 Hello and welcome to this session in which we will discuss diluted earnings per share, specifically using the what if method. When we say diluted earnings per share we have to compare and contrast diluted to basic earnings per share which we talked about in the prior session. So if you don't understand basic earnings per share right now stop go to the prior session learn about basic earnings per share because before we compute diluted earnings per share we have to compute basic earnings per share. Now when do we have diluted earnings per share when do we have to do when do we have to compute this earnings per share that's diluted it's when we have a capital complex capital structure what is that well it's when we have dilute of securities what are dilute of securities convertible securities such as convertible bonds convertible preferred stock options warrant or any other rights that if converted if turned into common stock will dilute the shares so if converted or exercised there is a potential of dilution effect dilution means it's potentially could reduce your earnings per share that's that's what we mean by potentially because sometime if exercised they may not dilute they may increase and we'll work an example don't worry about that so this is how we have to compute diluted earnings per share first we have to compute basic earnings per share the basic EPS then which is equal to net income minus preferred dividend divided by the weighted average number of shares outstanding and this is the basic and this is what we learned in the prior session and that's why I said if you're not comfortable with basic don't try to don't try to compute diluted then from this formula we are going to deduct the convertible effect then we're going to deduct the options and the warrant effect and this is what we're going to be learning in this session once we once we did that dose two after we compute basic earnings per share it's going to give us dilutives earnings per share and we only report the dilutive if if if the dilutive is lower than the basic if we computed the dilutive and it's higher than the basic we just don't report anything we only report if dilutive if it's not dilutive we call it it's anti dilutive now we have two methods to compute the dilutive earnings per share we have the what if method and we have the treasury method in this session we use the if converted method what if or if converted method the if converted method is used when we convert convertible bonds and when we convert convertible preferred stock we're going to start by looking at convertible bonds we're going to assume that the conversion happened at the beginning of the period unless the bonds were issued during the year in other words we're going to assume that if we have a bond if this is year one and this is year two if we have any bond outstanding convertible bond outstanding as of the beginning of the year we assume the conversion took place here now if the bonds were issued during the year we're going to assume the conversion took place as of the issue date and we're always going to add the interest net of tax why because the interest expense when we convert if we assume we converted the bond it means the company lost the interest deduction when we add when we add back the interest deduction it's going to be added net of tax and this concept in accounting is important net of tax now the rest way to illustrate this is to actually look at an example to show you all the computation that takes place but before we look at an example I would like to remind you whether you are an accounting student or a CPA candidate to take a look at my website farhatlectures.com I don't replace your CPA review course nor your accounting course my motto is saving CPA candidate an accounting student one at a time by providing you additional resources for your accounting courses this is a list of all the accounting courses that I cover this is actually a partial list lectures multiple choice true false additional exercises my CPA material is aligned with your becker wiley gleam and roger so it's very easy to go back and forth between my material and your CPA review course I also give you access to 1500 plus a AI CPA previously released questions with detailed solution if you have not connected with me on linkedin please do so and take a look at my linkedin recommendation like this recording on youtube it helps me a lot share it with other connect with me on instagram facebook twitter on reddit and i'm trying to i'm trying to grow my instagram followers the best way to illustrate the concept of diluted earnings per share is to actually look at an example adam company has not income of 400 000 for the year and a weighted average number of common share outstanding during the period one million so i'm giving you the weighted average number of shares you don't have to compute this we learn how to compute this in the prior session also adam has one million six percent convertible bond that is converted into 300 000 common stock and it's outstanding as of january first we all adam company also had a million 10 percent convertible bond into 400 000 common stock and those bonds the 10 percent were issued during april first it looks like interest rate went up and tax rate is 21 percent so the first thing we do as i showed you we compute basic earnings per share basic eps how do we compute basic eps well the good thing is we don't have any preferred dividend it's net income my divided by minus zero preferred dividend just to have the complete formula divided by the weighted average number of shares basic earnings per share is 30 pennies now we're gonna we're gonna we're gonna make an adjustment to the numerator we're gonna make an adjustment to the denominator to convert the bonds because we have two bonds that are convertible here's what's gonna happen first the first one million dollar bonds they are converted into 300 000 shares and they were outstanding as of january first what does that mean it means i'm gonna have to be at the denominator 300 000 for these bonds also i have another one million 10 percent convertible bond into 400 be careful those bonds were issued on april first issued april first it means they have to be prorated because they were not outstanding for the whole year so here here's what you have to do you have 400 000 shares and you're gonna have to multiply them 400 000 shares and you have to multiply them by all of april major and july august september october november and december by 9 12 of the year why 9 12 because we have to we have to start counting as of april first so simply put those are converted if we prorate them to 300 000 so we have 300 000 from the first bond and 300 000 from the second bond well it's a coincidence i should have used different numbers but that's fine okay but near it should be clearly because i don't want you to think it's always 300 000 so the one million shares the denominator we're going to add to the denominator 600 000 new shares so the new weighted average for the diluted is 1.6 million now we have to adjust the numerator what do we have to add to the numerator if we convert the bond we don't have to pay interest well that's good news so we have a million dollar worth of bonds times six percent if we convert them we're going to save 60 000 that's our savings that's the excellent news we're going to reduce our expense by 60 000 the bad news is we lost a deduction of 60 000 as a result we are going to be losing some tax savings what does that mean because you reduce your expenses your tax goes up now because you reduce your expenses by 60 000 and the tax rate is 21 percent simply put let me show you what's going to happen let me get the calculator ready here so if we take 60 000 60 000 times 0.21 so you lost in tax in tax in tax savings 12 600 so you you saved 60 000 you lost 12 600 your total net savings are how much so 60 000 60 000 minus 12 000 my fat fingers they keep 12 600 it's four so your net saving is 47 400 this is basically how i did it i think i took 60 000 in interest saved i my tax losses were my because my income went up my taxes went up by 12 600 interest net of tax is 47 400 now the formula to convert some number from tax from from gross to tax to net of tax is taking that number 60 000 multiplied by one minus one minus the tax rate and it's going to give us 47 400 which is the same thing i broke it down into two steps to show you what net of tax is but the formula is you take the interest multiplied by one minus the tax rate to find out the savings net of tax and we'll do the same thing so simply put what we have to do we have to add to the numerator 47 400 now we're also going to save the interest on the 10 percent bond well we have a million dollar times 10 percent times 9 12 why 9 12 because the bond was issued in april so we only save interest of 75 000 gross then we multiply the 75 000 by the tax rate we lose in tax savings 15 750 the interest net of tax is 59 5 25 or we can take 75 000 times one minus the tax rate to come up with a figure automatically now we are ready to compute our diluted earnings per share so we have to add to the numerator 59 250 now we take 400 000 plus the interest of on the first bond net of tax plus the interest on the second bond net of tax and the denominator will take a million plus 300 000 for the first bond the six percent bond 300 000 for the 10 percent bond and we find out that this is diluted we find out that the diluted eps is 31 pennies almost 32 pennies which is diluted because it went down from it went down basically from 40 pennies to 31 pennies now this is how we convert a bond let's assume we have a convertible preferred stock at the beginning of the year adam has 40 000 shares of 10 percent convertible cumulative preferred 50 par value each convertible each share is convertible into 10 shares of common stock net income for the year of half is a half a million there were 750 000 shares outstanding during the year the first thing i'm going to ask you to do is to compute basic earnings per share and that's easy my net income is 1.5 million my common stock is 700 000 great i gave you easy numbers it's two dollar per share wrong there's a trick here and i did this on purpose the reason it's wrong because what i did is i kind of walked over this but i told you you have a cumulative preferred stock if the preferred stock is cumulative you always have to deduct the preferred dividend for that year well the preferred dividend how much does this stock paid it has a par value of 50 the rate is 10 percent times 10 percent this stock pays $5 per share we have 40 000 shares so this preferred stock paid dividend of 200 000 therefore we're going to take 1.5 million minus 200 000 notice i try to trick you divided by 750 000 share so the basic earnings per share is $1.73 remember if it's cumulative you always deduct that year worth of dividend if it's non cumulative you have to see whether they declare that or not now we have to compute the dilutive earnings per share well what's going to happen is this if those preferred stock are are converted we have 40 000 of them and each one is converted into 10 shares we're going to add to the denominator 400 000 okay what's going to happen too if we convert we no longer have to pay the preferred dividend we add 200 000 to the net income therefore notice net income will stay the same so the diluted earnings per share is 1.5 million minus the preferred dividend 200 000 plus the preferred dividend eliminated 200 000 simply put back to net income simply put the the numerator is net income because we're not paying anything to the preferred dividend if they convert we don't have to pay them then 750 000 plus 400 000 is 1 million 150 000 now the diluted earnings per share which is indeed diluted is $1.30 pennies diluted why because it went down from $1.73 to $1.30 which we consider it diluted now let's change the scenario a little bit and assume each share is converted into only two shares of common stock so rather than 10 we're going to say it's only two shares let's do the let's do the computation again again the numerator is only net income 1.5 million minus 200 000 plus 200 000 and if we have 40 000 shares converted into two shares of common stock we're going to add to the denominator 80 000 shares now when we compute the new EPS it's $80 actually it's anti-dilutive well if the preferred shareholder convert the regular shareholders will be better because the earnings per share will go up therefore we don't report anti-dilutive simply put we do this computation we throw it in the garbage we don't say anything we don't report it now the best way to learn this is to go to farhatlectures.com and work additional multiple choice questions look at additional practice exercises don't shortchange yourself i give you additional resources to help you succeed on your CPA exam and your accounting courses invest in your career invest in yourself the CPA exam is worth it good luck study hard and of course stay safe