# Diluted Earnings per Share

```StIce | StIce |Skousen
Earnings Per Share
Chapter 18
Intermediate Accounting
16E
Prepared by: Sarita Sheth | Santa Monica College
Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are
Learning Objectives
1.
2.
3.
4.
Know the difference between a simple and a
complex capital structure, and understand how
dilutive securities affect earnings per share
computations.
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.
Use the treasury stock method to compute
diluted earnings per share when a firm has
outstanding stock options, warrants, and rights.
Use the if-converted method to compute diluted
earnings per share when a company has
convertible preferred stock or convertible bond
outstanding.
Learning Objectives
5.
6.
7.
8.
Factor into the diluted EPS computations the effect
of actual conversion of convertible securities or the
exercise or options, warrants, or rights during the
period, and understand the anti-dilutive effect of
potential common shares when a firm reports a
loss from continuing operations.
Determine the order in which multiple potentially
dilutive securities should be considered in
computing diluted EPS.
Understand the disclosure requirements associated
with basic and diluted EPS computations.
Make complex EPS computations involving multiple
potentially dilutive securities.
Simple and Complex Capital
Structures
• Dilutive Securities- Securities whose
assumed exercise or conversion
results in a reduction in earnings per
share.
• Antidilutive Securities:- Securities
whose assumed conversion or exercise
results in an increase in earnings per
share.
Simple and Complex Capital
Structures
Basic
Considers only
common shares
issued and
outstanding.
Simple and Complex Capital
Structures
Basic
Considers only
common shares
issued and
outstanding.
Diluted
Reflects the
maximum
potential dilution
from all possible
stock conversions
that would have
decreased EPS.
Capital Structures
Simple Capital
Structure- The
corporation has only
common and
nonconvertible
preferred stock and
has no convertible
securities, stock
options, warrants, or
other rights
outstanding.
Complex Capital
Structure- The
corporation has one
or more instruments
outstanding that
could result in
common shares. For
example, a firm with
potential for per
share dilution.
Basic Earnings Per Share
The Basic Equation:
Net Income – Preferred Dividend
Weighted-Average
Common Shares Outstanding
The Complications:
– Issuance or reacquisition of
common stock
– Stock dividends or stock splits
Basic Earnings Per Share
Weighted-Average Number of Shares
–Shares Outstanding January 1:
–New Shares Issued May 1:
–Shares Repurchased November 1:
10,000
5,000
2,000
Jan. 1 to May 1
10,000 x 4/12 = 3,333
May 1 to Nov. 1
15,000 x 6/12 = 7,500
Nov. 1 to Dec. 31
13,000 x 2/12 = 2,167
Dec. 31 Weighted-average shares 13,000
Stock Dividends and Stock
Splits
–Shares outstanding January 1…….. 2,600
–Shares issued for exercise
of options on February 1………….
400
–Shares issued for 10% stock
dividend on May 1…………………..
300
–Shares sold for cash on September 1.. 1,200
–Shares repurchased on November 1… 400
–Shares issued for 3-for-1 stock split
on December 15……………………… 8,200
Stock Dividends and Stock
Splits
Date
1/1 to 2/1
2/1 Option
2/1 to 5/1
No. of
Stock Stock
Shares Dividend Split
2,600
400
3,000
Portion of
Year
Weighted
Average
Stock Dividends and Stock
Splits
No. of
Stock
Stock
Shares Dividend Split
Date
1/1
2/1
2/1
5/1
5/1
to 2/1
Option
to 5/1
Dividend
to 9/1
2,600
400
3,000
300
3,300
x 1.10
x 1.10
Portion of
Year
Weighted
Average
Stock Dividends and Stock
Splits
No. of
Stock
Stock
Shares Dividend Split
Date
1/1
2/1
2/1
5/1
5/1
9/1
9/1
to 2/1
Option
to 5/1
Dividend
to 9/1
Sale
to 11/1
2,600
400
3,000
300
3,300
1,200
4,500
x 1.10
x 1.10
Portion of
Year
Weighted
Average
Stock Dividends and Stock
Splits
Date
No. of
Stock
Stock
Shares Dividend Split
1/1 to 2/1
2/1 Option
2/1 to 5/1
5/1 Dividend
5/1 to 9/1
9/1 Sale
9/1 to 11/1
11/1 Purchase
11/1 to 12/1
2,600
400
3,000
300
3,300
1,200
4,500
(400)
4,100
x 1.10
x 1.10
Portion of
Year
Weighted
Average
Stock Dividends and Stock
Splits
Date
No. of
Stock
Stock
Shares Dividend Split
1/1 to 2/1
2/1 Option
2/1 to 5/1
5/1 Dividend
5/1 to 9/1
9/1 Sale
9/1 to 11/1
11/1 Purchase
11/1 to 12/1
12/1 Split
12/1 to 12/31
2,600 x 1.10
400
3,000 x 1.10
300
3,300
1,200
4,500
(400)
4,100
8,200
12,300
Portion of
Year
Weighted
Average
Stock Dividends and Stock
Splits
Date
No. of
Stock
Stock
Shares Dividend Split
1/1 to 2/1
2,600 x 1.10 x 3.0
2/1 Option
400
2/1 to 5/1
3,000 x 1.10 x 3.0
5/1 Dividend
300
5/1 to 9/1
3,300
x 3.0
9/1 Sale
1,200
9/1 to 11/1
4,500
x 3.0 x
11/1 Purchase (400)
11/1 to 12/1
4,100
x 3.0
12/1 Split
8,200
12/1 to 12/31 12,300
Weighted-average number of shares
Portion of
Year
Weighted
Average
x
1/12
=
715
x
3/12
= 2,475
x
4/12
= 3,300
2/12= 2,250
x
1/12= 1,025
x
1/12
= 1,025
10,790
Stock Dividends and
Stock Splits
• All stock splits and stock
dividends must be
incorporated into the
computation of weighted
average shares outstanding.
• This must done for all
periods presented in
the financial
statements.
• Current EPS figures may
have to be changed in the
future as a result of stock
splits or dividends.
Stop and Think
Why must basic EPS
associated with prior
stock splits or stock
dividends that occurred
in the current period?
Preferred Stock Included in
Capital Structure
• Basic EPS reflects only income
available to common stockholders; it
does not include preferred stock.
• Dividends on preferred stock should
be deducted from income before
extraordinary or other special items
from net income for EPS, if preferred
stock is in the capital structure.
Preferred Stock Included in
Capital Structure
To illustrate a simple capital structure for
two years, assume the following data:
•On December 31, 2006, the firm had
10,000 shares of preferred stock and
200,000 shares of common stock
outstanding.
• On June 30, 2007, issued 100,000
shares of common stock.
Preferred Stock Included in
Capital Structure
Date
No. of
Shares
1/1 to 6/30
200,000
Stock
Dividend
Portion of
Year
Weighted
Average
x 6/12
100,000
Preferred Stock Included in
Capital Structure
• On June 30, 2007 the firm paid:
– An 8% dividend on preferred stock (\$80,000)
– A \$0.30 per share dividend on common stock
(300,000 shares x \$0.30 = 90,000).
• No additional stocks were issued during
2007.
• These cash dividends would not affect the
weighted-average number of shares of
common stock.
• However, Retained Earnings would decrease
by \$170,000.
Preferred Stock Included in
Capital Structure
Date
No. of
Shares
1/1 to 6/30
7/1 to 12/31
200,000
300,000
Stock
Dividend
Portion of
Year
Weighted
Average
x 6/12
x 6/12
100,000
150,000
250,000
There are 250,000 weighted-average
shares outstanding in 2007
On May 1, 2008, the firm issued a
50% stock dividend on common stock.
Preferred Stock Included in
Capital Structure
2007
Date
No. of
Shares
1/1 to 6/30
7/1 to 12/31
Stock
Portion of
Dividend
Year
Weighted
Average
200,000
300,000
x 6/12
x 6/12
100,000
150,000
250,000
300,000
x 4/12
100,000
2008
1/1 to 4/30
The weight-average before considering
the stock dividend. The stock dividend
was the only stock transaction for 2008.
Preferred Stock Included in
Capital Structure
2007
Date
1/1 to 6/30
7/1 to 12/31
No. of
Shares
Stock
Portion of
Dividend
Year
Weighted
Average
200,000
300,000
x 6/12
x 6/12
100,000
150,000
250,000
300,000
450,000
x 4/12
x 8/12
100,000
300,000
2008
1/1 to 4/30
5/1 to 12/31
WAIT! We are not finished. The stock dividend
300,000 x 1.5
must be “rolled back” for all years displayed.
Preferred Stock Included in
Capital Structure
2007
Date
1/1 to 6/30
7/1 to 12/31
No. of
Shares
Stock
Portion of
Dividend
Year
Weighted
Average
200,000
300,000
x 1.5
x 1.5
x 6/12
x 6/12
150,000
225,000
375,000
300,000
450,000
x 1.5
x 4/12
x 8/12
150,000
300,000
450,000
2008
1/1 to 4/30
5/1 to 12/31
Preferred Stock Included in
Capital Structure
Assume that in 2007 the firm made a net
income, including a \$75,000 extraordinary
gain, of \$380,000.
Basic EPS (common), continuing operations (2007):
Net income
\$305,000
\$80,000 Dividends
after EI –– Preferred
Weighted-average
375,000 shares
shares
of of
common stock outstanding
Earnings per share from
continuing operations = \$0.60
Preferred Stock Included in
Capital Structure
Basic EPS (common),
extraordinary gain (2007):
Extraordinary
\$75,000 gain
Weighted-average
375,000 sharesshares
of
of common stock
outstanding
Earnings per share from
extraordinary gain = \$0.20
Preferred Stock Included in
Capital Structure
Basic EPS (common): net
income per share (2007):
Net income after EI – Preferred
Dividend
\$380,000 – \$80,000
Weighted-average
375,000 sharesshares
of
of common stock
outstanding
Earnings per share from
extraordinary gain = \$0.80
Preferred Stock Included in
Capital Structure
Assume that in 2008 the firm had a
net loss of \$55,000 and that there were
no extraordinary items.
Basic EPS (common), continuing operations (2005):
Net\$55,000
loss + Preferred
+
\$80,000
Dividends
Weighted-average
450,000 sharesshares
of
of common
stockdividends
Preferred
Note that a
outstanding
included
even
loss isare
.
though they were
not declared.
Basic loss per share
= \$(0.30)
Diluted Earnings per ShareOptions, Warrants, and Rights
• Dilution occurs if inclusion of a potentially
dilutive security reduces the basic EPS or
increases the basic loss per share.
• Proceeds from conversion are assumed to
be used for purchase of treasury stock at
current market price.
• Treasury stock is assumed to be reissued to
option or warrant holders.
• Any additional shares issued, over treasury
stock, are added to “weighted- average
shares outstanding.”
• Exercise is assumed to occur on the first
day of the year unless issue date is later.
Diluted Earnings per ShareOptions, Warrants, and Rights
• Number of shares of common stock
• Average market price of stock per
share during the year
• Exercise price per share on options
5,000
Number of shares sold
Proceeds from sale (5,000 x \$40) = \$200,000
Number of shares that could be
purchased with the proceeds
(\$200,000 &divide; \$50)
Number of shares used for diluted EPS
\$50
\$40
5,000
4,000
1,000
Diluted Earnings per ShareOptions, Warrants, and Rights
•Rasband Corporation had net income for the
year of \$92,800.
•There were 100,000 shares of common stock
outstanding all year.
•There are 20,000 options outstanding to
\$92,800
purchase shares.
100,000 = \$0.93
Basic EPS =
•The exercise price per share is \$6 and the
average market price during the year was \$10.
•The firm had a net income of \$92,800 and there
were 100,000 shares outstanding throughout the
year.
Diluted Earnings per ShareOptions, Warrants, and Rights
Proceeds from assumed exercise of options
outstanding (20,000 x \$6)
\$120,000
Number of outstanding shares assumed to
be repurchased with proceeds from options
(\$120,000 &divide; \$10)
12,000
Number of Shares to be Used in
Computing Diluted EPS
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
Diluted Earnings per ShareOptions, Warrants, and Rights
Diluted Earnings per Share:
\$92,800
108,000
The diluted
= \$0.86
EPS is less
than the basic
COMPARED TO— EPS, so it is
acceptable.
Basic Earnings per Share:
\$92,800
100,000
= \$0.93
Diluted Earnings per ShareConvertible Securities
• Convertible securities- potential new shares
of common stock that can become actual
common shares.
• There is no need for approval from existing
common shareholders.
• Conversion of these securities can
potentially impact the earnings that will
flow to the existing shareholders.
• To make them aware of the magnitude of
potential dilution use the if-converted
method for the EPS calculation.
Diluted Earnings per ShareConvertible Securities
Assume the following:
•Net income………………………\$10,000
•10% convertible bonds
issued 1/1/08………………..5,000
•15% convertible bonds
issued 7/1/08………………..2,000
•Common shares outstanding
(no changes during year)…10,000
•Tax rate……………………………….40%
Conversion terms:
•10% Bonds: 15 common shares per \$100 bond
•15% Bonds: 20 common shares per \$100 bond
Diluted Earnings per ShareConvertible Securities
Net income – Preferred dividend
Basic EPS =
Weighted-average
common shares outstanding
\$10,000
Basic EPS = 10,000
Basic EPS =
\$1.00
Diluted Earnings per ShareConvertible Securities
Net income
Interest savings
10% bond
15% bond
Less: tax effect
\$10,000
\$ 500
150
(260)
390
\$10,390
Actual shares outstanding
10,000
Incremental Shares:
10% bond (\$5,000/\$100 x 15) 750
15% bond (\$2,000/\$100 x 20
x 1/2)
200
950
Total shares assumed issued
10,950
Diluted Earnings per ShareConvertible Securities
Diluted =
EPS
Adjusted Net Income – Preferred Dividend
Total Shares Assumed Issued
Diluted EPS =
\$10,390
10,950
Diluted EPS = \$0.95
Diluted Earnings per ShareConvertible Securities
• Continually remind yourself
that the events you are
considering when computing
diluted EPS did not occur.
• Bonds were not
converted, options
were not exercised,
etc.
• Diluted EPS is providing
information as if these
events occurred.
Effect of Actual Exercise
or Conversion
Net Income…………...…………………….\$2,300,000
Common shares outstanding
at the beginning of the year………………..400,000
Options outstanding at the beginning of
the year to purchase equivalent shares....100,000
Proceeds from actual exercise or options
on 10/1 of current year…..…………………900,000
Market price of common stock
at exercise date 10/1…………………….……\$15.00
Effect of Actual Exercise
or Conversion
Basic EPS
\$2,300,000
425,000
?
= \$5.41
Actual number of shares outstanding for
full year
400,000
Weighted-average shares issued on
October 1 (100,000 x 3/12)
25,000
Weighted-average number of shares for
basic EPS
425,000
Effect of Actual Exercise
or Conversion
Diluted EPS
\$2,300,000
= \$5.05
455,000
?
Weighted-average number of shares for
basic EPS
425,000
Issued (assumed) exercise of options100,000
Less: assumed repurchase of shares
with proceeds (\$900,000 &divide; \$15) 60,000
Incremental shares
40,000
Weighted-average (40,000 x 9/12)
30,000
Weighted-average
455,000
Stop and Think
In the case of securities actually
converted during the year, why must
we assume conversion occurred at the
beginning of the period in the
computation of diluted EPS when we
know it did not?
Multiple Potentially Dilutive
Securities
• Remember that preferred
dividends were initially
subtracted from income to
arrive at income available to
common shareholders.
• When we assume conversion
of the preferred stock, those
back.
• When we assume conversion
of the preferred stock, those
back.
Multiple Potentially Dilutive
Securities
Financial Statement
Presentation
•
Firms are also 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.
Financial Statement
Presentation
3. Securities (antidilutive for the current
year) that could potentially dilute basic
EPS in the future that were not included
in comparative diluted EPS this period.
4. 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.
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