# Concepts, Rules, and Examples

### Simple Capital Structure

A simple capital structure may be said to exist either when the capital structure consists solely of ordinary (equity) 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 earnings per share. 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 earnings per share.

#### Computational guidelines.

In its simplest form, the EPS calculation is net income divided by the weighted-average number of ordinary shares outstanding. The objective of the EPS calculation is to determine the amount of earnings available to each ordinary share. Complexities arise because net income does not necessarily represent the earnings available to the ordinary shareholder, 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 net income figure used as the numerator in any of the EPS computations must reflect any claims against it by holders of senior securities. The justification for this reduction is that the claims of the senior securities must be satisfied before any income is available to the common shareholder. These securities are usually in the form of preference shares, and the deduction from income is the amount of the dividend declared during the year on the preference shares. If the preference shares are cumulative, the dividend is to be deducted from income (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 effects of the rights given to senior securities on the EPS calculation.

#### Denominator.

The weighted-average number of ordinary shares outstanding is used so that the effect of increases or decreases in outstanding shares on EPS data is related to the portion of the period during which the related consideration affected operations. 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 analyze all the possibilities, the following discussion presents some of the more common transactions affecting the number of ordinary shares outstanding. The theoretical construct set forth in these relatively simple examples can be followed in all other situations.

If a company reacquires its own shares (referred to as treasury stock) in countries where it is legally permissible to do so, the number of shares reacquired should be excluded from EPS calculations as of the date of acquisition. The same theory 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 the consideration for the shares was not available to generate earnings until the shares were issued. This same logic applies to the reacquired shares because the consideration relative to those shares was no longer available to generate earnings after the acquisition date.

A stock dividend (bonus issue) or a stock (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 stock split or dividend, or decrease in shares as a result of a reverse split, should be given retroactive recognition as an appropriate equivalent charge for all periods presented. Thus, even if a stock dividend or split occurs at the end of the period, it is considered outstanding for the entire period of each period presented. The reasoning is that a stock dividend or split has no effect on the ownership percentage of the common stockholder. As such, to show a dilution in the EPS reported 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 stock dividend or split.

IAS 33 carries this logic one step further by requiring the disclosure of pro forma (adjusted) amounts of basic and diluted earnings per share for the period in case of issue of shares with no corresponding change in resources (e.g., stock dividends or splits) occurring after the balance sheet date, but before the issuance of the financial statements. The reason given is that the nondisclosure of such transactions would affect the ability of the users of the financial statements to make proper evaluations and decisions. It is to be noted, however, that the EPS numbers as presented on the face of the income statement are not required by IAS 33 to be retroactively adjusted, as is the case under US GAAP, because such transactions do not reflect the amount of capital used to produce the net profit or loss for the period.

Complications also arise when a business combination occurs during the period. The treatment of the additional shares depends on the nature of the combination. If the business combination is recorded as a uniting of interests, the additional shares are assumed to have been issued at the beginning of the year regardless of when the combination occurred. Conversely, if the combination is accounted for as an acquisition, the shares are considered issued and outstanding as of the date of acquisition. The reason for this varied treatment lies in the income statement treatment accorded a uniting of interests versus an acquisition. In a uniting of interests, the income of the acquired company is included in the statements for the entire year, whereas in an acquisition, the income is included only for the period after acquisition.

IAS 33 recognizes 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. Further, in the case of contingently issuable shares (i.e., ordinary shares issuable on fulfillment 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 earnings per share only when all the 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 3-to-1 bonus issue the number of shares outstanding prior to the issue is multiplied by a factor of 4. These and other situations are summarized in the tabular list that follows.

Weighted-Average (W/A) Computation

Transaction

Effect on W/A computation

Common stock outstanding at the beginning of the period

Increase number of shares outstanding by the number of shares

Issuance of common stock during the period

Increase number of shares outstanding by the number of shares issued times the portion of the year outstanding

Conversion into common stock

Increase number of shares outstanding by the number of shares converted times the portion of the year outstanding

Company reacquires its stock

Decrease number of shares outstanding by number of shares reacquired times portion of the year outstanding

Stock dividend or split

Increase number of shares outstanding by number of shares issued or increased due to the split

Reverse split

Decrease number of shares outstanding by decrease in shares

Pooling of interest

Increase number of shares outstanding by number of shares issued

Purchase

Increase number of shares outstanding by number of shares issued times portion of year since acquisition

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 do not characterize 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

1. Income from ordinary activities before extraordinary items

\$130,000

1. Common shares outstanding 1/1/03

100,000

1. Extraordinary loss (net of tax)

30,000

1. Shares issued for cash 4/1/03

20,000

1. Net income

100,000

1. Shares issued in 10% stock dividend declared in July 2003

12,000

1. 6% cumulative preference shares, \$100 par, 1,000 shrs. issued and outstanding

100,000

1. Shares of treasury stock purchased 10/1/03

10,000

When calculating the numerator, the claims of senior securities (i.e., preference shares) should he deducted to arrive at the earnings attributable to ordinary (equity) shareholders. 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 x \$100 x 6%) against 2003 earnings. Therefore, \$6,000 must be deducted from the numerator to arrive at the net income attributable to the holders 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 noncumulative preferred only if a dividend of this amount had been declared during the period. The EPS calculations follow.

Earnings per common share

 On income from continuing operations before extraordinary items = (\$130,000 - \$6,000) Ordinary shares outstanding = \$1.00 On net income = (\$100,000 - \$6,000) Ordinary shares outstanding = \$0.76

The computation of the denominator is based on the weighted-average number of ordinary shares outstanding. Recall that a simple weighted-average is not considered appropriate because of the various complexities. The table below illustrates one way of computing the weighted-average number of shares outstanding.

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 1/1/03

110,000

[100,000 + 10%(100,000)]

12/12

110,000

Shares issued 4/1/03

22,000

[20,000 + 10% (20,000)]

9/12

16,500

Treasury shares purchased 10/1/03

(10,000)

3/12

(2,500)

Weighted-average number of common shares outstanding

124,000

Recall that the stock dividend declared in July is considered to be retroactive to the beginning of the year. Thus, for the period 1/1 through 4/1, 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 stock 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 stock 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 common shares outstanding to arrive at EPS.

 On income from continuing operations before extraordinary items = (\$130,000 - \$6,000) 124,000 common shares = \$1.00 On net income = (\$100,000 - \$6,000) 124,000 common shares = \$0.76

Reporting a \$0.24 loss per share (\$30,000 124,000) due to the extraordinary item is optional. The numbers computed above for the EPS based on net income are the only presentation required on the face of the income statement.

### 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 that have the potential to be exercised and reduce EPS. The effects of any antidilutive potential ordinary shares (those that increase EPS) is not to be included in the computation of diluted earnings per share.

Note that a complex structure requires dual presentation of both basic EPS and diluted EPS unless the basic earnings per share is a loss per share. In case the basic EPS is a loss per share, IAS 33 does not prohibit an enterprise from disclosing the figure for the diluted EPS.

For the purposes of calculating diluted EPS, the net profit attributable to ordinary shareholders and the weighted-average number of shares outstanding should be adjusted for the effects of all the dilutive potential ordinary shares.

According to IAS 33, the numerator, representing the net profit attributable to the ordinary shareholders for the period, should be adjusted by the after-tax effect, if any, of the following items:

1. Interest recognized in the period for the dilutive potential ordinary shares

2. Any dividends recognized in the period for the dilutive potential ordinary shares, where those dividends have been deducted in arriving at net profit attributable to ordinary shareholders

3. Any other changes in income or expenses that would result from the conversion of the dilutive potential ordinary shares

For instance, conversion of debentures into ordinary shares will reduce interest expense which 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, employer's contribution to an employee profit sharing plan. The effect of such consequential changes on the bottom line 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.

### Contingent Issuances of Ordinary Shares

As in the computation of the basic EPS, shares whose issuance is contingent on the occurrence of certain events are considered outstanding and included in the computation of diluted EPS only if the stipulated conditions have been met (the event has occurred). Issuances that are dependent on certain conditions being met can be illustrated through the following example. For instance, there may be a condition or requirement in a contract to increase earnings over a period of time to a certain stipulated level and that upon attainment of this level of earnings, the issuance of shares to take place; this is regarded as a contingent issuance of shares. These securities are included in the computation of diluted EPS.

There are basically two methods used to incorporate the effects of potential ordinary shares, popularly referred to as

1. The treasury stock method

2. The if-converted method

These terms were first popularized by the former US GAAP requirements set forth in APB 15. IAS 33 does not specifically refer to the methods it has prescribed by the foregoing names, but does mention, in the case of the method of accounting for share warrants and options that, in effect, the method prescribed by it produces the same results as the treasury stock method.

#### Treasury stock method.

The treasury stock method, which is used to account for the hypothetical exercise of most warrants or options, requires that EPS be computed as if the options or warrants were exercised at the beginning of the period (or date of issuance, if later) and that the funds obtained from the exercise were used to purchase common stock at the average market price for the period.

For example, if a corporation has warrants outstanding for 1,000 shares of common stock exercisable at \$10 per share and the average market price of the common stock is \$16 per share, the following would hypothetically occur: The company would receive \$10,000 (1,000 x \$10) and issue 1,000 shares from the exercise of the warrants that would enable it to purchase 625 shares (\$10,000 \$16) in the open market. The net increase in the denominator (which effects a dilution in EPS) is 375 shares (1,000 issued less 625 repurchased). Under the terminology of IAS 33, those 375 shares are deemed to have been issued "for no consideration." In all cases where the exercise price is lower than the market price, assumed exercise will be dilutive and some portion of the shares will be deemed issued for no consideration. If the exercise price is greater than the average market price, the exercise should not be assumed since the result of this would be antidilutive.

Treasury 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

#### If-converted method.

The if-converted method is used for those securities that are currently sharing in the earnings of the company through the receipt of interest or dividends as senior securities but have the potential for sharing in the earnings as ordinary shares. The if-converted method logically recognizes that the convertible security can only share in the earnings of the company as one or the other, not as both. Thus, the dividends or interest less tax effects applicable to the convertible security as a senior security are not recognized in the net income figure used to compute EPS, and the weighted-average number of shares is adjusted to reflect the conversion as of the beginning of the year (or date of issuance, if later). See the example of the if-converted method for illustration of treatment of convertible securities when they are issued during the period and therefore were not outstanding for the entire year.

Example of the if-converted method

Assume a net income of \$50,000 and a weighted-average number of common shares outstanding of 10,000. The following information is provided regarding the capital structure.

1. 7% convertible debt, 200 bonds each convertible into 40 ordinary shares. The bonds were outstanding the entire year. The income tax rate is 40%. The bonds were issued at par (\$1,000 per bond). No bonds were converted during the year.

2. 4% convertible, cumulative preferred stock, par \$100, 1,000 shares issued and outstanding. Each preferred share is convertible into 2 common shares. The preferred shares were issued at par and were outstanding the entire year. No shares were converted during the year.

The first step is to compute the basic EPS, that is, assuming only the issued and outstanding ordinary shares. This figure is simply computed as \$4.60 (\$50,000 - \$4,000 preferred dividends) (10,000 ordinary shares outstanding). The diluted EPS must be less than this amount for the capital structure to be considered complex and for a dual presentation of EPS to be necessary.

To determine the dilutive effect of the preferred stock, an assumption (generally referred to as the if-converted method) is made that all of the preferred stock is converted at the earliest date that it could have been during the year. In this example, the date would be January 1. (If the preferred had been first issued during the year, the earliest date conversion could have occurred would have been the issuance date.) The effects of this assumption are twofold: (1) if the preferred is converted, there will be no preferred dividends of \$4,000 for the year; and (2) there will be an additional 2,000 shares of common outstanding during the year (the conversion rate is 2 for 1 on 1,000 shares of preferred). Diluted EPS is computed, as follows, reflecting these two assumptions:

The convertible preferred is dilutive because it reduced EPS from \$4.60 to \$4.17. Accordingly, a dual presentation of EPS is required.

In the example, the convertible bonds are also assumed to have been converted at the beginning of the year. Again, the effects of the assumption are twofold: (1) if the bonds are converted, there will be no interest expense of \$14,000 (7% x \$200,000 face value), and (2) there will be an additional 8,000 shares (200 bonds x 40 shares) of common stock outstanding during the year. One note of caution, however, must be mentioned; namely, the effect of not having \$14,000 of interest expense will increase income, but it will also increase tax expense. Consequently, the net effect of not having interest expense of \$14,000 is \$8,400 [(1 - 0.40) x \$14,000]. Diluted EPS is computed as follows, reflecting the dilutive preferred and the effects noted above for the convertible bonds.

The convertible debt is also dilutive, as it reduces EPS from \$4.17 to \$2.92. Together the convertible bonds and preferred reduced EPS from \$4.60 to \$2.92. The following table summarizes the computations made for this example.

Computations of Basic and Diluted Earnings Per Share

Items

FPS on outstanding common stock (the benchmark EPS)

Basic

Diluted

Numerator

Denominator

Numerator

Denominator

Numerator

Denominator

Net income

\$50,000

\$50,000

\$50,000

Preferred dividend

(4,000)

Common shs outstanding

10,000 shs

10,000 shs

10,000 shs

Conversion of preferred

2,000

2,000

Conversion of bonds

8,400

8,000

• Totals

\$46,000

10,000 shs

\$50.000

12,000 shs

\$58,400

20,000 shs

• EPS

\$4.60

\$4.17

\$2.92

The preceding example was simplified to the extent that none of the convertible securities were, in fact, converted during the year. In most real situations, some or all of the securities may have been converted, and thus actual reported earnings (and basic EPS) would already have reflected the fact that preferred dividends were paid for only part of the year and/or that interest on convertible debt was accrued for only part of the year. These factors would need to be taken into consideration in developing a time-weighted numerator and denominator for the EPS equations.

Furthermore, the sequence followed in testing the dilution effects of each of several series of convertible securities may affect the outcome, although this is not always true. It is best to perform the sequential procedures illustrated above by computing the impact of each issue of potential ordinary shares from the most dilutive to the least dilutive. This rule also applies if convertible securities (for which the if-converted method will be applied) and options (for which the treasury stock approach will be applied) are outstanding simultaneously.

Finally, if some potential ordinary shares are only issuable on the occurrence of a contingency, conversion should be assumed for EPS computation purposes only to the extent that the conditions were met as of the balance sheet date. In effect, the end of the reporting period should be treated as if it were also the end of the contingency period.

#### No antidilution.

No assumptions of conversion should be made if the effect would be antidilutive. As in the discussion above, it may be that the sequence in which the different issues or series of convertible or other instruments that are potentially ordinary shares are considered will affect the ultimate computation. The goal in computing diluted EPS is to calculate the maximum dilutive effect. The individual issues of convertible securities, options, and other items should be dealt with from the most dilutive to the least dilutive to effect this result.

Modified Treasury Stock Method

Numerator

Net income recomputed to reflect retirement of debt or income from investments

• Add interest expense less tax effects

• Add income from investments less tax effects

Denominator

Common stock outstanding + Number of shares not acquired with proceeds from options and warrants

### Changes to Earnings Per Share Calculations Being Proposed

As part of IASB's Improvements Project, it has proposed that certain changes be made to IAS 33. Inasmuch as these proposed changes are anticipated to become effective in 2003, the likely changes are set forth in the following discussion. IASB has proposed to include or exclude contracts that may be settled either in common stock (referred to as "ordinary shares") or in cash, at the issuer's option, in the calculation of the number of potential ordinary shares in the diluted earnings per share calculation based on a rebuttable presumption that the contracts will be settled in shares, rather than for cash. This is a conservative assumption that will show the maximum dilutive effects of the settlement. SIC 24 will be withdrawn if this approach is incorporated in the revised Standard. Currently, SIC 24 requires that if a potential ordinary share is dilutive (that is, its conversion to ordinary shares would decrease net profit per share from continuing ordinary operations), its dilutive effect is included in calculating diluted earnings per share. Thus, the effect of the amendment is essentially to incorporate existing SIC guidance into the revised Standard itself.

The amendment will also stipulate that when a contract having the foregoing characteristics is presented for accounting purposes as an asset or a liability, or has both an equity component and a liability component, the reporting entity will need to adjust the numerator for any changes in earnings that would have resulted during the period if the contract has been classified wholly as an equity instrument. That adjustment is similar to the one already prescribed when potentially dilutive shares (from conversion of convertible debt, etc.) are assumed diluted for EPS computation purposes under IAS 33 currently. The objective is to avoid "double counting" the impact of assumed conversion or exercise by having both the number of assumed shares outstanding increased, and by having the income being allocated to shares decreased by the related expenses or dividends actually paid or accrued on the outstanding securities whose conversion or exercise is being hypothesized.

IAS 33 is also about to be amended to clarify that adjustments are required in calculating basic earnings per share for particular transactions involving an entity's preferred shares or other securities classified as equity instruments. For instance, the excess of consideration paid to acquire preference shares over their carrying amount is deducted in computing the numerator for the purpose of calculating basic earnings per share. In other words, although the premium paid by the reporting entity, being a transaction in the entity's own shares, is recorded as a charge directly against retained earnings, for EPS calculation purposes it is treated as an income statement event. This is consistent with other guidance already contained in IAS 33.

The existing standard will also be amended to provide additional guidance and illustrative examples on particular, more complex matters, such as the effects of contingently issuable shares; potential ordinary shares of subsidiaries, joint ventures or associates; participating securities; written put options; and purchased put and call options. Compared to the existing standard, the guidance in the draft amended standard is vastly expanded.

### Disclosure Requirements under IAS 33

1. Enterprises should present both basic EPS and diluted EPS on the face of the income statement for each class of ordinary shares that has a different right to share in the net profit for the period. Equal prominence should be given to both the basic EPS and diluted EPS figures for all periods presented.

2. Enterprises should present basic EPS and diluted EPS even if the amounts disclosed are negative. In other words, the standard mandates disclosure of not just earnings per share, but even loss per share figures.

3. Enterprises should disclose amounts used as the numerator in calculating basic EPS and diluted EPS along with a reconciliation of those amounts to the net profit or loss for the period. Disclosure is also required of the weighted-average number of ordinary shares used as the denominator in calculating basic EPS and diluted EPS along with a reconciliation of these denominators to each other.

1. In addition to the disclosure of the figures for basic EPS and diluted EPS, as required above, if an enterprise chooses to disclose per share amounts using a reported component of net profit, other than net profit or loss for the period attributable to ordinary shareholders, such amounts should be calculated using the weighted-average number of ordinary shares determined in accordance with the requirements of IAS 33; this will ensure comparability of the per share amounts disclosed;

2. In cases where an enterprise chooses to disclose the above per share amounts using a component of net profit not reported as a line item in the income statement, a reconciliation is mandated by the standard, which should reconcile the difference between the component of net income used with a line item reported in the income statement; and

3. When additional disclosure is made by an enterprise of the above per share amounts, basic and diluted per share amounts should be disclosed with equal prominence (just as basic EPS and diluted EPS figures are given equal prominence).

4. Enterprises are encouraged to disclose the terms and conditions of financial instruments or contracts generating potential ordinary shares since such terms and conditions may determine whether or not any potential ordinary shares are dilutive and, if so, the effect on the weighted-average number of shares outstanding and any consequent adjustments to the net profit attributable to the ordinary shareholders.

5. If changes (resulting from a bonus issue or share split, etc.) in the number of ordinary or potential ordinary shares occur after the balance sheet date but before issuance of the financial statements, and the per share calculations reflect such changes in the number of shares, such a fact should be disclosed.

6. Enterprises are also encouraged to disclose a description of ordinary share transactions or potential ordinary share transactions other than capitalization issues and share splits, occurring after the balance sheet date that are of such importance that nondisclosure would affect the ability of the users of the financial statements to make proper evaluations and decisions.

WILEY IAS 2003: Interpretation and Application of International Accounting Standards
ISBN: 0471227366
EAN: 2147483647
Year: 2005
Pages: 147

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