Intermediate accounting 17e stice skousen cengage chapter 18

• has only common stock• has only common and nonconvertible preferred stock outstanding • has no convertible securities, stock options, warrants, or other rights outstanding Simple and

Dividend Payout Ratio

• Investors are interested in dividends and can use

EPS data to compute a dividend payout ratio

• Compute by dividing dividends per share by

earnings per share.

• Earnings per share data receive wide recognition

in the annual reports issued by companies, in the press, and in financial reporting publications.

Simple and Complex Capital

Structures

• Dilutive securities are securities whose

assumed exercise or conversion results in a

reduction in earnings per share

• Antidilutive securities are securities whose

assumed conversion or exercise results in an increase in earnings per share

(continues)

Simple and Complex Capital

Structures

• In February 1997 the FASB, working with

the IASC, issued Statement No 128,

“Earnings per Share.”

• The new standard eliminated most of the

arbitrary and complex EPS computations

that had evolved and replaced them with a

historical-based basic EPS

Considers only common shares

issued and outstanding.

Basic

Simple and Complex Capital

Structures

Reflects the maximum potential dilution from all possible stock conversions that would have decreased EPS.

Diluted

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• has only common stock

• has only common and nonconvertible

preferred stock outstanding

• has no convertible securities, stock

options, warrants, or other rights outstanding

Simple and Complex Capital

Structures

A simple capital structure is one where a

corporation―

(continues)

The Basic Equation for EPS:

Net Income – Preferred Dividends

Weighted-Average Common Shares Outstanding

Simple and Complex Capital

Structures

(continues)

Simple and Complex Capital

Structures

If the corporation has one or more instruments outstanding that could result in issuance of

additional common shares, thus causing a

dilution of earnings per share, it has a complex capital structure

Stock Dividends and Stock

Splits

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Stock Dividends and

Stock Splits

• All stock splits and stock dividends must be

incorporated into the computation of weighted average shares outstanding.

• This must be done for all periods presented in

the financial statements.

• Current EPS figures may have to be changed in the future as a result of stock splits or stock dividends.

Preferred Stock Included in Capital

Structure

• Basic EPS reflects only income available to

common stockholders; it does not include

preferred stock

• Dividends on preferred stock should be

deducted from income before extraordinary or other special items from net income in arriving

at earnings related to common shares

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Preferred Stock Included in Capital

Structure

• If preferred dividends are cumulative, the full amount of dividends on preferred stock for the period, whether declared or not, should be

deducted from income in arriving at the

earnings or loss balance related to the common stock

(continues)

(continues)Preferred Stock Included in Capital

Structure

Structure

• On June 30, 2011 the firm paid:

 An 8% dividend on preferred stock (10,000 shares

at $100 par × 0.08 = $80,000)

 A $0.30 per share dividend on common stock

(300,000 shares × $0.30 = $90,000).

• These cash dividends would not affect the

weighted-average number of shares of common stock.

(continues)Preferred Stock Included in Capital

Structure

Preferred Stock Included in Capital

Structure

On June 30, 2010, the company issued

100,000 shares of common stock After the

issuance, the firm has 300,000 shares of

common stock outstanding However, these 300,000 are only outstanding for six months,

or one-half of the year

There are 250,000 weighted-average shares outstanding at the end of 2010.

On May 1, 2011, the firm issued a 50% stock

dividend on common stock.

Structure

Now let’s “roll back” the stock dividend for

all the years displayed.

(continues)Preferred Stock Included in Capital

Structure

Now let’s “roll back” the stock dividend for

all the years displayed.

450,000 shares due to the stock dividend.

Preferred Stock Included in Capital

Structure

Structure

In 2010, the firm made a net income, (including a

$75,000 extraordinary gain) of $380,000 The basic earnings per share before the extraordinary gain is

as follows:

Preferred dividends

Weighted-average shares of common stock outstanding

$80,000 375,000 shares of

Earnings per share from continuing operations = $0.60

Net income after EI – $305,000 Preferred Stock Included in Capital

Structure

Basic earnings per common share, extraordinary gain for 2010 is as follows:

Weighted-average shares of common stock outstanding

Structure

Basic earnings per common share, net income

per share (2010):

Weighted-average shares of common stock outstanding

375,000 shares of Net income per share = $0.80

Net income after extraordinary item

Structure

Weighted-average shares of common stock outstanding

In 2011, the firm had a net loss of $55,000 and

there were no extraordinary items The basic loss per share is as follows:

Net loss + Preferred dividends

($55,000) + ($80,000)

450,000 shares of average common outstanding Basic loss per share = Preferred dividends $(0.30)

weighted-are included even though they were not

declared.

Preferred dividends are included even though they were not

declared.

Preferred Stock Included in Capital

Structure

Participating Securities and the

Two-Class Method

• Sometimes a company issues more than one

class of stock with ownership privileges

• The two classes do not always have the same

claim upon dividends.

• In such a case, earnings attributed to each share

of the different classes of stock are different and EPS is computed using the two-class method.

Participating Securities and the

Two-Class Method

Consider the following data for Kay Company.

• Common shares outstanding: 100,000 for the entire

year

• Participating preferred shares outstanding: 50,000

shares for the entire year

• Net income: $500,000

• Dividends on participating preferred shares: $2.00 per

share plus a per-share increase 50% as large as the

per-share increase of common dividends above $1.00 per share.

(continues)

Participating Securities and the

Two-Class Method

• Common dividends paid for the year: $1.80 per share

making a total of $180,000 ($1.80 per share × 100,000 shares)

• Participating preferred dividends paid for the year:

$2.40 per share making a total of $120,000 ($2.40 per share × 50,000 shares)

Participating Securities and the

Two-Class Method

The basic earnings per share amounts are

computed and reported as follows:

Diluted Earnings per Share— Options,

Warrants, and Rights

• Dilution occurs if inclusion of a potentially dilutive security reduces the basic EPS or

increases the basic loss per share

• In general, securities classified as antidilutive are not included in computing diluted EPS

(continues)

The two major types of potentially dilutive

Diluted Earnings per Share— Options,

Warrants, and Rights

Stock Options, Warrants, and

Rights

• Stock options, warrants, and rights provide no

cash yield to investors.

• Options, warrants, and rights are included in the

computation of diluted EPS for a particular

period only if they are dilutive.

• The FASB selected the treasury stock method

for computing EPS when options, warrants, or

rights are involved.

• Number of shares of common stock

made available to employees

5,000

• Average market price of stock per

share during the year

Proceeds from sale (5,000 × $40) = $200,000

Number of shares that could be purchased with the proceeds ($200,000 ÷ $50)

4,000

Number of shares used for diluted EPS

Treasury Stock Method

• There are 20,000 options outstanding to purchase shares.

• The exercise price per share is $6.

• The average market price per share during the year was

$10.

(continues)

Illustration of Diluted EPS with

Stock Option

$92,800 100,000 Basic EPS = = $0.93

Basic Earnings per Share Basic Earnings per Share

(continues)

Number of outstanding shares assumed

to be repurchased with proceeds from

options ($120,000 ÷ $10) 12,000

Actual number of shares outstanding

Diluted Earnings per Share:

$92,800 108,000 = $0.86

COMPARED TO—

Basic Earnings per Share:

$92,800 100,000 = $0.93

The diluted EPS is less than the basic EPS, so it is acceptable.

Illustration of Diluted EPS with

Stock Option

Diluted Earnings per Share―

Convertible Securities

• The method of including convertible

securities in the EPS computation is referred to as the if-converted method

• To test for dilution, each potentially

dilutive convertible must be evaluated individually

The following example for Reid Corporation illustrates the computation of diluted EPS when convertible

securities exist.

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Illustration of Diluted Earnings per Share

with Convertible Securities

Net income + Interest after tax savings

Total shares assumed issued

Diluted

EPS =

$83,000 + $28,000 100,000 + 40,000

Diluted

Note

Illustration of Diluted Earnings per Share

with Convertible Securities

Computation of Diluted Earnings per Share for

Securities issued during the Year

If the securities had been issued by Reid Corporation on

June 30 of the current year, an adjustment in the calculation would be needed to reflect the issuance date, or one-half of

a year.

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Computation of Diluted Earnings per Share for

Securities Issued during the Year

In the previous illustration, instead of 8%

convertible bonds, assume the company has

8% preferred stock outstanding, par value

$500,000, convertible into 40,000 shares of

common stock The preferred stock was

outstanding for the entire year

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Computation of Diluted Earnings per Share for

Securities Issued during the Year

Basic earnings per share:

Net income, without the deduction for

Computation of Diluted Earnings per Share for

Securities Issued during the Year

Diluted earnings per share:

Net income assuming no payment of

preferred dividends due to conversion

$111,000

Actual number of shares outstanding

100,000

Additional shares issued on assumed

conversion of preferred stock

Effect of Actual Exercise

or Conversion

Effect of a Loss from Continuing

Operations on EPS

Assume the following data for Boggs Co

Computation of basic and diluted EPS is shown on

Slide 18-51

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Multiple Potentially Dilutive

Securities

• The FASB requires selection of the

combination of securities producing the lowest possible EPS figure

• Any dilutive stock options and warrants are

considered first before introducing convertible securities into the computations

(continues)

Multiple Potentially Dilutive

Securities

A company had no stock options but did have four

convertible securities that would have the following effects on diluted EPS if each were considered

separately.

(continues)

Multiple Potentially Dilutive

Securities

Basic EPS was $6.50 ($2,275,000/350,000 outstanding shares) Dilution is determined by adding one security at a time to the basic EPS figure as follows:

Financial Statement Presentation

1 A reconciliation of both the numerators and the

denominators of the basic and diluted EPS

computations for income from continuing

Financial Statement Presentation

3 Securities that could potentially dilute basic EPS in

the future that were not included in computing diluted EPS this period because those securities were

antidilutive for the current period

4 Disclosures of transactions that occurred after the

period ended but prior to the issuance of financial

statements that would have materially affected the

number of common shares outstanding or potentially outstanding such as the issuance of stock options