Chapter 19Earnings Per Share

462

Chapter 19Earnings Per Share

MULTIPLE CHOICE

1.Earnings per share disclosures are required only for

a.

companies with complex capital structures.

b.

companies that change their capital structures during the reporting period.

c.

public companies.

d.

private companies.

ANS:COBJ:LO 1

2.In computing the earnings per share of common stock, noncumulative preferred dividends not declared should be

a.

deducted from the net income for the year.

b.

added to the net income for the year.

c.

ignored.

d.

deducted from the net income for the year, net of tax.

ANS:COBJ:LO 2

3.Which earnings per share computation should be reported on the face of the income statement?

Basic EPS

Diluted EPS

a.

Yes Yes

b.

Yes No

c.

No Yes

d.

No No

ANS:AOBJ:LO 7

4.When computing earnings per share on common stock, dividends on cumulative, nonconvertible preferred stock should be

a.

deducted from net income only if the dividends were declared or paid in the current period.

b.

deducted from net income regardless of whether the dividends were not paid or declared in the period.

c.

deducted from net income only if net income is greater than the dividends.

d.

ignored.

ANS:BOBJ:LO 2

5.In calculating diluted earnings per share, which of the following should not be considered?

a.

The weighted average number of common shares outstanding

b.

The amount of dividends declared on cumulative preferred shares

c.

The amount of cash dividends declared on common shares

d.

The number of common shares resulting from the assumed conversion of debentures outstanding

ANS:COBJ:LO 4

6.What is the correct treatment of a stock dividend issued in mid year when computing the weighted-average number of common shares outstanding for earnings per share purposes?

a.

The stock dividend should be weighted by the length of time that the additional number of shares are outstanding during the period.

b.

The stock dividend should be included in the weighted-average number of common shares outstanding only if the additional shares result in a decrease of 3 percent or more in earnings per share.

c.

The stock dividend should be weighted as if the additional shares were issued at the beginning of the year.

d.

The stock dividend should be ignored since no additional capital was received.

ANS:COBJ:LO 2

7.The EPS computation that is forward-looking and based on assumptions about future transactions is

a.

diluted EPS.

b.

basic EPS.

c.

continuing operations EPS.

d.

extraordinary EPS.

ANS:AOBJ:LO 1

8.When computing diluted earnings per share, stock options are

a.

recognized only if they are dilutive.

b.

recognized only if they are antidilutive.

c.

recognized only if they were exercised.

d.

ignored.

ANS:AOBJ:LO 3

9.Of the following, select the incorrect statement concerning earnings per share.

a.

During periods when all income is paid out as dividends, earnings per share and dividends per share under a simple capital structure would be identical.

b.

Under a simple capital structure, no adjustment to shares outstanding is necessary for a stock split on the last day of the fiscal period.

c.

During a period, changes in stock issued or reacquired by a company may affect earnings per share.

d.

During a loss period, the amount of loss attributed to each share of common stock should be computed.

ANS:BOBJ:LO 5

10.In applying the treasury stock method of computing diluted earnings per share, when is it appropriate to use the average market price of common stock during the year as the assumed repurchase price?

a.

Always

b.

Never

c.

When the average market price is higher than the exercise price

d.

When the average market price is lower than the exercise price

ANS:COBJ:LO 3

11.Earnings per share information should be reported for all of the following except

a.

continuing operations.

b.

extraordinary gain.

c.

net income.

d.

cash flows from operating activities.

ANS:DOBJ:LO 7

12.When using the if-converted method to compute diluted earnings per share, convertible securities should be

a.

included only if antidilutive.

b.

included only if dilutive.

c.

included whether dilutive or not.

d.

not included.

ANS:BOBJ:LO 4

13.The if-converted method of computing EPS data assumes conversion of convertible securities at the

a.

beginning of the earliest period reported (or at time of issuance, if later).

b.

beginning of the earliest period reported (regardless of time of issuance).

c.

middle of the earliest period reported (regardless of time of issuance).

d.

ending of the earliest period reported (regardless of time of issuance).

ANS:AOBJ:LO 4

14.When computing dilutive EPS, the treasury stock method can be used for all of the following except

a.

convertible preferred stock.

b.

stock warrants.

c.

stock options.

d.

stock rights.

ANS:AOBJ:LO 3

15.For a company having several different issues of convertible securities and/or stock options and warrants, the FASB requires selection of the combination of securities producing

a.

the lowest possible earnings per share.

b.

the highest possible earnings per share.

c.

the earnings per share figure midway between the lowest possible and the highest possible earnings per share.

d.

any earnings per share figure between the lowest possible and the highest possible earnings per share.

ANS:AOBJ:LO 6

16.For purposes of computing the weighted-average number of shares outstanding during the year, a midyear event that must be treated as occurring at the beginning of the year is the

a.

declaration and issuance of a stock dividend.

b.

purchase of treasury stock.

c.

sale of additional common stock.

d.

issuance of stock warrants.

ANS:AOBJ:LO 2

17.Where in the financial statements should basic and complex EPS figures for income from continuing operations be reported?

a.

In the accompanying notes

b.

In management's discussion and analysis

c.

On the income statement

d.

On the statement of cash flows

ANS:COBJ:LO 7

18.The main purpose of reporting diluted earnings per share is to

a.

provide a comparison figure for debt holders.

b.

indicate earnings shareholders will receive in future periods.

c.

distinguish between companies with a complex capital structure and companies with a simple capital structure.

d.

show the maximum possible dilution of earnings.

ANS:DOBJ:LO 1

19.In determining earnings per share, interest expense, net of applicable income taxes, on convertible debt which is dilutive should be

a.

ignored for diluted earnings per share.

b.

added back to net income for diluted earnings per share.

c.

deducted from net income for diluted earnings per share.

d.

none of the above.

ANS:BOBJ:LO 4

20.When computing diluted EPS for a company with a complex capital structure, what is the denominator in the computation?

a.

Number of common shares outstanding at year-end

b.

Weighted-average number of common shares outstanding

c.

Weighted-average number of common shares outstanding plus all other potentially antidilutive securities

d.

Weighted-average number of common shares outstanding plus all other potentially dilutive securities

ANS:DOBJ:LO 1

21.Under current GAAP, a company with a complex capital structure and potential earnings per share dilution must present

a.

primary and fully diluted earnings per share.

b.

basic and diluted earnings per share.

c.

basic and primary earnings per share.

d.

basic earnings per share and cash flow per share.

ANS:BOBJ:LO 1

22.Under current GAAP, common stock equivalents

a.

are considered in calculating basic earnings per share.

b.

are considered in calculating primary earnings per share.

c.

are not considered in calculating basic earnings per share.

d.

are not considered in calculating fully diluted earnings per share.

ANS:COBJ:LO 1

23.In calculating earning per share, stock options warrants, and rights are

a.

always dilutive.

b.

never dilutive.

c.

dilutive if the exercise price is less than the average market price of the common stock.

d.

dilutive if the exercise price is more than the average market price of the common stock.

ANS:COBJ:LO 6

24.For companies with a complex capital structure, a convertible security is potentially dilutive if

a.

its incremental EPS is greater than basic EPS after considering any stock options, rights, and warrants.

b.

its incremental EPS is less than basic EPS after considering any stock options, rights, and warrants.

c.

its incremental EPS is equal to basic EPS after considering any stock options, rights, and warrants.

d.

its incremental EPS is less than 1.00 after considering any stock options, rights, and warrants.

ANS:BOBJ:LO 6

25.An entity that reports a discontinued operation, an extraordinary item, or a cumulative effect of an accounting change shall present basic and diluted

earnings per share amounts for those line items

a.

only on the face of the income statement.

b.

only in the notes to the financial statements.

c.

either on the face of the income statement or in the notes to the financial statements.

d.

only if management chooses to do so as these amounts are note required to be disclosed either in the financial statements or the notes thereto.

ANS:COBJ:LO 7

26.On December 31, 2005, Superior, Inc. had 600,000 shares of common stock issued and outstanding. Superior issued a 10 percent stock dividend on July 1, 2006. On October 1, 2006, Superior reacquired 48,000 shares of its common stock and recorded the purchase using the cost method of accounting for treasury stock. What number of shares should be used in computing basic earnings per share for the year ended December 31, 2006?

a.

612,000

b.

618,000

c.

648,000

d.

660,000

ANS:COBJ:LO 2

27.At December 31, 2005, the Murdock Company had 150,000 shares of common stock issued and outstanding. On April 1, 2006, an additional 30,000 shares of common stock were issued. Murdock's net income for the year ended December 31, 2006, was $517,500. During 2006, Murdock declared and paid $300,000 in cash dividends on its nonconvertible preferred stock. The basic earnings per common share, rounded to the nearest penny, for the year ended December 31, 2006, should be

a.

$3.00.

b.

$2.00.

c.

$1.45.

d.

$1.26.

ANS:DOBJ:LO 2

28.At December 31, 2006 and 2005, Lapham Corp. had 200,000 shares of common stock and 20,000 shares of 5 percent, $100 par value cumulative preferred stock outstanding. No dividends were declared on either the preferred or common stock in 2006 or 2005. Net income for 2006 was $1,000,000. For 2006, basic earnings per common share amounted to

a.

$5.00.

b.

$4.75.

c.

$4.50.

d.

$4.00.

ANS:COBJ:LO 2

29.The Thomas Company's net income for the year ended December 31 was $30,000. During the year, Thomas declared and paid $3,000 in cash dividends on preferred stock and $5,250 in cash dividends on common stock. At December 31, 36,000 shares of common stock were outstanding, 30,000 of which had been issued and outstanding throughout the year and 6,000 of which were issued on July 1. There were no other common stock transactions during the year, and there is no potential dilution of earnings per share. What should be the year's basic earnings per common share of Thomas, rounded to the nearest penny?

a.

$0.66

b.

$0.75

c.

$0.82

d.

$0.91

ANS:COBJ:LO 2

30.Bay Area Supplies had 60,000 shares of common stock outstanding at January 1. On May 1, Bay Areas Supplies issued 31,500 shares of common stock. Outstanding all year were 30,000 shares of nonconvertible preferred stock on which a dividend of $4 per share was paid in December. Net income for the year was $290,100. Bay Area Supplies should report basic earnings per share for the year of

a.

$1.86.

b.

$2.10.

c.

$2.84.

d.

$3.17.

ANS:BOBJ:LO 2

31.Landrover, Inc. had 150,000 shares of common stock issued and outstanding at December 31, 2005. On July 1, 2006, an additional 25,000 shares of common stock were issued for cash. Landrover also had unexercised stock options to purchase 20,000 shares of common stock at $15 per share outstanding at the beginning and end of 2006. The market price of Landrover's common stock was $20 throughout 2006. What number of shares should be used in computing diluted earnings per share for the year ended December 31, 2006?

a.

182,500

b.

180,000

c.

177,500

d.

167,500

ANS:DOBJ:LO 3

32.Glendale Enterprises had 200,000 shares of common stock issued and outstanding at December 31, 2005. On July 1, 2006, Glendale issued a 10 percent stock dividend. Unexercised stock options to purchase 40,000 shares of common stock (adjusted for the 2006 stock dividend) at $20 per share were outstanding at the beginning and end of 2006. The market price of Glendale's common stock (which was not affected by the stock dividend) was $25 per share during 2006. Net income for the year ended December 31, 2006, was $1,100,000. What should be Glendale's 2006 diluted earnings per common share, rounded to the nearest penny?

a.

$4.23

b.

$4.82

c.

$5.00

d.

$5.05

ANS:BOBJ:LO 3

33.On January 2, 2005, Worley Co. issued at par $50,000 of 4 percent bonds convertible, in total, into 5,000 shares of Worley's common stock. No bonds were converted during 2005. Throughout 2005 Worley had 5,000 shares of common stock outstanding. Worley's 2005 net income was $5,000. Worley's income tax rate is 40 percent. No potentially dilutive securities other than the convertible bonds were outstanding during 2005. Worley's diluted earnings per share for 2005 would be

a.

$0.58.

b.

$0.62.

c.

$0.70.

d.

$1.16.

ANS:BOBJ:LO 4

34.At December 31, 2005, Dayplanner Inc. had 250,000 shares of common stock outstanding. On October 1, 2006, an additional 60,000 shares of common stock were issued for cash. Dayplanner also had 2,000,000 of 8 percent convertible bonds outstanding at December 31, 2006, which are convertible into 50,000 shares of common stock. The bonds are dilutive in the 2006 earnings per share computation. No bonds were issued or converted into common stock during 2006. What is the number of shares that should be used in computing diluted earnings per share for the year ended December 31, 2006?

a.

265,000

b.

300,000

c.

310,000

d.

315,000

ANS:DOBJ:LO 4

35.The JVB Corporation had 200,000 shares of common stock and 10,000 shares of cumulative, $6 preferred stock outstanding during 2006. The preferred stock is convertible at the rate of three shares of common per share of preferred. For 2006, the company had a $60,000 net loss from operations and declared no dividends. JVB should report 2006 diluted loss per share of (rounded to the nearest cent)

a.

$(0.30).

b.

$(0.52).

c.

$(0.58).

d.

$(0.60).

ANS:BOBJ:LO 5

36.Zacor Incorporated has 2,500,000 shares of common stock outstanding on December 31, 2005. An additional 500,000 shares of common stock were issued April 1, 2006, and 250,000 more on July 1, 2006. On October 1, 2006, Zacor issued 5,000, $1,000 face value, 7 percent convertible bonds. Each bond is convertible into 40 shares of common stock. No bonds were converted into common stock in 2006. What is the number of shares to be used in computing basic earnings per share and diluted earnings per share, respectively?

a.

2,875,000 and 2,925,000

b.

2,875,000 and 3,075,000

c.

3,000,000 and 3,050,000

d.

3,000,000 and 3,200,000

ANS:COBJ:LO 4

37.Shoemaker Company had 1,000 common shares issued and outstanding at January 1. During the year, Shoemaker also had the common stock transactions listed below.

April 1

Issued 300 previously unissued shares

May 1

Split the stock 2-for-1

June 30

Purchased 100 shares for the treasury

July 30

Distributed a 20 percent stock dividend

December 31

Split the stock 3-for-1

Given this information, what is the weighted-average number of shares that Shoemaker should use for earnings per share purposes?

a.

2,880

b.

8,640

c.

8,820

d.

9,720

ANS:BOBJ:LO 2

38.During its fiscal year, Richards' Distributing had net income of $100,000 (no extraordinary items) and 50,000 shares of common stock and 10,000 shares of preferred stock outstanding. Richards declared and paid dividends of $.50 per share to common and $6.00 per share to preferred. The preferred stock is convertible into common stock on a share-for-share basis. For the year, Richards Distributing should report diluted earnings (loss) per share of

a.

$(0.80).

b.

$1.00.

c.

$1.67.

d.

$2.67.

ANS:COBJ:LO 4

39.At December 31, 2005, the Roberts Company had 700,000 shares of common stock outstanding. On September 1, 2006, an additional 300,000 shares of common stock were issued. In addition, Roberts had $20,000,000 of 8 percent convertible bonds outstanding at December 31, 2005, which are convertible into 400,000 shares of common stock. No bonds were converted into common stock in 2006. The net income for the year ended December 31, 2006, was $6,000,000. Assuming the income tax rate was 40 percent, what should be the diluted earnings per share for the year ended December 31, 2006?

a.

$5.00

b.

$5.53

c.

$5.80

d.

$8.30

ANS:COBJ:LO 4

40.The 2006 net income of Atwater Inc. was $200,000 and 100,000 shares of its common stock were outstanding during the entire year. In addition, there were outstanding options to purchase 10,000 shares of common stock at $10 per share. These options were granted in 2003 and none had been exercised by December 31, 2006. Market prices of Atwater's common stock during 2006 were

January 1

$20 per share

December 31

$40 per share

Average Price

$25 per share

The amount that should be shown as Atwater's diluted earnings per share for 2006 (rounded to the nearest cent) is

a.

$2.00.

b.

$1.95.

c.

$1.89.

d.

$1.86.

ANS:COBJ:LO 3

41.Warrants exercisable at $20 each to obtain 20,000 shares of common stock were outstanding during a period when the average and year-end market price of the common stock was $25. Application of the treasury stock method for the assumed exercise of these warrants in computing diluted earnings per share will increase the weighted-average number of outstanding common shares by

a.

20,000.

b.

16,667.

c.

16,000.

d.

4,000.

ANS:DOBJ:LO 3

42.The following information relates to the capital structure of Metcalf Corp.:

12/31/05

12/31/06

Outstanding shares:

Common stock ..............................

180,000

180,000

Preferred stock, convertible into 60,000

shares of common ..........................

60,000

60,000

10% convertible bonds, convertible into

40,000 shares of common ...................

$2,000,000

$2,000,000

During 2006 Metcalf paid $90,000 in dividends on the preferred stock. Metcalf's net income for 2006 was $1,960,000 and the income tax rate was 40 percent. For the year ended December 31, 2006, the diluted earnings per share is

a.

$7.29.

b.

$7.43.

c.

$8.17.

d.

$8.29.

ANS:BOBJ:LO 5

43.At December 31, 2005, Lefton, Inc. had 600,000 shares of common stock outstanding. On April 1, 2006, an additional 180,000 shares of common stock were issued for cash. Lefton also had $5,000,000 of 8% convertible bonds outstanding at December 31, 2006, which are convertible into 150,000 shares of common stock. The bonds are dilutive in the 2006 EPS computation. No bonds were issued or converted into common stock during 2006. What is the number of shares that should be used in computing basic earnings per share for 2006?

a.

735,000

b.

780,000

c.

885,000

d.

910,000

ANS:AOBJ:LO 4

44.At December 31, 2005, Lefton, Inc. had 600,000 shares of common stock outstanding. On April 1, 2006, an additional 180,000 shares of common stock were issued for cash. Lefton also had $5,000,000 of 8% convertible bonds outstanding at December 31, 2006, which are convertible into 150,000 shares of common stock. The bonds are dilutive in the 2006 EPS computation. No bonds were issued or converted into common stock during 2006. What is the number of shares that should be used in computing diluted earnings per share for 2006?

a.

735,000

b.

780,000

c.

885,000

d.

910,000

ANS:COBJ:LO 4

45.Datatec, Inc., had 400,000 shares of $20 par common stock and 40,000 shares of $100 par, 6% cumulative, convertible preferred stock outstanding for the entire year ended December 31, 2006. Each share of the preferred stock is convertible into 5 shares of common stock. Datatec's net income for 2006 was $1,680,000. For the year ended December 31, 2006, the diluted earnings per share is

a.

$2.40.

b.

$2.80.

c.

$3.60.

d.

$4.20.

ANS:BOBJ:LO 4

46.On December 31, 2004, Feterik Company had 7,000 shares of common stock issued and outstanding. On April 1, 2005, an additional 1,000 shares of common stock were issued and on July 1, 500 more shares were issued. On October 1, 2005, Feterik issued 10, $1,000 maturity value, 8% convertible bonds. Each bond is convertible into 40 shares of common stock. No bonds were converted into common stock in 2005. Assuming there are no antidilutive securities, what is the number of shares Feterik should use to compute diluted earnings per share for the year ended December 31, 2005?

a.

7,950

b.

8,100

c.

8,150

d.

8,400

ANS:BOBJ:LO 4

James Corporation

James Corporation currently has stock rights outstanding for 2,000 common shares. The exercise price of these shares is $20. The options were issued in January of 2003. The average market price of the related common stock during the year 2003 was $25. The average market price of the related common stock during 2004 was $21 and during 2005 was $19. The company's fiscal year ends on December 31 of each year.

47.Refer to James Corporation. How should these stock rights be treated in earnings per share calculations for the year ending December 31, 2003?

a.

The stock options are antidilutive and should not be included either in basic and diluted earnings per share.

b.

The stock options are dilutive and should be included both in basic and diluted earnings per share.

c.

The stock options are dilutive and should be included both in basic and diluted earnings per share in the amount of 400 shares.

d.

The stock options are dilutive and should be included only in diluted earnings per share in the amount of 400 shares.

ANS:DOBJ:LO 6

48.Refer to James Corporation. How should these stock rights be treated in the earnings per share calculation for the year ending December 31, 2004?

a.

The stock options are antidilutive and should not be included either in basic or diluted earnings per share.

b.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 95 shares.

c.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 2,000 shares.

d.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 400 shares.

ANS:BOBJ:LO 6

49.Refer to James Corp. How should these stock rights be treated in the earnings per share calculation for the year ending December 31, 2005?

a.

The stock options are antidilutive and should not be included with in basic or diluted earnings per share.

b.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 105 shares.

c.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 2,000 shares.

d.

The stock options are dilutive and should be included in diluted earnings per share in the amount of 400 shares.

ANS:AOBJ:LO 6

PROBLEMS

1.On December 31, 2004, Jamfest Travel Inc. had 450,000 shares of no-par common stock issued and outstanding. All shares were sold for $7.50. On June 30, 2005, the firm issued an additional 135,000 shares for $7 per share. The 2005 income was $319,200. On September 1, 2006, a 15 percent stock dividend was issued to all common shareholders. On October 1, 2006, 60,000 shares were reacquired as treasury shares. Net income in 2006 was $278,063.

(1)

Compute the weighted-average number of common shares outstanding for 2005 and 2006 that should be shown on comparative statements at the end of 2006.

(2)

Compute the basic earnings per share in 2005 and 2006 to be reported on comparative statements at the end of 2006.

ANS:

(1)

2005:

450,000 12/12 1.15 =

517,500

135,000 6/12 1.15 =

77,625

595,125

shares

2006:

585,000 12/12 1.15 =

672,750

(60,000) 3/12 =

(15,000)

657,750

(2)

2005:

($319,200 / 595,125) =

$.54

(rounded)

2006:

($278,063 / 657,750) =

$.42

(rounded)

OBJ:LO 2

2.The income statement of Micro Computers, Inc. showed the following information on December 31, 2006.

Income before income tax .............................

$1,472,000

Income tax expense ...................................

441,600

Income from continuing operations ....................

$1,030,400

Extraordinary loss (net of tax savings) ..............

(100,000)

Net income ...........................................

$ 930,400

Compute earnings per share figures for common stock under the assumption that Micro Computer Inc. has

(1)

320,000 shares of $24 par value common stock outstanding.

(2)

9,600 shares of $100, par 8% cumulative preferred stock, and 240,000 shares of no-par common stock. Dividends are not in arrears.

Note: Assumption (1) is independent of (2).

ANS:

(1)

EPS--continuing operations ........................

$3.22 *

EPS--extraordinary items ..........................

(.31)**

EPS ...............................................

$2.91

(rounded)

*$1,030,400/320,000 = $3.22

**$(100,000)/320,000 = $(.31)

(2)

EPS--continuing operations ........................

$3.97*

EPS--extraordinary items ..........................

(.42)**

EPS

$3.55

*[$1,030,400 - ($8.00 9,600)] / 240,000 = ($1,030,400 - $76,800) / 240,000 = $3.97

**(100,000) / 240,000 = $(.42)

OBJ:LO 2

3.During 2006, the Ellis Corporation had 370,000 shares of $20 par common stock outstanding. On January 1, 2006, 2,000, 8 percent bonds were issued with a maturity value of $1,000 each. To enhance the bond sale, the company offered a conversion of 50 shares of common stock for each bond at the option of the purchaser. Net income for 2006 was $464,000. The income tax rate was 30 percent. Compute the diluted earnings per share of common stock.

ANS:

Diluted EPS

= ($464,000 + $160,000 - $48,000) / (370,000 + 100,000)

= $576,000 / 470,000

= $1.23 (rounded)

OBJ:LO 4

4.During 2006, Wright Corp. had outstanding 125,000 shares of common stock and 7,500 shares of noncumulative, 8 percent, $50 par preferred stock. Each preferred share is convertible into 8 shares of common stock. In 2006, net income was $231,500.

(1)

Compute basic and diluted earnings per share for 2006 assuming no dividends were declared or paid.

(2)

Compute basic and diluted earnings per share for 2006 assuming dividends were declared and paid on the preferred stock.

ANS:

(1)

BEPS

= ($231,500 / 125,000) = $1.85 (rounded)

DEPS

= $231,500 / [125,000 + (8 7,500)]

= $231,500 / 185,000

= $1.25 (rounded)

(2)

BEPS

= ($231,500 - 30,000) / 125,000 = $1.61 (rounded)

DEPS

= $231,500 / (125,000 + 60,000)

= $231,500 / 185,000

= $1.25 (rounded)

OBJ:LO 2

5.On December 31, 2006, Masters Inc. had outstanding 180,000 shares of common stock. Net income for 2006 was $285,000. Outstanding options (granted July 1, 2006) to purchase 15,000 shares of common stock at $20 per share had not been exercised by December 31, 2006. During 2006, market prices for the common stock were:

July 1, 2006 ....................................

$18 per share

December 31, 2006 ...............................

$32 per share

Average market ..................................

$25 per share

(1)

Compute the basic earnings per common share in 2006.

(2)

Compute the diluted earnings per common share in 2006.

ANS:

(1)

BEPS

= $285,000 / 180,000

= $1.58 (rounded)

(2)

DEPS =

$285,000 / [180,000 + (15,000 - 12,000*) x 6/12]

= $285,000 / 181,500

= $1.57 (rounded)

* $300,000/$25 = 12,000 shares

OBJ:LO 4

6.Data Controls Inc. had 250,000 shares of common stock outstanding at the end of 2004. During 2005 and 2006, the following transactions took place.

2005

March 1

Sold 24,000 shares

July 24

Issued a 20 percent stock dividend

October 1

Sold 16,000 shares

December 1

Purchased 15,000 shares to be held in treasury

2006

June 1

3-for-1 stock split

September 1

Sold 60,000 shares

Data Controls Inc. has a simple capital structure.

Compute the weighted average number of shares for 2005 and 2006 to be used in the earnings per share computation for comparative financial statements at the end of 2006.

ANS:

2005

January 1

250,000 12/12 1.20 3 =

900,000

March 1

24,000 10/12 1.20 3 =

72,000

October 1

16,000 3/12 3 =

12,000

December 1

(15,000) 1/12 3 =

(3,750)

980,250

2006

January 1

329,800* 12/12 3 =

989,400

September 1

60,000 4/12 =

20,000

1,009,400

*2005

January 1

250,000

March 1

Issuance

24,000

July 24

20% stock dividend

54,800

October 1

Issuance

16,000

December 1

Treasury stock

(15,000)

329,800

OBJ:LO 2

7.The following is a partial balance sheet for Anderson Corp. for the year ended December 31, 2005:

9 percent Convertible Bonds (issued at par) .............

$1,800,000

Common Stock, 180,000 shares issued and outstanding,

$50 par .................................................

$9,000,000

(a)

Each $1,000 convertible bond can be converted into 80 shares of common stock.

(b)

On September 1, 2006, one-third of the convertible debt was converted into common stock.

(c)

Anderson reported net income of $1,550,000 in 2006. The income tax rate was 30 percent.

(d)

No other stock transactions took place during 2006.

(1)

Compute basic earnings per share for 2006.

(2)

Compute diluted earnings per share for 2006.

ANS:

(1)

BEPS

= $1,550,000 / [180,000 + (4/12 48,000)]

= $1,550,000 / 196,000

= $7.91 (rounded)

Conversion (600 bonds x 80) = 48,000 shares

(2)

DEPS

= $1,550,000 + ($144,000 0.7) / 196,000 + 128,000

= $1,650,800 / 324,000

= $5.10

Interest Avoided

$1,200,000 x 9% 12/12 =

$108,000

$ 600,000 x 9% 8/12 =

36,000

$144,000

Equivalent Shares

1,200 bonds 12/12 80 =

96,000

600 bonds 80 8/12 =

32,000

128,000

OBJ:LO 5

8.The Stanley Corp. provides the following data for 2006:

Transactions in common stock:

January 1, 2006, beginning balance ................

300,000 shares

April 1, 2006, issuance ...........................

100,000 shares

8% $100 par nonconvertible cumulative preferred

stock .............................................

$100,000

Issued at par

6% $100 par convertible cumulative preferred stock

$200,000

Issued at $105

Convertible into 20,000 shares

Stock options .....................................

60,000 shares

Option price ......................................

$25

Average market ....................................

$35

Year-end market ...................................

$40

The net income for 2006 is $2,300,000. The company's tax rate is 30 percent. No conversions or options were exercised during 2006.

(1)

Compute basic earnings per share.

(2)

Compute diluted earnings per share.

ANS:

(1)

BEPS

= ($2,300,000 - $8,000 - $12,000) / [300,000 + 9/12 (100,000)]

= $2,280,000 / 375,000

= $6.08

(2)

DEPS

= ($2,300,000 - $8,000) / (375,000 + 20,000 + 60,000 - 42,857)

= $2,292,000 / 412,143

= $5.56

Options

= 60,000 $25 = $1,500,000

$1,500,000/$35 = 42,857

OBJ:LO 3

9.At December 31, 2005, Rollins Inc. had 400,000 shares of common stock outstanding. The company also had 40,000 shares of $7 convertible preferred stock. Each share is convertible into 4 shares of common stock. (Dividends were declared and paid.)

Transactions during 2006:

July 1, 2006

Sold 200,000 shares

July 8, 2006

Declared 100% stock dividend

September 1, 2006

Sold 120,000 shares

October 1, 2006

Purchased 60,000 shares to be held in Treasury

Rollins Inc. reported a loss of $670,700 for 2006

(1)

Compute basic earnings (loss) per share.

(2)

Compute diluted earnings (loss) per share.

ANS:

Weighted-average computation:

January 1, 2006

400,000 12/12 2 = 800,000

July 1, 2006

200,000 6/12 2 = 200,000

September 1, 2006

120,000 4/12 = 40,000

October 1, 2006

(60,000) 3/12 = (15,000)

1,025,000

(1)

BEPS

= [$(670,700) - $280,000] / 1,025,000

=$(.93)

(2)

DEPS

= $(670,700) / [(1,025,000 + (160,000 x 2)]

= $(670,700) / 1,345,000

= $(.50) *

*The convertible preferred stock is antidilutive. Rollins would report a loss per common share of $.93 for 2006.

OBJ:LO 5

10.During all of 2005, Dawson Manufacturing Company had 950,000 shares of common stock outstanding. On June 30, 2005, the company issued 10,000 7 percent convertible bonds at par. The maturity value of each bond is $1,000. Each bond is convertible into 20 shares of common stock. None were converted during 2005.

Dawson also had 60,000 stock warrants outstanding for all of 2005. The option price is $10 per share. The market price of the common stock was $40 on December 31, 2005, and the average market price for 2005 was $30.

Dawson reported a net income of $3,650,000 for 2005. Assume the company had a 40 percent income tax rate.

(1)

Compute the basic earnings per share.

(2)

Compute diluted earnings per share.

ANS:

(1)

BEPS

= $3,650,000 / 950,000

= $3.84 (rounded)

(2)

DEPS

= ($3,650,000 + 350,000 - 140,000) / [950,000 + 6/12 (200,000) +

(60,000 - 20,000)]

= $3,860,000 / 1,090,000

= $3.54 (rounded)

Bonds--dilutive:

($10,000,000 .07 .60) / (10,000 20) = $2.10

$2.10 < $3.84

Incremental shares = 10,000 20 = 200,000

Interest avoided = $10,000,000 7% x 6/12 = $350,000

Tax savings on interest = $350,000 0.40 = $140,000

Stock options--dilutive

Proceeds $10 60,000 = $600,000

$600,000 / $30 = 20,000 shares

Incremental shares = 60,000 - 20,000 = 40,000

OBJ:LO 4

11.At December 31, 2005, EMD Company had 500,000 shares of common stock outstanding. EMD sold 50,000 shares on October 1, 2006. Net income for 2006 was $2,417,875; the income tax rate was 30%. In addition, EMD had the following debt and equity securities on its books on December 31, 2006:

(a)

18,000 shares of $100 par, 12% cumulative preferred stock.

(b)

28,000 shares of $100 par, 10% cumulative preferred stock, par $100, sold at 110. Each share of preferred stock is convertible into 2 shares of common stock.

(c)

$2,000,000 face value of 9% bonds sold at par.

(d)

$3,000,000 face value of 7% convertible bonds sold to yield 8%. Unamortized bond discount is $100,000 at December 31, 2006. Each $1,000 bond is convertible into 20 shares of common stock.

Options to purchase 10,000 shares of common stock were issued May 1, 2006.

Exercise price is $30 per share; market value at date of option was $29; average market value May 1 to December 31, 2006, was $40.

Compute the earnings per share amounts for the year ended December 31, 2006.

ANS:

1.

Computation of basic earnings per share:

Net income ...........................

$2,417,875

Less: Dividends on cumulative

preferred stock:

18,000 x $100 x .12 ................

$216,000

28,000 x $100 x .10 ................

280,000

496,000

Net income identified with common stock

$1,921,875

Weighted average number of shares:

Jan. 1 to Oct. 1 (500,000 x 3/4)......

375,000

Oct. 1 to Dec. 31 (550,000 x 1/4).....

137,500

Total...............................

512,500

Basic earnings per share ...............

$3.75

2.

Computation of diluted earnings per share:

Test for dilution of convertible securities:

Net Income

Number of

Incremental

Impact

Shares

EPS

7% Convertible bonds

$168,000 *

60,000

$2.80

10% Convertible preferred stock

280,000

56,000

5.00

*$3,000,000 .08 .70 = $168,000; effective interest is amount charged to interest expense, not interest paid.

Since only the convertible bonds are less than the basic earnings per share of $3.75, only the convertible bonds are potentially dilutive.

Net

Number of

Part of

Weighted

Description

Income

Shares

Year

Average

EPS

Basic earnings per share

$1,921,875

512,500

$3.75

May 1, 2006, options as if

exercised May 1, 2006:

Number of shares assumed issued:

10,000

Less: number of treasury shares (10,000 $30) $40

7,500

2,500

8/12

1,667

$1,921,875

514,167

$3.74

7% convertible bonds

168,000

60,000

Diluted earnings per share

$2,089,875

574,167

$3.64

OBJ:LO 6

12.Statement of Financial Accounting Standards No. 128, "Earnings Per Share," requires that earnings per share figures be presented only by companies with publicly held common stock or potential common stock.

List arguments for and against the exclusion of nonpublic companies from the requirement of reporting earnings per share.

ANS:

Perhaps the major argument for not requiring earnings per share for nonpublic enterprises relates to the issue of standards overload. Authoritative accounting pronouncements have increased both in quantity and complexity. Managers of small companies believe that the cost of complying with complex standards exceeds the value of the benefits derived from the information disclosed under these standards. Small firms having limited resources cannot afford the enormous cost of complying with complex and costly standards that require information of questionable value.

A major argument for requiring earnings per share information even for nonpublic companies is the fact that many enterprises exempted from the requirement are neither small nor closely held. Many nonpublic enterprises are large and complex entities whose financial reports are widely distributed. Such enterprises may be in direct competition with enterprises whose securities are traded in public markets. Suspension of the requirement for reporting earnings per share for some enterprises in an industry, but not for others, is not sustainable solely on the basis of differences in form of ownership. Arguments regarding the cost and benefits of pronouncements are problematical because costs of applying a standard may be identified, but valuing the benefits derived is difficult. The increasing complexity of business transactions suggests that the statement reader should be provided with as much information as possible in order to make an informed decision about the financial condition of the enterprise and the integrity and stewardship of management. If the standards relating to earnings per share and other matters are complex, it is only because the standards are reflecting the complexity of the transactions.

OBJ:LO 7

13.You are an independent CPA and have just acquired a new client, A. Dunn Manufacturing Company. The president of the company recently read an article advising a firm's management team to seek to maximize the long-run value of the firm's stock. The article mentioned profit maximization, earnings per share, and the role of these two factors in stock price maximization. The president wants your advice on how the choice of inventory cost flow methods (e.g., FIFO vs. LIFO) relates to profit maximization, earnings per share, and stock price maximization.

ANS:

The objective of a firm is not to maximize earnings per share or the accounting definition of profit. The correct objective is to maximize shareholder wealth, which is the price per share that is equivalent to the discounted cash flows of the firm. Maximizing earnings per share may actually result in a reduction in cash flows. For example, earnings per share during a period of rising prices would be higher for a firm that adopts FIFO inventory accounting rather than LIFO. FIFO matches older, lower costs against current revenues, resulting in a higher net income and higher earnings per share. LIFO would produce lower net income and earnings per share because more recent, higher costs are matched against current revenues. Nevertheless, FIFO is the wrong choice in a period of rising prices because it minimizes cash flow by maximizing taxes. LIFO should be chosen because it provides higher cash flows as a result of reducing income and thus reducing taxes. Since shareholders are concerned about discounted cash flow, they will assign a higher value to the shares of a company that uses LIFO accounting.

OBJ:LO 7

14.The price-earnings ratio frequently is used by analysts and investors for evaluating stock prices because it relates the earnings of the business to the current market price

of the stock. The ratio is computed by dividing the market price per share by the earnings per share before extraordinary items.

Explain how the price-earnings ratio should be interpreted, including any problems associated with the interpretation of the ratio.

ANS:

A stock selling at a high price-earnings ratio generally is regarded favorably by analysts. A high ratio shows that investors believe that the firm has good growth opportunities and that the firm's earnings are relatively safe. The lower risk of the earnings lowers the discount rate used in discounting future earnings to the present thus raising the present value of these discounted future cash flows and raising the stock price as a result. Nonetheless, a firm could have a high price-earnings ratio, not because stock price is high, but because earnings are low.

A major problem with the price-earnings ratios is the use of earnings per share in the denominator. Earnings per share reflect the somewhat arbitrary choices of accounting principles used to determine earnings. A firm's reported earnings could be changed substantially by the adoption of more conservative or less conservative accounting procedures. An additional problem with the price-earnings ratio is that only at the end of the fiscal year are the numerator and denominator measured as of the same date. The price-earnings ratio often is computed during the year using the earnings per share amount from the most recent financial statements or by using a moving quarterly average.

OBJ:LO 7