Simple Capital Structure

A simple capital structure may be said to exist either when the capital structure consists solely of ordinary shares or when it includes no potential ordinary shares, which could be in the form of options, warrants or other rights, that on conversion or exercise could, in the aggregate, dilute earnings per share. Dilutive securities are essentially those that exhibit the rights of debt or other senior security holders (including warrants and options) and which have the potential on their issuance to reduce the earnings per share.

Denominator

The weighted-average number of ordinary shares outstanding is used to calculate the denominator. The difficulty in computing the weighted-average exists because of the effect that various transactions have on the computation of ordinary shares outstanding. Although it is impossible to analyse all the possibilities, the following discussion presents some of the more common transactions affecting the number of ordinary shares outstanding.

If a company reacquires its own shares in countries where it is legally permissible to do so, the number of shares reacquired (referred to as treasury shares) should be excluded from EPS calculations from the date of acquisition. The same computational approach holds for the issuance of ordinary shares during the period. The number of shares newly issued is included in the computation only for the period after their issuance date. The logic for this treatment is that since the consideration for the shares was not available to the reporting entity, and hence could not contribute to the generation of earnings, until the shares were issued, the shares should not be included in the EPS computation prior to issuance. This same logic applies to the reacquired shares because the consideration expended in the repurchase of those shares was no longer available to generate earnings after the reacquisition date.

A share dividend (bonus issue) or a share split does not generate additional resources or consideration, but it does increase the number of shares outstanding. The increase in shares as a result of a share split or dividend, or the decrease in shares as a result of a reverse split, should be given retrospective recognition for all periods presented. Thus, even if a share dividend or split occurs at the end of the period, it is considered effective for the entire period of each (i.e., current and historical) period presented. The reasoning is that a share dividend or split has no effect on the ownership percentage of ordinary shares, and likewise has no impact on the resources available for productive investment by the reporting entity. As such, to show a dilution in the EPS in the period of the split or dividend would erroneously give the impression of a decline in profitability when in fact it was merely an increase in the shares outstanding due to the share dividend or split. Furthermore, financial statement users' frame of reference is the number of shares outstanding at the end of the reporting period, including shares resulting from the split or dividend, and using this in computing all periods' EPS serves to most effectively communicate to them.

Complications also arise when a business combination occurs during the period. In a combination accounted for as an acquisition the shares issued in connection with a business combination are considered issued as of the date of acquisition and the income of the acquired company is included only for the period after acquisition.

IAS 33 recognises that in certain countries it is permissible for ordinary shares to be issued in partly paid form, and the standard accordingly stipulates that partly paid instruments should be included as ordinary share equivalents to the extent to which they carry rights (during the financial reporting year) to participate in dividends in the same manner as fully paid shares.

Further, in the case of contingently issuable shares (i.e., ordinary shares issuable on fulfilment of certain conditions, such as achieving a certain level of profits or sales), IAS 33 requires that such shares be considered outstanding and included in the computation of basic earnings per share only when all these required conditions have been satisfied.

IAS 33 gives examples of situations where ordinary shares may be issued, or the number of shares outstanding may be reduced, without causing corresponding changes in resources of the corporation. Such examples include bonus issues, a bonus element in other issues such as a rights issue (to existing shareholders), a share split, a reverse share split and a capital reduction without a corresponding refund of capital. In all such cases, the number of ordinary shares outstanding before the event is adjusted, as if the event had occurred at the beginning of the earliest period reported. For instance, in a “5-for-4 bonus issue” the number of shares outstanding prior to the issue is multiplied by a factor of 1.25. These and other situations are summarised in the tabular list that follows.

Weighted-Average (W/A) Computation
Transaction	Effect on W/A computation
Ordinary shares outstanding at the beginning of the period	Increase number of shares outstanding by the number of shares
Issuance of ordinary shares during the period	Increase number of shares outstanding by the number of shares issued weighted by the portion of the year the ordinary shares are outstanding
Conversion into ordinary shares	Increase number of shares outstanding by the number of shares converted weighted by the portion of the year shares are outstanding
Company reacquires its shares	Decrease number of shares outstanding by the number of shares reacquired times the portion of the year outstanding
Share dividend or split	Increase number of shares outstanding by the number of shares issued or increased due to the split
Reverse split	Decrease number of shares outstanding by decrease in shares
Acquisition	Increase number of shares outstanding by the number of shares issued weighted by the portion of year since the date of acquisition

Rights offerings are used to raise additional capital from existing shareholders. These involve the granting of rights in proportion to the number of shares owned by each shareholder (e.g., one right for each 100 shares held). The right gives the holder the opportunity to purchase a share at a discounted value, as an inducement to invest further in the entity and in recognition of the fact that, generally, rights offerings are less costly as a means of floating more shares, versus open market transactions which involve fees to brokers. In the case of rights shares, the number of ordinary shares to be used in calculating basic EPS is the number of ordinary shares outstanding prior to the issue, multiplied by the following factor:

There are several ways to compute the theoretical value of the shares on an ex-rights basis. IAS 33 suggests that this be derived by adding the aggregate fair value of the shares immediately prior to exercise of the rights to the proceeds from the exercise, and dividing the total by the number of shares outstanding after exercise.

To illustrate, consider that the entity currently has 10,000 shares outstanding, with a market value of €15 per share, when it offers each holder rights to acquire one new share at €10 for each four shares held. The theoretical value ex-rights would be given as follows:

Thus, the ex-rights value of the ordinary shares is €14 each. The foregoing does not characterise all possible complexities arising in the EPS computation; however, most of the others occur under a complex structure which is considered in the following section of this chapter. The illustration below applies the foregoing concepts to a simple capital structure.

Complex Capital Structure

The computation of EPS under a complex capital structure involves all of the complexities discussed under the simple structure and many more. By definition, a complex capital structure is one that has dilutive potential ordinary shares, which are shares or other instruments that have the potential to be converted or exercised and thereby reduce EPS. The effects of any antidilutive potential ordinary shares (those that would increase EPS) are not to be included in the computation of diluted earnings per share. Thus, diluted EPS can never provide a more favourable impression of financial performance than the basic EPS.

Note that a complex structure requires dual presentation of both basic EPS and diluted EPS even when the basic earnings per share is a loss per share. Under the current standard, both basic and diluted EPS must be presented, unless diluted EPS would be antidilutive.

For the purposes of calculating diluted EPS, the profit or loss attributable to ordinary equity holders and the weighted-average number of ordinary shares outstanding should be adjusted for the effects of the dilutive potential ordinary shares. That is, the presumption is that the dilutive securities have been converted or exercised, with ordinary shares being outstanding for the entire period, and with the effects of the dilution removed from earnings (e.g., interest or dividends). In removing the effects of dilutive securities that in fact were outstanding during the period, the associated tax effects must also be eliminated, and all consequent changes—such as employee profit-sharing contributions that are based on reported profit or loss—must similarly be adjusted.

According to IAS 33, the numerator, representing the profit or loss attributable to the ordinary equity holders for the period, should be adjusted by the after-tax effect, if any, of the following items:

1. Interest recognised in the period for the convertible debt which constitutes dilutive potential ordinary shares;
2. Any dividends recognised in the period for the convertible preferred shares which constitute dilutive potential ordinary shares, where those dividends have been deducted in arriving at net profit attributable to ordinary equity holders; and
3. Any other consequential changes in profit or loss that would result from the conversion of the dilutive potential ordinary shares.

For example, the conversion of debentures into ordinary shares will reduce interest expense, which in turn will cause an increase in the profit for the period. This will have a consequential effect on contributions based on the profit figure, for example, the employer's contribution to an employee profit-sharing plan. The effect of such consequential changes on profit or loss available for ordinary equity holders should be considered in the computation of the numerator of the diluted EPS ratio.

The denominator, which has the weighted number of ordinary shares, should be adjusted (increased) by the weighted-average number of ordinary shares that would have been outstanding assuming the conversion of all dilutive potential ordinary shares.

Determining Dilution Effects

In the foregoing example, the assumed conversion of the convertible debentures proved to be dilutive. If it had been antidilutive, presentation of the (more favourable) diluted EPS would not be permitted under IFRS. To ascertain whether the effect would be dilutive or antidilutive, each potential ordinary share issue (i.e., each convertible debenture, convertible preferred or other issuance outstanding having distinct terms) must be evaluated separately from other potential ordinary share issuances. Since the interactions among potential ordinary share issues might cause diluted EPS to be moderated under certain circumstances, it is important that each issue be considered in the order of decreasing effect on dilution. In other words, the most dilutive of the potential ordinary share issues must be dealt with first, then the next most dilutive, and so on.

Potential ordinary shares are generally deemed to have been outstanding ordinary shares for the entire reporting period. However, if the potential shares were only first issued, or became expired or were otherwise cancelled during the reporting period, then the related ordinary shares are deemed to have been outstanding for only a portion of the reporting period. Similarly, if potential shares are exercised during the period, then for that part of the year the actual shares outstanding are included for purposes of determining basic EPS, and the potential (i.e., unexercised) shares are used in the determination of diluted EPS by deeming these to have been exercised or converted for only that fraction of the year before the exercise occurred.

Contingent Issuances of Ordinary Shares

As for the computation of basic EPS, shares whose issuance is contingent on the occurrence of certain events are considered outstanding and included in the computation of basic EPS only if the stipulated conditions have been met (i.e., the event has occurred). If at the end of the reporting period the triggering event has not occurred, issuance of the contingently issuable shares is not to be assumed for the computation of basic EPS.

Issuances that are dependent on certain conditions being met can be illustrated as follows. Assume that a condition or requirement exists in a contract to increase earnings over a period of time to a certain stipulated level and that, upon attainment of this targeted level of earnings, the issuance of shares is to take place. This is regarded as a contingent issuance of shares for purposes of applying IAS 33. If the condition is met at the end of the reporting period, the effect is included in basic EPS, even if the actual issuance takes place after year-end (e.g., upon delivery of the audited financial statements, per terms of the contingency agreement).

If the condition must be met and then maintained for a subsequent period, such as for a two-year period, then the effect of the contingent issuance is excluded from basic EPS, but is included in diluted EPS. In other words, the contingent shares, which will not be issued until the defined condition is met for two consecutive years, are assumed to be met for diluted EPS computation if the condition is met at the end of the reporting period. Meeting the terms of the contingency for the current period forms the basis for the expectation that the terms may again be met in the subsequent period, which would trigger the issuance of the added shares, causing dilution of EPS.

In some instances, the terms of the contingent issuance arrangement make reference to share prices over a period of time extending beyond the end of the reporting period. In such instances, if issuance is to be assumed for purposes of computing diluted EPS, only the prices or other data through the end of the reporting period should be deemed pertinent to the computation of diluted EPS. Basic EPS is not affected, of course, since the contingent condition is not met at the end of the reporting period.

IAS 33 identifies circumstances in which the issuance of contingent shares is dependent upon meeting both future earnings and future share price threshold levels. Reference must be made to both these conditions, as they exist at the end of the reporting period. If both threshold conditions are met, the effect of the contingently issuable shares is included in the computation of diluted EPS.

The standard also cites circumstances where the contingency does not pertain to market price of ordinary shares or to earnings of the reporting entity. One such example is the achievement of a defined business expansion goal, such as the opening of a targeted number of retail outlets; other examples could be the achievement of a defined level of gross revenues, or development of a certain number of commercial contracts. For purposes of computing diluted EPS, the number of retail outlets, level of revenue, etc., at the end of the reporting period are to be presumed to remain constant until the expiration of the contingency period.

Contracts Which May Be Settled in Shares or for Cash

Increasingly complex financial instruments have been issued by entities in recent decades. Among these are obligations that can be settled in cash or by the issuance of shares, at the option of the debtor (the reporting entity). Thus, debt may be incurred and later settled, at the entity's option, by increasing the number of its ordinary shares outstanding, thereby diluting EPS but averting the need to disperse its resources for purposes of debt retirement.

Note that this situation differs from convertible debt, discussed above, as it is the debtor, not the debt holder, which has the right to trigger the issuance of shares.

It is to be presumed that the debtor will elect to issue shares to retire this debt, if making that assumption results in a dilution of EPS. This is assumed for the calculation of diluted EPS, but is not included in basic EPS.

A similar result obtains when the reporting entity has written (i.e., issued) a call option to creditors, giving them the right to demand shares instead of cash in settlement of an obligation. Again, if dilutive, share issuance is to be presumed for diluted EPS computation purposes.

Sequencing of Dilution Effects

The sequence followed in testing the dilution effects of each of several series of convertible securities may affect the outcome, although this is not always true. It is best to perform the sequential procedures by computing the impact of each issue of potential ordinary shares from the most dilutive to the least dilutive. This rule also applies if convertible securities (for which the if-converted method will be applied) and options (for which the treasury stock approach will be applied) are outstanding simultaneously.

To determine the sequencing of the dilution analysis, it is necessary to use a “trial and error” approach. However, options and warrants should be dealt with first, since these will not affect the numerator of the EPS equation, and thus are most dilutive in their impact. Convertible securities are dealt with subsequently, and these issues will affect both numerator and denominator, with varying dilutive effects.

No antidilution. No assumptions of conversion should be made if the effect would be antidilutive. As in the discussion above, it may be that the sequence in which the different issues or series of convertible or other instruments that are potentially ordinary shares are considered will affect the ultimate computation. The goal in computing diluted EPS is to calculate the maximum dilutive effect. The individual issues of convertible securities, options and other items should be dealt with from the most dilutive to the least dilutive to effect this result.

Presentation and Disclosure Requirements Under IAS 33

Entities should disclose amounts used as the numerator in calculating basic EPS and diluted EPS along with a reconciliation of those amounts to profit or loss for the period. Disclosure is also required of the weighted-average number of ordinary shares used as the denominator in calculating basic EPS and diluted EPS along with a reconciliation of these denominators to each other, including instruments (i.e., contingently issuable shares) that could potentially dilute basic EPS in the future, but were not included in the calculation of diluted EPS because they were antidilutive for the period(s) presented.

If an entity chooses to disclose per share amounts using a reported component of the separate statement of profit or loss other than profit or loss for the period attributable to ordinary equity holders, such amounts should be calculated using the weighted-average number of ordinary shares determined in accordance with the requirements of IAS 33; this will ensure comparability of the per share amounts disclosed.

In cases where an entity chooses to disclose the above per share amounts using a reported component of the separate statement of profit or loss, other than profit or loss for the year, a reconciliation is mandated by the standard, which should reconcile the difference between the reported component of profit or loss and profit or loss reported in the statement of profit or loss and comprehensive income or separate statement of profit or loss presented.

When additional disclosure is made by an entity of the above per share amounts, basic and diluted per share amounts should be disclosed with equal prominence (just as basic EPS and diluted EPS figures are given equal prominence).

Entities are encouraged to disclose the terms and conditions of financial instruments or contracts generating potential ordinary shares since such terms and conditions may determine whether or not any potential ordinary shares are dilutive and, if so, the effect on the weighted-average number of shares outstanding and any consequent adjustments to profit or loss attributable to the ordinary equity holders.

If changes (resulting from a bonus issue or share split, etc.) in the number of ordinary or potential ordinary shares occur after the end of the reporting period but before issuance of the financial statements, and the per share calculations reflect such changes in the number of shares, such a fact should be disclosed.

Entities are also encouraged to disclose a description of ordinary share transactions or potential ordinary share transactions other than capitalisation issues and share splits, occurring after the end of the reporting period that are of such importance that non-disclosure would affect the ability of the users of the financial statements to make proper evaluations and decisions.