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Advance Financial Accounting (FIN-611)
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LESSON # 35
DILUTED EARNINGS PER SHARE
At the end of an accounting period, a company may have in issue some securities
which do not (at present) have any claim to a share of equity earnings, but may give
rise to such a claim in the future. These securities include:
a)
A separate class of equity shares which at present is not entitled to any
dividend, but will be entitled after some future date
b)
Convertible Debentures or convertible preferred shares which give their
holders the right at some future date to exchange their securities for
ordinary shares of the company, at a pre-determined conversion rate
c)
Option or warrants
In such circumstances, the future number of ordinary shares in issue might increase.
This in turn results in a fall in the EPS. In other words, a future increase in the number
of ordinary shares will cause a dilution of equity, and it is possible to calculate diluted
earnings per share (i.e. the EPS that would have been obtained during the financial
period if the dilution had already taken place). This will indicate to investors the
possible effects of a future dilution.
Earnings:
The earnings calculated for basic EPS should be adjusted by the post-tax (including
deferred tax) effect of
a)
Any dividends on dilutive potential ordinary shares that were deducted to
arrive at earnings for basic EPS
b)
Interest recognized in the period for the dilutive potential ordinary shares
c)
Any other changes in income or expenses (fee and discount, premium
accounted for as yield adjustments) that would result from the conversion of
the dilutive potential ordinary shares
The conversion of some potential ordinary shares may lead to changes in other income
or expenses. For example, the reduction of interest expense related to potential
ordinary shares and the resulting increase in net profit for the period may lead to an
increase in the expense relating to non-discretionary employee profit sharing plan.
When calculating diluted EPS, the net profit or loss for the period is adjusted for any
such consequential changes in income or expense.
Per Share:
The number of ordinary shares is the weighted average number of ordinary shares
calculated for basic EPS plus the weighted average number of shares that would be
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Advance Financial Accounting (FIN-611)
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issued on the conversion of all the dilutive potential ordinary shares into ordinary
shares.
It should be assumed that diluted ordinary shares were converted into ordinary shares
at the beginning of the period or, if later, at the actual date of issue.
Solved problem # 1:
Basic EPS of a company is Rs. 1.05 per share based on earnings of Rs. 105,000 and
100,000 ordinary Re. 1 shares. It also had in issue Rs. 40,000 15% Convertible
Debentures which is convertible in two years' time at the rate of 4 ordinary shares for
every Rs. 5 of debenture. The rate of tax is 30%. In 2007 gross profit of Rs. 200,000 and
expenses of Rs. 50,000 were recorded, including interest payable of Rs. 6,000
Income Statement before conversion of debentures into the ordinary shares
Rupees
Gross profit
200,000
Operating expenses
(44,000)
Profit from operations
156,000
Financial expenses
(6,000)
Profit before tax
150,000
Income tax 30%
(45,000)
Profit after tax (earnings)
105,000
Diluted earnings per share
a)
Conversion of debentures into the ordinary number of shares
Rs. 40,000 x 4/5 = 32,000 number of ordinary shares
b)
Adjustment of profits after the conversion of debentures into the ordinary
shares
c)
Rupees
Gross profit
200,000
Operating expenses
(44,000)
Profit from operations
156,000
Income tax 30%
(46,800)
Profit after tax (earnings)
109,200
d)
Diluted EPS
Rs. 109,200 = Rs. 0.827 per share
132,000
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Advance Financial Accounting (FIN-611)
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e)
Dilution:
The dilution in earnings would be Rs. 1.05 less 0.827 = Rs. 0.223/share.
Dilutive potential ordinary shares
Those convertible debentures or securities that will cause an increase in Basic EPS had
these would have been converted in the current year are anti-dilutive potential
ordinary shares.
According to IAS 33, potential ordinary shares should be treated as dilutive when, and
only when, their conversion to ordinary shares would decrease net profit per share
from continuing operations. This point is illustrated in the following example:
Profit from operations
156,000
Financial charges (interest @ 25%of Rs. 40,000 debentures) (10,000)
Profit before tax
146,000
Income tax (@ 30%)
(43,800)
Profit after tax
102,200
Ordinary number of shares
100,000
Basic EPS
Rs. 123,300  = Rs. 1.022 per shares
100,000 shares
Diluted EPS
Conversion rate is 3 ordinary shares will be issued against each Rs. 20 debentures in
issue
Rs. 40,000 x 3/20 = 6,000 number of shares
Revised Income statement after conversion
Rupees
Profit from operations
156,000
Financial charges
0
Profit before tax
156,000
Income Tax @ 30%
(46,800)
Profit after tax
109,200
Revised earnings per share after conversion
Rs. 109,200 = Rs. 1.030 per share
106,000shares
There is no dilution as the post conversion EPS is greater than the basic EPS.
This can also be understood by calculating individual EPS of the security/debenture.
If the individual EPS of the security is lesser than the basic EPS then it is a dilutive
potential shares, whereas, if the individual EPS of the security is greater than the basic
EPS then it is a non dilutive potential shares.
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Like is this case:
Rupees
Savings of financial charges
10,000
Income tax impact @ 30%
(3,000)
Impact on the earnings to the extent of the security
7,000
Rs. 7,000 = Rs. 1.667
Individual EPS
6,000 shares
This individual EPS is greater than the basic EPS i.e. 1.022 per share therefore this
security is anti-dilutive potential share and should not be converted into the ordinary
shares before calculating the diluted earnings per share.
Solved problem # 2:
Ali Imran Co has 5,000,000 ordinary shares in issue, and also had in issue in 2004:
a)
Rs. 1,000,000 of 14% convertible debentures, convertible in three years'
time at the rate of 2 shares peer Rs. 10 of debentures
b)
Rs. 2,000,000 of 10% convertible debentures, convertible in one year's
time at the rate of 3 shares per Rs. 5 of debenture.
The total earnings in 2004 were Rs. 1,750,000
The rate of income tax is 35%
Requited: Calculate the basic EPS and the diluted EPS
Solution:
Basic EPS = Rs. 1,750,000 = 35 paisa
5,000,000
Diluted EPS:
Before calculating diluted EPS we must decide which of the potential ordinary shares
(the convertible debentures) are dilutive.
a)
Conversion into ordinary shares Rs. 1,000,000 x 2/10 = 20,000 ordinary shares
Savings of financial charges Rs. 1,000,000 x 14%
140,000
Income tax impact @ 35%
(49,000)
Impact on the earnings to the extent of the security
91,000
Individual EPS
Rs. 91,000 = 45.5 paisa (greater than the basic EPS)
20,000
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b)
Conversion into ordinary shares Rs. 2,000,000 x 3/5 = 1,200,000 ordinary shares
Savings of financial charges Rs. 2,000,000 x 10%
200,000
Income tax impact @ 35%
(70,000)
Impact on the earnings to the extent of the security
130,000
Individual EPS
Rs. 130,000 = 10.8 paisa (lesser than the basic EPS)
1,200,000
Therefore the diluted EPS will be calculated after converting the 10% debentures.
Rs. 1,750,000 + Rs. 130,000 = Rs. 1,880,000 = 30.30 paisa
5,000,000 + 1,200,000
6,200,000
Dilution is equal to
Basic EPS
35.00
Diluted EPS
30.30
Dilution
4.70
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Table of Contents:
  1. ACCOUNTING FOR INCOMPLETE RECORDS
  2. PRACTICING ACCOUNTING FOR INCOMPLETE RECORDS
  3. CONVERSION OF SINGLE ENTRY IN DOUBLE ENTRY ACCOUNTING SYSTEM
  4. SINGLE ENTRY CALCULATION OF MISSING INFORMATION
  5. SINGLE ENTRY CALCULATION OF MARKUP AND MARGIN
  6. ACCOUNTING SYSTEM IN NON-PROFIT ORGANIZATIONS
  7. NON-PROFIT ORGANIZATIONS
  8. PREPARATION OF FINANCIAL STATEMENTS OF NON-PROFIT ORGANIZATIONS FROM INCOMPLETE RECORDS
  9. DEPARTMENTAL ACCOUNTS 1
  10. DEPARTMENTAL ACCOUNTS 2
  11. BRANCH ACCOUNTING SYSTEMS
  12. BRANCH ACCOUNTING
  13. BRANCH ACCOUNTING - STOCK AND DEBTOR SYSTEM
  14. STOCK AND DEBTORS SYSTEM
  15. INDEPENDENT BRANCH
  16. BRANCH ACCOUNTING 1
  17. BRANCH ACCOUNTING 2
  18. ESSENTIALS OF PARTNERSHIP
  19. Partnership Accounts Changes in partnership firm
  20. COMPANY ACCOUNTS 1
  21. COMPANY ACCOUNTS 2
  22. Problems Solving
  23. COMPANY ACCOUNTS
  24. RETURNS ON FINANCIAL SOURCES
  25. IASBíS FRAMEWORK
  26. ELEMENTS OF FINANCIAL STATEMENTS
  27. EVENTS AFTER THE BALANCE SHEET DATE
  28. PROVISIONS, CONTINGENT LIABILITIES AND CONTINGENT ASSETS
  29. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 1
  30. ACCOUNTING POLICIES, CHANGES IN ACCOUNTING ESTIMATES AND ERRORS 2
  31. BORROWING COST
  32. EXCESS OF THE CARRYING AMOUNT OF THE QUALIFYING ASSET OVER RECOVERABLE AMOUNT
  33. EARNINGS PER SHARE
  34. Earnings per Share
  35. DILUTED EARNINGS PER SHARE
  36. GROUP ACCOUNTS
  37. Pre-acquisition Reserves
  38. GROUP ACCOUNTS: Minority Interest
  39. GROUP ACCOUNTS: Inter Company Trading (P to S)
  40. GROUP ACCOUNTS: Fair Value Adjustments
  41. GROUP ACCOUNTS: Pre-acquistion Profits, Dividends
  42. GROUP ACCOUNTS: Profit & Loss
  43. GROUP ACCOUNTS: Minority Interest, Inter Co.
  44. GROUP ACCOUNTS: Inter Co. Trading (when there is unrealized profit)
  45. Comprehensive Workings in Group Accounts Consolidated Balance Sheet