Earnings Per Share (EPS) Calculations: CPA FAR Exam Guide
Master basic and diluted EPS calculations for the CPA FAR exam. Covers weighted-average shares, convertible securities, stock options, and the treasury stock method.
Overview of EPS Under ASC 260
Earnings per share is one of the most important metrics reported on the income statement. ASC 260 requires public entities to present both basic EPS and diluted EPS on the face of the income statement for income from continuing operations and for net income. EPS calculations are a staple of the CPA FAR exam and appear in both multiple-choice and simulation formats.
Basic Earnings Per Share
Basic EPS measures earnings available to common shareholders on a per-share basis. The formula is:
Basic EPS = (Net Income - Preferred Dividends) / Weighted-Average Common Shares Outstanding
Numerator: Income Available to Common Shareholders
Start with net income and subtract preferred dividends. For cumulative preferred stock, subtract the current-year dividend whether or not declared. For noncumulative preferred stock, subtract only dividends that were actually declared during the period.
Denominator: Weighted-Average Shares Outstanding
The weighted-average calculation considers shares outstanding during each portion of the period. Shares issued during the year are weighted by the fraction of the year they were outstanding. Treasury stock repurchased during the year reduces the weighted average from the date of repurchase.
Stock dividends and stock splits are treated as if they occurred at the beginning of the earliest period presented. This means they are applied retroactively when computing the weighted-average shares outstanding, even if the dividend or split occurred during or after the current period but before the financial statements are issued.
Diluted Earnings Per Share
Diluted EPS reflects the potential dilution that would occur if all dilutive securities were converted into common stock. The formula starts with basic EPS and adjusts both the numerator and denominator for the effects of potentially dilutive securities.
The If-Converted Method: Convertible Securities
For convertible bonds, the numerator is adjusted by adding back the after-tax interest expense on the convertible bonds (since the bonds would no longer be outstanding if converted). The denominator is increased by the number of common shares that would be issued upon conversion, weighted for the period the bonds were outstanding.
For convertible preferred stock, the numerator is adjusted by adding back the preferred dividends that were subtracted in the basic EPS calculation. The denominator is increased by the number of common shares issuable upon conversion.
The Treasury Stock Method: Stock Options and Warrants
Under the treasury stock method, it is assumed that the proceeds from the exercise of options and warrants are used to repurchase common shares at the average market price during the period. Only the incremental shares (shares issued upon exercise minus shares assumed repurchased) are added to the denominator. The numerator is not adjusted.
Example: An entity has 10,000 options outstanding with an exercise price of $20. The average market price during the period is $50. Upon assumed exercise, 10,000 shares would be issued and $200,000 in proceeds would be received. At $50 per share, the proceeds would buy back 4,000 shares. The incremental shares added to the denominator are 6,000 (10,000 minus 4,000).
Options and warrants are dilutive only when the exercise price is below the average market price (in the money). If the exercise price exceeds the average market price, the options are antidilutive and are excluded from diluted EPS.
Antidilution
A potentially dilutive security is antidilutive if its inclusion would increase EPS or decrease the loss per share. Antidilutive securities are excluded from diluted EPS. The test for dilution must be applied individually to each potentially dilutive security, and they are included in diluted EPS in order from most dilutive to least dilutive (the ranking approach ensures that a security that is individually dilutive but would be antidilutive in combination with others is correctly excluded).
Contingently Issuable Shares
Shares that are issuable upon the satisfaction of certain conditions (such as achieving a performance target) are included in diluted EPS if the conditions are currently met as of the end of the reporting period. They are included in basic EPS only if all conditions have been satisfied and the shares are issuable for no additional consideration.
Presentation Requirements
EPS must be presented on the face of the income statement for income from continuing operations and for net income. EPS for discontinued operations may be presented on the face or in the notes. Per-share amounts for each component must be computed using the same denominator.
Exam Preparation Tips
- Always compute basic EPS first, then diluted EPS.
- Memorize the treasury stock method for options and warrants and the if-converted method for convertible securities.
- Stock dividends and stock splits are retroactive; adjust the denominator for all periods presented.
- Test each potentially dilutive security individually for dilution before including it in diluted EPS.
- Remember: for cumulative preferred stock, subtract the annual dividend from net income whether declared or not.
Practice What You Learned
Study with 1,200+ flashcards and 140 practice exams across all 4 CPA sections.