Intermediate Accounting — Earnings per Share: Weighted Average Shares and Dilution

Earnings per share (EPS) is the profit earned by one ordinary share in a period. As the denominator of the price-earnings ratio (PER), it is among the figures investors look at most often. K-IFRS 1033 (IAS 33) requires listed companies and others to present basic EPS and diluted EPS on the face of the income statement. The accounting for equity transactions was covered in chapter 9 and share options in chapter 15.

1. Basic earnings per share

A. Weighted average number of ordinary shares

Shares are weighted by the time they are outstanding. However, transactions that change the number of shares without a change in resources (bonus issues, stock dividends, share splits) are adjusted retrospectively as if they had occurred at the start of the period, and comparative EPS is restated too.

Company QQ’s figures for 20X1: 10,000 shares outstanding at the start of the year; 3,000 shares issued at market price on 1 April; a 10% bonus issue on 1 July; 1,200 treasury shares bought on 1 October.

The bonus issue applies to both the existing shares and the April issue, so both are multiplied by 1.1. The treasury shares were bought after the bonus issue, so no adjustment is made. When a rights issue is offered to shareholders below market price, it combines an issue at fair value with a bonus element, and the bonus element is separated and adjusted retrospectively.

With profit of ₩20 million and cumulative preference dividends of ₩2 million, basic EPS is $18{,}000{,}000 / 13{,}175 ≈$ ₩1,366.

2. Diluted earnings per share

Diluted EPS assumes that all potential ordinary shares (share options, convertible bonds, convertible preference shares, etc.) have been converted into ordinary shares. Only dilutive items are included; any that would increase EPS (antidilutive) are excluded.

A. Share options: the treasury stock method

When options are exercised, the company receives the exercise price in cash. It is assumed to use that cash to buy back shares at the average market price, and only the net shares issued for nothing are added to the denominator. The numerator is not adjusted.

For 1,000 options with an exercise price of ₩8,000 and an average share price for the period of ₩10,000, the ₩8 million of exercise proceeds would buy back 800 shares. The incremental shares are $1{,}000 - 800 = 200$. If the exercise price exceeds the average share price, the options are antidilutive and excluded.

B. Convertible bonds: the if-converted method

The convertible bond is assumed to have been converted at the start of the period (or at issue). The shares on conversion are added to the denominator, and after-tax interest expense is added to the numerator, because interest would not have been paid had the bond been converted.

If QQ has had a convertible bond since the start of the year with interest expense of ₩1 million (tax rate 20%) and 1,000 shares issuable on conversion, the numerator adjustment is ₩800,000 and the denominator adjustment 1,000 shares.

C. Order of inclusion

When there are several potential ordinary shares, they are added in order from the lowest earnings per incremental share, testing for dilution at each step. The options’ earnings per incremental share are ₩0 ($0/200$) and the convertible bond’s ₩800 ($800{,}000/1{,}000$).

Diluted EPS is ₩1,308. Had adding the convertible bond pushed EPS above ₩1,346, it would be antidilutive and excluded, and ₩1,346 would be used.

Check your understanding

Company RR’s profit for 20X1 is ₩33 million and it has no preference shares. It had 20,000 shares outstanding at the start of the year, issued 6,000 shares at market price on 1 May, and paid a stock dividend of 0.2 shares per share on 1 September. What is basic EPS?

The stock dividend applies retrospectively to both the opening shares and the May issue. The opening shares become $20{,}000 \times 1.2 = 24{,}000$ (12 months) and the May issue $6{,}000 \times 1.2 = 7{,}200$, weighted by 8/12 to 4,800. The weighted average number of ordinary shares is 28,800, and basic EPS is $33{,}000{,}000 / 28{,}800 ≈$ ₩1,146.

References

• Korea Accounting Standards Board, K-IFRS 1033 Earnings per Share
• IASB, IAS 33 Earnings per Share
• Donald Kieso, Jerry Weygandt and Terry Warfield, Intermediate Accounting: IFRS Edition, ch. 16