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2. For purposes of computing earnings per share residual securities are those securitiesderiving a major portion of their value from their right to be converted into common stockthrough the exercise of an option or conversion privilege by the owner of the security.Convertible preferred stock, convertible debt, common stock options and common stockwarrants are examples of such securities.
c.Treatments to be given to the listed items in computing earnings per share are:i.Dividends on preferred stock should be deducted from net income and also net incomebefore extraordinary items before computing earnings per share applicable to thecommon stock and other residual securities. If the preferred stock is cumulative thisadjustment is appropriate whether or not the amounts of the dividends are declared orearned. ii.Minor reacquisitions of outstanding common stock which are placed in the treasurymay be excluded in the computation of earnings per share. However, in determiningearnings per share during the period when a major acquisition of treasury commonstock was made, the computation should be based on the weighted average number ofshares outstanding during the period.iii.When the number of common shares outstanding increases as a result of a stock splitduring the year, the computation should be based on shares outstanding at year end andretroactive recognition should be given for an appropriate number of prior years.iv. The existence of a provision for a contingent liability on a possible lawsuit created outof retained earnings will not affect the computation of earnings per share since theappropriation of retained earnings does not affect net income or the number of shares ofstock outstanding.v. Outstanding preferred stock with a par value liquidation right issued at a premium,although affecting the determination of book value, will not affect the computation ofearnings per share for common stock except with respect to the dividends as discussedin c.i. above.vi. The exercise of a common stock option which results only in a minor increase in thenumber of shares outstanding during the period may be disregarded in the computationof earnings per share. If, however, the exercise of a common stock option results in amajor increase in the number of shares outstanding, the computation of earnings pershare should be based on the weighted average number of shares outstanding during theperiod. The exercise of a stock option by the grantee does not affect earnings, but anycompensation to the officers from the granting of the options would reduce net incomeand earnings per share.vii. The replacement of a machine immediately prior to the close of the current fiscal yearwill not affect the computation of earnings per share for the year in which the machineis replaced. The number of shares remains unchanged and since the old machine wassold for its book value, earnings are unaffectedCase 6-8 Classification of Accounting Changes Morgan CompanyMorgan Company grows various crops and then processes them for sale to retailers. Morgan has