April 28, 2025 113 NOTES

Earnings Per Share (EPS)

Complex vs. Simple Capital Structure

• The exercise involves a complex capital structure due to the presence of potential diluters.
• Potential diluters in this case are convertible preferred stock and options.
• Bonds payable were noted as nonconvertible, thus not a potential diluter.

Basic Earnings Per Share (Basic EPS)

• Formula: \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}
• Net income is given as 120,000.
• Need to subtract preferred dividends from net income.

Preferred Stock Details

• Preferred stock: 50 par, 7\% cumulative, convertible into common stock, share for share.
• Authorized: 10,000 shares, issued and outstanding: 2,000 shares.
• No dividends declared during the year, but dividends are cumulative.
• Cumulative dividends must be subtracted regardless of declaration.

Calculating Preferred Dividends

• Expressed as a percent: 7\%.
• Can calculate as: 50 \times 2,000 \text{ shares}, but in this problem, the total par value is given.
• If total par value isn't given, multiply par value per share by the number of shares issued and outstanding.

Weighted Average Shares Outstanding

• 100,000 shares authorized, issued, and outstanding.

Basic EPS Calculation

• \frac{120,000 - (0.07 \times 50 \times 2000)}{50,000}
• \frac{120,000 - 7,000}{50,000} = \frac{113,000}{50,000} = 2.26
• Basic EPS = $2.26

Diluted Earnings Per Share (Diluted EPS)

• Identified preferred stock and options as potential diluters.

Options

• Quick test: Compare exercise price to market price.
• Exercise price: $15 per share, market price: $25 per share.
• Since the exercise price is less than the market price, the options are dilutive.

Individual Dilution for Options

• Formula: \frac{\text{Numerator Effect}}{\text{Denominator Effect}}
• Numerator effect is always zero because options don't affect net income.
• Method for the denominator effect: Treasury Stock Method.

Treasury Stock Method

• Calculate cash proceeds from the pretend exercise.

• Cash proceeds = Exercise price (\times) number of shares.

• 15 \times 10,000 = 150,000

• Pretend to buy back shares at the average market price.

• Buyback = \frac{\text{Cash Proceeds}}{\text{Market Price}} = \frac{150,000}{25} = 6,000

• Common Mistake: Students incorrectly use the 6,000 as the denominator.

• Need the net increase in the denominator.

• Net increase = New shares - Buyback shares.

• 10,000 - 6,000 = 4,000

Impact on Diluted EPS

• The individual dilution for options is \frac{0}{4,000} = 0

Preferred Stock

Individual Dilution

• Formula: \frac{\text{Numerator Effect}}{\text{Denominator Effect}}
• Numerator effect: 7,000 (preferred dividends).
• Denominator effect: Number of shares the preferred stock is convertible into.
• Share per share conversion: 2,000 shares.
• Individual dilution: \frac{7,000}{2,000} = 3.50

Individual Dilution Test

• Compare the individual dilution to the basic EPS (2.26).
• 3.50 > 2.26, so the preferred stock is antidilutive and should be ignored.

Ranking

• Only stock options are included in the calculation.

Incorporating Options into Diluted EPS

• Start with the basic EPS formula and incorporate the numerator and denominator effects of the options.

• \frac{113,000 + 0}{50,000 + 4,000} = \frac{113,000}{54,000} = 2.09

• Diluted EPS = $2.09

Verification

• Compare the calculated value to the basic EPS.
• 2.09 < 2.26, so it is dilutive.
• Final diluted EPS: $2.09

Partial Income Statement Presentation

• Heading includes: Company name, Income Statement, For the Year Ending.
• Net Income: $120,000
• Basic EPS: $2.26
• Diluted EPS: $2.09

Scenarios and Decision Making

Scenario 1: Incorrectly Including Preferred Stock

• Even if the preferred stock is incorrectly included in the ranking, it's possible to correct it later.
• Incorporate options first, get $2.09.
• Then incorporate preferred stock: \frac{113,000 + 7,000}{50,000 + 4,000 + 2,000} = \frac{120,000}{56,000} = 2.14.
• Compare $2.14 to $2.09.
• Since $2.14 > 2.09, the preferred stock is antidilutive and should be excluded.

Scenario 2: Adjusted Numbers

• Basic EPS: $2.26, Options: 0, Preferred stock: $2.00.
• Options are dilutive (compared to basic).
• Preferred stock is dilutive (compared to basic).
• Rank: Options, Preferred.
• Incorporate options, get $2.09, compare to basic, keep it.
• Incorporate preferred, result is $2.08, compare to $2.09, keep it.

Scenario 3: Antidilutive After Incorporation

• Preferred stock is individually dilutive, but after incorporation, the result is $2.10.
• Compare to $2.09, antidilutive, throw it out.

Scenario 4: Result is the Same

• Incorporate preferred stock, result is $2.09.
• Compare to $2.09, antidilutive, throw it out.

Ranking Rule Reminder

• Rank based on which security has the smaller individual dilution.

Pensions

General Information

• Pensions will be covered in the next week.
• Pensions is a significant topic, but coverage is minimized because the CPA exam no longer covers it extensively.
• Even though this course isn't strictly for the CPA exam, pension plans still exist and must be covered.
• Pensions is a big, big topic, but we only have one week on it because the CPA exam no longer covers it.
• A lot of things are given instead of you having to compute them. So that's kind of relief. You have less formulas you have to remember and things to do, but there's still quite a bit..

Defined Contribution Plans vs. Defined Benefit Plans

• Most companies now have defined contribution plans like 401(k)s and 403(b)s.
• Defined benefit plans are less common now.

Defined Contribution Plans

• The company puts in cash and expenses it.
• Straightforward accounting.

Defined Benefit Plans

• More complex accounting issues.

Measuring Pension Obligations

• Obligation = Liability.
• Three ways to measure pension obligation for defined benefit plans:
  • Vested Benefit Obligation.
  • Accumulated Benefit Obligation (ABO).
  • Projected Benefit Obligation (PBO).

Vested Benefit Obligation

• Measures benefits for employees who are vested.

Accumulated Benefit Obligation (ABO)

• Includes vested and non-vested employees.
• Uses current salaries.

Projected Benefit Obligation (PBO)

• Includes vested and non-vested employees at future salaries.
• Most plans are based on future salaries.
• All of these obligations have to be disclosed.

Present Value and Actuaries

• Numbers are taken to the present value.
• Actuaries estimate future salaries and retirement ages.
• Actuaries are in high demand.
• Actuarial science is one of the hardest degrees you can actually get.

Interest and Discount Rate

• OACV \times ER = \text{Interest}
• OACD (Opening of the period carrying value) times ER (Effective Rate) equals interest, which is an expense.
• The effective rate varies by topic.
• For pensions, the effective rate is the discount rate.
• The discount rate is what they call a pure present value computation.