Download Chapter 19 | You Will Learn... 1. To detail recent changes in

CHAPTER 19
| YOU WILL LEARN...
1.
To detail recent changes in accounting standards relating to earnings per share,
and know why the changes were made and how these changes will affect
computations relating to earnings per share.
 In 1997, the FASB issued Statement No. 128, which provides new
requirements associated with earnings per share computations and
disclosure.
 Requires two EPS computations—basic and diluted.
 Dilution relates to those convertible securities and stock options that, if
exercised, would result in a decrease in EPS.
 The International Accountings Standards Committee issued a similar EPS
standard.
2.
To see the difference between a simple and a complex capital structure, and
understand how dilutive securities affect earnings per share computations.
 A simple capital structure exists when a company has only common stock, or
common and nonconvertible bonds outstanding, and there are no convertible
securities, stock options, warrants, or other rights outstanding.
 A company with convertible securities or stock options that would, if
exercised, result in a dilution in EPS is considered to have a complex capital
structure.
3.
To compute basic earnings per share, taking into account the sale and
repurchase of stock during the period as well as the effects of stock splits and
stock dividends.
 Basic EPS is computed by dividing income available to common shareholders
by the weighted average number of common shares outstanding.
 If a company splits its stock or declares a stock dividend, a retroactive
recognition of this change must be made in determining the weighted average
number of shares outstanding.
 When comparative financial statements are presented, the common shares
outstanding for all periods shown must be adjusted to reflect any stock
dividend or stock split in the current period.
4.
To use the treasury stock method to compute diluted earnings per share when a
firm has outstanding stock options, warrants, and rights.
 If a firm has stock options, warrants, or rights outstanding, a determination
must be made as to their potential effects on earnings per share.
 If the exercise price is less than the average market price for the period, the
option, warrant, or right is considered dilutive and would be included in
computing diluted EPS.
 The treasury stock method involves determining the number of incremental
shares that would be issued assuming the options, warrants, or rights were
exercised and the proceeds used to buy treasury shares on the market.
5.
To use the if-converted method to compute diluted earnings per share when a
company has convertible preferred stock or convertible bonds outstanding.
 A company with convertible securities may be required to adjust both the
numerator and the denominator in computing diluted earnings per share if
those convertible securities are determined to be potentially dilutive.
 In the case of convertible bonds, interest expense (net of tax) must be added
back to the numerator, and the number of shares that would be issued upon
conversion would be included in the denominator.
 For convertible preferred stock, preferred dividends must be added back to
income available to common shareholders, and the denominator would be
increased by the number of shares that would be issued upon conversion.
6.
To factor into the diluted earnings per share computations the effect of actual
conversion of convertible securities or the exercise of options, warrants, or rights
during the period, and understand the antidilutive effect of potential common
shares when a firm reports a loss from continuing operations.
 If conversion actually takes place during a period, an adjustment must be
made to reflect what the EPS would have been if conversion or exercise had
taken place at the beginning of the period or issuance date, whichever comes
later.
 In the case of a firm reporting a loss from continuing operations, no dual
presentation of EPS is required since inclusion of stock options or convertible
securities would decrease the loss per share and thus always would be
antidilutive.
7.
To determine the order in which multiple potential dilutive securities should be
considered in computing diluted earnings per share.
 In those instances where a firm has multiple potentially dilutive securities, the
FASB requires a systematic procedure for determining the order in which the
various securities are considered.
 The individual effect of each security is computed, and the securities are
considered in turn beginning with the security with the least favorable effect
on basic EPS.

The procedure is repeated until the diluted EPS figure is lower than the next
security’s incremental impact.
8.
To understand the disclosure requirements associated with basic and diluted
earnings per share computations.
 Basic and diluted EPS are required to be disclosed on the face of the income
statement for those companies with a complex capital structure.
 Firms reporting below-the-line items on their income statement may report the
per-share effects of these items either on the face of the income statement or
in the notes.
 In addition, a schedule reconciling both the numerator and the denominator
for the basic and diluted per-share computations must be provided in the
notes to the financial statements.
9.
To make complex earnings per share computations involving multiple potentially
dilutive securities.
 For firms with stock options, warrants, rights, convertible preferred stock,
and/or convertible bonds, the computations associated with diluted EPS can
become quite complex.
 For those items that are dilutive or potentially dilutive, considering them in the
proper sequence will ensure that diluted EPS is properly calculated.
| IMPORTANT POINTS
Complexity of EPS Calculations
You may have difficulty with earnings per share calculations.
A conceptual
understanding is necessary but content mastery requires extensive practice of the
actual calculations. Systematic, step-wise approaches should be utilized to achieve
constant reinforcement of overall computational approaches as each additional
complexity is introduced.
Usefulness of EPS Calculations for Complex Capital Structures
Substantial departure from realism occurs progressively with the abundance of pro
forma assumptions that must be made as EPS computations advance along the
succession from basic EPS to diluted EPS. Think about possible alternatives to the
dual presentation scheme currently required by professional standards.
Incremental EPS Impact of Potentially Dilutive Securities
You may have difficulty dealing with the order of entry of individual convertible securities
into the computation of EPS when multiple dilutive securities exist. Emphasize the use
of the incremental EPS impact computation.