#cfa-level-1 #fra-introduction #income-statement
When a company has stock options, warrants, or their equivalents49 outstanding, diluted EPS is calculated as if the financial instruments had been exercised and the company had used the proceeds from exercise to repurchase as many shares of common stock as possible at the average market price of common stock during the period. The weighted average number of shares outstanding for diluted EPS is thus increased by the number of shares that would be issued upon exercise minus the number of shares that would have been purchased with the proceeds. This method is called the treasury stock method under US GAAP because companies typically hold repurchased shares as treasury stock. The same method is used under IFRS but is not named.
For the calculation of diluted EPS using this method, the assumed exercise of these financial instruments would have the following effects:
The company is assumed to receive cash upon exercise and, in exchange, to issue shares.
The company is assumed to use the cash proceeds to repurchase shares at the weighted average market price during the period.
As a result of these two effects, the number of shares outstanding would increase by the incremental number of shares issued (the difference between the number of shares issued to the holders and the number of shares assumed to be repurchased by the company). For calculating diluted EPS, the incremental number of shares is weighted based upon the length of time the financial instrument was outstanding in the year. If the financial instrument was issued prior to the beginning of the year, the weighted average number of shares outstanding increases by the incremental number of shares. If the financial instruments were issued during the year, then the incremental shares are weighted by the amount of time the financial instruments were outstanding during the year.
The assumed exercise of these financial instruments would not affect net income. For calculating EPS, therefore, no change is made to the numerator. The formula to calculate diluted EPS using the treasury stock method (same method as used under IFRS but not named) for options is:
Diluted EPS When a Company Has Stock Options, Warrants, or Their Equivalents Outstanding =
(Net income − Preferred dividends)
[Weighted average number of shares outstanding +( New shares that would have been issued at option exercise − Shares that could have been purchased with cash received upon exercise ) × (Proportion of year during which the financial instruments were outstanding)]