16-1

PREVIEW OF CHAPTER 16

Intermediate Accounting
16th Edition
Kieso ● Weygandt ● Warfield
16-2
 Dilutive Securities
16 and Earnings per
Share
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the accounting for 3 Describe the accounting and
the issuance, conversion, and reporting for stock compensation
retirement of convertible plans.
securities. 4 Compute basic earnings per
2 Contrast the accounting for stock share.
warrants and for stock warrants 5 Compute diluted earnings per
issued with other securities. share.

16-3 LO 1
 DILUTIVE SECURITIES

Accounting for Convertible Debt

Convertible bonds can be changed into other corporate
securities during some specified period of time after
issuance.

Benefit of a Bond (guaranteed interest and principal)

+
Privilege of Exchanging it for Stock
(at the holder’s option)

16-4 LO 1
 Accounting for Convertible Debt

Two main reasons corporations issue convertibles:

To raise equity capital without giving up more

ownership control than necessary.

Obtain debt financing at cheaper rates.

The accounting for convertible debt involves reporting

issues at the time of (1) issuance, (2) conversion, and (3)
retirement.

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 Accounting for Convertible Debt

At Time of Issuance
Recording convertible bonds follows the method used to
record straight debt issues, with any discount or premium
amortized over the term of the debt.

16-6 LO 1
 Accounting for Convertible Debt

Illustration: Miller Corporation issued $4,000,000 par value, 7%

convertible bonds at 99 for cash. If the bonds had not included
the conversion feature, they would have sold for 95. Record the
entry at date of issuance.

Issue Price = ($4,000,000 x 99% = $3,960,000)

Cash 3,960,000
Discount on Bonds Payable 40,000
Bonds Payable 4,000,000

16-7 LO 1
 Accounting for Convertible Debt

At Time of Conversion
Companies use the book value method when converting
bonds.
When the debtholder converts the debt to equity, the issuing
company recognizes no gain or loss upon conversion.

16-8 LO 1
 Accounting for Convertible Debt

Illustration: Moore Corporation has outstanding 2,000, $1,000

bonds, each convertible into 50 shares of $10 par value common
stock. The bonds are converted on December 31, 2017, when the
unamortized discount is $30,000 and the market price of the stock
is $21 per share. Prepare the entry to record the conversion of the
bonds.

Bonds Payable 2,000,000

Discount on Bonds Payable 30,000
Common Stock (2,000 x 50 x $10) 1,000,000
Paid-in Capital in Excess of Par—Common
970,000
16-9 LO 1
 Accounting for Convertible Debt

Illustration: Moore Corporation has outstanding 2,000, $1,000

bonds, each convertible into 50 shares of $10 par value common
stock. Assume Moore wanted to reduce its annual interest cost
and agreed to pay the bondholders $70,000 to convert.

Bonds Payable 2,000,000

Discount on Bonds Payable 30,000
Common Stock (2,000 x 50 x $10) 1,000,000
Paid-in Capital in Excess of Par—Common
970,000
Debt Conversion Expense 70,000
Cash 70,000

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 Accounting for Convertible Debt

Retirement of Convertible Debt

 Recognized same as retiring debt that is not
convertible.
 Difference between the cash acquisition price and
carrying amount should be reported as gain or loss in
the income statement.

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 DILUTIVE SECURITIES

Convertible Preferred Stock

Convertible preferred stock includes an option for the
holder to convert preferred shares into a fixed number of
common shares.
 Classified as part of stockholders’ equity, unless mandatory
redemption exists.
 No theoretical justification for recognizing a gain or loss
when exercised.

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 Convertible Preferred Stock

Illustration: Gall Inc. issued 2,000 shares of $10 par value

common stock upon conversion of 1,000 shares of $50 par value
preferred stock. The preferred stock was originally issued at $60
per share. The common stock is trading at $26 per share at the
time of conversion. Prepare the entry to record the conversion.

Preferred Stock 50,000

Paid-in Capital in Excess of Par—Preferred 10,000
Common Stock (2,000 x $10) 20,000
Paid-in Capital in Excess of Par—Common 40,000

16-13 LO 1
 WHAT DO THE NUMBERS MEAN? HOW
WHAT’S LOW PRINCIPLE
YOUR CAN YOU GO?

What do Tesla Motors Inc., Twitter Inc., AOL Inc., Red Hat Inc., and Priceline
Group Inc. all have in common? They are part of the wave of U.S. companies who
have raised capital in the convertible bond market. And quite a wave it is. As
indicated in the chart below, U.S. companies recently issued over $40 billion of
convertible bonds.
These bonds are popular
with issuing companies and
investors. As we have
discussed, companies like
them because they allow
them to raise money at rates
lower than those on ordinary
bonds. Investors like them
because, at a time of low
interest rates, they can book
extra profit if the issuer’s stock
price rises. However,

16-14 (continued) LO 1
 WHAT DO THE NUMBERS MEAN? HOW
WHAT’S LOW PRINCIPLE
YOUR CAN YOU GO?

depending on the features of the bond and the stock value, some unusual results
may be observed. Consider the convertible bonds issued by STMicroelectronics
(STM). STM’s 10-year bonds have a zero coupon and are convertible into STM
common stock at an exercise price of $33.43. When issued, the bonds sold at an
effective yield of minus 0.05 percent. That’s right—a negative yield. How could this
happen? When STM issued the bonds, investors thought the options to convert
were so valuable that they were willing to take zero interest payments and invest an
amount in excess of the maturity value of the bonds. In essence, the investors are
paying interest to STM, and STM records interest revenue. Why would investors do
this? If the stock price rises, as many thought it would for STM and many tech
companies at this time, these bond investors could convert and get a big gain in the
stock. Investors did get some additional protection in the deal: They can redeem the
$1,000 bonds after three years and receive $975 (and after five and seven years,
for lower amounts) if it looks like the bonds will never convert. In the end, STM has
issued bonds with a significant equity component. And because the entire bond
issue is classified as debt, STM records negative interest expense.
Sources: STM Financial Reports. See also Floyd Norris, “Legal but Absurd: They Borrow a Billion and Report a Profit,” The New York
Times (August 8, 2003), p. C1; and M. Cherney, “Convertible Bonds Take Off in Low-Yield Era,” Wall Street Journal (October 5, 2014).

16-15
LO 1
 Dilutive Securities
16 and Earnings per
Share
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the accounting for the 3 Describe the accounting and
issuance, conversion, and reporting for stock compensation
retirement of convertible plans.
securities. 4 Compute basic earnings per
2 Contrast the accounting for share.
stock warrants and for stock 5 Compute diluted earnings per
warrants issued with other share.
securities.

16-16 LO 2
 STOCK WARRANTS

Warrants are certificates entitling the holder to acquire shares

of stock at a certain price within a stated period.

Normally arises under three situations:

1. To make the security more attractive.

2. Existing stockholders have a preemptive right to purchase

common stock first.

3. To executives and employees as a form of

compensation.

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 STOCK WARRANTS

Stock Warrants Issued with Other Securities

Basically long-term options to buy common stock at a fixed price.
 Generally life of warrants is five years, occasionally ten years.
 Proceeds allocated between the two securities.
 Allocation based on fair market values.
 Two methods of allocation:

(1) proportional method

(2) incremental method

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 STOCK WARRANTS

Proportional Method
Determine:
1. value of the bonds without the warrants, and

2. value of the warrants.

The proportional method allocates the proceeds using the

proportion of the two amounts, based on fair values.

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 Proportional Method

Illustration: Margolf Corp. issued 2,000, $1,000 bonds at 101. Each

bond was issued with one detachable stock warrant. After issuance,
the bonds were selling in the market at 98, and the warrants had a
market value of $40. Use the proportional method to record the
issuance of the bonds and warrants.

Number Amount Price Total Percent

Bonds 2,000 x $ 1,000 x 98% = $ 1,960,000 96%
Warrants 2,000 x $ 40 = 80,000 4%
Total Fair Market Value $ 2,040,000 100%

Allocation: Bonds Warrants

Issue price $ 2,020,000 $ 2,020,000 Bond face value $ 2,000,000
Allocation % 96% 4% Allocated FMV 1,940,784
Total $ 1,940,784 $ 79,216 Discount $ 59,216

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LO 2
 Proportional Method

Cash 2,020,000
Discount on Bonds Payable 59,216
Bonds Payable 2,000,000
Paid-in Capital – Stock Warrants 79,216

Number Amount Price Total Percent

Bonds 2,000 x $ 1,000 x 98% = $ 1,960,000 96%
Warrants 2,000 x $ 40 = 80,000 4%
Total Fair Market Value $ 2,040,000 100%

Allocation: Bonds Warrants

Issue price $ 2,020,000 $ 2,020,000 Bond face value $ 2,000,000
Allocation % 96% 4% Allocated FMV 1,940,784
Total $ 1,940,784 $ 79,216 Discount $ 59,216

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 Proportional Method

Illustration: Assume each warrant can be exercised to buy one share

of common stock ($5 par value) of Margolf Inc. for $30 per share. If
investors exercise all 2,000 warrants (one warrant per one share of
stock), Margolf Inc. makes the following entry.

Cash (2,000 x $30) 60,000

Paid-in Capital – Stock Warrants 79,216
Common Stock (2,000 x $5) 10,000
Paid-in Capital in Excess of Par—Common Stock
129,216

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 STOCK WARRANTS

Incremental Method
Where a company cannot determine the fair value of either
the warrants or the bonds.
 Use the security for which fair value can determined.
 Allocate the remainder of the purchase price to the
security for which it does not know fair value.

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 Incremental Method

Illustration: McCarthy Inc. issued 2,000, $1,000 bonds at 101. Each

bond was issued with one detachable stock warrant. After issuance,
the bonds were selling in the market at 98. Market price of the
warrants, without the bonds, cannot be determined. Use the
incremental method to record issuance of the bonds and warrants.

Number Amount Price Total Percent

Bonds 2,000 x $ 1,000 x 98% = $ 1,960,000 100%
Warrants 2,000 x = - 0%
Total Fair Market Value $ 1,960,000 100%

Allocation: Bonds
Issue price $ 2,020,000 Bond face value $ 2,000,000
Bonds 1,960,000 Allocated FMV 1,960,000
Warrants $ 60,000 Discount $ 40,000

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 Incremental Method

Cash 2,020,000
Discount on Bonds Payable 40,000
Bonds Payable 2,000,000
Paid-in Capital – Stock Warrants 60,000

Number Amount Price Total Percent

Bonds 2,000 x $ 1,000 x 98% = $ 1,960,000 100%
Warrants 2,000 x = - 0%
Total Fair Market Value $ 1,960,000 100%

Allocation: Bonds
Issue price $ 2,020,000 Bond face value $ 2,000,000
Bonds 1,960,000 Allocated FMV 1,960,000
Warrants $ 60,000 Discount $ 40,000

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 STOCK WARRANTS

Conceptual Questions
Detachable warrants involves two securities,
 a debt security,
 a warrant to purchase common stock.

Nondetachable warrants
 do not require an allocation of proceeds between the bonds
and the warrants,
 companies record the entire proceeds as debt.

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 STOCK WARRANTS

Rights to Subscribe to Additional Shares

Stock Right - existing stockholders have the right
(preemptive privilege) to purchase newly issued shares in
proportion to their holdings.
 Price is normally less than current price of the shares.
 Companies make only a memorandum entry.

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 EVOLVING ISSUE IS THAT
WHAT’S YOUR ALL DEBT?
PRINCIPLE
Many argue that the conversion feature of a convertible bond is not significantly
different in nature from the call represented by a warrant. The question is
whether, although the legal forms differ, sufficient similarities of substance exist
to support the same accounting treatment. Some contend that inseparability
per se is an insufficient basis for restricting allocation between identifiable
components of a transaction.
Examples of allocation between assets of value in a single transaction do
exist, such as allocation of values in basket purchases and separation of
principal and interest in capitalizing long-term leases. Critics of the current
accounting for convertibles say that to deny recognition of value to the
conversion feature merely looks to the form of the instrument and does not
deal with the substance of the transaction. In an exposure draft on this subject
(project now inactive), the FASB indicates that companies should separate the
debt and equity components of securities such as convertible debt or bonds
issued with nondetachable warrants (see footnotes 1 and 6).
We agree with this position. In both situations (convertible debt and debt
issued with warrants, whether detachable or not), the investor has made a
16-28 (continued) LO 2
 EVOLVING ISSUE IS THAT
WHAT’S YOUR ALL DEBT?
PRINCIPLE
payment to the company for an equity feature—the right to acquire an equity
instrument in the future. The only real distinction between them is that the
additional payment made when the equity instrument is formally acquired takes
different forms. The warrant holder pays additional cash to the issuing
company; the convertible debt holder pays for stock by forgoing the receipt of
interest from conversion date until maturity date and by forgoing the receipt of
the maturity value itself. Thus, the difference is one of method or form of
payment only, rather than one of substance. However, until the profession
officially reverses its stand with respect to accounting for convertible debt,
companies will continue to report convertible debt and bonds issued with
nondetachable warrants solely as debt.

16-29 LO 2
 Dilutive Securities
16 and Earnings per
Share
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the accounting for the 3 Describe the accounting and
issuance, conversion, and reporting for stock
retirement of convertible compensation plans.
securities. 4 Compute basic earnings per
2 Contrast the accounting for stock share.
warrants and for stock warrants 5 Compute diluted earnings per
issued with other securities. share.

16-30 LO 3
 STOCK COMPENSATION PLANS

Stock Option - gives key employees option to purchase

common stock at a given price over extended period of time.

Effective compensation programs are ones that:

1. Base compensation on performance.
2. Motivate employees.
3. Help retain executives and recruit new talent.
4. Maximize employee’s after-tax benefit.
5. Use performance criteria over which employee has control.

16-31 LO 3
 STOCK COMPENSATION PLANS

Illustration 16-3 indicates that option expense is a much smaller

element of compensation relative to restricted stock at
ILLUSTRATION 16-3
companies such as Ford and Wal-Mart Stores, Inc. 2014 Company Equity
Grants ($ in millions)

Many companies decided to cut back on the issuance of options,

both to avoid such accounting manipulations and to head off
investor doubts. In addition, GAAP now results in companies
recording a higher expense when stock options are granted.
16-32 LO 3
 STOCK COMPENSATION PLANS

Measurement—Stock Compensation
GAAP requires companies to recognize compensation cost
using the fair-value method.

Under the fair-value method, companies use acceptable

option-pricing models to value the options at the date of grant.

16-33 LO 3
 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR
WHAT’S THE DEBATE ABOUT?
PRINCIPLE

The FASB faced considerable opposition when it proposed the fair value
method for accounting for stock options. This is not surprising, given that the
fair value method results in greater compensation costs relative to the intrinsic-
value model. Merrill Lynch estimated that if all S&P 500 companies were to
expense options, reported profits would fall by as much as 10 percent.
Nevertheless, some companies, such as Coca-Cola, General Electric,
Wachovia, and Bank One, decided to use the fair value method.
You might think investors would punish companies that decided to expense
stock options. After all, most of corporate America has been battling for years
to avoid having to expense them, worried that accounting for those perks would
destroy earnings. Yet, for this small band of big-name companies that
voluntarily made the switch to expensing, investors for the most part showered
them with love. As shown in the following table, with a few exceptions, the
stock prices of the “expensers,” from Cinergy to The Washington Post,
outpaced the market after they announced the change.

16-34 (continued) LO 3
 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR
WHAT’S THE DEBATE ABOUT?
PRINCIPLE

16-35 (continued) LO 3
 WHAT DO THE NUMBERS MEAN? WHAT’S YOUR
WHAT’S THE DEBATE ABOUT?
PRINCIPLE

So what’s the fuss? As the CFO of Coca-Cola stated, “There is no doubt

that stock options are compensation. If they weren’t, none of us would want
them.” It is puzzling why some companies continued to fight implementation of
the expensing rule. Indeed, the market’s general positive reaction to the
expensing of stock options provides a good case study supporting the value
that investors place on transparent accounting and earnings.
Sources: David Stires, “A Little Honesty Goes a Long Way,” Fortune (September 2, 2002), p.
186; and Troy Wolverton, “Foes of Expensing Welcome FASB Delay,” [Link] (October 15,
2004).

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 STOCK COMPENSATION PLANS

Recognition—Stock Compensation
Two main accounting issues:
1. How to determine compensation expense.
2. Over what periods to allocate compensation expense.

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 Recognition—Stock Compensation

Determining Expense
 Compensation expense based on the fair value of the
options expected to vest on the date they grant the
options to the employee(s) (i.e., the grant date).

Allocating Compensation Expense

 Recognizes compensation expense in the periods in
which its employees perform the service—the service
period.

16-38 LO 3
 Recognition—Stock Compensation

Illustration: On November 1, 2016, the stockholders of Searle

Company approve a plan that grants the company’s five executives
options to purchase 2,000 shares each of the company’s $1 par
value common stock. The company grants the options on January 1,
2017. The executives may exercise the options at any time within the
next 10 years. The option price per share is $60, and the market
price of the shares at the date of grant is $70 per share. Under the
fair value method, the company computes total compensation
expense by applying an acceptable fair value option-pricing model.
The fair value option-pricing model determines Searle’s total
compensation expense to be $220,000.

16-39 LO 3
 Recognition—Stock Compensation

Basic Entries. Assume that the expected period of benefit is two

years, starting with the grant date. Searle would record the
transactions related to this option contract as follows.

Dec. 31, 2017

*
Compensation Expense 110,000
Paid-in Capital – Stock Options 110,000

Dec. 31, 2018

Compensation Expense 110,000

Paid-in Capital - Stock Options 110,000

* ($220,000 ÷ 2)
16-40 LO 3
 Recognition—Stock Compensation

Exercise. If Searle’s executives exercise 2,000 of the 10,000

options (20 percent of the options) on June 1, 2020 (three years and
five months after date of grant), the company records the following
journal entry.

June 1, 2020

Cash (2,000 x $60) 120,000

Paid-in Capital - Stock Options 44,000*
Common Stock (2,000 x $1) 2,000
Paid-in Capital in Excess of Par - Common
162,000
*$220,000*20%= $44,000
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 Recognition—Stock Compensation

Expiration. If Searle’s executives fail to exercise the remaining stock

options before their expiration date, the company records the
following at the date of expiration.

Jan. 1, 2027

Paid-in Capital - Stock Options 176,000 *

Paid-in Capital – Expired Stock Options

176,000

* ($220,000 x 80%)
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 Recognition—Stock Compensation

Adjustment. A company does not adjust compensation expense

upon expiration of the options.
However, if an employee forfeits a stock option because the
employee fails to satisfy a service requirement (e.g., leaves
employment), the company should adjust the estimate of
compensation expense recorded in the current period (as a change
in estimate).

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 STOCK COMPENSATION PLANS

Restricted Stock
Restricted-stock plans transfer shares of stock to employees,
subject to an agreement that the shares cannot be sold,
transferred, or pledged until vesting occurs.

Major Advantages:
1. Never becomes completely worthless.

2. Generally results in less dilution to existing stockholders.

3. Better aligns employee incentives with company incentives.

16-44 LO 3
 Restricted Stock Example

Illustration: On January 1, 2017, Skidmore Company issues 1,000

shares of restricted stock to its CEO, Rail Stalker. Skidmore’s stock
has a fair value of $20 per share on January 1, 2017. Additional
information is as follows.
1. The service period related to the restricted stock is five years.
2. Vesting occurs if Stalker stays with the company for a five-year
period.
3. The par value of the stock is $1 per share.
Skidmore makes the following entry on the grant date (January 1,
2017).

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 Restricted Stock Example

Illustration: Skidmore makes the following entry on the grant date

(January 1, 2017).

Unearned Compensation 20,000

Common Stock (1,000 x $1) 1,000
Paid-in Capital in Excess of Par (1,000 x $19) 19,000

Unearned Compensation represents the cost of services yet to be

performed, which is not an asset. It is the unamortized portion of a
grant to employees of restricted or deferred stock measured at the
market value on the date of grant. Unearned Compensation is reported
as a component of stockholders’ equity in the balance sheet.

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 Restricted Stock Example

Illustration: Record the journal entry at December 31, 2017,

Skidmore records compensation expense.

Compensation Expense 4,000

Unearned Compensation 4,000

Skidmore records compensation expense of $4,000 for each of

the next four years (2018, 2019, 2020, and 2021).

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 Restricted Stock Example

Illustration: Assume that Stalker leaves on February 3, 2019 (before

any expense has been recorded during 2019). The entry to record this
forfeiture is as follows

Common Stock 1,000

Paid-in Capital in Excess of Par - Common 19,000
Compensation Expense ($4,000 x 2*) 8,000
Unearned Compensation 12,000
*2017 and 2018

16-48 LO 3
 STOCK COMPENSATION PLANS

Employee Stock-Purchase Plans

 Generally permit all employees to purchase stock at a
discounted price for a short period of time.
 Plans are considered compensatory unless they satisfy all
three conditions presented below.
1. Substantially all full-time employees may participate on an
equitable basis.

2. The discount from market is small.

3. The plan offers no substantive option feature.

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 STOCK COMPENSATION PLANS

Disclosure of Compensation Plans

Company with one or more share-based payment arrangements
must disclose:
1. Nature and extent of such arrangements.

2. Effect on the income statement of compensation cost.

3. Method of estimating the fair value of the goods or services

received, or the fair value of the equity instruments granted
(or offered to grant).

4. Cash flow effects.

16-50 LO 3
 Dilutive Securities
16 and Earnings per
Share
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the accounting for the 3 Describe the accounting and
issuance, conversion, and reporting for stock compensation
retirement of convertible plans.
securities. 4 Compute basic earnings per
2 Contrast the accounting for stock share.
warrants and for stock warrants 5 Compute diluted earnings per
issued with other securities. share.

16-51 LO 4
 BASIC EARNINGS PER SHARE

Earnings per share indicates the income earned by each share

of common stock.
 Companies report earnings per share only for common stock.
ILLUSTRATION 16-7
Income Statement
Presentation of EPS

 When the income statement contains intermediate

components, such as discontinued operations, companies
should disclose earnings per share for each component.
ILLUSTRATION 16-8
Income Statement
Presentation of EPS
Components

16-52 LO 4
 BASIC EARNINGS PER SHARE

Earnings per Share—Simple Capital Structure

 Simple Structure--Common stock; no potentially dilutive
securities.
 Complex Structure--Includes securities that could dilute
earnings per common share.
 “Dilutive” means the ability to influence the EPS in a
downward direction.

16-53 LO 4
 BASIC EARNINGS PER SHARE

Preferred Stock Dividends

Subtracts the current-year preferred stock dividend from net
income to arrive at income available to common stockholders.

ILLUSTRATION 16-9
Formula for Computing
Preferred dividends are subtracted on cumulative Earnings per Share

preferred stock, whether declared or not.

16-54 LO 4
 BASIC EARNINGS PER SHARE

Weighted-Average Number of Shares

Outstanding
Companies must weight the shares by the fraction of the
period they are outstanding.
When stock dividends or share splits occur, companies need to
restate the shares outstanding before the share dividend or
split.

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 Weighted-Average Shares Outstanding

Illustration: Zachsmith Inc. has the following changes in its

common stock during the period.

ILLUSTRATION 16-10
Compute the weighted-average number of shares Shares Outstanding,
Ending Balance
outstanding for Zachsmith Inc.
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 Weighted-Average Shares Outstanding

ILLUSTRATION
16-10

ILLUSTRATION 16-11
Weighted-Average
Number of Shares
Outstanding

16-57
LO 4
 Weighted-Average Shares Outstanding

Illustration: Bergman Company has the following changes in its

common stock during the period.

ILLUSTRATION 16-12
Compute the weighted-average number of Shares Outstanding, Ending
Balance— Bergman
Company
shares outstanding for Bergman Company.
16-58 LO 4
 Weighted-Average Shares Outstanding
ILLUSTRATION
16-12

ILLUSTRATION 16-13
16-59 Weighted-Average Number of Shares Outstanding— Stock Issue and Stock Dividend LO 4
 Dilutive Securities
16 and Earnings per
Share
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1 Describe the accounting for the 3 Describe the accounting and
issuance, conversion, and reporting for stock compensation
retirement of convertible plans.
securities. 4 Compute basic earnings per
2 Contrast the accounting for stock share.
warrants and for stock warrants 5 Compute diluted earnings per
issued with other securities. share.

16-60 LO 5
 DILUTED EARNINGS PER SHARE

Complex Capital Structure exists when a business has

 convertible securities,
 options, warrants, or other rights

that upon conversion or exercise could dilute earnings per

share.

Company generally reports

both basic and diluted
earnings per share.

16-61 LO 5
 DILUTED EARNINGS PER SHARE

Diluted EPS includes the effect of all potential dilutive common

shares that were outstanding during the period.

ILLUSTRATION 16-18
Companies will not report diluted EPS if the Relationship between
Basic and Diluted EPS
securities in their capital structure are antidilutive.
16-62 LO 5
 DILUTED EARNINGS PER SHARE

Diluted EPS — Convertible Securities

Measure the dilutive effects of potential conversion on EPS
using the if-converted method.

This method for a convertible bond assumes:

1. the conversion at the beginning of the period (or at the time
of issuance of the security, if issued during the period), and

2. the elimination of related interest, net of tax.

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 Example — If-Converted Method

Illustration: Mayfield Corporation has net income of $210,000

for the year and a weighted-average number of common shares
outstanding during the period of 100,000 shares. The company
has two convertible debenture bond issues outstanding. One is a
6 percent issue sold at 100 (total $1,000,000) in a prior year and
convertible into 20,000 common shares. Interest expense on the
6 percent convertibles is $60,000. The other is a 10 percent
issue sold at 100 (total $1,000,000) on April 1 of the current year
and convertible into 32,000 common shares. Interest expense on
the 10 percent convertible bond is $75,000. The tax rate is 40
percent.

16-64 LO 5
 Example — If-Converted Method

Calculate basic earnings per share.

Net income = $210,000

= $2.10
Weighted-average shares = 100,000

16-65 LO 5
 Example — If-Converted Method

Mayfield calculates the weighted-average number of shares

outstanding, as follows.

ILLUSTRATION 16-20
Computation of
Calculate diluted earnings per share. Weighted-Average
Number of Shares

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 Example — If-Converted Method

When calculating Diluted EPS, begin with basic EPS.

Basic 6% 10%
EPS Debentures Debentures

$210,000 + $60,000 x (1 - .40) + $100,000 x (1 - .40) x 9/12

=
100,000 + 20,000 + 24,000

Basic EPS
= $2.10 Effect on EPS Effect on EPS = $1.875
= $1.80
Diluted EPS = $2.02

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 Example — If-Converted Method

Other Factors
The conversion rate on a dilutive security may change during
the period in which the security is outstanding. In this situation,
the company uses the most dilutive conversion rate available.

For Convertible Preferred Stock the company does not subtract

preferred dividends from net income in computing the numerator.
Why not?
Because for purposes of computing EPS, it assumes conversion
of the convertible preferreds to outstanding common shares.

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 Example — If-Converted Method

Illustration: In 2016, Chirac Enterprises issued, at par, 60, $1,000,

8% bonds, each convertible into 100 shares of common stock.
Chirac had revenues of $17,500 and expenses other than interest
and taxes of $8,400 for 2017. (Assume that the tax rate is 40%.)
Throughout 2017, 2,000 shares of common stock were outstanding;
none of the bonds was converted or redeemed.

Instructions

(a) Compute diluted earnings per share for 2017.

(b) Assume same facts as those for Part (a), except the 60 bonds
were issued on September 1, 2017 (rather than in 2016), and
none have been converted or redeemed.

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 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017.

Calculation of Net Income

Revenues $17,500
Expenses 8,400
Bond interest expense (60 x $1,000 x 8%) 4,800
Income before taxes 4,300
Income tax expense (40%) 1,740
Net income $ 2,580

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 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017.

When calculating Diluted EPS, begin with basic EPS.

Basic EPS

Net income = $2,580

= $1.29
Weighted average shares = 2,000

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 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017.

When calculating Diluted EPS, begin with basic EPS.

Diluted EPS

$2,580 + $4,800 (1 - .40) $5,460

= = $.68
2,000 + 6,000 8,000

Basic EPS
Effect on EPS = $.48
= $1.29
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 Example — If-Converted Method

(b) Assume bonds were issued on Sept. 1, 2017 .

Calculation of Net Income

Revenues $ 17,500
Expenses 8,400
Bond interest expense (60 x $1,000 x 8% x 4/12) 1,600
Income before taxes 7,500
Income taxes (40%) 3,000
Net income $ 4,500

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 Example — If-Converted Method

(b) Assume bonds were issued on Sept. 1, 2017 .

When calculating Diluted EPS, begin with basic EPS.

Diluted EPS

$4,500 + $1,600 (1 - .40) $5,460

= = $1.37
2,000 + 6,000 x 4/12 yr. 4,000

Basic EPS
Effect on EPS = $.48
= $2.25
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 Example — If-Converted Method

Illustration: Prior to 2017, Barkley Company issued 40,000

shares of 6% convertible, cumulative preferred stock, $100 par
value. Each share is convertible into 5 shares of common stock.
Net income for 2017 was $1,200,000. There were 600,000
common shares outstanding during 2017. There were no changes
during 2017 in the number of common or preferred shares
outstanding.

Instructions

(a) Compute diluted earnings per share for 2017.

16-75 LO 5
 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017.

When calculating Diluted EPS, begin with basic EPS.

Basic EPS

Net income $1,200,000 – Pfd. Div. $240,000 *

= $1.60
Weighted average shares = 600,000

* 40,000 shares x $100 par x 6% = $240,000 dividend

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 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017.

When calculating Diluted EPS, begin with basic EPS.

Diluted EPS

$1,200,000 – $240,000 + $240,000 $1,200,000

= =
600,000 + 200,000* 800,000

$1.50
Effect on
Basic EPS = $1.60 *(40,000 x 5)
EPS = $1.20
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 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017 assuming

each share of preferred is convertible into 3 shares of
common stock.

Diluted EPS

$1,200,000 – $240,000 + $240,000 $1,200,000

= =
600,000 + 120,000* 720,000

$1.67
Effect on
Basic EPS = $1.60 *(40,000 x 3)
EPS = $2.00
16-78 LO 5
 Example — If-Converted Method

(a) Compute diluted earnings per share for 2017 assuming

each share of preferred is convertible into 3 shares of
common stock.

Diluted EPS Basic = Diluted EPS

$1,200,000 – $240,000 + $240,000 $1,200,000

= =
600,000 + 120,000* 720,000
Antidilutive
$1.67
Effect on
Basic EPS = $1.60 *(40,000 x 3)
EPS = $2.00
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 DILUTED EARNINGS PER SHARE

Diluted EPS – Options and Warrants

Measure the dilutive effects of potential conversion using the
treasury-stock method.

This method assumes:

(1) the exercise the options or warrants at the beginning of the
year (or date of issue if later), and

(2) that the company uses those proceeds to purchase common

stock for the treasury.

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 Example — Treasury-Stock Method

Illustration: Zambrano Company’s net income for 2017 is $40,000.

The only potentially dilutive securities outstanding were 1,000
options issued during 2016, each exercisable for one share at $8.
None has been exercised, and 10,000 shares of common were
outstanding during 2017. The average market price of the stock
during 2017 was $20.

Instructions

(a) Compute diluted earnings per share.

(b) Assume the 1,000 options were issued on October 1, 2017

(rather than in 2016). The average market price during the
last 3 months of 2017 was $20.

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 Example — Treasury-Stock Method

(a) Compute diluted earnings per share for 2017.

Treasury-Stock Method
Proceeds if shares issued (1,000 x $8) $8,000
Purchase price for treasury shares ÷ $20
Shares assumed purchased 400
Shares assumed issued 1,000
Incremental share increase 600

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 Example — Treasury-Stock Method

(a) Compute diluted earnings per share for 2017.

When calculating Diluted EPS, begin with basic EPS.

Diluted EPS

$40,000 + $40,000
= = $3.77
10,000 + 600 10,600

Basic EPS Options

= $4.00
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 Example — Treasury-Stock Method

(b) Compute diluted earnings per share assuming the 1,000

options were issued on October 1, 2017.
Treasury-Stock Method
Proceeds if shares issued (1,000 x $8) $ 8,000
Purchase price for treasury shares ÷ $ 20
Shares assumed purchased 400
Shares assumed issued 1,000
Incremental share increase 600
Weight for 3 months assumed outstanding x 3/12
Weighted incremental share increase 150

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 Example — Treasury-Stock Method

(b) Compute diluted earnings per share assuming the 1,000

options were issued on October 1, 2017.

Diluted EPS

$40,000 $40,000
= = $3.94
10,000 + 150 10,150

Basic EPS Options

= $4.00

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 DILUTED EARNINGS PER SHARE

Contingent Issue Agreement

Contingent shares are issued as a result of the
1. passage of time condition or

2. upon attainment of a certain earnings or market price level.

Antidilution Revisited
Ignore antidilutive securities in all calculations and in computing
diluted earnings per share.

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 DILUTED EARNINGS PER SHARE

EPS Presentation and Disclosure

A company should show per share amounts for:
 Income from continuing operations,
 Income before extraordinary items, and
 Net income.

Per share amounts for a discontinued operation or an

extraordinary item should be presented on the face of the income
statement or in the notes.

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 EPS Presentation and Disclosure

Complex capital structures and dual presentation of EPS require the

following additional disclosures in note form.
1. Description of pertinent rights and privileges of the various securities
outstanding.
2. A reconciliation of the numerators and denominators of the basic and
diluted per share computations, including individual income and share
amount effects of all securities that affect EPS.
3. The effect given preferred dividends in determining income available to
common stockholders in computing basic EPS.
4. Securities that could potentially dilute basic EPS in the future that were
excluded in the computation because they would be antidilutive.
5. Effect of conversions subsequent to year-end, but before issuing
statements.

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 WHAT DO THE NUMBERS MEAN? PRO FORMA
WHAT’S YOUREPS CONFUSION
PRINCIPLE
Many companies are reporting pro forma EPS numbers along with GAAP-based
EPS numbers in the financial information provided to investors. Pro forma earnings
generally exceed GAAP earnings because the pro forma numbers exclude such
items as restructuring charges, impairments of assets, R&D expenditures, and
stock compensation expense. In some industries such as high-tech, the major item
excluded is stock compensation expense.
Google is a classic example.
As indicated by one analyst,
Google paid out huge, share-
laden compensation packages
totaling more than $300 million
recently to three key executives.
Only a small amount of this
compensation will be reported in
the non-GAAP income
measures.

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 WHAT DO THE NUMBERS MEAN? PRO FORMA
WHAT’S YOUREPS CONFUSION
PRINCIPLE
Another case of possibly misleading pro forma reporting is social gaming company
Zynga. It recently reported so much stock-compensation expense ($600 million)
that it overwhelmed its operating profit; these expenses took operating profit
negative to the tune of $406 million. The accounting? Zynga “window dressed” the
expense by encouraging Wall Street analysts to use a non-GAAP pro forma
accounting figure—“adjusted earnings before interest, taxes, depreciation and
amortization”—that ignores the stock compensation. LinkedIn and Groupon also
use non-GAAP metrics that exclude stock compensation. LinkedIn’s $30 million
stock compensation expense roughly halved its operating profit, while Groupon’s
$94 million took operating profit $203 million into the red. Wall Street analysts tend
to go along with the accounting hocus-pocus, as it allows them to justify higher
valuations for stocks. Investors should remember, however, that employee equity
awards are real costs. As discussed in Chapter 4, SEC Regulation G requires
companies to provide a clear reconciliation between pro forma and GAAP
information. And this applies to EPS measures as well. This reconciliation is
especially important, given the spike in pro forma reporting by companies adding
back employee stock-option expense.
Sources: M. Moran, A. J. Cohen, and K. Shaustyuk, “Stock Option Expensing: The Battle Has Been Won; Now Comes the Aftermath,” Portfolio
Strategy/Accounting, Goldman Sachs (March 17, 2005); R. Winkler, “Stock and Awe at Facebook and Zynga,” Wall Street Journal (February
16-90 16, 2012); and A. Bary, “How Much Do Silicon Valley Firms Really Earn?” Barrons (June 27, 2015). LO 5
 Summary of EPS Computation
ILLUSTRATION 16-28
Calculating EPS,
Simple Capital Structure

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 Earnings per
Share

ILLUSTRATION 16-29
Calculating EPS, Complex
Capital Structure
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 COPYRIGHT

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16-93