SHARE-BASED COMPENSATION AND EARNINGS PER SHARE

Overview
We’ve discussed a variety of employee compensation plans in prior chapters, including
pension and other postretirement benefits in Chapter 17. 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 stock. We will see that these “share-based”
compensation plans – stock awards, stock options, and stock appreciation rights - create
shareholders’ equity, the topic of the previous chapter and also often affect the way we
calculate earnings per share, the topic of the second part of the current chapter. Specifically,
we view these as ”potential common shares” along with convertible securities and calculate
earnings per share as if they already had been exercised or converted into additional common
shares.

Learning Objectives
1. Explain and implement the accounting for stock award plans.
2. Explain and implement the accounting for stock options.
3. Explain and implement the accounting for employee share purchase plans.
4. Distinguish between a simple and a complex capital structure.
5. Describe what is meant by the weighted average number of common shares.
6. Differentiate the effect on EPS of the sale of new shares, a stock dividend or stock split,
and the reacquisition of shares.
7. Describe how preferred dividends affect the determination of EPS.
8. Describe how options, rights, and warrants are incorporated in the calculation of EPS.
9. Describe how convertible securities are incorporated in the calculation of EPS.
10. Determine whether potential common shares are antidilutive.
11. Determine the three components of the proceeds used in the treasury stock method.
12. Explain the way contingently issuable shares are incorporated in the calculation of EPS.
13. Describe the way EPS information should be reported in an income statement.
14. Discuss the primary differences between U.S. GAAP and IFRS with respect to
accounting for share-based compensation and EPS.

Lecture Outline
Part A: Share-Based Compensation
A. Typically, an executive compensation plan is tied to performance in a way that uses
compensation to motivate its recipients.
B. Many plans include share-based awards.
C. Whichever form such a plan assumes, the accounting objective is to record the fair
value of compensation expense over the periods in which related services are
performed.
D. This requires:
1. Determining the fair value of the compensation.
2. Expensing that compensation over the periods in which participants perform
services.
I. Stock Award Plans (T19-1)
A. The compensation is a grant of shares of stock.
B. The shares usually are restricted so that benefits are tied to continued employment.
1. Usually shares are subject to forfeiture if employment is terminated within some
specified number of years from the date of grant.
2. The employee cannot sell the shares during the restriction period.
C. The compensation is simply the market price of the stock at the grant date.
1. Compensation is accrued as expense over the service period for which
participants receive the shares.
2. The service period usually is the period from the date of grant to when restrictions
are lifted (the vesting date). (T19-2)
D. If restricted stock is forfeited, related entries previously made would simply be
reversed.
II. Stock Option Plans (T19-3)
A. Allow recipients the option to purchase (a) a specified number of shares of the firm's
stock, (b) at a specified price, (c) during a specified period of time.
B. For tax purposes, plans can either qualify as an “incentive stock option plan” under the
Tax Code or be "unqualified plans." Under a qualified incentive plan, the recipient
pays no income tax until any shares acquired are subsequently sold. On the other hand,
the company gets no tax deduction at all. With a nonqualified plan the employee can’t
delay paying income tax, but the employer is permitted to deduct the difference
between the exercise price and the market price at the exercise date. (T19-4)
C. The accounting objective is to report the fair value of compensation expense during the
period of service for which the compensation is given. (T19-5)
D. Compensation is measured at the grant date, estimated using an option-pricing model
that considers the exercise price and expected term of the option, the current market
price of the underlying stock and its expected volatility, expected dividends, and the
expected risk-free rate of return.
E. When forfeiture estimates change, the cumulative effect on compensation is reflected
in current earnings. (T19-6)
F. When options are exercised, cash is debited for the amount received, and stock accounts
replace paid-in capital – stock options. (T19-7)
G. If compensation from a stock option depends on meeting a performance target, then
whether we record compensation depends on whether or not we feel it’s probable the
target will be met. (T19-8)
H. If the target is based on changes in the market rather than on performance, we record
compensation as if there were no target.
I. Under U.S. GAAP, a deferred tax asset is created for the cumulative amount of the fair
value of the options expensed. Under IFRS, the deferred tax asset isn’t created until
the award is “in the money;” that is, has intrinsic value. (T19-9)
J. If recipients gradually become eligible to exercise their options rather than all at once,
the plan is said to have “graded vesting.” In such a case, most companies view each
vesting group (or tranche) separately, as if it were a separate award. Companies also
are allowed to account for the entire award on straight-line basis over the entire vesting
period. Either way, the company must recognize at least the amount of the award that
has vested by that date.
 K. Under IFRS, the straight-line choice is not permitted. Also, there’s no requirement that
the company must recognize at least the amount of the award that has vested by each
reporting date.

III. Employee Share Purchase Plans (T19-10)

A. Employee share purchase plans allow employees to buy company stock under
convenient or favorable terms.
B. Most such plans are considered compensatory and require the fair value of any discount
to be recorded as compensation expense.