A Review of the Accounting Cycle

1
Earnings Per Share
2
Learning Objectives

• Detail recent changes in accounting standards
  relating to earnings per share, and know why the
  changes were made and how these changes will
  affect computations relating to earnings per
  share.
• Know the difference between a simple and a
  complex capital structure, and understand how
  dilutive securities affect earnings per share
  computations.

3
Learning Objectives

• 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.
• Use the treasury stock method to compute diluted
  earnings per share when a firm has outstanding
  stock options, warrants, and rights.

4
Learning Objectives

• Use the if-converted method to compute diluted
  earnings per share when a company has convertible
  preferred stock or convertible bonds outstanding.
• Factor into the diluted earnings per share
  computations the effect of actual conversion of
  convertible securities or the exercise of
  options, warrants, or rights during the period,
  and understand the antidilutive effect of
  potential common shares when a firm reports a
  loss from continuing operations.

5
Learning Objectives

• Determine the order in which multiple potential
  dilutive securities should be considered in
  computed diluted earnings per share.
• Understand the disclosure requirements associated
  with basic and diluted earnings per share
  computations.

EXPANDED MATERIAL

• Make complex earnings per share computations
  involving multiple potentially dilutive
  securities.

6
A firms net income does not necessarily
correlate with its earnings per share figure.
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Two EPS Computations
Basic
Considers only common shares issued
and outstanding.
8
Two EPS Computations
Diluted
Basic
Reflects the maximum potential dilution from all
possible stock conversions that would have
decreased EPS.
Considers only common shares issued
and outstanding.
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Dilution of Earnings

• 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.

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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.

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Capital Structures
Complex Capital Structure The corporation has
one or more instruments outstanding that could
result in issuance of additional common shares.
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Capital Structures
Therefore, a company with potential per share
dilution is considered to have a complex capital
structure.
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Basic Earnings Per Share

• The Basic Equation

Net Income - Preferred Dividend Weighted-Average C
ommon Shares Outstanding

• The Complications
• Issuance or reacquisition of common stock.
• Stock dividends or stock splits.

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Issuance or Reacquisition of Common Stock

• Assume the following
• Shares Outstanding January 1 1,000
• New Shares Issued May 1 1,000
• Shares Repurchased November 1 500

Calculate weighted-average shares outstanding on
December 31.
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Issuance or Reacquisition of Common Stock

• Jan. 1 to May 1 1,000 x 4/12 333
• May 1 to Nov. 1 2,000 x 6/12 1,000
• Nov. 1 to Dec. 31 1,500 x 2/12 250
• Dec. 31 Weighted-average shares 1,583

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Issuance or Reacquisition of Common Stock
That was easy. Now lets try one with a stock
dividend and a stock split.
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Issuance or Reacquisition of Common Stock

• Assume the following
• Shares outstanding January 1 2,600
• Shares issued for exercise
• of options on February 1 400
• Shares issued for 10 stock
• dividend on May 1 300
• 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

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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 2/1 Option 400
2/1-5/1 3,000
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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 2/1 Option 400
2/1-5/1 3,000 x 1.10 5/1 Dividend 300
5/1-9/1 3,300
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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 2/1 Option 400
2/1-5/1 3,000 x 1.10 5/1 Dividend 300
5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500

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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 2/1 Option 400
2/1-5/1 3,000 x 1.10 5/1 Dividend 300
5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500
11/1 Purchase (400) 11/1-12/1 4,100
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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 2/1 Option 400
2/1-5/1 3,000 x 1.10 5/1 Dividend 300
5/1-9/1 3,300 9/1 Sale 1,200 9/1-11/1 4,500
11/1 Purchase (400) 11/1-12/1 4,100
12/1 Split 8,200 12/1-12/31 12,300
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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 x 3.0 2/1 Option 400
2/1-5/1 3,000 x 1.10 x 3.0 5/1 Dividend
300 5/1-9/1 3,300 x 3.0 9/1 Sale 1,200
9/1-11/1 4,500 x 3.0 11/1 Purchase
(400) 11/1-12/1 4,100 x 3.0 12/1 Split 8,200
12/1-12/31 12,300
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Issuance or Reacquisition of Common Stock
No. of Stock
Stock Portion of Weighted Date
Shares Dividend Split Year
Average
1/1-2/1 2,600 x 1.10 x 3.0 x 1/12 715 2/1
Option 400 2/1-5/1 3,000 x 1.10 x 3.0 x
3/12 2,475 5/1 Dividend 300 5/1-9/1 3,300
x 3.0 x 4/12 3,300 9/1 Sale 1,200
9/1-11/1 4,500 x 3.0 x 2/12 2,250 11/1
Purchase (400) 11/1-12/1 4,100 x 3.0 x 1/12
1,025 12/1 Split 8,200 12/1-12/31 12,300 x
1/12 1,025
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Stock Splits Dividends

• 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.

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Diluted Earnings Per Share
Dilution occurs if inclusion of a potentially
dilutive security reduces the basic EPS or
increases the basic loss per share.
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Treasury Stock Method

• 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.

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Treasury Stock Method--Example Basic Data

• Assume the following
• Net Income 8,000
• Common Shares Outstanding
• (entire year) 6,000
• 10 Bonds Payable 20,000
• 1-for-1 Options Outstanding 2,000
• Exercise Price Per Share on Options 30
• Average Price of Common Shares 40
• Income Tax Rate 40

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Treasury Stock Method--Example Basic Earnings
Per Share
Net Income - Preferred Dividend Weighted Average
Common Shares Outstanding
Basic EPS
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Treasury Stock Method--Example Option Proceeds

• Options Assumed Exercised 2,000
• Shares Assumed Repurchased With
• Proceeds (60,000 / 40) 1,500
• Additional Shares Assumed Issued 500
• Amount of Proceeds (2,000 x 30) 60,000

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Treasury Stock Method--Example Number of Shares

• Actual Shares Outstanding 6,000
• Incremental Shares
• Issued Assuming Exercise 2,000
• Repurchased From Proceeds 1,500 500
• Total Shares Assumed Issued 6,500

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Treasury Stock Method--Example Diluted Earnings
Per Share
Diluted EPS
Adjusted Net Income - Preferred Dividend Total
Shares Assumed Issued

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Diluted EPS -- As If

• 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.
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If-Converted Method--Example Basic Data

• Assume the following
• Net Income 10,000
• 10 Convertible Bonds
• issued 1/1/01 5,000
• 15 Convertible Bonds
• issued 7/1/01 2,000
• Common Shares Outstanding
• (no changes during year) 10,000

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If-Converted Method--Example Basic Data
(continued)

• Tax Rate 40
• Conversion Terms
• 10 Bonds 15 common shares per 100 bond
• 15 Bonds 20 common shares per 100 bond

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If-Converted Method--Example Basic Earnings
Per Share
Net Income - Preferred Dividend Weighted-Average C
ommon Shares Outstanding
Basic EPS
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If-Converted Method--Example Net Income for
Diluted EPS

• Net Income 10,000
• Interest Savings
• 10 Bond 500
• 15 Bond 150
• Less Tax Effect (260) 390
• Adjusted Net Income 10,390

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If-Converted Method--Example Number of Shares

• Actual Shares Outstanding 10,000
• Incremental Shares
• 10 Bond (5,000/100 x 15) 750
• 15 Bond (2,000/100 x 20 x 1/2) 200 950
• Total Shares Assumed Issued 10,950

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If-Converted Method--Example Fully Diluted
Earnings Per Share
Adjusted Net Income - Preferred Dividend Total
Shares Assumed Issued
Diluted EPS

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Convertible Preferred Stock

• 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.
Also remember there is no tax effect associated
with dividends.
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The End