17 EARNINGS PER SHARE After studying this chapter, you should be able to: Understand why earnings per share (EPS) is an important number. Understand when and how earnings per share must be presented, including related disclosures. Calculate earnings per share for companies with a simple capital structure. Calculate earnings per share for companies with a complex capital structure. Identify the major differences in accounting between ASPE and IFRS, and what changes are expected in the near future.

Earnings Per Share Overview Basic EPS Diluted EPS IFRS/ASPE Comparison Objective of EPS Presentation and Disclosure Basic EPS Capital structure Income available to common/ordinary shareholders Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warrants Contingently issuable shares Antidilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS/ASPE Comparison Analysis Comparison of IFRS and private enterprise GAAP Looking ahead

Objective of EPS Earnings per share tells common shareholders how much of the available income is associated with the shares they own (their share of the pie) Provides insight to common shareholders about: Future dividend payout The value of their shareholdings Impact of other financial instruments on their potential earnings (Diluted EPS) L01

EPS Calculation = EPS Income available to common shareholders Weighted average number of common shares L01

EPS Calculation Basic 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 L01

Presentation & Disclosure Under IFRS, EPS must be reported as part of the income statement Exception: non public (privately held) corporations (not required under ASPE) Reported for each income component as reported on the income statement EPS relating to discontinued operations (if applicable) may be presented on face of income statement, or disclosed in notes 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 L02

Presentation & Disclosure If diluted EPS data are reported for at least one period, they should be reported for all periods that are presented, even if they are the same as basic EPS When the results of operations of a prior period have been restated as a result of a prior period adjustment, the EPS should also be restated The effect of the restatement should then be disclosed in the year of the restatement L02

Presentation & Disclosure - Example Income Statement Presentation of EPS Components Earnings per share: Income from continuing operations $4.00 Loss from discontinued operations, net of tax (.60) Net Income $3.40 L02

Presentation & Disclosure - Example EPS Presentation – Complex Capital Structure Earnings per common share: Basic earnings per share $3.80 Diluted earnings per share $3.35 L02

Presentation & Disclosure - Example EPS Presentation, with discontinued operations and complex capital structure Basic earnings per share: Income before discontinued operations $3.80 Discontinued operations (.80) Net Income $3.00 Diluted earnings per share: Income before discontinued operations $3.35 Discontinued operations (.65) Net Income $2.70 L02

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Capital structure Income available to common/ordinary shareholders Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warrants Contingently issuable shares Antidilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Analysis Comparison of IFRS and private enterprise GAAP Looking ahead

Capital Structure Method of EPS calculation based on the corporation’s capital structure Simple Capital Structure When only common shares and preferred share are issued and/or debt with no conversion rights Basic EPS calculated and presented Complex Capital Structure When common shares plus dilutive securities are issued (i.e. a potential common shares) Basic and Diluted EPS calculated and presented L03

Capital Structure Potential/ordinary shares are 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 (i.e. may cause EPS to decrease) Examples: debt and equity instruments that are convertible into common shares, warrants, and options Contingently issuable shares Shares issued for minimal consideration (asset exchange) once a certain condition has been met L03

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 Other Basic and Diluted EPS L03

EPS – Simple Capital Structure Common shareholders have a residual interest in the company’s income: Therefore, Income Available to Common Shareholders = Net Income - Preferred Share Dividends L03

EPS - Simple Capital Structure If the preferred shares are non-cumulative deduct only declared dividends If the preferred shares are cumulative deduct only declared dividends, or if no dividends declared, deduct only one year’s dividends L03

EPS - Simple Capital Structure If dividends on preferred shares are declared and a net loss occurs, the preferred dividend is added to the loss in calculating the loss per share In reporting earnings per share information, dividends declared on preferred shares should be subtracted from income from continuing operations and from net income In other words, dividends on preferred shares should not be deducted in calculating EPS from discontinued operations L03

EPS - Simple Capital Structure - Example Given: Michael Limited’s 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 Calculate the income available to common shareholders L03

EPS - Simple Capital Structure - Example 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 L03 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 The weighted average number of shares outstanding 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 L03

EPS - Simple Capital Structure - Example 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 L03

EPS - Simple Capital Structure - Example Dates Outstanding Shares Outstanding Fraction Weighted Shares Portion of Year Outstanding Weighted Shares Jan. 1st to March 31st 90,000 3/12 22,500 April 1st to June 30th 120,000 30,000 July 1st to October 31st 81,000 4/12 27,000 Nov 1st to Dec 31st 141,000 2/12 23,500 Weighted Average Shares Outstanding 103,000 L03

EPS - Simple Capital Structure Stock splits and stock dividends require restatement of the weighted average number of shares outstanding from the beginning of the year Because there has been no change in the company’s assets or in the shareholders’ total investment By restating the number, valid comparisons of earnings per share can be made between periods before and after the stock split or stock dividend L03

EPS - Simple Capital Structure 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 L03

EPS - Simple Capital Structure - Example 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 L03

EPS - Simple Capital Structure - Example 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 L03

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Capital structure Income available to common/ordinary shareholders Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warrants Contingently issuable shares Antidilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Analysis Comparison of IFRS and private enterprise GAAP Looking ahead

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 is not reported, only basic EPS L04

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 The purpose of presenting both EPS numbers is to inform financial statement users of situations that will likely occur and to provide worst-case situations L04

EPS - Complex Capital Structure 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) L04

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) L04

If Converted Method - Example Given: Net income for the year: $210,000 Common shares outstanding during the period: 100,000 Additional securities outstanding: 6% convertible debenture bond sold at 100 for $1,000,000, convertible to 20,000 common shares 10% convertible debenture bond sold at 100 for $1,000,000, convertible to 32,000 common shares and issued April 1st of current year Calculate diluted EPS assuming a tax rate of 30% L04

If Converted Method - Example Net income for the year $410,000 Add back: Interest on 6% debentures $60,000 x (1-.30) 42,000 Interest on 10% debentures $50,000 x (1-.30) x 9/12 26,250 Adjusted Net Income $478,250 L04

If Converted Method - Example Weighted Average Number of Shares 100,000 Add: Shares assumed issued: 6% debentures 20,000 10% debentures* 24,000 Adjusted Weighted Average Number of Shares 144,000 *32,000 shares x 9/12 L04

If Converted Method - Example 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 L04

Example - Field Corporation EPS Calculation and Disclosure: Net income for the year $410,000 Basic EPS ($410,000  100,000) $4.10 Diluted EPS ($478,250  144,000) $3.32 L04

Options and Warrants Options and warrants (and their equivalents) are included in EPS computations An option gives the holder the right to either buy or sell shares Generally speaking, the holder of options will exercise the right if the options are “in the money” They are “in the money” if the holder of the options will benefit from exercising them If company sells (or writes) options, they must be included in the diluted EPS calculations if dilutive Purchased options will always be antidilutive since they will only be exercised when they are in the money Therefore, they are not included in EPS L04

Treasury Stock Method Applies to written call options and equivalents Two assumptions under this method: The options 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 L04

Treasury Stock Method - Example 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 Calculate the incremental shares outstanding L04

Treasury Stock Method - Example Total proceeds from exercise (1,500 x $30) $45,000 Shares issued upon exercise of options 1,500 Treasury shares purchased with proceeds 900* Incremental shares outstanding 600 * ($45,000/$50) Dilution occurs because, on a net basis, more common shares are assumed to be outstanding after the exercise L04

Reverse Treasury Stock Method Applies to written 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 The exercise price per share must be greater than the market price per share for dilution to occur L04

Reverse Treasury Stock Method - Example 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 Calculate the incremental shares outstanding L04

Reverse Treasury Stock Method - Example Amount needed to buy 1,500 shares (1,500 x $30): $45,000 Shares issued to obtain $45,000 ($45,000  $20): 2,250 Number of shares purchased under the put option: 1,500 Incremental shares outstanding: 750 Dilution occurs because, on a net basis, more common shares are assumed to be outstanding after the exercise L04

Antidilution Revisited Securities that cause an increase in EPS if included in EPS calculations are antidilutive Antidilution can be identified by: Computing Diluted EPS resulting from the conversion and comparing it to Basic EPS Computing incremental EPS resulting from the conversion and comparing it to Basic EPS L04

Antidilution - Example Given: Kohl Corporation has $1 million in 6% convertible debt (convertible to 10,000 common shares) Net income is $210,000 100,000 common shares outstanding Tax rate: 30% Basic EPS = $2.10 per share Determine whether the convertible debt is dilutive L04

Antidilution - Example Test for Antidilution (Option #1 – Diluted EPS) Adjusted Net Income: Net Income $210,000 After-tax interest adjustment ($1.0m x 6%)(1-.30) 42,000 Adjusted Net Income $252,000 L04 Adjusted Number of Shares: Shares outstanding 100,000 Shares issued on conversion 10,000 Adjusted Number of shares 110,000

Antidilution - Example Basic EPS $2.10 Diluted EPS ($246,000  110,000) $2.24 Antidilutive, therefore not disclosed L04

Antidilution - Example Test for Antidilution (Option #2 – Incremental EPS) Incremental Net Income: After-tax interest adjustment ($1.0m x 6%)(1-.30) 42,000 Adjusted Net Income $ 42,000 L04 Incremental Number of Shares: Shares issued on conversion 10,000 Adjusted Number of shares 10,000

Antidilution - Example Basic EPS $2.10 Incremental EPS ($42,000  10,000) $4.20 Antidilutive, therefore not disclosed L04

Additional Disclosures Disclosed in notes to financial statements: Amounts used in both numerator and denominator in calculating basic and diluted EPS Reconciliation of both the numerator and denominator values for basic and diluted earnings per share calculations for income before discontinued operations Potentially dilutive securities that were not included in the calculation of EPS because they were antidilutive Description of common share transactions after reporting period that could have impacted EPS numbers L04

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Capital structure Income available to common/ordinary shareholders Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warrants Contingently issuable shares Antidilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Analysis Comparison of IFRS and private enterprise GAAP Looking ahead

Analysis EPS is one of the most highly visible standards of measurement for assessing: Management stewardship and Predicting a company's future value IFRS is therefore very specific regarding its calculation L05

Comparison of IFRS and ASPE ASPE does not include standards for calculating EPS L05

Looking Ahead EPS standards continue to be revisited as accounting rules for underlying financial instruments evolve L05

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