Question

For the year ending 30 June 2016, XYZ Ltd earns a profit after tax of $1.05 million. Dividends on 400 000 convertible, cumulative preference shares amount to $200 000. The preference dividends are not treated as expenses in the accounts of Lennox Ltd (the preference shares have been disclosed as equity in the statement of financial position). As at 1 July 2015 there were 500 000 fully paid ordinary shares. There were no additional share issues during the year.

As at 1 July 2015 there were also:

$250 000 in convertible debentures, which paid interest at a rate of 10% per year, and which could be converted to 125 000 ordinary shares, at the option of the debenture holder;

20 000 share options currently on issue, with an exercise price of $2.00;

the 400 000 convertible, cumulative preference shares, which were issued in 2010 and are convertible into 120 000 ordinary shares at the option of the preference shareholders;

Assume the tax rate is 30% and that the average market price for ordinary shares during the year was $5

Calculate XYZ Ltd’s:

(a) basic EPS

(b) diluted EPS

Answer 1

BASIC EPS

Profit After Tax $1050000

Less: Preference dividend ($200000)  

Profit After Tax and Preference Dividend $850000

BASIC EPS =$850000/500000

=$1.70 per share

b.Diluted EPS

Each security must be considered separately

Convertible debentures

If the debentures are converted to ordinary shares, the pre-tax earnings would be increased by $25 000. This would lead to an after-tax increase in earnings of $17500, which is $25 000 × (1 – 0.30)

As an additional 125 000 shares would be created, the increase in earnings attributable to ordinary shareholders on conversion of the convertible debentures would, on an incremental share basis, be: $17500 ÷ 125 000 = $0.14

Share options

As the options have been on issue for the entire year, we treat them as potentially dilutive as of the beginning of the year

The standard requires that we consider the number of shares that would effectively be issued for no consideration if these options are exercised. To determine this we perform the following calculation:

Number of shares issuable 20 000

Number of shares that would be issued at market price

for the actual proceeds of $40 000 = $40 000 ÷ $5 8 000

Number of shares deemed issued for no consideration 12 000

Given that there is no adjustment to earnings recognised in relation to the options, the earnings per incremental share are $nil. Twelve thousand shares will be added to the denominator to calculate diluted EPS

Convertible, cumulative preference shares

If the preference shares are converted, dividends of $200 000 would be saved. Their conversion would lead to an increase in ordinary shares by 120 000. The increase in earnings per incremental share (because the preference share dividends were initially excluded when calculating EPS) would be:                  $200 000/120 000 = $1.667

Ranking the potential ordinary shares from greatest to least dilution

when we consider whether potential ordinary shares are dilutive, each issue or series of potential ordinary shares must be considered separately, rather than in aggregate. Each issue or series of potential ordinary shares must be considered in sequence from the most dilutive (smallest earnings per incremental share) to the least dilutive (largest earnings per incremental share)

The order from most dilutive to least dilutive is:

Increase in shares Earnings per incremental share

Options 12 000 $nil

Convertible debentures 125 000 $0.14

Convertible preference shares 120 000 $1.667

The sequence in which potential ordinary shares are considered might affect whether or not they are dilutive. If potential ordinary shares are not dilutive, the standard generally requires that they be ignored when calculating diluted EPS

Determining the ‘trigger test’

If the shares cause EPS to decrease from the initial amount determined for the trigger test, they are considered dilutive. The standard uses profit or loss from continuing operations attributable to the parent entity as the initial amount for the trigger test to determine whether potential ordinary shares are dilutive

Profit used to calculate basic EPS $850 000

less Adjustments   $nil

Net profit from continuing operations for the trigger test $850 000

$850 000 ÷ 500 000 = $1.70

Profit and Ordinary adjustments shares EPS Dilutive?

Net profit from continuing operations $850 000 500 000 $1.70

Options NIL 12000

$850 000 512 000 $1.6602 Yes

Convertible debentures $17500 125 000

$867500 637 000 $1.3618 Yes

Convertible preference shares $200 000 120 000

$1 066 750 757 000 $1.4092 No

In the above calculation, profit or loss from continuing operations is the starting point in the trigger test. After this point, each potential ordinary share is considered in order of smallest earnings per incremental share to largest earnings per incremental share. If a particular security does not dilute EPS, it is not to be included when calculating diluted EPS

Calculation of diluted EPS

While net profit from continuing operations is used to assess whether or not potential ordinary shares are dilutive then net profit or loss to be used in the calculation of diluted EPS. As noted above, the earnings figure used in the actual calculation of diluted EPS includes discontinuing operations, adjustments for changes in accounting policies and corrections of material errors. As with basic EPS, the preference dividends paid are excluded

Profit Ordinary shares

As reported for basic EPS $850 000 500 000

Options Nil 12 000

Convertible debentures $16 750   125 000

$866 750   637 000

Diluted EPS = $866 750 ÷ 637 000 = 1.3607

Again, as the preference shares are not dilutive, they are not included in the calculation of diluted EPS