Intermediate Accounting

Transcription

1 Intermediate Accounting Thomas H. Beechy Schulich School of Business, York University Joan E. D. Conrod Faculty of Management, Dalhousie University PowerPoint slides by: Bruce W. MacLean, Faculty of Management, Dalhousie University

2 Earnings Per Share

3 Introduction Earnings per share is one of the most widely used indicators of a corporation s financial performance. Managers often discuss the earnings per share (or EPS) of their companies as indications of past performance, and make predictions about future EPS. Analysts use EPS figures regularly, and news reports on the earnings of public companies almost always mention the earnings per share, sometimes accompanied by a chart illustrating the EPS performance over the past several years. Earnings per share is intended to indicate whether a company s performance has improved or deteriorated as compared to previous periods.

4 Earnings Per Share (EPS) Because it is computed on a per share basis, EPS removes the effect on earnings of increases in net income due to larger invested capital obtained through new share issues Earnings per share is conceptually very simple: the earnings of the company divided by the number of shares outstanding. Significant complications. For example: What if new shares were issued during the year? What if there are several different classes of shares outstanding? Which measure of earnings should be used? What effect would convertible senior securities have on EPS if they were converted? What about outstanding stock options? Section 3500 of the CICA Handbook

5 Applicability Of Section CICA 3500 The CICA Handbook recommendations on earnings per share do not apply to companies with few shareholders. In substance, they apply only to public companies. Section 3500 of the CICA Handbook obviously applies only to corporations, since only corporations have shares. The section specifically exempts four types of corporations [CICA ]: corporations that do not have share capital (e.g., nonprofit corporations) government-owned corporations wholly-owned subsidiaries companies with few shareholders

6 Recommended Types Of EPS Figures EPS figures are computed both before and after the impact of discontinued operations and extraordinary items Change in the corporation s capital structure may require that additional EPS amounts be presented to the shareholders. Basic EPS Adjusted basic EPS Fully diluted EPS Pro-forma EPS Pro-forma fully diluted EPS

7 Basic Earnings Per Share Basic EPS is the basis for comparing the current period s earnings with that of prior periods. The basic earnings per share calculation for the year (or for an interim period, such as a quarter) is as follows: Net income available to common shareholders Weighted average number of common shares outstanding The intent of the EPS calculation is to adjust for the income effect of issuing new shares or retiring old shares. If there were share splits or share dividends during the year, the denominator is stated in equivalent share units after the split or dividend. As well, all previous EPS calculations (which are used for comparative purposes) are restated

8 Earnings Available To Common Shareholders The numerator, net income available to common shareholders, is the net income of the company minus the dividends attributable to senior shares For cumulative senior shares, the prescribed dividend is subtracted from net income regardless of whether they have been paid for the year; any future dividend distributions to common shareholders must be made only after dividend arrearages to the senior shares have been remedied. For noncumulative senior shares, only those dividends actually declared during the period are subtracted in determining the EPS numerator.

9 Discontinued Operations And Extraordinary Items When a corporation reports discontinued operations and/or extraordinary items, the CICA Handbook recommends that two EPS amounts be calculated, based on: income before discontinued operations and extraordinary items; and net income for the period. In a complex earnings situation, it actually becomes possible for a corporation to report more than just these two EPS amounts, such as EPS after discontinued operations but before extraordinary items. Financial Reporting in Canada 1995 reported that a few of their surveyed companies do occasionally report three or four basic EPS numbers, but that the practice is rare. The important point, however, is that section 3500 defines the EPS calculations that should be reported; it does not prohibit companies from reporting additional EPS amounts if the company thinks that such amounts would be helpful to the reader.

10 Multiple Classes Of Shares Canadian corporations often have multiple classes of common or residual shares outstanding. A primary reason for having two or more classes of common shares is to vary the voting rights between the different classes, normally in order to prevent the controlling shareholders from losing control to hostile investors. The fact of multiple classes does not, in itself, mean that there is a difference in dividend privileges. As long as the several classes share dividends equally, share for share, then they are all lumped together in the denominator of the EPS calculation.

11 A Note On Terminology The expression basic EPS is used in the CICA Handbook and in common practice in order to differentiate that basic calculation from other EPS figures that have special names. However, basic is not actually a part of the name and need not be used in financial reporting. Basic EPS is analogous to calling a senior academic a full professor (to differentiate from one that is only partially full, such as an assistant professor or associate professor) or to referring to a military person as a full colonel (to differentiate from a Lt. Colonel). Nevertheless, Basic EPS is sometimes used in published financial statements.

12 Convertible Senior Securities Convertible securities are issued in the hope and expectation that the corporation will be sufficiently successful that the price of its common shares will increase enough to make conversion attractive for the holder. If the redemption price of a bond or preferred share is less than the value of the common shares into which it is convertible, conversion can be either voluntary or forced: A voluntary conversion occurs when the holder of the convertible senior securities voluntarily submits the convertible bond or preferred share for conversion into the equivalent number of common shares. A forced (or induced) conversion occurs when the issuer (that is, the corporation) calls in the senior security or, if the security has a fixed maturity date, waits until the debt has matured and must be submitted for redemption. If the value of the common shares into which the senior security is convertible is greater than its redemption value, a holder would be foolish to accept the redemption price instead of converting.

13 Adjusted Basic EPS If convertible senior securities (either preferred shares or debt instruments) were converted during the reporting period, adjusted basic EPS must be calculated. The adjustment restates basic EPS as though the actual conversion had occurred at the beginning of the accounting period. Adjusted basic EPS forms the basis for comparisons with future periods (or forecasts relating to future periods). Prior periods EPS are not restated for conversions

14 Interest And Dividends Adjustments A question frequently arises about the adjustments to EAC when conversions occur between interest dates or between dividend declarations. Interest accrues, and accrued interest must be paid whenever the bonds are sold, redeemed, traded, or converted. Preferred dividends, on the other hand, do not accrue. There is no legal obligation for a corporation to pay dividends until the dividends have been declared by the board of directors. This is true regardless of whether or not the dividends are cumulative. If preferred shares are converted between dividend declarations, there is no obligation for the corporation to pay accrued dividends for the intervening period.

15 Bond Premium And Discount Most bonds are issued at or very near the market rate of interest. There are both tax reasons and image reasons for keeping the nominal rate very close to the market rate. However, there may be situations in which a bond is offered at a significant discount or premium. When that happens, it complicates our EPS calculations a bit. The complication arises from the fact that when there is a material premium or discount, the interest expense does not coincide with interest paid. In the adjusted basic EPS calculation, and in the fully-diluted EPS calculations in the following sections, the adjustment to the numerator (i.e., earnings available to common shareholders) must be for interest expense. A simple adjustment based on the nominal rate of interest will not work discount or premium amortization must also be taken into account.

16 Fully Diluted EPS When a company has potentially dilutive senior securities or options, fully diluted EPS should be calculated. Fully diluted EPS excludes the effect of convertible securities that have the effect of increasing EPS, and excludes securities that are not convertible (and options that are not exercisable) within ten years. While adjusted basic EPS and fully diluted EPS should normally be calculated if the conditions giving rise to them exist, they need not be reported unless the results are materially different from basic EPS.

17 Anti-Dilution When calculating fully diluted EPS, we exclude any security or option that, if converted, would have the effect of increasing EPS. A conversion (or exercise of options) that increases EPS is said to be anti-dilutive. One way to find out if a conversion or exercise is anti-dilutive is to work through the full calculation and see if including each has the effect of increasing or decreasing EPS. Fortunately, there is a much easier way to test for anti-dilution. The first step is to calculate the basic EPS. This becomes the benchmark against which the impact of conversions is compared. Then, the impact on the numerator and the denominator for each type of convertible security or option is calculated. If the ratio of the impacts on the numerator and denominator is greater than the basic EPS, that class of security or option is anti-dilutive.

18 Disclosure Practices EPS can be reported either on the income statement or in the notes. The most common practice is to report them on the face of the income statement. Fully diluted EPS need not be reported on a comparative basis. However, most companies do report comparative fully diluted EPS.

19 Using EPS Basic EPS: This is a historical amount. It can be compared with basic EPS numbers from past years to see whether the company is earning more or less for its common shareholders. Adjusted basic EPS: This amount is intended for comparison with future EPS amounts, since it alters the basis of calculation to agree with the capital structure that the company has as it continues into the future. In effect, adjusted basic EPS adjusts for the discontinuity introduced into the basic EPS numbers by the change in capital structure through conversion of senior securities. Fully diluted EPS: If the company is successful in its financing strategy, the convertible senior securities will be converted before the due date. Therefore, the fully diluted EPS gives an indication of the long-run impact that the likely conversions (and options exercises) will have on the earnings attributable to common shares. One important aspect of EPS numbers is that they mean nothing by themselves. Like all economic indices, they are meaningful only as part of a series. They do adjust for changes in capital structure, thereby removing the normal earnings expansion effect that arises through additional share issuances.

20 Pro-Forma EPS When significant changes in a corporation s capital structure occur after the end of the year but before management has finalized the financial statements, it may be necessary to prepare pro-forma EPS. Pro-forma EPS essentially restate the EPS as though the capital structure changes had occurred at the beginning of the reporting year. In substance, they are similar to adjusted basic EPS in that they adjust for the effects of an actual capital structure change in order to provide a basis for future comparisons. Pro-forma EPS is recommended whenever there has been a significant change in a corporation s capital structure shortly after the end of the fiscal year as a result of (1) a reorganization, (2) a substantial conversion of senior securities that were outstanding at the end of the reporting year, or (3) a new issue of common shares, the proceeds of which were used to reduce senior securities that were outstanding at the end of the reporting year.

21 Circumstances Calling For Pro-Forma EPS The requirement for pro-forma EPS is not triggered by the issuance of common shares for other reasons, nor is it required when options are exercised after the end of the fiscal year. The recommendations concerning pro-forma EPS are somewhat inconsistent with those in the CICA Handbook regarding other EPS calculations. There is no recommendation that a company report adjusted basic EPS when a company issues common shares and uses the proceeds to retire senior securities before the end of the year, and yet pro-forma EPS is required if that happens after the end of the year. In addition, the Handbook implies that the starting point for pro-forma calculations is basic EPS, when consistency would suggest that the starting point should be adjusted basic EPS.

22 Calculating Pro-Forma EPS Fully diluted pro-forma is not required in the case of a conversion of existing senior securities, because fully diluted pro-forma EPS would be exactly the same as the regular fully diluted EPS. If only part of the proceeds of a new share issue are used to retire senior securities after year-end, the impact of the share issue is recognized in pro-forma EPS only to the proportionate extent that the proceeds were used to retire senior securities.

23 Summary Of Earnings Per Share Measures The CICA Handbook recommends up to five different EPS calculations for public companies, each of which should be presented both before and after discontinued operations and extraordinary items. Basic EPS is intended for historical comparisons, but the other four are all intended to form the basis for comparisons with future earnings predictions. Exhibit 21-9 summarizes these five types of EPS, including: the circumstances when each calculation is required, the arithmetic of the calculation, and the user objectives of each. There is a logic underlying each of the EPS figures, and the calculations can most easily be remembered if the user objective of each EPS is understood.

24 Cash Flow Per Share Figures reported as cash flow per share usually reflect the net increase in working capital from operations, rather than cash flow from operations. Practice in this area is not uniform, as there are no guidelines for computing cash flow per share

25 A Final Comment Despite the attention given to EPS numbers, it is extraordinarily difficult to evaluate just what the numbers mean. A firm s asset structure changes over time, making comparisons difficult. The emphasis on EPS may encourage transactions that have little purpose except to generate book profits that will enhance EPS. One company sold land each year so that the gains produced a constant EPS growth rate year after year. EPS calculations are complex, and their meaning is sufficiently uncertain that many accountants believe the level of reliance on them is unwarranted. Using EPS as an important element in a company s goal structure can contribute to a short-term management attitude.

26 EPS Question A company had 200,000 common shares, 10,000 of $1 cumulative preferred shares, and 30,000 $.50 noncumulative preferred shares outstanding during the year. Net income after taxes was $1,500,000. No dividends were declared during the year. Basic EPS would be a. $7.50 b. $7.43 c. $7.45 d. $7.38 $1,500,000 (10,000 5% $20 par) 200,000 shares Since dividends were not declared, only the cumulative preferred stock dividends are subtracted.

27 Computing EPS Simple Capital Structure Common shares issued as part of stock dividends and stock splits are treated retroactively as subdivisions of the shares already outstanding at the date of the split or dividend.

28 Computing EPS Simple Capital Structure Retroactive treatment: If new shares were not issued in the period, the stock dividend or split is treated as outstanding from the beginning of the period. If new shares were issued in the period, the stock dividend or split is applied retroactively in proportion to the number of shares outstanding at the time of the dividend or split.

29 EPS Example 1 Compute the weighted average number of common outstanding. Date Transaction # of Shares 1/1 Balance outstanding 100,000 4/1 Issued shares 50,000 10/1 Issued shares 10,000

30 EPS Solution 1 Compute the weighted average number of common outstanding. Date Transaction # of Shares # Mos. Outstd. Weighted Shares 1/1 Balance outstanding 100,000 12/12 100,000 4/1 Issued shares 50,000 9/12 37,500 10/1 Issued shares 10,000 3/12 2,500 Total Weighted Avg. 140,000

31 EPS Example 2 Compute the weighted average number of common outstanding. Date Transaction # of Shares 1/1 Balance outstanding 100,000 4/1 Issued shares 50,000 5/1 100% stock dividend 150,000 10/1 Issued shares 10,000

32 EPS SOLUTION 2 Compute the weighted average number of common outstanding. Date Transaction # of Shares # Mos. Outstd. Weighted Shares 1/1 Balance outstanding 100,000 12/12 100,000 4/1 Issued shares 50,000 9/12 37,500 5/1 100% stock dividend Retroactive to 1/1 100,000 12/12 100,000 Retroactive to 4/1 50,000 9/12 37,500 10/1 Issued shares 10,000 3/12 2,500 Total Weighted Avg. 277,500

33 Computing EPS Complex Capital Structure Dual presentation of EPS requires two computations: Basic EPS (PEPS) Fully diluted EPS (FDEPS)

34 Are we at the end of the chapter?

35 FDEPS Reflects the maximum dilution of EPS that would occur if conversion or exercise of all dilutive securities took place at the beginning of the period ( or issuance date if later)

36 FDEPS Potentially dilutive elements Convertible senior shares Add to Numerator Dividends (DCSS) Add to denominator Shares to be issued (STBI)

37 FDEPS Potentially dilutive elements Convertible senior shares Add to Numerator Dividends (DCSS) Add to denominator Shares to be issued (STBI) NI NI (after tax) Pref. div.+ DCSS Wgt. avg o/s common shares + STBI

38 FDEPS Potentially dilutive elements Convertible debt Add to Numerator After-tax interest (ATI) Add to denominator Shares to be issued (STBI)

39 FDEPS Potentially dilutive elements Convertible debt Add to Numerator After-tax interest (ATI) Add to denominator Shares to be issued (STBI) NI NI (after tax) Pref. div.+ ATI Wgt. avg o/s common shares + STBI

40 FDEPS Potentially dilutive elements Options Add to Numerator After-tax earnings on proceeds (ATEOP) Add to denominator Shares to be issued (STBI)

41 FDEPS Potentially dilutive elements Options Add to Numerator After-tax earnings on proceeds (ATEOP) Add to denominator Shares to be issued (STBI) NI NI (after tax) Pref. div.+ ATEOP Wgt. avg o/s common shares + STBI

42 FDEPS -EXAMPLE Apple Co. 7% Bonds $1,000,000 Convertible to 500,000 Common Shares $9 Cumulative Preferred Shares (40,000 shares) $4,000,000 Convertible to 400,000 Common Shares Options for: 1,000,000 Common $50 per share Tax Rate 40% and Bank Interest Rate 8%

43 FDEPS - Example Basic EPS (given) NI - Pref Div WACS = $2,360,000 - $360,000 2,000,000 = $1 Which elements are dilutive?

44 FDEPS Bonds - Individual Effect Interest: $1,000,000 X.07 X (1-.4) Shares: 500,000 = $42,000 = $ ,000 Lower than basic EPS : dilutive

45 FDEPS Preferred Shares - Individual Effect Dividends: $300,000 Shares: 400,000 = $0.08 Lower than basic EPS : dilutive

46 FDEPS Options - Individual Effect Earnings: $1,000,000 X $50 X.08 X (1-.4) Shares: 1,000,000 = $2,400,000 = $2.40 1,000,000 Higher than basic EPS : antidilutive

47 FDEPS - D/A Test Only include items that will reduce Basic EPS Start with the most dilutive number Pick combination that produces lowest FDEPS

48 FDEPS Calculation (000's): NI Shares EPS Basic $2,000 2,000 $1.00 Bonds $2,042 2,500.81

49 FDEPS - Part Year Rule If securities issues during the year, only 'back date' conversion to date of issue Example: 12% Bonds, $10,000,000 Issued November 1 Convertible to 12,000,000 common shares Tax rate, 40%

50 FDEPS - Part Year Rule Calculation - Individual effect Interest: $10,000,000 X.12 X (1-.4) X 2/12 Shares: 12,000,000 X 2/12 = $120,000 = $0.06 2,000,000

51 FDEPS Convertible securities only included if conversion possible in 10 year time span If various terms included, use most dilutive option FDEPS only need be disclosed if materially different than Basic FDEPS - Dual disclosure (NI before... and NI)

52 ADJUSTED BASIC EPS Requires if : Common shares are issued on conversion of senior shares or debt during the period Calculation: EPS as though conversion took place at beginning of year

53 ADJUSTED BASIC EPS - EXAMPLE Basic EPS (given) NI - Pref Div WACS = $1,000,000 - $100, ,000 = $1 On August 1, $1,000,000 of 12% bonds had converted to 100,000 common shares

54 ADJUSTED BASIC EPS Adjusted EPS $900,000 + ($1,000,000 X.12 X (1-.4) X 7/12) 900,000 + (100,000 X 7/12)

55 ADJUSTED BASIC EPS May be higher or lower than Basic Need only be disclosed if different than Basic If calculated, are the starting point for FDEPS

56 PRO FORMA EPS Required if common shares issued after the balance sheet date For cash, cash used to retire senior shares or debt On conversion of senior shares or debt In a reorganization Calculation: EPS as though conversion/issuance took place at the beginning of the year

57 PRO FORMA EPS - EXAMPLE Basic EPS (given) NI - Pref Div WACS = $1,000,000 - $100, ,000 = $1 On January 15, after the year end 200,000 shares were issued to retire $1,0000,000 of 12% bonds. What is the proforma basic?

58 PRO FORMA EPS - EXAMPLE Pro forma Basic Calculation $900,000 + ($1,000,000 X.12 X (1-.4)) 900, ,000 = $920,000 = $0.88 1,100,000

59 PRO FORMA EPS Calculate of Basic and FD Only disclose if materially different from Basic and FD

60 US RULES Basic EPS like Canadian Primary and FDEPS for complex capital structures Primary EPS involves calculation of Common Stock Equivalents Treasury stock method used for dilutive options

61 Now we are finished!!