Chapter 17 Earnings Per Share Prepared by: Dragan Stojanovic, CA Rotman School of Management, University of Toronto

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Simple capital structure Income available to common/ordinary shareholders Mandatory convertible instruments Contingently issuable shares Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warranties Contingently issuable shares Anti-dilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Usefulness of EPS Comparison of IFRS and private enterprise GAAP Looking ahead

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Simple capital structure Income available to common/ordinary shareholders Mandatory convertible instruments Contingently issuable shares Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warranties Contingently issuable shares Anti-dilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Usefulness of EPS Comparison of IFRS and private enterprise GAAP Looking ahead

Importance of EPS Earnings per share is one of the most highly visible standards of measurement for assessing: management stewardship and predicting a company’s future value GAAP is very specific in regard to its calculation EPS is calculated for common shares

Importance of EPS Earnings per share tells common shareholders how much of the available income is associated with the shares they own (their share of the pie) Provides insight to common shareholders about: Future dividend payout The value of their shareholdings Impact of other financial instruments on their potential earnings (Diluted EPS)

EPS Calculation 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 actually converted

EPS Calculation = Income available to common shareholders EPS Weighted average number of common shares

EPS Disclosure EPS must be reported as part of the income statement Exception: non public (privately held) corporations Reported for each income component as reported on the income statement EPS relating to discontinued operations (if applicable) may be presented on face of income statement, or disclosed in notes Where applicable, both Basic EPS and Diluted EPS reported Presented for all periods reported Prior period EPS restated for any stock dividends or stock splits

EPS Disclosure If diluted EPS data are reported for at least one period, they should be reported for all periods that are presented, even if they are the same as basic EPS When the results of operations of a prior period have been restated as a result of a prior period adjustment, the EPS should also be restated The effect of the restatement should then be disclosed in the year of the restatement

EPS Disclosure Income Statement Presentation of EPS Components Earnings per share: Income from continuing operations $4.00 Loss from discontinued operations, net of tax (.60) Net Income $3.40

EPS Disclosure EPS Presentation – Complex Capital Structure Earnings per common share: Basic earnings per share $3.80 Diluted earnings per share $3.35

EPS Disclosure EPS Presentation, with discontinued operations and complex capital structure Basic earnings per share: Income before discontinued operations $3.80 Discontinued operations (.80) Net Income $3.00 Diluted earnings per share: Income before discontinued operations $3.35 Discontinued operations (.65) Net Income $2.70

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Simple capital structure Income available to common/ordinary shareholders Mandatory convertible instruments Contingently issuable shares Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warranties Contingently issuable shares Anti-dilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Usefulness of EPS Comparison of IFRS and private enterprise GAAP Looking ahead

Capital Structure Method of EPS calculation based on the corporations capital structure Simple Capital Structure When only common shares and preferred share are issued and/or debt with no conversion rights Basic EPS calculated and presented Complex Capital Structure When common shares plus dilutive securities are issued (i.e. a potential common share) Basic and Diluted EPS calculated and presented

Potential Common Shares Securities, or other financial instruments issued by a corporation that have an option for the holder to convert the security into common shares This conversion could have a negative, or dilutive effect on EPS (i.e. may cause EPS to decrease) Examples: debt and equity instruments that are convertible into common shares, warrants, and options Contingently issuable shares Shares issued for minimal consideration (asset exchange) once a certain condition has been met

EPS Reporting Requirements Capital Structure Major Types of Equity Instruments Impact on EPS Calculations Simple Common shares Preferred shares Basic EPS only Complex Potential Common shares: Convertible preferred shares Convertible debt Options/warrants Contingently issuable Other Basic and Diluted EPS

EPS - Simple Capital Structure Net Income – Preferred Dividends Weighted Average # of Shares Outstanding If the preferred shares are non-cumulative deduct only declared dividends If the preferred shares are cumulative deduct only declared dividends, or if no dividends declared, deduct only one year’s dividends

EPS - Simple Capital Structure If dividends on preferred shares are declared and a net loss occurs, the preferred dividend is added to the loss in calculating the loss per share In reporting earnings per share information, dividends declared on preferred shares should be subtracted from income from continuing operations and from net income In other words, dividends on preferred shares should not be deducted in calculating EPS from discontinued operations

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

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 - Simple Capital Structure 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 Date Share Changes Shares Outstanding January 1 Beginning balance 90,000 April 1 30,000 shares issued 120,000 July 1 39,000 shares purchased 81,000 November 1 60,000 shares issued 141,000 December 31 Year end balance

EPS – The Denominator Dates Outstanding Shares Outstanding Fraction Weighted Shares Portion of Year Outstanding Weighted Shares Jan. 1st to March 31st 90,000 3/12 22,500 April 1st to June 30th 120,000 30,000 July 1st to October 31st 81,000 4/12 27,000 Nov 1st to Dec 31st 141,000 2/12 23,500 Weighted Average Shares Outstanding 103,000

EPS – The Denominator Net Income – Preferred Dividends Weighted Average # of Shares Outstanding 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 By restating the number, valid comparisons of earnings per share can be made between periods before and after the stock split or stock dividend

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 – The Denominator Given – Baiye Limited: January 1: 100,000 shares outstanding March 1: Issued 20,000 shares June 1: 50% Stock dividend (60,000 additional shares issued) November 1: Issued 30,000 shares December 31: Ending Balance = 210,000 shares outstanding

EPS – The Denominator Dates O/S Shares O/S Restatement Fraction of Year Weighted Shares Jan-Mar 100,000 X 1.50 X 2/12 = 25,000 Mar-Jun 120,000 3/12 = 45,000 Jun-Nov 180,000 X 5/12 = 75,000 Nov-Dec 210,000 35,000 Weighted average shares outstanding

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Simple capital structure Income available to common/ordinary shareholders Mandatory convertible instruments Contingently issuable shares Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warranties Contingently issuable shares Anti-dilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Usefulness of EPS Comparison of IFRS and private enterprise GAAP Looking ahead

Complex Capital Structure When corporation has convertible securities, options, warrants or other rights, and When converted these could dilute EPS Dilution is the reduction in EPS, if: Securities, potentially convertible into common stock, are converted (assumed at beginning of the year) Anti-dilutive securities Securities, when converted, increase EPS Anti-dilutive EPS are not reported, only basic EPS

EPS - Complex Capital Structure Requires dual presentation of EPS Basic earnings per share Presented for each separate class of common share Fully diluted earnings per share Only securities that reduce earnings per share (dilutive) are considered Securities that increase earnings per share (anti-dilutive) are ignored The purpose of presenting both EPS numbers is to inform financial statement users of situations that will likely occur and to provide worst-case situations

Diluted Earnings per Share - Methods The dilutive effect of convertible securities is measured by the if-converted method The dilutive effect of options and warrants is measured by the treasury stock method For computing dilution, the rate of conversion most advantageous to the security holder is used (maximum dilutive conversion rate)

The If-Converted Method The conversion of the securities into common stock is assumed to occur at the beginning of the year The net income must be adjusted for: Interest (net of tax) on the convertible debt Dividends on the convertible preferred shares The weighted average number of shares is increased by the additional common shares assumed issued (at the beginning of year)

The If-Converted Method Adjust Net Income Convertible debt issues: Income is adjusted for the after-tax interest that would not have been paid if the debt were converted to common shares (Interest adjusted for any premium or discount amortization) Convertible preferred shares: Preferred dividends on convertible preferred shares are also eliminated - no dividends would be paid on these preferred shares had they been converted to common shares (no tax effect as not tax deductible)

Example - Field Corporation Net Income for the Year $210,000 Common shares outstanding during the period: 100,000 Additional securities outstanding: 6% convertible debenture bond sold at 100 for $1,000,000, convertible to 20,000 common shares 10% convertible debenture bond sold at 100 for $1,000,000, convertible to 32,000 common shares and issued April 1st of current year Assume tax of 40% and calculate diluted EPS

Example - Field Corporation Net Income for the Year $210,000 Add back: Interest on 6% debentures $60,000 x (1-.40) 36,000 Interest on 10% debentures $100,000 x (1-.40) x 9/12 45,000 Adjusted Net Income $291,000

Example - Field Corporation Unadjusted Weighted Average Number of Shares 100,000 Add: Shares assumed issued (converted) 6% debentures 20,000 10% debentures * 24,000 Weighted Average Number of Shares 144,000 *32,000 shares x 9/12

Example - Field Corporation Conversion is always assumed to be at the beginning of the year If a convertible security is not outstanding for the full 12 months of the year Conversion is pro-rated for the number of months the convertible security is actually issued Field Corporation 10% debenture was issued April 1st, therefore the conversion is 32,000 shares times 9 out of 12 months

Example - Field Corporation EPS Calculation and Disclosure: Net Income $210,000 Basic EPS $210,000  100,000 $2.10 Diluted EPS $291,000  144,000 $2.02

Options and Warrants An option gives the holder the right to either buy or sell shares Generally speaking, the holder of options will exercise the right if the options are “in the money” They are “in the money” if the holder of the options will benefit from exercising them If the option is a “call option” i.e. it gives the holder the right to buy the shares at a preset/exercise price—the holder will exercise it if the exercise price is lower than the current market price

Options and Warrants If company sells (or writes) options, they must be included in the diluted EPS calculations if dilutive Example: company sold call options for $2 that allow the purchaser to buy the shares at $10 (the exercise price) - assume share price increases to $15, this will result in dilution Assume company sold put options that allow purchaser to sell the shares to the company at $8 - if share price decreases to $6, this will result in dilution Purchased options will always be antidilutive since they will only be exercised when they are in the money – therefore, not included in EPS

The Treasury Stock Method Applies to written call options and equivalents Options and warrants (and their equivalents) are included in EPS computations They 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 The exercise price per share must be less than the market price per share for dilution to occur

Options and Warrants - Treasury Stock Method Given: Exercise price of an option (for one share of stock) $ 30 Market price of one share at exercise date: $ 50 Options deemed exercised: 1,500 Total proceeds from exercise (1500 x $30) $45,000 Shares issued on exercise: 1,500 Assumed reacquisition of shares ($45,000/$50) 900 Incremental shares: 1,500 - 900 = 600 (potential common shares) Dilution occurs because, on a net basis, more common shares are assumed to be outstanding after the exercise

Reverse Treasury Stock Method Applies to written put options and forward purchase contracts Two assumptions under this method Enough common shares issued at beginning of the year for the company to purchase shares under the option or forward contract Proceeds from the share issue will be used to purchase shares under the option or forward contract

Reverse Treasury Stock Method Given: Exercise price of an option (for one share of stock) $ 30 Market price of one share at exercise date: $ 20 Options deemed exercised: 1,500 Amount needed to buy back the 1,500 shares: (1,500 x $30) $45,000 Shares issued to acquire needed cash: ($45,000  $20) 2,250 Number of shares purchased through put: 1,500 Incremental shares: 2,250 – 1,500 = 750 (potential common shares) This is dilutive because there will be 750 more shares

Antidilutive Potential Common Shares Securities that cause an increase in EPS if included in EPS calculations Convertible debt is antidilutive if conversion causes EPS to increase by a greater amount than EPS before conversion For example:

Antidilutive EPS: Example Kohl Corporation $1 million in 6% convertible debt – convertible to 10,000 common shares Net Income is $210,000 100,000 common shares outstanding Tax rate: 40% Basic EPS = $2.10 per share

Antidilutive Shares: Example Test for Antidilution Adjusted Net Income: Net Income $210,000 After-tax interest adjustment ($1.0m x 6%)(1-.40) 36,000 Adjusted Net Income $246,000 Adjusted Number of Shares: Shares outstanding 100,000 Shares issued on conversion 10,000 Adjusted Number of shares 110,000

Antidilutive Shares Diluted EPS = $246,000  110,000 = $2.24 Basic EPS = $2.10 Antidilutive, therefore not disclosed

Earnings per Share: Complex Structures - Summary Dual EPS Presentation Basic EPS Diluted EPS Net Income adjusted for interest (net of tax) and preferred dividends Weighted average number of common shares assuming maximum dilution Dilutive Convertibles Dilutive Options and Warrants Dilutive Contingent Issues

Additional Disclosure Disclosed in notes to financial statements Amounts used in both numerator and denominator in calculating basic and diluted EPS Reconciliation of both the numerator and denominator values for basic and diluted earnings per share calculations for income before discontinued operations Potentially dilutive securities, that were not included in the calculation of EPS because they were anti-dilutive Description of common share transactions after reporting period that could have impacted EPS numbers

Earnings Per Share Overview Basic EPS Diluted EPS Objective of EPS Presentation and Disclosure Basic EPS Simple capital structure Income available to common/ordinary shareholders Mandatory convertible instruments Contingently issuable shares Weighted average common/ordinary shares Comprehensive illustration Diluted EPS Complex capital structure Convertible securities Options and warranties Contingently issuable shares Anti-dilution revisited Additional disclosures Comprehensive earnings per share exercise IFRS and Private Enterprise GAAP Comparison Usefulness of EPS Comparison of IFRS and private enterprise GAAP Looking ahead

Looking Ahead EPS standards continue to be revisited as accounting rules for underlying financial instruments evolve

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