Dilutive Securities and EPS: ACCT 320 Spring 2021 Samia Ali

Dilutive Securities and EPS
ACCT 320
Spring 2021
Samia Ali
16-1
LO 1 – Describe the accounting for
the issuance, conversion, and
retirement of convertible securities
16-2
Dilutive Securities
Debt and Equity

Should companies report these instruments as a liability
or equity?
Convertible Preference
Share Options
Securities Shares
16-3
Convertible Debt
Bonds which can be changed into other corporate

securities are called convertible bonds.
Benefit of a Bond (guaranteed interest and principal)
+
Privilege of Exchanging it for Shares
(at the holder’s option)
16-4
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.
16-5
Convertible Debt
Accounting for Convertible Debt

Convertible debt is accounted for as a compound instrument.
Companies use the “with-and-without” method to value
compound instruments.
ILLUSTRATION 16.1
Convertible Debt Components
16-6
Implementation of the with-and-without approach:

1. First, determine total fair value of convertible debt with both
the liability and equity component.
2. Second, determine liability component by computing net

present value of all contractual future cash flows discounted
at the market rate of interest. Principal + interest
3. Finally, subtract liability component estimated in second

step from fair value of convertible debt (issue proceeds) to
arrive at the equity component.
16-7
Accounting at Time of Issuance
Roche Group issues 2,000 convertible bonds at the beginning of
2019.
The bonds have a four-year term with a stated rate of interest of 6%

and are issued at par with a face value of €1,000 per bond (the total
proceeds received from issuance of the bonds are €2,000,000).
Interest is payable annually at December 31.
Each bond is convertible into 250 ordinary shares with a par value of
€1.
The market rate of interest on similar non-convertible debt is 9%.
16-8
Accounting for Convertible Debt ILLUSTRATION 16.2
Time Diagram for
USE MARKET RATE TO DISCOUNT Convertible Bond
Accounting
at Time of
Issuance
ILLUSTRATION 16.3
Fair Value of Liability
Component of Convertible Bond
16-9
Accounting at Time of Issuance ILLUSTRATION 16.3

Fair Value of Liability
Component of Convertible Bond
ILLUSTRATION 16.4
Equity Component of
Convertible Bond
Journal Cash 2,000,000

Entry Bonds Payable 1,805,606
Share Premium—Conversion Equity 194,394
16-10
Settlement of Convertible Bonds

1) Repurchase at Maturity.
2) Conversion of Bonds at Maturity
3) Conversion before maturity
4) Repurchase before maturity
16-11
Repurchase at Maturity. If the bonds are not converted at maturity,
Roche makes the following entry to pay off the convertible debtholders.
Bonds Payable 2,000,000

Cash 2,000,000
NOTE: The amount originally allocated to equity of €194,384 either remains in the
Share Premium—Conversion Equity account or is transferred to the Share
Premium—Ordinary account.
16-12
Conversion of Bonds at Maturity. If the bonds are converted at
maturity, Roche makes the following entry.

Share Capital—Ordinary 500,000
Share Premium—Ordinary 1,694,394
NOTE: The amount originally allocated to equity of €194,384 is transferred to

the Share Premium—Ordinary account.
16-13
Conversion of Bonds before Maturity.
ILLUSTRATION 16.5
Convertible Bond Amortization Schedule
Carrying value at date of conversion

In this example conversion at 12/31/20
16-14
Conversion of Bonds before Maturity. Assuming that Roche

converts its bonds into ordinary shares on December 31, 2020.

NOTE: The amount originally allocated to equity (€194,374) is transferred to

the Share Premium—Ordinary account.
16-15
Repurchase before Maturity.
Determine
1. Gain or loss on repurchase is the difference between
• Fair value of liability component (PV of cash flows of a non

convertible bond issued at the date of repurchase with the original
maturity date) and
• Carrying value of liability component at the date of conversion
16-16
Repurchase before Maturity.
2. Adjustment to equity
• Fair value of a convertible debt (including both liability and equity

components), based on market prices at time of repurchase
• Fair value of liability component (PV of cash flows of a non

convertible bond issued at the date of repurchase with the original
maturity date) and
16-17
Repurchase before Maturity. Assume:

 Fair value of the convertible debt (including both liability
and equity components), based on market prices at
December 31, 2020, is €1,965,000.
 The fair value of the liability component is €1,904,900. This
amount is based on computing the present value of a non-
convertible bond with a two-year term (which corresponds
to the shortened time to maturity of the repurchased
bonds.)
16-18
First, determine the gain or loss on the liability component.
ILLUSTRATION 16.6 & 7
Next, determine any adjustment to the equity.

Journal Share Premium—Conversion Equity 60,100
Entry
Loss on Repurchase 10,436
Cash 1,965,000
16-19
Convertible Debt
Induced Conversion
 Issuer wishes to encourage prompt conversion.
 Issuer offers additional consideration, called a
“sweetener,” to induce conversion.
 Sweetener is an expense of the current period.
16-20
Induced Conversion
Helloid, Inc. has outstanding $1,000,000 par value convertible
debentures convertible into 100,000 ordinary shares ($1 par value).
When issued, Helloid recorded Share Premium—Conversions Equity of
$15,000. Helloid wishes to reduce its annual interest cost. To do so,
Helloid agrees to pay the holders of its convertible debentures an
additional $80,000 if they will convert. Assuming conversion occurs,
Helloid makes the following entry.
Conversion Expense 80,000
Share Premium—Ordinary 915,000
Cash 80,000
16-21
LO 2 – Accounting for convertible
preference shares
16-22
Convertible Preference Shares
Convertible preference shares include an option for the

holder to convert preference shares into a fixed number of
ordinary shares.
 Convertible preference shares are reported as part of
equity.
 When preference shares are converted or repurchased,
there is no gain or loss recognized.
16-23
Morse AG issues 1,000 convertible preference shares that have a

par value of €1 per share. The shares were issued at a price of €200
per share. The journal entry to record this transaction is as follows.
Cash (1,000 x €200) 200,000

Share Capital—Preference (1,000 x €1) 1,000
16-24
If each share is subsequently converted into 25 each ordinary

shares (€2 par value) that have a fair value of €410,000, the
journal entry to record the conversion is as follows.
Share Capital—Preference 1,000

Share Capital—Ordinary (1,000 x 25 x €2) 50,000
16-25 LO 1
If the convertible preference shares are repurchased at their fair

value instead of converted, Morse makes the following entry.
Share Capital—Preference 1,000

Retained Earnings 210,000
Cash 410,000
Any excess paid above the book value of the convertible preference
shares is often debited to Retained Earnings.
16-26
LO 3 – Describe the accounting for
share warrants and for share warrants
issued with other securities
16-27
Share Warrants
Warrants are certificates entitling the holder to acquire shares

at a certain price within a stated period.
Normally arises under three situations:
1. To make the security more attractive.
2. Existing shareholders have a preemptive right to
purchase ordinary shares.
3. To executives and employees as a form of compensation.
16-28
Share Warrants Issued with other securities
Warrants issued with other securities are basically long-term

options to buy ordinary shares at a fixed price.
 Generally, the life of warrants is five years, occasionally 10
years.
 Company should use the with-and-without method? to
allocate the proceeds between the two components.
16-29
Warrants Issued with Other Securities
• At one time, Siemens AG issued bonds with detachable 5-yr warrants.
• Assume that the five-year warrants provide the option to buy one
ordinary share (par value €5) at €25.
• At the time, an ordinary share of Siemens was selling for approximately

€30.
• These warrants enabled Siemens to price its bond offering (with a

€10,000,000 face value) at par with an 8¾ percent yield (quite a bit
lower than prevailing rates at that time).
• Siemens was able to sell the bonds plus the warrants for €10,200,000.
• To account for the proceeds from this sale, Siemens uses the with-and-
without method.
16-30
Using this approach, Siemens determines the present value of the
future cash flows related to the bonds, which is €9,707,852.
Initial Recognition
The bonds sell at a discount. Siemens records the sale as follows.
Cash 9,705,852
Cash 492,148
Share Premium-Share Warrants 492,148
16-31
Subsequent measurement
Liability portion?
Warrants
Assuming investors exercise all 10,000 warrants (one warrant per

one ordinary share), Siemens makes the following entry.
Cash (10,000 x €25) 250,000

Share Premium—Share Warrants 492,148
Share Capital—Ordinary (10,000 x €5) 50,000
Note: If investor fails to exercise then Dr Share premium –
share warrant and Cr Share premium – expired share warrants
16-32
Share Warrants – Rights to Subscribe to
additional shares
Share Rights - existing stockholders have the right (preemptive

privilege) to purchase newly issued shares in proportion to their
holdings.
 Price is normally less than current market value.
 Companies make only a memorandum entry.
16-33
LO 4 – Share compensation plans
16-34
Share Compensation Plans
Share Option - gives key employees option to purchase ordinary
shares 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 and minimize employer’s
after-tax cost.
5. Use performance criteria over which employee has control.
16-35
Measurement—Share Compensation
IASB guidelines 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.
16-36
Recognition—Share Compensation
Share-Option Plans
Two main accounting issues:
1. How to determine compensation expense.
2. Over what periods to allocate compensation expense.
16-37
Share-Option Plans
Determining Expense
 Companies compute total 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).
 Vesting date is the date when the option is earned/vested
Allocating Compensation Expense

 Recognize compensation expense in the periods in which
employees perform the service—the service period.
Service period is usually the vesting period (time between
grant date and vesting date)
16-38
Share Compensation Example
• On November 1, 2018, the shareholders of Chen Ltd. approve a plan
that grants the company’s five executives options to purchase 2,000
shares each of the company’s ¥100 par value ordinary shares.
• The company grants the options on January 1, 2019. The executives
may exercise the options at any time within the next 10 years.
• The option price per share is ¥6,000, and the market price of the
shares at the date of grant is ¥7,000 per share.
• We assume that the fair value option-pricing model determines Chen’s
total compensation expense to be ¥22,000,000.
16-39
Assume that the expected period of benefit is two years, starting
with the grant date. Chen would record the transactions related to
this option contract as follows.
Dec. 31, 2019
Compensation Expense 11,000,000 *
Share Premium—Share Options 11,000,000
Dec. 31, 2020
Compensation Expense 11,000,000

* (¥22,000,000 ÷ 2)
16-40
Exercise. If Chen’s executives exercise 2,000 of the 10,000
options (20 percent of the options) on June 1, 2022 (three years
and five months after date of grant), the company records the
following journal entry.
June 1, 2022
Cash (2,000 x ¥6,000) 12,000,000

Share Capital—Ordinary (2,000 x ¥100) 200,000
16-41
Expiration. If Chen’s executives fail to exercise the remaining

share options before their expiration date, the company records
the following at the date of expiration.
Jan. 1, 2029
Share Premium—Share Options 17,600,000 *
Share Premium—Expired Share Options 17,600,000
* (¥22,000,000 x 80%)
16-42
Adjustment. Once the total compensation is measured at

the date of grant, can it be changed in future periods?
Depends on whether the adjustment is caused by a

 service condition – yes allowed
 market condition. – not allowed
16-43
Restricted Shares
Restricted-share plans transfer shares to employees, subject to
an agreement that the shares cannot be sold, transferred, or
pledged until vesting occurs.
Major Advantages:
1. Shares never becomes completely worthless.
2. Shares generally results in less dilution to existing

shareholders.
3. Shares better aligns employee incentives with company

incentives.
16-44
Restricted Shares
Example: On January 1, 2019, Ogden Company issues 1,000

restricted shares to its CEO, Christie DeGeorge. Ogden’s shares have a
fair value of $20 per share on January 1, 2019. Additional information is
as follows.
 Service period related to the restricted shares is five years.
 Vesting occurs if DeGeorge stays with the company for a five-year
period.
 Par value of the stock is $1 per share.
Ogden makes the following entry on the grant date (January 1, 2019).
16-45
Restricted Shares
Restricted Shares Example: Ogden makes the following entry on

the grant date (January 1, 2019).
Unearned Compensation 20,000

Share Capital--Ordinary (1,000 x $1) 1,000
Share Premium--Ordinary (1,000 x $19) 19,000
Unearned Compensation represents the cost of services yet to be

performed, which is not an asset. Reported in equity in the statement
of financial position, as a contra equity account
16-46
Restricted Shares
Restricted Shares Example: Record the journal entry at

December 31, 2019, Ogden records compensation expense.
Compensation expense 4,000

Unearned compensation 4,000
Ogden records compensation expense of $4,000 for each of the

next four years (2020, 2021, 2022, and 2023).
16-47
Restricted Shares
Restricted Shares Example: Assume that DeGeorge leaves on

February 3, 2021(before any expense has been recorded during
2021). The entry to record this forfeiture is as follows
Share Capital--Ordinary 1,000

Share Premium--Ordinary 19,000
Compensation Expense ($4,000 x 2) 8,000
Unearned Compensation 12,000
16-48
Employee Share-Purchase Plans

 Generally permit all employees to purchase shares at a
discounted price for a short period of time.
 Considered compensatory and should be recorded as
expense over the service period.
16-49
Illustration: Masthead plc offers all its 1,000 employees the

opportunity to participate in an employee share-purchase plan.
Under the terms of the plan, the employees are entitled to purchase
100 ordinary shares (par value £1 per share) at a 20 percent
discount. The purchase price must be paid immediately upon
acceptance of the offer. In total, 800 employees accept the offer,
and each employee purchases on average 80 shares. That is, the
employees purchase a total of 64,000 shares. The weighted-
average market price of the shares at the purchase date is £30 per
share, and the weighted-average purchase price is £24 per share.
16-50
Illustration: The entry to record this transaction is as follows.
Cash (64,000 x £24) 1,536,000

Compensation Expense [64,000 x (£30 - £24)] 384,000
Share Capital—Ordinary (64,000 x £1) 64,000
The IASB indicates that there is no reason to treat broad-based

employee share plans differently from other employee share plans.
16-51
Disclosure of Compensation Plans

Company with one or more share-based payment arrangements
must disclose:
1. Nature and extent of share-based payment arrangements that
existed during the period.
2. How the fair value of the goods and services received, or the
fair value of the equity instruments granted during the period,
was determined.
3. Effect of share-based payment transactions on the company’s
net income (loss) during the period and on its financial
position.
16-52
LO 5 – Controversy involving share
compensation plans
16-53
Debate over Share-Option Accounting
The IASB faced considerable opposition when it proposed the fair

value method for accounting for share options. This is not surprising,
given that the fair value method results in greater compensation costs
relative to the intrinsic-value model.
Transparent financial reporting—including recognition of share-based
expense—should not be criticized because companies will report
lower income.
If we write standards to achieve some social, economic, or public
policy goal, financial reporting loses its credibility.
16-54

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Dilutive Securities and EPS

Debt and Equity

Bonds which can be changed into other corporate

Benefit of a Bond (guaranteed interest and principal)

Two main reasons corporations issue convertibles:

To raise equity capital without giving up more

Obtain debt financing at cheaper rates.

Accounting for Convertible Debt

Implementation of the with-and-without approach:

2. Second, determine liability component by computing net

3. Finally, subtract liability component estimated in second

The bonds have a four-year term with a stated rate of interest of 6%

Interest is payable annually at December 31.

The market rate of interest on similar non-convertible debt is 9%.

Accounting at Time of Issuance ILLUSTRATION 16.3

Journal Cash 2,000,000

Settlement of Convertible Bonds

Bonds Payable 2,000,000

Share Premium—Conversion Equity 194,394

NOTE: The amount originally allocated to equity of €194,384 is transferred to

Conversion of Bonds before Maturity.

Carrying value at date of conversion

Conversion of Bonds before Maturity. Assuming that Roche

Share Premium—Conversion Equity 194,374

NOTE: The amount originally allocated to equity (€194,374) is transferred to

• Fair value of liability component (PV of cash flows of a non

• Carrying value of liability component at the date of conversion

• Fair value of a convertible debt (including both liability and equity

• Fair value of liability component (PV of cash flows of a non

Repurchase before Maturity. Assume:

Next, determine any adjustment to the equity.

Bonds Payable 1,894,464

Convertible preference shares include an option for the

Morse AG issues 1,000 convertible preference shares that have a

Cash (1,000 x €200) 200,000

If each share is subsequently converted into 25 each ordinary

Share Capital—Preference 1,000

If the convertible preference shares are repurchased at their fair

Share Capital—Preference 1,000

Warrants are certificates entitling the holder to acquire shares

Warrants issued with other securities are basically long-term

• At the time, an ordinary share of Siemens was selling for approximately

• These warrants enabled Siemens to price its bond offering (with a

The bonds sell at a discount. Siemens records the sale as follows.

Assuming investors exercise all 10,000 warrants (one warrant per

Cash (10,000 x €25) 250,000

Share Rights - existing stockholders have the right (preemptive

Under the fair-value method, companies use acceptable

2. Over what periods to allocate compensation expense.

Allocating Compensation Expense

Dec. 31, 2019

Compensation Expense 11,000,000 *

Share Premium—Share Options 11,000,000

Dec. 31, 2020

Compensation Expense 11,000,000

Cash (2,000 x ¥6,000) 12,000,000

Expiration. If Chen’s executives fail to exercise the remaining

Share Premium—Share Options 17,600,000 *

Share Premium—Expired Share Options 17,600,000