Workbook on IAS 33 Earnings per share

OVERVIEW

Objective

The objective of IAS 33 is to prescribe principles for the calculation and presentation of earnings per share. This is to improve comparisons between different undertakings in the same reporting period, and between different reporting periods for the same undertaking.

Even though earnings per share data have limitations, due to the different accounting policies that may be used for determining ‘earnings’, a standard denominator (the number of shares) enhances financial reporting. The focus of IAS 33 is on the denominator of the earnings per share calculation.

Scope

IAS 33 shall be applied by undertakings whose shares, and potential shares, are publicly traded, and by undertakings that are in the process of issuing shares, or potential shares in public markets. Others may provide such information if it is produced according to IAS 33.

When an undertaking presents both consolidated and separate financial statements, the disclosures required by IAS 33 need be presented only for the consolidated information.

EXAMPLE- consolidated and separate financial statements

You produce both consolidated and separate financial statements. You calculate earnings per share for the consolidated accounts, but do not need to do so for the parent company accounts.

IAS 33 shall apply to:

a. the separate or individual financial statements of an undertaking:

i. whose ordinary shares or potential ordinary shares are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets) or

ii. that files, or is in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing ordinary shares in a public market; and

b. the consolidated financial statements of a group with a parent:

i. whose ordinary shares or potential ordinary shares are traded in a public market (a domestic or foreign stock exchange or an over-the-counter market, including local and regional markets) or

ii. that files, or is in the process of filing, its financial statements with a securities commission or other regulatory organisation for the purpose of issuing ordinary shares in a public market.

An undertaking that discloses earnings per share, based on its separate financial statements, shall present such information only on the face of its separate income statement.

EXAMPLE- consolidated and separate financial statements-parent company accounts

You produce both consolidated and separate financial statements. You calculate earnings per share for both. The parent company accounts’ figure should only appear on the balance sheet (SFP) of those accounts.

Definitions

Antidilution is an increase in earnings per share when convertible instruments are converted to ordinary shares.

EXAMPLE-antidilution

You convert some high-interest debt to ordinary shares. The interest saved (earnings) increases the earnings per share, even allowing for the additional shares in issue.

A contingent share agreement is an agreement to issue shares, which is dependent on the satisfaction of specified conditions.

EXAMPLE-contingent share agreement

You have provided staff with share options. If they work for you for 3 years, they will be able to buy shares at a discount. This is a contingent share agreement.

Contingently-issuable ordinary shares are shares issuable for little, or no, cash upon the satisfaction of specified conditions, in a contingent share agreement.

EXAMPLE-contingently-issuable ordinary shares

You buy a business in exchange for your shares. If the share price falls by more than 25% in the first 6 months, you will issue more shares (free) to the vendors, as compensation.

Dilution is a reduction in earnings per share resulting from the assumption that convertible instruments are converted, that options (or warrants) are exercised, or that shares are issued upon the satisfaction of specified conditions.

EXAMPLE-dilution

You convert some low-interest debt to ordinary shares. The interest saved (earnings) decreases the earnings per share, as the additional shares in issue increase substantially.

Options, warrants and their equivalents are financial instruments that give the holder the right to purchase shares.

EXAMPLE-warrant

To reduce the interest rate of your bonds, you offer a warrant with each bond. Each warrant allows the holder to buy a share at $55 in 3 years’ time.

If the market price is above $55 at that time, the holder will exercise the warrant to buy a share at a discount. If not, the warrant will not be exercised, as the holder can buy a share cheaper in the market.

An ordinary share is an equity instrument that is subordinate to all other classes of equity instruments.

Ordinary shares participate in profit only after other types of shares (such as preference shares) have participated. An undertaking may have more than one class of ordinary shares. Ordinary shares of the same class have the same rights to receive dividends.

A potential ordinary share is a financial instrument (or other contract) that may entitle its holder to ordinary shares.

Examples of potential ordinary shares are:

(i) financial liabilities (or equity instruments), including preference shares, that are convertible into ordinary shares;

(ii) options and warrants;

(iii) shares that would be issued upon the satisfaction of conditions resulting from contractual arrangements, such as the purchase of a business, or other assets.

EXAMPLE- potential ordinary share

Your preferred shares can be converted into an equal number of ordinary shares in 2 years’ time.

They represent potential ordinary shares, even though you do not know whether the holders will convert them. (It will depend on the prices of each class of share at the time.)

If the price of the ordinary share is higher than that of the preferred share, the holders will convert, and will make a profit. If the price is lower, they will not).

Put options on ordinary shares are contracts that give the holder the right to sell ordinary shares, at a specified price, for a given period.

EXAMPLE- put options on ordinary shares

You issue a new class of shares at $10 per share. A put option allows the holder to sell back the share to the company in 4 years’ time for $16. If the price in the market is lower than $16, the holder will sell you the share. If the price is higher, the holder will make more profit selling in the market.

EXAMPLES-preference shares

You have reserves of $100m. Your preference dividend will cost $75m. This will be paid in full before the ordinary shareholders receive any dividend. Their dividend will be a maximum of $25m.

You have reserves of $75m. Your preference dividend will cost $75m. This will be paid in full before the ordinary shareholders receive any dividend. The ordinary shareholders will receive nothing.

If you have no reserves, no preference dividend can be paid.

IAS 32 defines financial instrument, financial asset, financial liability, equity instrument and fair value, and provides guidance on applying those definitions.

Basic Earnings per Share

An undertaking shall calculate basic earnings per share amounts for profit attributable to ordinary equity holders of the parent undertaking and, if presented, profit from continuing operations, attributable to those equity holders.

EXAMPLE- profit from continuing operations

Your retail business is being sold, and has been classified as held-for sale (see IFRS 5). Your remaining business is a wholesale operation. This is the continuing operation. You will show the earnings per share for the whole business, and a separate calculation for the earnings per share, based on the continuing operation alone.

Basic earnings per share shall be calculated by dividing profit attributable to ordinary shareholders of the parent undertaking (the numerator) by the weighted-average number of ordinary shares outstanding (the denominator) during the period.

EXAMPLE-basic earnings per share

Your net profit after tax, preference dividends and minority interests is $500m. You have 25m shares. The earnings per share = 500/25 = $20 per share.

The objective of basic earnings per share information is to provide a measure of the interests of each ordinary share of a parent undertaking, in the performance over the reporting period.

Earnings

For the purpose of calculating basic earnings per share, the amounts attributable to ordinary equity holders of the parent undertaking, in respect of:

(i) profit from continuing operations, attributable to the parent undertaking; and

(ii) profit attributable to the parent undertaking

shall be adjusted for the after-tax amounts of preference dividends, differences arising on the settlement of preference shares, and other similar effects of preference shares classified as equity.

Include all items of income and expense, attributable to ordinary equity holders of the parent undertaking, that are recorded in a period, (including tax expense and dividends on preference shares).

The after-tax amount of preference dividends that is deducted from profit (or loss) is:

(i) the after-tax amount of any dividends on non-cumulative preference shares, declared in respect of the period; and

EXAMPLE-non-cumulative preference shares

In period 1, you do not pay the dividend on the non-cumulative preference shares of $140m In period 2, you pay $140m preference dividend relating to the period. For period 1, no preference dividend expense has been incurred. For period 2, you include $140m as the expense of the preference dividend.

Contrast this with cumulative preference shares (see below).

(ii) the after-tax amount of the dividends for cumulative preference shares required for the period, whether or not the dividends have been declared.

Exclude the amount of any dividends for cumulative preference shares paid (or declared) during the current period, in respect of previous periods.

EXAMPLE-cumulative preference shares

In period 1, you do not pay the dividend on the cumulative preference shares of $80m. In period 2, you pay $80m preference dividend relating to period 1, and another $80m for period 2.

In both periods, you include $80m as the expense of the preference dividend.

Preference shares, that provide for a low initial dividend to compensate an undertaking for selling the preference shares at a discount, or an above-market dividend in later periods to compensate investors for purchasing preference shares at a premium, are sometimes referred to as ‘increasing rate’ preference shares.

Any original issue discount (or premium) on ‘increasing rate’ preference shares is amortised to retained earnings, using the effective interest method, and treated as a preference dividend for the purposes of calculating earnings per share.

EXAMPLE-original issue discount

You have sold $100 preference shares at $96. (However, you will repay the owner of the share $100 at the end of the life of the preference share.)The $4 is amortised to retained earnings over the life of the preference share. No amount is recorded in the income statement for this amortisation. For earnings per share purposes, the amortised amount is added to the preference dividend in each period.

Preference shares may be repurchased under a tender offer to the holders.

The excess of the fair value of the consideration (paid to the preference shareholders) over the carrying amount of the preference shares, represents a return to the holders of the preference shares, and a charge to retained earnings for the undertaking.

This amount is deducted in calculating profit (or loss) attributable to ordinary equity holders of the parent undertaking.

EXAMPLE-repurchase of preference shares

You had issued preference shares at $100 each 10 years ago. You now have some spare cash, and buy back the shares for $114 each. The $14 premium for each share is charged to retained earnings. No amount is recorded in the income statement for this transaction. However, for earnings per share purposes, the $14 for each share is charged in the period of the transaction.

Early conversion of convertible preference shares may be encouraged by favourable changes to the original conversion terms, or the payment of additional consideration.

The excess of the fair value of the ordinary shares (or other consideration paid over the fair value of the ordinary shares issuable under the original conversion terms) is a return to the preference shareholders, and is deducted in calculating profit attributable to ordinary shareholders.

EXAMPLE-conversion of preference shares 1

You had issued preference shares at $50 each 6 years ago. The holders now convert each share into an ordinary share. The current market price of an ordinary share is $62 each. For earnings per share purposes, the $12 premium for each share is charged in the period of the transaction.

If the company can force the holders to convert when the price is below $50, the discount will be credited to the calculation of earnings for earnings per share.

Any excess of the carrying amount of preference shares (over the fair value of the consideration paid to settle them) is added in calculating profit attributable to ordinary shareholders.

EXAMPLE-conversion of preference shares 2

You had issued preference shares at $10 each 5 years ago. The holders now must convert each share into an ordinary share. The current market price of an ordinary share is $8 each. For earnings per share purposes, the $2 discount for each share is credited in the period of the transaction.

Shares

For the purpose of calculating basic earnings per share, the number of ordinary shares shall be the weighted-average number of shares, outstanding during the period.

The weighted-average number of shares outstanding during the period is the number of shares outstanding at the start of the period, adjusted by the number of shares bought back (or issued) during the period multiplied by a time-weighting factor.

The time-weighting factor is the number of days that the shares are outstanding, as a proportion of the total number of days in the period; a reasonable approximation of the weighted-average is often adequate.

EXAMPLES-weighted-average shares

Your period is a calendar year.

On January 1^st , there were 100 shares. This rose to 150 on July 1^st . The weighted average for the period (ending 31^st December) was 125.

On January 1^st , there were 400 shares. This rose to 600 on April 1^st . The weighted average for the period (ending 31^st December) was 550.

(For 1 quarter, there were 400 shares; for 3 quarters, there were 600.)

Shares are usually included in the weighted-average number of shares from the date consideration is receivable (which is generally the date of their issue), for example:

(i) shares, issued in exchange for cash, are included when cash is receivable;

(ii) shares, issued on the voluntary reinvestment of dividends, are included when dividends are reinvested;

EXAMPLE- dividends are reinvested

The board declares a dividend on June 15^th . It will be paid on June 30^th . You decide to receive extra shares for your dividend, rather than cash. These shares will be included in the weighted-average calculation from June 30^th .

(iii) shares issued, as a result of the conversion of a debt instrument to shares, are included from the date that interest ceases to accrue;

EXAMPLE-date that interest ceases to accrue 1

You hold a bond. You will receive interest until August 31^st , after which it will be converted into a share. The share will be included in the weighted-average calculation from September 1st.

(iv) shares issued, in place of interest (or principal on other financial instruments) are included from the date that interest ceases to accrue;

EXAMPLE-date that interest ceases to accrue 2

You hold a bond. The company is having cash flow problems. Instead of receiving interest for the period March 1^st —August 1^st , you will receive a share. You will receive the share on August 20^th .

The share will be included in the weighted-average calculation from March 1st., when interest ceased to accrue.

(v) shares, issued in exchange for the settlement of a liability, are included from the settlement date;

EXAMPLE- shares issued in exchange for the settlement of a liability

In payment for fees, your professional advisors agree to receive shares. Your shares are issued on May 4^th , and this is considered to be the settlement date

These shares will be included in the weighted-average calculation from May 4^th .

(vi) shares, issued as consideration for the acquisition of an asset other than cash, are included as of the date on which the acquisition is recorded; and

EXAMPLE- shares issued as consideration for the acquisition of an asset

Rather than pay cash, you issue shares to buy a building. The acquisition of the building is recorded in your books on February 21^st . The shares will be included in the weighted-average calculation from February 21^st .

(vii) shares, issued for the rendering of services, are included as the services are rendered.

EXAMPLE- shares issued for the rendering of services

In payment for fees for achieving a stock-exchange listing, your professional advisors agree to receive shares. Your shares are issued on May 14^th , but you do not give your advisors their shares until July 31st.

These shares will be included in the weighted-average calculation from May 14^th , as this was when the services were rendered.

Shares issued, as part of the purchase consideration of an acquisition, are included in the weighted-average number of shares from the date of the acquisition. The acquirer incorporates the results of the acquiree from that date.

EXAMPLE- shares issued as consideration for the acquisition of a company

Rather than pay cash, you issue shares to buy a company. The acquisition of the company is recorded in your books on November 1^st . The shares will be included in the weighted-average calculation from November 1^st .

Shares, that will be issued upon the conversion of a mandatorily convertible instrument, are included in the calculation of basic earnings per share from the date the contract is entered into.

EXAMPLE- conversion of a mandatorily convertible instrument

You issue preference shares in 2XX8. In 2X14, each will exchanged for an ordinary share. They will be included in the calculation of basic earnings per share from 2XX8. Any preference dividend will be excluded from the calculation.

Contingently-issuable shares are treated as outstanding, and are included in the calculation of basic earnings per share, only from the date when all necessary conditions are satisfied (i.e. the events have occurred).

EXAMPLE- contingently-issuable shares

You buy a company for shares in 2XX7. If the profits for calendar years 2XX7 and 2XX8 meet budget, you will issue more shares to the vendor in February 2XX9. These additional shares will be included in the weighted-average calculation from January 1st 2XX9, if the targets are met.

Shares that are issuable solely after the passage of time are not contingently-issuable shares, because the passage of time is a certainty.

Outstanding shares that are contingently-returnable (subject to recall) are not treated as outstanding, and are excluded from the calculation of basic earnings per share, until the date the shares are no longer subject to recall.

EXAMPLE- contingently- returnable shares

You issue 100m shares in 2XX5 at $10 each. These are a new class of ordinary shares that can be cancelled by the company in 2X10, if the holders are paid $16 each. They will be excluded from the calculation of basic earnings per share, until 2X11. In 2X11, the shares will no longer subject to recall.

Shares may be issued, or reduced, without a corresponding change in resources.

EXAMPLES-no change in resources

(i) a capitalisation or bonus issue (sometimes referred to as a stock dividend); Rather than pay a cash dividend, you give shareholders additional shares.

(ii) a bonus element in any other issue, for example a bonus element in a rights issue to existing shareholders;

If shareholders hold their shares for 3 years, they will receive 1 bonus share for each 10 shares they own.

(iii) a share split; and

You have 2m shares. The market price is $1.000 each. You change the shares to 200m of $10 each, to make each share less expensive.

(iv) a reverse share split (consolidation of shares).

You have 100m shares in issue.

Your shares have a market value of $0.50 each, following losses. You decide to consolidate the shares into 2m shares of $25 each.

A consolidation of shares generally reduces the number of shares outstanding, without a corresponding reduction in resources.

In a capitalisation issue (or bonus issue or a share split), shares are issued to existing shareholders, for no additional consideration. The number of shares outstanding is increased without an increase in resources.

The number of shares, outstanding before the event, is adjusted for the proportionate change in the number of shares outstanding, as if the event had occurred at the start of the earliest period presented.

EXAMPLE-adjustment to the earliest period presented

You have consolidated your shares in 2XX9, from $2 to $30. You present years 2XX5-2XX9 in your accounts. All weighted-average share figures from 2XX5-2XX8 should be divided by 15 ($30/$2) to be comparable with 2XX9.

In a two-for-one bonus issue, the number of shares, outstanding before the issue, is multiplied by three, to obtain the new total number of shares.

When the overall effect is a share repurchase at fair value, the reduction in the number of shares outstanding is the result of a corresponding reduction in resources.

An example is a share consolidation combined with a special dividend. The weighted-average number of shares outstanding for the period in which the combined transaction takes place, is adjusted for the reduction in the number of shares, from the date the special dividend is recognised.

EXAMPLE-share consolidation combined with a special dividend

You decide to consolidate your shares from 15^th September. 20*$1 shares will be replaced by 1*$20 share. On September 30^th, each $20 shareholder will receive a special dividend of $1 per share. The revised number of shares will be included in the weighted-average calculation from September 30^th .

Diluted Earnings per Share

If there are no potential shares outstanding, there will be no diluted earnings per share. If there are, diluted earnings per share will be required, wherever basic earnings per share are presented.

For the purpose of calculating diluted earnings per share, an undertaking shall adjust profit, and the weighted-average number of shares outstanding, for the effects of all dilutive potential shares.

EXAMPLE- diluted earnings per share – convertible bonds

You have 100m* $10 shares in issue. You also have 2m*$100 convertible bonds. The bonds have an interest rate of 8%. The tax rate =25%. Each bond will be convertible into 10 shares. Earnings for the period were $740m.

The basic earnings per share calculation =$740m/100m = $7,40 per share.

To calculate the diluted earnings per share:

1. Add back the cost of interest that was payable on the bonds. The amount is to be calculated after tax: 2m* $100*8%*(1-25%)=$12m. The profit excluding the interest payment = $740m + $12m = $752m.

2. Add the number of new shares that would be issued, if all bonds were converted, to the current number of shares: 2m*10shares= 20m + 100m =120m shares and potential shares.

3. Divide the revised profit by the revised number of shares: $752m / 120m shares and potential shares = $6,27 per share.

Analysis.

The bonds may be converted in the future. If they were converted today, earnings per share would fall from $7,40 per share to $6,27 per share. Whilst earnings would rise, due to interest not needing to be paid, the number of shares would rise steeply to achieve this, leaving existing shareholders with less value than they currently enjoy.

The objective of diluted earnings per share is to give effect to all dilutive potential ordinary shares outstanding during the period. As a result:

(i) profit is increased by the:

- after-tax amount of dividends and

- interest recorded in the period

EXAMPLE- diluted earnings per share – convertible shares

You have 100m*$10 shares in issue. You also have 3m*$400 convertible preference shares. The shares have a dividend rate of 11%. The dividends have been paid after tax. Each convertible preference share will be convertible into 40 ordinary shares. Earnings for the period were $740m.

The basic earnings per share calculation =$740m/100m = $7,40 per share.

To calculate the diluted earnings per share:

1. Add back the cost of dividends that was payable on the shares: 3m* $400*11%=$132m

The profit excluding the preference dividend = $740m + $132m = $872m.

2. Add the number of new shares that would be issued, if all preferred shares were converted, to the current number of shares: 3m*40shares= 120m + 100m =220m shares and potential shares.

3. Divide the revised profit by the revised number of shares: $872m / 220m shares and potential shares = $3,96 per share.

Analysis.

The preference shares may be converted in the future. If they were converted today, earnings per share would fall from $7,40 per share to $3,96 per share. Whilst earnings would rise, due to preference dividends not needing to be paid, the number of shares would rise steeply to achieve this, leaving existing shareholders with less value than they currently enjoy.

in respect of the dilutive potential shares, and is adjusted for any other changes in income (or expense) that would result from the conversion of the dilutive potential shares; and

(ii) the weighted-average number of shares outstanding is increased by the weighted-average number of additional shares that would have been outstanding, assuming the conversion of all dilutive potential shares.

EXAMPLE- diluted earnings per share – convertible bonds and shares

(this combines the previous two examples)

You have 100m*$10 shares in issue. You have 2m*$100 convertible bonds. The bonds have an interest rate of 8%. The tax rate =25%. Each bond will be convertible into 10 shares. Earnings for the period were $740m.

You also have 3m*$400 convertible preference shares. The shares have a dividend rate of 11%. The dividends have been paid after tax. Each convertible preference share will be convertible into 40 ordinary shares. Earnings for the period were $740m.

The basic earnings per share calculation =$740m/100m = $7,40 per share.To calculate the diluted earnings per share:

1. Add back the cost of interest that was payable on the bonds. The amount is to be calculated after tax: 2m* $100*8%*(1-25%)=$12m

2. Add back the cost of dividends that was payable on the convertible preference shares: 3m* $400*11%=$132m

The profit excluding the preference dividend and interest payments = $740m +$12m+ $132m = $884m.

3. Add the number of new shares that would be issued, if all bonds and preferred shares were converted, to the current number of shares: (2m*10shares)+ (3m*40shares)= 20m+120m + 100m =240m shares and potential shares.

4. Divide the revised profit by the revised number of shares: $884m / 240m shares and potential shares = $4,02 per share.

Analysis.

The bonds and preference shares may be converted in the future. If they were converted today, earnings per share would fall from $7,40 per share to $4,02 per share.

Earnings

For the purpose of calculating diluted earnings per share, an undertaking shall adjust profit by the after-tax effect of:

(i) any dividends (or other items) related to dilutive potential shares, deducted in arriving at profit;

(ii) any interest recognised in the period, related to dilutive potential shares; and

(iii) any other changes in income (or expense), that would result from the conversion of the dilutive potential shares.

After the potential shares are converted into shares, the above 3 issues ((i)-(iii)) disappear. Instead, the new shares are entitled to participate in profit.

Therefore, profit is adjusted for the items identified in (i)-(iii) and any related taxes.

The expenses associated with potential shares include transaction costs and discounts.

EXAMPLE-expenses

You have 100m*$10 shares in issue. You also have 3m*$400 convertible preference shares. The shares have a dividend rate of 11%. The dividends have been paid after tax. Each convertible preference share will be convertible into 40 ordinary shares. Earnings for the period were $740m.

For conversion, the professional expenses for registration and tax are 1% of the total value of the new shares to be issued.

The basic earnings per share calculation =$740m/100m = $7,40 per share.

To calculate the diluted earnings per share:

1. Add back the cost of dividends that was payable on the shares: 3m* $400*11% =$132m

2. Calculate the cost of conversion: 3m* $400*1%=$12m

The profit excluding the preference dividend, but adding the cost of conversion = $740m + $132m -$12m= $860m.

3. Add the number of new shares that would be issued, if all preferred shares were converted, to the current number of shares: 3m*40shares= 120m + 100m =220m shares and potential shares.

4. Divide the revised profit by the revised number of shares: $860m / 220m shares and potential shares = $3,91 per share.

Analysis.

The preference shares may be converted in the future. If they were converted today, earnings per share would fall from $7,40 per share to $3,91 per share. The costs of conversion =$0,05 per share ($3,96-$3,91).

The conversion of potential shares may lead to consequential changes in income, or expenses. The reduction of interest expense related to potential shares, and the resulting increase in profit may lead to an increase in the expense related to an employee profit-sharing plan.

For the purpose of calculating diluted earnings per share, profit is adjusted for any such changes in income, or expense.

EXAMPLE-employee profit-sharing plan

Your employees benefit from an employee profit-sharing plan, which provides 5% of net profit after tax, as calculated for basic earnings per share or diluted earnings per share, whichever is the lower.

Using the previous example, diluted earnings per share are lower, so the calculation will be: 5% of $860m = $43m.

The revised diluted earnings per share would be = $860m-$43m = $817m / 220m shares and potential shares = $3,71

Basic earnings are $740m. 5% would yield $37m.

The revised basic earnings per share would be: ($740m-$43m)/100m shares = $6,97 per share.

Shares

For the purpose of calculating diluted earnings per share, the number of shares shall be the weighted-average number of shares, plus the weighted-average number of shares that would be issued on the conversion of all the dilutive potential shares into shares.

Dilutive potential shares shall be deemed to have been converted into shares at the start of the period or, if later, the date of the issue of the potential shares.

Dilutive potential shares shall be determined independently for each period presented. The number of dilutive potential shares, included in the year-to-date period, is not a weighted-average of the dilutive potential shares, included in each interim computation.

Potential shares are weighted for the period they are outstanding. Potential shares, that are cancelled (or allowed to lapse) during the period, are included in the calculation of diluted earnings per share only for the portion of the period during which they are outstanding.

EXAMPLE-lapsed shares

You are producing the accounts for 2XX8. On January 1^st , there were 5m potential shares. Most of these related to directors’ share option schemes. On June 30^th , a director left, and his 1m share options were cancelled.

This reduced the potential shares to 4m. This figure remained unchanged until December 31^st . The potential shares would be 5m for the first half-year, and 4m for the second half-year.

Potential shares, that are converted into shares during the period, are included in the calculation of diluted earnings per share from the start of the period to the date of conversion; from the date of conversion, the resulting shares are included in both basic (and diluted) earnings per share.

The number of shares that would be issued on conversion of dilutive potential shares is determined from the terms of the potential shares. When more than one basis of conversion exists, the calculation assumes the most advantageous conversion rate (or exercise price) for the holder of the potential shares.

EXAMPLE-most advantageous conversion rate

You issued some preference shares for $100 each, five years ago. The holders have the option next year to convert their shares into cash, for $125 per share, or alternatively for one ordinary share.

Your ordinary shares were trading at $143 per share at the balance sheet date. For the calculation, it should be assumed that holders will choose to convert to ordinary shares, rather than receive cash.

A subsidiary, joint venture or associate may issue to parties other than the parent, venturer or investor potential ordinary shares that are convertible into either ordinary shares of the subsidiary, joint venture or associate, or ordinary shares of the parent, venturer or investor (the reporting undertaking).

If these potential ordinary shares of the subsidiary, joint venture or associate have a dilutive effect on the basic earnings per share of the reporting undertaking, they are included in the calculation of diluted earnings per share.

Dilutive Potential Shares

Potential shares shall be treated as dilutive only when their conversion to shares would reduce earnings per share from continuing operations.

An undertaking uses profit from continuing operations as the control number, to establish whether potential shares are dilutive, or antidilutive. Profit is adjusted, and excludes items relating to discontinuing operations.

Potential shares are antidilutive when their conversion to shares would increase earnings per share from continuing operations. The calculation of diluted earnings per share does not assume conversion, exercise, or other issue of potential shares that would have an antidilutive effect on earnings per share.

In determining whether potential shares are dilutive or antidilutive, each issue of potential shares is considered separately. The sequence in which potential shares are considered may affect whether they are dilutive.

To maximise the dilution of basic earnings per share, each issue of potential shares is considered in sequence, from the most dilutive to the least dilutive: dilutive potential shares with the lowest ‘earnings per incremental share’ are included in the diluted earnings per share calculation, before those with a higher earnings per incremental share.

Options and warrants are generally included first because they do not affect the numerator of the calculation.

Options, warrants and their equivalents

For the purpose of calculating diluted earnings per share, an undertaking shall assume the exercise of dilutive options and warrants of the undertaking.

The assumed proceeds from these instruments shall be regarded as having been received, from the issue of shares, at the average market price of shares during the period.

EXAMPLE-warrants-average market price

You have 200m shares in issue.You have issued warrants for 10m shares to be exercised the following year. The issue price will be $37.

The average market price of your shares during the current period was $37.

Such shares are assumed to be fairly priced, and to be neither dilutive, nor antidilutive. They are ignored in the calculation of diluted earnings per share.

The difference between the number of shares issued, and the number of shares that would have been issued at the average market price of shares during the period, shall be treated as an issue of shares for no consideration.

Options and warrants are dilutive, when they would result in the issue of shares for less than the average market price of shares during the period. The amount of the dilution is the average market price of shares during the period, minus the issue price.

EXAMPLE-warrants- below average market price

You have issued warrants for 10m shares to be exercised the following year. The issue price will be $33.

The average market price of your shares during the current period was $37.

The $4 ($37-$33) is the dilution per share of the warrants.

Such shares generate no proceeds, and have no effect on profit attributable to ordinary shares outstanding. They are dilutive, and are added to the number of shares outstanding in the calculation of diluted earnings per share.

Options and warrants have a dilutive effect, only when the average market price of shares during the period, exceeds the exercise price of the options, or warrants (i.e. they are ‘in the money’). Previously reported earnings per share are not retroactively adjusted, to reflect changes in prices of shares.

Staff share options with fixed terms are treated as options in the calculation of diluted earnings per share. They are treated as outstanding on the grant date.

EXAMPLE-staff share options

In 2XX5, you issued some staff share options that can be exercised after 3 years’ service. They are treated as outstanding on the grant date in 2XX5, for diluted earnings per share purposes.

Performance-based staff share options are treated as contingently-issuable shares, because their issue is contingent upon satisfying specified conditions,

in addition to the passage of time.

EXAMPLE-performance-based staff share options 1

In 2XX8, you issued some staff share options that can be exercised if profits for the next 3 years’ service grow by more than 10% each year. They are treated as contingently-issuable shares, for diluted earnings per share purposes. (See below)

Convertible instruments

The dilutive effect of convertible instruments shall be reflected in diluted earnings per share.

Convertible preference shares are antidilutive, whenever the amount of the dividend on such shares for the current period, exceeds basic earnings per share.

EXAMPLE-convertible preference shares – antidilutive

The dividend on your convertible preference shares is 15%. The earnings per share was 12% of the average market price of the share. As each preference share earned more, it is antidilutive.

Similarly, convertible debt is antidilutive when its interest (net of tax and other changes in income, or expense) per ordinary share obtainable on conversion, exceeds basic earnings per share.

EXAMPLE-convertible debt – antidilutive

The interest cost of your convertible bonds is 11% after tax. The earnings per share was 8% of the average market price of the share. As each bond earned more, it is antidilutive.

Contracts that may be settled in ordinary shares (or cash)

When an undertaking has issued a contract that may be settled in shares, or cash at the undertaking’s option, the undertaking shall presume that the contract will be settled in shares, and the resulting potential shares shall be included in diluted earnings per share, if the effect is dilutive.

EXAMPLE-cash or shares 1

You are buying a building. The vendor gives you the option to pay the $10m in cash, or by issuing shares to the same value.

For the purpose of diluted earnings per share calculations, you assume that payment will be made in shares. If the shares are issued at below market price, you include them in the calculation.

For contracts that may be settled in shares, or cash at the holder's option, the more dilutive of cash settlement and share settlement, shall be used in calculating diluted earnings per share.

EXAMPLE-cash or shares 2

An example of a contract that may be settled in shares, or cash, is a debt instrument that, on maturity, gives the undertaking the unrestricted right to settle the principal amount in cash, or in its own shares.

Another example is a written put option, that gives the holder a choice of settling in shares, or cash.

Average Market Price of Ordinary Shares

To calculate diluted earnings per share, the average market price of shares is calculated on the basis of the average market price of the shares during the period.

A simple average of weekly (or monthly) prices is usually adequate.

Generally, closing market prices are adequate for calculating the average market price. When prices fluctuate widely, an average of the high and low prices produces a more representative price. The method used to calculate the average market price is used consistently, unless it is no longer representative.

An undertaking that uses closing market prices to calculate the average market price for several years of relatively stable prices, might change to an average of high and low prices, if prices start fluctuating, and the closing market prices no longer produce a representative average price.

Purchased options

Contracts, such as purchased put options and purchased call options (i.e. options held by the undertaking on its own shares) are not included in the calculation of diluted earnings per share, as including them would be antidilutive.

The put option gives the company the right to sell shares, if it wishes. It would be exercised only if the exercise price were higher than the market price.

A call option allows the company to buy shares at a fixed price. This would reduce the capital of the company. A call option would be exercised only if the exercise price were lower than the market price.

Written put options

Contracts that require the undertaking to repurchase its own shares, such as written put options and forward purchase contracts, are reflected in the calculation of diluted earnings per share, if the effect is dilutive.

EXAMPLE-put option

You have bought the right to sell a share at $150. The right lasts for a 3-month period. If the market price is $130, you can buy a share at $130 and sell it for $150, making a profit of $20.

If the period has not expired, you may wish to wait, hoping that the market price will fall further. If the market price falls to less than $130, your profit will increase.

Any price below $150 is called ‘in the money’, as a profit can be made.

Any price above $150 is ‘out of the money’, as no profit can be made at that price

If these contracts are ‘in the money’ during the period (ie the exercise ‘settlement’ price is above the average market price for that period), the potential dilutive effect on earnings per share is calculated.

Rights Issues

The issue of shares, at the time of exercise (or conversion) of potential shares does not usually give rise to a bonus element. This is because the potential shares are usually issued for full value, resulting in a proportionate change in the resources available to the undertaking.

Where the rights are to be publicly traded separately from the shares before the exercise date, fair value for the purposes of this calculation is established, at the close of the last day on which the shares are traded together with the rights.

Options, Warrants and Their Equivalents

Options (or warrants) to purchase convertible instruments are assumed to be exercised to purchase the convertible instrument, whenever it is profitable to do so.

In the calculation of diluted earnings per share, those options (or warrants) have a dilutive effect if the holder buys or sells at a better price than would be achieved in the market.

If tendering cash is more advantageous to the option (or warrant) holder and the contract permits tendering cash, tendering of cash is assumed

Similar treatment is given to preference shares that have similar provisions (or to other instruments) that have conversion options, that permit the investor to pay cash for a more favourable conversion rate.

The underlying terms of certain options (or warrants) may require the proceeds received from the exercise of those instruments to be applied to redeem debt, or other instruments, of the undertaking (or its parent or a subsidiary).

In the calculation of diluted earnings per share, those options (or warrants) are assumed to be exercised, and the proceeds applied to purchase the debt, at its average market price, rather than to purchase ordinary shares.

However, the excess proceeds received from the assumed exercise, over the amount used for the assumed purchase of debt, are considered (assumed to be used to buy back ordinary shares) in the diluted earnings per share calculation. Interest (net of tax) on any debt assumed to be purchased, is added back as an adjustment to the profit.

Written put options

EXAMPLE-written put options

An undertaking has outstanding 120 written put options on its shares with an exercise price of $35 (=$4,200). The average market price of its shares for the period is $28.

In calculating diluted earnings per share, the undertaking assumes that it issued 150 shares at $28 per share at the start of the period to satisfy its put obligation of $4,200.

The difference between the 150 shares issued and the 120 shares received from satisfying the put option (30 incremental shares) is added to the denominator in calculating diluted earnings per share.

Partly-Paid Shares

Where shares are issued but not fully paid, they are treated in the calculation of basic earnings per share as a fraction of a share, to the extent that they were entitled to participate in dividends, during the period relative to a fully-paid share.

To the extent that partly-paid shares are not entitled to participate in dividends during the period, they are treated as the equivalent of warrants (or options) in the calculation of diluted earnings per share. The unpaid balance is assumed to represent proceeds used to purchase ordinary shares.

The number of shares included in diluted earnings per share is the difference between the number of shares subscribed, and the number of shares assumed to be purchased.

ACCA Past papers - Dec 2018 (20 marks)

IAS® 33 – Earnings per Share – sets out requirements for the calculation and presentation of earnings per share in financial statements of listed entities. The requirements include the disclosure of basic earnings per share and, where an entity has potential ordinary shares in issue, the additional disclosure of diluted earnings per share in certain circumstances.

Kappa is a listed entity with a number of subsidiaries. Extracts from the consolidated statement of profit or loss and other comprehensive income of Kappa for the year ended 30 September 2018 appear below:
Attributable Non-controlling Total to Kappa interest
$’000 $’000 $’000
Profit for the year 39,000 3,000 42,000
Other comprehensive income 5,000 Nil 5,000
Total comprehensive income 44,000 3,000 47,000
The long-term finance of Kappa comprises:
(i) 200 million ordinary shares in issue at the start of the year. On 1 January 2018, Kappa issued 50 million new ordinary shares at full market value.
(ii) 80 million irredeemable preference shares. These shares were in issue for the whole of the year ended 30 September 2018. The dividend on these preference shares is discretionary.
(iii) $180 million 6% convertible loan stock issued on 1 October 2016 and repayable on 30 September 2021 at par. Interest is payable annually in arrears. As an alternative to repayment at par, the lenders on maturity can elect to exchange their loan stock for 100 million ordinary shares in Kappa. On 1 October 2016, the prevailing market interest rate for five-year loan stock which had no right of conversion was 8%. Using an annual discount rate of 8%, the present value of $1 payable in five years is $0·68 and the cumulative present value of $1 payable at the end of years one to five is $3·99.

In the year ended 30 September 2018, Kappa declared an ordinary dividend of 10 cents per share and a dividend of 5 cents per share on the irredeemable preference shares. The annual rate of income tax applicable to Kappa and its subsidiaries is 20%. All transactions have been correctly accounted for in the financial statements of Kappa for the year ended 30 September 2018.
Required:
(a) Explain the meaning of the term ‘potential ordinary shares’ and provide TWO examples of potential ordinary shares OTHER THAN convertible loans. (3 marks)
(b) Explain how the diluted earnings per share is calculated and when it needs to be disclosed. (3 marks)
(c) Compute the finance cost of the convertible loan stock which will be shown in the consolidated statement of profit or loss of Kappa for the year ended 30 September 2018 and the related loan liability which will be shown in the consolidated statement of financial position of Kappa at 30 September 2018. (6 marks)
(d) Compute the basic and diluted earnings per share amounts for Kappa for the year ended 30 September 2018 which will be presented in its consolidated financial statements for that year.

Answer