 welcome to this session in which we will discuss an earnings per share problem. This problem could be a CPA exam simulation or it could be just the college exercise asking you to compute EPS. So, Adam had revenues of 19,500 expenses other than interest and taxes of 8,600 for the year x-ray. We're assuming a 21% x-ray. Adam also had 50-1000 bonds paying 8%. Each of these bonds is convertible into 100 shares. Well, that's mean we're going to have to compute the basic and the dilutive. Why? Because the shares are the bonds are convertible. It means we have a complex capital structure. A complex capital structure would require you to compute both basic and dilutive. Throughout 20 x-ray, 2,000 shares of common stock were outstanding and none of the bonds were converted or redeemed. So, we're going to compute the basic earnings per share. Then we are going to assume the 50 bonds were issued as of October 1st rather than January 1st. So, in the first scenario, we will assume the bonds of this is year 20 x-ray. The bonds were issued as of January 1st. So, they were outstanding for the full year. Then we will work the scenario as if the bonds were issued October 1st and we compute basic earnings per share, basic EPS and dilutive EPS. Now, in this example, you are not giving the net income and we don't have a preferred stock. So, no, we don't have preferred stock. So, we don't have to worry about this. But bear in mind that we have to take net income minus preferred stock over the outstanding shares, over the shares to find the basic. But in this example, we don't have preferred stock. The best way to illustrate this example is to switch to an Excel sheet and show you the computation. Before we proceed any further, I have a public announcement about my company, farhatlectures.com. Farhat Accounting Lectures is a supplemental educational tool that's going to help you with your CPA exam preparation as well as your accounting courses. My CPA material is aligned with your CPA review course, such as Becker, Roger, Wiley, Gleam, Miles. My accounting courses are aligned with your accounting courses, broken down by chapter and topics. My resources consist of lectures, multiple choice questions, true-false questions, as well as exercises. Go ahead, start your free trial today. No obligation, no credit card required. So, we are giving 2,000 shares, number of bonds 50, they're paying 8%, and those 50 bonds, they are converted into 100 common stock. Therefore, they might increase our common stock to 5,000. Let's compute net income using the information that we are giving, which is revenues minus expenses, which will give us something called EBIT earnings before interest and taxes. And the reason we compute EBIT to kind of show you interest and taxes are reported separately, which they are indeed. Then we compute our interest. Our interest is, which is the bond, which is 50 bonds times 1,000 times 8%, which will give us interest of 4,000. Then we compute our earnings before taxes, 6,400. Then we compute our taxes using 21%, then earnings before taxes minus the taxes will give us net income. Once we have net income, we can compute our basic earnings per share, which is net income 5,056 minus 0 preferred stock divided by 2,000 shares, and that's going to give us 253. So, I'm going to round it to 253. So, that is the basic earnings per share. Now, what we're going to do next, we are going to compute the dilutive. The dilutive means what? It means your converted bonds are converted into stocks. So, what happened as a result? As a result, your interest expense should be zero. So, let's go through this computation to find out what is our dilutive EPS. Again, we have revenues of 19,000, expenses of 8,600, net income of 10,400. Now, our interest expense is zero. We don't have interest expense. Therefore, our earnings before taxes is 10,400. Our taxes is 2,184, which is 21%, and our net income is 8,216. So, what we did is this. So, what happened when we have dilutive earnings, dilutive securities such as convertible bond? What's going to happen is this. We are going to add, we are going to add to the numerator, we're going to add to the numerator, interest net of tax. Now, what is interest net of tax? Interest is 4,000, but we cannot add the 4,000 because as we lose the 4,000, we are going to pay more taxes. So, we lost the 4,000, but notice our taxes went up. Therefore, we have to add interest net of tax. How do we add interest net of tax? Well, we'll take the amount times 1 minus 0.1, which is 1 minus the tax rate. So, simply put all what we did is we took 4,000, let's see, 1 minus 0.21 is 0.79 times 4,000. So, all what we did is we added to net income 3,160. This is interest net of tax. So, if we take 3,160 plus 5,056 and it's going to give us 8,016. So, this is what we did. So, this is what we should have done in the formula, net income plus interest net of tax, but I did the complete income statement to show you how it's computed 8,216. So, we have to add the interest net of tax. Now, also we have to add 5,000 shares to the denominator because if we are converting, we have more shares. And what happened now is dilutive earnings per share is indeed dilutive 224. So, it went from 253 to 224. So, the key here is to remember when you add the interest, you added net of tax. How do you add it net of tax? You take interest expense times 1 minus whatever your tax rate is happens to be 0.21 for this example. Now, this is assuming the bonds were issued January 1st. What happened if the bonds were issued October 1st? Well, let's start with the top part, revenues minus expenses equal to operating income, then interest expense. Now, interest expense, it's going to be different. It's going to be only 1,000. Why? Because we're going to take, we have 50 bonds times $1,000, those are the bonds, which is 50,000 times 8% the interest for the full year times one third. Why one third? Because they were outstanding October, November and December. As a result, you're going to have interest expense of only $1,000. So, if the bonds, if the convertible bond were issued during the year, you have to kind of only, not kind of, you have to compute the expense only for that portion of the year, which is 1,000. Your earning before taxes is 9,400. Your taxes are 1,974. Your net income is 7,426. Now, what you do is you compute basic earnings per share, which is $3.71. Now, we're going to compute the dilutive. Simply put, we're going to eliminate the interest and see what our net income would become and what will be our dilutive. Earnings before interest and taxes still 10,400. We don't have any interest. Earnings before interest and taxes is 10,400. The taxes are 8,184 and net income is 8,216. So, I'm going to go ahead and do the same formula that I did up there, which was going to be 7,426 plus interest net of tax. Interest net of tax is 1,000 times 0.79, which is 790. So, if we take 7,426 plus 790 is plus 790 equal to 8,216, which is what we computed here. I just want to show you in the income statement what it looks like and in the formula what it looks like. Now, we're going to divide this. We're going to divide this by, initially we had 2,000 shares, now we're going to convert. Now, we have to be careful. Just as we prorated, just as we prorated the interest expense, we only had 1,000 of interest expense, we have to prorate the 5,000 shares. The 5,000 shares, they're only outstanding of one third of the year, October, November and December. Therefore, we're going to take 0.33 times 5,000 and we are only going to add to the denominator 1,650. Therefore, the dilutive earnings per share, let's see, the dilutives earnings per share is how much. Let's see, let's reveal the formula here and dilutives earnings per share is $2.24, which is how did we come up with this. Again, we took now the new net income minus zero dividend because we don't have any dividend, divided by the 2,000 plus one third of 5,000, which is 1,650, which will give us a dilutive's earnings per share of $2.24, which is dilutive because earnings per share went down. So in this example, I showed you what did we do in this example. I showed you if the bonds were issued at as of the beginning of the year, we computed the basic earnings per share. Most of the time they give you net income, but this is, I like this example because you have to compute net income and you will see the effect of interest. Then if it was converted, this is what the income statement would look like. It would look zero interest expense. Then we computed assuming the bonds were issued throughout the year. It means you have to only compute the interest expense for that portion, but also you have to convert the bond only proportionally as well. So you cannot convert the full 5,000. You convert the 5,000 times one third. It happens to be October, November, and December, three months for this example. What should you do now? Go to Farhat Lectures and look at additional resources for EPS. EPS is an important topic. Good luck, study hard, and of course, stay safe.