EPS looks like division, and that is why errors survive review. The numerator is adjusted for preferred dividends and participating securities, the denominator is a weighted average, and diluted EPS adds instruments in a prescribed order. A wrong share count or a missed deemed dividend moves the one number investors read first.
This guide works each calculation with small numbers so a reviewer can recompute the footnote.
Who must present EPS?
ASC 260 requires EPS for entities with publicly traded common stock or potential common stock, such as options or warrants, and for entities that have filed or are filing with a regulator to sell securities in a public market. A private company may elect to present EPS, and if it does, it must follow all of ASC 260. EPS is not required for investment companies under ASC 946 or for the statements of wholly-owned subsidiaries.
Basic EPS
Basic EPS is income available to common stockholders divided by the weighted average number of common shares outstanding. EPS is presented for income from continuing operations, if applicable, and for net income. Discontinued operations EPS can be on the face of the income statement or in the notes.
Numerator adjustments. Deduct dividends declared on preferred stock and cumulative preferred dividends whether or not declared. When a loss is reported, the preferred adjustment increases the loss. When preferred stock is redeemed for more than its carrying amount, the excess is a deemed dividend that reduces the numerator.
An illustration. Preferred stock carried at $1,000,000 is redeemed for $1,200,000.
| Account | Debit | Credit |
|---|---|---|
| Preferred stock | 1,000,000 | |
| Retained earnings | 200,000 | |
| Cash | 1,200,000 |
The $200,000 reduces income available to common stockholders in basic EPS.
Denominator. An illustration. Net income is $500,000 and preferred dividends are $50,000. There are 100,000 common shares at the start of the year, and 20,000 more are issued on October 1.
- Weighted average shares: 100,000 + (20,000 x 3/12) = 105,000
- Income available to common: $500,000 - $50,000 = $450,000
- Basic EPS: $450,000 / 105,000 = $4.29
The two-class method
A participating security shares in undistributed earnings with common stock, so its holders are allocated earnings even when no dividends are paid. Undistributed earnings are allocated as if all earnings were distributed, using contractual participation rights. A participating security absorbs losses only if it has a contractual obligation to share them on an objectively determinable basis.
An illustration. Net income is $50,000,000. There are 10,000,000 common shares and 2,000,000 convertible preferred shares, each convertible into 3 common shares. Common dividends are $20,000,000 and preferred dividends are $12,000,000.
| Step | Amount |
|---|---|
| Net income | 50,000,000 |
| Less dividends declared (20,000,000 + 12,000,000) | (32,000,000) |
| Undistributed earnings | 18,000,000 |
| Common share of undistributed: 10M / 16M x 18M | 11,250,000 |
| Preferred share of undistributed: 6M / 16M x 18M | 6,750,000 |
| Income allocated to common (50,000,000 - 12,000,000 - 6,750,000) | 31,250,000 |
Basic EPS to common is $31,250,000 / 10,000,000 = $3.13.
Diluted EPS
Diluted EPS adjusts the numerator and the denominator for the presumed issuance of potential common shares, weighted from the start of the period or from issuance if later.
How does the treasury stock method work?
It applies to options, warrants and similar instruments. Assume exercise at the start of the period or issuance if later, assume the proceeds buy back shares at the average market price for the period, and count the net increase in shares. For stock compensation, assumed proceeds include the average unrecognized compensation cost. An option or warrant is anti-dilutive, and excluded, when its exercise price (plus unrecognized compensation cost per share for stock awards) is above the average market price.
An illustration. A company has 500,000 warrants with a $10 exercise price, and the average market price for the year is $20.
- Assumed proceeds: 500,000 x $10 = $5,000,000
- Shares repurchased: $5,000,000 / $20 = 250,000
- Incremental shares: 500,000 - 250,000 = 250,000
How does the if-converted method work?
ASU 2020-06 requires the if-converted method for convertible instruments and says the treasury stock method should no longer be used for them. Convertible instruments are assumed converted at the start of the period or at issuance if later. Interest charges on convertible debt are added back to the numerator, net of tax, and dividends on convertible preferred stock are added back. Interest is not added back on convertible debt whose principal must be paid in cash, and only the conversion premium enters the share count. Conversion is not assumed when it would be anti-dilutive. The calculation does not depend on the stock price compared to the conversion price.
An illustration. A company issues $10 million of 2% convertible bonds at par, convertible into 8 shares per $1,000 bond, or 80,000 shares. The after-tax interest add-back is $30,000 a quarter ($50,000 less $20,000 of tax at 40%). Quarterly net income is $50 million and weighted average shares are 10 million.
| Basic | Diluted | |
|---|---|---|
| Numerator | 50,000,000 | 50,030,000 |
| Denominator | 10,000,000 | 10,080,000 |
| EPS | $5.00 | $4.96 |
The bonds are dilutive because diluted EPS is lower than basic.
What order do dilutive securities go in?
The control number is income or loss from continuing operations, adjusted for preferred dividends. Each issue is tested separately, then instruments are included from most dilutive to least dilutive, meaning the lowest earnings per incremental share first. The same potential share count used for continuing operations is applied to discontinued operations and net income. Year-to-date diluted EPS may not equal the sum of the quarters.
Required disclosures
- A reconciliation of the numerators and denominators of basic and diluted EPS for income from continuing operations, with the individual effects of all securities that affect EPS.
- The effect of preferred dividends on basic EPS.
- Securities that could dilute basic EPS in the future but were excluded as anti-dilutive, with their terms.
- A description of transactions after period end and before issuance that would have materially changed the common or potential common shares outstanding.
- Retroactive adjustment of all periods presented for stock dividends and splits.
Audit angle
- Check the requirement. Public or filing entities must present EPS. For a private client that elected EPS, check that all of ASC 260 is applied.
- Rebuild the share roll. Agree beginning shares, issuances, repurchases and conversions to the stock ledger and transfer agent records, then recompute the weighted average.
- Recompute the numerator. Agree preferred dividends, including cumulative undeclared amounts, and deemed dividends on redemptions to the equity rollforward. See /us/blog/statement-of-stockholders-equity-rollforward-guide.
- Identify participating securities. Read the terms of preferred stock, restricted stock and warrants for participation and loss absorption.
- Recompute dilution. For options and warrants, recompute proceeds using average prices and unrecognized compensation. For convertibles, recompute the add-back and tax effect. See /us/standards/asc-470-20-convertible-debt-asu-2020-06.
- Check the order and the control number. Check that anti-dilutive instruments are excluded and the control number is continuing operations.
- Agree the reconciliation footnote. Tie the table to the income statement and to the recomputation.
Common misstatements: period-end shares instead of weighted shares, preferred dividends ignored in a loss year, current stock price used instead of the average price, and anti-dilutive securities included in diluted EPS.
CORAA prepares ready-to-review audit files for US CPA firms from QuickBooks books; you review and sign. See /us.
Sources
- PwC Viewpoint, Financial statement presentation guide, 7.4 Basic EPS: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_7_earnings_p_US/74_basic_eps_US.html
- PwC Viewpoint, Financial statement presentation guide, 7.5 Diluted EPS: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_7_earnings_p_US/75_diluted_eps_US.html
- PwC Viewpoint, Financial statement presentation guide, 7.2 Scope and relevant guidance: https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/chapter_7_earnings_p_US/72_scope_and_relevan_US.html
- FASB, ASU 2020-06 (if-converted method required for convertible instruments, cash-settled principal, effective dates): https://storage.fasb.org/ASU%202020-06.pdf
- RSM, Financial reporting insights: Earnings per share (October 2024; scope, participating securities, dilution order, disclosures): https://rsmus.com/content/dam/rsm/insights/financial-reporting/1pdf/financial-reporting-insights-earnings-per-share-202410.pdf
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