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ACCA Paper F 7 Financial Reporting F7FR Session27 d08

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(1)

OVERVIEW

Objective

¾

To explain the provisions of IAS 33.

SIGNIFICANCE OF EPS

INTRODUCTION

DILUTED EARNINGS PER

SHARE EARNINGS PER

SHARE (EPS)

¾ Earnings

performance ¾ Scope

¾ Definitions

¾ Basic EPS ¾ Which earnings?

WEIGHTED AVERAGE NUMBER

OF SHARES

¾ Presentation ¾ Disclosure ¾ Basic rule

¾ Issues of shares – no consideration ¾ Multiple capital changes

¾ Issuable shares

¾ Purpose ¾ Method ¾ Options

PRESENTATION AND DISCLOSURE

(2)

1

INTRODUCTION

1.1

Earnings performance

¾

Earnings (EPS) shows the trend of earnings performance for a company over the years.

¾

It is felt to be more useful than an absolute profit figure, which will not contain information about the increase in investment that has been made in the period.

¾

It isnot useful in comparing companies.

1.2

Scope

¾

IAS 33 applies to the separate financial statements of entities whose debt or equity instruments are publicly traded (or are in the process of being issued in a public market).

¾

IAS 33 also applies to the consolidated financial statements of a group whose parent is required to apply IAS 33 to its separate financial statements.

¾

An entity that disclosed EPS should calculate and present it in accordance with IAS 33.

1.3

Definitions

¾

An ordinary share is an equity instrument that is subordinate to all other classes of equity instruments.

¾

An equity instrument is any contract that evidences a residual interest in the assets of an entity after deducting all of its liabilities.

¾

A potential ordinary share is a financial instrument or other contract that may entitle its holder to ordinary shares. For example:

‰ convertible instruments; ‰ share options and warrants; ‰ share purchase plans;

‰ shares which will be issued subject to certain conditions being met.

¾

Options, warrants and their equivalents are financial instruments that give the holder the right to purchase ordinary shares.

¾

Dilution is the reduction in EPS (or an increase in loss per share) resulting from the assumption that convertible instruments are converted, that warrants/options are exercised. Or that ordinary shares are issued upon the satisfaction of specified conditions.

¾

Contingently issuable ordinary shares are ordinary shares issuable for little or no cash or other consideration upon the satisfaction of specified
(3)

2

EARNINGS PER SHARE (EPS)

2.1

Basic EPS

¾

An entity is required to present the basic earnings per share for

‰ Profit or loss attributable to ordinary shareholders AND

‰ Profit or loss relating to continuing operations attributable to those ordinary shareholders.

¾

The basic EPS calculation is made by dividing the profit (or loss) relating to the ordinary shareholders by the weighted average number of ordinary shares outstanding in the period.

2.2

Which earnings?

¾

Basic EPS should be

‰ The profit or loss attributable to ordinary shareholders and

‰ The profit or loss relating to continuing operations attributable to the ordinary shareholders

¾

Adjusted for

‰ Post-tax effect of preference dividends (and other items relating to preference shares) and

‰ Non-controlling interest.

3

WEIGHTED AVERAGE NUMBER OF ORDINARY SHARES

3.1

Basic rule

¾

The number of ordinary shares will be the weighted average number of ordinary shares outstanding during the period.

¾

The number in existence at the beginning of the period should be adjusted for shares that have been issued for consideration during the period.
(4)

¾

In each case the earnings will be boosted from the date of issue. In order to ensure consistency between the top and bottom of the basic EPS calculation the shares are also included from the date of issue.

Therefore weight the number of shares:

Proforma

Number No before ×

12

3 = X

No after × 12

9 = X

___ X ___

3.2

Issues of shares where no consideration is received

¾

The weighted average number of ordinary shares outstanding during the period and for all periods presented should be adjusted for events, that have changed the number of ordinary shares outstanding, without a corresponding change in resources. For example:

‰ Bonus issues;

‰ Bonus elements in another issue (e.g. a rights issue); ‰ Share splits;

‰ Reverse share splits.

3.2.1

Bonus issues

¾

Treat as if the new shares have been in issue for the whole of the period.

¾

Multiply the number of shares in issue by the bonus fraction.

Illustration 1

Bonus issue of 1 for 10

Bonus fraction:

10 11 10

1 10+ =

(5)

¾

The comparative figure and any other figures from earlier periods that are being used in an analysis must be adjusted. This is done by multiplying the comparative by the inverse of the bonus fraction.

Illustration 2

Last year’s EPS

11 10 ×

3.2.2

Rights issues

¾

A rights issue has features in common with a bonus issue and with an issue at full market price. A rights issue gives a shareholder the right to buy shares from the company at a price set below the market value. Thus:

‰ the company will receive a consideration which is available to boost earnings (like an issue at full price); and

‰ the shareholder receives part of the share for no consideration (like a bonus issue).

¾

The method of calculating the number of shares in periods when there has been a rights issue reflects the above.

¾

A bonus fraction is applied to the number of shares in issue before the date of the rights issue and the new shares issued are pro-rated as for issues for consideration.

¾

The bonus fraction is the cum-rights price per share (CRP) divided by the theoretical ex-rights price per share (TERP). See Illustration 3.

Illustration 3

X Inc 1 January Shares in issue 1,000,000 31 March − Rights issue 1 for 5 at 90c

− MV of shares $1 (cum-rights price)

Required:

(6)

Solution

Number 1 January − 31 March

1,000,000 × 3 12×

1 9833

. 254,237

1 April − 31 December 1,200,000 × 9

12 900,000

_________ 1,154,237 _________

Rights issue bonus fraction

Shares @ $ $

Cum 5 1 5.0

Rights 1 0.9 0.9

___ ____

Ex 6 5.9

___ ____

TERP

6 9 . 5

= 0.9833

Bonus fraction

TERP CRP

=

9833 .

1

¾

For presentational purposes, in order to ensure consistency, the comparative figure for EPS must be restated to account for the bonus element of the issue. This is achieved by multiplying last years EPS by the inverse of the bonus fraction.

3.3

Multiple capital changes

Method

¾

Write down the number of shares at start of year.

¾

Look forward through year and write down the total number of shares after each capital change.

¾

Multiply each number by the fraction of the year that it was in existence.
(7)

Illustration 4

X Inc

1 January 1,000,000 in issue

28 February Issued 200,000 at full market price 31 August Bonus issue 1 for 4

30 November Issued 250,000 at full market price

Required:

Calculate the number of shares which would be used in the basic EPS calculation.

Solution

1 January − 28 February

1,000,000 ×

12

2 × 4

5 = 208,333

1 March 31 August

1,200,000 ×

126 × 4

5 = 750,000

1 September 30 November

1,500,000 ×

12

3 = 375,000

1 December 31 December

1,750,000 ×

12

1 = 145,833

(8)

Example 1 — Multiple capital changes

1 January 1,000,000 in issue

28 February Full market price 400,000 31 March Bonus issue 1 for 2

31 July Full market price 900,000

30 September Rights issue 1 for 3  21 22 fraction Bonus

Required:

Calculate the number of shares which would be used in the basic EPS calculation.

Proforma solution

Number

1 January – 28 February

1 March 31 March

1 April 31 July

1 August 30 September

1 October 31 December

(9)

3.4

Issuable shares

3.4.1

Mandatorily convertible instrument

¾

Shares that will be issued on the conversion of mandatorily issuable instruments will be included in the weighted average number of shares from the date that the contract is entered into.

Commentary

This is consistent with IAS 39. These are items that will be classified as equity instruments and therefore it is appropriate to include in the EPS calculation.

3.4.2

Contingently issuable shares

¾

Contingently issuable shares will be included in the weighted average number of ordinary shares from the date all necessary conditions and events have occurred to allow the issue of the shares.

Commentary

This is again consistent with IAS 39 as they will be included in liabilities unless the likelihood of settlement in cash is remote. On conversion they will be included in equity and also in the EPS calculation.

4

DILUTED EARNINGS PER SHARE

4.1

Purpose

¾

Potential ordinary shares may exist whose owners may become shareholders in the future.

¾

If these parties become ordinary shareholders the earnings will be spread over a larger number of shares i.e. they will become diluted.

Commentary

Diluted EPS is calculated as a warning to existing shareholders that this may happen.

(10)

4.2.1

New number of ordinary shares

¾

This should be the weighted average number of ordinary shares used in the basic EPS calculation plus the weighted average number of ordinary shares which would be issued on the conversion of all the dilutive potential ordinary shares into ordinary shares.

¾

Dilutive potential ordinary shares should be deemed to have been converted into ordinary shares at the beginning of the period or, if later, the date of the issue of the potential ordinary shares.

¾

New number of shares

Basic number X

No of shares which could exist in the future: from the later of

− first day of accounting period

− date of issue X

____ X ____

4.2.2

New earnings figure

¾

The amount of profit or loss for the period attributable to ordinary shareholder, used in the basic EPS calculation, should be adjusted by the after-tax effect of the potential ordinary shares becoming ordinary shares, i.e. add back:

‰ Any dividends on dilutive potential ordinary shares, which have been deducted in arriving at the profit or loss for the period, attributed to ordinary shareholders.

‰ Interest recognised in the period for the dilutive potential ordinary shares.

(11)

Illustration 5 — Diluted EPS

Convertible bonds

1 January Shares in issue 1,000,000

Profit for the year ended 31 December $200,000

31 March Co issues $200,000 6% convertible bonds

Terms of conversion

100 shares/$100 if within five years 110 shares/$100 if after five years Tax rate 33%

Basic EPS

000 , 000 , 1

000 , 200

= 20c

Required:

Calculate diluted EPS.

Solution

Number of

shares Profit

$

Basic 1,000,000 200,000

Dilution

Shares: 100 200,000

× 110 × 12

9 165,000

Interest

$200,000 × 6% × 12

(12)

¾

When there has been an actual conversion of the dilutive potential ordinary shares into ordinary shares in the period, a further adjustment has to be made.

¾

The new shares will have been included in the basic EPS from the date of conversion. These shares must then be included in the diluted EPS calculation up to the date of conversion.

4.3

Options

¾

An entity should assume the exercise of dilutive options and other dilutive potential ordinary shares of the entity.

‰ The assumed proceeds from these issues should be considered to be received from the issue of shares at fair value.

‰ The difference between the number of shares issued and the number of shares that would have been issued at fair value should be treated as an issue of ordinary shares for no consideration.

¾

Options will be dilutive only when they result in the entity issuing shares at below fair value.

¾

Each issue of shares under an option is deemed to consist of two elements.

‰ A contract to issue a number of shares at a fair value. (This is taken to be the average fair value during the period.)

Commentary

These are non dilutive.

‰ A contract to issue the remaining ordinary shares granted under the option for no consideration.(a bonus issue).

Commentary

These are dilutive.

Illustration 6

Options

1 January Shares in issue 1,000,000

Profit for the year ended 31 December $100,000

Average fair value $8

The company has in issue options to purchase 200,000 ordinary shares

Exercise price $6

Required:

(13)

Solution

Diluted EPS:

Number of

shares Profit EPS

$

Basic 1,000,000 100,000 10c

Dilution (W) 50,000

_________ ______

1,050,000 100,000 9.5c

_________ ______

WORKING

Proceeds of issue 200,000 × $6 1,200,000

Number that would have been issued at FV ÷ $8 = 150,000

Number actually issued 200,000

_______

Number for “free” 50,000

_______

5

SIGNIFICANCE OF EPS

5.1

EPS vs earnings

¾

Prior to 1960, the decision to report EPS, the manner in which it was calculated, and where it was reported was left solely to the discretion of company management.

¾

As expected, management chose to report performance in whole dollar earnings only, which tended to favour large corporations over small companies. EPS became a reporting necessity to create a “level playing field” in performance measurement comparability.

¾

EPS allows comparison between different-sized companies whereas, if only actual earnings were being compared, the relative size of the company could not be taken into account.

5.2

Performance measure

(14)

5.3

Problems with EPS

¾

EPS is affected by a company’s choice of accounting policy, so can be manipulated. It also means that comparisons with other companies is not possible if different policies are being used.

¾

EPS is a historic figure and should not be used as a prediction of future earnings. A high EPS figure could be achieved through a lack of investment in new assets, but this will have a detrimental effect on future profits as lack of investment will lead to companies falling behind their competitors.

¾

EPS is a measure of profitability, but profitability is only one measure of performance. Many companies now place much higher significance on other performance measures such as:

‰ customer satisfaction; ‰ cash flow;

‰ manufacturing effectiveness, and ‰ innovation.

6

PRESENTATION AND DISCLOSURE

6.1

Presentation

¾

Basic and diluted earnings per share (or loss per share if negative) should be presented on the face of the statement of comprehensive income for

‰ The profit or loss from continuing operations and ‰ The profit or loss for the period

‰ Each class of ordinary shares that has a different right to share in the net profit for the period.

(15)

Illustration 7

Consolidated income statement for year ended 31 December 2006 (extract) (in CHF)

Earnings per share from continuing operations

Basic earnings per share 7 23.71 20.82

Fully diluted earnings per share 7 23.56 20.63

Nestl

é

Consolidated accounts 2006

6.2

Disclosure

6.2.1

General

¾

The amounts used as the numerators in calculating basic and diluted earnings per share, and a reconciliation of those amounts to the profit or loss for the period.

¾

The weighted average number of ordinary shares used as the denominator in calculating basic and diluted earnings per share, and a reconciliation of these denominators to each other.

¾

Instruments that could potentially dilute basic EPS in the future but they were not included in the diluted EPS because they are anti-dilutive for the period
(16)

Illustration 8

7. Earnings per share from continuing operations

2006 2005 (a)

Basic earnings per share (in CHF) (b) 23.71 20.82 Net profit from continuing operations (in millions of CHF) 9 123 8 095 Weighted average number of shares outstanding 384 801 089 388 812 584

Fully diluted earnings per share (in CHF) 23.56 20.63 Theoretical net profit from continuing operations (b)

assuming the exercise of all outstanding options

and sale of all treasury shares (in millions of CHF) 9 262 8 248 Number of shares (c) 393 072 500 399 860 700

(a) 2005 comparatives have been restated following the first application of the option of IAS 19 Employee B

Determining whether an Arrangement contains a Lease, as well as the decision to transfer the fresh che Nutrition (refer to Note 29).

(b) Profit for the period attributable to the shareholders of the parent adjusted for the net profit/(loss) on disc

(c) Net of the Nestlé S.A. shares held in connection with the Share Buy-Back Programme (refer to Note 25)

Nestl

é

Consolidated accounts 2006

6.2.2

Additional EPS

¾

If an additional EPS figure using a reported component of profit other than profit or loss for the period attributable to ordinary shareholders, is disclosed, such amounts should be calculated using the weighted average number of ordinary shares determined in accordance with IAS 33.

¾

A non-standard profit figure can be used to calculate an EPS in addition to that required by IAS 33 but the standard number of shares must be used in the calculation.

¾

If a profit figure is used which is not a reported as a line item in the statement of comprehensive income, a reconciliation should be provided between the figure and a line item, which is reported in the statement of comprehensive income.

¾

This additional EPS figure may not be shown on the face of the statement of

comprehensive income, it can only be disclosed in the notes to the financial statements.

6.2.3

Retrospective adjustments

¾

If an EPS figure includes the effects of:

‰ a capitalisation or bonus issue; or ‰ share split; or

(17)

The calculation of basic and diluted earnings per share for all periods presented should be adjusted retrospectively.

¾

For changes after the end of the reporting period but before issue of the financial statements, the per share calculations for those and any prior period financial statements presented should be based on the new number of shares.

¾

Basic and diluted EPS of all periods presented should be adjusted for the effects of errors, and adjustments resulting from changes in accounting policies.

FOCUS

You should now be able to:

¾

calculate the EPS in accordance with relevant accounting standards, dealing with bonus issues, full market value issues and rights issues;

¾

explain the relevance of the diluted EPS and calculate the diluted EPS involving convertible debt and share options or warrants;

¾

explain why the trend of EPS may be a more accurate indicator of performance than a company’s profit trend and the importance of EPS as a stock market indicator;
(18)

EXAMPLE SOLUTION

Solution 1 — Multiple capital change

1 January − 28 February

1,000,000 ×

12 2 ×

2 3 ×

21

22 = 261,905

1 March 31 March

1,400,000 ×

12 1 ×

2 3 ×

21

22 = 183,333

1 April 31 July

2,100,000 ×

12 4 ×

21

22 = 733,333

1 August 30 September

3,000,000 ×

12 2 ×

21

22 = 523,810

1 October 31 December

4,000,000 ×

12

3 × =1,000,000

________

2,702,381

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