© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 20 Earnings Per Share.

© 2004 The McGraw-Hill Companies, Inc.McGraw-Hill/Irwin

Chapter 20Chapter 20

Earnings Per ShareEarnings Per Share


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Earnings Per Share (EPS)

Of the myriad of facts and figures generated Of the myriad of facts and figures generated by accountants, the single accounting by accountants, the single accounting

number that is reported most frequently in number that is reported most frequently in the media and receives by far the most the media and receives by far the most attention by investors and creditors is attention by investors and creditors is

earnings per share.earnings per share.


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Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

Number of shares outstanding× Number of months outstanding ÷ 12 Weighted average shares outstanding

Simple Capital Structure(Basic EPS)

Basic Earnings Per Share

Net income (after tax) – Preferred dividends*Weighted average outstanding common stock Net income (after tax) – Preferred dividends*Weighted average outstanding common stock

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and noncumulative preferred stock dividends noncumulative preferred stock dividends

(only if declared).(only if declared).

*Current period’s cumulative preferred stock period’s cumulative preferred stock dividends (whether or not declared) and dividends (whether or not declared) and noncumulative preferred stock dividends noncumulative preferred stock dividends

(only if declared).(only if declared).


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Earnings Per Share A company had 200,000 shares of $50 par value A company had 200,000 shares of $50 par value

common stock, 10,000 shares of 5%, $20 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during was $1,500,000. No dividends were declared during the year. EPS would be the year. EPS would be

a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38

A company had 200,000 shares of $50 par value A company had 200,000 shares of $50 par value common stock, 10,000 shares of 5%, $20 par value common stock, 10,000 shares of 5%, $20 par value cumulative preferred stock, and 30,000 shares of 5%, cumulative preferred stock, and 30,000 shares of 5%, $10 par value noncumulative preferred stock $10 par value noncumulative preferred stock outstanding during the year. Net income after taxes outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during was $1,500,000. No dividends were declared during the year. EPS would be the year. EPS would be

a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38


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a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38


a. $7.50a. $7.50

b. $7.43b. $7.43

c. $7.45c. $7.45

d. $7.38d. $7.38

Earnings Per Share

$1,500,000 – (10,000 × 5% × $20 par)$1,500,000 – (10,000 × 5% × $20 par)200,000 shares200,000 shares

Since dividends were Since dividends were notnot declared, only declared, only the the cumulative preferred stockcumulative preferred stock dividends dividends

are subtracted.are subtracted.

$1,500,000 – (10,000 × 5% × $20 par)$1,500,000 – (10,000 × 5% × $20 par)200,000 shares200,000 shares

Since dividends were Since dividends were notnot declared, only declared, only the the cumulative preferred stockcumulative preferred stock dividends dividends

are subtracted.are subtracted.


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Issuance of New Shares

Date Description No. of Shares1/1 Balance 100,000 4/1 Issued 50,000 10/1 Issued 10,000

Compute the weighted average number of Compute the weighted average number of shares of common stock outstanding.shares of common stock outstanding.


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Issuance of New Shares

Date Description No. of SharesMonths

OutstandingWeighted

Shares

1/1 Balance 100,000 12/12 100,000 4/1 Issued 50,000 9/12 37,500 10/1 Issued 10,000 3/12 2,500 Weighted average shares outstanding 140,000



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Stock Dividends and Stock Splits

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the retroactively as subdivisions of the shares already outstanding at the date shares already outstanding at the date

of the split or dividend.of the split or dividend.

Common shares issued as part of stock Common shares issued as part of stock dividends and stock splits are treated dividends and stock splits are treated

retroactively as subdivisions of the retroactively as subdivisions of the shares already outstanding at the date shares already outstanding at the date

of the split or dividend.of the split or dividend.


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Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Stock dividend(100%) 150,000 10/1 Issued 10,000


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1/1 Balance 100,000 12/12 100,0004/1 Issued shares 50,000 9/12 37,5005/1 100% stock dividend

Retroactive to 1/1 100,000 12/12 100,000 Retroactive to 4/1 50,000 9/12 37,500

10/1 Issued shares 10,000 3/12 2,500Weighted average shares outstanding 277,500

1/1 Balance 100,000 12/12 100,0004/1 Issued shares 50,000 9/12 37,5005/1 100% stock dividend

Retroactive to 1/1 100,000 12/12 100,000 Retroactive to 4/1 50,000 9/12 37,500

10/1 Issued shares 10,000 3/12 2,500Weighted average shares outstanding 277,500



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Stock Dividends and Stock SplitsRetroactive treatment:Retroactive treatment:

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the period.beginning of the period.

Stock dividend or split Stock dividend or split is treated as is treated as

outstanding from the outstanding from the beginning of the period.beginning of the period.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the time shares outstanding at the time

of the dividend or split.of the dividend or split.

Stock dividend or split is Stock dividend or split is applied retroactively in applied retroactively in

proportion to the number of proportion to the number of shares outstanding at the time shares outstanding at the time

of the dividend or split.of the dividend or split.

New sharesNew sharesissued this period?issued this period?

New sharesNew sharesissued this period?issued this period?

YesYes NoNo


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Reacquired Shares

The weighted average number of shares is The weighted average number of shares is reduced by the number of reacquired reduced by the number of reacquired

shares, time-weighted for the shares, time-weighted for the fraction of the fraction of the year they were year they were notnot outstanding outstanding..

The weighted average number of shares is The weighted average number of shares is reduced by the number of reacquired reduced by the number of reacquired

shares, time-weighted for the shares, time-weighted for the fraction of the fraction of the year they were year they were notnot outstanding outstanding..


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Reacquired Shares


Date Description No. of Shares

1/1 Balance 100,000 4/1 Issued 50,000 5/1 Repurchased shares 12,000 10/1 Issued 10,000


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Reacquired Shares


Date Description No. of SharesMonths

OutstandingWeighted

Shares

1/1 Balance 100,000 12/12 100,000 4/1 Issued 50,000 9/12 37,500 5/1 Reacquired (12,000) 8/12 (8,000) 10/1 Issued 10,000 3/12 2,500 Weighted average shares outstanding 132,000


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Complex Capital StructureComplex Capital Structure(dual EPS)(dual EPS)

Dilution/Antidilution TestDilution/Antidilution Test

Equity Equity contractscontracts

Convertible Convertible securitiessecurities

Treasury Treasury stock methodstock method

If-converted If-converted methodmethod

Contingently Contingently issuable issuable sharesshares

Potentially dilutive securities:Potentially dilutive securities:•Stock options, rights, and warrantsStock options, rights, and warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock issuesContingent common stock issues

Potentially dilutive securities:Potentially dilutive securities:•Stock options, rights, and warrantsStock options, rights, and warrants•Convertible bonds and stockConvertible bonds and stock•Contingent common stock issuesContingent common stock issues

Diluted Earnings Per share


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Complex Capital Structure

Dual presentation of Earnings Per Share:Dual presentation of Earnings Per Share:

Basic EPS Basic EPS Diluted EPSDiluted EPS


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Options, Rights, and Warrants

ProceedsProceeds

Used toUsed to

Purchase Purchase treasury treasury sharesshares

At At average average market market priceprice

The treasury stock method The treasury stock method assumes that proceeds from assumes that proceeds from

the exercise of equity the exercise of equity contracts are used to purchase contracts are used to purchase treasury shares. This method treasury shares. This method

usually results in a net usually results in a net increase in shares included in increase in shares included in

the denominator of the the denominator of the calculation of diluted calculation of diluted earnings per share.earnings per share.

The treasury stock method The treasury stock method assumes that proceeds from assumes that proceeds from

the exercise of equity the exercise of equity contracts are used to purchase contracts are used to purchase treasury shares. This method treasury shares. This method

usually results in a net usually results in a net increase in shares included in increase in shares included in

the denominator of the the denominator of the calculation of diluted calculation of diluted earnings per share.earnings per share.


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Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Proceeds from assumed exerciseProceeds from assumed exercise

AverageAverage market price of stock market price of stock

Determine new shares from assumed Determine new shares from assumed exercise of equity contract.exercise of equity contract.

Compute shares purchased for the treasury. Compute shares purchased for the treasury.


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Determine new shares from assumed Determine new shares from assumed exercise of equity contract.exercise of equity contract.

Compute shares purchased for the treasury. Compute shares purchased for the treasury. Compute the incremental shares assumed Compute the incremental shares assumed

outstanding.outstanding.New shares from assumed exercise (1)New shares from assumed exercise (1)

Less: Treasury shares assumed purchasedLess: Treasury shares assumed purchased (2) (2)

Net increase in shares outstanding (3)Net increase in shares outstanding (3)


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When the exercise price When the exercise price exceeds the market exceeds the market

price, the options are price, the options are antidilutiveantidilutive..

When the exercise price When the exercise price exceeds the market exceeds the market

price, the options are price, the options are antidilutiveantidilutive..


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Treasury Stock Method

Common stock outstanding was 100,000 shares. Common stock outstanding was 100,000 shares. Options to purchase 5,000 shares of common Options to purchase 5,000 shares of common stock were outstanding at the beginning of the stock were outstanding at the beginning of the year. The options can be exercised to purchase year. The options can be exercised to purchase stock at $50 per share. The average market stock at $50 per share. The average market price of the stock was $80. The net increase in price of the stock was $80. The net increase in the dilutive earnings per share denominator isthe dilutive earnings per share denominator isa. 25,000 shares a. 25,000 shares b. 5,000 sharesb. 5,000 sharesc. 3,125 sharesc. 3,125 sharesd. 1,875 sharesd. 1,875 shares



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Treasury Stock Method

New shares = 5,000New shares = 5,000Treasury shares = 3,125Treasury shares = 3,125 (5,000 × $50) ÷ $80 (5,000 × $50) ÷ $80Incremental shares = 1,875Incremental shares = 1,875 (5,000 - 3,125)(5,000 - 3,125)

New shares = 5,000New shares = 5,000Treasury shares = 3,125Treasury shares = 3,125 (5,000 × $50) ÷ $80 (5,000 × $50) ÷ $80Incremental shares = 1,875Incremental shares = 1,875 (5,000 - 3,125)(5,000 - 3,125)


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Next: Convertible Securities


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Convertible Securities

The The if-converted methodif-converted method is used for is used for

Convertible debt and equity Convertible debt and equity securitiessecurities

The method assumes conversion occurs as of The method assumes conversion occurs as of the the beginningbeginning of the period or date of of the period or date of

issuanceissuance, if later., if later.


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Convertible Securities

The assumed conversion of convertible The assumed conversion of convertible bonds or preferred stock has two effects on bonds or preferred stock has two effects on dilutive earnings per share:dilutive earnings per share: Increases the denominatorIncreases the denominator by the number of by the number of

common shares issuable upon conversion.common shares issuable upon conversion. Increases the numeratorIncreases the numerator by decreasing after-tax by decreasing after-tax

interest expense on convertible bonds, and interest expense on convertible bonds, and dividends on convertible preferred stock.dividends on convertible preferred stock.


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Convertible SecuritiesDilutive earnings per share may decrease or Dilutive earnings per share may decrease or

increase after the assumed conversion.increase after the assumed conversion.

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per share If dilutive earnings per share decreasesdecreases, , the securities are the securities are dilutivedilutive and are and are

assumed assumed convertedconverted..

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.

If dilutive earnings per shareIf dilutive earnings per share increases increases, , the securities are the securities are antidilutiveantidilutive and are and are

notnot considered converted. considered converted.


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If-Converted Method

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, cumulative convertible preferred stock cumulative convertible preferred stock dividends of $25,000, common stock dividends of $25,000, common stock

outstanding of 50,000 shares, and a tax rate of outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is 30%. The convertible preferred stock is

convertible into 5,000 shares of common stock. convertible into 5,000 shares of common stock.

Is the convertible preferred stock dilutive?Is the convertible preferred stock dilutive?

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, cumulative convertible preferred stock cumulative convertible preferred stock dividends of $25,000, common stock dividends of $25,000, common stock

outstanding of 50,000 shares, and a tax rate of outstanding of 50,000 shares, and a tax rate of 30%. The convertible preferred stock is 30%. The convertible preferred stock is

convertible into 5,000 shares of common stock. convertible into 5,000 shares of common stock.

Is the convertible preferred stock dilutive?Is the convertible preferred stock dilutive?


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If-Converted Method

= $9.50 EPS= $9.50 EPSEPS without conversion:EPS without conversion:

$500,000 – $500,000 – $25,000$25,000

50,000 shares50,000 sharesIf the preferred stock is converted, we would not have If the preferred stock is converted, we would not have dividends and the number of shares of common stock would dividends and the number of shares of common stock would

increase by 5,000 shares. There is not a tax effect.increase by 5,000 shares. There is not a tax effect.

= $9.09 EPS= $9.09 EPS Dilutive.Dilutive.Dilutive.Dilutive.

EPS afterEPS afterassumedassumedconversion:conversion:

$500,000 – $0$500,000 – $055,000 shares55,000 shares


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If-Converted Method

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, convertible bonds with interest expense of convertible bonds with interest expense of

$50,000, common stock outstanding of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of bonds are convertible into 2,000 shares of

common stock. common stock.

Are the convertible bonds dilutive?Are the convertible bonds dilutive?

Assume net income (after tax) of $500,000, Assume net income (after tax) of $500,000, convertible bonds with interest expense of convertible bonds with interest expense of

$50,000, common stock outstanding of $50,000, common stock outstanding of 50,000 shares, and a tax rate of 30%. The 50,000 shares, and a tax rate of 30%. The bonds are convertible into 2,000 shares of bonds are convertible into 2,000 shares of

common stock. common stock.

Are the convertible bonds dilutive?Are the convertible bonds dilutive?


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If-Converted Method

= $10.00 EPS= $10.00 EPS

EPS without conversion:EPS without conversion: $500,000$500,000 50,000 shares50,000 shares

If the bonds are converted, net income would increase by If the bonds are converted, net income would increase by $35,000 (after taxes) and the number of shares of common $35,000 (after taxes) and the number of shares of common

stock would increase by 2,000 shares. stock would increase by 2,000 shares.

= $10.29 EPS= $10.29 EPSNo, they are No, they are antidilutive.antidilutive.No, they are No, they are antidilutive.antidilutive.

EPS after assumed EPS after assumed conversion:conversion:

$535,000$535,00052,000 shares52,000 shares


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Order of Entry for Multiple Convertible Securities

When a company has more than one When a company has more than one potentially dilutive security, they potentially dilutive security, they

are considered for inclusion in are considered for inclusion in dilutive EPS in sequence from the dilutive EPS in sequence from the most dilutive to the least dilutivemost dilutive to the least dilutive..

When a company has more than one When a company has more than one potentially dilutive security, they potentially dilutive security, they

are considered for inclusion in are considered for inclusion in dilutive EPS in sequence from the dilutive EPS in sequence from the most dilutive to the least dilutivemost dilutive to the least dilutive..


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Contingently Issuable Shares

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain upon the satisfaction of certain conditions.conditions.

Contingent shares are issuable in the Contingent shares are issuable in the future for little or no cash consideration future for little or no cash consideration

upon the satisfaction of certain upon the satisfaction of certain conditions.conditions.

FutureFuture


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Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Shares are issued Shares are issued merely due to passage merely due to passage

of time.of time.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Some target performance Some target performance level has already been level has already been met and is expected to met and is expected to

continue to the end of the continue to the end of the contingency period.contingency period.

Contingent shares are included in Contingent shares are included in dilutive EPS if:dilutive EPS if:

Contingent shares are included in Contingent shares are included in dilutive EPS if:dilutive EPS if:

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.

Example: Additional shares may be Example: Additional shares may be issued based on future earnings. issued based on future earnings.


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Contingent shares are considered Contingent shares are considered outstanding common shares and are outstanding common shares and are

included in basic EPS as of the date that all included in basic EPS as of the date that all necessary conditions have been satisfied.necessary conditions have been satisfied.

Contingent shares are considered Contingent shares are considered outstanding common shares and are outstanding common shares and are

included in basic EPS as of the date that all included in basic EPS as of the date that all necessary conditions have been satisfied.necessary conditions have been satisfied.


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Summary

Potential Common Shares Basic EPS Diluted EPS Stock options (or warrants, rights) no yes Convertible securities (bonds, notes, preferred stock) no yes Contingently issuable shares no yes

Dilutive Effect Shown?


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Summary

Potential Common Shares Numerator Denominator

Stock options (or warrants, rights)None

Add incremental shares

Convertible bonds or notes Add after tax interest

Add shares issuable upon

conversion

Convertible preferred Add back dividends declared

Add shares issuable upon

conversion Contingently issuable shares

Conditions being currently met None

Add shares issuable

Conditions not being met None None

Impact


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Financial Statement Presentation of EPS Data

Income from continuing operations.Income from continuing operations. Discontinued operations.Discontinued operations. Extraordinary items.Extraordinary items. Cumulative effect of change in accounting Cumulative effect of change in accounting

principle.principle. Net income.Net income.

Earnings per share values are desirable (but Earnings per share values are desirable (but not required) for extraordinary items and not required) for extraordinary items and

discontinued operations.discontinued operations.

Income from continuing operations.Income from continuing operations. Discontinued operations.Discontinued operations. Extraordinary items.Extraordinary items. Cumulative effect of change in accounting Cumulative effect of change in accounting

principle.principle. Net income.Net income.

Earnings per share values are desirable (but Earnings per share values are desirable (but not required) for extraordinary items and not required) for extraordinary items and

discontinued operations.discontinued operations.


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End of Chapter 20

© 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 20 Earnings Per Share.

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Transcript of © 2004 The McGraw-Hill Companies, Inc. McGraw-Hill/Irwin Chapter 20 Earnings Per Share.