2. PARENT AND CONSOLIDATED EARNINGS PER SHARE All firms need to calculate and report basic and diluted (where applicable) earnings per share (EPS). Consolidated entities disclose EPS on a consolidated basis.

3. PARENT AND CONSOLIDATED EARNINGS PER SHARE A parent’s net income and EPS under the equity method are equal to the controlling share of consolidated net income and controlling share of consolidated EPS. However, the computational differences in determining parent and consolidated net income (that is, one-line consolidation versus consolidation) do not extend to EPS calculations.

4. PARENT AND CONSOLIDATED EARNINGS PER SHARE Parent procedures for computing EPS depend on the subsidiary’s capital structure. When the subsidiary (or equity investee) has no potentially dilutive securities, the procedures applied in computing consolidated EPS are the same as for separate entities. When the subsidiary does have potentially dilutive securities outstanding, the potential dilution has to be considered in computing the parent’s diluted EPS.

5. PARENT AND CONSOLIDATED EARNINGS PER SHARE We compute basic EPS the same way for a consolidated entity as for separate entities (assuming the equity method is used).

6. Convertible into subsidiary common stock The nature of the adjustment to parent EPS calculations depends on whether the subsidiary’s potentially dilutive securities are convertible into subsidiary or parent common stock. If convertible into subsidiary common stock, we reflect the potential dilution in subsidiary EPS computations, which are then used in determining parent (and consolidated) EPS.

7. Convertible into parent company common stock If the dilutive securities of the subsidiary are convertible into parent company common stock, we treat them as parent dilutive securities and include them directly in computing the parent EPS. We do not need subsidiary EPS computations in parent EPS computations.

8. General formats for EPS calculations General formats for EPS calculations in these situations are summarized in Exhibit 10-3 for diluted EPS.

9. Subsidiary has no potentially dilutive securities The first column of Exhibit 10-3 EPS computations are the same as those for unrelated entities, and no adjustments are necessary for subsidiary income included in parent income.

11. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares The second column of Exhibit 10-3 We adjust diluted earnings of the parent (the numerators of the EPS calculations) by excluding the parent’s equity in subsidiary realized income and replacing that equity with the parent’s share of diluted earnings of the subsidiary.

12. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares Parent’s equity in subsidiary realized income is the parent’s percentage interest in reported income of the subsidiary adjusted for the effects of intercompany profits from upstream sales and constructive gains or losses of the subsidiary.

13. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares Note that “parent’s equity in subsidiary’s realized income” in column 2 of Exhibit 10-3 differs from “parent’s income from subsidiary,” which includes amortization of valuation differentials and the income effects of all intercompany transactions. The parent’s investment valuation differentials, unrealized profits from downstream sales, and constructive gains and losses assigned to the parent do not affect the equity of the subsidiary’s security holders; therefore, we exclude these items from the replacement calculation.

14. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares This adjustment to remove the potential dilution from the parent’s diluted earnings is based on separate EPS computations for the subsidiary. We make these computations of subsidiary EPS only for the purpose of calculating the parent’s EPS, and they are not necessarily the same as those prepared by the subsidiary for its own external reporting.

15. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares We use the subsidiary’s diluted EPS in determining diluted earnings of the parent (see column 2of Exhibit 10-3 ), so EPS computations for the subsidiary (based on subsidiary realized income) are made as a first step in computing the parent’s EPS.

16. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares In computing the subsidiary’s diluted earnings, we eliminate unrealized profits of the subsidiary and include constructive gains and losses of the subsidiary. We reflect the resulting EPS calculations of the subsidiary in the parent EPS calculation by replacing the “parent’s equity in subsidiary’s realized income” with the “parent’s equity in subsidiary’s diluted earnings.”

17. Dilutive Securities of Subsidiary Convertible into Subsidiary Shares We determine the parent’s equity in the subsidiary’s diluted earnings by multiplying the subsidiary shares owned by the parent by the subsidiary’s diluted EPS. This replacement allocates the subsidiary’s realized income for EPS purposes to holders of the subsidiary’s common stock and potentially dilutive securities, rather than only to the subsidiary’s common stockholders.

18. Diluted Securities of Subsidiary Convertible into Parent Shares Parent common shares (the denominators of EPSs) are identical in columns 1 and 2 of Exhibit 10-3 but increase in column 3 for subsidiary securities that are convertible into parent common stock. This adjustment in column 3 is necessary when the subsidiary’s potentially dilutive securities are potentially dilutive securities of the parent rather than of the subsidiary.

19. Diluted Securities of Subsidiary Convertible into Parent Shares When potentially dilutive securities of a subsidiary are convertible into parent common stock, income attributable to these securities under the if-converted method must be added back in calculating the parent’s diluted earnings.

20. Diluted Securities of Subsidiary Convertible into Parent Shares Column 3 of Exhibit 10-3 includes the item “adjustment for subsidiary’s dilutive securities convertible into parent common stock,” which is not applicable when the subsidiary does not have potentially dilutive securities (column 1) or when such securities are convertible into subsidiary common stock (column 2).

21. SUBSIDIARY WITH CONVERTIBLE PREFERRED STOCK P purchases 90 of S’s outstanding voting common stock for $328,000 on 1/1, 2011. On this date, the stockholders’ equity of the two corporations consists of the following :

22. SUBSIDIARY WITH CONVERTIBLE PREFERRED STOCK During 2011, S reports $50,000 net income and pays $25,000 dividends, $10,000 to preferred and $15,000 to common. P’s net income for 2011 is $186,000, determined as follows:

23. Subsidiary Preferred Stock Convertible into Subsidiary Common Stock S’s preferred stock is convertible into 12,000 shares of S’s common stock. Neither P nor S has other potentially dilutive securities outstanding. S’s realized net income is $40,000. S’s diluted EPS is $1.5625 [$50,000 earnings / (20,000 common shares +12,000 share dilution)], and P’s diluted EPS is $0.89, computed as follows :

24. Subsidiary Preferred Stock Convertible into Subsidiary Common Stock The $7,875 ($186,000-$178,125)potential dilution reflected in P’s diluted earnings results from replacing P’s equity in S’s realized income with P’s equity in S’s diluted earnings per share. Note that P’s equity in S’s realized income is $36,000, which is the same as P’s income from S.

25. Subsidiary Preferred Stock Convertible into Parent Common Stock S’s preferred stock is convertible into 24,000 shares of Pan’s common stock. Neither P nor S has other potentially dilutive securities outstanding. P’s diluted EPS is computed as follows:

26. Subsidiary Preferred Stock Convertible into Parent Common Stock Note: S’s diluted EPS (not used in P’s EPS computations) is $2 per share ($40,000 income to common ÷ 20,000 common shares outstanding) because the preferred stock is not a dilutive security of S.

27. SUBSIDIARY WITH OPTIONS AND CONVERTIBLE BONDS P has $1,500,000 income from its own operations for 2011 and $300,000 income from 80% S. The $300,000 income from S consists of 80 % of S $450,000 net income for 2011, less 80 % of a $50,000 unrealized gain on land purchased from S, less $20,000 (80%) amortization of the excess of fair value over the book value of S.

28. SUBSIDIARY WITH OPTIONS AND CONVERTIBLE BONDS The excess was assigned to a previously unrecognized patent. Assume the tax rate is 34 %. Outstanding securities of the two corporations throughout 2011 are:

29. Options and Bonds Convertible into Subsidiary Common Stock Assume that the options are exercisable and the bonds are convertible into S’s common stock. Exhibit 10-4 shows computations for S’s diluted EPS. Under the treasury stock approach for options and warrants, the effect of options on EPS is dilutive when the average market price of the shares to which the options apply exceeds the exercise price.

30. Options and Bonds Convertible into Subsidiary Common Stock

31. If holders of S’s options had exercised rights to acquire 60,000 shares of S’s common stock at $10 per share, S would have received $600,000 cash. Under the treasury stock approach, we assume S uses this cash to reacquire 40,000 shares of its own stock ($600,000 ÷ $15 average market price). This assumed exercise and repurchase of treasury shares increases S’s outstanding common stock for EPS computations by 20,000 shares.

32. Options and Bonds Convertible into Subsidiary Common Stock The convertible bonds must also be included in S diluted EPS computations. Under the if converted method, we include $46,200 net-of-tax interest in S’s diluted earnings and include the80,000 shares issuable upon conversion in calculating S’s diluted common shares. We use S’s $0.89 diluted EPS in the EPS computations for P. Exhibit 10-5 shows computations for P’s diluted EPS.

33. Options and Bonds Convertible into Subsidiary Common Stock

34. In the computation of P’s diluted earnings, we replace Pad’s equity in Syd’s realized income ($320,000) with P’s share of S’s diluted earnings ($284,800). This replacement decreases P’s diluted earnings by $35,200. This dilution results from allocating S’s $400,000 realized income plus $46,200 net-of- tax interest effect from the convertible bonds to holders of S’s common shares, options, and convertible bonds, rather than just to S’s common stockholders.

35. Options and Convertible Bonds with Parent’s Common Stock Exhibit 10-6 presents computations for P’s diluted EPS under the assumptions that S’s options can be used to purchase 60,000 shares of P’s common stock (a net new 20,000 shares under the Treasury Stock method as discussed above) and that S’s bonds are convertible into 80,000 shares of Pad Corporation’s common stock.

36. Options and Convertible Bonds with Parent’s Common Stock

37. Under these assumptions, we do not need S’s diluted EPS in determining P’s diluted EPS because we only use subsidiary EPS computations for replacement computations when subsidiary dilutive securities are convertible into subsidiary shares. The subsidiary dilutive securities are convertible into parent shares in this example, so we only need parent EPS computations.