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L. Diluted Earnings Per Share

L. Diluted Earnings Per Share

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Module 15: Stockholders’ Equity



590



The calculation of diluted EPS is based upon outstanding common stock and all dilutive common shares that

were outstanding during the period. In the example, the options and warrants are the only potentially dilutive security. Options and warrants are considered to be common stock equivalents at all times. Consequently, the only question that must be resolved is whether or not the options and warrants are dilutive.

This question is resolved by comparing the average market price per common share of $10 with the exercise

price of $8. If the average market price is > the exercise price, the effect of assuming the exercise of options and warrants is dilutive. However, if the average market price is < the exercise price, the effect of assuming the exercise of

options and warrants would be antidilutive (i.e., EPS would stay the same or increase). In the example, the options

and warrants are dilutive ($10 > $8).

The method used to determine the dilutive effects of options and warrants is called the treasury stock method.

This method assumes:



Cash



Exercising

stockholders



Corporation



Shares issued



Treasury shares

Cash



Selling

stockholders



Dilutive effect = Number of shares issued to exercising stockholders – Shares acquired from selling stockholders



In the example above, all of the options and warrants are assumed to be exercised at the beginning of the year

(the options and warrants were outstanding the entire year) and the cash received is used to reacquire shares (treasury

stock) at the average market price. The computation below illustrates the “treasury stock” method.

Proceeds from assumed exercise of options and warrants (1,000 shares × $8)

Number of shares issued

Number of shares reacquired ($8,000 ÷ $10)

Number of shares assumed issued and not reacquired



$8,000

1,000

800

200



* An alternative approach that can be used to calculate this number for diluted EPS is demonstrated below.



Average market price – Exercise price

Average market price

$10 – 8

$10



×



× 1,000 shares =



Number of shares under

options/warrants



=



Shares not reacquired



200 shares



Diluted EPS can now be calculated, as follows, including the effects of applying the “treasury stock” method.

Net income – Preferred dividends

Weighted-average of common shares outstanding

+ Number of shares not acquired with proceeds

from options and warrants



=



$50,000 − 4,000

10,000 + 200 shares



= $4.51



NOTE: The incremental effects of the treasury stock method; there was no effect on the numerator

of the EPS calculation while there were 200 shares added to the denominator. Note also that the

options and warrants are dilutive. EPS is reduced from $4.60 to $4.51.



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Module 15: Stockholders’ Equity







a. One difference between the computation of diluted and basic EPS is that the denominator of the diluted

EPS computation is increased to include the number of additional common shares that would have been

outstanding if the dilutive potential common shares had been issued.

b. In addition, the numerator is adjusted to add back any convertible preferred dividends, the after-tax amount

of interest recognized in the period associated with any convertible debt, and any other changes in income

(loss) that would result from the assumed conversion of the potential common shares.

c. Diluted EPS should be based on the security holder’s most advantageous conversion rate or exercise price.

d. Similar to basic EPS, all antidilutive securities are disregarded.













591



2. The following two independent examples will illustrate the procedures necessary to calculate basic and diluted EPS.







a. Table II summarizes the calculations made for the first example involving diluted EPS.

TABLE II

Basic EPS

Numerator

Denominator



Items

Net income

Preferred div.



$50,000



$50,000



  (4,000)



  (4,000)



Common shares

outstanding

Options and warrants

Totals

EPS



Diluted EPS

Numerator

Denominator



10,000 shs.

$46,000



10,000 shs.



÷ 10,000 shs.

$4.60



$46,000



÷

$4.51



200

10,200 shs.



EXAMPLE

Assume net income is $50,000, and the weighted-average of common shares outstanding is 10,000.

Assume the following additional information:









1. 8% convertible debt, 200 bonds each convertible into 40 common shares. The bonds were outstanding the

entire year. The average AA corporate bond yield was 10% at the date the bonds were issued. The income tax

rate is 40%. The bonds were issued at par ($1,000 per bond). No bonds were converted during the year.

2. 4% convertible, cumulative preferred stock, par $100, 1,000 shares issued and outstanding. Each preferred

share is convertible into 2 common shares. The preferred stock was outstanding the entire year, and the

average AA corporate bond yield at the date the preferred stock was issued was 10%. The preferred stock

was issued at par. No preferred stock was converted during the year.



The capital structure is complex in this example because of the presence of the two convertible securities. The

first step in the solution of this example is the calculation of basic EPS based upon weighted-average of common

shares outstanding. This basic EPS is the same as it was for the first example (i.e., $4.60). The next step is the computation of diluted EPS. The diluted EPS computation will include the convertible preferred stock if it is dilutive.

To determine the dilutive effect of the preferred stock, an assumption (called the if-converted method) is made

that all of the preferred stock is converted at the earliest date that it could have occurred during the year. In this

example, the date would be January 1. The effects of this assumption are twofold. One, if the preferred stock is converted, there will be no preferred dividend of $4,000 for the year; and, two, there will be an additional 2,000 shares

of common stock outstanding during the year (the conversion rate is 2 common for 1 preferred). EPS is computed, as

follows, reflecting these two assumptions.

Net income – Preferred dividends

Weighted-average of common shares outstanding

+ Shares issued upon conversion

of preferred stock



=



$50,000 − 4,000

10,000 + 200 shares



= $4.17



The convertible preferred stock is dilutive because it reduced EPS from $4.60 to $4.17.

In the example, the convertible bonds are assumed to have been converted at the beginning of the year. The

effects of this assumption are twofold. One, if the bonds are converted, there will be no interest expense of $16,000

(8% × $200,000 face value); and, two, there will be an additional 8,000 shares (200 bonds × 40 shares) of common

stock outstanding during the year. One note of caution, however, must be mentioned; namely, the effect of not having

$16,000 of interest expense will increase income, but it will also increase tax expense. Consequently, the net effect of

not having interest expense is $9,600 [$16,000 – (40% × $16,000)]. Diluted EPS is computed, as follows, reflecting

the dilutive preferred stock and the effects noted above for the convertible bonds:



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Module 15: Stockholders’ Equity



592



Net income + Interest expense (net of tax)



$50,000 + 9,600



=



 = $2.98



10,000 + 2,000 + 8,000 shares



Weighted-average of common shares outstanding

+ Shares issued upon conversion of preferred and

conversion of bonds



The convertible debt is dilutive. Both the convertible bonds and preferred stock reduced EPS from $4.60 to $2.98.

Table III summarizes the computations made for the second example.



The income statement disclosures for EPS, as a result of the second example, would be as follows:

Earnings per common share (see Note X)



$4.60



Earnings per common share assuming dilution



2.98



Note X would state the assumptions made in determining both basic and diluted EPS numbers.







b. Table III summarizes the computations made for the second example.

TABLE III

Items

Net income

Preferred div.



Basic EPS

Numerator

Denominator

$50,000



$50,000



  (4,000)



Common shares

outstanding

Conversion of

preferred

Conversion of bonds

Totals

EPS



Diluted EPS

Numerator

Denominator



10,000 shs.



10,000 shs.

2,000



$46,000



÷ 10,000 shs.

$4.60



  9,600

$59,600



÷

$2.98



8,000

20,000 shs.



EXAMPLE 1

Suppose the convertible bonds in the second example were issued during the current year on July 1. If all other

facts remain unchanged, diluted EPS would be computed as follows:

Net income + Interest expense (net of tax)

Weighted-average of common shares outstanding

+ Shares issued upon conversion of preferred and

conversion of bonds



=



$50,000 + ½ (9,600)

10,000 + 2,000 + ½ (8,000)



= $3.43



The convertible debt is dilutive whether or not it is outstanding the entire year or for part of a year.











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c. In the two examples, all of the potentially dilutive securities were outstanding the entire year and no

conversions or exercises were made during the year. If a potentially dilutive security was not outstanding the

entire year, then the numerator and denominator effects would have to be “time-weighted.”

d. If actual conversions or exercises take place during a period, the common shares issued will be outstanding

from their date of issuance and, therefore, will be in the weighted-average of common shares outstanding.

These shares are then weighted from their respective times of issuance.

e. It should also be noted that when convertible debt is issued for a premium or discount, the interest expense

net of taxes must be computed after giving effect to premium/discount amortization.



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Module 15: Stockholders’ Equity



593



EXAMPLE

For example, assume that all the bonds in the second example are converted on July 1 into 8,000 common shares.

Several important effects should be noted, as follows:















1. The weighted-average of common shares outstanding will be increased by (8,000)(.5) or 4,000. Income

will increase by $4,800 net of tax because the bonds are no longer outstanding.

2. The “if converted” method is applied to the period January 1 to July 1 because it was during this period

that the bonds were potentially dilutive. The interest expense, net of tax, of $4,800 is added to the

income, and 4,000 shares (.5 of 8,000) are added to the denominator.

3. Interestingly, the net effect of items 1 and 2 is the same for the period whether these dilutive bonds were

outstanding the entire period or converted during the period.



f. The benchmark used to determine if including individual securities decreases income is income from

continuing operations unless an enterprise has no discontinued operations. In that case income before

extraordinary items would be the benchmark number.



3. Redemption of preferred stock. The SEC requires that if preferred stock is redeemed, the difference between

the fair value of the consideration transferred and the carrying amount of the preferred stock should be treated

the same as a divided to preferred shareholders in calculating earnings per share.







a. If the consideration transferred is greater than the carrying amount of the preferred stock, it should be

subtracted from net income in the calculation of EPS.

b. If the consideration transferred is less than the carrying amount, then it should be added to net income in

calculating the numerator for EPS.



4. Contingent issuances of common stock. Also mentioned are contingent issuances of common stock (e.g.,

stock subscriptions). If shares are to be issued in the future with no restrictions on issuance other than the

passage of time, they are to be considered issued and treated as outstanding in the computation of dilutive EPS.

Other issuances that are dependent upon certain conditions being met are to be evaluated in a different respect.







a. If the contingency is to merely maintain the earnings levels currently being attained, then the shares are

considered outstanding for the entire period and considered in the computation of dilutive EPS if the effect

is dilutive.

b. If the requirement is to increase earnings over a period of time, the diluted EPS computation shall include

those shares that would be issued based on the assumption that current amount of earnings will remain

unchanged, if the effect is dilutive.



5. EPS on comprehensive income and other comprehensive income components. EPS numbers below net

income are not required for comprehensive income components.

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 62 THROUGH 70























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M. Corporate Bankruptcy

1.The going concern assumption is one of the basic principles underlying the primary financial statements

(balance sheet, income statement and statement of cash flows). However, this assumption of continued

existence is threatened in corporations that are in severe financial trouble.

a. A range of alternative actions is available to a company before it enters bankruptcy, such as seeking

extensions on due dates of debt, restructuring its debt, or allowing a court-appointed trustee to manage the

corporation.

(1) These pre-bankruptcy options are presented in the following modules:

(a) Creditor’s agreements—Module 30, Bankruptcy

(b) Troubled debt restructurings—Module 13, Present Value, Section C

2. Bankruptcy is the final legal act for a company. In bankruptcy, the accounting and financial reporting must

present the information necessary for the liquidation of the business.



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Module 15: Stockholders’ Equity



594



































a.The Statement of Affairs is prepared to present the current market values of the assets and the status of the

various categories of the equity interests of the corporation.

(1)The Statement of Affairs classifies assets in the following order of priority (highest to lowest):

(a) Assets pledged with fully secured creditors—assets having a fair valuation equal to or greater than

the debts for which they serve as collateral

(b) Assets pledged with partially secured creditors—assets having a fair valuation less than their

associated debts

(c) Free assets—uncommitted assets available for remaining equity interests

b. The accountant must provide a prioritization of the creditors’ claims against the net assets of the

corporation. The legal rights of each creditor are determined by the terms of the credit agreement it has with

the company and by the National Bankruptcy Act.

(1) The equity interests are classified in the following order (highest to lowest):

(a) Preferred claims—these claims have priority as specified in the Bankruptcy Act

(b) Fully secured creditors—these are claims which should be fully covered with the realizations from

the assets pledged to the claims

(c) Partially secured creditors—these are claims which may not be fully covered by the realizations of

the pledged assets for these claims; the amount of the uncovered claims goes to the unsecured

creditors category

(d) Unsecured creditors—these are claims that have no priority and do not have any collateral claims to

any specific assets

(e) Stockholders’ equity—this represents any residual claim

c. The historical cost valuation principles used in a balance sheet assume a going concern assumption.

(1) As a business enters bankruptcy, the liquidation values of the assets become the most relevant measures.

In addition, anticipated costs of liquidation should be recognized.

(2) The Statement of Affairs begins with the present book values of the company’s assets in order to

articulate with the balance sheet. After relating the projected proceeds from the liquidation of the assets

to the various equity interests, the statement concludes with the estimated dollar amount of unsecured

claims that cannot be paid (estimated deficiency).



EXAMPLE

The Vann Corporation’s balance sheet for December 31, year 1, is shown below. The corporation is entering bankruptcy and expects to incur $8,000 of costs for the liquidation process. The estimated current values of the assets

are determined and the various equity claims are prioritized. The Statement of Affairs for Vann Corporation is

presented on the following page.

The Vann Corporation

BALANCE SHEET

December 31, Year 1

Assets

Cash

$ 1,500

Marketable securities

10,000

Accounts receivable (net)

18,000

Merchandise inventory

41,000

Prepaid expenses

2,000

Land

6,000

Building (net of depreciation)

65,000

Machinery (net of depreciation)

21,000

10,000

Goodwill

$174,500



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Module 15: Stockholders’ Equity



Equities

Accounts payable

Notes payable

Accrued wages

Mortgages payable

Capital stock ($10 par)

Retained earnings (deficit)



595



$ 30,000

37,000

6,500

45,000

100,000

(44,000)

$174,500



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 71 THROUGH 73









































N.Reorganizations

Chapter 11 of the Bankruptcy Reform Act of 1978 and The Bankruptcy Abuse and Consumer Protection Act of

2005 allow legal protection from creditors to provide time for a bankrupt corporation to return its operations to a

profitable level.

1. The balance sheet, income statement, and statement of cash flows must distinguish events and transactions

related with the reorganization from those related to ongoing operations.

2. Liabilities should be reported at expected amounts per the plan on the balance sheet. Liabilities should be

classified as unsecured or secured liabilities before reorganization and liabilities incurred after the filing date

for Chapter 11.

3. Transactions directly related to the reorganization should be reported separately on the income statement in the

period incurred, and disclosure should be made of any anticipated changes in common stock or common stock

equivalents.

4. Cash flows related to the reorganization should be reported separately from those related to regular operations.

5. At confirmation of the plan of reorganization, an entity may be considered a new entity for reporting purposes

if the reorganization value of assets before confirmation is less than liabilities incurred after petition for Chapter

11 and voting shareholders before confirmation receive less than 50% of the voting shares of the emerging

entity.

6. If the entity does not qualify as a new entity, the reorganization should be accounted for as troubled debt

restructuring which is discussed in Section C of Module 13.

O. Quasi Reorganization

The purpose of a quasi reorganization is to allow companies to avoid formal bankruptcy proceedings through

an informal proceeding. The procedure is applicable for a situation where a going concern exists except for

overvalued assets and a possible deficit. The overvalued assets result in high depreciation charges and losses or

lower net income. The deficit precludes payment of dividends. The procedure is applicable during a period of

declining price levels (normally associated with decreased economic activity), such as the 1930s.

1. The procedures involve

a. Proper authorization including that from stockholders and creditors where required

b. Revaluation of assets to current values

c. Elimination of any deficit by charging paid-in capital

(1) First, capital surplus

(2) Second, capital stock

2. To write down assets: here the adjustments are taken directly to retained earnings. An alternative is to use an

intermediary account such as “adjustment account” which would later be closed to retained earnings.

Retained earnings

Assets



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(write-down)

(write-down)



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ASSETS

Estimated

current

values



Book

values



$



The Vann Corporation

STATEMENT OF AFFAIRS

December 31, year 1



6,000

65,000



(1) Assets Pledged with Fully



Secured Creditors:

Land

Building





10,000



1,500

18,000

41,000

2,000

21,000

10,000



Less Mortgages Payable



(2) Assets Pledged with Partially



Secured Creditors:



Marketable Securities



Notes Payable

(3) Free Assets

Cash



Accounts Receivable (net)



Merchandise Inventory



Prepaid Expenses

Machinery

Goodwill



Estimated amount

available



Less: creditors with

priority



Net Estimated amount



available to unsecured

creditors



(81 cents on the dollar)







$ 174,500



Estimated deficiency to

unsecured creditors



$12,000

41,000

$53,000

45,000



Amount available

to unsecured

claims



Book

values



Amount

unsecured



(1) Creditors with Priority



Estimated Liquidation

Expenses (accounting,

legal and other costs of

liquidation process)

$0

6,500    Accrued Wages



$ 8,000



(2) Fully Secured Creditors

Mortgages Payable





$12,000

37,000



1,500

14,000

22,500

0

13,200

0



EQUITIES



45,000



(3) Partially Secured Creditors



Notes Payable Less



Marketable Securities





37,000





$ 8,000



6,500



$14,500



45,000



25,000



37,000



12,000



51,200



59,200

30,000

(14,500)



(4) Unsecured Creditors Accounts

Payable



30,000



100,000

(44,000)



44,700



(5) Stockholders’ Equity



Capital Stock



Retained Earnings (deficit)



10,300



$ 174,500



$55,000









$55,000



596



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Module 15: Stockholders’ Equity

3. To eliminate the deficit

Paid-in capital

Retained earnings











(deficit)

(deficit)



4. In many cases, paid-in capital in excess of par value will be insufficient, and the par or stated value of the

capital stock must be reduced to eliminate the deficit.

Existing paid-in capital

Capital stock

Retained earnings

Paid-in capital from

quasi reorganization







597



(amount on the books)

(total reduction in par)

(deficit)

(forced figure)



a. The paid-in capital arises from reducing the par or stated value from, for example, $100 to $50 rather than

to $59.415. The $59.415 would come from dividing the shares outstanding into the retained earnings deficit.

b. Retained earnings must be dated for ten years (less than ten years justified under exceptional circumstances)

after a quasi reorganization takes place. Disclosure similar to “since quasi reorganization of June 30, 2010,”

would be appropriate.

NOW REVIEW MULTIPLE-CHOICE QUESTIONS 74 THROUGH 77









P. Stock Rights

1. Generally, before additional stock is offered to the public, stock rights are issued to existing shareholders to

prevent involuntary dilution of their voting rights (e.g., the preemptive privilege). The stock rights, evidenced

by warrants, indicate the number and price at which the shares may be purchased. At issuance, the issuer makes

only a memorandum entry. Upon exercise, the following entry is made:

Cash



(proceeds)

Common stock

Paid-in capital











2. Information relating to stock rights outstanding must be disclosed. Detachable stock rights issued with

preferred stock are treated like those on bonds (see Module 13, Section B.6.). Treatment of stock rights by

recipients is discussed in Module 16, Section G.

Q. Employee Stock Ownership Plan (ESOP)

An employee stock ownership plan (ESOP) is a qualified stock bonus plan designed to invest primarily in

qualifying employer securities, including stock and other marketable obligations.







1. In some instances, the ESOP will borrow funds from a bank or other lender in order to acquire shares of the

employer’s stock.







a. If such an obligation of the ESOP is guaranteed by the employer (assumption by the employer of the

ESOP’s debt), it should be recorded as a liability in the employer’s financial statements.

b. The offsetting debit to the liability should be accounted for as a reduction of shareholders’ equity.









(1) Shareholders’ equity will increase symmetrically with the reduction of the liability as the ESOP makes

payments on the debt.







c. Assets held by an ESOP should not be included in the employer’s financial statements, because such assets

are owned by the employees, not the employer.

d. Additionally, the employer should charge to compensation expense the amount the employer contributed or

committed to be contributed to an ESOP with respect to a given year. This is done regardless of whether or

not the ESOP has borrowed funds.







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(par)

(plug)



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Module 15: Stockholders’ Equity



598



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 78 THROUGH 86







R.Ratios

The following ratios use stockholders’ equity components in their calculations:



1.

Dividend payout—measures percentage of earnings distributed as dividends

Dividends per share

Earnings per share



2.

Book value of common stock (at a point in time)—not a meaningful measure because assets are carried at

historical costs

Common stockholders’ equity

Common shares outstanding



3.

Rate of return on common stockholders’ equity—measures the return earned on the stockholders’

investment in the firm

Net income available to common stockholders

Common stockholders’ equity



4.

Debt to equity—shows creditors the corporation’s ability to sustain losses

Total debt (all liabilities)

Stockholders’ equity



NOW REVIEW MULTIPLE-CHOICE QUESTIONS 87 THROUGH 91









S. Research Component—Accounting Standards Codification

1. Stockholders’ equity includes a variety of transactions and accounts that are addressed in several places in the

Codification. The Statement of Shareholder Equity is found in ASC Topic 215. Earnings per Share rules are

in ASC Topic 260. Accounting rules for specific shareholder equity transactions are found in ASC Topic 505,

Equity. ASC Topic 505 includes accounting for stock dividends and stock splits, treasury stock, and equitybased payments to nonemployees. Although share-based payments to employees and nonemployees were

previously covered by one accounting standard, SFAS 123(R), the rules for share-based payments are now

located in two areas of the Codification. Share-based payments to nonemployees are located in ASC Topic

505 and are referred to as equity-based payments. Share-based payments to employees are located in ASC

Topic 718, Compensation—Stock Compensation. Notice that Topic 718 is further divided into the following

subtopics:

718-20

718-30

718-40

718-50



Awards Classified as Equity

Awards Classified as Liabilities

Employee Stock Ownership Plans

Employee Share Purchase Plans







2. A list of useful keywords for research is shown below.







a. Basic stockholders’ equity definitions and issues

Appropriation retained earnings

Capital stock

Capital surplus



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Earned surplus

Retained earnings

Retained income



Undistributed profits



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