DILUTED EARNINGS PER SHARE

<< Earnings per Share

GROUP ACCOUNTS >>

Advance Financial Accounting (FIN-611)

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 separate class of equity shares which at present is not entitled to any

dividend, but will be entitled after some future date

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

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

Any dividends on dilutive potential ordinary shares that were deducted to

arrive at earnings for basic EPS

Interest recognized in the period for the dilutive potential ordinary shares

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

188

Advance Financial Accounting (FIN-611)

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

Conversion of debentures into the ordinary number of shares

Rs. 40,000 x 4/5 = 32,000 number of ordinary shares

Adjustment of profits after the conversion of debentures into the ordinary

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

Diluted EPS

Rs. 109,200 = Rs. 0.827 per share

132,000

189

Advance Financial Accounting (FIN-611)

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

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.

190

Advance Financial Accounting (FIN-611)

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:

Rs. 1,000,000 of 14% convertible debentures, convertible in three years'

time at the rate of 2 shares peer Rs. 10 of debentures

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.

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

191

Advance Financial Accounting (FIN-611)

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

192

Table of Contents: