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Intermediate Accounting_ Seventh Canadian Edition

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					   CHAPTER

         17
Earnings per Share (EPS)
  Questions We Need to Answer

1. Why Earnings per share (EPS) is an
   important number?
2. What are GAAP requirements on reporting
   EPS?
3. How to calculate basic EPS and diluted EPS?
            Importance of EPS

• Calculated for common shares
• Tells shareholders how much of the available
  income is associated with the shares they own
• Provides insight to shareholders
   – Future dividend payout



   – Future share value
   – Impact of other financial instruments on
     their potential earnings (Diluted EPS)
       Basic EPS vs. Diluted EPS

• Basic EPS
  – Actual earnings and actual number of issued
    common shares
• Diluted EPS
  – Earnings and number of common shares adjusted
    for “what-if”
     • What would the EPS be if any financial instruments
       that could be converted to common shares were
       converted
          EPS Calculation


             Income available to common
             shareholders

EPS   =
            Weighted average number of
            common shares
               EPS Disclosure

• CICA Handbook, Section 3500.60 requires
  EPS to be reported as part of the income
  statement
• Reported for each income component as
  reported on the income statement
• If the firm has complex capital structure, both
  Basic EPS and Diluted EPS reported
• Presented for all periods reported
         EPS Reporting Requirements
  Capital        Major Types of Equity     Impact on EPS
 Structure           Instruments            Calculations

Simple       Common shares                Basic EPS only
             Preferred shares
Complex      Common shares                 Basic and
             Potential Common shares:      Diluted EPS
             –Convertible preferred shares
             –Convertible debt
             –Options/warrants
             –Contingently issuable
Example of EPS Disclosure
   EPS - Simple Capital Structure

         Net Income – Preferred Dividends
    Weighted Average # of Shares Outstanding

• If the preferred shares are non-cumulative
   – include only declared dividends
• If the preferred shares are cumulative
  – include only declared dividends, or
  – if no dividends declared, include only one year’s
    dividends
         EPS – The Numerator

Example: Michael Limited
• Net Income             $3,000,000
• Shares
  – 100,000 Class A preferred, cumulative shares,
    dividend amount $4.00 per share
  – 100,000 Class B preferred, non-cumulative
    shares, dividend amount $3.00 per share
• No dividends declared or paid in the current
  year and the previous year.
            EPS – The Numerator

  Net Income                       $3,000,000
  Amount attributable to Class A:
    100,000 x $4.00                   400,000
                                    2,600,000
  Amount attributable to Class B:
    100,000 x $0.00                       -0-
  Income available to
    common shareholders           $2,600,000

The Class B shares are non-cumulative, with no dividends
declared for the year no amount is deducted from Net Income
        EPS – The Denominator

         Net Income – Preferred Dividends
    Weighted Average # of Shares Outstanding

• Number of shares issued is weighted by the
  period of time they were outstanding
• Each transaction (issue of shares,
  reacquisition of shares, retirement of shares)
  represents a weighting period
          EPS – The Denominator

                                Shares      Dates
   Date     Share Changes
                              Outstanding Outstanding
Jan. 1    Beginning balance        90,000      ?

April 1   30,000 shares          120,000       ?
          issued
July 1    39,000 shares           81,000       ?
          purchased
Nov. 1    60,000 shares          141,000       ?
          issued
Dec. 31   Year end balance       141,000            --
            EPS – The Denominator

Dates Outstanding       Shares        Fraction Weighted Shares
                    Outstanding (A)
                                      Portion of Year   Weighted
                                      Outstanding (B)    Shares
                                                          (A*B)
       3 months              90,000        3/12           22,500
       3 months             120,000        3/12           30,000
       4 months              81,000        4/12           27,000
       2 months             141,000        2/12           23,500
Weighted Average Shares Outstanding                      103,000
        EPS – The Denominator

• Stock splits and stock dividends require
  restatement of the outstanding number of shares
  from the beginning of the year
   – Because there has been no change in the
     company’s assets, or in the shareholders’ total
     investment
           EPS – The Denominator

                                    Shares      Dates
    Date      Share Changes
                                  Outstanding Outstanding
Jan. 1     Beginning balance            90,000   3 months

April 1    30,000 shares issued       120,000    3 months

July 1     39,000 shares            81,000*2     4 months
           purchased, and 2 for     =162,000
           1 stock split
Nov. 1     60,000 shares issued      162k+60k    2 months
                                     =222,000
Dec. 31    Year end balance           222,000          --
              EPS – The Denominator

  Dates       Shares Outstanding (A)   Fraction Weighted Shares
Outstanding
                                       Portion of Year   Weighted
                                       Outstanding (B)    Shares
                                                           (A*B)
  3 months          90,000*2=180,000        3/12           45,000
  3 months         120,000*2=240,000        3/12           60,000
  4 months          81,000*2=162,000        4/12           54,000
  2 months    162,000+60,000=222,000        2/12           37,000
Weighted Average Shares Outstanding                       196,000
         EPS – The Denominator

• If there is a stock split or stock dividend after the
  year end but before the publication of the
  financial statements
      • The weighted average number of shares
        outstanding must be restated
      • This applies to the current year, as well as
        previous years if comparative statements are
        issued
         EPS Reporting Requirements
  Capital        Major Types of Equity     Impact on EPS
 Structure           Instruments            Calculations

Simple       Common shares                Basic EPS only
             Preferred shares
Complex      Common shares                 Basic and
             Potential Common shares:      Diluted EPS
             –Convertible preferred shares
             –Convertible debt
             –Options/warrants
             –Contingently issuable
    Diluted Earnings per Share -
              Methods
• The dilutive effect of convertible securities is
  measured by the if-converted method
• For computing dilution, the rate of conversion
  most advantageous to the security holder is used
  (maximum dilutive conversion rate)
• The dilutive effect of options and warrants is
  measured by the treasury stock method or
  reverse treasury stock method
       If-Converted Method (1)

• Step 1: Anti-dilutive Test
  – Anti-dilutive instruments will be excluded
    from the calculation of diluted EPS.
  – A convertible debt or a convertible preferred
    share is anti-dilutive if EPS after conversion
    is higher than EPS before conversion
       If-Converted Method (2)

• Step 2: Re-calculate Income available to common
  shareholders
  – Convertible debt
     • Income is adjusted for the after-tax interest
       expenses that would not have been recognized if
       the debt were converted to common shares
  – Convertible preferred shares
     • No adjustment to the net income if there are
       convertible preferred shares
       If-Converted Method (3)

• Step 3: Re-calculate weighted average
  number of shares
  – Adjusted as if all convertible securities were
    converted to common shares at the beginning of
    the year or at the issuing date
• Step 4: Calculate Dilutive EPS
     If-Converted Method-Example
•   Net income:=$210,000; Weighted average number of
    common shares outstanding=100,000; Basic EPS=$1.8
•   Three convertible bonds outstanding:
       • $1M, 10% bond, issued at par in a prior year,
           convertible into 10,000 common shares.
       • $1M, 6% bond, issued at par on April 1 of the
           current year, convertible into 40,000 common
           shares.
       • 10,000 $3 convertible preferred shares, issued
           for 1M on April 1 of the current year, convertible
           into 40,000 common shares.
•   Tax rate: 40%
                  Step 1:Anti-dilutive Test


Anti-dilutive Test (Basic EPS=$1.8)
                   Interests/Dividends Saved Number of Shares Increased Incremental EPS
10% Bond               1M*10%*(1-40%)=60,000                      10,000              $6 Anti-dilutive
6% Bond            1M*6%*9/12*(1-40%)=27,000        40,000*9/12=30,000              $0.9 Dilutive
$3 Pref. Shares                          30,000     40,000*9/12=30,000                $1 Dilutive
     Step 2: Re-calculate Income
  available to common shareholders

Net Income for the Year        $210,000
Add back:
Interest saved on 6% bonds
      1M*6% x 9/12 x (1-40%)    $27,000
Adjusted Net Income            $237,000
   Step 3: Re-calculate weighted
     average number of shares
Unadjusted Weighted Average
     Number of Shares                      100,000
Add: Shares assumed issued (converted)
     6% debentures (as of date of issue)   30,000*
     $3 pref. shares (as of date of issue) 30,000*
Weighted Average Number of Shares 160,000
*30,000=9/12x40,000
Step 4: Diluted EPS= $237,000/160,000=$1.48
      The Treasury Stock Method

• Used with written call options when they are dilutive


• A written call option is dilutive when the exercise price is
  less than the market price.

• Options and warrants are assumed exercised at the
  beginning of the year

• The proceeds from the exercise of options are assumed
  to be used to buy back common shares
          Options and Warrants -
          Treasury Stock Method
 Given:
 • Exercise price of a written call option (for one share of
 stock) $ 30
 • Average market price of one share during the year: $ 50
 • Options deemed exercised: 1,500
 • Compute the number of weighted shares for determining
 diluted earnings per share
Calculation:
Total proceeds from exercise (1,500*$30):           $45,000
Shares issued on exercise:                            1,500
Assumed reacquisition of shares ( $45,000/$50): 900
Dilution: 1,500 - 900        =                  600 Shares
(increase in outstanding shares)
    Reverse Treasury Stock Method

•    Used with written put options when they are dilutive

•    A written put option is dilutive when the exercise price
     is higher than the market price.

•    Options and warrants are assumed exercised at the
     beginning of the year.

•    The firm is assumed to issue new shares to generate
     enough funds to buy the shares from the option holder
     when the put option is exercised.
   Reverse Treasury Stock Method
 Given:
 Exercise price of a written put option (for one share of stock) : $ 30
 Average market price of one share during the year: $ 20
 Options deemed exercised: 1,500
 Compute the number of weighted shares for determining
 diluted earnings per share
Calculation:
Amount needed to buy back the 1,500 shares:
         (1,500 * $30)                                     $45,000
Shares issued to acquire needed cash:
         ( $45,000  $20)                                     2,250
Number of shares purchased through option:                    1,500
Dilution: 2,250 – 1,500 = 750 Shares
(increase in outstanding shares)
               About Mid-Term

• Structure:
  – 12 Multiple Choices, 36%
  – 3 Problems, 64%
• Time and Location:
  Oct. 23, Lecture Room
• Coverage: Chapter 13 to Chapter 17
            Case for next week

• CA17-1, in page 1069 of the textbook
• Question of the case will be changed to:
   “If you were a shareholder of CP, what is your analysis of
      the situation described, and how would you react to
      CP’s plan to exchange the convertible notes?”
• Team #4 of each tutorial section will present the
  case solution next week (Oct. 16).
• The 2-page report is due at the beginning of the
  tutorial on Oct. 30. (One week after the mid-term).

				
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