How often do earnings per share (EPS) calculations need to be done and why? Learn how EPS can help determine company performance across time when calculated on a consistent basis.
Roger Philipp, CPA presents:
WHAT YOU NEED TO KNOW ABOUT "EARNINGS PER SHARE"
Alright, the next area is earnings per share. Now, earnings per share is one of the most talked about numbers in the financial statements because both investors and creditors want to know, "Hey, if I invest in the company, will my stock go up in value and will I get a dividend?" Creditors want to know,"If I loan you money, will I get the principal back? Will I get the interest? What are your earnings per share?" Now, with EPS it's number that we need to calculate on a consistent basis, so companies can tell year to year to year how the company is doing. The other reason, too, is we want to know, "Should I invest in the company?" Now, if we calculated it in a different way every year, then the number would be meaningless because in today's day and age, you're watching channel 58, or whatever, and you watch the numbers go by and CNBC, and it says, "Their earnings were one cent above expectations, analyst expectations." What happens? Stock goes through the roof. If it was two cents below, drops through the floor. So, we have to figure out how to calculate this number on a consistent basis. Now, a lot of times people think earnings per share means how much you're getting in the form of dividend. It doesn't, because earnings per share is a theoretical number only. It says, theoretically speaking, if all of our earnings were paid out now in the form of a dividend, how much would you get? It's not how much we're actually going to pay you, but it says, theoretically speaking, if we were to pay it out, how much would you earn? Now, we're going to show earnings per share for, remember my mnemonic for the GAAP income statement? I like to go surfing on the TIDE N OC. We're going to show it for income from continuing operations and net income. You also were going to disclose D and E, but it doesn't have to be on the face of the income statement. That could be in the footnotes. So, we're going to disclose what our earnings per share is for D, E...well, for basically income from continuing and for net income. You're also going to disclose D and E, again, either on the face or in the footnotes. You do not have to show earnings per share for comprehensive income, and as I mentioned, when I taught you cash flows, you also don't show earnings per share for cash flows. You don't have to show that either. So, the wrong answer. Just so you realize as far as what they're asking. Alright, let's look at our notes. It says, "A publicly held company is required to present earnings per share, EPS, for basic and diluted earnings per share on the face of the income statement for income from continuing and net income. The company must also either present it on the face or in the notes for D and E." Now, remember, I've taught you in the past for IFRS, there are no E, there are no longer any extraordinary gains or losses. Just so you remember that. It says, "The company does not present other comprehensive income or total comprehensive income on a share basis or cash flows per share are also not disclosed." So, those are things that are not disclosed. Now, what are we looking at? We're looking at what we call a simple capital structure or a complex capital structure. So, it's either simple, called basic earnings per share, or it's very complex, like my wife...no, just kidding...complex, which is called dilutive earnings per share. So, let's look over here, and we're going to talk about what we call simple earnings per share or a basic earnings per share, which is a simple capital structure, and we're going to have what we call diluted earnings per share, also called a complex capital structure. This means that they're what we call potentially dilutive securities, and we're assuming anyone who could convert does so at the earliest point in time. So, as I go through the formulas later on, we're going to be calculating earnings per share in different ways. We're going to have what we call simple or basic earnings per share. That assumes there's nothing potentially dilutive. What do I mean by potentially dilutive? Things that are convertible into common stock, like options, rights, warrants, things like that. Then we have diluted. That means there are things that are potentially dilutive that can dilute or weaken, like dilute, like you get up in the morning, you make orange juice, frozen orange juice and you add too much water, it gets too diluted or too weak. So, what we're saying is that diluted. It's a complex structure. Anyone who could convert does so. Okay, now, in looking at this simple or complex capital structure, we're going to be calculating our basic earnings per share and our diluted earnings per share. Now, when we calculate it, we're going to be looking at, and I'll start with the simple and then we'll drift over. So, we'll start here, and then we'll come over to the complex. With simple, we start with our net income, from that we're going to subtract what I'll call A, our preferred dividends. So, we subtract our preferred dividends. That gives us the amount of money we have available to distribute because when we talk about earnings per share, it is the earnings per share that the common shareholder would get. Common shareholder meaning common stock. So, that's why...who gets paid first? Preferred. Remember, preferred stock had certain preferences over common. What are the preferences? Liquidation preference, they could be convertible, they could have warrants ,also they get paid a dividend before common. So, that means if we had net income, who gets paid first? The preferred. That gives us how much money is left available to give to all the common shareholders. Now, I put a little A here because I'm going to take the A here. What does the A mean? What it says is preferred...remember preferred can be cumulative or non-cumulative. Let's review what that meant. If it was cumulative, it meant that if we don't declare it last year, it's still going to have to get paid if we ever do declare a dividend. So, the next year we don't declare, then we finally declare a dividend. If it's cumulative, it accumulates in arrears. Where's your rear? Behind you, your behind. So, that means we owe this, we owe this, we owe current. If it's non-cumulative, that means if you don't declare it, it's lost forever, you never owe it. So, here's the rule. Listen carefully, and then I'll show it to you in the notes. If it is cumulative, then you take it out whether it's declared or not because you'll eventually owe it. If it is non-cumulative, that means that if it's not declared, you're never going to owe it. So, if it's non-cumulative you only deduct it if declared. So, one more time. If it's non-cumulative, only take it out if declared. If it's cumulative, you take it out whether declared or not, but you take it out for how many years? For one year only. Why for one year only? Because this is a theoretical number. This just says, theoretically speaking, "How much would each shareholder get each year?" So, we have to calculate on a consistent basis, So, A is going to be if non-cumulative only if declared. If cumulative, whether declared or not declared. To declare or not declare, that is the question, right? Who was that? Shakespeare? So, if cumulative, declared not declared, but only for one year. Alright, let's do that again. If it's non-cumulative, you're going to take it out only if its declared because if it's not declared, you never owe it. If it's cumulative, whether declared or not, you take it out, but only for one year. Why? Because if last year's was not declared, but it's cumulative, you would have included it in last year's calculation and this year you calculate it in this year, and next year, next year. Then when you finally declare it, you'll just pay it out...but we're, again, trying to come up with this theoretical number which says, theoretically speaking, how much would we owe if it was all paid out in the form of a dividend. Alrighty. So, you'll see that. Look in your notes, bottom of the page, it says, "Earnings equals net income minus preferred." Shares, we'll come back to. "Since the EPS is being computed on the common stock, earnings must be reduced by the dividends payable to preferred shareholders. If preferred stock is not cumulative, only dividends declared for the year are subtracted. If they are cumulative, the annual dividend preference is subtracted each year regardless of whether it is or isn't declared since the amounts not paid accumulate and will never be payable to common shareholders." Because, again, it's never going to go to common. It's always going to get a preferred because it's cumulative. It says simple or basic, net income minus preferred, which again is all cumulative and non-cumulative, but only if declared, and, again, my question to you is, for how many years? For one year only. This year only, this year only, this year. Okay? And that always seems to confuse people, but if this year only, then we divided by something called the weighted average number of common stock outstanding. So, that's what I'm going to put here as a one. I'm going to divide it by the weighted average number common stock outstanding. So, I'm going to show you how to calculate that. So, we're going to take the dollars divided by the weighted average number of shares. So, one more time. Our simple or basic assumes there's nothing potentially dilutive, you take net income minus preferred is the dollars you have available divided by the weighted average number. Now, the top, in case you didn't know, is called the numerator and the d-d-d-d-down, denominator. I know it seems stupid, but you may not remember. Numerator is the top part of the fraction, denominator is the d-d-d-down denominator. Okay? Numerator denominator. So, the numerator is the top, that's the dollars, divided by the number of shares. So, if I had $900,000 dollars and 100 shares, that would be $9 per share. Numerator is 900 the d-d-d-down denominator is the 100. Okay. So, that's what we're looking at. Now, the question is, how do you come up with weighted average number of common stock outstanding? What does weighted average mean? It means, on average, how much stock could I have outstanding for the entire year? That's weighted average. So, what we're looking at is, if I had 100 shares outstanding on day one, then I have 100 shares outstanding for the whole year, but let's say I issue them halfway through the year, then I have 100 outstanding at the end of the year, but on average, it was only 100 divided by 2 or 50 for the whole year. So, that's what we mean by a weighted average. It's an average that is weighted based on the length of time that the shares were outstanding. So, on page 2, you'll see a number 1, and that's where I'm going to show you how to calculate the weighted average number of common stock outstanding. Alright, that's the weighted average number of common stock outstanding. Here's where we're going to have to calculate it. Now, a couple of things...dividends and split are treated retroactively. Huh? What does that mean? Dividends and splits are treated as if they happen at the beginning the year. So, if halfway through the year I issue a stock dividend, then you go back as if they were outstanding for 12/12ths of the year. If I do a two-for-one split, then you act as if it was for the whole year and any previous years as well. So, they're retroactive, not only at the beginning the year, but the beginning of time. So, if you're doing comparative x1, x2, and you have a dividend or splint in x2, you've got to go back and add 10%, or go back and do a two-for-one. So, let me show you what's going on as far as weighted average. It says, "Weighted average, number shares of common stock outstanding...the determination of the number of shares to include the denominator is the calculation, and this can be very tricky. The amount to be used is the weighted average of the number of common shares outstanding during the year. As a result shares sold to the public during the year must be pro-rated for the portion of time that they were outstanding." So, let's say, for example, I have 100 shares outstanding on January 1st. That means theyíre outstanding for 12/12ths. Then, let's say I have 80 shares outstanding on 9/1. What's 9/1? 9...for January, February, March...for April 1st. So, April 1st. That means, let's try this again. On 3/1...no, let's do 4/1...no, 3/1. So, that means they're outstanding for how many months? January, Februa...no, let's do 4/1...I'm not even sure what I'm doing... January, February, March...that's 3 months that they were not outstanding. So, they are outstanding for 9/12ths of the year. So, 9/12ths of the year 80 at three quarters is 60. So, that means I've got I've got 160 shares outstanding. Now, I really have 180 shares outstanding, but on average, I have 100 for the whole year, and I had 80 for three quarters of the year, which is 60. It's kind of like when I teach you in BEC. We're going to talk about equivalent whole units of production. Let's say, for example, I'm building these beautiful Roger CPA Review shirts, gorgeous shirts, huh? Gotta love 'em. I go out to clubs and stuff, "Hey, where'd you get that shirt?" "Roger CPA Review." "Cool." Right? People are lining up, wanting to shake my hand. I hang out with Kim Kardashian all the time. Wear the shirt. So, oh, so, I'm building this shirt. Now, I don't take it, build one shirt, finish a shirt and start another. You take a shirt, and you cut it, then you take 50 shirts and you sew them, then you take...see what I'm saying? Then you do like a production line. So, you take, let's say, 80 shirts and you cut the one sleeve, then you cut the other sleeve, then you sew on a collar and so on and so forth. So, let's say, for example, I have 80 shirts that are three quarters of the way done. How many whole shirts could I have done if I would have done one shirt and then started another shirt and then started another shirt? If I would have done one shirt at a time and finished it, then if I had 80 shirts three quarters of the way done, as far as we call conversion cost, I could have done 60 whole shirts. That's all we're saying. If I have 80 shares outstanding for three quarters of the year, that's like having 60 shares outstanding for the whole year. That's really what we're saying. So, that's what I mean by weighted average. So, when we're doing this, dividends and splits are treated retroactively. You'll see this in your notes. It says at the bottom of the page, "The reason for pro-rating shares issued during the year is that the funds received from issuance are only available for productive use by the corp from that point on, not the entire year. This would not be the case, however, if shares were issued as a result of a stock dividend or a stock split or a delayed issuance called a stock subscription." It says, "If these...in these cases, the shares are treated as if they've always been outstanding and are included at full amount for the current year. They're are also included for earlier years that are shown in comparative statements. In the case have a reverse stock split, these would retroactively reduce the shares outstanding." Because a stock split might be like a two-for-one split, and we talked about that in stockholder's equity where you basically get rid of the one common stock for 100 bucks, give them another common stock. So, let's say I had 1 share at $100, and now I'm going to have 2 shares at 50. That's called a two-for-one split. So, I take 1 share back, and give you 2. So now, I have double the shares. So, if I did this in x2 for comparative purposes, I've got to go back and adjust x1 as well and do a two-for-one. A reverse is the other way. Let's say Google is 500 bucks a share, and nobody's going to buy one share. So, what do I do? I'll do a reverse. What I'll do is, I'll take out...or no, let's do...I'm sorry... that that would be a stock split. Let's do a reverse stock split, but let's say, for example, the stock is trading at 100 bucks for 10 shares, so it's 10 bucks a share, 10 shares at 10 bucks is 100 bucks. I'm going to do a reverse. So, I'm going to give you 5 shares at 20 bucks a share. So, it's still 100, but I'm cutting the shares in half. Same thing, you'd retroactively cut the shares in half. So, whether it's a stock split, double them, if it's reverse stock split, you cut them in half or cut them in fewer...and that's just like...let's say you have a stock trading at 20 cents a share. Nobody wants a penny stock. So, we'll do a reverse split and instead of give me 20 shares, and I'll give you 1 share, so that way it's trading at a much higher cost. Alright. So, remember dividend splits stock subscriptions are treated how? Retroactively, which means you go back, and you have to restate. Look at the example on page 2. For example, assume the following facts apply to the client for the first 2 years of the existence. Alright, so let's look over here. We're going to do accommodation. On 1/1 we had 500 shares outstanding. So, on January 1st, we have 500 shares outstanding, 500 shares outstanding, that would be for 12/12ths of the year. That's 500. Then it says we issued on July 1st 100 shares. So, we issued 100 shares on July 1st. That means they're outstanding for 6/12ths of the year, which is 50. Then it says on 10/1, we issued another 300 shares. So, we have 300 shares. We issued these on 10 /1. So, again, you use your fingers, you're allowed to bring them to the exam. That means that these are outstanding for how much of the year? 10/1, all of 10, all of 11, all of 12. So, they're outstanding 3/12ths of the year, which equals something like 75. So, we've got 5, 6, 25. Now, notice we really have 5, 8, 900 shares outstanding. So, on the balance sheet, remember we talked about authorized issued outstanding? How many shares were outstanding? 900 but for earnings per share calculations, we don't use 900, we use the weighted average number of shares outstanding. How many were on outstanding for the entire year? Basically 625. So, that's the number we would use for our earnings per share calculation. Okay. Alright. Let's do a little trickier question on page 3, middle of the page it says example. On 1/1 we have 100,000 shares of common stock outstanding. On April 1st, 80,000 shares are issued. On July 1st, a 10% stock dividend is issued. Now, remember, how do we treat stock dividends and splits, everybody? Retroactively. Good! On September 1st, 18,000 shares of treasury stock are re-purchased. Now, what is treasury stock? Stock that is authorized, issued, but no longer outstanding. Therefore, what we're going to say is, if you buy back the stock, then that's going to be a minus because that's stock that's not outstanding. On December 31st, a two-for-one split occurs. Again, a split is also retroactive. And then calculate the weighted average number of shares of stock outstanding. Okay, so, on 1/1 we had 100,000 shares outstanding. So, let's do this again. January 1st, 100,000 shares. So, we have a 100,000 shares outstanding times 12/12ths of the year is 100,000. Then, on April 1st, here's on April 1st 80,000 shares are issued on April 1st. So, that means they're outstanding for what? 9/12ths of the year, which I did earlier, which is three quarters, which is 60. Then, on July 1st, we do a 10%, a 10% dividend, so a 10% dividend is issued. That means right now, we've got 160 shares. We're going to add 10% or 16,000, 176. And again, remember, it's treated retroactive. So, if we had a previous, year, you go back and add 10% as well. Then on 9/1, 18,000 shares of treasury stock are re-purchased. So, if you're re-purchasing 18,000 shares of treasury stock, what that means is, of the 100, 18 was not outstanding from 9...because it was 9...9, 10, 11, 12. So, basically, this is not outstanding for 4/12ths of the year. So, 4/12ths of that is 6000. That gives us 170. Then, on December 31st, we do a two-for-one split. So, on 12/31 a two-for-one, which means you're going to go back and double everything. So, just do times 2, which is 340. So, notice, 340,000 shares is our weighted average number of stock outstanding. Now, how much is really outstanding? 100 plus 80 plus 18 minus 18 is...times 2 is 360. So, we really have 360 outstanding, but on average it's 340. It's 100 plus 80, 180 plus 10% is 18 is 198, minus 18 is 180 times 2, 360. So, again, on average 340. So, when you do the calculation over here, what would you do? You take this and divide it by 340, which is the weighted average, weighted average. So, that's the weighted average, not the total, okay? See that? So, that's the weighted average, not the total outstanding. Alright. Let's try a question on that. How about number 7? Temp Inc. had the follo...Ooops...Last sentence first. What were Temp's weighted average shares outstanding? Temp Inc. had the following common stock balances and transactions during the year. On 1/1, common stock outstanding 300...30,000. On 2/1, we issued a 10% dividend. How are they treated? Retroactively. On 7/1, we issued common stock for cash. Total outstanding is 41. What's the weighted average outstanding? So, let's see what we've got. We've got 30,000 outstanding at the beginning. So, we've got 30,000 outstanding times 12/12ths is 30,000. Then we've got on 2/1 a 10% dividend, 10% dividend is treated retroactive, 10%, so it doesn't matter when it's issued, you assume it's outstanding for the whole year, which is another 3,000. Then we've got 7/1. We issued 8,000 shares for cash. Now, 8,000 shares on 7/1. That means it's outstanding for how long? For 6/12ths or half the year, which is 4,000, 33 and 4, 37,000. So, notice, we have 41,000 outstanding, but for the calculation, weighted average is what? 37,000 shares of stock. Beautiful. Alright, now, let's turn back and let's get a little bit uglier, back to about page 3, and let's come back to my formulas over here. Now, over here you'll notice that we started out, we said, let's take net income minus preferred is the money, divided by number 1, which is the weighted average number of stock outstanding. Now, that's called a simple or basic earnings per share. Now, I want to get to diluted. What does diluted mean? Diluted is called the complex capital structure. What does that mean? It means anyone who could convert, does so. When? At the earliest point possible or when issued if their issued during the year, the latter of the 2. So, what this says is, we're going to take our net income number, and I'm going to bring that over here. We're going to take our weighted average shares and bring it over here. Then I'm going to make 2 adjustments for number 2 and number 3, number 2 and number 3. That's how we're going to take this, to modify this. That's going to give us our diluted or called the complex capital structure because this will give me based on what could the people that could have converted. Alright. Now, number 2 is called the if converted method, and the if converted method, this is for convertible preferred stock and convertible bonds. So, let's start up here. Number 2 with the if converted method. If converted method, and, again, the if converted method is for convertible bonds and convertible preferred stock because, let's think about it, if you have not convertible bonds or convertible preferred stock, if they convert, what are they converting into? Common stock. Well, if had a convertible preferred, and they converted, you give them common. What do you not have to pay? A preferred dividend. Ooohhh...if you have a bond and they convert, what do you not have to pay them? Interest. But what do you give them? Common shares. So, you're going to have more shares outstanding, but you're also going to have more money because you save that interest income. Ohhh...So, the if converted method says assuming the convertible bonds or convertible preferred converted, what would you not have to give them? What would you have outstanding? So, for the if converted method, in the numerator up here, the numerator, plus if it was a convertible preferred, what would we not pay them? Well, over here, you subtracted the preferred dividend. Well, if they converted, you wouldn't have to pay it to them. So, add back plus the preferred dividend, not net of tax. Now, why is it not net of tax? Because dividends come out of after tax dollars. Therefore, you would just...So if it was a 20 dollar dividend, if they converted, you wouldn't have to give them the 20. Add it back. And then what would you add down in the d-d-d-denominator? Plus the number of shares of common stock converted into. Because it might say that, if they converted, you don't have to pay them the $20 in dividend, but each person's going to get 10,000 shares of stock plus 10. So, in the numerator, you add the dollars, in the denominator, the shares. So, that's 20 over 10 or $2 a share. So, as long as your basic earnings per share was more than 2, then that's called diluted because here's an important point, earnings per share should start big, get smaller. It could be big, stay the same, but it could never go big bigger because if the earnings per share goes up, that means people gave up more and got less. We don't assume they're morons, unless they really are. But, basically, what we're saying is earnings per share should start big and then get diluted or get smaller, get weaker. So, in other words, let's say, for example, we had $900, $900 of income and 100 shares. So, that's $9 a share. Would you give up $2 to get 9? Don't think too hard. You give me 2, I give you 9. Would you do it? Yeah. So, therefore what would our earnings per share be? It would be 900 plus 20 over 100 plus 10, it would be 920 over 110. So, I have no idea what that is off the top of my head, but basically it would be? 920 divided by 110 which gives you $8.36. So, 8.36 So, earnings per share went from $9 down to 836, that tells you it went from 9 down to 8.36, that's diluted. If it went from 9 to 10, that's anti-diluted, which means people gave up more and less. So, again what would happen here is, that's called diluted, we include it. So, notice in the numerator, you add in the preferred dividends, not net of tax. Why not? Because they come out of after tax dollars. You're basically just adding back whatever you took out here, and the denominator, the number shares converted into. Now, that's for preferred stock. What about bonds? Bonds are a little trickier. Why? Because bonds are...the interest income is taxable. So, you're going to have to add in the net of tax savings. So, the if converted method is talking about convertible bonds. Let's say, for example I had 10 million dollars of bonds, and let's say they're paying 6% interest. So if you converted, it would save me $600,000 of interest. Now, let's say the 10 million of bonds are converted into 300,000 shares of common stock. So, there's 10 million dollars worth of bonds, if you convert, what's going to happen? If you convert, I'm going to give you 300,000 shares of common stock. Okay, now, let's say the tax rate is 1.4. So, that means, after tax, you're left with $360,000 of interest income because the interest income I save if you convert is 600,000, but the government says, ìOh, you have 600,000 more of income. Give us 40%.î Well, if I have to give you 40%, 6 times 0 is 240, that means I'm left with 360. So, the 360, let's see, 360 divided by 300, equals, like, $1.20 a share. So, basically, the interest you're earning is $1.20 a share. So, if basic earnings per share was 900 over 100, $9 a share, would you give up $1.20 to get 9? Yeah. Therefore, it would be like 900 plus 360 over 300 plus 100 equals 9, 10, 11, wait, 9, 10, 11, 12, 60 over 400, which, I don't know, let's say is 3.20 a share. So, basically everyone went from 9 down to 3.20. That's diluted. You went from $1.20 up to 3.20. Would you give up a $1.20 to get 3.20? Yes. Everyone else gets less. That's called dilutive. If it's anti-dilutive, if it went from from 9 to 11, don't include it. So, what we have to do with bonds, let me do it again. We have 10 million dollars of bond that are converted into 30,000...300,000 shares of common stock. They pay 6% interest. That's 600,000 of interest The tax rate is 40%. So, that means, this is your net of tax savings if we convert. If you convert, I save 600,000 of interest. After tax 360. What are you converting into? 300,000 shares. What is that per share? About $1.20 a share. Would you give up $1.20 to get $9? Yes, though how does that affect everyone else? Basically it dilutes everyone else down to about 3.20. Okay. So, that's what we have. So, what am I going to add in the numerator. I'm going to add this, 360. What do I add in the denominator? This. So, let's put that into words. For convertible bonds plus the interest expense saved net of tax, which is that 600...this side... there we go...600,000, right, which is the 600,000 interest expense saved net of tax. What do I put down here? The number of shares converted into, which would be what? Like 360 up here, 300 down here. Okay, that's what I'm talking about. I'm only talking about this right now. Okay? So, that's what we're looking at, 360, 300. So, that's what we call diluted, complex, good. That's what's happening as far as the calculation. So, that's kind of what we need to think about. That's called the if converted method because if converted says, if they're converted, what happens to preferred? What happens to the bonds? That's the if convert...let's read it in the notes, page 3, number 2. "The if converted method. The calculation of diluted earnings per share assumes that anyone who could convert does so. For a company with convertible preferred or convertible bonds, it starts with the computation just discussed, which is called basic. For convertible securities, the following adjustments are made. In the numerator, earnings are increased by the dividends after tax that would have been due if the securities have been converted to common stock. Denominator, the shares increased." It says, "If the calculation results in EPS which is higher than basic, the securities are anti-dilutive and not included. To determine whether or not an item is anti-dilutive, each item is considered separately in sequence from the most to the least dilutive. One would normally consider options and warrants first." Now, what are we looking at on the next page? You'll see here it says net income. This is for dilutive, plus the preferred dividends not net of tax, plus the interest expense saved from convertible bonds net of tax and then in the bottom, number 2, the number of shares converted into for both preferred and convertible. You don't weight them. It's all of them. The bottom of the page says, "The conversion of bonds. The if converted method requires considering the tax effect since the reduction of interest expense is accompanied by the increase in taxable income. It is assumed that the conversion occurred at the beginning of the earliest period or at the time of issuance if later." What do I mean by that? What I mean is, it doesn't matter... What if they don't convert? Do you still include it? Yes, as long as it's dilutive. What if the convertible bonds or convertible preferred or not converted? You still include them. Why? Because this could. It's not what is, but it's could. Could they convert? Yes. Would it dilute? Yes. Remember, earnings per share is a theoretical number only. Theoretically speaking, if people converted, how much would you get? We have to assume that if they could have converted and it's economically advantageous it is dilutive, and you would do it as of the earliest point in time. So, if they were outstanding for the whole year, as the beginning of the year if they were converted...I'm sorry...if they were only outstanding for half year, then they couldn't have convert the first half, then you just do half a year. So, again, it's as of the earliest point in time. For example, page 4, assume that a company reported 932 of income for the year had the following capital structure which did not change. We had preferred stock, 100 dollar par, 8% percent cumulative, 4 shares each convertible into 10 shares of common stock. So, what is our dividend per preferred? It is 100 at 8%, 8 bucks. There are 4 shares, 8 times 4 is 32. Common stock, $1 par 100 shares. So, we have 932 of income and 32 of preferred, and we have 100 shares outstanding. So, let's do our basic earnings per share. So, coming over here, we've got, net income is 900 bucks, the preferred dividends are 32. Therefore, we have 900, and their weighted average number of shares outstanding for number 1 is 100. We can do this, 900 over 100 equals 9 bucks a share. That's called basic. Now, let's assume that that's preferred. It says here each is convertible into 10 shares of common stock. Now, that means that if they convert, there are 10 shares per preferred, and there's 4 shares of preferred outstanding. So, let's go and do this. You start here, and bring it up here to 900. You start here and bring it over here for 100, and you say, "Okay, if they convert, what happens?" The preferred, this $32 dividend would not have to be paid. 900 plus 32...I now have 932 in the numerator. And, how many shares are they convertible into? 100 plus 40 or 140. So, what is 932 divided by 140? Gives you something like $6.66. Notice, what happened to earnings per share? It went from $9 down to 6.66. That's dilutive. Do you include it? Yes. What if they didn't convert? Doesn't matter. Could they? Yes. Is it economically advantageous? Yes. Then you include it. Okay, look at the example in your notes under conversion of bond. For example, assume a client with $800 of income and an effective tax rate to 30% have the following capital structure...6% convertible bond, $1000 face value convertible into 20 shares of common stock, common stock,$1 and 200 shares outstanding. So, we've got $800 of income. Here, we're not looking at preferred, we're looking at bonds. So, we have $800. There are 6% $1000 bonds. So, there's $1000 bonds. Let's see what we've got. I've got $1000 bond 6%. So, I have $1000 bond at 6%, it means $60 of interest. So, if you convert, it saves me 60 bucks. However, if I have an extra 60 bucks, the government says, "Hey! Good job! 60 bucks...We want our taxable income." And the tax rate in this case is 30%. So, 1 minus 0.3, I'm going to be left with the 7 times 6, $42. That is going to be the interest expense saved net of tax. How many shares are they convertible into? It says they're convertible into 20 shares of stock. So, that means these bonds are convertible into 20 shares of common stock. So, basically, it's like 42 over 20, it's like 2 bucks a share. Well, if you're making 4 and this is 2, would you give up 2 to get 4? Yes. That'll dilute everyone else. So, what we need to do is, let's come back and recalculate our basic earnings per share based on this example, and then we'll come over and do diluted. So, our basic, it said, is $800 minus 0, because there's no preferred in this example, is 800 and there's 200 shares of common stock outstanding, I could even do this in my head. That's how smart I am. 800 over 200 equals what? 4 bucks a share. Now, if you convert, what happens? In the numerator, I bring the 800 plus what do I add to that? I'm going to add the interest expense save net of tax, and in this case, the interest expense save net of tax over here was 1000 at 6% is 60 government wants 30%, I'm left with 42. So, I'm going to add in plus 42 gives me 842. In the d-d-d-down denominator, I bring this over, which is the 200, and we said the 200 are converted, the bonds are convertible into 20 shares of common stock, that gives me to 220, 842 over 220, of course, equals something like $3.83. What happened? It went from $4 down to 3.83, okay? Is that dilutive? Yes, it is. So, that's how you handle what we call the if converted method. The if converted method is for what? Convertible preferred, convertible bonds. Then we have the 3rd adjustment we're going to make, and this is called the treasury stock method. So, we start here with basic, we go here, we do number 2, number 2, then we do number 3, number 3, called the treasury stock method, treasury stock method. So, let's teach you number 3, the treasury stock method. Let's come down here. Under the treasury stock method, here's what it says. It says for number 3, treasury stock method...and treasury stock method...this is going to be for options, rights and warrants because, remember, when I talked about treasury stock...What is treasury stock? It is your stock you buy back and you hold where? In the treasury, in the safe. Does it vote? No. Does it get a dividend? No. But that's called treasury stock. So, treasury stock is the stock you buy back and you hold in the treasury in the safe. Now, if I give you a stock option, stock right, stock warrant, what are those? Those give you the opportunity to acquire more shares of stock. So, a stock... they go to different people. Stock options go to employees, stock rights go to stockholders, stock warrants...warrants go with bonds. With detachable stock purchase warrants, we learned that in the bond class preferred stock with detachable warrants. So, it could be preferred with warrants, bonds with warrants, but basically, it gives you the chance to do what? Buy more stock. So, let's say, for example, you gave me the option. So, if I gave you options and you exercised them, what would you give me? You give me money. What do I give you? Stock. So, what's going to happen? If you give me money, okay, and then I give you stock, well, instead of just putting the money in the numerator and giving it out, I will theoretically go out on the open market and buy back my own stock. When you buy back your own stock, what's that called? Treasury stock. So, here's the concept...is, I gave you an option, you exercised it, you would then give me money, I would give you stock. I would then minimize the dilutive effect by going out on the open market buying back my treasury stock. So, let's say, for example, you gave me $15 a share, but I would have to go out and buy it on the open market at 20. Therefore I'm losing $5 a share. That's the dilutive effect. So, in a sense, I'm not going to give the money away that you give me. I'm going to theoretically go and buy back my own stock, and that's why it's called the treasury stock method. You use this method for options, right, and warrants. Am I really buying back my stock? No. Did you even actually convert? No. Did you actually even exercise the options, rights and warrants? No. You don't have to actually do it. This is all theoretical. Could you have done it? Yes. When do we assume you did? As of the earliest point in time. So, it says here, The treasury stock method. The effective options on diluted EPS is to first increase the shares by the number that would have been issued had they been exercised, then decrease by the number that could have been repurchased by the court at the average market price. So, that's the average market price of the common stock. This is known as the treasury stock method. The exercise of options has no effect on earnings since options pay no dividends or interest. If market price changes, previously reported EPS would not be adjusted. For example, 40,000 options are issued at an option price of 15 bucks a share when the average market price is 20 bucks a share. What is the dilutive effect? Okay. So, I'm giving 40,000 options 15 bucks to share. So, here's 40,000 options, and if you exercise it, the exercise price is $15 a share. You would give me $600,000. So, you give me $600,000, and I'm going to give you 40,000 shares of common stock. So, what am I going to do? I now go out on the open market, and I buy back my own stock at the average market price. Now, let's say the average market price is 20 bucks a share. That means I could theoretically buy back 30,000 shares of treasury stock. That means, I gave you 40,000, you gave me 600,000. I theoretically go out, spend all 600 to buy back 30,000 shares. That means I gave you 40, bought back 30. What's the incremental number of shares outstanding? 10,000. Now, let me ask you this. If you give me 600,000, and I spend all the money. How much is left after I spent all the money? 0. So, in the numerator in the formula up here for treasury stock, I'm going to add in for number 3 plus $0. Why? Because theoretically I spent it all. And in the d-d-d-denominator, what am I going to add in? I'm going to add in plus the incremental number of common stock outstanding at the average market price. It used to be year end, and then it said average market price. So, in my example, in the numerator, I had 0, in the denominator, it would be 40,000 that I gave you minus the 30,000 I bought back, or I'd add in 10,000 shares. So, that's what we mean by what we call the treasury stock method. Does that make sense? Yeah, it kind of makes sense, because I'm going out, and again, it's a theoretical approach only. Theoretically speaking, if I went out and bought it back, how much would I get? That's theoretically speaking. Now, let me just mention IFRS here, because it's really nothing. It says, "Under IFRS, it's very similar. You still report basic and diluted on continuing operations and net income, however, EPS on extraordinary aren't reported." So, it's really the same calculation for basic and diluted. No real difference. The one difference is EPS doesn't exist...I'm sorry...EPS...extraordinary gains and losses don't exist, so you wouldn't have to worry about calculating it under extraordinary. Alright, that is called EPS. Let's do a couple questions. Question number 1, last sentence first. What amount should Stroch report as basic earnings per share in its x2 and x3 comparative statements? How much should Stroch, beautiful name. Stroch Co. has one class of common stock outstanding and no other securities that are potentially convertible into common stock. During the year, 100,000 shares of common stock were outstanding. In x3, 2 distributions of additional common shares occurred. On April 1st, 20,000 shares of treasury stock were sold. On July 1st, a two-for-one split was issued, net income was 410 and 350. What amount should Stroch report as its basic earnings per share in x3 and x2 comparative statements? Alright, so, what we need to do is, they want x2 and x3. So, let's see if we can figure this out. Here's x2. Here's x3. Alright. What was the income? It said x2's income was 350 and x2's inc...x3's income was 410. Alright, that's income. So, 350 and 410. Now, it said they had one class of stock outstanding. During the year 100,000 shares were issued and outstanding. So, for the whole year we had divided by 100,000 shares. Looks like about 3.50 a share. Then it said, during x2, 100,000 shares were outstanding. During x3, 2 distributions of additional stock occurred. On April 1st. April 1st... April Fool's Day, 20,000 shares of treasury stock were sold. On July 1st, a two-for-one split was issued. Okay. Net income was 410 and 350. Okay, so, what do I have outstanding? I've got 100,000 shares outstanding for 12/12ths. Then we did a...mmm...20,000 shares were sold on April 1st. So, on 4/1, 20,000 shares. Now those 20,000 shares were outstanding for how much of the year? About three quarters, 9/12ths. So, that's going to be 100 plus three quarters is 15, 115. Then on July...on July 1st, two-for-one split. What did we learn earlier? Stock dividends and splits subscriptions are what? Retroactive. Retroactive. So, that's going to be times 2. which gives me 230. So, now, what is my weighted average number of stock outstanding? 230. So, if you come back over here 410 over 230, 410 divided by 230 gives me something like a $1.78. So, it's $1.78 in x3, and in x2, it looks like what? 350. Oh my goodness! 350 and went down to...You know what? Sell! Sell! Sell! Why? Because it dropped. But wait a sec. You can't compare apples and oranges. We're not making fruit salad. It's apples and apples. So, how do you compare apples and apples? Remember over here, what did we say about dividends and splits? Retroactive. To where? All the previous years! Oooohh. So, if I were to come back and double this times 2 for 1 is 200, 350 over 2 is now a $1.75. Now, what? Oh! Buy! Buy! Buy! So now I call my broker and I go, ìBuy!î Why? Because it went up, it went up. So, notice, $1.75 up...so, you've got to be consistent in the calculation. That's why dividends and splits are treated how? They're treated retroactively. Alright, let's do another question. Question number 3, question 3. Question 3 is tricky. That's why I'm doing it. Last sentence, In its December 31st income statement, what amount should Uta report as basic earnings per share? What is basic earnings per share? It said, "Uta had the following capital structure during x2 and x3. Preferred stock is $10 par 4% cumulative. 25,000 shares issued outstanding for 2.50. Common stock, $5 par. 200,000 shares issued and outstanding. Uta reported net income of $500,000 for the year ended December 31st, x3. Uta paid no preferred dividends during x2 and paid $16,000 in preferred during x3. In its December 31st income statement, what amount should Uta report as basic earnings per share?" Hmmm...ok, so we're trying to figure out our basic earnings per share. What is basic earnings per share? Net income minus preferred dividends divided by shares outstanding. So, what we're going to have to do is say, "Okay, what is net income minus preferred dividends?" So, we're going to have our net income minus preferred is the dollars divided by weighted average number of shares outstanding, and it told us the shares outstanding are 200,000. So, we have 200,000 shares of common stock. We've got to figure out the numerator. We have net income of 500,000. Then they paid out preferred dividends. Now, what are the rules? Preferred dividends. We said, let's come back over on this side and look. We said, take out, if it's non-cumulative only if its declared. If it's cumulative, whether it's declared or not. For how many years? For this year only. Why? Because theoretically, last year was already deducted in last year's because, down the road, if you eventually declare a dividend, that money isn't going to go to common, it goes back to preferred because it's cumulative. So, in this case, it said our dividend is going to be what ? $10 4% 25,000. So, 25,000 times $10 is 250, 4% of 250 is 10,000 bucks. So, our dividend is $10,000. Now, it says that last year, they preferred dividend...no preferred dividends...Uta paid no dividends last year and paid 16 this year. So, here's what happened. In x2, they paid 0. In x3, they're paying $16. It is cumulative. How much did we owe last year? 10. How much do we owe this year? 10. How much do we owe next year? 10. Now, it's not a liability till it's declared, but what are you supposed to do? You're supposed to take it out. Oh. Now, wait a sec. We paid 0, then this year we're paying 16. What do we owe? 10. So, last year we should have done what? Taken out 10. This year what should we do? It doesn't matter how much you pay. It's what would you eventually owe 10. So, you need to take out 10, and here's where I like to confuse you. How much should I take out? 0, 10, 16, 20, 30? All of the above? Ha ha ha. Right? 0? No. But doesn't matter. 16 is what you paid. That's not what you take out. You take out what you owe. What would you owe? You would owe if it's cumulative whether declared or not. You take out this year only. What is that? That's going to be 4% of $250,000, which is 10,000 bucks. So, therefore it's going to be 490 over 200, which gives you something like $2.45. Tricky, tricky question. Again, I need you to practice that. Look at number 5. The if converted method of computing earnings per share data assumes conversion of convertible securities when? The if converted over here says, if converted for preferred dividends or a convertible preferred stock or for convertible bonds. It assumes you converted when? As of the earliest point of time or of issue if the latter of the 2. So, it says A, beginning of the earliest period reported or time of issuance if later. True. Beginning at the earliest regardless of time of issuance middle and no. Best answer, A. Number 6. In determining earnings per share, interest expense net of tax on convertible debt that is dilutive should be what? Earnings per share, interest expense, net of tax. What do we do? Interest expense net of tax. Here, we add interest expense net of tax in the numerator, and in the denominator, you add in the number of shares converted into. So, A, add it back to weighted average shares? No. It's in the top. Add it back to net income for diluted. Yes. Add it back to net income for diluted...for deducted. No. Deduct it from weighted average. No. Best answer, B. Alright, so, again, that is earnings per share. Iím going to do a couple of more questions. Again, if you're in class, make sure you log into your student account so you can do a few more. If you're watching me online, USB, here we go. We're going to do them in just a sec.