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FASB reconsiders earnings per share.

Ealier this year, the Financial Accounting Standards Board (FASB) decided to add a project on earnings per share to its agenda. The project is consistent with the Board's stated mission of enhancing the quality of financial reporting by promoting international comparability of accounting standards. Concurrent with FASB's decision to redeliberate earnings per share, the International Accounting Standards Committee (IASC) will also be studying the same topic. While both standard setting organizations will cooperate with each other in exchanging information, their efforts do not represent a joint project.

FASB has indicated that the goals of its project are to simplify current U.S. accounting requirements on earnings per share as well as issue new rules that mirror those which the IASC are expected to issue. The focus of the limited scope project is on the consideration of the number of shares used in the denominator of the earnings per share calculation and any resulting impact on the numerator. The Board has stated that it would not address the conceptual definition of earnings.

In June the IASC issued a Statement of Principles, Earnings per Share, which will provide a framework for an IASC Exposure Draft. The Statement's basic provisions are compatible with FASB's preliminary conclusions on this issue. Both standard-setting organizations have come out in favor of a relatively simple, basic/diluted earnings per share approach.

Popularity of Earnings per Share

Earnings per share is the most popular statistic used by financial analysts, shareholders, and others to assess the profitability of an enterprise. It indicates the amount of income earned by each share of common stock. Over several reporting periods, an analysis of earnings per share may signal the eventual success or failure of an enterprise. Some financial statement users even regard the statistic as a long-run indicator of cash flow per share. When used in conjunction with the price per share of common stock (that is, the price/earnings ratio), it suggests how optimistic investors are about an enterprise's growth potential.

Presently, different national standard setters impose different requirements for calculating earnings per share. For example, while Australia, Canada, and Great Britain prescribe a relatively simple, basic (net income divided by weighted average common shares outstanding) and fully diluted presentation, current U.S. accounting rules (Opinion No. 15 as amended and interpreted), require public enterprises with complex capital structures (includes securities that could have a dilutive effect on earnings per share) to present primary earnings per share (net income divided by common stock and common stock equivalent shares outstanding) as well as fully diluted earnings per share.

The lack of uniform requirements for the computation of earnings per share is potentially problematic. If users of earnings per share data are to make meaningful comparative analyses that transcend national boundaries, they will require more homogeneity in the manner the statistic is computed. Standardizing earnings per share is crucial for the efficient allocation of capital resources in today's ever-expanding global arena.

Complexity of Opinion No. 15

Since its issuance in the late 1960s, critics have charged that many provisions of Opinion No. 15 (as amended and interpreted), especially as they pertain to the computation of primary earnings per share, are too complex. Among these is the requirement for assessing whether a security (convertible preferred stock or convertible bond) is a common stock equivalent. A common stock equivalent is defined as a security that while in form is not common stock is, in substance, equivalent to common stock because of its provisions. While stock options and warrants are always regarded as common stock equivalents, convertible securities are considered common stock equivalents if, at issuance, their effective yield is less than two-thirds of the average Aa corporate bond yield. Under current accounting rules, a security that qualifies as a common stock equivalent is included in primary earnings per share if it has a dilutive effect (that is, decrease earnings per share).

In addition to its complexity, critics have charged that the common stock equivalency test contains several assumptions that are unrealistic and difficult to support. For example, it requires assessment of common stock equivalence only at the time a convertible security is issued. Changing circumstances, such as market prices, interest rates, or investor expectations, which may affect a decision to convert are ignored. Thus, if a convertible security is initially classified as a common stock equivalent, it is always a common stock equivalent even though current economic conditions may render its conversion into common stock unlikely. Similarly, a security initially not classified as a common stock equivalent will never enter into primary earnings per share regardless if conversion becomes imminent because of changed conditions.

The common stock equivalency test has also been described as biased against the classification of a convertible security as a common stock equivalent since it requires comparing the return of a relatively risk-free security (Aa corporate bond) with that of a riskier convertible security. This rule has more of an adverse impact on convertible preferred stock. Convertible preferred stock generally commands a higher rate of return because it does not have preference over convertible bonds with respect to liquidation of corporate assets. The higher return makes it less likely to qualify as a common stock equivalent.

The common stock equivalency test appears to be based on the assumption that investors would be willing to realize a yield of less than two-thirds of the average Aa bond yield only when they anticipate converting their securities into common stock. Thus, it would seem that the test's purpose should be to determine those securities that are likely candidates for conversion so users of financial information can assess the possible effect on earnings per share.

How realistic are the test's assumptions, particularly the inclusion of an arbitrarily selected threshold of 66 2/3 percent, is debatable. Further, doubts exist about the use of the common stock equivalency test as an effective tool of prognostication. In this regard, accounting researchers have provided evidence suggesting that the test does not do a particularly good job in predicting conversion.

Given the problems associated with the commonstock equivalency test, it seems that FASB is on solid ground in tentatively concluding to replace the presentation of primary earnings per share currently required by Opinion No. 15 with a simpler, basic earnings per share.

FASB's Tentative Conclusions

FASB hopes its project on earnings per share, by correcting some of the deficiencies of Opinion No. 15, will reduce complexity and increase international comparability. However, because the Board will not address earnings per share on a comprehensive basis at this time, it expects to retain the scope of Opinion No. 15.

Following the lead of the IASC, the Board has tentatively concluded to replace primary earnings per share with basic earnings per share. The notion of common stock equivalents would no longer exist. Basic earnings per share would be computed by dividing income attributable to common shareholders by the weighted average number of common shares outstanding during the period. The Board has noted that the objective of basic earnings per share is to measure the performance of an enterprise over the period per share of common stock. While basic earnings per share would essentially exclude the effects of dilution, contingently issuable shares would be included in the statistic if shares are vested (that is, the condition has been met, the shares are no longer contingent, and issuance of shares is pending only time).

FASB has also tentatively concluded to replace fully diluted earnings per share with diluted earnings per share. The Board has stated that the objective of the diluted earnings per share computation is to measure the performance of an enterprise over the period per share of outstanding stock while giving effect to all potentially dilutive shares that might in the future participate in earnings. In essence, all contingent issuances (options, warrants, convertible securities, and contingent shares) of common stock that would reduce earnings per share would be included in the statistic regardless of the period of time in which they must be exercised, converted, or issued.

"If-Converted" and "Treasury Stock" Methods Retained

Preparers would calculate diluted earnings per share using the "if-converted" method for convertible securities prescribed by Opinion No. 15. The method assumes a convertible security to have been converted into common stock at the beginning of the earliest period reported or at the date of issuance of the security, if later. Under this assumption of conversion, the numerator of the earnings per share statistic is increased by the amount of bond interest expense (net of tax) that would not have been incurred or the amount of preferred stock dividends that would not have been declared. The denominator is increased by the additional shares assumed converted.

For example, assume a basic earnings per share of $2.50 (net income of $12,000 - $2,000 preferred dividends/4,000 weighted average common shares outstanding). Also, assume that outstanding during the entire period was convertible preferred stock (convertible into 1,000 common shares) on which the $2,000 of cash dividends were declared. Under the "if-convened" method, the numerator of earnings per share is increased to $12,000, while 1,000 shares are added to the denominator. Diluted earnings per share would be $2.40 ($12,000/5,000 shares).

The treasury stock method, as prescribed by Opinion No. 15, would be used for options and warrants in the computation of diluted earnings per share. Like the "if-convened" approach, the method assumes options or warrants are exercised at the beginning of the earliest period reported or at the date of issue, if later. The treasury stock method is so named because it assumes the proceeds from the exercise of options and warrants are used to purchase common stock for the treasury.

Options or warrants would be included in diluted earnings per share if the exercise price is lower than the average market price of the common stock for the period. When the average market price exceeds the exercise price, the options or warrants are dilutive. The difference between the number of shares assumed issued and the amount assumed purchased for the treasury are added to the weighted average number of shares outstanding for purposes of calculating diluted earnings per share.

To illustrate the treasury stock approach under the proposed rules, assume a basic earnings per share of $4.00 ($20,000 net income/5,000 weighted average common shares outstanding). Further, assume 1,000 options outstanding at an exercise price of $3.00 a common share and a common stock average market price per share of $5.00. The proceeds ($3,000 = 1,000 options X $3) from the assumed exercise of the options are used to reacquire 600 ($3,000/$5) common shares. Thus, 400 incremental shares (1,000 shares issued -600 reacquired) would be used to compute diluted earnings per share of $3.70 ($20,000/5,400 shares).

Under current practice, the closing market price per share of common stock, if it exceeds the average price, is used to determine the assumed number of common shares reacquired when computing fully diluted earnings per share. However, FASB has tentatively decided that the treasury stock method would always use the average price during the period.

According to FASB's preliminary conclusions, all public enterprises with complex capital structures would be required to present both basic and diluted earnings per share on the face of the income statement, even if they are the same amount. Enterprises with simple capital structures (consists of only common stock or includes no potentially dilutive convertible securities, options, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per share) would present only basic earnings per share.

Since both primary and fully diluted earnings per share incorporate dilution under current practice, financial statement users may not fully realize the magnitude of total potential dilution. A basic/diluted earnings per share presentation may prove more useful for decision-making because it would focus on the spread between a current, historically based statistic (basic earnings per share) and the maximum amount of potential dilution (diluted earnings per share).


FASB and IASC are in agreement relative to advocating a fairly simple, basic/diluted earnings per share presentation. Members of the IASC Earnings per Share Steering Committee are scheduled to meet with FASB this month to discuss the Board's tentative conclusions. The Board expects to issue an Exposure Draft concurrently with the IASC early in 1995.

William J. Read, Ph.D., CPA is a professor of accountancy at Bentley College, Waltham, MA.
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Title Annotation:Financial Accounting Standards Board
Author:Read, William J.
Publication:Business Credit
Date:Sep 1, 1994
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