New Earnings per Share

Standard

Simplifying the computationBy John E. Elsea and Bill D. CoxIn Brief

Two Goals--Simplification and Comparability

In February l997, the FASB issued Statement of Financial Accounting Standards No. 128, Earnings per Share, which contains new standards for determining and reporting earnings per share (EPS). These new standards are intended to simplify the current standards and make them comparable to international EPS standards. They are effective for financial statements issued for periods ending after December 15, l997.

APB Opinion No. 15, Earnings per Share, issued in l969, was the first official accounting pronouncement to require presentation of EPS figures in the income statement and provide detailed information on how to compute EPS. This opinion, which guides current practice, proved to be so complex and controversial that by 1971 the AICPA had published 102 accounting interpretations related to it. According to the FASB, the EPS rules contained in Opinion No. 15 often are misunderstood by preparers and auditors and are not always applied correctly.

SFAS No. 128 will replace "primary EPS" with "basic EPS." Basic EPS is calculated by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. As a result of the elimination of primary EPS, several tests for common stock equivalency are also eliminated. Companies with simple capital structures need only report basic EPS. Companies with complex capital structures must present basic and "diluted EPS." The computation of diluted EPS involves possible consideration of three major security groups: options and warrants, contingent shares, and convertible securities.

In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 128, Earnings per Share, which contains new rules for determining and reporting earnings per share (EPS). The new statement is intended to simplify current standards for computing and presenting EPS and make them comparable to international standards. SFAS No. 128 is effective for financial statements issued for periods ending after December 15, 1997, and applies to companies with publicly held common stock or potential common stock.

Historical Background

Approximately a half century ago, accountants were discouraged from being associated with the reporting of EPS amounts. In Accounting Research Bulletin (ARB) No. 43 (AICPA, 1961), the Committee on Accounting Procedure (CAP) expressed concern that undue importance was being attached to a single net income figure and to earnings per share. The CAP also asserted it was undesirable in many cases to disseminate "information in which major prominence is given to a single figure of net income or net income per share." The CAP stated further, ". . . if such income data are reported . . . the committee strongly urges that any determination of income per share be related to the amount designated in the income statement as net income and that where material extraordinary charges or credits have been excluded from the determination of net income, the corresponding total or per-share amount of such charges and credits also be reported separately and simultaneously."

During the l950s, earnings per share presentations became quite common. In ARB No. 49, Earnings per Share (AICPA, l961), the CAP reaffirmed its positions given in ARB No. 43, and suggested three general guides to be used in computing EPS. These were l) ". . . the term earnings per share should be used to designate the amount applicable to each share of common stock or other residual security outstanding, 2) earnings per share, . . . should generally be stated in terms of the common stock position as it existed in the years to which the statistics relate, unless it is clear that the growth or decline of earnings will be more fairly presented, as for example, in the case of a stock split, by dividing prior years' earnings by the current equivalent of the number of shares then outstanding, and 3) in all cases in which there have been significant changes in stock during the period to which the computations relate, an appropriate explanation of the method used should accompany the presentation of earnings per share."

The Accounting Principles Board (APB) first addressed the subject of EPS in APB Opinion No. 9, Reporting the Results of Operations (AICPA, 1966). In this opinion, the APB strongly encouraged companies to disclose EPS amounts in the income statement for income before extraordinary items, extraordinary items (if any), and net income, instead of reporting a single EPS figure. The APB also stated that if potential dilution in EPS may occur as a result of conversions, outstanding options and warrants, or contingent share distributions, supplementary pro forma EPS amounts should be reported in the income statement showing what the earnings would be if the conversions or other stock issuances took place. Unfortunately, Opinion No. 9 gave only limited guidance on how to compute EPS.

Current Practice

APB Opinion No. 15, Earnings per Share (AICPA, 1969), which guides current practice and provided a standard for computing EPS on a consistent basis, was the first official accounting pronouncement to require the presentation of EPS figures in the income statement and to provide detailed information on how to compute EPS. This opinion identifies two types of capital structures--simple and complex. A simple capital structure is one that consists of only common stock or includes no potential dilutive securities, warrants, options, or other rights, that upon conversion or exercise, could dilute EPS. Companies with simple capital structures are required to present a single presentation of EPS. Companies with capital structures that do not qualify as simple capital structures are considered to have complex capital structures and are required to present two types of EPS data--primary EPS and fully diluted EPS. A dual presentation is not required, however, if dilution in the aggregate is less than three percent.

In addition to primary EPS and fully diluted EPS, Opinion No. 15 introduced several new terms and concepts (e.g., common stock equivalents, the "if converted" method, and the treasury stock method) in computing EPS.

Opinion No. 15 proved to be so complex and controversial that by 1971 the AICPA had published 102 accounting interpretations relating to it. According to the FASB, a number of empirical studies have indicated the EPS rules contained in Opinion No. 15 often are misunderstood by preparers and auditors and are not always applied correctly. As indicated previously, one of the objectives of SFAS No. 128 is to simplify the standards for computing and presenting EPS.

Basic Earnings per Share

SFAS No. 128 replaces "primary earnings per share" with "basic earnings per share." Basic earnings per share is determined from historical data and measures the earnings per common share for the accounting period. It is calculated by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period as was done to calculate simple earnings per share under Opinion No. 15. Income available to common shareholders is defined as net income (or income from continuing operations) minus preferred dividends paid or declared and any current year preferred dividends on cumulative preferred stock not declared or paid. Companies that have a discontinued operation, extraordinary item, or cumulative effect of a change in accounting principle are to use income from continuing operations as the "control number" in determining whether potential common shares are dilutive or antidilutive. Weighted average number of shares are calculated the same as they were under Opinion No. 15, taking into consideration all items such as stock sales, treasury stock transactions, securities exercised or converted during the period, and stock splits and stock dividends, retroactively applied. Entities with only common stock outstanding and no other securities that can result in the issuance of common shares have a simple capital structure and only need to report basic per share amounts.

SFAS No. 128 eliminates primary earnings per share and, as a result, also eliminates several tests for common stock equivalency. They are the "five-year test" and "three-month rule" for options and warrants, and the "five-year test" and "effective-yield test" for convertible securities. The "three-percent rule or method" for determining when primary or fully diluted earnings per share should be presented has also been eliminated.

Diluted Earnings per Share

Entities with securities exercisable or convertible into common shares have a complex capital structure and must present basic and diluted earnings per share amounts. According to the FASB, "The objective of diluted EPS is consistent with that of basic EPS--to measure the performance of an entity over the reporting period while giving effect to all dilutive potential common shares that were outstanding during the period." While basic EPS is determined from historical data, dilutive EPS also takes prospective events into consideration and presents a conservative scenario. As a result, the reader is made aware of the range within which EPS might fall. The computation of dilutive earnings per share involves possible consideration of three major security groups: options and warrants, contingent shares, and convertible securities. A major difference between SFAS No. 128 and Opinion No. 15 is that all securities in the above groups will be used in the calculation of diluted EPS, if dilutive.

Options and Warrants. SFAS No. 128 is also similar to Opinion No. 15 in that the treasury stock method is used to determine the dilutive effect of outstanding options, warrants, and their equivalents. The treasury stock method formula is as shown in Exhibit 1:

A departure from Opinion No. 15 is found in the denominator of the formula. Fully diluted EPS under Opinion No. 15 uses the higher of the average or end of the period market price. Opinion No. 15 requires that the "modified treasury stock" method, also known as the 20% rule, be used if the number of common shares issuable upon exercise of all options and warrants in the aggregate exceed 20% of the number of outstanding shares at the end of the accounting period. This method has been eliminated in SFAS No. 128.

Contingent Shares. Contingent shares may be issuable upon the passage of time or upon attainment of certain conditions such as a certain earnings level. When all required conditions have been satisfied by the end of the accounting period, shares whose issuance are contingent upon those conditions are considered to be outstanding and included in the calculation of both basic and diluted EPS. For the purpose of calculating diluted EPS, when all the required conditions have not been met, contingently issuable shares are included based on current period earnings projected to remain constant until the end of the contingency period. The FASB decided to eliminate any increase in earnings (the numerator) for possible future earnings levels and restatement of prior period EPS for differences between actual and assumed earnings levels as required in Opinion No. 15.

Convertible Securities. Convertible securities such as convertible preferred stock and convertible bonds are to be included in the computation of diluted EPS using the "if converted" method, the same as under Opinion No. 15. These securities are assumed to be converted at the beginning of the period or issuance date, if later. The incremental amount to be added back to income will consist of the interest on debt (net of tax) and dividends on preferred stock. Convertible securities issued or converted during the period are to be included in the calculation of diluted EPS for that portion of the year they were in the form of convertible securities.

Earnings per Incremental Share. Earnings per incremental share should be calculated for each item that can be exercised or converted into common stock by dividing the amount that would be added back to income (income adjustment) by the number of additional shares that would be issued (share adjustment). Items are then included in the computation of diluted EPS in sequence from the most dilutive to the least dilutive. Under no circumstances are antidilutive securities to be included in the calculation of diluted EPS.

Presentation of Earnings per Share

Companies with a simple capital structure are required to present basic earnings per share from continuing operations and net income on the face of the income statement; whereas, companies with a complex capital structure must report both basic EPS and diluted EPS for these two items. EPS for discontinued operations, extraordinary items, and cumulative effect of a change in accounting principle may be shown on the face of the income statement or disclosed in a footnote (see Exhibit 2).

Disclosures

Certain disclosures are required by SFAS No. 128 each time an income statement is presented:

* Antidilutive securities not used in the calculation of diluted EPS in the current period that might be dilutive in the future

* The treatment given to preferred dividends in arriving at income available to common shareholders, and

* A reconciliation of basic and dilutive per share calculations for income from continuing operations (see Exhibit 3).

An additional disclosure is required for the last period for which an income statement is presented for transactions occurring after the balance sheet date, but prior to the issuance of the financial statements, that would have materially changed the number of outstanding common shares or potential common shares at the end of the period.

An Illustrative Case

This example illustrates the annual computation of basic and diluted EPS and the related incomes statement presentation for Lakeside Yachts Inc., a hypothetical company. Assumed data are presented below:

* Lakeside has income from continuing operations of $505,000, an extraordinary loss of $45,000, and a gain on cumulative effect of a change in accounting principle of $25,000 for the year ended December 31, 19X6. It had 100,000 shares of common stock outstanding throughout the year.

* $2,000,000 of 10-year, 8% bonds, with interest payable annually were issued in 19X5 at par value. Each $1,000 bond is convertible into 20 shares of common stock.

* 14,000 shares of $100 par value, 7.5% cumulative preferred stock were issued April 1, 19X3. Each share is convertible into two shares of common stock.

* 5,000 options were issued in 19X4, giving the holder of each option the right to purchase one share of common stock for $55. None of the options were exercised in 19X6. The stock was not volatile; therefore, quarterly averaging is not used. The average market price for the
year was $60, and the year-end price was $62.

* Stockholders of Lakeside Yachts, Inc. have voted to issue 6,000 shares of common stock to corporate officers as an incentive plan if income from continuing operations exceeds $550,000 for two consecutive years prior to 19X8. Income from operations in 19X5 was $475,000.

* The applicable tax rate is 30%.

The calculations of earnings per incremental shares are shown in Exhibit 4. Exhibit 5 shows the calculation of both basic and diluted EPS and Exhibit 6 shows the appropriate presentation in the income statement. *

John E. Elsea, PhD, CPA, is a professor of accounting, and Bill D. Cox, PhD, CPA, an associate professor of accounting, both at the University of Northern Colorado.