AR I Z O NA S TAT E CFA Review – Level 1 Review of Financial Reporting & Analysis Prof. Phil Drake CFA Exam Weights Our Approach Tonight • We have only two hours. – Giddy up • The emphasis is on review. • You should know this material, but not at the depth you need to understand. • Assume you know how the financial statements articulate. • Review the balance sheet, then the income statement … you are on your own for cash flows. Asset Definition 1. Probable future economic benefit 2. Obtained or controlled by the entity 3. As a result of past transactions Current vs. Non-Current - based on year or operating cycle, which ever is longer. Cash and Cash Equivalents • Cash, of course. • Equivalents include money market instruments such as ST CDs, high quality commercial paper, Treasuries, money market funds that mature in three months or less. Investments in Debt Securities Three Categories Held to Maturity Requires ability and intent Available for Sale Cash Management Trading Intent to sell in the near term Accounting for Debt Securities Accounting & Valuation Held to Maturity Interest revenue, gain/loss on sale Reported on balance sheet at amortized cost Available for Sale Interest revenue, gain/loss on sale Fair value … with Unrealized Holding G/L to Comprehensive Income (i.e., equity) Trading Interest Revenue, gain/loss on sale Fair value … with Unrealized Holding G/L to Current Income (i.e., Income Statement, then Retained Earnings) Investments in Equity Securities Accounting is based on level of influence Minority, Passive (less than 20% ownership) Fair Value Method Minority, Active (20% - 50% ownership) Equity Method Majority, Active (more than 50% ownership) Consolidation Method Accounting for Equity Securities Accounting for Minority, Passive Investments Available for Sale Dividend Income, gain/loss on sale to Income Statement Fair value … with Unrealized Holding G/L to Comprehensive Income (i.e., equity) Trading Dividend Income, gain/loss on sale to Income Statement Fair value … with Unrealized Holding G/L to Current Income (i.e., Income Statement, then Retained Earnings) Accounting for Equity Securities Accounting for Minority, Active Investments Record purchase at cost. Single line acquisition If purchase price exceeds proportionate share of investee’s book value, identify fair values of underlying assets & liabilities. Recognize proportionate share of investee’s income as an increase in the Investment Recognize proportionate share of investee’s dividends as reduction in Investment Valuation Fair Value Method Annual Adjustment Trading – Unrealized Holding G/L in current income Available for Sale – Unrealized Holding G/L in Comprehensive Income (i.e., equity) Equity Method Annual Adjustment Proportional Share of Income = Income Proportional Share of income less Dividends = Investment Adjustment Valuation The Fair Value Option • • • Held-to-maturity Available-for-sale Equity method Report unrealized gains and losses through the income statement (not though comprehensive income) Brand-new and not many takers yet. Consolidations Basic Idea: The Parent company along with its Subsidiaries are a single economic unit. Combine the financial results for Parent & all Subsidiaries, then – Eliminate Intercompany Payables – Eliminate Intercompany Sales – Eliminate double-counting of Investment – Eliminate double-counting of Income Consolidations – non-controlling Interests Non-controlling Interest - (aka Minority Interests) Occurs when the Parent does not own 100% of the subsidiary. The percentage of ownership not controlled by the Parent. For the Balance Sheet, Non-controlling Interests represent the percent of net assets (assets less liabilities of the subsidiary). Appears between Liabilities & Equities For the Income Statement, Non-controlling Interest is the percentage of subsidiary income held by the minority shareholders. Consolidating Foreign Subsidiaries Companies often have international subsidiaries that must be consolidated with the Parent’s financial statements. Typically, the subsidiaries accounts are maintained with local currency (and, sometimes, local GAAP). The amounts on the foreign subsidiaries financial statements must be translated in U.S. dollars. To translate a foreign subsidiary’s financial statements into U.S. dollars, conversion is made with both Historical Exchange Rates (those which existed at the time a transaction occurred) and Current Exchange Rates (Exchange rates which exist as of the balance sheet date) Consolidating Foreign Subsidiaries The use of different exchange rates means the resulting financial statements will not balance. To force the statements to balance, an account called “Translation Adjustment” is used. Two approaches are used depending on the independence of the subsidiary from the Parent company. Self-contained: All-current method (local currency is functional) - Extension of US Parent: Monetary-Nonmonetary method (US dollar is functional currency) - Subsidiaries in countries with hyperinflation (100+%) use the U.S. dollar as the functional currency. Accounts Receivable Involves the application of two concepts – Definition of an Asset & Matching Definition of an asset: - Probable future economic benefit Obtained or controlled by the entity As a result of past transactions What is the cost of extending credit? - Bad debts. Accounts Receivable Acct Rec. Beg. Bal. Allowance for Bad Debts What I can Collect Beg. Bal. Collections Bad Debt Expense Sales Write-Offs Write-Offs End Bal. What I expect to Collect End Bal. Net Account Receivable Accounts Receivable Example Year 1 Sales December 31, Year 1 Accounts Receivable Allowance for Bad Debts Accounts Receivable, net $1,500,000 Based on $175,000 Analysis (10,000) $165,000 Goes to the Balance Sheet Accounts Receivable Example December 31, Year 1 Bad Debt Expense $10,000 Allowance for Bad Debts $10,000 This entry applies the two important concepts: - matching expenses with the related revenues - recording the asset at its net realizable value (NRV) Accounts Receivable Example Year 2 Sales $5,000,000 Identified and wrote-off as uncollectible $21,500 of accounts receivable. Allowance for Bad Debts $21,500 Accounts Receivable Note, No impact of Net A/R $21,500 Accounts Receivable Example Year 2 December 31, Year 2 Accounts Receivable Allowance for Bad Debts Accounts Receivable, net Based on Analysis $330,000 (25,000) $305,000 Goes to the Balance Sheet Accounts Receivable Example Allowance for Bad Debts 10,000 Beg. Balance Write-Offs 21,500 36,500 Bad Debt Exp. 25,000 End Balance December 31, Year 2 Bad Debt Expense Allowance for Bad Debts $36,500 $36,500 Inventory – Basic Approach Beg. Inventory + Purchases Cost of Goods Available for Sale Sold Cost of Goods Sold (Income Statement) Not Sold End. Inventory (Balance Sheet) Inventory – Costing Methods Beg. Inventory Purchase Sale Purchase Purchase Sale End Inventory 300 units @ $10 per unit 100 units @ $12 per unit 200 units @ $30 per unit 600 units @ $14 per unit 200 units @ $15 per unit 600 units @ $30 per unit 400 units LIFO – Periodic Cost of Goods Sold $11,400 Ending Inventory $ 4,200 LIFO – Perpetual Cost of Goods Sold $10,800 Ending Inventory $ 4,800 Inventory – Costing Methods Cost of Goods Sold Ending Inventory FIFO Periodic FIFO Perpetual $ 9,800 9,800 LIFO Periodic LIFO Perpetual $11,400 10,800 W/A Periodic $10,400 W/A Perpetual 10,200 FIFO Periodic FIFO Perpetual $ 5,800 5,800 LIFO Periodic LIFO Perpetual $ 4,200 4,800 W/A Periodic $ 5,200 W/A Perpetual 5,400 Inventory – Valuation (LCM) • After determining FIFO/LIFO/W-A Ending Inventory, must compare to market valuation. – • Follows the definition of an asset Report on the balance sheet, the lower of cost or market. Write-downs of inventory from cost to market are included in cost of goods sold. – Can establish a reserve account for obsolesce. Inventory – LIFO Layers As inventory levels increase, a LIFO layer is added. Can result in very old costs embedded in inventory. 15 units at $20 per unit 20 units at $17 per unit 40 units at $13 per unit 100 units at $10 per unit Inventory – LIFO Liquidations Assume current costs are now $25 per unit. Delay purchases to “dip” into the LIFO layers … Instead of CGS at $25 per unit, now it is $20, then $17, then $13 and eventually, $10 per unit 15 units at $20 per unit 20 units at $17 per unit 40 units at $13 per unit 100 units at $10 per unit Inventory – LIFO Liquidations LIFO Liquidations come at a very high cost – taxes!! LIFO Conformity rule states that if you use LIFO accounting for your tax return, you use it for your financial statements as well. It costs real money to dip into your LIFO Layers. Inventory – Comparability 1. 2. 3. 4. BIF + P – CGSF = EIF BIL + P – CGSL = EIL P = CGSL + EIL – BIL Substitute 3 into 1 BIF + (CGSL + EIL – BIL) – CGSF = EIF Rearrange … CGSF = CGSL - [(EIF - EIL) – (BIF - BIL)] CGSF = CGSL – (LIFO ReserveE – LIFO ReserveB) CGSF = CGSL – Change in LIFO Reserve Inventory – Comparability LIFO FIFO CGS Higher Lower Income before taxes Lower Higher Income taxes Lower Higher Net Income Lower Higher Cash Flow Higher Lower Inventory Balance Lower Higher Assume rising inventory costs and stable or Increasing inventory levels. Inventory - Summary Inventory Beg. Bal. Cost of Goods Sold Purchases Obsolescence End. Bal. Long-Lived Assets – Major Issues Multi-period assets whose costs are matched to the revenues they help generate. • Smooths the impact on income (Asset) Capitalize Costs Allocate Expense Impairment Issues Based on the definition of an asset Great opportunities to shift expenses from one period to another. Long-lived Assets Long-lived Asset Acc. Depreciation Beg. Bal. Beg. Bal. Disposals Acquisitions Impairments End Bal. Disposals Depreciation Expense Impairments End Bal. Long-lived Assets – Acquisitions Acquisition Cost – All the costs necessary to ready the asset for its intended use. Specialized machinery for a manufacturer. Invoice price Taxes Delivery charges Speeding ticket during delivery Installation costs (including repouring floor) Repair work for damage during installation Setup costs (labor and materials) Long-lived Assets – Depreciation Depreciation – Allocating the cost of the asset over the period of benefit. Accounting depreciation ≠ Economic Depreciation Depreciable amount = Acquisition Cost less Residual Value Cost Residual Value - $1,000,000 - $250,000 Depreciable Amount - $750,000 The amount to be expensed over the estimated useful life of the asset. Long-lived Assets – Depreciation Methods Straight-Line: Simple and most pervasive. Other methods: Sum-of-the-years digits Declining balance Depreciation Expense Units of production MACRS (tax return only) Book Value Long-lived Assets – Betterments vs. Repairs Betterment – Costs incurred after the asset has been placed in service. A betterment extends the asset’s useful life, increases the asset’s productive capacity, or increases the asset’s productive efficiency. Capitalize costs incurred. Repairs – No increase in economic benefit or increased service potential. Expense costs as incurred. Long-lived Assets – Disposals & Exchanges Disposal – Compare the asset’s book value to the value received from the sale. The difference is either a gain or loss. Exchange – One productive asset (e.g., inventory) for another asset (e.g., equipment). General rule: The new asset is recorded as the Fair market value (FMV) of the asset exchanged. Exceptions for exchanges of similar assets or where FMV is not ascertainable. Long-lived Assets – Change in market Value Revaluation – Not with U.S. GAAP. However, IFRS and other countries allow revaluation up to market value. Impairments – Decline in market value of an asset. There are different kinds of tests for different kinds of long-lived assets. Long-lived Assets – Acquired Intangibles Acquired Business Tangible Assets Marketing related • Trademarks • Trade names • Marketing materials • Style guide (unique color, shape or package design) • Mastheads • Domain names Identifiable Intangibles Other Balance Sheet Customer related Technology related Contract related • Distributor relationships • Retailer relationships • Order or production backlog • Contractual and noncontractual customer relationships • Trade secrets, such as secret formulas, processes or recipes • Patented and unpatented technology • Computer software • Databases • Supply contracts • Advertising, management & service contracts • Licensing & royalty agreements • Lease agreements • Construction permits • Franchise agreements • Non-compete agreements Goodwill Goodwill arises when the purchase price paid for another business exceeds the fair market value of the acquired net assets of that business. $1 million $1 million $3 million $10 million - Goodwill - Identifiable Intangibles - Excess net asset FMV over BV $5 million - Net asset book value Consideration transferred Allocation Long-lived Assets – Intangibles Amortization Depends on the type of intangible asset it is. • Limited Life intangible assets – Amortize straight-line over estimated economic life. • Indefinitive Life intangible assets – Assets that the firm intends to maintain for an unknown period of time. – No amortization. • Goodwill – No amortization. Long-lived Assets – Impairments Property, Plant & Equipment and Limited Life Intangible Assets (Category 1) Two Step Impairment Test: Step one: Compare future estimated undiscounted cash flows to book value. If cash flows are less than book value, the asset is impaired. Step two: Write the asset down to either fair market value (FMV) or discounted future cash flows & recognize the impairment loss. Long-lived Assets – Impairments Indefinite-Life Intangible Assets (other than Goodwill) (Category 2) One Step Impairment Test: Step one: Write the asset down to either fair market value (FMV) or discounted future cash flows if below book value. Long-lived Assets – Impairments Goodwill (Category 3) Two Step Impairment Test: Step one: Compare the fair value of the reporting unit to its book value including goodwill If fair value is below book value, then go to step two. Step two: Determine the implied fair value of goodwill by comparing the fair value of the reporting to the fair value of net identifiable assets. Write goodwill down if needed. Long-lived Assets – Impairments The FASB added a new Step Zero for Intangibles and Goodwill. – Step zero is an optional, qualitative assessment. – If determined that it is more likely than not (i.e., a greater than 50% likelihood) that the fair value of a reporting unit exceeds its carrying value, then no further work required. Liabilities – Major Issues Fixed Payment Dates & Amts. Fixed Payment Amts, Est. Dates Est. Date Advances Mutually & Amount & Unexecuted Executed Agreements Contracts Note Payable Interest Pay. Bonds Pay. Accounts Pay. Taxes Pay. Warranties Payable Recognized as Accounting Liabilities Rental Fees Purchase Subscriptions Employment Insurance Commitments Contingent Obligations Pending Lawsuits Off BS Instruments Generally Not Recognized as Accounting Liability Liabilities – Basic Definition 1. Probable future economic sacrifice, 2. The obligation belongs to the firm, and 3. Is the result of past transactions. Parallels the definition of an asset. Liabilities – Current • • • • Accounts payable Wages, salaries, and other payroll items Short-term notes and Interest payable Warranties – Matching concept. • Estimate the warranty liability at the time of sale and record the expense. • Reduce the liability based on actual costs incurred. Bonds– Early retirement Example: The $100,000 bond is two years from maturing. Originally issued at a market rate of 8%, now trades in the market at 12%. Journal Entry Reported in the Income Statement Bonds Payable $103,630 Cash $ 96,535 Gain on early retirement 7,095 Contingent Liabilities When is a liability a liability? If there is uncertainty regarding the outcome of an event (e.g., litigation, possible assessments, expropriation of assets). Disclosure or Recognize? Two Criteria for Accruing a Liability: - “Probable” “Reasonably estimated” Liabilities – Capital Leases Requirements Must meet one of the four criteria: 1. 2. 3. 4. The lease transfers the ownership to the lessee at the end of the lease term. The lease contains an option to purchase substantially less than the expected fair market value at the end of the lease term. The lease term is equal to 75% or more of the estimated remaining economic life. At the beginning of the lease term, the present value of the minimum lease payments equals or exceeds 90% of the fair market value of the leased asset Liabilities – Operating Leases No entry at lease inception - executory contract Lease Payment Journal Entry Rent Expense $ xx Cash $ xx No asset nor liability recognized on the balance sheet. Footnote disclosures are substantial including description and payment schedule. Liabilities – Capital Leases Present value of Minimum Lease Payments At Lease Inception Leased Asset Lease Liability $ xx $ xx Amortize the leased asset over the life of the lease. Amortization Expense $ xx Leased Asset $ xx Lease payments follow Long-Debt GP Interest Expense $ xx Lease Liability Difference $ xx Cash Second GP $ xx Leases Managerial considerations On Balance sheet or off? – • Are investors really fooled? Cash flows – • • • Operating leases – Operating cash flows Capital leases – Investing cash flows Performance metrics Pensions – Defined Contribution Plans Defined Contribution Plans are the dominate pension vehicle. • Transfers ownership of risks to employees • Easy accounting: Pension Expense Cash $ XX $ XX Pensions – Defined Benefit Plans Rose in popularity following WWII. • Employer bear risks of funds market returns • Conceptual Underpinnings – – – • Matching concept Record expenses in period of benefit Record liability Management Incentives – Management prefers not to report a liability Cost of Credit Share price impact Pensions – Defined Benefit Plans Three Concepts Vested benefits - Legal issue with respect to employee right. If they leave the firm prior to achieving retirement conditions (e.g., age, years of service). Accumulated Benefit Obligation (ABO) - - Vest & non-vested benefits Non-vested benefits are estimated “Actuarial” net present value of benefits earned to date at today’s pay levels. Pensions – Defined Benefit Plans Three Concepts Projected Benefit Obligation (PBO) - - PBO equals … “Actuarial” net present value of benefits earned to date projected at future pay rates The real liability conceptually • Best estimate of future payments Pensions – Defined Benefit Plans Three Elements of Pension Accounting Record liability for deferred cash flows - - Increase for interest recognized over time Decrease for cash payments Record asset for invested funds Recognize earnings on invested funds - Increase cash contributions to fund - Decrease for payments made to retirees - Record expense for “service cost” - NPV of incremental benefit earned for current year services Pensions – Defined Benefit Plans Violations of FASB Conceptual Framework Off-set Revenues and Expenses Annual pension expense = Net of … Interest expense Service Cost expense Investment Returns Off-set Asset & Liabilities Net Pension asset or Liability on Balance Sheet The Plan is said to be either “over-funded” or “underfunded” Pensions – Components of Pension Exp. 1. 2. 3. 4. 5. Service Cost – Increase in PBO because employees have worked another year. Interest Cost – The PBO is the discounted present value of expected benefits to be paid to employees. As the payment date gets closer, interest cost must be recognized (2nd general principle of long-term debt) Expected Return on Plan Assets – The off-sets pension costs and makes pension expense smaller. The expected return is used rather than the actual return to avoid the effects of the stock market’s volatility. Prior Year Service Cost – Adjustments to PBO for additional benefits granted to employees … “sweeteners.” Amortization of Excessive Plan Gains & Losses – Due to changes in Fund earnings experience or PBO assumptions. Accounting for Dividends Stock Dividend Small (less than 20 – 25% of outstanding stock) Retained Earnings $ FMV Common Stock $ Par Additional Paid-In Capital Difference Large (more than 20 – 25% of outstanding stock) Retained Earnings $ Par Common Stock $ Par Accounting for Dividends Stock Split Just like a stock dividend, increases the number of shares outstanding … without impacting Retained Earnings. No entry is record. Par value and shares outstanding are adjusted to reflect the split. PhilDrakeCo has 1,000,000 shares of $10 par common stock. Following a 2 for 1 stock split, there are 2,000,000 shares outstanding with a par value of $5. Treasury Stock Purchase 10,000 shares of PhilDrakeCo at $11 per share. Treasury Stock Contra-Equity $ 110,000 Cash $ 110,000 Reissue Above Cost - $15 per share Cash $ 150,000 Treasury Stock $ 110,000 Paid-In Capital – TS 40,000 Reissue Below Cost - $5 per share Cash $ 50,000 Paid-In Capital – TS 60,000 Treasury Stock $ 110,000 Convertible Securities Convertible securities (debt and preferred stock) is the underlying security with an option to convert the security into common stock. Terms of conversion are typically fixed (i.e., 50 shares common stock for each $1,000 bond). For debt, the conversion feature reduces the interest rate due to the investor … lowers cost of borrowing. When the security is converted, no gain or loss is recognized. Thus, the conversion is done at the convertible security’s book value. Revenue Recognition The Securities and Exchange Commission (SEC) has issued authoritative statements in Staff Accounting Bulletin (SAB) 104. Revenue, generally, is realized or realizable and earned when all of the following criteria are meet: 1. 2. 3. 4. There is persuasive evidence that an arrangement exists, Delivery has occurred or services have been rendered*, The seller’s price to the buyer is fixed or determinable, and Collectability is reasonable assured. * Risk of loss is transfer or no future performance required Research & Development • Companies engage in R&D with the expectation of producing profitable future goods and services. However, there is the risk that these expenditures will have no value for the firm. • The resulting assets typically have values unrelated to the R&D costs. • Expensed as incurred. Lacks the probable future economic benefit criteria of an asset. • Creditors generally do not lend on R&D projects. Restructuring Activities Most firms experience some type of restructuring. It is a natural evolution of business. Restructuring can include employee layoffs, lease terminations, asset write-downs, moving locations, closing operations and other reorganizations. Following the commitment to a formal plan of restructuring, recognize a liability & expense. Restructuring Activities Provides management with a tool for earnings management. The Big Bath Theory. As the restructuring unfolds, the liability & expense are updated for the new information. This creates an incentive to front-load expenses. Strangely, restructuring costs imposed by a merger as expensed as incurred. No liability is established due to past abuses. Accounting for Income Taxes GAAP FASB, SEC Tax law Congress The basics Book Income ≠ Taxable Income Timing differences Permanent differences A timing difference results when a revenue (gain) or expense (loss) enters book income in one period but affects taxable income in a different (earlier or later) period. A permanent difference results when a revenue (gain) or expense (loss) enters book income but never recognized in taxable income or vise versa. Temporary Differences Book Income Tax Income Installment Sales Revenue Today Income Later Product Warranties Expense Today Deduction Later Bad Debt Expense Expense Today Deduction Later Rent Rec’d in Advance Revenue Later Income Today Depreciation Expense Straight-Line Accelerated Expense Later Deduction Today Event Prepaid Expenses Def. Tax Asset Def. Tax Liability X X X X X X Deferred Tax Liability when Future Taxable Income > Future Book Income Deferred Tax Asset when Future Taxable Income < Future Book Income Permanent Differences • Permanent differences will not reverse in the future. Thus, book and tax will never equalize. • Common permanent differences: – – – – – • Fines and Penalties Meals and Entertainment Political Contributions Officers Life Insurance Tax-exempt Interest Permanent differences are ignored for financial accounting purposes. Accounting for Taxes – Mechanics Income tax expense is the “plug” after determining the tax liability and changes in deferred taxes. Record the tax liability 2.Record the changes in the deferred tax accounts 3.Plug “Income tax expense.” 1. Unusual occurrence – Income tax expense when there is a net loss. Deferred Tax Assets Deferred tax assets must pass the definition on an asset … “probable future economic benefit” If there is uncertainty realizing the deferred tax asset (e.g., history of operating losses/profits, unsettled circumstances, presence of existing contracts or backlog), then a valuation allowance (contra asset) must be establish. The criteria for the valuation allowance is needed is whether the it is “more likely than not” that the tax benefits will be realized. Net Operating Losses The U.S. income Tax code allows firms reporting operating losses to offset those losses against past or future tax payments. Valuation Allowance When a valuation allowance is recognized, there is a corresponding increase in the income tax expense. If it subsequently determined that the deferred tax benefit will be realized, then the entry that established the valuation allowance is reversed. This results in a decrease in income tax expense and an increase in net income. Some analysts call this cookie jar accounting. Also reveals information about the long-term prospects of a firm’s profitability. General Motors established a $38.6 billion valuation allowance in the 3rd quarter, 2007. Effective v. Marginal Tax Rates • Effective Tax Rate (ETR) – – Income tax expense divided by pretax book income. Provides information as to a firm’s tax management. • Marginal Tax Rate – Income tax for the next dollar of taxable income. – For the U.S. companies, use a marginal federal rate of 35% plus estimated 5% state and local tax rate. • In conducting incremental analysis and after-tax effects (e.g., interest costs), use the marginal tax rate. Foreign Currency Transactions Amerco, a U.S. company, sells goods to a German customer at a price of 1 million Euros (€) when the spot exchange rate is $1.50 per Euro. If payment were received at the date of sale, Amerco would convert 1 million Euros into $1,500,000. Instead, Amerco allows the German customer 30 days to pay. At the end of 30 days, the euro had depreciated to $1.45 per Euro and Amerco can convert the 1 million euros into $1,450,000. How should Amerco account for the $50,000 decrease in value? Foreign Currency Transactions Two-transaction perspective: The export sale - The decision to extend credit - Date of Sale Accounts Receivable Sales $1,500,000 Goes to Income Stmt Date of Collection Foreign Exchange Loss $ Accounts Receivable Cash $1,500,000 50,000 $ 50,000 $1,450,000 Accounts Receivable $1,450,000 Below the line components Discontinued Operations & Extraordinary Items - Reported net of tax - Separate EPS calculations Proctor & Gamble Earnings Per Share Very powerful … highly cited, moves markets, motivates people, affects M&As. The most important single financial number. Simple Capital Structure – No potential common stock (e.g., NO convertible bonds, convertible preferred stock, stock warrants, stock options) Net Income - Preferred Dividends EPS = Weighted Average Number of Shares Outstanding Earnings Per Share Complex Capital Structure: Dual Structure- Basic EPS, Diluted EPS For Diluted EPS calculation include only dilutive securities, exclude antidilutive securities. Impact of Conversions & Options The “if converted” method: The “treasury stock” method: • Assumes that all convertible bonds are exchanged for stock at the beginning of the reporting period. • Assumes that proceeds received on exercise of the options ($100 per share) are used to buy back shares at the average market price. • But conversion is unlikely if the stock price ($75) is substantially below the conversion price ($100). • If the average market price is below the exercise price, the options are not dilutive for EPS purposes. • The resulting diluted EPS figure understates likely dilution and overstates diluted EPS. • The resulting diluted EPS figure overstates likely dilution in this case and thus understates EPS. Good Luck with the CFA Exam! Work some magic!