FAR Exam Earnings Per Share

Alright, the next area is earnings per share.
Now, earnings per share is one of the most talked about numbers in the financial statements
because both investors and creditors want to know, Hey, if I invest in the company,
will my stock go up in value and will I get a dividend? Creditors want to know, If
I loan you money, will I get the principal back? Will I get the interest? What are your
earnings per share? Now, with EPS its number that we need to calculate on a consistent
basis, so companies can tell year to year to year how the company is doing. The other
reason, too, is we want to know, Should I invest in the company? Now, if we calculated
it in a different way every year, then the number would be meaningless because in today's
day and age, youre watching channel 58, or whatever, and you watch the numbers go
by and CNBC, and it says, Their earnings were one cent above expectations, analyst
expectations. What happens? Stock goes through the roof. If it was two cents below,
drops through the floor.

So, we have to figure out how to calculate this number on a consistent
basis. Now, a lot of times people think earnings per share means how much youre getting
in the form of dividend. It doesn't, because earnings per share is a theoretical number
only. It says, theoretically speaking, if all of our earnings were paid out now in the
form of a dividend, how much would you get? Its not how much we're actually going to
pay you, but it says, theoretically speaking, if we were to pay it out, how much would you
earn? Now, we're going to show earnings per share for, remember my mnemonic for the GAAP
income statement? I like to go surfing on the TIDE N OC.

We're going to show it for
income from continuing operations and net income. You also were going to disclose D
and E, but it doesn't have to be on the face of the income statement. That could be in
the footnotes. So, we're going to disclose what our earnings per share is for D, E...Well,
for basically income from continuing and for net income.

Youre also going to disclose
D and E, again, either on the face or in the footnotes. You do not have to show earnings
per share for comprehensive income, and as I mentioned, when I taught you cash flows,
you also don't show earnings per share for cash flows. You don't have to show that either.
So, the wrong answer. Just so you realize as far as what they're asking.

Alright, let's
look at our notes. It says, A publicly held company is required to present earnings
per share, EPS, for basic and diluted earnings per share on the face of the income statement
for income from continuing and net income. The company must also either present it on
the face or in the notes for D and E. Now, remember, Ive taught you in the past for
IFRS, there are no E, there are no longer any extraordinary gains or losses.

Just so
you remember that. It says, The Company does not present other comprehensive income
or total comprehensive income on a share basis or cash flows per share are also not disclosed.
So, those are things that are not disclosed. Now, what are we looking at? We're looking
at what we call a simple capital structure or a complex capital structure. So, its
either simple, called basic earnings per share, or it's very complex, like my wife...No, just
kidding...Complex, which is called dilutive earnings per share.

So, let's look over here,
and we're going to talk about what we call simple earnings per share or a basic earnings
per share, which is a simple capital structure, and we're going to have what we call diluted
earnings per share, also called a complex capital structure. This means that theyre
what we call potentially dilutive securities, and we're assuming anyone who could convert
does so at the earliest point in time. So, as I go through the formulas later on, we're
going to be calculating earnings per share in different ways. We're going to have what
we call simple or basic earnings per share.

That assumes there's nothing potentially dilutive.
What do I mean by potentially dilutive? Things that are convertible into common stock, like
options, rights, warrants, things like that. Then we have diluted. That means there are
things that are potentially dilutive that can dilute or weaken, like dilute, like you
get up in the morning, you make orange juice, frozen orange juice and you add too much water,
it gets too diluted or too weak. So, what we're saying is that diluted.

It's a complex
structure. Anyone who could convert does so. Okay, now, in looking at this simple or complex
capital structure, we're going to be calculating our basic earnings per share and our diluted
earnings per share. Now, when we calculate it, we're going to be looking at, and I'll
start with the simple and then we'll drift over.

So, we'll start here, and then well
come over to the complex. With simple, we start with our net income, from that we're
going to subtract what Ill call A, our preferred dividends. So, we subtract our preferred
dividends. That gives us the amount of money we have available to distribute because when
we talk about earnings per share, it is the earnings per share that the common shareholder
would get.

Common shareholder meaning common stock. So, that's why...Who gets paid first?
Preferred. Remember, preferred stock had certain preferences over common. What are the preferences?
Liquidation preference, they could be convertible, they could have warrants, and also they get
paid a dividend before common.

So, that means if we had net income, who gets paid first?
The preferred. That gives us how much money is left available to give to all the common
shareholders. Now, I put a little A here because I'm going to take the A here. What does the
A mean? What it says is preferred...Remember preferred can be cumulative or non-cumulative.
Let's review what that meant.

If it was cumulative, it meant that if we don't declare it last
year, it's still going to have to get paid if we ever do declare a dividend. So, the
next year we don't declare, then we finally declare a dividend. If it's cumulative, it
accumulates in arrears. Wheres your rear? Behind you, youre behind.

So, that means
we owe this, we owe this, we owe current. If its non-cumulative, that means if you
don't declare it, it's lost forever, you never owe it. So, here's the rule. Listen carefully,
and then I'll show it to you in the notes.

If it is cumulative, then you take it out
whether it's declared or not because you'll eventually owe it. If it is non-cumulative,
that means that if it's not declared, you're never going to owe it. So, if its non-cumulative
you only deduct it if declared. So, one more time.

If its non-cumulative, only take
it out if declared. If its cumulative, you take it out whether declared or not, but
you take it out for how many years? For one year only. Why for one year only? Because
this is a theoretical number. This just says, theoretically speaking, How much would
each shareholder get each year? So, we have to calculate on a consistent basis, So,
A is going to be if non-cumulative only if declared.

If cumulative, whether declared
or not declared. To declare or not declare, that is the question, right? Who was that?
Shakespeare? So, if cumulative, declared not declared, but only for one year. Alright,
let's do that again. If its non-cumulative, you're going to take it out only if its
declared because if its not declared, you never owe it.

If its cumulative, whether
declared or not, you take it out, but only for one year. Why? Because if last year's
was not declared, but its cumulative, you would have included it in last years calculation
and this year you calculate it in this year, and next year, next year. Then when you finally
declare it, youll just pay it out...But were, again, trying to come up with this
theoretical number which says, theoretically speaking, how much would we owe if it was
all paid out in the form of a dividend. Alrighty.

So, you'll see that. Look in your notes, bottom
of the page, it says, Earnings equals net income minus preferred. Shares, well
come back to. Since the EPS is being computed on the common stock, earnings must be reduced
by the dividends payable to preferred shareholders.

If preferred stock is not cumulative, only
dividends declared for the year are subtracted. If they are cumulative, the annual dividend
preference is subtracted each year regardless of whether it is or isn't declared since the
amounts not paid accumulate and will never be payable to common shareholders. Because,
again, its never going to go to common. It's always going to get a preferred because
it's cumulative.

It says simple or basic, net income minus preferred, which again is
all cumulative and non-cumulative, but only if declared, and, again, my question to you
is, for how many years? For one year only. This year only, this year only, this year.
Okay? And that always seems to confuse people, but if this year only, then we divided by
something called the weighted average number of common stock outstanding. So, that's what
I'm going to put here as a one. I'm going to divide it by the weighted average number
common stock outstanding.

So, I'm going to show you how to calculate that. So, we're
going to take the dollars divided by the weighted average number of shares. So, one more time.
Our simple or basic assumes there's nothing potentially dilutive, you take net income
minus preferred is the dollars you have available divided by the weighted average number. Now,
the top, in case you didn't know, is called the numerator and the d-d-d-d-down, denominator.
I know it seems stupid, but you may not remember.

Numerator is the top part of the fraction,
denominator is the d-d-d-down denominator. Okay? Numerator denominator. So, the numerator
is the top, thats the dollars, divided by the number of shares. So, if I had $900,000
dollars and 100 shares that would be $9 per share.

Numerator is 900 the d-d-d-down denominator
is the 100. Okay. So, thats what we're looking at. Now, the question is, how do you
come up with weighted average number of common stock outstanding? What does weighted average
mean? It means, on average, how much stock could I have outstanding for the entire year?
Thats weighted average.

So, what we're looking at is, if I had 100 shares outstanding
on day one, then I have 100 shares outstanding for the whole year, but let's say I issue
them halfway through the year, then I have 100 outstanding at the end of the year, but
on average, it was only 100 divided by 2 or 50 for the whole year. So, that's what we
mean by a weighted average. Its an average that is weighted based on the length of time
that the shares were outstanding. So, on page 2, you'll see a number 1, and that's where
I'm going to show you how to calculate the weighted average number of common stock outstanding.
Alright, thats the weighted average number of common stock outstanding.

Here's where
we're going to have to calculate it. Now, a couple of things...Dividends and split are
treated retroactively. Huh? What does that mean? Dividends and splits are treated as
if they happen at the beginning the year. So, if halfway through the year I issue a
stock dividend, then you go back as if they were outstanding for 12/12ths of the year.
If I do a two-for-one split, then you act as if it was for the whole year and any previous
years as well.

So, theyre retroactive, not only at the beginning the year, but the
beginning of time. So, if you're doing comparative x1, x2, and you have a dividend or splint
in x2, youve got to go back and add 10%, or go back and do a two-for-one. So, let me
show you what's going on as far as weighted average. It says, Weighted average, number
shares of common stock outstanding...The determination of the number of shares to include the denominator
is the calculation, and this can be very tricky.

The amount to be used is the weighted average
of the number of common shares outstanding during the year. As a result shares sold to
the public during the year must be pro-rated for the portion of time that they were outstanding.
So, let's say, for example, I have 100 shares outstanding on January 1st. That means theyre
outstanding for 12/12ths. Then, let's say I have 80 shares outstanding on 9/1.

Whats
9/1? 9...For January, February, March...For April 1st. So, April 1st. That means, let's
try this again. On 3/1...No, lets do 4/1...No, 3/1.

So, that means theyre outstanding
for how many months? January, Februa...No, lets do 4/1...I'm not even sure what I'm
doing... January, February, March...Thats 3 months that they were not outstanding. So,
they are outstanding for 9/12ths of the year. So, 9/12ths of the year 80 at three quarters
is 60.

So, that means Ive got Ive got 160 shares outstanding. Now, I really have
180 shares outstanding, but on average, I. Have 100 for the whole year, and I had 80
for three quarters of the year, which is 60. It's kind of like when I teach you in BEC.
We're going to talk about equivalent whole units of production.

Let's say, for example,
I'm building these beautiful Roger CPA Review shirts, gorgeous shirts, huh? Gotta love em.
I go out to clubs and stuff, Hey, where'd you get that shirt? Roger CPA Review.
Cool. Right? People are lining up, wanting to shake my hand. I hang out with Kim Kardashian
all the time. Wear the shirt.

So, oh, so, I'm building this shirt. Now, I don't take
it, build one shirt, finish a shirt and start another. You take a shirt, and you cut it,
then you take 50 shirts and you sew them, then you take...See what Im saying? Then
you do like a production line. So, you take, let's say, 80 shirts and you cut the one sleeve,
then you cut the other sleeve, then you sew on a collar and so on and so forth.

So, let's
say, for example, I have 80 shirts that are three quarters of the way done. How many whole
shirts could I have done if I would have done one shirt and then started another shirt and
then started another shirt? If I would have done one shirt at a time and finished it,
then if I had 80 shirts three quarters of the way done, as far as we call conversion
cost, I could have done 60 whole shirts. That's all we're saying. If I have 80 shares outstanding
for three quarters of the year, that's like having 60 shares outstanding for the whole
year.

That's really what we're saying. So, that's what I mean by weighted average. So,
when we're doing this, dividends and splits are treated retroactively. You'll see this
in your notes.

It says at the bottom of the page, The reason for pro-rating shares
issued during the year is that the funds received from issuance are only available for productive
use by the corp from that point on, not the entire year. This would not be the case, however,
if shares were issued as a result of a stock dividend or a stock split or a delayed issuance
called a stock subscription. It says, If these...In these cases, the shares are treated
as if they've always been outstanding and are included at full amount for the current
year. There are also included for earlier years that are shown in comparative statements.
In the case have a reverse stock split, these would retroactively reduce the shares outstanding.
Because a stock split might be like a two-for-one split, and we talked about that in stockholders
equity where you basically get rid of the one common stock for 100 bucks, give them
another common stock.

So, let's say I had 1 share at $100, and now I'm going to have
2 shares at 50. That's called a two-for-one split. So, I take 1 share back, and give you
2. So now, I have double the shares.

So, if I did this in x2 for comparative purposes,
Ive got to go back and adjust x1 as well and do a two-for-one. A reverse is the other
way. Let's say Google is 500 bucks a share, and nobody's going to buy one share. So, what
do I do? I'll do a reverse.

What Ill do is, I'll take out...Or no, lets do...I'm
sorry... That that would be a stock split. Lets do a reverse stock split, but let's
say, for example, the stock is trading at 100 bucks for 10 shares, so its 10 bucks a
share, 10 shares at 10 bucks is 100 bucks. I'm going to do a reverse.

So, I'm going to
give you 5 shares at 20 bucks a share. So, it's still 100, but I'm cutting the shares
in half. Same thing, youd retroactively cut the shares in half. So, whether it's a
stock split, double them, if its reverse stock split, you cut them in half or cut them
in fewer...And that's just like...Lets say you have a stock trading at 20 cents a
share.

Nobody wants a penny stock. So, we'll do a reverse split and instead of give me
20 shares, and Ill give you 1 share, so that way its trading at a much higher cost.
Alright. So, remember dividend splits stock subscriptions are treated how? Retroactively,
which means you go back, and you have to restate. Look at the example on page 2.

For example,
assume the following facts apply to the client for the first 2 years of the existence. Alright,
so lets look over here. Were going to do accommodation. On 1/1 we had 500 shares
outstanding.

So, on January 1st, we have 500 shares outstanding, 500 shares outstanding
that would be for 12/12ths of the year. That's 500. Then it says we issued on July 1st 100
shares. So, we issued 100 shares on July 1st.

That means theyre outstanding for 6/12ths
of the year, which is 50. Then it says on 10/1, we issued another 300 shares. So, we
have 300 shares. We issued these on 10 /1.

So, again, you use your fingers, youre
allowed to bring them to the exam. That means that these are outstanding for how much of
the year? 10/1, All of 10, all of 11, all of 12. So, theyre outstanding 3/12ths of
the year, which equals something like 75. So, we've got 5, 6, and 25.

Now, notice we
really have 5, 8, 900 shares outstanding. So, on the balance sheet, remember we talked
about authorized issued outstanding? How many shares were outstanding? 900 But for earnings
per share calculations, we don't use 900, we use the weighted average number of shares
outstanding. How many were on outstanding for the entire year? Basically 625. So, that's
the number we would use for our earnings per share calculation.

Okay. Alright. Let's do
a little trickier question on page 3, middle of the page it says example. On 1/1 we have
100,000 shares of common stock outstanding.

On April 1st, 80,000 shares are issued. On
July 1st, a 10% stock dividend is issued. Now, remember, how do we treat stock dividends
and splits, everybody? Retroactively. Good! On September 1st, 18,000 shares of treasury
stock are re-purchased.

Now, what is treasury stock? Stock that is authorized, issued, but
no longer outstanding. Therefore, what we're going to say is, if you buy back the stock,
then that's going to be a minus because thats stock that's not outstanding. On December
31st, a two-for-one split occurs. Again, a split is also retroactive.

And then calculate
the weighted average number of shares of stock outstanding. Okay, so, on 1/1 we had 100,000
shares outstanding. So, let's do this again. January 1st, 100,000 shares.

So, we have a
100,000 shares outstanding times 12/12ths of the year is 100,000. Then, on April 1st,
here's on April 1st 80,000 shares are issued on April 1st. So, that means theyre outstanding
for what? 9/12Ths of the year, which I did earlier, which is three quarters, which is
60. Then, on July 1st, we do a 10%, a 10% dividend, so a 10% dividend is issued.

That
means right now, we've got 160 shares. Were going to add 10% or 16,000, 176. And again,
remember, it's treated retroactive. So, if we had a previous, year, you go back and add
10% as well.

Then on 9/1, 18,000 shares of treasury stock are re-purchased. So, if youre
re-purchasing 18,000 shares of treasury stock, what that means is, of the 100, 18 was not
outstanding from 9...Because it was 9...9, 10, 11, And 12. So, basically, this is not
outstanding for 4/12ths of the year. So, 4/12ths of that is 6000.

That gives us 170. Then,
on December 31st, we do a two-for-one split. So, on 12/31 a two-for-one, which means youre
going to go back and double everything. So, just do times 2, which is 340.

So, notice,
340,000 shares is our weighted average number of stock outstanding. Now, how much is really
outstanding? 100 Plus 80 plus 18 minus 18 is...Times 2 is 360. So, we really have 360
outstanding, but on average its 340. Its 100 plus 80, 180 plus 10% is 18 is 198, minus
18 is 180 times 2, 360.

So, again, on average 340. So, when you do the calculation over
here, what would you do? You take this and divide it by 340, which is the weighted average,
weighted average. So, that's the weighted average, not the total, okay? See that? So,
thats the weighted average, not the total outstanding. Alright.

Let's try a question
on that. How about number 7? Temp Inc. Had the follo...Ooops...Last sentence first. What
were Temps weighted average shares outstanding? Temp Inc.

Had the following common stock balances
and transactions during the year. On 1/1, common stock outstanding 300...30,000. On
2/1, we issued a 10% dividend. How are they treated? Retroactively.

On 7/1, we issued
common stock for cash. Total outstanding is 41. Whats the weighted average outstanding?
So, let's see what we've got. We've got 30,000 outstanding at the beginning.

So, we've got
30,000 outstanding times 12/12ths is 30,000. Then we've got on 2/1 a 10% dividend, 10%
dividend is treated retroactive, 10%, so it doesnt matter when its issued, you assume
its outstanding for the whole year, which is another 3,000. Then we've got 7/1. We issued
8,000 shares for cash.

Now, 8,000 shares on 7/1. That means its outstanding for how
long? For 6/12ths or half the year, which is 4,000, 33 and 4, 37,000. So, notice, we
have 41,000 outstanding, but for the calculation, weighted average is what? 37,000 Shares of
stock. Beautiful.

Alright, now, let's turn back and let's get a little bit uglier, back
to about page 3, and let's come back to my formulas over here. Now, over here you'll
notice that we started out, we said, let's take net income minus preferred is the money,
divided by number 1, which is the weighted average number of stock outstanding. Now,
that's called a simple or basic earnings per share. Now, I want to get too diluted.

What
does diluted mean? Diluted is called the complex capital structure. What does that mean? It
means anyone who could convert, does so. When? At the earliest point possible or when issued
if their issued during the year, the latter of the 2. So, what this says is, we're going
to take our net income number, and I'm going to bring that over here.

We're going to take
our weighted average shares and bring it over here. Then I'm going to make 2 adjustments
for number 2 and number 3, number 2 and number 3. That's how we're going to take this, to
modify this. That's going to give us our diluted or called the complex capital structure because
this will give me based on what could the people that could have converted.

Alright.
Now, number 2 is called the if converted method, and the if converted method, this is for convertible
preferred stock and convertible bonds. So, let's start up here. Number 2 with the if
converted method. If converted method, and, again, the if converted method is for convertible
bonds and convertible preferred stock because, let's think about it, if you have not convertible
bonds or convertible preferred stock, if they convert, what are they converting into? Common
stock.

Well, if had a convertible preferred, and they converted, you give them common.
What do you not have to pay? A preferred dividend. Ooohhh...If you have a bond and they convert,
what do you not have to pay them? Interest. But what do you give them? Common shares.
So, you're going to have more shares outstanding, but you're also going to have more money because
you save that interest income. Ohhh...So, the if converted method says assuming the
convertible bonds or convertible preferred converted, what would you not have to give
them? What would you have outstanding? So, for the if converted method, in the numerator
up here, the numerator, plus if it was a convertible preferred, what would we not pay them? Well,
over here, you subtracted the preferred dividend.

Well, if they converted, you wouldn't have
to pay it to them. So, add back plus the preferred dividend, not net of tax. Now, why is it not
net of tax? Because dividends come out of after tax dollars. Therefore, you would just...So
if it was a 20 dollar dividend, if they converted, you wouldn't have to give them the 20.

Add
it back. And then what would you add down in the d-d-d-denominator? Plus the number
of shares of common stock converted into. Because it might say that, if they converted,
you don't have to pay them the $20 in dividend, but each person's going to get 10,000 shares
of stock plus 10. So, in the numerator, you add the dollars, in the denominator, the shares.
So, that's 20 over 10 or $2 a share.

So, as long as your basic earnings per share was
more than 2, then that's called diluted because here's an important point, earnings per share
should start big, get smaller. It could be big, stay the same, but it could never go
big bigger because if the earnings per share goes up that means people gave up more and
got less. We don't assume they're morons, unless they really are. But, basically, what
we're saying is earnings per share should start big and then get diluted or get smaller,
get weaker.

So, in other words, let's say, for example, we had $900, $900 of income and
100 shares. So, thats $9 a share. Would you give up $2 to get 9? Don't think too hard.
You give me 2, I give you 9. Would you do it? Yeah.

So, therefore what would our earnings
per share be? It would be 900 plus 20 over 100 plus 10, it would be 920 over 110. So,
I have no idea what that is off the top of my head, but basically it would be? 920 Divided
by 110 which gives you $8.36. So, 8.36 So, earnings per share went from $9 down to 836,
that tells you it went from 9 down to 8.36, Thats diluted. If it went from 9 to 10,
thats anti-diluted, which means people gave up more and less.

So, again what would
happen here is, thats called diluted, we include it. So, notice in the numerator, you
add in the preferred dividends, not net of tax. Why not? Because they come out of after
tax dollars. You're basically just adding back whatever you took out here, and the denominator,
the number shares converted into.

Now, that's for preferred stock. What about bonds? Bonds
are a little trickier. Why? Because bonds are...The interest income is taxable. So,
you're going to have to add in the net of tax savings.

So, the if converted method is
talking about convertible bonds. Let's say, for example I had 10 million dollars of bonds,
and let's say they're paying 6% interest. So if you converted, it would save me $600,000
of interest. Now, let's say the 10 million of bonds are converted into 300,000 shares
of common stock.

So, there's 10 million dollars worth of bonds, if you convert, what's going
to happen? If you convert, Im going to give you 300,000 shares of common stock. Okay,
now, let's say the tax rate is 1.4. So, that means, after tax, you're left with $360,000
of interest income because the interest income I save if you convert is 600,000, but the
government says, Oh, you have 600,000 more of income. Give us 40%.

Well, if I have
to give you 40%, 6 times 0 is 240 that means I'm left with 360. So, the 360, let's see,
360 divided by 300, equals, like, $1.20 A share. So, basically, the interest youre
earning is $1.20 A share. So, if basic earnings per share was 900 over 100, $9 a share, would
you give up $1.20 To get 9? Yeah.

Therefore, it would be like 900 plus 360 over 300 plus
100 equals 9, 10, 11, wait, 9, 10, 11, 12, 60 over 400, which, I don't know, let's say
is 3.20 A share. So, basically everyone went from 9 down to 3.20. Thats diluted. You
went from $1.20 Up to 3.20.

Would you give up a $1.20 To get 3.20? Yes. Everyone else
gets less. Thats called dilutive. If it's anti-dilutive, if it went from from 9 to 11,
don't include it.

So, what we have to do with bonds, let me do it again. We have 10 million
dollars of bond that are converted into 30,000...300,000 Shares of common stock. They pay 6% interest.
Thats 600,000 of interest the tax rate is 40%. So, that means, this is your net of
tax savings if we convert.

If you convert, I save 600,000 of interest. After tax 360.
What are you converting into? 300,000 Shares. What is that per share? About $1.20 A share.
Would you give up $1.20 To get $9? Yes, though how does that affect everyone else? Basically
it dilutes everyone else down to about 3.20. Okay.

So, that's what we have. So, what am
I going to add in the numerator? I'm going to add this, 360. What do I add in the denominator?
This. So, let's put that into words.

For convertible bonds plus the interest expense saved net
of tax, which is that 600...This side... There we go...600,000, Right, which is the 600,000
interest expense saved net of tax. What do I put down here? The number of shares converted
into, which would be what? Like 360 up here, 300 down here. Okay, that's what Im talking
about.

Im only talking about this right now. Okay? So, that's what we're looking at,
360, and 300. So, thats what we call diluted, complex, and good. That's what's happening
as far as the calculation.

So, that's kind of what we need to think about. Thats called
the if converted method because if converted says, if they're converted, what happens to
preferred? What happens to the bonds? Thats the if convert...Lets read it in the notes,
page 3, and number 2. The if converted method. The calculation of diluted earnings
per share assumes that anyone who could convert does so.

For a company with convertible preferred
or convertible bonds, it starts with the computation just discussed, which is called basic. For
convertible securities, the following adjustments are made. In the numerator, earnings are increased
by the dividends after tax that would have been due if the securities have been converted
to common stock. Denominator, the shares increased.

It says, If the calculation results in
EPS which is higher than basic, the securities are anti-dilutive and not included. To determine
whether or not an item is anti-dilutive, each item is considered separately in sequence
from the most to the least dilutive. One would normally consider options and warrants first.
Now, what are we looking at on the next page? You'll see here it says net income. This is
for dilutive, plus the preferred dividends not net of tax, plus the interest expense
saved from convertible bonds net of tax and then in the bottom, number 2, the number of
shares converted into for both preferred and convertible.

You don't weight them. Its
all of them. The bottom of the page says, The conversion of bonds. The if converted
method requires considering the tax effect since the reduction of interest expense is
accompanied by the increase in taxable income.

It is assumed that the conversion occurred
at the beginning of the earliest period or at the time of issuance if later. What
do I mean by that? What I mean is, it doesn't matter... What if they dont convert? Do
you still include it? Yes, as long as its dilutive. What if the convertible bonds or
convertible preferred or not converted? You still include them.

Why? Because this could.
It's not what is, but its could. Could they convert? Yes. Would it dilute? Yes. Remember,
earnings per share is a theoretical number only.

Theoretically speaking, if people converted,
how much would you get? We have to assume that if they could have converted and it's
economically advantageous it is dilutive, and you would do it as of the earliest point
in time. So, if they were outstanding for the whole year, as the beginning of the year
if they were converted...I'm sorry...If they were only outstanding for half year, then
they couldnt have convert the first half, then you just do half a year. So, again, its
as of the earliest point in time. For example, page 4, assume that a company reported 932
of income for the year had the following capital structure which did not change.

We had preferred
stock, 100 dollar par, 8% percent cumulative, 4 shares each convertible into 10 shares of
common stock. So, what is our dividend per preferred? It is 100 at 8%, 8 bucks. There
are 4 shares, 8 times 4 is 32. Common stock, $1 par 100 shares.

So, we have 932 of income
and 32 of preferred, and we have 100 shares outstanding. So, let's do our basic earnings
per share. So, coming over here, we've got, net income is 900 bucks, the preferred dividends
are 32. Therefore, we have 900, and their weighted average number of shares outstanding
for number 1 is 100.

We can do this, 900 over 100 equals 9 bucks a share. Thats called
basic. Now, let's assume that thats preferred. It says here each is convertible into 10 shares
of common stock.

Now, that means that if they convert, there are 10 shares per preferred,
and there's 4 shares of preferred outstanding. So, let's go and do this. You start here,
and bring it up here to 900. You start here and bring it over here for 100, and you say,
Okay, if they convert, what happens? The preferred, this $32 dividend would not
have to be paid.

900 Plus 32...I now have 932 in the numerator. And, how many shares
are they convertible into? 100 Plus 40 or 140. So, what is 932 divided by 140? Gives
you something like $6.66. Notice, what happened to earnings per share? It went from $9 down
to 6.66.

Thats dilutive. Do you include it? Yes. What if they didn't convert? Doesn't
matter. Could they? Yes.

Is it economically advantageous? Yes. Then you include it. Okay,
look at the example in your notes under conversion of bond. For example, assume a client with
$800 of income and an effective tax rate to 30% have the following capital structure...6%
Convertible bond, $1000 face value convertible into 20 shares of common stock, common stock,$1
and 200 shares outstanding.

So, we've got $800 of income. Here, we're not looking at
preferred, we're looking at bonds. So, we have $800. There are 6% $1000 bonds.

So, there's
$1000 bonds. Let's see what we've got. I've got $1000 bond 6%. So, I have $1000 bond at
6%, it means $60 of interest.

So, if you convert, it saves me 60 bucks. However, if I have an
extra 60 bucks, the government says, Hey! Good job! 60 Bucks...We want our taxable income.
And the tax rate in this case is 30%. So, 1 minus 0.3, I'm going to be left with the
7 times 6, $42. That is going to be the interest expense saved net of tax.

How many shares
are they convertible into? It says they're convertible into 20 shares of stock. So, that
means these bonds are convertible into 20 shares of common stock. So, basically, it's
like 42 over 20, its like 2 bucks a share. Well, if you're making 4 and this is 2, would
you give up 2 to get 4? Yes.

That'll dilute everyone else. So, what we need to do is,
let's come back and recalculate our basic earnings per share based on this example,
and then we'll come over and do diluted. So, our basic, it said, is $800 minus 0, because
there's no preferred in this example, is 800 and there's 200 shares of common stock outstanding,
I could even do this in my head. Thats how smart I am.

800 Over 200 equals what?
4 Bucks a share. Now, if you convert, what happens? In the numerator, I bring the 800
plus what do I add to that? I'm going to add the interest expense save net of tax, and
in this case, the interest expense save net of tax over here was 1000 at 6% is 60 government
wants 30%, I'm left with 42. So, I'm going to add in plus 42 gives me 842. In the d-d-d-down
denominator, I bring this over, which is the 200, and we said the 200 are converted, the
bonds are convertible into 20 shares of common stock, that gives me to 220, 842 over 220,
of course, equals something like $3.83.

What happened? It went from $4 down to 3.83, Okay?
Is that dilutive? Yes, it is. So, that's how you handle what we call the if converted method.
The if converted method is for what? Convertible preferred, convertible bonds. Then we have
the 3rd adjustment we're going to make, and this is called the treasury stock method.
So, we start here with basic, we go here, we do number 2, number 2, then we do number
3, number 3, called the treasury stock method, treasury stock method. So, let's teach your
number 3, the treasury stock method.

Let's come down here. Under the treasury stock method,
here's what it says. It says for number 3, treasury stock method...And treasury stock
method...This is going to be for options, rights and warrants because, remember, when
I talked about treasury stock...What is treasury stock? It is your stock you buy back and you
hold where? In the treasury, in the safe. Does it vote? No.

Does it get a dividend?
No. But that's called treasury stock. So, treasury stock is the stock you buy back and
you hold in the treasury in the safe. Now, if I give you a stock option, stock right,
stock warrant, what are those? Those give you the opportunity to acquire more shares
of stock.

So, a stock... They go to different people. Stock options go to employees, stock
rights go to stockholders, and stock warrants...Warrants go with bonds. With detachable stock purchase
warrants, we learned that in the bond class preferred stock with detachable warrants.
So, it could be preferred with warrants, bonds with warrants, but basically, it gives you
the chance to do what? Buy more stock.

So, let's say, for example, you gave me the option.
So, if I gave you options and you exercised them, what would you give me? You give me
money. What do I give you? Stock. So, what's going to happen? If you give me money, okay,
and then I give you stock, well, instead of just putting the money in the numerator and
giving it out, I will theoretically go out on the open market and buy back my own stock.
When you buy back your own stock, whats that called? Treasury stock. So, here's the
concept...Is, I gave you an option, you exercised it, you would then give me money, I would
give you stock.

I would then minimize the dilutive effect by going out on the open market
buying back my treasury stock. So, let's say, for example, you gave me $15 a share, but
I would have to go out and buy it on the open market at 20. Therefore I'm losing $5 a share.
Thats the dilutive effect. So, in a sense, I'm not going to give the money away that
you give me.

I'm going to theoretically go and buy back my own stock, and that's why
it's called the treasury stock method. You use this method for options, right, and warrants.
Am I really buying back my stock? No. Did you even actually convert? No. Did you actually
even exercise the options, rights and warrants? No.

You don't have to actually do it. This
is all theoretical. Could you have done it? Yes. When do we assume you did? As of the
earliest point in time.

So, it says here, the treasury stock method. The effective options
on diluted EPS is to first increase the shares by the number that would have been issued
had they been exercised, then decrease by the number that could have been repurchased
by the court at the average market price. So, thats the average market price of the
common stock. This is known as the treasury stock method.

The exercise of options has
no effect on earnings since options pay no dividends or interest. If market price changes,
previously reported EPS would not be adjusted. For example, 40,000 options are issued at
an option price of 15 bucks a share when the average market price is 20 bucks a share.
What is the dilutive effect? Okay. So, I'm giving 40,000 options 15 bucks to share.
So, here's 40,000 options, and if you exercise it, the exercise price is $15 a share.

You
would give me $600,000. So, you give me $600,000, and Im going to give you 40,000 shares
of common stock. So, what am I going to do? I now go out on the open market, and I buy
back my own stock at the average market price. Now, let's say the average market price is
20 bucks a share.

That means I could theoretically buy back 30,000 shares of treasury stock.
That means, I gave you 40,000, you gave me 600,000. I theoretically go out, spend all
600 to buy back 30,000 shares. That means I gave you 40, bought back 30. What's the
incremental number of shares outstanding? 10,000.

Now, let me ask you this. If you give
me 600,000, and I spend all the money. How much is left after I spent all the money?
0. So, in the numerator in the formula up here for treasury stock, I'm going to add
in for number 3 plus $0.

Why? Because theoretically I spent it all. And in the d-d-d-denominator,
what am I going to add in? Im going to add in plus the incremental number of common
stock outstanding at the average market price. It used to be year end, and then it said average
market price. So, in my example, in the numerator, I had 0, in the denominator, it would be 40,000
that I gave you minus the 30,000 I bought back, or Id add in 10,000 shares.

So, that's
what we mean by what we call the treasury stock method. Does that make sense? Yeah,
it kind of makes sense, because I'm going out, and again, its a theoretical approach
only. Theoretically speaking, if I went out and bought it back, how much would I get?
That's theoretically speaking. Now, let me just mention IFRS here, because its really
nothing.

It says, Under IFRS, it's very similar. You still report basic and diluted
on continuing operations and net income, however, EPS on extraordinary arent reported.
So, it's really the same calculation for basic and diluted. No real difference. The one difference
is EPS doesnt exist...I'm sorry...EPS...Extraordinary gains and losses don't exist, so you wouldn't
have to worry about calculating it under extraordinary.

Alright, that is called EPS. Let's do a couple
questions. Question number 1, last sentence first. What amount should Stroch report as
basic earnings per share in its x2 and x3 comparative statements? How much should Stroch,
beautiful name.

Stroch Co. Has one class of common stock outstanding and no other securities
that are potentially convertible into common stock. During the year, 100,000 shares of
common stock were outstanding. In x3, 2 distributions of additional common shares occurred.

On April
1st, 20,000 shares of treasury stock were sold. On July 1st, a two-for-one split was
issued, net income was 410 and 350. What amount should Stroch report as its basic earnings
per share in x3 and x2 comparative statements? Alright, so, what we need to do is, they want
x2 and x3. So, let's see if we can figure this out.

Heres x2. Heres x3. Alright.
What was the income? It said x2s income was 350 and x2s Inc...X3s income was
410. Alright, that's income.

So, 350 and 410. Now, it said they had one class of stock outstanding.
During the year 100,000 shares were issued and outstanding. So, for the whole year we
had divided by 100,000 shares. Looks like about 3.50 A share.

Then it said, during x2,
100,000 shares were outstanding. During x3, 2 distributions of additional stock occurred.
On April 1st. April 1st... April fools Day, 20,000 shares of treasury stock were
sold.

On July 1st, a two-for-one split was issued. Okay. Net income was 410 and 350.
Okay, so, what do I have outstanding? I've got 100,000 shares outstanding for 12/12ths.
Then we did a...Mmm...20,000 Shares were sold on April 1st. So, on 4/1, 20,000 shares.

Now
those 20,000 shares were outstanding for how much of the year? About three quarters, 9/12ths.
So, that's going to be 100 plus three quarters is 15, 115. Then on July...On July 1st, two-for-one
split. What did we learn earlier? Stock dividends and splits subscriptions are what? Retroactive.
Retroactive. So, that's going to be times 2.

Which gives me 230. So, now, what is my
weighted average number of stock outstanding? 230. So, if you come back over here 410 over
230, 410 divided by 230 gives me something like a $1.78. So, its $1.78 In x3, and in
x2, it looks like what? 350.

Oh my goodness! 350 And went down to...You know what? Sell!
Sell! Sell! Why? Because it dropped. But wait a sec. You can't compare apples and oranges.
Were not making fruit salad. Its apples and apples.

So, how do you compare apples
and apples? Remember over here, what did we say about dividends and splits? Retroactive.
To where? All the previous years! Oooohh. So, if I were to come back and double this
times 2 for 1 is 200, 350 over 2 is now a $1.75. Now, what? Oh! Buy! Buy! Buy! So now
I call my broker and I go, Buy! Why? Because it went up, it went up. So, notice,
$1.75 Up...So, you've got to be consistent in the calculation.

That's why dividends and
splits are treated how? Theyre treated retroactively. Alright, let's do another question.
Question number 3, question 3. Question 3 is tricky. That's why I'm doing it.

Last sentence,
in its December 31st income statement, what amount should Uta report as basic earnings
per share? What is basic earnings per share? It said, Uta had the following capital
structure during x2 and x3. Preferred stock is $10 par 4% cumulative. 25,000 Shares issued
outstanding for 2.50. Common stock, $5 par.

200,000 Shares issued and outstanding. Uta
reported net income of $500,000 for the year ended December 31st, x3. Uta paid no preferred
dividends during x2 and paid $16,000 in preferred during x3. In its December 31st income statement,
what amount should Uta report as basic earnings per share? Hmmm...Ok, so we're trying to figure
out our basic earnings per share.

What is basic earnings per share? Net income minus
preferred dividends divided by shares outstanding. So, what we're going to have to do is say,
Okay, what is net income minus preferred dividends? So, we're going to have our
net income minus preferred is the dollars divided by weighted average number of shares
outstanding, and it told us the shares outstanding are 200,000. So, we have 200,000 shares of
common stock. Weve got to figure out the numerator.

We have net income of 500,000.
Then they paid out preferred dividends. Now, what are the rules? Preferred dividends. We
said, let's come back over on this side and look. We said, take out, if its non-cumulative
only if its declared.

If its cumulative, whether it's declared or not. For how many
years? For this year only. Why? Because theoretically, last year was already deducted in last year's
because, down the road, if you eventually declare a dividend, that money isn't going
to go to common, it goes back to preferred because it's cumulative. So, in this case,
it said our dividend is going to be what? $10 4% 25,000.

So, 25,000 times $10 is 250,
4% of 250 is 10,000 bucks. So, our dividend is $10,000. Now, it says that last year, they
preferred dividend...No preferred dividends...Uta paid no dividends last year and paid 16 this
year. So, here's what happened.

In x2, they paid 0. In x3, they're paying $16. It is cumulative.
How much did we owe last year? 10. How much do we owe this year? 10.

How much do we owe
next year? 10. Now, it's not a liability till its declared, but what are you supposed
to do? You're supposed to take it out. Oh. Now, wait a sec.

We paid 0, then this year
we're paying 16. What do we owe? 10. So, last year we should have done what? Taken out 10.
This year what should we do? It doesn't matter how much you pay. It's what would you eventually
owe 10.

So, you need to take out 10, and here where I like to confuse you. How much should
I take out? 0, 10, 16, 20, 30? All of the above? Ha ha. Right? 0? No. But doesn't matter.
16 Is what you paid.

Thats not what you take out. You take out what you owe. What
would you owe? You would owe if its cumulative whether declared or not. You take out this
year only.

What is that? That's going to be 4% of $250,000, which is 10,000 bucks. So,
therefore it's going to be 490 over 200, which gives you something like $2.45. Tricky, tricky
question. Again, I need you to practice that.

Look at number 5. The if converted method
of computing earnings per share data assumes conversion of convertible securities when?
The if converted over here says, if converted for preferred dividends or a convertible preferred
stock or for convertible bonds. It assumes you converted when? As of the earliest point
of time or of issue if the latter of the 2. So, it says a, beginning of the earliest period
reported or time of issuance if later.

True. Beginning at the earliest regardless of time
of issuance middle and no. Best answer, A. Number 6.

In determining earnings per share,
interest expense net of tax on convertible debt that is dilutive should be what? Earnings
per share, interest expense, net of tax. What do we do? Interest expense net of tax. Here,
we add interest expense net of tax in the numerator, and in the denominator, you add
in the number of shares converted into. So, A, add it back to weighted average shares?
No.

Its in the top. Add it back to net income for diluted. Yes. Add it back to net
income for diluted...For deducted.

No. Deduct it from weighted average. No. Best answer,
B.

Alright, so, again, that is earnings per share. Im going to do a couple of more
questions. Again, if you're in class, make sure you log into your student account so
you can do a few more. If you're watching me online, USB, here we go.

Were going
to do them in just a sec..