Question

III. Essay Questions (10 points) Answer one of the following three questions: 1. a. Describe the accounting treatment for employee stock options under the fair value method (SFAS 123 (R): Share-Based Payment). b. What is the reason for applying stock dividends and stock split events retroactively in calculating the earnings per share? 2. What are the advantages of leasing compared to purchase for lessees?

Answer 1

Q.1(b) What is the reason for applying stock dividends and stock split events retroactively in calculating the earnings per share?

Ans: Earnings per share(EPS) is the amount of earnings earned by the company per share. Per share here means the weighted average number of shares for the reporting period for which Earnings per share is calculated. Earnings per share is calculated by dividing the After tax earnings by the weighted average number of shares. Formula for EPS:

                                                          

Earningsafter Tax Weightedaveragenumberof shares

(Please read the following bulleted points again and again to gain clarity. There is no need to write them. They are for understanding purpose only)

• Weighted Average Number of shares is the denominator.
• Increase in Denominator will result in decrease in EPS and vice versa.

                                                                                                                      Due to stock split events the number of shares rises(without actual rise in the capital) for the reporting period. This results in decrease in Earnings per share for the reporting period. Now, Here is the catch. We are also required to state the EPS for previous year. Since, stock split has happened in current year, the EPS for current year will fall due to increase in denominator(denominator is the weighted average number of shares). This means that, EPS has suddenly fallen in the current year as compared to the previous year without actual increase in capital. In order to avoid the distortion of performances and making sure that performances are reflected appropriately, we are required to restate them retroactively from the beginning of the previous year.

                               If we apply the retroactive adjustment, we are assuming that we have done the adjustment(stock split) from the previous year itself, this would result in increasing the denominator(for calculation of EPS)of previous year. Increase in denominator means decrease in EPS. Now, when we look at both the EPS (of previous and current year), we will see that earnings capacity of the entity is appropriately reflected in the financial statements.

                                                                                                                     For the same reasons mentioned above, we make retroactive adjustment in case of Stock Dividends. In case of stock dividends, stockholders are issued additional stocks instead of cash payment. This also results in increase in the number of shares in the reporting period and resulting in fall of EPS.