The consolidation process affects one other intermediate accounting topic, the computation of earnings per share (EPS). Publicly held companies must disclose EPS each period.
The following steps calculate such figures:
• Determine basic EPS by dividing the parent’s share of consolidated net income (after reduction for preferred stock dividends) by the weighted average number of common stock shares outstanding for the period. If the reporting entity has no dilutive options, warrants, or other convertible items, only basic EPS is presented on the face of the income statement.
However, diluted EPS also must be presented if any dilutive convertibles are present.
• Compute diluted EPS by combining the effects of any dilutive securitieswith basic earn- ings per share. Stock options, stock warrants, convertible debt, and convertible preferred stock often qualify as dilutive securities.10
In most instances, the computation of EPS for a business combination follows the same general pattern. Consolidated net income attributable to the parent company owners along with the number of outstanding parent shares provides the basis for calculating basic EPS. Any convertibles, warrants, or options for the parent’s stock that can possibly dilute the reported figure must be included as described earlier in determining diluted EPS.
However, a problem arises if warrants, options, or convertibles that can dilute the sub- sidiary’s earnings are outstanding. Although the parent company is not directly affected, the potential impact of these items on their share of consolidated net income must be given weight in computing diluted EPS for the consolidated income statement. Because of possible conversion,
LO5
Compute basic and diluted earnings per share for a business combination.
10Complete coverage of the EPS computation can be found in virtually any intermediate accounting textbook. To adequately understand this process, a number of complex procedures must be mastered, including these:
• Calculation of the weighted average number of common shares outstanding.
• Understanding the method of including stock rights, convertible debt, and convertible preferred stock within the computation of diluted EPS.
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the subsidiary earnings figure included in consolidated net income is not necessarily applica- ble to the diluted EPS computation. Thus, the accountant must separately determine the par- ent’s share of subsidiary income that should be used in deriving diluted EPS.
Finally, the focus is on earnings per share for the parent company stockholders, even in the presence of a noncontrolling interest. As stated in the FASB ASC (para. 260-10-45-11A):
For purposes of computing EPS in consolidated financial statements (both basic and diluted), if one or more less-than-wholly-owned subsidiaries are included in the consolidated group, income from continuing operations and net income shall exclude the income attributable to the noncontrolling interest in subsidiaries.
Thus, consolidated income attributable to the parent’s interest forms the basis for the numera- tor in all EPS calculations for consolidated financial reporting.
Earnings per Share Illustration
Assume that Big Corporation has 100,000 shares of its common stock outstanding during the current year. The company also has issued 20,000 shares of nonvoting preferred stock, paying an annual cumulative preferred dividend of $5 per share ($100,000 total). Each of these pre- ferred shares is convertible into two shares of Big’s common stock.
Assume also that Big owns 90 percent of Little’s common stock and 60 percent of its pre- ferred stock (which pays $12,000 in preferred dividends per year). Annual amortization is
$26,000 attributable to various intangibles. EPS computations currently are being made for 2011. During the year, Big reported separate income of $600,000 and Little earned $100,000.
A simplified consolidation of the figures for the year indicates consolidated net income attributable to Big of $663,000:
Big’s separate income for 2011 . . . $600,000 Little’s separate income for 2011 . . . $100,000
Amortization expense resulting from original fair-value allocation. . . (26,000)
Little’s income after excess fair-value amortization . . . 74,000 Consolidated net income . . . $674,000
Noncontrolling interest in Little––common stock
(10% of $74,000 income after $12,000 in preferred stock dividends) $ (6,200) Noncontrolling interest in Little––
preferred stock (40% of dividends) . . . (4,800)
Total noncontrolling interest in consolidated net income . . . (11,000) Consolidated net income attributable to Big (parent) . . . $663,000
Little has 20,000 shares of common stock and 4,000 shares of preferred stock outstanding.
The preferred shares pay a $3 per year dividend, and each can be converted into two shares of common stock (or 8,000 shares in total). Because Big owns only 60 percent of Little’s pre- ferred stock, a $4,800 dividend is distributed each year to the outside owners (40 percent of
$12,000 total payment).
Assume finally that the subsidiary also has $200,000 in convertible bonds outstanding that were originally issued at face value. This debt has a cash and an effective interest rate of 10 percent ($20,000 per year) and can be converted by the owners into 9,000 shares of Little’s common stock. Big owns none of these bonds. Little’s tax rate is 30 percent.
To better visualize these factors, the convertible items are scheduled as follows:
264 Chapter 6
Interest or
Company Item Dividend Conversion Big Owns
Big Preferred stock $100,000/year 40,000 shares Not applicable
Little Preferred stock 12,000/year 8,000 shares 60%
Little Bonds 14,000/year* 9,000 shares –0–
*Interest on the bonds is shown net of the 30 percent tax effect ($20,000 interest less $6,000 tax savings). No tax is computed for the preferred shares because distributed dividends do not create a tax impact.
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Variable Interest Entities, Intra-Entity Debt, Consolidated Cash Flows, and Other Issues 265
Because the subsidiary has convertible items that can affect the company’s outstanding shares and net income, Little’s diluted earnings per share must be derived beforeBig’s diluted EPS can be determined. As shown in Exhibit 6.7, Little’s diluted EPS are $2.38. Two aspects of this schedule should be noted:
• The individual impact of the convertibles ($1.50 for the preferred stock and $1.56 for the bonds) did not raise the EPS figures. Thus, neither the preferred stock nor the bonds are an- tidilutive, and both are properly included in these computations.
• Determining diluted EPS of the subsidiary is necessary only because of the possible dilu- tive impact. Without the subsidiary’s convertible bonds and preferred stock, the parent’s share of consolidated net income would form the basis for computing EPS, and only basic EPS would be reported.
According to Exhibit 6.7, Little’s income is $88,000 for diluted EPS. The issue for the ac- countant is how much of this amount should be included in computing the parent’s diluted EPS. This allocation is based on the percentage of shares controlled by the parent. Note that if the subsidiary’s preferred stock and bonds are converted into common shares, Big’s ownership falls from 90 to 62 percent. For diluted EPS, 37,000 shares are appropriate. Big’s 62 percent ownership (22,800/37,000) is the basis for allocating the subsidiary’s $88,000 income to the parent.
Supporting Calculations for Diluted Earnings per Share
Little Company Big’s Big’s Shares Percentage Ownership
Common stock 20,000 90% 18,000
Possible new shares—preferred stock 8,000 60 4,800
Possible new shares—bonds 9,000 –0– –0–
Total 37,000 22,800
Big’s ownership (diluted): 22,800/37,000 ⫽62% (rounded) Income assigned to Big (diluted earnings per share computation):
$88,000 ⫻62% ⫽$54,560
We can now determine Big Company’s EPS. Only $54,560 of subsidiary income is appropri- ate for the diluted EPS computation. Because two different income figures are utilized, basic and diluted calculations are made separately as in Exhibit 6.8. Consequently, these schedules determine that Big Company should report basic EPS of $5.63, with diluted earnings per share of $4.68.
EXHIBIT 6.7 Subsidiary’s Diluted Earnings per Share
LITTLE COMPANY Diluted Earnings per Common Share
For Year Ending December 31, 2011
Earnings Shares
Little’s income after amortization . . . . $74,000 20,000 Preferred stock dividends . . . . (12,000)
Effect of possible preferred stock conversion:
Dividends saved . . . . 12,000 New shares 8,000 $1.50 impact (12,000/8,000) Effect of possible bond conversion:
Interest saved (net of taxes) . . . . 14,000 9,000 $ 1.56 impact (14,000/9,000) Diluted EPS . . . . $88,000 37,000 $ 2.38 (rounded) hoy36628_ch06_241-292.qxd 12/29/09 4:39 PM Page 265
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