Chapter 3: Diluted earnings per share

Requirement to calculate diluted earnings per share

IAS 33 requires entities to calculate diluted earnings per share amounts for profit or loss attributable to ordinary equity holders of the parent entity and, when presented, profit or loss from continuing operations attributable to those equity holders.

The objective of diluted EPS is consistent with that of basic earnings per share (i.e. to provide a measure of the interest of each ordinary share in the performance of an entity) while giving effect to all dilutive potential ordinary shares outstanding during a period. Accordingly:

• profit or loss attributable to ordinary equity holders of the parent entity is increased by the after-tax amount of dividends and interest recognised in the period in respect of dilutive potential ordinary shares and is adjusted for any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares; and
• the weighted average number of ordinary shares outstanding is increased by the weighted average number of additional ordinary shares that would have been outstanding assuming the conversion of all dilutive potential ordinary shares.

Measurement

Basic EPS is calculated on the number of ordinary shares outstanding in respect of the period. Sometimes, entities might have ‘potential ordinary shares’ in issue, defined as financial instruments or other contracts that might entitle their holder to ordinary shares. Such instruments must be assessed to determine if they are dilutive.

What is diluted EPS used for by users of accounts? Although existing ordinary shareholders are interested in future dilution, the diluted EPS figure is not intended to be a predictor of dilution, or a forward-looking number. It is seen as an additional historical measure. The IASB concluded that, since the objective of basic EPS is to measure performance over the reporting period, the objective of diluted EPS should be consistent with that objective, while giving effect to all dilutive potential ordinary shares that were outstanding during the period. A past performance method of computing diluted EPS aids comparison between diluted EPS of different periods. Presenting diluted EPS with undiluted (basic) EPS, calculated on a consistent basis, will enable users to view the spread between the two figures as representing a reasonable estimate of the potential dilution that exists in the entity’s capital structure.

Examples of potential ordinary shares are:

• Financial liabilities or equity instruments, including preference shares, that are convertible into ordinary shares.
• Options (including employee share options) and warrants.
• Shares that would be issued on satisfaction of certain conditions that result from contractual arrangements, such as the purchase of a business or other assets.

Contracts that might result in the issue of ordinary shares of the entity to the holder of the contract, at the option of the issuer or the holder, are potential ordinary shares.

Calculation of diluted EPS, in addition to basic EPS, is required for profit or loss attributable to the parent entity’s ordinary equity holders and separately for each of continuing and discontinued operations where these are presented in accordance with IFRS 5.

The profit or loss for the period attributable to ordinary equity holders is adjusted for the effects of all dilutive potential ordinary shares for the purpose of calculating diluted EPS. The weighted average number of shares outstanding is also adjusted for the effects of all dilutive potential ordinary shares.

Profit-related pay and similar bonus schemes Some compensation plans are based on the price of the entity’s shares, but will not result in the actual issue of shares (e.g. phantom shares and formula plans). Rather, the compensation to the employee under the plan is settled entirely in cash. For plans of this nature, the computation of EPS will not be affected by the existence of the plan (other than as a result of the compensation cost charged as an expense against profit or loss attributable to ordinary equity holders).

Computation of earnings

The profit or loss attributable to the parent entity’s ordinary equity holders for the purpose of calculating diluted EPS should be adjusted for the after-tax effect of:

• Dividends or other items related to dilutive potential ordinary shares that have been deducted in arriving at profit attributable to ordinary equity holders for the purpose of calculating basic EPS, such as dividends on dilutive convertible preference shares.
• Interest recognised in the period on dilutive potential ordinary shares, such as interest on dilutive convertible debt.
• Any other changes in income or expense that would result from the conversion of the dilutive potential ordinary shares.

‘If-converted’ and ‘treasury stock’ methods

When a financial liability is forgiven as consideration for the issue of shares (as is the case for convertible debt), the number of shares to be added to the denominator is the number of shares that would be issued to the holder assuming the convertible debt was converted in full. This is often referred to as the ‘if-converted’ method. This method does not consider what the average share price is compared to the exercise price inherent in the convertible debt. Thus, convertible debt may be dilutive for EPS purposes even though the conversion option is not ‘in the money’ and, therefore, the holder would have no economic incentive for converting.

A different approach is used for stand-alone warrants and options to deliver ordinary shares. This approach determines dilution by comparing the average share price with the exercise price of the option. The approach illustrates how many shares are issued for nil consideration and, therefore, unlike the if-converted method, does take into account the extent to which the written option is in the money. This is referred to as the ‘treasury stock’ method.

The existence of two different approaches in determining the adjustment for the denominator can result in different EPS amounts for very similar arrangements. For example, applying the ‘if-converted’ method for an issue of convertible bonds will result in a larger adjustment to the denominator compared to an issue of debt plus a stand-alone warrant to which the ‘treasury stock’ method will apply.

What is an example of a situation where an adjustment is made to earnings for the purpose of diluted EPS? A situation that often arises in practice is where the equity conversion option in a foreign currency convertible bond, which is treated as a liability, is marked to market through profit or loss. The marked-to-market adjustment needs to be removed from profit or loss for the purpose of calculating diluted EPS.

What tax rate should be used for calculating adjustments to earnings for the purpose of diluted EPS? When calculating tax for the purpose of diluted EPS, the standard tax rate is used rather than the entity’s effective tax rate. This is because the effective tax rate might be influenced by factors (such as group relief) that affect the entity’s results, other than the expenses associated with the potential ordinary shares.

Adjustment to earnings for bonds marked to market through profit or loss Entity A has in issue 25,000 4% debentures with a nominal value of C1. The debentures are convertible to ordinary shares at a rate of 1:1 at any time until 20X9. The entity’s management receives a bonus based on 1% of profit before tax. Entity A’s results for 20X2 showed a profit before tax of C80,000 and a profit after tax of C64,000 (for simplicity, a tax rate of 20% is assumed in this example). For the purpose of calculating diluted EPS, the earnings should be adjusted for the reduction in the interest charge that would occur if the debentures were converted, and for the increase in the management bonus payment that would arise from the increased profit. C Profit after tax 64,000 Add: Reduction in interest cost1 25,000 × 4% 1,000 Less tax expense 1,000 × 20% (200) Less: Increase in management bonus 1,000 × 1% (10) Add tax benefit 10 × 20% 2 Earnings for the purpose of diluted EPS 64,7921 1Note that, for simplicity, this example does not classify the components of the convertible debenture as liabilities and equity, as required by IAS 32.

How should basic EPS earnings be adjusted to get to diluted EPS earnings? Whether convertible preference shares are treated as a liability or as equity under IAS 32, where the instruments are dilutive, the profit attributable to ordinary shareholders for the purpose of calculating diluted EPS is the amount before deducting the preference dividend. For the purpose of basic EPS, preference dividends will have been charged as finance costs in arriving at profit for the year if the preference shares are treated as a financial liability under IAS 32, and no adjustment will have been necessary to arrive at profit attributable to ordinary shareholders. In other cases, if the preference shares are classified as equity under IAS 32, an adjustment will have to be made to profit for the year to arrive at profit attributable to ordinary shareholders for the purposes of basic EPS calculation.

Once potential ordinary shares are converted into ordinary shares during the period the dividends, interest and other expense associated with those potential ordinary shares will no longer arise. Adjustments to profit or loss attributable to ordinary equity holders are required to add back:

• Transaction costs and discounts (or subtract premiums) on potential ordinary shares that are allocated to periods in accordance with the effective interest method in Appendix A to IFRS 9.
• Issue costs (or similar) amortised in the period.
• Interest/dividend costs.
• Any related taxes.

The adjustments to earnings to reflect the conversion of potential ordinary shares includes the direct savings in debt servicing cost, dividends and other adjustments, and other consequential changes in other income or expense arising as a result of the conversion. For example, an increase in an employee non-discretionary profit-sharing plan, as a result of the savings in after-tax interest cost following conversion of convertible debt, would be adjusted for in calculating diluted EPS.

Computation of number of ordinary shares

The denominator of diluted EPS should be calculated as the sum of the weighted average number of ordinary shares used in the basic EPS calculation and the weighted average number of ordinary shares that would be issued on the conversion of all the dilutive potential ordinary shares into ordinary shares.

All potential ordinary shares are assumed converted into ordinary shares at the beginning of the period or, if not in existence at the beginning of the period, at the date of issue of the potential ordinary shares. The date of issue is the date the financial instrument was issued or the granting of the rights by which they are generated. This is sometimes referred to as the ‘if converted’ method.

The conversion into ordinary shares should be determined from the terms of the financial instrument or the rights granted. This determination should assume the most advantageous conversion rate or exercise price from the standpoint of the holder of the potential ordinary shares.

How is number of shares determined if more than one conversion basis exists? When calculating diluted EPS, the calculation should assume the most advantageous conversion rate or exercise price from the standpoint of the holder of the potential ordinary shares, that is, based on the maximum number of new shares that would be issuable under the instrument’s terms. In practice, it might be that not all conversion rights or warrants are exercised, in which case the dilutive effect in reality would be less than the diluted EPS figure would suggest.

How do you calculate EPS with an instrument with variable conversion terms? Where an instrument has variable conversion terms, such that it is convertible at reducing rates over its life, the conversion rate at the end of the period is used to determine the number of shares that would be issued on conversion. This is because the maximum number of new shares would not take into consideration the higher conversion rates in previous periods, because the instrument could no longer be converted at those higher rates.

Calculation of earnings for diluted EPS with convertible securities, with no conversion during the year Example – Calculation of earnings for diluted EPS No conversion during the year At 30 June 20X1, the issued share capital of an entity consisted of 1,500,000 ordinary shares of C1 each. On 1 October 20X1 the entity issued C1,250,000 of 8% convertible loan stock for cash at par. Each C100 nominal of the loan stock may be converted, at any time during the years ended 20X6 to 20X9, into the number of ordinary shares set out below: 30 June 20X6: 135 ordinary shares; 30 June 20X7: 130 ordinary shares; 30 June 20X8: 125 ordinary shares; and 30 June 20X9: 120 ordinary shares. If the loan stocks are not converted by 20X9, they would be redeemed at par. There are two different ways of assessing these instruments under IAS 32: the conversion option, to convert to a number of shares which varies only with time, could be viewed as either an option to convert to a variable or a fixed number of shares and recognised as either a liability or equity respectively. This example assumes that the written equity conversion option is accounted for as a derivative liability and marked to market through profit or loss. The change in the options’ fair value reported in 20X2 and 20X3 amounted to losses of C2,500 and C2,650 respectively. It is assumed that there are no tax consequences arising from these losses. The profit before interest, fair value movements and taxation for the year ended 30 June 20X2 and 20X3 amounted to C825,000 and C895,000 respectively and relate wholly to continuing operations. The rate of tax for both periods is 33%. 20X3 20X2 Trading results C C Profit before interest, fair value movements and tax 895,000 825,000 Interest on 8% convertible loan stock (20X2: 9/12 × C100,000) (100,000) (75,000) Change in fair value of embedded option (2,650) (2,500) Profit before tax 792,350 747,500 Taxation @ 33% (262,350) (247,500) Profit after tax 530,000 500,000 Calculation of basic EPS Number of equities shares outstanding 1,500,000 1,500,000 Basic EPS C530,000 C500,000 1,500,000 1,500,000 35.3c 33.3c Calculation of diluted EPS Test whether convertibles are dilutive: The saving in after-tax earnings, resulting from the conversion of C100 nominal of loan stock, amounts to C100 × 8% × 67% + C2,650/12,500 = C5.36 + C0.21 = C5.57. There will then be 135 extra shares in issue. Therefore, the incremental EPS = 4.12c (that is, C5.57/135). As this incremental EPS is less than the basic EPS at the continuing level, it will have the effect of reducing the basic EPS of 35.3c. Hence the convertibles are dilutive. 20X3 20X2 Adjusted earnings C C Profit for basic EPS 530,000 500,000 Add: interest and other charges on earnings saved as a result of the conversion 102,650 77,500 Less: tax relief thereon (33,988) (25,661) Adjusted earnings for equity 598,662 551,839 Adjusted number of shares From the conversion terms, it is clear that the maximum number of shares issuable on conversion of C1,250,000 loan stock after the end of the financial year would be at the rate of 135 shares per C100 nominal (that is, 1,687,500 shares). Number of equity shares for basic EPS 1,500,000 1,500,000 Maximum conversion at date of issue 1,687,500 × 9/12 – 1,265,625 Maximum conversion after balance sheet date 1,687,500 – Adjusted capital 3,187,500 2,765,625 Diluted EPS C598,662 C551,839 3,187,500 2,765,625 18.8c 20.0c

Potential ordinary shares are included in the diluted EPS calculation on a weighted basis only for the period they were outstanding. Potential ordinary shares that are issued during the year are included on a time-weighted basis from the date of issue to the balance sheet date. Likewise, potential ordinary shares that are outstanding at the beginning of the period, but which are converted during the year, are included on a weighted average basis from the beginning of the year to the date of conversion. The same principles apply where potential ordinary shares are cancelled or allowed to lapse during the reporting period instead of being converted.

The new ordinary shares that are issued on conversion are included from the date of conversion, in both basic and diluted EPS, on a weighted basis.

Only potential ordinary shares that are dilutive are considered in the calculation of diluted EPS. Potential ordinary shares should be treated as dilutive only when their conversion to ordinary shares would decrease profit per share or increase loss per share from continuing operations attributable to ordinary equity holders.

The effects of anti-dilutive potential ordinary shares are ignored in calculating diluted EPS.

An entity might have a number of different types of potential ordinary shares in issue. Each one would need to be considered separately rather than in aggregate.

If the potential ordinary shares are dilutive, based on profit or loss from continuing operations attributable to ordinary equity holders, they should be treated as dilutive for all other EPS calculations. This includes, for example, total EPS, discontinued operations EPS and any additional EPS given, whether or not they are actually dilutive at the relevant level of profit.

Partly paid shares

Partly paid shares are included in the computation of basic EPS to the extent that they rank for dividends during the period. Partly paid shares that do not rank for dividends during the period (for example, they do not rank until they are fully paid) are regarded as the equivalent of share options and warrants. The unpaid balance is assumed to be the proceeds used to purchase ordinary shares under the treasury stock method. The number of shares included in diluted EPS is the difference between the number of partly paid shares already in issue and the number of shares assumed to be purchased at average market price during the period.

Convertible securities

Convertible preference shares are dilutive where the amount of dividend on such shares, declared or accrued in the period per ordinary share obtainable on conversion, is below basic EPS for continuing operations. If the amount exceeds basic EPS, the convertible preference shares are anti-dilutive.

Calculation of earnings for diluted EPS with convertible securities, with partial conversion during the year Partial conversion during the year The facts are the same as set out in the previous example, except that, at 1 January 20X6, the holders of half of the loan stock exercised their right of conversion. 20X6 20X5 Trading results C C Profit before interest and tax 1,220,000 1,000,000 Interest on 8% convertible loan stock (75,000) * (100,000) Change in fair value of embedded option (2,750) (5,000) Profit before tax 1,142,250 895,000 Taxation @ 33% (377,850) (297,000) Profit after tax 764,400 598,000 *Interest = (C1,250,000 × 8% × ½) + (C625,000 × 8% × ½) = C75,000 Calculation of basic EPS Adjusted number of shares: Number outstanding before conversion 1,500,000 1,500,000 Weighted average shares issued on conversion at 1 January 20X6 = 843,750/2 (1,250,000 × ½ × 135/100) 421,875 – Adjusted number of shares 1,921,875 1,500,000 Basic EPS C764,400 C598,000 1,921,875 1,500,000 39.8c 39.9c Calculation of diluted EPS Adjusted earnings C C Profit for basic EPS 764,400 598,000 Add: interest and other charges on earnings saved as a result of conversion 77,750 105,000 Less: tax relief thereon (24,743) (34,766) Adjusted earnings 816,407 668,234 Adjusted number of shares Number of equity shares for basic EPS 1,921,875 1,500,000 Assumed conversion of C1,250,000 loan stock outstanding at the beginning of the year, at the maximum rate of 135 shares per C100 of stock up to 1 January 20X6 (6 months) 843,750 – Assumed conversion of C625,000 of remaining stock outstanding at 30 June 20X6, at the maximum rate of 135 shares per C100 of stock (6 months) 421,875 – Maximum conversion after balance sheet date, at the rate of 135 shares per C100 of stock – 1,687,500 Adjusted number of shares 3,187,500 3,187,500 Diluted EPS C816,407 C668,234 3,187,500 3,187,500 25.6c 21.0c

Calculation of earnings for diluted EPS with convertible securities, with final conversion during the year Final conversion during the year The facts are the same as set out in the previous example, except that the holders of half of the loan stock had exercised their right of conversion on 1 January 20X6 at 135 shares per C100 stock, and the remaining stock was converted on 30 June 20X7 at 130 shares per C100 stock. 20X7 20X6 Trading results C C Profit before interest and tax 1,450,000 1,220,000 Interest on 8% convertible loan stock (50,000) * (75,000) Change in fair value of embedded option (3,500) (2,750) Profit before tax 1,396,500 1,142,250 Taxation @ 33% (462,000) (377,850) Profit after tax 934,500 764,400 *Interest = C625,000 × 8% = C50,000 Calculation of basic EPS Adjusted number of shares: Number outstanding before conversion 1,500,000 1,500,000 Weighted average shares issued on conversion at 1 January 20X6 843,750 421,875 Weighted average shares issued on conversion at 30 June 20X7 – – Adjusted number of equity shares 2,343,750 1,921,875 Basic EPS C934,500 C764,400 2,343,750 1,921,875 39.9c 39.8c Calculation of diluted EPS Adjusted earnings C C Profit for basic EPS 934,500 764,400 Add: interest and other charges on earnings saved as a result of conversion 53,500 77,750 Less: tax thereon (17,699) (25,719) Adjusted earnings 970,301 816,431 Adjusted number of shares Number of equity shares for basic EPS 2,343,750 1,921,875 Assumed conversion of C1,250,000 loan stock outstanding at the beginning of the year, at the maximum rate of 135 shares per C100 of stock up to 1 January 20X6 (6 months) – 843,750 Assumed conversion of £625,000 of remaining stock outstanding at 30 June 20X6, at the maximum rate of 135 shares per C100 of stock (6 months) – 421,875 Assumed conversion of C625,000 of stock outstanding at the maximum rate of 130 shares per C100 of stock† 812,500 – Adjusted number of shares 3,156,250 3,187,500 † Deemed to be outstanding for the whole year, because the remaining loan stock of C625,000 was redeemed on the last day of the financial year (that is, on 30 June 20X7). Diluted EPS                                                                     C970,301                                          C816,431 3,156,250                                         3,187,500 30.7c                                                  25.6c

Convertible debt is dilutive where the interest, net of tax and other changes in income or expense, per ordinary share obtainable on conversion is lower than basic EPS for continuing operations. If the amount exceeds basic EPS, the convertible debt is anti-dilutive.

Share warrants, options and other potential ordinary shares

Warrants or options are defined as financial instruments that give the holder the right to purchase ordinary shares.

Warrants issued to subscribe for shares at fixed prices on specified dates in the future, or share options granted to directors and employees are taken into account in the calculation of diluted EPS, if they are dilutive.

Warrants and options are dilutive where they would result in the issue of ordinary shares for less than the average market price of ordinary shares during the period.

When are share options dilutive? Where an entity has incurred a loss from continuing operations, options that are ‘in the money’ would only be dilutive if they increased the loss per share from continuing operations (that is, they made the loss per share more negative). Because bringing ‘in more’ shares will increase the denominator and thus reduce the loss per share, in the money options are anti-dilutive, and so they are not included in diluted EPS.

Diluted EPS where an entity has granted options At 31 December 20X7 and 20X8, the issued share capital of an entity consisted of 4,000,000 ordinary shares of 25c each. The entity has granted options that give holders the right to subscribe for ordinary shares between 20Y6 and 20Y9 at 70c per share. Options outstanding at 31 December 20X7 and 20X8 were 630,000. There were no grants, exercises or lapses of options during the year. The profit after tax, attributable to ordinary equity holders for the years ended 31 December 20X7 and 20X8, amounted to C500,000 and C600,000 respectively (wholly relating to continuing operations). Average market price of share: Year ended 31 December 20X7 = C1.20 Year ended 31 December 20X8 = C1.60 Calculation of basic EPS 20X8 20X7 Basic EPS C600,000 C500,000 4,000,000 4,000,000 15.0c 12.5c Calculation of diluted EPS Adjusted number of shares Number of shares under option: Issued at full market price: (630,000 × 0.70) ÷ 1.20 367,500 (630,000 × 0.70) ÷ 1.60 275,625 Issued at nil consideration — dilutive 354,375 262,500 Total number of shares under option 630,000 630,000 Number of equity shares for basic EPS 4,000,000 4,000,000 Number of dilutive shares under option 354,375 262,500 Adjusted number of shares 4,354,375 4,262,500 Diluted EPS C600,000 C500,000 4,354,375 4,262,500 13.8c 11.7c Percentage dilution 8.00% 6.40% Note – if options had been granted or exercised during the period, the number of ‘nil consideration’ shares in respect of these options would be included in the diluted EPS calculation on a weighted average basis for the period prior to exercise.

The method by which dilutive warrants and share options are taken into account in the calculation of diluted EPS is called the ‘treasury stock method’. In the calculation of diluted EPS, the expected proceeds from the exercise of the dilutive share warrants and options are deemed to be used by the entity in purchasing as many of its ordinary shares as possible in the open market, using an average market price for the period. Since this number of shares would be fairly priced and neither dilutive nor anti-dilutive, it is ignored in the diluted EPS calculation. The number of shares that would be purchased in the open market is therefore deducted from the number of shares to be issued under the options or warrants, to give the number of shares deemed to be issued at no consideration. The shares issued for no consideration are dilutive, and are added to the weighted average number of ordinary shares outstanding in the computation of diluted EPS.

The treasury stock method reflects more dilution, because the value of options and warrants increases relative to the value of the underlying share. As the average market price for the underlying share increases, the assumed proceeds from exercise will buy fewer shares, thus increasing the number of shares issued for nil consideration and therefore increasing the denominator of the diluted EPS calculation.

Although increases in the share price over a number of periods might increase the dilutive effect, previously reported EPS figures are not retrospectively adjusted to reflect changes in share prices.

The fair value of share options and warrants under the treasury stock method should always be calculated on the basis of the average price of an ordinary share for the period rather than the period-end market price. The use of the average stock price is consistent with the objective of diluted EPS to measure EPS for the period based on period information.

What does ‘average price for the period’ mean? Although IAS 33 does not specifically say so, it should be assumed that the ‘average price for the period’ means the average price during the period covered by the financial statements. However, where options are issued during the period, the average price should be taken to be the average price during the period for which the options were in issue. This might affect whether the options are dilutive or anti-dilutive. A pragmatic basis of calculation, such as a simple average of weekly or monthly prices, is usually adequate for calculating the average price for the period. Generally, closing market prices are adequate for calculating the average market price; but, where prices fluctuate widely, an average of the high and low prices generally produces a more representative price. The method of calculation of the average price for the period chosen by an entity should be used consistently, unless it becomes unrepresentative due to changed market conditions. For example, an entity that had used closing market prices to calculate the average market price during several years of relatively stable prices might change to using an average of high and low prices, if prices began to fluctuate widely and closing prices no longer produced a representative average price.

Determination of average price for options issued in the period An entity issued share options on 1 January 20X3. The share options are exercisable upon issue. The exercise price of the share options is 20c. The average share price during the year was as follows: Average share price 1 January 20X3 to 30 June 20X3 8c Average share price 1 July 20X3 to 31 December 20X3 22c Average share price for the year to 31 December 20X3 15c Management is preparing the financial statements for the year ended 31 December 20X3 and is considering the effect on diluted EPS of the following two scenarios for year-end share prices: (a) the share price is 18c at 31 December 20X3; or (b) the share price is 23c at 31 December 20X3. Scenario (a): The fact that the year-end share price is less than the exercise price is not relevant, because IAS 33 requires the comparison to be made between the exercise price and the average market price of the shares for the period, and not the price at the year-end. The share options should not be included in the diluted EPS calculation, because they are ‘out-of-the money’, – that is, the exercise price (20c) is higher than the average price of the ordinary shares for the period (15c). Scenario (b): Similarly, the fact that the year-end share price is more than the exercise price is not relevant. There is no change in the answer from that given in (a), because the extent of dilution is calculated by reference to the exercise price and the average share price during the period. The exercise price is 20c and the average fair value of the shares is 15c, and therefore the options are still ‘out of the money’ for the purpose of the diluted EPS calculation. The answer would change, however, if the options had been issued at 1 July 20X3. The average price of the shares during the second half of the year (22c) was above the exercise price of the options (20c), so the share options would be included in the diluted EPS calculation.

The treasury stock method might not always be applicable for calculating the dilutive effects of options or warrants. Sometimes, options or warrants might require or permit the tendering of debt or other securities of the entity in payment of all or part of the exercise price. In computing diluted EPS:

• Those options or warrants are assumed to be exercised, and the debt or other securities are assumed to be tendered.

• Interest (net of tax) on any debt assumed to be tendered is added back as an adjustment to the numerator.

• If tendering cash would be more advantageous to the option holder or warrant holder and the contract permits tendering cash, the tendering of cash should be assumed.

Warrants issued during the year An entity issued 50,000 warrants at the beginning of the year. Each warrant may be exercised to purchase 10 ordinary shares, by tendering either C100 cash or C100 nominal of outstanding 6% debentures of the entity. The market value of the debentures at the balance sheet date is C92, and the average market price of the entity’s shares for the period and at the balance sheet date is C9.50 and C9.60 respectively. In the calculation of diluted EPS, it is first necessary to consider whether the warrants are dilutive. The warrants would be dilutive if either: (a) they are exercised for cash, and the average market price of the related ordinary shares for the period exceeds the exercise price; this is not the case here, because the average share price of C95 (10 shares @ C9.50) is less than the exercise price of C10 (C100 / 10 ordinary shares); or (b) they are exercised by tendering the entity’s debentures, and the selling price of the debenture to be tendered is below that at which the debenture may be tendered under the warrant agreement, and the resulting discount establishes an effective exercise price below the market price of the ordinary shares obtained upon exercise; this is the case here, because the market value of the debentures of C92 (nominal value C100) is less than the market price of the shares obtained (C96) at the balance sheet date. Therefore, the warrants are dilutive, and it is assumed that the debentures will be tendered, because it will be more advantageous to the warrant holder to surrender the entity’s debentures that have a market value of C92 rather than pay cash of C100 to obtain 10 ordinary shares with a market value of C96. For the purpose of calculating diluted EPS, the entity will increase the numerator by the after-tax interest saved of C210,000 (C5m @ 6% less tax @ 30%) on effectively repurchasing C5m (C100 nominal for each 50,000 warrants) of the entity’s outstanding debentures. In addition, the full amount of 500,000 shares to be issued following the exercise of warrants (rather than the number computed under the treasury stock method, using an effective exercise price equal to the market value of C92 for the debenture and an average share price of C9.50) is included in the denominator. This treatment reflects the fact that a repurchase of debt with the warrant/option proceeds, followed by an issue of shares under the warrant/option agreement, is, in substance, equivalent to a traditional or conventional debt instrument that is convertible into a fixed number of shares. On the other hand, if the tendering of cash is considered to be more advantageous to the warrant holder (for instance, if cash tendered in this example was C90 for each warrant), tendering of cash would be considered to be dilutive, because the exercise price is less than the average share price. In that situation, the number of dilutive shares included in the denominator would be calculated under the treasury stock method in the normal way for options and warrants. Furthermore, where both cash and debt instruments are tendered, the number of dilutive shares included in the denominator would be the sum of (a) the amount calculated using the treasury stock method by applying the cash proceeds, and (b) the amount calculated by treating the debt tendered as a conventional convertible debt.

Options issued during the year An entity granted 500,000 new options over ordinary shares, at the beginning of the year, to its debenture holders that also own all of the entity’s 6% redeemable 20,000 nominal C100 debentures. The exercise price of the option is C6.50. The terms of the options require the entity to use the proceeds, received from the exercise of options, to repurchase the entity’s outstanding debentures. The average market prices of a nominal C100 debenture and an ordinary share for the period are C105 and C8 respectively. For the purpose of calculating diluted EPS, these options are assumed to be exercised, and the proceeds of C3,250,000 (500,000 @ 6.50) are applied to purchase all of the outstanding 20,000 nominal debentures at the average price of C105 for C2,100,000. The excess proceeds of C1,150,000 are deemed to be applied to purchase shares in the market at C8 per share (that is, 143,750 shares). Therefore, the number of dilutive shares that are included in the denominator, under the treasury stock method, is 500,000 – 143,750 = 356,250. In addition, the entity would increase the numerator by the after-tax interest saved on the assumed repurchase of the debentures – that is, C84,000 (C2m @ 6% less tax @ 30%). The incremental EPS = C84,000 ÷ 356,250 = C0.24. The options would be included in the diluted EPS calculation if the incremental EPS of C0.24 is less than the basic EPS at the continuing operations level.

The proceeds from the exercise of options or warrants might need to be applied to redeem the entity’s existing debt instruments. On the assumed exercise of such options or warrants, the proceeds are applied to purchase the debt at its market price rather than to purchase ordinary shares under the treasury stock method. The treasury stock method is applied, however, for the excess proceeds received from the assumed exercise of the options or warrants over the amount used for the assumed purchase of debt. Interest, net of income tax, on any debt assumed to be purchased is added back as an adjustment to the numerator.

Considering whether potential ordinary shares are dilutive

Only potential ordinary shares that are dilutive are considered in the calculation of diluted EPS. Potential ordinary shares should be treated as dilutive only when their conversion to ordinary shares would decrease profit or increase loss per share from continuing operations attributable to ordinary equity holders.

Profit from continuing operations, as calculated for basic EPS, is the control number used to establish whether potential ordinary shares are dilutive or anti-dilutive. A potential ordinary share would be dilutive if its assumed conversion results in reducing this EPS from continuing operations below the basic level. If the effect is to increase this EPS above the basic level, the security is anti-dilutive and should be excluded from the diluted EPS calculation.

Why is profit from continuing operations used as the control number for determining dilution? Dilution should never be tested by reference to whether the conversion of a potential ordinary share reduces the standard basic EPS calculated on the total profit or loss for the period. The reason for choosing ‘profit from continuing operations’ as a control number is that this level of profit, unaffected by discontinued operations, is likely to remain stable over time and to reflect the earnings that will exist in the future when the dilution occurs. This is a sensible approach because, if there is a loss from discontinued operations and this turns the overall EPS attributable to ordinary equity holders into a loss per share, the exercise of, say, an option will increase the denominator and result in a lower overall loss per share. This is because the loss is ‘shared’ among a higher number of shares. In that situation, the option is anti-dilutive at this level, but it might well be dilutive at the continuing operations level.

If, at the level of overall loss, applying the dilution decreases loss per share, is it still correct to show the effect of diluted EPS? An entity has a profit from continuing activities, but a loss for the year overall because of losses on discontinued operations. Options are dilutive when considered at the level of profit from continuing operations, because the diluted EPS at that level decreases profit per share. However, at the level of overall loss for the year, applying the dilution caused by the options decrease’s loss per share. Is it still correct to show the effect of the options in the diluted EPS? Yes. If the options are dilutive at the level of profit from continuing operations, they should be included in the diluted EPS calculation at the level of the loss for the year. If that reduces loss per share, the entity should explain the circumstances. A form of explanation might be: “Options are dilutive at the level of profit from continuing operations and so, in accordance with IAS 33, have been treated as dilutive for the purpose of diluted EPS. The diluted loss per share is lower than basic loss per share because of the effect of losses on discontinued operations”. In addition to disclosing basic and diluted EPS for the overall loss for the year, the entity would be required to disclose basic and diluted EPS at the level of continuing operations (on the face of the income statement) and the basic and diluted EPS for discontinued operations (either on the face of the income statement or in the notes).

Each particular convertible instrument, option or warrant is considered separately to determine if they are dilutive. Each issue or series of potential ordinary shares is considered in sequence, from the most dilutive to the least dilutive.

How would an entity carry out a test to determine if a series of convertible instruments, warrants and options is dilutive? This consideration is complicated and involves the following steps: Step 1 – the entity calculates the profit or loss from continuing operations attributable to ordinary equity holders. Step 2 – the entity calculates the earnings per incremental share for each type of potential ordinary share. The earnings per incremental share is the increase in profit or loss (or, less commonly, the decrease) that would result from the exercise or conversion of the security, divided by the weighted average increase in the number of ordinary shares that would result from the conversion. Step 3 – the entity ranks all potential ordinary shares, from the most dilutive (lowest earnings per incremental share) to the least dilutive (highest earnings per incremental share). Options and warrants are generally included first, because they do not affect the numerator of the calculation, and so are most dilutive. Step 4 – the entity calculates a basic EPS, using profit or loss from continuing operations attributable to ordinary equity holders as the numerator. Step 5 – the most dilutive potential ordinary share with the lowest earnings per incremental share is included, and a new EPS (as indicated above) is calculated. If this new figure is lower than the previous one, the entity recalculates EPS including the potential shares with the next lowest earnings per incremental share. Step 6 – this process of including increasingly less dilutive shares continues until the resulting EPS figure increases, or there are no more potential ordinary shares to consider. Step 7 – any potential ordinary share that has the effect of increasing the cumulative EPS from continuing operations is considered to be anti-dilutive, and it is excluded from the diluted EPS calculation. Step 8 – all other potential ordinary shares with higher rankings are considered to be dilutive potential ordinary shares, and they are included in the diluted EPS calculation in the normal way.

Does an entity test to determine whether an instrument is dilutive when there is a loss from continuing operations? In most instances, where there is a loss from continuing operations, there would be no difference between the basic and diluted EPS, because potential ordinary shares would be anti-dilutive.

Determination of dilutive effects The sequence of including each issue or series of potential ordinary shares, from the most dilutive to the least dilutive, guarantees that the final diluted EPS figure expresses maximum dilution of basic EPS. A numerical example is shown here: The issued share capital of C plc at 31 December 20X7 and 20X8 comprises 2,000,000 ordinary shares of 10c each. C plc granted options over 100,000 ordinary shares in 20X6. The options can be exercised between 20X9 and 20Y1 at 60c per share. The average market price of C plc’s shares during 20X8 was 75c. In addition, C plc has 800,000 8% C1 convertible cumulative preference shares (treated as an equity instrument under IAS 32) and C1,000,000 5% convertible bonds in issue throughout 20X8. Each preference shares and bond is convertible into 2 ordinary shares. C plc’s results for the year ended 31 December 20X8 comprised operating profit from continuing operations of C300,000 and operating profit from discontinued operations of C100,000. Interest expense and tax at 30% amounted to C100,000 and C90,000 respectively. The profit for the year was C210,000. The necessary steps to calculate C plc’s diluted EPS for 20X8 are set out below (comparative figures for 20X7 have not been included in this example). The sequence of including each issue or series of potential ordinary shares, from the most dilutive to the least dilutive, guarantees that the final diluted EPS figure expresses maximum dilution of basic EPS. A numerical example is shown here: Step 1: Calculate profit from continuing operations Total Continuing operations Discontinued operations C C C Operating profit from continuing operations 300,000 300,000 Operating profit from discontinued operations* 100,000 100,000 Profit before interest expense 400,000 300,000 100,000 Interest expense** (100,000) (76,000) (24,000) Profit after interest 300,000 224,000 76,000 Tax @ 30% ** (90,000) (67,200) (22,800) Profit 210,000 156,800 53,200 Less: Preference dividend (64,000) (64,000) (–) Profit attributable to ordinary equity holders 146,000 92,800 53,200 * These workings are for illustrative purposes and do not show the discontinued operations because they are required to be presented in the income statement by IAS 1 and IFRS 5. ** Interest has been allocated to the discontinued operations on the basis of the debt that has been attributed to the discontinued operations. Taxation has been attributed on the basis of the taxation actually payable by the discontinued operations. Step 2: Determine earnings per incremental share for each class of potential ordinary share and rank them from the most dilutive to least dilutive Increase in earnings Increase in number of ordinary shares Earnings per incremental share Rank (note) C (C) Options Increase in earnings nil Incremental shares issued for nil consideration 100,000 × (75 – 60)/75 20,000 nil 1 8% convertible preference shares Increase in earnings 8% × C800,000 64,000 Incremental shares 2 × 800,000 1,600,000 4.00 3 5% convertible bonds Increase in earnings after taxes 1,000,000 × 5% × 70% 35,000 Incremental shares 1,000,000 × 2 2,000,000 1.75 2 Note: ranking is in ascending order of earnings per incremental share. Since the options, convertible preference shares and convertible bonds have been in issue throughout 20X8, the increase in the number of ordinary shares is also their weighted average for the year. If options are granted during the year, they are brought into the averaging calculation from the date of grant. If there were more than one series, say, of options, these would have to be ranked by series. Step 3: Calculate the cumulative dilution effect on profit per share from continuing operations Profit from continuing Weighted average Profit from continuing operations per share (c) Profit 92,800 2,000,000 4.64 Options – 20,000 92,800 2,020,000 4.59 Dilutive 5% convertible bonds 35,000 2,000,000 127,800 4,020,000 3.18 Dilutive 8% convertible preference shares 64,000 1,600,000 191,800 5,620,000 3.41 Antidilutive Since diluted EPS from continuing operations is increased when taking the convertible preference shares into account (from 3.18 to 3.41), the convertible preference shares are anti-dilutive, and so they are ignored in the calculation of diluted EPS. Step 4: Calculate diluted earnings per share including only dilutive potential ordinary shares Earnings Weighted average number of shares Earnings per share C (C) Profit attributable to ordinary equity holders 146,000 2,000,000 7.30 Options – 20,000 146,000 2,020,000 – 5% convertible bonds 35,000 2,000,000 – Diluted earnings 181,000 4,020,000 4.50 The final diluted EPS is calculated by reference to profit attributable to ordinary equity holders, but the dilution test is carried out by using the profit from continuing operations as the ‘control number’, as set out in step 3 above. This example deals only with the calculation of the diluted EPS for the total profit attributable to ordinary equity holders. However, IAS 33 also requires disclosure of the basic and diluted EPS attributable to continuing and to discontinued operations. The figures to be disclosed would be as follows: Basic EPS Diluted EPS (C) (C) Profit attributable to ordinary equity holders 7.30 4.50 Profit from continuing operations 4.641 3.181 Profit from discontinued operations 2.662 1.322 Notes: 1As per step 3, basic = 92,800/2,000,000 = 4.64; diluted = 127,800/4,020,000 = 3.18 2Basic = 53,200/2,000,000 = 2.66; diluted = 53,200/4,020,000 = 1.32 Note that the income statement effect of the convertible bonds is not adjusted against the discontinued operations results, because it relates to continuing operations. The additional shares are taken into account, because the discontinued operations EPS is measured as one element of the EPS for the total entity result. Also, the sum of the continuing operations EPS and discontinued operations EPS (for both basic and diluted) equals the EPS calculated on the profit attributable to ordinary equity holders.

Application of the control number to determine whether potential ordinary shares are dilutive IAS 33 illustrates the application of the ‘control number’ with a useful example, from which this example is derived. An entity has a profit from continuing operations of C4 million, a loss from discontinued operations of C7 million, a loss for the year attributable to equity holders of C3 million, and 4 million ordinary shares and 1 million potential ordinary shares outstanding. The entity’s basic EPS for continuing operations is C1 for continuing operations, a (C1.75) loss for discontinued operations and a (C0.75) loss for the year. The 1 million potential ordinary shares are included in the diluted EPS calculation, because (assuming no income statement effect for the potential ordinary shares) their effect on the EPS calculation for continuing operations is dilutive. On that assumption, the resulting diluted EPS for continuing operations is C0.8. Because the profit from continuing operations is the control number, the potential ordinary shares are also included in the calculation of the diluted EPS for the loss from discontinued operations and for the total loss for the year attributable to equity holders. The resulting diluted EPS figures are (C1.4) for discontinued operations and (C0.6) for the loss attributable to equity holders, respectively. This is despite the fact that these figures are antidilutive to their comparable basic EPS figures of (C1.75) and (C0.75).

EPS for interim periods

Dilutive potential ordinary shares should be determined independently for each period presented. The number of dilutive potential ordinary shares included in the year-to-date period should not be a weighted average of the dilutive potential ordinary shares included in each interim computation. Rather, the number of dilutive potential ordinary shares should be determined for each interim period, based on the year-todate position at the end of the interim period.

EPS for interim periods An entity made an acquisition in the previous year and entered into an agreement to issue 1,000 additional ordinary shares for each C50,000 of consolidated profit in excess of C1 million in the following year, based on the entity’s consolidated financial statements. The entity reports quarterly. The results for each quarter are as follows: C Cumulative C First quarter 600,000 600,000 Second quarter 700,000 1,300,000 Third quarter (200,000) * 1,100,000 Fourth quarter 400,000 1,500,000 *Includes a loss from discontinued operations of C300,000. The entity has 100,000 ordinary shares outstanding during the year. Assume that changes in the fair value of the liability are immaterial, so that no adjustment is made to the numerator. The basic and diluted EPS for each quarter are as follows: Quarter 1 Quarter 2 Quarter 3 Quarter 4 Year Numerator C600,000 C700,000 (C200,000) C400,000 C1,500,000 Denominator: Ordinary shares 100,000 100,000 100,000 100,000 100,000 Basic EPS* C6 C7 (C2) C4 C15 Potential ordinary shares − 6,000 2,000** 10,000 10,000 Total denominator for diluted EPS 100,000 106,000 102,000 110,000 110,000 Diluted EPS   C6 C6.6 (C1.96) C3.64 C13.64 * The potential ordinary shares are not included in the calculation of the basic EPS, because there is no certainty that the condition will be satisfied until the end of the period. ** In quarter 3, there is a profit from continuing operations of C100,000 and a loss from discontinued operations of C300,000; because the potential ordinary shares are dilutive at the continuing operations level, they are taken into account in the diluted EPS, even though they are anti-dilutive at the total loss level. This example demonstrates that the diluted EPS for the year differs from any average or weighted average of the diluted EPS figures reported in the individual quarterly accounts. This is because the denominator used in each of the first three quarters differs from the denominator at the year-end. Under IAS 33, the diluted EPS figure for the year should be based on the year-to-date figures; so, at the year-end, the figure should be disclosed as C13.64.

Identifying dilutive potential ordinary shares

Steps for identifying dilutive potential ordinary shares

Antidilutive potential ordinary shares are disregarded in the calculation of diluted EPS. Therefore, once the entity has identified all of the potential ordinary shares in issue, the next step is to determine which of these are dilutive, and which are antidilutive.

Potential ordinary shares are treated as dilutive if their conversion to ordinary shares would decrease earnings per share or increase loss per share from continuing operations.

IAS 33 specifies the steps to be followed in determining which potential ordinary shares are dilutive, as set out below. Each different category of potential ordinary shares is tested. The order in which they are tested is not left to each entity to choose, but is set out in the Standard.

Net profit per share from continuing operations

In order to determine which potential ordinary shares are dilutive, IAS 33 requires an analysis of the effect of conversion to ordinary shares on profit or loss from continuing operations attributable to the parent entity.

Profit or loss per share from continuing operations is calculated as:

Example Calculation of weighted average number of shares: determining the order in which to include dilutive instruments Note that this example does not illustrate the classification of the components of convertible financial instruments as liabilities and equity or the classification of related interest and dividends as expenses and equity as required by IAS 32. Earnings CU  Profit from continuing operations attributable to the parent entity 16,400,000 Less dividends on preference shares (6,400,000) Profit from continuing operations attributable to ordinary equity holders of the parent entity 10,000,000 Loss from discontinued operations attributable to the parent entity (4,000,000) Profit attributable to ordinary equity holders of the parent entity  6,000,000 Ordinary shares outstanding 2,000,000 Average market price of one ordinary share during year CU75.00 Potential ordinary shares Options 100,000 with exercise price of CU60 Convertible preference shares 800,000 shares with a par value of CU100 entitled to a cumulative dividend of CU8 per share. Each preference share is convertible to two ordinary shares. 5 per cent convertible bonds Nominal amount CU100,000,000. Each CU1,000 bond is convertible to 20 ordinary shares. There is no amortisation of premium or discount affecting the determination of interest expense. Tax rate 40 per cent Increase in earnings attributable to ordinary equity holders on conversion of potential ordinary shares Increase in earnings Increase in number of ordinary shares Earnings per incremental share CU CU Options Increase in earnings Nil Incremental shares issued for no consideration 100,000 × (CU75 – CU60) ÷ CU75 20,000 Nil Convertible preference shares Increase in profit CU800,000 × 100 × 0.08 6,400,000 Incremental shares 2 × 800,000 1,600,000 4.00 5 per cent convertible bonds Increase in profit CU100,000,000 × 0.05 × (1 – 0.40) 3,000,000 Incremental shares 100,000 × 20 2,000,000 1.50 The order in which to include the dilutive instruments is therefore: (1) Options (2) 5% convertible bonds (3) Convertible preference shares Calculation of diluted earnings per share Profit from continuing operations attributable to ordinary equity holders of the parent entity (control number) Ordinary shares Per share CU CU As reported 10,000,000 2,000,000 5.00 Options         –    20,000 10,000,000 2,020,000 4.95 Dilutive 5 per cent convertible bonds  3,000,000 2,000,000 13,000,000 4,020,000 3.23 Dilutive Convertible preference shares  6,400,000 1,600,000 19,400,000 5,620,000 3.45 Antidilutive Because diluted earnings per share is increased when taking the convertible preference shares into account (from CU3.23 to CU3.45), the convertible preference shares are antidilutive and are ignored in the calculation of diluted earnings per share. Therefore, diluted earnings per share for profit from continuing operations is CU3.23: Basic EPS   Diluted EPS   CU   CU   Profit from continuing operations attributable to ordinary equity holders of the parent entity 5.00 3.23 Loss from discontinued operations attributable to ordinary equity holders of the parent entity (2.00)a (0.99)b Profit attributable to ordinary equity holders of the parent entity 3.00c 2.24d A (CU4,000,000) ÷ 2,000,000 = (CU2.00) B (CU4,000,000) ÷ 4,020,000 = (CU0.99) C CU6,000,000 ÷ 2,000,000 = CU3.00 D (CU6,000,000 + CU3,000,000) ÷ 4,020,000 = CU2.24

Circumstance when diluted EPS can be greater than basic EPS When an entity reports discontinued operations, it is possible for diluted EPS on total earnings to be greater than basic EPS. The reason for this is that IAS 33 treats potential ordinary shares as dilutive if their conversion would decrease earnings per share or increase loss per share from continuing operations. Both basic and diluted EPS, on the other hand, will be calculated both on profit or loss from continuing operations and on total profit or loss. Thus, although diluted EPS can never exceed basic EPS for continuing operations, it is possible for diluted EPS to exceed basic EPS when calculated for total profit or loss.

Control number Assume that an entity has profit from continuing operations attributable to the parent entity of CU4,800, a loss from discontinued operations attributable to the parent entity of (CU7,200), a loss attributable to the parent entity of (CU2,400), and 2,000 ordinary shares and 400 potential ordinary shares outstanding. The entity’s basic earnings per share is CU2.40 for continuing operations, (CU3.60) for discontinued operations and (CU1.20) for the loss. The 400 potential ordinary shares are included in the diluted earnings per share calculation because the resulting CU2.00 earnings per share for continuing operations is dilutive, assuming no profit or loss impact of those 400 potential ordinary shares. Because profit from continuing operations attributable to the parent entity is the control number, the entity also includes those 400 potential ordinary shares in the calculation of the other earnings per share amounts, even though the resulting earnings per share amounts are antidilutive to their comparable basic earnings per share amounts, i.e. the loss per share is less [(CU3.00) per share for the loss from discontinued operations and (CU1.00) per share for the loss].

Effect of current value of ordinary shares on diluted EPS calculation The current value of the ordinary shares relative to the conversion price of the convertible instrument is not, by itself, a determinant of whether an instrument is dilutive or antidilutive. For example, Company A has convertible debt that, pursuant to its original conversion terms, converts at a rate of CU10 per ordinary share. The market price of Company A’s ordinary shares at the date the convertible debt was issued was CU8 per share. By the end of the reporting period, Company A’s share price had fallen to CU6 per share. Even though an economically rational person would not be expected to convert the debt to ordinary shares at that time, the convertible debt is included in the computation of diluted EPS if the interest expense (net of tax and other adjustments) per ordinary share obtainable on conversion does not exceed basic EPS. In other words, the instrument will be antidilutive for Company A if the adjustment to profits by adding back the interest expense is greater in relative terms than the adjustment to the increase in the number of shares (i.e. the increase in the numerator is greater than the increase in the denominator). To illustrate, if Company A had 1,000 ordinary shares in issue and profits of CU500, the basic EPS would be CU0.50. If interest expense on the convertible debt was CU50 and the number of ordinary shares potentially issued under the terms of the convertible debt is 100, then the convertible bond is not dilutive because the adjustment to earnings is exactly in proportion to the adjustment to the number of shares [(CU500 + CU50) / (1,000 + 100) = CU0.50]. If the interest expense per ordinary share that may be issued under the convertible bond is less than CU0.50, the convertible bond will be dilutive.

Adjustment to earnings arising from convertible instruments – example An entity has a profit attributable to ordinary shareholders for the year ended 31 December 20X5 of CU7,400,000. The entity has three different types of potential ordinary shares in issue, as follows: CU1 million 6 per cent convertible redeemable bonds (issued in 20X2); CU1 million 8 per cent convertible bonds (issued 1 July 20X5); and 1,000,000 CU1 17 per cent convertible preference shares (issued in 20X3). The finance costs recognised in profit or loss (and associated tax effects) for the year ended 31 December 20X5 were as follows. Finance costs recognised in profit or loss for the year Associated tax credit Net of tax cost CU CU CU 6 per cent bonds* 70,000 21,000 49,000 8 per cent bonds** 40,000 12,000 28,000 Preference shares 170,000 – 170,000 * Including accrued redemption premium. ** The bonds were only issued on 1 July 20X5 and so the finance cost is calculated from that date. The right hand column, headed ‘net of tax cost’, is used to adjust earnings in the diluted EPS calculation if the potential ordinary shares are dilutive.

Securities of subsidiaries, joint ventures and associates

A subsidiary, joint venture or associate might issue potential ordinary shares to parties other than the parent, venturer or investor. These potential ordinary shares might be convertible into either ordinary share of the subsidiary, joint venture or associate, or they might be convertible into shares of the parent, venturer or investor (the reporting entity). If the potential ordinary shares have a dilutive effect on the reporting entity’s basic EPS, they should be included in the reporting entity’s calculation of diluted EPS.

If the holder of a potential ordinary share may obtain an interest in an entity, those potential ordinary shares must be included in the calculation of that entity’s EPS. If the potential ordinary shares issued by a subsidiary enable their holders to obtain ordinary shares in the subsidiary, those potential ordinary shares should be included in computing the subsidiary’s EPS figures (if, indeed, the subsidiary is calculating an EPS figure). In any event, those EPS amounts would be included in the consolidated EPS, based on the group’s holdings of the subsidiary’s securities. On the other hand, if the potential shares issued by the subsidiary enable their holders to obtain ordinary shares in the parent, these potential ordinary shares should be considered, along with the other potential ordinary shares issued by the parent, in the computation of consolidated diluted EPS. The same considerations apply where potential ordinary shares issued by an associate or a joint venture are exchangeable into ordinary shares of the associate or joint venture, or into the reporting entity’s ordinary shares. They should be included in the reporting entity’s EPS computation if considered to be dilutive.

Options to exchange preference shares for ordinary shares – example Company A issued 1,000 options that, if exercised, entitle the holder to tender each preference share in Company A in exchange for 500 ordinary shares in Company A. Each preference share has a face value of CU2,750. On the date the option was issued, the ordinary shares of Company A were trading at CU5 per share. The preference shares pay dividends at 10 per cent of face value annually. The following year, Company A had a net profit of CU15 million, weighted average shares outstanding of 4,000,000, and the ordinary shares of Company A had an average market price of CU15 per share. Because the terms of the options entitle the holder to tender a preference share, the effect of the options is to change 1,000 preference shares into convertible instruments. The impact on diluted EPS is therefore calculated as for other convertible instruments. The exercise of the option is dilutive to EPS, computed as follows. Basic Adjustments Diluted Net profit attributable to ordinary shareholders CU15,000,000 CU275,000a CU15,275,000 divided by Weighted average shares outstanding 4,000,000 500,000b 4,500,000 Earnings per share CU3.75 CU3.39 a Adjustment to the numerator (CU2,750 × 1,000 × 10%) = CU275,000 b Adjustment to the denominator (1,000 options × 500 shares) = 500,000

Forward sale of own shares A forward sale of own shares is similar in substance to a written call option at the forward sale price and a purchased put option at the forward sale price. Consistent with IAS 33, the purchased put option is not dilutive. The effect of the written call option on the denominator should be determined in accordance with IAS 33. If the forward sale contract has been recognised as a derivative as at fair value through profit or loss, any gain or loss recognised in earnings should be adjusted for the purposes of calculating diluted EPS.

Options, warrants and similar items – adjustments to earnings In the case of an option that is a potential ordinary share and that is classified as equity under IAS 32, there is no adjustment to the numerator when computing diluted EPS because the equity instrument is not remeasured and, therefore, it has no effect on earnings during its life. In contrast, if an option is classified as at fair value through profit or loss (FVTPL) under IFRS 9 (or, for entities that have not yet adopted IFRS 9, under IAS 39) because it does not meet the definition of equity in IAS 32 (e.g. because it is not an exchange of a fixed amount of shares for a fixed amount of functional currency cash or another financial asset of the issuer), changes in the fair value of the option are recognised directly in earnings during the life of the instrument. If the options are determined to be dilutive (see below), the earnings numerator should be adjusted for the purposes of diluted EPS to reflect what would have been the impact on earnings if shares had been issued in accordance with the terms of the option at the start of the reporting period (or later if the option is entered into part way through the reporting period). Instruments that fall within this category include written call options or forward sale contracts for an exchange of a fixed amount of shares for a variable amount of cash, or an exchange of a fixed amount of shares for a fixed amount of cash with a net cash settlement alternative. For such instruments (assuming that they are dilutive), the earnings numerator for diluted EPS should be adjusted for fair value gains or losses (net of the tax effect). Potential ordinary shares are only included in the computation of diluted EPS if they are dilutive. Under IAS 33, in order to determine whether a potential ordinary share is dilutive or antidilutive, each issue or series of potential ordinary shares is considered separately, in sequence from the most dilutive to the least dilutive. In the case of options that are potential ordinary shares measured at FVTPL, the adjustment to the numerator may be positive or negative and, therefore, care will be needed in determining whether they are dilutive. Potential ordinary shares that are classified as equity and, therefore, do not affect earnings are usually the most dilutive.

Average fair value for options granted during the reporting period IAS 33 does not provide any further guidance on what is meant by the ‘average market price of the ordinary shares during the period’. When options or warrants are issued during the reporting period, the Standard does not specify if the average market price for this purpose should be taken to be the average for the entire reporting period or only for the period the options or warrants were outstanding. Logically, the fair value of the ordinary shares prior to the issue of the options or warrants should have no bearing on whether the options or warrants are dilutive or antidilutive. Therefore, the average for the shorter of (1) the period the options or warrants were outstanding, and (2) the reporting period, should be used.

Consideration for acquisition of a subsidiary to be settled in cash or in shares – example Company A acquires Company B. The purchase price of CU16 million is to be paid in three instalments: CU3 million at the close of the transaction, CU10 million in one year, and CU3 million in two years. At the seller’s option, the final payment will be made either in cash or 100,000 of Company A’s ordinary shares. The terms of the final instalment constitute a written call option for Company A. The seller of Company B may call for 100,000 shares at a strike price of CU3 million. Prior to the exercise or expiry of the written call option, diluted EPS should be determined in accordance with IAS 33 (i.e. using the treasury stock method).

Example Effect of share options on diluted earnings per share Profit attributable to ordinary equity holders of the parent entity for year 20X1 CU1,200,000 Weighted average number of ordinary shares outstanding during year 20X1 500,000 shares Average market price of one ordinary share during year 20X1 CU20.00 Weighted average number of shares under option during year 20X1 100,000 shares Exercise price for shares under option during Year 20X1 CU15.00 Calculation of earnings per share Earnings Shares  Per share Profit attributable to ordinary equity holders of the parent entity for year 20X1 CU1,200,000 Weighted average shares outstanding during year 20X1 500,000 Basic earnings per share CU2.40 Weighted average number of shares under option 100,000 Weighted average number of shares that would have been issued at average market price: (100,000 × CU15.00)/CU20.00 a (75,000) Diluted earnings per share CU1,200,000 525,000 CU2.29 A Earnings have not increased because the total number of shares has increased only by the number of shares (25,000) deemed to have been issued for no consideration.

Potential ordinary shares issued by a subsidiary A parent entity has profit attributable to ordinary shareholders of C100,000 (excluding any earnings of the subsidiary). There are 10,000 ordinary shares outstanding. The parent owns 800 ordinary shares in the subsidiary, representing 80% of the subsidiary’s ordinary share capital; it also owns 200 convertible preference shares in the subsidiary, representing 50% of the subsidiary’s preference share capital (which is treated as an equity instrument under IAS 32). The parent also has 20 warrants exercisable to purchase ordinary shares in the subsidiary. The subsidiary has profit attributable to ordinary shareholders of C6,000. Its ordinary share capital consists of 1,000 ordinary shares, and it has 400 convertible (one-for-one) preference shares in issue. It has also issued 150 warrants exercisable to subscribe for ordinary shares of the subsidiary, with an exercise price of C5 per warrant. The average market price of one ordinary share of the subsidiary was C10. Dividends on the preference shares are C1 per share. There were no inter-entity transactions or eliminations, other than dividends. Tax has been ignored for the purposes of this example. Subsidiary’s earnings per share Basic EPS 6,000 − 400 = C5.6 1,000 This is calculated as the subsidiary’s profit, from which is deducted the preference dividend that had been charged to retained earnings. The result is divided by the number of the subsidiary’s ordinary shares. Diluted EPS 6,000 − 400 = C4.07 1,000 + 75 + 400 This is the subsidiary’s profit (preference dividends are not deducted, because they would be saved on conversion of the preference shares), divided by the number of ordinary shares, plus the ordinary shares that would be issued on conversion of the preference shares (on the basis of one for one) and the number of ordinary shares that would be issued for nil consideration on exercise of the warrants, calculated as follows: Proceeds of warrants: 150 × C5 = C750 Number of ordinary shares that could be issued at fair value: C750 ÷ C10 = 75 Number of ordinary shares that would be issued at nil consideration: 150 − 75 = 75 Consolidated earnings per share Basic EPS 100,000 + 4,680 = C10.47 10,000 The earnings are calculated as the profit attributable to ordinary shareholders, before taking account of the subsidiary’s results that are included in the consolidated financial statements, of C100,000, plus the share of the subsidiary’s profits, calculated as: 6,000 − 400 = 5,600, then 5,600 × 800 ÷ 1000 = 4,480, then 4,480 + 200 (share of preference dividend) = 4,680 Diluted EPS 100,000 + 3,256 + 41 + 814 = C10.41 10,000 The earnings figure comprises: (a) The profit of the parent entity attributable to ordinary shares (excluding dividends from subsidiary) of C100,000. (b) The share of the subsidiary’s profit, calculated as 800 shares × 4.07 = C3,256 (C4.07 being the diluted EPS of the subsidiary). (c) The parent’s proportionate interest in the subsidiary’s earnings attributable to the warrants, calculated as (75 shares × 4.07) × 20 ÷ 150 = C40.7. (d) The parent’s proportionate interest in the subsidiary’s earnings attributable to the convertible preference shares, calculated as 200 shares × 4.07 = C814. This means that the effect, on the group diluted EPS, of options in a subsidiary that are convertible into shares of the subsidiary.

IAS 33 also covers the situation where securities of the reporting entity are issued that are convertible into ordinary shares of a subsidiary, joint venture or associate. In this situation, the securities are assumed to be converted and the profit or loss attributable to ordinary equity holders of the reporting entity is adjusted, in the normal way, for any changes in dividends, interest or other changes that would result from conversion. The profit or loss is also adjusted for any changes in the reporting entity’s share of results of the subsidiary, joint venture or associate that would result from the change in the number of shares in the subsidiary, joint venture or associate held by the reporting entity as a result of conversion. The denominator (number of shares and potential ordinary shares) of the diluted EPS calculation is not adjusted, because the number of shares of the reporting entity itself would not change following conversion.

Identifying dilutive options – example At 1 January and 31 December 20X1, an entity had the following written call options outstanding. Number of shares under option Exercise price (CU) Average share price during year (CU) Dilutive (D) or antidilutive (A) Number of shares deemed issued for no consideration 10,000 7 10 D 3,000 5,000 8 10 D 1,000 15,000 9 10 D 1,500 10,000 12 10 A – 20,000 11 10 A     – 5,500

Employee share and incentive plans

Many entities have share options and other share award schemes in place to remunerate officers and other employees. Non-performance-based employee share options, with fixed or determinable terms and non-vested ordinary shares, are treated as options in calculating diluted EPS.

How are share-based payments with no specified performance criteria regarded for diluted EPS purposes? All awards that do not specify a performance criterion should be regarded as options for the purpose of computing diluted EPS. They should be considered to be outstanding as of the grant date, for the purpose of computing diluted EPS, even though their exercise might be contingent upon vesting. They should be included in the diluted EPS computation, even if the employee might not receive (or be able to sell) the stock until some future date. Accordingly, all shares to be issued should be included in computing diluted EPS if the effect is dilutive. The dilutive effect should be computed using the treasury stock method.

Performance-related employee share options are treated as contingently issuable shares, because their issue is contingent on satisfying specified conditions in addition to the passage of time.

If the share awards were granted during the period, the shares issuable should be weighted to reflect the portion of the period during which the awards were outstanding.

The assumed exercise price used in the treasury stock method should include the fair value (as calculated on grant date) of any goods or services to be supplied to the entity in the future for share options and other share-based payment schemes in scope of IFRS 2. The assumed exercise price, for the purpose of determining the incremental number of shares issued for nil consideration, includes any amount that the employee must pay upon exercise and the balance of any amounts calculated under IFRS 2 that have not yet been charged to the income statement. The assumed proceeds should not include cost attributable to past service. No adjustments are made to the numerator in respect of the IFRS 2 charge to the income statement, because the charge represents the cost of issuing potential ordinary shares that would not be saved on conversion.

Impact of options when the entity makes a loss When an entity has a loss from continuing operations, the exercise of in the money options will increase the number of shares to which that loss is allocated, so that loss per share will decrease. Therefore, in the money options are not dilutive for such an entity, because dilution is defined by IAS 33 as a reduction in earnings per share or an increase in loss per share resulting from the assumption that options are exercised. This raises the question as to whether out of the money options should be considered dilutive for an entity with a loss from continuing operations. The option holders would (irrationally) be paying too much for these shares, which is equivalent, under the approach to dilution taken by IAS 33, to the entity issuing a negative number of shares for no consideration (i.e. buying back some shares for no consideration). Accordingly, because the exercise of out of the money options would, if this method is applied, result in a reduction in the number of shares, it is mathematically correct that loss per share will increase. Although the definition of dilution in IAS 33 might apparently lead to out of the money options being considered dilutive, IAS 33 states that “options and warrants have a dilutive effect only when the average market price of ordinary shares during the period exceeds the exercise price of the options or warrants (i.e. they are ‘in the money’)”. Accordingly, because it would also be economically irrational for holders to exercise out of the money options, it appears that out of the money options should not be treated as dilutive for an entity with a loss from continuing operations.

Determining the exercise price of employee share options Weighted average number of unvested share options per employee 1,000 Weighted average amount per employee to be recognised over the remainder of the vesting period for employee services to be rendered as consideration for the share options, determined in accordance with IFRS 2 Share-based Payment CU1,200 Cash exercise price of unvested share options CU15 Calculation of adjusted exercise price Fair value of services yet to be rendered per employee: CU1,200 Fair value of services yet to be rendered per option: (CU1,200/1,000) CU1.20 Total exercise price of share options: (CU15.00 + CU1.20) CU16.20

Share options and share-based payment arrangements Share option scheme not related to performance Entity A has in place an employee share option scheme that awards share options to employees on the basis of period of service with the entity. The provisions of the scheme, at the 20X0 year-end, are as follows: Date of grant 1 January 20X0 Market price of option at grant date C2.10 Exercise price of option C2.50 Date of vesting 31 December 20X2 Number of shares under option 1 million Applying IFRS 2, the income statement is charged with 70c per option in each of the three years from 20X0 to 20X2 (that is, C2.10/3). Profit for year 20X0 (after compensation expense) C1,200,000 Weighted average number of ordinary shares outstanding 5 million Average market price of an ordinary share during the year C5.00 Assumed proceeds per option C3.90 (being the exercise price of C2.50 and the IFRS 2 expense attributable to future service, not yet recognised, of C1.40). Next year: C3.20 (being C2.50 + 70c).   Computation of earnings per share per share earnings shares Profit for year 20X0 C1,200,000 Weighted average shares outstanding for 20X0 5,000,000 Basic EPS 24.0c Number of shares under option 1,000,000 Number of shares that would have been issued at fair value: (1 million × C3.90)/C5.00 (780,000) Diluted EPS 23.0c C1,200,000 5,220,000 Please note that this example ignores the effect of tax.

Computation of average market price when trading volume is limited – example Company A’s shares trade in an over-the-counter market. During the fourth quarter of 20X1, Company A’s shares were traded on only 15 days. The frequency of trades during the fourth quarter is representative of the normal trading volume on Company A’s ordinary shares. When an entity’s ordinary shares trade on a very irregular basis (e.g. limited trading volume), such that an average of the closing ordinary share price is not meaningful, it would be acceptable to use the average of the bid and ask price for the ordinary shares for a period to determine the average ordinary trading price. This method should be applied until the entity’s ordinary shares trade on a regular basis and an average of the closing prices would yield an effective average ordinary share price.

Options in issue for only part of a period – example An entity’s share price is CU3 for the four months 1 January to 30 April, CU4 for the four months 1 May to 31 August and CU5 for the four months 1 September to 31 December. The average price for the year is therefore CU4. On 1 July, the entity grants 100,000 options exercisable at CU4 per share, the then market price. The average price from 1 July to 31 December is CU4.67. In the circumstances described, the shares are neither dilutive nor antidilutive if compared with the average for the year, but are dilutive if compared to the average price since the date the options were granted. Using the average for the year results in no dilution, whereas using the average from the date of grant of the options results in dilution. Given that the latter approach reflects the substance of what has happened, it seems appropriate that the entity should use the average from the date of grant of the options, notwithstanding that a literal reading of IAS 33 could point to the former approach. Similar considerations apply when options are exercised during the year.

Application of treasury stock method to options to purchase convertible preference shares – example Company A issued 1,000 options; each option allows the holder to purchase one convertible preference share at CU5,000 per share. Each convertible preference share is convertible to ordinary shares at CU25 per ordinary share after two years (i.e. each convertible preference share is converted into 200 ordinary shares without further payment). On the date the options were issued, the ordinary shares of Company A were trading at CU25 per share. Three years later the ordinary shares of Company A had an average market price of CU40 per share. At the end of Year 3, the options on the ordinary shares are in the money. Therefore, using the treasury stock method (illustrated below), Company A would assume that the holders of the options would elect to exercise their options and receive the convertible preference shares for CU5,000 per share. The treasury stock method should be applied to compute the incremental dilutive shares as follows. Shares assumed issued (1,000 × 200) 200,000 Total assumed proceeds (1,000 × CU5,000) CU5 million Divided by the average market price 40 Less: shares assumed to be issued at full value (125,000) Incremental shares to be included in diluted EPS  75,000 The 1,000 options do not meet the definition of equity per IAS 32 (because they represent an option over an instrument that itself has an option to convert into equity); therefore, the options would be measured at fair value through profit or loss. If the add back of the fair value gains/losses in the period to the numerator was less in proportion to the incremental shares added to the denominator, then the effect would be dilutive.

Proceeds from options applied to repurchase preference shares – example Company A issued 400,000 options, which allow the holder to purchase ordinary shares at CU40 per share. If the options are exercised, Company A is required to use the proceeds to repurchase 1,000 preference shares of CU2,750 face value per share. The preference shares pay dividends at 10 per cent annually and had an average fair value of CU2,800. The following year, Company A had net income of CU15 million, weighted average shares outstanding of 4,000,000, and the ordinary shares of Company A had an average market price of CU50 per share. Because the exercise of the options does not require the holder to be the holder of a preference share, the dilutive effect of these options should be determined in accordance with IAS 33. The options on the ordinary shares are in the money. Therefore, using the treasury stock method, Company A would assume that the holders of the options would elect to exercise their options. Because the exercise of the options would dilute EPS, Company A would apply the treasury stock method to compute the incremental dilutive shares as follows. Basic Adjustments  Diluted Net profit attributable to ordinary shareholders CU15,000,000 CU275,000a CU15,275,000 divided by Weighted average shares outstanding 4,000,000 136,000b 4,136,000 Earnings per share 3.75 3.69 A Adjustment to the numerator (CU2,750 × 1,000 × 10%) = CU275,000 B Adjustment to weighted number of shares outstanding is calculated as follows: Shares in issue 400,000 Total assumed proceeds (400,000 × CU40) CU16,000,000 Less: amount required to retire preference shares (CU2,800 × 1,000) CU2,800,000 Excess proceeds assumed to buy treasury shares CU13,200,000 Divided by the average price of the ordinary shares 50 Less: shares assumed to be issued at average price (264,000) Adjustment to the denominator (incremental shares) 136,000

Condition expressed as an average over a period When a condition is expressed as an average over a period, it has the same effect as if it were expressed as a cumulative amount over the period, i.e. the performance achieved to date is deemed to be that achieved over the whole of the contingency period. For example, if the number of shares to be issued depends on whether profits average CU1 million per annum over a three-year period, the condition is expressed in terms of a cumulative target of CU3 million over the three-year period. If, at the end of the first year, profits are CU1.5 million, no additional shares are brought into the calculation. On the other hand, if profits of CU5 million have been achieved at the end of the first year, the additional shares are included in the calculation of diluted EPS because, if the end of the first year were the end of the contingency period, the condition would have been achieved. Again, this can be contrasted with the treatment for the purposes of basic EPS, as discussed. Even when CU5 million has been earned by the end of the first year, the shares are not included for the purposes of basic EPS, because the condition has not been achieved. It cannot be achieved until the end of the contingency period – because there is a possibility (however remote) of losses for the remainder of the period, which could reduce average profits below the target level. To illustrate calculation of diluted EPS when there is a contingency based on average profits consider the following example. The following example illustrates the calculation of diluted EPS when there is a contingency based on average profits. A Limited acquires B Limited on 1 January 20X1. A Limited agrees to issue 100,000 shares to the vendor on 1 January 20X4 if B Limited’s profits for the three years to 31 December 20X3 average CU10 million or more. B Limited’s profits for 20X1 and 20X2 are CU17 million each year. The requirement for average profits of CU10 million over three years is treated as a requirement for total profits of CU30 million over the three years. Actual profits in 20X1 of CU17 million are below the target of CU30 million and, accordingly, the 100,000 shares are excluded from the diluted EPS calculation for 20X1. Actual profits for 20X1 and 20X2 together total CU34 million. This exceeds the target and, thus, the 100,000 shares should be included in diluted EPS for 20X2. The shares will be included even if B Limited expects to make a loss of CU4 million or more in 20X3.

How are share-based awards, where the entity or the employee has a settlement choice, considered for diluted EPS purposes? Whilst IAS 33 does not specifically cover the point if a contract may be settled in cash or shares at either the entities or the employee’s option, the more restrictive of the rules set out that is, where only the issuer has an option) should be applied. In practice, IAS 33 recognises that it is likely that only one party will have the option because, otherwise, there could be a conflict.

Pre-purchased shares held by an entity, to satisfy its obligations under share award schemes through an ESOP trust are excluded from both basic and diluted EPS because they are not shares outstanding in the market.