Chapter 19Earnings Per Share

MULTIPLE CHOICE
1. Earnings per share disclosures are required only for
a. companies with complex capital structures.
b. companies that change their capital structures during the reporting period.
c. public companies.
d. private companies.
ANS: C

OBJ: LO 1

2. In computing the earnings per share of common stock, noncumulative preferred dividends not
declared should be
a. deducted from the net income for the year.
b. added to the net income for the year.
c. ignored.
d. deducted from the net income for the year, net of tax.
ANS: C

OBJ: LO 2

3. Which earnings per share computation should be reported on the face of the income statement?
Basic EPS
a.
b.
c.
d.

Yes
Yes
No
No

ANS: A

Diluted EPS
Yes
No
Yes
No

OBJ: LO 7

4. When computing earnings per share on common stock, dividends on cumulative, nonconvertible
preferred stock should be
a. deducted from net income only if the dividends were declared or paid in the current period.
b. deducted from net income regardless of whether the dividends were not paid or declared in
the period.
c. deducted from net income only if net income is greater than the dividends.
d. ignored.
ANS: B

OBJ: LO 2

5. In calculating diluted earnings per share, which of the following should not be considered?
a. The weighted average number of common shares outstanding
b. The amount of dividends declared on cumulative preferred shares
c. The amount of cash dividends declared on common shares
d. The number of common shares resulting from the assumed conversion of debentures
outstanding
ANS: C

OBJ: LO 4

6.
What is the correct treatment of a stock dividend issued in mid year when
computing the weighted-average number of common shares outstanding for earnings per share
purposes?
a. The stock dividend should be weighted by the length of time that the additional number of
shares are outstanding during the period.
b. The stock dividend should be included in the weighted-average number of common shares
outstanding only if the additional shares result in a decrease of 3 percent or more in
earnings per share.
c. The stock dividend should be weighted as if the additional shares were issued at the
beginning of the year.
d. The stock dividend should be ignored since no additional capital was received.
ANS: C

OBJ: LO 2

7. The EPS computation that is forward-looking and based on assumptions about future transactions
is
a. diluted EPS.
b. basic EPS.
c. continuing operations EPS.
d. extraordinary EPS.
ANS: A

OBJ: LO 1

8. When computing diluted earnings per share, stock options are

a. recognized only if they are dilutive.
b. recognized only if they are antidilutive.
c. recognized only if they were exercised.
d. ignored.
ANS: A

OBJ: LO 3

9. Of the following, select the incorrect statement concerning earnings per share.
a. During periods when all income is paid out as dividends, earnings per share and dividends
per share under a simple capital structure would be identical.
b. Under a simple capital structure, no adjustment to shares outstanding is necessary for a
stock split on the last day of the fiscal period.
c. During a period, changes in stock issued or reacquired by a company may affect earnings
per share.
d. During a loss period, the amount of loss attributed to each share of common stock should
be computed.
ANS: B

OBJ: LO 5

10. In applying the treasury stock method of computing diluted earnings per share, when is it
appropriate to use the average market price of common stock during the year as the assumed
repurchase price?
a. Always
b. Never
c. When the average market price is higher than the exercise price
d. When the average market price is lower than the exercise price
ANS: C

OBJ: LO 3

11. Earnings per share information should be reported for all of the following except
a. continuing operations.

b. extraordinary gain.
c. net income.
d. cash flows from operating activities.
ANS: D

OBJ: LO 7

12. When using the if-converted method to compute diluted earnings per share, convertible securities
should be
a. included only if antidilutive.
b. included only if dilutive.
c. included whether dilutive or not.
d. not included.
ANS: B

OBJ: LO 4

13. The if-converted method of computing EPS data assumes conversion of convertible securities at
the
a. beginning of the earliest period reported (or at time of issuance, if later).
b. beginning of the earliest period reported (regardless of time of issuance).
c. middle of the earliest period reported (regardless of time of issuance).
d. ending of the earliest period reported (regardless of time of issuance).
ANS: A

OBJ: LO 4

14. When computing dilutive EPS, the treasury stock method can be used for all of the following
except
a. convertible preferred stock.
b. stock warrants.
c. stock options.
d. stock rights.
ANS: A

OBJ: LO 3

15. For a company having several different issues of convertible securities and/or stock options and
warrants, the FASB requires selection of the combination of securities producing
a. the lowest possible earnings per share.
b. the highest possible earnings per share.
c. the earnings per share figure midway between the lowest possible and the highest possible
earnings per share.
d. any earnings per share figure between the lowest possible and the highest possible earnings
per share.
ANS: A

OBJ: LO 6

16. For purposes of computing the weighted-average number of shares outstanding during the year, a
midyear event that must be treated as occurring at the beginning of the year is the
a. declaration and issuance of a stock dividend.
b. purchase of treasury stock.
c. sale of additional common stock.
d. issuance of stock warrants.
ANS: A

OBJ: LO 2

17.
Where in the financial statements should basic and complex EPS figures for
income from continuing operations be reported?
a. In the accompanying notes
b. In management's discussion and analysis
c. On the income statement
d. On the statement of cash flows
ANS: C

OBJ: LO 7

18. The main purpose of reporting diluted earnings per share is to

a. provide a comparison figure for debt holders.
b. indicate earnings shareholders will receive in future periods.
c. distinguish between companies with a complex capital structure and companies with a
simple capital structure.
d. show the maximum possible dilution of earnings.
ANS: D

OBJ: LO 1

19. In determining earnings per share, interest expense, net of applicable income taxes, on
convertible debt which is dilutive should be
a. ignored for diluted earnings per share.
b. added back to net income for diluted earnings per share.
c. deducted from net income for diluted earnings per share.
d. none of the above.
ANS: B

OBJ: LO 4

20. When computing diluted EPS for a company with a complex capital structure, what is the
denominator in the computation?
a. Number of common shares outstanding at year-end
b. Weighted-average number of common shares outstanding
c. Weighted-average number of common shares outstanding plus all other potentially
antidilutive securities
d. Weighted-average number of common shares outstanding plus all other potentially dilutive
securities
ANS: D

OBJ: LO 1

21. Under current GAAP, a company with a complex capital structure and potential earnings per
share dilution must present
a. primary and fully diluted earnings per share.
b. basic and diluted earnings per share.
c. basic and primary earnings per share.
d. basic earnings per share and cash flow per share.
ANS: B

OBJ: LO 1

22. Under current GAAP, common stock equivalents

a. are considered in calculating basic earnings per share.
b. are considered in calculating primary earnings per share.
c. are not considered in calculating basic earnings per share.
d. are not considered in calculating fully diluted earnings per share.
ANS: C

OBJ: LO 1

23. In calculating earning per share, stock options warrants, and rights are
a. always dilutive.
b. never dilutive.
c. dilutive if the exercise price is less than the average market price of the common stock.
d. dilutive if the exercise price is more than the average market price of the common stock.
ANS: C

OBJ: LO 6

24. For companies with a complex capital structure, a convertible security is potentially dilutive if
a. its incremental EPS is greater than basic EPS after considering any stock options, rights,
and warrants.
b. its incremental EPS is less than basic EPS after considering any stock options, rights, and
warrants.
c. its incremental EPS is equal to basic EPS after considering any stock options, rights, and
warrants.
d. its incremental EPS is less than 1.00 after considering any stock options, rights, and
warrants.
ANS: B

OBJ: LO 6

25. An entity that reports a discontinued operation, an extraordinary item, or a cumulative effect of
an accounting change shall present basic and diluted
earnings per share amounts for those line items
a. only on the face of the income statement.
b. only in the notes to the financial statements.
c. either on the face of the income statement or in the notes to the financial statements.
d. only if management chooses to do so as these amounts are note required to be disclosed
either in the financial statements or the notes thereto.
ANS: C

OBJ: LO 7

26. On December 31, 2005, Superior, Inc. had 600,000 shares of common stock issued and
outstanding. Superior issued a 10 percent stock dividend on July 1, 2006. On October 1, 2006,
Superior reacquired 48,000 shares of its common stock and recorded the purchase using the cost
method of accounting for treasury stock. What number of shares should be used in computing
basic earnings per share for the year ended December 31, 2006?
a. 612,000
b. 618,000
c. 648,000
d. 660,000
ANS: C

OBJ: LO 2

27. At December 31, 2005, the Murdock Company had 150,000 shares of common stock issued and
outstanding. On April 1, 2006, an additional 30,000 shares of common stock were issued.
Murdock's net income for the year ended December 31, 2006, was $517,500. During 2006,
Murdock declared and paid $300,000 in cash dividends on its nonconvertible preferred stock. The
basic earnings per common share, rounded to the nearest penny, for the year ended December 31,
2006, should be
a. $3.00.
b. $2.00.
c. $1.45.
d. $1.26.
ANS: D

OBJ: LO 2

28. At December 31, 2006 and 2005, Lapham Corp. had 200,000 shares of common stock and 20,000
shares of 5 percent, $100 par value cumulative preferred stock outstanding. No dividends were
declared on either the preferred or common stock in 2006 or 2005. Net income for 2006 was
$1,000,000. For 2006, basic earnings per common share amounted to
a. $5.00.
b. $4.75.
c. $4.50.
d. $4.00.
ANS: C

OBJ: LO 2

29. The Thomas Company's net income for the year ended December 31 was $30,000. During the
year, Thomas declared and paid $3,000 in cash dividends on preferred stock and $5,250 in cash
dividends on common stock. At December 31, 36,000 shares of common stock were outstanding,
30,000 of which had been issued and outstanding throughout the year and 6,000 of which were
issued on July 1. There were no other common stock transactions during the year, and there is no
potential dilution of earnings per share. What should be the year's basic earnings per common
share of Thomas, rounded to the nearest penny?
a. $0.66
b. $0.75
c. $0.82
d. $0.91
ANS: C

OBJ: LO 2

30. Bay Area Supplies had 60,000 shares of common stock outstanding at January 1. On May 1, Bay
Areas Supplies issued 31,500 shares of common stock. Outstanding all year were 30,000 shares
of nonconvertible preferred stock on which a dividend of $4 per share was paid in December. Net
income for the year was $290,100. Bay Area Supplies should report basic earnings per share for
the year of
a. $1.86.
b. $2.10.
c. $2.84.
d. $3.17.
ANS: B

OBJ: LO 2

31. Landrover, Inc. had 150,000 shares of common stock issued and outstanding at December 31,
2005. On July 1, 2006, an additional 25,000 shares of common stock were issued for cash.
Landrover also had unexercised stock options to purchase 20,000 shares of common stock at $15
per share outstanding at the beginning and end of 2006. The market price of Landrover's common
stock was $20 throughout 2006. What number of shares should be used in computing diluted
earnings per share for the year ended December 31, 2006?
a. 182,500
b. 180,000
c. 177,500
d. 167,500
ANS: D

OBJ: LO 3

32. Glendale Enterprises had 200,000 shares of common stock issued and outstanding at December
31, 2005. On July 1, 2006, Glendale issued a 10 percent stock dividend. Unexercised stock
options to purchase 40,000 shares of common stock (adjusted for the 2006 stock dividend) at $20
per share were outstanding at the beginning and end of 2006. The market price of Glendale's
common stock (which was not affected by the stock dividend) was $25 per share during 2006.
Net income for the year ended December 31, 2006, was $1,100,000. What should be Glendale's
2006 diluted earnings per common share, rounded to the nearest penny?
a. $4.23
b. $4.82
c. $5.00
d. $5.05
ANS: B

OBJ: LO 3

33. On January 2, 2005, Worley Co. issued at par $50,000 of 4 percent bonds convertible, in total,
into 5,000 shares of Worley's common stock. No bonds were converted during 2005. Throughout
2005 Worley had 5,000 shares of common stock outstanding. Worley's 2005 net income was
$5,000. Worley's income tax rate is 40 percent. No potentially dilutive securities other than the
convertible bonds were outstanding during 2005. Worley's diluted earnings per share for 2005
would be
a. $0.58.
b. $0.62.
c. $0.70.
d. $1.16.
ANS: B

OBJ: LO 4

34. At December 31, 2005, Dayplanner Inc. had 250,000 shares of common stock outstanding. On
October 1, 2006, an additional 60,000 shares of common stock were issued for cash. Dayplanner
also had 2,000,000 of 8 percent convertible bonds outstanding at December 31, 2006, which are
convertible into 50,000 shares of common stock. The bonds are dilutive in the 2006 earnings per
share computation. No bonds were issued or converted into common stock during 2006. What is
the number of shares that should be used in computing diluted earnings per share for the year
ended December 31, 2006?
a. 265,000
b. 300,000
c. 310,000
d. 315,000
ANS: D

OBJ: LO 4

35. The JVB Corporation had 200,000 shares of common stock and 10,000 shares of cumulative, $6
preferred stock outstanding during 2006. The preferred stock is convertible at the rate of three
shares of common per share of preferred. For 2006, the company had a $60,000 net loss from
operations and declared no dividends. JVB should report 2006 diluted loss per share of (rounded
to the nearest cent)
a. $(0.30).
b. $(0.52).
c. $(0.58).
d. $(0.60).
ANS: B

OBJ: LO 5

36. Zacor Incorporated has 2,500,000 shares of common stock outstanding on December 31, 2005.
An additional 500,000 shares of common stock were issued April 1, 2006, and 250,000 more on
July 1, 2006. On October 1, 2006, Zacor issued 5,000, $1,000 face value, 7 percent convertible
bonds. Each bond is convertible into 40 shares of common stock. No bonds were converted into
common stock in 2006. What is the number of shares to be used in computing basic earnings per
share and diluted earnings per share, respectively?
a. 2,875,000 and 2,925,000
b. 2,875,000 and 3,075,000
c. 3,000,000 and 3,050,000
d. 3,000,000 and 3,200,000
ANS: C

OBJ: LO 4

37. Shoemaker Company had 1,000 common shares issued and outstanding at January 1. During the
year, Shoemaker also had the common stock transactions listed below.
April 1
May 1
June 30
July 30
December 31

Issued 300 previously unissued shares

Split the stock 2-for-1
Purchased 100 shares for the treasury
Distributed a 20 percent stock dividend
Split the stock 3-for-1

Given this information, what is the weighted-average number of shares that Shoemaker should
use for earnings per share purposes?
a. 2,880
b. 8,640
c. 8,820
d. 9,720
ANS: B

OBJ: LO 2

38. During its fiscal year, Richards' Distributing had net income of $100,000 (no extraordinary items)
and 50,000 shares of common stock and 10,000 shares of preferred stock outstanding. Richards
declared and paid dividends of $.50 per share to common and $6.00 per share to preferred. The
preferred stock is convertible into common stock on a share-for-share basis. For the year,
Richards Distributing should report diluted earnings (loss) per share of
a. $(0.80).
b. $1.00.
c. $1.67.
d. $2.67.
ANS: C

OBJ: LO 4

39. At December 31, 2005, the Roberts Company had 700,000 shares of common stock outstanding.
On September 1, 2006, an additional 300,000 shares of common stock were issued. In addition,
Roberts had $20,000,000 of 8 percent convertible bonds outstanding at December 31, 2005,
which are convertible into 400,000 shares of common stock. No bonds were converted into
common stock in 2006. The net income for the year ended December 31, 2006, was $6,000,000.
Assuming the income tax rate was 40 percent, what should be the diluted earnings per share for
the year ended December 31, 2006?
a. $5.00
b. $5.53
c. $5.80
d. $8.30
ANS: C

OBJ: LO 4

40. The 2006 net income of Atwater Inc. was $200,000 and 100,000 shares of its common stock were
outstanding during the entire year. In addition, there were outstanding options to purchase 10,000
shares of common stock at $10 per share. These options were granted in 2003 and none had been
exercised by December 31, 2006. Market prices of Atwater's common stock during 2006 were
January 1
December 31
Average Price

$20 per share

$40 per share
$25 per share

The amount that should be shown as Atwater's diluted earnings per share for 2006 (rounded to the
nearest cent) is
a. $2.00.
b. $1.95.
c. $1.89.
d. $1.86.
ANS: C

OBJ: LO 3

41. Warrants exercisable at $20 each to obtain 20,000 shares of common stock were outstanding
during a period when the average and year-end market price of the common stock was $25.
Application of the treasury stock method for the assumed exercise of these warrants in computing
diluted earnings per share will increase the weighted-average number of outstanding common
shares by
a. 20,000.
b. 16,667.
c. 16,000.
d. 4,000.
ANS: D

OBJ: LO 3

42. The following information relates to the capital structure of Metcalf Corp.:
Outstanding shares:
Common stock ..............................
Preferred stock, convertible into 60,000
shares of common ..........................
10% convertible bonds, convertible into
40,000 shares of common ...................

12/31/05

12/31/06

180,000

180,000

60,000

60,000

$2,000,000

$2,000,000

During 2006 Metcalf paid $90,000 in dividends on the preferred stock. Metcalf's net income for
2006 was $1,960,000 and the income tax rate was 40 percent. For the year ended December 31,
2006, the diluted earnings per share is
a. $7.29.
b. $7.43.
c. $8.17.
d. $8.29.
ANS: B

OBJ: LO 5

43. At December 31, 2005, Lefton, Inc. had 600,000 shares of common stock outstanding. On April
1, 2006, an additional 180,000 shares of common stock were issued for cash. Lefton also had
$5,000,000 of 8% convertible bonds outstanding at December 31, 2006, which are convertible
into 150,000 shares of common stock. The bonds are dilutive in the 2006 EPS computation. No
bonds were issued or converted into common stock during 2006. What is the number of shares
that should be used in computing basic earnings per share for 2006?
a. 735,000
b. 780,000
c. 885,000
d. 910,000
ANS: A

OBJ: LO 4

44. At December 31, 2005, Lefton, Inc. had 600,000 shares of common stock outstanding. On April
1, 2006, an additional 180,000 shares of common stock were issued for cash. Lefton also had
$5,000,000 of 8% convertible bonds outstanding at December 31, 2006, which are convertible
into 150,000 shares of common stock. The bonds are dilutive in the 2006 EPS computation. No
bonds were issued or converted into common stock during 2006. What is the number of shares
that should be used in computing diluted earnings per share for 2006?
a. 735,000
b. 780,000
c. 885,000
d. 910,000
ANS: C

OBJ: LO 4

45. Datatec, Inc., had 400,000 shares of $20 par common stock and 40,000 shares of $100 par, 6%
cumulative, convertible preferred stock outstanding for the entire year ended December 31, 2006.
Each share of the preferred stock is convertible into 5 shares of common stock. Datatec's net
income for 2006 was $1,680,000. For the year ended December 31, 2006, the diluted earnings per
share is
a. $2.40.
b. $2.80.
c. $3.60.
d. $4.20.
ANS: B

OBJ: LO 4

46. On December 31, 2004, Feterik Company had 7,000 shares of common stock issued and
outstanding. On April 1, 2005, an additional 1,000 shares of common stock were issued and on
July 1, 500 more shares were issued. On October 1, 2005, Feterik issued 10, $1,000 maturity
value, 8% convertible bonds. Each bond is convertible into 40 shares of common stock. No bonds
were converted into common stock in 2005. Assuming there are no antidilutive securities, what is
the number of shares Feterik should use to compute diluted earnings per share for the year ended
December 31, 2005?
a. 7,950
b. 8,100
c. 8,150
d. 8,400
ANS: B

OBJ: LO 4

10

James Corporation
James Corporation currently has stock rights outstanding for 2,000 common shares. The exercise
price of these shares is $20. The options were issued in January of 2003. The average market
price of the related common stock during the year 2003 was $25. The average market price of the
related common stock during 2004 was $21 and during 2005 was $19. The company's fiscal year
ends on December 31 of each year.
47. Refer to James Corporation. How should these stock rights be treated in earnings per share
calculations for the year ending December 31, 2003?
a. The stock options are antidilutive and should not be included either in basic and diluted
earnings per share.
b. The stock options are dilutive and should be included both in basic and diluted earnings
per share.
c. The stock options are dilutive and should be included both in basic and diluted earnings
per share in the amount of 400 shares.
d. The stock options are dilutive and should be included only in diluted earnings per share in
the amount of 400 shares.
ANS: D

OBJ: LO 6

48. Refer to James Corporation. How should these stock rights be treated in the earnings per share
calculation for the year ending December 31, 2004?
a. The stock options are antidilutive and should not be included either in basic or diluted
earnings per share.
b. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 95 shares.
c. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 2,000 shares.
d. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 400 shares.
ANS: B

OBJ: LO 6

49. Refer to James Corp. How should these stock rights be treated in the earnings per share
calculation for the year ending December 31, 2005?
a. The stock options are antidilutive and should not be included with in basic or diluted
earnings per share.
b. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 105 shares.
c. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 2,000 shares.
d. The stock options are dilutive and should be included in diluted earnings per share in the
amount of 400 shares.
ANS: A

OBJ: LO 6

PROBLEMS
1. On December 31, 2004, Jamfest Travel Inc. had 450,000 shares of no-par common stock issued
and outstanding. All shares were sold for $7.50. On June 30, 2005, the firm issued an additional
135,000 shares for $7 per share. The 2005 income was $319,200. On September 1, 2006, a 15
percent stock dividend was issued to all common shareholders. On October 1, 2006, 60,000
shares were reacquired as treasury shares. Net income in 2006 was $278,063.

11

(1)
(2)
ANS:
(1)
2005:

2006:

Compute the weighted-average number of common shares outstanding for 2005

and 2006 that should be shown on comparative statements at the end of 2006.
Compute the basic earnings per share in 2005 and 2006 to be reported on
comparative statements at the end of 2006.

450,000 12/12 1.15 =

135,000 6/12 1.15 =

517,500
77,625
595,125 shares

585,000 12/12 1.15 =

(60,000) 3/12 =

672,750
(15,000)
657,750

(2)
2005:

($319,200 / 595,125) =

$.54 (rounded)

2006:

($278,063 / 657,750) =

$.42 (rounded)

OBJ:

LO 2

2. The income statement of Micro Computers, Inc. showed the following information on December
31, 2006.
Income before income tax .............................
Income tax expense ...................................
Income from continuing operations ....................
Extraordinary loss (net of tax savings) ..............
Net income ...........................................

$1,472,000
441,600
$1,030,400
(100,000)
$ 930,400

Compute earnings per share figures for common stock under the assumption that Micro
Computer Inc. has
(1)
(2)

320,000 shares of $24 par value common stock outstanding.

9,600 shares of $100, par 8% cumulative preferred stock, and 240,000 shares of nopar common stock. Dividends are not in arrears.

Note: Assumption (1) is independent of (2).

ANS:
(1)
EPS--continuing operations ........................
EPS--extraordinary items ..........................
EPS ...............................................
*$1,030,400/320,000 = $3.22
**$(100,000)/320,000 = $(.31)
(2)
EPS--continuing operations ........................
EPS--extraordinary items ..........................
EPS

12

$3.22 *
(.31)**
$2.91
(rounded)

$3.97*
(.42)**
$3.55

*[$1,030,400 - ($8.00 9,600)] / 240,000 = ($1,030,400 - $76,800) / 240,000 = $3.97

**(100,000) / 240,000 = $(.42)
OBJ:

LO 2

3. During 2006, the Ellis Corporation had 370,000 shares of $20 par common stock outstanding. On
January 1, 2006, 2,000, 8 percent bonds were issued with a maturity value of $1,000 each. To
enhance the bond sale, the company offered a conversion of 50 shares of common stock for each
bond at the option of the purchaser. Net income for 2006 was $464,000. The income tax rate was
30 percent. Compute the diluted earnings per share of common stock.
ANS:
Diluted EPS

OBJ:

= ($464,000 + $160,000 - $48,000) / (370,000 + 100,000)

= $576,000 / 470,000
= $1.23 (rounded)

LO 4

4. During 2006, Wright Corp. had outstanding 125,000 shares of common stock and 7,500 shares of
noncumulative, 8 percent, $50 par preferred stock. Each preferred share is convertible into 8
shares of common stock. In 2006, net income was $231,500.
(1)
(2)

Compute basic and diluted earnings per share for 2006 assuming no dividends were
declared or paid.
Compute basic and diluted earnings per share for 2006 assuming dividends were
declared and paid on the preferred stock.

ANS:
(1)
BEPS

= ($231,500 / 125,000) = $1.85 (rounded)

DEPS

= $231,500 / [125,000 + (8 7,500)]

= $231,500 / 185,000
= $1.25 (rounded)

(2)
BEPS

= ($231,500 - 30,000) / 125,000 = $1.61 (rounded)

DEPS

OBJ:

= $231,500 / (125,000 + 60,000)

= $231,500 / 185,000
= $1.25 (rounded)
LO 2

5. On December 31, 2006, Masters Inc. had outstanding 180,000 shares of common stock. Net
income for 2006 was $285,000. Outstanding options (granted July 1, 2006) to purchase 15,000
shares of common stock at $20 per share had not been exercised by December 31, 2006. During
2006, market prices for the common stock were:
July 1, 2006 ....................................
December 31, 2006 ...............................

13

$18 per share

$32 per share

Average market ..................................

(1)
(2)

$25 per share

Compute the basic earnings per common share in 2006.

Compute the diluted earnings per common share in 2006.

ANS:
(1)
BEPS

= $285,000 / 180,000
= $1.58 (rounded)

(2)
DEPS =

$285,000 / [180,000 + (15,000 - 12,000*) x 6/12]

= $285,000 / 181,500
= $1.57 (rounded)
* $300,000/$25 = 12,000 shares
OBJ:

LO 4

6. Data Controls Inc. had 250,000 shares of common stock outstanding at the end of 2004. During
2005 and 2006, the following transactions took place.
2005

March 1
July 24
October 1
December 1

Sold 24,000 shares

Issued a 20 percent stock dividend
Sold 16,000 shares
Purchased 15,000 shares to be held in treasury

2006

June 1
September 1

3-for-1 stock split

Sold 60,000 shares

Data Controls Inc. has a simple capital structure.

Compute the weighted average number of shares for 2005 and 2006 to be used in the earnings per
share computation for comparative financial statements at the end of 2006.
ANS:
2005

January 1
March 1
October 1
December 1

250,000 12/12 1.20 3 =

24,000 10/12 1.20 3 =
16,000 3/12 3 =
(15,000) 1/12 3 =

2006

January 1
September 1

329,800* 12/12 3 =
60,000 4/12 =

*2005

January 1
March 1
July 24
October 1
December 1

Issuance
20% stock dividend
Issuance
Treasury stock

14

900,000
72,000
12,000
(3,750)
980,250
989,400
20,000
1,009,400
250,000
24,000
54,800
16,000
(15,000)
329,800

OBJ: LO 2
7. The following is a partial balance sheet for Anderson Corp. for the year ended December 31,
2005:
9 percent Convertible Bonds (issued at par) .............
Common Stock, 180,000 shares issued and outstanding,
$50 par .................................................

(a)
(b)

$1,800,000
$9,000,000

(d)

Each $1,000 convertible bond can be converted into 80 shares of common stock.
On September 1, 2006, one-third of the convertible debt was converted into
common stock.
Anderson reported net income of $1,550,000 in 2006. The income tax rate was 30
percent.
No other stock transactions took place during 2006.

(1)
(2)

Compute basic earnings per share for 2006.

Compute diluted earnings per share for 2006.

(c)

ANS:
(1)
BEPS

= $1,550,000 / [180,000 + (4/12 48,000)]

= $1,550,000 / 196,000
= $7.91 (rounded)

Conversion (600 bonds x 80) = 48,000 shares

(2)
DEPS

= $1,550,000 + ($144,000 0.7) / 196,000 + 128,000

= $1,650,800 / 324,000
= $5.10
Interest Avoided
$1,200,000 x 9% 12/12 =
$ 600,000 x 9% 8/12 =

$108,000
36,000
$144,000

Equivalent Shares
1,200 bonds 12/12 80 =
600 bonds 80 8/12 =
OBJ:

96,000
32,000
128,000

LO 5

8. The Stanley Corp. provides the following data for 2006:

Transactions in common stock:
January 1, 2006, beginning balance ................
April 1, 2006, issuance ...........................
8% $100 par nonconvertible cumulative preferred
stock .............................................
Issued at par

15

300,000 shares
100,000 shares
$100,000

6% $100 par convertible cumulative preferred stock

Issued at $105
Convertible into 20,000 shares
Stock options .....................................
Option price ......................................
Average market ....................................
Year-end market ...................................

$200,000

60,000 shares
$25
$35
$40

The net income for 2006 is $2,300,000. The company's tax rate is 30 percent. No conversions or
options were exercised during 2006.
(1)
(2)

Compute basic earnings per share.

Compute diluted earnings per share.

ANS:
(1)
BEPS

= ($2,300,000 - $8,000 - $12,000) / [300,000 + 9/12 (100,000)]

= $2,280,000 / 375,000
= $6.08

(2)
DEPS

= ($2,300,000 - $8,000) / (375,000 + 20,000 + 60,000 - 42,857)

= $2,292,000 / 412,143
= $5.56

Options
OBJ:

= 60,000 $25 = $1,500,000

$1,500,000/$35 = 42,857
LO 3

9. At December 31, 2005, Rollins Inc. had 400,000 shares of common stock outstanding. The
company also had 40,000 shares of $7 convertible preferred stock. Each share is convertible into
4 shares of common stock. (Dividends were declared and paid.)
Transactions during 2006:
July 1, 2006
July 8, 2006
September 1, 2006
October 1, 2006

(1)
(2)

Sold 200,000 shares

Declared 100% stock dividend
Sold 120,000 shares
Purchased 60,000 shares to be held in
Treasury
Rollins Inc. reported a loss of $670,700 for
2006

Compute basic earnings (loss) per share.

Compute diluted earnings (loss) per share.

ANS:
Weighted-average computation:
January 1, 2006
July 1, 2006

400,000 12/12 2 =
200,000 6/12 2 =

16

800,000
200,000

September 1, 2006
October 1, 2006
(1)
BEPS

120,000 4/12 =
(60,000) 3/12 =

40,000
(15,000)
1,025,000

= [$(670,700) - $280,000] / 1,025,000

=$(.93)

(2)
DEPS

= $(670,700) / [(1,025,000 + (160,000 x 2)]

= $(670,700) / 1,345,000
= $(.50) *

*The convertible preferred stock is antidilutive. Rollins would report a loss per common share of
$.93 for 2006.
OBJ:

LO 5

10. During all of 2005, Dawson Manufacturing Company had 950,000 shares of common stock
outstanding. On June 30, 2005, the company issued 10,000 7 percent convertible bonds at par.
The maturity value of each bond is $1,000. Each bond is convertible into 20 shares of common
stock. None were converted during 2005.
Dawson also had 60,000 stock warrants outstanding for all of 2005. The option price is $10 per
share. The market price of the common stock was $40 on December 31, 2005, and the average
market price for 2005 was $30.
Dawson reported a net income of $3,650,000 for 2005. Assume the company had a 40 percent
income tax rate.
(1)
(2)

Compute the basic earnings per share.

Compute diluted earnings per share.

ANS:
(1)
BEPS
(2)
DEPS

= $3,650,000 / 950,000
= $3.84 (rounded)
= ($3,650,000 + 350,000 - 140,000) / [950,000 + 6/12 (200,000) +
(60,000 - 20,000)]
= $3,860,000 / 1,090,000
= $3.54 (rounded)

Bonds--dilutive:
($10,000,000 .07 .60) / (10,000 20) = $2.10
$2.10 < $3.84
Incremental shares = 10,000 20 = 200,000
Interest avoided = $10,000,000 7% x 6/12 = $350,000
Tax savings on interest = $350,000 0.40 = $140,000
Stock options--dilutive
Proceeds $10 60,000 = $600,000

17

$600,000 / $30 = 20,000 shares

Incremental shares = 60,000 - 20,000 = 40,000
OBJ: LO 4
11. At December 31, 2005, EMD Company had 500,000 shares of common stock outstanding. EMD
sold 50,000 shares on October 1, 2006. Net income for 2006 was $2,417,875; the income tax rate
was 30%. In addition, EMD had the following debt and equity securities on its books on
December 31, 2006:
(a)
(b)
(c)
(d)

18,000 shares of $100 par, 12% cumulative preferred stock.

28,000 shares of $100 par, 10% cumulative preferred stock, par $100, sold at 110.
Each share of preferred stock is convertible into 2 shares of common stock.
$2,000,000 face value of 9% bonds sold at par.
$3,000,000 face value of 7% convertible bonds sold to yield 8%. Unamortized
bond discount is $100,000 at December 31, 2006. Each $1,000 bond is convertible
into 20 shares of common stock.

Options to purchase 10,000 shares of common stock were issued May 1, 2006.
Exercise price is $30 per share; market value at date of option was $29; average market value
May 1 to December 31, 2006, was $40.
Compute the earnings per share amounts for the year ended December 31, 2006.
ANS:
1.
Computation of basic earnings per share:
Net income ...........................
Less: Dividends on cumulative
preferred stock:
18,000 x $100 x .12 ................
28,000 x $100 x .10 ................
Net income identified with common stock

$2,417,875

$216,000
280,000

Weighted average number of shares:

Jan. 1 to Oct. 1 (500,000 x 3/4)......
Oct. 1 to Dec. 31 (550,000 x 1/4).....
Total...............................
Basic earnings per share ...............

496,000
$1,921,875

375,000
137,500
512,500
$3.75

2.
Computation of diluted earnings per share:
Test for dilution of convertible securities:

7% Convertible bonds
10% Convertible preferred stock

Net Income
Impact

Number of
Shares

Incremental
EPS

$168,000 *
280,000

60,000
56,000

$2.80
5.00

$3,000,000 .08 .70 = $168,000; effective interest is amount charged to interest expense, not
interest paid.
*

Since only the convertible bonds are less than the basic earnings per share of $3.75, only the
convertible bonds are potentially dilutive.

18

Description
Basic earnings per share
May 1, 2006, options as if
exercised May 1, 2006:
Number of shares assumed
issued:
Less: number of treasury
shares (10,000 $30) $40
7% convertible bonds
Diluted earnings per share

OBJ:

Net
Income

Number of
Shares

Part of
Year

$1,921,875

Weighted
Average
512,500

EPS
$3.75

10,000
2,500

8/12

1,667

7,500
$1,921,875
168,000
$2,089,875

514,167
60,000
574,167

$3.74
$3.64

LO 6

12. Statement of Financial Accounting Standards No. 128, "Earnings Per Share," requires that
earnings per share figures be presented only by companies with publicly held common stock or
potential common stock.
List arguments for and against the exclusion of nonpublic companies from the requirement of
reporting earnings per share.
ANS:
Perhaps the major argument for not requiring earnings per share for nonpublic enterprises relates
to the issue of standards overload. Authoritative accounting pronouncements have increased both
in quantity and complexity. Managers of small companies believe that the cost of complying with
complex standards exceeds the value of the benefits derived from the information disclosed under
these standards. Small firms having limited resources cannot afford the enormous cost of
complying with complex and costly standards that require information of questionable value.
A major argument for requiring earnings per share information even for nonpublic companies is
the fact that many enterprises exempted from the requirement are neither small nor closely held.
Many nonpublic enterprises are large and complex entities whose financial reports are widely
distributed. Such enterprises may be in direct competition with enterprises whose securities are
traded in public markets. Suspension of the requirement for reporting earnings per share for some
enterprises in an industry, but not for others, is not sustainable solely on the basis of differences
in form of ownership. Arguments regarding the cost and benefits of pronouncements are
problematical because costs of applying a standard may be identified, but valuing the benefits
derived is difficult. The increasing complexity of business transactions suggests that the
statement reader should be provided with as much information as possible in order to make an
informed decision about the financial condition of the enterprise and the integrity and
stewardship of management. If the standards relating to earnings per share and other matters are
complex, it is only because the standards are reflecting the complexity of the transactions.
OBJ:

LO 7

19

13. You are an independent CPA and have just acquired a new client, A. Dunn Manufacturing
Company. The president of the company recently read an article advising a firm's management
team to seek to maximize the long-run value of the firm's stock. The article mentioned profit
maximization, earnings per share, and the role of these two factors in stock price maximization.
The president wants your advice on how the choice of inventory cost flow methods (e.g., FIFO
vs. LIFO) relates to profit maximization, earnings per share, and stock price maximization.
ANS:
The objective of a firm is not to maximize earnings per share or the accounting definition of
profit. The correct objective is to maximize shareholder wealth, which is the price per share that
is equivalent to the discounted cash flows of the firm. Maximizing earnings per share may
actually result in a reduction in cash flows. For example, earnings per share during a period of
rising prices would be higher for a firm that adopts FIFO inventory accounting rather than LIFO.
FIFO matches older, lower costs against current revenues, resulting in a higher net income and
higher earnings per share. LIFO would produce lower net income and earnings per share because
more recent, higher costs are matched against current revenues. Nevertheless, FIFO is the wrong
choice in a period of rising prices because it minimizes cash flow by maximizing taxes. LIFO
should be chosen because it provides higher cash flows as a result of reducing income and thus
reducing taxes. Since shareholders are concerned about discounted cash flow, they will assign a
higher value to the shares of a company that uses LIFO accounting.
OBJ:

LO 7

14. The price-earnings ratio frequently is used by analysts and investors for evaluating stock prices
because it relates the earnings of the business to the current market price
of the stock. The ratio is computed by dividing the market price per share by the earnings per
share before extraordinary items.
Explain how the price-earnings ratio should be interpreted, including any problems associated
with the interpretation of the ratio.
ANS:
A stock selling at a high price-earnings ratio generally is regarded favorably by analysts. A high
ratio shows that investors believe that the firm has good growth opportunities and that the firm's
earnings are relatively safe. The lower risk of the earnings lowers the discount rate used in
discounting future earnings to the present thus raising the present value of these discounted future
cash flows and raising the stock price as a result. Nonetheless, a firm could have a high priceearnings ratio, not because stock price is high, but because earnings are low.
A major problem with the price-earnings ratios is the use of earnings per share in the
denominator. Earnings per share reflect the somewhat arbitrary choices of accounting principles
used to determine earnings. A firm's reported earnings could be changed substantially by the
adoption of more conservative or less conservative accounting procedures. An additional problem
with the price-earnings ratio is that only at the end of the fiscal year are the numerator and
denominator measured as of the same date. The price-earnings ratio often is computed during the
year using the earnings per share amount from the most recent financial statements or by using a
moving quarterly average.
OBJ:

LO 7

20