#cfa-level-1 #financial-reporting-and-analysis #understanding-income-statement
A company’s capital is composed of its equity and debt. Some types of equity have preference over others, and some debt (and other instruments) may be converted into equity. Under IFRS, the type of equity for which EPS is presented is referred to as ordinary. Ordinary shares are those equity shares that are subordinate to all other types of equity. The ordinary shareholders are basically the owners of the company—the equity holders who are paid last in a liquidation of the company and who benefit the most when the company does well. Under US GAAP, this ordinary equity is referred to as common stock or common shares, reflecting US language usage. The terms “ordinary shares,” “common stock,” and “common shares” are used interchangeably in the following discussion.
When a company has issued any financial instruments that are potentially convertible into common stock, it is said to have a complex capital structure. Examples of financial instruments that are potentially convertible into common stock include convertible bonds, convertible preferred stock, employee stock options, and warrants.48 If a company’s capital structure does not include such potentially convertible financial instruments, it is said to have a simple capital structure.
The distinction between simple versus complex capital structure is relevant to the calculation of EPS because financial instruments that are potentially convertible into common stock could, as a result of conversion or exercise, potentially dilute (i.e., decrease) EPS. Information about such a potential dilution is valuable to a company’s current and potential shareholders; therefore, accounting standards require companies to disclose what their EPS would be if all dilutive financial instruments were converted into common stock. The EPS that would result if all dilutive financial instruments were converted is called diluted EPS. In contrast, basic EPS is calculated using the reported earnings available to common shareholders of the parent company and the weighted average number of shares outstanding.
Companies are required to report both basic and diluted EPS. For example, Danone reported basic EPS (“before dilution”) and diluted EPS (“after dilution”) of €2.57 for 2009, somewhat lower than 2008. Kraft reported basic EPS of $2.04 and diluted EPS of $2.03 for 2009, much higher than basic and diluted EPS (from continuing operations) of $1.22 and $1.21 for 2008. (The EPS information appears at the bottom of Danone’s and Kraft’s income statements.) An analyst would try to determine the causes underlying the changes in EPS, a topic we will address following an explanation of the calculations of both basic and diluted EPS.