Intermediate Financial
Accounting
Earnings Per Share
by Professor Hsieh
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 Share
2
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 Share
3
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 Share
4
Simple Capital Structure(contd.)

For a simple capital structure, the basic
earnings per share (EPS) computation
is:
Net Income - Preferred Dividend
= --------------------------------------------------Weighted Average Number of Common
Shares Outstanding
Earnings Per Share
5
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 Share
6
Exhibit 1:
Simple Capital Structure
Months shares
Shares * Fraction of Year = Equivalent
Are Outstanding Outstanding Outstanding
Whole Units
Jan - Feb
12,000
2/12
Mar.-June
14,700
4/12
July - Nov
18,000
5/12
December
17,520
1/12
Total Weighted Average Common Shares
Earnings Per Share
2,000
4,900
7,500
1,460
15,860
=====
7
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 Share
8
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 twofor-one split is assumed to have
occurred on January1, 20x4.
Earnings Per Share
9
Weighted Average Shares and Stock Dividends or Splits
Example (contd.)



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.
Earnings Per Share
10
Weighted Average Shares and Stock Dividends or Splits
Example (contd.)


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.
Earnings Per Share
11
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
20x4
Jan -Deca
5,000
12,000b
12/12
12,000
20x5
Jan - May
10,000
12,000c
5/12
5,000
Jun - July
15,000
18,000d
2/12
3,000
Aug- Sep e
18,000
18,000
2/12
3,000
Oct - 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 Share
12
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 Share
13
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 Share
14
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 Share
15
Example (contd.)
Earnings Per Share Subtotals
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 Share
16
Example (contd.)
Earnings Per Share Subtotals
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 Share
17
Exhibit 4:

Earnings Per Share Subtotals
Earnings per share computation for
20x5:
Earnings Shares
Adjust. Adjust.
Net income $14,000
P.S. div.a
(2,400)
C.S. shares b
4,917
Earnings
= Per Share
Earnings and $11,600  4,917 =
Shares
Earnings Per Share
$2.36
18
Exhibit 4 :(contd.)
Earnings Per Share Subtotals
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*2
6,000c * 2/12 = 1,000 c.2,500*2+1,000
WACS
4,917
Earnings Per Share
19
Exhibit 4 :(contd.)

Earnings Per Share Subtotals
Condensed income statement presentation for
20x5:
Income before extraordinary items
Extraordinary gain (net of I/T)
Net income
Basic earnings per com.share
outstanding (see Note A):
Income before extra. items
Extraordinary gain
Net income
Earnings Per Share
$10,400
3,600
14,000
$1.63
0.73
$2.36
20
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 Share
21
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 Share
22
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 Share
23
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 Share
24
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 Share
25
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 Share
26
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 Share
27
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 Share
28
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 Share
29
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 Share
30
Step 2 (contd.)


Diluted Earnings Per Share
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.
Earnings Per Share
31
Step 2 (contd.)


Diluted Earnings Per Share
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).
Earnings Per Share
32
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
Earnings Peras
Sharefollow:
33
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 Share
34
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 Share
35
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 Share
36
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 Share
37
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 Share
38
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 Share
39
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 Share
40
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 Share
41
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 Share
42
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 Share
43
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 Share
44
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 Share
45
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 Share
46
Example: Impact of Assumed
Conversion of CSE and Ranking
A. 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 Share
47
.
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 was
recorded during the year. The bonds are
convertible into 3,150 shares of common
stock.
Earnings Per Share
.
48
Exhibit 5: Impact of Assumed
Conversion of CSE and Ranking(contd.)
B. Computation and Rankings
Security Impact
A
$5,400/3,000
= $1.80
B
$4,800/1,920
= $2.50
C
$8,000/5,000
= $1.60
D
$6,300/3,150
= $2.00
Order in Ranking
2
4
1 (most dilutive one)
3
Earnings Per Share
49
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 Share
50
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 Share
51
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 Share
52
Example:
Computation of Tentative and Final DEPS.
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 Share
53
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 Share
54
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 Share
55
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 Share
56
Computation of Tentative and Final DEPS.
Example:(contd.)
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.
Earnings Per Share
57
Computation of Tentative and Final DEPS.
Example:(contd.)
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.
Earnings Per Share
58
Computation of Tentative and Final DEPS.
Example:(contd.)
3. Impact on earning per share and resulting
rankings:
Diluted
Security
Impact on EPS
Ranking
7.5% Preferred
9% Preferred
0.075 * $16,000 = $1.50
160 * 5
0.09 * $10,000 = $2.25
100 * 4
2
4
6% Bonds [($30,000 * 0.06) - $80] * (1 - 0.3) = $2.11
3
30 * 19
9.2% Bonds ($25,000 * 0.092) + $50] * (1 - 0.3) = $1.46
25 * 45 Earnings Per Share
1
59
Computation of Tentative and Final DEPS.
Example :(contd.)
4. Diluted earnings per share computation for 20x7
Earnings
Shares
Earnings
Explanation
(Adjustments) (Adjustments) = Per Share
Basic earnings and shares
$13,800a
6,000
= $2.30 Basic
Increment in shares (options)
267b
DEPS1
$13,800
6,267
= $2.20 DEPS1
Earnings saving in 9.2%
bond interest expense
1,645c
Increment in shares
1,125d
DEPS2
$15,445
7,392
= $2.09 DEPS2
Earnings savings in 7.5%
preferred dividends
1,200e
Increment in shares
800f
Diluted earnings and share
$16,645
8,192g
= $2.03h Diluted
Earnings Per Share
60
Computation of Tentative and Final DEPS.
Example:(contd.)
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.
Earnings Per Share
61
Computation of Tentative and Final DEPS.
Example:(contd.)
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].
Earnings Per Share
62
Computation of Tentative and Final DEPS.
Example:(contd.)
5. Condensed income statement presentation for
20x7:
Income before extraordinary items
$17,400
Extraordinary 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) $ 2.21
Extraordinary loss
(.18)
Net income
$2.03
Earnings Per Share
63
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 Share
64
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 Share
65
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 Share
66
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.
Earnings Per Share
67
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 Share
68