Part B: Earnings Per Share

I. For analysts and the financial press, earnings per share is the most frequently cited and
reported measure of a company’s performance.
A. EPS is reported in the income statement of all publicly traded firms.
B. In general, EPS is simply earnings available to common shareholders divided by the
weighted average number of common shares outstanding.

II. If a company has no “potential common shares” we consider it to have a simple capital
structure.
A. For a simple capital structure, a single presentation of basic EPS is sufficient.
B. If there are no securities other than common stock and the number of common shares
remained unchanged, basic EPS is simply net income divided by common shares. (T19-
11)

III. When the number of shares changes, EPS calculations are based on the weighted average
number of shares outstanding during the period.
A. New shares issued during a reporting period are time-weighted by the fraction of the
period they were outstanding and then added to the number of shares outstanding for
the period. For instance, if 12,000 new shares are sold on October 1, the denominator
of the EPS fraction would be increased by: 12,000 x 3/12, or 3,000 shares. (T19-12)
B. On the contrary, an increase in shares due to a stock dividend or stock split is not time-
weighted. (T19-13)
1. For a stock dividend or stock split, the shares outstanding prior to the stock
distribution are restated to reflect the increase in shares. That is, we simply
increase the outstanding shares by the number of new shares.
2. The firm would simply have a larger number of less valuable shares (the same
pie is cut into more slices).
3. For example, EPS after a 2 for 1 stock split would be half of what it was before,
other things being equal.
4. When reported again in the comparative financial statements, previous years’
EPS are restated for comparability.
C. If common shares are reacquired (as treasury stock or to be retired) those shares are
time-weighted for the fraction of the period they were not outstanding. The time-
weighted shares then are subtracted from the number of shares in the denominator of
the EPS fraction. (T19-14)
IV. Any dividends on preferred stock outstanding are subtracted from reported net income. (T19-
15)
A. This is because the denominator in the EPS calculation is the weighted average number
of common shares, so the numerator should reflect earnings available to common
shareholders.
B. This adjustment is made for cumulative preferred stock whether or not dividends are
declared that period. The assumption is that eventually the dividends will be paid if
the preferred stock is cumulative.

V. When a company has securities that could potentially dilute (i.e., reduce) earnings per share,
it is classified as a complex capital structure. (T19-16)
A. These potential common shares include stock options and convertible securities.
B. The company reports both basic and diluted earnings per share.
C. For diluted EPS, the impact of each potentially dilutive security is reflected by
calculating earnings per share as if the security already had been exercised or converted
into additional common shares.
D. Stock options (also stock rights and stock warrants) give their holders the right to
exercise their option to purchase common stock, typically at a specified exercise price.
The increase in shares would reduce EPS. (T19-17)
1. When calculating diluted EPS, we pretend the stock options had been exercised
at the beginning of the period (or at the time the options are issued, if later).
2. We also assume the cash proceeds from the assumed sale were used to buy back
(as treasury stock) as many of those shares as could be acquired at the average
market price of the shares during the period.
3. If the options haven’t vested, “proceeds” also include any compensation not yet
expensed.
4. If the options are not incentive options, “proceeds” also include any “excess tax
benefits.” (T19-18)
5. Restricted stock is potentially dilutive and also is included in diluted EPS by the
treasury stock method. (T19-19)
E. For convertible securities, we pretend for the purpose of calculating diluted EPS that
the conversion already has occurred. (T19-20)
1. To include convertible bonds in the calculation of diluted EPS, we pretend the
conversion occurred at the beginning of the period (or at the time the convertible
security is issued, if later). (T19-21)
a. The denominator of the EPS fraction is adjusted for the additional common
shares assumed.
b. The numerator is increased by the interest (after-tax) that would have been
avoided in the event of conversion.
2. To include convertible preferred stock in the calculation of diluted EPS, we
pretend the conversion occurred at the beginning of the period (or at the time the
convertible security is issued, if later). (T19-22)
a. The denominator of the EPS fraction is adjusted for the additional common
shares assumed.
b. The numerator is not reduced by the preferred dividends because they would
have been avoided in the event of conversion.
VI. If the effect of the assumed conversion or exercise of potential common shares would be to
increase, rather than decrease, EPS, we consider them “antidilutive securities.” Antidilutive
securities are ignored when calculating both basic and diluted EPS. (T19-23)

VII. Contingently issuable shares also are potential common shares. (T19-24)
A. These are considered outstanding in the computation of diluted EPS if the conditions
for their issuance currently are met.
B. For instance, if 50,000 shares will be issued next year if the market price of common
shares next year is at least $35 and the market price currently is $36, the 50,000
additional shares would be simply added to the denominator.

VIII. Financial statement disclosures include both basic and diluted EPS for both income from
continuing operations and net income. (T19-25)
A. Per share amounts also are reported for:
1. Discontinued operations,
2. Extraordinary items, and
3. An accounting change.
B. Disclosures should include a reconciliation of the numerator and denominator used
in the computations.
C. IAS No. 33 and U.S. GAAP are similar in most respects. The differences that remain
are the result of differences in the application of the treasury stock method, the
treatment of contracts that may be settled in shares or cash, and contingently issuable
shares. (T19-26)