1. Advanced Financial Accounting: Chapter 11
Earnings per Share
Tan & Lee Chapter 11
© 2009

2. Learning Objectives Significance of earnings per share
Difference between basic and diluted earnings per share
How new issues affect earnings per share through the weighted average number of shares
Concept of dilution
Concept of control number in diluted earnings per share
Apply methods for calculating diluted earnings per share:
If-converted method
Treasury method
Tan & Lee Chapter 11
© 2009

3. Content Introduction 1. Introduction
Computation of a Weighted-Average Number of Shares
Diluted Earnings per Share
Tan & Lee Chapter 11
© 2009

4. Significance of EPS Two main functions: Measure firm’s profitability
Denominator in price-earnings ratio (PE ratio)
PE ratio is widely used as a basis for comparing share-valuation with peers
Two types of PE ratio:
Historic PE
Current market price/ EPS in the most recent period
Prospective PE
Current market price/ projected EPS for the upcoming period
Tan & Lee Chapter 11
© 2009

5. Report basic and diluted EPS only
Basic vs Diluted EPS
Capital Structure
Complex Capital Structure
Includes potential ordinary shares, e.g. convertible bonds/ preference shares, warrants, options, or other contractual rights which, when exercised, could in the aggregate decrease earnings per ordinary share
Simple Capital Structure
Does not include potential ordinary shares
Report basic EPS only
Report basic and diluted EPS only
Tan & Lee Chapter 11
© 2009

6. Content
Introduction
Computation of a Weighted-Average Number of Shares
Diluted Earnings per Share
Computation of a Weighted-Average Number
of Shares
Tan & Lee Chapter 11
© 2009

7. Basic EPS
Numerator:
After deducting amounts due to preference shareholders in respect of:
Preference dividends
Gains/ losses arising on the repurchase or early conversion of preference shares
Amortization of discount or premium on increasing rate preference shares
Net profit attributable to ordinary shareholders of a parent entity
Basic EPS =
Weighted average no. of ordinary shares during a reporting period
Tan & Lee Chapter 11
© 2009

8. Definition of Different Types of Preference Shares
Cumulative preference shares require the issuer to pay dividends, even if in arrears.
Increasing rate preference shares are shares that are issued at a discount and that provide a low initial dividend to compensate the issuer for selling at a discount.
Tan & Lee Chapter 11
© 2009

9. Adjusting for Preference Dividends
Scenario
Treatment
Non-cumulative preference shares
Deduct when declared
Cumulative preference shares
Deduct when due
Increasing rate preference shares
Amortization of discount/ premium treated as part of preference dividend
Tan & Lee Chapter 11
© 2009

10. Adjusting for Preference Dividends
Scenario
Treatment
Non-cumulative preference shares
Deduct when declared
Cumulative preference shares
Deduct when due
Increasing rate preference shares
Amortization of discount/ premium treated as part of preference dividend
Tan & Lee Chapter 11
© 2009

11. Adjusting for Preference Dividends
Scenario
Treatment
Preference shares repurchased in a tender offer
(FV > carrying value)
Excess deducted from net profit attributable to ordinary equity holders of parent entity
Early conversion of preference shares (Consideration > FV of ordinary shares issuable)
This is a loss to the issuer and a return to the preference shareholders. Deduct loss from net profit attributable to ordinary equity holders of parent entity
Tan & Lee Chapter 11
© 2009

12. Basic EPS Denominator (examples):
The term “weighted average” refers to time-weighting, when there are changes in the number of ordinary shares during the financial year.
General rule:
Shares are time-weighted from the date consideration is receivable (usually the date of share issue)
Time-weighting is only performed when there is an inflow of resources
Tan & Lee Chapter 11
© 2009

13. Date to use for time-weighting
Basic EPS
Denominator: - examples
Scenario
Date to use for time-weighting
Shares issued for acquisition/ Business combination
Date of acquisition
Conversion of mandatory convertible instrument
Date of contract
Contingently issuable shares are issued
Date when all necessary conditions are satisfied
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© 2009

14. Calculating Basic EPS for Various Scenarios
Scenario 1: New shares are issued for cash/ other assets
Illustration 11.2
Company A had issued share capital of 5,000,000 ordinary shares at the beginning of the year. On 30 June, it issued 3,000,000 shares at fair market value for cash. Net profit attributable to ordinary shares was $300,000 for the first 6 months and $800,000 for the full year.
Tan & Lee Chapter 11
© 2009

15. Calculating Basic EPS for Various Scenarios
Illustration 11.2
Net profit = $300,000
Net profit = $500,000
1 January
No. of shares
= 5,000,000
30 June
No. of shares
= 8,000,000
31 December
No. of shares
= 8,000,000
$800,000
Basic EPS =
(5,000,000 x ½) + (8,000,000 x ½)
= cents
Note: Time-weighting is proportionate to the periods when the resources are made available to the firm.
Tan & Lee Chapter 11
© 2009

16. Calculating Basic EPS for Various Scenarios
Scenario 2: Issue of bonus shares (stock dividends)
Reserves
(Retained
earnings
+ Capital
reserves)
Reserves
Bonus issue
Total
Equity
Total
Equity
Share capital
Share capital
shareholders
Tan & Lee Chapter 11
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17. Calculating Basic EPS for Various Scenarios
Bonus shares are issued out of reserves, such as capital reserves or retained earnings.
Share capital increases, total number of shares increase, reserves decrease, total shareholders’ equity remains unchanged
 No inflow of resources  not time-weighted
Treatment:
Any bonus issues taking place in a period are assumed to be issued at the beginning of the period. (no time-weighting)
Retroactively restate previous year’s EPS comparatives based on new number of shares.
Tan & Lee Chapter 11
© 2009

18. Calculating Basic EPS for Various Scenarios
Scenario 3: Share splits
An existing share is split into 2 or more shares
No inflow of resources  not time-weighted
Retroactive restatement of comparative EPS
Scenario 4: Consolidation of existing shares through reverse splits
2 or more shares are consolidated into one share
No inflow of resources  not time-weighted.
Tan & Lee Chapter 11
© 2009

19. Calculating Basic EPS for Various Scenarios
Scenario 5: Rights Issue (Discount to market price)
No. of shares issued = No. of shares if issue was at market price
+ No. of shares in the “bonus element”
Illustration 11.4
On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue at a subscription price of $1.50 per share to existing shareholders. The market price immediately before the exercise of rights issue was $3.00. Atlantis Co’s paid-up capital consisted of 10,000,000 shares as at 1 Jan 20x4. The company reported net profit attributable to ordinary shareholders of $2,500,000 for the year ended 31 Dec 20x4.

20. Calculating Basic EPS for Various Scenarios
Illustration 11.4
On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue at a subscription price of $1.50 per share to existing shareholders. The market price immediately before the exercise of rights issue was $3.00. Atlantis Co’s paid-up capital consisted of 10,000,000 shares as at 1 Jan 20x4. The company reported net profit attributable to ordinary shareholders of $2,500,000 for the year ended 31 Dec 20x4.

21. Calculating Basic EPS for Various Scenarios
This solution applies the treasury method.
5,000,000 new shares.
5,000,000 x $1.50 = $7,500,000 total proceeds
 inflow of new resources  time-weighting involved
If the issue was made at full market price, only 2,500,000 new shares needed to be issued ($7,500,000 / $3). Therefore no. of shares in bonus element = 2,500,000
Tan & Lee Chapter 11
© 2009

22. Calculating Basic EPS for Various Scenarios
Reasoning – the treasury method:
Company B needs to buy back 2,500,000 shares from the open market to issue to shareholders, with the proceeds it collected from the rights issue of $7,500,000.
An additional 2,500,000 are issued as bonus shares M +2.5M+2.5M
Actual number of shares issued = 15,000,000
Number of shares issued for cash = 12,500,000
Tan & Lee Chapter 11
© 2009
10M +2.5M

23. Calculating Basic EPS for Various Scenarios
The bonus issue factor is 1.2 (15,000,000/ 12,500,000) shares for every 1 existing share held.
The bonus factor should be applied retrospectively to outstanding shares before the rights issue.
Tan & Lee Chapter 11
© 2009

24. Calculating Basic EPS for Various Scenarios
From 1 January 20x4 to 30 September 20x4
10,000,000 x 1.2 x 9/12
= 9,000,000
From 1 October 20x4 to 31 December 20x4
15,000,000 x 3/12
= 3,750,000
Weighted average number of shares
12,750,00
Net profit attributable to ordinary shareholders
$2,500,000
Basic earnings per share
= 19.6 cents
Tan & Lee Chapter 11
© 2009

25. Calculating Basic EPS for Various Scenarios
Scenario 6: New issue of shares from the conversion of debt
No inflow of cash, but reduction of debt  which increases net assets of issuer.
Interest expense on debt is saved  Earnings increase
Therefore, time-weighting should be applied.
Tan & Lee Chapter 11
© 2009

26. Calculating Basic EPS for Various Scenarios
Scenario 7: Contingently issuable shares
IAS 33:5: These are ordinary shares issuable for little/ no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement
When contingent events have occurred, such shares are time-weighted, even if the shares have yet to be issued.
Tan & Lee Chapter 11
© 2009