Lecture Intermediate accounting (IFRS/e) - Chapter 19: Share-based compensation and earnings per share

In this chapter we look at some common forms of compensation in which the amount of the compensation employees receive is tied to the market price of company share. We will see that these share-based compensation plans – share awards, share options, and share appreciation rights – create shareholders’ equity. The nature of this compensation will impact the way we calculate earnings per share, the topic of the second part of this chapter.

SHARE-BASED

COMPENSATION AND

EARNINGS PER SHARE

Chapter 19

Share-Based Compensation

Compensation:

• Salary

• Share awards

Share Award Plans

Restricted share plans

• Usually tied to continuing employment,

• Compensation is market price at date of grant,

• Compensation expense accrued over service period

Share Option Plans

to buy

(a) a specified a specified number number of shares of the firm's

share,

(b) at a specified at a specified exercise price exercise price ,

(c) during a specified during a specified period of time period of time

 The fair value The fair value is accrued as compensation is accrued as compensation

Expense – The Great Debate

Historically, options have been measured

at their intrinsic value – the simple difference between the market price of the shares and the option price at which they can be acquired If the market and exercise price are equal on the date of grant, no compensation expense is recognized even

if the options provide executives with

substantial income.

Historically, options have been measured

difference between the market price of the shares and the option price at which they can be acquired If the market and exercise price are equal on the date of grant, no

compensation expense is recognized even

if the options provide executives with

substantial income.

Current Requirements

Things changed in November 2002 when the IASB issued its exposure draft ED 2 on Share-based Payment (This was followed by the standard IFRS No 2 in February

2004.)

The release of ED 2 came in the aftermath of the

accounting scandals and the “dot-com” crisis, and the

shell-shocked market were more willing to accept a

higher level of discipline with regards to disclosures on

management compensation

Thus the requirement for companies to measure options

Things changed in November 2002 when the IASB issued its exposure draft ED 2 on Share-based Payment (This was followed by the standard IFRS No 2 in February

2004.)

The release of ED 2 came in the aftermath of the

accounting scandals and the “dot-com” crisis, and the

shell-shocked market were more willing to accept a

higher level of discipline with regards to disclosures on

management compensation

Thus the requirement for companies to measure options

Measurement Objectives

Recognizing Fair Value of Options

Accounting for share options parallels the accounting for restricted share we discussed earlier We now are required to estimate the fair value of share option

on the grant date.

Accounting for share options parallels the accounting for restricted share we discussed earlier We now are required to estimate the fair value of share option

on the grant date.

IFRS (and U.S GAAP) requires that

compensation expense be measured using one of several option pricing models that deal with:

1 Exercise price of the option

2 Expected term of the option

Plans with Performance or Market

Conditions

If compensation from a share option depends on meeting

a performance target, then whether we record

compensation depends

• Initially on the best available estimate of the expected number of options that will vest (i.e based on the

company’s assessment of the likelihood of the

performance target being met) and

• Ultimately on whether the performance target actually is met

If the target is based on changes in the market rather than on performance, we record compensation as if there were no target

U S GAAP vs IFRS

• A deferred tax asset (DTA) is

created for the cumulative amount of the fair value of the options the company has

recorded for compensation expense.

There are more similarities than differences in the treatment of share options One major difference is the treatment of deferred tax assets and when options have

graded-vesting.

• The deferred tax asset is not created until the award is “in the money;” that is it has intrinsic value.

• Straight-line choice is not

permitted Companies not

Plans With Graded-Vesting

Rather than share option plans vesting on a single date, more plans

awards specify that recipients gradually become eligible to exercise their options rather than all at once This is called “graded vesting.”

The company should view each vesting group separately, as if it were a separate award

For example, a company may award share options

that vest 25% in the first year, 25% in second year,

and 50% the third years For accounting purposes

we have three separate awards

The line method

straight-is not

allowed

Employee share option plans

 Permit employees to buy shares directly from

their employer

 Usually the plan is considered compensatory,

and compensation expense is recorded

 As long as

1 A company grants all holders of a particular class the right to

buy equity instruments at a discount and

2 An employee happens to be an investor in that particular class

and transacts with the company as an investor

 The option plan it is simply record as a sale of new shares to employees :

Employee share option plans

 However, If the discounted sale is meant to benefit

only employees and is not extended to all investors in a particular class, accounting is similar to other share-

based plans

 The discount to employees, then, is considered to be

compensation, and that amount is recorded as expense

 The company measures the difference between the fair value of shares issued and the cash received as the compensation expense

Compensation expense (100 × $1.50) 150

Ordinary shares (100 × $10.00) 1,000

Market value

Earnings Per Share (EPS)

Of the myriad facts and figures generated by accountants, the single accounting number that is reported most frequently in the media and receives by far the most attention by investors and

creditors is

creditors is earnings per share earnings per share .

Simple Capital Structure

(Basic EPS)

Basic Earnings Per Share

Net income (after tax) – preference dividends*

Weighted average outstanding ordinary share

Net income (after tax) – preference dividends*

Weighted average outstanding ordinary share

*Current period’s cumulative preference bonus issues (whether or not declared) and noncumulative preference bonus issues (only if declared).

* Current period’s cumulative preference bonus issues (whether or not period’s cumulative preference bonus issues (whether or not

declared) and noncumulative preference bonus issues (only if declared).

Number of shares outstanding

× Number of months outstanding ÷ 12 Weighted average shares outstanding

Number of shares outstanding

× Number of months outstanding ÷ 12 Weighted average shares outstanding

Issuance of New Shares

Compute the weighted average number of

shares of ordinary share outstanding.

Date Description No of Shares

Issuance of New Shares

Compute the weighted average number of

shares of ordinary share outstanding.

New Shares

Annual Weighting

Annual Weighting

Bonus Issues and Share Splits

Ordinary shares issued as part of bonus

issues (also known as share or stock dividends) and share splits are treated retroactively as subdivisions of the shares already outstanding at the date

of the split or dividend.

Ordinary shares issued as part of bonus

issues (also known as share or stock dividends) and share splits are treated retroactively as subdivisions of the shares already outstanding at the date

of the split or dividend.

Bonus Issues and Share Splits Compute the weighted average number of shares

of ordinary share outstanding.

Date Description No of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Stock dividend(100%) 150,000

Bonus Issues and Share Splits Compute the weighted-average number of

shares of ordinary share outstanding.

bonus issue adjustment

Annual Weighting

Bonus Issues and Share Splits

Retroactive treatment:

Bonus issue or split is treated as outstanding from the beginning of

the period

Bonus issue or split is treated as outstanding from the beginning of

the period

Bonus issue or split is applied retroactively in proportion to the number of

shares outstanding at the

time of the dividend or split

Bonus issue or split is applied retroactively in proportion to the number of

shares outstanding at the

time of the dividend or split

New sharesissued this period?

New sharesissued this period?

Share Buy-Back

Compute the weighted-average number of

shares of ordinary share outstanding.

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Repurchased shares 12,000

Share Buy-Back

Compute the weighted-average number of

shares of ordinary share outstanding.

Treasury Shares

Annual Weighting

Annual Weighting

Earnings Available to Ordinary Shareholders

Net income

Less: Current period’s cumulative preference share*

dividends (whether or not declared)

Less: Noncumulative preference share* dividends (only if

declared)Net income available to ordinary shareholders

*Or more senior classes of shareholders

Complex Capital Structure

(Dual EPS)

Share Options

Convertible securities

Treasury share method

If-converted method

Contingently issuable shares

Potential Ordinary Shares:

• Share options and warrants

• Convertible bonds and share

• Contingent ordinary share

issues

Potential Ordinary Shares:

• Share options and warrants

• Convertible bonds and share

• Contingent ordinary share

issues

Diluted Earnings Per Share

Options, Rights, and Warrants

Proceeds

Used to

Purchase treasury shares

At average market price

The treasury share method assumes that proceeds from the exercise of options are used to purchase treasury shares This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share.

The

The treasury share treasury share

method assumes that proceeds from the exercise of options are used to purchase treasury shares This method usually results in a net increase in shares included in the denominator of the calculation of diluted earnings per share.

Options, Rights, and Warrants

Proceeds from assumed exercise Average-of-period market price of share

Proceeds from assumed exercise Average-of-period market price of share

 Determine new shares from assumed

exercise of share options.

 Compute number of shares

repurchased

Options, Rights, and Warrants

 Determine new shares from assumed

exercise of share options.

 Compute shares purchased for the

Options and Warrants

When the exercise price exceeds the market price, the securities are antidilutive and

are excluded from the calculation of diluted EPS.

When the exercise price exceeds the market price, the securities are

securities are antidilutive antidilutive and

are excluded from the calculation of diluted EPS.

Anti-Dilutive Securities

When all the dilutive securities are included in the calculation of diluted EPS, at the same time, we may not arrive at a diluted EPS that is the lowest possible figure or the “worst case” EPS

Anti-Dilutive Securities

In-the-money” option or warrant is the most dilutive security among potential ordinary shares

Convertible Securities

convertible debt and equity

Convertible Securities

The assumed conversion of convertible bonds or preference shares has two effects on dilutive

earnings per share:

increases the denominator by the number of ordinary shares issuable upon conversion,

increases the numerator by decreasing after-tax increases the numerator by decreasing after-tax

interest expense on convertible bonds, and dividends on convertible preference shares

Anti-Dilutive SecuritiesFor convertible securities (convertible bonds and convertible

preference shares), we determine whether convertible securities are dilutive by comparing the “incremental effect” on EPS from the

assumed conversion

Additional EPS Issues

Contingent shares are issuable in the future for little or no cash consideration upon the satisfaction of certain conditions

Contingently issuable shares are considered to be outstanding in the computation of EPS if the target

Contingent shares are issuable in the future for little or no cash consideration upon the satisfaction of certain conditions

Contingently issuable shares are considered to be outstanding in the computation of EPS if the target

Contingently Issuable Shares

Contingently Issuable Shares

Shares are issued merely due to passage

Some target performance level has already been met and is expected to continue to the end of the contingency period

Contingent shares are included in

dilutive EPS if:

Contingent shares are included in

dilutive EPS if:

Example: Additional shares may be issued based on future earnings

Example: Additional shares may be issued based on future earnings

Convertible securities (bonds, notes,

Dilutive Effect Shown?

shares

Add shares created

by vesting, reduced

by repurchased shares at the average stock price

interest

Add shares issuable upon conversion

Add shares issuable upon Modification to Diluted EPS Equation

Financial Statement Presentation

Report EPS data separately for:

1 Income from Continuing Operations

2 Discontinued Operations

3 Net Income

Appendix 19A – Option-Pricing Theory

Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than buying the underlying share directly

An option that permits an employee to buy $25 share for $10, has an intrinsic value of $15.

Intrinsic value is the benefit the holder of an option would realize by exercising the option rather than buying the underlying share directly

An option that permits an employee to buy $25 share for $10, has an intrinsic value of $15.

Options have a time value because the holder of an option does

Options have a time value because the holder of an option does

 The SARs are considered to be equity if the employer

can elect to settle in shares;

– Unless the employer has a present obligation to the employee to settle in cash, or unless the employee has a valid expectation to receive cash

 The amount of compensation is estimated at the grant date as the fair value of the SARs

Appendix 19B - Share Appreciation

Rights

Usually the same as the fair value

of a share option with similar terms.

Share Appreciation Rights

 The SARs are considered to be a liability if the employee

has the right to receive cash upon settlement In that

case, the amount of compensation (and related liability)

is estimated each period and continuously adjusted to reflect changes in the fair value of the SARs until the

compensation is finally paid

 The current expense (and adjustment to the liability) is the

recipients of the SARs (based on the elapsed

percentage of the service period), reduced by any

amounts expensed in prior periods

 The employer may have to recognize the expense

immediately if the services have already been received

Share Appreciation Rights

End of Chapter 19