COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Earnings Per Share Chapter 18 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Prepared by: Sarita Sheth | Santa Monica College

Learning Objectives 1.Know the difference between a simple and a complex capital structure, and understand how dilutive securities affect earnings per share computations. 2.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. 3.Use the treasury stock method to compute diluted earnings per share when a firm has outstanding stock options, warrants, and rights. 4.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.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. 6.Determine the order in which multiple potentially dilutive securities should be considered in computing diluted EPS. 7.Understand the disclosure requirements associated with basic and diluted EPS computations. 8.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 Considers only common shares issued and outstanding. Basic

Simple and Complex Capital Structures Considers only common shares issued and outstanding. Basic Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS. Diluted

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 issuance of additional 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 The Complications : –Issuance or reacquisition of common stock –Stock dividends or stock splits

Basic Earnings Per Share –Shares Outstanding January 1:10,000 –New Shares Issued May 1:5,000 –Shares Repurchased November 1: 2,000 Weighted-Average Number of Shares Jan. 1 to May 110,000 x 4/12 =3,333 May 1 to Nov. 1 15,000 x 6/12 = 7,500 Nov. 1 to Dec ,000 x 2/12 = 2,167 Dec. 31 Weighted-average shares13,000

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………………… –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 1/1 to 2/12,600 2/1 Option 400 2/1 to 5/13,000 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average

Stock Dividends and Stock Splits No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average 1/1 to 2/12,600 x /1 Option 400 2/1 to 5/13,000 x /1 Dividend 300 5/1 to 9/13,300

Stock Dividends and Stock Splits No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average 1/1 to 2/12,600 x /1 Option 400 2/1 to 5/13,000 x /1 Dividend 300 5/1 to 9/13,300 9/1 Sale 1,200 9/1 to 11/1 4,500

Stock Dividends and Stock Splits No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average 1/1 to 2/12,600 x /1 Option 400 2/1 to 5/13,000 x /1 Dividend 300 5/1 to 9/13,300 9/1 Sale 1,200 9/1 to 11/1 4,500 11/1 Purchase (400) 11/1 to 12/1 4,100

Stock Dividends and Stock Splits No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average 1/1 to 2/12,600 x /1 Option 400 2/1 to 5/13,000 x /1 Dividend 300 5/1 to 9/1 3,300 9/1 Sale 1,200 9/1 to 11/1 4,500 11/1 Purchase (400) 11/1 to 12/1 4,100 12/1 Split 8,200 12/1 to 12/31 12,300

Stock Dividends and Stock Splits No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average 1/1 to 2/12,600 x 1.10 x 3.0 x 1/12= 715 2/1 Option 400 2/1 to 5/13,000 x 1.10 x 3.0 x 3/12= 2,475 5/1 Dividend 300 5/1 to 9/1 3,300 x 3.0 x 4/12= 3,300 9/1 Sale 1,200 9/1 to 11/1 4,500 x 3.0 x 2/12= 2,250 11/1 Purchase (400) 11/1 to 12/1 4,100 x 3.0 x 1/12= 1,025 12/1 Split 8,200 12/1 to 12/31 12,300 x 1/12= 1,025 Weighted-average number of shares 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 periods be adjusted for 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 June 30, 2007, issued 100,000 shares of common stock. On December 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of common stock outstanding.

Preferred Stock Included in Capital Structure 1/1 to 6/30200,000x 6/12100,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average

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 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 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150, ,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average 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 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150, , No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 4/12100,000 The weight-average before considering the stock dividend. The stock dividend was the only stock transaction for

Preferred Stock Included in Capital Structure 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150, , No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 4/12100,000 5/1 to 12/31450,000x 8/12300, ,000 x 1.5 WAIT! We are not finished. The stock dividend must be “rolled back” for all years displayed.

Preferred Stock Included in Capital Structure 1/1 to 6/30200,000x 1.5x 6/12150,000 7/1 to 12/31 300,000 x 1.5 x 6/12 225, , No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 1.5x 4/12150,000 5/1 to 12/31450,000x 8/12300, ,

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): – Preferred Dividends Weighted-average shares of common stock outstanding – $80, ,000 shares of Earnings per share from continuing operations = $0.60 Net income after EI $305,000

Preferred Stock Included in Capital Structure Basic EPS (common), extraordinary gain (2007): Weighted-average shares of common stock outstanding 375,000 shares of Earnings per share from extraordinary gain = $0.20 Extraordinary gain$75,000

Preferred Stock Included in Capital Structure Basic EPS (common): net income per share (2007): Weighted-average shares of common stock outstanding 375,000 shares of Earnings per share from extraordinary gain = $0.80 Net income after EI – Preferred Dividend $380,000 – $80,000

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 loss + Preferred Dividends Weighted-average shares of common stock outstanding $55,000 + $80, ,000 shares of Basic loss per share = $(0.30) Preferred dividends are included even though they were not declared. Note that a loss is added.

Diluted Earnings per Share- Options, 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.

Number of shares of common stock made available to employees 5,000 Average market price of stock per share during the year$50 Exercise price per share on options$40 Number of shares sold 5,000 Proceeds from sale (5,000 x $40) = $200,000 Number of shares that could be purchased with the proceeds ($200,000 ÷ $50)4,000 Number of shares used for diluted EPS1,000 Number of shares sold 5,000 Proceeds from sale (5,000 x $40) = $200,000 Number of shares that could be purchased with the proceeds ($200,000 ÷ $50)4,000 Number of shares used for diluted EPS1,000 Diluted Earnings per Share- Options, 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 purchase shares. 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. $92, ,000 Basic EPS = = $0.93

Diluted Earnings per Share- Options, 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 ÷ $10)12,000 Number of Shares to be Used in Computing Diluted EPS Actual number of shares outstanding100,000 Issued on assumed exercise of options 20,000 Less assumed options repurchased 12,000 8,000 Total108,000

Diluted Earnings per Share- Options, Warrants, and Rights Diluted Earnings per Share: $92, ,000 = $0.86 COMPARED TO— Basic Earnings per Share: $92, ,000 = $0.93 The diluted EPS is less than the basic EPS, so it is acceptable.

Diluted Earnings per Share- Convertible 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 Share- Convertible 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 Share- Convertible Securities Net income – Preferred dividend Weighted-average common shares outstanding Basic EPS = $10,000 10,000 $1.00 Basic EPS =

Diluted Earnings per Share- Convertible Securities Actual shares outstanding10,000 Incremental Shares: 10% bond ($5,000/$100 x 15) % bond ($2,000/$100 x 20 x 1/2) Total shares assumed issued 10,950 Net income$10,000 Interest savings 10% bond$ % bond 150 Less: tax effect (260) 390 Adjusted net income$ 10,390

Diluted Earnings per Share- Convertible Securities Adjusted Net Income – Preferred Dividend Total Shares Assumed Issued Diluted EPS Diluted EPS = $10,390 $0.95 Diluted EPS = = 10,950

Diluted Earnings per Share- Convertible 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 ,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 ? Actual number of shares outstanding for full year400,000 Weighted-average shares issued on October 1 (100,000 x 3/12) 25,000 Weighted-average number of shares for basic EPS425, ,000 = $5.41

Effect of Actual Exercise or Conversion Diluted EPS $2,300,000 ? = $ ,000 Weighted-average number of shares for basic EPS425,000 Issued (assumed) exercise of options100,000 Less: assumed repurchase of shares with proceeds ($900,000 ÷ $15) 60,000 Incremental shares 40,000 Weighted-average (40,000 x 9/12) 30,000 Weighted-average455,000

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 dividends must be added 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.