Acct 592 Notes & Examples

Prof. Teresa Gordon

Introduction to
EARNINGS PER SHARE
CAPITAL STRUCTURE
SIMPLE - no potentially dilutive securities exist
No Convertible Preferred Stock
No Convertible Bonds Or Other Debt
No Stock Options Or Warrants
No Contingent Shares
BASIC EARNINGS PER SHARE =
(Net Income - Preferred Dividends*)
Weighted average of common shares outstanding
* If preferred stock is cumulative, deduct dividends whether or not paid or
declared. If preferred is noncumulative, deduct dividends only if declared.

FOR PUBLICLY TRADED CORPORATIONS WITH COMPLEX CAPITAL

STRUCTURE:
Dual presentation of earnings per share:
Basic earnings per share
Diluted earnings per share

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Acct 592 Notes & Examples

Prof. Teresa Gordon

EFFECT OF POTENTIALLY DILUTIVE SECURITIES ON EPS

Convertible bonds and preferred stock:
WHAT IF METHOD
Stock options, warrants and other contingent issues:
TREASURY STOCK METHOD

DILUTED EARNINGS PER SHARE =

Net income

Preferred dividends if
preferred stock is NOT
convertible

After-tax bond
interest on
convertible
bonds
Weighted average of common shares assuming
maximum dilution (including options)

TREASURY STOCK METHOD PROCEDURES

1.

Compute amount of cash that would be received if all the stock

options or warrants were exercised.
Note: If the options are part of the employee compensation
package, add (to the cash received based on option price) the
amount (if any) of compensation expense not yet recognized in
income and any tax benefits (both deferred and current) that
would be credited to additional paid in capital if the options were
exercised (SFAS 128 21).

2.

Compute the number of shares that could be purchased with the

cash amount from step 1 using average market price for period

3.

Compute the number of NET new shares - subtract the number

acquired (step 2) from the total number of options or warrants
that would be exercised (step 1).

Or use formula:
Net new shares

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Number of shares to which

option holders are entitled

Avg Mkt Price Option Price

Avg Mkt Price

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Acct 592 Notes & Examples

Prof. Teresa Gordon

Note: Under the treasury stock method, you cannot use a negative number
(decrease in denominator)! There will be no dilutive effect if options are out of the
money or at the money

EARNINGS PER SHARE DISCLOSURES:

ON INCOME STATEMENT
PER SHARE AMOUNTS FOR
Income From Continuing Operations
Income Before Extraordinary Items
CumulativeEffectOfChangeInAccountingPrinciple
Net Income

(Basic and diluted eps are both shown for each item if appropriate)
Weighted average shares used in computations
WARNING WATCH OUT FOR ANTI-DILUTIVE SECURITIES
Earnings per share should be lowest possible number
An anti-dilutive security is one that
causes the earnings per share to INCREASE
or the loss per share to DECREASE

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Acct 592 Notes & Examples

Prof. Teresa Gordon

Using straight formulas may get you wrong answer if there are antidilutive securities involved.
FOR COMPLEX SITUATIONS, USE THE FOLLOWING ALGORITHM:
1.

Compute the per share effect of each potentially

dilutive security separately.

2.

Make a list from smallest per share number to

largest
per share number

3.

Compute basic earnings per share

4.

For diluted EPS, take the securities into EPS

computation one at a time until the next item on
the list is bigger than the most recent EPS figure.

There are many complex situations in computing earnings per share you will
need to consult FARS CD. The rules are primarily in FAS128 but it has been
amended. For example, SFAS No. 150:
Exclude from denominator common shares that are to be redeemed or
repurchased pursuant to financial instruments described in FAS150.
Exclude from numerator any amounts (including contractual or
accumulated dividends and participation rights in undistributed
earnings) attributable to shares that are to be redeemed or
repurchased UNLESS such amounts have been recognized as interest
costs in earnings. The technique would be consistent with the two
class method set forth in in paragraph 61 of FASB Statement No. 128

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EPS REVIEW EXAMPLE #1 JKL Corp. reported net income of $1,000,000 for 2011. This amount
included a 50,000 extraordinary gain. The tax rate was 40%. As of 1/1/11,
200,000 shares of common stock were outstanding. On 6/1/11 30,000 new
shares were sold. There are no potentially dilutive securities outstanding but
JKL has 2,000 shares of 8% cumulative preferred stock ($10 par) which was
outstanding all year.
JKL also has an issue of convertible preferred stock (cumulative)
that was outstanding during the entire year. The preferred stock has a $100
par value and pays a $10 annual dividend. The 5,000 shares were
outstanding all year. Each share of preferred stock can be converted into 5
shares of common stock.
JKL also has $3,000,000 in convertible bonds outstanding all year.
The bonds were sold at face value and pay 6% interest semi-annually. Each
$1000 bond can be converted into 50 shares of common stock.
JKL Corp. also has stock options outstanding. During the next five
years, option holders can buy 40,000 shares of common stock at $10 per
share. The average market price during 2001 was $40 and the year-end
closing price was $45 per share.

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Working paper for #1

EARNINGS PER SHARE
Net income

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NUMERATOR
$1,000,000

DENOMINATOR

EPS

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Earnings Per Share Review Example #2

CONSIDER THE FOLLOWING TRANSACTIONS IN COMMON STOCK:
ISSUED
Common shares outstanding Jan 1 to Feb
March 1, treasury stock sold
Shares outstanding Mar 1 to May 31
Jun 1, new shares issued
Shares outstanding Jun 1 to Aug 31
Sep 1, acquired treasury stock
Shares outstanding Sep 1 to Oct 31
Nov 1, 200% stock dividend issued
Shares outstanding Nov 1 to Dec 31
Dates

Actual Shares
Outstanding

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28100,000
100,000
20,000
120,000
120,000
228,000
348,000

Retroactive
Stock
Splits &
Dividends

SHARES IN
TREASURY
5,000
-1,000
4,000
4,000
2,000
6,000
6,000

Months
Outstanding

OUTSTANDING
95,000
1,000
96,000
20,000
116,000
- 2,000
114,000
228,000
342,000

Weighted
shares
Outstanding

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EARNINGS PER SHARE EXAMPLE #3

Using the algorithm
Campbell Company had five convertible securities outstanding all during the year. It paid the
appropriate interest and amortized the premiums and discounts using either the straight-line
method or the effective interest method (as indicated below). All dividends on preferred
stock were paid. The corporate tax rate was 30%. The following table describes each
security. Prepare a schedule that lists the impact of assumed conversion of each convertible
security on diluted earnings per share and put them in the order in which they would be
included in the computation of diluted earnings per share.
A. 9.5% preferred
stock

B. 11.0% bonds

C. 8.0% preferred
stock

D. 8.0% bonds

E. 9% bonds

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$2,000,000 par value. Issued at

112. Each $100 par preferred
stock is convertible into 5 shares of
common stock. This stock is not
cumulative but the dividend for the
year was paid.
$300,000 face value. Issued at
par. Each $1,000 bond is
convertible into 44 shares of
common stock.
$150,000 par value. Issued at par.
Each $100 par preferred stock is
convertible into 3 shares of
common stock. The stock is
cumulative with no dividends in
arrears.
Face value of $5,000,000. Bonds
were issued at a discount.
Because the impact was material,
the company uses the effective
interest method. The bonds pay
interest semi-annually on June 30
and December 31. The yield on
the bonds was 10%. The book
value at the beginning of the year
was $4,783,526. Each $1000
bond can be converted into 50
shares of common stock.
Face value of $5,000,000. Bonds
were issued at 101. Since the
premium was not material, the
company uses the straight-line
method to amortize the premium
over the 20 year life of the bond.
Each 5000 bond is convertible into
150 shares of common stock.

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Teaching transparency Example #3

A. 9.5% preferred stock $2,000,000 par value. Issued at 112. Each
$100 par preferred stock is convertible into 5 shares
of common stock. This stock is not cumulative but
the dividend for the year was paid.

B. 11.0% bonds
$300,000 face value. Issued at par. Each $1,000
bond is convertible into 44 shares of common stock.

C. 8.0% preferred stock $150,000 par value. Issued at par. Each $100
par preferred stock is convertible into 3 shares of
common stock. The stock is cumulative with no
dividends in arrears.

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Teaching transparency Example #3

D. 8.0% bonds Face value of $5,000,000. Bonds were issued at a discount.
Because the impact was material, the company uses the
effective interest method. The bonds pay interest semiannually on June 30 and December 31. The yield on the
bonds was 10%. The book value at the beginning of the
year was $4,783,526. Each $1000 bond can be converted
into 50 shares of common stock.

E. 9% bonds

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Face value of $5,000,000. Bonds were issued at 101.

Since the premium was not material, the company uses
the straight-line method to amortize the premium over
the 20 year life of the bond. Each $5,000 bond is
convertible into 150 shares of common stock.

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Worksheet for Example #3

Assume net income for year was $1,385,000 and the weighted
average common shares was 500,000
EARNINGS PER SHARE
Net income

NUMERATOR
$1,385,000

DENOMINATOR
500,000

EPS

Reminder Work #4 (separate file) for homework to reinforce the algorithm

approach before we dig into the complications caused by stock-based
compensation for employees

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Problem 4 (homework) Also available in an Excel File

Mel Company has four convertible securities. For the bonds, the company paid the
appropriate interest and amortized the premiums and discounts using either the
straight-line method or the effective interest method (as indicated below). All
dividends on preferred stock were paid. All stock prices shown have been adjusted
for the Sept. 30 stock split (see A).
A. Common Stock. Authorized 50,000,000 shares,
issued 150,000 shares, outstanding at the beginning of
the year, 120,000 shares.
On March 28, Mel purchased another 10,000 shares of
treasury stock.
During the year, Mel sold 50,000 shares on July 1.

Net income =

$1,000,000

Tax rate =

40%

On September 30, Mel issued a 200% stock dividend

to all issued shares (i.e., the treasury stock and the
outstanding shares both receive the stock dividend).
Numerator

Denominator

B. $10 Preferred Stock. There were 50,000 shares

outstanding all year. Each $100 par preferred stock is
convertible into 4 shares of common stock before the
stock dividend and 12 shares after the 200% stock
dividend (see A). The stock is cumulative with no
dividends in arrears.
C. Stock options. Mel issued 100,000 options five
years ago. The exercise price was $30. The average
market price for the current year is $45. Each option
converts into 3 shares of common stock after the stock
dividend. No options were exercised during the year.
D. Convertible Bonds. The bonds have been
outstanding all year. The face value is $10,000,000
with a coupon rate of 10%. Bonds were issued at a
premium. Because the impact was material, the
company uses the effective interest method. The
bonds pay interest semi-annually on June 30 and
December 31. The yield on the bonds was 8%. The
book value at the beginning of the year was
$11,576,073. Each $1,000 bond can be converted into
20 shares of common stock before the stock dividend
and 60 shares after the stock dividend.
E. Convertible Bonds. Mel issued the bonds on July 1
of the current year at 103. The face value is
$8,000,000 and the coupon rate is 9%. Since the
discount was not material, the company uses the
straight-line method to amortize the discount over the
20 year life of the bond. Each $5,000 bond was
convertible into 60 shares of common stock before the
stock dividend and 180 shares after stock dividend.
Warning: The excel file may be missing the end of certain cells due to copy/paste limitations

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Index

EPS Problem #5 - Using Treasury Stock Method when there is Share-based Compensation

Based on Stock Options Example 2 (Cliff Vesting Equity Award)

For a Christmas bonus on December 31, 2010, Genessee Engineering, Inc. gave its executives
stock options that entitle them to purchase up to 5,000 shares of Genessee Engineering
company stock for $20 per share. The executives cannot exercise the options until January 1,
2013, and they must decide whether to exercise their option to buy stock at $20 per share on
or before July 1, 2013. To remain eligible for the stock options, they have to remain in the
employment of Genessee Engineering. On December 31, 2010, the date of the grant,
Genessee Engineering stock was selling for $25 per share. Assume that the fair value of the
options at 12-31-10 was $9.00 each and that there were 20 executives eligible for
participation. Based on past history, Genessee Engineering expects a 5% annual turnover
rate among its executives. The companys income tax rate is 34%. Weve already worked
this example and prepared journal entries related to the share-based compensation..

Assume that Genessee Engineering has no potentially dilutive securities other

than the executive stock options. There are no preferred stock and no
convertible bonds. The fair value of the options was $9.00 at the grant date.
Compute earnings per share for 2011, 2012, and 2013 using the following
additional information. Refer to Illustration 8 in SFAS No. 128 as revised by
SFAS No. 123(R) in 2004.

Year

Net income

2011
2012
2013

$1,000,000
$1,200,000
$1,300,000

Options Outstanding
at end of year

Weighted
Average Shares
of Common
Stock
Outstanding

Average
market price

95,000
90,000

250,000
300,000

$24.95
$26.82

0 at 12/31
85,000 exercised at
4/1

To be
computed,
beginning of
year = 325,000

For 1/1 to
4/1 $30.25

5,000 expired on
7/1

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Tax rate

34%
34%
34%

For 1/1 to
7/1 $27.56

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Check Figures for Example Problems:

1.

Basic before extraordinary items = $4.36

Net income per share = $2.62

2.

W. A. shares outstanding = 320,500

3.

Basic = $2.37
Diluted = $2.01

4.

Homework, no check figures

5.

See separate solution file in Excel

2011 Basic = $4.00; Diluted = $4.00
2012 Basic = $4.00; Diluted = $3.77
2013 Basic = $3.34; Diluted = $3.28

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