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Welcome back. Up to this point we've been talking about basic earnings per share.

Basic earnings per share is sufficient if all you have is a simple capital structure,

but once you get into having things such as options, stock options, warrants,

convertible preferred shares, convertible debt,

or other complex financial instruments that are classified in equity,

you're going to need to calculate a diluted earnings per share as well.

So in early lessons,

remember we talked about the accounting for conversion features,

so conversion and exercise it impacts basic earnings per share,

by changing the number of shares outstanding.

I think that's pretty easy to see.

GAAP requires a separate diluted earnings per share to be calculated "as if"

contingent shares were issued though even if the stocks have not yet been issued.

So we're going to look at two different things.

Of course if the shares are converted,

I'm going to consider them outstanding for the period

I've issued do I weighted average calculation.

But if they haven't been converted yet,

I'm going to calculate a separate earnings per share number,

diluted earnings per share.

And that's going to be calculated as if those contingent shares,

convertible shares, were actually converted.

And of course we're going to calculate that as if they were

converted when the convertible instrument was issued.

So if there's been outstanding for the entire period I would assume that

they were outstanding from the beginning of the period.

If the convertible stock,

or preferred stock or the convertible debt,

was issued partway through the reporting period I would do a weighted average.

If the convertible stock or the convertible that were

issued partway through the reporting period I

would use a weighted average when calculating the diluted earnings per share as well.

So here are some vocabulary;

dilution is a reduction in earnings per share

resulting from conversion of convertible securities,

exercise of options or warrants,

or issue of other shares under certain conditions.

This is from the FASB.

Diluted earnings per share then is earnings available to

each share of common stock outstanding

plus shares that would have been

outstanding if all dilutive potential shares were issued.

So, you could quote "subjunctive case

earnings per share" but we will call it

diluted earnings per share and like the FASB does.

So, let's look at the effect on the numerator.

So if the convertible securities,

are converted, well, we may have an effect on both the numerator and the denominator.

The issued shares is the effect on the denominator,

but what is the effect on the numerator?

Well, if there are preferred stock dividends,

I'm going to add back any of those preferred stock dividends because they wouldn't be

payable if their convertible preferred stock was in fact converted.

So, the amount of money that's available to my common shareholders would go up,

but of course a number of common shares would also go up.

What if it's convertible debt or convertible debt doesn't have dividends,

but it does have interest that would be paid on it,

but interest is also tax deductible as opposed to dividends.

So we're going to look at the after tax amount of

interest recognized in the period associated with any convertible debt.

So, if the debt had been converted,

I would not have incurred the interest,

if I had not incurred the interest,

I would not have had the deduction on my tax return,

hence I'm going to take

the after tax amount of interest recognized in the period when I'm

looking at using this "If-Converted" Method

for calculating diluted earnings per share and convertible debt.

So the numerator is also adjusted for

any other changes in incremental loss that would result from

the assumed conversion of shares and these could be profit sharing expenses for example.

What about the denominator?

Well the computation of diluted earnings per share is

similar to the computations of basic earnings per share except now

that denominator has increased to include

the number of additional common shares that would have been

outstanding as if the diluted potential common shares had been issued.

So I changed the numerator effect to reflect either dividends or interest,

I changed the denominator to

reflect the number of shares that would have been outstanding.

So let's take an example with preferred stock.

Let's look at Stone Cold again.

Recall that in the first quarter SCR had

$3,000,000 of income with 30,000 of preferred dividends,

and then we said there were 333,333 shares outstanding.

So what if that preferred stock is convertible into 600,000 shares of stock,

well we would have to adjust both the numerator and the denominator to

reflect dilution when calculating diluted earnings per share.

So, we would add back 30,000 of preferred dividends to

the numerator and add 600,000 shares to the denominator.

So now let's look at the two different metrics.

Remember previously, we calculated basic earnings per share

and that was the $3,000,000 of earnings minus the

30,000 of preferred stock dividends that are not available to the common shareholders.

And we got 89 cents per share when we divided it by the 3,333,333 shares outstanding.

Well, for diluted earnings per share if this was

the only dilutive item that was in SCR's capital structure,

we would have the 3,000,000 we would not subtract the 30,000,

but we would assume the conversion of

600,000 shares and since the preferred shares were outstanding for the entire period,

we would assume the common shares were outstanding for

the entire period and we would get 77 cents per share

rounded for the diluted earnings per share

assuming "as if" that preferred stock had been converted.

What if it had been convertible debt,

though instead of preferred stock,

well the calculation will nearly the same if it was debt,

but now we are going to use the after tax amount of

interest paid on the debt added back to the numerator.

After all again if the shares were converted no interest would have been paid,

if no interest was paid there would have been no tax deduction for interest expense.

So let's change our example.

So then instead of preferred stock,

SCR has debt that converts into 600,000 shares,

SCR paid $30,000 of interest during the period,

and has an effective tax rate of 20 percent.

So the numerator is adjusted by adding back net interest.

So that's $30,000 of interest was paid,

let's subtract 20 percent of 30,000.

This is the tax deduction that we would have gotten for that expense,

and so we have a net adjustment of 24,000,

the denominator has still increased by 600,000 shares so,

the denominator is increased by 600,000 shares.

So now we're going to adjust by adding back

that amount to the numerator so if the net income had been $3,000,000,

and we add back 24,000,

we'd have 3,024,000 of net income and

we'd still have an increase in the number of shares by 600,000.

So it's very similar to that preferred stock example.

The differences, we have to adjust for

the net tax effect because the interest is tax deductible.

So what if those shares were actually converted during

the period instead of being part of diluted earnings per share.

It's going to be part of a basic earnings per share

for the time when it's actually outstanding it'll go

into the weighted average which we calculate

basic earnings per share just like any other issuance of stock.

However, the diluted earnings per share would still use that "If-Converted"

Method for the portion of the period prior to exercise,

adjusting for net interest.

So, what you're going to see is you're still going to have to

adjust the numerator and the denominator

when calculated diluted earnings per share for the portion of

the period when the stock had not been converted.

The basic earnings per share is going to reflect

the amount of shares issued on the conversion.

Now don't forget you don't adjust with basic earnings per share,

you don't adjust the net interest paid up on the top

because that will already have been

included automatically in your calculation of net income.

That after tax adjustment for interest or adding back

the preferred stock dividends that only occurs in diluted earnings per share

and not in calculating basic earnings per share.

So let's change our example again,

now SCR has debt convertible into

600,000 shares and the debt is actually converted on March 1.

So SCR did pay $20,000 of interest from

January 1 to March 1 and has an effective tax rate of 20 percent.

So how is this going to affect our numerator and denominator?

Well let's look at the basic EPS first.

Again the 600,000 shares would be included on a weighted average.

So the denominator is adjusted by 600,000 times one-third equals 200,000 shares,

the numerator would not be changed.

Why? The interest was actually paid during

the first two quarters that was included in the net income,

and no interest was paid in the third month of the quarter,

so net income is already correct.

You're just going to change the numerator for the fact that you had shares issued.

But for basic earnings per share,

that's the correct answer for diluted earnings per share,

the denominator is going to be increased by an additional 400,000.

In other words as if the entire 600,000 shares were outstanding for

the whole period we increased it by 200,000 for basic earnings per share,

will increase by an additional 400,000 for diluted earnings per share.

We are going to show the 600,000 shares as if they were outstanding for the whole period.

So that's the "If-Converted" Method.

Now what about the numerator?

Well, we're just going to add back though

the net interest from the "If-Converted" period,

we're not going to make an adjustment when interest was not paid in the third month.

So we have the $20,000 of interest that was paid during the first two months,

we'll take the after tax effect by taking

the effective tax rate times the amount of

the deduction you would have taken which would be $4,000.

So, the after tax amount would be $16,000.

So we will adjust the numerator by $16,000,

well just the denominator by an additional

400,000 or 600,000 shares total when calculating the diluted earnings per share.

And that's pretty much the "If-Converted" Method.

We're going to look at the stocks as if they had

been converted at the time when the convertible instrument was issued.

Unless of course the instrument is actually converted during the period,

in which case we'll look at the impact on

basic earnings per share based upon the conversion without changing the numerator

and looking at the incremental impact on

diluted earnings per share by assuming as if there had been outstanding in

the entire period and adjusting for

either any net interest or any preferred stock dividends

that were payable during the period. Thank you.