Even when there are dividends in arrears, only the current year’s cumulative preferred stock dividend is deducted in the earnings per share computation. from previous years have already been deducted in the prior years’ earnings per share’ computations.
Presentation of ‘Earnings per Share ln the Income Statement A publicly owned corporations’ are required to present earnings per share figures in their income state mentor If an income statement includes’ subtotals for income from continuing operations,
or for income before extraordinary items, per-share figures are shown for these amounts as well as for net income.
These additional per-share amounts are computed by substituting the amount of the appropriate subtotal for the net income figure in’ the’ preceding calculation.
To illustrate all of the potential per-share, computations, we will expand our Tanner Corporation example to include income from continuing operations and income before extraordinary items. We should point out, however, that all of these figures seldom appear in the same income statement. Very few companies have discontinued operations, an extraordinary item, and an accounting change to report in the same year.
The condensed income statement shown on the following page is intended to illustrate the proper format for presenting earnings per share figures’ and to provide a review of the calculations Interpreting the Different per-Share Amounts To informed users of financial statements, each ofthese figures has a different significance.
Earnings per share from continuing operations represents the results of. continuing and ordinary business activity. This figure is the most useful one for predicting future operating results. Net earnings per share oil the other hand, shows the overall operating results .of the current year, including any . discontinued operations or extraordinary items Unfortunately, the tern, earnings per share often is used without qualification in referring to various types of per-share data.
When using per-share information, it is important to know exactly which per-share statistic is being presented.
For example, the ‘price-earnings ratios (market price divided by earnings per share) for common stocks listed on major stock exchanges are reported daily in The Wall Street Journal and many other newspapers. Which earnings per share figures are used in computing these ratios? If a company reports an extraordinary gain or loss, the price-earnings ratio is computed using the per-share earnings before the extraordinary item. Otherwise, the ratio is based on net earnings
•.Basic and Diluted Earnings per Share Let us assume that a company has an outstanding issue of preferred stock that is convertible into shares of common stock at a rate of two shares of common stock for each share of preferred stock.
The conversion of this preferred stock would increase the number of common shares outstanding and might dilute (reduce) earnings per -share.
Any Distinguish between· basic and diluted earnings per share The FAS exempted closely held corporalioM (1hosCnot publicly owned) from the requirement of computing and reporting earnings per are common stockholder interested in the trend of earnings per share will want to know what effect the conversion of the preferred stock would have on earnings per share of common stock.
To inform investors of the potential dilution that might occur, two figures are presented for each income number from the income statement. The first figure, called basic earnings per share, is based on the weighted-average number of common shares actually outstanding during the year.
This figure ignores the potential dilution represented by the convertible preferred stock.
The second figure, called diluted earnings per share incorporates the impact that conversion of the preferred stock would have on basic earnings per share. Basic earnings per share are computed in the same manner as illustratedin our preceding example of Tanner Corporation.
Diluted earnings per share, on the other hand are computed on the assumption that all the preferred stock had been converted into common stock at the beginning of the current year” (The mechanics of computing diluted earnings per share are covered in more advanced accounting courses.)Diluted earnings per share represent a hypothetical case and are often referred to as pro forma calculations, meaning that they incorporate events and transactions that have not yet occurred.
Diluted earnings per share are computed even though the preferred stock actually was not converted during the year. The purpose of showing diluted earnings per share is to warn common stockholders about what could have happened.
When the difference between basic and diluted earnings per share becomes significant, investors should recognize the risk that future earnings per share may be reduced by conversions of other securities into additional shares of common stock. When a company reports both basic and diluted earnings. per share, ~he priceearnings ratio shown in newspapers is based on the basic figure.