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ACCOUNTINGEARNINGS PER SHARE‹PRESENT AND PROPOSEDBy Lynn K. Saubert, R. Wayne Saubert, and Philip L. Little Earnings per share (EPS) is a summary statistic calculated under the rules of APB Opinion No. 15, Earnings per Share, issued in 1969. Since then, there have been various interpretations and modifications of the methods used in the calculations. More substantive changes may soon be forthcoming regarding the calculation and presentation of EPS. In March 1994, the FASB added an EPS project to its agenda in conjunction with a similar project of the International Accounting Standards Committee (IASC). The FASB anticipates the probable issuance of an Exposure Draft on EPS in the first quarter of 1996. APB Opinion No. 15 RequirementsUnder Opinion No. 15, companies have either simple or complex capital structures. For those companies with simple capital structures, that is those having no dilutive securities outstanding, simple EPS is the relevant statistic. Simple EPS, or earnings per share of common stock, is calculated as net income less preferred stock dividends divided by the weighted average number of common shares outstanding during the period. Companies having dilutive securities outstanding‹such as options, warrants, convertible bonds, or convertible stock‹must calculate two additional EPS numbers, primary and fully diluted EPS. Primary EPS is simple EPS adjusted to include the effects of common stock equivalents exercisable within five years. Fully diluted EPS is simple EPS adjusted to reflect the effects of all dilutive securities, not just those deemed to be common stock equivalents. The time frame for exercise is extended to ten years for fully diluted EPS. Table 1 summarizes these relationships. Common Stock Equivalency. Common stock equivalency (CSE) status is determined using specified guidelines. Options and warrants are always common stock equivalents, but are included in EPS computations only if dilutive. They are considered dilutive if the exercise price is below the market price for a period of three consecutive months, ending on the financial statement date. The common stock equivalency status for convertible stocks and bonds is determined at the date of issuance. This status, either "yes" or "no," will prevail during the entire outstanding life of these securities. The test to determine CSE status compares the effective cash yield based on the issue price of the securities and the Bond Aa rate at the issuance date. If the effective cash yield is less than twothirds of the Bond Aa rate at that date, the security is deemed to be a common stock equivalent. Computing Dilution. Opinion No. 15 prescribes several rules and procedures for incorporating dilutive securities in EPS calculations: * The treasury stock method is used to include the effects of options and warrants. * The "if converted" method is used to include the effects of convertible securities. Treasury Stock Method. The treasury stock method affects the denominator of the EPS equation. The method assumes the proceeds from exercised options would be used to repurchase outstanding stock, therefore the net number of shares added to the denominator is less than the additional shares that would be outstanding from exercised options. To illustrate, assume 10,000 options are outstanding to purchase shares at $24 per share. Shares have been selling at an average of $30 per share. Using the treasury stock method, we would compute an incremental number of shares to be added to the denominator. The proceeds from the exercise of the options would be $240,000 (10,000 x $24). Using the proceeds of $240,000 to purchase stock at $30 per share would result in the purchase of 8,000 shares ($240,000/$30). The incremental number of shares would be: Shares under option 10,000 Shares repurchased 8,000 Incremental shares 2,000 Using the numbers, it can be seen that if the average market price per share were less than the option price, the incremental number of shares would be negative, indicating an antidilutive security. Antidilutive securities are ignored in EPS calculations. When calculating fully diluted EPS, shares are repurchased at the average or yearend market price, whichever is higher. If the yearend market price is higher, fewer shares can be repurchased from the proceeds, thereby increasing the incremental number of shares to be added to the denominator. Therefore, the higher yearend price further dilutes the EPS statistic. The "IfConverted" Method. The if converted method assumes convertible securities are converted during the period of time they are outstanding. This method affects both the numerator and the denominator of the EPS calculation. If bonds were converted, interest expense (less applicable taxes) would be avoided, therefore net income would increase. If preferred stock were converted, no dividends would be paid, therefore dividends would not be deducted from net income in the numerator. Conversion of either bonds or preferred stock would increase the denominator number of shares. Three Percent Materiality Test. After simple, primary, and fully diluted EPS have been calculated, the three percent materiality test is used to determine what EPS statistic should be presented. If the change from simple to fully diluted EPS is less than three percent, only simple EPS is presented. If the dilution is three percent or greater, both primary and fully diluted EPS are presented instead of simple EPS. Concerns and Criticisms of Opinion No. 15 RequirementsSeveral concerns have been raised regarding the assumptions required and methods used when calculating EPS. Common Stock Equivalency Test. In dealing with dilutive securities, the determination of common stock equivalency status for convertibles has two problems. First, CSE status is determined only at the date of issuance; the status at that date is considered permanent throughout the life of the security and ignores any changes in market factors. Secondly, the probability of conversion based on this CSE status remains unproven. Treasury Stock Method. Use of the treasury stock method to incorporate the effects of options and warrants has also been criticized. This method assumes management will use the proceeds from exercised options and warrants to repurchase outstanding shares at either the average or yearend market price. There appears to be no support for the assumption management will necessarily use these proceeds to purchase their own common stock rather than numerous other investment alternatives. Further, by making this assumption, the denominator effect on diluting EPS is diminished since only the incremental net additional shares are included, rather than the total number of additional shares issued. This method is further arbitrarily complicated by use of the modified treasury stock approach that limits reacquisition to 20% of common shares outstanding. Any excess proceeds are assumed to first reduce outstanding debt and then acquire government securities, which could therefore affect the numerator income by decreasing interest expense or increasing interest income, respectively. Disclosure of Dilutive Possibilities. An additional concern is whether the presented EPS data adequately disclose dilutive possibilities. As discussed earlier, first simple EPS must be calculated, followed by an incorporation of the effects of dilutive securities to compute two diluted EPS numbers‹primary and fully diluted. The three percent materiality test is then applied to determine whether to present simple EPS or both of the diluted measures. Several problems relate to this choice of presentation: * The three percent test assumes potential dilution of less than three percent is immaterial, therefore is of no interest to readers. * The presentation of only simple EPS provides no disclosure of potential dilution. * If both diluted EPS numbers are presented, the simple EPS number is not included, which completely substitutes pro forma possibilities for historical data. * The two diluted EPS numbers do not represent the minimum nor maximum points on the range of EPS. Date of Exercisability. An additional problem concerns the date of exercisability of dilutive securities. The effects of dilutive securities are not included in primary EPS if the securities are not exercisable within five years, while the effects are not included in fully diluted if not exercisable within 10 years. While the time limits appear reasonable, they are relatively arbitrary and empirically unsubstantiated. Ignoring the effects of securities exercisable beyond these time limits diminishes disclosure of the range of potential dilution. Tentative FASB ConclusionsA primary objective of the FASB project is to simplify the computation of EPS, which many consider difficult, burdensome, and arbitrary. After considerable debate, the FASB project personnel have reached some tentative conclusions. It is expected the FASB will reaffirm the major provisions of APB Opinion No. 15 and its applicability to publicly held companies. Nonpublic companies would comply with these guidelines if presenting EPS. However, specific calculation and presentation changes will be recommended. * "Basic EPS" will replace "Primary EPS." Basic EPS will be the same as simple EPS as presently calculated. * Only one "Diluted EPS" number will be calculated and presented. This calculation will include convertible securities using the ifconverted method and options and warrants using the treasury stock method. * Three changes are advocated in the treasury stock method. * Only the average price for the period would be used when repurchasing stock. * The modified treasury stock approach that limited the repurchase of stock to 20% of outstanding stock would be eliminated. * All dilutive securities would be included in the diluted EPS calculation, regardless of the time period of exercisability. * "Income from Operations" rather than "Net Income" would become the control number for determining whether incremental denominator shares in the diluted EPS become antidilutive. This is important in the case of a loss, since adding additional shares to the denominator reduces the loss per share. In this case, basic and diluted EPS would be the same number, even if dilutive securities are present in the capital structure. * The three percent materiality test is eliminated, thus both Basic and Diluted EPS would be presented, even if they are the same number. * EPS on all items below income from continuing operationsi.e., discontinued operations, extraordinary items, and cumulative effect of a change in accounting principlewould be presented. These EPS statistics would be presented on the face of the income statement or in supplemental notes to the financial statements Comparison of Present vs. Proposed EPS RequirementsTable 2 summarizes the current requirements for calculating and presenting EPS as well as the FASB project's tentative conclusions for revising these rules. Additional recommendations include‹ * subsequent period balancesheet changes materially affecting the number of shares outstanding must be disclosed. * a reconciliation of both the numerator and denominator between "basic" and "diluted" EPS must be presented. * retroactive restatement of prior periods' EPS to meet new standards. Does the Proposal Answer All Criticisms?All the criticisms of APB Opinion No. 15 have not been addressed by the FASB's proposal. Calculation and Assumption Issues. In implementing APB Opinion No. 15, the tests for determining common stock equivalency status and the means of including dilutive securities in EPS calculations were strongly criticized. There will be no test for CSE status under the tentative proposals. Since CSE status was only applicable for primary EPS, eliminating primary EPS has eliminated the test for CSE. The ifconverted method would be retained as the means of including the effects of convertible securities. However, the five and 10 year time limits for exercisability would be dropped for all dilutive securities‹convertibles, options, and warrants. With regard to including options and warrants, the treasury stock method would be retained. Although this method assumes management intends to use the proceeds to repurchase stock and dampens the dilutive effect of options and warrants, the FASB would retain its use. When implementing the treasury stock method, calculation difficulties would be eased by assuming average repurchase price and dropping the 20% outstanding share limit. This would reduce necessary comparisons between average and yearend prices. Also, no adjustment to the income numerator for possible reduction of interest expense or increased interest income from hypothetical management investment alternatives would be required. Presentation Issues. Tentative conclusions would remove the three percent materiality test, therefore, both basic and diluted EPS are presented. This would address the concerns of an either/or presentation. Basic EPS would be based on reported financial data, while diluted EPS would present pro forma information. This also would remove the assumption that threepercent dilution is the materiality threshold for inclusion. Consistency of presentation would be required for income items below taxes. EPS on all items would be required. Additional post balancesheet changes that substantially affect the number of shares outstanding would be disclosed. A new reconciliation between basic and diluted EPS will provide additional disclosure. * Lynn K. Saubert, PhD, CMA, CPA, is a professor of accounting and R. Wayne Saubert an associate professor of accounting, both at Radford University in Radford, VA. Philip L. Little, DBA, CPA, is an associate professor of accounting at Western Carolina University. Dilutive Exercise Securities Period Primary EPS Only common stock 5 years equivalents Fully Diluted EPS All 10 years TABLE 1 COMPARISON OF PRIMARY AND Editor: Douglas R. Carmichael, PhD, CPA Baruch College JANUARY 1996 / THE CPA JOURNAL Companies with simple capital structures provide only simple EPS. Companies with complex capital structures present either simple EPS or both primary and fully diluted EPS, depending on threepercent test of dilution. Convertible securities are included using the if converted method. Options and warrants are included using the "treasury stock method." Treasury stock method assumes repurchase of shares at average price for the period for primary EPS; but assumes repurchase of shares at average or yearend price, whichever is higher, for fully diluted EPS. Modified treasury stock method limits repurchase of shares to 20% of outstanding stock, then assumes retirement of debt and purchase of government securities, sequentially. EPS data required for cumulative effect, but optional for discontinued operations & extraordinary items. For primary EPS, dilutive securities are included if exercisable within five years. For fully diluted EPS, include if exercisable within ten years. Tentative Conclusions Same requirement, only would be called "basic EPS" Companies with complex capital structures present two EPS numbersbasic and diluted EPS (even if the same amount). Same Same (with some modifications) Treasury stock method would always use average for the period price. Modified treasury stock method is eliminated. EPS data for discontinued operations, extraordinary items and cumulative effects must be disclosed, either on the income statement or in notes to financial statements. Dilutive securities are included in calculation of diluted EPS regardless of date of exercisability. TABLE 2 PRESENT & PROPOSED EPS REQUIREMENTS JANUARY 1996 / THE CPA JOURNAL
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