ACCA F7 (INT) Financial Reporting - Study text - 2010

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Chapter 16: Earnings per share

Example

The following information relates to Entity Q for the year ended 31 December Year 5.

Number of ordinary shares in issue 10,000,000

Reported earnings in the year $1,500,000

Average market price of shares

during the year $8

Potential ordinary shares:

Options 600,000 options, with an exercise price of $6

4% convertible bond: $5,000,000 Each bond is convertible in Year 10 into

ordinary shares at the rate of 40 new shares

for every $100 of bonds

1,000,000 7% convertible preference

shares of $1 each

Each preference share is convertible in Year 9

into ordinary shares at the rate of 1 ordinary

share for every 2 preference shares

Tax rate = 30%

Required

Calculate the diluted EPS for the year to 31 December Year 5.

Answer

If all the options are exercised, the cash received will be 600,000 × $6 = $3,600,000.

This would purchase 450,000 shares ($3,600,000/$8) at the average market price in

Year 5. The dilutive increase in the number of shares would therefore be (600,000 –

450,000) = 150,000.



Increasein

earnings

Increasein

numberof

ordinary

Earnings

perextra

newshare

Rankingin

orderof

dilutiveness

 $ $

Options 0 150,000 0.00 1



Convertiblebonds 140,000 2,000,000 0.07 2

(4%×$5,000,000) 

lesstax30%

Preferenceshares 70,000 500,000 0.14 3

(7%×$1,000,000)

Taking these three dilutive potential ordinary shares in order of their ranking, we

need to calculate the diluted EPS as follows.

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Earnings

Number

of shares

EPS

As reported, basic EPS 1,500,000

10,000,000 0.1500

Options 0

150,000

–

–––––––

–

––––––––

Diluted EPS, options only 1,500,000

10,150,000 0.1478 Dilutive

Convertible bonds 140,000

2,000,000

Diluted EPS, options and convertible

bonds

1,640,000

12,150,000 0.1350 Dilutive

Convertible preference shares 70,000

500,000

–

–––––––

–

––––––––

Diluted EPS, options and all

convertibles

1,710,000

12,650,000 0.1352

Not

dilutive

The convertible preference shares are not dilutive, and the reported diluted EPS

should be $0.1350 (and

not $0.1352)

Chapter 16: Earnings per share

IAS33: presentation and disclosure requirements

 IAS33: Presentation requirements

 IAS33: Disclosure requirements

 Alternative measures of earnings per share

5 IAS33: Presentation and disclosure requirements

5.1 IAS33: Presentation requirements

An entity should present in the statement of comprehensive income:

 the basic EPS and

 the diluted EPS

 for the profit or loss from continuing operations.

For consolidated accounts, this is the EPS and diluted EPS attributable the owners of

the parent company.

The basic EPS and diluted EPS should be presented with equal prominence for all

the periods presented (the current year and the previous year). These figures are

presented at the end of the statement of comprehensive income.

If the entity presents a separate statement for the components of profit or loss (i.e. a

separate income statement):

 the EPS and diluted EPS should be shown in this statement, and

 not in the statement of comprehensive income.

If there is a

discontinued operation, the basic EPS and diluted EPS from

discontinued operation should be shown either on the face of the statement of

comprehensive income or in a note to the financial statements.

The basic and the diluted EPS should be presented, even if it is a negative figure (=

even if it is a loss per share).

5.2 IAS33: Disclosure requirements

IAS33 also requires disclosure in a note to the financial statements of the following:

 The total amounts used as the numerators (= total earnings figures) to calculate

the basic EPS and diluted EPS, and a reconciliation of these numerator figures to

the profit or loss for the period

 The total amounts used in the denominators (= weighted average number of

shares) to calculate the basic EPS and diluted EPS, and a reconciliation of these

two denominator figures to each other.

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5.3 Alternative measures of earnings per share

IAS 33 allows an entity to disclose an alternative measure of EPS in addition to the

EPS calculated in accordance with IAS 33. For example, EPS could be calculated

after adjusting earnings for large and unusual items.

If an alternative EPS figure is presented, IAS 33 states that:

 a reconciliation must be shown between the earnings figure used in the

alternative measure and the amounts shown in the statement of comprehensive

income

 the alternative EPS must use the same weighted average number of shares as the

IAS 33 calculation

 basic and diluted EPS should both be disclosed with equal prominence, and

 the alternative figure must only be shown in the notes, not on the face of the

statement of comprehensive income.

Chapter 16: Earnings per share

Earnings per share as a performance measure

 Earnings per share and trends

 Limitations of earnings per share

6 Earnings per share as a performance measure

6.1 Earnings per share and trends

Investors and their advisers pay close attention to an entity’s net profit for the

period. However, profit for the period can include large and unusual items and also

the results of discontinued operations. This may make it volatile: liable to fluctuate

rapidly up and down. Users can then find it difficult to assess trends in the profit

figure or to use the current year’s profit to predict an entity’s performance in future

years.

The trend (improvement or deterioration) in an entity’s published EPS figure can

sometimes be a more reliable indicator of future performance. There are a number

of reasons for this.

 The standard version of both basic and diluted EPS is based on profit from

continuing operations. This means that the results of discontinued operations

(which may distort total profit) are excluded.

 An entity may also choose to present one or more alternative versions of EPS.

These normally exclude large or unusual items so that EPS is based on ‘normal’

recurring earnings.

 EPS measures an entity’s performance from the viewpoint of investors. It shows

the amount of earnings available to each ordinary shareholder. This means that

EPS takes the effect of preference dividends (if any) into account. It also takes

share issues into account.

 Diluted EPS can provide an ‘early warning’ of any changes to an investor’s

potential return on their investment due to future share issues.

6.2 Limitations of earnings per share

EPS is probably the single most important indicator of an entity’s performance. It is

a very useful measure when it is used as the starting point for a more detailed

analysis of an entity’s performance.

However, EPS can have serious limitations:

 Not all entities use the same accounting policies. It may not always be possible

to make meaningful comparisons between the EPS of different entities.

 EPS does not take account of inflation, so that growth in EPS over time might be

misleading.

 EPS measures an entity’s profitability, but this is only part of an entity’s overall

performance. An entity’s cash flow can be just as important as its profit (and

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more essential to its immediate survival). Changes in the value of assets (holding

gains) can also be an important part of performance for some entities.

 Diluted EPS is often described as an ‘early warning’ to investors that the return

on their investment may fall sometime in the future. However, diluted EPS is

based on current earnings, not forecast earnings. This means that it may not be a

reliable predictor of future EPS.

One of the main problems with EPS can be the way that it is used by investors and

others. Users often rely on EPS as the main or only measure of an entity’s

performance. Management know this and try to make EPS appear as high as

possible. They may attempt to manipulate the figure by using ‘creative accounting’.

They may also make decisions which increase EPS in the short term but which

damage the entity in the longer term.

Paper F7 (INT)

Financial reporting

CHAPTER

Statements of cash flows

Contents

1 Purpose of statements of cash flows. Cash and cash

equivalents

2 Overview of statements of cash flows

3 Preparing a statement of cash flows: cash flows

from operating activities – indirect method

4 Indirect method: adjustments for working capital

5 Preparing a statement of cash flows: cash flows

from operating activities – direct method

6 Preparing a statement of cash flows: cash flows

from investing activities

7 Preparing a statement of cash flows: cash flows

from financing activities

8 The uses of cash flow information

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Purpose of statements of cash flows. Cash and cash equivalents

 Purpose of statements of cash flows

 Reporting changes in cash and cash equivalents

 Definitions of cash and cash equivalents

 Note to the statement of cash flows on cash and cash equivalents

 Bank overdrafts

1 Purpose of statements of cash flows. Cash and cash

equivalents

1.1 Purpose of statements of cash flows

IAS1 states that a statement of cash flows is a part of a complete set of the financial

statements of an entity. It provides information about:

 the cash flows of the entity during the reporting period, and

 the changes in cash and cash equivalents during the period.

IAS7 Statements of cash flows sets out the benefits of cash flow information to

users of financial statements.

 A statement of cash flows provides information that helps users to evaluate

changes in the net assets of an entity and in its financial structure (including its

liquidity and solvency).

 It provides information that helps users to assess the ability of the entity to affect

the amount and timing of its cash flows in order to adapt to changing

circumstances and unexpected opportunities.

 It is useful in assessing the ability of the entity to generate cash and cash

equivalents.

 It helps users of accounts to compare the performance of different entities

because unlike profits, comparisons of cash flows are not affected by the

different accounting policies used by different entities.

 Historical cash flows are often a fairly reliable indicator of the amount, timing

and certainty of future cash flows.

1.2 Reporting changes in cash and cash equivalents

A statement of cash flows reports the change in the amount of cash and cash

equivalents held by the entity during the financial period.

This information is summarised at the end of the statement of cash flows, which

shows the change in cash and cash equivalents during the period, the amount and

the beginning of the period and the amount the end of the period.

Chapter 17: Statements of cash flows

At the end of a statement of cash flows, the increase or decrease in cash and cash

equivalents during the period is shown as follows. (Figures are included, for the

purpose of illustration).

$000

Increase in cash and cash equivalents during the period 54

Cash and cash equivalents at the beginning of the period 208

–––

Cash and cash equivalents at the end of the period 262

–––

1.3 Definitions of cash and cash equivalents

IAS7 defines cash and cash equivalents.

 Cash consists of cash (or other financial instruments) that can be withdrawn on

demand.

 Cash equivalents are short-term, highly-liquid investments that are readily

convertible into known amounts of cash and which are subject to an insignificant

risk of changes in value.

Examples of cash equivalents are:

 a bank deposit where some notice of withdrawal is required

 short-term investments with a maturity of three months or less, such as

government bills (such as Treasury bills in the UK) and short-term Certificates of

Deposit. IAS7 states that to be treated as a cash equivalent in the statement of

cash flows, rather than as an investment, short-term investments should have a

maturity (repayment date or redemption date) of, ‘say, three months or less from

the date of acquisition’.

Cash and cash equivalents are held in order to meet short-term cash commitments,

rather than for investment purposes or other purposes.

1.4 Note to the statement of cash flows on cash and cash equivalents

The following disclosures about cash and cash equivalents are also required, as a

supplementary note to the cash flow statement.

 a note showing the components of cash and cash equivalents

 a reconciliation showing the amounts in the cash flow statement with the

amounts in the balance sheet.

This note to the cash flow statement might therefore be shown as follows.

Current year

Previous year

$000

Cash on hand and balances with banks 193

172

Short-term investments 69

–

––

–

––

Cash and cash equivalents 262

208

–

––

–

––

Paper F7: Financial reporting (International)

1.5 Bank overdrafts

Bank overdrafts that are repayable on demand form an integral part of an entity’s cash

management arrangements. An overdraft balance of this type would therefore count as

‘negative’ cash.

In contrast, when a bank overdraft is a part of a committed revolving borrowing

facility, and is not repayable on demand, changes in the overdraft balance during a

period would probably be treated as a financing activity, not a change in cash and cash

equivalents.

Cash flows from financing activities are described later. However, when changes in

the bank overdraft are reported as a financing activity:

 an increase in the bank overdraft is a source of finance

 a decrease in the bank overdraft is a repayment of a borrowing.

Example

A company had a bank overdraft of $20,000 at the beginning of the financial year

and a bank overdraft of $70,000 at the end of the year.

Depending on whether or not the bank overdraft is repayable on demand, the

increase in the bank overdraft might be reported in the statement of cash flows as

either:

 a change in cash and cash equivalents, representing a fall in cash and cash

equivalents of $50,000, or

 a source of finance of $50,000, with no change in the cash and cash equivalents as

a consequence of the increase in the overdraft.

ACCA F7 (INT) Financial Reporting - Study text - 2010 - Emile Woolf Publishing

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