Introduction

Diluted earnings per Share (EPS) is an important concept of accounting. In this article we are covering below topics of diluted EPS;

• Meaning of Dilution
• Convertible shares and convertible bonds
• Options and Warrants
• Employee share options

 

Basic Concept of Diluted EPS

Dilution means reduction in strength. A company issues convertible shares / bonds, options and warrants which increases the share capital of the company and reduces earning per share hence dilution.

Diluted EPS is calculated by adjusting earnings of the company and also its number of shares. Earnings are adjusted because interest or dividend shall no longer be paid upon conversion of shares / bonds into share capital.

Convertible shares dividend is added back in the earnings and for convertible bonds finance cost net of tax is also added.

 

Diluted EPS Convertible shares and convertible bonds

Convertible shares dividend is added back in the earnings and for convertible bonds finance cost net of tax is added to arrive at the adjusted earnings.

The concept can be further understood through below example;

Example of Diluted Earnings Per Share for convertible bonds

A company have 15 million shares and Rs.5 million convertible bonds @4% convertible in year 2 for 25 shares for every 100 shares. Total earnings for the year 1 is Rs.45 million. Tax rate is 35%.

Answer:

Basic EPS:

45,000,000/15,000,000 = Rs.3 per share

 

Diluted Earnings Per Share:

	Number of shares	Earnings (Rs.)	EPS (Rs.)
Basic	15,000,000	45,000,000	3
Dilution:
Number of shares
5,000,000 x 25/100 (25 shares for every 100 shares)	1,250,000
Interest add back
4% x Rs.5,000,000		200,000
Tax @35%		(70,000)
Adjusted Numbers	16,250,000	45,130,000	2.78

 Diluted EPS = Rs.2.78

[mkd_highlight background_color=”” color=”green” padding=”” line_height=”” font_size=”17″]If shares are issued during the period for example on May 1 then number of shares shall be calculated as; 5,000,000 x 25/100 x 8/12 = 833,333. (shares from May 1 to Dec 31 i.e. 8 months)[/mkd_highlight]

 

Diluted EPS Share Options and Warrants

Options and warrants give the holder the option to buy shares at the pre- determined price in future period. The amount received on exercise of the option shall not be considered as it shall not dilute the earnings rather cash can be utilized in future earnings of the company, it’s only the free shares that cause dilution.

Calculation of free shares on share options and warrants

• Calculate cash proceeds on exercise of options.
• Divide by average share market price
• Subtract shares calculated in step 2 from options in step 1 to arrive at free shares

To explain these steps below example shall help;

Example of Diluted EPS for share options

A company has earnings of Rs.20 million. It has 4 million ordinary shares. There are 250,000 share options to be exercised in future date at Rs.75. Average market price of shares is Rs.100.

Step 1
Cash proceeds 250,000 x 75	Rs.18,750,000
Step 2
Divide by average share market price	Rs.100
	187,500
Step 3
Subtract shares in step 2 from options in step 1	250,000 – 187,500 = 62,500 free shares

 

	Number of shares	Earnings (Rs.)	EPS (Rs.)
Basic	4,000,000	20,000,000	5
Dilution:
Number of shares (calculated above)	62,500
Adjusted Numbers	4,062,500	20,000,000	4.92

 

“[mkd_highlight background_color=”” color=”green” padding=”” line_height=”” font_size=”17″]If option price is more than market price of the share it is called out of the money and shall not be exercised[/mkd_highlight].

[mkd_highlight background_color=”” color=”green” padding=”” line_height=”” font_size=”17″]”Options shall only be exercised if option price is less than the market price of the share it is called in the money.”[/mkd_highlight] 

 

Diluted EPS Employee share option scheme

Vested Options:

The employee share option which are already vested shall be treated as per share options as explained above.

Unvested Options:

For unvested options company recognize an expense over the vesting period in accordance with IFRS 2. IAS 33 requires that this expense shall be added to cash proceeds, the reason of adding is that this expense represents the service of the employee that shall be used by the company in the future.

Steps for calculation shall be as follows:

 

• Calculate cash proceeds on exercise of options and add future expense.
• Divide by average share market price.
• Subtract shares calculated in step 2 from options in step 1 to arrive at free shares

 

To explain these steps below example shall help;

Example of Diluted EPS for employee share option scheme.

 

A company has earnings of Rs.20 million. It has 4 million ordinary shares. There are 250,000 unvested employees share options to be exercised in future date at Rs.75. The future expense that company expects to recognize in respect of these options up to the vesting period is Rs.2.25 million. Average market price of shares is Rs.100.

Step 1
Cash proceeds 250,000 x 75	Rs.18,750,000
Future employee Service	Rs.2,250,000
	Rs.21,000,000
Step 2
Divide by average share market price	Rs.100
	210,000
Step 3
Subtract shares in step 2 from options in step 1	250,000 – 210,000 = 40,000 free shares

 

	Number of shares	Earnings (Rs.)	EPS (Rs.)
Basic	4,000,000	20,000,000	5
Dilution:
Number of shares	40,000
Adjusted Numbers	4,040,000	20,000,000	4.95

 

About the Article:

The author searched the topic of Diluted EPS on internet and found only the formula of EPS or IAS 33 summary, so he feels that there is need to explain Diluted EPS in little bit detail with examples.

Audience:

The article is for students to learn basic concept of IAS 33 and for professionals so that they can revise the topic for usage in practical life.

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Earnings per Share (EPS) – IAS 33