|DAVID T. MEETING, CPA, DBA, is associate professor
of accounting at Cleveland State University in Ohio. |
DAVID B. LAW, CPA, DBA, is associate professor of accounting at Youngstown State University, Youngstown, Ohio.
RANDALL W. LUECKE, CPA, CMA, is vice-president, administration and chief financial officer of IAS, a division of the Canadian Standards Association in Westlake, Ohio.
Many CPAs and financial statement users believed Accounting Principles Board Opinion no. 15, Earnings per Share , was arbitrary and unnecessarily complex. A major concern was the concept of common stock equivalents in computing primary earnings per share (EPS). Under the old rule, primary EPS was designed to reflect the dilution of common stockholders earnings resulting from the increase in common shares due to the probable conversion or exercise of common stock equivalents. CPAs and financial statement users thought primary EPS should reflect no dilution. A new Financial Accounting Standards Board statement addresses this concern by simplifying the computation, eliminating primary EPS and common stock equivalents and replacing them with basic EPS, which reflects no dilution.
SPLIT IN TWO
The FASB issued an exposure draft, Earnings per Share and Disclosure of Information About Capital Structure , in January 1996. In issuing a final statement, the ED was split into two parts because each had a different scope.
- Statement no. 128, Earnings per Share , requires all entities with publicly held common stock or potential common stock to report EPS according to the statement. It applies only to public companies and replaces APB Opinion no. 15; American Institute of CPAs Accounting Interpretation nos. 1 to 102 of Opinion no. 15; Accounting Interpretation nos. 1 and 2 of Opinion no. 20, Accounting Changes ; FASB Interpretation no. 31, Treatment of Stock Compensation Plans in EPS Computations ; and FASB Statement no. 85, Yield Test for Determining whether a Convertible Security Is a Common Stock Equivalent .
- Statement no. 129, Disclosure of Information about Capital Structure , consolidates existing pronouncements on required disclosures about a companys capital structure. It applies to all entities.
The International Accounting Standards Committee also had issued an ED on EPS. Both EDs focused solely on determining the number of shares in the EPS denominator. The two major components of EPS are the earnings available to common shareholders—the numerator—and some measure of the number of common shares—the denominator. The FASB and the IASC worked jointly to resolve denominator-related issues because they believed there were more areas of agreement and less complexity about share calculations than about income measurement.
Statement no. 128 simplifies U.S. generally accepted accounting principles and tries to harmonize U.S. and international GAAP on this issue. The statement also advances the FASBs goal of increasing comparability of global accounting standards. International Accounting Standard no. 33, Earnings Per Share, which has substantially the same requirements as Statement no. 128, was issued at the same time as the FASB statement.
Statement no. 128 requires all public companies to disclose basic EPS if they have a simple capital structure with no potential common shares from convertible securities, stock options or warrants. Any company with potential common shares has a complex capital structure and must disclose both basic and diluted EPS.
The objective of basic EPS is to measure performance for the reporting period by dividing income available to common shareholders by the weighted average number of shares outstanding (see the flowchart). The statement requires companies to use income from continuing operations or a similar line on the income statement. Shares issued or reacquired (treasury stock) are weighted for the period they are outstanding.
The number of common shares outstanding is adjusted retroactively for stock dividends, stock splits and reverse stock splits. For example, if a stock splits in June 1997, the weighted average number of shares is computed assuming the split occurred at the beginning of 1997. A companys presentation of EPS in its financial statements for any earlier years also has to be adjusted for the split. If the split occurs in early 1998, before the 1997 statements are issued, those statements and all other years presented have to be adjusted as well. The same handling of stock splits and stock dividends applies to diluted EPS.
Common shares issued in partly paid form and stock subscriptions that are entitled to dividends in proportion to the amount paid are part of the basic EPS computation. A company must include the equivalent common shares in the denominator. Stock subscriptions that are partially paid and do not share in dividends until fully paid are treated like warrants and included in diluted EPS using the treasury stock method, discussed later.
Income available to common shareholders is operating income less preferred stock dividends declared for noncumulative preferred stock. For a cumulative preferred stock, current-year dividends are deducted whether declared or not. If a company has preferred stock for which the dividends are cumulative only if earned, it must deduct the dividends earned in calculating EPS.
A company with a simple capital structure and no potential common shares has to report EPS for continuing operations and net income on the face of the income statement. EPS for discontinued operations, extraordinary items and the cumulative effect of an accounting change must be disclosed in the income statement or in the notes to the financial statements.
Glossary of Terms
Antidilution . A decrease in the loss per share or increase in earnings per share caused by inclusion of a contingent security, convertible security, option or warrant in diluted EPS.
Basic EPS . The per share amount of earnings for the period available for each common stock share outstanding.
Common stock equivalent . A security under APB Opinion no. 15 that is in substance equivalent to common stock because of the terms or circumstances at the time of issuance. These securities were deemed to be those whose exercise or conversion was probable.
Contingently issuable shares . Shares issuable when certain conditions are met. Usually little or no cash consideration is involved.
Convertible security . A security convertible into common stock at a predetermined conversion rate—for example, a convertible preferred stock where each share of preferred stock is convertible into three shares of common stock.
Diluted EPS . EPS calculated to show, on a pro forma basis, per share earnings for the period available to common shareholders assuming the exercise or conversion of all securities that are exercisable or convertible into common stock and which would either dilute or not affect basic EPS.
Dilution . The "watering down" or decrease in EPS from the exercise or conversion of securities into common stock. Diluted EPS shows dilution on a pro forma basis.
Earnings per share . In a general sense, these are earnings attributable to each share of common stock for a period. However, per common share amounts also are calculated for income from continuing operations and intermediary items, such as discontinued operations, extraordinary items and changes in accounting principles.
Exercise proceeds . Amounts assumed received by a company from the pro forma exercise of options, warrants and convertible securities.
Primary EPS . Earnings attributable to each share of common stock, taking into account the pro forma exercise or conversion to common shares of common stock equivalents. This was required under APB Opinion no. 15 and was to represent the dilution of earnings that would result from the probable exercise or conversion of securities to common stock.
CALCULATING DILUTED EPS
A company with potential common shares has, by definition, a complex capital structure. Income or loss from continuing operations is the number used to determine whether diluted EPS is decreased relative to basic EPS by the possible effect of potential common shares. For a company with a loss from continuing operations, the exercise or conversion of any potential shares increases the number of shares in the denominator and results in a lower loss per share. In that situation, the potential shares are antidilutive and not included in the companys EPS calculation. Statement no. 128 says that if there is a loss from continuing operations, diluted EPS is the same as basic EPS.
A company with income from continuing operations must calculate diluted EPS. Statement no. 128 requires companies to calculate earnings per incremental share for each group of potential common shares. In general, earnings per incremental share—or the incremental per share effect of any security that could produce common shares—is the increase in net income from the pro forma exercise or conversion of the security divided by the weighted average increase in the number of common shares that would result from the conversion. The company ranks the potential shares and includes them in the diluted EPS calculation by first including the most dilutive shares, then the next most dilutive and so on to the least dilutive shares. The process stops when the resulting diluted EPS is the lowest figure obtainable.
Contingent shares whose issuance depends solely on the passage of time are considered already issued in calculating diluted EPS. A company calculates an earnings per incremental share for each block of shares. A company makes the same computation for each block of shares whose issuance is contingent on factors other than time (such as income or the number of stores opened for a retail company) when the contingency is currently satisfied.
Convertible securities . These enter into the EPS calculation through the "if-converted" method whereby the securities are assumed converted and an earnings per incremental share is computed. APB Opinion no. 15 used the if-converted method for convertible securities but did not require an incremental per share effect to be calculated.
Convertible securities outstanding for the entire period are assumed converted at the beginning of the period. Convertible securities issued during the period are treated as if they were converted at the date of issuance. For example, for a calendar-year corporation, convertible bonds issued in a prior period are treated as if they were converted at January 1 of the current period. Convertible bonds issued March 1 are assumed converted as of that date. In either case, the foregone interest expense—aftertax—must be added to the EPS numerator. The earnings per incremental share is the aftertax foregone interest expense divided by the number of shares of common stock that would have been issued from the conversion weighted for the period they would have been outstanding.
The if-converted method also applies to convertible preferred stock. The stock is assumed converted at the beginning of the period if it is outstanding at that time. Stock issued during the period is treated as if it were converted at the date of issuance. The earnings per incremental share equals the preferred stock dividends (if deducted from income available to common shareholders in the basic EPS calculation) divided by the number of shares of common stock issued from the assumed conversion.
Illustration . On March 1, ABC Corp., a calendar-year corporation, issues 2,000 convertible 6%, $1,000 bonds. Each bond is convertible into 40 shares of common stock. The tax rate is 40%. The pretax bond interest expense is $100,000 ([$1,000 3 2,000] 3 .06 3 10/12). The if-converted method assumes the bonds were converted on March 1. In this scenario, ABC avoids the $100,000 pretax interest expense, increasing its operating income by $60,000 ($100,000 3 [1-.40]). The number of shares from the assumed conversion is 80,000 (40 shares 3 2,000 bonds). Since the conversion is assumed to occur on March 1, the shares must be weighted for the period they were assumed outstanding (10 of 12 months), resulting in 66,667 weighted average shares (80,000 3 10/12). The per share incremental effect is the aftertax interest saved divided by the weighted average shares or $0.90 ($60,000/66,667).
A company must calculate the incremental per share effect for each group of convertible securities. Any such security for which the effect is greater than basic EPS based on operating income is considered antidilutive and is not included in a companys diluted EPS computation. Convertible securities with an incremental per share effect less than basic EPS, based on operating income, will be ranked by the company later.
WHAT TO DO WITH OPTIONS, WARRANTS AND EQUIVALENTS
Options, warrants and their equivalents are included in EPS calculations through the treasury stock method. However, there are some differences between the treasury stock method in Opinion no. 15 and that in Statement no. 128. In the new statement, the treasury stock method is used for options, warrants and their equivalents with an average market price of the companys stock that is greater than the option or exercise price. This method assumes holders of the options, warrants or equivalents exercise them at the later of the beginning of the year or the date of issuance and that the company uses the exercise proceeds to buy treasury stock at the average market price of the companys stock for the accounting period. An incremental per share effect is calculated for each option, warrant or equivalent, although it would be zero in most cases. The denominator is the number of incremental shares assumed to be issued from the security, less the number of shares assumed to be repurchased, weighted by the period they are assumed to be outstanding.
Opinion no. 15 had an upper limit of 20% of shares outstanding at the end of the year that could be assumed to be repurchased under the treasury stock method. In an effort at simplification, Statement no. 128 has no upper limit on how much treasury stock is assumed to be repurchased.
After calculating incremental EPS for each contingent share group, convertible security and group of options, warrants and equivalents, a companys next step is to rank all potential common shares from the lowest EPS effect (most dilutive) to the highest EPS effect (least dilutive), excluding all potential shares with an incremental per share effect greater than basic EPS for income from continuing operations. The company then calculates EPS for continuing operations, taking into account the potential shares with the lowest incremental EPS first. If the new figure is lower than the previous one, the company recalculates EPS, including the potential shares with the next lowest incremental EPS. The process of including increasingly less dilutive shares continues until the resulting EPS figure increases or there are no more potential shares. Introducing blocks of potential common shares in the order of decreasing effect on diluted EPS guarantees that the final figure expresses maximum dilution.
INCOME STATEMENT PRESENTATION
Companies with only common stock outstanding have a simple capital structure and should present basic EPS for income from continuing operations and net income on the face of the income statement. A company that does not report a discontinued operation but reports an extraordinary item or cumulative effect of an accounting change should report basic EPS for net income before extraordinary items or net income before accounting change and net income on the face of the income statement. A company should report per share amounts for discontinued operations, extraordinary items and the cumulative effect of an accounting change in a period either on the face of the income statement or in the notes to the financial statements. It should present basic EPS for all periods for which income statements or summaries of earnings are presented.
Companies with complex capital structures should present basic and diluted EPS for income from continuing operations and net income in the same way. Similarly, companies without discontinued operations but that report an extraordinary item or cumulative effect of an accounting change should report EPS figures as described above. A company also should report per share amounts for discontinued operations, extraordinary items and the cumulative effect of an accounting change in a period as described above. Statement no. 128 requires dual presentation of EPS for all periods for which income statements or summaries of earnings are shown. Also, if diluted EPS is reported for at least one period, it must be reported for all—even if basic and diluted EPS are the same.
NEW COMPUTATIONS REQUIRED
While Statement no. 128 retains the treasury stock and if-converted methods as the main means of calculating diluted EPS (see the flowchart), the statement introduces two new computational methods, as well as retaining rules for combining or blending the old methods. The treasury stock and if-converted methods are blended when securities combine features of both convertible securities and options and warrants.
For example, when a cash payment is required or permitted at the conversion of a convertible security, the cash proceeds assumed to be received also are assumed—using the treasury stock method—to be applied to repurchase common stock. The if-converted method is used for the conversion itself. Another example is when stock options or warrants include a feature requiring that the cash proceeds be used to retire debt. In that situation, the company uses the if-converted method to calculate the effect on operating income available to common shareholders from the assumed debt retirement, while it uses the treasury stock method to figure the effect of the excess proceeds. Some options and warrants permit or require the holders to tender debt or other securities of the issuer when exercising the options or warrants. If tendering the debt is more advantageous to the holder, the if-converted method is used to calculate the incremental per share effect.
Reverse treasury stock method . The first of the new methods is applied to any contract, such as written put options or forward purchase contracts, that requires an entity to repurchase its own stock and that is "in the money"—the exercise price is above the average market price—during the reporting period. To calculate the potential dilution, assume a company issues common stock at the beginning of a period at the average market price. It then uses the proceeds to repurchase fewer shares at the higher exercise price. The incremental number of shares remaining increases the denominator of diluted EPS.
Theoretical ex-rights method . The second new method replaces the treasury stock method when calculating the effect of a stock rights issue. The bonus element in a rights issue has the same effect as a stock dividend, requiring a restatement of shares outstanding. The restatement factor applied to the number of common shares a company has outstanding is determined by dividing the fair value of common stock on the day the rights issue was offered by the theoretical fair value of the stock immediately after the rights were offered. A company calculates the theoretical value by dividing the sum of the stocks market capitalization on the day of the rights issue and the total assumed proceeds from it by the total number of shares outstanding and assumed issued for the rights issue. The restatement factor is applied to the denominator of both basic and diluted EPS.
FASB 129: Information About Capital Structure
Financial Accounting Standards Board Statement no. 129, Disclosure of Information about Capital Structure , consolidates the established accounting pronouncements on required disclosure of information about a companys capital structure. The disclosure rules apply to all entities. The statement contains no new requirements for companies that reported previously under Accounting Principles Board Opinion no. 10, Omnibus Opinion-1966 , APB Opinion no. 15, Earnings per Share and FASB Statement no. 47, Disclosure of Long-Term Obligations .
Statement no. 129 consolidates
Effective date. Statement no. 129 is effective for financial statements for both interim and annual periods ending after December 15, 1997.
For each period for which a company presents an income statement, it must disclose
- A reconciliation of the numerators and denominators of basic and diluted EPS from continuing operations, including the individual income and per share effects of all securities used in the computations.
- The effect of preferred dividends in arriving at income available to common stockholders in basic EPS.
- The securities not included in the diluted EPS computation (because they were antidilutive in the current period) that could potentially dilute basic EPS in the future.
- A description of any transaction that occurs after the end of the period but before the financial statements are issued that would materially change the number of common shares or potential shares.
The mandatory reconciliation of the numerators and denominators of basic and diluted EPS allows users to assess each securitys dilutive effect. Combining that information with the details about securities not used because they are antidilutive allows users to determine their own measures of EPS.
Effective date . Statement no. 128 is effective for financial statements for both interim and annual periods ending after December 15, 1997. After the effective date, all prior- period EPS data must be restated to conform to the statement. Early application is not permitted.
Statement no. 128 simplifies the computation of EPS compared with earlier accounting standards. The simplification, brought about by eliminating common stock equivalents and the primary EPS calculation, also eliminates a source of arbitrariness. Substituting basic EPS for primary EPS in dual presentations (basic and diluted EPS) for companies with complex capital structures allows financial statement users to have more relevant figures available to them.
FASB Statement no. 128 and IASC Standard 33 bring U.S. and international GAAP into concurrence on calculating the number of shares in the EPS denominator. Although the numerator in EPS calculations in both statements is income available to common shareholders, the two standard-setting bodies avoided addressing differences between U.S. and international GAAP in computing net income. While these statements bring some comparability to EPS in companies from different countries, users must be aware that the net income computation is not necessarily comparable and hence EPS amounts of such companies are not completely comparable. However, Statement no. 128 is tangible evidence of what the two standard-setting bodies can accomplish when they cooperate.