Question

3. Discuss the accounting treatment, if any, that should be given to each of the following items in computing earnings per share of ordinary shares for financial statement reporting.

a) Outstanding preference shares issued at a premium with a par value liquidation right.

b) The exercise at a price below market value but above book value of an ordinary share option issued during the current fiscal year to officers of the corporation.

c) The replacement of a machine immediately prior to the close of the current fiscal year at a cost 20% above the original cost of the replaced machine. The new machine will perform the same function as the old machine that was sold for its book value.

d) The declaration of current dividends on cumulative preference shares.

e) The acquisition of some of the corporation's outstanding ordinary shares during the current fiscal year. The shares were classified as treasury shares.

f) A 2-for-1 share split of ordinary shares during the current fiscal year.

g) A provision created out of retained earnings for a contingent liability from a possible lawsuit.

Answer 1

Answer 2

Earning Per Share is earnings available per share to ordinary shareholders. It is a useful to measure for tracking performance over a long time period.

EPS=Total Earnings/Outstanding Shares

Total Earnings available to Ordinary Shareholder=Net Income after tax -Preference dividend

Outstanding Shares= Shares Outstanding as on balance sheet date eligible for the dividend.

a)Outstanding preference shares issued at a premium with a par value liquidation right.

Preference Shares issued at a premium will be paid dividends on face value only, hence the issue of preference shares and par value; liquidation will not affect the dividend on it.

Hence in this case,

EPS=Net Profit after Tax-Preference dividend on face value/Outstanding Ordinary Shares.

b) Officers of corporation opting for options at an exercise price below market value but above book value

Options given to officers for a price above book value but below market value, when exercised by them, leads to an increase in outstanding ordinary shares and the premium collected

on shares will be reflected in the balance sheet through Retained Earnings.

The issue of shares options does not affect earnings (Net Profit after Tax) available to ordinary shareholders.

Hence EPS=Net Profit after Tax-Preference dividend(If any)/Outstanding Ordinary Shares

Outstanding Ordinary Shares=Opening Number of ordinary Shares+ Number of Shares issued to officers as options.

c)Replacement of Machine at a cost of 20% above the original cost of the machine replaced. Machine replaced was sold at book value.

Replacement of Machine is a capital expenditure affecting Balance sheet and reflected in fixed assets of the corporation. However, the Sale value of the old machine affects the Net Profit of the corporation.

In this case, the old Machine is sold at book value which neither generates profit or loss on disposal. Hence there is no effect on Net profit before Tax.

Further, there is no effect on Outstanding Ordinary shares also.

Hence EPS=Net Profit after Tax-Preference dividend(If any)/Outstanding Ordinary Shares

e)Acquisition of corporation outstanding shares and classified at treasury shares.

Treasury Stock refers to the stock bought back from the shareholders by the issuing company. The result is that the total number of outstanding shares in the open market decreases.

These shares are issued but no longer outstanding and are not included for the distribution of dividends or calculation of EPS.

Hence EPS=Net Profit after Tax-Preference dividend(If any)/Outstanding Ordinary Shares

Outstanding Ordinary Shares= Number of shares outstanding in the beginning-Number of shares bought back

f)2 for 1 split of Ordinary shares

Split of 2 for 1 share increase the number of outstanding share by 2 times.

The split of shares does affect Net Profit before Tax.

Hence EPS=Net Profit after Tax-Preference dividend(If any)/Outstanding Ordinary Shares

Outstanding Ordinary Shares= Number of shares outstanding in the beginning*2

g)Provision created out of Retained Earnings for contingent Liability of possible lawsuit.

Provision for a contingent liability is created out of retained earnings of the corporation.

Hence it will not affect net profit after tax available for Ordinary Shareholders.

Hence EPS=Net Profit after Tax-Preference dividend(If any)/Outstanding Ordinary Shares