10.06 Flashcards
Which of the following is not a required component of the 10-K filing?
- Product market share.
- Description of the business.
- Market price of common stock.
- Executive compensation.
Product market share.
**The market share of the company’s product is not a required disclosure. The company may chose to voluntarily present this information, but it is not a required disclosure.
Wood Co.’s dividends on noncumulative preferred stock have been declared but not paid. Wood has not declared or paid dividends on its cumulative preferred stock in the current or the prior year and has reported a net loss in the current year. For the purpose of computing basic earnings per share, how should the income available to common stockholders be calculated?
- The current-year dividends and the dividends in arrears on the cumulative preferred stock should be added to the net loss, but the dividends on the noncumulative preferred stock should NOT be included in the calculation.
- The dividends on the noncumulative preferred stock should be added to the net loss, but the current-year dividends and the dividends in arrears on the cumulative preferred stock should NOT be included in the calculation.
- The dividends on the noncumulative preferred stock and the current-year dividends on the cumulative preferred stock should be added to the net loss.
- Neither the dividends on the noncumulative preferred stock nor the current-year dividends and the dividends in arrears on cumulative preferred stock should be included in the calculation.
The dividends on the noncumulative preferred stock and the current-year dividends on the cumulative preferred stock should be added to the net loss.
**In general, the dividends subtracted in computing basic EPS are (1) the annual dividend commitment on cumulative preferred whether or not declared or paid, and (2) declared dividends on noncumulative preferred whether paid or not. The firm has negative income. This answer means that the dividends reduce the numerator further - beyond the loss. The final numerator amount is less than (more negative than) the loss. Also, arrear dividends are never included in EPS because they were subtracted in computing EPS in a previous year.
Strauch Co. has one class of common stock outstanding and no other securities that are potentially convertible into common stock. During Year 1, 100,000 shares of common stock were outstanding. In Year 2, two distributions of additional common shares occurred:
On April 1, 20,000 shares of treasury stock were sold, and on July 1, a 2-for-1 stock split was issued.
Net income was $410,000 in Year 2 and $350,000 in Year 1.
What amounts should Strauch report as earnings per share in its Year 2 and Year 1 comparative income statements?
Year 2
Year 1
Year 2-1.78
Year 1-1.75
**For EPS purposes, stock dividends and splits are retroactively applied to all periods presented, and to all share changes within the year of the split or dividend. This procedure ensures comparability.
The 2-for-1 split in Year 2 does not substantively change the value of any shares outstanding. Without retroactive application, EPS would be cut roughly in half in Year 2 compared to Year 1. Yet there was little substantive change in the performance of the firm. For reporting in Year 2:
Weighted average shares, Year 1 = 100,000(2) = 200,000.
EPS, Year 1 = $350,000/200,000 = $1.75.
Weighted average shares, 2006 = [100,000 + 20,000(9/12)]2 = 230,000
EPS, 2006 = $410,000/230,000 = $1.78.
Had the Year 1 shares not been adjusted for the split, Year 1 EPS would be $3.50 = $350,000/100,000, or roughly double the EPS of Year 2. Without retroactive application, it would appear that the firm had a drastic reduction in EPS in Year 2. The retroactive application of the split ensures that the base on which EPS is computed uses the same measuring unit.
On January 31, 2004, Pack, Inc. split its common stock 2 for 1, and Young, Inc. issued a 5% stock dividend. Both companies issued their December 31, 2003, financial statements on March 1, 2004.
Should Pack’s 2003 earnings per share (EPS) take into consideration the stock split, and should Young’s 2003 EPS take into consideration the stock dividend?
Pack’s 2003 EPS
Young’s 2003 EPS
Pack’s 2003 EPS-YES
Young’s 2003 EPS-YES
**EPS is used primarily as an input to predictions of future earnings. The stock split and dividend cause the number of shares outstanding to increase, and thus affect the future earnings prospects on a per share basis. These events should be included in the computation of EPS even though they did not occur as of the balance sheet date. Financial statement users view the information as if it were current as of the date of publication.
A firm with a net income of $30,000 and weighted average actual shares outstanding of 15,000 for the year also had the following two securities outstanding the entire year: (1) 2,000 options to purchase one share of stock for $12 per share. The average share price during the year was $20, (2) cumulative convertible preferred stock with an annual dividend commitment of $4,500. Total common shares issued on conversion are 2,900. Compute diluted EPS for this firm. $1.70 $1.60 $1.55 $1.61
1.60
**The options and convertible preferred stock are potential common stock (PCS). First compute basic EPS as the basis for diluted EPS, and also as a benchmark for determining whether the two potential common stock securities are dilutive. Basic EPS = ($30,000 – $4,500)/15,000 = $1.70. The preferred dividend is subtracted from income because the preferred is cumulative. Then determine the numerator and denominator effects of the PCS to enter them into diluted EPS in the order of lowest ratio of numerator to denominator effect (n/d) first. The option’s numerator effect is zero; the denominator effect = 2,000 – (2,000)$12/$20 = 800. 2,000 shares would be issued upon exercise but under the treasury stock method the firm is assumed to apply the proceeds from exercise (2,000 × $12) and purchase shares of the firm’s stock for $20 each. Thus, the n/d for options = 0/800 = 0. The n/d for the convertible preferred stock is the ratio of dividends that would not have been declared if the stock converted, to the common shares assumed issued on conversion. n/d = $4,500/2,900 = $1.55. Enter the options into diluted EPS first, because the options have the lower n/d. DEPS tentative = ($30,000 − $4,500)/(15,000 + 800) = $1.61. The convertible preferred is dilutive because its n/d ratio of $1.55 is less than $1.61, the tentative or first-pass amount for diluted EPS. DEPS final = ($30,000 – $4,500 + $4,500)/(15,000 + 800 + 2,900) = $1.60.
LM Company has net income of $130,000, weighted average shares of common stock outstanding of 50,000, and preferred dividends for the period of $20,000. What is LM’s earnings per share of common stock? $2.60 $2.50 $2.20 $0.40
$2.20
**Earnings per share (EPS) is calculated on net income available to the common stockholders, $130,000 − $20,000, or $110,000, divided by weighted average shares of common stock outstanding, 50,000. The EPS = $110,000 / 50,000 = $2.20
If everything else is held constant, earnings per share is increased by:
- Purchase of treasury stock.
- Issuance of new shares of common stock.
- Payment of a cash dividend to common stockholders.
- Payment of a cash dividend to both preferred and common stockholders.
Purchase of treasury stock.
**Earnings per share is calculated by dividing earnings (profit) available to common stockholders by weighted average number of shares of common stock outstanding. If the denominator is decreased by purchasing treasury stock, then the EPS result is increased.
Why do preferred stock dividends appear in the calculation of earnings per share (EPS)?
- Preferred stock may be converted into common stock at the option of the shareholder.
- Preferred stock dividends are not included in the calculation of EPS unless they have been outstanding for the entire year.
- The denominator includes the weighted average number of shares of both preferred and common shares outstanding.
- Preferred stock dividends are subtracted from the earnings for the period in the calculation of earnings per share.
Preferred stock dividends are subtracted from the earnings for the period in the calculation of earnings per share.
**Earnings per share (EPS) is calculated on net income available to the common stockholders, divided by weighted average shares of common stock outstanding. The preferred dividends must be subtracted from the net income, as that amount is not available to the common stockholders.
AB Company reported earnings per share of $10.50 on income before discontinued operations, ($2.00) on income (loss) attributed to discontinued operations, and $8.50 on net income. Which EPS figure is more relevant to a potential investor? ($2.00) $7.50 $8.50 $10.50
$10.50
**Potential investors and current investors are interested in the future earnings potential of the entity. Thus, they are interested in the earnings per share on continuing income, which would be the $10.50 per share. The EPS attributed to discontinued operations cannot be used in predicting future earnings, as they are one-time events.
