Earnings per Share (EPS) is a measurement which includes both income and investment information. GAAP has required its presentation on the income statement since 1969. It receives wide recognition in the annual reports issued by companies, in the press, and in financial reporting publications. The data included in its computation can also be used to compute a dividend payout ratio: divide dividends per share by earnings per share.

A complication in the calculation of EPS arises when stock options or convertible securities (bonds or preferred stock) are outstanding. Exercise or conversion may cause EPS to decline, resulting in dilution of earnings. or, less likely, to increase, resulting in antidilution of earnings. Stock options and convertible securities are accordingly called dilutive securities or antidilutive securities. depending on whether their exercise or conversion would have one or the other result. EPS may then be recalculated, for purposes of comparison, on the supposition that potential conversions and exercises could actually take place.

Because such calculations can be carried out in different ways, the Accounting Principles Board (APB) issued in 1969 APB Opinion No. 15, which together with numerous subsequent Accounting Interpretations, specified in detail how future-oriented “as-if” figures were to be computed. In February 1997 the FASB issued FASB Statement No. 128; “Earnings per Share”, in collaboration with the International Accounting Standards Committee (IASC). This brought U.S. GAAP closer to the simpler Canadian approach of presenting a basic and a diluted EPS as preferred by the IASC. Thus a historical-based basic EPS is to be presented by all companies, while for companies with a complex capital structure a diluted EPS is also to be presented.

If a company has only common stock, or common stock and nonconvertible preferred stock outstanding, with no convertible securities, stock options, warrants, or other rights outstanding, it is said to have a simple capital structure. Then EPS is calculated by dividing income available to common shareholders by the weighted-average number of common shares outstanding for the period. If net income includes extraordinary gains or losses or other below-the-line items a separate EPS is required for each major component of income as well as for net income. These figures are referred to as basic earnings per share.

A simple capital structure exists even if there are outstanding convertible securities, stock options, warrants or other rights, if these have no potential dilutive effect from their conversion or exercise, based on the conditions existing at the financial statement date. Only if potential EPS dilution exists is a complex capital structure present. In such cases the basic and the diluted EPS are both presented. The basic EPS uses only results of actual transactions. The diluted EPS is based on calculations of what the effect on EPS would be if transactions should occur which have not yet occurred but are likely to occur in the future. This gives users of the financial statements a “worst case” scenario relating to the exercise of existing options or the conversion of existing securities.

Basic EPS is fairly simple to calculate. The major complication is that is common shares are issued or reacquired during the period, earnings will be affected by the proceeds of the sale or the expenditure to reacquire the common shares, in that the resources available to generate earnings are thereby changed without any necessary change in the profitability of the firm. Such changes should therefore be factored into the EPS calculation to provide a measure of the per-share profitability given the resources available. This is done by calculating a weighted-average for shares outstanding over the period. A separate period computation is required each time stock is sold or reacquired. See page 1079 for an example.

If the number of common shares outstanding is changed by a stock dividend, a stock split, or a reverse split, the weighted-average number of shares outstanding must retroactively recognize the change: otherwise the stock shares are not comparable throughout the period. See the example on Pages 1079-80.

When a capital structure includes preferred stock, dividends on preferred stock should be deducted from income before extraordinary or other below-the-line items and from net income before calculating the basic EPS. If the preferred stock is n oncumulative, only the declared dividends need be deducted, but if it is cumulative, both declared and undeclared dividends should be deducted. See pages 1081 – 2.

Calculation of diluted EPS in case of a complex capital structure involves adjusting the numerator and denominator of basic EPS depending on the nature of the dilutive or anti — dilutive security in question. For reporting below-the-line items the “control number” used to determine whether the security is dilutive or not is “Income from continuing operations”. Generally anti — dilutive securities are not included in computing diluted EPS.

All computations of diluted EPS are made as if the exercise or conversion took place at the beginning of the company’s fiscal year or at the issue date of the stock option or convertible security, whichever comes later.

If the exercise price of options, warrants, or other rights (i. e. the price for which stock can be acquired) is lower than the average market price during the period, exercise is probable and the effect would be dilutive. Otherwise there is no potential dilution from these securities. The FASB believes that use of an average price rather than the market price at the end of the period is more realistic (see page 1083), and that the cash received from the exercise should be assumed to be used for a non-revenue-producing purpose: namely, to purchase treasury stock at the average market price. Also, it is to be assumed that the shares of treasury stock are to be issued to those exercising their options, warrants, or rights, and that the remaining shares required to be issued will be added as incremental shares to the actual number of shares outstanding to compute diluted EPS. This method of including warrants, options, and rights in the EPS computation is called the treasury stock method. Carefully study the example on Pages 1084.

Diluted EPS with convertible securities present requires adjustment to both net income and to the number of common shares outstanding, to reflect what the amounts would have been if the conversion had occurred at the beginning of the current year or the date of issuance of the convertible securities, whichever comes later. This is called the if-converted method. For bonds, add back to net income the interest expense net of tax and add to the number of shares outstanding the number that would have been issued on conversion. For preferred stock, the is no reduction to net income for preferred dividends (as there would be in the calculation of basic EPS) and the number of shares outstanding is increased by the number that would have been issued upon conversion. In testing for dilution each potentially dilutive convertible security must be evaluated individually. See examples on Pages 1086-7.

There is a shortcut test for anti — dilution for convertible securities. If the company has net income rather than a net loss, compute the conversion would contribute to per-share earnings and compare to the pre — conversion basic EPS. See page 1087.

If securities are actually converted or warrants, options, or rights are actually exercised, the newly issued shares must be included in the computation of the weighted-average number of common shares outstanding for the period, but there is also an adjustment to make to reflect what the EPS would have been if conversion or exercise had occurred at the beginning of the current year or on the issuance date, whichever comes later, whether dilutive or not. See page 1088.

If there is a loss from continuing operations (the so-called control number ) no dual calculation of EPS is needed for options or convertible securities because their inclusion would always be anti — dilutive, even if below-the-line items result in positive net income. See page 1089.

When there are two or more potentially dilutive securities, the one giving the lowest diluted EPS (the worst-case scenario) must be identified. To do this efficiently, compute the incremental EPS for each potentially dilutive security; then rank the securities from smallest to largest incremental EPS and calculate a cumulative EPS until the EPS is lower than the next security’s incremental value. Then all later securities will be antidilutive. Stock options and warrants are considered first before any convertible securities. See pages 1090 – 1.

Basic EPS must be presented on the face of the income statement in all cases. Companies with a complex capital structure must also present diluted EPS as well, each for income from continuing operations and also for net income. If there are extraordinary items or income or losses from discontinued operations, EPS amounts for each of them may be presented either on the face of the income statement or in the notes to the financial statements. Also the following disclosure items must be presented in the notes:

Reconciliation of both numerator and denominator of basic and diluted EPS for income from continuing operations, Effect of preferred dividends on EPS calculations. Securities that may potentially dilute basic EPS in the future though antidilutive in the current period. Transactions occurring after the end of the current period but prior to the issuance of the financial statements which would materially have affected the number of common shares outstanding or potentially outstanding.

EPS data should be presented for all periods covered by the income statement. Both basic and diluted EPS should be presented for each period if potential dilution exists in any period.