Advanced Financial Accounting: Chapter 11 Earnings per Share Tan & Lee Chapter 11 © 2009

Learning Objectives Significance of earnings per share Difference between basic and diluted earnings per share How new issues affect earnings per share through the weighted average number of shares Concept of dilution Concept of control number in diluted earnings per share Apply methods for calculating diluted earnings per share: If-converted method Treasury method Tan & Lee Chapter 11 © 2009

Content Introduction 1. Introduction Computation of a Weighted-Average Number of Shares Diluted Earnings per Share Tan & Lee Chapter 11 © 2009

Significance of EPS Two main functions: Measure firm’s profitability Denominator in price-earnings ratio (PE ratio) PE ratio is widely used as a basis for comparing share-valuation with peers Two types of PE ratio: Historic PE Current market price/ EPS in the most recent period Prospective PE Current market price/ projected EPS for the upcoming period Tan & Lee Chapter 11 © 2009

Report basic and diluted EPS only Basic vs Diluted EPS Capital Structure Complex Capital Structure Includes potential ordinary shares, e.g. convertible bonds/ preference shares, warrants, options, or other contractual rights which, when exercised, could in the aggregate decrease earnings per ordinary share Simple Capital Structure Does not include potential ordinary shares Report basic EPS only Report basic and diluted EPS only Tan & Lee Chapter 11 © 2009

Content Introduction Computation of a Weighted-Average Number of Shares Diluted Earnings per Share Computation of a Weighted-Average Number of Shares Tan & Lee Chapter 11 © 2009

Basic EPS Numerator: After deducting amounts due to preference shareholders in respect of: Preference dividends Gains/ losses arising on the repurchase or early conversion of preference shares Amortization of discount or premium on increasing rate preference shares Net profit attributable to ordinary shareholders of a parent entity Basic EPS = Weighted average no. of ordinary shares during a reporting period Tan & Lee Chapter 11 © 2009

Definition of Different Types of Preference Shares Cumulative preference shares require the issuer to pay dividends, even if in arrears. Increasing rate preference shares are shares that are issued at a discount and that provide a low initial dividend to compensate the issuer for selling at a discount. Tan & Lee Chapter 11 © 2009

Adjusting for Preference Dividends Scenario Treatment Non-cumulative preference shares Deduct when declared Cumulative preference shares Deduct when due Increasing rate preference shares Amortization of discount/ premium treated as part of preference dividend Tan & Lee Chapter 11 © 2009

Adjusting for Preference Dividends Scenario Treatment Non-cumulative preference shares Deduct when declared Cumulative preference shares Deduct when due Increasing rate preference shares Amortization of discount/ premium treated as part of preference dividend Tan & Lee Chapter 11 © 2009

Adjusting for Preference Dividends Scenario Treatment Preference shares repurchased in a tender offer (FV > carrying value) Excess deducted from net profit attributable to ordinary equity holders of parent entity Early conversion of preference shares (Consideration > FV of ordinary shares issuable) This is a loss to the issuer and a return to the preference shareholders. Deduct loss from net profit attributable to ordinary equity holders of parent entity Tan & Lee Chapter 11 © 2009

Basic EPS Denominator (examples): The term “weighted average” refers to time-weighting, when there are changes in the number of ordinary shares during the financial year. General rule: Shares are time-weighted from the date consideration is receivable (usually the date of share issue) Time-weighting is only performed when there is an inflow of resources Tan & Lee Chapter 11 © 2009

Date to use for time-weighting Basic EPS Denominator: - examples Scenario Date to use for time-weighting Shares issued for acquisition/ Business combination Date of acquisition Conversion of mandatory convertible instrument Date of contract Contingently issuable shares are issued Date when all necessary conditions are satisfied Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 1: New shares are issued for cash/ other assets Illustration 11.2 Company A had issued share capital of 5,000,000 ordinary shares at the beginning of the year. On 30 June, it issued 3,000,000 shares at fair market value for cash. Net profit attributable to ordinary shares was $300,000 for the first 6 months and $800,000 for the full year. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Illustration 11.2 Net profit = $300,000 Net profit = $500,000 1 January No. of shares = 5,000,000 30 June No. of shares = 8,000,000 31 December No. of shares = 8,000,000 $800,000 Basic EPS = (5,000,000 x ½) + (8,000,000 x ½) = 12.3 cents Note: Time-weighting is proportionate to the periods when the resources are made available to the firm. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 2: Issue of bonus shares (stock dividends) Reserves (Retained earnings + Capital reserves) Reserves Bonus issue Total Equity Total Equity Share capital Share capital shareholders Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Bonus shares are issued out of reserves, such as capital reserves or retained earnings. Share capital increases, total number of shares increase, reserves decrease, total shareholders’ equity remains unchanged  No inflow of resources  not time-weighted Treatment: Any bonus issues taking place in a period are assumed to be issued at the beginning of the period. (no time-weighting) Retroactively restate previous year’s EPS comparatives based on new number of shares. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 3: Share splits An existing share is split into 2 or more shares No inflow of resources  not time-weighted Retroactive restatement of comparative EPS Scenario 4: Consolidation of existing shares through reverse splits 2 or more shares are consolidated into one share No inflow of resources  not time-weighted. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 5: Rights Issue (Discount to market price) No. of shares issued = No. of shares if issue was at market price + No. of shares in the “bonus element” Illustration 11.4 On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue at a subscription price of $1.50 per share to existing shareholders. The market price immediately before the exercise of rights issue was $3.00. Atlantis Co’s paid-up capital consisted of 10,000,000 shares as at 1 Jan 20x4. The company reported net profit attributable to ordinary shareholders of $2,500,000 for the year ended 31 Dec 20x4.

Calculating Basic EPS for Various Scenarios Illustration 11.4 On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue at a subscription price of $1.50 per share to existing shareholders. The market price immediately before the exercise of rights issue was $3.00. Atlantis Co’s paid-up capital consisted of 10,000,000 shares as at 1 Jan 20x4. The company reported net profit attributable to ordinary shareholders of $2,500,000 for the year ended 31 Dec 20x4.

Calculating Basic EPS for Various Scenarios This solution applies the treasury method. 5,000,000 new shares. 5,000,000 x $1.50 = $7,500,000 total proceeds  inflow of new resources  time-weighting involved If the issue was made at full market price, only 2,500,000 new shares needed to be issued ($7,500,000 / $3). Therefore no. of shares in bonus element = 2,500,000 Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Reasoning – the treasury method: Company B needs to buy back 2,500,000 shares from the open market to issue to shareholders, with the proceeds it collected from the rights issue of $7,500,000. An additional 2,500,000 are issued as bonus shares. 10M +2.5M+2.5M Actual number of shares issued = 15,000,000 Number of shares issued for cash = 12,500,000 Tan & Lee Chapter 11 © 2009 10M +2.5M

Calculating Basic EPS for Various Scenarios The bonus issue factor is 1.2 (15,000,000/ 12,500,000) shares for every 1 existing share held. The bonus factor should be applied retrospectively to outstanding shares before the rights issue. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios From 1 January 20x4 to 30 September 20x4 10,000,000 x 1.2 x 9/12 = 9,000,000 From 1 October 20x4 to 31 December 20x4 15,000,000 x 3/12 = 3,750,000 Weighted average number of shares 12,750,00 Net profit attributable to ordinary shareholders $2,500,000 Basic earnings per share = 19.6 cents Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 6: New issue of shares from the conversion of debt No inflow of cash, but reduction of debt  which increases net assets of issuer. Interest expense on debt is saved  Earnings increase Therefore, time-weighting should be applied. Tan & Lee Chapter 11 © 2009

Calculating Basic EPS for Various Scenarios Scenario 7: Contingently issuable shares IAS 33:5: These are ordinary shares issuable for little/ no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement When contingent events have occurred, such shares are time-weighted, even if the shares have yet to be issued. Tan & Lee Chapter 11 © 2009