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Chapter 16: 6CA (page 887)

CA16-6 WRITING (EPS, Antidilution) Brad Dolan, a stockholder of Rhode Corporation, has asked you, the firm鈥檚 accountant, to explain why his stock warrants were not included in diluted EPS. In order to explain this situation, you must briefly explain what dilutive securities are, why they are included in the EPS calculation, and why some securities are antidilutive and thus not included in this calculation.

Rhode Corporation earned \(228,000 during the period, when it had an average of 100,000 shares of common stock outstanding. The common stock sold at an average market price of \)25 per share during the period. Also outstanding were 30,000 warrants that could be exercised to purchase one share of common stock at $30 per warrant.

Instructions

Write Mr. Dolan a 1鈥�1.5-page letter explaining why the warrants are not included in the calculation.

Short Answer

Expert verified

Warrants are not included in the earnings per share calculationbecause these are anti-dilutive securities.

Step by step solution

01

Definition of Diluted Earnings per Share

The financial metric that calculates the earnings per share, assuming that all investors will convert their convertible debt securities into equity security, is diluted earnings per share.

02

Letter for explaining why warrants are not included in the calculation of diluted earnings per share

Dear Mr. Dolan

Earnings per share are the metric that will provide information about the profit generated for each common share outstanding. It is calculated using the following formula:

Earningspershare=Netincome-PreferreddividendCommonsharesoutstanding

Some corporations have different varieties of shares outstanding such as convertible bonds, convertible preferred stock, and stock options. Such shares are convertible into common stock and therefore have a dilutive effect on the earnings per share.

Analysts believe that financial statements must provide fair and true information to their users. Therefore, basic EPS calculation includes only common shares outstanding while dilutive EPS calculation includes dilutive securities also. Basic EPS uses only shares outstanding, while dilutive earnings per share assume that all convertible securities are converted into shares.

Some of the securities are anti-dilutive, inflating the value of earnings per share rather than diluting it. Therefore, these securities are excluded from the calculation of earnings per share.

Now taking the above situation:

If 30,000 warrants are exercised at $30, it will not increase the outstanding shares by 30,000; rather, it will dilute the EPS. The company will retire the shares of treasury stock from the proceeds received.

Retiredshares=Outstandingwarrants脳ParvalueofwarrantParvalueoftreasurystock=30,000$30$25=36,000

Therefore, the company can repurchase 36,000 shares using the proceeds received from the exercise of warrants. This process will increase the outstanding shares by 30,000 and decrease them by 36,000. Therefore, the total outstanding shares will reduce by 6,000 shares. Due to a reduction in the denominator, earnings per share will increase, and the aim of exercising the warrant will remain unachieved. Therefore, these warrants are anti-dilutive and will not be included in calculating earnings per share.

Regards,

Accountant

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Most popular questions from this chapter

How is antidilution determined when multiple securities are involved?

(Conversion of Bonds) Aubrey Inc. issued \(4,000,000 of 10%, 10-year convertible bonds on June 1, 2017, at 98 plus accrued interest. The bonds were dated April 1, 2017, with interest payable April 1 and October 1. Bond discount is amortized semi-annually on a straight-line basis.On April 1, 2018, \)1,500,000 of these bonds were converted into 30,000 shares of $20 par value common stock. Accrued interest was paid in cash at the time of conversion.

(a) Prepare the entry to record the interest expense at October 1, 2017. Assume that accrued interest payable was credited when the bonds were issued. (Round to nearest dollar.)

(b) Prepare the entry(ies) to record the conversion on April 1, 2018. (Book value method is used.) Assume that the entry to record amortization of the bond discount and interest payment has been made

What effect do stock dividends or stock splits have on the computation of the weighted-average number of shares outstanding?

DiCenta Corporation reported net income of \(270,000 in 2017 and had 50,000 shares of common stock outstanding throughout the year. Also outstanding all year were 5,000 shares of cumulative preferred stock, each convertible into 2 shares of common. The preferred stock pays an annual dividend of \)5 per share. DiCenta鈥檚 tax rate is 40%. Compute DiCenta鈥檚 2017 diluted earnings per share.

(Warrants Issued with Bonds and Convertible Bonds) Incurring long-term debt with an arrangement whereby lenders receive an option to buy common stock during all or a portion of the time the debt is outstanding is a frequent corporate financing practice. In some situations, the result is achieved through the issuance of convertible bonds; in others, the debt instruments and the warrants to buy stock are separate.

Instructions

(a) (1) Describe the differences that exist in current accounting for original proceeds of the issuance of convertible bonds and of debt instruments with separate warrants to purchase common stock.

(2) Discuss the underlying rationale for the differences described in (a)(1) above.

(3) Summarize the arguments that have been presented in favor of accounting for convertible bonds in the same manner as accounting for debt with separate warrants.

(b) At the start of the year, Huish Company issued \(18,000,000 of 12% bonds along with detachable warrants to buy 1,200,000 shares of its \)10 par value common stock at \(18 per share. The bonds mature over the next 10 years, starting one year from date of issuance, with annual maturities of \)1,800,000. At the time, Huish had 9,600,000 shares of common stock outstanding. The company received $20,040,000 for the bonds and the warrants. For Huish Company, 12% was a relatively low borrowing rate. If offered alone, at this time, the bonds would have sold in the market at a 22% discount. Prepare the journal entry (or entries) for the issuance of the bonds and warrants for the cash consideration received.
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