Financial Accounting II Lecture 43

Diluted EPS At the end of an accounting period, a company may have in issue some securities which do not (at present) have any claim to a share of equity earnings, but may give rise to such a claim in the future. These securities include. A separate class of equity shares which at present is not entitled to any dividend, but will be entitled after some future date.

Diluted EPS Convertible loan stock or convertible preferred shares which give their holders the right at some future date to exchange their securities for ordinary shares of the company, at a pre-determined conversion rate. Options or Warrants.

Diluted EPS In such circumstances, the future number of shares ranking for dividend might increase, which in turn results in a fall in the EPS. In other words, a future increase in the number of equity shares will cause a dilution or “watering down” of equity, and it is possible to calculate a diluted earnings per share (i.e. the EPS that would have been obtained during the financial period if the dilution had already taken place). This will indicate to investors the possible effects of a future dilution.

Effects on EPS of Changes in Capital Structure We looked at the effect of issues of new shares or buy-backs of shares on basic EPS above. In these situations, the corresponding figures for EPS for the previous year will be comparable with the current year because, as the weighted average of shares has risen or fallen, there has been a corresponding increase or decrease in resources. Money has been received when shares were issued, and money has been paid out to repurchase shares. It is assumed that the sales or purchases have been made at full market price.

Effects on EPS of Changes in Capital Structure But there are other events, however, which change the number of shares outstanding, without a corresponding change in resources. In these circumstances it is necessary to make adjustments so that the current and prior period EPS figures are comparable. Four such events are considered by IAS 33 these are

Effects on EPS of Changes in Capital Structure Capitalisation or bonus issue. Bonus element in any other issue. e.g. a right issue to existing shareholders. Share split Reverse share split (Consolidation of shares)

Presentation of EPS Basic and diluted EPS should be presented by an enterprise on the face of the income statement for each class of ordinary share that has a different right to share in the net profit for the period. The basic and diluted EPS should be presented with equal prominence for all periods presented.

Disclosure of EPS Disclosure must still be made where the EPS figures (basic and/or diluted) are negative (i.e. a loss per share) The amounts used as the numerators in calculating basic and diluted EPS, and a reconciliation of those amounts to the net profit or loss for the period. The weighted average number of ordinary shares used as the denominator in calculating basic and diluted EPS, and a reconciliation of these denominators to each other.

Significance of Earnings per Share EPS has served as a means of assessing the stewardship and management role performed by company directors and managers. Remuneration packages might be linked to EPS growth, thereby increasing the pressure on management to improve EPS. The danger of this, however, is that management effort may go into distorting results to produce a favorable EPS.