Advanced Financial
Accounting: Chapter 11
Earnings per Share
Tan & Lee Chapter 11
© 2009
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Content
1. Introduction
2. Computation of a Weighted-Average Number
of Shares
3. Diluted
Diluted Earnings
Earnings per
per Share
Share
Tan & Lee Chapter 11
© 2009
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Diluted EPS
• It is EPS under the assumption of full conversion or
exercise of potential ordinary shares or issuance on
satisfaction of specified conditions
• It is the “worst-case scenario” EPS
• What is the purpose of presenting diluted EPS?
–
Enhance comparability for firms with complex capital
structures
 Focuses on profitability rather than timing of actual
conversions
–
Provides indication of dilutive impact of existing potential
ordinary shares
Tan & Lee Chapter 11
© 2009
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Anti-dilution
• If a conversion/ exercise of potential ordinary
shares cause EPS to increase, anti-dilution
occurs
• IAS 33:41 – Potential ordinary shares that are
anti-dilutive are excluded from the calculation of
diluted EPS
–
How do we know if they are anti-dilutive?
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© 2009
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Anti-dilution
Is diluted EPS from continuing operations >
basic EPS from continuing operations?
yes
no
Anti-dilution occurs.
Diluted EPS for
(overall) profit/ loss
attributable to ordinary
shareholders is equal
to basic EPS.
Tan & Lee Chapter 11
No anti-dilution. Include
the potential ordinary
shares in the
computation of diluted
EPS for (overall) profit/
loss attributable to
ordinary shareholders.
© 2009
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Adjustments to Numerator of Diluted
EPS
Scenario
Impact on numerator
Dividends on convertible
preference shares
Not deducted from net profit
After-tax interest and amortization
expenses on convertible bond
Added back to net profit after tax
Other expense (income) relating to
potential ordinary shares
Added back (deducted from)
NPAT
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Adjustments to Denominator of Diluted
EPS
• Potential ordinary shares are included in the
denominator at the beginning of reporting period
or date of issue of potential ordinary shares,
whichever is the later
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Calculating Diluted EPS for Various
Scenarios
1. Options/ Warrants
•
•
Call options and warrants are only dilutive if they are
“in-the-money”
Use the treasury method to calculate dilutive EPS (the
same method as applied to calculate EPS for a rights
issue)
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Calculating Diluted EPS for Various
Scenarios
2. Convertible Instruments
Use the “if-converted” method.
•
If the amount of preference dividends declared (or
accumulated) for the period or the interest (net of
tax) per ordinary share on conversion is more than
the basic EPS, the convertible preference shares is
anti-dilutive  excluded from calculation of diluted
EPS
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Calculating Diluted EPS for Various
Scenarios
2nd test for anti-dilution
• If earnings per preference share without conversion >
earnings per preference share with conversion
•  deemed anti-dilutive
•  excluded from calculation of diluted EPS
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© 2009
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Calculating Diluted EPS for Various
Scenarios
3. Contingently Issuable Shares
•
•
If the contingent events are met, these shares are
included in the calculation of diluted EPS, from
beginning of period or date of agreement, if later
If the contingent events are not met, we take the
number of shares issuable if the end of the period is
the end of the contingency period (IAS 33:52)
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Anti-dilution Sequencing
• Purpose of reporting diluted EPS is to report
maximum dilution
• A potential ordinary share may be dilutive on its
own, but may be anti-dilutive when included with
other potential ordinary shares
• There are so many permutations and combinations,
so we need to find an order of inclusion
–
Start with the most dilutive. Process stops when the
inclusion of a potential ordinary share increases the
diluted EPS
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© 2009
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Anti-dilution Sequencing
Approach to calculate diluted EPS:
1.
2.
Compute basic EPS
Compute earnings per incremental share (EPIS) for
each class of potential ordinary shares
Increase in earnings from assumed conversion or exercise
EPIS =
•
Incremental number of shares from assumed conversion or
exercise
The class of shares with the lowest impact on the
numerator (earnings) and the highest impact on the
denominator (the no. of shares) has the lowest EPIS
and is the most dilutive.
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© 2009
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Anti-dilution Sequencing
3. Rank them from the most dilutive to the least
dilutive and include the most dilutive first in diluted
EPS calculation.
4. The process stops when all the potential ordinary
shares have been included or when the inclusion of
the next ranked potential ordinary share results in a
higher diluted EPS than the previous provisional
diluted EPS.
* The reported diluted EPS is the lowest possible figure and
must never be higher than the basic EPS.
Tan & Lee Chapter 11
© 2009
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Diluted EPS Illustration
Financial statement and share information of Company A
are as follows:
20x6
Net profit after tax
12,000,000
Less preference dividends
Net profit attributable to ordinary
shareholders
No. of issued ordinary shares at
31 December
Tan & Lee Chapter 11
© 2009
-24,000
11,976,000
4,250,000
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Diluted EPS Illustration
Information on movements in ordinary shares:
1 Jan 20x4
New issue for cash (incorporation)
1 April 20x5
New issue for cash
1 July 20x5
Bonus issue: 1 for 1
1 Oct 20x5
From conversion of preference shares
1 July 20x6
New shares from rights issue
1,000,000
200,000
1,200,000
500,000
1,450,000
1 new share for every 2 existing shares
Exercise price: $2
Market price: $3
All rights were taken up
1 Oct 20x6
Tan & Lee Chapter 11
Shares re-purchased at fair value
© 2009
-100,000
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Diluted EPS Illustration
Information on Potential Ordinary Shares (dilutive instruments)
1. On 1 July 20x4, the company issued 1,000,000 6% noncumulative preference shares that are convertible to 500,000
ordinary shares. The original conversion ratio is 2 preference
shares to 1 ordinary share. After the bonus issue, each
reference share was convertible to 1 ordinary share. (Ignore
the effects of the rights issue on the conversion ratio)
On 1 Oct 20x5, 500,000 preference shares were converted to
ordinary shares. Preference dividends were declared on
outstanding balance of preference shares as at 30 June of
each year.
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Diluted EPS Illustration
2. On 1 July 20x5, the company issued 500,000 units of
stock options. Each stock option unit entitles the holder to
purchase 1 unit of ordinary share.
Exercise price:
Average market price
(20x6)
$2.50
$3.00
None were exercised during the period because of a
vesting period requirement.
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© 2009
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Diluted EPS Illustration
3. On 1 Oct 20x5, the company issued $10,000,000
convertible bonds which are convertible to 10,000,000
ordinary shares
Market interest
rate:
5% per annum
Tax rate:
20%. None were converted during
20x5 or 20x6
Required: Prepare diluted EPS for 20x6
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© 2009
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Diluted EPS Illustration
Worked solution
Step 1: Determine the Earnings per Incremental Share (EPIS)
for each type of potential ordinary shares.
a) Convertible preference shares
Incremental shares arising from the assumed conversion of the
preference shares as at 1 Jan 20x6
Assumed converted from 1 Jan 20x6 to 31 Dec 20x6: 500,000
(500,000 x 12/12)
(No partial conversions during the year; hence, assume the
balance at year-end is converted at beginning of year)
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Diluted EPS Illustration
Impact on profit attributable to ordinary shareholders from
assumed conversion:
Avoidance of dividends declared on preference shares
during 20x6 (500,000*6%*0.8)
24,000
Earnings per Incremental Share
Tan & Lee Chapter 11
© 2009
0.048
(24,000/500,000)
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Diluted EPS Illustration
Worked solution
b) Stock Options
Incremental shares arising from the assumed exercise of options
as at 1 Jan 20x6
No. of ordinary shares issued if outstanding options are exercised:
500,000
Equivalent number of shares at fair market value: 416,667
(500,000 x 2.5)/ 3.0
Incremental number of shares issued for no consideration: 83,333
Apply a whole year’s weighting since the stock options were in
existence at beginning of 20x6.
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Diluted EPS Illustration
Impact on profit attributable to ordinary shareholders from
assumed exercise
0
Earning per Incremental Share
0
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Diluted EPS Illustration
Worked solution
c) Convertible Bonds
Incremental shares arising from the assumed conversion of
convertible bonds as at 1 Jan 20x6
No. of ordinary shares issued if the convertible bonds were
converted: 10,000,000 (10,000,000 x 12/12)
Tan & Lee Chapter 11
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Diluted EPS Illustration
Impact on profit attributable to ordinary shareholders from
assumed conversion as at 1 Jan 20x6
Savings of interest expense (after-tax) on convertible
bonds: 10,000,000 x 5% x 12/12 x 0.8 = 400,000
Earnings per Incremental Share
Tan & Lee Chapter 11
© 2009
0.04
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Diluted EPS Illustration
Worked solution
Step 2:
Ranking by EPIS
1) Stock Options
2) Convertible Bonds
3) Convertible Preference Shares
Tan & Lee Chapter 11
© 2009
EPIS
0 (most dilutive)
0.04
0.048 (least dilutive)
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Diluted EPS Illustration
Changes in number of ordinary shares in 20x5
Date
Item
1 Jan 20x5
Balance at start
1 Apr 20x5
New issue for cash
1 July 20x5
Bonus issue
1 Oct 20x5
Conversion of
preference shares
31 Dec 20x5
Balance at year-end
Tan & Lee Chapter 11
Increase in ordinary
shares
© 2009
1,000,000
200,000
1,200,000
500,000
2,900,000
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Diluted EPS Illustration
Calculating weighted average number of shares in 20x6
Date
1 Jan 20x6
1 July 20x6
1 Oct 20x6
Item
Balance at
start
Rights issue
Shares repurchased
Increase in ordinary shares
2,900,000
1,450,000
-100,000
362,500
-362,500
Cumulative balance
3,262,500
4,350,000
4,250,000
Period outstanding
1 Jan – 1 Jul
1 Jul – 1 Oct
1 Oct – 31
Dec
Time weight
1/2
1/4
1/4
Weighted average number of
shares
1,631,250
1,087,500
1,062,500
Add bonus issue
Tan & Lee Chapter 11
© 2009
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Diluted EPS Illustration
Fair value of shares before rights = 2,900,000 x $3 = $8,700,000
Proceeds from the rights = 1,450,000 x $2 = $2,900,000
Theoretical ex-rights price
= Fair value of shares before rights + Proceeds from rights
Existing shares + New shares from rights
=
$11,600,000
=
4,350,000
Bonus issue adjustment factor implicit in rights
= 3/2.67
Bonus issue applied retrospectively
= (1.125 x 2.9 m) - 2.9 m
Tan & Lee Chapter 11
© 2008
2.67
1.125
362,500
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Diluted EPS Illustration
• Number of ordinary shares as at 31.12.20x6
= 2,900,000 + 1,450,000 – 100,000
= 4,250,000
• Weighted average number of shares in 20x6
= 1,631,250 + 1,087,500 + 1,062,500
= 3,781,250
Tan & Lee Chapter 11
© 2009
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Diluted EPS Illustration
Worked solution
Step 3: Introduce the most dilutive security first into aggregate DEPS calculation
Profit
Basic EPS
11,976,000
Include effects of assumed exercise of
options
Aggregate DEPS
0
11,976,000
Include effects of assumed conversion of
convertible bonds
Aggregate DEPS
400,000
12,376,000
Include effects of assumed conversion of
convertible preference shares
Aggregate DEPS
24,000
12,400,000
Reported DEPS (20x6)
Tan & Lee Chapter 11
WA no. of
shares
DEPS
3,781,250 3.167207
83,333
3,864,583 3.098911
Dilutive
10,000,000
13,864,583 0.892634
Dilutive
500,000
14,364,583 0.863234
Dilutive
0.863234
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Presentation and Disclosures
• Basic and diluted EPS to be presented in income
statement, in respect of:
– Profit attributable to ordinary shareholders of parent company
from continuing operations
– Profit attributable to ordinary shareholders of parent company for
the period
• Where there are discontinued operations, basic and
diluted EPS for discontinued operations must be
disclosed in the income statement or in the notes
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Presentation and Disclosures
•
Other information that should be in the notes (IAS
33:70):
1.
Earnings used in numerator of EPS, as well as a reconciliation
of earnings to the income statement. (Include individual
earnings effect of each class of instruments on EPS)
2.
Denominator in calculating basic and diluted EPS and a
reconciliation of both denominators. (Include individual
denominator effect of each class of instruments on EPS)
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© 2009
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Presentation and Disclosures
3. Potential ordinary shares that were not included in
the calculation of diluted EPS, because they were
anti-dilutive
4. Post-balance sheet events – description of
transactions which would have significantly
changed the no. of ordinary shares/ potential
ordinary shares outstanding at the end of period
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© 2009
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