THE CPA BOARD EXAMS OUTLINES
by John Mahatma G. Agripa, CPA
FINANCIAL ACCOUNTING AND REPORTING
EARNINGS
PER SHARE:
BASIC & DILUTED
Based on lectures by Tom Siy, CPA and Christian Aris Valix, CPA (CPAR)
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DEFINITIONS Earnings per share (EPS) is a figure representing company earnings attributable only to shareholders holding ordinary shares, which is required to be disclosed among public/listed entities since they are determinant of market price of shares. Losses per share is also computed if such was the case
This does not apply to preference shareholders since they have a fixed rate of return, expressed as a percentage of the share’s par value
EPS may be basic or diluted. Diluted EPS assumes that all potential ordinary shares – arising from either convertible bonds, convertible preference shares, or share options and warrants – are all converted in the period. It also represents the lowest possible earnings per share (or highest possible loss per share)
The aforementioned securities are considered in the computation of diluted EPS if their exercise prices are lower than the market price. Otherwise, they are considered antidilutive, and would cause EPS to go higher (or LPS to go lower)
BASIC EARNINGS PER SHARE
The formula for basic earnings per share is as follows:
Net income – Declared preference dividends xx
DIVIDE: Weighted average number of ordinary shares xx
Basic EPS xx
Net income in the above formula shall be after all deductions, including interest expense, taxes and income attributed to minority
interest, if such was the case
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current year (arrears not considered). They have to be declared to be included in the computation. Of course, if the preference shares are cumulative, the dividends are automatically deducted. In cases of losses per share, the dividend is still deducted If the dividends were declared out of redeemable preference shares, no deduction is necessary, since the dividends are considered interest expenses, which has been already deducted from net income. Redeemable preference shares are considered financial liabilities for the corporation
The weighted average number of outstanding ordinary shares can be calculated as follows. The fraction represents the portion of the year the effects of the transactions have become outstanding in the current year
Beginning number of shares x 12/12 xx
ADD: New shares issued x 10/12 (if issued on March) xx
ADD: New shares subscribed x 10/12 (if subscribed in March) xx
DEDUCT: Shares put in treasury x 9/12 (if bought on April) xx
MULTIPLY: All split-ups (multiply by 2 if 2-for-1) xx
DIVIDE: All split-downs (divide by 2 if 1-for-2) xx
MULTIPLY: All share dividends (1 + rate) xx
Weighted-average ordinary shares outstanding xx
MULTIPLY: Bonus element from stock rights xx
Adjusted WAOSO xx
This figure may be affected by transactions that have a retroactive effect, namely share splits and share dividends. For example, if a 20% share dividend is declared in May, all outstanding ordinary shares as of May shall be multiplied by 1.20. All the subsequent share transactions are no longer adjusted for this particular share dividend. If another 20% share dividend is declared in November, the outstanding ordinary shares as of November is further multiplied with 1.20
The computed weighted average number of ordinary shares outstanding is further adjusted for any stock rights. These are instruments that the corporation gives its shareholders that gives them the right to purchase new shares at a lower price, as to maintain their proportionate share of the entity. The bonus
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element above is computed as follows:
Market price right-on (the actual market price) xx
DIVIDE: Market price ex-right xx
Bonus element xx
If not given as well, the market price ex-right (without the stock right) is computed as follows:
Market price right-on (the actual market price) xx
DEDUCT: [ (Market price right on – exercise price
Number of rights to be used for one share + 1) ] xx
Market price ex-right xx
DILUTED EARNINGS PER SHARE: SINGLE DILUTER
The formula for diluted earnings per share changes for each type of diluter. With the presence of convertible preference shares, diluted EPS is computed as follows:
Net income xx
DIVIDE: WAOSO + potential ordinary shares xx
Diluted EPS xx
Potential ordinary shares refer to all ordinary shares that will be added if all the convertible preference shares are converted. Preference dividends are no longer deducted from net income since there’s no more preference shares (they are assumed to be converted)
For convertible bonds, diluted EPS is computed as follows:
Net income + Interest expense, after tax xx
DIVIDE: WAOSO + potential ordinary shares xx
Diluted EPS xx
Interest expense (after tax) is added back to net income (after tax) for the same reason preference dividends is no longer deducted from net income in the previous case. If the bonds were issued in
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May, for example, the interest expense to be added back and all
the potential ordinary shares shall be multiplied with 8/12 to
prorate them
As to share options and warrants, the formula is as follows:
Net income xx
DIVIDE: WAOSO + incremental ordinary shares xx
Diluted EPS xx
As a shortcut to the treasury share method, incremental ordinary shares above can also be computed as follows:
All ordinary shares from the option/warrant xx
MULTIPLY: [(Market price – Option price) ÷ Market price] xx
Incremental ordinary shares xx
To differentiate, share options are usually given to company employees as compensation for services, while share warrants are for bondholders and preference shareholders, all of which (including stock rights) give their holders the right to acquire new shares at below market price
DILUTED EARNINGS PER SHARE: MULTIPLE DILUTERS
When two or all diluters are present, the stepladder approach is used for computing diluted EPS. The first step is to determine the diluter with the lower incremental EPS, which is the one to be computed with diluted EPS first. This can be computed as follows:
Adjustment to net income (net income figure not included) xx
DIVIDE: Potential ordinary shares (WAOSO not included) xx
Incremental EPS xx
Share options and warrants have zero incremental EPS since they
have no adjustment to net income, which means they are the first in the order always. For convertible bonds, the dividend is after-tax interest income (prorated), and the divisor is the potential ordinary
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shares (prorated). For convertible preference shares, the dividend is the declared preference dividend, and the divisor is the entire potential ordinary shares
Remember that if the exercise price of these securities is higher
than market price, they are antidilutive and are thus ignored. An
exception is written put options, which remain dilutive even if the exercise price is higher than market price
ILLUSTRATION (CPAR FINAL PRE-BOARD ITEM) At
December 31, 2015, Jason Company has 900,000 ordinary shares outstanding. On September 1, 2016, additional 300,000 ordinary shares were issued. In addition, Jason issued Php 10,000,000, 6% convertible bonds on May 1, 2016, which are convertible into 300,000 ordinary shares. No bonds were converted during the year. Jason also had 40,000 share options outstanding during 2015 and 2016 with an option price of Php 22.50, and a market price of Php 30.00. Net income for 2016 amounted to Php 2,250,000. Income tax rate is 30%. Compute for the diluted EPS
o Since two potential diluters are present, stepladder method is used. There is no need to compute for incremental EPS since the share options will go first than the bonds. However, the following computations are made still:
Option shares 40,000
MULTIPLY: [(30 – 22.5) ÷ 30] 0.25
Incremental ordinary shares from options 10,000
After-tax interest expense (10,000,000 × 6% × 8/12 × 70%) 280,000
DIVIDE: Potential ordinary shares (300,000 × 8/12) 200,000
Incremental ordinary shares 1.4
January 2016 (900,000 × 12/12) 900,000
ADD: September 2016 (300,000 × 4/12) 100,000
Incremental ordinary shares 1,000.000
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format. Note that the adjustment of one diluter cumulates to the next one
Net income Shares EPS
Basic 2,250,000 1,000,000 2.25
Share options - 10,000
Diluted EPS after options 2,250,000 1,010,000 2.23
Convertible bonds 280,000 200,000
