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Outline the main contents of the International Accounting standard 33 (IAS33) EPS

Outline the main contents of the International Accounting standard 33 (IAS33) EPS

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Expert Solution

IAS33 is very broad and detailed standard that lays down the importance and method of presentation of EPS. I have tried to summarize below the main content:

EPS shows net income earned in lieu of each equity share and helps in calculating return on equity and valuation multiples to determine if investment should be made in company’s equity share capital. Increase in EPS over years is indicative of successful management and effective policy and decision-making and vice-versa. Earnings for ordinary shareholders are net income available after preferred dividend payments

Thus BEPS uses actual earnings after preferred stock dividends. Common stock dividends are not subtracted from net income. Weighted average number of common shares is the number of shares outstanding during the year weighted by the period they were outstanding for in a year.

While calculating BEPS, please note that:

  • A stock split or a stock dividend is considered to contribute to total numbers of outstanding shares right from the beginning of the period (even if they occur any time during the year) for which EPS is being calculated.
  • For cumulative preferred stock, only the current year’s preferred dividends are subtracted in the calculation, whether or not this dividend is paid. Cumulative preferred dividends in arrears are not included.

Diluted EPS (DEPS) is the EPS if all convertible securities were exercised and is mathematically given as:

Tax rate in the formula above should be marginal tax rate. DEPS thus accounts for the complex capital structure of a firm (lack of convertible securities in the capital structure of a firm make it simple). It is a performance metric used to gauge the quality of a company's earnings and in a way presents the worst case scenario for EPS. Convertible securities refers to all outstanding convertible preferred shares, convertible debentures, stock options (primarily employee based) and warrants.
DEPS is thus an extension of earnings per share. It shows net income earned in lieu of each equity share post accounting for EPS dilutive securities such as share warrants, convertible debentures and preference shares. Equivalent equity shares for convertible securities are added to outstanding equity shares to calculate diluted EPS. It highlights the impact of EPS dilution and thereby, dilution of existing investor return due to issue of convertible securities. A large difference between EPS and diluted EPS for a company indicates potential reduction in returns for the original investors.

Thus BEPS uses actual earnings after preferred stock dividends. Common stock dividends are not subtracted from net income. Weighted average number of common shares is the number of shares outstanding during the year weighted by the period they were outstanding for in a year.

While calculating BEPS, please note that:

  • A stock split or a stock dividend is considered to contribute to total numbers of outstanding shares right from the beginning of the period (even if they occur any time during the year) for which EPS is being calculated.
  • For cumulative preferred stock, only the current year’s preferred dividends are subtracted in the calculation, whether or not this dividend is paid. Cumulative preferred dividends in arrears are not included.

Diluted EPS (DEPS) is the EPS if all convertible securities were exercised and is mathematically given as:

4Diluted Earnings per share=DEPS= Net income-Preferred dividends+Convertible preferred dividend+convertible debt interest*(1-tax rate)Diluted Weighted average nos. of shares outstanding

Tax rate in the formula above should be marginal tax rate. DEPS thus accounts for the complex capital structure of a firm (lack of convertible securities in the capital structure of a firm make it simple). It is a performance metric used to gauge the quality of a company's earnings and in a way presents the worst case scenario for EPS. Convertible securities refers to all outstanding convertible preferred shares, convertible debentures, stock options (primarily employee based) and warrants.

DEPS is thus an extension of earnings per share. It shows net income earned in lieu of each equity share post accounting for EPS dilutive securities such as share warrants, convertible debentures and preference shares. Equivalent equity shares for convertible securities are added to outstanding equity shares to calculate diluted EPS. It highlights the impact of EPS dilution and thereby, dilution of existing investor return due to issue of convertible securities. A large difference between EPS and diluted EPS for a company indicates potential reduction in returns for the original investors.

While calculating DEPS, please note that:

  1. Numerator is the earnings available to common share assuming all the convertible securities were converted at the beginning of the period. Hence, impact of the conversions are adjusted in the earnings. Hence, numerator in case of DEPS = numerator in case of BEPS (Net income – preferred dividend) + dividend on convertible preferred dividend + interest on the convertible debt x (1 – tax rate).
  2. Please note that only impact due to convertible preferred stock will be adjusted here. Non-convertible preferred stock will not have any impact here.
  3. Interest on the convertible debt should be calculated as coupon rate x face value of the bond. Market interest rate will not have any role to play.
  4. Denominator will be diluted weighted nos. of shares outstanding = denominator in case of BEPS (weighted nos. of shares outstanding) + ordinary shares resulting due to assumed conversion of convertible preference shares, convertible debt, stocks options & warrants.
  5. Converted shares due to convertible preferred shares and debt will be as per respective conversion formula while that for options will be as per treasury method (Nos. of resultant shares per option = (ST – K) / ST where ST is the average common stock share price during the year and K is the strike price. Only in the money options (ST > K for call option, K > ST in case of put options) will contribute to conversion.
  6. Out of money options will have no role to play. They will not be exercised and hence not considered for DEPS calculation.
  7. When the options are issued as employee compensation, and were charged to expense. In this case, the after-tax expense must be added back to the numerator.
  8. Assume conversion of dilutive securities from the beginning of the period or from date of issue whichever is later.
  9. Note that conversion increases the number of shares outstanding but it also raises the EPS numerator. The numerator rises, because if convertible preferred stock is converted, there are no preferred stock dividends. If convertible bonds are converted, there is no interest expense, so net income goes up. If the numerator effect is greater than the denominator effect, EPS will rise and in that case it will be called anti-dilutive.
  10. Thus, firms with potentially dilutive securities will usually show 2 EPS numbers, BEPS and DEPS. However, DEPS will be shown only if conversion is dilutive.
  11. DEPS assumes that only dilutive securities are converted or exercised (included in the DEPS calculation). It assumes that anti-dilutive securities are not converted/exercised (not included in the EPS calculation).
  12. Thus, if DEPS is shown separately, BEPS ≥ DEPS.

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