Chapter 16, Problem 22P

Roseau Company is preparing its annual earnings per share amounts to be disclosed on its 2019 income statement. It has collected the following information at the end of 2019:

1. Net income: $120,400. Included in the net income is income from continuing operations of $130,400 and a loss from discontinued operations (net of income taxes) of $10,000. Corporate income tax rate: 30%.

2. Common stock outstanding on January 1, 2019: 20,000 shares.

3. Common stock issuances during 2019: July 6, 4,000 shares; August 24, 3,000 shares.

4. Stock dividend: On October 19, 2019, the company declared a 10% stock dividend that resulted in 2,700 additional outstanding shares of common stock.

5. Common stock prices: 2019 average market price, $30 per share; 2019 ending market price, $27 per share.

6. 7% preferred stock outstanding on January 1, 2019: 1,000 shares. Terms: $100 par, nonconvertible. Current dividends have been paid. No preferred stock issued during 2019.

7. 8% convertible preferred stock outstanding on January 1, 2019: 800 shares. The stock was issued in 2018 at $130 per share. Each $100 par preferred stock is currently convertible into 1.7 shares of common stock. Current dividends have been paid. To date, no preferred stock has been converted.

8. Bonds payable outstanding on January 1, 2019: $100,000 face value. These bonds were issued several years ago at 97 and pay annual interest of 9.6%. The discount is being amortized in the amount of $300 per year. Each $1,000 bond is currently convertible into 22 shares of common stock. To date, no bonds have been converted.

9. Compensatory share options outstanding: Key executives may currently acquire 3,000 shares of common stock at $20 per share. The options were granted in 2018. To date, none have been exercised. The unrecognized compensation cost (net of tax) related to the options is $4 per share.

Required:

1. Compute the basic earnings per share. Show supporting calculations.

2. Compute the diluted earnings per share. Show supporting calculations.

3. Show how Roseau would report these earnings per share figures on its 2019 income statement. Include an explanatory note to the financial statements.

To determine

Calculate the basic earnings per share and diluted earnings per share.

Explanation of Solution

Calculate the basic earnings per share and diluted earnings per share:

(Figure 1)

Working notes:

(1) Calculate the numerator for the basic earnings per share:

$\begin{array}{c}\text{Numerator earnings per share = Net income }-\left[\begin{array}{l}\text{Preferred dividend for 7\%+}\\ \text{Preferred dividend for 8\%}\end{array}\right]\\ =\$130,400-\left[(1000\times \$100\times 7\%)+\left(800\times \$100\times 8\%\right)\right]\\ =\$130,400-\left[7,000+\$6,400\right]\\ =\$117,000\end{array}$

(2) Calculate the number of shares used in computing the basic earnings per share:

(Figure 2)

(3) Calculate the increase in the share options:

$\begin{array}{c}\begin{array}{l}\text{Increase in the }\\ \text{share options}\end{array}\}\text{=}\left(\begin{array}{l}\text{Number of }\\ \text{shares issued }\end{array}\right)-\left[\frac{\left(\left(\begin{array}{l}\text{Number of }\\ \text{shares acquired}\end{array}\right)\times \left[\begin{array}{l}\text{Stock pric per share+}\\ \text{ Share option per share}\end{array}\right]\right)}{\text{Average per share}}\right]\\ =3,000-\left[\frac{3,000\times \left(\$20+\$4\right)}{\$30}\right]\\ =3,000-2,400\\ =600\end{array}$

(4) Calculate the impact of 8% preferred on diluted earnings per share and ranking:

$\begin{array}{c}\begin{array}{l}\text{8\% preferred on diluted}\\ \text{ earnings per share }\end{array}\}\text{=}\frac{\left(\text{Value of preferred stock}\right)\times \text{Percent of dividend }}{\left(\begin{array}{l}\text{Number of shares }\\ \text{outstanding}\\ \text{ in common stock}\end{array}\right)+\left(\begin{array}{l}\text{Additional shares on }\\ \text{bonds that are convertible }\end{array}\right)}\\ =\frac{\$80,000\times 8\%}{800\times 1.7}\\ =\frac{\$6,400}{1,360}\\ =\$4.71\end{array}$

(5) Calculate the impact of 9.6% bonds on diluted earnings per share and ranking:

$\begin{array}{c}\text{Diluted earnings per share =}\frac{\left(\begin{array}{l}\left\{\text{Net income obtained on 10}\text{.2\% bonds+Discount }\right\}\times \\ \text{Corporation income tax rate}\end{array}\right)}{\left(\begin{array}{l}\text{Number of shares of bonds}\\ \text{ convertible into common stock }\end{array}\right)}\\ =\frac{\left(\left\{\$100,000\times 9.6\%+\$300\right\}\right)\times \left(1-30\%\right)}{100\times 22}\\ =\frac{\$9,900\times 0.7}{2,200}\\ =\frac{\$6,930}{2,200}\end{array}$

$\text{ =3}\text{.15}$

Note:

• The Company has occurred loss form the discontinuing operations, the impact of the convertible security is compared with earnings per share that is related to income from continuing operations.
• The percentage of stock dividend that is required to identify the assumed shared outstanding is ascertained using below formula :

           $\begin{array}{c}\text{Total percent of stock dividend = 1+ Percent of stock dividend}\\ \text{=1+}1\text{0\%}\\ \text{=1}\text{.10}\end{array}$

To determine

Identify whether basic or diluted earnings per share will be reported by the Company R on its 2019 income statement.

Explanation of Solution

The Company R must report an amount of (6) $4.23 as basic earnings per  share and (7)  $4.05 as diluted earnings  per share in its 2019 income statement.

Working notes:

(6) Calculate the basic earnings per share after deducting loss from discontinuing operations:

$\begin{array}{c}\begin{array}{l}\text{Basic earnings per }\\ \text{share after deducting}\\ \text{loss from }\\ \text{discontinuing operations}\end{array}\}=\left(\begin{array}{l}\text{Basic earnings}\\ \text{ per share}\end{array}\right)-\left[\frac{\text{Loss from discontinued operations}}{\text{Weighted averages shares outstanding}}\right]\\ =\$4.62-\left[\frac{\$10,000}{25,300}\right]\\ =\$4.62-\$0.39\\ =\$4.23\end{array}$

(7) Calculate the basic earnings per share after deducting loss from discontinuing operations:

$\begin{array}{c}\begin{array}{l}\text{Diluted earnings per }\\ \text{share after deducting }\\ \text{loss from }\\ \text{discontinuing operations}\end{array}\}=\left(\begin{array}{l}\text{Diluted earnings }\\ \text{per share}\end{array}\right)-\left[\frac{\text{Loss from discontinued operations}}{\text{Weighted averages shares outstanding}}\right]\\ =\$4.41-\left[\frac{\$10,000}{28,100}\right]\\ =\$4.41-\$0.36\\ =\$4.05\end{array}$

Notes to financial statement:

Note 1: Basic earnings per share of the company are based on average common shares outstanding; 7% and 8% preferred dividends are deducted from net income to ascertain the earnings available to common shareholders. Diluted earnings per share are obtained from 600 shares of stock options and 2,200 shares of bonds that are convertible. Diluted earnings available to common shareholders are assumed to have no interest expense of $6,930 on the converted bonds.