ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Paper F7 (INT)
Financial reporting
CHAPTER
16
Earnings per share
Contents
1 P/E ratio and earnings per share
2 Objective and scope of IAS33 and definitions
3 Calculating basic EPS
4 Diluted EPS
5 IAS33: Presentation and disclosure requirements
6 Earnings per share as a performance measure
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P/E ratio and earnings per share
Earnings per share
The price/earnings ratio
EPS and IAS33
1 P/E ratio and earnings per share
1.1 Earnings per share
Earnings are profits available for equity (ordinary shareholders). Earnings per share
(EPS) is a measure of the amount of earnings in a financial period for each equity
share. As its name implies, EPS is calculated as reported earnings divided by the
number of ordinary shares in issue.
EPS = Total earnings/Number of ordinary shares
EPS is used by investors as a measure of the performance of companies in which
they invest – or might possibly invest. Investors are usually interested in changes in
a company’s EPS over time – trends – and also in the size of EPS relative to the
current market price of the company’s shares.
1.2 The price/earnings ratio
The price/earnings ratio (P/E ratio) is a key stock market ratio. It is a measure of the
company’s current share price (market price) in relation to the EPS. The P/E ratio is
calculated as follows.
P/E ratio =
Market value of share
EPS
The P/E ratio
can be used by investors to assess whether the shares of a company
appear expensive or cheap. A high P/E ratio usually indicates that the stock market
expects strong performance from the company in the future and investors are
therefore prepared to pay a high multiple of historical earnings to buy the shares.
1.3 EPS and IAS33
Stock market investors monitor P/E ratios and EPS very closely. They compare the
P/E ratios of different companies, and growth or decline in their EPS over time.
Their investment decisions may be made on the basis of these comparisons.
EPS should therefore be calculated by all companies in a standard way, so that
investors can obtain a reliable comparison between the EPS and P/E ratios of
different companies. The rules for calculating EPS are set out in IAS33
Earnings per
share.
Chapter 16: Earnings per share
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The concept of EPS is quite simple. It is simply the amount of profit earned in the
previous financial year for each ordinary share in issue. However, there are some
complexities with the calculation of EPS, particularly when:
new shares were issued during the year, or
there is the possibility of a ‘dilution’ in the EPS in the future, due to the existence
of ‘potential ordinary shares’.
Preference shares and EPS
Preference shares are not ordinary shares. Since EPS is a measure of earnings per
ordinary share in a financial year, preference shares are excluded from the number
of shares.
The dividends paid to preference shareholders must therefore be excluded from the
total earnings for the period. A broad definition of ‘earnings’ is therefore profit after
tax less preference dividends paid.
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Objective and scope of IAS33 and definitions
Objective of IAS33
Scope of IAS33
Definitions
2 Objective and scope of IAS33 and definitions
2.1 Objective of IAS33
The objective of IAS33 is to set out principles for:
the calculation of EPS, and
the presentation of EPS in the financial statements.
The purpose of standardising the calculation and presentation of EPS is to make it
easier for the users of financial statements to compare the performance of:
different entities in the same reporting period, and
the same entity for different reporting periods over time.
2.2 Scope of IAS33
IAS33 applies only to publicly-traded entities or those which are about to be publicly
traded. A publicly-traded entity is an entity whose shares are traded by the investing
public, for example on a stock exchange.
Most publicly-traded entities prepare consolidated financial statements as well as
individual financial statements. When this is the case, IAS33 requires disclosure
only of EPS based on the figures in the consolidated financial statements.
2.3 Definitions
An ordinary share is an equity instrument that is subordinate to all other classes of
equity instruments.
The ordinary shares used in the EPS calculation are those entitled to the residual
profits of the entity, after dividends relating to all other shares have been paid. As
stated earlier, if you are given an examination question on this topic, preference
shares are not ordinary shares because they give more rights to their holders than
ordinary shares.
A
potential ordinary share is a financial instrument or other contract that may
entitle its holder to ordinary shares at some time in the future. The following
examples of potential ordinary shares are given by IAS33:
financial liabilities or equity instruments that are convertible into new ordinary
shares at some time in the future (convertible debentures, convertible preference
shares)
Chapter 16: Earnings per share
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share options and warrants. Options and warrants are financial instruments that
give the holder the right (but not the obligation) to purchase new ordinary
shares at some time in the future, at a fixed price
shares that will be issued if certain contractual conditions are met, such as
contractual conditions relating to the purchase of a business.
Basic and diluted earnings per share
IAS33 requires entities to calculate:
the basic earnings per share on its continuing operations
the diluted earnings per share on its continuing operations.
Additional requirements apply to earnings relating to discontinued operations.
Diluted EPS and basic EPS will usually differ when there are potential ordinary
shares in existence.
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Calculating basic EPS
The calculation: total earnings
Number of shares: issue of shares at full market price#
Bonus issues of shares
Rights issues of shares
3 Calculating basic EPS
3.1 The calculation: total earnings
Basic earnings per share is calculated by dividing the profit or loss on continuing
operations
by the weighted average number of ordinary shares in issue during the
period.
The calculation of the basic EPS is therefore as follows.
EPS =
Net profit (or loss) attributable to ordinar
y
shareholders during a period
Weighted average number of ordinary shares in issue during the period
The
net profit (or loss) attributable to ordinary shareholders during a period is
commonly referred to as ‘total earnings’.
Total earnings are calculated as:
the profit or loss from continuing operations
after deducting tax and preference dividends (and in the case of consolidated
financial statements, after excluding the earnings attributable to non-controlling
interests or minority interests).
Total earnings include any income from associates (i.e. any share of profits of
associates).
Where preference dividends are cumulative, they should be deducted from total
earnings whether the dividend has actually been paid or not.
When there is a net loss, total earnings and the EPS are negative.
Earnings from discontinued operations are dealt with separately. An EPS from any
discontinued operations must also be disclosed, but this does not have to be
disclosed on the face of the statement of comprehensive income. Instead, it may be
shown in a note to the financial statements.
Example
In the year ended 31 December Year 1, Entity G made profit after tax of $350,000. Of
this, $300,000 was from continuing operations and $50,000 from discontinued
operations. It paid ordinary dividends of $150,000 and preference dividends of
$65,000. Throughout the year it had 1 million ordinary shares in issue.
Chapter 16: Earnings per share
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Required
Calculate the basic EPS for Entity G for the year ended 31 December Year 1.
Answer
EPS =
Net profit (loss) attributable to ordinar
y
shareholders during a period
Weighted average number of ordinary shares in issue during the period
=
$300,000 - $65,000
1,000,000
= $0.235 or 23.5c
3.2 Number of shares: issue of shares at full market price
The calculation of the basic EPS is more complex when new shares have been
issued during the financial year
.
Shares issued during a financial period should be included in the calculation of the
weighted average number of shares. They should be included from the date that the
consideration (payment from the shareholder) is received for the shares. This is
because it is only from that date that the new shares are able to contribute to
earnings (through investing the cash or other assets obtained as the proceeds from
the share issue).
The starting point for the weighted average number of shares is the number of
shares in issue at the beginning of the period. This is then adjusted for any shares
issued during the period, to which a time weighting factor must be applied.
For example, if an entity with a financial year ending 31 December issues new
shares on 1 October (= 9 months into the year), the number of new shares should be
adjusted by a factor of × 3/12.
Example
Entity H has a financial year ending 31 December. On 1 January Year 1 there were
6,000,000 ordinary shares in issue. On 1 April, it issued 1,000,000 new shares at full
market price. Total earnings in Year 1 were $2,700,000.
Required
What was the EPS in Year 1?
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Answer
There are two methods of calculating the weighted average number of shares.
Method 1
Weighted
average
number
Sharesat1JanuaryYear1 6,000,000
Sharesissuedon1April 1,000,000×9/12 750,000
–
–––––––
6,750,000
–
–––––––
EPS = $2,700,000/6,750,000 shares = $0.40 or 40c.
Method 2
With the following method, a weighted average number is calculated from each
new issue of shares. A time factor is applied to the total number of shares after the
new share issue. The time factor to apply is either:
for the remaining number of months to the year end, or
for the number of months to the next share issue, if this is sooner.
This method produces exactly the same result as Method 1.
Date
Detail
Number
ofshares
Time
factor
Weighted
average
number
1January Broughtforward 6,000,000 ×3/121,500,000
1April Issueatfullmarketprice 1,000,000
–
–––––––
31December Carriedforward 7,000,000 ×9/125,250,000
–
––––––– ––––––––
6,750,000
––––––––
EPS = $2,700,000/6,750,000 shares = $0.40 or 40c.
Method 2 will be used in future examples in this chapter. It is probably easier to use
than Method 1 when there are several issues of new shares during the financial
year, and it is therefore the method that we recommend you should use.
Example
Entity J has a financial year ending 31 December. On 1 January Year 3, there were
9,000,000 ordinary shares in issue. On 1 May, Entity J issued 1,200,000 new shares at
full market price. On 1 October, it issued a further 1,800,000 shares, also at full
market price. Total earnings in Year 3 were $3,690,000.
Required
Calculate the EPS for the year to 31 December Year 3.
Chapter 16: Earnings per share
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Answer
Date
Detail
Number
ofshares
Time
factor
(seenotes)
Weighted
average
number
1January Broughtforward 9,000,000 ×4/12 3,000,000
1May Issueatfullmarketprice 1,200,000
–
––––––––
Sharesafterthenewissue 10,200,000 ×5/12 4,250,000
1October Issueatfullmarketprice 1,800,000
–
––––––––
31Dec Carriedforward 12,000,000 × 3/12 3,000,000
–
–––––––– –––––––––
10,250,000
–––––––––
Notes
(1) The first new share issue is in May, after 4 months. Therefore the number of
shares at the beginning of the year is given a time factor of × 4/12.
(2) There are 5 months between the two share issues, therefore the time factor to
apply to the number of shares after the first issue is × 5/12.
(3) The total number of shares in issue from 1 October to the end of the year
(three months) is 12,000,000. These are given a time weighting of × 3/12.
EPS = $3,690,000/10,250,000 = $0.36.
3.3 Bonus issues of shares
A bonus issue of shares is also called a scrip issue or a capitalisation issue. It is an
issue of new shares to existing shareholders, in proportion to their existing
shareholding, for no consideration. In other words, the new shares are issued ‘free
of charge’ to existing shareholders. The new shares are created by converting equity
reserves instatement of financial position, often some or all of the share premium
account, into ordinary share capital.
When there is a bonus issue of shares, the situation is different from a new issue of
shares at full market price. With a bonus issue of shares, no cash is raised from the
issue because the new shares are issued ‘free’. Therefore the new shares do nothing
to generate additional profits/earnings.
Unless a suitable adjustment is made to the EPS calculation, the comparison of EPS
in the current year (after the bonus issue) with EPS in the previous year (before the
bonus issue) will be misleading.
In order to ensure that the EPS in the year of the bonus issue is comparable with the
previous year’s EPS, IAS33 requires that the weighted average number of shares
should be calculated as if the bonus shares had always been in issue. IAS33 states
that: ‘The number of ordinary shares outstanding before the [bonus issue] is
adjusted for the proportionate number of shares outstanding as if the [bonus issue]
has occurred at the beginning of the earliest period presented..’ This means that:
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the current period’s shares are adjusted as if the bonus shares were issued on the
first day of the year
the comparative EPS for the previous year is restated on the same basis.
Example
Entity H made a 1 for 4 bonus issue on 1 July Year 5. Its financial year ends on 31
December. The financial results for Entity H in Year 4 and Year 5 were as follows.
Year 5
Year 4
Total earnings $2,100,000
$2,000,000
Number of shares in issue at 31 December 5,000,000
4,000,000
The basic EPS could be calculated for the Year 5 financial statements as follows, by
taking as the number of shares for the current period and the previous period the
total number of shares after the bonus issue.
Year 5
Year 4
Total earnings $2,100,000
$2,000,000
Number of shares 5,000,000
5,000,000
= $0.42
= $0.40
Another way of calculating the weighted average number of shares in the current
year would be:
Date
Number
of shares
Bonus
fraction
Time
factor
Weighted
average
number
1 January Brought forward 4,000,000
× 5/4
× 6/12 2,500,000
1 July Bonus issue 1,000,000
Shares after the
new issue
5,000,000
× 6/12 2,500,000
5,000,000
Comparative EPS for previous year
In the Year 4 financial statements, the EPS would have been reported as
$2,000,000/4,000,000 = $0.50, because there were only 4 million shares in issue in
Year 4
In Year 5, we can calculate the comparative EPS for Year 4 (for the purpose of the
Year 5 financial statements) by adjusting the original Year 4 EPS by the following
factor:
EPS reported last year ×
Number of shares before the bonus issue
Number of shares after the bonus issue
In this example, for every 4 shares in issue before the bonus issue, there are 5 in
issue after the bonus issue. The comparative EPS for Year 4, for inclusion in the
financial statements for Year 5, would therefore be:
$0.50 × 4/5 = $0.40.