Unit 5 Discussion: The Effects of Dilutive Securities on Earnings per Share

Organizations with complex capital structures offer securities, such as convertible securities, preferred stock, options or warrants. These securities can have a significant impact on the organizations basic Earnings per Share (EPS) computation. In order to prevent investors and creditors from being misled by the basic EPS, the firm must compute another EPS calculation that accounts for the dilutive effects of these securities.

In general, consolidated EPS is computed the same way for the parent company as it would be for a single company. The computation for consolidated diluted EPS, however, is more complicated. This is because in computing the diluted EPS, the parents percentage of ownership changes when a subsidiarys convertible securities are treated as common stock.

For example, if a parent has a 60% ownership interest, without considering the effects of dilutive securities, it may have a smaller interest once the convertible securities are considered. If the parent owns 600,000 of 1,000,000 shares outstanding they have a 60% interest; however, if after considering the effects of the additional potential shares, the parent may have 600,000 out of 1,250,000 shares, which is then only a 48% interest. Additionally, dividends declared can affect consolidated net income.

Instructions:

1. Go to the FASB website www.fasb.org
2. Access the Free Basic version of the Accounting Standards Codification. You will need to register to access the free basic version.
3. From the FASB home page, select the Standards link.
4. From the Standards tab, click Accounting Standards Codification.
5. Select the Order Professional or Basic View link.
6. Create an account and register. Once you have registered, from the Accounting Standards Codification Basic View main page, select Presentation.
7. Select FASB ASC 260, Earnings per Share. Read through the topic information for guidance and illustrations for computing diluted EPS. Specifically, focus your reading on paragraphs 260-10-55-20 and 260-10-55-64.

Read the following scenario:

Scenario Company B is a subsidiary of First Corp. and is considering issuing the following types of securities: convertible 8% preferred stock and convertible 8% debentures. Both securities are convertible for 10 shares of common stock.

Discuss

Jane Smith, the CFO for the parent First Corp., asks you to discuss the relative effects of offering these securities. Specifically, she would like you to address:

1. Which security, if converted, would have the greatest impact on Company Bs Basic EPS?
2. Which security, if converted, would cause the larger increase in Consolidated Net Income?
3. How will Consolidated Net Income be affected?

Discuss the impact of the above questions and make a recommendation to the CFO on which security would be the most prudent for Company B to offer. Be sure to use citations of and quotations from the authoritative literature to support your arguments.

Title your Post with your recommendation, i.e. Preferred stock, or 70%-30% Combination. Try to choose a method that has not been used more than once so that we will have some variety in our conversations.