Chapter 20 - EPS
summary of key judgments
-various issues related to the 5 steps of revenue recognition -measurement of bad debt expense -initial measurement of inventory -choice of inventory cost flow assumptions -initial measurement of PPE -measurement of impairments of PPE -Initial measurement of ARO -recognition and measurement of contingencies -bifurcation of debt and equity components of hybrid securities -classification of investments -measurement of impairments of investments -determination of valuation allowance -determination of tax contingency -classification of lease types -measurement of stock-based compensation -measurement of the pension obligation
why do we use the weighted average # of CS
1 creates a denominator consistent with the net income flow 2 matches the number of shares with the income generated from the economic resources provided by the shares issued
Under the if-converted assumption, a company assumes that both hypothetical and actual conversions of potentially dilutive securities occur:
1. At the beginning of the year if the potentially dilutive security is outstanding as of the beginning of the year 2.At the issue date of the dilutive security if the potentially dilutive security is issued during the year
The retroactive assumption is a sound approach because:
1. In contrast to new issues and treasury share purchases, stock dividends and stock splits do not change cash or net assets. That is, stock dividends and stock splits do not change the economic resources available to generate income. As a result, including the additional shares on a retroactive basis does not mismatch the numerator and denominator of the EPS fraction. 2.It results in stating the shares before and after a stock dividend or split on the same basis. Financial statement users can therefore compare changes in EPS over time. 3. The retroactive assumption prevents management manipulation of EPS by the timing of stock dividends and stock splits.
There are two key factors to consider for the adjustment to the denominator when options or warrants are present
1. The increase in common shares outstanding due to the assumed option/warrant exercise of in-the-money instruments 2. The cash proceeds the company receives from the assumed exercise of the options or warrants
Other required disclosures for EPS include:
A discussion of adjustments to the numerator for preferred dividends A reconciliation of both the numerator and denominator of basic EPS to diluted EPS for income from continuing operations A discussion of antidilutive securities that were excluded from the computation of diluted EPS Any transactions that occurred after the close of the period that would have materially impacted the denominator of the EPS calculations (such as a new stock issue)
an obligation with an option that permits the debtholder to convert the debt into common stock.
Convertible debt
are securities that can be converted to a fixed number of shares of common stock at the option of preferred shareholders.
Convertible preferred shares
Any judgment that affects income also affects ---.
EPS
provides a snapshot of the performance of the firm in terms of each share of stock investors own.
EPS
Conversion of preferred stock requires adjustments to both the numerator and the denominator of the EPS equation from applying the if-converted assumption:
If the firm issues the preferred stock during the year: Assume conversion at the issue date. If convertible preferred shares were outstanding as of the beginning of the year: Assume conversion occurs at the beginning of the year.
The weighted average has two advantages:
It creates a denominator that is consistent with the net income flow. It matches the number of shares with the income generated from the economic resources provided by the shares issued.
Managers may make decisions for the sole purpose of impacting EPS. Why?
Managers are incentivized to manage EPS to meet analysts' forecasts as well as to increase their own compensation when bonus plans or other compensation schemes are based on net income or stock price.
computation of diluted EPS with convertible PS
Numerator: (NI - preferred div requirements + preferred divs avoided on convertible PS)/ Denominator:(WA number of common shares outstanding + weighted common shares on PS conversion)
give the holder the right, but not the obligation, to acquire equity shares from the issuing corporation over a fixed time period and at a specified price.
Stock options and warrants
An ---- effect occurs if EPS increases or loss per share decreases when assuming the conversion of securities or exercising options and warrants.
antidilutive
When EPS is negative, it will always result in ---- per share effects when including potentially dilutive securities in the computation.
antidilutive
measure of the EPS available to common shareholders that does not consider the potentially dilutive effects of convertible securities and employee options
basic EPS
why is interest added back for diluted EPS
because by assuming you converted at beg of year the firm avoids the interest expense associated with the debt since the debt is now stock
convertible securities can either have a dilutive or antidilutive effect. why
because they impact both the numerator and the denominator of EPS
we assume that a stock split or dividends occurs at the --- for shares that were outstanding as of the beginning of the year
beginning of the year
Calculating diluted EPS for a company with outstanding convertible debt requires adjusting
both the numerator and the denominator.
the diluted EPS denominator for options and warrants assumes that the company uses the proceeds to...
buy its own shares in the market
A company's ---- --- indicates its sources of funds from debt and equity issuances used to finance overall operations and capital expenditures.
capital structure
basic EPS is a measure of the EPS available to....
common shareholders
Firms exclude the effects of all antidilutive securities in the EPS computation, per the standard setters' intention that diluted EPS be the most --- measure of EPS.
conservative
Firms report EPS numbers for (3) things
continuing operations, discontinued operations, and net income.
Companies with complex capital structures issue potentially dilutive securities, including
convertible debt, convertible preferred stock, employee options, and stock warrants.
As a result, firms can ignore the preferred dividends and therefore eliminate the effect of the preferred dividend requirements related to the
convertible preferred shares.
when options and warrants are present only the numerator/denominator is affected
denom Num: net income - preferred div requirements / weighted average number of CS outstanding + incremental common shares on option or warrant exercise
The --- EPS computation incorporates the effects of potentially dilutive securities.
diluted
stock --- and stock --- impact the computation of WACSO
dividends and splits
preferred div requirements include both
dividends declared on PS and the current-year divs in arrears on cumulative PS
In addition, firms must disclose a number of items, such as per-share data for discontinued operations. The company may also include this information on the ---
face of the income statement.
dividends are taxed. T/F
false generally tax-deductible so tax effects are not applicable
The resulting denominator is larger than if the actual event date is used to weight the shares under which assumption
if-converted
This conservative approach maximizes the number of shares that reduce diluted EPS by assuming that events that increase the number of common shares outstanding and reduce EPS occur at the earliest possible point during the year.
if-converted
places the conversion of all convertible debt into CS at the earliest possible point during the year
if-converted assumption
When considering the effects of options and warrants on diluted EPS, the security must be ----- —that is, the exercise price must be less than the market price—to assume exercise.
in the money
Antidilution is tested at the ---- level.
income from continuing operations
Firms present basic EPS and diluted EPS (when applicable) on the --- ---- for all periods for which they provide financial data.
income statement
Reducing the number of shares outstanding by purchasing treasury stock is another way for a company to --- EPS.
increase
In-the-money securities result in ----- ----; out-of-the-money securities result in negative incremental shares and are antidilutive.
incremental shares
Subtracting the treasury shares assumed to be repurchased from the total number of shares issued on the assumed exercise determines the ---- ----remaining in the market.
incremental shares
what are the dates involved to calculated weighted shares outstanding
issue date to year end is the # of months
how do you know what averag3e market price to use for the TS method?
it depends for example companies that are actively traded a meaningful average would be the daily or weekly average price. for a company where shares are not actively traded and there are no significant changes in cap structure you could use a simple annual average price little fluctuation in share p during year - closing price can be considered a meaningful average
Therefore, no potentially dilutive securities should be included in the computation of diluted EPS when there is a...
loss from continuing operations.
The greater the difference between basic EPS and diluted EPS, the --- the potential return to current shareholders.
lower This is because if the potentially dilutive securities actually result in additional shares outstanding, an investor's market price per share will decline.
diluted EPS is always --- than basic
lower because your denominator is increasing
net income available to common shareholders
net income - preferred div requirements
euation for basic EPS
net income - preferred div requirements / weighted average # common shares outstanding
adjustments to basic EPS computation dilutive security: convertible debt numerator: ? denominator: ?
num: add back after tax interest expense denom: add additional weighted shares on debt conversion
adjustments to basic EPS computation dilutive security: convertible PS numerator: ? denominator: ?
num: add back preferred divs on convertible PS denom: add additional weighted shares on PS conversion
The if-converted assumption does not usually impact the EPS --- because there is typically no impact on net income available to common shareholders when the options or warrants are exercised.
numerator
diluted EPS equation
numerator: net income - preferred div requirements + interest expense (1-tax rate) denominator: WA common shares outstanding + weighted common shares on debt conversion
adjustments to basic EPS computation dilutive security: options/warrants numerator: ? denominator: ?
numerator: no change denom: add weighted increment shares on otpion or warrant exercise using the if converted assumption and the TS method
With ---- securities, the issuing company has more funds received than it needs to buy back the issued shares, and it will be able to acquire more shares than it issued. The number of outstanding shares will decrease, and EPS will increase.
out-of-the-money -buying back more than issued decreasing denominator and therefore increasing EPS
EPS is highly relevant to investors because it measures the overall
performance of the firm.
A simple capital structures implies there are no --- --- ---
potentially dilutive securities
EPS provides both--- value for assessing the likely future performance of the firm as well as--- value in evaluating prior predictions about the firm.
predictive, confirmatory
Applying the if-converted assumption avoids the dividends for the convertible ------
preferred shares.
Potentially dilutive securities can increase the number of common shares outstanding when exercised or converted into common shares, thus ---- or diluting EPS.
reducing (by making the denominator larger)
for shares issued that occur before the split or div the ---- assumption assumes that the split or dividend occurred at the time of issuance
retroactive
prevents management manipulation of EPS by the timing of the stock divs/splits
retroactive assumption
potentially dilutive securities are
securities that are not currently common shares but could become common stock through conversion or exercise
the weighted average is based off of
the amount of time that the shares are outstanding
The ---- ---- method assumes that firms use the proceeds from the hypothetical exercise of in-the-money options or warrants to purchase treasury stock at the average market price of the common stock for the period.
treasury stock
