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The FASB and the IASC redeliberate EPS.

The Financial Accounting Standards Board has been redeliberating earnings per share with the objective of issuing new accounting rules that would simplify EPS calculations and enhance international comparability. The International Accounting Standards Committee also is studying EPS. It approved a Statement of Principles, Earnings per Share, in June 1994. While the standard setters have agreed to cooperate with each other in sharing information, they will issue separate statements. When the cooperative undertaking is completed, financial information users should be better able to compare the performance of enterprises of various nations.

The FASB added EPS to its agenda after constituents and advisory groups recommended it undertake a project limited to considering the number of shares used in the denominator and any resulting impact on the numerator. A broad-based approach that would address the conceptual definition of earnings was not recommended.

The FASB--IASC EPS project is part of the FASBS plan to become more active in international accounting matters as outlined in the FASB's Plan for International Activities (1991). A crucial part of the plan calls for the FASB to join the IASC in a global standard-setting project that has the potential to attain broad international agreement in a reasonable period. Based on developments to date, the EPS project seems to have that potential. This article provides an overview of the FASB and IASC tentative conclusions on EPS. A glossary of terms appears on page 47.


EPS generally is considered useful to those who make economic decisions. It is perhaps the most often cited and reported measure of an enterprise's performance. Investors, creditors, analysts and others use the statistic to evaluate how successful an enterprise has been in attaining its profit goal. Financial statement users also use EPS data to assess earnings potential and prospects for future dividends.

Developing the requirements for EPS has been an evolutionary process. Initial guidance was issued as Accounting Research Bulletin no. 49, Earnings per Share, which offered general guidelines for calculating and presenting EPS. However, although many enterprises voluntarily provided EPS information, they employed various procedures for computing and disclosing it.

More definitive guidelines, which significantly enhanced comparability of EPS data, were later issued in Accounting Principles Board Opinion no. 9, Reporting the Results of Operations. Although Opinion no. 9 did not require EPS disclosure, it did recommend how to calculate the statistic as well as a format for presenting it in the income statement. Because more decision makers were using EPS data, the APB changed its recommendation to a requirement in 1969 by issuing Opinion no. 15, Earnings per Share. This opinion, as amended most significantly by FASB Statement no. 85, Yield Test for Determining whether a Convertible Security Is a Common Stock Equivalent, along with the 102 interpretations of Opinion no. 15, constitute US. practice today.


The EPS project provides the FASB with an opportunity to correct some deficiencies commonly associated with current computation and reporting rules. Constituents have long complained that several provisions of Opinion no. 15 (as amended and interpreted), especially as they pertain to calculating primary EPS, are arbitrary and illogical. For example, critics cite the requirement for determining whether a security is a common stock equivalent. While stock options and warrants always are regarded as common stock equivalents, convertibles are classified as common stock equivalents only if, at issuance, their effective yield is less than two-thirds of the average yield on Aa-rated corporate bonds with similar characteristics but without the conversion option. Subsequent changes in market prices, which may change the nature of a convertible from senior security to essentially common stock, are ignored. Changes in market prices may cause similar securities to be classified--as to their common stock equivalence--differently among reporting enterprises.

In addition, the two-thirds yield test seems to be biased against common stock equivalence, since it compares the return of a relatively low-risk Aa-rated corporate bond with that of a given company's convertible security that may be riskier because of the company's credit standing. Due to the additional risk, convertibles' yields often exceed two-thirds of the Aa corporate bond rate. Adding to the bias against common stock equivalence is the arbitrary selection of two-thirds as the test's cutoff point. If the preliminary conclusions are adopted, the need to determine a convertible security's common stock equivalency status will be eliminated.

Current U.S. standards also have been criticized by small companies which complain they are overburdened with the required information because it often is costly to prepare. They believe more useful, cost-efficient information is conveyed with a basic-diluted approach similar to that prescribed in other countries, such as Canada and England. Such a relatively simplified approach provides financial statement users with a range from no dilution to maximum dilution. Both the FASB and the IASC favor this EPS presentation.


The FASB tentatively has decided to replace primary EPS with basic EPS. Basic EPS-derived from historically based data--would be calculated by dividing income available to common stockholders by the weighted average number of common shares outstanding during the period. The objective is to measure an enterprise's performance per share of common stock for the period. Enterprises with simple capital structures would present only basic EPS.

Under the FASB's tentative conclusions, fully diluted EPS would be replaced with diluted EPS. The objective of diluted EPS is consistent with that of basic EPS: to measure the enterprise's performance over the period while giving effect to all dilutive securities assumed converted to common stock. Included in the calculation of diluted EPS would be all dilutive options, warrants, convertibles and contingently issuable shares regardless of when they must be exercised, converted or issued. Under existing rules, options and warrants are excluded from fully diluted EPS if the conversion privilege is not effective within 10 years from the end of the fiscal period.

Diluted EPS would be calculated by the "if-converted" method for convertible securities prescribed by Opinion no. 15. For calculating the dilutive effects of options and warrants, the FASB would retain Opinion no. 15's treasury stock method. Both methods assume conversion of a security at the beginning of the earliest period reported or at the date of issue, if later.

In a departure from current practice, the FASB would require preparers to use the average market price of the common stock during the period when calculating diluted EPS. Currently, the stock's closing market price, when it exceeds average, is used to calculate the number of incremental common shares that are added to the weighted average number of shares outstanding.

The FASB also has decided not to retain the modified treasury stock approach. Under that method's assumptions, proceeds from the exercise of warrants and options are limited to the repurchase of no more than 20% of the enterprise's outstanding common stock at fiscal yearend. Any remaining funds are assumed to be used first to reduce short- or long-term obligations with any balance invested in government securities. Under the FASB tentative conclusions, the number of shares assumed repurchased on exercise of warrants or options would no longer be capped at 20% of the already outstanding common stock for diluted EPS.

Enterprises presenting both basic and diluted EPS would be required under the tentative conclusions to disclose

* A reconciliation of the numerator and denominator of the basic statistic to the numerator and the denominator of the diluted number.

* The amounts of preferred dividends in arrears.

* Antidilutive securities not included in diluted EPS.

The IASC would require similar disclosures.

Exhibit 1, page 45, compares certain aspects of the IASC and the FASB tentative conclusions with Opinion no. 15.


Exhibit 2, page 46, provides an example of how US. generally accepted accounting principles for EPS will change if the FASB's tentative conclusions are adopted. In the example, the convertible preferred shares are common stock equivalents since their effective yield of 5% ($3,500/$70,000) is less than two-thirds of the Aa corporate bond rate (1 0%). However, the 8% convertible bonds will not be considered common stock equivalents. In the example, fully diluted EPS is $3.99, while diluted EPS is calculated to be $4.08. The difference is explained by the use of the average common stock price for the period in calculating incremental shares outstanding under the treasury stock method.


The lack of uniformity in EPS requirements in the global arena is potentially problematic. If users of EPS data are to make meaningful comparative analyses that transcend national boundaries, they will require more homogeneity in the way the statistic is computed. Standardizing EPS is crucial for the efficient allocation of capital resources. In deciding to redeliberate EPS with the IASC, the FASB has moved toward a more aggressive international posture. The FASB and the IASC issued exposure drafts on EPS in January.


* BOTH THE FASB AND THE IASC ARE tackling the issue of earnings per share. For the FASB, the objective is to simplify the calculations and enhance international comparability. For financial information users, the result should be easier-to-understand performance data for enterprises of various nations.

* THE JOINT EPS PROJECT IS PART OF THE FASB's plan to become more active in international accounting matters. Both the FASB and the IASC issued exposure drafts on EPS in January.

* EPS CALCULATIONS HAVE EVOLVED OVER a period of years. Critics have argued that some aspects of current generally accepted accounting principles are arbitrary and illogical and mask the impact of total potential dillution on a company.

* THE FASB TENTATIVELY HAS DECIDED to replace primary EPS with basic EPS, which would be derived from historical data. The computation would be made by dividing income available to common shareholders by the weighted average number of common shares outstanding during the period. Fully diluted EPS would be replaced with diluted EPS.

* IF USERS OF EPS DATA ARE TO MAKE comparative analyses that transcend national boundaries, the EPS computation must be more homogeneous. The FASB and the IASC issued exposure drafts in January.

DORIS M. BLASCH, CPA, is a manager in the professional standards group of Arthur Andersen in Chicago. She formerly was a technical associate with the Financial Accounting Standards Board in Norwalk, Connecticut. JEROME KELLIHER is a staff accountant at Ernst & Young in Boston. WILLIAM J. READ, CPA, PhD, is professor of accountancy at Bentley College, Waltham, Massachusetts.

Glossary of Terms

Antidilutive securities. Securities whose inclusion in earnings per share computations increases EPS (or reduces net loss per share).

Common stock equivalents. Under existing rules, a security that, because of its terms and the circumstances under which it was issued, is in substance equivalent to common stock.

Complex capital structure. The capital structure of a company with potentially dilutive convertible securities, stock options, warrants or other rights.

Convertible security. A security such as a bond or preferred stock that may be converted or exchanged for common shares. Convertible securities enter into EPS computations when their assumed conversion is dilutive--they reduce earnings per share.

Earnings per share (EPS). The amount of earnings attributable to each share of common stock.

Bagic EPS. The amount of earnings for the period available to each share of common stock outstanding during the reporting period.

"Fully" diluted EPS. The amount of earnings for a period available to each share of common stock outstanding and to each share that would have been outstanding had all common stock equivalents been converted.

Primary EPS. The amount of earnings for the period available to each share of common stock outstanding, including common stock equivalents.

If-converted method. The method used to determine the dilutive effect of a convertible security. The technique assumes the conversion of convertible securities at the beginning of the reporting period (or at the time of issuance, if later).

Simple capital structure. The structure of a company that consists only of common stock or of common and nonconvertible preferred stock outstanding.

Treasury stock method. A method used to determine the dilutive effect of stock options, warrants and rights. The technique assumes proceeds from the exercise of options and warrants are to be used by the company to purchase common stock.

Two-thirds effective yield test. Under existing rules, a convertible security is a common stock equivalent if at the time it is issued it has an effective yield of less than two-thirds of the current average Aa-rated corporate bond yield.

Weighted average number of shares outstanding. The sum of shares of common stock weighted by the fraction of the year they were outstanding.
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Title Annotation:earnings per share
Author:Read, William J.
Publication:Journal of Accountancy
Date:Feb 1, 1996
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