Chapter 11 (Tan - Lee)

Advanced Financial
Accounting: Chapter 11
Earnings per Share
Tan & Lee Chapter 11 © 2009 1

Learning Objectives
1. Significance of earnings per share
2. Difference between basic and diluted earnings per
share
3. How new issues affect earnings per share through
the weighted average number of shares
4. Concept of dilution
5. Concept of control number in diluted earnings per
share
6. Apply methods for calculating diluted earnings per
share:
• If-converted method
• Treasury method
Content
1. Introduction
2. Computation of a Weighted-Average Number
of Shares
3. Diluted Earnings per Share

Significance of EPS
Two main functions:

1. Measure firm’s profitability
2. Denominator in price-earnings ratio (PE ratio)
– PE ratio is widely used as a basis for comparing
share-valuation with peers
– Two types of PE ratio:
• Historic PE
– Current market price/ EPS in the most recent period
• Prospective PE
– Current market price/ projected EPS for the
upcoming period
Basic vs Diluted EPS
Capital Structure
Simple Capital Structure Complex Capital Structure

Does not include potential Includes potential ordinary
ordinary shares shares, e.g. convertible bonds/
preference shares, warrants,
options, or other contractual
rights which, when exercised,
could in the aggregate
decrease earnings per ordinary
share
Report basic EPS only Report basic and diluted EPS only

Content
1. Introduction
2. Computation
Computation of
of aa Weighted-Average
Weighted-Average Number
Number
of Shares
3. Diluted Earnings per Share

Basic EPS
Net profit attributable to ordinary shareholders of a parent entity

Basic EPS =
Weighted average no. of ordinary shares during a reporting period
Numerator:
• After deducting amounts due to preference shareholders
in respect of:
– Preference dividends
– Gains/ losses arising on the repurchase or early
conversion of preference shares
– Amortization of discount or premium on increasing
rate preference shares
Definition of Different Types of Preference
Shares
• Cumulative preference shares require the issuer to
pay dividends, even if in arrears.
• Increasing rate preference shares are shares that are

issued at a discount and that provide a low initial
dividend to compensate the issuer for selling at a
discount.

Adjusting for Preference Dividends
Scenario Treatment
Non-cumulative preference Deduct when declared
shares
Cumulative preference Deduct when due
shares
Increasing rate preference Amortization of discount/ premium
shares treated as part of preference dividend

Scenario Treatment
Non-cumulative preference Deduct when declared
shares
Cumulative preference Deduct when due
shares
Increasing rate preference Amortization of discount/ premium
shares treated as part of preference dividend

Scenario Treatment
Preference shares Excess deducted from net profit
repurchased in a tender offer attributable to ordinary equity holders
(FV > carrying value) of parent entity
Early conversion of This is a loss to the issuer and a return
preference shares to the preference shareholders. Deduct
(Consideration > FV of loss from net profit attributable to
ordinary shares issuable) ordinary equity holders of parent entity

Basic EPS
Denominator (examples):
The term “weighted average” refers to time-weighting,
when there are changes in the number of ordinary
shares during the financial year.
General rule:
• Shares are time-weighted from the date consideration is
receivable (usually the date of share issue)
• Time-weighting is only performed when there is an inflow
of resources

Basic EPS
Denominator: - examples
Scenario Date to use for time-weighting

Shares issued for acquisition/ Date of acquisition
Business combination
Conversion of mandatorily Date of contract

convertible instrument
Contingently issuable shares are Date when all necessary

issued conditions are satisfied

Calculating Basic EPS for Various
Scenarios
Scenario 1: New shares are issued for cash/ other assets
Illustration 11.2
Company A had issued share capital of 5,000,000 ordinary
shares at the beginning of the year. On 30 June, it issued
3,000,000 shares at fair market value for cash. Net profit
attributable to ordinary shares was $300,000 for the first 6
months and $800,000 for the full year.

Scenarios
Illustration 11.2
Net profit = $300,000 Net profit = $500,000
1 January 30 June 31 December

No. of shares No. of shares No. of shares
= 5,000,000 = 8,000,000 = 8,000,000
$800,000
Basic EPS =
(5,000,000 x ½) + (8,000,000 x ½)
= 12.3 cents
Note: Time-weighting is proportionate to the periods when the resources
are made available to the firm.
Scenarios
Scenario 2: Issue of bonus shares (stock dividends)
Reserves
Reserves
(Retained
earnings
+ Capital Bonus issue
reserves) Total Total
Equity Equity
Share
capital
Share
capital
shareholders
Scenarios
• Bonus shares are issued out of reserves, such as capital
reserves or retained earnings.
• Share capital increases, total number of shares increase,
reserves decrease, total shareholders’ equity remains
unchanged
 No inflow of resources  not time-weighted
• Treatment:
– Any bonus issues taking place in a period are assumed
to be issued at the beginning of the period. (no time-
weighting)
– Retroactively restate previous year’s EPS comparatives
based on new number of shares.
Scenarios
Scenario 3: Share splits
• An existing share is split into 2 or more shares
• No inflow of resources  not time-weighted
• Retroactive restatement of comparative EPS
Scenario 4: Consolidation of existing shares through

reverse splits
• 2 or more shares are consolidated into one share
• No inflow of resources  not time-weighted.
• Retroactive restatement of comparative EPS

Scenarios
Scenario 5: Rights Issue (Discount to market price)
No. of shares issued = No. of shares if issue was at market price
+ No. of shares in the “bonus element”
Illustration 11.4
On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue
at a subscription price of $1.50 per share to existing
shareholders. The market price immediately before the
exercise of rights issue was $3.00. Atlantis Co’s paid-up
capital consisted of 10,000,000 shares as at 1 Jan 20x4.
The company reported net profit attributable to ordinary
shareholders of $2,500,000 for the year ended 31 Dec 20x4.
Scenarios
Illustration 11.4
On 30 Sep 20x4, Atlantis Co made a one-for-two rights issue
at a subscription price of $1.50 per share to existing
shareholders. The market price immediately before the
exercise of rights issue was $3.00. Atlantis Co’s paid-up
capital consisted of 10,000,000 shares as at 1 Jan 20x4.
The company reported net profit attributable to ordinary
shareholders of $2,500,000 for the year ended 31 Dec 20x4.
Scenarios
This solution applies the treasury method.
• 5,000,000 new shares.
• 5,000,000 x $1.50 = $7,500,000 total proceeds
 inflow of new resources  time-weighting involved
• If the issue was made at full market price, only
2,500,000 new shares needed to be issued
($7,500,000 / $3). Therefore no. of shares in bonus
element = 2,500,000

Scenarios
Reasoning – the treasury method:
• Company B needs to buy back 2,500,000 shares
from the open market to issue to shareholders, with
the proceeds it collected from the rights issue of
$7,500,000.
• An additional 2,500,000 are issued as bonus

shares.
• Actual number of shares issued = 15,000,000
• Number of shares issued for cash = 12,500,000

Scenarios
• The bonus issue factor is 1.2 (15,000,000/
12,500,000) shares for every 1 existing share held.
• The bonus factor should be applied retrospectively

to outstanding shares before the rights issue.

Scenarios
From 1 January 20x4 to 30 10,000,000 x
September 20x4 1.2 x 9/12 = 9,000,000
From 1 October 20x4 to 31 15,000,000 x
December 20x4 3/12 = 3,750,000
Weighted average number
of shares 12,750,00
Net profit attributable to
ordinary shareholders $2,500,000
Basic earnings per share = 19.6 cents

Scenarios
Scenario 6: New issue of shares from the
conversion of debt
• No inflow of cash, but reduction of debt  which
increases net assets of issuer.
• Interest expense on debt is saved  Earnings increase
• Therefore, time-weighting should be applied.

Scenarios
Scenario 7: Contingently issuable shares
• IAS 33:5: These are ordinary shares issuable for little/ no
cash or other consideration upon the satisfaction of
specified conditions in a contingent share agreement
• When contingent events have occurred, such shares are
time-weighted, even if the shares have yet to be issued.

Content
1. Introduction
2. Computation of a Weighted-Average Number
of Shares
3. Diluted
Diluted Earnings
Earnings per
per Share
Share

Diluted EPS
• It is EPS under the assumption of full conversion or

exercise of potential ordinary shares or issuance on
satisfaction of specified conditions
• It is the “worst-case scenario” EPS
• What is the purpose of presenting diluted EPS?
– Enhance comparability for firms with complex capital
structures
 Focuses on profitability rather than timing of actual
conversions
– Provides indication of dilutive impact of existing potential
ordinary shares

Anti-dilution
• If a conversion/ exercise of potential ordinary

shares cause EPS to increase, anti-dilution
occurs
• IAS 33:41 – Potential ordinary shares that are
anti-dilutive are excluded from the calculation of
diluted EPS
– How do we know if they are anti-dilutive?

Anti-dilution
Is diluted EPS from continuing operations >

basic EPS from continuing operations?
yes no
Anti-dilution occurs. No anti-dilution. Include

Diluted EPS for the potential ordinary
(overall) profit/ loss shares in the
attributable to ordinary computation of diluted
shareholders is equal EPS for (overall) profit/
to basic EPS. loss attributable to
ordinary shareholders.

Adjustments to Numerator of Diluted
EPS
Scenario Impact on numerator

Dividends on convertible Not deducted from net profit
preference shares
After-tax interest and amortization Added back to net profit after tax
expenses on convertible bond
Other expense (income) relating to Added back (deducted from)
potential ordinary shares NPAT

Adjustments to Denominator of Diluted
EPS
• Potential ordinary shares are included in the
denominator at the beginning of reporting period
or date of issue of potential ordinary shares,
whichever is the later

Calculating Diluted EPS for Various
Scenarios
1. Options/ Warrants
• Call options and warrants are only dilutive if they are
“in-the-money”
• Use the treasury method to calculate dilutive EPS (the
same method as applied to calculate EPS for a rights
issue)

Scenarios
2. Convertible Instruments
Use the “if-converted” method.
• If the amount of preference dividends declared (or
accumulated) for the period or the interest (net of
tax) per ordinary share on conversion is more than
the basic EPS, the convertible preference shares is
anti-dilutive  excluded from calculation of diluted
EPS

Scenarios
2nd test for anti-dilution
• If earnings per preference share without conversion >
earnings per preference share with conversion
•  deemed anti-dilutive
•  excluded from calculation of diluted EPS

Scenarios
3. Contingently Issuable Shares
• If the contingent events are met, these shares are
included in the calculation of diluted EPS, from
beginning of period or date of agreement, if later
• If the contingent events are not met, we take the
number of shares issuable if the end of the period is
the end of the contingency period (IAS 33:52)

Anti-dilution Sequencing
• Purpose of reporting diluted EPS is to report

maximum dilution
• A potential ordinary share may be dilutive on its
own, but may be anti-dilutive when included with
other potential ordinary shares
• There are so many permutations and combinations,
so we need to find an order of inclusion
– Start with the most dilutive. Process stops when the
inclusion of a potential ordinary share increases the
diluted EPS

Approach to calculate diluted EPS:

1. Compute basic EPS
2. Compute earnings per incremental share (EPIS) for
each class of potential ordinary shares
Increase in earnings from assumed conversion or exercise
EPIS =
Incremental number of shares from assumed conversion or
exercise
• The class of shares with the lowest impact on the
numerator (earnings) and the highest impact on the
denominator (the no. of shares) has the lowest EPIS
and is the most dilutive.
3. Rank them from the most dilutive to the least

dilutive and include the most dilutive first in diluted
EPS calculation.
4. The process stops when all the potential ordinary
shares have been included or when the inclusion of
the next ranked potential ordinary share results in a
higher diluted EPS than the previous provisional
diluted EPS.
* The reported diluted EPS is the lowest possible figure and

must never be higher than the basic EPS.
Diluted EPS Illustration
Financial statement and share information of Company A

are as follows:
20x6
Net profit after tax 12,000,000
Less preference dividends -24,000
Net profit attributable to ordinary
shareholders 11,976,000
No. of issued ordinary shares at
31 December 4,250,000

Information on movements in ordinary shares:

1 Jan 20x4 New issue for cash (incorporation) 1,000,000
1 April 20x5 New issue for cash 200,000
1 July 20x5 Bonus issue: 1 for 1 1,200,000
1 Oct 20x5 From conversion of preference shares 500,000
1 July 20x6 New shares from rights issue 1,450,000
1 new share for every 2 existing shares
Exercise price: $2
Market price: $3
All rights were taken up
1 Oct 20x6 Shares re-purchased at fair value -100,000

Information on Potential Ordinary Shares (dilutive instruments)
1. On 1 July 20x4, the company issued 1,000,000 6% non-

cumulative preference shares that are convertible to 500,000
ordinary shares. The original conversion ratio is 2 preference
shares to 1 ordinary share. After the bonus issue, each
reference share was convertible to 1 ordinary share. (Ignore
the effects of the rights issue on the conversion ratio)
On 1 Oct 20x5, 500,000 preference shares were converted

to ordinary shares. Preference dividends were declared on
outstanding balance of preference shares as at 30 June of
each year.
2. On 1 July 20x5, the company issued 500,000 units of

stock options. Each stock option unit entitles the holder to
purchase 1 unit of ordinary share.
Exercise price: $2.50
Average market price
(20x6) $3.00
None were exercised during the period because of a
vesting period requirement.

3. On 1 Oct 20x5, the company issued $10,000,000

convertible bonds which are convertible to 10,000,000
ordinary shares
Market interest 5% per annum
rate:
Tax rate: 20%. None were converted during
20x5 or 20x6
Required: Prepare diluted EPS for 20x6

Worked solution
Step 1: Determine the Earnings per Incremental Share (EPIS)
for each type of potential ordinary shares.
a) Convertible preference shares

Incremental shares arising from the assumed conversion of the
preference shares as at 1 Jan 20x6
Assumed converted from 1 Jan 20x6 to 31 Dec 20x6: 500,000

(500,000 x 12/12)
(No partial conversions during the year; hence, assume the

balance at year-end is converted at beginning of year)
Impact on profit attributable to ordinary shareholders from

assumed conversion:
Avoidance of dividends declared on preference shares

during 20x6 24,000
Earnings per Incremental Share 0.048

(24,000/500,000)

Worked solution
b) Stock Options
Incremental shares arising from the assumed exercise of options
as at 1 Jan 20x6
No. of ordinary shares issued if outstanding options are exercised:

500,000
Equivalent number of shares at fair market value: 416,667
(500,000 x 2.5)/ 3.0
Incremental number of shares issued for no consideration: 83,333
Apply a whole year’s weighting since the stock options were in

existence at beginning of 20x6.


assumed exercise 0
Earning per Incremental Share 0

Worked solution
c) Convertible Bonds
Incremental shares arising from the assumed conversion of
convertible bonds as at 1 Jan 20x6
No. of ordinary shares issued if the convertible bonds were

converted: 10,000,000 (10,000,000 x 12/12)


assumed conversion as at 1 Jan 20x6
Savings of interest expense (after-tax) on convertible

bonds: 10,000,000 x 5% x 12/12 x 0.8 = 400,000
Earnings per Incremental Share 0.04

Worked solution
Step 2:
Ranking by EPIS EPIS
1) Stock Options 0 (most dilutive)
2) Convertible Bonds 0.04
3) Convertible Preference Shares 0.048 (least dilutive)

Changes in number of ordinary shares in 20x5

Date Item Increase in ordinary
shares
1 Jan 20x5 Balance at start 1,000,000
1 Apr 20x5 New issue for cash 200,000
1 July 20x5 Bonus issue 1,200,000
1 Oct 20x5 Conversion of 500,000

preference shares
31 Dec 20x5 Balance at year-end 2,900,000

Calculating weighted average number of shares in 20x6
Date 1 Jan 20x6 1 July 20x6 1 Oct 20x6
Item Balance at Rights issue Shares re-
start purchased
Increase in ordinary shares 2,900,000 1,450,000 -100,000
Add bonus issue 362,500 -362,500
Cumulative balance 3,262,500 4,350,000 4,250,000
Period outstanding 1 Jan – 1 Jul 1 Jul – 1 Oct 1 Oct – 31
Dec
Time weight 1/2 1/4 1/4
Weighted average number of 1,631,250 1,087,500 1,062,500
shares

Fair value of shares before rights = 2,900,000 x $3 = $8,700,000

Proceeds from the rights = 1,450,000 x $2 = $2,900,000
Theoretical ex-rights price
= Fair value of shares before rights + Proceeds from rights
Existing shares + New shares from rights
= $11,600,000 = 2.67
4,350,000
Bonus issue adjustment factor implicit in rights
= 3/2.67 1.125
Bonus issue applied retrospectively

= (1.125 x 2.9 m) - 2.9 m 362,500

• Number of ordinary shares as at 31.12.20x6

= 2,900,000 + 1,450,000 – 100,000
= 4,250,000
• Weighted average number of shares in 20x6

= 1,631,250 + 1,087,500 + 1,062,500
= 3,781,250

Worked solution
Step 3: Introduce the most dilutive security first into aggregate DEPS calculation
Profit WA no. of DEPS
shares
Basic EPS 11,976,000 3,781,250 3.167207
Include effects of assumed exercise of 0 83,333
options
Aggregate DEPS 11,976,000 3,864,583 3.098911 Dilutive
Include effects of assumed conversion of 400,000 10,000,000
convertible bonds
Include effects of assumed conversion of 24,000 500,000
convertible preference shares
Reported DEPS (20x6) 0.863234

Presentation and Disclosures
• Basic and diluted EPS to be presented in income
statement, in respect of:
– Profit attributable to ordinary shareholders of parent company
from continuing operations
– Profit attributable to ordinary shareholders of parent company for
the period
• Where there are discontinued operations, basic and

diluted EPS for discontinued operations must be
disclosed in the income statement or in the notes

• Other information that should be in the notes (IAS
33:70):
1. Earnings used in numerator of EPS, as well as a reconciliation
of earnings to the income statement. (Include individual
earnings effect of each class of instruments on EPS)
2. Denominator in calculating basic and diluted EPS and a

reconciliation of both denominators. (Include individual
denominator effect of each class of instruments on EPS)

3. Potential ordinary shares that were not included in
the calculation of diluted EPS, because they were
anti-dilutive
4. Post-balance sheet events – description of

transactions which would have significantly changed
the no. of ordinary shares/ potential ordinary shares
outstanding at the end of period

Chapter 11 (Tan - Lee)

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Chapter 11 (Tan - Lee)

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Advanced Financial

Tan & Lee Chapter 11 © 2009 1

Tan & Lee Chapter 11 © 2009 3

Two main functions:

Simple Capital Structure Complex Capital Structure

Tan & Lee Chapter 11 © 2009 5

Tan & Lee Chapter 11 © 2009 6

Net profit attributable to ordinary shareholders of a parent entity

• Increasing rate preference shares are shares that are

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Scenario Date to use for time-weighting

Conversion of mandatorily Date of contract

Contingently issuable shares are Date when all necessary

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Net profit = $300,000 Net profit = $500,000

1 January 30 June 31 December

Scenario 4: Consolidation of existing shares through

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• An additional 2,500,000 are issued as bonus

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• The bonus factor should be applied retrospectively

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• It is EPS under the assumption of full conversion or

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• If a conversion/ exercise of potential ordinary

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Is diluted EPS from continuing operations >

Anti-dilution occurs. No anti-dilution. Include

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Scenario Impact on numerator

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• Purpose of reporting diluted EPS is to report

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Approach to calculate diluted EPS:

3. Rank them from the most dilutive to the least

* The reported diluted EPS is the lowest possible figure and

Financial statement and share information of Company A

Tan & Lee Chapter 11 © 2009 40

Information on movements in ordinary shares:

Tan & Lee Chapter 11 © 2009 41

1. On 1 July 20x4, the company issued 1,000,000 6% non-

On 1 Oct 20x5, 500,000 preference shares were converted

2. On 1 July 20x5, the company issued 500,000 units of

Tan & Lee Chapter 11 © 2009 43

3. On 1 Oct 20x5, the company issued $10,000,000

Required: Prepare diluted EPS for 20x6

Tan & Lee Chapter 11 © 2009 44

a) Convertible preference shares