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Chapter 25. Earnings per share. Objectives. Be able to define and calculate basic earnings per share Know how to adjust the calculation of basic earnings per share to take account of the existence of a bonus or rights entitlement

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Chapter 25 l.jpg
Chapter 25

Earnings per share

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


Objectives l.jpg
Objectives

  • Be able to define and calculate basic earnings per share

  • Know how to adjust the calculation of basic earnings per share to take account of the existence of a bonus or rights entitlement

  • Understand what potential ordinary shares are, and be able to determine whether they are dilutive

  • Understand how to calculate diluted earnings per share

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Introduction to accounting for earnings per share

  • AASB 133 ‘Earnings per Share’ issued in July 2004

  • Requires disclosure of basic earnings per share and diluted earnings per share on the face of the income statement (per AASB 133 par. 66)

  • Applies to:

    • All companies listed on the Australian Stock Exchange

    • Other entities that are listed or have on issue ordinary shares or partly paid ordinary shares

    • Entities in the process of listing and

    • Entities that voluntarily disclose earnings per share

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Introduction to accounting for earnings per share (cont.)

  • An entity must disclose earnings per share on the face of the income statement and must be presented even if the amounts are negative (loss per share) under AASB 133, par. 69

  • Comparatives must also be shown

  • Standard need only apply to the consolidated financial report

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share

  • Need to consider at least two issues:

    • How earnings are defined

    • How the number of shares are determined

  • Prior to standard being issued:

    • Inconsistency in computing earnings and/or number of shares issues

    • Inconsistencies made inter-firm comparisons difficult

  • Basic earnings per share determined by dividing the earnings of the entityfor the reporting period by the weighted-average number of shares of the entity

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

  • Basic earnings per share determined by dividing the earnings of the entityfor the reporting period by the weighted-average number of shares of the entity

  • Earnings determined after deducting:

    • any preference share dividends appropriated for the financial year to the extent that they have not been treated as expenses of the entity

  • Preference share dividends are deducted to provide earnings on the basis that EPS is calculated from the perspective of the ordinary shareholders—EPS relates to earnings per ordinary share

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Preference dividends

  • In periods where preference dividend not paid, need to consider whether or not preference shares are cumulative

    • If cumulative, dividends not paid in one year must be paid in later years before ordinary shareholders are entitled to dividends

    • If not cumulative and no preference dividend paid, it is ignored for purposes of calculating earnings per share

      Refer to AASB 133 (par. 14)

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Earnings must be calculated to exclude the following:

  • Any portion attributable to minority interests

  • Any costs of servicing equity, paid or provided for, other than dividends on ordinary shares and partly-paid shares

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Calculating weighted-average number of ordinary shares

  • Need to consider:

    • definition of ordinary shares

    • number of shares

    • weighting to consider both fully and partly paid shares

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Definition of ordinary shares (AASB 133, par. 5)

  • An equity instrument that is subordinate to all other classes of equity instruments

  • For the purposes of the standard, it does not matter what the shares are called

  • If they have the above characteristics, they are treated as ordinary shares—standard applies a substance-over-form test

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Determining number of shares

  • Number of ordinary shares outstanding at beginning of financial year adjusted as follows:

    • Increased by ordinary shares issued during year from unissued capital, weighted by reference to the number of days from the date of issue of those shares to the reporting date as a proportion of the total number of days in the reporting period; and

    • decreased by ordinary shares bought back during financial year, weighted by reference to the number of days from the date of reduction to reporting date as a proportion of the total number of days in the reporting period.

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Considering partly paid shares in weighted average

  • Weighted average number of ordinary shares (denominator when calculating EPS) also needs to take into account partly paid shares

  • Partly paid shares will be included only to the extent that they carry rights to participate in dividends relative to an ordinary share (AASB 133, par. 15)

  • Where the partly paid ordinary shares carry no rights to participate in earnings, they would not be included in the weighted-average number of ordinary shares

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Mandatory convertible securities

  • Entities might also have on issue mandatory convertible securities (securities that must be ultimately be converted to ordinary shares)

  • Ordinary shares that will be issued upon the conversion of a mandatory convertible instrument are included in the calculation of basic earnings per share from the date the contract is entered into (AASB 133 par. 23)

    Refer to Worked Example 25.1 on pp. 853–4—Calculation of basic EPS

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Adjustment for bonus issues

  • Bonus issues have an impact on the weighted-average number of ordinary shares

  • The bonus issue does not change total shareholders’ funds—it involves a transfer from retained profits to share capital (assuming funded from retained earnings)

  • The number of shares outstanding before the bonus issue should be increased as if the bonus has been in place for the entire reporting period

  • Weighted-average number of ordinary shares prior to rights or other issue is divided by an adjustment factor

    Refer to AASB 133 (pars 27 and 28)

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Adjustment for bonus issues (cont.)

  • If one-for-one bonus issue, number of shares would double

  • Given no effect on earnings, doubling shares would halve EPS

  • Prior period comparatives for EPS are also adjusted for the bonus issue so that comparisons can be made as if the bonus shares had been issued in the previous period

  • If shares issued at the prevailing market price, there is no bonus element, and no adjustment is necessary

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Calculation of adjustment factor

Adjustment factor = Px ÷ Po, where:

Px = theoretical ex-rights price = [(Po x No) + Pr] ÷ (No + 1)

Po = last sales price or, if higher, last bid price cum rights

No= no. of shares required for one right

Pr= subscription price of right + present value of dividends forgone in respect of ordinary shares required for one right not presently participating in dividends

Refer to Exhibit 25.1 on page 855—Adjustment factor for EPS in respect of the bonus element in an issue of ordinary shares

Refer to Worked Example 25.2 on page 857—Calculation of EPS in the presence of a bonus issue

(continues)

Computation of basic earnings per share (cont.)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Computation of basic earnings per share (cont.)

Rights issue

  • Existing shares may be provided with rights to acquire additional shares at price below current market price of the firm’s shares

  • If exercise price is less than the market price of the shares, the rights issue includes a bonus element

  • Where there is a bonus element the weighted-average number of shares needs to be adjusted using the previous formula

    Refer to Worked Example 25.3 on pp. 858–9—Calculation of EPS in the presence of a rights issue with a bonus element

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share

  • AASB 133 requires that diluted EPS be disclosed together with basic EPS on the face of the income statement

  • Diluted EPS must be calculated where an entity has on issue ‘potential ordinary shares’ that are, in fact, dilutive

  • Refer to AASB 133, par. 31

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Potential ordinary shares (AASB 133, par. 5)

  • A financial instrument or other contract that may entitle its holder to ordinary shares

  • Potential ordinary shares are considered dilutive when and only when the conversion to, calling of, or subscription for ordinary shares would decrease (or increase) net profit (or loss) from continuing ordinary operations per share

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Potential ordinary shares (cont.)

  • If securities currently on issue might be converted to ordinary shares, this will increase the number of ordinary shares on issue, leading to a decrease in EPS

  • Users of financial reports need to know about this potential reduction (dilution) in EPS

  • Diluted earnings per share will show how EPS would fall if the potential ordinary shares were actually converted to ordinary shares—aim is to inform investors about how EPS could be affected in the future

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Examples of potential ordinary shares:

  • Convertible preference shares

  • Share options

  • Convertible bonds

  • Convertible notes

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

To determine diluted EPS

  • Weighted-average number of shares calculated as per basic EPS

    • Adjusted by a factor based on weighted-average number of potential ordinary shares that the company had on issue throughout all or part of the financial year

  • General rule applies that if a potential ordinary share issue would increase EPS, it is not considered to be dilutive

    • Excluded from calculation of diluted EPS

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

To determine diluted EPS (cont.)

  • Each type of potential ordinary share needs to be considered separately

  • If the conversion is at the option of the entity, and the conversion is probable, the potential ordinary shares must be included in the diluted EPS calculation—even if their inclusion does not dilute EPS

  • If conversion of potential ordinary shares to ordinary shares is mandatory, they would have already been included in basic EPS calculation

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Calculating earnings for diluted EPS

  • Start with earnings used to calculate basic EPS and make adjustments for the after-tax effect of (AASB 133, par 33):

    • any dividends or other items related to dilutive potential ordinary shares deducted in arriving at profit or loss attributable to ordinary equity holders of the parent entity as calculated in accordance with paragraph 12

    • any interest recognised in the period related to dilutive potential ordinary shares

    • any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares

      Refer also to AASB 133, pars 32 and 35

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Calculating the weighted-average number of shares for diluted EPS

  • Start with number used to calculate basic EPS and add the following:

    • weighted-average number of shares deemed to be issued for no consideration

    • weighted-average number of shares that are contingently issued

      Dilutive potential ordinary shares are weighted by the number of days they were outstanding

      (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Shares issued for no consideration

  • If the price paid for the shares is less than the market price

  • Refer to AASB 133, pars 46 and 47

  • In the case of options, for example, there is a need to calculate the number of shares issued for no consideration—this number is added to the number of ordinary shares (to the denominator) in the computation of EPS

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Contingently issuable shares

  • Ordinary shares issued for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement (AASB 133, par. 5)

  • Refer to AASB 133, par. 52

    (continues)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Diluted earnings per share (cont.)

Refer to Worked Example 25.4 on pp. 862–5—Calculation of basic and diluted EPS

  • Need to initially calculate basic EPS

  • Each potential ordinary share to be considered separately, i.e. convertible debentures, share options, convertible cumulative preference shares

  • Potential ordinary shares need to be ranked from greatest to least dilution

  • A trigger test needs to be applied to determine whether potential ordinary shares are, in fact, dilutive—if a particular security does not dilute EPS, it is not to be included when calculating diluted EPS (unless conversion is mandatory or probable and at the option of the entity)

  • Potential ordinary shares found to be dilutive based on trigger test are used in calculation of diluted EPS

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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Australian-listed entities and those in the process of listing are required, pursuant to AASB 133, to disclose information about EPS in their annual reports

EPS calculated from the perspective of the ordinary shareholder

Determined by dividing the earnings of the company by the weighted-average number of ordinary shares outstanding during the year

In determining earnings, preference share dividends are excluded

Need to consider the implications of a bonus issue or a rights issue and the use of an adjustment factor in the calculation of weighted-average number of shares

(continues)

Summary

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


Summary cont l.jpg

Diluted EPS is also disclosed together with basic EPS on the face of the income statement

In calculating diluted EPS, the adjusted earnings (calculated on the notional basis that the various securities have actually been converted to ordinary shares) are to be divided by the weighted-average number of ordinary and potential ordinary dilutive shares

Each type of potential ordinary share must be considered separately when calculating diluted EPS

If a particular type of potential ordinary share (e.g. convertible notes, convertible preference shares, or share options) is not considered to be dilutive, it should be excluded from the calculation of diluted EPS

Summary (cont.)

Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Australian Financial Accounting 4e by Craig Deegan


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