Simple Capital Structure
A simple capital structure may be said to exist either when the capital structure consists solely of ordinary shares or when it includes no potential ordinary shares, which could be in the form of options, warrants or other rights, that on conversion or exercise could, in the aggregate, dilute EPS.
Dilutive securities are essentially those that exhibit the rights of debt or other senior security holders (including warrants and options) and which have the potential on their issuance to reduce the EPS.
Computational guidelines
In its simplest form, the EPS calculation is profit or loss divided by the weighted‐average number of ordinary shares outstanding. The objective of the EPS calculation is to determine the amount of earnings attributable to each ordinary share. Complexities arise because profit or loss does not necessarily represent the earnings available to the ordinary equity holder, and a simple weighted‐average of ordinary shares outstanding does not necessarily reflect the true nature of the situation. Adjustments can take the form of manipulations of the numerator or of the denominator of the formula used to compute EPS, as discussed in the following paragraphs.
Numerator
The numerator is the profit or loss attributable to ordinary equity shareholders of the entity, and, if presented, from continuing operations.
Preference share dividends are therefore deducted from profit or loss. If the preference shares are cumulative, the dividend is to be deducted from profit (or added to the loss), whether it is declared or not. If preference shares do not have a cumulative right to dividends and current period dividends have been omitted, such dividends should not be deducted in computing EPS. Cumulative dividends in arrears that are paid currently do not affect the calculation of EPS in the current period, since such dividends have already been considered in prior periods' EPS computations.
However, the amount in arrears should be disclosed, as should all of the other effects of rights given to senior securities on the EPS calculation.
There may be various complications resulting from the existence, issuance or redemption of preferred shares. Thus, if “increasing rate” preferred shares are outstanding—where contractually the dividend rate is lower in early years and higher in later years—the amount of preferred dividends in the early years must be adjusted to accrete the value of later, increased dividends, using an effective yield method akin to that used to amortise bond discount. If a premium is paid to preferred shareholders to retire the shares during the reporting period, this payment is treated as additional preferred dividends paid for purposes of EPS computations. Similarly, if a premium is paid (in cash or in terms of improved conversion terms) to encourage the conversion of convertible preferred shares, that payment (including the fair value of additional ordinary shares granted as an inducement) is included in the preferred dividends paid in the reporting period, thereby reducing earnings allocable to ordinary shares for EPS calculation purposes. Contrariwise, if preferred shares are redeemed at a value lower than carrying (book) amount—admittedly, not a very likely occurrence—that amount is used to reduce earnings available for ordinary equity holders in the period, thereby increasing EPS.
Denominator
The weighted‐average number of ordinary shares outstanding is used to calculate the denominator. The difficulty in computing the weighted‐ average exists because of the effect that various transactions have on the computation of ordinary shares outstanding. Although it is impossible to analyse all the possibilities, the following discussion presents some of the more common transactions affecting the number of ordinary shares outstanding.
If a company reacquires its own shares in countries where it is legally permissible to do so, the number of shares reacquired (referred to as treasury shares) should be excluded from EPS calculations from the date of acquisition. The same computational approach holds for the issuance of ordinary shares during the period. The number of shares newly issued is included in the computation only for the period after their issuance date. The logic for this treatment is that since the consideration for the shares was not available to the reporting entity, and hence could not contribute to the generation of earnings, until the shares were issued, the shares should not be included in the EPS computation prior to issuance. This same logic applies to the reacquired shares because the consideration expended in the repurchase of those shares was no longer available to generate earnings after the reacquisition date.
A share dividend (bonus issue) or a share split does not generate additional resources or consideration, but it does increase the number of shares outstanding. The increase in shares as a result of a share split or dividend, or the decrease in shares as a result of a reverse split, should be given retrospective recognition for all periods presented. Thus, even if a share dividend or split occurs at the end of the period, it is considered effective for the entire period of each (i.e., current and historical) period presented. The reasoning is that a share dividend or split has no effect on the ownership percentage of ordinary shares, and likewise has no impact on the resources available for productive investment by the reporting entity. As such, to show a dilution in the EPS in the period of the split or dividend would erroneously give the impression of a decline in profitability when in fact it was merely an increase in the shares outstanding due to the share dividend or split. Furthermore, financial statement users' frame
of reference is the number of shares outstanding at the end of the reporting period, including shares resulting from the split or dividend, and using this in computing all periods' EPS serves to most effectively communicate to them.
Complications also arise when a business combination occurs during the period. In a combination accounted for as an acquisition the shares issued in connection with a business combination are considered issued as of the date of acquisition and the income of the acquired company is included only for the period after acquisition.
IAS 33 recognises that in certain countries it is permissible for ordinary shares to be issued in partly paid form, and the standard accordingly stipulates that partly paid instruments should be included as ordinary share equivalents to the extent to which they carry rights (during the financial reporting year) to participate in dividends in the same manner as fully paid shares.
Furthermore, in the case of contingently issuable shares (i.e., ordinary shares issuable on fulfilment of certain conditions, such as achieving a certain level of profits or sales), IAS 33 requires that such shares be considered outstanding and included in the computation of basic EPS only when all these required conditions have been satisfied.
IAS 33 gives examples of situations where ordinary shares may be issued, or the number of shares outstanding may be reduced, without causing corresponding changes in resources of the corporation. Such examples include bonus issues, a bonus element in other issues such as a rights issue (to existing shareholders), a share split, a reverse share split and a capital reduction without a corresponding refund of capital. In all such cases, the number of ordinary shares outstanding before the event is adjusted, as if the event had occurred at the beginning of the earliest period reported. For instance, in a “5‐for‐4 bonus issue” the number of shares outstanding prior to the issue is multiplied by a factor of 1.25. These and other situations are summarised in the tabular list that follows.
Weighted‐average computation
Transaction Effect on weight‐average computation
Ordinary shares outstanding at the
beginning of the period Increase number of shares outstanding by the number of shares Issuance of ordinary shares during the
period
Increase number of shares outstanding by the number of shares issued weighted by the portion of the year the ordinary shares are outstanding
Conversion into ordinary shares Increase number of shares outstanding by the number of shares converted weighted by the portion of the year shares are outstanding
Company reacquires its shares Decrease number of shares outstanding by the number of shares reacquired times the portion of the year outstanding
Share dividend or split Increase number of shares outstanding by the number of shares issued or increased due to the split Reverse split Decrease number of shares outstanding by decrease in shares
Acquisition Increase number of shares outstanding by the number of shares issued weighted by the portion of year since the date of acquisition
Rights offerings are used to raise additional capital from existing shareholders. These involve the granting of rights in proportion to the number of shares owned by each shareholder (e.g., one right for each 100 shares held). The right gives the holder the opportunity to purchase a share at a discounted value, as an inducement to invest further in the entity and in recognition of the fact that, generally, rights offerings are less costly as a means of floating more shares, versus open market transactions which involve fees to brokers. In the case of rights shares, the number of ordinary shares to be used in calculating basic EPS is the number of ordinary shares outstanding prior to the issue, multiplied by the following factor:
There are several ways to compute the theoretical value of the shares on an ex‐rights basis. IAS 33 suggests that this be derived by adding the aggregate fair value of the shares immediately prior to exercise of the rights to the proceeds from the exercise, and dividing the total by the number of shares outstanding after exercise.
To illustrate, consider that the entity currently has 10,000 shares outstanding, with a market value of €15 per share, when it offers each holder rights to acquire one new share at €10 for each four shares held. The theoretical value ex‐rights would be given as follows:
Thus, the ex‐rights value of the ordinary shares is €14 each. The foregoing does not characterise all possible complexities arising in the EPS computation; however, most of the others occur under a complex structure which is considered in the following section of this chapter. The illustration below applies the foregoing concepts to a simple capital structure.
Example of EPS computation—Simple capital structure
Assume the following information:
Numerator information Denominator information
a.Profit from continuing operations €130,000 a.Ordinary shares outstanding January 1, 202X 100,000
b. Loss on discontinued operations 30,000 b. Shares issued for cash April 1, 202X 20,000
c. Profit for the year 100,000 c. Shares issued in 10% share dividend declared
in July 202X 12,000
d. 6% cumulative preference shares, €100 par, 1,000 shares issued 100,000 d. Treasury shares purchased October 1, 202X 10,000
and outstanding 100,000 d. Treasury shares purchased October 1, 202X 10,000 When calculating the numerator, the claims of preference shares should be deducted to arrive at the earnings attributable to ordinary equity holders. In this example, the preference shares are cumulative. Thus, regardless of whether or not the board of directors declares a preference dividend, holders of the preference shares have a claim of €6,000 (1,000 shares × €100 × 6%) against 202X earnings. Therefore, €6,000 must be deducted from the numerator to arrive at profit or loss attributable to the owners of ordinary shares.
Note that any cumulative preference dividends in arrears are ignored in computing this period's EPS since they would have been incorporated into previous periods' EPS calculations. Also note that this €6,000 would have been deducted for non‐cumulative preferred only if a dividend of this amount had been declared during the period. The EPS calculations for the foregoing fact pattern follow:
Earnings per ordinary share
On profit from continuing operations = (€130,000 − €6,000 preference dividends) ÷ Weighted number of ordinary shares outstanding (see below)
=
€1.00 On profit for the year = (€130,000 − €30,000 − €6,000) ÷ Weighted number of ordinary shares outstanding (see below) =
€0.76 Only the EPS amounts relating to the parent company from continued operations, in the case of consolidated (group) financial statements, must be provided.
The computation of the denominator is based on the weighted‐average number of ordinary shares outstanding. Recall that use of a simple average (e.g., the sum of year‐beginning and year end outstanding shares, divided by two) is not considered appropriate because it fails to accurately give effect to various complexities. The table below illustrates one way of computing the weighted‐average number of shares
outstanding. Note that, had share issuances occurred mid‐month, the weighted‐average number of shares would have been based on the number of days elapsing between events.
Item Number of shares actually
outstanding
Fraction of the year outstanding
Shares times fraction of the year
Number of shares as of beginning of the year January 1, 202X
110,000 [100,000 + 10%
(100,000)] 12/12 110,000
Shares issued April 1, 202X 22,000 [20,000 + 10% (20,000)] 9/12 16,500
Treasury shares purchased October 1, 202X (10,000) 3/12 (2,500)
Weighted‐average number of ordinary shares
outstanding 124,000
Recall that the share dividend declared in July is considered to be retroactive to the beginning of the year. Thus, for the period January 1, 202X through April 1, 202X, 110,000 shares are considered to be outstanding. When shares are issued, they are included in the weighted‐average beginning with the date of issuance. The share dividend applicable to these newly issued shares is also assumed to have existed for the same period. Thus, we can see that of the 12,000‐share dividend, 10,000 shares relate to the beginning balance and 2,000 shares to the new issuance (10% of 100,000 and 20,000, respectively). The purchase of the treasury shares requires that these shares be excluded from the calculation for the remainder of the period after their acquisition date. The figure is subtracted from the calculation because the shares were purchased from those outstanding prior to acquisition. To complete the example, we divided the previously derived numerator by the weighted‐average number of ordinary shares outstanding to arrive at EPS, which is [(€100,000 − €6,000) ÷ 124,000 =] €0.76.
Reporting a €0.24 loss per share (€30,000 ÷ 124,000) due to the discontinued operations is optional. The numbers computed above for the EPS based on profit for the year are the only presentation required in the statement of profit or loss and other comprehensive income (or separate statement of profit or loss, if presented).
Complex Capital Structure
The computation of EPS under a complex capital structure involves all of the complexities discussed under the simple structure and many more.
By definition, a complex capital structure is one that has dilutive potential ordinary shares, which are shares or other instruments that have the potential to be converted or exercised and thereby reduce EPS. The effects of any antidilutive potential ordinary shares (those that would increase EPS) are not to be included in the computation of diluted EPS. Thus, diluted EPS can never provide a more favourable impression of financial performance than the basic EPS.
Note that a complex structure requires dual presentation of both basic EPS and diluted EPS even when the basic EPS is a loss per share. Under the current standard, both basic and diluted EPS must be presented, unless diluted EPS would be antidilutive.
For the purposes of calculating diluted EPS, the profit or loss attributable to ordinary equity holders and the weighted‐average number of ordinary shares outstanding should be adjusted for the effects of the dilutive potential ordinary shares. That is, the presumption is that the dilutive securities have been converted or exercised, with ordinary shares being outstanding for the entire period, and with the effects of the dilution removed from earnings (e.g., interest or dividends). In removing the effects of dilutive securities that in fact were outstanding during the period, the associated tax effects must also be eliminated, and all consequent changes—such as employee profit‐sharing contributions that are based on reported profit or loss—must similarly be adjusted.
According to IAS 33, the numerator, representing the profit or loss attributable to the ordinary equity holders for the period, should be adjusted by the after‐tax effect, if any, of the following items:
1. Interest recognised in the period for the convertible debt which constitutes dilutive potential ordinary shares;
2. Any dividends recognised in the period for the convertible preferred shares which constitute dilutive potential ordinary shares, where those dividends have been deducted in arriving at net profit attributable to ordinary equity holders; and
3. Any other consequential changes in profit or loss that would result from the conversion of the dilutive potential ordinary shares.
For example, the conversion of debentures into ordinary shares will reduce interest expense, which in turn will cause an increase in the profit for the period. This will have a consequential effect on contributions based on the profit figure, for example the employer's contribution to an employee profit‐sharing plan. The effect of such consequential changes on profit or loss available for ordinary equity holders should be considered in the computation of the numerator of the diluted EPS ratio.
The denominator, which has the weighted number of ordinary shares, should be adjusted (increased) by the weighted‐average number of ordinary shares that would have been outstanding assuming the conversion of all dilutive potential ordinary shares.
Example—Truly Dilutive
To illustrate, consider Chelsea Corporation, which has 100,000 ordinary shares outstanding for the entire period. It also has convertible debentures outstanding, on which interest of €30,000 was paid during the year. The debentures are convertible into 100,000 shares. Profit after tax (effective rate is 30%) amounts to €15,000, which is net of an employee profit‐sharing contribution of €10,000, determined as 40% of after‐tax income. Basic EPS is €15,000 ÷ 100,000 shares = €0.15. Diluted EPS assumes that the debentures were converted at the beginning of the year, thereby averting €30,000 of interest which, after tax effect, would add €21,000 to net results for the year. Conversion also would add 100,000 shares, for a total of 200,000 shares outstanding. Furthermore, had operating results been boosted by the €21,000 of avoided after‐tax interest cost, the employee profit sharing would have increased by €21,000 × 40% = €8,400, producing net results for the year of €15,000 +
€21,000 − €8,400 = €27,600. Diluted EPS is thus €27,600 ÷ 200,000 = €0.138. Since this is truly dilutive, IFRS requires presentation of this amount.
Determining Dilution Effects
In the foregoing example, the assumed conversion of the convertible debentures proved to be dilutive. If it had been antidilutive, presentation of the (more favourable) diluted EPS would not be permitted under IFRS. To ascertain whether the effect would be dilutive or antidilutive, each potential ordinary share issue (i.e., each convertible debenture, convertible preferred or other issuance outstanding having distinct terms) must be evaluated separately from other potential ordinary share issuances. Since the interactions among potential ordinary share issues might cause diluted EPS to be moderated under certain circumstances, it is important that each issue be considered in the order of decreasing effect on dilution. In other words, the most dilutive of the potential ordinary share issues must be dealt with first, then the next most dilutive, and so on.
Potential ordinary shares are generally deemed to have been outstanding ordinary shares for the entire reporting period. However, if the potential shares were only first issued, or became expired or were otherwise cancelled during the reporting period, then the related ordinary shares are deemed to have been outstanding for only a portion of the reporting period. Similarly, if potential shares are exercised during the period, then for that part of the year the actual shares outstanding are included for purposes of determining basic EPS, and the potential (i.e., unexercised) shares are used in the determination of diluted EPS by deeming these to have been exercised or converted for only that fraction of the year before the exercise occurred.
Options and warrants
The exercise of options and warrants results in proceeds being received by the reporting entity. If actual exercise occurs, of course, the entity has resources which it will, logically, put to productive use, thereby increasing earnings to be enjoyed by ordinary equity holders (both those previously existing and those resulting from exercising their options and warrants). However, the presumed exercise for purposes of diluted EPS
computations does not invoke actual resources being received, and earnings are not enhanced as they might have been in the case of actual exercise. If this fact were not dealt with, diluted EPS would be unrealistically depressed since the number of assumed shares would be increased but earnings would reflect the lower, actual level of investment being utilised by the entity.
IFRS prescribes the use of the “treasury share method” to deal with the hypothetical proceeds from the presumed option and warrant exercises.
This method assumes that the proceeds from the option and warrant exercises would have been used to repurchase outstanding shares, at the average prevailing market price during the reporting period. This assumed repurchase of shares eliminates the need to speculate as to what productive use the hypothetical proceeds from option and warrant exercise would be put, and also reduces the assumed number of outstanding shares for diluted EPS calculation.
Treasury Share (Stock) Method
Denominator must be increased by net dilution, as follows:
Net dilution = Shares issued – Shares repurchased where:
Shares issued = Proceeds received/Exercise price
Shares repurchased = Proceeds received/Average market price per share
IAS 33's way of expressing the required use of the “treasury share/stock method” is as follows: “The difference between the number of ordinary shares issued and the number of ordinary shares that would have been issued at the average market price of ordinary shares during the period shall be treated as an issue of ordinary shares for no consideration.”
Example
Assume the reporting entity issued 1,000 ordinary shares to option holders who exercised their rights and paid €15,000 to the entity. During the reporting period, the average price of ordinary shares was €25. Using the proceeds of €15,000 to acquire shares at a per share cost of €25 would have resulted in the purchase of 600 shares. Thus, a net of 400 additional shares would be assumed outstanding for the year, at no net consideration to or from the entity.