Intermediate Accounting

Volume 2 Twelfth Canadian Edition

Kieso ● Weygandt ● Warfield ● Wiecek ● McConomy

Chapter 17

Earnings Per Share

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Chapter 17: Earnings Per Share
After studying this chapter, you should be able to:
1. Understand why earnings per share (EPS) is an important
number and how it should be presented, disclosed and
analyzed.
2. Calculate basic earnings per share.
3. Calculate diluted earnings per share.
4. Identify differences in accounting between IFRS and ASPE,
and what changes are expected in the near future.

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Objective of Earnings Per Share
• Common shareholders have a residual interest in a company
• Return on investment is based on how well the company is
doing
• EPS provides insight to shareholders about
• How much of a company’s available income can be attributed to
the shares they own
• Assessing future dividend pay-outs
• Assessing the value of each share
• EPS disclosures help by indicating the amount of income earned
by each share

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Earnings Per Share Calculation
• EPS calculation is done for basic and diluted earnings per
share
• Basic EPS: Actual earnings; actual number of common
shares outstanding (prorated for time)
• Diluted EPS: “what if” calculation; considers possible
negative impact on common shares from convertible debt
and options
• EPS Formula:
Income available to common shareholders
EPS =
Weighted average number of common shares
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Presentation and Disclosure (1 of 3)
• Under IFRS, EPS information must be reported; usually
after net income in the income statement
• Earnings per share should be disclosed separately for
continuing operations, discontinued operations and
net income
• Provides impact of continuing operations because it
excludes gains/losses from operations not continuing
in the future
• When both types of operations exist, show both basic
and diluted earnings per share for both types
(discontinued operations can be reported in the notes)
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Presentation and Disclosure (2 of 3)
• The following show a typical presentation of basic and
diluted earnings per share on the face of the income
statement when both continuing and discontinued
operations are included
Basic earnings per share:
Income before discontinued operations $3.80
Discontinued operations (0.80)
Net income $3.00
Diluted earnings per share:
Income before discontinued operations $3.35
Discontinued operations (0.65)
Net income $2.70

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Presentation and Disclosure (3 of 3)
• IFRS disclosures requirements:
• Earnings per share for all periods presented
• With a stock split or dividend, per share amounts from prior
periods must be restated
• If diluted EPS is reported for one period, it should be reported
for all periods (even if it’s the same as basic EPS)
• When results of operations for prior period are restated, EPS
data should be restated along with the restatement’s effect
• ASPE does not require EPS calculations or disclosures—
ASPE is not used for public companies

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Analysis
• EPS is one of the most highly visible standards for
• Assessing management performance
• Predicting a company’s future value
• IFRS is very specific about its calculation; important to analyze
the potential dilutive impact of securities
• Price-earnings ratio: relates earnings to the price the shares
are trading
• Quick estimate of the value of the shares
• Easy comparison with other companies
• Called the “multiplier”—shows the per share value that
each dollar of earnings generate

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Basic Earnings Per Share (1 of 2)
• Simple capital structure:
• Common shares and non-convertible securities
• Only need to calculate and present basic EPS
• Complex capital structure:
• Common shares and securities that have a dilutive effect
on earnings per common share
• Debt and equity instruments (preferred shares),
warrants, options, and contingently issuable shares
• Calculate and present basic and diluted EPS

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Basic Earnings Per Share (2 of 2)
• Potential common (ordinary) share: gives the holder
the right to obtain a common share
• Contingently issuable shares are issuable for little or no
consideration once a condition has been resolved
• Calculation of earnings per share for a simple capital
structure involves two amounts:
• Income available to common shareholders
• Weighted average number of common shares
outstanding

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Income Available to Common
Shareholders
Income available to common shareholders =
net income less amounts set aside to cover other
obligations (such as preferred dividends) that rank in
preference over common shares
• If preferred shares are cumulative and the dividend is
not declared in the current year, then subtract it from
current net income or add it to net loss
• Dividends in arrears would have been included in
previous years’ calculations

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Income Available to Common
Shareholders: Example
Company has net income of $3 million
100,000 Class A, $4 cumulative shares
100,000 Class B, $3 non-cumulative shares
No dividend declarations or payments during the year

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Weighted Average Common Shares
• All EPS calculations use the weighted average number
of common shares as the denominator

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WACS: Dividends, Splits, and Reverse
Splits (1 of 2)
• When stock dividends or stock splits occur, calculation of
weighted average number of shares also requires
restatement of the shares outstanding before the stock
dividend or split
• A stock dividend or split does not change shareholders’
total investment; it only increases the number of common
shares.
• By restating the number, valid comparisons of earnings per
share can be made between periods before and after

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WACS: Dividends, Splits, and Reverse
Splits (2 of 2)
• The shares outstanding before the stock dividend must also
be restated
• ‘Before’ shares adjusted for the stock dividend so that
these shares are stated on the same basis as shares issued
after the stock dividend
• If stock dividend or split occurs between the end of the
year and when financial statements are issued, the
weighted average number of shares, EPS and comparative
amounts must be restated

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WACS: Dividends, Splits, and Reverse
Splits--Example
• The shares outstanding before the stock split must be
restated to put them on the same basis as those after

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WACS: Mandatorily Convertible
Instruments
• Financial instruments where common shares will be
issued in the future due to mandatory conversion
• Assume conversion has already taken place
• WACS calculated as though the instruments were
already converted and the common shares were
outstanding

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WACS: Contingently Issuable Shares
• Potential common shares
• Not considered contingently issuable if dependent on
the passage of time—it is certain time will pass
• When based on something else (profit levels or
performance targets) include in the EPS calculation
when the conditions are satisfied

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Diluted EPS: Complex Capital Structure
• Complex when a corporation has potential common shares-
-could dilute earnings per share if converted or exercised
• With a complex capital structure, both basic and diluted
EPS are reported
• Diluted EPS includes effect of all dilutive potential common
shares on both income and shares
• Will not include antidilutive securities—would increase
earnings per share (or reduce loss)
• If securities are antidilutive, remote chance the conversion
will take place

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Diluted EPS: Convertible Securities
• At conversion, convertible securities are exchanged for
common shares
• They are potential common shares and may be dilutive
• If-converted method used to measure the dilutive effects of
a potential conversion (such as convertible debt and
preferred shares)
• Assumes instruments are converted at the beginning of the
year (or issue date, if later)
• Assumes any related interest (net of tax) or dividend is
avoided
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Diluted EPS: If-Converted Method
Example (1 of 4)
Company has net income, $410,000 and 100,000 WACS; 30% tax
• $1 million, 6% issue sold at 100 in a prior year; convertible to 20,000
common shares
• $500,000, 10% issue sold at 100 on April 1; convertible to 32,000
common shares

• Two-step process
1. Convertible securities are converted (beginning of the year or issue
date)
2. Related interest (net of tax) and preferred dividends are eliminated

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Diluted E P S: If-Converted Method
Example (2 of 4)
Basic earnings per share: $4.10 ($410,000 ÷ 100,000)
Diluted earnings per share: Adjust net income

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Diluted EPS: If-Converted Method
Example (3 of 4)
Restate weighted average common shares:

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Diluted EPS: If-Converted Method
Example (4 of 4)
Diluted earnings per share: $3.32 ($478,250 ÷ 144,000)

Net income for the year $ 410,000

Presentation on Earnings per share:
income statement: Basic earnings per share $ 4.10
Diluted earnings per share $ 3.32

Other factors:
• If bonds have a premium or discount, use interest expense (not
interest paid)
• If conversion rate changes, use the most advantageous rate for
security holder
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Diluted EPS: Options and Warrants (1 of 3)
• Stock options allow holder to buy or sell shares at a pre-set price
(the exercise price)
• Company can write (sell) options or purchase them
• Options allow the holder to buy the shares (call options) or sell
the shares (put options)
• If holder exercises options, the company has to deliver (either
buy or sell) the shares
• Holder of options will exercise the right if they are “in the
money”; holder benefits from exercising them
• ”In the money” options are dilutive; must be included in the
diluted EPS calculations

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Diluted EPS: Options and Warrants (2 of 3)
• Expired options and options that are not in the money are
excluded from the diluted EPS calculation
• Written put options have same impact as forward purchase
contracts: include in calculations if purchase price is higher
than average market price
• Written call options have same impact as forward sales
contracts: include in calculations if forward selling price is
lower than average market price
• Purchased options are antidilutive—only exercised when
they are in the money; would always be favourable to the
company, so not included in EPS
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Diluted EPS: Options and Warrants (3 of 3)
Scenario #1: A company sold call Scenario #2: A company sold
options for $2 that allow the put options for $2 that allow
holder to purchase their shares the holder to sell their shares
for $10. At the time the shares back to the company for $8. At
were trading at $9, but the time the shares were
subsequently increased to $15. trading at $9, but subsequently
went down to $6.
If the holder exercises the options,
the company will have to issue its If the holder exercises the put
own shares for the exercise price options, the company will have
of $10. The options are in the to buy the shares for the
money, since the market price is exercise price of $8. The options
$15. are in the money, since the
market price is $6.

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Diluted EPS: Treasury Stock Method
(1 of 2)
• The treasury stock method looks at the impact of
written call options on EPS numbers
• It assumes that
• Options are exercised at the beginning of the year
(or date issued if issued during the year)
• the money is used to buy back shares for the
treasury at the average market price during the year
• Incremental number of shares to be issued above the
number purchased is added to the WACS outstanding
• There is no adjustment to the numerator
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Diluted EPS: Treasury Stock Method
(2 of 2)
Assume that 1,500 (written) call options are outstanding
at an exercise price of $30 for a common share. The
average market price per common share is $50.
Proceeds from exercise of 1,500 options (1,500 × $30) $45,000
Shares issued upon exercise of options 1,500
Treasury issued purchasable with proceeds ($45,000 ÷ $50) 900
Incremental shares outstanding (additional potential common shares) 600

• If exercise price < the market price, dilution occurs

• If exercise price > the market price, the options would
not be exercised (not included in the calculation)
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Diluted E P S: Treasury Stock Method
Example (1 of 2)
A company has net income for the year of $220,000, with
WACS of 100,000 outstanding. Although not exercisable
at this time, written call options exist for 5,000 shares at
$20 each. Market price of shares during the year was $28.

• Since the only dilutive security is a call option, use the

treasury stock method
• Call options are in the money: exercise price = $20 < average
market price = $28
• No change to the net income

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Diluted EPS: Treasury Stock Method
Example (2 of 2)

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Diluted EPS: Reverse Treasury Stock
Method
• The reverse treasury stock method looks at the impact of
written put options on EPS numbers
• It assumes that
• Options are exercised at the beginning of the year
• The company first issues shares in the market to obtain funds to
buy the shares under the option
• When average market price < exercise price, option
considered in the money; dilutive
• If market price > exercise price, option would not be
exercised

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Diluted EPS: Reverse Treasury Stock
Method Example
Assume 1,500 written put options are outstanding at an exercise
price of $30 for a common share. Average market price is $20.

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Diluted EPS: Contingently Issuable
Shares
• Potential common shares
• If issuable upon attaining certain conditions, and they
are met by year end, considered issuable shares
outstanding from beginning of the year
• If conditions have not been met, number of shares
included would be the amount that would be issued
• if the end of the reporting period was the end of the
contingency period
• If the impact was dilutive
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Diluted EPS: Antidilution Revisited
• Antidilutive potential common shares would result in diluted EPS
that are higher than basic EPS
• Diluted EPS must show a lower EPS
• Need to determine which securities are dilutive and which are
antidilutive, so the latter can be excluded from the calculation
• Process to follow:
1. Determine the incremental effect of each security
2. Rank results from the most to the least dilutive
3. Recalculate EPS by adding effects from step 1 until the security
is antidilutive

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Diluted EPS: Antidilution Revisited
Example
A company has a $1-million, 6% debt issue that is convertible into 10,000
common shares. Net income for the year is $210,000, weighted average
common shares outstanding is 100,000, and the tax rate is 20%.

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Additional Disclosures
• A dual presentation requires additional disclosures:
• Numerator, Denominator for Basic and Diluted EPS
• Reconciliation of numerators and denominators of basic and
diluted EPS for income before discontinued operations
(individual income and share amounts of each class)
• Securities that could dilute Basic EPS in the future, but not
included because of antidilutive features
• Description of common share transactions after reporting
period that would significantly change EPS numbers

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A Comparison of IFRS and ASPE, and
Looking Ahead
The main difference between the standards is that ASPE does
not prescribe standards for calculating EPS at all. EPS
standards therefore apply only to publicly accountable
entities and private enterprises that choose to apply IFRS.

As the accounting for derivatives and financial instruments

continues to evolve, standard setters are gradually revisiting
other areas to determine the impact of the standards for
financial instruments on these other areas. Earnings per share
is one such area. IASB and FASB have paused work in this area.

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Copyright
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the information contained herein.

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