Friday, February 5, 2010

Earnings Per Share

Hello Friends!

It's been some time since I last wrote on "Pension Accounting". I apologize for not being able to keep up with the desired pace and will endeavour not to lose track of it. Laying my thoughts aside on how I feel about neglecting the job I volunteered for, I shift to an interesting topic “Earnings Per Share(EPS)” .

Simply put, EPS is the piece of an entity's income allocated to each outstanding share of common stock. It is the key indicator of a company's profitability and a major component of price-to-earnings ratio. FASB Statement 128 (Codification Topic 260) requires the computation, presentation and disclosure of EPS for publicly traded entities.

All entities with publicly held common stock start off by computing Basic EPS while ignoring any potentially dilutive securities. In addition to Basic EPS, Diluted EPS is determined where the capital structure of an entity includes potentially dilutive securities. The objective of Basic EPS is to assess performance of an entity over its reporting period and that of Diluted EPS is to provide similar results while giving effect to all dilutive potential common shares that were outstanding during that period.

Note: A security is considered potentially dilutive if any other contract/security allows its owner to acquire common stock during the reporting period or after the end of the reporting period. For example, stock options/warrants,  and convertible bonds/preferred stock.

Both Basic and Diluted EPS  must be presented for two elements:-

a) Income from Continuing Operations - It is the income (or loss) available to common stock holders after adjusting the preferred stock dividend.
Dividend on cumulative preferred stock is always backed out whether declared or not from the net income. However, in case of non-cumulative preferred stock, a deduction is made for the dividend that has been declared.

b) Net Income - Not only an adjustment is made for preferred stock dividend as discussed above but also for income from discontinued operations, extraordinary items and cumulative effect of a change in accounting principle.

Presentation - EPS is reported on the face of Income statement for both the elements mentioned above. Where an entity reports a discontinued operation, an extraordinary item or the cumulative effects of accounting changes, the EPS must either be presented on the face of income statement or in the notes to financial statements.
Computation of Basic EPS

Basic EPS = Income from Continuing operations or Net Income   
                 Weigheted-average no. of common shares outstanding

Weighted-average number of shares outstanding during the period include shares outstanding the entire period, shares issued during the period and shares where all of the conditions of the issuance have been met. 

In computing the weighted-average no. of shares following adjustments are required:-

1. Treasury shares are excluded as of the date of repurchase. Example - if on Jan 1, year 1 shares issued and outstanding were 20,000 and on Jul 1, year 1 the company reacquired its 4000 shares and held in treasury, the weighted average shares outstanding for year 1 would be 18,000 (20,000 * 6/12 + 16,000 * 6/12).

2. Stock Dividends and Stock Splits - If stock dividends and stock splits are given effect to during the year,  they are reflected in EPS retroactively for all periods presented i.e they should be considered outstanding for the entire period in which they were issued. Example - if 10,000 shares were outstanding on Jan 1 and on Jul 1stock dividend of 10% is issued, the no. shares outstanding on Jan 1 will be 11,000 (10,000 + 10% of 10,000).

If the events take place after the close of the period but before the completion of financial report, the per share contribution should be based on the new number of shares.
The retroactive treatment is given to stock dividends and stock splits for the reason that they change the total number of shares but not the proportionate shares outstanding.

Computation of Diluted EPS

a) If-converted method - It is identical to Basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding during the period, if dilutive common shares would have been issued from conversion of debt or preferred stock. The numerator  is adjusted to add back i) any dividends on convertible preferred stock and ii) the after tax amount of interest recognized in the period associated with any convertible debt.

Dilutive Effect: Convertible preferred stock is dilutive if Basic EPS is greater than preferred dividend per share of common stock obtainable. Similarly, convertible bonds are dilutive if Basic EPS is greater than interest net of tax per share of Common stock obtainable. Only when the dilutive effect is established, both numerator and denominator are adjusted for the items mentioned above.

In other words, the conversion, exercise or contingent issuance of securities should not have an anti-dilutive effect. Anti-dilutive ssecurities are excluded from diluted EPS. Thus, it is important to calculate the per share effect of each potentially dilutive security and include only those which have a dilutive effect.

Where a loss from continuing operations already exists, including potential shares in the denominator of a Diluted EPS will result in an anti-dilutive per-share amount. Thus, potential common shares are excluded in computation of diluted EPS when a loss from continuing operations exist, even if the entity reports net income.

b) Treasury Stock method applies to options and warrants. Under this method exercise of warrants is assumed at the beginning of the period or at the time of issuance, whichever, is later and proceeds from exercise are assumed to be used to purchase common stock at the average market price during the period.

This method is applied indivdually to each option and warrant to asssess if they are dilutive. If the average market price is less than the exercise price, the options and warrants are anti-dilutive.

The effect of options and warrants is only on the denominator i.e weighted average number of shares, for the net additional shares that are issued.

The difference between i) additional number of shares issuable under the warrant/option and ii) number of shares assumed to be purchased at the average market price is included in the denominator.

Example: Entity X has 1,000 warrants outstanding exercisable at $54 per share. The average market price of the share is $60. Assuming that the warrants are exercised, the incremental shares includible in the denominator would be 100 (1,000 - (1000*54/60)). Since options/warrants have only a denominator effect, its per share effect is $0.00. 

Remember, Diluted EPS should reflect the maximum dilution of all potentially dilutive securities. Thus, always begin with the security with the smallest individual per share effect or the most dilutive security and include all with a dilutive effect. Because options and warrants have $ 0.00 per share effect, they are always the most dilutive securities.

With this, I wrap up the topic on Earnings Per Share. Once again, before I close...a confession...somewhere in my thoughts I felt culpable and lost by not joining in any dialogue with you in the last two weeks but at this point in time I feel less remorseful.

Have a Nice Weekend!


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