20
Earnings Chapter Per Share
QUESTIONS FOR REVIEW OF KEY TOPICS
Question 20-1
A firm has a simple capital structure if it has no potential common shares outstanding. These are securities that are not yet common stock, but might become common stock if exercised or converted. Thus, they could potentially dilute (meaning reduce) earnings per share. For a firm with a simple capital structure, EPS is simply earnings available to common shareholders divided by the weighted-average number of common shares outstanding.
Question 20-2
There is a fundamental difference between the increase in shares caused by stock dividends and stock splits and an increase from selling new shares. When additional shares are sold, both the assets of the firm and shareholders' equity are increased by an additional investment by owners. On the other hand, stock dividends or stock splits merely increase the number of shares without affecting the firm's assets. As a consequence, the same pie is divided into more pieces resulting in a larger number of less valuable shares. Shares outstanding prior to a stock dividend or stock split are retroactively restated to reflect the increase in shares, as if the distribution occurred at the beginning of the period. On the other hand, any new shares issued are time-weighted' by the fraction of the period they were outstanding and then added to the number of shares outstanding for the entire period.
Question 20-3
The weighted-average number of shares for calculating EPS would be 104,500 determined as follows: 100,000 (1.05) 1,200 (5/12) = 104,500 shares shares stock treasury at Jan. 1 dividend shares adjustment The 1,200 shares retired are weighted by (5/12) to reflect the fact they were not outstanding the last five months of the year. Purchases of shares that occur after a stock dividend or split are not affected by the distribution.
Question 20-4
Preferred dividends are deducted from the numerator in the EPS fraction so that earnings available to common shareholders will be divided by the weighted-average number of common shares. An exception would be when the preferred stock is noncumulative and no dividends were declared in the reporting period. Another time the deduction is not made is when the preferred stock is convertible and the calculation of EPS assumes the preferred stock has been converted and therefore no dividends are paid.
Solutions Manual, Vol.2, Chapter 20 The McGraw-Hill Companies, Inc., 2004 20-1
Answers to Questions (continued) Question 20-5
Basic EPS does not reflect the dilutive effect of potential common shares. On the other hand, diluted EPS incorporates the dilutive effect of all potential common shares, if the effect is not antidilutive.
Question 20-6
When calculating diluted EPS, we assume that the shares specified by stock options, warrants, and rights are issued at the exercise price and that the proceeds are used to buy back as treasury stock as many of those shares as could be acquired at the average market price during the reporting period.
Question 20-7
The potentially dilutive effect of convertible bonds is reflected in diluted EPS calculations by assuming the bonds were converted into common stock. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible bonds were issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. The numerator is increased by the after-tax interest that would have been avoided if the bonds really had not been outstanding. This effect is reflected in diluted EPS calculations only if the effect is dilutive.
Question 20-8
The potentially dilutive effect of convertible preferred stock is reflected in diluted EPS calculations by assuming the preferred stock was converted into common stock, just as is done with convertible bonds. The conversion is assumed to have occurred at the beginning of the period, or at the time the convertible preferred stock was issued, if later. When conversion is assumed, the additional common shares that would have been issued upon conversion are added to the denominator of the EPS fraction. Since EPS are calculated as if the preferred shares had been converted into common shares, there would be no dividends on the preferred stock; so, earnings available to common shareholders are increased in the calculation by the dividends that otherwise would have been distributed to preferred shareholders. This is similar to the way after-tax interest would be added back to net income if the securities were convertible bonds. The difference is that dividends have no tax effect to consider. This effect is reflected in diluted EPS calculations only if the effect is dilutive.
Question 20-9
The order in which convertible securities are included in the dilutive EPS calculation is determined by comparing the incremental effect of their conversion. They should be included in numerical order, beginning with the lowest incremental effect (that is, the most dilutive).
The McGraw-Hill Companies, Inc., 2004 20-2
Intermediate Accounting, 3/e
Answers to Questions (concluded) Question 20-10
Contingently issuable shares are considered outstanding in the computation of diluted EPS when they will later be issued upon the mere passage of time or because of conditions that currently are met. If this year's operating income were $2.2 million, the additional shares would be considered outstanding in the computation of diluted EPS by simply adding 50,000 additional shares to the denominator of the EPS fraction:
Contingently issuable shares:
no numerator adjustment ---------------------- + 50,000 additional shares If conditions specified for issuance are not yet met, the additional shares are ignored in the calculation. This would be the case if this year's operating income had been $2 million.
Question 20-11
The calculation of diluted EPS assumes convertible bonds had been converted at the beginning of the year (unless they actually were issued later). If they actually had been converted, the actual conversion would cause an actual increase in shares at the conversion date. These additional shares would be time-weighted for the remainder of the year. The numerator would be higher because net income actually would be increased by the after-tax interest saved on the bonds for that period. But the calculation also would assume conversion for the period before the actual conversion date because they were potentially dilutive during that period. The shares assumed outstanding would be time-weighted for the fraction of the year before the conversion, and the numerator would be increased by the after-tax interest assumed saved on the bonds for the same period.
Question 20-12
EPS data (both basic and diluted for a complex capital structure) must be reported on the face of the income statement for income from continuing operations and net income. Per share numbers for discontinued operations, extraordinary items, and the cumulative effect of a change in accounting principle also should be reported either on the face of the income statement or in related disclosure notes when these components of net income are present.
Question 20-13
Disclosure notes should include (a) a summary description of the rights and privileges of the company's various securities and (b) supplemental EPS data for transactions that occur after the balance sheet date that result in a material change to the number of shares outstanding at the balance sheet date, and (c) a reconciliation of the numerator and denominator used in the basic EPS computations to the numerator and the denominator used in the diluted EPS computations.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-3
EXERCISES
Exercise 20-1
(amounts in millions, except per share amount) net income Earnings Per Share
$741 $741 ---------------------------------------------- = ---- = $1.30 544 + 36 (10/12) 6 (8/12) 570
shares at Jan. 1 new shares shares retired
Exercise 20-2
(amounts in thousands, except per share amount) net income Earnings Per Share
$655 $655 ------------------------------------------------ = ---- 900(1.05) + 60 (8/12) (1.05) + 72 (7/12) 1,029
shares at Jan. 1 new shares ___ stock dividend ___ adjustment new shares
= $.64
Exercise 20-3
(amounts in millions, except per share amount) net preferred income dividends
$426 $16 $410 ------------------------------------ = ---- = $.50 820 820
common shares
Earnings Per Share
Since the preferred stock is cumulative, the dividends (8% x $200 million = $16 million) are deducted even though no dividends were declared. There are no potential common shares, so a single calculation of EPS is appropriate.
The McGraw-Hill Companies, Inc., 2004 20-4
Intermediate Accounting, 3/e
Exercise 20-4
(amounts in thousands, except per share amount) net income preferred dividends Earnings Per Share
$2,000 $50 ---------------------------------- = 800 (1.25)
shares at Jan. 1 stock dividend adjustment
$1,950 -------- 1,000
= $1.95
Exercise 20-5
(amounts in thousands, except per share amount) net loss preferred dividends $761 Net Loss Per Share
$114 - $190 -------------------------------------------- = ---- 373 + 12 (7/12) 380
shares at Jan. 1 19.5% new shares
= ($.50)
x $800* = $76
*8,000 shares x $100 par = $800,000
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-5
Exercise 20-6
1. EPS in 2003
(amounts in thousands, except per share amount) net income Earnings Per Share
$400 ---------------------------------------------------- 202 - 6 (10/12) + 6 (2/12) + 24 (1/12)
shares at Jan. 1 treasury shares treasury shares sold new shares
$400 = $2.00 200
2. EPS in 2004
(amounts in thousands, except per share amount) net income Earnings Per Share
$400 ---------------------------------------------------- (202 - 6 + 6 + 24) x (2.00)
shares at Jan. 1 stock dividend adjustment
$400 = 452
$.88
3. 2003 EPS in the 2004 comparative financial statements
(amounts in thousands, except per share amount) net income Earnings Per Share
$400 ---------------------------------------------------- 200 x (2.00)
weighted-average shares as previously calculated stock dividend adjustment
$400 = $1.00 400
The McGraw-Hill Companies, Inc., 2004 20-6
Intermediate Accounting, 3/e
Exercise 20-7
(amounts in millions, except per share amount) net income preferred dividends Earnings Per Share
$150 $271 -------------------------------------------- 200 (1.05) 24 (10/12) (1.05) + 4 (3/12)
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment 19% new shares
$123 = ------ = 190
$.65
x $300 = $27
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-7
Exercise 20-8
(amounts in millions, except per share amount) Basic EPS net income preferred dividends
$150 $27 ---------------------------------------------------- 200 (1.05) 24 (10/12) (1.05) + 4 (3/12)
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares
$123 = ---- = $.65 190
Diluted EPS net income preferred dividends
$150 $27 ---------------------------------------------------- 200 (1.05) 24 (10/12) (1.05) + 4 (3/12) + (30 24*)
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares assumed exercise of options
$123 = ---- = $.63 196
*Purchase
of treasury stock 30 million shares x $56 (exercise price) $1,680 million $70 (average market price) 24 million shares
The McGraw-Hill Companies, Inc., 2004 20-8
Intermediate Accounting, 3/e
Exercise 20-9
(amounts in millions, except per share amount) Basic EPS net income preferred dividends
$150 $27 ---------------------------------------------------- 200 (1.05) 24 (10/12) (1.05) + 4 (3/12) + 30(4/12)
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares actual exercise of options
$123 = ---- = $.62 200
Diluted EPS net income preferred dividends
$150 $27 -------------------------------------------------------- 200 (1.05) 24(10/12) (1.05) + 4(3/12) + (30 24*)(8/12) + 30(4/12)
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares assumed exercise of options actual exercise of options
$123 = ---- = $.60 204
*Purchase
of treasury stock 30 million shares x $56 (exercise price) $1,680 million $70 (average market price) 24 million shares
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-9
Exercise 20-10
(amounts in millions, except per share amount) Basic EPS net income preferred dividends
$150 $27 $123 -------------------------------------------------------- = -- = $.65 200(1.05) 24 (10/12) (1.05) + 4 (3/12) 190
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares
Diluted EPS net income
preferred dividends
after-tax interest savings
$150 $27 + $5* 40% ($5*) $126 -------------------------------------------------------- = -- = $.62 200 (1.05) 24 (10/12) (1.05) + 4 (3/12) + (30 24**) + 6 202
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares exercise of options conversion of bonds
*8% x $62.5 million = $5 million interest
**Purchase
of treasury stock 30 million shares x $56 (exercise price) $1,680 million $70 (average market price) 24 million shares
The McGraw-Hill Companies, Inc., 2004 20-10
Intermediate Accounting, 3/e
Exercise 20-11
24,000 shares 20,000 shares* = 4,000 shares of treasury shares 24,000 shares x $50 (exercise price) $1,200,000 $60 (average market price) 20,000 shares
*Purchase
Exercise 20-12
(amounts in thousands, except per share amounts)
Basic EPS
net income preferred dividends
$1,500 $60 $1,440 ---------------------------------- = ------ 800 800
shares at Jan. 1
= $1.80
Diluted EPS
net income
$1,500 -------------------------------- = 800 + 200
shares at Jan. 1 conversion* of preferred shares
$1,500 ------ 1,000
= $1.50
*
The preferred shares are considered converted when calculating diluted EPS. If converted, there would be no preferred dividends.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-11
Exercise 20-13
(amounts in thousands, except per share amounts)
Basic EPS
net income
$500 $440 ---------------------------------------------- = ------ = $4.40 100 100
shares at Jan. 1
preferred dividends 60*
Diluted EPS
net income
$500 + $560 ------------------------------------------------------ = ---- = $3.46 100 +32 + 30 162
shares at Jan. 1 conversion of preferred stock conversion of bonds
preferred dividends 60*
preferred dividends +60*
after-tax interest savings $100** 40% ($100)
*
**
12,000 shares x $5 $1,000,000 x 10%
The McGraw-Hill Companies, Inc., 2004 20-12
Intermediate Accounting, 3/e
Exercise 20-14
(amounts in millions, except per share amounts)
Basic EPS
net income
$250 $250 ---------------------------------------------------- = ------ = $4.72 50 + 12 (3/12) 53
shares at Jan. 1 new shares
Diluted EPS
net income after-tax interest savings
$250 +$40* 40% ($40*) $274 ---------------------------------------------------- = ------ = $4.35 50 + 12 (3/12) + 10 63
shares at Jan. 1 new shares conversion of bonds
* $400 x 10%
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-13
Exercise 20-15
(amounts in millions, except per share amount)
Basic EPS
net income
$900 $900 ------------------------------------------------ = ------ 191 + 9 (8/12) 197
shares at Jan. 1 new shares
= $4.57
Diluted EPS
net income
$900 $900 ------------------------------------------------ = ------ 191 + 9 (8/12) + (48 44*) 201
shares at Jan. 1 new shares exercise of options
= $4.48
*Purchase
x
of treasury shares 48 million shares $11 (exercise price) $528 million $12 (average market price)* 44 million shares
The McGraw-Hill Companies, Inc., 2004 20-14
Intermediate Accounting, 3/e
Exercise 20-16
(amounts in thousands, except per share amount)
Basic EPS
net income
$720 $720 ---------------------------------------- = ---- 80 + 15 (4/12) 85
shares at Jan. 1 new shares
= $8.47
Diluted EPS
net income
$720 $720 -------------------------------------------- = ---- 80 + 15 (4/12) + (24 20)* 89
shares at Jan. 1 new shares exercise of warrants
= $8.09
of treasury shares 24,000 shares x $37.50 (exercise price) $900,000 $45 (average market price) 20,000 shares
*Purchase
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-15
Exercise 20-17
(amounts in millions, except per share amounts)
Basic EPS
net income
$148 $148 ---------------------------------------------------- = ------ = $3.89 35 + 4 (9/12) 38
shares at Jan. 1 new shares
Diluted EPS
net income
$148 $148 ---------------------------------------------------- = ------ = $3.79 35 + 4 (9/12) +1 39
shares at Jan. 1 new shares additional shares
Because the conditions are met for issuing 1 million shares, those shares are assumed issued for diluted EPS. Conditions for the other 1 million shares are not yet met, so as they are ignored.
The McGraw-Hill Companies, Inc., 2004 20-16
Intermediate Accounting, 3/e
Exercise 20-18
(amounts in thousands, except per share amounts)
Basic EPS
net income
$2,000 $2,000 ---------------------------------------------------- = ------ = $2.96 600 + 100 (9/12) 675
shares at Jan. 1 new shares
Diluted EPS
net income
$2,000 $2,000 ---------------------------------------------------- = ------ = $2.74 600 + 100 (9/12) + 4 x 10 + 15 730
shares at Jan. 1 * new shares contingent shares* contingent shares**
Because the conditions currently are met (i.e., market price exceeds $48) for issuing 10,000 shares in each of the next 4 years, those shares are assumed issued for diluted EPS. The condition for the other 15,000 shares also is met (the controller is employed), so those shares are assumed issued for diluted EPS.
**
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-17
Exercise 20-19 List A List B
a. b. c. d. e. f. g. h. i. j. Options exercised. Simple capital structure. Basic EPS. Convertible preferred stock. Earnings available to common shareholders. Antidilutive. Increased marketability. Extraordinary items. Stock dividend. Add after-tax interest to numerator. Diluted EPS. Noncumulative, undeclared. preferred dividends. Common shares retired in August. Include in diluted EPS when conditions for issuance are met.
__e_ 1. Subtract preferred dividends. __m_ 2. Time-weighted by 5/12. __a_ 3. Time-weighted shares assumed issued plus time-weighted-actual shares. __i_ 4. Midyear event treated as if it occurred at the beginning of the reporting period. __l_ 5. Preferred dividends do not reduce earnings. __b_ 6. Single EPS presentation. __g_ 7. Stock split. __d_ 8. __f_ 9. __c_10. __j_ 11.
Potentially dilutive security. k. Exercise price exceeds market price. l. No dilution assumed. Convertible bonds. m.
_n_ 12. Contingently issuable shares. n. _k_ 13. Maximum potential dilution. _h_ 14. Per share amounts for net income and for income from continuing operations.
The McGraw-Hill Companies, Inc., 2004 20-18
Intermediate Accounting, 3/e
PROBLEMS
Problem 20-1
1. Net loss per share for the year ended December 31, 2003:
(amounts in millions, except per share amount) net loss preferred dividends $1601 Net Loss Per Share
$140 - $300 ---------------------------------------------------- = ------ 600 (1.05) 30 (8/12) (1.05) + 12 (4/12) 613
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment new shares
= ($.49)
2. Per share amount of income or loss from continuing operations for the year ended December 31, 2003:
(amounts in millions, except per share amount) Income from Continuing Operations Per Share
$100 -------------------------------------------------- = ------ = $.16 600(1.05) 30 (8/12) (1.05) + 12 (4/12) 613
shares at Jan. 1 treasury shares ___ stock dividend ___ adjustment 1 20 million shares x $100 x 8% = $160 million 2 $400 $140 = $260 million new shares
operating income $2602
preferred dividends $1601
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-19
Problem 20-1 (concluded) 3. 2003 and 2002 comparative income statements:
(amounts in millions, except per share amount)
2003 Earnings (Loss) Per Common Share: Income (loss) from operations before extraordinary items Extraordinary loss from litigation settlement Net income (loss)
Note:
2002
$ .16 (.65) ($ .49)
$.71 -- $.71
The weighted-average number of common shares in 2002 should be adjusted for the stock dividend in 2003 for the purpose of reporting 2002 EPS in subsequent years for comparative purposes:
net income
Earnings Per Share
$450 $450 ---------------------- = ------ 600 (1.05) 630
shares at Jan. 1 stock dividend adjustment
= $.71
The McGraw-Hill Companies, Inc., 2004 20-20
Intermediate Accounting, 3/e
Problem 20-2
2001
net loss Net Loss Per Share
$160,500 -------------------- 1,855,000
shares
= ($.09)
2002
net income Earnings Per Share
$2,240,900 $2,240,900 ---------------------------------- = -------------- = $1.23 1,855,000 110,000 (3/12) 1,827,500
shares at Jan. 1 retired shares
2003
net income Earnings Per Share
$3,308,700 $3,308,700 ---------------------------------- = -------------- = $1.86 1,745,000* x (1.02)** 1,779,900
shares at Jan. 1 * ** stock dividend adjustment
1,855,000 110,000 = 1,745,000 shares This is a 2% stock dividend: 34,900 1,745,000 = 2%. Alternatively, the additional 34,900 shares could be simply added to the 1,745,000 initial shares outstanding.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-21
Problem 20-3
(amounts in millions, except per share amount)
2001
net income preferred dividends Earnings Per Share
$290 $1 ---------------------------------- 55 + 9 (6/12)
shares at Jan. 1 new shares
$289 = ------ 59.5
=
$4.86
2002
net income preferred dividends Earnings Per Share
$380 $1 ---------------------------------- 64 (1.50) 4 (9/12) (1.50)
shares at Jan. 1 retired shares ___ stock split ___ adjustment
$379 = ------ 91.5
=
$4.14
2003
net income preferred dividends Earnings Per Share
$412 $2 ---------------------------------- 90 (1.10) + 3 (4/12)
shares at Jan. 1 stock dividend adjustment new shares
$410 = ------ 100
= $4.10
The McGraw-Hill Companies, Inc., 2004 20-22
Intermediate Accounting, 3/e
Problem 20-4
(amounts in thousands, except per share amount) net income preferred dividends Earnings Per Share
$2,100 $75 $2,025 -------------------------------------------------- = ------ 600 (1.04) + 60 (10/12) (1.04) 2 (6/12) 675
shares at Jan. 1 new shares ___ stock dividend ___ adjustment shares retired
= $3.00
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-23
Problem 20-5
The options issued in 2001 are not considered when calculating 2003 EPS because the exercise price ($33) is not less than the 2003 average market price of $32 (although they would have been considered when calculating 2001 or 2002 EPS if the average price those years had been more than $33). The options issued in 2003 do not affect the calculation of 2003 EPS because they were issued at December 31. Options are assumed exercised at the beginning of the year or when granted, whichever is later -- when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2002 are considered exercised for 8,000 shares when calculating 2003 EPS because the exercise price ($24) is less than the 2003 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 x $24 $192,000 $32 6,000 shares (exercise price) (average market price) shares
The McGraw-Hill Companies, Inc., 2004 20-24
Intermediate Accounting, 3/e
Problem 20-5 (concluded)
(amounts in thousands, except per share amount)
Basic EPS
net income preferred dividends
$2,100 $75 $2,025 ---------------------------------------------------- = ---- 600(1.04) + 60 (10/12) (1.04) 2 (6/12) 675
shares at Jan. 1 new shares ___ stock dividend ___ adjustment shares retired
= $3.00
Diluted EPS
net income preferred dividends
$2,100 $75 $2,025 ---------------------------------------------------- = ---- 600(1.04) + 60 (10/12) (1.04) 2 (6/12) +(8 6) 677
shares at Jan. 1 new shares ___ stock dividend ___ adjustment shares retired exercise of options
= $2.99
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-25
Problem 20-6
The options issued in 2001 are not considered when calculating 2003 EPS because the exercise price ($33) is not less than the 2003 average market price of $32 (although they would have been considered when calculating 2001 or 2002 EPS if the average price those years had been more than $33). The options issued in 2003 do not affect the calculation of 2003 EPS because they were issued at December 31. Options are assumed exercised at the beginning of the year or when granted, whichever is later -- when granted, in this case. So, the fraction of the year the shares are assumed outstanding is 0/12, meaning no increase in the weighted-average shares. The options issued in 2002 are considered exercised for 8,000 shares when calculating 2003 EPS because the exercise price ($24) is less than the 2003 average market price of $32. Treasury shares are assumed repurchased at the average price for diluted EPS: 8,000 x $24 $192,000 $32 6,000 shares (exercise price) (average market price) shares
The McGraw-Hill Companies, Inc., 2004 20-26
Intermediate Accounting, 3/e
Problem 20-6 (concluded)
(amounts in thousands, except per share amounts)
Basic EPS
net income preferred dividends
$2,100 $75 $2,025 ------------------------------------------------------ = ---- 600(1.04) + 60 (10/12) (1.04) 2 (6/12) 675
shares at Jan. 1 new shares ___ stock dividend ___ adjustment shares retired
= $3.00
Diluted EPS
net income preferred dividends after-tax interest savings
$2,100 $75 + $80 40%($80) $2,073 -------------------------------------------------------- = -- = $2.86 600(1.04) + 60(10/12) (1.04) 2 (6/12) + (8 6) + 23* + 24** 724
shares at Jan. 1 new shares ___ stock dividend ___ adjustment shares retired exercise of options contingent shares conversion of bonds
* The contingently issuable shares are considered issued when calculating diluted EPS because the condition for issuance (Merrill net income > $500,000) currently is being met. ** The bonds are considered converted when calculating diluted EPS: 800 bonds x 30 shares = 24,000 shares upon conversion. Interest = $800,000 x 10% = $80,000.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-27
Problem 20-7
Requirement 1
(amounts in thousands, except per share amount)
Basic EPS:
net income preferred dividends
$150 $77 $73 -------------------------------- = ------ = 40 40
weighted-average shares
$1.83
With conversion of preferred stock (Diluted EPS):
net income
$150 $150 -------------------------------- = ------ = 40 + 20 60
weighted-average shares conversion of preferred shares
$2.50
Since the assumed conversion of the convertible preferred stock causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS.
The McGraw-Hill Companies, Inc., 2004 20-28
Intermediate Accounting, 3/e
Problem 20-7 (concluded) Requirement 2 Basic EPS:
net income
$150 ------------------ 40
weighted-average shares
= $3.75
With conversion of bonds:
net income after-tax interest savings
$150 + $40 40% ($40) $174 -------------------------------- = ------ = 40 +5 45
weighted-average shares conversion of bonds
$3.87
Since the assumed conversion of the convertible bonds causes EPS to increase, it is antidilutive and therefore ignored when calculating EPS. Requirement 3 Since the exercise price is less than average market price, the options are not antidilutive and therefore assumed exercised when calculating diluted EPS. Requirement 4 Since the exercise price is higher than the average market price, the warrants are antidilutive and therefore ignored when calculating diluted EPS. Requirement 5 The 5,000 shares are added to the denominator when calculating diluted EPS since 2003 net income is higher than the conditional amount. Since only the is denominator increased, the effect is not antidilutive.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-29
Problem 20-8
(amounts in millions, except per share amounts)
Basic EPS
net income
$560 $560 -------------------------------------------- = ---- = $1.44 400 30 (4/12) 390
shares at Jan. 1 new shares
Diluted EPS
net income after-tax* interest savings
$560 + $30 40% ($30) $578 -------------------------------------------- = ---- = $1.36 400 30 (4/12) + 36 426
shares at Jan. 1 *Interest new shares conversion of bonds
on the bonds = $300 million x 10% = $30 million. If the bonds were not outstanding, interest expense would have been $30 million lower, and tax expense would have been 40% x $30 million, or $12 million higher, a net after-tax savings of $18 million.
The McGraw-Hill Companies, Inc., 2004 20-30
Intermediate Accounting, 3/e
Problem 20-9
(amounts in thousands, except per share amounts)
Basic EPS
net income
$650
preferred dividends $40*
$610 $1.37
-------------------------------------------------------------------- = ------ = 440 + 16 (3/12) 444 shares at Jan. 1 new shares
Diluted EPS
net income
$650
preferred dividends $40*
preferred dividends + 40*
$650 $1.33
------------------------------------------------------------------ = ------ = 440 + 16 (3/12) + (20 15**) + 40 489 shares at Jan. 1 new shares exercise of options conversion of preferred shares
* 4,000
shares x $100 par x 10% = $40,000
purchase of treasury shares 20,000 shares x $30 (exercise price) $600,000 $40 (average market price) 15,000 shares
**Assumed
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-31
Problem 20-10
Basic EPS
net income preferred dividends
$1,476
$60*
$1,416 = $2.27
------------------------------------------------------------------------------ = ------ 600 + 72 (4/12) 624 shares new at Jan. 1 shares
Diluted EPS
net income preferred dividends after-tax Interest savings
$1,512 ------------------------------------------------------------------------------ = ------ = $2.09 600 + 72 (4/12) + (60 40)** + 80 724
shares at Jan. 1 new shares exercise of options conversion of bonds
$1,476
$60*
+ $160 - 40% ($160)
*Preferred dividends: 6% x $50 x 20 million shares = $60 million **Computation of Treasury Shares: 60 million x $12 $720 million $18 40 million shares exercise price proceeds average share price treasury shares
The McGraw-Hill Companies, Inc., 2004 20-32
Intermediate Accounting, 3/e
CASES
Judgment Case 20-1
Although net income declined during the period, a combination of events caused EPS to increase in spite of declining profits. Specifically, retiring the preferred shares increased earnings available to common shareholders; retiring common shares and retiring convertible debt each decreased the weighted-average number of common shares. The following calculations show the effect of these events:
(amounts in millions, except per share amount)
2001
net income preferred dividends Basic EPS
$145 $16* $129 -------------------------------------- = ---- 60 60
shares at Jan. 1
= $2.15
net income
preferred dividends
after-tax interest savings
Diluted EPS
$145 $16* + $5 40% ($5) $132 -------------------------------------- = ---- 60 +9 69
shares at Jan. 1 * conversion of bonds
= $1.91
8% x [$10 x 20 million] = $16
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-33
Case 20-1 (concluded) 2002
net income
$134 $122 -------------------------------------- = ---- 60 12 (10/12) 50
shares at Jan. 1 retired shares
preferred dividends $12
Basic EPS
= $2.44
net income
$134 + $5 40% ($5) $125 -------------------------------------- = ---- 60 12 (10/12) +9 59
shares at Jan. 1 retired shares conversion of bonds
preferred dividends $12
after-tax interest savings
Diluted EPS
= $2.12
2003
net income Basic EPS
$95 $95 -------------------------------------- = ---- 48 12 (10/12) 38
shares at Jan. 1 retired shares
= $2.50
net income
Diluted EPS
$95 $95 -------------------------------------- = ---- 48 12 (10/12) 38
shares at Jan. 1 retired shares
= $2.50
$16 (6/12 x 8% x [$10 x 20 million x 1/2]): calculation reflects the retirement of half the shares on July 1 60 - 12
The McGraw-Hill Companies, Inc., 2004 20-34
Intermediate Accounting, 3/e
Communication Case 20-2
Suggested Grading Concepts and Grading Scheme: Content (80% ) 60 Convertible securities are included in the computation. Of diluted earnings per share. By assuming they were converted, the ifconverted method, as it's called. The denominator of the EPS fraction is increased by the additional common shares that would have been issued upon conversion. The numerator is increased by the interest (after-tax) or preferred dividends that would have been avoided. 20 Antidilutive securities. Antidilutive means EPS increases rather than decreases. Ignored when calculating earnings per share. (4) Provides detail regarding the tax effect calculation for convertible bonds. Interest on bonds is tax deductible. Tax expense will increase by the tax rate times interest. 80-84 points
Bonus
Writing (20%) 5 Terminology and tone appropriate to the audience of division managers. 6 Organization permits ease of understanding. Introduction that states purpose. Paragraphs separate main points. 9 English Word selection. Spelling. Grammar. 20 points
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-35
Real World Case 20-3
Requirement 1 The disclosure note refers to adjustments for dilutive stock options. Stock options give their holders the right to exercise their option to purchase common stock at a specified exercise price. The dilution that would result from their exercise should be reflected in the calculation of diluted EPS, but not basic EPS. To include the dilutive effect of a security means to calculate EPS as if the potential increase in shares already has occurred (even though it hasn't yet). So, for stock options, we pretend the options have been exercised. In fact, we assume the options were exercised at the beginning of the reporting period, or when the options were issued if that's later. We then assume the cash proceeds from selling the new shares at the exercise price are used to buy back as many shares as possible at the shares' average market price during the year. The disclosure note refers to contingently issuable shares. When an agreement specifies that additional shares of common stock will be issued, contingent upon the occurrence of some future circumstance, perhaps issuable to shareholders of an acquired company, certain key executives, or others in the event a certain level of performance is achieved. Contingent performance may be a desired level of income, a target stock price, or some other measurable activity level. When calculating EPS, contingently issuable shares are considered to be outstanding in the computation of diluted EPS if shares are to be issued merely as a result of time passing, or if some target performance level already is being met (assumed to remain at existing levels until the end of the contingency period). For example, if shares will be issued at a future date if a certain level of income is achieved and that level of income or more was already earned this year, those additional shares are simply added to the denominator of the diluted EPS fraction. The shares should be included in both basic and diluted EPS if all conditions have actually been met so that there is no circumstance under which those shares would not be issued. In essence, these are no longer contingent shares. This apparently is the case for Harris because the adjustment is made for both basic and diluted EPS.
The McGraw-Hill Companies, Inc., 2004 20-36
Intermediate Accounting, 3/e
Case 20-3 (concluded) Requirement 2 Yes, is it possible for stock options not to be dilutive. Sometimes, the effect of the exercise of options would be to increase, rather than decrease, EPS. These we refer to as antidilutive securities. Such options are ignored when calculating both basic and diluted EPS. For example, when we adjust shares for the effect of the options being exercised, we apply what's called the treasury stock method. The number of shares assumed repurchased is fewer than the number of shares assumed sold any time the buy-back (average market) price is higher than the exercise price. In those cases, there will be a net increase in the number of shares so earnings per share will decline. This was the case for Harris' options referred to in the note. On the other hand, if the exercise price is higher than the market price, to assume shares are sold at the exercise price and repurchased at the market price would mean buying back more shares than were sold. This would produce a net decrease in the number of shares. EPS would increase, not decrease, if we were to assume the exercise of stock options. These would have an antidilutive effect and would not be considered exercised. For that matter, a rational investor would not exercise options at an exercise price higher than the current market price anyway. Requirement 3 Here is the presentation of basic and diluted earnings per share for 2001, 2000, and 1999 that Harris reports in its 2001 annual report. Net Income Per Common Share Basic: Continuing operations Discontinued operations Extraordinary item Diluted: Continuing operations Discontinued operations Extraordinary item 2001 $0.32 2000 $0.34 (0.09) $0.25 $0.34 (0.09) $0.25 1999 $0.63 0.16 (0.12) $0.67 $0.63 0.16 (0.12) $0.67
$0.32 $0.32
$0.32
Note that basic and diluted EPS are the same each year because the dilutive effect of stock options was very small. Rounding of the calculations produces the same EPS numbers.
Solutions Manual, Vol.2, Chapter 20 The McGraw-Hill Companies, Inc., 2004 20-37
International Case 20-4
The report should indicate similarities and differences between the United States and the chosen country focusing on the following issues: a. Earnings for the numerator of the EPS calculation are defined in the United States as earnings available for common shareholders. Separate calculations are required for ordinary income and net income when differences exist. In some countries (Norway, e.g.), earnings are defined as ordinary income only. b. In the United States, both basic and diluted EPS are reported. Some countries have similar requirements but define the two calculations differently from the US. Other countries require only one of the two calculations. Japan requires basic only, for example. Still other countries require no EPS disclosure at all, but disclosure may be provided anyway. (Germany, Spain, and Switzerland are examples.) c. Some countries require disclosures not provided by US companies. Japan, for instance, also discloses net assets per share. Optionally, the report might compare (a) the degree of conservatism in the approaches taken by the two countries or (b) whether cultural differences are likely contributors to the differences observed.
The McGraw-Hill Companies, Inc., 2004 20-38
Intermediate Accounting, 3/e
Analysis Case 20-5
Requirement 1 In its simplest form, earnings per share is merely a firm's net income divided by the number of shares outstanding throughout the year.
Earnings per share = Income available to common shareholders Weighted-average shares outstanding
=
$487 181 $2.69
= Requirement 2
Price-earnings ratio =
Market price per share Earnings per share
=
$47.00 $2.69 17.5
=
The ratio is a measure of the market's perception of the quality of a company's earnings. It indicates the price multiple the capital market is willing to pay for the company's earnings. In a way, this ratio reflects the market's perceptions of the company's growth potential, stability, and relative risk in that the ratio relates these performance measures with the external judgment of the marketplace concerning the value of the firm. The calculation indicates that IGF's share price represents $17.50 for every dollar of earnings. In that regard, it measures the quality of earnings in the sense that it represents the market's expectation of future earnings as indicated by current earnings. We should be aware, though, that a ratio might be low, not because earnings expectations are low, but because of abnormally elevated current earnings, or, the ratio might be high, not because earnings expectations are high, but because the company's current earnings are temporarily depressed.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-39
Case 20-5 (concluded) Requirement 3 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. To calculate the ratio for IGF with the information provided, we must estimate dividends from analysis of the retained earnings account: Retained Earnings 2,428 487 Dividends ? 2,730 Dividends apparently were $185,000,000. Dividends per share, then, would be $185 / 181 = $1.02
Dividend payout ratio = Cash dividends per share Earnings per share
Net income
=
$1.02 $2.69 37.9%
=
IGF paid cash dividends of $1.02 cents per share during the most recent year, almost 38% of earnings. The ratio provides an indication of the firm's reinvestment strategy. If the payout ratio is low, it suggests that the company retains a large portion of earnings for reinvestment for purposes such as new facilities and current operations. Sometimes, though, the ratio just reflects managerial strategy regarding the mix of internal versus external financing. Investors who, for tax or other reasons, prefer current income over market price appreciation, or vice versa, are particularly interested in this ratio.
The McGraw-Hill Companies, Inc., 2004 20-40
Intermediate Accounting, 3/e
Ethics Case 20-6
Discussion should include these elements. Effect of share repurchase on EPS. Reducing the number of shares will increase earnings per share. That impact will be lessened, though, the closer to the end of the year the shares are bought due to the way the share reduction is time-weighted for the fraction of the year they are not outstanding. Ethical Dilemma: Apparently, a more productive use for available funds will be offered by Barber. How does a less-than-optimal use of company funds compare with the perceived need to maintain a record of increasing reported EPS? Who is affected? Mashburn Lane Managers under the bonus plan Shareholders Potential shareholders Employees Creditors
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-41
Integrating Case 20-7
Requirement 1 The 898 million options outstanding will not affect basic EPS. Only shares actually issued upon the exercise of options affect that calculation. However, diluted EPS will reflect the potential dilution from the assumed exercise of those options. Specifically, that calculation assumes the outstanding options had been exercised at the beginning of the year, or when the options were issued for those granted during the current period. The assumed proceeds from the exercise would be assumed used to buy back as many of the 898 million shares as could be purchased at the average market price of the shares. Requirement 2 If there were no actual changes in shares, and no potential common shares other than options, we could explain the difference as follows: shares assumed issued upon the exercise of the options at the beginning of the period (457 million) difference in actual shares and number used in EPS calculations (5,482 million 5,025 million) 441 million shares assumed repurchased at the average market price per share Note: The restrictive assumptions were made for convenience. Microsoft's dilutive potential common shares were due primarily to stock options, but partly also to other potential common shares. Also, Microsoft's shares actually did change in fiscal 2001 as a result of common stock repurchases and the actual exercise of options. Also, the options outstanding changed during the year as follows: Balance, June 30, 2000 Granted Exercised Canceled Balance, June 30, 2001 832 224 (123) (35) 898 898 million
The McGraw-Hill Companies, Inc., 2004 20-42
Intermediate Accounting, 3/e
Research Case 20-8
The results students report will vary somewhat depending on the dates and times quotes were accessed. It is unlikely, though, that their relative comparisons or conclusions will differ. The PE ratio is the market price per share divided by the earning per share. It measures the market's perception of the quality of a company's earnings by indicating the price multiple the capital market is willing to pay for the company's earnings. The ratio reflects the information provided by all financial information in that the market price reflects analysts' perceptions of the company's growth potential, stability, and relative risk. The price-earnings ratio relates these performance measures with the external judgment of the marketplace concerning the value of the firm. The ratio measures the quality of earnings in the sense that it represents the market's expectation of future earnings as indicated by current earnings. Caution is called for in comparing price-earnings ratios. Historically, the ratio for both companies has been relatively high, reflecting growth expectations.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-43
Analysis Case 20-9
Requirement 1 Yes and no. The income statement sometimes reports items that require separate presentation within the statement, including one or more of the following: Income from continuing operations Discontinued operations Extraordinary items Cumulative effect of a change in accounting principle Net income When net income includes one or more of the separately reported items, EPS data (both basic and diluted) must also be reported separately for income from continuing operations and net income. Requirement 2 The price-earnings ratio is simply the market price per share divided by the earnings per share. For Kellogg's most recent 12 months, the ratio is: $30.40 ($.23 + .86) = 27.9 It purports to measure the market's perception of the quality of a company's earnings by indicating the price multiple the securities market is willing to pay for the company's earnings. The P/E ratio reflects analysts' perceptions of the company's growth potential, stability, and relative risk by relating these performance measures with the external judgment of the marketplace in regard to the value of the company. Care is needed when evaluating price-earnings ratios. Like other ratios, it is best evaluated in context of P/E ratios of earlier periods and other, similar companies. For example, although Kellogg's results were lower than the previous year, they are up from two years before. Also, the P/E ratio of General Mills, Kellogg's prime competitor was 20.5 at the same time. Both are high relative to the average P/E ratio for all companies at the time, which was approximately 17.
The McGraw-Hill Companies, Inc., 2004 20-44
Intermediate Accounting, 3/e
Case 20-9 (concluded) Requirement 3 The dividend payout ratio expresses the percentage of earnings that is distributed to shareholders as dividends. The ratio is calculated by dividing dividends per common share by the earnings per share. For Kellogg's most recent 12 months, the ratio is: ($.2525 x 4) ($.23 + .86) = 93% Relative to the average company, this payout percentage is quite high. It also is high relative to General Mills, Kellogg's prime competitor. General Mills' payout ratio was 48% at the same time. Historically, both companies and the industry in general have relatively high dividend payouts. This ratio provides an indication of a firm's reinvestment strategy. A low payout percentage suggests that a company is retaining a large portion of earnings for reinvestment in new projects. Low ratios often are found in growth industries. High payouts, like those of General Mills and Kellogg, often are found in mature industries. Sometimes, the ratio is just an indication of management strategy related to the mix of internal versus external financing. A high ratio is preferred by investors who, for tax or other reasons, prefer current income to market price appreciation.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-45
Analysis Case 20-10
Requirement 1 When calculating basic earnings per share, the numerator in the computation is the earnings available to common shareholders. This will be net income reduced by dividends payable to preferred shareholders. Since the preferred stock is cumulative we subtract preferred dividends even if not declared. Because unpaid dividends accumulate to be paid in a future year when (if) dividends are subsequently declared, the presumption is that, although the year's dividend preference isn't distributed this year, it eventually will be paid. Requirement 2 When calculating basic earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during 2003. Thus, the 8 million shares outstanding at January l, 2003, plus a portion of the shares sold will result in the weighted-average number of shares outstanding for calculating basic EPS. The 3 million common shares issued during 2003 must be included in computing the weighted-average number of shares outstanding. The 3 million shares will be weighted one-third because they were outstanding only for the four months of 2003. The 1 million common shares issued upon the exercise of stock options must be included in computing the weighted-average number of shares outstanding. The 1 million shares will be weighted one-half because they were outstanding only for the six months of 2003. Requirement 3 When calculating diluted earnings per share, the numerator in the computation is the earnings available to common shareholders. Proactive will not reduce net income by dividends payable to preferred shareholders because it will treat the convertible preferred stock as if the preferred shares were converted and 4 million common shares were outstanding, unless including these shares in the denominator would increase earnings per share (be antidilutive). This means that it would not reduce the numerator for the preferred dividends as it would do if the preferred shares were assumed outstanding, as in calculating basic EPS. Requirement 4 When calculating diluted earnings per share, the denominator in the computation is the weighted-average number of common shares outstanding during the reporting period. But since potential common shares exist in a complex capital structure, as in this situation, the calculation of the denominator becomes more involved.
The McGraw-Hill Companies, Inc., 2004 20-46
Intermediate Accounting, 3/e
Case 20-10 (concluded) We begin by determining the weighted-average of the number of common shares outstanding during 2003, the 8 million shares outstanding at January l, 2003, plus a portion of the shares sold. The 3 million common shares issued during 2003 must be included in computing the weighted-average number of shares outstanding. The 3 million shares will be weighted one-third because they were outstanding only for the four months of 2003. The 1 million common shares issued upon the exercise of stock options must be included in computing the weighted-average number of shares outstanding. The 1 million shares will be weighted one-half because they were outstanding only for the six months of 2003. For diluted EPS, two adjustments are needed to the denominator. First, we treat the convertible preferred stock as if the preferred shares were converted and 4 million additional common shares were outstanding, unless including these shares in the denominator would increase earnings per share (be antidilutive). As noted in requirement 2, this means also that we would not reduce the numerator for the preferred dividends as we would do if the preferred shares were assumed still outstanding. Second, we treat the stock options outstanding under the employee stock option plan as having been exercised. The number of common shares represented by the options outstanding should be computed by application of the treasury stock method. By this method, earnings per share is computed as if the options were exercised at the beginning of the period (or at time of issue, if later) and as if the cash received were used to purchase common stock at the average market price during the period. The weightedaverage number of shares outstanding for 2003 includes (a) the 1 million shares represented by the 1 million options outstanding for the full year, plus (b) a time-weighted proportion of the 1 million exercised in 2003, and (c) a time-weighted proportion of the 1.5 million granted during 2003. We cannot determine the weighted-average number of options outstanding from the data provided because no exercise or grant dates were given. The 1 million shares issued when the options were exercised during 2003 must be included in the computation of the weighted-average number of shares outstanding from the date exercised to the year-end. Again, we cannot determine this number because the exercise dates were not given. Note that the options outstanding for only part of the reporting period are included in the denominator on a time-weighted basis. For the 1.5 million options granted during the year, the denominator would include the appropriate incremental shares x the appropriate time-weighting fraction. Likewise, for the options exercised during the year, the weighted average shares should include (a) the appropriate incremental shares x the appropriate time-weighting fraction for the period prior to actual exercise and (b) the appropriate actual shares issued x the appropriate time-weighting fraction for the period after the exercise.
Solutions Manual, Vol.2, Chapter 20
The McGraw-Hill Companies, Inc., 2004 20-47
Real World Case 20-11
Requirement 1 The note indicates that diluted net income per share is computed using the weighted-average number of common and dilutive potential common shares. Securities like stock options or convertible bonds, while not being common stock, may become common stock through their exercise or conversion. As a result, they may dilute (reduce) earnings per share and therefore are called potential common shares. Diluted EPS incorporates the dilutive effect of all potential common shares. Requirement 2 In fiscal 2000, Cisco includes 521 million dilutive potential common shares from employee stock options. To include the dilutive effect of a security means to calculate EPS as if the potential increase in shares already has occurred, even though it hasn't yet. Therefore, for its stock options Cisco pretends the options have been exercised. Specifically, it assumed the options were exercised at the beginning of the reporting period, or when the options were issued if that's later. Cisco assumed the cash proceeds from selling the new shares at the exercise price were used to buy back as many shares as possible at the shares' average market price during the year. The net difference, shares issued minus shares repurchased, was 521 million shares. Requirement 3 In fiscal 2001, Cisco does not include dilutive potential common shares from employee stock options. The reason is stated in the disclosure note: Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is antidilutive. The dilutive potential common shares that were antidilutive for fiscal 2001 amounted to 348 million shares. If Cisco had included the 348 million dilutive potential common shares from employee stock options, the loss per share would have declined from ($.14) to ($.13), ($1,014) / [7,196 + 348]. Whenever a company reports a net loss, as Cisco did in 2001, it reports a loss per share. In that situation, stock options that otherwise are dilutive will be antidilutive. The loss per share declines. This represents an increase in performance not a dilution of performance. The options would be considered antidilutive, then, and not included in the calculation of the net loss per share.
The McGraw-Hill Companies, Inc., 2004 20-48
Intermediate Accounting, 3/e