IAS 33 – EARNINGS PER SHARE
Earnings Per Share (EPS) is an unusual accounting ratio in that it has a whole standard devoted to its calculation and presentation. The importance attached to this ratio derives from the fact that it is used as a basis for a number of significant statistics used by investors.
USES OF EPS
The uses of EPS as a financial indicator include:
- The assessment of management performance over time.
- Trend analysis of EPS to give an indication of earnings performance.
- An indicator of dividend payouts. The higher the EPS the greater the expectation of an increased dividend compared to previous periods.
- An important component in determining the entity’s price/earnings (P/E) ratio.
Scope and Objective
The objective of the standard is to prescribe principles for the determination and presentation of earning per share in order to improve performance comparisons between different entities in the same period and over time for the same entity.
IAS 33 only applies to entities whose securities are publicly traded or that are in the process of issuing securities to the public. This is because entities, whose securities are not traded, do not have a readily observable market price which would make it difficult to calculate a P/E ratio.
Ordinary shares: an equity instrument that is subordinate to all other classes of equity shares. Potential ordinary shares: a financial instrument or other contract that may entitle its holder to ordinary shares.
Examples of potential ordinary shares include:
- Convertible debt
- Convertible preference shares
- Share warrants Share options
Warrants or options: financial instruments that give the holder the right to purchase ordinary shares. Dilution: a reduction in EPS or an increase in loss per share resulting from the assumption that convertible instruments are converted, the options or warranties are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions.
Antidilution: an increase in EPS or a reduction in loss per share resulting from the assumption that convertible instruments are converted, the options or warranties are exercised, or that ordinary shares are issued upon the satisfaction of specified conditions.
The basic EPS should be calculated by dividing the net profit or loss attributable to ordinary equity shareholders by the weighted average number of ordinary shares outstanding during the period.
The net profit is profit after tax and preference dividends.
CHANGES IN THE CAPITAL STRUCTURE
Most of the complications in the computation of EPS arise from changes in the share capital. The underlying principle is that EPS should be comparable from period to period.
Thus in arriving at the denominator in the EPS calculation, the shares in issue at the beginning of the period may need to be adjusted for shares bought back or issued during the period multiplied by a time weighting factor.
It is necessary to time apportion and come up with a weighted average number of shares outstanding; because where capital has been invested through the issue of shares part-way through the year, additional earnings will only have been generated from the date at which the investment took place. If earnings for the year were apportioned over shares in issue at the year end the resultant EPS would not fairly reflect performance for the current period in comparison to a previous period when there may have been no such change in equity. Similar logic applies where shares have been bought back in the year.
The four most common reasons for adjusting shares in issue at the beginning of the period are:
- Issue of new shares during the period (fully or partly paid)
- Bonus issues
- Rights issues;
- Potential ordinary shares (resulting in calculation of diluted EPS)
Issue of new shares during the period (Fully paid)
Shares should be included in the weighted average calculation from the date consideration is receivable
Issue of new shares during the period (Partly paid)
The general principle under IAS 33 that shares should be included in the weighted average calculation from the date consideration is receivable does not apply to shares that are issued in partly paid form. Partly paid shares are treated as fractions of shares; based on payments received to date as a proportion of the total subscription price. These shares are included in the averaging calculation only to the extent that they participate in dividends for the period. Dividend entitlement of such shareholders is usually restricted to an amount based on this fraction.
The weighted average number of shares should be restricted based on this fraction. If the actual receipts to date were only applied to the issue of fully paid shares, then the number of fully paid shares would be smaller than was actually the case for partly paid shares being issued.
Bonus issue, share split and share consolidation
Where a company issues new shares by way of a capitalisation of reserves (a bonus issue) during the period, the effect is to increase only the number of shares outstanding after the issue. There is no effect on earnings as there is no inflow of funds as a result of the issue.
As shareholders rights are not affected; each individual will hold the same proportion of outstanding shares as before the issue. IAS 33 requires that the bonus shares are treated as if they had occurred at the beginning of the period. The EPS from the previous period should also be recalculated using the new number of shares in issue to allow comparison with the current year’s EPS, as if the issue had taken place at the beginning of that period as well.
When calculating the prior period EPS comparator then multiply last year’s EPS by the factor:
Number of Shares before bonus issue
Number of Shares after bonus issue
When calculating the weighted average number of shares then the bonus factor to apply is the inverse of the above, i.e.
Number of Shares after bonus issue
Number of Shares before bonus issue
Similar considerations apply where ordinary shares are split into shares of smaller nominal value (a share of $1 is split into four share of 25c each) or consolidated into shares of higher nominal value (four shares of 25c each are consolidated into one share of $1). In both these situations, the number of shares outstanding before the event is adjusted for the proportionate change in the number of shares outstanding after the event.
With a rights issue additional capital is raised by the issue of the shares. Existing shareholders are offered the right to purchase new shares from the company, usually at a discount to the current market price.
Then when dealing with a rights issue at a discount, calculation of EPS should mark adjustment for the two elements:
- A bonus issue (reflecting the fact that the cash received would not pay for all the/shares issued if based on fair values, rather than being discounted).
- An assumed issue at full price (reflecting the fact that new shares are issued in return for cash);
Consequently the number of shares outstanding at the beginning of the year should be adjusted for the bonus factor to give a deemed number of shares in issue before the rights issue. This should be weighted for the period up to the date of the rights issue.
The bonus factor is equal to: Fair Value before rights issue
Theoretical ex – rights Price after rights issue
Additionally the number of shares actually in issue after the rights issue is weighted for the period after the rights issue.
As in the section on bonus issues, the prior period EPS should be adjusted for the bonus factor. This is achieved by taking the reciprocal of the bonus factor (turn fraction Upside down) and multiplying by last year’s EPS.
DILUTED EARNINGS PER SHARE
An entity may have in issue at the reporting date a number of financial instruments that give rights to ordinary shares at a future date. IAS 33 refers to these as potential ordinary shares. Examples of potential ordinary shares include:
- Convertible debt;
- Convertible preference shares;
- Share warrants Share options
Where these rights are exercised they will increase the number of shares. Earnings may also be affected. The overall effect will tend towards lowering (or diluting) the EPS.
This will tend to be the case because holders of these rights will only take them if it is to their benefit which tends to be prejudicial to existing shareholders
So that existing shareholders can see the potential dilution of their present earnings, IAS 33 requires that a diluted EPS is calculated.
The calculation is performed as if the potential ordinary shares had been in issue throughout the period. If the rights were granted during the reporting the period, then time apportion.
The diluted EPS is:
Earnings as per basic eps + Adjustment for dilutive potential ordinary shares Weighted Average number of shares per basic EPS + Adjustment for dilutive potential ordinal
CONVERTIBLE FINANCIAL INSTRUMENTS
CALCULATION OF EARNINGS
The basic earnings figure should be adjusted to reflect any changes in profit that would arise when the potential ordinary shares outstanding are actually issued. Adjust:
There will be a saving of interest. Interest is a tax-deductible expense and so the post- tax effects will be brought into the adjusted profits.
There will be a saving of preference dividend. There is no associated tax effect.
Therefore, the numerator should be adjusted for the after-tax effects of dividends and interest charged in relation to dilutive potential ordinary shares and for any other changes in income that would result from the conversion of the potential ordinary shares.
- The number of shares
The denominator should include shares that would be issued on the conversion.
The potential ordinary shares are deemed to be converted to ordinary shares at the start of the period unless they were issued during the reporting period.
SHARE WARRANTS AND OPTIONS
A share option or warrant gives the holder the right to purchase or subscribe for ordinary shares. IAS 33 requires that the assumed proceeds from these shares should be considered to have been received from the issue of shares at fair value. These would have no effect on EPS.
The difference between the number of shares that would have been issued at fair value and the number of shares actually issued is treated as an issue of ordinary shares for no consideration. This bonus element has a dilutive effect with regard to existing shareholders.