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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

(Issuance, Exercise, and Termination of Stock Options) On January 1, 2016, Nichols Corporation granted 10,000 options to key executives. Each option allows the executive to purchase one share of Nichols鈥� \(5 par value common stock at a price of \)20 per share. The options were exercisable within a 2-year period beginning January 1, 2018, if the grantee is still employed by the company at the time of the exercise. On the grant date, Nichols鈥� stock was trading at \(25 per share, and a fairvalue option-pricing model determines total compensation to be \)400,000.On May 1, 2018, 8,000 options were exercised when the market price of Nichols鈥� stock was $30 per share. The remaining options lapsed in 2020 because executives decided not to exercise their options.

Instructions

Prepare the necessary journal entries related to the stock option plan for the years 2016 through 2020.

(EPS with Complex Capital Structure) Amy Dyken, controller at Fitzgerald Pharmaceutical Industries, a public company, is currently preparing the calculation for basic and diluted earnings per share and the related disclosure for Fitzgerald鈥檚 financial statements. Below is selected financial information for the fiscal year ended June 30, 2017.

FITZGERALD PHARMACEUTICAL INDUSTRIES

SELECTED BALANCE SHEET

INFORMATION

JUNE 30, 2017

Long-term debt

Notes payable, 10% \( 1,000,000

8% convertible bonds payable 5,000,000

10% bonds payable 6,000,000

Total long-term debt \)12,000,000

Shareholders鈥� equity

Preferred stock, 6% cumulative, \(50 par value,

100,000 shares authorized, 25,000 shares issued

and outstanding \) 1,250,000

Common stock, \(1 par, 10,000,000 shares authorized,

1,000,000 shares issued and outstanding 1,000,000

Additional paid-in capital 4,000,000

Retained earnings 6,000,000

Total shareholders鈥� equity \)12,250,000

The following transactions have also occurred at Fitzgerald.

1. Options were granted on July 1, 2016, to purchase 200,000 shares at \(15 per share. Although no options were exercised

during fiscal year 2017, the average price per common share during fiscal year 2017 was \)20 per share.

2. Each bond was issued at face value. The 8% convertible bonds will convert into common stock at 50 shares per \(1,000

bond. The bonds are exercisable after 5 years and were issued in fiscal year 2016.

3. The preferred stock was issued in 2016.

4. There are no preferred dividends in arrears; however, preferred dividends were not declared in fiscal year 2017.

5. The 1,000,000 shares of common stock were outstanding for the entire 2017 fiscal year.

6. Net income for fiscal year 2017 was \)1,500,000, and the average income tax rate is 40%.

Instructions

For the fiscal year ended June 30, 2017, calculate the following for Fitzgerald Pharmaceutical Industries.

(a) Basic earnings per share.

(b) Diluted earnings per share.

(EPS: Simple Capital Structure) A portion of the combined statement of income and retained earnings of Seminole Inc. for the current year follows.

Income from continuing operations \(15,000,000

Loss from discontinued operations, net of

applicable income tax (Note 1) 1,340,000

Net income 13,660,000

Retained earnings at the beginning of the year 83,250,000

96,910,000

Dividends declared:

On preferred stock鈥擻)6.00 per share \( 300,000

On common stock鈥擻)1.75 per share 14,875,000 15,175,000

Retained earnings at the end of the year \(81,735,000

Note 1. During the year, Seminole Inc. suffered a major loss from discontinued operations of \)1,340,000 after applicable income tax reduction of \(1,200,000.

At the end of the current year, Seminole Inc. has outstanding 8,500,000 shares of \)10 par common stock and 50,000 shares of 6% preferred. On April 1 of the current year, Seminole Inc. issued 1,000,000 shares of common stock for $32 per share to help finance the loss from discontinued operations.

Instructions

Compute the earnings per share on common stock for the current year as it should be reported to stockholders

EPS: Simple Capital Structure) On January 1, 2018, Wilke Corp. had 480,000 shares of common stock outstanding. During 2018, it had the following transactions that affected the common stock account.

February 1 Issued 120,000 shares

March 1 Issued a 10% stock dividend

May 1 Acquired 100,000 shares of treasury stock

June 1 Issued a 3-for-1 stock split

October 1 Reissued 60,000 shares of treasury stock

Instructions

(a) Determine the weighted-average number of shares outstanding as of December 31, 2018.

(b) Assume that Wilke Corp. earned net income of \(3,456,000 during 2018. In addition, it had 100,000 shares of 9%, \)100 par nonconvertible, noncumulative preferred stock outstanding for the entire year. Because of liquidity considerations, however, the company did not declare and pay a preferred dividend in 2018. Compute earnings per share for 2018, using the weighted-average number of shares determined in part (a).

(c) Assume the same facts as in part (b), except that the preferred stock was cumulative. Compute earnings per share for 2018.

(d) Assume the same facts as in part (b), except that net income included a loss from discontinued operations of $432,000 (net of tax). Compute earnings per share for 2018.

Question: (Conversion of Bonds) On January 1, 2017, Gottlieb Corporation issued \(4,000,000 of 10-year, 8% convertible debentures at 102. Interest is to be paid semi-annually on June 30 and December 31. Each \)1,000 debenture can be converted into eight shares of Gottlieb Corporation \(100 par value common stock after December 31, 2018. On January 1, 2019, \)400,000 of debentures are converted into common stock, which is then selling at \(110. An additional \)400,000 of debentures are converted on March 31, 2019. The market price of the common stock is then $115. Accrued interest at March 31 will be paid on the next interest date. Bond premium is amortized on a straight-line basis.

Make the necessary journal entries for:

(a) December 31, 2018. (c) March 31, 2019.

(b) January 1, 2019. (d) June 30, 2019.

Record the conversions using the book value method
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