chapter 18 earnings per share - · pdf file18-2 simple and complex capital structures...

18-1

1. A simple and a complex capital

2. Compute basic earnings per share

3. Use the treasury stock method to compute diluted

EPS

4. Use the if-converted method to compute diluted EPS

5. The actual conversion of convertible securities or the

exercise of options, warrants, or rights

6. Multiple potentially dilutive securities considered in

computing diluted earnings per share

7. Disclosure requirements associated with basic and

diluted earnings per share computations

8. The complex earnings per share computations

Chapter 18 Earnings Per Share

18-2

Simple and Complex Capital Structures

• Dilutive securities are securities whose assumed exercise or conversion results in a reduction in earnings per share, or lead to a dilution in earnings per share.

• Antidilutive securities are securities whose assumed conversion or exercise results in an increase in earnings per share, or lead to antidilution in earnings per share.

1. Know the difference between a simple and

a complex capital structure, and understand

how dilutive securities affect earnings per

share computations

18-3


• A company’s capital structure may be classified as

simple or complex.

• If a company has only common stock, or common

and nonconvertible preferred stock outstanding

and there are no convertible securities, stock

options, warrants or other rights outstanding, it is

classified as a simple capital structure.

• If net income includes extraordinary gains or

losses or other below-the-line items, a separate

EPS figure is required for each major component

of income, as well as for net income. These

historical EPS amounts are referred to as basic

earnings per share.

18-4


• Potential EPS dilution exists if the EPS would

decrease or the loss per share would increase

as a result of the conversion of securities or

exercise stock options, warrants, or other

rights based on the conditions existing at the

financial statement date.

• A company with potential earnings per share

dilution is considered to have a complex

capital structure.

18-5

Net Income – Preferred Dividends

Weighted-Average

Common Shares Outstanding

The weighted-average number of

shares can be computed by

determining “month-shares” of

outstanding stock and dividing by 12.

Issuance or Reacquisition of Common Stock

2. 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

18-6

Issuance or Reacquisition of Common Stock

Jan. 1 to May 1 10,000 × 4/12 = 3,333

May 1 to Nov. 1 15,000 × 6/12 = 7,500

Nov. 1 to Dec. 31 13,000 × 2/12 = 2,167

Weighted-average number of shares 13,000

18-7

Stock Dividends and Stock Splits

A company had 2,600 shares of common stock

outstanding on January 1. The following activities

affecting common stock took place during the year.

(continued)

Dates Economic Event Changes in Shares Outstanding

Feb. 1 Exercise of stock option + 400

May 1 10% stock dividend

(3,000 x 10%) + 300

Sept 1 Sale of stock for cash + 1,200

Nov. 1 Purchase of treasury stock – 400

Dec. 1 3-for-1 stock split + 8,200

18-8


18-9

• All stock splits and stock dividends must be

incorporated into the computation of weighted

average shares outstanding.

• When comparative financial statements are

presented, the common shares outstanding for all

periods shown must be adjusted to reflect any

stock dividend or stock split in the current period.


• Retroactive adjustments must be made even if a

stock dividend or stock split occurs after the end

of the period but before the financial statements

are prepared.

• Disclosure of the situation should be made in a

note to the financial statements.

18-10

Preferred Stock Included in Capital Structure

• Basic EPS reflects only income available to

common stockholders; it does not include preferred

stock.

• When a capital structure includes preferred stock,

dividends on preferred stock should be deducted

from income before extraordinary or other special

items from net income in arriving at earnings

related to common shares.

• If preferred dividends are cumulative, the full

amount of dividends on preferred stock for the

period, whether declared or not, should be

deducted from income in arriving at the earnings or

loss balance related to the common stock.

18-12

2012

1/1 to 6/30 200,000 × 6/12 100,000

No. of Stock Portion of Weighted

Date Shares Dividend Year Average


• On June 30, 2012 the firm paid:

An 8% dividend on preferred stock (10,000

shares at $100 par × 0.08 = $80,000)

A $0.30 per share dividend on common stock

(300,000 shares × $0.30 = $90,000)

• These cash dividends would not affect the

weighted-average number of shares of common

stock.

18-13

(continues)

On June 30, 2012, the company issued

100,000 shares of common stock. After the

issuance, the firm has 300,000 shares of

common stock outstanding. However, these

300,000 are only outstanding for six months, or

one-half of the year.


18-14

There are 250,000 weighted-average

shares outstanding at the end of 2010.

On May 1, 2013, the firm issued a 50% stock

dividend on common stock.

2012

1/1 to 6/30 200,000 × 6/12 100,000

7/1 to 12/31 300,000 × 6/12 150,000

250,000



(continued)


18-15

2012

1/1 to 6/30 200,000 × 6/12 100,000

7/1 to 12/31 300,000 × 6/12 150,000

250,000

2013

1/1 to 5/1 300,000 1.5 × 4/12 150,000



Now let’s “roll back” the stock

dividend for all the years displayed.

(continued)


18-16

2012

1/1 to 6/30 200,000 1.5 × 6/12 150,000

7/1 to 12/31 300,000 1.5 × 6/12 225,000

375,000

2013

1/1 to 5/1 300,000 1.5 × 4/12 150,000



(continued)


Now let’s “roll back” the stock

dividend for all the years displayed.

18-17

2012

1/1 to 6/30 200,000 1.5 × 6/12 150,000

7/1 to 12/31 300,000 1.5 × 6/12 225,000

375,000

2013

1/1 to 5/1 300,000 1.5 × 4/12 150,000

5/1 to 12/31 450,000 × 8/12 300,000



The number of shares of common stock outstanding

before the stock dividend (300,000) now becomes

450,000 shares due to the stock dividend.

(continued)


18-18

2012

1/1 to 6/30 200,000 1.5 × 6/12 150,000

7/1 to 12/31 300,000 1.5 × 6/12 225,000

375,000

2013

1/1 to 5/1 300,000 1.5 × 4/12 150,000

5/1 to 12/31 450,000 × 8/12 300,000

450,000




18-19

In 2012, the firm made a net income, (including

a $75,000 extraordinary gain) of $380,000. The

basic earnings per share before the

extraordinary gain is as follows:

Preferred dividends

Weighted-average shares of

common stock outstanding

$80,000

375,000 shares of

Earnings per share from continuing operations = $0.60

Net income after EI –$305,000

(continued)


18-20

Basic earnings per common share,

extraordinary gain for 2012 is as follows:



375,000 shares of

Earnings per share from

extraordinary gain = $0.20

Extraordinary gain$75,000

(continued)


18-21

Basic earnings per common share, net income

per share (2012):



375,000 shares of

Net income per share = $0.80

Net income after

extraordinary item

Preferred

Dividend –$380,000 – $80,000

(continued)


18-22



In 2013, the firm had a net loss of $55,000 and

there were no extraordinary items. The basic loss

per share is as follows:

Net loss + Preferred dividends($55,000) + ($80,000)

450,000 shares of weighted-

average common outstanding

Basic loss per share = $(0.30)

Preferred dividends are

included even though

they were not declared.


18-23

Participating Securities and

the Two-Class Method

• Sometimes a company issues more than one class

of stock with ownership privileges.

• Different classes do not always have the same

claim upon dividends.

• In such a case, earnings attributed to each share of

the different classes of stock are different and EPS

is computed using the two-class method.

18-24

Consider the following data for Kay Company.

• Common shares outstanding: 100,000 for the

entire year

• Participating preferred shares outstanding:

50,000 shares for the entire year

• Net income: $500,000

• Dividends on participating preferred shares:

$2.00 per share plus a per-share increase 50%

as large as the per-share increase of common

dividends above $1.00 per share.

(continued)

Participating Securities and

the Two-Class Method

18-25

(continued)

• Common dividends paid for the year: $1.80 per

share making a total of $180,000 ($1.80 per

share × 100,000 shares)

• Participating preferred dividends paid for the

year: $2.40 per share making a total of

$120,000 ($2.40 per share × 50,000 shares)

Participating Securities and the

Two-Class Method

18-26

The undistributed earnings of $200,000 ($500,000 net

income – $180,000 common dividends – $120,000

participating preferred dividends) are allocated as

follows:

Participating Securities and the Two-Class Method

18-27

Dilutive Earnings per Share—

Options, Warrants, and Rights

• The two major types of potentially dilutive securities

are (1) common stock options, warrants, and rights,

and (2) convertible bonds and convertible preferred

stock.

• All computations of diluted EPS are made as if the

exercise or conversion took place at the beginning of

the company’s fiscal year or at the issue date of the

stock option or convertible security, whichever

comes later.

3. Use the treasury stock method to compute

diluted earnings per share when a firm has

outstanding stock options, warrants, and rights

18-28

Stock Options, Warrants, and Rights

• Stock options, warrants, and rights provide no

cash yield to the investors, but they have value

because they permit the acquisition of common

stock.

• It is assumed that exercise of options, warrants,

or rights takes place as of the beginning of the

year or the date they are issued, whichever

comes later.

18-29

• Options, warrants, and rights are included in

the computation of diluted EPS for a particular

period only if they are dilutive.

• The FASB selected the treasury stock

method and recommended it be assumed that

the cash proceeds from the exercise of

options, warrants, or rights to purchase

common stock on the market (treasury stock)

at the average market price.


18-30


Treasury Stock Method Demonstrated

• At the beginning of the current year,

employees were granted options to acquire

5,000 shares of common stock at $40 per

share.

• The average market price of the stock for

the year is $50.

(continued)

18-31

Number of shares sold 5,000

Proceeds from sale (5,000 × $40) = $200,000

Number of shares that could be purchased with

the proceeds ($200,000/$50) 4,000

Number of shares used for diluted EPS 1,000


The number of shares (using the treasury stock

method) to use for calculating diluted earnings

per share is calculated as follows:

18-32

Illustration of Diluted EPS with Stock Options

• Rasband Corporation had net income of $92,800 for

the year.

• There are 100,000 shares of common stock

outstanding all year.

• There are 20,000 options outstanding to purchase

shares.

• The exercise price per share is $6.

• The average market price per share during the

year was $10.

$92,800

100,000Basic EPS = = $0.93

Basic Earnings per Share

18-33

Proceeds from assumed exercise of

options outstanding (20,000 × $6) $120,000

Number of outstanding shares assumed

to be repurchased with proceeds from

options ($120,000/$10) 12,000

Actual number of shares outstanding 100,000

Issued on assumed exercise of

options 20,000

Less assumed options repurchased 12,000 8,000

Total 108,000

(continued)


18-34

Diluted Earnings per Share:

$92,800

108,000 = $0.86

COMPARED TO:

Basic Earnings per Share:

$92,800

100,000 = $0.93

The diluted

EPS is less

than the basic

EPS, so it is

acceptable.


18-35

Diluted Earnings per Share―

Convertible Securities

• The method of including convertible securities as

if conversion had taken place in the EPS

computation is referred to as the if-converted

method.

• To test for dilution, each potentially dilutive

convertible must be evaluated individually.

4. Use the if-converted method to compute

diluted earnings per share when a company

has convertible preferred stock or convertible

bonds outstanding

18-36

The following example for Reid Corporation

illustrates the computation of diluted EPS when

convertible securities exist.

Illustration of Diluted Earnings per Share

with Convertible Securities

18-37

Net income + Interest after tax savings

Total shares assumed issuedDiluted

EPS=

$83,000 + $28,000

100,000 + 40,000Diluted

EPS= = $0.79

Note

Illustration of Diluted Earnings per Share

with Convertible Securities

18-38

Computation of Diluted Earnings per Share

for Securities issued during the Year

If the convertible bonds had been issued by Reid

Corporation on June 30 of the current year, the

adjustment would be made to reflect one-half of a

year.

18-39

• In the previous illustration, instead of 8%

convertible bonds, assume the company has

8% preferred stock outstanding, par value

$500,000, convertible into 40,000 shares of

common stock.

• The preferred stock was outstanding for the

entire year. The reported net income would be

$111,000 ($83,000 + $28,000 bond interest net

of tax savings).



18-40

Basic earnings per share:

Net income, without the deduction for

interest on bonds $111,000

Less: Preferred dividends 40,000

Net income identified with common stock $ 71,000

Actual number of shares outstanding ÷100,000

Basic EPS ($71,000/100,000) $0.71



18-41

Diluted earnings per share:

Net income assuming no payment of

preferred dividends due to conversion $111,000

Actual number of shares outstanding 100,000

Additional shares issued on assumed

conversion of preferred stock 40,000

Adjusted number of shares 140,000

Diluted EPS ($111,000/140,000) $0.79



18-42

Effect of Actual Exercise or ConversionStock Options are Exercised During the Year

400,000 × 9/12 of year 300,000

500,000 × 3/12 of year 125,000

Weighted-average number of shares for basic EPS 425,000

5. 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

18-43

Effect of Actual Exercise or Conversion

18-44

Effect of a Loss from Continuing Operations

on Earnings per Share

Assume the following data for Boggs Co.

18-45

Effect of a Loss from Continuing Operations

on Earnings per Share

18-46

Multiple Potentially Dilutive Securities

• The FASB requires selection of the combination

of securities producing the lowest possible EPS

figure.

• To avoid having to test a large number of

different combinations to find the lowest one,

companies can compute the incremental EPS for

each potentially dilutive security.

• Any dilutive stock options and warrants are

considered first before introducing convertible

securities into the computations.

6. Determine the order in which multiple potentially

dilutive securities should be considered in

computing diluted earnings per share

18-47

A company had no stock options but did have four

convertible securities that would have the following

effects on diluted EPS if each were considered

separately.


18-48

Basic EPS was $6.50 ($2,275,000 income divided by

350,000 outstanding shares). Dilution is determined by

adding one security at a time to the basic EPS figure as

shown on the next slide.


It would not be necessary to continue the

computation beyond Security B because the…

18-49

…EPS at that point is lower than the incremental

EPS impact of Security C.


18-50(continued) 18-50

18-51


18-52


18-53

Financial Statement Presentation

1. A reconciliation of both the numerators and

the denominators of the basic and diluted

EPS computations for income from continuing

operations.

2. The effect that preferred dividends have on

the EPS computations.

Firms are required to provide the following

disclosure items in the notes to the financial

statements:

7. Understand the disclosure requirements

associated with basic and diluted

earnings per share computations

18-54

3. Securities that could potentially dilute basic

EPS in the future that were not included in

computing diluted EPS this period because

those securities were antidilutive for the

current period.

4. Disclosure of transactions that occurred after

the period ended but prior to the issuance of

financial statements that would have

materially affected the number of common

shares outstanding or potentially outstanding

such as the issuance of stock options.

Financial Statement Presentation

18-55(continued) 18-55

18-5618-56

18-57

Complex Illustration

Circle West Transportation Company has the

following outstanding stocks and bonds on

January 1, 2013. All securities were sold at par

or face value. The date of issue of each type of

security is shown on the next slide.

8. Make complex earnings per share

computations involving multiple potentially

dilutive securities

18-58


18-59

Circle West also had stock options outstanding

at January 1, 2013, for the purchase of 20,000

shares of common stock. During 2013, options

were granted for an additional 40,000 shares.

The terms of these stock options are as follows:


18-60

• On December 1, 2013, Circle West paid a full

year’s dividend on the 6% preferred stock and

on the 8% preferred stock. Income from

continuing operations for 2013 was $1,026,000.

The income tax rate is 30%.

• The common stock market price was $62 on

October 1, 2013 and was $61 on December 31,

2013. On April 1, 2013, Circle West issued

30,000 shares at $56 per share. On October 1,

20,000 shares were issued from January 1,

2010, options.


18-61(continued)

Step 1


18-62

(continued)

Step 2

18-62

18-63

Step 3

18-63

chapter 18 earnings per share - · pdf file18-2 simple and complex capital structures...

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