CHAPTER 16 - DILUTIVE SECURITIES AND EARNINGS PER SHARE
Companies are rethinking the use of various forms of share-
based compensation, which are based on dilutive securities.
Share options are a form of compensation that gives key
employees the choice to purchase shares at a given (usually
lower-than-market) price. The combination of a hot equity
market and favorable accounting treatment made share options
the incentive of choice. However, the accounting rules changed,
resulting in required expensing of the fair value of share options
when granted.
DILUTIVE SECURITIES
DEBT AND EQUITY
Many of the controversies related to the accounting for financial instruments such as share options, convertible securities, and
preference shares relate to whether companies should report these instruments as a liability or as equity. In this chapter, we
discuss securities that have characteristics of both debt and equity. For example, a convertible bond has both debt and equity
characteristics. 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.
CONVERTIBLE DEBT
Convertible bonds can be changed into other company 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 shares at the holder’s option. Investors who purchase it
want the security of a bond investment (guaranteed interest and principal) plus the added option of conversion if the value of the
shares appreciates significantly. Companies issue convertible securities for two main reasons. One is to raise equity capital without
giving up more ownership control than necessary. A second reason to issue convertibles is to obtain debt financing at cheaper rates.
The conversion privilege entices the investor to accept a lower interest rate than would normally be the case on a straight debt
issue.
Accounting for Convertible Debt
Convertible debt is accounted for as a compound
instrument because it contains both a liability and an
equity component. IFRS requires that compound
instruments be separated into their liability and equity
components for purposes of accounting. IFRS does not permit companies to assign a value to the equity amount first and then
determine the liability component. To do so would be inconsistent with the definition of equity, which is considered a residual
amount.
To implement the with-and-without approach, a company does the following:
1. First, determine the total fair value of the convertible debt with both the liability and equity component. This is
straightforward, as this amount is the proceeds received upon issuance.
2. Second, determine the liability component by computing the net present value of all contractual future cash flows
discounted at the market rate of interest. This market rate is the rate the company would pay on similar non-convertible
debt.
3. Finally, subtract the liability component estimated in the second step from the fair value of the convertible debt (issue
proceeds) to arrive at the equity component. That is, the equity component is the fair value of the convertible debt
without the liability component.
The journal entry to record the issuance of convertible debt is:
Cash 2,000,000
Bonds Payable 1,805,626
Share Premium – Conversion Equity 194,374
The amount of the discount recorded in the Bonds Payable account relative to the face value of the bond is amortized at each
reporting period. So at maturity, the Bonds Payable account is reported at €2,000,000 (face value). The equity component of the
convertible bond is recorded in the Share Premium—Conversion Equity account and is reported in the equity section of the
statement of financial position. Because this amount is considered part of contributed capital, it does not change over the life of the
convertible.
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, Four settlement situations can exist:
1. Repurchase at maturity
Bonds Payable 2,000,000
Cash 2,000,000
The amount originally allocated to equity of €194,374 either remains in the Share Premium—Conversion Equity account
or is transferred to Share Premium—Ordinary.
2. Conversion at maturity
Share Premium – Conversion Equity 194,374
Bonds Payable 2,000,000
Share Capital – Ordinary 500,000
Share Premium - Ordinary 1,694,374
This accounting approach is often referred to as the book value method in that the carrying amount (book value) of the
bond and related conversion equity determines the amount in the ordinary equity accounts.
3. Conversion before maturity
Share Premium – Conversion Equity 194,374
Bonds Payable 1,894,464
Share Capital – Ordinary 500,000
Share Premium – Ordinary 1,588,838
The Bonds Payable account is debited for its carrying value on the date of conversion.
4. Repurchase before maturity
Bonds Payable 1,894,464
Share Premium – Conversion Equity 60,100
Loss on Repurchase 10,436
Cash 1,965,000
The approach used for allocating the amount paid upon repurchase follows the approach used when the convertible bond
was originally issued. That is, the company determines the fair value of the liability component of the convertible bonds at
the repurchase date, and then subtracts this amount from the fair value of the convertible bond issue (including the
equity component) to arrive at the value for the equity. After this allocation is completed: 1. The difference between the
consideration allocated to the liability component and the carrying amount of the liability is recognized as a gain or loss,
and 2. The amount of consideration relating to the equity component is recognized (as a reduction) in equity.
Sometimes, the issuer wants to encourage prompt conversion of its convertible debt to equity securities in order to reduce interest
costs or to improve its debt to equity ratio. In this situation, the issuer may offer some form of additional consideration (such as
cash or ordinary shares), called a “sweetener,” to induce conversion. The issuing company reports the sweetener as an expense of
the current period. Its amount is the fair value of the additional securities or other consideration given. The journal entry to record an
induced conversion is as follows:
Conversion Expense 80,000
Share Premium – Conversion Equity 15,000
Bonds Payable 1,000,000
Share Capital – Ordinary 100,000
Share Premium – Ordinary 915,000
Cash 80,000
The IASB indicated that when an issuer makes an additional payment to encourage conversion, the payment is for a service
(bondholders converting at a given time) and should be reported as an expense.
CONVERTIBLE PREFERENCE SHARES
Convertible preference shares include an option for the holder to convert preference shares into a fixed number of ordinary shares.
The major difference between accounting for a convertible bond and a convertible preference share is their classification.
Convertible bonds are compound instruments because they have both a liability and an equity component. Convertible preference
shares (unless mandatory redemption exists) are not compound instruments because they have only an equity component. As a
result, convertible preference shares are reported as part of equity. When preference shares are converted or repurchased, there is
no gain or loss recognized. The rationale is that a company does not recognize a gain or loss involving transactions with its existing
shareholders.
The journal entry to record the issuance of convertible preference shares is as follows:
Cash 200,000
Share Capital – Preference 1,000
Share Premium – Conversion Equity 199,000
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