EXECUTIVE SUMMARY

• IN AN EFFORT AT SIMPLIFICATION, the Financial Accounting Standards Board issued Statement no. 128, Earnings per Share. to replace Accounting Principles Board Opinion no. 15 of the same name. The new statement simplifies EPS by eliminating primary EPS and common stock equivalents, replacing them with basic EPS.
• AT THE SAME TIME, THE FASB ISSUED Statement no. 129, Disclosure of Information about Capital Structure. This statement consolidates existing accounting pronouncements on required disclosures about a companys capital structure.
• STATEMENT NO. 128 REQUIRES ALL PUBLIC companies to disclose basic EPS if the company has a simple capital structure with no potential common shares from convertible securities, options or warrants. A company with potential common shares has a complex capital structure and must disclose both basic and diluted EPS.
• OPTIONS, WARRANTS AND THEIR equivalents are included in EPS using the treasury stock method, which is different from the method used in Opinion no. 15. Under Statement no. 128, the treasury stock method is used for options, warrants and their equivalents with an average market price of the companys stock greater than the option or exercise price.
• IN ADDITION TO RETAINING THE treasury stock and if-converted methods to calculate diluted EPS, Statement no. 128 introduces the reverse treasury stock and theoretical ex-rights methods. Rules for blending the treasury stock and if-converted methods also are retained for use when securities combine features of both convertible securities and options and warrants.
• STATEMENT NO. 128 IS EFFECTIVE FOR financial statements for both interim and annual periods ending after December 15, 1997. All prior-period EPS data must be restated. Early application is not permitted.

DAVID T. MEETING, CPA, DBA. is associate professor of accounting at Cleveland State University in Ohio.

DAVID B. LAW, CPA, DBA. is associate professor of accounting at Youngstown State University, Youngstown, Ohio.

M any CPAs and financial statement users believed Accounting Principles Board Opinion no. 15, Earnings per Share. was arbitrary and unnecessarily complex. A major concern was the concept of common stock equivalents in computing primary earnings per share (EPS). Under the old rule, primary EPS was designed to reflect the dilution of common stockholders earnings resulting from the increase in common shares due to the probable conversion or exercise of common stock equivalents. CPAs and financial statement users thought primary EPS should reflect no dilution. A new Financial Accounting Standards Board statement addresses this concern by simplifying the computation, eliminating primary EPS and common stock equivalents and replacing them with basic EPS, which reflects no dilution.

The FASB issued an exposure draft, Earnings per Share and Disclosure of Information About Capital Structure. in January 1996. In issuing a final statement, the ED was split into two parts because each had a different scope.

• Statement no. 128, Earnings per Share. requires all entities with publicly held common stock or potential common stock to report EPS according to the statement. It applies only to public companies and replaces APB Opinion no. 15; American Institute of CPAs Accounting Interpretation nos. 1 to 102 of Opinion no. 15; Accounting Interpretation nos. 1 and 2 of Opinion no. 20, Accounting Changes ; FASB Interpretation no. 31, Treatment of Stock Compensation Plans in EPS Computations ; and FASB Statement no. 85, Yield Test for Determining whether a Convertible Security Is a Common Stock Equivalent .
• Statement no. 129, Disclosure of Information about Capital Structure. consolidates existing pronouncements on required disclosures about a companys capital structure. It applies to all entities.

The International Accounting Standards Committee also had issued an ED on EPS. Both EDs focused solely on determining the number of shares in the EPS denominator. The two major components of EPS are the earnings available to common shareholders—the numerator—and some measure of the number of common shares—the denominator. The FASB and the IASC worked jointly to resolve denominator-related issues because they believed there were more areas of agreement and less complexity about share calculations than about income measurement.

Statement no. 128 simplifies U.S. generally accepted accounting principles and tries to harmonize U.S. and international GAAP on this issue. The statement also advances the FASBs goal of increasing comparability of global accounting standards. International Accounting Standard no. 33, Earnings Per Share, which has substantially the same requirements as Statement no. 128, was issued at the same time as the FASB statement.

Statement no. 128 requires all public companies to disclose basic EPS if they have a simple capital structure with no potential common shares from convertible securities, stock options or warrants. Any company with potential common shares has a complex capital structure and must disclose both basic and diluted EPS.

The objective of basic EPS is to measure performance for the reporting period by dividing income available to common shareholders by the weighted average number of shares outstanding (see the flowchart). The statement requires companies to use income from continuing operations or a similar line on the income statement. Shares issued or reacquired (treasury stock) are weighted for the period they are outstanding.

The number of common shares outstanding is adjusted retroactively for stock dividends, stock splits and reverse stock splits. For example, if a stock splits in June 1997, the weighted average number of shares is computed assuming the split occurred at the beginning of 1997. A companys presentation of EPS in its financial statements for any earlier years also has to be adjusted for the split. If the split occurs in early 1998, before the 1997 statements are issued, those statements and all other years presented have to be adjusted as well. The same handling of stock splits and stock dividends applies to diluted EPS.

Common shares issued in partly paid form and stock subscriptions that are entitled to dividends in proportion to the amount paid are part of the basic EPS computation. A company must include the equivalent common shares in the denominator. Stock subscriptions that are partially paid and do not share in dividends until fully paid are treated like warrants and included in diluted EPS using the treasury stock method, discussed later.

Income available to common shareholders is operating income less preferred stock dividends declared for noncumulative preferred stock. For a cumulative preferred stock, current-year dividends are deducted whether declared or not. If a company has preferred stock for which the dividends are cumulative only if earned, it must deduct the dividends earned in calculating EPS.

A company with a simple capital structure and no potential common shares has to report EPS for continuing operations and net income on the face of the income statement. EPS for discontinued operations, extraordinary items and the cumulative effect of an accounting change must be disclosed in the income statement or in the notes to the financial statements.

Antidilution . A decrease in the loss per share or increase in earnings per share caused by inclusion of a contingent security, convertible security, option or warrant in diluted EPS.

Basic EPS . The per share amount of earnings for the period available for each common stock share outstanding.

Common stock equivalent . A security under APB Opinion no. 15 that is in substance equivalent to common stock because of the terms or circumstances at the time of issuance. These securities were deemed to be those whose exercise or conversion was probable.

Contingently issuable shares . Shares issuable when certain conditions are met. Usually little or no cash consideration is involved.

Convertible security . A security convertible into common stock at a predetermined conversion rate—for example, a convertible preferred stock where each share of preferred stock is convertible into three shares of common stock.

Diluted EPS . EPS calculated to show, on a pro forma basis, per share earnings for the period available to common shareholders assuming the exercise or conversion of all securities that are exercisable or convertible into common stock and which would either dilute or not affect basic EPS.

Dilution . The watering down or decrease in EPS from the exercise or conversion of securities into common stock. Diluted EPS shows dilution on a pro forma basis.

Earnings per share . In a general sense, these are earnings attributable to each share of common stock for a period. However, per common share amounts also are calculated for income from continuing operations and intermediary items, such as discontinued operations, extraordinary items and changes in accounting principles.

Exercise proceeds . Amounts assumed received by a company from the pro forma exercise of options, warrants and convertible securities.

Primary EPS . Earnings attributable to each share of common stock, taking into account the pro forma exercise or conversion to common shares of common stock equivalents. This was required under APB Opinion no. 15 and was to represent the dilution of earnings that would result from the probable exercise or conversion of securities to common stock.

CALCULATING DILUTED EPS

A company with potential common shares has, by definition, a complex capital structure. Income or loss from continuing operations is the number used to determine whether diluted EPS is decreased relative to basic EPS by the possible effect of potential common shares. For a company with a loss from continuing operations, the exercise or conversion of any potential shares increases the number of shares in the denominator and results in a lower loss per share. In that situation, the potential shares are antidilutive and not included in the companys EPS calculation. Statement no. 128 says that if there is a loss from continuing operations, diluted EPS is the same as basic EPS.

A company with income from continuing operations must calculate diluted EPS. Statement no. 128 requires companies to calculate earnings per incremental share for each group of potential common shares. In general, earnings per incremental share—or the incremental per share effect of any security that could produce common shares—is the increase in net income from the pro forma exercise or conversion of the security divided by the weighted average increase in the number of common shares that would result from the conversion. The company ranks the potential shares and includes them in the diluted EPS calculation by first including the most dilutive shares, then the next most dilutive and so on to the least dilutive shares. The process stops when the resulting diluted EPS is the lowest figure obtainable.

Contingent shares whose issuance depends solely on the passage of time are considered already issued in calculating diluted EPS. A company calculates an earnings per incremental share for each block of shares. A company makes the same computation for each block of shares whose issuance is contingent on factors other than time (such as income or the number of stores opened for a retail company) when the contingency is currently satisfied.

Convertible securities . These enter into the EPS calculation through the if-converted method whereby the securities are assumed converted and an earnings per incremental share is computed. APB Opinion no. 15 used the if-converted method for convertible securities but did not require an incremental per share effect to be calculated.

Convertible securities outstanding for the entire period are assumed converted at the beginning of the period. Convertible securities issued during the period are treated as if they were converted at the date of issuance. For example, for a calendar-year corporation, convertible bonds issued in a prior period are treated as if they were converted at January 1 of the current period. Convertible bonds issued March 1 are assumed converted as of that date. In either case, the foregone interest expense—aftertax—must be added to the EPS numerator. The earnings per incremental share is the aftertax foregone interest expense divided by the number of shares of common stock that would have been issued from the conversion weighted for the period they would have been outstanding.

The if-converted method also applies to convertible preferred stock. The stock is assumed converted at the beginning of the period if it is outstanding at that time. Stock issued during the period is treated as if it were converted at the date of issuance. The earnings per incremental share equals the preferred stock dividends (if deducted from income available to common shareholders in the basic EPS calculation) divided by the number of shares of common stock issued from the assumed conversion.

Illustration . On March 1, ABC Corp. a calendar-year corporation, issues 2,000 convertible 6%, $1,000 bonds. Each bond is convertible into 40 shares of common stock. The tax rate is 40%. The pretax bond interest expense is $100,000 ([$1,000 3 2,000] 3 .06 3 10/12). The if-converted method assumes the bonds were converted on March 1. In this scenario, ABC avoids the $100,000 pretax interest expense, increasing its operating income by $60,000 ($100,000 3 [1-.40]). The number of shares from the assumed conversion is 80,000 (40 shares 3 2,000 bonds). Since the conversion is assumed to occur on March 1, the shares must be weighted for the period they were assumed outstanding (10 of 12 months), resulting in 66,667 weighted average shares (80,000 3 10/12). The per share incremental effect is the aftertax interest saved divided by the weighted average shares or $0.90 ($60,000/66,667).

A company must calculate the incremental per share effect for each group of convertible securities. Any such security for which the effect is greater than basic EPS based on operating income is considered antidilutive and is not included in a companys diluted EPS computation. Convertible securities with an incremental per share effect less than basic EPS, based on operating income, will be ranked by the company later.

The mandatory reconciliation of the numerators and denominators of basic and diluted EPS allows users to assess each securitys dilutive effect. Combining that information with the details about securities not used because they are antidilutive allows users to determine their own measures of EPS.

Effective date . Statement no. 128 is effective for financial statements for both interim and annual periods ending after December 15, 1997. After the effective date, all prior- period EPS data must be restated to conform to the statement. Early application is not permitted.

SIMPLIFIED COMPUTATIONS

Statement no. 128 simplifies the computation of EPS compared with earlier accounting standards. The simplification, brought about by eliminating common stock equivalents and the primary EPS calculation, also eliminates a source of arbitrariness. Substituting basic EPS for primary EPS in dual presentations (basic and diluted EPS) for companies with complex capital structures allows financial statement users to have more relevant figures available to them.

FASB Statement no. 128 and IASC Standard 33 bring U.S. and international GAAP into concurrence on calculating the number of shares in the EPS denominator. Although the numerator in EPS calculations in both statements is income available to common shareholders, the two standard-setting bodies avoided addressing differences between U.S. and international GAAP in computing net income. While these statements bring some comparability to EPS in companies from different countries, users must be aware that the net income computation is not necessarily comparable and hence EPS amounts of such companies are not completely comparable. However, Statement no. 128 is tangible evidence of what the two standard-setting bodies can accomplish when they cooperate.