Accounting for Liabilities and Equities.

BACT 212

EARNINGS PER SHARE

Basic and diluted earnings per share
Earnings per share (EPS) measures each common share’s interest in a company’s earnings. The
EPS figure is used by investors and analysts to assess company performance, to predict future
earnings, and to estimate the value of the firm’s shares. There are two EPS statistics:
1. Basic EPS-Basic EPS indicates ownership earnings based on the average number of
ordinary shares outstanding during the period.
2. Diluted EPS- it considers the effect of potentially dilutive securities—securities that
could lead to the issuance of additional ordinary e.g., convertible securities and stock
options.
The need for basic EPS is to increase the understandability and comparability of the earnings
number. The need for diluted EPS is to prevent moral hazard. In the absence of diluted EPS, it
would be easier for management to mislead shareholders regarding the profitability of the company
by issuing securities such as convertible bonds and stock options that do not entail the issuance of
ordinary shares immediately, but which could lead to share issuances in the future.
Calculating Basic EPS
Basic EPS is an indicator of profitability that measures how much of the company’s earnings are
attributable (belong) to each ordinary share.

Net income available to ordinary shareholders

Basic EPS =
Weighted average number of ordinary shares outstanding

Net income available to ordinary shareholders

Net income available to ordinary shareholders, is calculated as net income less dividends on
preferred shares. Other comprehensive income (OCI) is excluded from the numerator because
EPS is intended to measure performance. For cumulative preferred shares, the preferred
shareholders’ entitlement is deducted from the dividends according to the stated dividend rate
regardless of whether they were declared or paid. If there are dividends in arrears, only the current
period’s dividend rate should be considered. For non-cumulative preferred shares, the dividends
declared (whether paid or not) are deducted without considering the stated entitlement.
Illustration
• For the year ended December 31, 2021, Wart Ltd earned sh.5,000,000.
• Wart had sh.1,000,000 in cumulative preferred shares outstanding the entire year. The
dividend rate is 4% (i.e., sh.40,000 per year).
• The dividends on the cumulative preferred shares were not declared in 2020.
• Wart had sh.2,000,000 in non-cumulative preferred shares outstanding for the entire year.
The dividend rate is 5% (i.e., sh.100,000 per year)
• Dividend declaration and payment dates are noted as follows:

Scenario 1 Scenario 2 Scenario 3

Cumulative preferred shares
Amount declared in 2021 Sh.80,000 Sh.40,000 0
Amount paid 60,000 0 0
Dividend payment date Jan 15, 2022 Oct 15, 2021 N/A

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Non-cumulative preferred shares

Amount declared in 2021 Sh.100,000 Sh.100,000 Sh.0
Amount paid 100,000 30,000 0
Dividend payment date Jan 15, 2022 Oct 15, 2021 N/A

Notes
a. Scenario 1: The sh.80,000 declaration includes sh. 40,000 for 2020 and sh.40,000 for 2021.
b. Scenario 2: The dividends declared on the cumulative preferred shares pertain to 2020

Required: Determine net income available to ordinary shareholders

Weighted average number of ordinary shares outstanding (WASO)

A weighted average rather than the number of shares at the year-end is used because the number
of ordinary shares outstanding may change significantly during the year. Reasons for the change
in the number of shares are many include: new share issues to raise capital, a stock split or stock
dividend etc. The weights are the number of days a particular share has been outstanding during
the fiscal year.
Illustration
o `Wart Ltd had 120,000 ordinary shares outstanding on January 1, 2021.
o On March 1, 2021, Wart issued an additional 60,000 ordinary shares.
o On June 1, 2021, Wart repurchased 30,000 ordinary shares and cancelled them.
o On November 1, 2021, Wart issued an additional 90,000 ordinary shares
Required: Determine WASO for Wart Ltd at the end of the year.

Complicating factors
There are two factors that complicate the computation of WASO: (i) treasury shares, and (ii) stock
splits and stock dividends.
Treasury Shares
Shares in treasury are issued but not outstanding, so they are not included in WASO.
Illustration
o Wart Ltd had 120,000 ordinary shares outstanding on January 1, 2021.
o On March 1, 2021, Wart issued an additional 60,000 ordinary shares.
o On June 1, 2021, Wart repurchased 30,000 ordinary shares and held them as treasury
shares.
o On November 1, 2021, Wart sold 90,000 ordinary shares including the 30,000 shares held
in treasury

Stock splits and stock dividends

Stock splits and stock dividends affect EPS because they increase the number of shares
outstanding. However, both stock splits and stock dividends do not bring any changes in company
resources and obligations. Unlike share issuances or repurchases, the actual date of the stock split
or dividend is not considered for computing WASO. Instead, all shares are converted to end of
year equivalents.

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Accounting for Liabilities and Equities. BACT 212

Illustration
o Wart Ltd had 120,000 ordinary shares outstanding on January 1, 2021.
o On March 1, 2021, Wart issued an additional 60,000 ordinary shares.
o On April 1, 2021, Wart declared and issued a two-for-one stock split.
o On June 1, 2021, Wart repurchased 60,000 ordinary shares.
o On November 1, 2021, Wart sold 180,000 ordinary shares.
o On December 1, 2021, Wart declared and issued a 10% stock dividend.
Required: Determine the number of shares outstanding at December 31 2021 for Walt Ltd

Basic EPS
Calculate the EPS for Walt Ltd.

Diluted EPS
Publicly accountable enterprises with a complex capital structure must report diluted EPS even if
it is the same as basic EPS. Diluted EPS measures the amount of the company’s earnings
attributable to each ordinary shareholder in a hypothetical scenario in which all dilutive securities
are converted to ordinary shares. It is a conservative metric that reports the lowest possible EPS.
Diluted EPS is calculated as

Net income available to ordinary shareholders + the income effect of dilutive potential ordinary shares
=
Weighted average number of ordinary shares outstanding + The share effect of dilutive potential ordinary shares

A potential ordinary share (POS) is a financial instrument or other contract that may entitle its
holder to ordinary shares. Not all POS are dilutive; some are antidilutive. Dilutive potential
ordinary shares are those POS that decrease EPS or increase the loss per share from continuing
operations. There are four steps in the process to separate dilutive from antidilutive POS and to
calculate diluted EPS:
1. Identify all potential ordinary shares.
2. Compute “incremental EPS” for each category of potential ordinary shares.
3. Rank order incremental EPS on potential ordinary shares from the lowest (the most
dilutive) to the highest (least dilutive).
4. Sequentially compare incremental EPS to “provisional EPS”7 to determine diluted EPS.
We now examine each of these four steps in more detail

1. Identify all potential ordinary shares

This involves identifying financial instruments or other contracts that entitle the holder to obtain
ordinary shares (potential ordinary shares) at a later date on predefined terms. Financial
instruments that give rise to POS include the following:
o convertible bonds that can be exchanged for ordinary shares;
o convertible preferred shares that can be exchanged for ordinary shares; and
o Stock options and warrants that permit the holder to buy ordinary shares from the
company at a predetermined price.
2. Compute incremental EPS for all potential ordinary shares
Incremental EPS is used to rank order the securities in terms of their dilutiveness. It is computed
as

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𝑇ℎ𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑓 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

𝐼𝑛𝑐𝑟𝑒𝑚𝑒𝑛𝑡𝑎𝑙 𝐸𝑃𝑆 =
𝑇ℎ𝑒 𝑠ℎ𝑎𝑟𝑒 𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑓 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝑜𝑟𝑑𝑖𝑛𝑎𝑟𝑦 𝑠ℎ𝑎𝑟𝑒𝑠

Income effect: The income effect indicates the incremental after-tax income available to ordinary
shareholders if a category of POS had been converted into ordinary shares.
Share effect: The share effect indicates the incremental number of ordinary shares outstanding if
a category of POS had been converted into ordinary shares. There is a different share effect for
each class of POS.
a. Convertible bonds and preferred shares: The if- converted method -incremental EPS on
convertible bonds and preferred shares using the if-converted method assumes (i) that the
security had been converted into ordinary shares at the beginning of the period and (ii) that the
company had not paid interest or preferred dividends on the security during the year.
Bonds
Income effect = Bonds carrying amount * Effective interest rate * (1-T)

Illustration 1: Bonds
Smithers Ltd has sh.1,000,000 in 6% bonds outstanding.
o The bonds’ carrying amount equals their face value; therefore, the yield equals the coupon
rate.
o The bonds were issued on January 1, 2021, and mature on January 1, 2029.
o Each sh.1,000 bond is convertible into 20 ordinary shares.
o The company’s income tax rate is 30%.
Required: Determine the incremental EPS of the bond issue for the year ended December 31,
2022.

Cumulative preferred shares

Income effect = Dividend entitlements
Non- cumulative preferred shares
Income effect = Dividends declared

Illustration 2: Convertible preferred shares

Smithers Ltd has 10,000 cumulative preferred shares outstanding with par value of sh.1,000,000
and dividend rate of 5%.
o The preferred shares were issued on January 1, 2021, and do not mature.
o Each sh.100 preferred share is convertible into three ordinary shares.
o Smithers income tax rate is 30%
Required: Determine the incremental EPS of the preferred share issue for the year ended
December 31, 2022

b. Options and warrants: the treasury stock method

Options or warrants are assumed to be exercised at the beginning of the period (or date of issuance
if the security was issued during the period). Only call options and warrants that are in-the-money
(when the market price of the underlying security exceeds the exercise price/strike price). Call
options and warrants are out-of-the-money when the market price of the security is less than the
exercise price. Options and warrants are at-the-money when the market price of the security is

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equal to the exercise price. The average market price for the reporting period, rather than the
period-end price, is used to determine whether an option is in the money.
Under the treasury stock method, the proceeds from the assumed option exercise are used to
purchase common shares from the market. However, since the exercise price of an in-the-money
call option or warrant is below the average market price in the year, the number of shares that
could be repurchased using the proceeds from the option exercise must be less than the number
of shares issued for the options. The difference between the number of shares needed for full
exercise and the number of shares that could be repurchased represents the incremental shares
that the company would have had to issue to cover the exercise. The incremental shares needed is
added to the weighted average number of shares outstanding in the denominator. Out-of-the
money and at-the-money options are ignored since holders of these options would not have
exercised their options.

Number of incremental shares = N * (S – K)/S

Or
𝑘
= N * (1- )
𝑠

Where N = number of shares that would have been issued

K = Strike price
S = Average market price of shares
Illustration
Smithers Ltd has options outstanding that entitle the holders to purchase 10,000 ordinary shares
for sh.42 each.
▪ The options were issued on January 1, 2021, and expire on January 1, 2027.
▪ The average market price of Smithers ordinary shares during 2022 was sh.48.
▪ The company’s income tax rate is 30%.
Required:
o Determine the incremental number of shares that may be issued for diluted EPS purposes.
o Determine the incremental EPS for the year ended December 31, 2022.

3. Rank order incremental EPS

This involves ranking order incremental EPS on POS from the lowest (the most dilutive) to the
highest (the least dilutive). Stock options and warrants are always the most dilutive because they
have incremental EPS of zero. If there is more than one in-the-money option or warrant, the in-
the-money options and warrants may be ranked in any order.
4. Sequentially compare incremental EPS to provisional EPS to determine diluted EPS
The aim of calculating diluted EPS is to identify the scenario that maximizes dilution. Using the
rankings just obtained in Step 3, the incremental EPS of the most dilutive POS to basic EPS is
compared. If incremental EPS is lower than basic EPS, the POS is included in the diluted EPS
computation to obtain provisional EPS.

Illustration
Calculate the diluted EPS for Smithers Ltd

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Illustration
Bob ltd net income for the year ended December 31,2018 Sh.500,000
Weighted average number of ordinary shares outstanding 390,000
Average market price of ordinary shares 2018 25
Fiscal 2018 year-end market price of ordinary shares 28
Bob income tax rate for 2018 30%
Potential ordinary shares (POS)
▪ 10% convertible bonds: sh.100,000 convertible bonds were sold at par on January 1, 2012,
maturing January 1, 2025. Each sh.1,000 bond is convertible into 60 ordinary shares at the
option of the holder at any time after January 1, 2020.
▪ 8% cumulative convertible preferred shares: sh.200,000 convertible preferred shares were sold
at par on July 1, 2011. Each sh.100 preferred share is convertible into 20 ordinary shares at the
option of the holder at any time after issuance. Dividends were not declared in 2018.
▪ Stock options A: Option to purchase 20,000 shares for sh.20 per share, expiring December 31,
2024. The options may be exercised at any time prior to expiry.
▪ Stock options B: Option to purchase 10,000 shares for sh. 30 per share, expiring June 30, 2019.
The options may be exercised at any time prior to expiry.
Required: Compute Bob basic and diluted earnings per share for 2018.

Effects of discontinued operations

IFRS requires EPS to be separately calculated and reported for continuing operations and for
discontinued operations. For computing diluted EPS, net income or loss available to ordinary
shareholders from continuing operations (which excludes the effect of discontinued operations) is
used as the control number (starting point) for determining the dilutiveness of POS.
Illustration
Assume that Bob’s net income for the year ended December 31, 2018, was sh.400,000, composed
of income from continuing operations of sh.500,000 and a loss from discontinued operations, net
of tax, of sh.100,000.
Required: Calculate the basic EPS and diluted EPS

Other considerations
a. Convertible securities issued, redeemed, or exchanged during the year
If convertible securities are issued during the year, both the income and share effect are pro-rated
to reflect the date of issuance. If a convertible security is redeemed or the right to convert expires
during the year, the income and share effects are pro-rated to include only the portion of the year
for which the security was outstanding. If a convertible security is exchanged during the year, the
income effect is the after-tax amount expensed during the period the security was outstanding.
The POS are included until the date of conversion. The shares issued for the conversion would
have already been included in the basic EPS calculation.
b. Convertible securities with more than one conversion option
Some securities have multiple conversion options. For example, a convertible bond might permit
the holder to exchange it for five ordinary shares on December 31, 2022, or four ordinary shares
on December 31, 2024. For EPS purposes, the most dilutive alternative available is used

c. Potential ordinary shares that are not yet eligible to be converted/exercised

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Many POS can be exchanged or exercised only at specific times or after a specific date. E.g., a
convertible bond may allow for conversion into 50 ordinary shares three years after the issue date
but not before. For diluted EPS purposes, the POS is included in the computation of diluted EPS
regardless of when the conversion option becomes effective.
d. Bonds sold at a discount or premium
The effective interest rate is used to determine the income effect of the bond issued at a premium
or discount.
e. Purchased options versus written options
Whereas issued options are potentially dilutive, purchased options are always antidilutive.

Comprehensive illustration
Scenario
▪ ZTA ordinary shares are actively traded on the Nairobi Securities Exchange.
▪ The company accountant has been asked to calculate ZTA’s basic and diluted EPS for the
year ended December 31, 2021.
Facts
▪ There were 75,000 ordinary shares outstanding at January 1, 2021. An additional 150,000
shares were issued on July 1, 2021.
▪ A two-for-one stock split was declared and distributed on October 1, 2021.(a)
▪ On January 1, 2020, ZTA issued at par sh.300,000 in 8% bonds that mature on January 1,
2028. Each sh.1,000 bond is convertible into 55 common shares. Assume that the effective
interest rate is 8%.
▪ There are 15,000 outstanding cumulative preferred shares that are each entitled to an
annual dividend of sh.0.30. Dividends were not declared or paid during 2021. Each
preferred share is convertible into two ordinary shares.
▪ ZTA previously granted its employees options to acquire 5,000 ordinary shares at an
exercise price of Sh.25 each. These options expire on June 30, 2026.
▪ ZTA previously granted its executives options to acquire 1,800 ordinary shares at an
exercise price of sh.20 each. These options expire on August 31, 2027.
▪ ZTA’s net income for the year ended December 31, 2021 was sh.183,000. Its income tax
rate is 30%. The average market price of its shares during 2021 was sh.24.
Required: Calculate the basic and diluted EPS

Presentation and disclosure

Information to be presented on the income statement includes:
o basic EPS;
o diluted EPS if the company has any POS, even if it is the same as basic EPS; and
o basic and diluted EPS arising from operations, continuing operations, and discontinued
operations if the company has discontinued operations.
Disclosure
Particulars that must be included in the notes to the financial statements include the following
items:
o the income available to ordinary shareholders used to calculate both basic and diluted EPS;

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o the weighted average number of ordinary shares used to calculate both basic and diluted
EPS;
o particulars of POS that were not included in the diluted EPS calculations as they were
antidilutive for the period;
o details of post-balance sheet date transactions that significantly change either the number
of ordinary shares outstanding or the number of POS; and
o information regarding stock splits or dividends that occur after year-end but before the
statements are authorized for issue. Note that basic and diluted EPS for the year is based
on the new number of outstanding shares.

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