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Accounting 2 - D249 Unit 3, Part 2 - Earnings Per Share.
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Accounting 2 - D249 Unit 3, Part 2 -Earnings Per Share test questions
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Kicking the Habit
Some habits die hard. Take stock options–called by some “the crack
cocaine of incentives.” Stock options are a form of compensation
that gives key employees the choice to purchase shares at a given
(usually lower-than-market) price. For many years, companies were
hooked on these products. Why? The combination of a hot equity
market and favorable accounting treatment made stock options the
incentive of choice. They were compensation with no expense to the
companies that granted them, and they were popular with key
employees, so companies granted them with abandon. However, the
accounting rules that took effect in 2005 required expensing the fair
value of stock options when granted. This new treatment has made
it easier for companies to kick this habit.
As shown in the following chart, for both large companies and high-
tech companies, a shift has occurred in the use of stock options
versus restricted stock. In fact, starting in 2006 (at the time of a
new standard on stock compensation), both types of companies
started switching to restricted-stock plans. As a spokesperson at
one company commented, “Once you begin expensing options, the
attractiveness significantly drops.”
These stock-based awards in most cases are reserved for the key
officers of a company. When coupled with other forms of
compensation, these pay elements often lead to compensation
levels that are quite high. To provide additional information on
these levels of compensation, Congress passed the Dodd-Frank Act
(2010), resulting in SEC rules requiring companies to disclose:
*The median of the annual total compensation of all employees of
the company, except the CEO
*The annual total compensation of its CEO
*The ratio of the two amounts.
,Often referred to as the “pay ratio rule,” the purpose of this
disclosure is to inform investors of the magnitude of a company’s
CEO pay package in relationship to the overall pay package of its
employees. Some believe that this requirement does not go far
enough because it shows only the CEO’s pay in relation to a median
pay of its employees (two data points) without consideration of the
allocations of pay amounts within the organization. Others contend
that this information may be helpful to the board of directors in
evaluating pay packages related to key executives.
For the largest 100 companies, these pay ratios are considerably
higher. For example, one study had an estimate of 235-to-1 for large
companies, whereas for smaller companies such as in the Russell
3000 index, the ratio is approximately 72-to-1. In some cases, the
ratio is quite high because certain companies employ large groups
of retail, temporary, or foreign workers whose wages are quite low.
To examples are Manpower Group (2,483-to-1) or
retailer Kohl’s 1,264-to-1. Conversely, Warren Buffet, one of the
richest individuals in the world and the CEO of Berkshire Hathaway,
only takes a salary of $100,000 plus costs related to security.
Berkshire Hathaway’s ratio is just 1.87-to-1.
Dilutive Securities
Describe the accounting for the issuance, conversion, and
retirement of convertible securities.
*Debt and Equity
*Convertible Debt
*Convertible Preferred Stock
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Debt and Equity
Many of the controversies related to the accounting for financial
instruments such as stock options, convertible securities, and
preferred stock relate to whether companies should report these
instruments as a liability or as equity. For example, companies
should classify non-redeemable common shares as equity because
the issuer has no obligation to pay dividends or repurchase the
stock. Declaration of dividends is at the issuer’s discretion, as is the
decision to repurchase the stock. Similarly, preferred stock that is
not redeemable does not require the issuer to pay dividends or
repurchase the stock. Thus, non-redeemable common or preferred
stock lacks an important characteristic of a liability–an obligation to
pay the holder of the common or preferred stock at some point in
the future.
However the classification is not as clear-cut for other financial
instruments. For example, in CH3 we discussed the accounting for
mandatorily redeemable preferred stock. Companies originally
classified this security as part of equity. The SEC then prohibited
equity classification, and most companies classified these securities
between debt and equity on the balance sheet in a separate section
often referred to as the “mezzanine section.” The FASB now
requires companies to report these types of securities as a liability.
In this CH, we discuss securities that have characteristics
of both debt and equity. For example, a convertible bond has both
debt and equity characteristics. Should a company classify this
security as debt, as equity, or as part debt and part equity? In
addition, how should a company compute earnings per share if it
has convertible bonds and other convertible securities in its capital
structure? Convertible securities as well as options, warrants, and
, other securities are often called dilutive securities because upon
exercise they may reduce (dilute) earnings per share.
Accounting for Convertible Debt
Convertible bonds can be change into other corporate securities
during some specified period of time after issuance. A convertible
bond combines the benefits of a bond with the privilege of
exchanging it for stock at the holder’s option. Investors who
purchase it desire the security of a bond holding (guaranteed
interest and principal) plus the added option of conversation if the
value of the stock appreciates significantly.
Corporations issue convertible securities for two main reasons. One
is to raise equity capital without giving up more ownership control
than necessary. To illustrate, assume a company wants to raise $1
million; its common stock is selling at $45 a share. To raise the $1
million, the company would have to sell 22,222 shares (ignoring
issue costs). By selling 1,000 bonds at $1,000 par, each convertible
into 20 shares of common stock, the company could raise $1 million
by committing only 20,000 shares of its common stock.
A second reason to issue convertibles is to obtain debt financing at
cheaper rates. Many companies could issue debt only at high
interest rates unless they attach a convertible covenant. The
conversion privilege entices the investor to accept a lower interest
rate than would normally be the case on a straight debt issue. For
example, Amazon .com at one time issued convertible bonds that
pay interest at an effective yield of 4.75%. This rate was much lower
than Amazon would have had to pay by issuing straight debt. For
this lower interest rate, the investor receives the right to buy
Amazon’s common stock at a fixed price until the bond’s maturity.
As indicated earlier, the accounting for convertible debt involves
reporting issues at the time of (1) issuance, (2) conversion, and (3)
retirement.
At Time of Issuance
The method for recording convertible bonds at the date of issue
follows the method used to record straight debt issues. None of the
proceeds are recorded as equity [Global View - IFRS requires that
the issuer of convertible debt record the liability and equity
components separately.] Companies amortize to the maturity date
any discount or premium that results from the issuance of
convertible bonds. Why this treatment? Because it is difficult to
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