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.

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.

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.

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.

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.

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.