Chapter 16: Q25Q (page 874)
What type of earnings per share presentation is required in a complex capital structure?
An organization with a complex capital structure report both basic EPS and diluted EPS in the financial statements.
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GROUPWORK (Computation of Basic and Diluted EPS) Charles Austin of the controller’s office of Thompson
Corporation was given the assignment of determining the basic and diluted earnings per share values for the year ending
December 31, 2018. Austin has compiled the information listed below.
1. The company is authorized to issue 8,000,000 shares of \(10 par value common stock. As of December 31, 2017, 2,000,000
shares had been issued and were outstanding.
2. The per share market prices of the common stock on selected dates were as follows.
Price per Share
July 1, 2017 \)20.00
January 1, 2018 21.00
April 1, 2018 25.00
July 1, 2018 11.00
August 1, 2018 10.50
November 1, 2018 9.00
December 31, 2018 10.00
3. A total of 700,000 shares of an authorized 1,200,000 shares of convertible preferred stock had been issued on July 1, 2017.
The stock was issued at its par value of \(25, and it has a cumulative dividend of \)3 per share. The stock is convertible into
common stock at the rate of one share of convertible preferred for one share of common. The rate of conversion is to be
automatically adjusted for stock splits and stock dividends. Dividends are paid quarterly on September 30, December 31,
March 31, and June 30.
4. Thompson Corporation is subject to a 40% income tax rate.
5. The after-tax net income for the year ended December 31, 2018, was \(11,550,000.
The following specific activities took place during 2018.
1. January 1—A 5% common stock dividend was issued. The dividend had been declared on December 1, 2017, to all stockholders
of record on December 29, 2017.
2. April 1—A total of 400,000 shares of the \)3 convertible preferred stock was converted into common stock. The company
issued new common stock and retired the preferred stock. This was the only conversion of the preferred stock during 2018.
3. July 1—A 2-for-1 split of the common stock became effective on this date. The board of directors had authorized the split
on June 1.
4. August 1—A total of 300,000 shares of common stock were issued to acquire a factory building.
5. November 1—A total of 24,000 shares of common stock were purchased on the open market at \(9 per share. These shares
were to be held as treasury stock and were still in the treasury as of December 31, 2018.
6. Common stock cash dividends—Cash dividends to common stockholders were declared and paid as follows.
April 15—\)0.30 per share
October 15—$0.20 per share
7. Preferred stock cash dividends—Cash dividends to preferred stockholders were declared and paid as scheduled.
Instructions
(a) Determine the number of shares used to compute basic earnings per share for the year ended December 31, 2018.
(b) Determine the number of shares used to compute diluted earnings per share for the year ended December 31, 2018.
(c) Compute the adjusted net income to be used as the numerator in the basic earnings per share calculation for the year
ended December 31, 2018.
CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) “Earnings per share” (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a “times earnings” figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.
Instructions
(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.
(b) One of the technical procedures applicable in EPS computations is the “treasury-stock method.” Briefly describe the circumstances under which it might be appropriate to apply the treasury stock method.
(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.
(Stock-Based Compensation) Assume that Amazon.com has a stock-option plan for top management. Each
stock option represents the right to purchase a share of Amazon \(1 par value common stock in the future at a price equal to the
fair value of the stock at the date of the grant. Amazon has 5,000 stock options outstanding, which were granted at the beginning
of 2017. The following data relate to the option grant.
Exercise price for options \)40
Market price at grant date (January 1, 2017) \(40
Fair value of options at grant date (January 1, 2017) \)6
Service period 5 years
Instructions
(a) Prepare the journal entry(ies) for the first year of the stock-option plan.
(b) Prepare the journal entry(ies) for the first year of the plan assuming that, rather than options, 700 shares of restricted
stock were granted at the beginning of 2017.
(c) Now assume that the market price of Amazon stock on the grant date was $45 per share. Repeat the requirements for
(a) and (b).
(d) Amazon would like to implement an employee stock-purchase plan for rank-and-file employees, but it would like to
avoid recording expense related to this plan. Which of the following provisions must be in place for the plan to avoid
recording compensation expense?
(1) Substantially all employees may participate.
(2) The discount from market is small (less than 5%).
(3) The plan offers no substantive option feature.
(4) There is no preferred stock outstanding
Financial Statement Analysis Case
Ragatz, Inc.
Ragatz, Inc., a drug company, reported the following information. The company prepares its financial statements in accordance with GAAP.
2017 (000) | |
Current liabilities | \(554,114 |
Convertible subordinated debts | 648,020 |
Total liabilities | 1,228,313 |
Stockholder’s equity | 176,413 |
Net income | 58,333 |
Analysts attempting to compare Ragatz to drug companies that issue debt with detachable warrants may face a challenge due to differences in accounting for convertible debt.
Instructions
(a) Compute the following ratios for Ragatz, Inc. (Assume that year-end balances approximate annual averages.)
(1) Return on assets.
(2) Return on common stock equity.
(3) Debt to assets ratio.
(b) Briefly discuss the operating performance and financial position of Ragatz. Industry averages for these ratios in 2017 were ROA 3.5%; return on equity 16%; and debt to assets 75%. Based on this analysis, would you make an investment in the company’s 5% convertible bonds? Explain.
(c) Assume you want to compare Ragatz to an IFRS company like Merck (which issues nonconvertible debt with detachable warrants). Assuming that the fair value of the equity component of Ragatz’s convertible bonds is \)150,000, how would you adjust the analysis above to make valid comparisons between Ragatz and Merck?
What are the arguments for giving separate accounting recognition to the conversion feature of debentures?
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