Chapter 24 Earnings per Share

1.       Objectives

1.1       Define earnings per share (EPS).
1.2       Describe the problem areas in determining EPS.
1.3       Be familiar with the disclosure requirements under HKAS 33.
1.4       Calculate the earnings per share for a given situation.
1.5       Discuss the implication of earnings per share where dilution of equity will occur and compute the fully diluted EPS.

2.       Basic EPS

2.1       EPS is perhaps the most extensively used stock market indicator. It shows the profit attributable to each equity share, and is considered by many investors to be an important measure for assessing the profitability of a company.
2.2       It also forms a basis for calculating the price/earnings rate (P/E ratio), which is the ratio of a share’s market price to its earnings per share.
2.3       It is of particular importance in comparing the operating results of a company over a period of time, or in comparing the performance of one company’s equity shares against that of another company’s equity shares. This comparison needs uniformity of calculation of EPS for all companies.

2.4

Definitions

(a)        An ordinary share – is an equity instrument that is subordinate to all other classes of equity instruments. (b)        An potential ordinary share – is a financial instrument or other contract that may entitle its holder to ordinary shares. Examples of potential ordinary shares are: (i)         debt or equity instruments, including preference shares, that are convertible into ordinary shares. This includes partly paid shares. (ii)        share warrants and options. (iii)       employee plans that allow employees to receive ordinary shares as part of their remuneration and other share purchase plans. (iv)       shares which would be issued upon the satisfaction of certain conditions resulting from contractual arrangements, such as the purchase of a business or other assets. (c)        Warrants or options are financial instruments that give the holder the right to purchase ordinary shares.

2.5       The basic EPS calculation is simply:

EPS =	Earnings
	Weighted average number of ordinary shares outstanding

2.6       Earnings – group profit after tax, less non-controlling interests and irredeemable preference share dividends.

3.       Computation of Basic EPS

(A)       Changes in capital structure

3.1       Wherever a change in ordinary share capital occurs during the accounting period, an adjustment is required to the number of shares in the basic EPS calculation for that period. Furthermore, in certain situations the basic EPS for previous periods will have to be recalculated.
3.2       The new issue of shares will take one of three possible forms:
(a)        issue at full market price;
(b)        capitalization or bonus issue; and
(c)        rights issue.

(a)       Issue at full market price

3.3       Where new ordinary shares have been issued for full consideration during the period, the earnings should be apportioned over the weighted average number of shares outstanding during the period.

3.4

Example 1

A company issued 200,000 shares at full market price ($3.00) on 1 July 2011. Relevant information:   2011 2010   $ $ Profit attributable to the ordinary shareholders for the year ended 31 Dec.   550,000   460,000 No. of ordinary shares in issue at 31 Dec. 1,000,000 800,000 Required: Calculate the EPS for each of the years. Solution: 2010 =  = 57.5c 2011 =  = 61.11c Since the 200,000 shares have only contributed finance for half a year, the number of shares is adjusted accordingly. Note that the solution is to use the earnings figure for the period without adjustment, but divide by the average number of shares weighted on a time basis.

(b)       Capitalization issues (bonus issue or scrip issue)

3.5       When an enterprise makes a bonus issue, the number of shares increases but no fresh capital comes in. To ensure that the EPS for the year of the bonus issue is taken for the whole year, regardless of the date in the year when the bonus issue took place, and comparative figures for earlier year are restated using the same increased figure.

3.6

Example 2

At 30 September 2011 ABC Ltd has issued share capital of $1,000,000 ordinary shares (4,000,000 shares of 25c) and $500,000 in 10% cumulative preference shares of $1. On 1 October 2011 the company further issued 1,000,000 ordinary shares fully paid by way of capitalization of reserves in the proportion of one for four. Calculate the basic EPS. Relevant information:   2011 2010   $ $ Profit after tax 550,000 460,000 Irredeemable preference dividends 50,000 50,000 Required: Calculate the EPS for each of the years. Solution:     2011 2010   $ $ Profit after tax 550,000 460,000 Less: Irredeemable preference dividends (50,000) (50,000) Earnings 500,000 400,000       Weighted average number of shares     At 1 January 4,000,000 4,000,000 Capitalization issue on 1 October 2011 1,000,000 1,000,000 No. of shares 5,000,000 5,000,000       Basic EPS 10.0c 8.0c In the 201 account, the EPS for the year would have appeared as 10c ($400,000/5,000,000). In the example above, the computation has been reworked from scratch. Since the old calculation was based on dividing by 4,000,000 while the new is determined by using 5,000,000, it would be necessary to multiply the EPS by the first and divide by the second. The fraction to apply is, therefore,  or Consequently 10c x  = 8.0c.

(c)        Rights issue

3.7       Rights issues present special problems, because they are normally below full market price and therefore combine the characteristics of issues at full market price and bonus issues as above.
3.8       In such a case, HKAS 33 states that it is necessary to adjust the number of shares in issue before the rights issue to reflect the bonus element inherent in the issue. The number of ordinary shares to be used in calculating basic EPS for all periods prior to the rights issue is the number of ordinary shares outstanding prior to the issue, multiplied by the following factor:

Fair value per share immediately prior to the exercise of rights

Theoretical ex-rights fair value per share

3.9

Example 3

At 30 June 2011 ABC Ltd has issued share capital of $1,000,000 ordinary shares (4,000,000 shares of 25c) and $500,000 in 10% cumulative preference shares of $1. The company made a rights issue of ordinary shares in the proportion of one for four at an exercise price of 50c per share (i.e. 1,000,000 shares for $500,000). The fair value of one ordinary share immediately prior to last date to exercise rights on 1 October 2011 was $1. Required: Calculate the basic EPS for 2010 and 2011. Solution: (1)       Theoretical ex-rights value per share   Number   $ Initial holding 4,000,000 Shares, fair value of $1 4,000,000 Rights taken up 1,000,000 Shares, at a cost of 50c 500,000   5,000,000   4,500,000 Therefore, theoretical ex-rights value per share = 90c, which is the average value per share of final holding. (2)       The calculation of adjustment factor is: Fair value per share immediately prior to the exercise of rights Theoretical ex-rights fair value per share =   (3)       Calculation of basic EPS   2011 2010   $ $ Profit after tax 500,000 450,000 Less: Irredeemable preference dividends (50,000) (50,000) Earnings 450,000 400,000       Basic EPS – 2010     As originally reported ($400,000/4,000,000)   10.0c Restated for rights issue [$400,000/(4,000,000 x 100/90)]     9.0c       Basic EPS – 2011     Including effects of rights issue     {$450,000/(4,000,000 x 100/90 x 9/12) + [(4,000,000 + 1,000,000) x 3/12]}   9.8c

 

(B)       Matters affecting the EPS calculation

3.10     Losses – where a loss is incurred or the amount earned for ordinary shares is a negative figure, the basic EPS should be determined in the normal manner and shown as a loss per share.

4.       The Diluted EPS

4.1       The EPS figure calculated as just described could be misleading to users if at some future time the number of shares in issue will increase without a commensurate increase in resources. For example, if an enterprise has issued bonds convertible at a later date into ordinary shares, on conversion the number of ordinary shares will rise, but no fresh capital enters the enterprise, though admittedly earnings rise by the savings in no loner having to pay the post-tax amount of the interest on the bonds. This effect is referred to as “dilution”
4.2       To avoid this possible problem, HKAS 33 requires an enterprise to disclose, as well as the basic EPS, the diluted EPS, calculated using current earnings but assuming that the future dilution has already happened.
4.3       For the purpose of calculating diluted EPS, the amount of net profit or loss attributable to the ordinary shareholders should be calculated as in basic EPS by adjusting for the tax effect of:
(a)        any dividend on dilutive potential ordinary shares which have been deducted;
(b)        interest recognized in the period for the dilutive potential ordinary shares; and
(c)        any changes in income or expenses that will no longer be incurred on the conversion of the dilutive potential ordinary shares.
4.4       The weighted average number of ordinary shares outstanding will be increased by additional weighted average number of ordinary shares which would be issued assuming conversion of all dilutive potential ordinary shares from the beginning of the period or the date of the issue, if later.
4.5       Examples of dilutive factors are:
(a)        convertible bonds and convertible preference shares;
(b)        options or warrants;
(c)        partly paid shares;
(d)        contingently issuable shares (i.e. shares issuable if certain conditions are met).

(A)       Effects of convertibles

4.6       When, for example, bondholders exercise their right to convert their bonds into ordinary share, the share capital will increase but no new resources enter the enterprise. In this case the earnings increase by the post tax amount of the bond interest.

4.7

Example 4

On 1 April 2011, an enterprise issued by way of rights or otherwise $1,250,000 8% convertible unsecured bonds for cash at par. Each $100 nominal of the bonds will be convertible in 2016/2019 into the number of ordinary shares set out below: On 31 December 2016 124 shares On 31 December 2017 120 shares On 31 December 2018 115 shares On 31 December 2019 110 shares Relevant information: Issues share capital: $500,000 in 10% cumulative irredeemable preference shares of $1; $1,000,000 in ordinary shares of 25c = 4,000,000 shares. Income tax rate is 45%. Trading results for the year ended 31 December   2012 2011   $ $ Profit before interest and tax 1,100,000 991,818 Interest on 8% convertible unsecured bonds 100,000 75,000 Profit before tax 1,000,000 916,818 Income tax 450,000 412,568 Profit after tax 550,000 504,250 Solution: 1.      Basic EPS   2012 2011   $ $ Profit after tax 550,000 504,250 Less: Preference dividend 50,000 50,000 Earnings 500,000 454,250       EPS based on 4,000,000 shares 12.5c 11.4c 2.      Diluted EPS   $ $ $ $ Earnings as above   500,000   454,250 Add: interest on the convertible bonds   100,000     75,000   Less: Tax (45,000)   (33,750)       55,000   41,250 Adjusted earnings   555,000   495,500           Diluted EPS based on 5,550,000 shares (2011 – 5,162,500)     10c     9.6c Notes: (a)     Up to 2015 the maximum number of shares issuable after the end of the financial year will be at the rate of 124 shares per $100, viz: 1,550,000 shares, making a total of 5,550,000. (b)    The weighted average number of shares issued and issuable for 2011 would have been one-quarter of 4,000,000 plus three-quarter of 5,550,000, i.e., 5,162,500.

(B)       Effects on share options

4.8       An option may give the holder the right to buy shares at some time in the future at below the market price. In this case some cash does enter the enterprise at the time the option is exercised, and the diluted EPS calculation must allow for this.
4.9       The number of shares for which the option is exercised is first reduced by the number of shares which could have been purchased at fair value by the consideration payable under the option. The remainder, the shares issued for no consideration, is added to the shares in issue.

4.10

Example 5

Profit for the year 2011 $1,200,000 Weighted average number of shares outstanding during year 2011   500,000 shares Average fair value of one share during 2011 $20 Weighted average number of shares under option during 2011   100,000 shares Exercise price for shares under option during 2011 $15 Calculation of EPS   Per share Earnings Shares Profit for year 2011   $1,200,000   Weighted average shares outstanding during year 2011       500,000 Basic EPS $2.40     No. of shares under option     100,000 No. of shares that would have been issued at fair value: (100,000 x 15/20)       (75,000) Diluted EPS $2.29 $1,200,000 525,000 Note: It is not necessary to adjust the earnings figure because the total number of shares has been increased only by the 25,000 shares deemed to have been issued for no consideration.

 

(C)       Multi-dilutive factors

4.11     Where a company has a number of potentially events in the future, HKAS 33 requires that they should be considered in order with the most dilutive first and the least dilutive last. This will ensure that the maximum possible dilution in EPS is identified.

4.12

Example 6

Earnings $10,000,000 Ordinary shares outstanding 2,000,000 Average fair value of one share during year $75 Potential ordinary shares: Options 100,000 with exercise price of $60 Convertible preference shares 800,000 shares entitled to a cumulative dividend of $8 per share. Each preference share is convertible to 2 ordinary shares. 5% convertible bond Nominal amount $100,000,000. Each $1,000 bond is convertible to 20 ordinary shares. There is no amortisation of premium or discount affecting the determination of interest expense. Tax rate 40% Required: Calculate the diluted EPS for the year. Solution: 1.      Determination of order   Increase in earnings Increase in no. of shares Earnings per incremental share   $   $ Options       Increase in earnings Nil     Incremental shares issued for no consideration [100,000 x (75 – 60)/75]     20,000   Nil Convertible preference shares       Increase in profit (8 x $800,000) 6,400,000     Incremental shares (2 x 800,000)   1,600,000 4.00 5% convertible bonds       Increase in profit [$100m x 5% x (1 – 0.4)]   3,000,000     Incremental shares (100,000 x 20)   2,000,000 1.50 These calculations allow us to place the three dilutive factors in order. Dealing with the most dilutive first we have: 2.      Computation of diluted EPS   Profit attributable Ordinary shares Per share     $   $   As reported 10,000,000 2,000,000 5.00   Options   20,000       10,000,000 2,020,000 4.95 Dilutive 5% convertible bonds   3,000,000   2,000,000       13,000,000 4,020,000 3.23 Dilutive Convertible preference shares   6,400,000   1,600,000       19,400,000 5,620,000 3.45 Anti-dilutive Since diluted EPS is increased when taking the convertible preference shares into account (from $3.23 to 3.45), the convertible preference shares are anti-dilutive and are ignored in the calculation of diluted earnings per share. Therefore, diluted earnings per share is $3.23. Conclusion – In determining the diluted EPS, each issue of potential ordinary shares must be considered in sequence, from the most dilutive to the least dilutive.

4.13     To understand the reasoning behind the ordering, it is necessary to realize that the lower the incremental EPS, the greater the dilutive effect. If a different order had been taken, the final EPS figure of $3.45 would have stayed the same, but the lower figure of $3.23 would not have emerged, as the following calculation demonstrates:

	Profit attributable	Ordinary shares	Per share
	$		$
As reported	10,000,000	2,000,000	5.00
Convertible preference shares	6,400,000	1,600,000
	16,400,000	3,600,000	4.56
5% convertible bonds	3,000,000	2,000,000
	19,400,000	5,600,000	3.46
Options	-	20,000
	19,400,000	5,620,000	3.45

4.14     Potential ordinary shares should be included in the calculation of diluted EPS when their conversion to ordinary shares would decrease net profit from continuing operations, rather than “net profit”. This means that items relating to discontinued operations, the effects of changes in accounting policies and correction of errors would all be excluded.

5.       Disclosure Requirements

5.1       An enterprise should present, with equal prominence, the basic and diluted EPS on the face of the profit and loss account for each class of ordinary shares that has a different right to share in the net profit for the period. Negative amount (a loss per share) should also be disclosed.
5.2       The following should be disclosed:
(a)        the amounts used as the numerators in calculating basic and diluted EPS, and a reconciliation of those amounts to the net profit or loss for the period; and
(b)        the weighted average number of ordinary shares used as the denominator in calculating basic and diluted EPS, and a reconciliation of these denominators to each other.

Examination Style Questions

Question 1
Fenton had 5,000,000 ordinary shares in issue on 1 January 20X1.

On 31 January 20X1, the company made a rights issue of 1 for 4 at $1.75. The cum rights price was $2 per share.

On 30 June 20X1, the company made an issue at full market price of 125,000 shares.

Finally, on 30 November 20X1, the company made a 1 for 10 bonus issue.

Profit for the year was $2,900,000.

The reported EPS for year ended 31 December 20X0 was 46.4c.

Required:

What was the earnings per share figure for year ended 31 December 20X1 and the restated EPS for year ended 31 December 20X0?

Question 2
Sinbad had the same 10 million ordinary shares in issue on both 1 January 20X1 and 31 December 20X1. On 1 January 20X1 the company issued 1,200,000 $1 units of 5% convertible loan stock. Each unit of stock is convertible into 4 ordinary shares on 1 January 20X9 at the option of the holder. The following is an extract from Sinbad's income statement for the year ended 31 December 20X1:

	$000
Profit before interest and tax	980
Interest payable on 5% convertible loan stock	(60)
Profit before tax	920
Income tax expense (at 30%)	(276)
Profit for the year	644

Required:

What are the basic and diluted EPS for the year ended 31 December 20X1?
Question 3
Talbot has in issue 5,000,000 50c ordinary shares throughout 20X3.

During 20X1 the company had given certain senior executives options over 400,000 shares exercisable at $1.10 at any time after 31 May 20X4. None were exercised during 20X3. The average market value of one ordinary share during the period was $1.60. Talbot had made a profit after tax of $540,000 in 20X3.

Required:

What is the basic and diluted earnings per share for the year ended 31 December 20X3?

Question 4
(a)     The issued share capital of Savoir, a publicly listed company, at 31 March 20X3 was $10 million. Its shares are denominated at 25 cents each. Savoir's earnings attributable to its ordinary shareholders for the year ended 31 March 20X3 were also $10 million, giving an earnings per share of 25 cents.

Year ended 31 March 20X4
On 1 July 20X3 Savoir issued eight million ordinary shares at full market value. On 1 January 20X4 a bonus issue of one new ordinary share for every four ordinary shares held was made. Earnings attributable to ordinary shareholders for the year ended 31 March 20X4 were $13,800,000.

Year ended 31 March 20X5
On 1 October 20X4 Savoir made a rights issue of shares of two new ordinary shares at a price of $1·00 each for every five ordinary shares held. The offer was fully subscribed. The market price of Savoir's ordinary shares immediately prior to the offer was $2·40 each. Earnings attributable to ordinary shareholders for the year ended 31 March 20X5 were $19,500,000.

Required:

Calculate Savoir's earnings per share for the years ended 31 March 20X4 and 20X5 including comparative figures.                                                                                                                   (9 marks)

(b)     On 1 April 20X5 Savoir issued $20 million 8% convertible loan stock at par. The terms of conversion (on 1 April 20X8) are that for every $100 of loan stock, 50 ordinary shares will be issued at the option of loan stockholders. Alternatively the loan stock will be redeemed at par for cash. Also on 1 April 20X5 the directors of Savoir were awarded share options on 12 million ordinary shares exercisable from 1 April 20X8 at $1·50 per share. The average market value of Savoir's ordinary shares for the year ended 31 March 20X6 was $2·50 each. The income tax rate is 25%. Earnings attributable to ordinary shareholders for the year ended 31 March 20X6 were $25,200,000. The share options have been correctly recorded in the income statement.

Required:

Calculate Savoir's basic and diluted earnings per share for the year ended 31 March 20X6 (comparative figures are not required).

You may assume that both the convertible loan stock and the directors' options are dilutive.          (4 marks)
(Total = 13 marks)
(Adapted ACCA 2.5 Financial Reporting June 2006 Q5(b) & (c))

Question 5
Extracts of Niagara's consolidated statement of comprehensive income for the year to 31 March 20X3 are:

	$000
Revenue	36,000
Cost of sales	(21,000)
Gross profit	15,000
Other operating expenses	(6,200)
Interest payable	(800)
Impairment of non-current assets	(4,000)
Share of profit of associates	1,500
Profit before tax	5,500
Income tax expense	(2,800)
Profit for the year	2,700
Profit attributable to:
Owners of the parent	2,585
Non-controlling interest	115
	2,700

This draft income statement does not include any amounts in respect of the preference dividends or equity dividends for the year.

The impairment of non-current assets attracted tax relief of $1 million which has been included in the tax charge.

Niagara paid an interim ordinary dividend of 3c per share in June 20X2 and declared a final dividend on 25 March 20X3 of 6c per share.

The issued share capital of Niagara on 1 April 20X2 was:

Ordinary shares of 25 c each	$3 million
8% Preference shares	$1 million

The preference shares are non-redeemable.

The company also had an issue $2 million 7% convertible loan stock dated 20X5. The loan stock will be redeemed at par in 20X5 or converted to ordinary shares on the basis of 40 new shares for each $100 of loan stock at the option of the stockholders. Niagara's income tax rate is 30%.

There are also in existence directors' share warrants (issued in 20X1) which entitle the directors to receive 750,000 new shares in total in 20X5 at no cost to the directors.

The following share issues took place during the year to 31 March 20X3:

• 1 July 20X2; a rights issue of 1 new share at $1·50 for every 5 shares held. The market price of Niagara's shares the day before the rights was $2·40.
• 1 October 20X2; an issue of $1 million 6% non-redeemable preference shares at par.

 

Both issues were fully subscribed.

Niagara's basic earnings per share in the year to 31 March 20X2 was correctly disclosed as 24c.

Required:

Calculate for Niagara for the year to 31 March 20X3:
(a)     the dividend cover and explain its significance;                                                   (3 marks)
(b)     the basic earnings per share including the comparative;                                       (4 marks)
(c)     the fully diluted earnings per share (ignore comparative); and advise a prospective investor of the significance of the diluted earnings per share figure.                                           (6 marks)
(Total = 13 marks)
(Adapted ACCA 2.5 Financial Reporting June 2003 Q5(b))

Question 6
(a)     Your assistant has been reading the HKICPA’s Framework for the preparation and presentation of financial statements (Framework) and as part of the qualitative characteristics of financial statements under the heading of ‘relevance’ he notes that the predictive value of information is considered important. He is aware that financial statements are prepared historically (i.e. after transactions have occurred) and offers the view that the predictive value of financial statements would be enhanced if forward-looking information (e.g. forecasts) were published rather than backward-looking historical statements.

Required:

By the use of specific examples, provide an explanation to your assistant of how HKFRS presentation and disclosure requirements can assist the predictive role of historically prepared financial statements.                                                                                                                               (6 marks)

(b)     The following summarised information is available in relation to Rebound, a publicly listed company:

Income statement extracts years ended 31 March:

Analysts expect profits from the market sector in which Rebound’s existing operations are based to increase by 6% in the year to 31 March 2012 and by 8% in the sector of its newly acquired operations.

On 1 April 2009 Rebound had:
$3 million of 25 cents equity shares in issue.

$5 million 8% convertible loan stock 2016; the terms of conversion are 40 equity shares in exchange for each $100 of loan stock. Assume an income tax rate of 30%.

On 1 October 2010 the directors of Rebound were granted options to buy 2 million shares in the company for $1 each. The average market price of Rebound’s shares for the year ending 31 March 2011 was $2·50 each.

Required:

(i)      Calculate Rebound’s estimated profit after tax for the year ending 31 March 2012 assuming the analysts’ expectations prove correct;                                                           (3 marks)
(ii)     Calculate the diluted earnings per share (EPS) on the continuing operations of Rebound for the year ended 31 March 2011 and the comparatives for 2010.
(6 marks)
(15 marks)
(ACCA F7 Financial Reporting June 2011 Q4)