Acct 414 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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EFFECT OF POTENTIALLY DILUTIVE SECURITIES ON EPS Convertible bonds and preferred stock: Use the IF CONVERTED METHOD Stock options, warrants and other contingent issues: Use the TREASURY STOCK METHOD DILUTED EARNINGS PER SHARE =
Net income

Preferred dividends if preferred stock is NOT convertible Weighted average of common shares assuming maximum dilution (including options)

After-tax bond interest on convertible bonds

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. 3. Compute the number of shares that could be purchased with the cash amount from step 1 using average market price for period 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). Number of shares to which option holders are entitled Avg Mkt Price Option Price Avg Mkt Price

Or use formula: Net new shares

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

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Acct 414 Notes & Examples

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EARNINGS PER SHARE DISCLOSURES: ON INCOME STATEMENT PER SHARE AMOUNTS FOR
Income From Continuing Operations Income Before Extraordinary Items Cumulative Effect Of Change In Accounting Principle 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 Using straight formulas may get you wrong answer if there are anti-dilutive securities involved. FOR COMPLEX SITUATIONS, USE THE FOLLOWING ALGORITHM: 1. 2. 3. Compute the per share effect of each potentially dilutive security separately. Make a list from smallest per share number to largest per share number Compute basic earnings per share

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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 EXAMPLE #1 BASIC EPS JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10 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.

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EPS EXAMPLE #2 WHAT IF METHOD - CONVERTIBLE PREFERRED

(Same as #1) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 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.

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EPS EXAMPLE #3 WHAT IF METHOD - CONVERTIBLE BONDS

(Same as #1 and #2) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 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.

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EPS EXAMPLE #4 TREASURY STOCK METHOD - STOCK OPTIONS

(Same as #1) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 30,000 new shares were sold. JKL has 2,000 shares of 8% cumulative preferred stock ($10 par) which was outstanding all year.

JKL Corp. also 40,000 stock options outstanding all year. At any time during the next five years, the option holders have the right to buy a share of common stock for $10 per share. The average market price during 2010 was $40 and the year-end closing price was $45 per share.

What if we also had the potentially dilutive securities discussed in examples #2 and #3?

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Earnings Per Share Example #5 Weighted Average Shares To Nearest Month

CONSIDER THE FOLLOWING TRANSACTIONS IN COMMON STOCK:

Common shares outstanding Jan 1 to Feb 28 March 1, new shares sold Shares outstanding Mar 1 to April 30 May 1, 100% stock dividend issued Shares outstanding May 1 to Oct 31 Nov 1, acquired treasury stock Shares outstanding Oct 31 to Nov 30 Dec 1, re-issued treasury stock Shares outstanding Dec 1 to Dec 31
Dates Actual Shares Outstanding Retroactive Stock Splits & Dividends Months Outstanding

20,000 1,000 21,000 21,000 42,000 -2,000 40,000 1,000 41,000

Weighted shares Outstanding

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EARNINGS PER SHARE EXAMPLE #6 WEIGHTED AVERAGE SHARES ISSUED Common shares outstanding Jan 1 to Feb 28 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

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

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

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

Months Outstanding

Retroactive Stock Splits & Dividends

Weighted shares Outstanding

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EARNINGS PER SHARE EXAMPLE #7 (revised for F06) 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
$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. $1,500,000 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. The options were issued last year with an exercise price of $15. The average market price for the current year is $35. Options can be exercised during a 5 year period that begins at the end of the next fiscal year. 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.

B. 8.0% preferred stock

C. 50,000 options

D. 8.0% bonds

E. 9% bonds

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Teaching transparency Example #7

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. 8.0% preferred stock

$1,500,000 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.

C. 50,000 options

The options were issued last year with an exercise price of $15. The average market price for the current year is $35. Options can be exercised during a 5 year period that begins at the end of the next fiscal year.

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Teaching transparency Example #7

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 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.

E. 9% bonds

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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Assume net income for year was $1,585,000 and the weighted average common shares was 500,000
EARNINGS PER SHARE NUMERATOR DENOMINATOR EPS

Worksheet for Example #7

Net income

$1,585,000

500,000

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Example 8 Also available in an Excel File

Jolly 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).
Net income is The corporate tax rate is $2,098,600 40%

A. Common Stock. Authorized 50,000,000 shares, issued 150,000 shares, outstanding at the beginning of the year, 120,000 shares. On February 28, Jolly purchased another 10,000 shares of treasury stock. During the year, Jolly sold 50,000 shares on August 1. On September 30, Jolly issued a 50% stock dividend to all issued shares (i.e., the treasury stock and the outstanding shares both receive the stock dividend).
Numerato r Denominator Index

B. $10 Preferred Stock. There were 40,000 shares outstanding all year. Each $100 par preferred stock is convertible into 4 shares of common stock before the stock dividend and 6 shares after the 50% stock dividend (see A). The stock is cumulative with no dividends in arrears. C. Stock options. Jolly issued 100,000 options five years ago. The exercise price was $20. The average market price for the current year is $45. Each option converts into 1.5 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 $5,000 bond can be converted into 50 shares of common stock before the stock dividend and 75 shares after the stock dividend. E. Convertible Bonds. Jolly issued the bonds on July 1 of the current year at 98. The face value is $8,000,000 and the coupon rate is 8%. 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 $1,000 bond was convertible into 25 shares of common stock before the stock dividend and 37.5 after stock dividend.

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Acct 414 Notes & Examples

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Check Figures for Example Problems: 1. 2. 3. 4. 5. 6. 7. 8. Net income per share = $4.59 Basic = $4.36 Diluted = $4.12 Basic = $4.36 Diluted = $2.82 Basic = $4.59 Diluted = $4.03 W. A. shares outstanding = 41,417 W. A. shares outstanding = 320,500 Basic = $2.55 Diluted = $2.05 Weighted Average Shares = 198,750 Basic = $8.55 Diluted = $3.30

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