ACCOUNTING STANDARD 20

EARNINGS PER SHARE

By : CA Chandrashekhar Shetty S

B.Com, PGDCA, PGDFM, DISA, ACS, ACWA, FCA

DISCUSSION ON :

- Why EPS ? - For Whom EPS ? - What is EPS ? - How EPS ?

- When EPS ?

EPS An Overview

Popular measure of the performance of a company and a factor in the valuation of its shares.

It is the reward of an investor for making his investment and it is the best measure of performance of a firm. Ordinary investors make their investment decision based on EPS.

Objective of financial management to maximize the EPS------ from the view point of both the investor and investee ---maximization of value measure in terms of market price of equity share

Effects Of EPS
EPS affects the following:
Value of a Share (Price Earning Ratio)
Market Price = EPS * P/E ratio

Valuation of the Business as a whole Expectations of the Investors Dividend Payout Ratio etc

Legal Framework

Accounting Standard - 20 issued by ICAI Commenced on 1-4-2001 Mandatory for Companies

Accounting Standard Interpretation 12

International Accounting Standard 33

Legal Framework

To provide for uniform computational methodology AS 20 was issued.

Its mandatory for Enterprises whose equity shares or potential equity shares are listed in India. Enterprises whose shares are not so listed and are willing to disclose the EPS Requirement of Part IV to Schedule VI of the Companies Act, 1956 Applicable for Level I Enterprises.

Level II and Level III Enterprises No Diluted EPS and Disclosure as per 48(ii)

ACCOUNTING STANDARDS INTERPRETATION - 12 APPLICABILITY OF AS 20

Every company, which is required to give information under Part IV of Schedule VI to the Companies Act, 1956, should calculate and disclose EPS in accordance with AS 20, whether or not its equity shares or potential equity shares are listed.

ACCOUNTING STANDARDS INTERPRETATION - 12 APPLICABILITY OF AS 20

Basis For Conclusions

AS 20 does not mandate an enterprise, which has neither equity shares nor potential equity shares which are so listed, to calculate and disclose EPS, but, if that enterprise discloses EPS for complying with the requirement of any statute, it should calculate and disclose EPS in accordance with AS 20

Areas of Concern : 1 Whether applicable for Banking and insurance companies?

2. Disclosure in Part IV only Basic or Both Basic and Diluted?

Practical Issues FY 05-06

Banking Sector
Vijaya Bank EPS on the face of P&L No (But in Notes On A/C) Balance Sheet No Abstract (Part IV) ING VYSYA Syndicate Bank Yes Yes

Yes

No

Practical Issues FY 05-06

Others

ITL Separate Disclosure of Extra-ordinary item Part IV Diluted EPS Yes

WIPRO No

Yes

No

Part IV Segregation of Extraordinary items

No

No

Objectives of AS 20

Prescribes principles for the determination and presentation of EPS. The focus of this statement is on the denominator of the EPS calculation.

Presentation-Para 8 and 9

An enterprise should present earnings per share for all periods

presented.

Presentation on the Face of P & L A/c. Separately for each class of equity share that has a different right to share in profit
Types of EPS Basic EPS Diluted EPS A ) Whether disclosure is must when Profit is Negative? B ) If yes, whether both Basic and Diluted EPS have to be presented?

Measurement
I. BASIC EARNINGS PER SHARE

A. Earnings Basic = PAT Pref. Div. incl. CDT

Points to Be Noted - Numerator 1. Tax and impact of AS -22 2. AS 5 Include Extraordinary items 3. Preference Dividend Non Cumulative Deduct if provided -- Cumulative - Full Dividend ( only of current year) 4. > one class of equity shares apportion the profits as per dividend rights

B. Per Share - Basic = Earnings / Weighted avg. No. Of Eq. shares Points to Ponder - Denominator 1. Consider the weighted average no. of equity shares o/s. during the period time weighting factor - Refer Table I 2. AS- 14 : Transferee company a. Purchase method from the date of acquisition b. Merger method From the beginning of the reporting period 3. Partly paid shares - proportion to div rights Refer Table II 4. Rights issue consider the bonus element Refer Table III 5. Bonus issue or share split - Increase in shares without increase in resources - Computation is from the beginning of the earliest period reported Refer Table IV

Table I - Weighted Average Number Of Shares (Accounting year 01-01-2001 to 31-12-2001)

NO of Shares Issued 1st January, 2001 Balance at beginning of year 1800 No. of Shares Bought Back No. of Shares Outstanding 1800

31st May, 2001

1st Nov, 2001 31st Dec, 2001

Issue of shares for cash

Buy Back of Shares Balance at end of year

600

2400

2400

300 300

2100 2100

Computation of Weighted Average No : (1800*5/12) + (2400*5/12) +(2100*2/12) = 2100 shares

The weighted average number of shares can alternatively be computed as follows : (1800*12/12) + (600*7/12) (300*2/12) = 2100 shares

Table II Partly paid shares

(Accounting year 01-01-2001 to 31-12-2001)

No. of shares issued

Nominal value of shares

Amount paid

1st Jan, 2001

Balance at beginning of year Issue of shares

1800

Rs 10

Rs 10

31st October, 2001

600

Rs 10

Rs 5

Assuming that partly paid shares are entitled to participate in the dividend to the extent of amount paid, number of partly paid equity shares would be taken as 300 for the purpose of calculation of EPS. Computation of Weighted Average would be as follows : (1800*12/12) + (300*2/12) = 1850 shares

Table III Right Issue

(Accounting year 01-01-2000 to 31-12-2000)
Net Profit Year 20*0 : Rs 11,00,000 Year 20*1 : Rs 15,00,000 5,00,000 shares

No. of shares outstanding prior to rights issue

Rights issue

One new share for each five outstanding (i.e. 1,00,000 new shares) Rights issue price : Rs 15.00
Rs 21.00

Fair value of one equity share immediately prior to exercise of rights on 1st March 2001

Computation of theoretical ex-rights fair value per share

Fair value of all outstanding shares immediately prior to exercise of rights + total amount received from exercise Number of shares outstanding prior to exercise + number of shares issued in the exercise (Rs 21 * 5,00,000 shares) + (Rs 15 * 1,00,000 shares) / 5,00,000 + 1,00,000 shares Theoretical ex-rights fair value per share = Rs 20.00

Computation of Adjustment factor

Rs 21.00 (Fair value per share prior to exercise of rights) / Rs 20.00(Theoretical ex-rights value per share) = 1.05

Computation of EPS
Year 2000 Year 2001

EPS for the year 2000 Rs 2.20 as originally reported : Rs 11,00,000/5,00,000 shares EPS for the year 2000 restated for rights issue : Rs 11,00,000 / (5,00,000 shares * 1.05) EPS for the year 2001 including effects of rights issue Rs 15,00,000 / (5,00,000 * 1.05 * 2/12) + (6,00,000 * 10/12) Rs 2.10

Rs 2.55

Table IV Bonus Issue

Net profit for the year 2000 Net profit for the year 2001 No. of equity shares outstanding until 30th September 2001 Bonus issue 1st Oct 2001

(Accounting year 01-01-2000 to 31-12-2000) Rs 18,00,000 Rs 60,00,000 20,00,000

2 equity shares for each equity share outstanding at 30th Sept, 20*1 20,00,000*2=40,00,000 60,00,000/(20,00,000 + 40,00,000) = Rs 1.00 18,00,000/(20,00,000+40,00,000) = Rs 0.3

Earnings per share for the year 2001 Adjusted EPS for the year 2000

Since the Bonus issue is an issue without consideration, the issue is treated as if it had occurred prior to the beginning of the year 2000, the earliest period reported.

Table V - Determining the Order in Which to Include Dilutive Securities in the Computing of Weighted Average Number Of Shares
Earnings, i.e., Net profit attributable to equity shareholders No. of equity shares outstanding Average fair value of one equity share during the year Rs 1,00,00,000 20,00,000 Rs 75.00

Potential Equity Shares

Options Convertible Preference shares 1,00,000 with exercise price of Rs 60 8,00,000 shares entitled to a cumulative dividend of Rs 8 per sahre. Each preference share is convertible into 2 equity shares. 10% Nominal amount Rs 10,00,00,000. Each debenture is convertible into 4 equity shares. 30%

Attributable tax, e.g., corporate dividend tax

12% Convertible Debentures of Rs 100 each Tax rate

Increase in Earnings Attributable to Equity Shareholders on Conversion of Potential Equity Shares

Increase in Earnings
Options
Increase in earnings No. of incremental shares issued for no consideration{1. 00,000*(7560)/75} Nil 20,000 Nil

Increase in no. Earnings per of Equity Incremental Shares share

Convertible Preference shares

Increase in net profit attributable to equity shareholders as adjusted by attributable tax [Rs 8*8,00,000)+10 %(8*8,00,000)] No. of incremental shares{2*8,00,0 00)] Rs 70,40,000

16,00,000

Rs 4.40

12% Convertible Debentures

Increase in net profit {Rs 10,00,00,000*0. 12*( 1 0.30)} No. of incremental shares{10,00,00 0*4} Rs 84,00,000

40,00,000

Rs 2.10

It may be noted from the above that options are most dilutive as their earnings per Incremental shares is nil. Hence, for the purpose of computation of diluted EPS, options will be considered first. 12% convertible debentures being second most dilutive will be considered next and thereafter convertible preference shares will be considered (see para 42)

Computation of Diluted EPS

Net Profit Attributable (Rs) No. of Equity Net profit attributable shares 20,00,000 20,000 1,00,00,000 20,20,000 40,00,000 4.95 Dilutive 5.00
per share (Rs)

As reported Options

1,00,000

12% Convertible Debentures

84,00,000

1,84,00,000 Convertible Pref shares 70,40,000

60,20,000 16,00,000

3.06

Dilutive

2,54,40,000

76,20,000

3.34

Ati-Dilutive

Since diluted EPS is increased when taking the convertible pref shares in A/C (from Rs 3.06 to Rs 3.34), the convertible pref shares are anti-dilutive and are ignored in the calculation of diluted EPS. Therefore, diluted EPS is Rs 3.06.

II. DILUTED EARNINGS PER SHARE A. Earnings Diluted

Points to Ponder
1.

Nr and Dr. adjusted for effects of dilutive potential equity shares. - Potential equity share is a financial instrument or other contract -Potential equity shares should be treated as dilutive when, and only when, their conversion to equity shares would decrease net profit per share from continuing ordinary operations (PARA 39) --Ignore Anti-dilutive potential equity shares`
that entitles, or may entitle, its holder to equity shares

Net Profit for the period attributable to equity shares - increased by dividends and tax - increased by interest subject to tax - any other item affecting profits

B. Per Share Diluted

Dilutive potential equity shares should be deemed to have been converted into equity shares at the beginning of the period or, if issued later, the date of the issue of the potential equity shares. -Share application money or advance share

application money is to be treated in same manner as dilutive potential equity shares.

Steps : Para 35 to 37

1. Assume the exercise of dilutuve securities e.g. ESOP 2. Determine the fair value of share( e.g. avg. of last 6 months weekly closing prices) 3. Determine the exercise price 4. Shares issued for no consideration = Step 2 - Step 3 5. Dilutive shares only to the extent of Step No. 4 ( Refer Table V) 6. Sequence Most dilutive to least dilutive

Most Dilutive = Earnings per Incremental Share is least

Free shares considered

A. Right and Buy back--- Both for Basic and Diluted

B. Options -- Only for Diluted ( Potential shares)

Factors Affecting EPS

Bonus issues, stock-splits and reverse stocksplits (consolidation of shares) change the number of outstanding shares without changing the resources available to the firm. Therefore, companies adjust the number of equity shares outstanding for those periods for bonus issues, stock-splits and reverse stock-splits while calculating the EPS.

RESTATEMENT

If the shares outstanding increases as a result of a bonus issue or decreases as a result of basic and diluted earnings per share should be adjusted for all the periods presented. An enterprise does not restate diluted earnings per share of any prior period presented for changes in the assumptions used or for the conversion of potential equity shares into equity shares outstanding. Normally, EPS is not adjusted for transaction occurring after the balance sheet date no effect on capital used.

Example

A firm XYZ whose net profit attributable to equity share holders for 2005 was Rs 10,00,000 and the number of outstanding shares 50,000. The EPS for 2005 will be 20. In the year 2006 if the profit is 15,00,000 and company issues 1:1 bonus. In the financial statement of 2006 the EPS for 2005 would be readjusted to Rs 10 (Rs10,00,000/1,00,000) to ensure comparability, even though it was reported at Rs 20 in financial statements for the year 2005.

DISCLOSURE - Para 48 to 51

48 (i)Where the statement of profit or loss includes extraordinary items, the enterprise should disclose basic and diluted EPS computed on the basis of earnings excluding extraordinary

items --- Prior period items ?

DISCLOSURE

48( ii) (a)the amounts used as numerators, and a reconciliation of those amounts to net profits or loss; (b) the weighted average number of equity shares used as the denominator; the nominal value of shares along with EPS figures.

AS 20 and other AS Interconnection

As - 1 AS 2 AS 4 AS 5 AS 6 AS 7

AS AS AS AS AS AS AS

9 10 -11 12 13 14 15

AS AS AS AS AS AS AS

19 21 22 24 25 28 29

Other Matters : IAS 33

January 1996
February 1997 1 January 1999 18 December

Exposure Draft -- Earnings Per Share

IAS 33 Share

Earnings Per

Effective Date of IAS 33 (1997) Revised version of IAS 33 issued by the IASB

2003
1 January 2005 Effective date of IAS 33 (Revised 2003)

Objective of IAS 33

to improve performance comparisons between different enterprises in the same period and between different accounting periods for the same enterprise.

Scope

IAS 33 applies to entities whose securities are publicly traded or that are in the process of issuing securities to the public. [IAS 33.2] Other entities that choose to present EPS information must also comply with IAS 33. [IAS 33.3]

Shortcomings of EPS
Does not consider the opportunity cost of capital and can be manipulated by short-term actions.

Let us take an example. Assume that a company has 20,000 outstanding shares and earnings available to shareholders is Rs 200,000. The EPS is (Rs 2,00,000/ 20,000), or Rs 10. Assume that the company borrows Rs 10,00,000 at an interest rate of 8 per cent to buy back 10,000 shares. Assuming an income tax rate of 40 per cent, the earnings available to shareholders after the shares are bought back will be [Rs 2,00,000 - (1.00 - 0.40) x Rs. 80,000] or 1.52,000. Accordingly, EPS will be reported at [Rs 1,52,000/10,000] or Rs 15.20.

Shortcomings of EPS

Indeed, financial economics tells us that (in the first approximation) these two effects cancel out exactly and the return on invested capital (ROIC) and the cost of capital do not change with a change in the capital structure. Accordingly, economic profit (often called EVA) too does not change with the change in the capital structure. Yet, the example above shows that the EPS can increase in such circumstances. Therefore, it is not correct to conclude that the increase in EPS always reflects better performance by the company.

For example, if a company finances a new project totally by debt, EPS will increase if the project returns are higher than the after-tax cost of debt, even if the project earns a return lower than the cost of capital (WACC) of the company. Although the EPS increases, such a project destroys value.

Shortcomings of EPS

Another important shortcoming of EPS is that it does not relate EPS with the invested capital. For example, two companies may have same EPS, even if one company has lower invested capital as compared to the other. Ignores the Scale and size of operations

Problems with EPS Reporting Standards

Complex Computation mechanism of Diluted EPS Basic EPS is subject to replacement on the income statement by two

hypothetical EPS numbers.

The test used to identify common stock equivalent securities is among the most controversial of those rules

Inability to pinpoint the meaning of common stock equivalency Changing relationships between the terms of particular securities and prevailing market conditions are not considered in the computational rules for EPS.

Do these complicated EPS disclosures assist investors and creditors in decision making? The answer is unclear. Millar, et. al., report in the September-October, 1987 Financial Analysts journal that basic EPS and cash flow per share numbers are more closely related to stock returns than either primary or fully diluted EPS. Additional research is needed to ascertain the relative usefulness of basic, primary and fully diluted EPS. In the mean time, accountants and auditors are saddled with complicated rules of questionable usefulness.

WRAP UP

Adhere to AS 20
Be practical and objective oriented

Make no little plans ; they have no magic to stir mens blood Daniel Hudson Burnham

THANK

YOU ONE AND ALL