 Hello and welcome to the session in which we'd look at a CPA exam question or a CPA exam simulation that deals with earnings per share specifically dilutive earnings per share. This topic dilutives earnings per share is extremely important on the CPA exam whether you need to know how to compute basic earnings per share, EPS you cannot compute dilutive without basic or you might have to compute dilutive which is what we will do in this session compute dilutive earnings per share. Now this question could be a multiple choice for example here I can give you option A, B, C and D and give you four options or I can give you this question in a form of a simulation just basically asking you what is the dilutives earnings per share and usually it will be part of another simulation basically first I'll ask you to compute basic then compute dilutive then compute the most dilutive security so on and so forth. Regardless you want to be very comfortable with this topic when you sit for the exam I'm gonna tell you the truth if you understand this problem once I'm done if you understand how to solve this problem if you can't pause it right now compute dilutives earnings per share in my opinion you are competent in this topic otherwise, let's go over it but before we start if you are a CPA candidate or an accounting students I strongly suggest you take a look at my website farhatlectures.com I don't replace your CPA review course. I am a useful addition I explain the material differently as you will see when I solve this problem I can be a useful addition that vitamin pill that's gonna help you pass the CPA exam help you understand the material differently. I'm an alternative explanation alternative resources for you by doing so you can increase your grade on your score on your CPA exam your risk try me one month of subscription you find it helpful you keep it if not you cancel that's your risk your potential return is passing the exam I have helped hundreds if not thousands of students pass the exam and I do I do have resources for other accounting courses as well If you haven't connected with me on LinkedIn, please do so take look at my LinkedIn recommendation like this recording share it What other connect with me on Instagram Facebook? Twitter and please connect with me on Reddit. So let's go ahead and get started Erem's company capital structure is as follow. They have 100,000 shares of common stock They have 10,000 shares of preferred stock and those preferred stock are convertible preferred Here it says three slash dot three slash share dividend It means they pay three dollars per share and it's cumulative. You have to understand here something that although I Am not going to say they declare the dividend the fact that it's cumulative you have to take into account the dividend convertible bond Paying nine percent and we have a one million dollar of bonds. This is what we have The convertible preferred are converted into 20,000 shares of common stock The convertible bonds are converted into 30,000 shares of common stock then that income for the year happens to be 350,000 compute earnings diluted earnings per share Well, the first thing you do before you compute diluted earnings per share You have to compute the basic earnings per share and you have to know this like immediately like basic earnings per share You have to know it like in your sleep basically and what is the basic earnings per share? It's net income 350,000 minus Preferred dividend. What is the preferred dividend? We have 10,000 shares. They're paying three dollars per share That's minus 30,000 dollar divided by the common shares outstanding 100,000 We found basic is three dollars and 20 cent and for some reason my pen is acting up I guess the tip is not working properly. So this is the basic So this is basic EPS now Why do we need to compute basic because we don't know whether something is dilutive or not unless we compare it to the basic now? here's so we're done with the basic so you have to do this immediately and They could give you this question this whole question on the exam and they could ask you Compute basic EPS and it should take you literally a minute a minute and a half max to answer a question like this But they could also ask you about dilutive and if they do give you a question like this You should be happy it means you are doing very well and you are being challenged on the exam Okay, now now we have to potentially dilute of securities. We have the convertible preferred and we have the convertible bonds The rule is we have to go with the most dilutive from the most dilutive security to the least dilutive Okay, what does that mean because certain convertible securities? They might be dilutive on their own, but when they are combined with other potential common stock Which is new common stock convertible common stock. They may not be dilutive. Therefore, we have to find which one is the most dilutive Do the computation first then look at the remaining shares in that order. Now, how do we how do we make this order? How do we find out which one is the most dilutive to the least dilutive? Well, we have to Compute the degree of dilution. Okay, what's the degree of dilution? It's that incremental effect on EPS We have to determine the incremental effect on EPS separately for each security. How do we compute this? Well Starting we have two different convertible two different convertible securities convertible preferred stock and convertible bonds So first we're gonna compute the degree of dilution for each one separately So let's end the lower the lower than answer the more dilutive that security is let's start with convertible preferred stock Well, if we convert if we convert the convertible preferred stock We no longer have to pay $30,000 and preferred dividend those $3 times 10,000 which is 30,000 and will divide this by 20,000 so 30,000 divided by 20,000 the incremental effect is $1.50 on EPS the incremental effect is $1.50 Now the lower it's the more dilutive it is the lower the incremental effect now We need to find out the incremental effect from the convertible preferred stock now. You have to be careful here Okay, what happened if we convert the bonds? Well, if we convert the bond we no longer have to pay interests That's the good news. So let's find out how much interest do we save? Well the bond the bond is a million dollar bond The interest rate is 9% now bear in mind We are assuming here that the bond was issued as of the beginning of the year on the exam day They might tell you the bond was issued in April or was issued in September. So you have to prorate that interest So you have to be very careful again for hat lectures dot com. This is where I discuss those special topics I don't expect to I don't expect you to see this type of questions on the exam day on the CPA exam I expect to see it on my exams or my classroom But not on the CPA exam day, but I just want to make you aware that it could be it could get more complicated now What is million times 9%? That's 90,000. Well, yes, I'm gonna save 90,000. Is this the only thing I'm going to save? Yes, except one. I don't have the interest. I'm gonna lose my I'm gonna lose my I'm gonna lose my tax savings now for the sake of illustration. We're gonna assume that the tax rate For the sake of the 30% so what's gonna happen is this? How do you compute? How much you're gonna be adding to the numerator? Well, you're gonna be adding 90,000 which is the amount of the interest but it's gonna be added net of tax Therefore, you're gonna have to multiply this by one minus the tax rate point three So to find out how much you're gonna be saving Remember if you convert the bond you don't have to pay the interest so you will save this is your saving I'm gonna do I'm gonna do this in two different color and You need to understand what net of tax is this is an important concept for the CPA exam Let me just change the color here because it's important that I illustrate this This is your savings 90 percent 90,000. That's the good news The bad news is once you take the 90,000 of interest expense from your income statement Well as a result your taxable income will go up It means you're gonna lose some savings on your taxes. What is what's the savings you multiplied by 1 minus the tax rate? Whatever that tax rate is so all in all Your net saving so so the times 1 minus 3 it gives you the net savings. It means the net savings The net interest saving is 63,000 net of tax 63,000 okay, so the good news is you saved 90,000 in taxes The bad news is the difference between 90,000 and 63,000 which is 27,000 This is lost in Tax savings because you have less deduction you have less Lost in tax saving. I do apologies about my pen. I'm gonna have to change the tip lost in tax Savings okay, so your net savings is 63,000 Okay, now we have to do the same thing we have to compute the degree of the degree of dilution So we have so the total the total is 63,000 and they prefer and the convertible bond can be converted into 30,000 shares So 63 divided by 30,000 is $2 and 10 cent now we notice the again the lower That degree the lower the ink the lower the number the lower the answer to 10 versus 150 The more dilutive that security is therefore common stock is more dilutive. So when we start our computation for the Dilutips earnings per share, we're gonna add first the common stock So let's go ahead and add the common stock first and see what would happen. Okay, so now we're gonna go Remember the basic formula here 350 minus 30,000 now we're gonna be we're gonna assume and we're gonna be converting the common stock So we're gonna be net income Minus 30,000 I'm gonna change colors So we're gonna convert we're gonna add back the 30,000 of dividend all divided by Let me change color again. I need the pen not the highlighter. Sorry I'm gonna do I'm gonna get the pen I'm gonna take 100,000 which is the original 100,000 plus I'm gonna add 20,000 shares when I convert the common stock. So if I convert the common stock my earnings per share will become two dollars and 92 cent this is my dilutive only converting the preferred should I proceed and Convert the bonds. Well, if I if I compare 292 to 210 to 10 is lower It means the bonds are also dilutive. I have to include that. Well, I'm gonna have to include the bond now I'm gonna have to include the bond. So I'm gonna take 350 Minus 30,000 plus 30,000, which is basically what we did earlier Then I'm gonna add to my numerator. I'm gonna now change colors I'm gonna add to my numerator the 63,000 the interest net of savings because that's gonna be added to my net income I don't add 90,000. I add only 63. I saved 90,000 on the interest I lost 27 on the tax therefore I add 63 and I'm gonna divide this by 100,000 shares of the original issuance plus 20,000 of the convertible stocks of the convertible stocks now I'm gonna convertible preferred stock now I'm gonna add 30,000 shares from the convertible bond Now I'm not only to compute this and it should be lower than 2.92. It is 2.75 So my dilutives EPS my dilutives earnings per share is $2 and 75 cent so indeed as I expected it was dilutive and It went down now if I did this computation and the answer was higher than 2.92 It's anti dilutive but it should not be then I did something wrong in my math So I'll have to redo all the math. So first the degree of dilution The preferred is more dilutive than the bond I will start with that and after I did I did convert the bond I did convert the preferred I noticed that the bond is also dilutive. So I added to the dilutive otherwise if My answer was below 210 if my if this answer was below 210 You don't add the bonds because they're no longer dilutive. Okay now at the end of this recording I'm gonna remind you if you are studying for your CPA exam. I don't replace your CPA review course I can't do that. I would love to but I can't but I can be useful addition to that CPA review course I work hand-in-hand with your material in other words My lessons are aligned to go with your CPA review course I can add 10 to 15 points to your CPA exam invest on your career. Give me a try for a month You like it. You keep it. You don't you cancel. Don't shortchange yourself. Good luck study hard and most importantly Stay safe