Chapter 18
Earnings Per Share
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
18-1
1.
Know the difference between a simple and
a complex capital structure, and understand
how dilutive securities affect earnings per
share computations
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.
18-2
Simple and Complex Capital Structures
•
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
18-3
earnings per share.
Simple and Complex Capital Structures
•
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.
18-4
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
Issuance or Reacquisition of Common Stock
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.
18-5
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
18-6
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.
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
(continued)
18-7
Stock Dividends and Stock Splits
18-8
Stock Dividends and Stock Splits
•
•
•
•
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.
18-9
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. 18-10
18-11
Preferred Stock Included in Capital Structure
Date
No. of
Shares
2012
1/1 to 6/30
200,000
Stock
Dividend
Portion of
Year
Weighted
Average
× 6/12
100,000
• 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.
18-12
Preferred Stock Included in Capital Structure
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.
(continues)
18-13
Preferred Stock Included in Capital Structure
Date
No. of
Shares
2012
1/1 to 6/30
7/1 to 12/31
200,000
300,000
Stock
Dividend
Portion of
Year
Weighted
Average
× 6/12
× 6/12
100,000
150,000
250,000
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.
(continued)
18-14
Preferred Stock Included in Capital Structure
Date
No. of
Shares
2012
1/1 to 6/30
7/1 to 12/31
200,000
300,000
2013
1/1 to 5/1
300,000
Stock
Dividend
1.5
Portion of
Year
Weighted
Average
× 6/12
× 6/12
100,000
150,000
250,000
× 4/12
150,000
Now let’s “roll back” the stock
dividend for all the years displayed.
(continued)
18-15
Preferred Stock Included in Capital Structure
Date
No. of
Shares
Stock
Dividend
Portion of
Year
Weighted
Average
2012
1/1 to 6/30
7/1 to 12/31
200,000
300,000
1.5
1.5
× 6/12
× 6/12
150,000
225,000
375,000
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
Preferred Stock Included in Capital Structure
Date
No. of
Shares
Stock
Dividend
Portion of
Year
Weighted
Average
2012
1/1 to 6/30
7/1 to 12/31
200,000
300,000
1.5
1.5
× 6/12
× 6/12
150,000
225,000
375,000
2013
1/1 to 5/1
5/1 to 12/31
300,000
450,000
1.5
× 4/12
× 8/12
150,000
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)
18-17
Preferred Stock Included in Capital Structure
Date
No. of
Shares
Stock
Dividend
Portion of
Year
Weighted
Average
2012
1/1 to 6/30
7/1 to 12/31
200,000
300,000
1.5
1.5
× 6/12
× 6/12
150,000
225,000
375,000
2013
1/1 to 5/1
5/1 to 12/31
300,000
450,000
1.5
× 4/12
× 8/12
150,000
300,000
450,000
18-18
Preferred Stock Included in Capital Structure
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:
$80,000
dividends
Net income
after EI – Preferred
$305,000
375,000 shares
of of
Weighted-average
shares
common stock outstanding
Earnings per share from continuing operations = $0.60
(continued)
18-19
Preferred Stock Included in Capital Structure
Basic earnings per common share,
extraordinary gain for 2012 is as follows:
Extraordinary
$75,000 gain
Weighted-average
375,000 shares
shares
of of
common stock outstanding
Earnings per share from
extraordinary gain = $0.20
(continued)
18-20
Preferred Stock Included in Capital Structure
Basic earnings per common share, net income
per share (2012):
Preferred
Net income after
– Dividend
$380,000
– $80,000
extraordinary
item
Weighted-average
375,000 shares
shares
of of
common stock outstanding
Net income per share = $0.80
(continued)
18-21
Preferred Stock Included in Capital Structure
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:
($55,000)
+ ($80,000)
Net
loss + Preferred
dividends
450,000
Weighted-average
shares of weightedshares of
average
common
common
stock outstanding
outstanding
Basic loss per share = $(0.30)
Preferred dividends are
included even though
they were not declared.
18-22
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.
18-23
Participating Securities and
the Two-Class Method
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)
18-24
Participating Securities and the
Two-Class Method
•
•
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)
(continued)
18-25
Participating Securities and the Two-Class Method
The undistributed earnings of $200,000 ($500,000 net
income – $180,000 common dividends – $120,000
participating preferred dividends) are allocated as
follows:
18-26
3.
•
•
Use the treasury stock method to compute
diluted earnings per share when a firm has
outstanding stock options, warrants, and rights
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.
18-27
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.
18-28
Stock Options, Warrants, and Rights
•
•
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.
18-29
Stock Options, Warrants, and Rights
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)
18-30
Stock Options, Warrants, and Rights
The number of shares (using the treasury stock
method) to use for calculating diluted earnings
per share is calculated as follows:
Number of shares sold
Proceeds from sale (5,000 × $40) = $200,000
Number of shares that could be purchased with
the proceeds ($200,000/$50)
Number of shares used for diluted EPS
5,000
4,000
1,000
18-31
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.
Basic Earnings per Share
$92,800
Basic EPS =
= $0.93
100,000
18-32
Illustration of Diluted EPS with Stock Options
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)
18-33
Illustration of Diluted EPS with Stock Options
Diluted Earnings per Share:
$92,800
108,000
= $0.86
COMPARED TO:
Basic Earnings per Share:
$92,800
100,000
The diluted
EPS is less
than the basic
EPS, so it is
acceptable.
= $0.93
18-34
4.
Use the if-converted method to compute
diluted earnings per share when a company
has convertible preferred stock or convertible
bonds outstanding
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.
18-35
Illustration of Diluted Earnings per Share
with Convertible Securities
The following example for Reid Corporation
illustrates the computation of diluted EPS when
convertible securities exist.
18-36
Illustration of Diluted Earnings per Share
with Convertible Securities
Note
Diluted =
EPS
Net income + Interest after tax savings
Total shares assumed issued
Diluted =
EPS
$83,000 + $28,000
= $0.79
100,000 + 40,000
18-37
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.
18-38
Computation of Diluted Earnings per Share
for Securities issued during the Year
•
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).
18-39
Computation of Diluted Earnings per Share
for Securities issued during the Year
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
18-40
Computation of Diluted Earnings per Share
for Securities issued during the Year
Diluted earnings per share:
Net income assuming no payment of
preferred dividends due to conversion
Actual number of shares outstanding
Additional shares issued on assumed
conversion of preferred stock
Adjusted number of shares
Diluted EPS ($111,000/140,000)
$111,000
100,000
40,000
140,000
$0.79
18-41
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
Effect of Actual Exercise or Conversion
Stock Options are Exercised During the Year
18-42
400,000 × 9/12 of year
500,000 × 3/12 of year
Weighted-average number of shares for basic EPS
300,000
125,000
425,000
Effect of Actual Exercise or Conversion
18-43
Effect of a Loss from Continuing Operations
on Earnings per Share
Assume the following data for Boggs Co.
18-44
Effect of a Loss from Continuing Operations
on Earnings per Share
18-45
6.
•
•
•
Determine the order in which multiple potentially
dilutive securities should be considered in
computing diluted earnings per share
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
18-46
securities into the computations.
Multiple Potentially Dilutive Securities
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.
18-47
Multiple Potentially Dilutive Securities
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…
18-48
Multiple Potentially Dilutive Securities
…EPS at that point is lower than the incremental
EPS impact of Security C.
18-49
(continued)
18-50
Multiple Potentially Dilutive Securities
18-51
Multiple Potentially Dilutive Securities
18-52
7.
Understand the disclosure requirements
associated with basic and diluted
earnings per share computations
Financial Statement Presentation
Firms are required to provide the following
disclosure items in the notes to the financial
statements:
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.
18-53
Financial Statement Presentation
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.
18-54
(continued)
18-55
18-56
8.
Make complex earnings per share
computations involving multiple potentially
dilutive securities
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.
18-57
Complex Illustration
18-58
Complex Illustration
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:
18-59
Complex Illustration
•
•
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.
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%.
18-60
Complex Illustration
Step 1
(continued)
18-61
Step 2
(continued)
18-62
Step 3
18-63