Stock dividend adjustment not necessary since the treasury shares were reacquired after the stock dividend and thus already reflect the adjustment.

8 (3/12)
treasury shares

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EARNINGS AVAILABLE TO COMMON SHAREHOLDERS

Common stock Preferred dividends are subtracted from net income so January 1 60 million common shares outstanding earnings to common shareholders is March 1 that 12 millionavailable new shares were sold by the weighted average number of common June 17 divided A 10% stock dividend was distributed shares. October 1 8 million shares reacquired as treasury stock Preferred stock, nonconvertible Jan. 1-Dec. 31 5 million 8%, \$10 par, shares Basic EPS:
net income preferred dividends

5,000,000 x \$10 x 8%

\$154

\$4 = 8 (3/12)
treasury shares

\$150 = \$2.00 75

60 (1.10) + 12 (10/12) (1.10)

shares at Jan. 1 new shares ___ stock dividend ___ adjustment

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COMPLEX CAPITAL STRUCTURE

Potential common shares Securities that, while not being common stock, may become common stock through their exercise or conversion and, therefore, may dilute (reduce) EPS. Examples: Convertible preferred stock, stock options, rights, or warrants, and contingently issuable securities Complex capital structure If potential common shares are outstanding A firm with a complex capital structure reports two EPS calculations: Basic EPS ignores the dilutive effect of potential common shares. Diluted EPS incorporates the dilutive effect of potential common shares. The dilutive effect is included essentially by pretending the securities already have been exercised, converted, or otherwise transformed into common shares.

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OPTIONS, RIGHTS, AND WARRANTS

Stock options, stock rights, and stock warrants give their holders the right to exercise their option to purchase common stock, usually at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS. Incentive stock options Executive stock options granted in 2009, exercisable after 2010 for 15 million common shares* at an exercise price of \$20 per share. The average market price was \$25.

Basic EPS

(amounts in millions, except per share amounts) net preferred income dividends

\$154 60 (1.10) + 12 (10/12) (1.10)

shares new at Jan. 1 shares ___ stock dividend ___ adjustment

\$4 = 8 (3/12)
treasury shares

\$150 = \$2.00 75
Basic EPS is unaffected

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OPTIONS, RIGHTS, AND WARRANTS (continued)

Diluted EPS
net income preferred dividends

We assume the \$300 million is used We assume the options are to buy back as many shares as exercised and 15 million possible (12 million) at the average shares are sold. market price.

\$154

\$4 = + (15 12)

\$150
_____

____________________________________________________________________

= \$1.92

60 (1.10) + 12 (10/12) (1.10) 8 (3/12)

shares at Jan. 1

78

new treasury exercise shares shares of options __ stock dividend ___ adjustment Shares Reacquired for Diluted EPS Assuming the exercise of 15 million shares x \$20 (exercise price) the options adds 3 million \$300 million shares to the denominator \$25 (average market price) of diluted EPS. 12 million shares reacquired

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Stock Options
Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common stock were outstanding at the beginning of the year. The options can be exercised to purchase stock at \$50 per share. The average market price of the stock was \$80. The net increase in the dilutive earnings per share denominator is a. 25,000 shares New shares = 5,000 b. 5,000 shares Treasury shares = 3,125 c. 3,125 shares (5,000 \$50) \$80 d. 1,875 shares Incremental shares = 1,875
(5,000 - 3,125)

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CONVERTIBLE SECURITIES
For Diluted EPS, conversion into common stock is assumed to have occurred at the beginning of the period (or at the time the convertible security is issued, if thats later). The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion. The numerator is increased by the interest (aftertax) or preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

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Convertible Bonds
10%, \$300 million face amount of bonds issued in 2005, convertible into 12 million common shares

Basic EPS

\$2.00 as before Diluted EPS

net income preferred dividends after-tax interest savings

\$154

\$4

= = \$1.87

60 (1.10) + 12 (10/12) (1.10) 8 (3/12) + (15 12)

shares at Jan. 1 new shares treasury shares

+ 12

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CONVERTIBLE PREFERRED STOCK

Now assume the preferred stock is convertible into common stock: Preferred stock, convertible 5 million, 8%, cumulative, \$10 par, shares, convertible into 3 million common shares*

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CONVERTIBLE PREFERRED STOCK (continued)

Basic EPS
net income (amounts in millions, except per share amounts) preferred dividends

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\$154

\$4

60 (1.10)+ 12 (10/12)(1.10) 8 (3/12)

shares at Jan. 1 new shares treasury shares

If we assume the \$150 preferred shares have = been converted to CS, 75 there would be no preferred dividends to subtract.

\$2.00

Diluted EPS
net income preferred dividends

\$154

\$4

Earnings available for CS does not include dividends after-tax interest savings to preferred payable + \$30 - (40% x \$30) \$172 shareholders.
= =

\$1.85

60 (1.10) + 12 (10/12)(1.10) 8 (3/12) + (15 12) + 12

shares at Jan. 1 new shares treasury shares exercise of options conv. of bonds

+3
conversion of preferred shares

93

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Earnings Per Share

A company had 200,000 shares of \$.50 par common stock, 10,000 shares of 5%, \$20 par cumulative preferred stock, and 30,000 shares of 5%, \$10 par preferred stock convertible into 10,000 common shares. Net income after taxes was \$1,500,000. No dividends were declared during the year. Diluted EPS would be (10,000 5% \$20 par) \$1,500,000 a. \$7.14 200,000 + 10,000 shares b. \$7.07 Even though dividends were not c. \$7.10 declared, the cumulative preferred stock dividends are subtracted. d. \$7.00

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ANTIDILUTIVE SECURITIES
At times, the effect of the conversion or exercise of potential common shares would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities. Such securities are ignored when calculating EPS. Stock warrants Warrants granted in 2010, exercisable for 4 million common shares* at an exercise price of \$32.50 per share

Calculations: The calculations of both basic and diluted EPS are unaffected by the warrants because the effect of exercising the warrants would be antidilutive. The \$32.50 exercise price is higher than the market price, \$25, so to assume shares are sold at the exercise price and repurchased at the market price would mean reacquiring more shares than were sold.

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CONTINGENTLY ISSUABLE SHARES

Considered to be outstanding in the computation of diluted EPS if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period). For example, assume 3 million additional shares will become issuable to certain executives in the following year (2012) if net income that year is \$150 million or more. If net income in 2011 was \$154 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 3 million additional shares to the denominator.
Assumed issuance of contingently issuable shares (diluted EPS): no adjustment to the numerator +3 additional shares

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Earnings Per Share Disclosure

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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End of Chapter 19