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Intermediate Financial Accounting

Intermediate Financial Accounting. Earnings Per Share. Objectives of the Chapter. To distinguish between a simple and a complex capital structure. To calculate basic earnings per share. To calculate diluted earnings per share for a company with a complex capital structure. Earnings Per Share.

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Intermediate Financial Accounting

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  1. Intermediate Financial Accounting Earnings Per Share

  2. Objectives of the Chapter • To distinguish between a simple and a complex capital structure. • To calculate basic earnings per share. • To calculate diluted earnings per share for a company with a complex capital structure. Earnings Per Share

  3. Earnings Per Share • Earnings per share is perceived to be the single measure that can best summarize the performance of a company. • It is reported most frequently in the media and receives the most attention by investors and creditors. Earnings Per Share

  4. Simple Capital Structure • A company with a simple capital structure can only have common stock (C.S.) and non-convertible preferred stock. • It cannot have any potentially dilutive securities (i.e.,stock options,warrants, convertible bonds, convertible preferred stock). Earnings Per Share

  5. Simple Capital Structure(contd.) • For a simple capital structure, the basic earnings per share (EPS) computation is: Net Income - Preferred Dividend = --------------------------------------------------- Weighted Average Number of Common Shares Outstanding Earnings Per Share

  6. Simple Capital Structure (contd.) • Example of computing weighted average shares: Assume a company had 12,000 shares of C.S. outstanding on 1/1. On 3/2, it issued 2700 shares; on7/3, it issued another 3,300 shares; and on December 1, it acquired 480 shares as treasury stock. The weighted average number of common shares is 15,860 shares, as computed in Exhibit 1: Earnings Per Share

  7. Simple Capital StructureExhibit 1: Months shares Shares * Fraction of Year = Equivalent Are OutstandingOutstandingOutstandingWhole Units Jan - Feb 12,000 2/12 2,000 Mar.-June 14,700 4/12 4,900 July - Nov 18,000 5/12 7,500 December 17,520 1/12 1,460 Total Weighted Average Common Shares 15,860 ===== Earnings Per Share

  8. Weighted Average Shares and Stock Dividends or Splits • Retroactive recognition is given to the events of stock dividend and stock split for all comparative income statement presented. • The purpose of the retroactive adjustment is to result in comparable EPS for all periods presented in terms of the most recent capital structure. Earnings Per Share

  9. Weighted Average Shares and Stock Dividends or Splits Example: • A company begins operations in January 20x4, and issues 5,000 shares of common stock that are outstanding during all 20x4. • On 12/31/x4, it has a two-for-one stock split. At the end of 20x4, the weighted average number of shares is 10,000 (5,000*200% *12/12) because the two- for-one split is assumed to have occurred on January1, 20x4. Earnings Per Share

  10. Weighted Average Shares and Stock Dividends or Splits Example (contd.) • On May 29, 20x5, the company issues 5,000 shares of common stock. • On August 3, 20x5, it issues a 20% stock dividend. • On October5, 20x5, it issues 2,000 shares of common stock. Earnings Per Share

  11. Weighted Average Shares and Stock Dividends or Splits Example (contd.) • When presenting comparative EPS for 20x4 and 20x5 at the end of 20x5, the weighted average number of shares are 12,000 and 16,000 shares for 20x4 and 20x5, respectively. • The computation is as shown in exhibit 2. Earnings Per Share

  12. Weighted Average Shares and Stock Dividends or Splits Exhibits 2: Actual Assumed Fraction Equiv. Months shares Shares Shares * of Year = Whole are OutstandingOutstandingOutstandingOutstandingShares 20x4 Jan -Deca 5,000 12,000b 12/12 12,000 20x5 Jan - May 10,000 12,000c 5/12 5,000 Jun - July 15,000 18,000d 2/12 3,000 Aug- Sep e 18,000 18,000 2/12 3,000 Oct - Dec 20,000 20,000 3/12 5,000 a. A 2 for 1 stock split on 12/31/20x4 16,000 b. 5,000 * 2 * 1.2 ; c. 10,000*1.2 ; d. 15,000*1.2 e. A 20% stock dividend on Aug. 3 Earnings Per Share

  13. Earnings Per Share Subtotals • EPS is presented by the components of net income. • Each of these EPS is based on the same weighted average number of shares and the components are summed to disclose the EPS of net income. • The intent is to show the contribution of each component of net income to EPS. Earnings Per Share

  14. Exhibit 3: Earnings Per Share Subtotals • NORCAT CORPORATION Earnings Per Share Disclosure Earnings Per common share outstanding: Income before extraordinary items $2.03 Extraordinary loss (0.37) Net income $1.76 Earnings Per Share

  15. Example:Computation and Disclosure of Basic Earnings Per Share (by subtotals) 1. Income statement information: a. Net income for 20x5 is $14,000. b. An extraordinary gain (net of income taxes) of $3,600 is included in net income. 2. Stockholders’ equity information (end of 20x5): a. 8% Preferred stock, $100 par $30,000 b. Common stock, $10 par $60,000 Earnings Per Share

  16. Earnings Per Share SubtotalsExample (contd.) 3. Additional information: a.No preferred stock was issued or reacquired during 20x5. b.Preferred dividends were declared during 20x5 at the stated rate. c. A review of the C.S.account showed that on January 1, 20x5, 2,000 shares of C.S. were outstanding. Earnings Per Share

  17. Earnings Per Share SubtotalsExample (contd.) d. On April, 500 shares of C.S. were issued for cash. e. On June 1, a two-for-one stock split occurred, resulting in 5,000 total C.S. f. On November 2, 1,000 shares of C.S. were issued for cash. Exhibit 4 shows the computation and disclosure of basic EPS by subtotals. Earnings Per Share

  18. Earnings Per Share SubtotalsExhibit 4: • Earnings per share computation for 20x5: Earnings Shares Earnings Adjust. Adjust. = Per Share Net income $14,000 P.S. div.a (2,400) C.S. shares b4,917 Earnings and $11,600  4,917 = $2.36 Shares Earnings Per Share

  19. Earnings Per Share SubtotalsExhibit 4 :(contd.) a. P.S. div.=$30,000 * 0.08 = $2,400. b. Weighted average shares: 4,000a * 3/12 =1,000 a.2,000*2(stk.sp) 5,000b * 7/12 = 2,917 b. 2,500*2 6,000c * 2/12 = 1,000 c.2,500*2+1,000 WACS 4,917 Earnings Per Share

  20. Earnings Per Share SubtotalsExhibit 4 :(contd.) • Condensed income statement presentation for 20x5: Income before extraordinary items $10,400 Extraordinary gain (net of I/T) 3,600 Net income 14,000 Basic earnings per com.share outstanding (see Note A): Income before extra. items $1.63 Extraordinary gain 0.73 Net income $2.36 Earnings Per Share

  21. Note A to financial statements: • Preferred dividends of $2,400 are deducted from income before extraordinary items and net income to determine earnings available to common stock. • The resulting amounts of $8,000 and $11,600 are divided by the 4,917 weighted average common shares to yield $1.63 and $2.36 earnings per share, respectively. Earnings Per Share

  22. Complex Capital Structure • The capital structure of many companies includes convertible securities, stock options and warrants. • Since conversion of these securities into common stock may decrease EPS, these securities are referred to as potentially dilutive securities. Earnings Per Share

  23. Complex Capital Structure (contd.) • These potentially dilutive securities are also referred to as common stock equivalents (CSE). • A CSE is a security that is not a common stock, but contains a provision enabling its holders to acquire common stock at predetermined terms which, at issuance, makes it, in substance, equivalent to a common stock. Earnings Per Share

  24. Complex Capital Structure (contd.) • Companies with complex capital structures are required to present both basic (no consideration of CSE) and diluted earnings per share (consider the potential impact of CSE) . Earnings Per Share

  25. Diluted Earnings Per Share • In computing diluted EPS (DEPS), the potential impact (i.e., the assumed conversion) of CSE is considered in addition to the weighted average shares. • The impact of assumed conversion of CSE on EPS will be on both numerator and denominator of EPS computation. Earnings Per Share

  26. Diluted Earnings Per Share (contd.) • To be included in the diluted EPS calculation, the CSE must have dilutive effect on EPS . • That is, the assumed conversion of the CSE has a negative impact on the EPS (i.e., reduce the EPS) Earnings Per Share

  27. Diluted Earnings Per Share(contd.) • The following sequence of steps should be followed for DEPS computation: Step 1: Compute the basic EPS. Step 2: Include dilutivestock options and warrants to compute a tentative DEPS. Step 3: Develop a ranking based on the assumedconversion impact of each CSE (other than stock options and warrants) on EPS. Earnings Per Share

  28. Diluted Earnings Per Share :(contd.) • Step 4: Include CSE in DEPS in a sequential order based on the ranking and compute a new tentative DEPS. Step 5: One CSE is included in the DEPS at a time to compute a tentative DEPS and the inclusion is cumulative. Step 6: Select the lowest tentative DEPS as the diluted EPS. Earnings Per Share

  29. Diluted Earnings Per ShareStock Options and Warrants (step 2) • Stock options and warrants are always considered to be CSE • Stock options and warrants are first to be included in the computation of DEPS if they are dilutive. Earnings Per Share

  30. Diluted Earnings Per ShareStock Options and Warrants (step 2) • Stock options or warrants were dilutive if the exercise of the options results in an increase of common shares using a treasury stock method. Earnings Per Share

  31. Diluted Earnings Per ShareStep 2 (contd.) • This method assumes that the options were exercised at the beginning of the period (or at the time of issuance of the options if it is later). • The assumed proceeds received from the assumed exercise were used (assumed) to reacquire the corporations common stock at the market price. Earnings Per Share

  32. Diluted Earnings Per ShareStep 2 (contd.) • The difference between the assumed shares issued (through the assumed exercise of options) and the shares reacquired (assumed) is added to the denominator in computing the DEPS. • Therefore, dilution occurs when the market price is greater (less) than the option price for a firm with profit (loss). Earnings Per Share

  33. Example: stock options and warrants • Assume a corporation has 10,000 common shares and options to purchase 1,000 common shares at $20 per share outstanding for the entire year. • The average market price for the common stock was $25 per share. • The net increase in the denominator would be 200 computed as follow: Earnings Per Share

  34. Example:(contd.) Shares assumed issued through the exercise of options 1,000 Shares assumed acquired: Proceeds = $20 * 1,000 = (800) Avg. market price $25 Assumed increase in common shares for computing DEPS 200 Earnings Per Share

  35. Diluted EPS with Stock options • Therefore, the stock options are dilutive and the 200 assumed increased shares would be added to the denominator in computing the DEPS. Earnings Per Share

  36. Diluted EPS (with CSE other than Stock Options and Warrants) • If CSE in the form of convertible bonds or convertible preferred stock were also outstanding, the DEPS which included only the dilutive options, would be “tentative” and subject to the possible inclusion of the convertible securities. Earnings Per Share

  37. Dilutive CSE • Other CSE (i.e., convertible securities) would be included in DEPS after stock options only if their inclusion has a dilutive effect on the EPS. Earnings Per Share

  38. Dilutive Effect on EPS – An example • Example: the following is selected data of BitZi Corp. for year 20x5: • Net income= $12,000, • Preferred dividend= $2,000, • Weighted Average Shares Out.= 10,000, • Convertible preferred stock out. = 1,000, Case A: each share of preferred stock is to be converted into four shares of common stock Earnings Per Share

  39. Dilutive Effect on EPS (contd.) • Basic EPS = ($12,000-$2000) = $1 10,000 Shares • Impact of the assumed conversion:$2000/4,000 shares = $0.5< Basic EPS • Thus, this CSE is dilutive and should be considered in the computation of DEPS as follows: • DEPS = $12,000/(10,000+4,000)=$.857 Earnings Per Share

  40. Dilutive Effect on EPS (contd.) • Case B: each convertible preferred stock is to be converted into one share of common stock. • Impact of the assumed conversion:$2000/1,000 shares = $2 > Basic EPS. • Thus, this CSE is anti-dilutive and should NOT be considered in the computation of DEPS. • If it is considered : the new EPS =$12,000/(10,000+1,000)=$1.09 >Basic EPS Earnings Per Share

  41. Ranking of Common Stock Equivalents (CSE) • A CSE may appear to be individually dilutive maybe anti-dilutive in combination with other CSE. • Therefore, a ranking is performed to determine the sequence in which the CSE (other than options) should be included in the DEPS computation. Earnings Per Share

  42. Ranking of Common Stock Equivalents (CSE) :(contd.) • This ranking is determined by comparing the impact on the EPS from the assumed conversion of each CSE at the beginning of the earliest period reported (or at the date of issuance of the CSE, if later). Earnings Per Share

  43. Ranking of Common Stock Equivalents (CSE) :(contd.) • The assumed conversion has impact on both numerator and denominator of DEPS. • The denominator will be increased and the numerator will also be increased (due to the decrease in interest expense or the savings on preferred dividends). Earnings Per Share

  44. Ranking of Common Stock Equivalents (CSE) :(contd.) • The impact of assumed conversion of CSE on DEPS is computed as: Change in EPS Numerator Impact on DEPS = ------------------------------------- Change in EPS Denominator The CSE with the smallest impact causes the least increase in the numerator relative to the increase in the denominator from the assumed conversion. Earnings Per Share

  45. Ranking of Common Stock Equivalents (CSE) :(contd.) • Thus, the CSE with the smallest impact will cause the greatest decrease in DEPS. • TheCSE with the smallest (largest) impact on DEPS is listed at the top (bottom) of the ranking. • The CSE with the smallest is the most dilutive CSE and is the first to be included in DEPS (after stock options). Earnings Per Share

  46. Ranking of Common Stock Equivalents (CSE) :(contd.) • The CSE are sequentially entered into the DEPS computation based on the ranking (beginning with the CSE listed on the top of the ranking). • Exhibits 5 illustrates the calculation of the ranking, assuming that Ashley Company has four CSE outstanding for the entire year. Earnings Per Share

  47. Example: Impact of Assumed Conversion of CSE and Ranking A. Summary of Common Stock Equivalents SecurityDescription . A 9% convertible preferred stock. Dividends of $5400 were declared during the year. The preferred shares are convertible into 3,000 shares of common stock. B 10% convertible bonds. Interest expense (net of income taxes) of $4,800 was recorded during the year. The bonds are convertible into 1,920 shares of common stock. Earnings Per Share

  48. Example: Impact of Assumed Conversion of CSE and Ranking (contd.) Security Description . C 8% convertible preferred stock. Dividends of $8,000 were declared during the year. The preferred shares are convertible into 5,000 shares of common stock. D 7% convertible bonds. Interest expense (net of income taxes) of $6,300 was recorded during the year. The bonds are convertible into 3,150 shares of common stock. Earnings Per Share

  49. Exhibit 5: Impact of Assumed Conversion of CSE and Ranking(contd.) B. Computation and Rankings SecurityImpact Order in Ranking A $5,400/3,000 2 = $1.80 B $4,800/1,920 = $2.50 4 C $8,000/5,000 = $1.60 1 (most dilutive one) D $6,300/3,150 = $2.00 3 Earnings Per Share

  50. Computation of Tentative and Final DEPS. • The CSE are sequentially included in the DEPS according to the Ranking to compute tentative DEPS. • One CSE is included in the DEPS at a time to compute a tentative DEPS and the inclusion is cumulative. Earnings Per Share

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