19.7 Chapter Summary

LO 1: Describe earnings per share (EPS) and their role in accounting and business.

Earnings per share measure how much income individual companies earn for each of its common shareholders. EPS is a per share method of describing net income (earnings), making EPS a good metric for investors. EPS is also a key metric used by stock market analysts to measure if the reported EPS is higher or lower than the analysts’ forecasted EPS. This movement affects the market price per share for this stock. Management can reinvest profits in hopes of making more profits or they can pay a dividend or a share buy-back to the investors to provide a return on the shareholders’ investment. EPS is the metric used to determine the magnitude of this return.

LO 2: Describe basic and diluted earnings per share in terms of an overview.

Basic EPS is a ratio that is calculated as net income available to common shareholders after preferred shares dividends, if applicable, divided by the weighted average number of common shares outstanding. A simple capital structure means that there are no debt or equity securities convertible into common shares. If there are, the company is said to have a complex capital structure. Diluted EPS is a worst-case scenario measurement where the effect on earnings per share is measured assuming that all potential additional common shares for convertible securities and options have already been issued. Publicly traded companies must report earnings per share while companies that follow ASPE, or companies that follow IFRS but are not publicly traded, do not. If the publicly traded company has a complex capital structure, they must report both basic and diluted EPS on the face of the income statement. EPS must also be broken down further to report EPS, discontinued operations, net of tax, if applicable.

LO 2.1: Calculate basic earnings per share.

To calculate basic EPS, net income available to common shareholders after preferred shares dividends is calculated for the numerator, and a weighted average number of common shares outstanding is calculated for the denominator. For the numerator, only net income, and not OCI, is relevant. The preferred shares dividends amount is subtracted from net income to determine the income available to common shareholders. The cumulative preferred shares dividend amount is based on dividend entitlement while the non-cumulative preferred shares dividends amount is based on dividend declared in the current reporting period. For the denominator, the weighted average common shares outstanding (WACS) is affected by common shares issued or repurchased as well as any stock dividends and stock splits, both of which are restated retroactively back to the beginning of the year. All these are further prorated by the number of months that they have been outstanding during the year. There are three steps that, if followed, will simplify this calculation.

LO 2.2: Calculate diluted earnings per share and report the final results.

Diluted EPS starts with the basic EPS numerator, denominator, and ratio. There are four steps that, if followed, will simplify this calculation. In basic terms, options, warrants, and contingent shares use the treasury stock method to determine their respective denominator amounts. For convertible securities such as convertible bonds and convertible preferred shares, the if-converted method is used to determine both the income effect (numerator) and the shares effect (denominator). All dilutive securities are, at this point, ranked from most to least dilutive and the diluted EPS is calculated using a subtotal between each security to ensure that each one continues to contribute a dilutive factor. Any that do not are removed.

The final results of the basic and diluted EPS from continuing operations, discontinued operations, and net income are disclosed. Basic and diluted EPS from continuing operations and net income must be disclosed on the face of the income statement while EPS for discontinued operations can be disclosed in the notes to the financial statements.

LO 3: Describe the issues that can affect both basic and diluted earnings per share.

There are several issues with regard to EPS. For example, convertible securities, options, and warrants can be issued, converted, redeemed, or can expire during the reporting period. Convertible securities can also have more than one conversion point, or may not be convertible until sometime in the future. Also, convertible bonds can be issued at a discount or at a premium, options can be repurchased from shareholders, or a company may experience a net loss. All these factors may affect basic and diluted EPS.

LO 4: Calculate basic and diluted earnings per share in terms of a comprehensive illustration.

A comprehensive step-by-step illustration is presented which applies the concepts as summarized above.

LO 5: Identify and explain how earnings per share and price-earnings ratio are used to analyze company performance from an investor perspective.

Basic EPS uses historical data to be useful and relevant while diluted EPS is more forward-looking and quantifies the impact that exercising options and potentially convertible securities has on current earnings available to common shareholders. Price-earnings ratio is a percentage-based measure of company performance and is an indicator of the share price that an investor can expect to pay to invest in the company. Ratios must be comparable to something, such as historical trends or industry standards, to be meaningful. As EPS is expressed as a single ratio figure it can obscure important information about a company’s selection of accounting policies, estimates, and valuations. Like any other ratio, EPS can be subject to manipulation and, therefore, should only be one of a more comprehensive set of ratios and other types of analysis techniques used to evaluate company performance.

LO 6: Explain the difference between ASPE and IFRS regarding earnings per share.

ASPE companies and non-publicly traded IFRS companies are not required to report EPS figures. However, publicly traded companies must report basic EPS and diluted EPS, if applicable.