1. COPYRIGHT © 2007 Thomson South-Western, a part of The Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. Earnings Per Share Chapter 18 S t I c e | S t I c e | S k o u s e n Intermediate Accounting 16E Modified by Ms. Phassawan S.

2. Learning Objectives 1.Capital Structure and Earnings per share 2.Compute basic EPS –Sale and repurchase of stocks –Stock splits –Stock dividends 3.Compute diluted EPS –Treasury stock method Options, warrants, rights –If-converted method Convertible preferred stocks, convertible bonds

3. Earnings per Share Considers only common shares issued & Outstanding. Basic Reflects the maximum potential dilution from all possible stock conversions, convertible securities, options, warrants, or rights, which would have decreased EPS. Diluted It is computed by dividing income available to common shareholders by the weighted average number of c/s outstanding for the period A company with potential earnings per share dilution (due to issuance of additional shares) is considered to have a complex capital structure The corporation has only common & nonconvertible preferred stock is considered to have a simple capital structure.

4. Earnings per Share Dilution of Earnings:- Earnings per share would decline if common stock were issued on conversion or exercise. –Dilutive securities Antidilution of Earnings:- A conversion of securities or exercise of options results in an increase in earnings per share. –Antidilutive securities

5. Learning Objectives 1.Capital Structure and Earnings per share 2.Compute basic EPS –Sale and repurchase of stocks –Stock splits –Stock dividends 3.Compute diluted EPS –Treasury stock method Options, warrants, rights –If-converted method Convertible preferred stocks, convertible bonds

6. Basic Earnings Per Share The Basic Equation : Net Income – Preferred Dividend Weighted-Average Common Shares Outstanding The Complications : –Issuance or repurchase of common stock –Stock dividends or stock splits The Complications : –Issuance or repurchase of common stock –Stock dividends or stock splits

7. (1) Issuance or Repurchase of Common Stock –Shares Outstanding January 1:10,000 –New Shares Issued May 1:5,000 –Shares Repurchased November 1: 2,000 Weighted-Average Number of Shares Jan. 1 to May 110,000 x 4/12 =3,333 May 1 to Nov. 1 (10,000+5,000) 15,000 x 6/12 = 7,500 Nov. 1 to Dec. 31 (15,000-2,000) 13,000 x 2/12 = 2,167 Dec. 31 Weighted-average shares13,000

8. (2) Stock Dividends & Stock Splits –Shares outstanding Jan 1…………… 2,600 –Shares issued for exercise of options on Feb 1………………… + 400 –Shares issued for 10% stock dividend on May 1 (3,000*10%)….. + 300 –Shares sold for cash on Sep 1………+1,200 –Shares repurchased on Nov 1……… - 400 –Shares issued for 3-for-1 stock split on Dec 15 (12,300-4,100).………. + 8,200

9. 1/1 to 2/12,600 2/1 Option 400 2/1 to 5/13,000 No. of Stock Stock Portion of Weighted Date Shares Dividend Split Year Average (2) Stock Dividends & Stock Splits 5/1 Dividend 300 5/1 to 9/1 3,300 x 1.10 9/1 Sale 1,200 9/1 to 11/1 4,500 11/1 Purchase (400) 11/1 to 12/1 4,100 12/1 Split 8,200 12/1 to 12/31 12,300 x 3.0 x 1/12 = 715 x 3/12 = 2,475 x 4/12 = 3,300 x 2/12 = 2,250 x 1/12 = 1,025 Weighted-average number of shares 10,790

10. (3) Preferred Stock Basic EPS reflects only income available to common stockholders ; it does not include preferred stock. Dividends on preferred stock should be deducted from income before extraordinary or other special items from net income for EPS, if preferred stock is in the capital structure.

11. 8% Cum. P/S $100 parC/S $0.10 ParR/E SharesAmountSharesAmount 12/31/06 Bal.10,000$1,000,000200,000$1,000,000$4,000,000 6/30/07 issue CS100,000600,000 6/30/07 Div PS(80,000) 6/30/07 Div CS(90,000) 12/31/07 NI + extra gain $75,000 380,000 12/31/07 Bal.10,000$1,000,000300,000$1,600,000$4,210,000 On June 30, 2007 the firm paid: An 8% dividend on preferred stock ($1 M *8% = $80,000) A $0.30 per share dividend on common stock (300,000 x $0.30 = 90,000) Ex: On Dec 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of c/s outstanding. On June 30, 2007, issued 100,000 shares of c/s.

12. 8% Cum. P/S $100 parC/S $0.10 ParR/E SharesAmountSharesAmount 12/31/06 Bal.10,000$1,000,000200,000$1,000,000$4,000,000 6/30/07 issue CS100,000600,000 6/30/07 Div PS(80,000) 6/30/07 Div CS(90,000) 12/31/07 NI + extra gain $75,000 380,000 12/31/07 Bal.10,000$1,000,000300,000$1,600,000$4,210,000 Ex: On Dec 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of c/s outstanding. On June 30, 2007, issued 100,000 shares of c/s. 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150,000 weighted-average shares outstanding in 2007 250,000 No. of Stock Portion of Weighted Date Shares Dividend Year Average

13. 8% Cum. P/S $100 parC/S $0.10 ParR/E SharesAmountSharesAmount 12/31/06 Bal.10,000$1,000,000200,000$1,000,000$4,000,000 6/30/07 issue CS100,000600,000 6/30/07 Div PS(80,000) 6/30/07 Div CS(90,000) 12/31/07 NI + extra gain $75,000 380,000 12/31/07 Bal.10,000$1,000,000300,000$1,600,000$4,210,000 Ex: On Dec 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of c/s outstanding. On June 30, 2007, issued 100,000 shares of c/s. On May 1, 2008, the firm issued a 50% stock dividend on common stock.

14. 8% Cum. PS $100 parCS $0.10 ParR/E SharesAmountSharesAmount 12/31/07 Bal.10,000$1,000,000200,000$1,000,000$4,000,000 6/30 issue CS100,000600,000 6/30 Div on PS(80,000) 6/30 Div on CS(90,000) 12/31 NI + ord. gains $75,000 380,0000 12/31/07 Bal10,000$1,000,000300,0001,600,0004,210,000 5/1/08 50% stock div 150,00015,000(15,000) 12/31 NL(55,000) 12/31/08 Bal.10,000$1,000,000450,0001,615,000$4,140,000 Ex: On Dec 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of c/s outstanding. On June 30, 2007, issued 100,000 shares of c/s.

15. 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150,000 250,000 2007 No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 4/12100,000 The weight-average before considering the stock dividend. The stock dividend was the only stock transaction for 2008. 2008 Ex: On Dec 31, 2006, the firm had 10,000 shares of preferred stock and 200,000 shares of c/s outstanding. On June 30, 2007, issued 100,000 shares of c/s.

16. 1/1 to 6/30200,000x 6/12100,000 7/1 to 12/31 300,000 x 6/12 150,000 250,000 2007 No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 4/12100,000 5/1 to 12/31450,000x 8/12300,000 2008 300,000 x 1.5 WAIT! We are not finished. The stock dividend must be “rolled back” for all years displayed. (3) Preferred Stock

17. 1/1 to 6/30200,000x 1.5x 6/12150,000 7/1 to 12/31 300,000 x 1.5 x 6/12 225,000 375,000 2007 No. of Stock Portion of Weighted Date Shares Dividend Year Average 1/1 to 4/30300,000x 1.5x 4/12150,000 5/1 to 12/31450,000x 8/12300,000 450,000 2008 (3) Preferred Stock

18. Partial Income Statement Presentation Calculate EPS for year 2007 Basic earnings per common share: Continuing operations$?? Extraordinary gains ?? Net Income per share ?? (3) Preferred Stock

19. Assume that in 2007 the firm made a net income, including a $75,000 extraordinary gain, of $380,000. Basic EPS, continuing operations (2007): – $80,000 375,000 shares = $0.60 $305,000 Basic EPS, extraordinary gain (2007): 375,000 shares $75,000 = $0.20 Basic EPS, net income per share (2007): 375,000 shares $380,000 – $80,000 = $0.80

20. Partial Income Statement Presentation Calculate EPS for year 2008 Basic earnings per common share: Continuing operations$?? Extraordinary gains ?? Net Income per share ?? (3) Preferred Stock

21. Assume that in 2008 the firm had a net loss of $55,000 and that there were no extraordinary items. Basic EPS (common), continuing operations (2008): Net loss + Preferred Dividends Weighted-average shares of common stock outstanding $55,000 + $80,000 450,000 shares of Basic loss per share = $(0.30) Preferred dividends are included even though they were not declared. a loss is added.

22. EPS for year 2007 Basic earnings per common share: Continuing operations$0.6 Extraordinary gains 0.2 Net Income per share $0.8 EPS for year 2008 Basic loss per common share $(0.30) Conclusion: EPS

23. Learning Objectives 1.Capital Structure and Earnings per share 2.Compute basic EPS –Sale and repurchase of stocks –Stock splits –Stock dividends 3.Compute diluted EPS –Treasury stock method Options, warrants, rights –If-converted method Convertible preferred stocks, convertible bonds

24. Diluted Earnings per Share Dilution occurs if inclusion of a potentially dilutive security reduces the basic EPS or increases the basic loss per share.  Two major types of potentially dilutive securities are 1. Common stock options, warrants, rights 2. Convertible bonds, and convertible preferred stock.

25. (1) Options, Warrants & Rights Options, warrants, and rights are included in the computation of diluted EPS for a particular period only if they are dilutive. –Exercise price < the average market price ------> the options, warrants, and rights probably would be exercised -----> dilution –Exercise price > the average market price ------> the options, warrants, and rights probably would not be exercised -----> antidilution

26. (1) Options, Warrants, & Rights 5 Things to Remember 1. It is assumed that the exercise of options, warrants, and rights takes place (1) as of the beginning of the year or (2) at the date they are issued, whichever comes later. 2. It is assumed that proceeds from conversion are assumed to be used for purchase of treasury stock (common stock on the market) at current market price.

27. (1) Options, Warrants, & Rights 3. It is further assumed that treasury stock is assumed to be reissued to option or warrant holders. 4. Any additional shares issued, over treasury stock, are added to “weighted- average shares outstanding” to compute dilute EPS. 5. The method of including warrants, options, and rights in the EPS computation is known as the Treasury Stock Method.

28. Example 1.1: Diluted EPS Assume that at the beginning of year, employees were granted options to acquire 5,000 shares of common stock at $40 per share. The average market price of the stock during the year is $50. “Exercise???” “Dilutive ???” The proceeds received by the firm from the issuance of the stock would be $200,000 (5,000*$40). These proceeds would purchase 4,000 shares of treasury stock ($200,000/$50 per share)

29. Example 1.1: Diluted EPS The net increase in share outstanding would be 1,000 shares, which will be used for computing diluted EPS. 5,0004,0001,000 Issued to employees Treasury Stock Additional shares

30. Example 1.2: Diluted EPS Rasband Corporation had net income for the year of $92,800. There were 100,000 shares of common stock outstanding all year. There are 20,000 options outstanding to purchase shares. The exercise price per share is $6 and the average market price during the year was $10. $92,800 100,000 Basic EPS = = $0.93

31. Proceeds from assumed exercise of options outstanding (20,000 x $6)$120,000 Number of outstanding shares assumed to be repurchased with proceeds from options ($120,000 ÷ $10)12,000 Actual number of shares outstanding100,000 Issued on assumed exercise of options 20,000 Less assumed options repurchased 12,000 8,000 Total shares used to computed EPS108,000 Example 1.2: Diluted EPS

32. Diluted Earnings per Share: $92,800 108,000 = $0.86 COMPARED TO— Basic Earnings per Share: $92,800 100,000 = $0.93 The diluted EPS is less than the basic EPS, so it is dilution (acceptable). Example 1.2: Diluted EPS Hence, the options that would decrease EPS are included in the calculation of diluted EPS.

33. Example 1.2: Diluted EPS If the stock options had been issued to employees on April 1 of the current year: –the incremental shares would be 8,000 shares * ¾ = 6,000 shares –the diluted EPS would be $0.88 ($92,800/106,000 shares)

34. Example 1.3: Diluted EPS Rasband Corporation had net income for the year of $92,800. There were 100,000 shares of common stock outstanding all year. There are 20,000 options outstanding to purchase shares. The exercise price per share is $6 and the average market price during the year was $5. $92,800 100,000 Basic EPS = = $0.93

35. Proceeds from assumed exercise of options outstanding (20,000 x $6)$120,000 Number of outstanding shares assumed to be repurchased with proceeds from options ($120,000 ÷ $5)24,000 Actual number of shares outstanding100,000 Issued on assumed exercise of options 20,000 Less assumed options repurchased 24,000 (4,000) Total98,000 Example 1.3: Diluted EPS

36. Diluted Earnings per Share: $92,800 98,000 = $0.97 COMPARED TO— Basic Earnings per Share: $92,800 100,000 = $0.93 The diluted EPS is less than the basic EPS, so it is antidilution (not acceptable ). Example 3: Diluted EPS Hence, the options that would increase EPS are excluded in the calculation of diluted EPS.

37. (2) Convertible Securities Convertible securities- Such as Bonds and preferred stock, whose term permits the holder to convert the investment into common stock of the issuing stock. To compute diluted EPS when convertible securities exists, adjustments must be made both to (1) Net income and (2) The number of shares of common stock outstanding.

38. (2) Convertible Securities The conversion had taken place at (1)the beginning of the current year or (2)the date of issuance of the convertible securities, whichever comes later. The method of including convertible securities in the EPS computation is referred to as the if- converted method.

39. (2) Convertible Securities Adjustment for Convertible Bonds 1.NI is adjusted by adding back the interest expense (net of tax) to the NI. 2.The # of shares c/s outstanding is increased by the # of shares that would have been issued on conversion. 3.Any amortization of initial premium or discount is included in the interest expense added back. 4.If the conversion is made during the year, adjustment would be made for the portion of year.

40. Example 2.1:Diluted EPS Assume the following: Net income………………………$83,000 8% convertible bonds issued 1/1/08 ……………..$500,000 Common shares outstanding (no changes during year)…100,000 Tax rate……………………………….30% Conversion terms: 8% Bonds: 80 common shares per $1,000 bond

41. Net income – Preferred dividend Weighted-average common shares outstanding Basic EPS = $83,000 100,000 $0.83 Basic EPS = Example 2.1:Diluted EPS

42. Actual shares outstanding100,000 Incremental Shares: 8% bond 40,000 ($500,000/$1,000 x 80) Total shares assumed issued 140,000 Net income$83,000 Interest savings 8% bond $ 40,000 (500,000*8%) Less: tax effect (40,000*30%) (12,000) 28,000 Adjusted net income $ 111,000 Example 2.1:Diluted EPS

43. Adjusted Net Income – Preferred Dividend Total Shares Assumed Issued Diluted EPS Diluted EPS = $110,000 $0.79 Diluted EPS = = 140,000 Example 2.1:Diluted EPS $0.83 Basic EPS =

44. Shortcut Test for Antidilution If the 8% bonds are converted, net income to the common shareholders increased by $28,000, and the number of shares outstanding increases by 40,000 shares. The contribution of the conversion to earnings is $0.70 ($28,000/40,000) per share < the basic EPS of $0.83 = the bonds are dilutive.

45. Example 2.2:Diluted EPS Assume the following: Net income………………………$83,000 8% convertible bonds issued 6/30/08 …………..$500,000 Common shares outstanding (no changes during year)…100,000 Tax rate……………………………….30% Conversion terms: 8% Bonds: 80 common shares per $1,000 bond

46. Actual shares outstanding100,000 Incremental Shares: 8% bond 20,000 ($500,000/$1,000 x 80 x 1/2) Total shares assumed issued 120,000 Net income$83,000 Interest savings 8% bond $ 20,000 (500,000*8%*1/2) Less: tax effect (20,000*30%) (6,000) 14,000 Adjusted net income $ 97,000 Example 2.2:Diluted EPS

47. Adjusted Net Income – Preferred Dividend Total Shares Assumed Issued Diluted EPS Diluted EPS = $97,000 $0.81 Diluted EPS = = 120,000 Example 2.2:Diluted EPS $0.83 Basic EPS =

48. (2) Convertible Securities Adjustment for Convertible Preferred Stocks 1.Subtract preferred dividend from the NI. 2.The # of shares c/s outstanding is increased by the # of shares that would have been issued on conversion. 3.If the conversion is made during the year, adjustment would be made for the portion of year.

49. Example 2.3:Diluted EPS Assume the following: Net income………………………$111,000 8% preferred stock outstanding issued at par 1/1/08 …..$500,000 Common shares outstanding (no changes during year)…100,000 Tax rate……………………………….30% Conversion terms: 80 common shares per $1,000

50. Actual shares outstanding 100,000 Basic EPS $ 0.71 Net income, without the deduction for interest on bonds $111,000 Less: Preferred dividend 40,000 Adjusted net income $ 71,000 Example 2.3:Diluted EPS Actual shares outstanding 100,000 Additional shares on conversion 40,000 Adjusted number of shares 140,000 Diluted EPS $ 0.79 Net income, assume no DIV payment of preferred dividend due to conversion $111,000

51. Shortcut Test for Antidilution If the preferred stock is converted, the preferred dividends of $40,000 would no longer be deducted from net income, and the number of shares outstanding increases by 40,000 shares. The contribution of the conversion to earnings is $1.00 ($40,000/40,000) per share > the basic EPS of $0.71 = the preferred stock is antidilutive.

52. QUESTIONS