 Welcome to this session in which we will discuss diluted earnings per share using the treasury method. Now, before we talk about diluted earnings per share, I want to make sure you have a good understanding of basic earnings per share. If not, stop and go to the prior session to view the recording about basic earnings per share. Also, we have another method for diluted earnings per share, and there is what if or the if method. We looked at that method in the prior session. So when do we have to compute diluted earnings per share? Simply put, it's when we have complex capital structure. What is that? What is a complex capital structure? It's when you have securities that are dilutive in nature such as convertible securities such as convertible bonds, convertible preferred stock, options, warrant or other rights that could be converted into common stock. If those securities are converted, there's a potential dilution effect on EPS. So let's compute basic EPS or earnings per share. It's starting by reviewing the basic formula, which is net income minus preferred dividend. Simply put, remember we have to take out the preferred dividend always if it's accumulative and if it's not cumulative only if declared. And we'll divide this numerator, which is net income applicable to common shareholders, divided by the weighted average number of shares outstanding. And this is basic earnings per share. Then from the basic earnings per share, we are going to deduct convertible bonds, convertible preferred stock. Also take out options, warrant and other dilutive securities. All of those taken together would give us dilutive earnings per share. We only report the dilutives earning per share if it's dilutive. If it's not dilutive, we don't report. Simply put, we perform the computation, then we throw it away because it's non dilutive. How does the Treasury method work and on which securities does it work? It's used when we have options, warrant and other similar securities. The Treasury method assumes that those securities, the holder of these securities like the holder of the option or the warrant, exercise them as of the beginning of the year. Unless the securities were issued during the year. It means they were not outstanding as of the beginning of the year. We also assume that when the company received the proceeds, because remember when you exercise your option, you have to pay the company money. The company took that money and they bought Treasury stock. They bought the stock on the market from the marketplace. The best way to illustrate this concept is to look at an example to see how this all fits together. Before we do so, I would like to remind you whether you are a student or a CPA candidate to take a look at my website, farhatlectures.com. I don't replace your CPA review course. I'm a useful addition. My motto is saving CPA candidates and accounting students one at a time. How so? I can provide you with additional resources, lectures, multiple choice, true, false. That's going to help you understand the material better. This is a partial list of all the courses that I cover. My CPA resources are aligned with your Becker, Wiley, Roger and Gleam. So it's very easy to go back and forth between my material and your CPA review course. If you have not connected with me on LinkedIn, please do so. Take a look at my LinkedIn recommendation. Like this recording. It's very helpful. Connect with me on Instagram, Facebook. I'm trying to grow my followers on Instagram, Twitter and Reddit. Let's take a look at an example to illustrate this what if concept. Let's assume Farhat Lecture Net Income for 20x5 is 400,000. The only potentially dilutive securities outstanding were 2,000 options issued during 2004. So they were outstanding as of the beginning of the year. Each exercisable for one share at $10. So you can buy the shares for $10. We have 40,000 shares of common stock outstanding during 2020. The average market price of the stock during the year was $25. So notice those options are in the market. It means what? It means the holders, if they exercise them to automatically make $15. Now, why wouldn't they do so? Because they want the price to be higher. They think the price could go up to 30. And the higher the price, the more is their profit. But that's beside the point. So now let's see what we have. First, we compute basic earnings per share, which is net income minus preferred stock of zero. We don't have any preferred stock divided by the weighted average shares. And we find out our basic earnings per share is $10 per share. Now, what we do is we have to assume that what would happen if those shares were exercisable? Well, here's what's going to happen. If the holder of those options exercised the shares, they have to pay $10 per share. So they have to take, they have to buy $2,000 shares at $10. They have to pay the company $20,000. The company is going to take this money and buy shares at $25 because the average number of shares is $25. They will buy 800 shares. The company will have to issue 2,000 shares to the shareholders. So the incremental increase is $1,200. So if those shares were exercised, if those shares were exercised, we have to increase our denominator by $1,200. What do we have to do to the numerator? Not applicable. For the options, the numerator is not affected. Therefore, the diluted earnings per share is $400,000 divided by $41,200 and it is diluted. It goes down to $9.70. Let's change the scenario a little bit and assume that those 2,000 options were issued as of September 1st, rather than being outstanding as of January 1st. What's going to happen is this. We're going to do the same computation. We're going to take 2,000 shares times $10, which is $20,000. The company will buy the shares at the average price of $25. They will buy 800 shares, shares to be issued $2,000. So the incremental increase is $1,200. Then what we do is we'll take the $1,200, multiply it by $412. Why $412? Because we have September, October, November, and December. What's going to happen is we prorate the incremental increase by $412. Therefore, the denominator will change by only $400. So what's going to happen is this. The numerator will stay the same. We're going to add $400 to the denominator. As a result, the basic earnings per share is diluted. Now 10 pennies and becomes $990, the diluted earnings per share. What should you do to learn about all of this? Go to farhatlectures.com, work additional multiple choice questions. Don't shortchange yourself. My subscription is nominal. Invest in yourself, invest in your career. Don't shortchange yourself. Your CPA exam is a long-term investment. Good luck, study hard, and of course, stay safe.