Dilution \"I thought I understood earnings per share,\" lamented Brad Dawson, \"

Question

Dilution

"I thought I understood earnings per share," lamented Brad Dawson, "but you're telling me we need to pretend our convertivle bonds have been converted! Or maybe not?"

Dawson, your boss, is the new manager of the Fabricating division of BVT Corporation. His background is engineering and he has only a basic understand of earnings per share. Knowing you are an accounting graduate, he asks you to explain the questions he has about the calculation fo the company's EPS. His reaction is to your explanation that the company's convertible bonds might be included in this year's calculation.

"Put it in a memo!" he grumbled as he left your office.

Required:

Write a memo to Dawson. Explain the effect on earnings per share of each of the following:

1) Convertible securities

2) Antidilutive securities

Explanation / Answer

Convertible Securities:

A "convertible security" is a security—usually a bond or a preferred stock—that can be converted into a different security—typically shares of the company's common stock. In most cases, the holder of the convertible determines whether and when to convert. In other cases, the company has the right to determine when the conversion occurs.
Sometimes corporations include a conversion feature as part of a bond offering, a note payable, or an issue of preferred stock. Convertible securities can be converted into (exchanged for) shares of stock at the option of the holder of the security. For that reason, convertible securities are potentially dilutive. EPS will be affected if and when such securities are converted and new shares of common stock are issued. In the previous section you learned that the potentially dilutive effect of stock options is reflected in diluted EPS calculations by assuming the options were exercised. Similarly, the potentially dilutive effect of convertible securities is reflected in diluted EPS calculations by assuming they were converted.

By the if converted method as it's called, we assume the conversion into common stock occurred at the beginning of the period (or at the time the convertible security is issued, if that's later). We increase the denominator of the EPS fraction by the additional common shares that would have been issued upon conversion. We increase the numerator by the interest (after-tax) on bonds or other debt or the preferred dividends that would have been avoided if the convertible securities had not been outstanding due to having been converted.

Antidilutive securities would increase EPS if exercised or converted to common stock. Antidilutive securities are securities that upon conversion or exercise increase earnings per share (or reduce the loss per share) ,A term describing the effects of securities retirement, securities conversion or corporate actions (such as acquisitions made through the issuance of common stock or other securities) on earnings per common share (EPS), where EPS is increased for shareholders.

A transaction is considered to be antidilutive if its effect is to increase the amount of EPS, either by lowering the share count or increasing earnings.

A second use of the term refers to ownership rights, whereby existing shareholders in a certain class of shares have rights to purchase additional shares when there is a new issuance of securities that would otherwise reduce the ownership percentage of existing holders. This is called an anti-dilution provision. For illustration, recall the way we treated the stock options in our continuing illustration. In applying the treasury stock method, the number of shares assumed repurchased is fewer than the number of shares assumed sold. This is the case any time the buyback (average market) price is higher than the exercise price. Consequently, there will be a net increase in the number of shares, so earnings per share will decline.

On the other hand, when the exercise price is higher than the market price, to assume shares are sold at the exercise price and repurchased at the market price would mean buying back more shares than were sold. This would produce a net decrease in the number of shares. EPS would increase, not decrease. These would have an antidilutive effect and would not be considered exercised. In fact, a rational investor would not exercise options at an exercise price higher than the current market price anyway.

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