Post on 11-Jan-2016
by Professor Hsieh
Intermediate Financial Accounting
Earnings Per Share
Earnings Per Share2
Objectives of the Chapter
To distinguish between a simple and a
complex capital structure.
To calculate basic earnings per share.
To calculate diluted earnings per share for
a company with a complex capital
structure.
Earnings Per Share3
Earnings Per Share
Earnings per share is perceived to be the
single measure that can best summarize
the performance of a company.
It is reported most frequently in the media
and receives the most attention by
investors and creditors.
Earnings Per Share4
Simple Capital Structure
A company with a simple capital structure
can only have common stock (C.S.) and
non-convertible preferred stock.
It cannot have any potentially dilutive
securities (i.e.,stock options,warrants,
convertible bonds, convertible preferred
stock).
Earnings Per Share5
For a simple capital structure, the basic earnings per share (EPS) computation is:
Net Income - Preferred Dividend
= --------------------------------------------------- Weighted Average Number of Common
Shares Outstanding
Simple Capital Structure(contd.)
Earnings Per Share6
Simple Capital Structure (contd.)
Example of computing weighted average shares:
Assume a company had 12,000 shares of C.S. outstanding on 1/1. On 3/2, it issued 2700 shares; on7/3, it issued another 3,300 shares; and on December 1, it acquired 480 shares as treasury stock. The weighted average number of common shares is 15,860 shares, as computed in Exhibit 1:
Earnings Per Share7
Simple Capital Structure
Exhibit 1:Months shares Shares * Fraction of Year = Equivalent
Are Outstanding Outstanding Outstanding Whole Units
Jan - Feb 12,000 2/12 2,000
Mar.-June 14,700 4/12 4,900
July - Nov 18,000 5/12 7,500
December 17,520 1/12 1,460
Total Weighted Average Common Shares 15,860
=====
Earnings Per Share8
Weighted Average Shares and Stock Dividends or Splits
Retroactive recognition is given to the events of stock dividend and stock split for all comparative income statement presented.
The purpose of the retroactive adjustment is to result in comparable EPS for all periods presented in terms of the most recent capital structure.
Earnings Per Share9
Weighted Average Shares and Stock Dividends or Splits Example:
A company begins operations in January 20x4, and issues 5,000 shares of common stock that are outstanding during all 20x4.
On 12/31/x4, it has a two-for-one stock split. At the end of 20x4, the weighted average number of shares is 10,000 (5,000*200% *12/12) because the two- for-one split is assumed to have occurred on January1, 20x4.
Earnings Per Share10
On May 29, 20x5, the company issues 5,000 shares of common stock.
On August 3, 20x5, it issues a 20% stock dividend.
On October5, 20x5, it issues 2,000 shares of common stock.
Weighted Average Shares and Stock Dividends or Splits Example (contd.)
Earnings Per Share11
When presenting comparative EPS for 20x4 and 20x5 at the end of 20x5, the weighted average number of shares are 12,000 and 16,000 shares for 20x4 and 20x5, respectively.
The computation is as shown in exhibit 2.
Weighted Average Shares and Stock Dividends or Splits Example (contd.)
Earnings Per Share12
Weighted Average Shares and Stock Dividends or Splits Exhibits 2:
Actual Assumed Fraction Equiv. Months shares Shares Shares * of Year = Whole are Outstanding Outstanding Outstanding Outstanding Shares 20x4Jan -Deca 5,000 12,000b 12/12 12,00020x5Jan - May 10,000 12,000c 5/12 5,000Jun - July 15,000 18,000d 2/12 3,000Aug- Sep e 18,000 18,000 2/12 3,000Oct - Dec 20,000 20,000 3/12 5,000 a. A 2 for 1 stock split on 12/31/20x4 16,000 b. 5,000 * 2 * 1.2 ; c. 10,000*1.2 ; d. 15,000*1.2 e. A 20% stock dividend on Aug. 3
Earnings Per Share13
Earnings Per Share Subtotals
EPS is presented by the components of net income.
Each of these EPS is based on the same weighted average number of shares and the components are summed to disclose the EPS of net income.
The intent is to show the contribution of each component of net income to EPS.
Earnings Per Share14
Exhibit 3: Earnings Per Share Subtotals
NORCAT CORPORATION
Earnings Per Share Disclosure
Earnings Per common share outstanding:
Income before extraordinary items $2.03
Extraordinary loss (0.37)
Net income $1.76
Earnings Per Share15
Example:Computation and Disclosure of Basic Earnings Per Share (by subtotals)
1. Income statement information:
a. Net income for 20x5 is $14,000.
b. An extraordinary gain (net of income taxes) of $3,600 is included in net income.
2. Stockholders’ equity information (end of 20x5):
a. 8% Preferred stock, $100 par$30,000
b. Common stock, $10 par $60,000
Earnings Per Share16
Earnings Per Share Subtotals
Example (contd.) 3. Additional information:
a.No preferred stock was issued or reacquired during 20x5.
b.Preferred dividends were declared during 20x5 at the stated rate.c. A review of the C.S.account showed that on January 1, 20x5, 2,000
shares of C.S. were outstanding.
Earnings Per Share17
Earnings Per Share Subtotals
Example (contd.) d. On April, 500 shares of C.S. were issued for cash.
e. On June 1, a two-for-one stock split occurred, resulting in 5,000 total C.S.
f. On November 2, 1,000 shares of C.S. were issued for cash.
Exhibit 4 shows the computation and disclosure of basic EPS by subtotals.
Earnings Per Share18
Earnings Per Share Subtotals
Exhibit 4: Earnings per share computation for
20x5: Earnings Shares Earnings
Adjust. Adjust. = Per Share
Net income $14,000P.S. div.a (2,400)C.S. shares b 4,917
Earnings and $11,600 4,917 = $2.36 Shares
Earnings Per Share19
Earnings Per Share Subtotals
Exhibit 4 :(contd.)
a. P.S. div.=$30,000 * 0.08 = $2,400.
b. Weighted average shares:
4,000a * 3/12 =1,000 a.2,000*2(stk.sp)5,000b * 7/12 = 2,917 b. 2,500*26,000c * 2/12 = 1,000 c.2,500*2+1,000
WACS 4,917
Earnings Per Share20
Condensed income statement presentation for 20x5:Income before extraordinary items $10,400Extraordinary gain (net of I/T) 3,600Net income 14,000
Basic earnings per com.shareoutstanding (see Note A):Income before extra. items $1.63Extraordinary gain 0.73Net income $2.36
Earnings Per Share Subtotals
Exhibit 4 :(contd.)
Earnings Per Share21
Note A to financial statements:
Preferred dividends of $2,400 are deducted from income before extraordinary items and net income to determine earnings available to common stock.
The resulting amounts of $8,000 and $11,600 are divided by the 4,917 weighted average common shares to yield $1.63 and $2.36 earnings per share, respectively.
Earnings Per Share22
Complex Capital Structure
The capital structure of many companies includes convertible securities, stock options and warrants.
Since conversion of these securities into common stock may decrease EPS, these securities are referred to as potentially dilutive securities.
Earnings Per Share23
Complex Capital Structure (contd.)
These potentially dilutive securities are also referred to as common stock equivalents (CSE).
A CSE is a security that is not a common stock, but contains a provision enabling its holders to acquire common stock at predetermined terms which, at issuance, makes it, in substance, equivalent to a common stock.
Earnings Per Share24
Complex Capital Structure (contd.)
Companies with complex capital structures are required to present both basic (no consideration of CSE) and diluted earnings per share (consider the potential impact of CSE) .
Earnings Per Share25
Diluted Earnings Per Share
In computing diluted EPS (DEPS), the potential impact (i.e., the assumed conversion) of CSE is considered in addition to the weighted average shares.
The impact of assumed conversion of CSE on EPS will be on both numerator and denominator of EPS computation.
Earnings Per Share26
Diluted Earnings Per Share (contd.)
To be included in the diluted EPS
calculation, the CSE must have
dilutive effect on EPS . That is, the assumed conversion of
the CSE has a negative impact on the EPS (i.e., reduce the EPS)
Earnings Per Share27
Diluted Earnings Per Share(contd.)
The following sequence of steps should be followed for DEPS computation:Step 1: Compute the basic EPS.Step 2: Include dilutive stock options
and warrants to compute a tentative DEPS.
Step 3: Develop a ranking based on the assumed conversion impact
of each CSE (other than stock options and warrants) on EPS.
Earnings Per Share28
Diluted Earnings Per Share :(contd.)
Step 4: Include CSE in DEPS in a sequential order based on the
ranking and compute a new tentative DEPS.Step 5: One CSE is included in the DEPS at
a time to compute a tentative DEPS and the inclusion is cumulative.
Step 6: Select the lowest tentative DEPS as the diluted EPS.
Earnings Per Share29
Diluted Earnings Per Share Stock Options and Warrants (step 2)
Stock options and warrants are always considered to be CSE
Stock options and warrants are first to be included in the computation of DEPS if they are dilutive.
Earnings Per Share30
Diluted Earnings Per Share Stock Options and Warrants (step 2)
Stock options or warrants were dilutive if the exercise of the options results in an increase of common shares using a treasury stock method.
Earnings Per Share31
This method assumes that the options were exercised at the beginning of the period (or at the time of issuance of the options if it is later).
The assumed proceeds received from the assumed exercise were used (assumed) to reacquire the corporations common stock at the market price.
Diluted Earnings Per Share Step 2 (contd.)
Earnings Per Share32
The difference between the assumed shares issued (through the assumed exercise of options) and the shares reacquired (assumed) is added to the denominator in computing the DEPS.
Therefore, dilution occurs when the market price is greater (less) than the option price for a firm with profit (loss).
Diluted Earnings Per Share Step 2 (contd.)
Earnings Per Share33
Example: stock options and warrants
Assume a corporation has 10,000 common shares and options to purchase 1,000 common shares at $20 per share outstanding for the entire year.
The average market price for the common stock was $25 per share.
The net increase in the denominator would be 200 computed as follow:
Earnings Per Share34
Example:(contd.)
Shares assumed issued through
the exercise of options 1,000
Shares assumed acquired:
Proceeds = $20 * 1,000 = (800)
Avg. market price $25
Assumed increase in common shares
for computing DEPS 200
Earnings Per Share35
Diluted EPS with Stock options Therefore, the stock options are
dilutive and the 200 assumed increased shares would be added to the denominator in computing the DEPS.
Earnings Per Share36
Diluted EPS (with CSE other than Stock Options and Warrants)
If CSE in the form of convertible bonds or convertible preferred stock were also outstanding, the DEPS which included only the dilutive options, would be “tentative” and subject to the possible inclusion of the convertible securities.
Earnings Per Share37
Dilutive CSE
Other CSE (i.e., convertible securities) would be included in DEPS after stock options only if their inclusion has a dilutive effect on the EPS.
Earnings Per Share38
Dilutive Effect on EPS – An example Example: the following is selected data
of BitZi Corp. for year 20x5: Net income= $12,000, Preferred dividend= $2,000, Weighted Average Shares Out.= 10,000, Convertible preferred stock out. = 1,000,
Case A: each share of preferred stock is to be converted into four shares of common stock
Earnings Per Share39
Dilutive Effect on EPS (contd.)
Basic EPS = ($12,000-$2000) = $1 10,000 Shares
Impact of the assumed conversion: $2000/4,000 shares = $0.5< Basic EPS
Thus, this CSE is dilutive and should be considered in the computation of DEPS as follows:
DEPS = $12,000/(10,000+4,000)=$.857
Earnings Per Share40
Dilutive Effect on EPS (contd.) Case B: each convertible preferred stock is to
be converted into one share of common stock. Impact of the assumed conversion:
$2000/1,000 shares = $2 > Basic EPS. Thus, this CSE is anti-dilutive and should NOT
be considered in the computation of DEPS. If it is considered : the new
EPS =$12,000/(10,000+1,000)=$1.09 >Basic EPS
Earnings Per Share41
Ranking of Common Stock Equivalents (CSE)
A CSE may appear to be individually dilutive maybe anti-dilutive in combination with other CSE.
Therefore, a ranking is performed to determine the sequence in which the CSE (other than options) should be included in the DEPS computation.
Earnings Per Share42
Ranking of Common Stock Equivalents (CSE) :(contd.)
This ranking is determined by comparing the impact on the EPS from the assumed conversion of each CSE at the beginning of the earliest period reported (or at the date of issuance of the CSE, if later).
Earnings Per Share43
Ranking of Common Stock Equivalents (CSE) :(contd.)
The assumed conversion has impact on both numerator and denominator of DEPS.
The denominator will be increased and the numerator will also be increased (due to the decrease in interest expense or the savings on preferred dividends).
Earnings Per Share44
Ranking of Common Stock Equivalents (CSE) :(contd.) The impact of assumed conversion of CSE on
DEPS is computed as: Change in EPS Numerator
Impact on DEPS = ------------------------------------- Change in EPS Denominator
The CSE with the smallest impact causes the least increase in the numerator relative to the increase in the denominator from the assumed conversion.
Earnings Per Share45
Ranking of Common Stock Equivalents (CSE) :(contd.)
Thus, the CSE with the smallest impact will cause the greatest decrease in DEPS.
The CSE with the smallest (largest) impact on DEPS is listed at the top (bottom) of the ranking.
The CSE with the smallest is the most dilutive CSE and is the first to be included in DEPS (after stock options).
Earnings Per Share46
Ranking of Common Stock Equivalents (CSE) :(contd.)
The CSE are sequentially entered into the DEPS computation based on the ranking (beginning with the CSE listed on the top of the ranking).
Exhibits 5 illustrates the calculation of the ranking, assuming that Ashley Company has four CSE outstanding for the entire year.
Earnings Per Share47
Example: Impact of Assumed Conversion of CSE and RankingA. Summary of Common Stock Equivalents
Security Description .
A 9% convertible preferred stock. Dividends of $5400 were declared during the year. The preferred shares are convertible into
3,000 shares of common stock.B 10% convertible bonds. Interest expense
(net of income taxes) of $4,800 was recorded during the year. The bonds are convertible into 1,920 shares of common stock.
Earnings Per Share48
Example: Impact of Assumed Conversion of CSE and Ranking (contd.)
Security Description .
C 8% convertible preferred stock. Dividends of $8,000 were declared during the year. The preferred shares are convertible into 5,000 shares of common stock.
D 7% convertible bonds. Interest expense (net of income taxes) of $6,300 wasrecorded during the year. The bonds are convertible into 3,150 shares of common stock.
Earnings Per Share49
B. Computation and Rankings
Security Impact Order in RankingA $5,400/3,000 2
= $1.80B $4,800/1,920
= $2.50 4C $8,000/5,000
= $1.60 1 (most dilutive one)D $6,300/3,150
= $2.00 3
Exhibit 5: Impact of Assumed Conversion of CSE and Ranking(contd.)
Earnings Per Share50
Computation of Tentative and Final DEPS.
The CSE are sequentially included in the DEPS according to the Ranking to compute tentative DEPS.
One CSE is included in the DEPS at a time to compute a tentative DEPS and the inclusion is cumulative.
Earnings Per Share51
Computation of Tentative and Final DEPS. :(contd.)
Thus, numerous tentative DEPS are obtained. The lowest tentative DEPS is the final DEPS.
In principle, when the most recently calculated (current) tentative DEPS is greater than the previous tentative DEPS, the iteration process can be stopped.
Earnings Per Share52
Computation of Tentative and Final DEPS. :(contd.)
The previous tentative DEPS is the lowest DEPS and thus, the final DEPS.
The rest of CSE (including the current one) are all anti-dilutive CSE.
The following is an example to illustrate the computation of DEPS.
Earnings Per Share53
Computation of Tentative and Final DEPS.
Example:
WATTS CORPORATION
Computation of Diluted Earnings Per Share:
1. Income statement information (20x7):
a. Income before extraordinary items 17,400
Extra. loss (net of income taxes) (1,500)
Net income $15,900
b. The effective income tax rate is 30%.
Earnings Per Share54
Computation of Tentative and Final DEPS.
Example :(contd.)
2. Balance sheet information:
a. 6,000 shares of common stock were outstanding the entire year. The stock was sold in the market at $30 per share.
b. Options to purchase 800 shares of common stock at $20 per share were outstanding the entire year.
Earnings Per Share55
Computation of Tentative and Final DEPS.
Example :(contd.)
2. Balance sheet information(contd.)
c. 7.5%, $100 par convertible preferred stock: $16,000 par value (issued at par), were outstanding the entire year.
$1,200 dividends were declared for the stock in 20x7.
Each share of this convertible PS can be converted into 5 shares of CS.
Earnings Per Share56
Computation of Tentative and Final DEPS.
Example:(contd.)2. Balance sheet information(contd.)
d. 9%, 100 par convertible preferred stock: $10,000 par value (issued at 112), were outstanding the entire year.
$900 dividends were declared for the stock in 20x7. Each share of this PS can be converted into 4 shares of common stock.
Earnings Per Share57
e. 6% convertible bonds: $30,000 face value, were outstanding the entire year.
The bonds were issued for $32,000, a price that yield 5.4%.
Bond interest expense of $1,720 was recorded in 20x7; the total premium is being amortized at $80 per year.
Each $1,000 bond is convertible into 19 shares of CS.
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share58
f. 9.2% convertible bonds: $25,000 face value, were outstanding the entire year. The bonds were issued at $23,750, a price that yielded 9.7% when the average Ana corporate bond yield was 14%.
Bond interest expense of $2,350 was recorded in 20x7; the total discount is being amortized at the rate of $50 per year. Each $1,000 bond is convertible into 45 shares of common stock.
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share59
3. Impact on earning per share and resulting rankings:
Diluted Security Impact on EPS Ranking7.5% Preferred 0.075 * $16,000 = $1.50 2
160 * 5 9% Preferred 0.09 * $10,000 = $2.25 4 100 * 46% Bonds [($30,000 * 0.06) - $80] * (1 - 0.3) = $2.11 3
30 * 199.2% Bonds ($25,000 * 0.092) + $50] * (1 - 0.3) = $1.46 1
25 * 45
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share60
4. Diluted earnings per share computation for 20x7 Earnings Shares Earnings
Explanation (Adjustments) (Adjustments) = Per ShareBasic earnings and shares $13,800a 6,000 = $2.30 Basic Increment in shares (options) 267b
DEPS1 $13,800 6,267 = $2.20 DEPS1Earnings saving in 9.2%bond interest expense 1,645c
Increment in shares 1,125d DEPS2 $15,445 7,392 = $2.09 DEPS2Earnings savings in 7.5% preferred dividends 1,200e
Increment in shares 800f
Diluted earnings and share $16,645 8,192g = $2.03h Diluted
Computation of Tentative and Final DEPS.
Example :(contd.)
Earnings Per Share61
a.$13,800 = $15,900 -$1,200 - $900
b. 267 = 800 - 800 * $20
$30
c. $1,645 = [($25,000 * 0.092) + $50] * (1 - 0.3)
d. 1,125 = 25 units of bonds * 45 shares
e. $1,200 = 0.075 * $16,000
f. 160*5 = 800.
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share62
g. Both 6% convertible bonds and the 9.2% convertible preferred stocks are antidilutive because their impacts ($2.11 and $2.25, respectively) are greater than $2.03.
h. Diluted earnings per share for income before extraordinary items is $2.21 [($16,645 + $1,500 extraordinary loss) / 8,192 share].
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share63
5. Condensed income statement presentation for 20x7:Income before extraordinary items $17,400Extraordinary loss (net of income taxes) (1,500)Net income $15,900
Diluted earnings per share (see Note A)
Income before extraordinary items(see Note A) $ 2.21Extraordinary loss (.18)Net income $2.03
Computation of Tentative and Final DEPS.
Example:(contd.)
Earnings Per Share64
Example (contd.)
Note A: diluted earnings per share is based on 6,000 average shares outstanding plus 2,192 incremental shares from dilutive effect to the assumed exercise of stock options and the conversion of two dilutive convertible securities, 9.2% convertible bonds and the 7.5% convertible preferred stock. Earnings available to common stockholders were adjusted accordingly. The remaining convertible securities are anti-dilutive and are not included in diluted earnings per share.
Earnings Per Share65
Additional Notes (EPS)
1.About 1/3 companies in the U.S. has convertible securities or warrants.
2.If convertible securities are Not issued until 4/1, the interest savings should be multiplied by 9/12. Also, the impact of the conversion on the weighted shares should also be multiplied by 9/12.
Earnings Per Share66
Additional Notes (EPS)
3.If conversion rate is different for different period, choose the highest conversion rate.
4.Anti-dilutive convertible securities or warrants should NOT be included in the computation of DEPS.
Earnings Per Share67
Additional Notes (EPS)
5.Contingent issue agreement (contingently issuable shares):
if all conditions for issuing additional shares are met, these shares should be included in the diluted EPS computation.
This usually occurs in business combination.
Additional Notes (EPS)
6. Contingently Convertible Bonds (Co-Co Bonds): should be considered in the dilutive EPS if dilutive regardless whether the market price trigger is met or not.
7. Partial year applies to the assumed conversion of convertible securities and the assumed exercise of options.
Earnings Per Share68