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1. Ch.17 Earnings Per Share

Chapter 17: Earnings Per Share Overview

Importance of Earnings Per Share (EPS)

  • EPS is a vital financial metric used for evaluating a company's performance over time.

  • It provides essential insights to shareholders and prospective investors regarding the income attributable to each common share, which can influence investment decisions, future dividends, and overall share value.

  • A higher EPS often suggests better profitability and financial health, while a low EPS may raise concerns about a company’s ability to generate profits consistently.

Objectives

  • Understand the significance of EPS: Recognizing how EPS reflects company performance and shareholder value.

  • Calculate basic EPS: Applying the formula to effectively determine earnings per share from net income.

  • Calculate diluted EPS: Accounting for potential dilution due to securities like convertible debt and stock options.

  • Identify differences: Understanding the variations between International Financial Reporting Standards (IFRS) and Accounting Standards for Private Enterprises (ASPE) relating to EPS calculations.

Earnings Per Share Calculation

Types of EPS

  • Basic EPS:

    • Formula:

      • EPS = (Income available for common shares) / (Weighted average number of common shares)

    • Example: If a company reports earnings of $3 million and has 1 million common shares, the basic EPS would be $3.

  • Diluted EPS:

    • Formula:

      • Diluted EPS considers potential dilution from securities that can convert into common stock, such as options and convertible bonds.

    • Example: If a company has $2.5 million in earnings with potential dilutive securities, the diluted EPS might evaluate these impacts, leading to a lower EPS than basic calculations due to dilution effects.

Presentation and Disclosure

IFRS vs. ASPE

  • Disclosure Requirements:

    • Under IFRS, companies are required to disclose EPS figures prominently in their financial statements while ASPE does not have stringent disclosure requirements.

    • EPS must be presented separately for continuing and discontinued operations to provide more insightful information to users of financial statements.

    • Both basic and diluted EPS must be reported for different types of operations to enhance transparency.

Disclosure Requirements under IFRS

  • Essential disclosures under IFRS include:

    • EPS for all reporting periods presented, such as quarterly and annually.

    • Restatement of EPS figures for stock splits or stock dividends to maintain consistency.

    • Maintenance of a consistent approach in reporting diluted EPS across accounting periods if applicable.

Analysis of EPS

Visibility and Use

  • EPS serves as a primary measure not only for assessing management performance but also for predicting future company value and market trends.

  • Diluted EPS is especially useful for investors to analyze the potential impact of options, convertible securities, and other instruments that could affect earnings per share.

  • EPS is frequently employed in valuation methods, including discounted cash flow analysis, making it indispensable for informed investment decisions.

Price Earnings Ratio (P/E)

  • Definition:

    • The Price Earnings Ratio relates a company's current share price to its earnings per share, offering a quick estimation of company value based on profitability.

  • Expression:

    • P/E Ratio = (Price per share) / (EPS)

    • This ratio provides insight into how much investors are willing to pay for each dollar of earnings, influencing perceptions of overvaluation or undervaluation in the market.

Capital Structure Implications

Simple vs. Complex Structures

  • Simple Structures:

    • Consist solely of common shares and non-convertible securities; in this case, only basic EPS is reported.

  • Complex Structures:

    • Include convertible securities or options that may dilute EPS; therefore, both basic and diluted EPS need to be calculated and presented to provide a comprehensive assessment of earnings attributable to common shareholders.

Income Available to Common Shareholders

  • The calculation for income available to common shareholders typically involves:

    • Starting with net income,

    • Subtracting preferred dividends that must be paid before common shareholders receive their share.

    • Cumulative preferred shares can impact EPS calculations, even if dividends have not been declared during the fiscal period.

Weighted Average Common Shares (WACS)

  • Definition:

    • All EPS calculations utilize the WACS which reflects shares outstanding during the reporting period.

    • Adjustments may be needed for stock dividends and splits to ensure comparability and accuracy of EPS reporting over different periods.

Basic EPS Calculation

  • Steps in determining income available to common shareholders include:

    • Calculating total net income for the period.

    • Subtracting the total amount of preferred dividends paid out from net income.

    • Finally, calculating EPS for both continuing and discontinued operations to reflect company’s overall performance accurately.

Diluted EPS for Complex Capital Structures

  • Conversion Considerations:

    • Diluted EPS must consider the effects of all convertible securities; often employing the if-converted method to assess potential dilutive impacts on earnings accurately.

  • Options and Warrants Impact on EPS:

    • Call/Put Options:

      • Call options lead to dilution when exercised, adding complexity to the EPS calculations.

      • Put options can also affect share calculations under market conditions.

    • Treasury Stock Method:

      • A method used to assess the dilutive effect of call options by assuming exercise and the repurchase of shares, thus impacting the EPS calculation.

Antidilution Considerations

  • Identifying Antidilutive Securities:

    • It is critical to exclude securities that would increase the EPS when deciding what to include in diluted calculations, ensuring that the financial representation is not misleading.

    • Ranking securities based on their dilutive effects can help in understanding which instruments affect EPS the most significantly.

Comparison of IFRS and ASPE

  • ASPE lacks clearly defined guidelines for EPS calculation, making it applicable primarily to publicly accountable entities (PAEs).

  • The continuous evolution in accounting standards may influence the future of EPS reporting, necessitating close attention to changes in legislation and financial reporting standards.