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Chapter 16: Q5CA (page 887)

CA16-5 (EPS: Preferred Dividends, Options, and Convertible Debt) 鈥淓arnings per share鈥� (EPS) is the most featured, single financial statistic about modern corporations. Daily published quotations of stock prices have recently been expanded to include for many securities a 鈥渢imes earnings鈥� figure that is based on EPS. Stock analysts often focus their discussions on the EPS of the corporations they study.

Instructions

(a) Explain how dividends or dividend requirements on any class of preferred stock that may be outstanding affect the computation of EPS.

(b) One of the technical procedures applicable in EPS computations is the 鈥渢reasury-stock method.鈥� Briefly describe the circumstances under which it might be appropriate to apply the treasury stock method.

(c) Convertible debentures are considered potentially dilutive common shares. Explain how convertible debentures are handled for purposes of EPS computations.

Short Answer

Expert verified
  1. Dividend declared/paid to preference shareholders is deducted from net income depending upon whether the preference shares are cumulative or non-cumulative.
  2. Treasury method is applied after comparing exercise price and average price.
  3. Interest on debentures and the number of shares increased due to conversion are considered while calculating earnings per share.

Step by step solution

01

Definition of Earnings Per Share

The financial calculation that determines the profit generated for each share is known as earnings per share. It is calculated using net income and numerator and outstanding shares as the denominator.

02

Effect of preferred dividend on the computation of earnings per share

Dividends of preferred shares are deducted from the net income to calculate the earnings per share. If the preferred shares are cumulative, the business entity must deduct the current year鈥檚 dividend from the net income, regardless of its declaration and payment. If the preferred shares are not cumulative, the business entity must deduct the dividend if paid or declared.

If the preferred shares are convertible, then it is assumed that they are converted into common stock, and the dividend paid to them is not deducted from net income to calculate earnings per share.

03

Circumstances under which it is appropriate to apply the treasury stock method

The Treasury stock method is appropriate to apply when options and the warrants that can be converted into common stock are outstanding. The exercise price of such warrants and options is lower than the average price at which the company's outstanding shares can be reacquired.

04

Convertible debentures in the computation of earnings per share

If convertible debentures are outstanding, then the interest on such debentures is added to net income, which is reported as a numerator in the calculation of earnings per share, and the number of weighted average shares in which the debentures can be converted are added to the shares outstanding reported as the denominator in the calculation of earnings per share.

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Most popular questions from this chapter

IFRS16-12 Assume the same information in IFRS16-11, except that Angela Corporation converts its convertible bonds on January 1, 2017.

Instructions

(a) Compute the carrying value of the bond payable on January 1, 2017.

(b) Prepare the journal entry to record the conversion on January 1, 2017.

(c) Assume that the bonds were repurchased on January 1, 2017, for \(1,940,000 cash instead of being converted. The net present value of the liability component of the convertible bonds on January 1, 2017, is \)1,900,000. Prepare the journal entry to record the repurchase on January 1, 2017.

Refer to the data for Barwood Corporation in BE16-6. Repeat the requirements assuming that instead of options, Barwood granted 2,000 shares of restricted stock.

(Weighted-Average Number of Shares) Newton Inc. uses a calendar year for financial reporting. The company is authorized to issue 9,000,000 shares of $10 par common stock. At no time has Newton issued any potentially dilutive securities. Listed below is a summary of Newton鈥檚 common stock activities.

1. Number of common shares issued and outstanding at December 31, 2015 2,000,000

2. Shares issued as a result of a 10% stock dividend on September 30, 2016 200,000

3. Shares issued for cash on March 31, 2017 2,000,000Number of common shares issued and outstanding at December 31, 2017 4,200,000

4. A 2-for-1 stock split of Newton鈥檚 common stock took place on March 31, 2018

Instructions

(a) Compute the weighted-average number of common shares used in computing earnings per common share for 2016 on the 2017 comparative income statement.

(b) Compute the weighted-average number of common shares used in computing earnings per common share for 2017 on the 2017 comparative income statement.

(c) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2017 on the 2018 comparative income statement.

(d) Compute the weighted-average number of common shares to be used in computing earnings per common share for 2018 on the 2018 comparative income statement

(Issuance and Conversion of Bonds) For each of the unrelated transactions described below, present the entry(ies) required to record each transaction.

1. Grand Corp. issued \(20,000,000 par value 10% convertible bonds at 99. If the bonds had not been convertible, the company鈥檚 investment banker estimates they would have been sold at 95.

2. Hoosier Company issued \)20,000,000 par value 10% bonds at 98. One detachable stock purchase warrant was issued with each \(100 par value bond. At the time of issuance, the warrants were selling for \)4.

3. Suppose Sepracor, Inc. called its convertible debt in 2017. Assume the following related to the transaction. The 11%, \(10,000,000 par value bonds were converted into 1,000,000 shares of \)1 par value common stock on July 1, 2017. On July 1, there was \(55,000 of unamortized discount applicable to the bonds, and the company paid an additional \)75,000 to the bondholders to induce conversion of all the bonds. The company records the conversion using the book value method.

Where can authoritative IFRS be found related to dilutive securities, stock-based compensation, and earnings per share?
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