Week 04 – Ch.

16 Dilutive Securities and Earnings Per Share

Ch.16 Dilutive Securities and Earnings Per Share

Chapter Learning Objectives
1. Describe the accounting for the issuance, conversion, and retirement of convertible
securities.
2. Describe the accounting for share warrants and for share warrants issued with other securities.
3. Describe the accounting and reporting for share compensation plans.
4. Compute basic earnings per share.
5. Compute diluted earnings per share.
*6. Explain the accounting for share-appreciation rights plans.
*7. Compute earnings per share in a complex situation.

Exercise 16.01 True or False

1. IFRS requires that convertible debt be separated into its liability and equity
components for accounting purposes.
2. Companies recognize a gain or loss on the conversion of convertible debt before
maturity.
3. When an issuer offers some form of additional consideration (a sweetener) to
encourage of its convertible debt, it reports the sweetener as a current period expense.
4. The issuer of convertible preference shares uses the fair value method to record the
conversion of the shares.
5. Companies recognize a gain or loss when shareholders exercise convertible preference
shares.
6. A company should allocate the proceeds from the sale of debt with detachable share
warrants between the two securities based on their a fair values.
7. Non-detachable warrants, unlike detachable warrants, are not considered a compound
instrument for accounting purposes.
8. The intrinsic value of a share option is the difference between the market price of the
shares and the exercise price of the options at the grant date.
9. Under the fair value method, companies compute total compensation expense based
on the fair value of options on the date of exercise.
10. The service period in share option plans is the time between the grant date and the
vesting date.
11. If an employee fails to exercise a share option before its expiration date, the company
should decrease compensation expense.
12. If a service condition exists, the company is not permitted to adjust the estimate of
compensation expense.
13. If preference shares are cumulative and no dividends are declared, the company
subtracts the current year preference dividend in computing earnings per share.
14. When share dividends or share splits occur, companies must restate the shares
outstand-ing after the share dividend or split, in order to compute the weighted-average
number of shares.
15. If a share dividend occurs after year-end, but before the financial statements, are
authorized for issuance, a company must restate the weighted-average number of
shares outstanding for the year.

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 Week 04 – Ch.16 Dilutive Securities and Earnings Per Share

16. Preference dividends are subtracted from net income but not income from continuing
operations in computing earnings per share.
17. When a company has a complex capital structure, it must report both basic and diluted
earnings per share.
18. In computing diluted earnings per share, share options are considered dilutive when
their option price is greater than the market price.
19. The number of contingent shares to be included in diluted earnings per share is based
on the number of shares that would be issuable as if the end of the period were the end
of the contingency period.
20. A company should report per share amounts for income from continuing operations,
but not for discontinued operations.

Exercise 16.02 Issuance and Conversion Repurchase of Convertible Bonds

Barone Corporation issues 3,000 convertible bonds at January 1, 2018. The bonds have a three
year life, and are issued at par with a face value of €1,000 per bond, giving total proceeds of
€3,000,000. Interest is payable annually at 6 percent. Each bond is convertible into 250 ordinary
shares (par value of €1). When the bonds are issued, the market rate of interest for similar debt
without the conversion option is 8%.

Instructions
(a) Compute the liability and equity component of the convertible bond on January 1, 2018.
(b) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2018.
(c) Prepare the journal entry to record the conversion on January 1, 2019.
(d) Assume that the bonds were repurchased on January 1, 2019, for €2,910,000 cash instead of
being converted. The net present value of the liability component of the convertible bonds on
January 1, 2019, is €2,850,000. Prepare the journal entry to record the repurchase on January
1, 2019.
Exercise 16.03 Convertible Bonds.
Koch Co. sold convertible bonds at a premium. Interest is paid on May 31 and November 30. On
May 31, after interest was paid, 100, €1,000 bonds are tendered for conversion into 3,000 shares of
€10 par value ordinary shares that had a market price of €40 per share. How should Koch Co.
account for the conversion of the bonds into ordinary shares under the book value method? Discuss
the rationale for this method.

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 Week 04 – Ch.16 Dilutive Securities and Earnings Per Share

Exercise 16.04 (Issuance, Conversion, Repurchase of Convertible Bonds)

On January 1, 2017, Lin Company issued a convertible bond with a par value of €100,000 in the
market for €120,000. The bonds are convertible into 12,000 ordinary shares of €1 per share par
value. The bond has a 5-year life and has a stated interest rate of 10% payable annually. The market
interest rate for a similar non-convertible bond at January 1, 2017, is 8%. The liability component of
the bond is computed to be €107,986. The following bond amortization schedule is provided for this
bond.

EFFECTIVE-INTEREST METHOD
10% BOND DISCOUNTED AT 8%

Carrying Amount
Date Cash Paid Interest Expense Premium Amortized of Bonds
1/1/17 €107,986
12/31/17 €10,000 €8,639 €1,361 106,625
12/31/18 10,000 8,530 1,470 105,155
12/31/19 10,000 8,412 1,588 103,567
12/31/20 10,000 8,285 1,715 101,852
12/31/21 10,000 8,148 1,852 100,000

Instructions

(a) Prepare the journal entry to record the issuance of the convertible bond on January 1, 2017.
(b) Assume that the bonds were converted on December 31, 2019. The fair value of the liability
component of the bond is determined to be €108,000 on December 31, 2019. Prepare the
journal entry to record the conversion on December 31, 2019. Assume that the accrual of
interest related to 2019 has been recorded.
(c) Assume that the convertible bonds were repurchased on December 31, 2019, for €111,000
instead of being converted. As indicated, the liability component of the bond is determined to be
€108,000 on December 31, 2019. Assume that the accrual of interest related to 2019 has been
recorded.
Exercise 16.05 (Issuance and Conversion of Bonds)
For each of the unrelated transactions described below, present the entry(ies) required to record
each transaction:
1. Baden Corp. issued €5,000,000 par value 10% convertible bonds at 99. If the bonds had not
been convertible, the company’s investment banker determines that they would have been sold
at 95.
2. Fleming Company issued €5,000,000 par value 10% bonds at 98. One share warrant was issued
with each €100 par value bond. At the time of issuance, the warrants were selling for €4. The
net present value of the bonds without the warrants was €4,800,000.
3. Jackson, Inc. called its convertible debt in 2019. Assume the following related to the transaction:
The 11% €5,000,000 par value bonds were converted into 500,000 shares of €1 par value
ordinary shares on July 1, 2019. The carrying amount of the debt on July 1 was €4,800,000.
The Share Premium––Conversion Equity account had a balance of €100,000 and the company
paid an additional €35,000 to the bondholders to induce conversion of all the bonds. The
company records the conversion using the book value method.

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Exercise 16.06 Share options.

Prepare the necessary entries from 1/1/17-2/1/19 for the following events using the fair value
method. If no entry is needed, write “No Entry Necessary.”

1. On 1/1/17, the shareholders adopted a share option plan for top executives whereby each might
receive rights to purchase up to 12,000 ordinary shares at £40 per share. The par value is $10
per share.

2. On 2/1/17, options were granted to each of five executives to purchase 12,000 shares. The
options were non-transferable and the executive had to remain an employee of the company to
exercise the option. The options expire on 2/1/19. It is assumed that the options were for services
performed equally in 2017 and 2018. The Black-Scholes option pricing model determines total
compensation expense to be $1,300,000.

3. At 2/1/19, four executives exercised their options. The fifth executive chose not to exercise his
options, which therefore were forfeited.

Exercise 16.07 Weighted average shares outstanding.

On January 1, 2019, Warren Corporation had 1,000,000 ordinary shares outstanding. On March 1,
the corporation issued 150,000 new shares to raise additional capital. On July 1, the corporation
declared and issued a 2-for-1 share split. On October 1, the corporation purchased on the market
600,000 of its own outstanding shares and retired them.

Instructions
Compute the weighted average number of shares to be used in computing earnings per share for
2019.

Exercise 16.08 Earnings per share.

Santana Corporation has 400,000 ordinary shares outstanding throughout 2019. In addition, the
corporation has 5,000, 20-year, 7% bonds issued at par in 2017. Each €1,000 bond is convertible
into 20 ordinary shares after 9/23/20. During the year 2019, the corporation earned €600,000 after
deducting all expenses. The tax rate was 30%.

Instructions
Compute the proper earnings per share for 2019.

Exercise 16.09 Diluted earnings per share.

Dunbar Company had 400,000 ordinary shares outstanding during the year 2019. In addition, at
December 31, 2019, 90,000 shares were issuable upon exercise of executive share options which
require a €40 cash payment upon exercise (options granted in 2017). The average market price
during 2019 was €50.

Instructions
Compute the number of shares to be used in determining diluted earnings per share for 2019.

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Exercise 16.10 Share appreciation rights.

On January 1, 2016, Orr Co. established a share appreciation rights plan for its executives. They
could receive cash at any time during the next four years equal to the difference between the market
price of the ordinary shares and a preestablished price of £16 on 300,000 SARs. The fair value of
the SARs is estimate as follows: 12/31/16—£5; 12/31/14—£2; 12/31/15—£3; 12/31/19—£4. On
December 31, 2018, 50,000 SARs are exercised, and the remaining SARs are exercised on
December 31, 2019.

Instructions
(a) Prepare a schedule that shows the amount of compensation expense for each of the four
years starting with 2016.
(b) Prepare the journal entry at 12/31/17 to record compensation expense.
(c) Prepare the journal entry at 12/31/19 to record the exercise of the remaining SARs.

Exercise 16.11 Convertible bonds and share warrants.

For each of the unrelated transactions described below, present the entry(ies) required to record the
bond transactions.
1. On August 1, 2019, Lane Corporation called its 10% convertible bonds for conversion. The
€8,000,000 par bonds were converted into 320,000 shares of €20 par ordinary shares. On August
1, there was €700,000 of unamortized premium applicable to the bonds. The Share Premium—
Conversion Equity account had a balance of €300,000. The fair value of the ordinary shares was
€20 per share. Ignore all interest payments.
2. Packard, Inc. decides to issue convertible bonds instead of ordinary shares. The company issues
10% convertible bonds, par €3,000,000, at 97. The investment banker indicates that if the bonds
had not been convertible they would have sold at 94.
3. Gomez Company issues €5,000,000 of bonds with a coupon rate of 8%. To help the sale,
detachable share warrants are issued at the rate of ten warrants for each €1,000 bond sold. It is
estimated that the fair value of the bonds without the warrants is €4,935,000. The bonds with the
warrants sold at 101.

Exercise 16.12 Earnings per share.

Colson Corp. had $500,000 net income in 2019. On January 1, 2019 there were 200,000 ordinary
shares outstanding. On April 1, 20,000 shares were issued and on September 1, Adcock bought
30,000 treasury shares. There are 30,000 options to buy ordinary shares at €40 a share outstanding.
The market price of the ordinary shares averaged €50 during 2019. The tax rate is 40%.

During 2019, there were 40,000 shares of cumulative convertible preference shares outstanding.
The preference is €100 par, pays €3.50 a year dividend, and is convertible into three ordinary shares.

Colson issued €2,000,000 of 8% convertible bonds at face value during 2018. Each €1,000 bond is
convertible into 30 ordinary shares.

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Exercise 16.13 Basic and diluted EPS.

Assume that the following data relative to Kane Company for 2019 is available:
Net Income €2,100,000

Transactions in Ordinary Shares Change Cumulative

Jan. 1, 2019, Beginning number 700,000
Mar. 1, 2019, Purchase of treasury shares (60,000) 640,000
June 1, 2019, Share split 2-1 640,000 1,280,000
Nov. 1, 2019, Issuance of shares 120,000 1,400,000
8% Cumulative Convertible Preference Shares
Sold at par, convertible into 200,000 ordinary shares
(adjusted for split). $1,000,000
Share Options
Exercisable at the option price of €25 per share. Average
market price in 2019, €30 (market price and option price
adjusted for split). 60,000 shares

Instructions
(a) Compute the basic earnings per share for 2019. (Round to the nearest penny.)
(b) Compute the diluted earnings per share for 2019. (Round to the nearest penny.)

Exercise 16.14 Basic and diluted EPS.

Presented below is information related to Starr Company.

1. Net Income [including a discontinued operations gain (net of tax) of £70,000] £230,000

2. Capital Structure
a. Cumulative 8% preference shares, £100 par,
6,000 shares issued and outstanding £600,000

b. £10 par, 74,000 ordinary shares outstanding on January 1.

On April 1, 40,000 shares were issued for cash. On October 1,
16,000 shares were purchased and retired. £980,000

c. On January 2 of the current year, Starr purchased Oslo Corporation.

One of the terms of the purchase was that if Starr's net income for the
following year is £200,000 or more, 50,000 additional shares would
be issued to Oslo stockholders next year.

3. Other Information
a. Average market price per ordinary share during entire year £30
b. Income tax rate 30%

Instructions
Compute earnings per share for the current year.

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Exercise 16.15 Basic and diluted EPS.

The following information was taken from the books and records of Ludwick, Inc.:

1. Net income € 280,000

2. Capital structure:
a. Convertible 6% bonds. Each of the 300, €1,000 bonds is convertible
into 50 ordinary shares at the present date and for the next
10 years. 300,000

b. €10 par, 200,000 ordinary shares issued and outstanding

during the entire year. 2,000,000
c. Share warrants outstanding to buy 16,000 ordinary shares
at €20 per share.

3. Other information:
a. Bonds converted during the year None
b. Income tax rate 30%
c. Convertible debt was outstanding the entire year
d. Average market price per share of common stock during the year €32
e. Warrants were outstanding the entire year
f. Warrants exercised during the year None

Instructions
Compute basic and diluted earnings per share.

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