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CHAPTER 16
Dilutive Securities and Earnings Per Share
ASSIGNMENT CLASSIFICATION TABLE (BY TOPIC)
Topics Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Convertible debt and preferred stock.
- Warrants and debt. 2, 3, 8, 9 4, 5 7, 8, 9 1 1, 3
- Stock options, restricted stock.
- Earnings Per Share (EPS)—terminology.
- EPS—Determining potentially dilutive securities.
- EPS—Treasury stock method.
- EPS—Weighted- average computation.
- EPS—General objectives.
- EPS—Comprehensive calculations.
- EPS—Contingent shares.
*11. Stock appreciation rights.
*This material is dealt with in an Appendix to the chapter.
ASSIGNMENT CLASSIFICATION TABLE (BY LEARNING OBJECTIVE)
Learning Objectives Questions
Brief Exercises Exercises Problems
Concepts for Analysis
- Describe the accounting for the issuance, conversion, and retirement of convertible securities.
1, 2 CA16-
- Contrast the accounting for stock warrants and for stock warrants issued with other securities.
3, 8, 9 4, 5 1, 7, 8, 9 1 CA16-1,
CA16-
- Describe the accounting and reporting for stock compensation plans.
1, 3, 4 CA16-2,
CA16-
- Compute basic earnings per share.
6, 7, 8, 9 CA16-
- Compute diluted earnings per share.
5, 7, 8 CA16-5,
CA16-
*6. Explain the accounting for stock-appreciation rights plans.
*7. Compute earnings per share in a complex situation.
ANSWERS TO QUESTIONS
- Securities such as convertible debt or stock options are dilutive because their features indicate that the holders of the securities can become common shareholders. When the common shares are issued, there will be a reduction—dilution—in earnings per share.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Corporations issue convertible securities for two reasons. One is to raise equity capital without giving up more ownership control than necessary. A second reason is to obtain financing at cheaper rates. The conversion privilege attracts investors willing to accept a lower interest rate than on a straight debt issue.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Convertible debt and debt issued with stock warrants are similar in that: (1) both allow the issuer to issue debt at a lower interest cost than would generally be available for straight debt; (2) both allow the holders to purchase the issuer’s stock at less than market value if the stock appreciates sufficiently in the future; (3) both provide the holder the protection of a debt security if the value of the stock does not appreciate; and (4) both are complex securities which contain elements of debt and equity at the time of issue.
Convertible debt and debt with stock warrants are different in that: (1) if the market price of the stock increases sufficiently, the issuer can force conversion of convertible debt into common stock by calling the issue for redemption, but the issuer cannot force exercise of the warrants; (2) convertible debt may be essentially equity capital, whereas debt with stock warrants is debt with the additional right to acquire equity; and (3) the conversion option and the convertible debt are inseparable and, in the absence of separate transferability, do not have separate values established in the market; whereas debt with detachable stock warrants can be separated into debt and the right to purchase stock, each having separate values established by the transactions in the market.
LO: 2, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The accounting treatment of the $160,000 “sweetener” to induce conversion of the bonds into common shares represents a departure from GAAP because the FASB views the transaction as the retirement of debt. Therefore, the FASB requires that the “sweetener” of $160,000 be reported as an expense.
LO: 1, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) From the point of view of the issuer, the conversion feature of convertible debt results in a lower cash interest cost than in the case of nonconvertible debt. In addition, the issuer in planning its long-range financing may view the convertible debt as a means of raising equity capital over the long term. Thus, if the market value of the underlying common stock increases sufficiently after the issue of the debt, the issuer will usually be able to force conversion of the convertible debt into common stock by calling the issue for redemption. Under the market conditions, the issuer can effectively eliminate the debt. On the other hand, if the market value of the common stock does not increase sufficiently to result in the conversion of the debt, the issuer will have received the benefit of the cash proceeds to the scheduled maturity dates at a relatively low cash interest cost.
Questions Chapter 16 (Continued)
(b) The purchaser obtains an option to receive either the face amount of the debt upon maturity or the specified number of common shares upon conversion. If the market value of the underlying common stock increases above the conversion price, the purchaser (either through conversion or through holding the convertible debt containing the conversion option) receives the benefits of appreciation. On the other hand, should the value of the underlying company stock not increase, the purchaser could nevertheless expect to receive the principal and (lower) interest.
LO: 1, Bloom: K, Difficulty: Simple, Time: 5-10, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The view that separate accounting recognition should be accorded the conversion feature of convertible debt is based on the premise that there is an economic value inherent in the conversion feature or call on the common stock and that the value of this feature should be recognized for accounting purposes by the issuer. It may be argued that the call is not significantly different in nature from the call contained in an option or warrant and its issue is thus a type of capital transaction. The fact that the conversion feature coexists with certain senior security characteristics in a complex security and cannot be physically separated from these elements or from the instrument does not constitute a logical or compelling reason why the values of the various elements should not receive separate accounting recognition. The fact that the eventual outcome of the option granted the purchaser of the convertible debt cannot be determined at date of issuance is not relevant to the question of effectively reflecting in the accounting records the various elements of the complex document at the date of issuance. The conversion feature has a value at date of issuance and should be recognized. Moreover, the difficulties of implementation are not insurmountable and should not be relied upon to govern the conclusion.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The method used by the company to record the exchange of convertible debentures for common stock can be supported on the grounds that when the company issued the convertible debentures, the proceeds could represent consideration received for the stock. Therefore, when conversion occurs, the book value of the obligation is simply transferred to the stock exchanged for it. Further justification is that conversion represents a transaction with stockholders which should not give rise to a gain or loss.
On the other hand, recording the issue of the common stock at the book value of the debentures is open to question. It may be argued that the exchange of the stock for the debentures completes the transaction cycle for the debentures and begins a new cycle for the stock. The consideration or value used for this new transaction cycle should then be the amount which would be received if the debentures were sold rather than exchanged, or the amount which would be received if the related stock were sold, whichever is more clearly determinable at the time of the exchange. This method recognizes changes in values which have occurred and subordinates a consideration determined at the time the debentures were issued.
LO: 1, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Cash ............................................................................................... 3,000, Discount on Bonds Payable ............................................................ 100, Bonds Payable ........................................................................ 3,000, Paid-in Capital—Stock Warrants ............................................. 100,
Value of bonds with warrants $3,000, Value of warrants (100,000) Value of bonds without warrants $2,900,
Questions Chapter 16 (Continued)
- Weighted-average number of shares outstanding Outstanding shares (all year) = .................................................. 400, October 1 to December 31 (200,000 X 1/4) =............................. 50, Weighted-average number of shares outstanding ..................... 450, Net income ........................................................................................ $2,000, Preferred dividends ........................................................................... (400,000) Income available to common stockholders ....................................... $1,600,
Earnings per share =
LO: 4, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- The computation of the weighted-average number of shares outstanding requires restatement of the shares outstanding before the stock dividend or split. The additional shares outstanding as a result of a stock dividend or split are assumed to have been outstanding since the beginning of the year. Shares outstanding prior to the stock dividend or split are adjusted so that these shares are stated on the same basis as shares issued after the stock dividend/split.
LO: 4, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- (a) Basic earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period.
(b) Potentially dilutive security is a security which can be exchanged for or converted into common stock and therefore upon conversion or exercise could dilute (or decrease) earnings per share. Included in this category are convertible securities, options, warrants, and other rights.
(c) Diluted earnings per share is the amount of earnings for the period available to each share of common stock outstanding and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during the reporting period.
(d) Complex capital structure exists whenever a company’s capital structure includes dilutive securities.
(e) Potential common stock is not common stock in form but does enable its holders to obtain common stock upon exercise or conversion.
LO: 5, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Convertible securities are potentially dilutive securities and part of diluted earnings per share if their conversion increases the EPS numerator less than it increases the EPS denominator; i.e., the EPS with conversion is less than the EPS before conversion.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
Questions Chapter 16 (Continued)
- The concept that a security may be the equivalent of common stock has evolved to meet the reporting needs of investors in corporations that have issued certain types of convertible securities, options, and warrants. A potentially dilutive security is a security which is not, in form, common stock but which enables its holder to obtain common stock upon exercise or conversion. The holders of these securities can expect to participate in the appreciation of the value of the common stock resulting principally from the earnings and earnings potential of the issuing corporation. This participation is essentially the same as that of a common stockholder except that the security may carry a specified dividend yielding a return different from that received by a common stockholder. The attractiveness to investors of this type of security is often based principally upon this potential right to share in increases in the earnings potential of the issuing corporation rather than upon its fixed return or upon other senior security characteristics. In addition, the call characteristic of the stock options and warrants gives the investor potential control over a far greater number of shares per dollar of investment than if the investor owned the shares outright.
LO: 5, Bloom: K, Difficulty: Moderate, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Convertible securities are considered to be potentially dilutive securities whenever their conversion would decrease earnings per share. If this situation does not result, conversion is not assumed and only basic EPS is reported.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Under the treasury-stock method, diluted earnings per share should be determined as if outstanding options and warrants were exercised at the beginning of year (or date of issue if later) and the funds obtained thereby were used to purchase common stock at the average market price for the period. For example, if a corporation has 10,000 warrants outstanding exercisable at $54, and the average market price of the common stock during the reported period is $60, the $540,000 which would be realized from exercise of warrants and issuance of 10, shares would be an amount sufficient to acquire 9,000 shares; thus, 1,000 shares would be added to the outstanding common shares in computing diluted earnings per share for the period. However, to avoid an incremental positive effect upon earnings per share, options and warrants should enter into the computation only when the average market price of the common stock exceeds the exercise price of the option or warrant.
LO: 5, Bloom: K, Difficulty: Simple, Time: 5-7, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Yes, if warrants or options are present, an increase in the market price of the common stock can increase the number of potentially dilutive common shares by decreasing the number of shares repurchasable. In addition, an increase in the market price of common stock can increase the compensation expense reported in a stock-appreciation rights plan. This would decrease net income and, consequently, earnings per share.
LO: 5, Bloom: K, Difficulty: Simple, Time: 3-5, AACSB: Communication, AICPA BB: None, AICPA FC: Reporting, AICPA PC: Communication
- Antidilution is an increase in earnings per share resulting from the assumption that convertible securities have been converted or that options and warrants have been exercised, or other shares have been issued upon the fulfillment of certain conditions. For example, an antidilutive condition would exist when the dividend or interest requirement (net of tax) of a convertible security exceeds the current EPS multiplied by the number of common shares issuable upon conversion of the security. This may be illustrated by assuming a company in the following situation:
Net income ........................................................................................................ $ 10, Weighted-average number of shares outstanding .............................................. 20, 6% Bonds payable (convertible into 5,000 shares of common stock) ................. $100, Tax rate ............................................................................................................. 40%
Basic earnings per share = $10,000/20,000 shares = $.
SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 16-
Cash ............................................................................. 3,960,
Discount on Bonds Payable ....................................... 40,
Bonds Payable ................................................. ... 4,000,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Bonds Payable ............................................................. 2,000,
Discount on Bonds Payable ................................ 30,
Common Stock (2,000 X 50 X $10) ...................... 1,000,
Paid-in Capital in Excess of Par—
Common Stock.................................................. 970,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Preferred Stock (1,000 X $50) ..................................... 50,
Paid-in Capital in Excess of Par—
Preferred Stock ($60 – $50) X 1,000 ....................... 10,
Common Stock (2,000 X $10) .............................. 20,
Paid-in Capital in Excess of Par—Common
Stock ($60 X 1,000) – (2,000 X $10) .................. 40,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Cash ............................................................................. 2,020,
Discount on Bonds Payable
Bonds Payable ..................................................... 2,000,
Paid-in Capital—Stock Warrants ........................ 79,
Fair value of bonds (2,000 X $1,000 X .98) ................. $1,960,
Fair value of warrants (2,000 X $40) ........................... 80,
Aggregate fair value .................................................... $2,040,
Allocated to bonds [($1,960/$2,040) X $2,020,000] .... $1,940,
Allocated to warrants [($80/$2,040) X $2,020,000]..... 79,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 5-7, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Cash ............................................................................... 2,020,
Discount on Bonds Payable
[$2,000,000 X (1 – .98)] .............................................. 40,
Bonds Payable ....................................................... 2,000,
Paid-in Capital—Stock Warrants .......................... 60,000*
*$2,000,000 X (1.01 – .98)
LO: 2, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
No entry
Compensation Expense ............................. 75,
Paid-in Capital—Stock
Options ............................................ 75,
Compensation Expense ............................. 75,
Paid-in Capital—Stock
Options ............................................ 75,
LO: 3, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Unearned Compensation ........................... 130,
Common Stock (2,000 X $5) ............... 10,
Paid in Capital in Excess of Par—
Common Stock
[($65 – $5) X 2,000] ........................... 120,
Compensation Expense ............................. 65,
Unearned Compensation .................... 65,
BRIEF EXERCISE 16-
Earnings per share
Income from discontinued operations ($600,000/100,000) $ 6.
Discontinued operations (loss) ($120,000/100,000) ........ (1.20)
Net income ($480,000/100,000) ......................................... $ 4.
LO: 4, 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Net income ................................................................................. $300,
Adjustment for interest, net of tax [$72,000* X (1 – .40)] ........ 43,
Adjusted net income ................................................................. $343,
Weighted-average number of shares outstanding adjusted for
dilutive securities (100,000 + 16,000) ................................... ÷116,
Diluted EPS ................................................................................ $2.
*$800,000 X.
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Net income ................................................................................. $270,
Weighted-average number of shares adjusted
for dilutive securities (50,000 + 10,000) ............................... ÷ 60,
Diluted EPS ................................................................................ $4.
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
BRIEF EXERCISE 16-
Proceeds from assumed exercise of 45,
options (45,000 X $10) ........................................................... $450,
Shares issued upon exercise ................................................... 45,
Treasury shares purchasable ($450,000 ÷ $15) ....................... (30,000)
Incremental shares.................................................................... 15,
Diluted EPS =
LO: 5, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
*BRIEF EXERCISE 16-
2017: (5,000 X $4) X 50% = $10,
2018: (5,000 X $9) – $10,000 = $35,
LO: 6, Bloom: AP, Difficulty: Simple, Time: 3-5, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 16-2 (Continued)
Months remaining 118
Discount per month $
($80,000 ÷ 118)
Discount amortized $2,
(4 X $678)
(b) Bonds Payable .................................................... 1,500,
Discount on Bonds Payable......................... 27,
Common Stock (30,000 X $20) ..................... 600,
Paid-in Capital in Excess of Par .................. 872,542*
Calculations:
Discount related to 3/8 of
the bonds ($80,000 X 3/8) $30,
Less: Discount amortized
[($30,000 ÷ 118) X 10] 2,
Unamortized bond discount $27,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 16-3 (10–20 minutes)
Conversion recorded at book value of the bonds:
Bonds Payable ............................................................ 500,
Premium on Bonds Payable ...................................... 7,
Preferred Stock (500 X 20 X $50) ....................... 500,
Paid-in Capital in Excess of Par
(Preferred Stock) ............................................. 7,
LO: 1, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 16-4 (15–20 minutes)
(a) Cash ..................................................................... 10,800,
Bonds Payable ............................................ 10,000,
Premium on Bonds Payable ....................... 800,
(To record issuance of $10,000,
of 8% convertible debentures for
$10,800,000. The bonds mature
in twenty years, and each $1,
bond is convertible into five shares
of $30 par value common stock)
EXERCISE 16-4 (Continued)
(b) Bonds Payable ............................................... 3,000,
Premium on Bonds Payable
(Schedule 1) .............................................. 216,
Common Stock, $15 par
(Schedule 2) ....................................... 450,
Paid-in Capital in Excess of Par ............ 2,766,
(To record conversion of 30%
of the outstanding 8% convertible
debentures after giving effect
to the 2-for-1 stock split)
Schedule 1
Computation of Unamortized Premium on Bonds Converted
Premium on bonds payable on January 1, 2016 $800,
Amortization for 2016 ($800,000 ÷ 20) $40,
Amortization for 2017 ($800,000 ÷ 20) 40,000 (80,000)
Premium on bonds payable on January 1, 2018 720,
Bonds converted X 30%
Unamortized premium on bonds converted $216,
Schedule 2
Computation of Common Stock Resulting from Conversion
Number of shares convertible on January 1, 2016:
Number of bonds ($10,000,000 ÷ $1,000) 10,
Number of shares for each bond X 5 50,
Stock split on January 1, 2017 X 2
Number of shares convertible after the stock split 100,
% of bonds converted X 30%
Number of shares issued 30,
Par value/per share X $
Total par value $450,
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 16-6 (Continued)
(c) March 31, 2019
Bond Interest Expense ........................................... 7,
Premium on Bonds Payable .................................. 200
($6,400 ÷ 8 years) X 3/
Bond Interest Payable..................................... 8,
($400,000 X 8% X 3/12)
Bonds Payable ........................................................ 400,
Premium on Bonds Payable .................................. 6,200*
Common Stock ................................................ 320,
Paid-in Capital in Excess of Par ..................... 86,
*Premium as of January 1, 2019
for $400,000 of bonds $6,
$6,400 ÷ 8 years remaining
X 3/12 (200)
Premium as of March 31, 2019
for $400,000 of bonds $6,
(d) June 30, 2019
Bond Interest Expense ........................................... 124,
Premium on Bonds Payable .................................. 3,
Bond Interest Payable ............................................ 8,
($400,000 X 8% X 1/4)***
Cash ................................................................. 136,000*
[Premium to be amortized:
($80,000 X 80%) X 1/20 = $3,200, or
$51,200** ÷ 16 (remaining interest and
amortization periods) = $3,200]
***Total to be paid: ($3,200,000 X 8% ÷ 2) + $8,000 = $136,
***Original premium $80,
2017 amortization (8,000)
2018 amortization (8,000)
Jan. 1, 2019 write-off (6,400)
Mar. 31, 2019 amortization (200)
Mar. 31, 2019 write-off (6,200)
***Assumes interest accrued on March 31. If not, debit Bond Interest
Expense for $132,800.
LO: 1, Bloom: AP, Difficulty: Moderate, Time: 15-20, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
EXERCISE 16-7 (10–15 minutes)
(a) Basic formulas:
Value of bonds without warrants
X Issue price = Value assigned to bonds
Value of bonds without warrants
+ Value of warrants
Value of warrants
X Issue price = Value assigned to warrants
Value of bonds without warrants
+ Value of warrants
X $152,000 = $129,200 Value assigned to bonds
X $152,000 = 22,
Value assigned to warrants
Total
Cash ........................................................................ 152,
Discount on Bonds Payable .................................. 40,
Bonds Payable ............................................... 170,
Paid-in Capital—Stock Warrants ................... 22,
(b) When the warrants are non-detachable, separate recognition is not
given to the warrants. The accounting treatment parallels that given
convertible debt because the debt and equity element cannot be
separated.
The entry if warrants were non-detachable is:
Cash ........................................................................ 152,
Discount on Bonds Payable .................................. 18,
Bonds Payable ............................................... 170,
LO: 2, Bloom: AP, Difficulty: Simple, Time: 10-15, AACSB: Analytic, AICPA BB: None, AICPA FC: Reporting, AICPA PC: None
