Acct 414 Notes & Examples Prof.

Teresa Gordon

Introduction to
EARNINGS PER SHARE
CAPITAL STRUCTURE
SIMPLE - no potentially dilutive securities exist
No Convertible Preferred Stock

No Convertible Bonds or Other Debt

No Stock Options or Warrants

No Contingent Shares

BASIC EARNINGS PER SHARE =

(Net Income - Preferred Dividends*)

Weighted average of common shares outstanding

* If preferred stock is cumulative, deduct dividends whether or not paid or declared. If preferred is noncumulative,
deduct dividends only if declared.

FOR PUBLICLY TRADED CORPORATIONS WITH COMPLEX CAPITAL

STRUCTURE:
Dual presentation of earnings per share:

Basic earnings per share

Diluted earnings per share

367274589.doc as of 09/29/17 Page 1

Acct 414 Notes & Examples Prof. Teresa Gordon

EFFECT OF POTENTIALLY DILUTIVE SECURITIES ON EPS

Convertible bonds and preferred stock:

Use the IF CONVERTED METHOD

Stock options, warrants and other contingent issues:

Use the TREASURY STOCK METHOD

DILUTED EARNINGS PER SHARE =

Net income
- Preferred dividends if preferred
stock is NOT convertible + After-tax bond interest
on convertible bonds
Weighted average of common shares assuming
maximum dilution (including options)

TREASURY STOCK METHOD PROCEDURES

1. Compute amount of cash that would be received if all the stock options or
warrants were exercised.

Note: If the options are part of the employee compensation package, add (to the
cash received based on option price) the amount (if any) of compensation expense
not yet recognized in income and any tax benefits (both deferred and current) that
would be credited to additional paid in capital if the options were exercised (SFAS
128 21).

2. Compute the number of shares that could be purchased with the cash amount from
step 1 using average market price for period

3. Compute the number of NET new shares - subtract the number acquired (step 2)
from the total number of options or warrants that would be exercised (step 1).

Or use formula:
Number of shares to which Avg Mkt Price Option Price
Net new shares = option holders are entitled * Avg Mkt Price
Note: Under the treasury stock method, you cannot use a negative number (decrease in denominator)!
There will be no dilutive effect if options are out of the money or at the money

367274589.doc as of 09/29/17 Page 2

Acct 414 Notes & Examples Prof. Teresa Gordon

EARNINGS PER SHARE DISCLOSURES:

ON INCOME STATEMENT
PER SHARE AMOUNTS FOR
Income From Continuing Operations

Income Before Extraordinary Items

Cumulative Effect Of Change In Accounting Principle

Net Income

(Basic and diluted eps are both shown for each item if appropriate)
Weighted average shares used in computations

WARNING -

WATCH OUT FOR ANTI-DILUTIVE SECURITIES

Earnings per share should be lowest possible number
An anti-dilutive security is one that
causes the earnings per share to INCREASE

or the loss per share to DECREASE

Using straight formulas may get you wrong answer if there are anti-dilutive
securities involved.

FOR COMPLEX SITUATIONS, USE THE FOLLOWING

ALGORITHM:
1. Compute the per share effect of each potentially dilutive security
separately.
2. Make a list from smallest per share number to largest
per share number
3. Compute basic earnings per share

367274589.doc as of 09/29/17 Page 3

Acct 414 Notes & Examples Prof. Teresa Gordon

4. For diluted EPS, take the securities into EPS computation one at a
time until the next item on the list is bigger than the most recent
EPS figure.

There are many complex situations in computing earnings per share you will
need to consult FARS CD. The rules are primarily in FAS128 but it has
been amended. For example, SFAS No. 150:
Exclude from denominator common shares that are to be redeemed or repurchased
pursuant to financial instruments described in FAS150. Exclude from numerator any
amounts (including contractual or accumulated dividends and participation rights in
undistributed earnings) attributable to shares that are to be redeemed or repurchased
UNLESS such amounts have been recognized as interest costs in earnings. The technique
would be consistent with the two class method set forth in in paragraph 61 of FASB
Statement No. 128

367274589.doc as of 09/29/17 Page 4

Acct 414 Notes & Examples Prof. Teresa Gordon

EPS EXAMPLE #1 -
BASIC EPS

JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As of
1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10 30,000 new
shares were sold. There are no potentially dilutive securities outstanding but JKL has
2,000 shares of 8% cumulative preferred stock ($10 par) which was outstanding all
year.

367274589.doc as of 09/29/17 Page 5

Acct 414 Notes & Examples Prof. Teresa Gordon

EPS EXAMPLE #2 -
WHAT IF METHOD - CONVERTIBLE PREFERRED
(Same as #1) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As
of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 30,000 new shares were
sold. There are no potentially dilutive securities outstanding but JKL has 2,000 shares of 8%
cumulative preferred stock ($10 par) which was outstanding all year.

JKL also has an issue of convertible preferred stock (cumulative) that was
outstanding during the entire year. The preferred stock has a $100 par value
and pays a $10 annual dividend. The 5,000 shares were outstanding all year.
Each share of preferred stock can be converted into 5 shares of common stock.

367274589.doc as of 09/29/17 Page 6

Acct 414 Notes & Examples Prof. Teresa Gordon

EPS EXAMPLE #3 -
WHAT IF METHOD - CONVERTIBLE BONDS
(Same as #1 and #2) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was
40%. As of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 30,000 new
shares were sold. There are no potentially dilutive securities outstanding but JKL has 2,000 shares
of 8% cumulative preferred stock ($10 par) which was outstanding all year. JKL also has an issue
of convertible preferred stock (cumulative) that was outstanding during the entire year. The
preferred stock has a $100 par value and pays a $10 annual dividend. The 5,000 shares were
outstanding all year. Each share of preferred stock can be converted into 5 shares of common
stock.

JKL also has $3,000,000 in convertible bonds outstanding all year. The bonds
were sold at face value and pay 6% interest semi-annually. Each $1000 bond
can be converted into 50 shares of common stock.

367274589.doc as of 09/29/17 Page 7

Acct 414 Notes & Examples Prof. Teresa Gordon

EPS EXAMPLE #4 -
TREASURY STOCK METHOD - STOCK OPTIONS
(Same as #1) JKL Corp. reported net income of $1,000,000 for 2010. The tax rate was 40%. As
of 1/1/10, 200,000 shares of common stock were outstanding. On 6/1/10, 30,000 new shares were
sold. JKL has 2,000 shares of 8% cumulative preferred stock ($10 par) which was outstanding all
year.

JKL Corp. also 40,000 stock options outstanding all year. At any time during
the next five years, the option holders have the right to buy a share of common
stock for $10 per share. The average market price during 2010 was $40 and
the year-end closing price was $45 per share.

What if we also had the potentially dilutive securities discussed in examples #2 and #3?

367274589.doc as of 09/29/17 Page 8

Acct 414 Notes & Examples Prof. Teresa Gordon

Earnings Per Share Example #5

Weighted Average Shares
To Nearest Month
CONSIDER THE FOLLOWING TRANSACTIONS IN COMMON STOCK:

Common shares outstanding Jan 1 to Feb 28 20,000

March 1, new shares sold 1,000
Shares outstanding Mar 1 to April 30 21,000
May 1, 100% stock dividend issued 21,000
Shares outstanding May 1 to Oct 31 42,000
Nov 1, acquired treasury stock -2,000
Shares outstanding Oct 31 to Nov 30 40,000
Dec 1, re-issued treasury stock 1,000
Shares outstanding Dec 1 to Dec 31 41,000

Dates Actual Shares Retroactive Stock Months Weighted shares

Outstanding Splits & Dividends Outstanding Outstanding

367274589.doc as of 09/29/17 Page 9

Acct 414 Notes & Examples Prof. Teresa Gordon

EARNINGS PER SHARE EXAMPLE #6

WEIGHTED AVERAGE SHARES

SHARES IN OUT-
ISSUED TREASURY STANDING

Common shares outstanding Jan 1 to Feb 28 100,000 5,000 95,000

March 1, treasury stock sold -1,000 1,000
Shares outstanding Mar 1 to May 31 100,000 4,000 96,000
Jun 1, new shares issued 20,000 20,000
Shares outstanding Jun 1 to Aug 31 120,000 4,000 116,000
Sep 1, acquired treasury stock 2,000 - 2,000
Shares outstanding Sep 1 to Oct 31 120,000 6,000 114,000
Nov 1, 200% stock dividend issued 228,000 228,000
Shares outstanding Nov 1 to Dec 31 348,000 6,000 342,000

Dates Actual Shares Retroactive Stock Months Weighted shares

Outstanding Splits & Dividends Outstanding Outstanding

367274589.doc as of 09/29/17 Page 10

Acct 414 Notes & Examples Prof. Teresa Gordon

EARNINGS PER SHARE EXAMPLE #7 (revised for F06)

Using the algorithm

Campbell Company had five convertible securities outstanding all during the year. It paid the
appropriate interest and amortized the premiums and discounts using either the straight-line method
or the effective interest method (as indicated below). All dividends on preferred stock were paid.
The corporate tax rate was 30%. The following table describes each security. Prepare a schedule
that lists the impact of assumed conversion of each convertible security on diluted earnings per
share and put them in the order in which they would be included in the computation of diluted
earnings per share.

A. 9.5% preferred $2,000,000 par value. Issued at 112.

stock Each $100 par preferred stock is
convertible into 5 shares of common
stock. This stock is not cumulative but
the dividend for the year was paid.
B. 8.0% preferred $1,500,000 par value. Issued at par.
stock Each $100 par preferred stock is
convertible into 3 shares of common
stock. The stock is cumulative with no
dividends in arrears.
C. 50,000 options The options were issued last year with
an exercise price of $15. The average
market price for the current year is $35.
Options can be exercised during a 5 year
period that begins at the end of the next
fiscal year.
D. 8.0% bonds Face value of $5,000,000. Bonds were
issued at a discount. Because the impact
was material, the company uses the
effective interest method. The bonds pay
interest semi-annually on June 30 and
December 31. The yield on the bonds
was 10%. The book value at the
beginning of the year was $4,783,526.
Each $1000 bond can be converted into
50 shares of common stock.
E. 9% bonds Face value of $5,000,000. Bonds were
issued at 101. Since the premium was
not material, the company uses the
straight-line method to amortize the
premium over the 20 year life of the
bond. Each 5000 bond is convertible
into 150 shares of common stock.

367274589.doc as of 09/29/17 Page 11

Acct 414 Notes & Examples Prof. Teresa Gordon

Teaching transparency Example #7

A. 9.5% preferred stock $2,000,000 par value. Issued at 112. Each $100 par preferred stock
is convertible into 5 shares of common stock. This stock is not
cumulative but the dividend for the year was paid.

B. 8.0% preferred stock $1,500,000 par value. Issued at par. Each $100 par preferred stock
is convertible into 3 shares of common stock. The stock is
cumulative with no dividends in arrears.

C. 50,000 options The options were issued last year with an exercise price of $15. The
average market price for the current year is $35. Options can be
exercised during a 5 year period that begins at the end of the next
fiscal year.

367274589.doc as of 09/29/17 Page 12

Acct 414 Notes & Examples Prof. Teresa Gordon

Teaching transparency Example #7

D. 8.0% bonds Face value of $5,000,000. Bonds were issued at a discount. Because the
impact was material, the company uses the effective interest method. The
bonds pay interest semi-annually on June 30 and December 31. The yield on
the bonds was 10%. The book value at the beginning of the year was
$4,783,526. Each $1000 bond can be converted into 50 shares of common
stock.

E. 9% bonds Face value of $5,000,000. Bonds were issued at 101. Since the premium
was not material, the company uses the straight-line method to amortize
the premium over the 20 year life of the bond. Each $5,000 bond is
convertible into 150 shares of common stock.

367274589.doc as of 09/29/17 Page 13

Acct 414 Notes & Examples Prof. Teresa Gordon

Worksheet for Example #7

Assume net income for year was $1,585,000 and the weighted average common
shares was 500,000
EARNINGS PER SHARE
NUMERATOR DENOMINATOR EPS
Net income $1,585,000 500,000

367274589.doc as of 09/29/17 Page 14

Acct 414 Notes & Examples Prof. Teresa Gordon

Example 8 Also available in an Excel File

Jolly Company has four convertible securities. For the bonds, the company paid the appropriate
interest and amortized the premiums and discounts using either the straight-line method or the
effective interest method (as indicated below). All dividends on preferred stock were paid. All
stock prices shown have been adjusted for the Sept. 30 stock split (see A).

Net income is $2,098,600

The corporate tax rate is 40%
A. Common Stock. Authorized 50,000,000 shares, issued
150,000 shares, outstanding at the beginning of the year,
120,000 shares.
On February 28, Jolly purchased another 10,000 shares of
treasury stock.
During the year, Jolly sold 50,000 shares on August 1.
On September 30, Jolly issued a 50% stock dividend to all
issued shares (i.e., the treasury stock and the outstanding
shares both receive the stock dividend).
Numerato Denominato
r r Index
B. $10 Preferred Stock. There were 40,000 shares
outstanding all year. Each $100 par preferred stock is
convertible into 4 shares of common stock before the stock
dividend and 6 shares after the 50% stock dividend (see A).
The stock is cumulative with no dividends in arrears.
C. Stock options. Jolly issued 100,000 options five years
ago. The exercise price was $20. The average market price
for the current year is $45. Each option converts into 1.5
shares of common stock after the stock dividend. No
options were exercised during the year.
D. Convertible Bonds. The bonds have been outstanding all
year. The face value is $10,000,000 with a coupon rate of
10%. Bonds were issued at a premium. Because the
impact was material, the company uses the effective
interest method. The bonds pay interest semi-annually on
June 30 and December 31. The yield on the bonds was
8%. The book value at the beginning of the year was
$11,576,073. Each $5,000 bond can be converted into 50
shares of common stock before the stock dividend and 75
shares after the stock dividend.
E. Convertible Bonds. Jolly issued the bonds on July 1 of
the current year at 98. The face value is $8,000,000 and
the coupon rate is 8%. Since the discount was not material,
the company uses the straight-line method to amortize the
discount over the 20 year life of the bond. Each $1,000
bond was convertible into 25 shares of common stock
before the stock dividend and 37.5 after stock dividend.

367274589.doc as of 09/29/17 Page 15

Acct 414 Notes & Examples Prof. Teresa Gordon

Check Figures for Example Problems:

1. Net income per share = $4.59

2. Basic = $4.36
Diluted = $4.12

3. Basic = $4.36
Diluted = $2.82

4. Basic = $4.59
Diluted = $4.03

5. W. A. shares outstanding = 41,417

6. W. A. shares outstanding = 320,500

7. Basic = $2.55
Diluted = $2.05

8. Weighted Average Shares = 198,750

Basic = $8.55
Diluted = $3.30

367274589.doc as of 09/29/17 Page 16