Chapter 19 Share Based Compansation and Earnings Per Share

BASIC EARNING PER SHARE

Earnings per share must be reported on the face of the income statement. It reflects the current
earnings available for each share of common stock. In addition, when the income statement
contains irregular items (items net of tax below the income from operations line) EPS should be
reported for each item.

Earnings per Share-Simple Capital Structure

In a simple capital structure the corporation has no securities that have a conversion option.

Preferred Stock Dividends: If the corporation has both preferred and common stock typically
preferred dividends must be subtracted from net income to derive income available to common
stockholders. If the preferred stock is cumulative, dividends are subtracted whether declared or
not. If the preferred stock in non-cumulative the dividends must be declared. The formula for
calculating basic earnings per share is as follows:

Net Income less Preferred Dividends

Basic EPS =
Weighted Average Number of Common Shares Outstanding

Issuance of New Shares

Current year preferred dividends are subtracted from net income to derive the net income
available to common stockholders. The weighted average of the number of shares of common
stock outstanding provides the basis for calculating the per share amount. We account for any
shares issued or repurchased during the period. This is accomplished by calculating the fraction
of the period that they are outstanding and adding this to the beginning balance of shares
outstanding.

Example: On January 1, 2003 Spencer Company had 500,000 shares of common stock
outstanding. On May 1, 2003 the company issued an additional 84,000 shares and on September
1 the company repurchased 42,000 shares (treasury stock). On November 1 the company resold
36,000 shares of the treasury stock. The weighted average of common stock outstanding for the
year is calculated as follows:

Weighted-Average Common Shares for Fiscal Year of 2003

Fraction Weighted
Description Dates Shares of Year Average
Beginning balance 1/1/03 500,000 4/12 166,667
Issued shares 5/1/03 84,000
Adjusted balance 584,000 4/12 194,667
Repurchased shares 9/1/03 (42,000)
Adjusted balance 542,000 2/12 90,333
Issued shares 11/1/03 36,000
Adjusted balance 578,000 2/12 96,333

Weighted average number of shares outstanding 548,000

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Chapter 19 Share Based Compansation and Earnings Per Share

Stock Dividends and Stock Splits

The above is fairly straight forward in that there are not complicating issues like stock dividends
and stock splits. If there is a stock dividend or stock split we must restate the number of shares
outstanding prior to the date of dividend or split. Lets assume that Spencer Company declared a
stock dividend of 40% on October 1, 2003. The calculation of the weighted average of common
shares outstanding for the year would be as follows:

Weighted-Average Common Shares for Fiscal Year of 2003

Restated Fraction Weighted
Description Dates Shares Restate Shares of Year Average
Beginning balance 1/1/03 500,000 1.40 700,000 4/12 233,333
Issued shares 5/1/02 84,000
Adjusted balance 584,000 1.40 817,600 4/12 272,533
Repurchased shares 9/1/02 (42,000)
Adjusted balance 542,000 1.40 758,800 1/12 63,233
40% stock dividend 10/1/02 216,800
Adjusted balance 758,800 758,800 1/12 63,233
Issued shares 11/1/02 36,000
Adjusted balance 794,800 794,800 2/12 132,467

Weighted average number of shares outstanding 764,800

If in the above example Spencer Company had the following items in the calculation of net
income, the related basic EPS would be presented on the income statement as follows.

Income before extraordinary item $400,000

Extraoridinary loss, net of tax (100,000)
Net income $300,000

Earnings per share:

Income before extraordinary item $0.52
Extraordinary item, net of tax (0.13)
Net income $0.39

Each item in the income statement is divided by the weighted average number of shares
outstanding, which are 764,800 in this example.

Answer the following questions regarding earnings per share with a simple capital
structure.

Question 1
With respect to the computation of earnings per share, which of the
following would be most indicative of a simple capital structure?

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Chapter 19 Share Based Compansation and Earnings Per Share

a. Common stock, preferred stock, and convertible securities

outstanding in lots of even thousands
b. Earnings derived from one primary line of business
c. Ownership interest consisting solely of common stock
d. None of these

Answer
c. Ownership interest consisting solely of common stock

Question 2
In computing earnings per share for a simple capital structure,
if the preferred stock is cumulative, the amount that should be
deducted as an adjustment to the numerator (earnings) is the
a. preferred dividends in arrears.
b. preferred dividends in arrears times (one minus the income tax
rate).
c. annual preferred dividend times (one minus the income tax rate).
d. annual preferred dividend.

Answer
d. annual preferred dividend.

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