ACC 318 Module 8 Earnings per Share Assignment Example

How Many Shares Share the Profit? Basic and Diluted Earnings per Share at a Composite Trampoline Park Chain

[Student Name]

Southern New Hampshire University

ACC 318: Intermediate Accounting II

Module Eight Assignment

[Instructor Name]

[Date]

The organization, setting and figures below are a composite written as a model document. No real employer, client, colleague or patient is described.

How Many Shares Share the Profit? Basic and Diluted Earnings per Share at a Composite Trampoline Park Chain

Why Two Figures

As a private company the park operator could skip EPS altogether, yet the investment agreement signed in July demands both basic and diluted figures, prepared under GAAP, because the investor's conversion decision and the managers' option values depend on them. Basic EPS tells common owners how much of the year's income belongs to each share outstanding, a figure Kieso et al. (2019) describe as the most widely quoted single measure of performance. Diluted EPS asks what that figure would be if everyone holding a right to become a common shareholder exercised it (Financial Accounting Standards Board, 1997). This assignment computes both for the year in which the company issued convertible preferred stock and granted options.

Weighted Average Common Shares

Table 1. Weighted Average Shares Outstanding

Basic EPS

Net income was $3,762,500. Because the preferred is cumulative and existed only from July, its six months of dividends, $300,000, belongs to preferred holders whether or not it was declared, and it is subtracted to find income available to common stockholders: $3,462,500. Basic EPS is $3,462,500 divided by 2,967,500, or $1.17.

Potential Common Shares

Two securities could increase the number of common shares.

Options. Managers hold options to buy 120,000 shares at $15, and the average market value of a common share this year, established by an independent appraisal used for the preferred issuance, was $20. Under the treasury stock method, the company is assumed to receive $1,800,000 on exercise and use it to buy back 90,000 shares at $20, so the net increase is 30,000 shares. No numerator adjustment is needed, so the incremental effect on EPS is zero per share, which makes the options the most dilutive security.

Convertible preferred. The 400,000 preferred shares convert into 800,000 common shares. Under the if-converted method, conversion is assumed at the later of the start of the year or the issue date, here July 1, so the shares are weighted for half the year: 400,000. If converted, no preferred dividend would be paid, so the $300,000 is added back to the numerator. The incremental effect is $300,000 divided by 400,000 shares, or $0.75 per share.

Ranking and Dilution Test

The cheapest dilution goes in first: each security joins the calculation in order of its per-share effect, and it stays only if the running EPS figure drops.

Table 2. Diluted EPS, Step by Step

Both securities reduce EPS, so both are included, and diluted EPS is $1.11. If the preferred's incremental effect had been above $1.16, adding it would have raised EPS, and it would have been excluded as antidilutive. The order matters for that reason. Had the preferred been tested first, against basic EPS of $1.17, it would still have been dilutive, but in a closer case a security can look dilutive against basic EPS and antidilutive once cheaper securities are already in, so the ranking prevents an overstated dilution that a careless calculation would report.

Presentation

Table 3. Earnings per Share

Because the company had no discontinued operations, EPS is shown for net income only. Had the company sold a line of business this year, EPS would also be shown separately for continuing and discontinued results, and the dilution test would be run on income from continuing operations, the control number, rather than on net income. The notes reconcile the numerators and denominators used in basic and diluted EPS and list any securities excluded as antidilutive, here none.

What Dilution Means for the Owners

The six-cent gap between basic and diluted EPS looks small this year, but it understates the long-run effect. The preferred stock was outstanding for only six months; in a full year it would add 800,000 weighted shares, more than a quarter of the common count, and diluted EPS on this year's income would fall to roughly $0.99. The founders should understand that the investor's conversion right is a claim on future profits as real as the dividend. Bens et al. (2003) found that public companies often buy back shares to offset EPS dilution from employee options, a reminder that managers pay attention to the diluted figure. For this company, the more useful response is the one the investor expects: grow income faster than the share count.

The options deserve a closer look as well. Their dilutive effect depends on the gap between the exercise price and the share's value. At an average value of $20, only 30,000 net shares enter the calculation; if the next appraisal valued the shares at $30, the treasury stock method would add 60,000 shares, and diluted EPS would fall further even with no change in income. Managers whose options rise in value therefore dilute the other owners more, which is one reason the investor negotiated a cap on future option grants.

A last point concerns the appraisal itself. Because the company's shares do not trade, the average market price used in the treasury stock method comes from an independent valuation. That valuation should be documented in the working papers, since an unsupported price would make the diluted figure unverifiable, and verifiability is one of the qualities the conceptual framework asks of reported numbers.

Conclusion

With 2,967,500 weighted average shares and $3,462,500 of income available to common stockholders, basic EPS is $1.17. Options add 30,000 shares under the treasury stock method, and the convertible preferred adds 400,000 weighted shares and $300,000 to the numerator under the if-converted method; both are dilutive, giving diluted EPS of $1.11. A full year of the preferred stock would widen the gap considerably, to roughly eighteen cents on this year's income.

References

Bens, D. A., Nagar, V., Skinner, D. J., & Wong, M. H. F. (2003). Employee stock options, EPS dilution, and stock repurchases. Journal of Accounting and Economics, 36(1-3), 51-90. https://doi.org/10.1016/j.jacceco.2003.10.006

Financial Accounting Standards Board. (1997). Earnings per share (Statement of Financial Accounting Standards No. 128). Author.

Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2019). Intermediate accounting (17th ed.). Wiley.