 Hello and welcome to the session. This is Professor Farhad and the session we would look at a comprehensive example that deals with earnings per share or EPS for short. Let's take a look at our liabilities. We have a notes payable that's not converted, which is 14%, which is really not relevant for us. We have an 8% convertible bond. This is a dilutive security, $2.5 million. We have a 10% convertible another bond of 2.5 million. So those two securities are convertible, which are dilutive. It means they are relevant to our problem. We also have, under the equity section of the balance sheet, we have a 10% notice cumulative. Cumulative means we have to deduct the preferred dividend, whether declared or not, when we compute earnings per share. It's also convertible preferred stock. It's a convertible preferred stock. We have common stock, 1.5 million shares authorized, 500 million shares outstanding. We have additional paid in capital and we have retained earnings. So this is what our balance sheet looks like. So we are mostly concerned with the dilutive securities and the dilutive securities. Let's identify them one more time. Let me highlight the dilutive securities. Those three securities are dilutive. Now what else do we have? In addition to those three securities, we have options that were granted in July. So options are also dilutive securities to purchase 50,000 shares of common stock at a price of 20. The average price for Webster common stock, which is the company for 2017, was $30. Well, guess what? Those options most probably will be dilutive. All options are still outstanding. So here's another dilutive security. We have a fourth one options. Let's take a look at number two. What additional information are we giving? Both the eight and the 10% convertible bond were issued in 2016 at face value. So look at the balance sheet. This was in 2017. So those were outstanding as of the beginning of the year. Each convertible into 40 shares of common stock. Each bond has a face value of a thousand. That's fine. The 10% cumulative convertible preferred was issued at the beginning of 2017. So it's available for the whole year made our life much easier. Each preferred is convertible into four shares. So each common stock is converted into four shares. The average income tax rate is 40%. The 500,000 shares of common stock were outstanding the entire year. Good. That's make our life easier for the denominator. Preferred dividend were not declared. It doesn't matter whether declared or not. Remember they were cumulative. Therefore, we have to deduct them. Net income was 1,750,000. No bonds or preferred were converted. Excellent. So this is the setup. So what do we need to do first? Well, in any earnings per share problem, the first thing you have to compute is basic earnings per share, whether you have a simple or a complex capital structure. So the first thing we're going to do is compute earnings per share for the simple capital structure. Simple capital structure means you don't take into account the dilute of securities. How do you compute earnings per share? Simply put, it's net income minus the preferred dividend divided by the average weighted average number of shares. And we have the information for all of this. We have net income. We are giving that income at 1,750,000. So net income 1,750,000 minus the preferred dividend. We know that we have a preferred dividend. Let's go back and see if we know how to compute the preferred dividend. So let's focus here on the preferred dividend. We have 2.5 million of preferred dividend and they're paying 10% times 10%. That's going to give us 250,000 of preferred dividend. Therefore, if we take net income minus 250,000, that's going to give us 1.5 million divided by, we said the average number of shares is half a million. So basically, what it boils down to 1.5 million divided by 500,000, that's going to give us a $3 basic earnings per share. So the basic earnings per share is $3. Pretty straightforward. So we know the numerator and we know the denominator. So the numerator was 1.5 million. The denominator was half a million. The weighted average number of shares outstanding. Therefore, earnings per share is $3. Now, the next thing we have to compute is the diluted earnings per share. And what makes this problem interesting is you have more than one security. Therefore, what you have to do is you have to follow the following steps. First, you have to determine each dilutive security. So first step, step one, per share effect, assuming exercise or convergence. So first, we have to find out what is the each dilutive security effect. Then we have to rank the results in step one. So after we compute step one and we have, we believe we have four securities. If you remember, we had two bonds, one preferred stock. That's convertible and one option. So we have four different securities and for each one of them, we have to compute step one for them. Then we're going to rank the results from the smallest to the highest that has the largest effect on earnings effect per share. Then after we do so, we're going to beginning with earnings per share, which is based upon the weighted average, which is the $3, the basic earning. Then we're going to recalculate earnings per share by adding the smallest per share effect from step two. We'll start with the smallest effect. That's why we need to perform step two. Then continue the process as long as the recalculation per share is smaller than the previous amount. Then we keep on recomputing the diluted earnings per share as long as earnings per share is going down. So let's go ahead and start with the first step. So the first step, remember, we have to compute the first step four times. Why four times? We have four securities, four securities that we have to take care of. This security, the 8% bond, the 10% bond, the preferred stock and the option. We're going to go ahead and start and let's go ahead and start with the first computation with step one. So first is to determine the per share effect for each potentially dilutive security. So we're going to start with the option. Remember what we have for the option. We have 50,000 options. We have 50,000 options. Assuming those options are exercised, the company would receive $20 per share because that's the exercise price. Therefore, the company would receive $1 million as a result of exercising those options because the employees, the executives that exercised their option will have to pay the company $20 and if they exercise all 50,000 options, the company would receive $1 million in cash. Now, the Treasury method, we're using the Treasury method for the stock option. The Treasury method assume you're going to go out there and buy the stocks. Therefore, you're going to take the million dollar, the company will take the million dollar and will buy the stock. Now, how did we determine it's $30? If you look at the problem, they told you the average price per share for the year was $30, the average price per share. So we assume we bought them throughout the year. So let's go back here. It means the company will use this money to buy back 33,333 shares. Well, if the company is showing 50,000 shares and they're buying back 33,333, it means the incremental increase of the number of shares is 16,667. So the denominator, our denominator will increase by 16,667. What about the numerator? Well, the numerator, there's no effect on the numerator. So remember, there's no incremental numerator effect when it comes to stock options. Why? Because when the company issue the stock options, they will debit cash, they will credit common stock, they will credit APIC, and they will credit stock option. The stock option, they will, I'm sorry, they will debit the stock option account. They will debit the stock option. Simply put, when the company issue the stocks, there's no effect on net income. So this entry does not involve net income when they issue the stocks. Therefore, net income is not affected assuming an exercise happens. So what happened, the numerator will go, I'm sorry, the denominator will have more shares, but the numerator will not change. Therefore, if we take 0 divided by this, so this is what we call, the per share effect is 0. So this is when we're trying to rank them, and this is the first step. So we're done with the option. We figure out the ranking is 0. Basically, the net effect is 0. Let's take a look at the second security. And the second security that we're going to be working with is the 8% bond. We're going to be using the if converted method. So let's go back and look at the 8% bond. All right, so we're dealing with this bond right here. So let's take a look at this. So the 8% bond, the first thing is we compute is the amount of interest. So it's an 8% bond and it's 2.5 million, the amount of the bond. So let's compute the interest amount. So this bond pays, it's 2.5 million and the bond pays 8%. So the interest component, the interest component is 200,000. Now this is the interest expense. Okay. Now, yes, we're going to eliminate the interest expense. However, remember, by eliminating the interest expense, our taxes will go up. Therefore, the numerator will be increased only by the net taxes. Simply put, what's going to happen is this. We eliminated 200,000 of expenses. But since we eliminated that, we lost 200,000 times 40% of tax savings. We lost tax savings of 80,000. So what is our net savings? Well, if this was the savings, 200,000, then we lost 80,000 on the taxes. So the net effect is 120,000. So the net savings by exercising the bond is 120,000. Yes, you saved 200,000 in interest, but you lost 80,000 in taxes. In other words, you have to pay more in taxes because you lost the deduction. Therefore, the shortcut is to take 200,000 times 1 minus 0.4, which will give us 120,000. This is the shortcut, 1 minus the tax rate will give you the tax savings. So simply put, what's going to happen is this. In the numerator, we're going to add 120,000 to the basic earnings per share. Now, each bond is converted into 40 shares of common stock. How many bonds do we have? Let's go back to the problem. So each bond is $1,000 bond. Therefore, if we have 2.8 million in bonds, let's go back here. So we have 2.5 million in bonds, and each bond is $1,000 bond. Therefore, what we have is we have 2,500 bonds, and each is converted into 40 shares of stocks. It means we're going to add to the denominator. My math is right, should be 100,000 shares. Well, what's the per share effect? The per share effect is $1.20. So this is the per share effect. This is for the ranking purposes. Let's go back to the slide here. So this is the basic. This was zero. The ranking was zero for the option. And for the first step, the ranking was $1.20 for the 8% bond. For the 8% bond, the ranking was $1.20. Let's take a look for the other bond, which is the 10% bond. Well, the 10% bond, let's do it here. Oops, the 10% bond, it's 2.5 million times base 10% interest. Therefore, the interest expense is $250,000. Now remember, yes, we're going to save on interest expense, but we're going to lose the tax effect. Therefore, if we take 2.5 million times 1 minus the tax rate, 1 minus 0.4, which would give us 0.6 times, which will give us $150,000. So base simply put, the taxes were 40%. So if we multiply this by 40%, the tax is $100,000. This is the tax. Therefore, the savings is $250,000 minus $100,000. So the net saving is $150,000. Therefore, in the numerator, we're going to add $150,000, which is the interest expense net of tax. And we have 2,500 bonds, and each bond is converted into 40 stocks. Therefore, we're going to add to the numerator 100,000, 100,000 shares. Therefore, this is 1.5. So this is the ranking of this. So once again, we compute the interest. Then the tax is $100,000. The interest expense net of tax is $150,000. That's the numerator. Then the denominator is 2,500 bonds, each converted into 40 shares of stocks. We add to the denominator 100,000. So the ranking of this bond is $50,000. And the third security, what else did we have? This is the 10%. This is the 10% converted. What else do we have? The 10%. We said we have four securities. And the last one is we did one. This is one. This is the first one. This is the second 8%. We still have the convertible preferred stock. That's right. The 10% convertible preferred stock. So remember, if you don't know this, what's going to happen is this. What is the effect on the numerator and the denominator? Well, what's going to happen is this. If the preferred stocks are converted, we have preferred stock of how much? Let's go back here. We have 2.5 million of preferred stock and the 2.5 million, they pay 10%. So 250,000. So generally, not generally speaking, the preferred stock pays 250,000. Let's go down here and work this last. So the preferred stock, we have 2.5 million. They pay 10%. Therefore, they pay dividend of 250,000. Remember, what's going to happen is this. This is the dividend. What happened to the numerator? If we convert, then we add to the numerator, 250,000. Because we put back the dividend, we add to the numerator, 250,000. And each stock, we have 255,000 shares of stocks. Why 25,000? Because 2.5 million and the par value is 100. The par value is 100. So if we take 2.5 million divided by 100 par value will give us 25,000 shares of preferred stock. 25,000 each converted into four shares of common stock. We're also going to add to the denominator 100,000. Now, remember those 100,000, it's strictly coincident. Don't just add 100,000 to the denominator. What's the per share earning effect? 2.5. This is for ranking purposes. So we're still working on the first step. And this is the computation. This is the computation. Now we're going to rank those four different securities. With their per share effect from the smallest to the largest. Remember the option had a zero per share effect. Convertible was 1.2. The 8% convertible, the 10% convertible. The 10% convertible 1.5 and the 10% preferred stock is 2.5. Now we know the ranking. What are we going to do? We're going to start from the lowest to the highest. So we're going to start by looking at the options and see what effect does the option makes if they were converted on the actual earnings per share. Now, we did all this only for the ranking purposes because we have multiple securities. Now we're going to take each security and see the effect of it starting with the smallest and going down. So first we're going to go with the options. Then we're going to go with the 8%, the 10%, and 10%. And we'll keep on computing this as long as earnings per share is going down being diluted. So let's start with the first step. So the next step is to determine earning per share given the effect to the ranking. Let's go back to the original equation. The original equation was the original basic earnings per share was 1.5 million divided by 500,000 shares. Which gave us the basic was 3. Now what's going to happen is this. So the basic was 3. So with the options, what's going to happen? No change plus 0. No change to the numerator. When we exercise the options, remember I told you there's no change to the numerator. What's going to happen to the denominator? We are going to add 16,667 shares. Well, if we take 1.5 million divide them by 516,667. It's going to give us 2.9. Well, 2.9 is lower than 3. Therefore the options are dilutive. And hopefully you know the options are dilutive because remember the exercise was the average price was 30 and the exercise was 20. Of course, they're dilutive, right? Of course, they're dilutive. If they told you on the problem that the average price was 15, then you don't even do this calculation because the options are not dilutive. No one's going to exercise their option. Okay. So the exercise, the options are dilutive. So since they are dilutive, we're going to move to the second option. So their dilutive will move to the second option. So let's take a look for the 8% convertible bond. The 8% convertible bond, we avoided 200,000 gross interest. But net of tax effect times 0.6, what we avoided is of interest 120,000. Simply put, what's going to happen? Let's go back to the basic earnings per share. The basic earnings per share was 1.5 million divided by 500,000. That was the basic. Then from the previous security, let me just use a different color. We added 16,667 plus 0 for the option. Now for the numerator, I'm going to use a different color. We added to the numerator. Now we're going to add to the numerator the interest that could be avoided from if we convert this bond. But as a result, we're going to add to the denominator 100,000 shares because those bonds are converted into 100,000 shares. So now we could compute the new dilutive earnings per share and see if it's dilutive or not. So in the numerator, we have 1,620,000. And in the denominator, we have 5,600, 616,667. Let me go ahead and compute this to see how much do we come up with. We come up with $2.63. Is this dilutive? And the answer is yes. It is dilutive. Why? Because we went from 3, the basic. Then when we involved the options, it went down to 2.9. And now from 2.9, earnings per share is 2.63. Therefore, converting this bond is considered dilutive because our earnings per share is $2.63. Now we're going to move on to the next security. The next security. And the next security is the 10% convertible. The 10% convertible bond. Remember, let's start with the previous. From the previous slide, what do we have is this. We are 1,620, 616,67. So from the previous slide, we have 1,620. And in the denominator, we have 616,667. Based on the previous slide. Now what's going to happen when we convert those new securities, the 10% convertible securities, we're going to add to the numerator. We're going to add, let me put it in a different color because now this is a new security. We're going to add to the numerator, 150,000. This was the savings net of tax. And in the denominator, we're going to add an additional 100,000 shares if we convert those bonds. If you don't know where these numbers are coming from, we did the computation earlier. Now we have a new computation to make now. So in the numerator, we have 1,770,000. That's the new adjusted income. And in the numerator, we have 700. In the denominator, 716,667. And what is our new $2.47. Again, we went from three, the basic exercising the option brought us to 2.9. Exercising the 8% bond brought us to 2.63. And now it's 2.47. So is this dilutive? Yes, it is. So the 10% convertible bond is dilutive. And this is the computation. Now we have the last security to compute. Now let's take a look at the last security, which is the convertible preferred. We're going to start, as I stated with the previous equation, which is 1,770,000. Divide them by 716,667. So what do we add to the numerator and what do we add to the denominator? With the convertible preferred bond, we are going to avoid paying dividend. And how much was the dividend? The dividend was the dividend on the convertible. It was 2.5 million times 10%. That's 250,000. So to the numerator, we're going to add back, let me put it in a different color because so this way, you know, this is a new security. We're going to add back 250,000 in dividend to the numerator and the denominator. We're going to also add 100,000 as the result of the conversion. Now we have a new numerator and denominator. It's 2,220,000. Divide them by 816,667. And that's going to give us 2.47. Guess what? We started with $3, basic earnings per share. With the option, we went down to 2.9. With the 8% convertible, we went to 2.63. With the 10% convertible, we went to 2.47. And they were all dilutive. And with this one, we are at 2.47. It did not dilute. Therefore, what we would say, we would say that this security is not dilutive because it did not bring the earnings per share any lower. At this point, we stop because anything else is not going to bring it any lower. Simply put, for this exercise, the basic earnings per share is $3. The diluted earnings per share is $2.47. This is basically the bottom line for this exercise. We know the diluted and the basic earnings per share. So hopefully, this exercise, it's a good exercise because it has many securities. Hopefully, you learn how to compute this. If you have any questions, any comments by all means, email me or see me in class. If you're studying for your CPA exam, study hard. It's worth it. I'm not sure if they will give you something like this on the exam. It could be assimilation. Who knows? I'm not going to rule it out. I can't rule it out. But I highly doubt that it will be a multiple choice question. You will need a lot of time to solve it, but it could be assimilation. Good luck and stay motivated.