Diluted EPS
Diluted EPS Earnings
Adjust Basic EPS Earnings to arrive at starting Diluted EPS Earnings
Most of the time, when you are calculating Diluted EPS, you will start with the earnings brought forward from Basic EPS. But at times, you will need to adjust your earnings to arrive at the correct starting diluted EPS.
For example, let us say that you have a foreign currency convertible bond with an equity conversion option. The equity conversion option is treated as a liability and needs to be marked to market through profit or loss. This marked-to-market adjustment needs to be removed from profit or loss when you calculate starting Diluted EPS Earnings.
If you are undecided about whether you need to adjust your starting Diluted EPS Earnings, you can temporarily fill the input box with the Basic EPS Earnings from Continuing Operations while you are trying to figure out the adjustments needed to arrive at starting Diluted EPS Earnings.
Recall that when you are calculating tax for the purpose of Diluted EPS Earnings, you should use the standard tax rate rather than your effective tax rate. The effective tax rate will change according to factors that affect your company's results other than the expenses associated with potential ordinary shares.
Also refer to the FAQs "How do I calculate Diluted EPS?" and "How does EPS-33 determine the numerator adjustments for EPIS?".
Potential Ordinary Shares
Different classes of POSs outstanding during the reporting period including:
- Options, warrants and their equivalents
- Convertible preference shares and convertible bonds
- Contingently issuable ordinary shares
- Contingently issuable potential ordinary shares
When calculating Diluted EPS on partly paid ordinary shares, no adjustment is required to the Diluted EPS numerator since the payment, by ordinary shareholders for the remaining balance on their partly paid ordinary shares, will have no appreciable effect on income or expense. You will need, however, to make an adjustment to the denominator.
To make the adjustment to the denominator, you will need to apply the treasury share method by: (1) taking the remaining balance due from partly paid ordinary shares and using it to purchase ordinary shares at the average market price; (2) calculating the adjustment to the denominator [ = (number of shares subscribed - number of ordinary shares purchased at the average market price) x time weighting].
Fill in the `Bonus Element*` with the difference between number of shares subscribed and the number of ordinary shares purchased at the average market price. If the partly paid shares were issued during the year, before you fill in the `Bonus Element*`, you will need to time apportion the issued shares by the number of months (or days if absolutely necessary) they were in issue.
Generally, your partly paid ordinary shares will be dilutive when the unpaid balance per share is lower than the average market price of an ordinary share during the period.
Illustration 1: Calculation of Bonus Element
Fraction of partly paid ordinary shares not entitled to dividends
a
Subscription price
b
Assumed proceeds (c = a x b)
c
Average market price of ordinary shares
d
Number of ordinary shares deemed to have been issued (e = c / d)
e
Bonus element (f = a - e)
f
Example 1: Fill in the Bonus Element
Fact pattern:
Net profit for the year
CU5,200,000
Opening number of ordinary shares
1,000,000
On 1 May, your company issues 300,000 shares with a subscription price of CU10. 80% payable on issue and with the balance required to be paid when called for. You receive 300,000 x 80% x CU10 = CU2,400,000. Keeping in accordance with your company's constitution, shareholders of partly paid ordinary shares are entitled to participate in dividends at the percentage the shares are paid up in comparison with fully paid ordinary shares. The average market price of your ordinary shares between 1 May and 31 December is CU17.
As in this example, partly paid ordinary shares should be considered POSs because they are treated as the equivalent of warrants or options (i.e. they are not entitled to dividends relative to fully paid ordinary shares).
Fraction of partly paid ordinary shares not entitled to dividends [(1 - 80%) x 300,000)]
60,000
Subscription price
CU10.00
Assumed proceeds (60,000 x CU10)
CU600,000
Average market price of ordinary shares
CU17
Number of ordinary shares deemed to have been issued ( CU600,000 / CU17)
35,294
Bonus element [(60,000 - 35,294) x 8/12]
16,471
Fill in 16,471 in the `Bonus Element` input box. The bonus element will be weighted for the period the ordinary shares are not fully paid — in this case 8 months. You can apportion by the number of days remaining if you prefer, but the months remaining is a reasonable estimate since you are calculating it by hand.
Convertible preference shares are equity instruments that allow an investor to receive your company's ordinary shares in whole or in part upon conversion. Convertible preference shares, other than those that are mandatorily convertible, are POSs because they may entitle their holders to your company's ordinary shares.
Example: Convertible Preference Shares
Let's say that your net profit after tax for the year is CU5,000,000 and the number of ordinary shares outstanding at the beginning of the year is 1,000,000. In a prior year, your company had issued 100,000 CU1 17% convertible preference shares. In this tax jurisdiction, preference shares are classified as equity and their dividends are not subject to tax.
Go to the `Basic EPS` tab. Fill in the `Profit / (Loss)*` input box with the value 5,000,000. Fill in `Returns on Equity-classified Preference Shares` input box with the value 17,000 (100,000 x CU1 x 17%). Fill in the `Ordinary Shares Outstanding on First Day of Reporting Period*` input box with the value 1,000,000. You will need to fill appropriate values for the `First Day of Reporting Period*` and `Last Day of the Reporting Period*` input boxes. You should get a Basic EPS value of CU4.98300.
Return to the `Convertible Preference Shares` section of the `Diluted EPS` tab. The full conversion of the issued preference shares will increase the number of outstanding shares by 100,000. Fill in the `Weighted-average Number of Ordinary Shares*` input box with the value 100,000. Since the preference shares are classified as equity and their dividends are not tax deductible, enter the value 17,000 (100,000 x CU1 x 17%) into the `Earnings` input box. You should get a Diluted EPS value of CU4.54545.
Illustration: Finding the Weighted-average Number of Ordinary Shares
Your company has a class of non-cumulative preference shares that are convertible to ordinary shares all with the same conversion terms. The following transaction occurred during the year:
- On 1 January, 2,000 preference shares are outstanding (2,000 x 3/12 = 500).
- On 1 April, 500 preference shares are converted into ordinary shares (2,000 - 500 = 1,500 x 3/12 = 375).
- On 1 July, another 1,000 preference shares are issued (1,500 + 1,000 = 2,500 x 6/12 = 1,250).
Weighted average for the year = 500 + 375 + 1,250 = 2,125. Enter 2,125 into the `Weighted-average Number of Ordinary Shares*` input box. Remember that the ordinary shares delivered by the 500 converted preference shares also enter the Basic EPS denominator from 1 April — enter them with the `[+] Issued` button on the Basic EPS tab.
Convertible bonds are debt instruments that allow an investor to receive your company's ordinary shares in whole or in part upon conversion. Convertible bonds, other than those that are mandatorily convertible, are POSs because they may entitle their holders to your company's ordinary shares.
Example: Convertible Debt
Let's say that your net profit after tax for the year is CU5,000,000 and the number of ordinary shares outstanding at the beginning of the year is 1,000,000. On 1 January, your company issues 500,000 convertible bonds for CU1 each. Every 10 of these bonds are convertible into one ordinary share at the holder's discretion. The interest expense for the year related to the liability component of the convertible bonds is CU100,000. In your tax jurisdiction, interest expense is tax-deductible with an applicable income tax rate of 40%.
Go to the `Basic EPS` tab. Fill in the `Profit / (Loss)*` input box with the value 5,000,000. Fill in the `Ordinary Shares Outstanding on First Day of Reporting Period*` input box with the value 1,000,000. You will need to fill appropriate values for the `First Day of the Reporting Period*` and `Last Day of the Reporting Period*` input boxes.
Return to the `Convertible Bonds` section of the `Diluted EPS` tab. The full conversion of the issued bonds will increase the number of outstanding shares by 50,000 (500,000 / 10). Fill in the `Weighted-average Number of Ordinary Shares*` input box with the value 50,000. The full conversion of the issued bonds would increase profit or loss for the year by the after-tax amount of the interest expense CU60,000 [(interest expenses on the convertible bonds) x (1 - income tax rate) = (100,000) x (1 - 40%) = 60,000]. Fill in the `Earnings` input box with the value 60,000. Including the impact of the convertible bonds in Diluted EPS will bring the Diluted EPS to CU4.82 [(5,000,000 + 60,000) / (1,000,000 + 50,000)].
Example: Numerator Adjustment for Employee Profit-sharing Plan Expense
Assume that your company has issued a convertible bond. During the year, the interest expense recognized on the bond is CU100,000. Your company also has a non-discretionary employee profit-sharing plan that pays 10% of its net profit annually to all eligible employees. All expenses are tax-deductible. The applicable income tax rate is 40%.
When you calculate EPIS for the convertible bond, you should assume that the bond is converted into ordinary shares from the beginning of the year. With the assumed conversion, the interest on the bond would not have been recognized in the year, and would have led automatically to an increase in the employee profit-sharing plan expense. Let's calculate the decrease in interest expense = CU100,000 - CU40,000 (CU100,000 x 40%) = CU60,000. Next, let's look at the increase in employee profit-sharing expense = - CU10,000 (- CU100,000 x 10%) + CU4,000 (CU10,000 x 40%) = - CU6,000. In total, you should enter CU54,000 (CU60,000 - CU6,000) in the `Earnings` input box.
Example: Numerator Adjustment on Capitalized Borrowing Costs
Assume that your company has issued a convertible bond that is convertible into its ordinary shares. During the year, the interest on the bond is CU120,000, of which CU90,000 is recognized in the income statement and CU30,000 is capitalized into the cost of property, plant and equipment in accordance with IAS 23. There are no other borrowing costs that would be capitalized if the instrument had been converted.
Of the interest of CU30,000 that is capitalized during the year, CU6,000 is recognized as part of the year's depreciation expenses.
All expenses are tax-deductible. The applicable income tax rate is 40%.
When you calculate the EPIS for the convertible bond, you should assume that the bond is converted into ordinary shares from the beginning of the year. With the assumed conversion, the interest on the bond would not have been recognized during the year leading to: (1) a reduction in the interest expense; (2) a reduction in the interest capitalized; and (3) a reduction in depreciation expense recognized in respect of such capitalized interest.
Let's calculate the decrease in interest expense = CU90,000 - CU36,000 (CU90,000 x 40%) = CU54,000. Next, let's look at the decrease in depreciation expense = CU6,000 - CU2,400 (CU6,000 x 40%) = CU3,600.
So, in total, you should enter CU57,600 (CU54,000 + CU3,600) in the `Earnings` input box.
After-tax Interest Add-back Calculator
Computes the `Earnings` add-back for an assumed conversion: the interest recognized on the liability component, plus or minus any consequential changes in other income or expenses (the profit-sharing and capitalized-interest examples above), all net of tax. The add-back increases the Diluted EPS numerator — it is added, never subtracted.
Enter this figure in the `Earnings` input box for this convertible-bond group — it is added to the Diluted EPS numerator.
Written put options and forward purchase contracts over your own ordinary shares oblige your company to buy back its shares: the holder of a written put may sell shares to your company at the exercise price, and a forward purchase contract commits your company to buy shares at the forward price. Contracts like these are reflected in Diluted EPS using the reverse treasury share method.
A written put or forward purchase contract is dilutive only when it is 'in the money' — that is, when the exercise (or settlement) price is above the average market price of your ordinary shares for the period. EPS-33 assumes that: (1) at the beginning of the period, your company issues enough ordinary shares at the average market price to raise the proceeds needed to satisfy the contract; and (2) the proceeds are used to buy back the contracted shares. The excess of the ordinary shares deemed issued over the shares bought back dilutes your EPS.
Example: Written Put Options
Fact pattern: Your company has 120,000 written put options outstanding for the whole period with an exercise price of CU35.00. The average market price of your ordinary shares for the period is CU28.00.
Proceeds needed to satisfy the contract (120,000 x CU35.00): CU4,200,000
Ordinary shares deemed issued at the average market price (CU4,200,000 / CU28.00): 150,000
Incremental ordinary shares (150,000 - 120,000): 30,000
Fill in the `Number of Written Put Options or Forwards*` input box with 120,000, the `Exercise Price*` input box with 35.00, and the `Average Market Price*` input box with 28.00 — EPS-33 derives the assumed proceeds, the shares deemed issued, and the 30,000 incremental shares for you. Fill in the `Proceeds / (Charges)` input box with any after-tax consequential change in profit or loss (usually there is none). When the exercise price is at or below the average market price, the contract is out of the money and anti-dilutive: EPS-33 excludes it from Diluted EPS and shows the tranche as 'Anti-dilutive — excluded' in the workings.
EPS-33 treats the shares subject to these contracts as outstanding for Basic EPS until they are actually repurchased — Alternative 1 in the FAQ "How should I treat forward purchase contracts and written put options over outstanding ordinary shares?"
Example: Applying the Treasury Share Method
Fact pattern: Your company has 100,000 employee share options outstanding for the whole period with an exercise price of CU0.60. The average market price of your ordinary shares for the period is CU0.75.
Assumed proceeds (100,000 x CU0.60): CU60,000
Ordinary shares deemed issued (CU60,000 / CU0.75): 80,000
Bonus element (100,000 - 80,000): 20,000
Fill in the `Weighted-average Number of Options*` input box with 100,000, the `Exercise Price*` input box with 0.60 and the `Average Market Price*` input box with 0.75 — EPS-33 derives the assumed proceeds, the shares deemed issued and the 20,000 bonus element for you. If the options were granted or exercised during the period, weight the number of options for the period they were outstanding before filling in the input box. For nil-cost awards (an exercise price of zero), the assumed proceeds are nil and the bonus element equals the full number of options.
Example: Numerator Adjustment When There is No Consequential Effect on the Income Statement
Consider a scenario where your company issues share options to your employees. Your company writes a call option to an investment bank to purchase its own shares at market price.
In this example, your company will conclude that the call option is not a derivative since the value of the option does not depend on an underlying variable — it always has a fair value of zero. Therefore, as far as the call option between your company and your investment bank is concerned, the assumed conversion of the employee options will not have any consequential effect to the profit or loss. No numerator adjustment is needed to the EPIS.
Example: No Numerator Adjustment When a Share Swap Hedges the Options
Continuing the above scenario, to reduce its exposure to an increase in the market price of its shares when the options become exercisable, your company enters into a share swap with your bank. Your company (1) takes a notional loan from the bank, with the principal amount equal to the purchase price of a notional number of shares at a notional share price; (2) pays interest on the notional loan and the bank pays dividends on the notional number of shares when your company declares dividends; and (3) may change the number of notional shares implicit in the notional loan by notifying the bank in advance, and has the intention of reducing the notional shares in line with the reduction in share options outstanding. The difference between the notional price and the market price of shares is refunded by the bank if the number of shares decreases. The difference between the notional price and the market price of shares needs to be topped up by your company if the number of shares increases.
Your company may intend to adjust the notional amount under the swap arrangement to hedge the share-based payment liability, the adjustment is not automatic and your company has the discretion to adjust its exposure.
Since there is no automatic connection between the swap arrangement with your bank and the exercise of the options, changes in the swap arrangement are not a consequential change to profit or loss from the assumed exercise. In this scenario, no numerator adjustment to the EPIS is necessary.
Also refer to the FAQs "How should you include options, warrants and their equivalents as POSs in Diluted EPS?", "How do I use the treasury share method to calculate the EPIS denominator adjustment for options, warrants or their equivalents?" and "How should you find the average price for the period when calculating Diluted EPS for options, warrants and their equivalents?".
Generally, ordinary shares issued to acquire a business impact only Basic EPS. Contingent consideration settleable in ordinary shares will, however, have an impact on Diluted EPS since they are POSs.
Example 1: Contingent Consideration Settleable in Ordinary Shares
Fact pattern:
On 1 January 2015, your company agrees to acquire company X as an IFRS 3 business combination. You acquire control on 1 March 2015 with the payment of cash consideration. There is contingent consideration of 200,000 ordinary shares if X's profit for the 12 month period ending 29 February 2016 is greater than CU750,000 or 300,000 ordinary shares if X's profit for the same period is greater than CU1,250,000. The contingent consideration is recognized as a financial liability.
The expense for the change in fair value of the contingent consideration recognized in profit or loss is CU100,000. The expense for the change in the fair value is tax-deductible and the applicable tax rate is 40%.
Net profit for the year end 31 December 2015
CU900,000
Opening number of ordinary shares
200,000
The cumulative earnings target will need to be tested on 29 February 2016. At 31 December 2015, X's cumulative earnings is CU900,000 which exceeds CU750,000 but is less than CU1,250,000. 200,000 ordinary shares will be included in the Diluted EPS denominator.
Increase in profit or loss from post-tax change in the fair value of the liability [CU100,000 x (1 - 40%)]
CU60,000
The weighted average number of shares to include on 1 March 2015 [200,000 x (10 / 12)]
166,667
Fill in 166,667 in the `Contingently Issuable Ordinary Shares*` input box — the 200,000 shares weighted from the 1 March 2015 acquisition date (200,000 x 10/12). Fill in 60,000 in the `Proceeds / (Charges)` input box — the post-tax increase in profit or loss from the change in the fair value of the contingent consideration liability.
Contingently issuable potential ordinary shares are POSs — such as share options, warrants or convertible instruments — that will themselves only be issued if specified conditions in a contingent share agreement are satisfied. They are different from contingently issuable ordinary shares, which deliver ordinary shares directly once the conditions are satisfied.
EPS-33 follows the two-step approach of IAS 33:
Step 1: Determine whether the conditions for issuing the POSs would be satisfied if the end of your reporting period were the end of the contingency period. If the conditions would not be satisfied, ignore the contingently issuable POSs.
Step 2: If the conditions would be satisfied, calculate the dilutive effect of the deemed-issued POSs using the rules that apply to that type of POS — for example, the treasury share method for options and warrants, or the if-converted method for convertible instruments.
Example: Performance-based Employee Share Options
Fact pattern: On 1 January 20X1, your company grants 300,000 employee share options with an exercise price of CU4.00. The options vest only if your company's cumulative profit for 20X1—20X3 reaches CU2,000,000 — a performance condition in addition to the passage of time — so they are contingently issuable POSs. Profit for the year ended 31 December 20X1 is CU2,400,000. The average market price of your ordinary shares during 20X1 is CU6.00.
Step 1: Treat 31 December 20X1 as if it were the end of the contingency period. Cumulative profit to date of CU2,400,000 already meets the CU2,000,000 target, so the options are deemed issuable. Do not forecast future profits when making this test.
Step 2: Apply the treasury share method to the deemed-issued options:
Assumed proceeds (300,000 x CU4.00): CU1,200,000
Ordinary shares deemed issued (CU1,200,000 / CU6.00): 200,000
Bonus element (300,000 - 200,000): 100,000
The options were deemed issuable for the whole period, so no further time apportionment is needed. If they had been granted on 1 July, you would weight the bonus element: 100,000 x 6/12 = 50,000.
Fill in the `Potential Ordinary Shares Issuable*` input box with 100,000. There is no consequential effect on profit or loss, so leave the `Proceeds / (Charges)` input box blank.
Diluted EPS Workings
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Diluted EPS = Basic EPS Numerator + Diluted POS Adjustments Basic EPS Denominator + Diluted POS Adjustments
Diluted EPS (Continuing Operations) =
Diluted EPS =
Diluted EPS (Continuing Operations) =
Diluted EPS (Discontinued Operations) =
Diluted EPS (Total Operations) =
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