Gabriela H. Schneider, CMA Northern Alberta Institute of Technology INTERMEDIATE ACCOUNTING Seventh Canadian Edition KIESO, WEYGANDT, WARFIELD, YOUNG, WIECEK Prepared by: Gabriela H. Schneider, CMA Northern Alberta Institute of Technology 2

C H A P T E R 18 Earnings Per Share

Learning Objectives Understand why EPS is an important number. Understand when and how EPS is required to be presented. Identify potential common shares. Calculate earnings per share in a simple capital structure.

Learning Objectives Calculate diluted earnings per share using the if-converted method. Calculate diluted earnings per share using the treasury stock method. Calculate diluted earnings per share using the reverse treasury stock method. Identify antidilutive potential common shares.

Earnings Per Share Overview Objective Presentation and disclosure Basic EPS Simple capital structure Income available to common shareholders Weighted average common shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities If-converted method Options and warrants Treasury stock method Reverse treasury stock method Contingently issuable shares Antidilution revisited Additional disclosures Comprehensive illustration Perspectives Usefulness of EPS

Importance of EPS Calculated for common shares Tells shareholders how much of the available income is associated with the shares they own (their share of the pie) Provides insight to shareholders Future dividend payout Future share value Impact of other financial instruments on their potential earnings (Diluted EPS)

EPS Calculation Basic EPS Diluted EPS Actual earnings and actual number of issued common shares Diluted EPS Earnings and number of common shares adjusted for “what-if” What would the EPS be if any financial instruments that could be converted to common shares were actually converted

EPS Calculation = Income available to common shareholders EPS Weighted average number of common shares

EPS Disclosure CICA Handbook, Section 3500.60 requires EPS to be reported as part of the income statement Exception: non public (privately held) corporation Reported for each income component as reported on the income statement Where applicable, both Basic EPS and Diluted EPS reported Presented for all periods reported Prior period EPS restated for any stock dividends or stock splits

EPS Disclosure Income Statement Presentation of EPS Components Earnings per share: Income from continuing operations $4.00 Loss from discontinued operations, net of tax (.60) Extraordinary gain, net of tax 1.00 Net Income $4.40

EPS Disclosure EPS Presentation – Complex Capital Structure Earnings per common share: Basic earnings per share $3.30 Diluted earnings per share $2.70

EPS Disclosure EPS Presentation, with Extraordinary Item Basic earnings per share: Income before extraordinary item $3.80 Extraordinary item .80 Net Income $3.00 Diluted earnings per share: Income before extraordinary item $3.35 Extraordinary item 65 Net Income $2.70

Brief Exercise BE 18-9 EPS Presentation for Schrempf Corp. Net Income $1,480,000 Extraordinary Loss $ 220,000 Common shares outstanding 50,000

Brief Exercise BE 18-9 Basic Earnings Per Share Total EPS Income before extraordinary loss $1,700,000 $34.00 Extraordinary loss 220,000 (4.40) Net Income $1,480,000 $29.60

Capital Structure Method of EPS calculation based on the corporations capital structure Simple Capital Structure When only common shares are issued Basic EPS calculated Complex Capital Structure When common shares plus dilutive securities are issued Potential common shares Diluted EPS calculated

Potential Common Shares Securities, or other financial instruments issued by a corporation that have an option for the holder to convert the security into common shares This conversion could have a negative, or dilutive effect on EPS Cause EPS to decrease Contingently issuable shares Shares issued for minimal consideration (asset exchange) once a certain condition has been met

EPS Reporting Requirements Capital Structure Major Types of Equity Instruments Impact on EPS Calculations Simple Common shares Preferred shares Basic EPS only Complex Potential Common shares: Convertible preferred shares Convertible debt Options/warrants Contingently issuable Basic and Diluted EPS

EPS - Simple Capital Structure Net Income – Preferred Dividends Weighted Average # of Shares Outstanding If the preferred shares are non-cumulative include only declared dividends If the preferred shares are cumulative include only declared dividends, or if no dividends declared, include only one year’s dividends

EPS – The Numerator Example: Michael Limited Net Income $3,000,000 Shares 100,000 Class A preferred, cumulative shares, dividend amount $4.00 per share 100,000 Class B preferred, non-cumulative shares, dividend amount $3.00 per share No dividends declared or paid in the current year

EPS – The Numerator Net Income $3,000,000 Amount attributable to Class A: 100,000 x $4.00 400,000 2,600,000 Amount attributable to Class B: 100,000 x $0.00 -0- Income available to common shareholders $2,600,000 The Class B shares are non-cumulative, with no dividends declared for the year no amount is deducted from Net Income

EPS - Simple Capital Structure Net Income – Preferred Dividends Weighted Average # of Shares Outstanding Number of shares issued is weighted by the period of time they were outstanding Each transaction (issue of shares, reacquisition of shares, retirement of shares) represents a weighting period

EPS – The Denominator Date Share Changes Shares Outstanding January 1 Beginning balance 90,000 April 1 30,000 shares issued 120,000 July 1 39,000 shares purchased 81,000 November 1 60,000 shares issued 141,000 December 31 Year end balance

EPS – The Denominator Dates Outstanding Shares Outstanding Fraction Weighted Shares Portion of Year Outstanding Weighted Shares Jan. 1st to April 1st 90,000 3/12 22,500 April 1st to July 1st 120,000 30,000 July 1st to Nov 1st 81,000 4/12 27,000 Nov 1st to Dec 31st 141,000 2/12 23,500 Weighted Average Shares Outstanding 103,000

EPS – The Denominator Net Income – Preferred Dividends Weighted Average # of Shares Outstanding Stock splits and stock dividends require restatement of the outstanding number of shares from the beginning of the year Because there has been no change in the company’s assets, or in the shareholders’ total investment

EPS – The Denominator A final note (CICA Handbook, Section 3500) If there is a stock split or stock dividend after the year end but before the publication of the financial statements The weighted average number of shares outstanding must be restated This applies to the current year, as well as previous years if comparative statements are issued

EPS – The Denominator Given – Baiye Limited: January 1: 100,000 shares outstanding March 1: Issued 20,000 shares June 1: 50% Stock dividend (60,000 additional shares issued) November 1: Issued 30,000 shares December 31: Ending Balance = 210,000 shares outstanding

EPS – The Denominator Dates O/S Shares O/S Restatement Fraction of Year Weighted Shares Jan-Mar 100,000 X 1.50 X 2/12 = 25,000 Mar-Jun 120,000 3/12 = 45,000 Jun-Nov 180,000 X 5/12 = 75,000 Nov-Dec 210,000 35,000 Weighted average shares outstanding

Complex Capital Structure When corporation has convertible securities, options, warrants or other rights, and When converted these could dilute EPS Dilution is the reduction in EPS, if: Securities, potentially convertible into common stock, are converted (assumed at beginning of the year) Anti-dilutive securities Securities, when converted, increase EPS Anti-dilutive EPS are not reported, only basic EPS

EPS - Complex Capital Structure Requires dual presentation of EPS Basic earnings per share Presented for each separate class of common share Fully diluted earnings per share Only securities that reduce earnings per share (dilutive) are considered Securities that increase earnings per share (anti-dilutive) are ignored

Diluted Earnings per Share - Methods The dilutive effect of convertible securities is measured by the if-converted method The dilutive effect of options and warrants is measured by the treasury stock method For computing dilution, the rate of conversion most advantageous to the security holder is used (maximum dilutive conversion rate)

The If-Converted Method The conversion of the securities into common stock is assumed to occur at the beginning of the year The net income must be adjusted for: Interest (net of tax) on the convertible debt Dividends on the convertible preferred shares The weighted average number of shares is increased by the additional common shares assumed issued (at the beginning of year)

The If-Converted Method Adjust Net Income Convertible debt issues Income is adjusted for the after-tax interest that would not have been paid if the debt were converted to common shares Interest adjusted for any premium or discount amortization Convertible preferred shares No adjustment to the numerator required if there are convertible preferred shares Adjust (re-calculate) weighted average number of shares Adjusted as if all convertible securities were converted to common shares

Field Corporation Net Income for the Year $210,000 Add back: Interest on 6% debentures $60,000 x (1-.40) 36,000 Interest on 10% debentures $100,000 x (1-.40) 45,000 Adjusted Net Income $291,000

Field Corporation Unadjusted Weighted Average Number of Shares 100,000 Add: Shares assumed issued (converted) 6% debentures 20,000 10% debentures * 24,000 Weighted Average Number of Shares 144,000

Field Corporation Conversion is always assumed to be at the beginning of the year If a convertible security is not outstanding for the full 12 months of the year Conversion is pro-rated for the number of months the convertible security is actually issued Field Corporation 10% debenture was issued April 1st, therefore the conversion is 32,000 shares times 9 out of 12 months

Field Corporation EPS Calculation and Disclosure Net Income $210,000 Basic EPS $210,000  100,000 $2.10 Diluted EPS $291,000  144,000 $2.02

The Treasury Stock Method Options and warrants (and their equivalents) included in EPS computations Options and warrants are assumed exercised at the beginning of the year The proceeds from the exercise of options are assumed to be used to buy back common shares The exercise price per share must be less than the market price per share for dilution to occur

Options and Warrants - Treasury Stock Method Given: Exercise price of an option (for one share of stock) $ 30 Market price of one share at exercise date: $ 50 Options deemed exercised: 1,500 Compute the number of weighted shares for determining diluted earnings per share Total proceeds from exercise: $45,000 Shares issued on exercise: 1,500 Assumed reacquisition of shares: 900 Dilution: 1,000 - 250 = 750 Shares (increase in outstanding shares)

Reverse Treasury Stock Method Used with put options and forward purchase contracts Two assumptions under this method Enough common shares issued at beginning of the year for the company to purchase shares under the option or forward contract Proceeds from the share issue will be used to purchase shares under the option or forward contract

Reverse Treasury Stock Method Given: Exercise price of an option (for one share of stock) $ 30 Market price of one share at exercise date: $ 20 Options deemed exercised: 1,500 Compute the number of weighted shares for determining diluted earnings per share Amount needed to buy back the 1,500 shares: (1,500 * $30) $45,000 Shares issued to acquire needed cash: ($45,000  $20) 2,250 Number of shares purchased through put: 1,500 Dilution: 2,250 – 1,500 = 750 Shares (increase in outstanding shares)

Antidilutive Potential Common Shares Securities that cause an increase in EPS if included in EPS calculations Convertible debt antidilutive if conversion increases EPS to increase by a greater amount than EPS before conversion For example:

Antidilutive EPS Kohl Corporation $1 million in 6% convertible debt – convertible to 10,000 common shares Net Income is $210,000 100,000 common shares outstanding Basic EPS = $2.10 per share

Antidilutive Shares Test for Antidilution Adjusted Net Income: Net Income $210,000 After-tax interest adjustment ($1.0m x 6%)(1-.40) 36,000 Adjusted Net Income $246,000 Adjusted Number of Shares: Shares outstanding 100,000 Shares issued on conversion 10,000 Adjusted Number of shares 110,000

Antidilutive Shares Diluted EPS = $246,000  110,000 = $2.24 Basic EPS = $2.10 Antidilutive, therefore not disclosed

Earnings per Share: Complex Structures - Summary Dual EPS Presentation Basic EPS Diluted EPS Net Income adjusted for interest (net of tax) and preferred dividends Weighted average number of common shares assuming maximum dilution Dilutive Convertibles Dilutive Options and Warrants Dilutive Contingent Issues

Additional Disclosure Disclosed in notes to financial statements Adjustments to income Reconciliation of both the numerator and denominator values Potentially dilutive securities

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