Fully Diluted Earnings Per Share: An Elaboration of
the CICA Handbook Section 3500

by G.R. Chesley

(My appreciation is extended to my student, Eric Fielding, who first pointed me to the wording of this accounting standard.)

Fully diluted earnings per share (Fdeps) is a common disclosure in financial statements. Changes made to section 3500 of the CICA Handbook in January 2001 pose some challenges for the explanation and demonstration of Fdeps when senior securities or options are converted (exercised) during an accounting period — a common occurrence. The demonstration provided in Appendix B of the Handbook section may confuse the reader in that it appears to contradict the “if converted” discussion made earlier. If the earlier definition alone were the basis for understanding the practice, erroneous information would be conveyed.  

The presentation below demonstrates the application of the “if converted” practices to Fdeps and highlights how the Handbook illustration is applied and why the suggested procedures are necessary in order to correctly present Fdeps. In particular, the treatment of converted (or exercised) senior securities (options) will be presented so that the logic of the procedure can be examined.  

Paragraph .05 states that “dilution is a reduction in earnings per share or an increase in loss per share resulting from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued upon satisfaction of certain conditions.”  

The “if converted” method referred to is a method of computing earnings-per-share data that assumes conversion of convertible securities at the beginning of the reporting period (or at the time of issuance, if later).  

Paragraph .05 goes on to introduce the treasury stock method, the major new change in the section, by stating that “the treasury stock method is a method of recognizing the use of proceeds that could be obtained upon exercise of options and warrants in computing diluted earnings per share.”  

Thus, early on, the standard does not suggest anything unusual. “If converted” implies that conversion or exercise has not happened.  

However, the discussion in section .37(d) states the key requirement for conversions when it states “potential common shares arising from a dilutive convertible security that was converted into common shares during the period are included up to the date of conversion.”  

Sections .38(a) and .43 deal with options and warrants. Section .43 is the most explicit when it states that “likewise, dilutive options or warrant exercised during the period are included in the denominator of diluted earnings per share for the period prior to the actual exercise.”  

Illustrations of the Provisions

1. Convertible preferred

Assume (1) a firm has 2,000 convertible preferred paying $8 per year in cumulative dividends; (2) the conversion rate is 2 common for 1 preferred, (3) the firm has 1 common share to start the period and a net income of $100,000 for the period; and (4) 1,500 preferred were converted on March 31 after the quarterly preferred dividend was paid.

 

(+) add the tables from the live site

 

* 1,200 shares is the number of shares that could have been issued for the same proceeds — that is, $30,000 ÷ $25 = 1,200 shares. These shares are needed in the reconciliation because of beginning with the basic EPS, which includes the cash of $30,000 in the equity.  

The Handbook section that illustrates FDEPS uses a somewhat more complex example where the market price changes each quarter. Such complexity does not change the logic, but it does mean that a weighted average back dating is necessary using an average market price.  

G.R. Chesley
Saint Mary’s University
Halifax, Nova Scotia
d.chesley@stmarys.ca