1. Chapter 17 Earnings Per Share
Prepared by:
Dragan Stojanovic, CA Rotman School of Management, University of Toronto

2. Earnings Per Share Overview Basic EPS Diluted EPS
Objective of EPS
Presentation and Disclosure
Basic EPS
Simple capital structure
Income available to common/ordinary shareholders
Mandatory convertible instruments
Contingently issuable shares
Weighted average common/ordinary shares
Comprehensive illustration
Diluted EPS
Complex capital structure
Convertible securities
Options and warranties
Contingently issuable shares
Anti-dilution revisited
Additional disclosures
Comprehensive earnings per share exercise
IFRS and Private Enterprise GAAP Comparison
Usefulness of EPS
Comparison of IFRS and private enterprise GAAP
Looking ahead

3. Earnings Per Share Overview Basic EPS Diluted EPS
Objective of EPS
Presentation and Disclosure
Basic EPS
Simple capital structure
Income available to common/ordinary shareholders
Mandatory convertible instruments
Contingently issuable shares
Weighted average common/ordinary shares
Comprehensive illustration
Diluted EPS
Complex capital structure
Convertible securities
Options and warranties
Contingently issuable shares
Anti-dilution revisited
Additional disclosures
Comprehensive earnings per share exercise
IFRS and Private Enterprise GAAP Comparison
Usefulness of EPS
Comparison of IFRS and private enterprise GAAP
Looking ahead

4. Importance of EPS
Earnings per share is one of the most highly visible standards of measurement for assessing:
management stewardship and
predicting a company’s future value
GAAP is very specific in regard to its calculation
EPS is calculated for common shares

5. Importance 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)

6. 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

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

8. EPS Disclosure EPS must be reported as part of the income statement
Exception: non public (privately held) corporations
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

9. EPS 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

10. 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)
Net Income $3.40

11. EPS Disclosure EPS Presentation – Complex Capital Structure
Earnings per common share:
Basic earnings per share $3.80
Diluted earnings per share $3.35

12. EPS Disclosure
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

13. Earnings Per Share Overview Basic EPS Diluted EPS
Objective of EPS
Presentation and Disclosure
Basic EPS
Simple capital structure
Income available to common/ordinary shareholders
Mandatory convertible instruments
Contingently issuable shares
Weighted average common/ordinary shares
Comprehensive illustration
Diluted EPS
Complex capital structure
Convertible securities
Options and warranties
Contingently issuable shares
Anti-dilution revisited
Additional disclosures
Comprehensive earnings per share exercise
IFRS and Private Enterprise GAAP Comparison
Usefulness of EPS
Comparison of IFRS and private enterprise GAAP
Looking ahead

14. Capital Structure
Method of EPS calculation based on the corporations 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 share)
Basic and Diluted EPS calculated and presented

15. 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 (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

16. 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

17. EPS - Simple Capital Structure
Net Income – Preferred Dividends
Weighted Average # of Shares Outstanding
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

18. 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

19. 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

20. EPS – The Numerator Net Income $3,000,000
Amount attributable to Class A:
100,000 x $ ,000
2,600,000
Amount attributable to Class B:
100,000 x $
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

21. 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

22. 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

23. EPS – The Denominator 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

24. 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
By restating the number, valid comparisons of earnings per share can be made between periods before and after the stock split or stock dividend

25. EPS – The Denominator
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

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

27. 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

28. Earnings Per Share Overview Basic EPS Diluted EPS
Objective of EPS
Presentation and Disclosure
Basic EPS
Simple capital structure
Income available to common/ordinary shareholders
Mandatory convertible instruments
Contingently issuable shares
Weighted average common/ordinary shares
Comprehensive illustration
Diluted EPS
Complex capital structure
Convertible securities
Options and warranties
Contingently issuable shares
Anti-dilution revisited
Additional disclosures
Comprehensive earnings per share exercise
IFRS and Private Enterprise GAAP Comparison
Usefulness of EPS
Comparison of IFRS and private enterprise GAAP
Looking ahead

29. 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

30. 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

31. 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)

32. 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)

33. 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:
Preferred dividends on convertible preferred shares are also eliminated - no dividends would be paid on these preferred shares had they been converted to common shares (no tax effect as not tax deductible)

34. Example - Field Corporation
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
Assume tax of 40% and calculate diluted EPS

35. Example - Field Corporation
Net Income for the Year $210,000
Add back:
Interest on 6% debentures
$60,000 x (1-.40) ,000
Interest on 10% debentures
$100,000 x (1-.40) x 9/ ,000
Adjusted Net Income $291,000

36. Example - Field Corporation
Unadjusted Weighted Average
Number of Shares 100,000
Add: Shares assumed issued (converted)
6% debentures ,000
10% debentures * ,000
Weighted Average Number of Shares 144,000
*32,000 shares x 9/12

37. Example - 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

38. Example - 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

39. Options and Warrants
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 the option is a “call option” i.e. it gives the holder the right to buy the shares at a preset/exercise price—the holder will exercise it if the exercise price is lower than the current market price

40. Options and Warrants
If company sells (or writes) options, they must be included in the diluted EPS calculations if dilutive
Example: company sold call options for $2 that allow the purchaser to buy the shares at $10 (the exercise price) - assume share price increases to $15, this will result in dilution
Assume company sold put options that allow purchaser to sell the shares to the company at $8 - if share price decreases to $6, this will result in dilution
Purchased options will always be antidilutive since they will only be exercised when they are in the money – therefore, not included in EPS

41. The Treasury Stock Method
Applies to written call options and equivalents
Options and warrants (and their equivalents) are included in EPS computations
They 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

42. 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
Total proceeds from exercise (1500 x $30) $45,000
Shares issued on exercise: ,500
Assumed reacquisition of shares
($45,000/$50)
Incremental shares: 1, = (potential common shares)
Dilution occurs because, on a net basis, more common shares are assumed to be outstanding after the exercise

43. 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

44. 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
Amount needed to buy back the 1,500 shares: (1,500 x $30) $45,000
Shares issued to acquire needed cash: ($45,000  $20) ,250
Number of shares purchased through put: ,500
Incremental shares: 2,250 – 1,500 = (potential common shares)
This is dilutive because there will be 750 more shares

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

46. Antidilutive EPS: Example
Kohl Corporation
$1 million in 6% convertible debt – convertible to 10,000 common shares
Net Income is $210,000
100,000 common shares outstanding
Tax rate: 40%
Basic EPS = $2.10 per share

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

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

49. 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

50. Additional Disclosure
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 anti-dilutive
Description of common share transactions after reporting period that could have impacted EPS numbers

51. Earnings Per Share Overview Basic EPS Diluted EPS
Objective of EPS
Presentation and Disclosure
Basic EPS
Simple capital structure
Income available to common/ordinary shareholders
Mandatory convertible instruments
Contingently issuable shares
Weighted average common/ordinary shares
Comprehensive illustration
Diluted EPS
Complex capital structure
Convertible securities
Options and warranties
Contingently issuable shares
Anti-dilution revisited
Additional disclosures
Comprehensive earnings per share exercise
IFRS and Private Enterprise GAAP Comparison
Usefulness of EPS
Comparison of IFRS and private enterprise GAAP
Looking ahead

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

53. COPYRIGHT
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