Download Earnings per share

INTERMEDIATE
ACCOUNTING
Chapter 16
Retained Earnings and Earnings Per Share
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Requirements to Distribute Dividends
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Retained Earnings is an account used by a corporation to
summarize the earned capital component of its shareholders’ equity,
which primarily comprises the cumulative amount of net income over
the life of the corporation, minus the cumulative amount of dividends
paid out to shareholders.
A deficit is a negative retained earnings balance resulting from a
corporation’s accumulated prior net losses or dividends in excess of
earnings.
To pay cash dividends, a corporation must meet legal requirements
and have assets available for distribution.
Usually, a corporation must restrict the amount of retained earnings
available for dividends by the cost of treasury shares held.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Cash Dividends
(Slide 1 of 2)
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The most common type of dividend is the cash dividend.
Four dates are important for any type of dividend:
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Declaration date
Ex-dividend date
Date of record
Date of payment
The declaration date is the date the board of directors formally
declares that a dividend will be distributed to shareholders of
record on a specific future date, typically four to six weeks.
The ex-dividend date occurs several days before the date of
record to enable the corporation to update its shareholders’
ledger by the date of record.
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Cash Dividends
(Slide 2 of 2)
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The ex-dividend date is important to investors because
on the ex-dividend date the stock stops selling with
dividends attached.
The date of record is the date which determines which
shareholders will receive the dividend for the next
payment date. These investors are listed in the
shareholders’ ledger on the date of record.
The date of payment is the date the corporation
distributes the dividend checks and makes a journal
entry to eliminate the liability and reduce cash.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Property Dividends
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A property dividend is a dividend that is payable in assets
other than cash (such as inventory or investments) and often
referred to as a dividend in kind.
A property dividend occurs when a corporation enters an
exchange in which it gives up something of value but for which it
receives no asset or service in return.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Script Dividends
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A corporation may have adequate retained earnings to
meet the legal dividend requirements but insufficient cash
to justify a current cash dividend.
In this case, it may declare a script dividend and issue
promissory notes (called “script”) requiring the corporation
to pay dividends at some future date.
The dividend liability will be classified as short-term or
long-term depending on the maturity date of the script.
Script dividends are rare.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock Dividends
(Slide 1 of 3)
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A stock dividend is a proportional (pro rata) distribution of
additional shares of a corporation’s own stock to its
shareholders.
Types of stock dividends:
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A stock dividend usually consists of the same class of shares. This
type of distribution is called an ordinary stock dividend.
The distribution of a different class of stock (i.e, common on
preferred) sometimes is called a special stock dividend.
A stock dividend differs from other dividends in that no
corporate assets are distributed.
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Stock Dividends
(Slide 2 of 3)
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The following factors may enhance the perceived
attractiveness of a stock dividend:
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The shareholders may see the stock dividend as evidence of
corporate growth.
The shareholders may see the stock dividend as evidence of
sound financial policy.
Other investors may see the stock dividend in a similar light,
and increased trading in the stock may cause the market price
not to decrease proportionally to the increased number of
shares.
The corporation may state that it will pay the same fixed cash
dividend per share.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock Dividends
(Slide 3 of 3)
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A stock dividend is not the same as a stock split.
Small stock dividends:
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Fair value is ordinarily the appropriate value to use when the
stock dividend is less than 20% or 25% of the previously
outstanding shares.
Large stock dividends:
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Valued at par value of the additional shares issued
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The total par value is transferred from retained earnings
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GAAP suggests that the use of the term dividend be avoided
or, when this is not possible, use terminology such as stock split
effected in the form of a dividend.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock Splits and Liquidating Dividends
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A stock split results in a corporation issuing additional shares.
A reverse stock split reduces the number of shares outstanding.
A stock split does not affect retained earnings.
Liquidating dividends represent a return of contributed
capital than a distribution of retained earnings.
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A corporation usually declares these dividends when it is ceasing or
reducing operations.
A liquidating dividend also may arise when a corporation with
natural resources pays a dividend based on earnings before
depletion.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How Do We Account for Prior Period
Adjustments (Restatements)?
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Prior period adjustments (restatements) are
retrospective adjustments of retained earnings that
can arise from changes in principles, change in
accounting entity, and corrections of errors of prior
periods.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Restrictions (Appropriations) of
Retained Earnings
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A restriction (appropriation) is a policy where the
board of directors makes a commitment that a
portion of retained earnings is unavailable for
dividends.
A board of directors may restrict retained earnings to
meet legal requirements, such as meeting a state’s
requirements concerning treasury stock.
The board may restrict retained earnings to meet
contractual restrictions related to issuing long-term
bonds.
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Accumulated Other Comprehensive Income
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Comprehensive income includes both net income and “other
comprehensive income.” Other comprehensive income (loss)
might include the following items:
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Unrealized increases (gains) or deceases (losses) in the fair value
of investments in available-for-sale securities
Translation adjustments from converting the financial statements
of a company’s foreign operations into U.S. dollars
Gains and losses on certain types of derivative financial
instruments that are designated as cash flow hedges
Certain types of pension plan gains, losses, and prior service cost
adjustments
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Earnings Per Share
(Slide 1 of 2)
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The primary components of net income (loss) are:
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Income (loss) from continuing operations, which includes operating
revenues and operating expenses
Results from discontinued operations, which includes the income (loss) from
the operations of a discontinued component as well as the gain (loss)
from the disposal of the discontinued component
Extraordinary gains or losses, which are the results of unusual and
infrequent events
Corporations are also required by GAAP to report earnings
per share information on its income statement.
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Earnings per share is calculated as net income minus preferred
dividends divided by weighted average number of common shares
outstanding.
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Earnings Per Share
(Slide 2 of 2)
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One ratio often used by investors to evaluate return
and risk is the price/earning ratio, which investors
often use in intercompany comparisons of share price
relative to profitability. The price/earnings ratio is
computed as follows:
Price
=
Earnings Ratio
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Market Price per Share (of the Common Stock)
Earnings per Share
When using earnings per share information for
intercompany comparisons, a user must be sure that
calculations are comparable.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
How are Basic Earnings per Share (EPS)
Computed?
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There are two types of corporate capital structure:
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A simple capital structure is a type of corporate capital structure
that consists of common stock outstanding and possibly
nonconvertible preferred stock.
A complex capital structure is a type of corporate structure that
has both common stock outstanding and potentially dilutive
securities, such as share options, convertible debt, or preferred
shares.
A corporation with a simple capital structure is required to
report basic earnings per share. Basic earnings per share
(sometimes called earnings per common share) is computed
as follows:
Basic Earnings per Share =
Net Income ‒ Preferred Dividends
Weighted Average Number of Common
Shares Outstanding
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Denominator Calculations
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If a corporation has issued or reacquired common shares during
the period, the denominator is the weighted average number of
common shares during the period, calculated as follows:
Actual Shares
Outstanding ×
Fraction of
Year
=
Outstanding
Weighted Average
Number of Common
Shares Outstanding
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Stock Dividends and Splits
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The simplest way of giving retroactive recognition to stock
dividends or stock splits is to assume (for EPS calculations) that
the stock dividend or split occurred at the beginning of its
earliest comparative period.
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When Do Companies Report Diluted Earnings
per Share?
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Share options and warrants, convertible preferred stock,
convertible bonds, participating securities, differing classes of
common stock, and contingent share are referred to as potential
common shares if they are securities that can be used by the
holder to acquire common stock.
A corporation with a complex capital structure is required to
report both basic and diluted earnings per share amounts on the
face of its income statement.
Diluted earnings per share (DEPS) is the earnings per share
after including all potential common shares that would reduce
earnings per share.
Potential common shares are only included in the calculation of
diluted EPS if they have a dilutive effect.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computing Diluted Earnings per Share
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The steps for computing DEPS are as follows:
Step 1. Compute the basic earnings per share for the company.
Step 2. Include all dilutive share options and warrants and compute a
tentative DEPS.
Step 3. Develop a ranking of the impact of each convertible preferred
stock and convertible bond on DEPS, from the most dilutive to
the least dilutive.
Step 4. Beginning with the most dilutive security first, include each
dilutive convertible security in DEPS in a sequential order
based on the ranking in Step 3 and compute a new tentative
DEPS.
Step 5. Report as the diluted EPS the lowest computed DEPS.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Flowchart of EPS Computations
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Share Options and Warrants
(Slide 1 of 2)
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A corporation always considers share options and share
warrants in its diluted earnings per share calculation if
these items are dilutive.
Dilution occurs whenever the average market price is
greater than the option (exercise) price.
The treasury stock method is used to calculate additional
dilutive shares resulting from stock options and stock
warrants.
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Under this method, the number of shares added to the
earnings per share denominator is the difference between the
assumed shares issued and the assumed shares reacquired.
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Share Options and Warrants
(slide 2 of 2)
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The steps for the treasury stock method are as follows:
Step 1. Determine the average market price of common shares during
the period.
Step 2. Compute the shares that would be issued from the assumed
exercise of all options and warrants.
Step 3. Compute the proceeds received from the assumed exercise by
multiplying the shares issued by the exercise price [plus any
unrecognized compensation cost (net of tax) per share].
Step 4. Compute the assumed shares that would be reacquired by
dividing the proceeds (Step 3) by the average market price
(Step 1).
Step 5. Compute the incremental common shares that would need to be
issued.
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Change in Shares—Treasury Stock Method
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Convertible Securities
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The if-converted method is used to calculate additional
dilutive shares resulting from convertible bonds and
convertible preferred stock.
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Each convertible stock or bond is assumed (for computing
DEPS) to have been converted into common stock at the
beginning of the earliest period reported.
The impact of each convertible security on the
corporation’s DEPS is computed as follows:
Impact on DEPS =
Increase in EPS Numerator
Increase in EPS Denominator
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Computation of Tentative and Final Diluted
Earnings per Share
(Slide 1 of 2)
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A corporation computes its diluted earnings per
share in the following sequence:
Step 1. Calculate basic earnings per share.
Step 2. Compute the incremental shares from the assumed
exercise of share options and warrants.
Step 3. Include the dilutive convertible securities in diluted
earnings per share in sequential order according
to their dilutive effect on tentative earnings per
share.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Computation of Tentative and Final Diluted
Earnings per Share
(Slide 2 of 2)
Step 4. Repeat with each dilutive security in the ranking until
the impact of the next convertible security is antidilutive (or
until all dilutive securities are used). Any remaining securities
in the ranking are antidilutive and are excluded from
diluted earnings per share.
 Step 5. Final diluted earnings per share is the last tentative
figure. It contains all the dilutive convertible securities
included in the tentative diluted earnings per share
computations.
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Calculation of Tentative EPS
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Special Issues Related to Diluted Earnings per
Share
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If a corporation reports a loss from continuing
operations, then it does not include potential common
shares in calculating diluted earnings per share.
A positive overall net income due to having gains
from extraordinary items or discontinued operations
does not change this requirement.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
Additional Considerations
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Conversion Ratios
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After issuing convertible securities or share options, a
corporation may declare a stock dividend or stock split.
Typically, the “conversion ratio” for convertible securities and
stock options is proportionally adjusted for the stock dividend
or split.
Contingent Issuances
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A corporation may be obligated to issue common shares in the
future if certain conditions are met.
This stock is referred to as contingently issuable common stock.
© 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.