Selected Additional Text Solutions - Chapter 19: Earnings Per Share

Exclusions: EPS calculations for multiple classes of common shares

Questions: note somequestions may not be relevant but all are included
1. EPS is used to indicate each share’s proportionate amount of company earnings. It
is a widely used indicator of a corporation’s financial performance in financial
markets and is important to managers, analysts and shareholders. Trends are often
significant when projecting future performance.

2. Public companies are required to disclose EPS, although non-public companies

may do so if relevant to their shareholders or other stakeholders.

3. The formula for basic EPS is,

Net income available to common shareholders

Weighted average number of common shares outstanding

The numerator is net income, less preferred dividends declared (or preferred
dividend entitlements, if shares are cumulative). Other returns to senior securities,
like losses on share retirement, must also be deducted from the numerator. The
denominator is the average number of shares outstanding, weighted to their day of
issuance. Shares issued due to a stock dividend or a stock split are weighted back
to the beginning of the period, an exception to the weighted-average rule.

4. Dividends on non-cumulative preferred shares are deducted to establish net income

available to common shareholders. Such dividends are deducted only to the extent
that they are declared by the board of directors during the year. If the dividend is
“passed over,” then the preferred shareholders lose their claim and all remaining
income accrues to the benefit of the common shareholders. (Dividends on
cumulative preferred shares are deducted whether declared or not, as they are a
permanent claim on retained earnings if undeclared.)

5. In addition to preferred share dividends, the numerator of the basic EPS calculation
must be adjusted for any loss on retirement of preferred shares, recorded in various
equity accounts. These adjustments render the numerator equal to net income
available to common shareholders.

6. Weighted average common shares outstanding are used to relate earnings to the
capital base used to generate those earnings. Since income was earned over the
year, the capital base must also be measured over that period—not at the
beginning, end, or middle. Common shares are used because the ratio relates only
to common equity, not total equity investment.

7. The stock split should be accounted for retroactively when determining the number
of shares outstanding. The 30 June stock split would be backdated to 1 January of
the current year, and back through the comparatives. Therefore, 8,000 (4,000 x 2)

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shares would be used this year. If 4,000 shares had been outstanding in the prior
year, this would be doubled to 8,000 to recast the EPS comparatives.

8. Weighted average common shares would equal:

100,000 x 5/12 x 1.2 = 50,000
80,000 x 4/12 x 1.2 = 32,000
(80,000 x 1.2) x 2/12 = 16,000
106,000 x 1/12 = 8,833
106,833

9. If there are extraordinary items or gains/losses from discontinued operations on the

income statement, EPS (basic, diluted) must be shown for:
1. Income before the discontinued operation or extraordinary item, and
2. The discontinued operation or extraordinary item, and
3. Net income
The per-share impact of the extraordinary item or discontinued operation may be
shown in the notes but the other disclosures must be on the face of the income
statement.

10. If a company has two classes of shares with the characteristics of common shares,
both are treated as common shares in the calculation of basic EPS. The two classes
are weighted based on their relative dividend entitlement—here, one is worth ten
times the other.

11. Diluted EPS is a ‘what if’ figure that reports the impact of dilutive elements in a
company’s capital structure, which could convert to common shares in the future.
Convertible bonds, convertible senior shares and options all must be considered, as
well as actual conversions. Diluted EPS indicates the maximum potential decline in
earnings if the company’s financing strategy – the conversion of securities and
exercise of options – is successful. This statistic is designed to serve users who are
trying to assess future prospects.

12. Convertible senior securities are securities that are senior to common shares in their
rights and privileges, that are also convertible into common shares.

13. Diluted EPS begins with the basic EPS numerator and denominator. Then, the
denominator is increased by shares that would be issued if (dilutive, or in-the-
money) options were exercised, and decreased by the number of shares that could
be purchased and retired with the option proceeds. Potentially dilutive elements are
then ranked, with the most dilutive element included first. Anti-dilutive elements
are excluded. (In this question, elements are stated to be dilutive). These items
include the effect of backdating the actual conversion of preferred shares to the
beginning of the year, adding dividends to the numerator and additional shares to

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the denominator. Also, conversion of the remaining preferred shares at the

beginning of the year is assumed, and dividends are added to the numerator and
additional common shares added to the denominator. The resulting fraction is
diluted EPS.

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14. Diluted EPS starts with the calculations used for basic EPS for income before
discontinued operations and extraordinary items.

15. Changes to the numerator and denominator for diluted EPS:

Element Numerator Denominator

Convertible Increase by dividend Increase by shares issued

Preferred shares claim avoided
Decrease
By loss on retirement

Convertible Increase by after-tax Increase by shares issued

Debt interest avoided

Options None Increase by shares issued

Decrease by shares retired
(Proceeds/ market value)

16. In relation to the outstanding options, the denominator of diluted EPS would
increase by 100,000 shares assumed issued, and decrease by 40,000 ((100,000 x
$10)/$25) shares assumed retired.

17. Dilutive and anti-dilutive securities are defined when calculating diluted EPS. A
dilutive security is one that causes a reduction in the earnings per share amount.
An anti-dilutive security is a security that causes the opposite effect, that is, an
increase in the earnings per share amount above that which would otherwise be
reported. The distinction is important in earnings per share considerations because
dilutive securities are included in the computation of diluted earnings per share,
whereas anti-dilutive securities are omitted.

18. Diluted EPS is $1.03 ($1,250,000 + (($320,000)(1 - .4)))/(1,000,000 + 400,000).

The bonds are dilutive since diluted EPS is lower than basic EPS of $1.25.

19. Diluted EPS is $0.98 ($1,250,000 + (($320,000)(1 - .4)))/(1,000,000 + 100,000 –

((100,000 x $10)/$40) + 400,000).

20. The numerator of diluted EPS would be increased by $50,000 (50,000 shares x $1).
The denominator would be increased by 100,000 shares (50,000 x 8 x 3/12). Note
that the assumed conversion is backdated only to the date of issuance.

21. Diluted elements are included from most dilutive to least dilutive, in a cascade.
Convertible bonds are the most dilutive, at $6, and would be included first. The
convertible preferred shares, with an individual effect of $12, would be second. If

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bonds reduce EPS to a subtotal below $12, then the convertible preferred shares
would be anti-dilutive and excluded.

22. Yes, the convertible preferred shares, with an individual effect of $4, are dilutive.
EPS is $6 based on income before discontinued operations, and this is the reference
point. $4 is less than $6. On the other hand, EPS based on net income, now $2,
will increase as a result of including this $4 dilutive element, but classifications are
made once and done consistently thereafter.

23. Interest expense is different than interest paid when there is premium or discount
amortization (discount amortization, in this case). The premium or discount would
have been recognized when the bond was originally issued. Interest expense, not
interest paid, is relevant in the calculation of diluted EPS, because the focus is on
the change in net income.

24. Adjustments to the denominator of diluted EPS are made for dilutive options,
calculated by quarter if the information is available.
Quarter 1 – anti-dilutive; exercise price is higher than share price
Quarter 2 – shares issued: 40,000 x 3/12 = 10,000;
shares retired, $400,000/$16 x 3/12 = 6,250
Quarter 3 – shares issued: 40,000 x 3/12 = 10,000;
shares retired, $400,000/$25 x 3/12 = 4,000
Quarter 4 – anti-dilutive; exercise price is higher than share price
Total – shares issued, 20,000; shares retired, 10,250.

25. Options are said to be in the money if the exercise price is less than the market
value of the shares. They are dilutive in this case, as more shares would be issued
than assumed retired.

26. Diluted EPS is unchanged from basic, a loss of $(1.11). All potentially dilutive
elements are anti-dilutive in a loss year, as they reduce the loss per share.

27. EPS of prior years must be restated if there has been a retrospective change in
accounting principle or an error correction that altered the reported results of prior
periods, or if there was a stock dividend or split in the current year.

28. When a company issues shares and redeems debt after the fiscal year-end but
before the audit report is signed, the effect on outstanding shares and EPS must be
disclosed. This is required because the new capital structure will be in place during
the next fiscal year, and financial statement readers must be alerted.

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Assignment 19-11 WEB

Earnings Weighted Earnings

available to average per
common shareholders number of shares Share
Basic EPS:
Net income $366,000
Preferred shares (30,000 x $.50) (15,000)
$351,000

Shares outstanding
150,000 x 6/12 75,000
450,000 x 5/12 187,500
516,000 (1) x 1/12 43,000
305,500
Basic EPS $1.15

(1) ($600,000/$1,000 x 110) + 450,000

Individual effect:
Preferred shares
Dividend avoided 15,000
Shares issued 30,000 x 2 60,000 $0.25
Actual conversion:
Interest avoided
$47,250 x (1-.3) 33,075
Shares issued
($600,000/$1,000) x 110 x 11/12 60,500 $0.55

Diluted EPS:
Basic EPS $351,000 305,500 $1.15
Preferred shares
Dividend avoided 15,000
Shares issued 30,000 x 2 ______ 60,000
366,000 365,500 1.00
Actual conversion:
Interest avoided 33,075
Shares issued

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60,500
Diluted EPS $399,075 426,000 $0.94

Assignment 19-19 WEB

Earnings available to Weighted average Earnings
common shareholders number of shares per Share
Basic EPS
Net income $600,000
Note: preferred dividends are
already deducted from net income _______
600,000
Shares outstanding
48,000* x 3/12 12,000
60,000 x 9/12 45,000
57,000
Basic EPS $10.53

* Bonds: ($1,500,000 / 1,000) x 8 = 12,000; 60,000 – 12,000 = 48,000

Individual effect:
Actual conversion, 12% debentures
Bond interest $48,000 x (1-.4) 28,800
Shares 12,000 x 3/12 3,000 $9.60
12% debentures outstanding
Interest
($624,000 - $48,000) x (1-.4) 345,600
Shares:
($4,500,000 / $1,000) x 8 36,000 9.60
12.4% debentures
Interest ($450,000) x (1-.4) $270,000
($3,000,000 / $1,000) x 8 24,000 $11.25

The options are anti-dilutive because exercise price is greater than market value. The
individual effect of the 12% debenture items are identical and their order is irrelevant.
The 12.4% debenture is anti-dilutive.

Diluted EPS:
Basic EPS 600,000 57,000 $10.53
Actual conversion:
Bond interest 28,800
Shares 3,000
12% debentures
Interest 345,600

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Shares ______ 36,000

Diluted EPS $974,400 96,000 $10.15

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Assignment 19-21 WEB

Requirement 1

Options: Shares issued Shares retired

Quarter 1 - 40,000 x 3/12 10,000
(40,000 x $25)/$40) x 3/12 6,250
Quarter 2 – anti-dilutive ($25 > $15)
Quarter 3 – anti-dilutive ($25 > $20)
Quarter 4 - 40,000 x 3/12 10,000
(40,000 x $25)/$35) x 3/12 ______ 7,143
20,000 13,393

Bonds: $562,000(1 - .4) = $3.37

($5,000,000/$1,000) x 20

Preferred shares 300,000 x $1.50 = $0.75

(300,000 x 2*)
*The most dilutive alternative is used.

Requirement 2
Earnings available to Weighted average Earnings
common shareholders number of shares per Share

Basic EPS:
Earnings $1,800,000
Less: preferred dividends ( 450,000)
1,350,000
Shares (given) 450,000
Basic EPS $3.00
Diluted EPS:
Options:
Shares issued 20,000
Shares retired _______ (13,393)
Subtotal 1,350,000 456,607 $2.96
Preferred Shares
Dividends (300,000 x $1.50) 450,000
Shares (300,000 x 2) 600,000
Bonds - Anti-dilutive; excluded
________
Diluted EPS $1,800,000 1,056,607 $1.70

Requirement 3

Basic and diluted EPS would be ($200,000 + $450,000)/ 450,000 = ($1.44).

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All potentially dilutive elements are anti-dilutive in a loss year.

Assignment 19-33 WEB

Earnings available to Weighted average Earnings

common shareholders number of shares per Share
Basic:
Net income $18,000,000
Preferred dividends
600,000 x $.20 ( 120,000)
$17,880,000
Average shares
3,300,000 x 12/12 3,300,000
3,320,000 (1) x 0/12 0
Basic EPS $5.42

(1) 10,000 x 2 = 20,000 shares issued on conversion 31 December 20x6

Individual effect of:

1. Preferred shares $.20 x 600,000 = $120,000 = $.20

600,000 600,000

2. Options Shares issued: 500,000 x 9/12 = 375,000 (Dilutive in three

quarters only)
Shares retired: 243,706
First quarter: ($53 x 500,000)/$100 x 3/12 = 66,250
Second quarter: ($53 x 500,000)/$80 x 3/12 = 82,813
Fourth quarter: ($53 x 500,000)/$70 x 3/12 = 94,643

3. Debentures [($9,000,000 x .10) + ($20,000 x .9)] (1 - .4) = $550,800 = $3.06

(9,000,000 / 100) x 2) 180,000

4. Debentures, converted

[($1,000,000 x .10) + ($20,000 x .1)] (1 - .4) = $61,200 = $3.06

(1,000,000 / 100) x 2) 20,000

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Earnings available to Weighted average Earnings

common shareholders number of shares per Share
Diluted:
Basic, above $17,880,000 3,300,000 $5.42
Options
Shares issued 375,000
Shares retired _________ (243,706)
$17,880,000 3,431,294 $5.21
Preferred shares
Dividends/Shares 120,000 _600,000
$18,000,000 4,031,294 $4.47
Actual conversion of debentures
Income 61,200
Shares 20,000
Debentures
Interest; Shares ___550,800 _180,000
Diluted EPS $18,612,000 4,231,294 $4.40

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