- EXPLANATORY NOTE
The need for the disclosure of Earnings Per Share (EPS) is based on the increasing use of the Price/Earnings (P/E) ratio as a standard stock market indicator. The formula for the calculation of the P/E ratio is:
Market Price of Share
EPS
Therefore, the P/E ratio can be seen as a “purchase of a number of year’s earnings” but perhaps more significantly, for many investors it also represents the future prospects of the share. A higher P/E ratio is believed to indicate a faster growth in the company’s EPS in the future. Conversely, the lower the P/E ratio, the lower the expected future growth.
The continued use of P/E ratios requires that the EPS, on which that ratio is based, should be calculated and disclosed on a comparable basis as between one company and another and as between one financial period and another, so far as this is possible.
In addition to this, the trend shown by a comparison of a company’s profits over time is a rather crude measure of performance and can be misleading without careful interpretation of all the events that the company has experienced. Particularly, this would be the case where a company is enlarged by amalgamation or issues of shares for cash. Profits can be expected to increase as the resources of the company increase. Earnings Per Share will show whether profits are increasing less, equally or more than the company’s resources. As new shares are issued, a company may well show rising profits without reflecting a corresponding growth in EPS.
IAS 33 Earnings Per Share outlines the principles for the determination and presentation of EPS, in order to improve comparisons between different companies in the same reporting period and between different reporting periods for the same company.
SCOPE
IAS 33 applies to entities whose ordinary shares (or potential ordinary shares) are publicly traded and to entities that are in the process of issuing shares (or potential ordinary shares) in public securities markets.
DEFINITIONS
Ordinary Share An equity instrument that is subordinate to all other classes of equity instruments. It is an instrument that falls under the definition of “equity shares” in IAS 32, i.e. a contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities. Ordinary shares participate in the net profit for the period only after other types of shares, such as preference shares. An entity may have more than one class of ordinary shares.
Earnings The earnings should be the after-tax net profit / loss after deducting preference dividends and other appropriations for non-equity shares. All items of income and expense that are recognised in a period, including exceptional items and Non-controlling Interests, are included in the determination of net profit or loss for the period.
Therefore, the calculation of the earnings figure effectively becomes:
Profit
Less Tax
Less Non-controlling Interest
Less Preference dividends (or other non-equity appropriations)
EPS is normally expressed in cents.
The amount of preference dividends that is deducted from the net profit for the period is:
- The amount of any preference dividends on non-cumulative preference shares declared in respect of the period;
OR
- The full amount of the required preference dividends for cumulative preference shares for the period, whether or not the dividends have been declared, as the undeclared amount is still deductible as an appropriation. The amount of preference dividends for the period does not include the amount of any preference dividends for Cumulative Preference Shares paid or declared during the current period n respect of previous periods.
Where an entity has more than one class of ordinary shares, the earnings for the period are apportioned over different classes of shares in accordance with their dividend rights or other rights.
NUMBER OF SHARES
For the purpose of calculating basic earnings per share, the number of shares should be the weighted average number of ordinary shares outstanding during the period.
The weighted average number of ordinary shares outstanding during the period reflects the fact that the amount of shareholders capital may be varied during the period as a result of a larger or lesser number of shares being outstanding at any time. It is the number of ordinary shares outstanding at the beginning of the period, adjusted by the number of ordinary 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 specific shares are outstanding as a proportion of the total number of days in the period (a reasonable approximation of the weighted average is adequate in many circumstances).
MEASUREMENT OF BASIC EARNINGS PER SHARE
EPS = Profit – Tax – Non-controlling Interest – Preference Dividends
Weighted average number of Ordinary Shares in issue during the period
IAS 33 says that the entity must calculate the EPS amounts for profit or loss attributable to ordinary equity holders of the parent entity and , if presented, profit or loss from continuing operations attributable to those equity holders.
CHANGES IN CAPITAL STRUCTURE
When a firm’s capital structure changes, the denominator of the EPS fraction changes also. There are a number of possible causes for such a change. The most common are:
- Issue of shares at their full market price
- A Capitalisation or Bonus issue
- A Rights Issue
- Share Exchange
- Issue Of Shares At Full Market Price
Rule = New shares should be included in the EPS calculation, weighted on a time basis
Do not adjust previous year’s EPS
The rationale of this approach is that cash or other assets are introduced into the business during the year as a result of the share issue. These assets should generate additional earnings for that portion of the year for which they are issued. Therefore, in order to compare like with like, the denominator should include the additional shares only for that portion of the year in which shares are issued.
- Bonus or Capitalisation Issue
This is also sometimes referred to as a scrip issue. In this type of issue, ordinary shares are issued to existing shareholders for no additional consideration, i.e. for free. Therefore the number of shares in issue is increased without an increase in resources.
Rule = Bonus shares are deemed to be issued on the 1st day of the earliest period being reported (usually, the 1st day of the comparative year). The effect will be as if the bonus shares had always been in issue. Thus, no time weighting
Adjust previous years EPS
- Rights Issue
A rights issue is an issue of shares, pro rata, to existing shareholders. The exercise price is often less than the fair value of the shares. Therefore, such a rights issue includes a bonus element in calculating EPS; this has to be taken into consideration. Rule = Calculate the “Theoretical Ex Rights Price” (TERP)
Weight shares on a time basis
Adjust previous years EPS
The Theoretical Ex Rights Price is the price the shares will have, in theory, after the rights issue occurs.
The market price of the shares immediately before the rights issue takes place is often referred to as the “Cum Rights Price”.
Both the Theoretical Rx Rights Price and the Cum Rights Price are used in the calculation of EPS and in the adjusting of the previous year’s EPS.
PRESENTATION AND DISCLOSURE
The entity must present, on the face of the Income Statement, the EPS in respect of the profit or loss from continuing operations, attributable to the ordinary equity holders.
If the entity reports a discontinued operation, it must disclose the EPS for the discontinued operation either on the face of the Income Statement or in the notes to the financial statements.
The entity must disclose the following:
- The amount used as the numerator in calculating EPS, together with a reconciliation of those amounts to the net profit or loss for the period
- The weighted average number of ordinary shares used as the denominator in calculating the EPS, together with a reconciliation of these denominators to each other.
If the entity makes a net loss for the period, the EPS is still calculated using the net loss (as adjusted) as the numerator. Thus, the EPS will be a negative figure. Disclosure is still mandatory when the EPS is negative.
RETROSPECTIVE ADJUSTMENTS
If the number of ordinary shares increases as a result of:
- A capitalisation / bonus / scrip issue; or
- A share split
The calculation of EPS for all periods must be adjusted retrospectively.
If these changes occur after the balance sheet date but before the financial statements are authorised for issue, the EPS calculations for those and any prior period financial statements presented must be based on the new number of shares. The fact that the EPS calculation reflects such changes in the number of shares must be disclosed.
In addition, the EPS of all periods presented in the financial statements must be adjusted for the effects of errors and adjustments arising from changes in accounting policies accounted for retrospectively.
[Note that other major share transactions after the balance sheet date are Non-Adjusting Events according to IAS 10 and so are not applied retrospectively. However, they must be disclosed in the notes to the financial statements].
FULLY DILUTED EARNINGS PER SHARE
IAS 33 requires the disclosure of fully diluted earnings per share.
The rationale of fully diluted earnings per share is that the existing earnings will be required to be spread over a greater number of shares in future as a result of the exercise of existing rights to share at some future date. The word “diluted” is used to indicate that the earnings are to be spread more widely – hence diluting the amount per share.
In essence, diluted earnings per share (DEPS) is showing the present effect of a future dilution, on the assumption that all the dilutive potential ordinary shares convert into ordinary shares.
Figures for basic and diluted earnings per share are required to be presented on the face of the profit and loss account.
There are a number of situations which give rise to the possible dilution of EPS in the future, that is, future shares may be issued in the future with or without a change in the earnings of the organisation. Examples of these “potential ordinary shares” are:
- Share warrants and options
- Contingently issuable shares
- Convertible debt
These are dealt with below.
SHARE WARRANTS AND OPTIONS
Share warrants and options allow the holder to buy shares in the future, usually at a price below the fair value. To calculate diluted earnings per share, assume that the warrants and options have already been exercised. The assumed proceeds should be regarded as having been received from the issue of a number of shares at fair value.
The difference between the number of shares issued and the number that would have been issued at fair value (to raise the same amount of finance) should be treated as a bonus issue and added to the existing number of ordinary shares. Fair value for this purpose is calculated on the basis of the average price of the ordinary shares during the year.
CONTINGENTLY ISSUABLE SHARES
These are shares which are issuable depending upon the outcome of some future event e.g. the opening of a new store or profits reaching a desired level.
These are included in the calculation of diluted earnings per share as at the beginning of the period when the relevant financial instrument is issued or the rights are granted. An example follows.
Example – Contingently issuable shares
Company A has 1 million ordinary shares outstanding at 1 January 20X0. The terms of a deferred consideration agreement, related to a recent business acquisition, provide for the following contingently issuable shares:
- 20,000 additional ordinary shares for every new retail outlet opened in each of the three years 20X0, 20X1, 20X2.
- 2,000 additional ordinary shares for each RWF1,000 of total net income in excess of RWF700,000 over the three years ending 20X2.
- CONVERTIBLE BONDS/LOAN STOCK
These are financial instruments which the holder usually has an option to convert the bond into ordinary shares at some future date.
Diluted Earnings Per Share Calculation:
Basic earnings are increased by the net of tax interest saved on conversion, whilst the basic number of shares is increased by the expected increase in ordinary shares. The computation assumes the most advantageous conversion rate from the standpoint of the holder.
DILUTIVE / ANTI-DILUTIVE POTENTIAL ORDINARY SHARES
Potential ordinary shares should be treated as dilutive only when the actual conversion to ordinary shares would have the effect of decreasing net profit or increasing a net loss per share from continuing operations. The effects of anti-dilutive potential ordinary shares are to be ignored in calculating diluted earnings per share.
