Effects on Diluted EPS Calculations

Understanding the Role of Diluted EPS

Let’s be honest: computing diluted earnings per share (EPS) can sometimes feel like solving a puzzle with an unending supply of extra puzzle pieces. You know that moment when you’re trying to see if your jigsaw has all the right shapes—then someone dumps more pieces on the table? That’s essentially what happens when we factor in share-based compensation such as stock options, restricted stock units (RSUs), and other potentially dilutive securities.

In this section, we’re going to carefully walk through why and how these additional puzzle pieces (i.e., “potentially dilutive shares”) must be considered in calculating diluted EPS. I remember the first time I tried to explain the treasury stock method to a colleague, and I saw their eyes glaze over at the idea that “in-the-money” options could inflate the share count. But once we slow it down and go step by step, it’s not so bad—even if it does add a bit of complexity to your calculations.

Distinguishing Basic EPS from Diluted EPS

We start by making sure we all know the difference between basic EPS and diluted EPS:

• Basic EPS measures how much net income is available for each share of common stock currently outstanding.
• Diluted EPS takes it a step further by considering all the “what if” scenarios—like if stock options were exercised, or warrants were converted, or convertible bonds were turned into equity. In other words, it’s an attempt to show a worst-case scenario for existing shareholders as if every possible avenue to create new shares was taken.

At first, it might seem like a downer to see EPS shrink once we factor in these possibilities. After all, more shares with the same total net income means fewer earnings per share. But, as you’ll see, accounting standards require us to reflect the hypothetical increase in shares to be transparent about how a company’s capital structure might look if certain events occur.

The Treasury Stock Method (TSM)

If you ever want to impress your friends—and by friends, I mean finance folks—mention “the treasury stock method.” This method is commonly used to figure out just how many new shares would be introduced into the market if all in-the-money options or warrants were exercised.

Why the Name?

The name “treasury stock method” suggests that when options are exercised, the company would theoretically use the proceeds from exercising those options to buy back some of its own shares from the market (as if it were a “treasury,” reacquiring stock). This “buyback” offsets some of the dilution caused by issuing new shares to option holders.

Breaking It Down

Suppose we have a certain number of stock options, each one giving the holder the right to purchase one share of the company’s stock at a certain exercise price (strike price). The treasury stock method then says:

1. Assume that in-the-money options are exercised.
2. Calculate the proceeds: number of options × exercise (strike) price.
3. Use those proceeds at the current market price of the shares to buy back as many shares as possible.
4. The net increase in shares = total new shares issued from the option exercise – shares bought back with proceeds.

The formula for incremental shares due to options is often expressed as:

To illustrate visually:

    flowchart LR
	    A["Options <br/>Exercised"] --> B["Proceeds <br/>(strike price × <br/>number of options)"]
	    B --> C["Use Proceeds to <br/>Repurchase Shares <br/>at Market Price"]
	    C --> D["Net New Shares <br/>= (Shares Issued) - (Repurchased)"]

An Example

Let’s say a firm has 1,000 options outstanding, each with a strike price of $20, and the market price of the stock is $50.

• Total proceeds = 1,000 × $20 = $20,000
• Number of shares repurchased at $50 market price = $20,000 ÷ $50 = 400
• Total shares issued = 1,000
• Net increase in shares = 1,000 – 400 = 600

So in calculating diluted EPS, we would add 600 shares to the denominator, not the full 1,000.

I once was involved in an audit where the CFO nearly had a heart attack when he realized that “only” 600 shares were counted instead of 1,000. But after calm discussion, he understood that the funds from the option exercise theoretically allow for share buybacks at the current market price, reducing the net dilutive effect.

RSUs and Other Share-Based Awards

Now, if you thought options were a handful, just wait until you deal with restricted stock units (RSUs) and other forms of share-based awards. There’s no “strike price” for an RSU, so the treasury stock method doesn’t apply in the same way. Instead, RSUs generally increase the share count once they vest because recipients don’t pay an exercise price; they just receive shares.

Typical RSU Scenario

• An employee is granted 500 RSUs that vest in three years.
• Once vested, the employee receives 500 shares, which are typically considered in the diluted EPS calculation if any portion is deemed vesting within the reporting period.

Additionally, when it comes to tax withholding, employees might forfeit a portion of RSUs to cover taxes, effectively reducing the shares delivered. However, from a diluted EPS perspective, the full 500 RSUs are typically assumed to be converted into common shares, with the withheld shares treated similarly to share repurchase.

IFRS vs. US GAAP Nuances

Both IFRS (International Financial Reporting Standards) and US GAAP (Generally Accepted Accounting Principles) follow the same general principle that any potentially dilutive instruments must be included for the diluted EPS calculation. The main standard references are:

• IFRS: IAS 33 — Earnings per Share
• US GAAP: ASC 260 — Earnings per Share

Common Differences

1. Contingently Issuable Shares: Under IAS 33, certain contingently issuable shares (e.g., performance shares) are included in the EPS calculation only if the conditions are satisfied at the end of the reporting period. US GAAP is generally similar but might differ slightly in the type of performance conditions and how probable those conditions need to be.
2. Convertible Instruments: IFRS and US GAAP can differ in how to account for certain convertible debt or convertible preferred shares. For pure share-based awards (like RSUs and options), these differences narrow.

The good news is that for your Level II exam, the conceptual approach is the same: if it’s in-the-money or meets certain vesting/performance criteria, it’s likely to be considered dilutive and must be included.

Adjusting Net Income (Or Not)

For share-based compensation such as stock options and RSUs, your net income used for basic EPS vs. diluted EPS remains the same. There’s no direct effect on net income unless we’re dealing with convertible debt or convertible preferred shares, which might reduce interest expense or preferred dividends upon conversion.

So, typically:

• Numerator: Net Income is unchanged for pure share-based awards.
• Denominator: Increase in weighted-average shares outstanding from potentially dilutive instruments.

This is a key point for exam takers because you might see a question that tries to trick you into adjusting net income for a scenario that only involves options or RSUs. Don’t fall for it. The only time net income changes is when some sort of interest expense or dividend is eliminated upon conversion (e.g., a convertible bond).

Example Calculation: Bringing It All Together

Let’s walk through a comprehensive example that includes both stock options and RSUs to demonstrate how you might see this tested on the exam.

Scenario

• Net Income = $100,000
• Average Common Shares Outstanding (Basic) = 10,000 shares
• 1,000 In-the-Money Options with a strike price of $25, market price of $40
• 500 RSUs that are fully vested at the beginning of the period and thus included in the diluted calculation

Step 1: Basic EPS

Step 2: Incremental Shares from Options using TSM

• Proceeds = 1,000 × $25 = $25,000
• Shares repurchased at $40 = $25,000 ÷ $40 = 625
• Net increase = 1,000 – 625 = 375

Step 3: RSUs

RSUs typically have no exercise price, so if they are vested, they add 500 shares directly to the share count.

Step 4: Diluted Shares

• Total new shares from options = 375
• RSUs = 500
• Diluted share count = 10,000 + 375 + 500 = 10,875

Step 5: Diluted EPS

So in this example, the diluted EPS of $9.19 is lower than the basic EPS of $10.00, which makes sense because more shares in the denominator reduce the per-share figure.

Pitfalls and Strategies for Exam Day

• Check for Anti-Dilution. Some securities might actually be anti-dilutive, meaning if they were exercised, they would increase EPS rather than decrease it. These are excluded from the diluted EPS calculation.
• Summation of Multiple Instruments. Watch for exam questions that test your ability to combine convertible debt, RSUs, and stock options. They often include partial-year considerations for weighting.
• Performance Conditions. Carefully check if any contingently issuable shares meet their performance threshold. If not, they’re excluded.
• Net Income Adjustments. Don’t mistakenly adjust net income unless there’s interest or dividend savings involved (e.g., convertible bonds or convertible preferred stock).

Personal Reflections

I’ll never forget reviewing an exam question with a candidate who had computed the net new shares for options correctly but forgot about the RSUs entirely—leading to an inflated diluted EPS. The dedication to the first calculation was so meticulous, but the oversight of the second instrument was, well, pricey in terms of exam points. The lesson? Always read the entire vignette carefully, note every potentially dilutive item, and systematically address each.

Diagram of Diluted EPS Flow

Here’s a high-level look at how you might piece together your approach for a multi-instrument scenario:

    flowchart TB
	    A["Net Income <br/>(Given or Adjusted)"] --> B["Determine Basic Shares"]
	    B --> C["Are There Convertible Securities<br/> (Bonds/Preferred)?"]
	    C --> D["Adjust Net Income <br/> & Shares If Dilutive"]
	    B --> E["Are There Stock Options <br/> or Warrants?"]
	    E --> F["Calculate Incremental Shares <br/> via Treasury Stock Method"]
	    B --> G["Are There RSUs <br/> or Performance Shares?"]
	    G --> H["Add Additional Shares <br/> If Conditions Met"]
	    D --> I["Final Count of Shares"]
	    F --> I
	    H --> I
	    I["Diluted EPS = Net Income ÷ <br/> (Total Diluted Shares)"]

Glossary

• Diluted EPS: EPS metric including potentially dilutive securities.
• Treasury Stock Method (TSM): A method for calculating the net increase in shares if all in-the-money options or warrants were exercised.
• In-the-money: When an option’s strike price is below the current market price.
• Contingently Issuable Shares: Shares issued only if specific performance or market conditions are met.
• Convertible Securities: Debt or preferred shares that can be converted into common equity, affecting both net income and shares outstanding upon conversion.

References & Further Reading

• IFRS: IAS 33, “Earnings per Share”
• US GAAP: ASC 260, “Earnings per Share”
• “Diluted EPS in Depth” by Harrington & Woods, Accounting Research Bulletin
• Official CFA Curriculum on Earnings per Share (Level II)
• Various Advanced Item-Set Collections covering share-based compensation examples

Test Your Knowledge: Diluted EPS Challenges

Final Exam Tips
• Carefully read every detail in the vignette. Look for multiple forms of share-based compensation.
• Practice the treasury stock method so it becomes second nature.
• Identify performance-based shares and confirm the conditions.
• Keep net income in mind: only adjust when convertible debt/preferred shares are involved.
• If in doubt, recalculate and confirm if the instrument is actually dilutive before including it in the final share count.

Remember, the goal is to reflect what happens in a scenario where all potentially dilutive securities are converted or exercised. It might reduce EPS significantly—so it’s definitely something to keep an eye on both in the real world and in your CFA exam. Good luck, and keep practicing!