Intermediate Accounting
Thomas H. Beechy
Schulich School of Business,
York University
Joan E. D. Conrod
Faculty of Management,
Dalhousie University
PowerPoint slides by:
Bruce W. MacLean,
Faculty of Management,
Dalhousie University
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21
Earnings Per Share
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Introduction
■
■
■
■
Earnings per share is one of the most widely used indicators of a
corporation’s financial performance.
Managers often discuss the earnings per share (or EPS
EPS) of their
companies as indications of past performance, and make
predictions about future EPS.
Analysts use EPS figures regularly, and news reports on the
earnings of public companies almost always mention the earnings
per share, sometimes accompanied by a chart illustrating the EPS
performance over the past several years.
Earnings per share is intended to indicate whether a company’s
performance has improved or deteriorated as compared to
previous periods.
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Earnings Per Share (EPS)
■
■
■
Because it is computed on a per share basis, EPS removes the
effect on earnings of increases in net income due to larger invested
capital obtained through new share issues
Earnings per share is conceptually very simple: the earnings of the
company divided by the number of shares outstanding.
Significant complications. For example:
•
•
•
•
•
■
What if new shares were issued during the year?
What if there are several different classes of shares outstanding?
Which measure of earnings should be used?
What effect would convertible senior securities have on EPS if
they were converted?
What about outstanding stock options?
Section 3500 of the CICA Handbook
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Applicability Of Section CICA 3500
■
■
The CICA Handbook recommendations on earnings per share do
not apply to companies with few shareholders. In substance, they
apply only to public companies.
Section 3500 of the CICA Handbook obviously applies only to
corporations, since only corporations have shares. The section
specifically exempts four types of corporations [CICA 3500.06]:
•
•
•
•
corporations that do not have share capital (e.g., nonprofit
corporations)
government-owned corporations
wholly-owned subsidiaries
companies with few shareholders
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■
■
Recommended Types Of EPS Figures
EPS figures are computed both before and after the impact
of discontinued operations and extraordinary items
Change in the corporation’s capital structure may require
that additional EPS amounts be presented to the
shareholders.
– ‘Basic’ EPS
–
–
–
–
Adjusted ‘basic’ EPS
Fully diluted EPS
Pro-forma EPS
Pro-forma fully diluted EPS
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■
■
Basic Earnings Per Share
Basic EPS is the basis for comparing the current period’s
earnings with that of prior periods.
The basic earnings per share calculation for the year (or for
an interim period, such as a quarter) is as follows:
Net income available to common shareholders
Weighted average number of common shares outstanding
■
■
The intent of the EPS calculation is to adjust for the income
effect of issuing new shares or retiring old shares.
If there were share splits or share dividends during the
year, the denominator is stated in equivalent share units after
the split or dividend. As well, all previous EPS calculations
(which are used for comparative purposes) are restated
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Earnings Available To Common
Shareholders
■
The numerator, net income available to common
shareholders,
shareholders is the net income of the company minus
the dividends attributable to senior shares
• For cumulative senior shares, the prescribed dividend is
subtracted from net income regardless of whether they have
been paid for the year; any future dividend distributions to
common shareholders must be made only after dividend
arrearages to the senior shares have been remedied.
• For noncumulative senior shares, only those dividends
actually declared during the period are subtracted in
determining the EPS numerator.
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■
Discontinued Operations And Extraordinary
Items
When a corporation reports discontinued operations and/or
extraordinary items, the CICA Handbook recommends that two EPS
amounts be calculated, based on:
✜
✜
■
income before discontinued operations and extraordinary items; and
net income for the period.
In a complex earnings situation, it actually becomes possible for a
corporation to report more than just these two EPS amounts, such as
EPS after discontinued operations but before extraordinary items.
Financial Reporting in Canada 1995 reported that a few of their
surveyed companies do occasionally report three or four basic EPS
numbers, but that the practice is rare. The important point, however, is
that section 3500 defines the EPS calculations that should be reported;
it does not prohibit companies from reporting additional EPS amounts if
the company thinks that such amounts would be helpful to the reader.
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Multiple Classes Of Shares
■
■
■
■
Canadian corporations often have multiple classes of
common or residual shares outstanding.
A primary reason for having two or more classes of
common shares is to vary the voting rights between the
different classes, normally in order to prevent the
controlling shareholders from losing control to hostile
investors.
The fact of multiple classes does not, in itself, mean
that there is a difference in dividend privileges.
As long as the several classes share dividends equally,
share for share, then they are all lumped together in the
denominator of the EPS calculation.
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A Note On Terminology
■
The expression basic EPS is used in the CICA
Handbook and in common practice in order to
differentiate that ‘basic’ calculation from other EPS
figures that have special names. However, ‘basic’ is
not actually a part of the name and need not be used in
financial reporting. ‘Basic’ EPS is analogous to calling
a senior academic a ‘full’ professor (to differentiate
from one that is only partially full, such as an assistant
professor or associate professor) or to referring to a
military person as a ‘full’ colonel (to differentiate from a
Lt. Colonel). Nevertheless, ‘Basic EPS’ is sometimes
used in published financial statements.
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Convertible Senior Securities
■
■
■
Convertible securities are issued in the hope and expectation that the
corporation will be sufficiently successful that the price of its common
shares will increase enough to make conversion attractive for the
holder. If the redemption price of a bond or preferred share is less than
the value of the common shares into which it is convertible, conversion
can be either voluntary or forced:
A voluntary conversion occurs when the holder of the convertible
senior securities voluntarily submits the convertible bond or preferred
share for conversion into the equivalent number of common shares.
A forced (or induced
induced) conversion occurs when the issuer (that is, the
corporation) calls in the senior security or, if the security has a fixed
maturity date, waits until the debt has matured and must be submitted
for redemption. If the value of the common shares into which the senior
security is convertible is greater than its redemption value, a holder
would be foolish to accept the redemption price instead of converting.
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Adjusted Basic EPS
■
■
■
■
If convertible senior securities (either preferred shares
or debt instruments) were converted during the
reporting period, adjusted basic EPS must be
calculated.
The adjustment restates basic EPS as though the
actual conversion had occurred at the beginning of the
accounting period.
Adjusted basic EPS forms the basis for comparisons
with future periods (or forecasts relating to future
periods).
Prior periods’ EPS are not restated for conversions
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■
■
Interest And Dividends Adjustments
A question frequently arises about the adjustments to EAC
when conversions occur between interest dates or between
dividend declarations. Interest accrues, and accrued
interest must be paid whenever the bonds are sold,
redeemed, traded, or converted.
Preferred dividends, on the other hand, do not accrue.
There is no legal obligation for a corporation to pay
dividends until the dividends have been declared by the
board of directors. This is true regardless of whether or not
the dividends are cumulative. If preferred shares are
converted between dividend declarations, there is no
obligation for the corporation to pay ‘accrued’ dividends for
the intervening period.
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Bond Premium And Discount
■
■
■
■
■
Most bonds are issued at or very near the market rate of interest.
There are both tax reasons and ‘image’ reasons for keeping the
nominal rate very close to the market rate.
However, there may be situations in which a bond is offered at a
significant discount or premium. When that happens, it complicates
our EPS calculations a bit.
The complication arises from the fact that when there is a material
premium or discount, the interest expense does not coincide with
interest paid.
In the adjusted basic EPS calculation, and in the fully-diluted EPS
calculations in the following sections, the adjustment to the numerator
(i.e., earnings available to common shareholders) must be for interest
expense.
A simple adjustment based on the nominal rate of interest will not work
– discount or premium amortization must also be taken into account.
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Fully Diluted EPS
■
■
■
When a company has potentially dilutive senior
securities or options, fully diluted EPS should be
calculated.
Fully diluted EPS excludes the effect of convertible
securities that have the effect of increasing EPS, and
excludes securities that are not convertible (and options
that are not exercisable) within ten years.
While adjusted basic EPS and fully diluted EPS should
normally be calculated if the conditions giving rise to
them exist, they need not be reported unless the results
are materially different from basic EPS.
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Anti-Dilution
■
■
■
When calculating fully diluted EPS, we exclude any security or
option that, if converted, would have the effect of increasing EPS.
A conversion (or exercise of options) that increases EPS is said to
be antianti-dilutive
dilutive.
One way to find out if a conversion or exercise is anti-dilutive is to
work through the full calculation and see if including each has the
effect of increasing or decreasing EPS. Fortunately, there is a
much easier way to test for anti-dilution.
The first step is to calculate the basic EPS. This becomes the
benchmark against which the impact of conversions is compared.
Then, the impact on the numerator and the denominator for each
type of convertible security or option is calculated. If the ratio of the
impacts on the numerator and denominator is greater than the
basic EPS, that class of security or option is anti-dilutive.
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Disclosure Practices
■
■
EPS can be reported either on the income statement or
in the notes. The most common practice is to report
them on the face of the income statement.
Fully diluted EPS need not be reported on a
comparative basis. However, most companies do report
comparative fully diluted EPS.
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Using EPS
■
■
■
■
Basic EPS: This is a historical amount. It can be compared with basic EPS
numbers from past years to see whether the company is earning more or less for its
common shareholders.
Adjusted basic EPS: This amount is intended for comparison with future EPS
amounts, since it alters the basis of calculation to agree with the capital structure
that the company has as it continues into the future. In effect, adjusted basic EPS
adjusts for the discontinuity introduced into the basic EPS numbers by the change
in capital structure through conversion of senior securities.
Fully diluted EPS: If the company is successful in its financing strategy, the
convertible senior securities will be converted before the due date. Therefore, the
fully diluted EPS gives an indication of the long-run impact that the likely
conversions (and options exercises) will have on the earnings attributable to
common shares.
One important aspect of EPS numbers is that they mean nothing by
themselves. Like all economic indices, they are meaningful only as part of
a series. They do adjust for changes in capital structure, thereby removing
the normal earnings expansion effect that arises through additional share
issuances.
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Pro-Forma EPS
■
■
When significant changes in a corporation’s capital structure occur after
the end of the year but before management has finalized the financial
statements, it may be necessary to prepare pro-forma EPS.
EPS
Pro-forma EPS essentially restate the EPS as though the capital structure
changes had occurred at the beginning of the reporting year. In substance,
they are similar to adjusted basic EPS in that they adjust for the effects of
an actual capital structure change in order to provide a basis for future
comparisons. Pro-forma EPS is recommended whenever there has been a
significant change in a corporation’s capital structure shortly after the end
of the fiscal year as a result of (1) a reorganization, (2) a substantial
conversion of senior securities that were outstanding at the end of the
reporting year, or (3) a new issue of common shares, the proceeds of
which were used to reduce senior securities that were outstanding at the
end of the reporting year.
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Circumstances Calling For Pro-Forma
EPS
■
■
The requirement for pro-forma EPS is not triggered by the
issuance of common shares for other reasons, nor is it required
when options are exercised after the end of the fiscal year.
The recommendations concerning pro-forma EPS are somewhat
inconsistent with those in the CICA Handbook regarding other
EPS calculations. There is no recommendation that a company
report adjusted basic EPS when a company issues common
shares and uses the proceeds to retire senior securities before the
end of the year, and yet pro-forma EPS is required if that happens
after the end of the year. In addition, the Handbook implies that
the starting point for pro-forma calculations is basic EPS, when
consistency would suggest that the starting point should be
adjusted basic EPS.
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Calculating Pro-Forma EPS
■
■
Fully diluted pro-forma is not required in the case of a
conversion of existing senior securities, because fully
diluted pro-forma EPS would be exactly the same as
the regular fully diluted EPS.
If only part of the proceeds of a new share issue are
used to retire senior securities after year-end, the
impact of the share issue is recognized in pro-forma
EPS only to the proportionate extent that the proceeds
were used to retire senior securities.
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Summary Of Earnings Per Share
Measures
■
■
The CICA Handbook recommends up to five different EPS
calculations for public companies, each of which should be
presented both before and after discontinued operations and
extraordinary items. Basic EPS is intended for historical
comparisons, but the other four are all intended to form the basis
for comparisons with future earnings predictions.
Exhibit 21-9 summarizes these five types of EPS, including:
– the circumstances when each calculation is required,
– the arithmetic of the calculation, and
– the user objectives of each.
■
There is a logic underlying each of the EPS figures, and the
calculations can most easily be remembered if the user objective of
each EPS is understood.
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Cash Flow Per Share
■
Figures reported as cash flow per share usually reflect
the net increase in working capital from operations,
rather than cash flow from operations. Practice in this
area is not uniform, as there are no guidelines for
computing cash flow per share
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A Final Comment
■
■
■
Despite the attention given to EPS numbers, it is extraordinarily
difficult to evaluate just what the numbers mean.
A firm’s asset structure changes over time, making comparisons
difficult. The emphasis on EPS may encourage transactions that
have little purpose except to generate book profits that will
enhance EPS. One company sold land each year so that the gains
produced a constant EPS growth rate year after year.
EPS calculations are complex, and their meaning is sufficiently
uncertain that many accountants believe the level of reliance on
them is unwarranted. Using EPS as an important element in a
company’s goal structure can contribute to a short-term
management attitude.
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EPS Question
a.
b.
c.
d.
A company had 200,000 common shares, 10,000 of $1
cumulative preferred shares, and 30,000 $.50
noncumulative preferred shares outstanding during the
year. Net income after taxes was $1,500,000. No
dividends were declared during the year. Basic EPS
would be
$7.50
$1,500,000 – (10,000 × 5% × $20 par)
$7.43
200,000 shares
$7.45
Since dividends were not declared,
$7.38
only the cumulative preferred stock
dividends are subtracted.
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Computing EPS
Simple Capital Structure
■
Common shares issued as part of stock dividends and
stock splits are treated retroactively as subdivisions of
the shares already outstanding at the date of the split or
dividend.
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Computing EPS
Simple Capital Structure
■
■
■
Retroactive treatment:
If new shares were not issued in the period, the stock
dividend or split is treated as outstanding from the
beginning of the period.
If new shares were issued in the period, the stock
dividend or split is applied retroactively in proportion to
the number of shares outstanding at the time of the
dividend or split.
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EPS
Example 1
■
Compute the weighted average number of common
outstanding.
Date
Transaction
1/1
Balance outstanding
4/1
Issued shares
10/1 Issued shares
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# of
Shares
100,000
50,000
10,000
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EPS
Solution 1
■
Compute the weighted average number of common
outstanding.
Date
Transaction
1/1
Balance outstanding
4/1
Issued shares
10/1 Issued shares
Total Weighted Avg.
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# of
# Mos. Weighted
Shares
Shares Outstd.
100,000
12/12
100,000
50,000
9/12
37,500
10,000
3/12
2,500
140,000
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EPS
Example 2
■
Compute the weighted average number of common
outstanding.
Date
1/1
4/1
5/1
10/1
Transaction
Balance outstanding
Issued shares
100% stock dividend
Issued shares
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# of
Shares
100,000
50,000
150,000
10,000
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EPS
SOLUTION 2
■
Compute the weighted average number of common
outstanding.
Date
Transaction
1/1
Balance outstanding
4/1
Issued shares
5/1
100% stock dividend
Retroactive to 1/1
Retroactive to 4/1
10/1 Issued shares
Total Weighted Avg.
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# of
# Mos. Weighted
Shares
Shares Outstd.
100,000
12/12
100,000
50,000
9/12
37,500
100,000
50,000
10,000
12/12
9/12
3/12
100,000
37,500
2,500
277,500
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Computing EPS Complex Capital
Structure
■
Dual presentation of EPS requires two computations:
– Basic EPS (PEPS)
– Fully diluted EPS (FDEPS)
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of the chapter?
21
FDEPS
■
Reflects the maximum
dilution of EPS that
would occur if conversion
or exercise of all dilutive
securities took place at
the beginning of the
period ( or issuance date
if later)
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FDEPS
■
■
■
Potentially dilutive elements
– Convertible senior shares
Add to Numerator
– Dividends (DCSS)
Add to denominator
– Shares to be issued (STBI)
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FDEPS
■
■
■
Potentially dilutive elements
– Convertible senior shares
Add to Numerator
– Dividends (DCSS)
Add to denominator
– Shares to be issued (STBI)
NI
NI (after
(aftertax)
tax) ––Pref.
Pref.div.+
div.+ DCSS
DCSS
Wgt.
Wgt. avg
avg o/s
o/scommon
commonshares
shares++STBI
STBI
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FDEPS
■
■
■
Potentially dilutive elements
– Convertible debt
Add to Numerator
– After-tax interest (ATI)
Add to denominator
– Shares to be issued (STBI)
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FDEPS
■
■
■
Potentially dilutive elements
– Convertible debt
Add to Numerator
– After-tax interest (ATI)
Add to denominator
– Shares to be issued (STBI)
NI
NI (after
(aftertax)
tax) ––Pref.
Pref.div.+
div.+ ATI
ATI
Wgt.
Wgt. avg
avg o/s
o/scommon
commonshares
shares++STBI
STBI
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FDEPS
■
■
■
Potentially dilutive elements
– Options
Add to Numerator
– After-tax earnings on proceeds (ATEOP)
Add to denominator
– Shares to be issued (STBI)
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FDEPS
■
■
■
Potentially dilutive elements
– Options
Add to Numerator
– After-tax earnings on proceeds (ATEOP)
Add to denominator
– Shares to be issued (STBI)
NI
NI (after
(aftertax)
tax) ––Pref.
Pref.div.+
div.+ ATEOP
ATEOP
Wgt.
Wgt. avg
avg o/s
o/scommon
commonshares
shares++STBI
STBI
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FDEPS -EXAMPLE
Apple Co.
■
■
■
■
■
7% Bonds
$1,000,000
– Convertible to 500,000 Common Shares
$9 Cumulative Preferred
Shares (40,000 shares) $4,000,000
– Convertible to 400,000 Common Shares
Options for:
– 1,000,000 Common Shares @ $50 per share
Tax Rate 40% and
Bank Interest Rate 8%
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FDEPS - Example
■
■
Basic EPS (given)
–
NI - Pref Div
WACS
– = $2,360,000 - $360,000
2,000,000
–
= $1
Which elements are dilutive?
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FDEPS
Bonds - Individual Effect
Interest: $1,000,000 X .07 X (1-.4)
Shares:
500,000
= $42,000 =
$0.08
500,000
Lower than basic EPS : dilutive
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FDEPS
Preferred Shares - Individual Effect
Dividends:
Shares:
$300,000
400,000
=
$0.08
Lower than basic EPS : dilutive
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FDEPS
Options - Individual Effect
Earnings: $1,000,000 X $50 X .08 X (1-.4)
Shares:
1,000,000
= $2,400,000 = $2.40
1,000,000
Higher than basic EPS : antidilutive
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FDEPS - D/A Test
■
■
■
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Only include items that will
reduce Basic EPS
Start with the most dilutive
number
Pick combination that produces
lowest FDEPS
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FDEPS
Calculation (000's):
Basic
Bonds
NI
$2,000
42
$2,042
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Shares
2,000
500
2,500
EPS
$1.00
.81
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FDEPS - Part Year Rule
■
■
If securities issues during the year, only 'back date'
conversion to date of issue
Example:
– 12% Bonds,
$10,000,000
✜
✜
✜
Issued November 1
Convertible to 12,000,000 common shares
Tax rate, 40%
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FDEPS - Part Year Rule
Calculation - Individual effect
Interest: $10,000,000 X .12 X (1-.4) X 2/12
Shares:
12,000,000 X 2/12
= $120,000 =
$0.06
2,000,000
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FDEPS
■
■
■
■
Convertible securities only included if conversion
possible in 10 year time span
If various terms included, use most dilutive option
FDEPS only need be disclosed if materially different
than Basic
FDEPS - Dual disclosure (NI before .... and NI)
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ADJUSTED BASIC EPS
■
■
Requires if :
– Common shares are issued on conversion of senior
shares or debt during the period
Calculation:
– EPS as though conversion took place at beginning
of year
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ADJUSTED BASIC EPS - EXAMPLE
■
■
Basic EPS (given)
–
NI - Pref Div
WACS
– = $1,000,000 - $100,000
900,000
–
= $1
On August 1, $1,000,000 of 12% bonds had converted
to 100,000 common shares
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ADJUSTED BASIC EPS
■
■
■
Adjusted EPS
$900,000 + ($1,000,000 X .12 X (1-.4) X 7/12)
900,000 + (100,000 X 7/12)
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ADJUSTED BASIC EPS
■
■
■
May be higher or lower than Basic
Need only be disclosed if different than Basic
If calculated, are the starting point for FDEPS
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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21
PRO FORMA EPS
■
■
Required if common shares issued after the balance
sheet date
– For cash, cash used to retire senior shares or debt
– On conversion of senior shares or debt
– In a reorganization
Calculation:
– EPS as though conversion/issuance took place at
the beginning of the year
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21
PRO FORMA EPS - EXAMPLE
■
■
■
Basic EPS (given)
–
NI - Pref Div
WACS
– = $1,000,000 - $100,000
900,000
–
= $1
On January 15, after the year end 200,000 shares were
issued to retire $1,0000,000 of 12% bonds.
What is the proforma basic?
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PRO FORMA EPS - EXAMPLE
●
Pro forma
forma Basic
Basic Calculation
Calculation
● Pro
$900,000
$900,000 ++ ($1,000,000
($1,000,000 XX .12
.12 XX (1-.4))
(1-.4))
900,000
900,000 ++ 200,000
200,000
== $920,000
$0.88
$920,000 ==
$0.88
1,100,000
1,100,000
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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21
PRO FORMA EPS
■
■
Calculate of Basic and FD
Only disclose if materially different from Basic and FD
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21
US RULES
■
■
■
■
Basic EPS like Canadian
Primary and FDEPS for complex capital structures
Primary EPS involves calculation of Common Stock
Equivalents
Treasury stock method used for dilutive options
Copyright  1998 McGraw-Hill Ryerson Limited, Canada
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Now we are
finished!!