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By Anthony F. Cocco and Tommy Moores

The Financial Accounting Standards Board (FASB) released an Exposure Draft (ED) dated January 19, 1996, titled Earnings per Share and Disclosure of Information About Capital Structure. If adopted, the new standard would supersede Accounting Principles Board Opinion No. 15 (APB No. 15), Earnings per Share, and would be effective for financial statements issued for periods ending after December 15, 1997. The comment period for the ED is past, and the FASB is in the midst of considering comments as it moves toward finalization of the statements. The two purposes for proposing a change in EPS computations are simplicity and comparability. That is, the proposed changes would greatly simplify the calculation of EPS and make the EPS figures of U.S. companies more comparable with those of companies throughout the world.

EPS Figures Presented

Current GAAP. Companies that do not have any dilutive convertible securities display a single EPS figure, earnings per common share. Companies that do have dilutive securities are required to present two EPS figures, primary earnings per share and fully diluted earnings per share. Primary earnings per share incorporates the effects of dilutive common stock equivalents, and fully-diluted earnings per share incorporates the effects of all dilutive convertible securities. However, if dilution from earnings per common share is less than three percent in the aggregate, only earnings per common share is reported.

ED Requirements. The ED would require companies with complex capital structures to display two EPS figures, basic EPS and diluted EPS, with no reference to a three percent test. Basic EPS would be equivalent to the figure currently presented by companies that do not have any dilutive convertible securities, earnings per common share.

Basic EPS= Income available to
common stockholders

Weighted average common
shares during the period

Income available to common stockholders subtracts preferred stock dividends from the relevant income figure.

Diluted EPS is analogous to the currently reported fully-diluted EPS, subject to some differences described later. This figure considers the effect of all dilutive convertible securities.

The concept of common stock equivalents would disappear entirely. Thus, there will be no EPS figure equivalent to primary EPS. Also, every company with a complex capital structure would report two EPS figures, even if they are identical.

Evaluation. The proposed changes likely will be eagerly accepted. The concept of common stock equivalents in the computation of primary earnings per share has been widely criticized as confusing, arbitrary, and misleading. The elimination of this concept will be a welcome change for preparers, auditors, and financial statement users.

Under the ED, the two earnings per share figures presented for companies with complex capital structures would represent two ends of a continuum. Basic EPS incorporates no dilution, and diluted EPS incorporates all dilution. There will probably be little objection to this general approach.

Treatment of Contingently
Issuable Shares

Current GAAP. The issue is the treatment of shares issuable on a contingency other than the mere passage of time. If attainment or maintenance of a certain level of earnings constitutes the contingency, and that level is currently being achieved, the shares are considered as outstanding for both primary and fully diluted EPS. If the earnings level is not currently being achieved, current earnings is adjusted to account for the necessary increase and the shares are then assumed to be issued, but only for fully diluted EPS and only if dilutive. Prior period EPS is restated if future events prove out differently than assumed.

If the contingency is based on attaining or maintaining a certain market price of common stock, APB No. 15 states that "computations of earnings per share should reflect the number of shares that would be issuable based on the market price at the close of the period being reported on." Again, restatement is required if future events fall differently than currently assumed.

ED Requirements. Shares are assumed issued only if all conditions for issuance are currently being met. Earnings levels are not adjusted, and no restatements are required or permitted.

Also, the ED addresses contingencies other than market price of the stock and earnings levels, such as opening a certain number of retail stores, which were not addressed by APB No. 15. Again, the shares are assumed issued only if all
conditions are being met at the end of the period.

Evaluation. The ED requirements are much simpler than those of current GAAP, and more logical. This change appears to be a free lunch--less costly for preparers and auditors, and better information for users.

Treasury Stock Method for
Options and Warrants

Current GAAP. If the exercise price of options or warrants is less than the market price of the stock (therefore dilutive), they are assumed exercised at the beginning of the year (or issue date if later). The assumed cash proceeds are then assumed to purchase treasury stock at the average market price of the common stock during the period for primary EPS. For fully diluted EPS, companies use the higher of the average price or the price at the close of the period. The net number of shares (shares assumed issued less shares assumed repurchased) are then assumed outstanding in the denominator for both primary and fully diluted EPS.

Finally, the modified treasury stock method is used if the number of options and warrants outstanding exceeds 20% of the common stock outstanding at the end of the period. The assumed proceeds are then assumed to be used for other purposes, described in detail in the Current Text.

ED Requirements. Dilutive options and warrants are only relevant for computing diluted EPS. Only the average market price would be used, and the modified treasury stock method would be eliminated.

Evaluation. As the FASB points out in the ED, the modified treasury stock method was rarely called for in practice. The major change is the use of only the average market price of common stock. The rationale used by the FASB is exceptionally lucid and logical as described in paragraph 101 of the ED:

The board believes that the use of the average stock price is consistent with the objective of diluted EPS to measure earnings per share for the period based on period information, rather than trying to predict future earnings per share based on end-of-period data or estimates of the future.

The FASB emphasizes this theme of treating EPS as a historic review of past performance and not a predictor of future events throughout the ED.

We believe the FASB is on target in emphasizing this theme. The ED and, for that matter, current GAAP focuses primarily on the denominator of EPS. The calculation of the numerator, earnings, is obviously beyond the scope of one pronouncement, and is the subject of the bulk of GAAP. The FASB notes that since the numerator describes past performance over a period of time, the denominator should also reflect past data. The job of predicting the future is then transferred to the users of financial statements.

Control Number for Assessing Dilution

Current GAAP. The control number is the number on the income statement used for testing for antidilution. Under APB No. 15 it is net income.

ED Requirements. The control number will be income from continuing operations, or a similar line item above net income if it appears on the income statement.

Evaluation. This provision at first glance appears logical. The FASB makes the point that EPS data are more comparable over time if income from continuing operations is the control number. However, if a company has income from continuing operations but a net loss for the period, its diluted net loss per share will be lower. This could cause some confusion for people such as analysts who may focus on only the bottom line.

To informally test this point, we made phone calls to analysts associated with two well-known, international brokerage firms. Both analysts indicated that they focus on net income, and not on any income figure that appears above the line.

Further, we would argue that it doesn't matter which EPS figure is focused on by most analysts. Undoubtedly, at least some analysts and investors will direct attention to diluted EPS for net income. *

Anthony F. Cocco, PhD, CPA, is an assistant professor of accounting and Tommy Moores, PhD, CPA, a professor of accounting, both at the University of Nevada, Las Vegas.


Douglas R. Carmichael, PhD, CPA

Baruch College

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