ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing
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Chapter 16: Earnings per share
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Example
The calculation of the weighted average number of shares can be complicated when
there is another issue of shares
for cash during the year, in addition to a bonus issue. In
such cases, it is recommended that you use the Method 2 described above, as follows.
Entity J had 2,000,000 ordinary shares in issue on 1 January Year 2.
On 1 April Year 2, it issued 500,000 ordinary shares, at full market price.
On 1 July Year 2, there was a 1 for 2 bonus issue (= one new bonus share for every
two shares held).
In Year 1, the EPS had been calculated as 0.25c.
The financial year ends on 31 December. In Year 1, the EPS had been calculated as
0.25c. In Year 2, total earnings were $855,000.
Required
Calculate the EPS for the year to 31 December Year 2, and the comparative EPS
figure for Year 1.
Answer
The weighted average number of shares in Year 2 is calculated as follows.
In every line in the table
before the bonus issue, the number of shares is increased
by a factor (a ‘
bonus fraction’) to allow for the bonus issue. The factor to apply is:
×
Number of shares after the bonus issue
Number of shares before the bonus issue
With a 1 for 2 bonus issue, the bonus issue adjustment fraction is × 3/2. This is
because for every 2 shares in issue before the bonus issue, there are 3 shares after the
bonus issue.
Date
Detail
Number
ofshares
Time
factor
Bonus
fraction
Weighted
average
number
1Jan Broughtforward 2,000,000 ×3/12 ×3/2 750,000
1April Issueatmarketprice 500,000
–
–––––––
2,500,000 ×3/12 ×3/2 937,500
1July Bonusissue(1 for2) 1,250,000
–
–––––––
31Dec Carriedforward 3,750,000 ×6/12 1,875,000
––––––––
3,562,500
––––––––
The weighted average number of shares for the EPS calculation for Year 2 is
therefore 3,562,500.
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EPS in Year 2 = $855,000/3,562,500 = $0.24.
To restate the comparative EPS figure for Year 1, the original EPS figure of $0.25 is
adjusted by a factor × 2/3, to allow for the 1 for 2 bonus issue.
The Year 1 EPS is therefore re-stated as:
$0.25 × 2/3 = $0.1667.
3.4 Rights issues of shares
A rights issue of shares is an issue of new shares for cash, where the new shares are
offered initially to current shareholders in proportion to their existing
shareholdings. The issue price of the new shares in a rights issue is always below
the current market price for the shares already in issue.
Because rights issues are usually at less than full market price they include a bonus
element. Since there is a bonus element in the issue price, an adjustment is needed
for the EPS calculation, to ensure a fair comparison of the current year EPS with the
previous year EPS.
Current year EPS
To adjust for the bonus element in the rights issue, the number of shares in the
current financial year must be adjusted. You should multiply the number shares in
issue before the rights issue by a factor (a ‘rights factor) of:
Actual cum rights price
Theoretical ex rights price
Theoretical ex-rights price is explained and illustrated later.
Previous year EPS
In addition, to provide a fair comparison of the current year EPS with the previous
year’s EPS, the comparative EPS for the previous year is obtained by adjusting the
EPS actually reported last year. The previous year’s EPS is reduced by the following
factor:
Theoretical ex rights price
Actual cum rights price
The
actual cum-rights price is the market price of the shares before the rights issue.
The
theoretical ex-rights price is the price that the shares ought to be, in theory,
after the rights issue. It is a weighted average price of the shares before the rights
issue and the new shares in the rights issue. If you are not sure how to calculate the
theoretical ex-rights price, study the following example carefully.
Example
Entity L had 36,000,000 shares in issue on 1 January Year 2. It made a 1 for 4 rights
Chapter 16: Earnings per share
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issue on 1 June Year 2, at a price of $4 per share. The share price just before the
rights issue was $5.
Total earnings in the financial year to 31 December Year 2 were $25,125,000. The
reported EPS in Year 1 was $0.64.
Required
Calculate the EPS for the year to 31 December Year 2, and the adjusted EPS for Year
5 for comparative purposes.
Answer
After the rights issue, there will be 1 new share for every 4 shares previously in issue
$
4existingshareshavea‘cumrights’valueof (4×$5) 20.00
1newshareisissuedfor 4.00
–––––
5sharesaftertheissuehaveatheoreticalvalueof 24.00
–––––
Theoretical ex-rights price = $24.00/5 = $4.80.
Date
Number
ofshares
Time
factor
Rights
fraction
Weighted
average
number
ofshares
1Jan Broughtforward 36,000,000 ×5/12 ×5.00/4.80 15,625,000
1June Rightsissue(1for4) 9,000,000
–
––––––––
31Dec Carriedforward 45,000,000 ×7/12 26,250,000
–––––––––
41,875,000
–––––––––
EPS Year 2 = $25,125,000/41,875,000 = $0.60, or 60c
Comparative EPS in Year 1 = $0.64 × ($4.80/$5.00) = $0.6144 or 61.44c.
Example
Entity M had 3 million ordinary shares in issue on 1 January Year 7. On 1 April Year
7, it made a 1 for 2 rights issue of 1,500,000 ordinary shares at $2 per share. The
market price of the shares prior to the rights issue was $5.
An issue of 400,000 shares at full market price was then made on 1 August Year 7.
In the year to 31 December Year 7, total earnings were $1,746,875. In Year 6 EPS had
been reported as $0.35.
Required
Calculate the EPS for the year to 31 December Year 7, and the adjusted EPS for Year
6 for comparative purposes.
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Answer
After the rights issue, there will be 1 new share for every 2 shares previously in
issue
$
2existingshareshavea‘cumrights’valueof (2×$5) 10.00
1newshareisissuedfor 2.00
–––––
3sharesaftertheissuehaveatheoreticalvalueof 12.00
–––––
Theoretical ex-rights price = $12/3 = $4.
Date
Number
ofshares
Time
factor
Rights
fraction
Weighted
average
numberof
shares
1Jan Broughtforward 3,000,000 ×3/12 ×5/4 937,500
1April Rightsissue(1for2) 1,500,000
–
–––––––
4,500,000 ×4/12 1,500,000
1August Issueatmarketprice 400,000
–
–––––––
4,900,000 ×5/12 2,041,667
––––––––
4,479,167
––––––––
EPS Year 7 = $1,746,875/4,479,167 = $0.39, or 39c
EPS Year 6 = $0.35 × 4.00/5.00 = $0.28 or 28c.
Chapter 16: Earnings per share
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Diluted EPS
The meaning of dilution
IAS33 and diluted EPS
Diluted EPS: convertible preference shares and convertible bonds
Diluted EPS: options and warrants
Potential ordinary shares that are not dilutive
4 Diluted EPS
4.1 The meaning of dilution
An entity might have some potential ordinary shares. When there are potential
ordinary shares, there is a possibility that they will become actual ordinary shares at
some time in the future.
For example, if an entity has issued some convertible bonds or convertible
preference shares, these might be converted into ordinary shares at some time in the
future. Similarly, holders of share options or warrants might exercise their right at a
future date to subscribe for new shares at a fixed price.
If potential shares become actual ordinary shares, there is a possibility – perhaps a
probability – that the EPS will be reduced because there will be a larger number of
ordinary shares in issue.
Dilution will occur if the EPS is reduced as a consequence of potential ordinary
shares becoming actual ordinary shares. (Note: ‘Dilution’ means ‘watering down’ or
‘reduction in strength’.)
4.2 IAS33 and diluted EPS
IAS33 requires publicly-traded companies to calculate a diluted EPS in addition to
their basic EPS for the current year (with a comparative diluted EPS for the previous
year), allowing for the effects of all dilutive potential ordinary shares.
Note: potential ordinary shares are ‘dilutive’ when there might have been a
reduction or ‘dilution’ in EPS if they had been actual ordinary shares during the
financial period.
Potential ordinary shares might not dilute the EPS. The diluted EPS should allow
only for potential ordinary shares that would be dilutive.
Earnings should be adjusted to allow for the dividends or interest that have been
recognised during the year for the potential ordinary shares, and for any other
income or expense that would alter as a result of the conversion of the potential
ordinary shares into actual ordinary shares.
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The main items of dividend or interest to adjust for are dividends on convertible
preference shares and interest on convertible debentures (convertible bonds). The
dividend or interest reduces total earnings. However, if they had already been
converted into ordinary shares (and the calculation of diluted EPS is based on this
assumption) the dividends or interest would not have been payable. Total earnings
would therefore have been higher. To calculate the diluted EPS, total earnings are
adjusted to allow for this.
The weighted average number of shares must also be adjusted. The method of
making this adjustment is different for:
convertible bonds or convertible preference shares and
share options or warrants.
4.3 Diluted EPS: convertible preference shares and convertible bonds
When there are convertible bonds or convertible preference shares, diluted EPS is
calculated as follows, by making adjustments to total earnings and the number of
shares in issue.
Basic assumption in calculating diluted EPS
It is assumed that all the convertible securities were converted into ordinary shares
on the first day of the financial period, and on the most favourable terms available
for the holders of the convertibles.
Total earnings
Total earnings must be adjusted. This is because the entity would not have to pay
the dividend or interest on the convertible securities.
For convertible preference shares, add back the preference dividend paid in the
year. If the preference shares are converted, this dividend will no longer be paid.
Total earnings will be increased by the preference dividend saved.
Adjusted total earnings = Actual total earnings + Convertible preference
dividend
For convertible bonds, add back the interest charge on the bonds in the year
minus the tax relief relating to that interest. If the bonds are converted, this
interest will no longer be paid. Total profits will increase by the interest saved,
but total earnings will increase only by the interest saved less tax.
Adjusted total earnings = Actual total earnings + (Convertible bond interest –
Tax on the interest).
Number of shares
The weighted average number of shares should be increased, by adding the
maximum number of new shares that would be created if all the potential ordinary
shares were converted into actual ordinary shares. The additional number of shares
should normally be calculated on the assumption that they were in issue at the
beginning of the year.
Chapter 16: Earnings per share
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Example
A company has 12,000,000 ordinary shares in issue and $4 million of 5% convertible
bonds. As at 31 December Year 2, there have been no new issues of shares or bonds
for several years. The bonds are convertible into ordinary shares in Year 3 or Year 4,
at the following rates:
At 31 December Year 3: 30 shares for every $100 of bonds
At 31 December Year 4: 25 shares for every $100 of bonds.
Total earnings for the year to 31 December Year 2 were $3,600,000. Total earnings
for the previous year (Year 1) were $3,300,000. Tax is payable at a rate of 30% on
profits.
Required
Calculate the basic EPS and diluted EPS for Year 2, and the comparative figures for
Year 1 (for reporting in the Year 2 financial statements).
Answer
Basic EPS:
(1) Year to 31 December Year 2: $3,600,000/12 million = $0.30
(2) Year to 31 December Year 1: $3,300,000/12 million = $0.275.
Diluted EPS:
Year2 Year1
$ $
Actualearnings 3,600,000 3,300,000
Addbackconvertiblebondinterest(5%×$4million) 200,000 200,000
Minustaxat30% (60,000) (60,000)
–
––––––– ––––––––
Adjustedtotalearnings 3,740,000 3,440,000
–
––––––– ––––––––
Numberofshares
Actual 12,000,000 12,000,000
Potential(4million×30/100) 1,200,000 1,200,000
–
–––––––– –––––––––
13,200,000 13,200,000
–
–––––––– –––––––––
DilutedEPS $0.2833 $0.2606
Note: The number of potential shares is calculated using the conversion rate of 30
shares for every $100 of bonds, because this conversion rate produces more new
shares than the other conversion rate, 25 shares for every $100 of bonds.
New issue of convertibles in the year
If new convertibles are issued during the course of the year, the additional number
of shares should be calculated only from the time that the convertibles were issued,
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and a time factor should be applied to calculate a weighted average number of
shares for the year.
Example
Entity N has 10,000,000 ordinary shares in issue. There has been no new issue of shares
for several years. However, the entity issued $2,000,000 of convertible 6% bonds on 1
April Year 5. These are convertible into ordinary shares at the following rates:
On 31 March Year 10 25 shares for every $100 of bonds
On 31 March Year 11 20 shares for every $100 of bonds
On 31 March Year 12 15 shares for every $100 of bonds
On 31 March Year 13 10 shares for every $100 of bonds
Tax is at the rate of 30%.
In the financial year to 31 December Year 6, total earnings were $4,536,000. In the
previous financial year to 31 December Year 5, total earnings were $4,087,000.
Required
Calculate the figures that should be reported in the financial statements for the year
to 31 December Year 6:
(a) the EPS for Year 6 and the comparative EPS figure for Year 5
(b) the diluted EPS for Year 6 and the comparative diluted EPS figure for Year 5.
Answer
(a) Basic EPS
Year 6 = $4,536,000/10,000,000 = $0.4536
Year 5 = $4,087,000/10,000,000 = $0.4087.
(b)
Diluted EPS
Adjustedtotalearnings
Year6Year5
$ $ $ $
Reported earnings 4,536,000 4,087,000
Add back interest saved
($2,000,000 × 6%):(9/12 ×
$2,000,000 × 6%):
120,000 90,000
Minus tax at 30% (36,000) (27,000)
–
–
–
–
–
––
84,000 63,000
–
––
–
–––– ––––––––
Adjusted total earnings 4,620,000 4,150,000
–
––––––– ––––––––
Chapter 16: Earnings per share
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Number of shares
The maximum number of new ordinary shares that might be created if the potential
ordinary shares are converted is 25 new shares for every $100 bonds. In a full year,
this represents $2,000,000 × 25/100 = 500,000.
However, the bonds were issued during Year 6; therefore a time factor should be
applied to calculate the ‘diluted’ number of shares in Year 6.
Year7
Numberofshares
1January Brought forward 10,000,000
Dilution 500,000
–
––––––––
31December 10,500,000
–
––––––––
Year6
Number
ofshares
Timefactor
Weighted
averagenumber
ofshares
1Jan Broughtforward 10,000,000 ×3/12 2,500,000
1April Bondissue:dilution 500,000
–
––––––––
10,500,000 ×9/12 7,875,000
–
–––––––– –––––––––
10,375,000
–––––––––
Diluted EPS, Year 7 = $4,620,000/10,500,000 = $0.44
Diluted EPS, Year 6 = $4,150,000/10,375,000 = $0.40.
4.4 Diluted EPS: options and warrants
A different situation applies with share options and share warrants. If these are
exercised, the holders of the options or warrants will pay cash to obtain new
ordinary shares.
If the options or warrants are exercised, the entity will receive cash that it can
invest to increase earnings. However, since the options or warrants have not yet
been exercised, it is impossible to predict how total earnings will be affected
when the cash is eventually received.
The exercise price for the options or warrants will be less than the full market
price for the shares. This means that there will be a bonus element in the issue.
These factors complicate the calculation of diluted EPS, but IAS33 has provided a
solution, as follows.
Calculate the number of shares that will be issued if all the options or warrants
are exercised.
Reduce this figure by the number of shares that could be purchased at full
market price with the cash received from the exercise of the options or warrants.
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The market price of the shares should be the average market price during the
period (the financial year).
This net figure is then added to the existing number of shares in issue, to obtain
the total shares for calculating the diluted EPS.
Example
Entity P had total earnings during Year 3 of $1,030,000.
It has 5,000,000 ordinary shares in issue. There are outstanding share options on
400,000 shares, which can be exercised at a future date, at an exercise price of $2.50
per share. The average market price of shares in Entity P during Year 3 was $4.
Required
Calculate the diluted EPS for Year 3.
Answer
Cash receivable on exercise of all the options = 400,000 × $2.50 = $1,000,000.
Number of shares this would buy at full market price in Year 3 = $1,000,000/$4 =
250,000 shares.
Shares
Options 400,000
Minusnumberofsharesatfairvalue (250,000)
–
–––––––
Netdilution 150,000
Existingsharesinissue 5,000,000
–
––––––
–
Totalshares 5,150,000
–
–––––––
Diluted EPS = $1,030,000/5,150,000 = $0.20 or 20c.
4.5 Potential ordinary shares that are not dilutive
If potential ordinary shares are not dilutive, they should be excluded from the
calculation of the diluted EPS.
When there are several types of potential ordinary share in issue, they should be
ranked in order of ‘dilutiveness’, with the most dilutive potential ordinary shares
ranked first.
A diluted EPS should then be calculated in stages, taking in one potential ordinary
share at a time, to establish whether any of them are not dilutive. An example might
help to illustrate the technique to use.