ACCA P2 (INT) Corporate Reporting - Study text

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Chapter 13: Reporting requirements for listed companies

IAS 33: Earnings per share

 Introduction and scope

 Basic earnings per share

 Basic earnings per share and a bonus issue of shares

 Basic earnings per share and a rights issue

 Diluted earnings per share

 Dealing with multiple dilutions

 Diluted losses

 ED: Simplifying Earnings per Share

2 IAS 33: Earnings per share

2.1 Introduction and scope

Earnings per share (EPS) is a key ratio used by investors to assess the performance

of a company. It provides a measure of the profit attributable to each ordinary

shareholder during the year. The EPS for both this year and the previous year must

be disclosed in the annual financial statements.

The disclosure should be made in the statement of comprehensive income, unless it

presents the components of profit or loss in a separate income statement, in which

case the EPS information should be disclosed in the income statement.

Basic EPS should be calculated by dividing the net profit or loss for the period

attributable to ordinary shareholders by the weighted average number of ordinary

shares outstanding during the period.

IAS 33 Earnings per share applies to entities whose ordinary shares are publicly

traded and by entities that are in the process of issuing ordinary shares in a public

market. EPS is therefore usually calculated from consolidated accounts.

This is not a key standard for the exam, so you will need to know this in outline.

Any questions set are likely to be testing adjustments that affect the earnings figure

which in turns affects the EPS.

2.2 Basic earnings per share

IAS 33 specifies how earnings per share should be calculated. This is to ensure that

measurements of EPS by different entities can be properly compared with each

other.

Earnings per share =

Earnings

Number of ordinary shares in issue

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Earnings are the profit (or loss) after tax from continuing operations that are

attributable to the ordinary equity shareholders. With consolidated accounts,

earnings are the profits after tax from continuing operations that are attributable to

ordinary equity shareholders of the parent company (excluding the profit

attributable to non-controlling interests).

Preference dividends are deducted in arriving at the profit attributable to ordinary

equity shareholders. Preference dividends should normally only be deducted from

profit after tax to calculate a figure for earnings if they have already been declared

by the end of the financial year. This is because the company does not have an

obligation to pay the dividend unless it is declared. However, there is an exception

in the case of dividends on ‘cumulative preference shares’. When a company has

cumulative preference shares, the dividend that should be paid must be deducted

from profit after tax to calculate earnings, even if it has not yet been formally

declared. This is because if no dividend is declared, the entitlement of the

shareholders to their dividend remains. There is an obligation on the company to

pay the dividend, and this carries forward to the next financial year, until the

dividend is eventually paid.

Number of ordinary shares in issue. This is the weighted average number of

ordinary shares during the period. Calculating the number of shares in issue can be

fairly complicated.

When shares are issued during the financial year

at a full market price, the number

of shares is a weighted average number of shares in issue during the year. This can

be calculated as follows:

Number of shares at the beginning of the year, plus A

Number of shares issued at full market price during the year

× [Number of months in the year after the share issue /12]

Weighted average number of shares in the year A + B



Example

A company issued 20,000 ordinary shares at their market price of $5 per share on 1

July 20X7. Its share capital prior to the issue was 200,000 and its profits after tax

were $50,000 for the year to December 20X6 and $70,000 for the year to 31 December

20X7.

The shares were issued at full market price.

The earnings per share in each year are calculated as follows:

20X6: EPS = $50,000/200,000 shares = $0.25

20X7: Weighted average number of shares = 200,000 + (20,000 × 6/12) = 210,000

EPS = $70,000/210,000 shares = $0.33.

Chapter 13: Reporting requirements for listed companies

Partly-paid shares

The EPS is based on the number of fully-paid ordinary shares. Sometimes shares are

issued with the money collected in stages, so if there are any shares which are not

fully paid up by the end of the reporting period, then the equivalent number of fully

paid shares must be established for use in the formula.



Example

At 1 January 20X7 a company had 100,000 $1 shares in issue, of which 800,000 are

fully paid up. The rest of the shares in issue were paid up to $0.75.

The remaining $0.25 on the partly-paid shares was collected on 30 June 20X7.

The weighted average number of shares in 20X7 is calculated as follows:

Fullypaid

1Januaryto31December–fullypaidup

800,000

Partlypaid

1Januaryto30June–paidupto75c:200,000×75c×6/12 = 75,000

1Julyto31December–fullypaid‐up:200,000×$1×6/12

= 100,000

Weightedaveragenumberofordina rysharesforEPScalculation

975,000

2.3 Basic earnings per share and a bonus issue of shares

A company may make a free issue of shares to its existing shareholders. This is

called a bonus issue, scrip issue or capitalisation issue. The issue does not bring any

new cash into the company and so cannot be expected to increase the total earnings.

The problem for calculating EPS when there has been a bonus issue in the period is

that it distorts the comparison of EPS in the current year with the EPS in the

previous year (for which a comparative figure is shown in the statement of

comprehensive income or income statement). So to ensure that the bonus issue does

not distort the comparison of EPS in the current year and previous year:

 the EPS for the current year is calculated as if the bonus issue took place at the

start of the year, and

 the previous year’s EPS is also re-stated as though the bonus shares had been in

existence throughout the whole of that year too.



Example

A company has a share capital of 400,000 ordinary shares, when it decides to make a

bonus issue of 1 for 4 on 1 April 20X6. Its profits for the year to 31 December 20X5

were $60,000 and its profits for the year to 31 December 20X6 were $65,000.

The EPS originally calculated in the financial statements for 20X5 was:

= $60,000/400,000 shares = $0.15.

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After the bonus issue in 20X6, when the company issues another 100,000 shares (1/4

× 400,000) there are 500,000 shares. To calculate the EPS for 20X6, it is assumed that

all these shares were in issue for the full year.

EPS for 20X6 = $65,000/500,000 shares = $0.13.

The EPS in 20X5 was $0.15 and the EPS in 20X6 is $0.13. This comparison would

suggest that the EPS has gone down, and the company has therefore performed

worse in 20X6. This is clearly not true: total earnings have gone up. The only

difference between 20X5 and 20X6 is that the company issued some free shares.

To make the EPS for 20X6 and 20X5 properly comparable, we have to adjust the EPS

for 20X5 for the purpose of making the comparison in the 20X6 financial statements,

assuming that 500,00 shares were in issue throughput 20X5 as well as 20X6.

Re-stated EPS for 20X5 = $60,000/500,000 shares = $0.12.

Alternatively, to calculate the re-stated EPS for the previous year the original EPS in

20X5 of 15p can be adjusted by the ‘bonus fraction’ to recognise that 400,000 shares

have now become 500,000 shares.

$0.12=

500,000

400,000

issue bonusafter shares ofNumber

shares ofnumber Original

$0.15 EPS Original ×

Both the 20X6 figure for EPS and the re-stated 20X5 figure will be presented at the

bottom of the statement of comprehensive income (or the income statement, if this is

presented separately) in the 20X6 financial statements.

2.4 Basic earnings per share and a rights issue

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.

Chapter 13: Reporting requirements for listed companies

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

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



$

4existingshareshavea‘cumrights’valueof (4 ×$5) 20.00

1newshareisissuedfor 4.00

 –––––

5sharesaftertheissuehaveatheoreticalvalueof 24.00

 –––––

Theoretical ex-rights price = $24.00/5 = $4.80.

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

Date



Number

ofshares



Time

factor



Rights

fraction

Weighted

average

number

ofshares

1Jan Broughtforward 36,000,000 ×5/12 ×5.00/4.80 15,625,000

1June Rightsissue(1for4) 9,000,000 



⎯



31Dec Carriedforward 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.



Answer

After the rights issue, there will be 1 new share for every 2 shares previously in

issue



$

2existingshareshavea‘cumrights’valueof (2×$5) 10.00

1newshareisissuedfor 2.00



⎯



3sharesaftertheissuehaveatheoreticalvalueof 12.00



⎯



Theoretical ex-rights price = $12/3 = $4.

Chapter 13: Reporting requirements for listed companies



Date



Number

ofshares



Time

factor



Rights

fraction

Weighted

average

numberof

1Jan Broughtforward 3,000,000 ×3/12 ×5/4 937,500

1April Rightsissue(1for2) 1,500,000 



⎯



 4,500,000 ×4/12  1,500,000

1August Issueatmarketprice 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.

2.5 Diluted earnings per share

In addition to the basic measure of EPS, a company must also disclose the diluted

EPS in its statement of comprehensive income (or income statement, if presented

separately). Diluted EPS warns existing shareholders that the EPS may fall in future

years because of

potential new ordinary shares that have been issued. Potential

new ordinary shares may become actual ordinary shares at some time in the future

Potential new ordinary shares may be issued in any of the following forms:

 Convertible bonds: (bonds or debentures that can be converted into ordinary

shares in the future, at the option of the bondholders)

 Convertible preference shares: (preference shares that can be converted into

ordinary shares in the future, at the option of the preference shareholders)

 Options and warrants: (holders of options and warrants have the right to buy

ordinary shares in the future at a predetermined fixed price)

 Contingently-issuable shares: (these are ordinary shares that will be issued if

certain conditions are met)

 Employee incentive schemes (share options issued to the company’s employees).

The owners of these instruments may become ordinary shareholders in the future. If

this happens, the company’s earnings will be shared by a larger number of

shareholders. There is a strong possibility that the EPS may fall, and the EPS will

become ‘diluted’. (‘Diluted’ means ‘watered down’, and in relation to EPS, it means

‘lower’.)

The diluted EPS is calculated by revising the total earnings and the weighted

average number of shares as though the potential ordinary shares had already been

issued.

Paper P2: Corporate Reporting (International)

The original earnings figure is revised by adjusting it for the dilutive effect of the

potential ordinary shares when they become actual ordinary shares. An adjustment

to total earnings is needed for convertible preference shares and convertible bonds.

 If convertible preference shares (potential ordinary shares) became actual

ordinary shares, there would be a reduction in preference dividend, so total

earnings would be higher.

 If convertible bonds (potential ordinary shares) became actual ordinary shares,

there would be a reduction in interest costs (although there would no longer be

tax relief on the interest costs), and total earnings would be higher.

When calculating the revised weighted average number of shares, the potential

ordinary shares are deemed to have been converted into ordinary shares at the

beginning of the period or, if later, the date of the issue.

Only dilutive shares should be included in the diluted EPS calculation.

 Potential new ordinary shares are not dilutive if EPS would have been higher if

the potential shares had been actual shares in the period.

 Potential ordinary shares are dilutive when their conversion to ordinary shares

decreases the EPS from continuing operations.

Diluted EPS and convertible debt and preference shares

Convertible instruments have two possible effects on EPS.

 Total earnings will increase because the interest or preference dividend will no

longer be payable. With convertible debt, the tax relief on the interest will be

lost, so the increase in total earnings is the interest no longer payable, minus the

associated tax relief.

 The weighted average number of shares will increase.

The holders of the convertible debt or shares may have a choice of dates for

conversion, and the rate of conversion into ordinary shares is often different for

each conversion date. IAS 33 requires the best rate (from the holder’s view) to be

used.



Example

On 1 January Year 1, a company has 700,000 ordinary shares in issue. On 31 March

Year 1, the company issues $200,000 6% convertible debentures. The terms of

conversion are as follows:

(1) 100 shares per $100 debt if conversion takes place by 30 June Year 3

(2) 110 shares per $100 debt if conversion takes place by 30 June Year 5

The profit for the year to 31 December Year 1 is $200,000 and the tax rate is 33%.

The

basic EPS for Year 1 is $200,000/ 700,000 = $0.29

Chapter 13: Reporting requirements for listed companies

Diluted EPS

As there is a choice of dates for conversion, IAS 33 requires that the diluted EPS

calculation uses the best conversion rate from the holder’s view. This will be 110

shares per $100 of debt. This would result in an additional 220,000 shares being

issued ($200,000 × 110/100).

The company will save $12,000 in annual interest costs when the debt converts (6%

× $200,000) but it will lose the tax relief on the interest. The tax relief is $12,000 ×

33% = $3,960.

The diluted EPS for Year is therefore calculated as follows:

Numberofshares

Earnings

Existingshares 700,000

200,000

Newsharesonconversion 220,000

Interestsaved

12,000

Taxrelieflost

(3,960)

Adjustedamounts 920,000

208,040

Diluted EPS = $208,040/920,000 shares = $0.23.

Diluted EPS and share options and warrants

Share options and share warrants allow the holder the right to buy new ordinary

shares at a future date, at a predetermined fixed price that is often lower than the

current market price for the shares. If the options or warrants are ‘exercised’, the

company will issue new shares and will receive less money than it would if the

shares had been issued at the full market price.

When options or warrants have an exercise price that is less than the market price,

there is a dilutive effect on EPS, and a diluted EPS must be calculated.

The technique for calculating diluted EPS for options and warrants is different from

the technique for convertible preference shares or convertible debt. This is because 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.

Paper P2: Corporate Reporting (International)

 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.

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

Minusnumberofsharesatfairvalue (250,000)



⎯

Netdilution 150,000

Existingsharesinissue 5,000,000



⎯

Totalshares 5,150,000



⎯

Diluted EPS = $1,030,000/5,150,000 = $0.20 or 20c.

Contingently-issuable shares

Contingently-issuable shares are ordinary shares issued for little or no cash when

another party satisfies certain conditions. They may, for example be issued to

employees if certain performance targets are met over a period of time, under the

terms of a share grant incentive scheme.

Such shares should be included in the diluted EPS calculation if the conditions or

targets have been met, and should be included from the beginning of the period, or

ACCA P2 (INT) Corporate Reporting - Study text - 2010 (Emile Woolf)

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