3.1 Flashcards
A company reported net income available to common stockholders of $2,000,000 for the year ended December 31, Year 2. The company had 1,500,000 shares of common stock outstanding as of January 1, Year 2, and issued 500,000 additional shares of common stock on May 1, Year 2. What amount is the company’s basic earnings per share for the year ended December 31, Year 2?
$1.09.
Basic earnings per share (BEPS) equals income available to common shareholders divided by the weighted-average number of common shares outstanding. The weighted-average number of common shares outstanding is determined by relating the portion of the period that the shares were outstanding to the total time in the period. The income available to common shareholders is given as $2,000,000. The company had 1,500,000 shares of common stock outstanding for the first 4 months (January 1-April 30) of the year. When the additional shares were issued on May 1, 2,000,000 shares were outstanding for the next 8 months (May 1-December 31) of the year. Thus, the weighted-average number of common shares outstanding equals 1,833,333.33 {[1,500,000 × (4 ÷ 12)] + [$2,000,000 × (8 ÷ 12)]}. BEPS therefore equals $1.09 ($2,000,000 income available to common shareholders ÷ 1,833,333.33 weighted-average number of common shares outstanding).
The Treasurer of Barker Corporation is considering the impact of the company’s convertible debt on its earnings per share. The firm has $10,000,000 of convertible debt outstanding, with a 10% coupon. It is convertible into Barker’s common stock at $200 per share. If this convertible debt remains outstanding, the income statement next year is forecast to appear as follows:
Operating income: $11,000,000 Interest expense: (1,000,000) Pretax income: $10,000,000 Tax expense: (4,000,000) Net income: $6,000,000 Shares outstanding: 1,000,000 Basic earnings per share: $6.00
Barker has a 40% tax rate. Assuming conversion of the debt occurs at the beginning of the year, the forecast effect on Barker’s basic earnings per share for the next year will be
Antidilutive.
Barker’s operating income will increase by $1,000,000 of pre-tax interest expense avoided if its convertible debt is converted. Forecast net income after conversion is calculated as follows:
Operating income: $11,000,000
Tax expense (40%): (4,400,000)
Net income: $6,600,000
The conversion adds 50,000 shares of common stock to those outstanding ($10,000,000 ÷ $200 per share). The new BEPS forecast is $6.29 ($6,600,000 ÷ 1,050,000), an amount greater than the forecast $6.00 BEPS without conversion. Thus, the convertible debt is antidilutive.
On June 30, Year 2, Lomond, Inc., issued 20, $10,000, 7% bonds at par. Each bond was convertible into 200 shares of common stock. On January 1, Year 3, 10,000 shares of common stock were outstanding. The bondholders converted all the bonds on July 1, Year 3. The following amounts were reported in Lomond’s income statement for the year ended December 31, Year 3:
Revenues: $977,000 Operating expenses: (920,000) Interest on bonds: (7,000) Income before income tax: 50,000 Income tax at 30%: (15,000) Net income: $35,000
What amount should Lomond report as its Year 3 diluted earnings per share (DEPS)?
$2.85
DEPS should be calculated even though no potential common shares were outstanding at year end. The reason is that the purpose of DEPS is to measure the performance of the entity over the reporting period while giving effect to all potential common shares that were outstanding during the period. The bonds were converted into 4,000 (20 bonds × 200 shares) shares of common stock on July 1, Year 3. Thus, the weighted-average number of shares of common stock outstanding is 12,000 shares [(10,000 × 12 ÷ 12) + (4,000 × 6 ÷ 12)]. BEPS therefore equals $2.92 ($35,000 net income ÷ 12,000). To determine if the potential common shares are dilutive, their incremental effect on EPS is calculated. This effect is equal to the after-tax interest that would be added back to net income divided by the potential common shares that would be added to the denominator. After-tax interest equals $4,900 [20 shares × $10,000 par value × 7% × (1 – 30% tax rate) × (6 months ÷ 12 months)], and the dilutive potential common shares equal 2,000 [20 bonds × 200 shares × (6 months ÷ 12 months)]. The computation is based on a half-year period because the convertible bonds were outstanding for only 6 months. The incremental effect on EPS of the assumed conversion at the beginning of the year is $2.45 ($4,900 ÷ 2,000 shares). This amount is less than BEPS, so the convertible bonds are dilutive. Thus, DEPS equals $2.85 [($35,000 + $4,900) ÷ (12,000 + 2,000)].
With respect to the computation of earnings per share, which of the following would be most indicative of a simple capital structure?
Common stock, preferred stock, and debt outstanding.
A simple capital structure has only common stock outstanding. A complex capital structure contains potential common stock. Potential common stock includes options, warrants, convertible securities, contingent stock requirements, and any other security or contract that may entitle the holder to obtain common stock.
The per-share amount must be reported on the face of a public company’s income statement for which of the following items?
Income from continuing operations.
Earnings per share (EPS) is the amount of current-period earnings that can be associated with a single share of a corporation’s common stock. All corporations must report per-share amounts for income from continuing operations and net income on the face of the income statement. If an entity has no discontinued operations, income from continuing operations equals net income. Thus, one or two amounts of EPS (basic EPS) for net income available to common shareholders must be presented on the face of the income statement if the entity has only common stock outstanding. All other entities must present basic EPS and dilutive EPS for income from continuing operations and net income. The entity also must report a per-share amount or amounts for a discontinued operation on the face of the income statement or in the notes.
Chape Co. had the following information related to common and preferred shares during the year:
Common shares outstanding, 1/1: 700,000
Common shares repurchased, 3/31: 20,000
Conversion of preferred shares, 6/30: 40,000
Common shares repurchased, 12/1: 36,000
Chape reported net income of $2,000,000 at December 31. What amount of shares should Chape use as the denominator in the computation of basic earnings per share?
$702,000.
Basic earnings per share (BEPS) equals income available to common shareholders divided by the weighted average of common shares outstanding. The BEPS denominator is weighted because some shares may have been issued or reacquired during the period. The weights are the fractions of the period that different amounts of shares are outstanding.
Ian Co. is calculating earnings per share amounts for inclusion in the Ian’s annual report to shareholders. Ian has obtained the following information from the controller’s office as well as shareholder services:
Net income from Jan 1 to Dec 31: $125,000 Number of outstanding shares: Jan 1 to March 31: 15,000 April 1 to May 31: 12,500 June 1 to Dec 31: 17,000
In addition, Ian has issued 10,000 incentive share options with an exercise price of $30 to its employees and an average market price for the year of $25 per share. What amount is Ian’s diluted earnings per share for the year ended December 31?
$7.94.
The numerator of diluted earnings per share (DEPS) is equal to the basic earnings per share (BEPS) numerator plus the effect of dilutive potential common stock (PCS). This amount is divided by the BEPS denominator plus the effect of dilutive PCS. The BEPS numerator is equal to net income available to common shareholders, or $125,000. The BEPS denominator is the weighted-average number of shares outstanding. It equals 15,750 {[15,000 × (3 ÷ 12)] + [12,500 × (2 ÷ 12)] + [17,000 × (7 ÷ 12)]}. Share options are considered to be dilutive if the average market price for the period exceeds the exercise price. Thus, because the average market price of $25 is less than the exercise price of $30, these options are antidilutive. Given that no dilutive PCS exists, DEPS equals BEPS of $7.94 ($125,000 ÷ 15,750).
At December 31, Year 1, Lex, Inc., had 600,000 shares of common stock outstanding. On April 1, Year 2, an additional 180,000 shares of common stock were issued for cash. Lex also had $5 million of 8% convertible bonds outstanding at December 31, Year 2, which are convertible into 150,000 shares of common stock. The bonds were dilutive in the Year 2 DEPS computation. No bonds were issued or converted into common stock during Year 2. What is the number of shares that should be used in computing DEPS for Year 2?
$885,000.
DEPS should be based on the weighted-average number of (1) shares of common stock outstanding and (2) the shares of common stock assumed to have been issued to reflect the conversion of the bonds. The weighted-average number of shares for Year 2 should therefore be 885,000, based on 750,000 shares outstanding for the entire year (600,000 beginning balance + 150,000 from the hypothetical conversion of bonds) and 180,000 additional shares issued on April 1.
750,000 × (3 ÷ 12) = 187,500
930,000 × (9 ÷ 12) = 697,500
885,000
Jen Co. had 200,000 shares of common stock and 20,000 shares of 10%, $100 par value cumulative preferred stock. No dividends on common stock were declared during the year. Net income was $2,000,000. What was Jen’s basic earnings per share?
$9.00
BEPS equals income available to common shareholders divided by the weighted-average common shares outstanding. The cumulative preferred dividends for the year, whether or not declared, are subtracted to determine the BEPS numerator. Accordingly, the numerator is $1,800,000 [$2,000,000 NI – (20,000 preferred shares × $100 par × 10%)]. Assuming the common shares were outstanding for the entire period, BEPS equals $9.00 ($1,800,000 ÷ 200,000 common shares).
Pubco is a public company that uses a calendar year and has a complex capital structure. Pubco reported in the first quarter income from continuing operations (net of tax) of $1 million and a loss on discontinued operations (net of tax) of $1.2 million.
The average market price of Pubco’s common stock for the first quarter was $25, the shares outstanding at the beginning of the period equaled 300,000, and 12,000 shares were issued on March 1.
At the beginning of the quarter, Pubco also had outstanding 120,000 shares of preferred stock paying a dividend of $.10 per share at the end of each quarter and convertible to common stock on a one-to-one basis. Holders of 60,000 shares of preferred stock exercised their conversion privilege on February 1.
The BEPS amount for Pubco’s net income or loss available to common shareholders for the first quarter is
$(.60).
The weighted-average number of shares used in the BEPS denominator is 344,000 {300,000 + [12,000 × (1 ÷ 3)] + [60,000 × (2 ÷ 3)]}. The numerator equals net income or loss minus preferred dividends. Thus, it equals $(206,000) [$1,000,000 income from continuing operations – $1,200,000 loss on discontinued operations – (60,000 × $0.1) preferred dividends]. The BEPS amount for the net income or loss available to common shareholders is $(0.60) [$(206,000) ÷ 344,000 shares].
Fact Pattern:
Peters Corp.’s capital structure was as follows:
Yr 7 Outstanding shares of stock: Common: 100,000 Convertible preferred: 10,000 9% convertible bonds: $1,000,000
Yr 8 Outstanding shares of stock: Common: 100,000 Convertible preferred: 10,000 9% convertible bonds: $1,000,000
During Year 8, Peters paid dividends of $3.00 per share on its preferred stock. The preferred shares are convertible into 20,000 shares of common stock, and the 9% bonds are convertible into 30,000 shares of common stock. Assume that the income tax rate is 30%.
If net income for Year 8 is $170,000, Peters should report DEPS as
$1.40.
Potential common stock is included in the calculation of DEPS if it is dilutive. When two or more issues of potential common stock are outstanding, each issue is considered separately in sequence from the most to the least dilutive. This procedure is necessary because a convertible security may be dilutive on its own but antidilutive when included with other potential common shares in the calculation of DEPS.
The incremental effect on EPS determines the degree of dilution. The lower the incremental effect, the more dilutive. The incremental effect of the convertible preferred stock is $1.50 [($3 preferred dividend × 10,000) ÷ 20,000 potential common shares]. The numerator effect of the conversion of the bonds is $63,000 [$1,000,000 × 9% × (1.0 – .30 tax rate)]. The incremental effect of the convertible debt is $2.10 ($63,000 ÷ 30,000 potential common shares). Given net income of $170,000, the BEPS amount equals $1.40 [($170,000 – $30,000) ÷ 100,000]. Thus, both convertible securities are antidilutive, and Peters should report that DEPS is equal to BEPS.
In determining diluted earnings per share for a complex capital structure, which of the following is a potential common stock?
Nonconvertible common stock:
Stock option:
No
Yes
Potential common stock is a security or other contract that may entitle its holder to obtain common stock during either the reporting period or some future accounting period. Potential common stocks include options, warrants, convertible preferred stock, convertible debt, and contingent stock agreements.
A construction company recognizes revenue from construction contracts over time using the input method based on costs incurred. It reports the following:
Yr 1
Construction costs: $100
Estimated cost to complete at year-end: $300
Yr 2
Construction costs: $200
Estimated cost to complete at year-end: $0
The contract price is $1,000. What is the profit recognized in Year 2?
$550.
At the end of Year 1, total cost was expected to be $400 ($100 incurred + $300 estimated cost to complete), and estimated total profit was $600 ($1,000 price – $400 estimated total cost). Thus, the amount of profit recognized in Year 1 was $150 [$600 × ($100 cost incurred ÷ $400 estimated total cost)]. The project was completed in Year 2 at an additional cost of $200. Actual profit was therefore $700 ($1,000 – $300 actual total cost). Profit recognized in Year 2 is $550 ($700 total – $150 recognized in Year 1).
On January 1, Year 1, an entity sold a product to a customer for $64,751 payable 36 months after delivery. The customer obtains control of the product at contract inception. The cash selling price of the product is $50,000. This price is the amount that the customer would pay upon delivery at contract inception assuming the same product is sold under otherwise identical terms and conditions. The contract includes an implicit interest rate of 9%. What amounts of revenue and interest income from this contract, if any, were recognized by the entity in Year 1?
Revenue from customers:
Interest income:
$50,000
$4,500
The revenue recognized must reflect the price that a customer would have paid for the promised goods or services if the cash payment had been made when the goods were transferred to the customer (the cash selling price). Thus, $50,000 of revenue from the customer must be recognized on 1/1/Year 1. The contract includes a significant financing component. This amount is the difference between the amount of promised consideration of $64,751 and the cash selling price of $50,000. The interest income from the adjustment of the transaction price for the effect of the time value of money is recognized using the effective interest method. Accordingly, the interest income recognized in Year 1 is $4,500 ($50,000 × 9%).
Based on the stock transactions below, what is the weighted average number of shares outstanding as of December 31, Year 1, that should be used in the calculation of basic earnings per share in financial statements issued on March 1, Year 2?
January 1, Year 1: Beginning balance 100,000
April 1, Year 1: Issued 30,000 shares for cash
June 1, Year 1: 50% stock dividend
February 15, Year 2: 2 for 1 stock split
March 15, Year 2: Issued 40,000 shares for cash
$367,500.
The weighted-average number of common shares outstanding is determined by relating the portion of the period that the shares were outstanding to the total time in the period. Weighting is necessary because some shares may have been issued or reacquired during the period. Stock dividends and stock splits require an adjustment to the weighted-average of common shares outstanding. EPS amounts for all periods presented are adjusted retroactively to reflect the change in capital structure as if it had occurred at the beginning of the first period presented. The following is the calculation:
