19.4 Comprehensive Illustration

Yondif Ltd. is a publicly traded corporation that follows IFRS. It has a complex capital structure with convertible debt and equity securities. Below is selected information about long-term debt and equity instruments as at December 31, 2020:

Long-term debt:

7% bonds, at face value, due April 1, 2033 $780,000

10-year, 8% convertible bonds, at face value 350,000

(Each $1,000 bond is convertible into 50 Class A Common shares, commencing

August 1, 2020)

Share capital:

$8, convertible, cumulative, preferred shares; each preferred share 250,000

is convertible into 1 Class A common share, issued and outstanding, 12,500 shares

Class A common shares, issued and outstanding, 122,500 shares 2,450,000

Options:

1,000 employee stock options, issued on December 31, 2017, each

exchangeable for 1 Class A common shares at a price of $18 per share any

time prior to December 31, 2023.

500 executive stock options, issued on December 31, 2017, each exchangeable

for 1 Class A common share as follows:

$20 per share prior to January 1, 2021

$25 per share from January 1, 2021 to December 31, 2021

$27 per share from January 1, 2022 to December 31, 2023

Options expire on January 1, 2024

Contingent shares:

The company has an agreement with each of its five divisional managers to

issue 500 Class A common shares on January 1, 2022, if the manager’s

respective division before-tax earnings for 2020 increases by more than 10%

compared to the 2019 year-end reported before-tax earnings. To date,

divisional earnings for three managers have met and surpassed the

10% increase.

Additional information:

  1. Earnings (net income) for the year ended December 31, 2020, were $690,000. Included were discontinued operations of $210,000 loss, net of tax. Income tax rate was 20%.
  2. The average market price for Class A common shares was $21.
  3. Dividends were paid on the preferred shares annually and no dividends were in arrears.
  4. On July 1, 2020, a 10% stock dividend was declared and issued to the Class A common shareholders. At the beginning of the year, the total number of common shares outstanding was 100,000.
  5. On June 1, 2020, ten-year, 8% bonds, were issued at par for $600,000. Each $1,000 bond is convertible into 50 Class A common shares commencing August 1, 2020. Using the residual value method, the liability component’s present value of cash flows for interest and principal at a market rate of 9% for non-convertible bonds was $561,494. The equity component was for the remainder of $38,506.
  6. On August 1, 2020, $250,000 of the 8% convertible bonds were converted.

Basic Earnings per Share Calculation:

Step 1: Record the opening balance of shares outstanding and each subsequent event, date, description, and number of shares for the current reporting. An event is where the outstanding number of shares changes.

Step 2: For stock dividends or stock splits, apply the required retroactive restatement factor(s) from the event point where it initially occurs and backwards to the beginning of the fiscal year.

Step 3: For each event, complete the duration between events under the date column and complete the corresponding fraction of the year column accordingly. Multiply the shares outstanding times the retroactive restatement factor(s) times the fraction of the year for each event. Sum the amounts to determine the WACS amount.

Event Date Description Shares Outstanding
Retroactive Restatement Factors
Fraction of the Year
Total Shares Outstanding × Factor × Fraction of the Year
1 January 1 Opening balance 100,000 1.1 6/12 55,000
Jan 1 – Jul 1
2 July 1 10% stock dividend x 1.1
Jul 1 – Aug 1 110,000 1/12 9,167
3 August 1 12,500 shares issued
Aug 1 – ($250,000 ÷ 1,000)
Dec 31 × 50 shares
12,500
122,500 5/12 51,042
Total WACS 12/12 115,209
Income WACS Basic EPS
Net income from continuing operations
($690,000 + $210,000 discontinued operations) 900,000
Less preferred dividends
(12,500 × $8) (100,000)
Net income available to common shareholders 800,000 115,209 $6.94

Note that income from continuing operations of $900,000, as shown above, was not given in the question data. The amount must be derived by working backwards from the net income amount of $690,000, after discontinued operations and net of tax, for $210,000. If the discontinued operations had been stated in before-tax dollars, an additional calculation would be required to determine the net of tax amount, which is the amount deducted from income from continuing operations to arrive at net income. There were no shares issued in 2020 due to contingent shares. However, the contingent shares disclosed by the company may be dilutive, which will be tested in the diluted EPS calculations in the next section.

Diluted Earnings per Share Calculation:

Step 1: Identify and calculate the individual effects for all potentially dilutive options, warrants, and other contingent commitments.

Income (Numerator)
Number of Shares (Denominator)
Individual EPS Effect
Basic EPS (from continuing operations) $800,000 115,209 $6.94
Options:
Employee stock options:
Shares issued @ $18 per share 1,000
Shares repurchased (1,000 × $18 ÷ $21) (857)
143
Executive stock options:
Shares issued @ $20 per share 500
Shares repurchased (500 × $20) ÷ $21 (476)
24
Contingent shares:
500 shares × 3 divisional managers 1,500
Subtotal $800,000 116,876 $6.84

The employee stock options have an exercise price of $18 per share, compared to the average market price of $21 per share. The options are in the money because the exercise price is less than the average market price and option holders will be motivated to exercise the options and purchase the common shares. As discussed previously, if the options were not in the money, they would be excluded from the dilutive calculation.

The executive stock options are in the money at the exercise price of $20 per share, so these will be included in the diluted EPS calculation as shown above.

Also, a portion of the contingently issuable shares is to be included in the dilutive calculation because three of the managers have already met the 10% increase.

Together, the options and contingently issuable shares are ranked number one, as the most dilutive securities as a group.

Step 2: Calculate the individual effect of each potentially dilutive convertible security and rank them from most to least dilutive.

Income (Numerator) Number of Shares (Denominator) Individual EPS Effect
Basic EPS (from continuing operations) $800,000 115,209 $6.94
Individual Effects: Preferred shares (per share) $8 1 $8.00 Not dilutive
8% bonds – actual conversion on Aug 1
Interest saved ($250,000 ÷ $600,000) × $561,494 × 9% × (1-0.2) ×  2 ÷ 12
June 1 to August 1
2,807
Additional shares ($250,000 ÷ $1,000) × 50 × 2 ÷ 12 2,083 $1.35 Dilutive
Remainder of the convertible 8% bonds
Interest saved ($350,000 ÷ $600,000) × $561,494 × 9% × (1 – 0.2) × (7 ÷ 12)
June 1 to December 31
13,757
Additional shares ($350,000 $1,000) × 50 shares ×  (7 ÷ 12) 10,208 $1.35 Dilutive

Note that the 7% bond is not convertible, so it is not dilutive. Also, a portion of the 8% convertible bonds was converted on August 1. Note that the basic EPS included the 12,500 converted shares from August 1 to December 31, or for the five months remaining after conversion. The diluted calculation for the interest saved and the additional shares calculates the effect from the August 1 conversion date backwards to June 1 purchase date, or for two months. The remainder of the 8% convertible bonds is calculated backwards from the purchase date of June 1 to year-end, since they have not been converted.

Ranking the securities above from most to least dilutive results in the 8% converted bonds being ranked as the second most dilutive after options and contingently issuable shares. The preferred shares are not dilutive at an individual EPS amount of $8.00 per share, compared to the basic EPS of $6.94.

Step 3: Consolidating the results – complete a diluted EPS schedule and report the results.

Income

(Numerator)

Number of Shares
(Denominator)
Individual EPS Effect
Basic EPS (from continuing operations) $800,000 115,209 $6.94
Options:
Employee stock options: Shares issued @ $18 per share 1,000
Shares repurchased(1,000 × $18) ÷ $21 (857)
143
Executive stock options:
Shares issued @ $20 per share 500
Shares repurchased (500 × $20) ÷ $21 (476)
24
Contingent shares:
500 shares × 3 divisional managers 1,500
Subtotal $800,000 116,876 $6.84
8% bonds converted August 1 2,807
Additional shares 2,083
Subtotal 802,807 118,959 6.75
8% bonds – remaining 13,757
Additional shares 10,208
Diluted EPS $816,564 129,167 $6.32

The dilutive securities are input into the schedule in ranked order from most to least dilutive. A subtotal diluted EPS is calculated between each entry to ensure that each security continues to contribute to the dilutive EPS. If any of the securities caused the diluted EPS subtotal to increase, it must be removed from the calculation, as it is no longer dilutive.

The final diluted EPS amounts are to be disclosed on the face of the income statement and rounded to the nearest two decimals. However, as stated previously, companies can choose to disclose the EPS for discontinued operations in the notes to the financial statements. Below is an example of the disclosure on the face of the income statement:

Earnings per share: Basic Diluted
Income from continuing operations $6.94 $6.32
Loss from discontinued operations, net of tax* (1.82) (1.63)
Net income $5.12 $4.69

* Basic – Discontinued operations:
(\$210,000\;net\;of\;tax\;loss\;\div\;115,209\;basic\;EPS\;shares)\;=(\$1.82)
Diluted – Discontinued operations:
(\$210,000\;net\;of\;tax\;loss\;\div\;129,167\;diluted\;EPS\;shares)\;=(\$1.63)

Restatement of EPS

Examples of when EPS is to be retrospectively restated include when a prior period error is discovered, when there is a change in accounting policy (voluntarily or in response to a change in accounting standard), when a stock dividend/split is declared, or when a subsequent event occurs. Subsequent events can occur after the fiscal year, but before the financial statement have been issued. Examples include an issuance, conversion or redemption of convertible securities, options or warrants, or a stock dividend or split declared after the fiscal year but before the financial statements have been issued. Restatements require extensive disclosures, which are discussed in a later chapter.

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Intermediate Financial Accounting 2 Copyright © 2022 by Michael Van Roestel is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 4.0 International License, except where otherwise noted.

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