Earnings Per Share
Hard Practice Test
Intermediate Accounting 2
Hard Practice Test
Click the “Check Your Answer” box below each problem to reveal the correct answer and explanation.
1. Which of the following requires earnings per share for all prior years presented to be restated?
a. issuing stock options to employees
b. stock dividends and stock splits
c. the conversion of convertible bonds
d. convertible preferred stock
Answer
B. Stock dividends and stock splits change the number of shares outstanding. In order to be comparable, prior years earnings per share must be restated to reflect the dividend or split ratio.
2. What is the impact to earnings per share when a company retires common stock that was previously held as treasury stock?
a. increase
b. decrease
c. no change
d. depends on when during the period the common stock is retired
Answer
C. Treasury stock is not considered outstanding and is not included in outstanding common shares. The retirement of treasury stock has no impact on outstanding shares.
3. What is a common method a company uses to increase basic earnings per share?
a. purchase treasury stock
b. issue a stock split
c. issue convertible bonds that pay interest
d. do not declare a stated dividend on cumulative preferred stock
Answer
A. Purchasing treasury stock decreases outstanding shares, increasing earnings per share. A stock split increases outstanding shares and will decrease earnings per share. Convertible bonds have no impact on basic earnings per share. A stated dividend on cumulative preferred stock is subtracted from net income even if it is not declared.
4. Nonconvertible, cumulative preferred stock where the dividend is not declared impacts the computation of
a. basic earnings per share
b. diluted earnings per share
c. both a. and b.
d. neither a. or b.
Answer
C. A cumulative preferred dividend is subtracted from basic earnings per share. Non convertible means the preferred stock can not be assumed converted to common stock and the dividend is also subtracted from diluted earnings per share.
5. Shares that may be issued given a contingent situation that is likely to occur are included in
a. basic weighted average shares
b. diluted weighted average shares
c. both a. and b.
d. neither a. or b.
Answer
B. Diluted weighted average shares includes all shares that could be outstanding given certain conditions occur. Contingent issuances that are likely to occur are assumed to occur. Basic shares only include shares that are actually outstanding during the year.
6. When determining the income that is applicable to common shareholders, dividends relative to non cumulative non convertible preferred stock should be
a. added to net income
b. subtracted to net income
c. ignored unless it was declared during the current period
d. ignored unless it was paid during the current period
Answer
C. Non cumulative preferred dividends are only subtracted from net income when they are declared by the board of directors.
7. A convertible security is considered to be a dilutive security when
a. the “if converted method” results in a lower earnings per share
b. the average yield on the bond is greater than the average yield on bonds of similar risk at the end of the period
c. incremental earnings per share is greater than $1
d. the security may be converted at the option of the investor within 5 years
Answer
A. Dilutive means earnings per share is lower. The if converted method is used when assuming conversion of convertible bonds and preferred stock.
8. Which of the following affects only the denominator when computing diluted earnings per share?
a. stock options
b. non convertible preferred stock
c. convertible bonds
d. convertible cumulative preferred stock
Answer
A. The denominator is weighted average shares outstanding. Stock options increase outstanding shares. Convertible bonds increase net income and shares outstanding. Convertible cumulative preferred stock changes the numerator when assuming the dividend will not be paid and the denominator when converting to common shares. Non convertible preferred stock does not change average shares outstanding.
9. When computing earnings per share, all of the following are true with respect to stock options with the exception of
a. net income is never impacted
b. the assumed exercise of stock options always increases the weighted average number of shares outstanding
c. it is assumed that cash from exercise is used to purchase treasury shares at an average fair market value for the period
d. stock options may be anti-dilutive
Answer
B. Assuming exercise will not increase shares when the exercise price is greater than the average fair market value. This is an anti-dilutive situation and this is not assumed to occur when computing diluted earnings per share.
10. When using the “if converted method”, interest expense is
a. added to net income net of tax
b. subtracted from net income net of tax
c. added to net income without considering the tax impact
d. added to weighted average number of shares, net of tax
Answer
A. The “if converted method” assumes the bond is converted as of the beginning of the year. Given the bond is converted, interest is not paid. The interest saved is added to net income net of tax because net income is net of tax.
Stock options granted in the prior year:
30,000 shares with an exercise price of $8 per share.
Average market price was $19 and the year end fair market value of the
common stock price was $21.
7,500 options were exercised on July 1st of the current year
Convertible bonds issued at par, face value of $400,000, coupon rate of 8%. Convertible into 0.5 shares for each $1 of face value.
The convertible bonds were issued on April 1st of the current year.
Non convertible preferred stock, $1,000,000 total par, dividend of 7%.
The preferred stock is cumulative and dividends were declared during the current year.
A. Compute weighted average outstanding common shares for the current year
B. Compute basic earnings per share for the current year
C. Compute diluted earnings per share for the current year
Answer
A.
| 1/1 to 3/31 500,000 x 1.1 x 3/12 = 137,500 4/1 to 6/30 480,000 x 1.1 x 3/12 = 132,000 7/1 to 11/14 487,500 x 1.1 x 4.5 /12 = 201,094 11/15 to 12/1 536,250 x 0.5 /12 = 22,344 12/1 to 12/31 526,250 x 1/12 = 43,854 Weighted Average = 536,792 |
Note: The stock dividend is issued on 507,500 total shares issued; however,
22,000 (20,000 x 1.1) are now treasury shares
B.
1,800,000 – 70,000 =
1,730,000 = $3.22
536,792
C.
1,800,000 – 70,000 + 18,000
536,792 + 15,199 + 150,000
1,748,000 = $2.49
701,991
|
Options From From Options: Shares Issued 30,000 22,500 = Net Shares Added 17,369 13,027 = 15,199 shares could be added |
Bonds: Issued April 1st – include 9 months
$400,000 x 8% = 32,000 x .75 = 24,000 interest saved x 9/12 = $18,000
400,000 x 0.5 = 200,000 shares issued on conversion x 9/12 = 150,000
Preferred Stock
Nonconvertible: subtract the preferred dividend for diluted
12. On December 31st of the prior year the company’s balance sheet was as follows:
| Preferred Stock, $50 par value, 5%, 20,000 shares issued and outstanding | $1,000,000 |
| Common Stock, $0.01 par value, 800,000 shares authorized, 600,000 shares issued, 550,000 shares outstanding | $ 6,000 |
| Paid in Capital – Common Stock | $ 986,000 |
| Treasury Stock, | $ 280,000 |
The following transactions occurred during the current year: On November 1, the company issued a 2:1 stock split; On December 1st, the company issued 100,000 shares of common stock. Net Income for the current year was $800,000. The preferred stock is cumulative and the dividend was declared. The tax rate for the current year was 30%. The company had the following convertible securities (shares have been adjusted for splits/dividends):
Stock options granted on May 1, three years prior:
60,000 shares with an exercise price of $14 per share.
Average market price was $19 and the year end closing stock price was $21.
2,000 options were exercised on November 15th of the current year.
Convertible bonds, face value of $400,000, coupon rate of 6%, issued 2 years ago. Convertible into 20 shares for each $1,000 face value.
$100,000 face value bonds were converted on March 1st of the current year.
A. Compute weighted average outstanding common shares for the current year
B. Compute basic earnings per share for the current year
C. Compute diluted earnings per share for the current year
Answer
A.
| 1/1 to 2/28 550,000 x 2 x 2/12 = 183,333 3/1 to 10/31 552,000 x 2 x 8/12 = 736,000 11/1 to 11/14 1,104,000 x 0.5/12 = 46,000 11/15 to 12/1 1,106,000 x 0.5/12 = 46,083 12/1 to 12/31 1,206,000 x 1/12 = 100,500 Weighted Average = 1,111,916 |
B.
$800,000 – $50,000 = $750,000
$750,000 = $0.67
1,111,916
Preferred dividend:
$50 x 20,000 x 5% = 50,000
C.
800,000 – 50,000 +13,300
1,111,916 + 15,724 + 6,333
$763,300 = $0.67
1,133,973
Options
|
Options: Shares Issued 60,000 58,000 = Net Shares 15,790 15,264 |
Bonds:
| $400,000 x 6% = 24,000 x .7 = 16,800 x 2/12 = 2,800 $300,000 x 6% = 18,000 x .7 = 12,600 x 10/12 = 10,500 Total interest saved 13,300 |
| 400,000 / 1,000 = 400 x 20 = 8,000 x 2/12 = 1,333 300,000 / 1,000 = 300 x 20 = 6,000 x 10/12 = 5,000 Total shares added on assumed conversion 6,333 |
Preferred Stock
Nonconvertible: subtract the preferred dividend
Warrants granted February 1st of the current year: 60,000 warrants to purchase 60,000 shares of common stock at a price of $20 per share. The average market price during the current year was $24 per share, and the December 31st, closing price was $18 per share.
Convertible bonds; face value of $200,000, coupon rate of 6%. The bonds are convertible to 300 shares of common stock for each $500 face value of the bond.
The bonds were issued during the prior year.
Convertible preferred stock; 10,000 shares at $75 par, paying a 9% dividend; cumulative, issued on January 1st of the current year. The preferred stock is convertible to 3 shares of common stock per preferred share. Dividends were declared at the end of the current year. 5,000 shares of preferred stock were converted on May 1st of the current year.
A. Compute weighted average outstanding common shares for the current year
B. Compute basic earnings per share for the current year
C. Compute diluted earnings per share for the current year
Answer
A.
| 1/1 to 3/31 1,000,000 x 1.4 x 3/12 = 350,000 4/1 to 4/30 810,000 x 1.4 x 1/12 = 94,500 5/1 to 5/31 825,000 x 1.4 x 1/12 = 96,250 6/1 to 9/29 875,000 x 1.4 x 4/12 = 408,333 9/30 to12/31 1,225,000 x 3/12 = 306,250 Weighted Average =1,255,333 |
B.
| 265,000 – 33,750 = 231,250 = $0.18 1,255,333 |
Preferred dividend =
10,000 – 5,000 converted = 5,000 shares end of year
x $75 par x 9% = $33,750 declared at end of year
C.
| 265,000 – 0 + 7,200 1,255,333 + 9,167 + 120,000 + 20,000 |
272,200 = $0.19 anti-dilutive
1,404,500
Remove preferred stock conversion; because it is anti-dilutive
Revised dilutive EPS:
265,000 – 33,750 + 7,200
1,255,333 + 9,167 + 120,000
238,450 = $0.17 diluted
1,384,500
Dilutive convertibles: No adjustment required:
Warrants (work just like options) granted on 2/1 of the current year
|
Warrants: Shares Issued 60,000 = Net shares 10,000 |
Shares added with nothing on top line makes it dilutive.
Bonds:
$200,000 x 6% = 12,000 x .60 = 7,200 interest saved
200,000 / 500 = 400 x 300 = 120,000 shares issued on conversion
7200 interest saved
120,000 shares issued = $0.06
Lower than basic makes it dilutive
Preferred Stock
| 10,000 x 3 = 30,000 x 4/12 = 10,000 5,000 x 3 = 15,000 x 8/12 = 10,000 Total shares added 20,000 |
Dividend $33,750
Shares issued 20,000 = $1.69
Higher than basic makes it anti-dilutive