Earnings per share (EPS) is one of the most important metrics for valuing a business. The FAR CPA exam will ask you how to calculate EPS; so you need to understand the factors that impact the earnings calculation in order to guarantee a passing score.
These tips will help you to answer the EPS questions successfully.
Check them out below:
Basic vs. Diluted Earnings Per Share
For starters, you need to understand the difference between basic EPS and diluted EPS:
The basic calculation for earnings per share is (Earnings per common share) / (Weighted average common stock shares outstanding). Note the following:
- Net income: Earnings refer to net income generated in the income statement and posted as an increase to equity in the balance sheet.
- Common shares: Basic EPS applies to company earnings that are available for common stock shareholders. Shareholders can benefit by receiving a portion of earnings as a cash dividend, and higher earnings may also result in a higher stock price per share. EPS focuses on common shareholders only.
- Weighted average common stock shares outstanding: The average is computed as [(beginning balance) + (ending balance)] / 2, and the average is typically computed on annual basis.
This basic calculation is heavily tested on the FAR test, so make sure you’ve got it down!
The term diluted EPS exists because there are securities that can be converted into common stock shares. Diluted EPS assumes that any security that can be converted into common stock is converted.
Keep in mind, however, that diluted EPS assumes that the dollar amount of earnings available to shareholders does not change. The earnings per share is diluted because the same dollar amount of earnings are “spread” over a larger number of common stock shares.
Assume, for example, that a company’s basic EPS is ($1,000,000 / 200,000 shares): $5 per share. If dilution increases the number of common stock shares to 400,000, EPS declines to $2.50 per share.
Securities That Dilute Earnings Per Share
Here are several securities that can be converted into shares of common stock:
Convertible bonds have a provision in the bond indenture (written agreement) that allows a bondholder to convert the bond into a specific number of common stock shares.
For example, assume that IBM issues a $1,000 corporate bond that is convertible into 20 shares of IBM common stock, and that the market value of the bond is $1,050. If the stock price of IBM common stock is $60 per share, the bondholder can convert the bonds and receive 20 shares of common stock worth $1,200 (20 shares X $60 per share).
Converting into common stock changes the investment from a bond (debt) instrument into equity, and the $1,200 market value of the stock is more than the bond’s $1,050 market value.
Convertible Preferred Stock
Preferred stock differs from common stock. If a company generates earnings and decides to pay a dividend, preferred shareholders receive their dividends before common shareholders.
As mentioned above, the EPS calculations only include earnings available to common shareholders. Consequently, earnings paid as dividends to preferred stockholders are excluded from the EPS calculation.
Some preferred stock is issued with the option of converting to common stock, and a conversion would increase common stock shares outstanding.
Many companies offer stock options as a form of additional compensation to employees.
As an example, assume that Sally is the CFO of a company, and she is granted the right to buy 500 shares of company stock at a price of $50 per share. If the market price of the stock moves to $65 a share, Sally can profit by exercising her right and buying the stock at $50. She can sell at $65, or hold the stock and try to recognize a larger profit later.
Stock options are dilutive for EPS. Get it?
Rights And Warrants
Rights and warrants also give an investor the means to purchase common stock, and a warrant may be attached as a “sweetener” to another investment, such as a corporate bond.
Ultimately, to compute diluted EPS, add up the total number of common stock shares that can be obtained by conversion and add that total to the existing common shares outstanding (held by the public).
Companies may issue more common stock shares to raise capital; this transaction increases the weighted average number of shares.
When a business issues more common stock shares but the dollar amount of earnings stays the same, basic and diluted EPS will decrease. The company will spread the same dollar amount of earnings over more shares of common stock.
Retiring Stock Shares
Alternatively, a business can repurchase common stock shares and retire them, meaning that the shares are no longer outstanding.
If shares are retired and the dollar amount of earnings stays the same, basic and diluted EPS will increase. The firm will earn more dollars per share of common stock outstanding.
Changes In Weighted Average Shares
The most time-consuming questions related to EPS involve calculating weighted average shares of common stock outstanding. These questions include transactions during the year that increase or decrease the number of shares outstanding.
If you’re a CPA candidate taking the test, you must compute the number of shares outstanding for a particular period and multiply them by the percentage of the year (number of months / 12).
Here’s an example:
- January 1st: 100,000 shares outstanding
- April 1st: Company issues 50,000 additional shares of common stock
- November 1st: Company retires 20,000 shares of common stock
Based on this data, here are the shares outstanding by period:
- January 1st to March 31st (3 months): 100,000 shares
- April 1st to October 31st (7 months): 150,000 shares
- November 1st to December 31st (2 months): 130,000 shares
Finally, here is the weighted average share calculation:
(100,000 X 3/12) + (150,000 X 7/12) + (130,000 X 2/12) = 134,167 shares
Before you dive into answering these questions, make sure that you understand how to organize the information!
Useful FAR CPA Exam Tools
Calculating earnings per share correctly is an important skill that a CPA needs to master. Use this article to study the factors impacting EPS and you will greatly improve your chances to pass the FAR section.
Good luck on your exam!