Appendix 4-B
EARNINGS PER SHARE—
ADDITIONAL ISSUES
Earnings per share is probably the most widely used indicator of corporate performance. Yet
most of those who use it do not understand how it is computed. Fewer still understand how it
is affected by the issuance of convertibles, options, or other potentially dilutive securities. In
the text we have outlined the procedures used in its calculation. In this appendix, we discuss
computational issues, disclosure requirements, and the few differences between US and
IASB standards.
COMPUTATIONAL ISSUES
Weighted Average Number of Common Shares Outstanding
The denominator must reflect all stock dividends and stock splits effective during the period
and those announced after the end of the reporting period (but before the financial statements
are issued) as if they had been effective at the beginning of the reporting period. All prior pe-
riods presented are restated for comparability.
Acquisitions
Shares issued in purchase method acquisitions (see Chapter 14) are included in the denomi-
nator only for the period following the acquisition date. Similarly, only the postacquisition
results of operations of the acquired firms are included in the numerator of the EPS computa-
tion. Note that no restatement of prior periods is permitted for purchase method acquisitions.
The impact of the pooling method is quite different. Merged firms are considered com-
bined entities for all years presented. The shares issued in the combination are assumed to
have been outstanding for all periods presented, and the results of operations for the two
firms are also combined for those periods in the EPS calculation.
Contingent Shares
Acquisitions and incentive compensation plans may require the issuance of common
shares if specific conditions, such as the passage of time, achievement of income levels, or
specified market prices of the common stock, are met. Securities whose issuance depends
solely on the passage of time are always included in the weighted average shares outstand-
ing. Other contingent shares are included in the computation of basic and diluted EPS if
the required income levels or market prices have been reached at the end of the reporting
period.
When the issuance of contingent shares depends on the achievement of earnings targets,
and when it is likely that those targets will be achieved, the computation of diluted earnings
per share includes both the incremental shares and the level of income assumed to have been
achieved. These adjustments to the EPS measures are required even if the incremental shares
are to be issued at a later date.
W3
W4 APPENDIX 4-B EARNINGS PER SHARE—ADDITIONAL SHARES
EPS Computations for Two-Class Securities
Some firms issue more than one class of common stock or have “participating” securities
that are entitled to share in the dividends paid on common stock. EPS computations for each
class of nonconvertible1 two-class securities are based on an allocation of earnings according
to dividends paid and participation rights in undistributed earnings.
Adjustments for Rights Issues
Both SFAS 128 and IAS 33 mandate the use of the ex-rights method in the computation of
basic and diluted EPS for the bonus element (discount to market price prior to the offering)
in a rights issue. Under prior US GAAP, the bonus element was ignored. The ex-rights
method recognizes dilution when rights are issued to buy shares below the current market
price.
Impact of New and Proposed Accounting Standards
SFAS 144 (2001) broadened the definition of discontinued operations as discussed on pages
54 and 275 of the text. This change means that, for firms disposing of unprofitable opera-
tions, income from continuing operations will be higher than it would have been under prior
accounting standards. Because income from continuing operations is the “control number”
used to determine whether options and convertible securities are dilutive, higher income
from continuing operations will result in more of these potential common shares entering
into the computation of dilutive EPS.
In its proposed reporting for securities with characteristics of liabilities or equity or both
(see Box 10-2 on page 338 of the text), the FASB intends to redefine the control number as
income from continuing operations attributable to controlling shareholders. Under current
GAAP, income allocated to minority or noncontrolling shareholders is deducted in comput-
ing the income from continuing operations. Thus, companies with profitable majority-owned
subsidiaries will report higher control numbers under this proposed standard. Again, more
potential common stock will be classified as dilutive securities.
INTERNATIONAL DIFFERENCES
As stated in the text, the FASB and IASB developed their new standards together. As a re-
sult, there are few differences between the two. The most important difference is that US
GAAP requires that EPS be reported for all components of net income. IASB GAAP re-
quires disclosure of EPS only for net income; any other components of EPS reported, how-
ever, must accord with the new standard.
Under SFAS 128, earnings from continuing operations is the “control number” used to
determine whether potential common shares are dilutive (see previous section). Thus, ac-
counting changes, discontinued operations, and extraordinary items do not affect determina-
tion of the dilutive effect. Under IAS 33, net income is the control number. Given the high
frequency of extraordinary items and other differences between earnings from continuing
operations and net income, it is likely that, for some firms, the dilutive effect will be different
depending on whether they use US GAAP or IASB GAAP.
1
If shares of one class are convertible into shares of another class, as is normally the case, the if-converted method
must be used for the convertible securities if the effect is dilutive.