FASB Statement No. 128 (Earnings Per Share) requires the computation of basic EPS and diluted EPS. Basic EPS includes only the actual number of outstanding shares during the period. Diluted EPS includes the effect of common shares actually outstanding and the effect of convertible securities, stock options, stock warrants, and their equivalents. Diluted EPS does not include anti dilutive securities (contingent issuance of securities increasing EPS or decreasing loss per share).
Basic EPS equals net income available to common stockholders divided by the weighted-average number of common shares outstanding.
Weighted-average common stock shares outstanding considers the number of months in which those shares were outstanding.
Let’s do some examples for easier understanding…
On 1/1/20X1 10,000 shares were issued. On 4/1/20X1 2,000 of those shares were reacquired. The weighted average common stock outstanding is:
(10, 000 × 3/12) + (8, 000 × 9/12) = 8, 500 share
The following information is presented for a business:
Preferred stock, $10 par, 6% cumulative, 30,000 shares issued, and outstanding $300,000
Common stock, $5 par, 100,000 shares issued and outstanding $500,000
Net income $400,000
Cash dividend on preferred stock = $300,000 × 6% = $18,000
Basic EPS = Net income less preferred dividends divided by common shares outstanding
$400,000 ? $18,000 = $320,000/100,000 shares = $3.82
On 1/1/20X5, a company had the following outstanding shares:
Cumulative preferred stock, 6%, $100 par 150,000 shares
Common stock, $5 par 500,000 shares
During the year, the following occurred:
On 4/1/20X5, the company issued 100,000 shares of common stock.
On 9/1/20X5, the company declared and issued a 10 percent stock dividend.
For the year ended 12/31/20X5, the net income was $2,200,000.
Basic EPS for 20X5 equals $2.06 ($1,300,000/632,500 shares) computed below.
Earnings available to common stockholders:
Net income $2,200,000
Less: Preferred dividend (150,000 shares × $6) $900,000
Earnings available to common stockholders = $1,300,000
Weighted-average number of common shares outstanding is computed as:
1/1/20X5 ? 3/31/20X5 (500,000 × 3/12 × 110%) 137,500
4/1/20X5 ? 8/31/20X5 (600,000 × 5/12 × 110%) 275,000
9/1/20X5 ? 12/31/20X5 (660,000 × 4/12) 220,000
So, weighted-average common shares outstanding is 632,500
Diluted EPS = Net income available to common stockholders + net of tax interest and/or dividend savings on convertible securities/weighted average number of common shares outstanding + effect of convertible securities + net effect of stock options
Assume the same information as in Example-3. Further assume that potentially diluted securities outstanding include 5 percent convertible bonds (each $1,000 bond is convertible into 25 shares of common stock) having a face value of $5 million. There are options to buy 50,000 shares of common stock at $10 per share. The average market price for common shares is $25 per share for 20X5. The tax rate is 30 percent.
Diluted EPS for 20X5 is $1.87 ($1,475,000/787,500 shares) as computed below.
Income for diluted EPS:
Earnings available to common stockholders $1,300,000
Interest expense on convertible bonds ($5,000,000 × 0.05) $ 250,000
Less: Tax savings ($250,000 × 0.30) $ 75,000
Interest expense (net of tax) $ 175,000
Income for diluted EPS = $1,475,000
While shares outstanding for diluted EPS:
Weighted-average outstanding common shares 632,500
Assumed issued common shares for convertible bonds (5,000 bonds × 25 shares) 125,000
Assumed issued common shares from exercise of option 50,000
Less: Assumed repurchase of treasury shares 20,000
Net amount of shares 30,000
Shares outstanding for diluted EPS 787,500
Basic EPS and diluted EPS (if required) must be disclosed on the face of the income statement. A reconciliation is required of the numerators and denominators for both basic and diluted EPS calculations.
When shares are issued because of a stock dividend or stock split, the computation of weighted-average common stock shares outstanding requires retroactive adjustment as if the shares were outstanding at the beginning of the year.
The common stock equivalency of options and warrants is determined using the treasury stock method. Options and warrants are assumed exercised at the beginning
of the year (or at time of issuance, if later).
One hundred shares are under option at an option price of $10. The average market price of stock is $25. The common stock equivalent is 60 shares as calculated below:
Issued shares from option 100 shares × $10 = $1,000
Less: Treasury shares 40 shares × $25 = $1,000
Common stock equivalent 60 shares
Convertible securities are accounted for using the ‘‘if converted method.’’ The convertible securities are assumed converted at the beginning of the earliest year presented or date of security issuance. Interest or dividends on them are added back to net income since the securities are considered part of equity in the denominator of the EPS calculation.
Net income less preferred dividends is in the numerator of the EPS fraction representing earnings available to common stockholders. On cumulative preferred stock, preferred dividends for the current year are subtracted whether paid or not. Furthermore, preferred dividends are only subtracted for the current year. Thus, if preferred dividends in arrears were for five years, all of which were paid plus the sixth-year dividend, only the sixth-year dividend (current year) would be deducted. Note that preferred dividends for each of the prior years would have been deducted in those years.
In computing EPS, preferred dividends are only subtracted on preferred stock that was not included as a common stock equivalent. If the preferred stock is a common stock equivalent, the preferred dividend will not be deducted because the equivalency of preferred shares into common shares are included in the denominator.
If convertible bonds are included in the denominator of EPS, they are considered as equivalent to common shares. Thus, interest expense (net of tax) has to be added back in the numerator.
Disclosure of EPS should include information on the capital structure, explanation of the computation of EPS, identification of common stock equivalents, number of shares converted, and assumptions made. Rights and privileges of the securities should also be disclosed. Such disclosure includes dividend and participation rights, conversion ratios, call prices, and sinking fund requirements.
A stock conversion occurring during the year, or between year-end and the audit report date, may have significantly impacted EPS if it had occurred at the beginning of the year. Thus, supplementary footnote disclosure should be made reflecting on an ‘‘as if’’ basis what the effects of these conversions would have had on EPS if they were made at the start of the accounting period.
If a subsidiary has been acquired under the purchase accounting method during the year, the weighted-average shares outstanding for the year is used from the purchase date.
When comparative financial statements are presented, there is a retroactive adjustment for stock splits and stock dividends. Assume that in 20X5 a 10 percent stock dividend occurs. The weighted-average shares used for previous year’s computations has to be increased by 10 percent to make EPS data comparable. When a prior period adjustment occurs that results in a restatement of previous years’ earnings, EPS should be restated.
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