INTERMEDIATE

ACCOUNTING
Sixth Canadian Edition
KIESO, WEYGANDT, WARFIELD, IRVINE, SILVESTER,
YOUNG, WIECEK

Prepared by
Gabriela H. Schneider, CMA; Grant MacEwan College

CHAPTER

18
Dilutive Securities and
Earnings Per Share

Learning Objectives
1. Describe the accounting for
issuance, conversion, and retirement
of convertible securities.
2. Explain the accounting for
convertible preferred shares.
3. Contrast the accounting for stock
warrants and stock warrants issued
with other securities.

Learning Objectives
4. Describe the accounting for stock
compensation plans under GAAP.
5. Explain the controversy involving
stock compensation plans.
6. Calculate earnings per share in a
simple capital structure.
7. Calculate earnings per share in a
complex capital structure.

Dilutive Securities and

Earnings Per Share
Dilutive Securities and
Compensation Plans

Computing
Earnings per
share

Convertible debt
Convertible preferred
shares
Stock warrants
Stock compensation plans
Disclosure

Simple capital
structure
Complex capital
structure

Dilutive Securities
Instrument entitling holder to
obtain common shares
When exercised cause existing
shareholder interest to dilute
Ownership interest (percentage)
impact
Impact on EPS

A.k.a. potential common shares

Convertible Debt
Bonds that are convertible to other forms
of securities (e.g. common shares) during
a specified period of time
Combines the benefits of a bond (interest
payments, principal repayment) with the
privilege of exchanging the bond for
shares at the bondholders option
Once the bond is converted, all interest
payments and principal are no longer
payable

Convertible Debt
Issued for two main reasons
1. Corporation can raise equity capital without
giving up ownership control
2. It can also achieve equity financing at a
lower cost
Conversion feature allows the corporation to
offer the bond issue at a lower coupon or stated
rate
Conversion feature provides investor with an
opportunity to own equity. This feature generally
results in the investor accepting a lower coupon
rate than they would with non-convertible debt

Convertible Debt
Accounting Issues
The reporting of convertible debt
and the conversion feature result
in three issues:
1. Reporting at the time of issuance
2. Reporting at the time of conversion
3. Reporting at the time of retirement

Reporting at the
Time of Issuance
On issue date, part of the proceeds are
allocated to liability and part to equity
This reflects the nature of the security
since a convertible debt is part
liability and part equity
The amounts allocated to liability and
equity are determined by using either:
The Incremental Method
The Proportional Method

The Incremental Method

The value of the most easily
measured component is
determined and allocated to that
component
Debt generally the easier component
to value

Remainder of the proceeds become

the value of the other component

The Incremental Method Example

Given:
$20,000,000 par value, 10% convertible
bonds issued at 99
If the bonds were not convertible, it is
estimated they would have been sold at
95

Bond issue costs were $70,000

What portion of the proceeds are allocated to Bo
Liability, and what portion to equity?

The Incremental Method Example

Total proceeds for the bond issue
($20,000,000 * .99)
$19,800,000

Fair value of the liability without the

conversion option ($20,000,000 * .95) =
$19,000,000
Cash
19,800,000 =
Residual allocated to option
$
Discount
1,000,000
800,000 on Bond
Bonds Payable

20,000,000

Contributed Surplus Stock Options

800,000

The Proportional Method

When values for both the liability
and equity components are known
or determinable
The Bond Discount (or Premium)
becomes a calculated amount
under the Proportional Method

The Proportional Method

Given:
$10,000,000 of 8% convertible debentures
due in 20 years issued for $10,800,000
Market value of the companys common
shares (on issue date) $80 per share
Present value of bonds at time of issuance
was $8,500,000
Corporation believed the difference between
the present value and the amount paid was
attributable to the conversion feature

The Proportional Method

Present value (fair value) of the bonds
$8,500,000
Fair value of conversion rights
(10,800,000 8,500,000)
Cash
10,800,000
$2,300,000
Discount on Bonds Payable
1,500,000
Bonds Payable

10,000,000

Contributed Surplus
2,300,000
Note that in this case we are clearly given the
fair values for both the liability and the

Reporting at Time of
Conversion
Main issue is determining the amount
at which to record the securities which
are being exchanged
Two approaches available
Market value approach
Gain or loss on conversion can occur

Book value approach

Gain or loss on conversion does not occur
Most common approach

Either method acceptable under GAAP

Book Value Approach

When market price of bonds or shares not
known
Book Value of the bonds and conversion rights
used to record the conversion

The basis for this method is that a swap

or exchange of security has taken place
The values were established when the
bonds were originally issued and
therefore should not be changed, as there
was a contract in place

Induced Conversion
When the corporation wants to
entice or induce the bondholders to
convert their bonds into shares
Additional consideration the
sweetener offered to the
bondholders to convert (cash,
common shares, etc.)
The inducement is recorded as an
expense in the period of conversion

Reporting at the
Time of Retirement
Treated the same as debt
retirement from Chapter 15
Clear any outstanding premiums,
discounts, bond issue costs, interest
accrued to bondholders
The conversion rights account must
be reallocated
Equity components remains in
Contributed Surplus

Convertible Preferred
Shares
Convertible preferred shares are
considered equity
Convertible debt considered liability and equity

At the time of issuance no allocation

between debt and equity components
Exception is redeemable preferred shares
When conversion occurs the book value
method is always used
Deemed the exchange of one equity for
another equity instrument

Stock Warrants
Entitle the (share)holder to acquire
shares at a specified price, within a
specified period of time
Attached to senior securities (bonds,
preferred shares)
Difference between convertibles and
warrants
With warrants the holder must pay an
amount of money in order to acquire the
shares

Stock Warrants
Warrants (options to purchase
additional shares) occur under
three scenarios
1. To make the original security more
attractive to the investor
2. To provide evidence of the pre-emptive
right to acquire more common shares
3. Used as compensation for executives
and employees

Stock Warrants
Rights are similar to warrants except that
rights have a shorter lifespan and are
attached only to common shares, in order
to purchase more common shares
No journal entry required when rights are issued

Use either the proportional or incremental

method of accounting when dealing with
detachable stock warrants
If warrants are non-detachable, no
allocation to warrants is needed

Stock Compensation Plans

A form of stock warrant a stock option

Provides the employee with an
opportunity to purchase shares at a given
price, within a specified period of time
Two accounting issues associated with
stock compensation plans
1. Determination of compensation expense
2. Periods of allocation for compensation
expense amounts

Stock Options - Important

Dates

Work
Grant
start date date
Options
are
granted to
employee

Vesting
date

Exercise
date

Expiration
date

Date that Employee Unexercised

employee exercises
options
can first
options
expire
exercise
options

Compensation Cost
Measurement

Two available methods

1. Intrinsic Value Method

Excess of market price over exercise price at grant date

Requires expanded note disclosure
Pro-forma net income and EPS under fair value
method

2. Fair Value Method

Measured at fair value of the stock options granted

Preferred method of measurement

Either method acceptable under GAAP,

based on newly developed and accepted
standard

The Measurement Date

Compensation expense is determined as of
Measurement date (usually the grant date)
Measurement date
is:

Grant date - if both the

number of shares offered
and option price are known

Exercise date - if facts

depend on events after
grant date

Options: Allocating
Compensation Expense
Compensation Expense

is determined as of the
measurement date
and is allocated over
the service period

The service period is the period benefited by

employees service
It is usually the period between the grant date
and the vesting date

Compensation Expense Example

Given:
5 Stock options granted January 1, 2001
Option to purchase:
2,000 shares each
Option price per share: $60.00
Market price per share: $70.00 (at grant date)
Stock option expires: 10 years
Service period:
2 years
Intrinsic Value Method:
Market value at grant date (5*2,000)*$70 = $700,000
Option price at grant date (5*2,000)*$60 = 600,000
Compensation expense
$100,000

Fair Value Method:

Expense calculated by applying an option pricing mode

Compensation Expense
Example: Journal Entries
Intrinsic Value
Grant Date
No Entry

Fair Value

No Entry

December 31, 2001

Compensation Expense 50,000110,000
Contributed SurplusStock Options
50,000
(100,000 2 years) // (220,000 2 years)
December 31, 2002
Compensation Expense
50,000110,000
Contributed SurplusStock Options
110,000

50,000

110,000

EPS - Simple Capital

Structure
Net Income Preferred Dividends
Weighted Average # of Shares Outstanding

If the preferred shares are noncumulative

include only declared dividends

If the preferred shares are cumulative

include only declared dividends, or
if no dividends declared, include only one

EPS - Simple Capital

Structure
Weighted average number of common
shares outstanding
To find the equivalent number of whole
shares outstanding for the year

Stock splits and stock dividends require

restatement of the outstanding number
of shares from the beginning of the year
Because there has been no change in the
companys assets, or in the shareholders
total investment

EPS - Simple Capital

Structure
A final note (CICA Handbook, Section
3500)
If there is a stock split or stock dividend
after the year end but before the
publication of the financial statements
The weighted average number of shares
outstanding must be restated
This applies to the current year, as well as
previous years if comparative statements are
issued

EPS Calculation Simple Capital Structure

Given:
January 1:
500,000 shares outstanding
March 1: Issued 20,000 shares
June 1: 50% Stock dividend (60,000 additional
shares issued)

November 1: Issued 30,000 shares

December 31: Ending Balance = 210,000
shares outstanding
Determine the weighted average number of
shares outstanding.

EPS Calculation Simple Capital Structure

Dates
O/S

Shares
O/S

Restatement

Jan-Mar 100,000 x

1.50

Mar-Jun 120,000 x

1.50

Fraction
of Year

Weighted
Shares

x
x

2/12 =

3/12 =

45,000

Jun-Nov 180,000

5/12 =

75,000

Nov-Dec 210,000

2/12 =

35,000

Weighted average shares outstanding

180,00

Complex Capital Structure

Complex capital structure:
When corporation has convertible securities,
options, warrants or other rights, and
When converted these could dilute EPS

Dilution is the reduction in EPS, if:

securities, potentially convertible into common
stock, are converted [assumed at beginning of
the year]

Anti-dilutive securities
Securities, when converted, increase EPS
Anti-dilutive EPS are not reported, only basic EPS

EPS - Complex Capital

Structure
Requires dual presentation of EPS
Basic earnings per share
Presented for each separate class of
common share
Fully diluted earnings per share
Only securities that reduce earnings
per share (dilutive) are considered
Securities that increase earnings per
share (anti-dilutive) are ignored

Diluted Earnings per Share Methods

The dilutive effect of convertible securities
is measured by the if-converted method
The dilutive effect of options and warrants
is measured by the treasury stock method
For computing dilution, the rate of
conversion most advantageous to the
security holder is used (maximum dilutive
conversion rate)

The If-Converted Method

The conversion of the securities into
common stock is assumed to occur at the
beginning of the year
The net income must be adjusted for:
Interest (net of tax) on the convertible debt
Dividends on the convertible preferred shares

The weighted average number of shares

is increased by the additional common
shares assumed issued (at the beginning
of year)

The Treasury Stock Method

Options and warrants (and their

equivalents) are included in EPS

computations
Options and warrants are assumed
exercised at the beginning of the year
The proceeds from the exercise of options
are assumed to be used to buy back
common shares
The exercise price per share must be less
than the market price per share for
dilution to occur

Options and Warrants Treasury Stock Method

Given:
Exercise price of an option - [for one share of
stock] $ 10
Market price of one share at exercise date:
$ 40
Options deemed exercised:
1,000
Total
proceeds
from exercise:
$10,000
Compute
the number
of weighted shares
for
Shares
assumed issued upon exercise:
1,000
determining
diluted
earnings
per share
Assumed
reacquisition
of shares:
250
Dilution: 1,000 - 250 =
750 Shares
(increase in outstanding shares)

Earnings per Share:

Complex Structures - Summary
Dual EPS Presentation
Basic EPS
Net Income adjusted for interest
(net of tax) and preferred dividends
-----------------------------------------Weighted average number of
common shares assuming
maximum dilution

Diluted EPS
Dilutive Convertibles
Dilutive Options and
Warrants
Dilutive Contingent
Issues

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