[Mike J]

NINJA Question –

At the end of 20X1, the following information applies to Brady Company:

Net income: $46,575
Common stock issued: $215,000 ($10 par value)
5%, $50 cumulative preferred stock issued: $50,000
Dividends declared on common stock: $21,500
Convertible, noncumulative preferred stock issued at $50 par: $50,000

Use this information to compute the basic and diluted earnings per share (EPS) below. Assume that the common shares given are presented as a weighted average.

Compute the basic and diluted EPS for Brady Company

…

The Basic EPS Solution:

For cumulative preferred stock, we must assume that the dividends will be issued even if they have not been declared.
• $50 × .05 = $2.50 per share
• $50,000 ÷ $50 = 1,000 shares
• $2.50 × $1,000 = $2,500 in preferred dividends

The noncumulative convertible preferred stock has no dividends issued and does not enter into the calculation.

Common stock is $215,000 at $10 par value, or 21,500 shares.
Basic EPS = $46,575 – $2,500
21,500 = $2.05 per share

I’m fine with the solution for Basic EPS. Although, computing the dividend was tricky. But, I do see it.

…

Solution for the Diluted EPS:

Diluted EPS = Net income – Dividends on preferred stock
Weighted average common shares + Potential common shares

The dilution results from the assumption that convertible securities were converted, that options or warrants were exercised, or that other shares were issued on the satisfaction of certain conditions.

In this problem, Brady Company has issued convertible preferred stock at $50 par ($50,000 ÷ $50 = 1,000 shares issued). These stockholders have the ability to convert to common stock.

This preferred stock is noncumulative, and no preferred dividends have been declared, so we do not have to take these dividends into account in the calculation.
Diluted EPS = $46,575 – $2,500
21,500 + 1,000 = $1.96 per share

…

My question is the with the solution to Diluted. If you assume the conversion of Preferred Stock into Common, can there be a dividend to subtract in the numerator?

So, shouldn’t the Dilutive Equation be: merely the 46,575 Net Income / 21,500 WACSO + 1,000 converted Pref Stock?
Why are we still subtracting the Preferred Stock Dividend if there is no preferred stock dividend?

Please explain.

[vodrldnr]

5%, $50 cumulative preferred stock issued: $50,000

Because the dividend for preferred stock is cumulative in this problem.

[Mike J]

@vodrldnr,

Thanks for responding.

For Basic–I know we have to subtract the preferred stock dividend regardless of if it's declared because it's cumulative.

For Diluted–shouldnt the preferred dividend disappear now because we assume conversion to common stock w diluted? Thus we add the shares to WACSO.

Thanks.

[vodrldnr]

@Mike030882

To get Diluted EPS, the first thing you need to is to find Basic EPS.

As you know, you need to subtract preferred stock dividend for Numerator.

Basic EPS * (Dividend that was avoided due the conversion / common share issued upon conversion of Preferred stock)

Think of it as two separate calculation. Basic EPS and Dilutive EPS.

[mjbey1s]

@vodrldnr, I do not think you are giving correct information. You do not always subtract preferred dividends when calculating diluted EPS. In fact, I do not think you ever do. You take Net Income and add back the interest on dilutive securities for the numerator

[mjbey1s]

correction…..you only add back preferred in the numerator if they are convertible preferred dividends.

[Mike J]

@mjbey1s

With respect to vodrldnr, I didn't think they were correct either.

I pasted the exact solution set.

…

For Basic, I believe Vod was correct. But, for Diluted, I thought the numerator is just Net Income and the denominator is the weighted average of common stock outstanding shares + the preferred shares that we assume are converted.

To put it another way, if we are assuming they are converted, there wouldn't be any preferred stock dividends to subtract because there would be no preferred stock, yes?

[Anonymous]

@mjbey1s I thought that you always subtract preferred dividends from the diluted EPS numerator whether they are convertible or not (because the numerator is income available to the common shareholders). Isn't that what they're doing in the solution Mike posted?

@Mike, I was wondering the same thing about the preferred dividends. I think the reason you have to subtract them might be because the company owes them to those shareholders right now regardless of whether or not they later choose to convert their stock.

[mjbey1s]

Sorry, I meant to say subtract preferred, not add to net income. My mistake. I really do not think that you ever subtract preferred from the numerator for diluted, only for Basic EPS.

We need to get an expert on this post so we can all get a greater understanding. I had a lot of questions on Basic and diluted EPS on my last FAR exam. Need to pass on 1/6 to be done!

[jeff]

I'll take a look at the question – I'll need some time to dive into it, so it won't be until Monday or so.

[mjbey1s]

Thanks Jeff, we would all really appreciate it. Have a great thanksgiving holiday.

[Mike J]

Thank you, Jeff. If memory serves, I believe how I described it is how it was described in the Bisk bodies.

By the way, the videos are excellent. $67 is an absolute steal!

[jeff]

Thanks Mike – so…is the issue that the NINJA MCQ question is wrong or the Bisk/PLUS video…or what…I'm confused now 🙂

[Mike J]

@Jeff

I'm sorry. I am basing my question off of what I believe the Bisk video said.

So yes, I believe the solution for the above-referenced NINJA SIM is incorrect.

The Basic EPS appears fine, just the Diluted appears wrong.

I also submitted a ticket.

[Mike J]

Oy spellcheck. Bisk bodies = Bisk Videos. Sorry that type-o was too dark considering…

[mjbey1s]

Everyone, I think I was wrong. Per the Becker FAR book, Chapter 7, page 25, the formula for Diluted EPS is the Income available to common shareholders PLUS interest on dilutive securities, divided by weighted avg common shares outstanding.

Per this information, to get to income available to common shareholders, you have to subtract preferred dividends, so i guess you always do subtract preferred dividends from the numerator for both Basis and Diluted EPS. Does anyone else agree with this?

Just trying to get this concept straight. Thanks

[Author]

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