Chapter 11: Earnings per share and distributable profits

Question 1

What is EPS used for?

Answer 1

The EPS is used to assess the ongoing financial performance of a company from year to year, and to compute the major stock market indicator of performance, the Price Earnings ratio (PE ratio)

The calculation for the PE ratio is:
PE ratio = Market value of share / EPS

As the PE ratio is an important stock market ratio, it is important that EPS is calculated in a standard way

Question 2

How does IAS 33 say earnings per share achieve comparability?

Answer 2

• defining earnings
• prescribing methods for determining the number of shares to be included in the calculation of EPS
• requiring standard presentation and disclosures. The basic EPS is required to be shown on the face of the statement of profit or loss

Question 3

What is compliance IAS 33 Earnings Per Share mandatory for?

Answer 3

• The separate financial statements of entities whose ordinary shares are publicly traded or in the process of being issued in public markets
• The consolidated financial statements for groups whose parent has shares similarly traded/being issued

Question 4

What is the basic EPS?

Answer 4

Earnings / Shares

Question 5

How does IAS 33 define earnings and shares?

Answer 5

• Earnings: the net ‘profit or loss for the period attributable to ordinary equity holders of the parent entity’
• Shares: the ‘weighted average number of ordinary shares outstanding (…) during the period’

Question 6

How do you treat redeemable preference shares?

Answer 6

Redeemable preference shares are treated as debt in the financial statements and the finance costs will already be included in the statement of profit or loss

Question 7

How do you treat irredeemable preference shares?

Answer 7

Irredeemable preference shares (without cumulative/mandatory dividends) are treated as equity so the dividend must be deducted from the net profit in the statement of profit or loss to arrive at earnings

Question 8

How do you treat cumulative preference shares?

Answer 8

For cumulative preference shares always treat dividends as having been paid in the correct period

Question 9

What do you do when a company issues shares at full market price?

Answer 9

• When a company issues new share capital at full market value it will increase earnings and share capital, although not necessarily proportionally
• To calculate the correct EPS figure, earnings should be apportioned over the weighted average number of equity shares (i.e. taking account of when shares are issued during the year)

Question 10

What is a bonus issue?

Answer 10

A bonus issue is where shares are offered to existing shareholders for free and therefore:

• does not provide additional resources to the issuer
• means that each shareholder owns the same proportion of the business before and after the issue

Question 11

How do you account for bonus shares in the EPS calculation?

Answer 11

In order to allow comparability year on year, in the calculation of EPS:

• the bonus shares are deemed to have been issued at the start of the year
• comparative figures are restated to allow for the proportional increase in share capital caused by the bonus issue i.e. treat the bonus issue as always having been in place

Question 12

What are the steps to calculating EPS from a bonus share?

Answer 12

1. Calculate bonus fraction = shares after the issue/shares before the issue
   e. g. if there is a 1 for 5 bonus issue, the bonus fraction = 6/5
2. In the calculation of the weighted average number of shares, adjust all shares in existence before the bonus issue by multiplying by the bonus fraction
3. Calculate EPS and re-state prior year comparative by multiplying by the inverse of the bonus fraction

Question 13

What is a rights issue and what problems do they represent?

Answer 13

When a company makes a rights issue, it issues shares to existing shareholders in proportion to their shareholding and at a price lower than the market value

• Whilst they contribute additional resources they are normally priced below full market price
• Therefore they combine the characteristics of issues at full market price and bonus issues
• In order to allow comparability year on year, an adjustment needs to be made for the bonus element of a rights issue

Question 14

What are the steps to dealing with a rights issue?

Answer 14

1. Calculate theoretical ex-rights price (TERP)
2. Calculate bonus fraction on the rights issue = Market price before the rights issue/TERP
3. Calculate weighted average number of shares by adjusting all shares in existence before the rights issue by multiplying by the bonus fraction
4. Calculate EPS and re-state prior year comparative, by multiplying the original EPS by the inverse of the bonus fraction

Question 15

What is the distributable profit figure calculation based on?

Answer 15

Based on individual company financial statements rather than consolidated financial statements

Question 16

What are the rules for all companies?

Answer 16

• A provision made in the accounts is a realised loss
• A revaluation surplus is an unrealised profit
• If non-current assets are revalued and, as a result, depreciation increases, the additional depreciation may be treated as part of the realised profit for dividend purposes
• On the disposal of a revalued asset any unrealised surplus or loss on valuation immediately becomes realised

Question 17

What happens when a revaluation of non-current assets takes place?

Answer 17

• Gains are unrealised unless they reverse a loss previously treated as realised
• Losses are realised except where the loss:
  Offsets a surplus on that asset-
  Arises from a reassessment of the value of all non-current assets-
  Arises from a reassessment of some non-current assets where the assets not revalued are worth at least their book value-

Question 18

What are additional rules for public companies?

Answer 18

In addition to the rules set out above, a public company may not reduce its net assets below the aggregate amount of its called-up share capital and undistributable reserves

Question 19

How do you calculate distributable profits for a public company?

Answer 19

(add) Net assets
(less) Called-up share capital
(less) Undistributable reserves
————
= Distributable profits for a public company

Question 20

What are undistributable reserves?

Answer 20

• The share premium account
• Excess unrealised profits over unrealised losses
• Any other reserve which the company is prohibited from distributing by any statute or by its memorandum or articles of association

Question 21

What is the second method for calculating distributable profits for a public company?

Answer 21

(add) Distributable profits for a private company (accumulated realised profits less accumulated realised losses)
(less) Excess of unrealised losses over unrealised profits (if any)
————-
Distributable profits for a public company