Earnings per share is the portion of a company’s profit allocated to each outstanding share of common stock. The computation of earnings per share is income minus preferred stock dividends divided by weighted average number of shares of common stock outstanding at the end of the period. Earning per share is considered to be the single most important metric to determine a company’s profitability which is crucial to the decision making of potential investors and creditors.
In other words, earnings per share helps people to have a better insight of different companies’ power to make money.
The higher the earnings per share with all other factors equal, the higher each share would be worth. By evaluating earnings per share, investors and creditors can make their decision whether the company is worth investing or lending the money to. Although earnings per share is a very important factor to present a company’s financial status and a significant indicator to investor and creditor, its existence and presentation have been disputed throughout the U.
S. history. Approximately a half century ago, accountants were not supposed to be associated with reporting of EPS amounts. In Accounting Research Bulletin (ARB) No. 3 (AICPA, 1961), the Committee on Accounting Procedure (CAP) stated that an undue attention was given to a single net income figure or earnings per share and regarded it as “undesirable”. However, Earnings per Share presentation has became very common during 1950s. In ARB No. 49, Earnings per Share (AICPA, l961), CAP restated its positions and suggested three guidelines to compute earnings per share.
The three guidelines were: “1). . . the term earnings per share should be used to designate the amount applicable to each share of common stock or other residual security outstanding, 2) earnings per share, . . should generally be stated in terms of the common stock position as it existed in the years to which the statistics relate, unless it is clear that the growth or decline of earnings will be more fairly presented, as for example, in the case of a stock split, by dividing prior years’ earnings by the current equivalent of the number of shares then outstanding, and 3) in all cases in which there have been significant changes in stock during the period to which the computations relate, an appropriate explanation of the method used should accompany the presentation of earnings per share. ”
In APB Opinion No. , Reporting the Results of Operations in 1966 (AICPA), the subject of EPS was first addressed. Instead of reporting a single EPS figure, APB strongly encouraged companies to provide EPS amounts for income before extraordinary items, extraordinary items (if any), and net income in the income statement. In further, APB announced that if there’s evidence of potential delusion which could occur due to convertibles, warrants and options, and other contingent share distributions, diluted EPS amounts should be included in the income statement representing what the earnings would be if the options were exercised.
However, Opinion No. 9 did not give out a detailed guidance of how to compute EPS. After three years, APB did realize the importance of the computation and disclosure of EPS since people were considering EPS as one of the most important indicators for decision making. In 1969, they issued the APB Opinion No. 15 which was the first official pronouncement that required companies to report EPS figures in the income statement. Also, Opinion No. 15 provided clear information on the computation of EPS on a consistent basis.
It guides the current practice and provides a standard at that time. However, it was considered very complicated and controversial. There are two types of capital structures are identified based on the opinion, simple and complex. “A simple capital structure is one that consists of only common stock or includes no potential dilutive securities, warrants, options, or other rights, that upon conversion or exercise, could dilute EPS. ” The single presentation of EPS is required to be reported if the companies have simple capital structure.
On the opposite, companies with complex capital structure are required to present two types of EPS—Primary EPS and Fully dilutive EPS. However, a dual presentation is not required if dilution in the aggregate is less than three percent. In addition to primary EPS and fully diluted EPS, Opinion No. 15 brought out some new concepts such as common stock equivalents, the “if-converted” method, and the treasury stock method in computing diluted EPS figures. In 1971, due to the complexity and controversy of Opinion No. 5, the AICPA had to publish 102 accounting interpretations relating to it by 1971. As a result, Opinion No. 15 was often misunderstood and misused according to many empirical studies that released by FASB. It was also kind of difficult for people to apply Opinion No. 15 correctly. In this case, FASB issued new standards regarding Earnings per Shares in February 1997 which was the Statement of Financial Accounting Standards No. 128. The goal of the Statement of Financial Accounting Standards No. 28 was to simplify and regularize the computation and disclosure of Earnings per Shares compared to the Opinion No. 15. In SFAS No. 128, “primary earnings per share” was replaced by “basic earnings per share. ” Basic earnings per share is determined from historical data and measures the earnings per common share for the accounting period.
The new calculation of EPS is dividing income available to common shareholders by the weighted average number of common shares outstanding during the period which was the same as the calculation of simple earnings per share in Opinion No. 5. “…Income available to common shareholders is defined as net income (or income from continuing operations) minus preferred dividends paid or declared and any current year preferred dividends on cumulative preferred stock not declared or paid. Companies that have a discontinued operation, extraordinary item, or cumulative effect of a change in accounting principle are to use income from continuing operations as the ‘control number’ in determining whether potential common shares are dilutive or antidilutive. In the new standards, weighted average number of shares is the same as in the Opinion No. 15, with consideration of all stock sales, treasury stock transactions, securities exercised or converted during the period, and stock splits and stock dividends, retroactively applied. If the entity only has common stock outstanding and no other securities that can result in the issuance of common shares, it will have a simple capital structure and only need to report basic per share amounts during the period. In SFAS No. 28, primary earnings per share is eliminated and, as a result, those tests for common stock equivalency are eliminated too which are the “five-year test” and “three-month rule” for options and warrants, and the “five-year test” and “effective-yield test” for convertible securities. The “three-percent rule or method” which determines when primary or fully diluted earnings per share should be presented has also been removed. The standards provided by SFAS No. 128 are almost the current practices in America today with little change.
However, there have been always some arguments about the EPS accounting report, for example, the report of diluted EPS, which has been disputed by scholars for long time. In A. Bruce Caster’s article “Is Diluted EPS Becoming More Art than Fact? ” (2006), the author states that companies have different ways to provide investor with financial instruments without issuing common stock, such as convertible securities (convertible debt and convertible preferred stock) and stock options.
Since these kinds of instruments do not act as additional shares of common stock when they are issued, they don’t have an effect on EPS automatically. However, the investors are able to turn these instruments into common stocks in future, so there must be a reasonable judgment about the potential impact on EPS if the instruments are turned into common stocks. Then here comes the computation and report of diluted EPS. Basic EPS is based on the historical information about events that . really did occur in the reporting period.
Diluted EPS is a “make believed” presentation which shows the potential influence of events that haven’t occurred yet but could occur in future. The limitation of diluted EPS is obvious because it is “based on a fixed set of assumptions regarding the specific categories of financial instruments that must be included in its computation. ” (Caster, 2006) That means companies would be appealed to create new financial instruments that have both desirable economic figures and desirable effects on the report of diluted EPS.
And those instruments could be categorized as contingent convertible debt and freestanding financial instruments. The most important figure of convertible debt is that the debt holders can convert the debt into a fixed number of shares of common stock. For the contingent convertible debt, there must be a contingency around before the debt holder can convert the debt to common stock. The most common one is the price premium which requires the market price of the common stock is higher than the conversion price by 10%-20% before the conversion is available.
Because of this additional requirement, the contingency can “delay the dilution of voting control and the decline in market value that typically results from conversion”. (Caster, 2006) In addition, the probability that company can call the debt and never have to issue new shares of common will be increased. One research (C. Marquardt and C. Wiedman, “Earnings Management Through Transaction Structuring: Contingent Convertible Debt and Diluted Earnings per Share,” Journal of Accounting Research, May 2005) shows that voluntary conversion of Contingent Convertible Debt are really rare.
Most companies prefer to call them before they are convertible even if the requirement has not been satisfied. Also, there is a chance that Contingent Convertible Debt may receive favorable treatment in the computation of diluted EPS. In order to avoid the problem, in November 2004, EITF 04-8,“The Effect of Contingently Convertible Debt on Diluted Earnings per Share,” was issued. It stated that Contingently Convertible Debt should be treated in the same way like any other convertible debt in computing diluted EPS if the conversion triggers are merely based on market price.
However, EITF 04-8 only applies to Contingent Convertible Debt with market-price contingency. Those whose conversion triggers are not based on market price are still not included in diluted EPS. So there is still a problem that companies can issue low-yield convertible debt to avoid the dilution which results from issuing common convertible debts. Both SFAS No. 128 and EITF 04-8 primarily focus on ordinary convertible securities and instruments that become convertible if the conversion contingency is satisfied.
But there is still no authoritative guidance to solve the problems above that have impact on diluted EPS. The second example raised by scholars regarding diluted EPS problem is freestanding financial instrument. Freestanding financial instrument is instrument “entered into separately and apart from any of the entity’s other financial instruments or equity transactions, or an instrument that is entered into in conjunction with some other transaction and is legally detachable and separately exercisable” (Caster, 2006), which is defined and classified by SFAS No. 50. SFAS No. 150 states that freestanding financial instrument should be classified as liabilities or assets under certain circumstances, even though it has equity figure. Instrument that subject to physically settled forward purchase contracts or mandatorily redeemable is excluded from basic and diluted EPS calculations. The reason for that is “accounting for physically settled forward contracts reduces equity even though the shares are still outstanding” (Caster, 2006).
Freestanding financial instrument is measured at the fair value, but it is also physically settled forward contracts that obligate the issuer to purchase a fixed number of its own shares for cash which are initially measured at the present value of the amount to be paid at the settlement date, so freestanding financial instrument should be excluded from EPS calculations. EITF 04-8 specifically focus on contingent convertible instruments on diluted EPS. But there is still no clear guidance on the calculation of EPS for freestanding instruments.
When we look at the securities that may not be included in the computation of diluted EPS, we can see that people have been trying to create securities that can raise capital while affecting diluted EPS at the least under the FASB rules. This make us rethink of the diluted EPS accounting report. The problem of FASB is that the guidance to improve the reporting of diluted EPS when new securities are created or developed is missing. FASB must develop the rules over time to make sure these securities are handled in the right ways. Some scholars argue that there is no clear definition of diluted EPS that based on conceptual basis.
The current definition of diluted EPS is a complicated computational process in which diluted EPS is regarded as a result number of the computation. Not like other definitions that FASB provided, the definition of diluted EPS cannot identify any particular external reality and provide conceptual basis for determining whether the current report method for diluted EPS is appropriate. Some scholars are afraid that the reporting of diluted EPS will finally lose its point. And diluted EPS will become a meaningless computational figure. Besides diluted EPS, the differences on EPS report between GAAP and IFRS have been disputed for years too.
The lack of uniformity in EPS reporting has been a historical problem in global business. It is inconvenient for people to switch between two EPS report methods and it can cause inefficiency. And the standardizing EPS has significant meaning for the allocation of capital resource. EPS computation has developed over a period of years. But GAAP for EPS was criticized by scholars as “arbitrary and illogical” (Kelliher, 1996). And the complexity of the standards made required information costly to prepare. Comparative analyses that transcend national boundaries require the EPS computation to be more homogeneous.
With the spirit of simplification and applicability for EPS, the FASB has decided to redeliberate EPS with the IASC in order to increase the international comparability. They have agreed to cooperate with each other and share the information. The FASB–IASC EPS Project (1991) is part of the FASB’s plan to participate more in the international accounting matters. And it provided the FASB the opportunity to correct some deficiencies regarding to the current GAAP of EPS. The goal of the cooperation was to make performance data from companies in various countries easier to understand to the financial information users. The FASB decided o replace primary EPS with basic EPS which would be computed by dividing income available to stockholders by the weighted average number of common shares outstanding throughout the period. Companies with simple capital structure only need to report basic EPS for the period. The purpose of that is to measure the performance of an entity over a period of time in a direct and simple way. Also, fully diluted EPS was replaced with diluted EPS. The computation of diluted EPS accounts for all dilutive options, convertibles, warrants, and contingently issuable shares not considering when they must be exercised, issued, or converted.
The calculation for diluted EPS uses the “if-converted” method for convertible securities. And for options and warrants, the treasury stock method is applied to calculate the dilutive effects. Both methods were introduced by the Opinion No. 15. Average market price is used when calculating diluted EPS. The dilutive EPS is a classic representative of the conservation of GAAP because it takes all the potential situations into account when calculating weighted-average common shares outstanding.
The purpose of diluted EPS is to show the stockholders what the EPS of an entity would be if all the convertibles and options are exercised. The FASB also stated that it “would not retain the modified treasury stock approach under which the proceeds from the exercise of options and warrants are not to be used to purchase more than 20% of the enterprise’s outstanding common stock at fiscal yearend”, which means an entity could only repurchase 20% of its outstanding common stock during its fiscal year.
And if there still remains capital, it should be used to decrease short-or-long term debt with any balances invested in government securities and it would not limit the repurchase of common stock outstanding to 20% for diluted EPS. When the basic and diluted EPS are determined, the three percent materiality test is required. The test states that if the difference between basic and diluted EPS is less than three percent, only basic EPS needs be presented on the face of income statement. But, if the difference is equal to or greater than three percent, both the basic and diluted EPS are required.
Although the FASB and the IASC have been working on the convergence and standardization of EPS report, there are still some major differences that excerpted from WILEY Interpretation and Application of International Financial Reporting Standards 2010: U. S GAAP:
To conclude, the US GAAP is never perfect, and the diversity between the US GAAP and IFRS always exists. In order to make EPS accounting report more conceptually understandable and acceptable, the FASB must reexamine the definition of EPS and develop the accounting standards for EPS over time.
Also, international cooperation between the FASB and the IASB is crucial. The FASB must balance the convergence and diversity of standards on EPS with IASB. In this way, professional can refer to better accounting standards when dealing with EPS report, especially in international issues.
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