Contingently issuable ordinary shares are defined as “ordinary shares issuable for little or no cash or other consideration upon the satisfaction of specified conditions in a contingent share agreement”.

How do contingently issuable ordinary shares arise? Often, acquisition agreements include a clause under which the purchaser of an acquired entity is required to transfer additional consideration in the form of ordinary shares in the future. The value of such shares might either be known precisely at the time of the acquisition, or it might be contingent upon the future performance or future evaluation of the acquired entity. The obligation might simply be deferred (deferred consideration), or the obligation might or might not arise, depending on whether or not certain earnings conditions are met (contingent consideration). In any event, the need to issue ordinary shares in future could lead to dilution of EPS. These are called ‘contingently issuable ordinary shares.

Contingently issuable shares are considered outstanding and are included in the calculation of diluted EPS as if the conditions of the contingency are deemed to have been met, based on the information available, at the end of the reporting period. The diluted EPS computation includes those shares that would be issued under the terms of the contingency, based on the current status of conditions, as if the end of the reporting period was the end of the contingency period. Ordinary shares issuable under such contingent share agreements are included in the diluted EPS calculation from the beginning of the period, or from the date of the contingent share agreement, if later. Contingently issuable shares should be included in the diluted EPS calculation only if the effect is dilutive.

Restatement of contingently issuable shares is not permitted if the conditions of the contingency are not met when the actual contingency period expires.

The relevant shares are included in the computation of both basic and diluted EPS if the conditions relating to the issue have been met (that is, the events have occurred) by the end of the period. The issuance of the shares is no longer contingent and there are no circumstances under which the shares would not be issued.

A contingent share arrangement may include the achievement or maintenance of a specified level of earnings. The condition may need to be both achieved at the end of the period and maintained for a further period. The additional ordinary shares are included, if dilutive, in the diluted EPS, because the end of the period is assumed to be the end of the contingency period for the purpose of diluted EPS, and the level of profit has been achieved at the end of the period. The shares are not included in basic EPS until the end of the actual contingency period (that is, the end of the further period for which the level of earnings must be maintained). Earnings might change in that further period, so the contingent condition might not be met at the end of the actual contingency period.

How should diluted EPS reflect other types of contingently issuable share arrangements? The guiding principle is that, where the number of contingently issuable shares depends upon the level of earnings, the diluted EPS computation should include those shares to the extent that they would be issuable under the agreement, based on the current amount of earnings. Earnings conditions in earn-out agreements come in various forms: ·        Further shares might be issued if the average profit earned over a period, is a specific amount. ·        Maintenance of the current earnings level, or the attainment of a specified increased level of earnings of an acquired entity for a specified number of years, might be the condition. ·        Conditions might specify the issue of shares when a minimum earnings target is reached, increasing rateably until the maximum earnings target is reached, with a cap on the maximum number of shares that could be issued.

Average earnings condition On 1 January 20X4, entity A acquired the whole of entity B’s issued share capital. The total consideration payable in respect of the acquisition comprises initial consideration and deferred contingent consideration. Under the terms of the deferred contingent consideration, entity A is required to issue 100,000 shares if entity B’s profit for the year averages C100,000 over a three-year period. Any additional shares will be issued on 1 January 20X7, after the end of the three-year contingency period. Entity B’s profit for the year ended 31 December 20X4 amounted to C120,000. Given that the terms stipulate the achievement of C100,000 of average profit for the three-year period, it would appear at first sight that the contingency condition at the balance sheet date has been met, as the profit for the year ended 31 December 20X4 exceeds C100,000. This is not the case, however, because it assumes that the entity will earn profit of at least C90,000 for each of the next two years ended 31 December 20X6. Projecting future earnings levels in this way is not permitted under IAS 33, because IAS 33 takes an historical approach and not a predictive or forward-looking approach in measuring dilution. The provisions relating to contingently issuable shares are quite specific and do not allow an entity to consider the probability of a contingent issue occurring. The correct analysis is to measure whether performance achieved in the current period is deemed to be that achieved over the whole of the contingency period, as if the end of the reporting period was the end of the contingency period. On this basis, an average over a period has the same effect as if it were expressed as a cumulative amount over the period. So, in this situation, the contingency condition should be expressed in terms of a cumulative target of C300,000 over the three-year period. Since the profit for the year ended 31 December 20X4 is only C120,000, which is less than C300,000, the contingency condition is not met at the balance sheet, and no additional shares would be brought into the diluted EPS computation. Similarly, if the profit for the year ended 31 December 20X5 were to increase to C150,000, again the contingency condition is not met in that year, because the cumulative earnings to date amount to C270,000. So, no additional shares would be included in that year. In the final year ended 31 December 20X6, when the contingency period comes to an end, the entity will know for certain whether or not the contingency conditions have been met. If the condition is met in that year, the entity will include 100,000 shares in both basic and diluted EPS.

Attainment of a specified increased level of earnings The facts are the same as in the previous example, except that the deferred contingent consideration agreement provides for the issue of 1,000 shares for each C1,000 of total profit in excess of C250,000 over the three years ending 31 December 20X6. Using the principles, the entity did not earn C250,000 for the year ended 31 December 20X4. Again, projecting future earnings levels (C120,000 for 3 years = C360,000) and including 110,000 ((C360,000 − C250,000)/C1,000 × 1,000) contingent shares in the diluted EPS calculation is not permitted. For the year ended 31 December 20X5, the cumulative amount earned to that date is C270,000. Because this amount exceeds C250,000, the contingency condition is met in that year, and the entity will include 20,000 contingently issuable shares in the diluted EPS calculation for that year. For the year ended 31 December 20X6, the cumulative amount earned to that date would be known, and the actual number of shares issued would be included in both basic and diluted EPS. If the actual number of shares amounts to, say, 50,000 shares, the prior year’s diluted EPS, which was based on 20,000 contingent shares, should not be restated. Similar considerations apply when computing diluted EPS for interim reports. If, at 30 June 20X5, the cumulative amount earned to that date was C245,000 (C120,000 to 31 December 20X4 + C125,000 to 30 June 20X5), the contingency provision is not met. Therefore, no contingently issuable shares would be included in calculating the diluted EPS for the half year, even though, at the time of preparing the interim report, it is apparent that 20,000 shares will be included in the year-end diluted EPS calculation.

The number of shares issuable in the future might depend on the market price of the shares at the future date. The computation of diluted EPS should reflect the number of shares that would be issued, based on the current market price at the end of the reporting period if the effect is dilutive. If the condition is based on an average of market prices over some period of time that extends beyond the end of the reporting period, the average for the period that has elapsed at the period end should be used. Basic EPS should not include such contingently issuable shares, because not all necessary conditions have been satisfied as the market price might change.

The number of contingently issuable ordinary shares might depend on both future earnings and the future market price of ordinary shares. The number of ordinary shares included in the diluted EPS calculation is based on both conditions. Unless both conditions are deemed to be met (using the guidance on each type of condition), the contingently issuable shares are not included in the diluted EPS.

How are contingently issuable ordinary shares accounted for where the number of shares to be issued is unknown? In some deferred consideration agreements, the value of the deferred consideration is known, but the number of shares to be issued when the deferred consideration falls due is not known. IAS 33 does not specifically consider this situation. However, we consider that the number of shares to be included in the calculation should be based on the market price at the balance sheet date, as if it were the end of the contingency period.

How are contingently issuable ordinary shares accounted for where there are a number of different conditions? If the contingency is based on a number of different conditions, we consider that the determination of the number of shares included in diluted EPS should be based on the status of all relevant conditions, as they exist at the end of each reporting period. If one of the conditions is not met at the end of the reporting period, no contingently issuable shares should be included in diluted EPS.

Some contingencies might be based on a condition other than earnings or market price (for example, opening a certain number of retail stores). Contingent shares should be included in the computation of diluted EPS based on the assumption that the current status (at the period end) of the condition will remain unchanged until the end of the contingency period. If only half of the required number of new stores that would result in the issue of shares were opened during the period, no contingently issuable shares would be included in the diluted EPS computation.

Contingently issuable potential ordinary shares that are not covered by a contingent share agreement, such as contingently issuable convertible instruments, should be included in diluted EPS on the following basis:

• Determine whether the potential ordinary shares could be assumed to be issued on the basis of the conditions specified for their issue under the contingently issuable share provisions.
• Depending on the type of those potential ordinary shares, they should be reflected in diluted EPS by following the provisions for convertible securities, for share options and warrants, for contracts that could be settled in ordinary shares or in cash, or other provisions, as appropriate.

However, exercise or conversion should not be assumed for the purpose of computing diluted EPS, unless exercise or conversion of similar outstanding potential ordinary shares that are not contingently issuable is assumed.

Contingency based on share price movements – example An entity is to issue the following shares to a third party on 1 October 20X2, dependent upon the entity’s share price on 30 September 20X2.   Number of shares  Share price on 30 September 20X2   Nil  CU10 or less   10,000  >CU10 and <CU11   15,000  CU11 or above If, on 31 December 20X1 (the last day of the entity’s reporting period), the share price were CU9, no shares would be included in the diluted EPS calculation, whereas an additional 10,000 shares would be included if the share price on 31 December 20X1 were CU10.20. If the share price had been above CU10 every day during the reporting period and up to the date the financial statements were authorised for issue, other than on 31 December 20X1 when the price dipped to CU9.98, based on the principles discussed above, none of these shares would be included in the diluted EPS calculation. If the issue had been conditional upon the average share price for the last five business days up to and including 30 September 20X2, the diluted EPS would be computed by looking at the share price on the last five business days up to and including 31 December 20X1 and comparing this with the target average price.

Contingency based on an event – example A Limited acquires B Limited on 1 January 20X1. A Limited agrees to issue 100,000 shares to the vendor on 1 January 20X3 if, at any point prior to that date, a new product developed by B Limited is granted a licence. A Limited’s year end is 31 December. The 20X1 financial statements are approved on 22 March 20X2. The product is granted a licence on 4 March 20X2. Even though the directors of A Limited know, at the date they approve the 20X1 financial statements, that the additional 100,000 shares will be issued to the vendor on 1 January 20X3, the shares are excluded from the calculation of diluted EPS for 20X1 because, at the end of the reporting period, the licence had not been granted. The 100,000 shares will be included in the calculation of diluted EPS for 20X2, as if they had been in issue throughout the entire year.

Shares contingently issuable upon the occurrence of a contingent event such as the favourable outcome of a lawsuit or the successful completion of an IPO Another example of a contingency based on an event is when shares are contingently issuable depending only on the favourable outcome of a lawsuit. Such shares should be excluded from the calculation of basic and diluted EPS until the outcome of the lawsuit is determined. When the outcome of the lawsuit is final, the shares should be included in basic EPS from the date of finalisation of the lawsuit and included in diluted EPS from the beginning of the period in which the lawsuit is finalised (or from the date of the contingent share agreement, if later). Similar logic should be applied for shares that will be issued in the event that the entity completes a successful Initial Public Offering (IPO). Because there are many factors that can affect the successful completion of an IPO, the contingency is not met until the IPO actually becomes effective. Therefore, for periods ending prior to the effective date of the IPO, the shares should not be considered in the denominator for computation of diluted EPS. For periods ending after the IPO is effective, the shares should be included in the denominator of diluted EPS from the beginning of the period in which the IPO is effective (or from the date of the contingent share agreement, if later). For basic EPS, shares that are contingently issuable in the event of an IPO should be included in the denominator from the effective date of the IPO (which may be earlier than the date the shares are actually issued), and then only on a weighted average basis.

Contingently issuable shares Ordinary shares outstanding during 20X1 1,000,000 (there were no options, warrants or convertible instruments outstanding during the period) An agreement related to a recent business combination provides for the issue of additional ordinary shares based on the following conditions: 5,000 additional ordinary shares for each new retail site opened during 20X1 1,000 additional ordinary shares for each CU1,000 of consolidated profit in excess of CU2,000,000 for the year ended 31 December 20X1 Retail sites opened during the year: one on 1 May 20X1 one on 1 September 20X1 Consolidated year-to-date profit attributable to ordinary equity holders of the parent entity: CU1,100,000 as of 31 March 20X1 CU2,300,000 as of 30 June 20X1 CU1,900,000 as of 30 September 20X1 (including a CU450,000 loss from a discontinued operation) CU2,900,000 as of 31 December 20X1 Diluted earnings per share First quarter  Second quarter  Third quarter  Fourth quarter  Full year  Numerator (CU) 1,100,000 1,200,000 (400,000) 1,000,000 2,900,000 Denominator: Ordinary shares outstanding 1,000,000 1,000,000 1,000,000 1,000,000 1,000,000 Retail site contingency – 5,000 10,000 10,000 10,000 Earnings contingency         –a   300,000b         –c   900,000d   900,000d Total shares 1,000,000 1,305,000 1,010,000 1,910,000 1,910,000 Diluted earnings per share (CU) 1.10 0.92 (0.40)e 0.52 1.52 A Company A does not have year-to-date profit exceeding CU2,000,000 at 31 March 20X1. The Standard does not permit projecting future earnings levels and including the related contingent shares. B [(CU2,300,000 – CU2,000,000)/1,000] × 1,000 shares = 300,000 shares. C Year-to-date profit is less than CU2,000,000. D [(CU2,900,000 – CU2,000,000)/1,000] × 1,000 shares = 900,000 shares. E Because the loss during the third quarter is attributable to a loss from a discontinued operation, the antidilution rules do not apply. The control number (i.e. profit or loss from continuing operations attributable to the equity holders of the parent entity) is positive. Accordingly, the effect of potential ordinary shares is included in the calculation of diluted earnings per share.

Contingently issuable options – example On 1 July 20X1, an entity agreed that, provided that its profit over the two years to 30 June 20X3 exceeds a specified target, on 1 July 20X3 it will issue 10,000 share options exercisable at CU5 per share from 1 July 20X4 to 30 June 20X9. The average market price of the entity’s ordinary shares during the year ended 31 December 20X2 was CU5.50. The treatment of the options will depend on whether the profit target has been reached at the end of the reporting period (31 December 20X2). If it has, the options will be included in the 20X2 diluted EPS calculation (using the treasury stock method). If it has not, nothing is included in the 20X2 diluted EPS calculation in respect of the options.

Example Convertible bonds settled in shares or cash at the issuer’s option An entity issues 2,000 convertible bonds at the beginning of Year 1. The bonds have a three-year term, and are issued at par with a face value of CU1,000 per bond, giving total proceeds of CU2,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 6 per cent. Each bond is convertible at any time up to maturity into 250 ordinary shares. The entity has an option to settle the principal amount of the convertible bonds in ordinary shares or in cash. When the bonds are issued, the prevailing market interest rate for similar debt without a conversion option is 9 per cent. At the issue date, the market price of one ordinary share is CU3. Income tax is ignored. Profit attributable to ordinary equity holders of the parent entity Year 1 CU1,000,000 Ordinary shares outstanding 1,200,000 Convertible bonds outstanding 2,000 Allocation of proceeds of the bond issue: Liability component CU1,848,122(a) Equity component   CU151,878 CU2,000,000 (a) This represents the present value of the principal and interest discounted at 9% – CU2,000,000 payable at the end of three years; CU120,000 payable annually in arrears for three years. The liability and equity components would be determined in accordance with IAS 32 Financial Instruments: Presentation. These amounts are recognised as the initial carrying amounts of the liability and equity components. The amount assigned to the issuer conversion option equity element is an addition to equity and is not adjusted. Basic earnings per share Year 1: CU1,000,000/1,200,000 = CU0.83 per ordinary share Diluted earnings per share Year 1: It is presumed that the issuer will settle the contract by the issue of ordinary shares. The dilutive effect is therefore calculated in accordance with the Standard. (CU1,000,000 + CU166,331(b))/(1,200,000 + 500,000(c)) = CU0.69 per share (b) Profit is adjusted for the accretion of CU166,331 (CU1,848,122 × 9%) of the liability because of the passage of time. (c) 500,000 ordinary shares = 250 ordinary shares × 2,000 convertible bonds.

Forward purchase contracts and written put options A forward purchase of own shares is similar in substance to a written put option at the forward sale price and a purchased call option at the forward sale price. Consistent with IAS 33, the purchased call option is not dilutive. The effect of the written put option on the denominator should be determined in accordance with IAS 33 described immediately above, i.e. the shares subject to forward purchase should be regarded as outstanding for the period. This guidance applies to forward purchase contracts even though the paragraph is headed Written put options because ‘forward purchase contracts’ are also referred to in that guidance. The interest cost recognised in profit or loss in respect of the forward purchase liability should be added back for the purposes of determining diluted EPS.

Example Written put options (1) Assume that an entity has outstanding 120 written put options on its ordinary shares with an exercise price of CU35. The average market price of its ordinary shares for the period is CU28. In calculating diluted earnings per share, the entity assumes that it issued 150 shares at CU28 per share at the beginning of the period to satisfy its put obligation of CU4,200. The difference between the 150 ordinary shares issued and the 120 ordinary shares received from satisfying the put option (30 incremental ordinary shares) is added to the denominator in calculating diluted earnings per share.

Written put options (2) – example Company A issued CU100 million in debt instruments with detachable put options on its ordinary shares. Purchasers of each CU1,000 note will receive 10 put options each, giving the holder the right to require Company A to purchase one share of its ordinary shares for CU25 (the market price of the ordinary shares on the date the put options were issued). The put options are exercisable at any time during a three-year period. Assume the average market price of the ordinary shares for the period is CU20 per share. The number of incremental shares to be added to the denominator of the diluted EPS calculation is computed as follows. Cash required to settle put option (CU100 million/CU1,000) × 10 options × CU25 CU25,000,000 Divided by the average market price per share 20 Number of shares that would need to be issued to settle put option 1,250,000 Less: Shares assumed repurchased under put option (CU100 million/CU1,000) × 10 options 1,000,000 Incremental shares   250,000 If the market price for the ordinary shares exceeds CU25 per share for the period being reported on, the put options are antidilutive, and therefore, would not be included in the computation of diluted EPS.

Summary of adjustments for potential ordinary shares in diluted EPS calculations

The following table sets out a summary of the adjustments to earnings and the number of shares in diluted EPS calculations for each of the major categories of potential ordinary shares.

Potential ordinary shares	Adjustment to earnings	Adjustment to number of shares
Convertible bonds, debentures and preference shares (classified as a compound instrument or wholly as a financial liability)	Add back interest, dividends, fair value gains/losses and other finance costs recognised in the period, net of tax.	Add number of new shares assuming full conversion.
Warrants and options, e.g. written call option for an exchange of a fixed amount of shares for a fixed amount of functional currency cash (classified as equity)	None.	Add number of shares deemed to be issued for no consideration.
Contingently issuable shares (classified as equity)	None.	Add number of shares that would be issued if the end of the reporting period were the end of the contingency period.
Warrants and options, e.g. written call option 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 (classified as a financial liability)	Add back fair value gains/losses, net of tax.	Add number of shares equal to the number of shares that would have been issued for nil consideration based on the average fair value of the shares over the period.
Forward purchase contract to buy own shares or a written put option to potentially reacquire own shares (classified as a financial liability)	Add back interest and any other gains/losses, net of tax.	Add number of shares equal to the number of shares that would have to be issued to satisfy the obligation based on the average fair value of the shares over the period less the number of shares that are to be acquired under the contract.

Potential ordinary shares issued by a subsidiary, joint venture or associate

Instruments that entitle holders to shares in a subsidiary, joint venture or an associate

A joint venture or associate may issue to parties other than the investors with joint control of, or significant influence over, the investee potential ordinary shares that are convertible into ordinary shares of the joint venture or associate. If these potential ordinary shares of the joint venture or associate have a dilutive effect on the basic earnings per share of the reporting entity, they are included in the calculation of diluted EPS.

Instruments issued by a subsidiary, joint venture or an associate that enable their holders to obtain ordinary shares of the subsidiary, joint venture or associate are included in calculating the diluted EPS data of the subsidiary, joint venture or associate. Those earnings per share are then included in the reporting entity’s EPS calculations based on the reporting entity’s holding of the instruments of the subsidiary, joint venture or associate.

For the purpose of determining the EPS effect of these instruments, they are assumed to be converted, and the numerator (profit or loss attributable to the ordinary equity holders of the parent entity) adjusted as necessary, as discussed. In addition to those adjustments, the numerator is adjusted for any change in the profit or loss recognised by the reporting entity (such as equity method income) that is attributable to the increase in the number of ordinary shares of the subsidiary, joint venture or associate as a result of the conversion. The denominator for the diluted EPS calculation at the consolidated level is unaffected because the number of shares of the reporting entity outstanding would not change upon the assumed conversion.

 

Example Instruments of a subsidiary: calculation of basic and diluted earnings per share Parent Profit attributable to ordinary equity holders or of the parent entity CU12,000 (excluding any earnings of, or dividends paid by, the subsidiary) Ordinary shares outstanding 10,000 Instruments of subsidiary owned by the parent 800 ordinary shares 30 warrants exercisable to purchase ordinary shares of subsidiary 300 convertible preference shares  Subsidiary Profit CU5,400 Ordinary shares outstanding 1,000 Warrants 150, exercisable to purchase ordinary shares of the subsidiary Exercise price CU10 Average market price of one ordinary share CU20 Convertible preference shares 400, each convertible into one ordinary share Dividends on preference shares CU1 per share No inter-company eliminations or adjustments were necessary except for dividends. For the purposes of this illustration, income taxes have been ignored.  Subsidiary’s earnings per share Basic EPS CU5.00 calculated: (CU5,400a – CU400b)/1,000c Diluted EPS CU3.66 calculated: CU5,400d/(1,000 + 75e + 400f) aSubsidiary’s profit attributable to ordinary equity holders. bDividends paid by subsidiary on convertible preference shares. cSubsidiary’s ordinary shares outstanding. dSubsidiary’s profit attributable to ordinary equity holders (CU5,000) increased by CU400 preference dividends for the purpose of calculating diluted earnings per share. eIncremental shares from warrants, calculated: [(CU20 – CU10)/CU20] × 150. fSubsidiary’s ordinary shares assumed outstanding from conversion of convertible preference shares, calculated: 400 convertible preference shares × conversion factor of 1.  Consolidated earnings per share Basic EPS CU1.63 calculated: (CU12,000g + CU4,300h)/10,000i Diluted EPS CU1.61 calculated: (CU12,000 + CU2,928j + CU55k + CU1,098l)/10,000 gParent’s profit attributable to ordinary equity holders of the parent entity. hPortion of subsidiary’s profit to be included in consolidated basic earnings per share, calculated: (800 × CU5.00) + (300 × CU1.00). iParent’s ordinary shares outstanding. jParent’s proportionate interest in subsidiary’s earnings attributable to ordinary shares, calculated: (800/1,000) × (1,000 shares × CU3.66 per share). kParent’s proportionate interest in subsidiary’s earnings attributable to warrants, calculated: (30/150) × (75 incremental shares × CU3.66 per share). lParent’s proportionate interest in subsidiary’s earnings attributable to convertible preference shares, calculated: (300/400) × (400 shares from conversion × CU3.66 per share).

Effect of the convertible preference shares issued by a joint venture or associate held by the reporting entity on the reporting entity’s diluted EPS calculations A reporting entity may hold instruments issued by a joint venture or associate that enable their holders, including the reporting entity, to obtain ordinary shares of the joint venture or associate. If converted, the reporting entity’s measurement basis for those instruments could change. For example, a preference share currently measured at fair value through profit or loss (FVTPL) may be converted into an ordinary share that would be accounted for applying the equity method. IAS 33 does not provide clear guidance on whether and how the effect of such change in the measurement basis should be reflected when calculating the reporting entity’s diluted EPS. However, in light of the purpose of the diluted EPS to provide a measure of interest of each ordinary share in the performance of an entity giving effect to “all” dilutive potential ordinary shares, it is appropriate to reflect all the effect of assumed conversion including the effect of change in the measurement basis, if any. For example, Entity X (the reporting entity) holds no ordinary shares in Entity A. However, Entity X holds 150 convertible preference shares issued by Entity A which, by virtue of voting rights attributed to the preference shares, gives Entity X significant influence over Entity A. At the option of the holder, each convertible preference share can be converted into one ordinary share. This instrument is not equivalent or similar to ordinary shares that would be accounted for applying the equity method. Therefore, Entity X accounts for the convertible preference shares as a financial asset measured at FVTPL in accordance with IFRS 9, as the convertible preference shares do not meet the conditions in IFRS 9 to be measured at amortised cost or fair value through other comprehensive income. If the conversion option is exercised, Entity X will account for the ordinary shares acquired as a result of the conversion by applying the equity method. The following tables summarise the necessary information required to calculate EPS for Entity X. Entity X (reporting entity) Profit for the year attributable to ordinary equity holders of Entity X (including CU700 fair value gain on the convertible preference shares issued by Entity A) CU200,000 Ordinary shares of Entity X outstanding 2,000 Convertible preference shares of Entity A owned by Entity X 150 Ordinary shares of Entity A owned by Entity X None Entity A (associate of Entity X) Profit for the year attributable to ordinary equity holders of Entity A* CU1,000 Ordinary shares of Entity A outstanding (each share has one voting right) 200 Convertible preference shares of Entity A (each share has one voting right) 300 Dividends on preference shares of Entity A CUnil *Entity A accounts for the convertible preference shares as a compound financial instrument that contains both a liability component (non-discretionary cash flows) and an equity component (being the residual interest and conversion into ordinary shares) in accordance with IAS 32. Interest expense associated with the liability component and recognised in profit or loss for the year is CU15. Entity X’s share of profit or loss of Entity A determined in accordance with IAS 28, assuming the conversion option is exercised, is 30 per cent (150 (convertible shares held by Entity X) / 500 (total ordinary and convertible preference shares issued by Entity A)). No inter-company eliminations or adjustments were necessary. For the purposes of this illustration, income taxes have been ignored. The EPS is calculated as follows: Entity A’s EPS Basic EPS (CU1,000a / 200b) CU5 Diluted EPS ((CU1,000a + CU15c) / (200b + 300d)) CU2.03 aEntity A’s profit attributable to ordinary equity holders. bEntity A’s ordinary shares outstanding. cElimination of the interest expense on the liability component of the preference shares. dEntity A’s ordinary shares assumed outstanding from conversion of convertible preference shares, calculated as 300 convertible preference shares × conversion factor of 1. Entity X’s EPS Basic EPS (CU200,000e / 2,000f) CU100 Diluted EPS ((CU200,000e – CU700g + CU305h) / 2,000f) CU99.8 eEntity X’s profit attributable to ordinary equity holders of the parent entity. fEntity X’s ordinary shares outstanding. gElimination of Entity X’s fair value gain on the convertible preference shares issued by Entity A. hEntity X’s proportionate interest in Entity A’s earnings attributable to convertible preference shares, calculated as 30% × CU1,015 or (150 / 300) x (300 shares from conversion x CU2.03 per share).

Potential ordinary shares in issue for part of an accounting period – example An entity has 1,000,000 ordinary shares in issue at the start of its accounting period, 1 January 20X1. In addition, on 1 January, it has CU100,000 convertible bonds in issue. The bonds are converted into 100,000 ordinary shares on 1 April 20X1. The finance cost recognised in profit or loss in respect of the bonds from 1 January to 31 March is CU2,500 and the associated tax relief is CU750. The profit attributable to ordinary shareholders (all from continuing operations) for 20X1 is CU100,000. The weighted average number of shares outstanding during 20X1 and used to calculate basic EPS is: (1,000,000 × 12/12) + (100,000 × 9/12) = 1,075,000 Thus, basic EPS is: CU100,000/1,075,000 = CU0.093 Diluted EPS is calculated as: (CU100,000 + CU2,500 – CU750) / (1,075,000 + (100,000 × 3/12)) = CU101,750/1,100,000* = CU0.925 * The denominator is equal to the number of shares that would have been outstanding had the convertible bond been fully converted at the start of the reporting period.

Contracts that may be settled in ordinary shares or in cash

If an entity has issued a contract that may be settled in ordinary shares or in cash at the entity’s option (but not at the holder’s option), the entity should assume that the contract will be settled in shares. The resulting potential ordinary shares should be included in diluted EPS, if the effect is dilutive.

An issued contract that may be settled in ordinary shares or cash at the entity’s option may give rise to an asset or a liability, or a hybrid instrument with both an equity and a liability component under IAS 32. The entity should adjust the numerator (profit or loss attributable to ordinary equity holders) for any changes in the profit or loss that would have resulted during the period if the contract had been classified wholly as an equity instrument.

What is an example of a contract that may be settled in ordinary shares or in cash at the entity’s option? An example of such a contract is a deferred or contingent consideration agreement, where the entity has the unrestricted right to settle the consideration in the form of ordinary shares or cash. At the date of acquisition, it might not be possible for the entity to determine how the deferred consideration will be settled. It should therefore be presumed that the contract will be settled in shares (that is, the more dilutive method), and the resulting potential ordinary shares will be included in diluted EPS in accordance with IAS 33’s relevant provisions.

Diluted EPS where an entity has in issue a convertible bond that may be settled in ordinary shares or in cash at the issuer’s option IAS 33 includes an example of the calculation of diluted EPS where the entity has in issue a convertible bond that may be settled in ordinary shares or in cash at the issuer’s option: An entity issues 1,000 convertible bonds at the beginning of 20X5. The bonds have a three-year term and are issued at par with a face value of C1,000 per bond, giving total proceeds of C1,000,000. Interest is payable annually in arrears at a nominal annual interest rate of 4%. Each bond is convertible at any time up to maturity into 150 common shares. The entity has an option to settle the principal amount of the convertible bonds in ordinary shares or in cash. When the bonds are issued, the prevailing market interest rate for similar debt without a conversion option is 9%. At the issue date, the market price of one common share is C3. Income tax is ignored. Profit 20X5 C1,000,000 Ordinary shares outstanding 1,200,000 Convertible bonds outstanding 1,000 Allocation of proceeds of the bond issue Liability component C873,4341 Equity component C126,566 Proceeds of the bond issue C1,000,000 Note 1: Present value of the principal and interest discounted at 9% – C1,000,000 payable at the end of three years; C40,000 payable annually in arrears for three years. The liability and equity components would be determined in accordance with IAS 32. These amounts would be recognised as the initial carrying amounts of the liability and equity components presented on the balance sheet. The amount assigned to the issuer conversion option equity element is a permanent addition to equity and is not adjusted. Basic EPS 20X5: C1,000,000 = C0.83 per ordinary share 1,200,000 Diluted EPS 20X5: It is presumed that the issuer will settle the contract by the issue of ordinary shares. C1,000,000 + C78,6091 = C0.80 per ordinary share 1,200,000 + 150,0002 1The earnings are adjusted for the interest recognised in the period on the convertible bond – that is, C78,609 (C873,434 × 9%). 2150,000 ordinary shares = 150 ordinary shares × 1,000 convertible bonds [IAS 33 Example 8].

For contracts that may be settled in ordinary shares or in cash at the holder’s option, the more dilutive of cash settlement and share settlement should be used in calculating diluted EPS. An example might be an incentive scheme where annual bonuses may be payable either in shares or in cash at the employee’s election. In that situation, it should be presumed that the contract will be settled by the more dilutive method. Another example is a written put option that gives the holder the choice of settling in ordinary shares or in cash.

How are contracts, where settlement can occur using cash or shares at either the issuers or the holder’s option, considered for EPS purposes? Whilst IAS 33 does not specifically cover the point, if a contract may be settled in cash or shares at either the issuers or the holder’s option, the more dilutive of the cash settlement and share settlement should be used in calculating diluted EPS (that is, the same approach as when only the holder has an option). In practice, the rules in IAS 33 recognise that it is likely that only one party will have the option because, otherwise, there could be a conflict.

Purchased options

A put option is defined as a contract that gives the holder the right to sell ordinary shares at a specified price for a given period.

Contracts such as purchased put options and purchased call options held by an entity over its own ordinary shares are not included in the calculation of diluted EPS. Their inclusion would be anti-dilutive. A put option would be exercised only if the option exercise price were higher than the market price. A call option would be exercised only if the option exercise price were lower than the market price. In both instances, the purchased options’ effect would be anti-dilutive under the treasury stock method and the reverse treasury stock method.

Written put options

Contracts that require the entity to repurchase its own shares (such as written put options and forward purchase contracts) are reflected in diluted EPS if their effect is dilutive. If the contracts are ‘in the money’ during the period (that is, if the exercise or settlement price is above the average market price for the period), their dilutive effects should be calculated using the ‘reverse treasury stock’ method. Under that method:

• It should be assumed that, at the beginning of the accounting period, sufficient ordinary shares will be issued at the average market price for the period to raise the necessary proceeds to satisfy the contracts.

• It should be assumed that the proceeds from this issue are used to satisfy the contract to buy back ordinary shares.

• The incremental ordinary shares – that is, the difference between the number of shares assumed to be issued and the number of shares received (bought back) on satisfying the contract – will be included in the calculation of diluted EPS.

Written put options Assume that an entity has 160 written put options outstanding on 160 of its ordinary shares, with an exercise price of C10 per option. The put obligation is therefore C1,600. The average market price of the entity’s ordinary shares is C8 for the period. In calculating diluted EPS, the entity assumes that it issues 200 ordinary shares at C8 per share to raise the proceeds necessary to satisfy the put option. The difference between the 200 ordinary shares assumed to be issued and the 160 ordinary shares that would have been received on exercise of the option (that is, 40 shares) is added to the denominator (number of shares) in calculating the diluted EPS. No adjustments are made to the numerator (profit attributable to ordinary shareholders), because the shares are deemed issued for nil proceeds. This example is derived from that in IAS 33.