Module 1, Ch. 15: Dilutive Securities and Earnings per Share
15.1 Dilutive Securities
What is a security?
A security is a financial instrument that has value and can be traded between parties.
1) Equity securities – represent ownership in a company.
- Example: Common stock, preferred stock.
2) Debt securities – represent money borrowed that must be repaid with interest.
- Example: Bonds, notes payable, commercial paper.
3) Derivative securities – get their value from an underlying asset.
- Example: Options, futures, warrants.
Dilutive Securities
Q: What are dilutive securities?
- Dilutive securities are financial instruments that have the potential to increase the number of
common shares outstanding.
Q: What types of dilutive securities are most common?
- Convertible bonds, Convertible preferred stock, Stock options, Employee compensation plans,
Warrants
1) Convertible bonds (debt security):
- A bondholder lends money to the company.
- Instead of just collecting interest and principal, they have the right to swap the bond
for common shares.
- Example: $1,000 bond convertible into 20 shares of stock (conversion price = $50).
2) Convertible preferred stock (equity security):
- Preferred shareholders get dividends and priority in liquidation.
- They can choose to give up preferred shares and convert into common shares (often if
common stock price rises).
Q: What has been the main controversy over accounting for dilutive securities?
- Whether some dilutive securities should be reported as debt, equity, or both.
Q: What is the key characteristic an item must have to be classified as a liability?
- It must include the obligation to pay the holder of the security in the future.
Convertible Debt
1
,Q: What is convertible debt?
- Convertible debt consists of bonds (or notes) that can be converted into common stock during a
specified period (generally five years).
Q. Why have companies like Airbnb, Ford Motor Company, and Twitter issued convertible bonds as a
financing method?
- To lower interest costs. Convertible debt offers lower interest rates because investors value the
conversion feature. For example, Ford’s recent convertible debt carried a zero-interest rate.
Without the conversion feature, Ford’s interest costs would have been much higher.
- To manage capital structure. Issuers often attach a call feature, allowing control if debt-to-equity
becomes too high. Tesla, for example, issued convertibles in 2013, 2014, 2017, and 2019, then
called some bonds to reduce its debt-to-equity ratio while funding growth at low interest rates.
Q: Why would an investor be interested in convertible debt?
- Equity gain. In a rising stock market, investors can benefit from stock appreciation. For instance,
Tesla’s 2014 convertibles yielded returns exceeding 800% when converted to common stock.
- Principal and interest protection. Convertibles provide protection in declining markets through
interest income and principal recovery. For example, Ford’s convertible bond investors may
recover principal even if Ford’s sales decline, despite not receiving interest.
Valuation of Convertible Debt
Q: What is the formula for finding the value of a convertible bond?
Value of the debt component + Value of the equity component = Value of the convertible bond
Q: Why is the equity portion of the convertible debt ignored for accounting purposes?
- The bondholder cannot separate the debit and equity components.
- If you hold the bond → you get interest and principal, but no stock.
- If you convert into stock → you give up the bond claim.
- Because these choices are mutually exclusive (you can only do one or the other), accounting rules
(U.S. GAAP) say you treat the whole thing as debt only until conversion actually happens.
Example 15.1 and 15.2: Lindor Company issues 50 convertible bonds with a 5-year life with a face
value of $1,000 each to Hernandez Inc. The bonds sold at 102. Each bond is convertible into 40 shares
of Lindor’s $1 par value common stock. The fair value of Lindor’s equity component at date of issuance
is $200 for each bond.
To record the issuance of the convertible debt:
Cash ($1,000 × 1.02 × 50) 51,000
Bonds Payable ($1,000 × 50) 50,000
Premium on Bonds Payable (.02 × $50,000) 1,000
2
, Hernandez decides to convert its 50 convertible bonds into common stock at the end of the second year.
At that time, the remaining premium on the convertible bonds is $580. In addition, at the time of
conversion, the fair value of Lindor’s common stock is now $1,300 per share. How should Lindor record
the conversion?
To record conversion into common stock:
Bonds Payable 50,000
Premium on Bonds Payable 580
Common Stock (50 × 40 × $1) 2,000
Paid-in Capital in Excess of Par—Common Stock 48,580
The rule:
- When bonds are converted, the company does not record a gain or loss.
- Instead, it uses the carrying value (book value) of the bonds being converted.
Q. Why do we ignore the fair value of stock when there is a conversion?
- U.S. GAAP views conversion not as a market transaction, but as the execution of a preexisting
contract.
- Think of it as: At issuance: investors bought (a) a bond + (b) a built-in option to become
shareholders.
- At conversion: they’re just exercising that option. The company doesn’t “sell” stock at market value
— it settles a contract.
Induced Conversions
Q: Why might an issuer want to encourage prompt conversion?
- To reduce interest costs or to improve its debt-to-equity ratio.
Q: What is a “sweetener” in the context of convertible debt?
- An additional consideration (such as cash or common stock) offered by the issuer to induce
bondholders to convert debt to equity.
Q: How is a sweetener recorded?
- It is recorded as an expense.
Example of convertible bonds: Graze, Inc. has outstanding $1,000,000 face value convertible bonds
convertible into 100,000 shares of $1 par value common stock. Graze wishes to reduce its annual
interest cost. To do so, Graze agrees to pay the holders of its convertible bonds an additional $80,000 if
they will convert.
Assuming conversion occurs, how should Graze record this transaction?
3
15.1 Dilutive Securities
What is a security?
A security is a financial instrument that has value and can be traded between parties.
1) Equity securities – represent ownership in a company.
- Example: Common stock, preferred stock.
2) Debt securities – represent money borrowed that must be repaid with interest.
- Example: Bonds, notes payable, commercial paper.
3) Derivative securities – get their value from an underlying asset.
- Example: Options, futures, warrants.
Dilutive Securities
Q: What are dilutive securities?
- Dilutive securities are financial instruments that have the potential to increase the number of
common shares outstanding.
Q: What types of dilutive securities are most common?
- Convertible bonds, Convertible preferred stock, Stock options, Employee compensation plans,
Warrants
1) Convertible bonds (debt security):
- A bondholder lends money to the company.
- Instead of just collecting interest and principal, they have the right to swap the bond
for common shares.
- Example: $1,000 bond convertible into 20 shares of stock (conversion price = $50).
2) Convertible preferred stock (equity security):
- Preferred shareholders get dividends and priority in liquidation.
- They can choose to give up preferred shares and convert into common shares (often if
common stock price rises).
Q: What has been the main controversy over accounting for dilutive securities?
- Whether some dilutive securities should be reported as debt, equity, or both.
Q: What is the key characteristic an item must have to be classified as a liability?
- It must include the obligation to pay the holder of the security in the future.
Convertible Debt
1
,Q: What is convertible debt?
- Convertible debt consists of bonds (or notes) that can be converted into common stock during a
specified period (generally five years).
Q. Why have companies like Airbnb, Ford Motor Company, and Twitter issued convertible bonds as a
financing method?
- To lower interest costs. Convertible debt offers lower interest rates because investors value the
conversion feature. For example, Ford’s recent convertible debt carried a zero-interest rate.
Without the conversion feature, Ford’s interest costs would have been much higher.
- To manage capital structure. Issuers often attach a call feature, allowing control if debt-to-equity
becomes too high. Tesla, for example, issued convertibles in 2013, 2014, 2017, and 2019, then
called some bonds to reduce its debt-to-equity ratio while funding growth at low interest rates.
Q: Why would an investor be interested in convertible debt?
- Equity gain. In a rising stock market, investors can benefit from stock appreciation. For instance,
Tesla’s 2014 convertibles yielded returns exceeding 800% when converted to common stock.
- Principal and interest protection. Convertibles provide protection in declining markets through
interest income and principal recovery. For example, Ford’s convertible bond investors may
recover principal even if Ford’s sales decline, despite not receiving interest.
Valuation of Convertible Debt
Q: What is the formula for finding the value of a convertible bond?
Value of the debt component + Value of the equity component = Value of the convertible bond
Q: Why is the equity portion of the convertible debt ignored for accounting purposes?
- The bondholder cannot separate the debit and equity components.
- If you hold the bond → you get interest and principal, but no stock.
- If you convert into stock → you give up the bond claim.
- Because these choices are mutually exclusive (you can only do one or the other), accounting rules
(U.S. GAAP) say you treat the whole thing as debt only until conversion actually happens.
Example 15.1 and 15.2: Lindor Company issues 50 convertible bonds with a 5-year life with a face
value of $1,000 each to Hernandez Inc. The bonds sold at 102. Each bond is convertible into 40 shares
of Lindor’s $1 par value common stock. The fair value of Lindor’s equity component at date of issuance
is $200 for each bond.
To record the issuance of the convertible debt:
Cash ($1,000 × 1.02 × 50) 51,000
Bonds Payable ($1,000 × 50) 50,000
Premium on Bonds Payable (.02 × $50,000) 1,000
2
, Hernandez decides to convert its 50 convertible bonds into common stock at the end of the second year.
At that time, the remaining premium on the convertible bonds is $580. In addition, at the time of
conversion, the fair value of Lindor’s common stock is now $1,300 per share. How should Lindor record
the conversion?
To record conversion into common stock:
Bonds Payable 50,000
Premium on Bonds Payable 580
Common Stock (50 × 40 × $1) 2,000
Paid-in Capital in Excess of Par—Common Stock 48,580
The rule:
- When bonds are converted, the company does not record a gain or loss.
- Instead, it uses the carrying value (book value) of the bonds being converted.
Q. Why do we ignore the fair value of stock when there is a conversion?
- U.S. GAAP views conversion not as a market transaction, but as the execution of a preexisting
contract.
- Think of it as: At issuance: investors bought (a) a bond + (b) a built-in option to become
shareholders.
- At conversion: they’re just exercising that option. The company doesn’t “sell” stock at market value
— it settles a contract.
Induced Conversions
Q: Why might an issuer want to encourage prompt conversion?
- To reduce interest costs or to improve its debt-to-equity ratio.
Q: What is a “sweetener” in the context of convertible debt?
- An additional consideration (such as cash or common stock) offered by the issuer to induce
bondholders to convert debt to equity.
Q: How is a sweetener recorded?
- It is recorded as an expense.
Example of convertible bonds: Graze, Inc. has outstanding $1,000,000 face value convertible bonds
convertible into 100,000 shares of $1 par value common stock. Graze wishes to reduce its annual
interest cost. To do so, Graze agrees to pay the holders of its convertible bonds an additional $80,000 if
they will convert.
Assuming conversion occurs, how should Graze record this transaction?
3
