Guay, John E. Core , professor of accounting at Wharton, and S. The paper was published in The Accounting Review in July , and has special relevance now because regulators such as the Financial Accounting Standards Board are expected to modify options accounting rules next year. Understating dilution inflates earnings per share, the authors say.
Employee options give their owners the right to buy shares at a set price anytime over a given period. The right to exercise the options may vest all at once or in stages on the first few anniversaries of the grant. Employee options usually expire if they are not exercised within 10 years. Options appeal to employees because they can convey great value without requiring that the employee put money at risk, as one does owning actual shares of stock.
Does Dilution Occur When Shares Are Granted or Exercised?
By , that figure had grown to 8. The growing use of options has raised a debate about how they should be accounted for.
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Some advocate carrying them as an expense, arguing options have value and should be considered a compensation cost just like wages and other benefits. This issue has received a great deal of attention in the past few years, and the FASB expected to issue new rules in requiring some form of expensing. But this still leaves the second problem of how to account for options-related dilution of share value, Guay and his colleagues say.
Companies have various ways of providing the shares needed to turn over to employees who exercise options.
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Some companies draw on a reserve of shares that have not yet been in circulation. Others use profits to buy back shares on the open market, using them to build a reserve to meet options exercises. If a company had one million shares outstanding and employees exercised options to purchase , shares, there would then be 1.
Fully Diluted Shares
In practice, the accounting is not as simple as in this example. Many options holders wait to exercise until shortly before their options expire, hoping the share price will rise further. Under current accounting rules, this uncertainty is handled in a fairly simple way: by figuring how many shares could be purchased at the current market price if all in-the-money options were exercised.
Those are options with a strike price lower than the current market price. A company might have one million options outstanding, but count only , in the diluted earnings per share calculation. The problem with this approach, the authors say, is that it uses too low a figure for potential options-related profits. That means it understates the number of shares that could be bought with those profits. It is adjusted for convertible securities, stock options and stock units. Similar to basic EPS, the measure is designed to allow for comparison between businesses of different sizes.
The Dangers of Share Dilution
The calculation above looks similar to basic EPS, but there are a number of key differences. First, the earnings used for diluted EPS those available to common or ordinary shareholders are adjusted for convertible bond interest. Basic earnings are increased by the post-tax interest saved as a result of the bond converting to equity. The second part of the calculation is the fully diluted WASO.
This starts with the basic WASO, but includes any contracts the business has which might increase the future share count. Only those which cause a decrease dilution of EPS are included in the calculation. It is important to always start with the most recent filing when sourcing the basic shares outstanding.
Stock Dilution: Can It Happen to You?
For the majority of US companies, this is found on the front page of the K or Q report. This assumes that the business will use the cash raised from the options exercised to buy back shares from the market and therefore minimize the dilution effect. Restricted stock units RSU are then added.
These are usually shares given to employees as compensation. Out of the money options and convertible debt where conversion is unlikely are also excluded from the calculation. Finally, for convertible bonds, the share count is adjusted by the number of new shares resulting from the exchange of bonds into equity. The net income used for EPS calculations should be after any preferred dividend and after any allocation of profits to non-controlling shareholders.