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Earnings Earnings Per SharePer Share

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Detail recent changes in accounting standards relating to earnings per share, and know why the changes were made and how these changes will affect computations relating to earnings per share.

Know the difference between a simple and a complex capital structure, and understand how dilutive securities affect earnings per share computations.

Learning Objectives

3

Compute basic earnings per share, taking into account the sale and repurchase of stock during the period as well as the effects of stock splits and stock dividends.

Use the treasury stock method to compute diluted earnings per share when a firm has outstanding stock options, warrants, and rights.

Learning Objectives

4

Use the if-converted method to compute diluted earnings per share when a company has convertible preferred stock or convertible bonds outstanding.

Factor into the diluted earnings per share computations the effect of actual conversion of convertible securities or the exercise of options, warrants, or rights during the period, and understand the antidilutive effect of potential common shares when a firm reports a loss from continuing operations.

Learning Objectives

5

Learning Objectives

Determine the order in which multiple potential dilutive securities should be considered in computed diluted earnings per share.

Understand the disclosure requirements associated with basic and diluted earnings per share computations.

Make complex earnings per share computations involving multiple potentially dilutive securities.

EXPANDED MATERIAL

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A firm’s net income does not necessarily correlate

with its earnings per share figure.

A firm’s net income does not necessarily correlate

with its earnings per share figure.

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Two EPS Computations

Considers onlyConsiders onlycommon shares common shares

issued andissued andoutstanding.outstanding.

BasicBasic

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Reflects the Reflects the maximum potential maximum potential

dilution from all dilution from all possible stock possible stock

conversions that conversions that would have decreased would have decreased

EPS.EPS.

DilutedDiluted

Two EPS Computations

Considers onlyConsiders onlycommon shares common shares

issued andissued andoutstanding.outstanding.

BasicBasic

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Dilution of Earnings

• Dilutive Securities: Securities whose assumed exercise or conversion results in a reduction in earnings per share.

• Antidilutive Securities: Securities whose assumed conversion or exercise results in an increase in earnings per share.

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Capital Structures

Simple Capital Structure: The corporation has only

common and nonconvertible preferred stock and has no

convertible securities, stock options, warrants, or other

rights outstanding.

Simple Capital Structure: The corporation has only

common and nonconvertible preferred stock and has no

convertible securities, stock options, warrants, or other

rights outstanding.

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Capital Structures

Complex Capital Structure: The corporation has one or

more instruments outstanding that could result in issuance of

additional common shares.

Complex Capital Structure: The corporation has one or

more instruments outstanding that could result in issuance of

additional common shares.

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Capital Structures

Therefore, a company with potential per share dilution is

considered to have a complex capital structure.

Therefore, a company with potential per share dilution is

considered to have a complex capital structure.

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Basic Earnings Per Share

The Basic Equation:

Net Income - Preferred DividendWeighted-Average

Common Shares Outstanding

The Complications:– Issuance or reacquisition of common

stock.

– Stock dividends or stock splits.

The Complications:– Issuance or reacquisition of common

stock.

– Stock dividends or stock splits.

14 Issuance or Reacquisition of Common Stock

• Assume the following :

– Shares Outstanding January 1: 1,000

– New Shares Issued May 1: 1,000

– Shares Repurchased November 1: 500

Calculate weighted-average shares outstanding on December 31.

Calculate weighted-average shares outstanding on December 31.

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Jan. 1 to May 1 1,000 x 4/12 = 333

May 1 to Nov. 1 2,000 x 6/12 = 1,000

Nov. 1 to Dec. 31 1,500 x 2/12 = 250

Dec. 31 Weighted-average shares 1,583

Issuance or Reacquisition of Common Stock

16 Issuance or Reacquisition of Common Stock

That was easy. Now let’s try one with a stock

dividend and a stock split.

That was easy. Now let’s try one with a stock

dividend and a stock split.

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• Assume the following:

– Shares outstanding January 1: 2,600

– Shares issued for exercise

of options on February 1: 400

– Shares issued for 10% stock

dividend on May 1: 300

– Shares sold for cash on September 1: 1,200

– Shares repurchased on November 1: 400

– Shares issued for 3-for-1 stock spliton December 15: 8,200

Issuance or Reacquisition of Common Stock

18 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 2/1 Option 400 2/1-5/1 3,000

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

19 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.102/1 Option 400 2/1-5/1 3,000 x 1.105/1 Dividend 300 5/1-9/1 3,300

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

20 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.102/1 Option 400 2/1-5/1 3,000 x 1.105/1 Dividend 300 5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

21 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.102/1 Option 400 2/1-5/1 3,000 x 1.105/1 Dividend 300 5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500 11/1 Purchase (400)11/1-12/1 4,100

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

22 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.102/1 Option 400 2/1-5/1 3,000 x 1.105/1 Dividend 300 5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500 11/1 Purchase (400)11/1-12/1 4,100 12/1 Split 8,200 12/1-12/31 12,300

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

23 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.10 x 3.02/1 Option 400 2/1-5/1 3,000 x 1.10 x 3.05/1 Dividend 300 5/1-9/1 3,300 x 3.09/1 Sale 1,200 9/1-11/1 4,500 x 3.011/1 Purchase (400)11/1-12/1 4,100 x 3.012/1 Split 8,200 12/1-12/31 12,300

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

24 Issuance or Reacquisition of Common Stock

1/1-2/1 2,600 x 1.10 x 3.0 x 1/12 = 7152/1 Option 400 2/1-5/1 3,000 x 1.10 x 3.0 x 3/12 = 2,4755/1 Dividend 300 5/1-9/1 3,300 x 3.0 x 4/12 = 3,3009/1 Sale 1,200 9/1-11/1 4,500 x 3.0 x 2/12 = 2,25011/1 Purchase (400)11/1-12/1 4,100 x 3.0 x 1/12 = 1,02512/1 Split 8,200 12/1-12/31 12,300 x 1/12 = 1,025

No. of Stock Stock Portion of Weighted

Date Shares Dividend Split Year Average

The weighted-average The weighted-average shares outstanding is shares outstanding is 10,790 (the sum of the 10,790 (the sum of the

weighted-average column).weighted-average column).

The weighted-average The weighted-average shares outstanding is shares outstanding is 10,790 (the sum of the 10,790 (the sum of the

weighted-average column).weighted-average column).

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Stock Splits & Dividends

• All stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding.

• All stock splits and stock dividends must be incorporated into the computation of weighted average shares outstanding.

• This must done for all periods presented in the financial statements.

• This must done for all periods presented in the financial statements.• Current EPS figures may

have to be changed in the future as a result of stock splits or dividends.

• Current EPS figures may have to be changed in the future as a result of stock splits or dividends.

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Diluted Earnings Per Share

Dilution occurs if inclusion of a potentially dilutive security

reduces the basic EPS or increases the basic loss per share.

Dilution occurs if inclusion of a potentially dilutive security

reduces the basic EPS or increases the basic loss per share.

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Treasury Stock Method

Proceeds from conversion are assumed to be used for purchase of treasury stock at current market price.

Treasury stock is assumed to be reissued to option or warrant holders.

Any additional shares issued, over treasury stock, are added to “weighted- average shares outstanding.”

Exercise is assumed to occur on the first day of the year unless issue date is later.

28Treasury Stock Method--Example: Basic Data

Assume the following:

• Net Income $8,000

• Common Shares Outstanding

(entire year) 6,000

• 10% Bonds Payable $20,000

• 1-for-1 Options Outstanding 2,000

• Exercise Price Per Share on Options $30

• Average Price of Common Shares $40

• Income Tax Rate 40%

29Treasury Stock Method--Example: Basic Earnings Per

Share

Net Income - Preferred DividendWeighted Average Common

Shares Outstanding

Basic EPS =

Basic EPS = $8,0006,000

$1.33Basic EPS =

30Treasury Stock Method--Example: Option Proceeds

Options Assumed Exercised 2,000

Shares Assumed Repurchased With

Proceeds* ($60,000 / $40) 1,500

Additional Shares Assumed Issued 500

*Amount of Proceeds (2,000 x $30) $ 60,000

31Treasury Stock Method--Example: Number of Shares

Actual Shares Outstanding 6,000

Incremental Shares:

Issued Assuming Exercise 2,000

Repurchased From Proceeds 1,500 500

Total Shares Assumed Issued 6,500

32Treasury Stock Method--Example: Diluted Earnings Per

Share

Adjusted Net Income - Preferred DividendTotal Shares Assumed Issued

DilutedEPS

Diluted EPS =$8,0006,500

=

$1.23Diluted EPS =

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Diluted EPS -- “As If ”

Continually remind yourself that the events

you are considering when computing diluted

EPS did not occur.

Continually remind yourself that the events

you are considering when computing diluted

EPS did not occur.

Bonds were not converted, options

were not exercised, etc.

Bonds were not converted, options

were not exercised, etc.

Diluted EPS is providing information as if these

events occurred.

Diluted EPS is providing information as if these

events occurred.

34“If-Converted” Method--Example: Basic Data

Assume the following:

– Net Income$10,000

– 10% Convertible Bonds

issued 1/1/01 5,000– 15% Convertible Bonds

issued 7/1/01 2,000– Common Shares Outstanding

(no changes during year) 10,000

35“If-Converted” Method--Example: Basic Data (continued)– Tax Rate 40%

– Conversion Terms:

• 10% Bonds: 15 common shares per $100 bond

• 15% Bonds: 20 common shares per $100 bond

36“If-Converted” Method--Example: Basic Earnings Per Share

Net Income - Preferred DividendWeighted-Average

Common Shares Outstanding

Basic EPS =

Basic EPS =$10,00010,000

$1.00Basic EPS =

37“If-Converted” Method--Example: Net Income for Diluted EPS

Net Income $10,000

Interest Savings

10% Bond $ 500

15% Bond 150

Less: Tax Effect (260) 390

Adjusted Net Income $10,390

38“If-Converted” Method--Example: Number of Shares

Actual Shares Outstanding 10,000

Incremental Shares:

10% Bond ($5,000/100 x 15) 750

15% Bond ($2,000/100 x 20 x 1/2) 200 950

Total Shares Assumed Issued 10,950

39“If-Converted” Method--Example: Fully Diluted Earnings Per Share

Adjusted Net Income - Preferred DividendTotal Shares Assumed Issued

DilutedEPS

Diluted EPS =$10,39010,950

=

$0.95Diluted EPS =

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Convertible Preferred Stock

Remember that preferred dividends were initially

subtracted from income to arrive at income available to common shareholders.

Remember that preferred dividends were initially

subtracted from income to arrive at income available to common shareholders.

When we assume conversion of the preferred stock, those

dividends must be added back.

When we assume conversion of the preferred stock, those

dividends must be added back.Also remember there is no tax effect associated

with dividends.

Also remember there is no tax effect associated

with dividends.

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The EndThe End