[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.

[Mike J]

But, if you're assuming conversion of the preferred stock into common, does that obligation still exist?

Aren't you giving up the privileges of preferred stock to have voting rights w common? Like with the WACSO calculation, aren't you assuming that stock splits happened from the beginning (eg not reducing it by a time conversion (stock x mm/12))?

If a tree falls in the forrest and no one is around does it still get to earn dividends?

[Anonymous]

@mjbey1s yes that's what I was trying to say earlier 🙂 my understanding is that you always subtract preferred dividends from the numerator to get both basic and diluted EPS. @mike, you still do this even though you are assuming conversion for the purposes of the weighted average shares of common stock. I have no idea why.

[mjbey1s]

@Mike030882, now i think you are right. I just found another example. Do either one of you have the Becker FAR book? Found a perfect example that might solve this topic.

[Mike J]

I have one from 2012. Yes, it's taken me awhile to get to only needing one exam.

[mjbey1s]

If could snap a picture of this page, all of our problems would be solved. In essence, @Mike030882 is correct.

Per the page I am currently reading and studying, “Note: The preferred stock dividends are not sutracted from Net Income for diluted EPS. We assume that since the preferred stock was converted into common stock, the preferred stock dividends were not paid.

So to conclude, if there is preferred dividends paid and and they are not converted to common stock, then you would subtract them in the numerator. If the preferred stock is converted to common, then you do not. You would only add back “after tax interest on bonds” if applicable.

[Anonymous]

I have the Becker FAR book too

[Anonymous]

Which page was that on?

[mjbey1s]

I have the newest FAR Becker book. Page 29 in F7 explains all of what i just described above in a great example if anyone wants to understand better.

[mjbey1s]

Let me know if looking at that example if it now makes sense.

[Mike J]

@mjbey1s,

Thanks. That's what I thought. Per the Bisk video, you are to assume conversion at its earliest point possible.

I'd still like Jeff to weigh in.

Regardless, thank you all for responding. This has been driving me nuts since Veterans' Day!

[mjbey1s]

@Mike030882, no problem, this topic haunted me on my last exam as i always seem to have tons of questions over the topic. Page 31 of the Becker book also has a pass key that specifically states that on Convertible P/S, do not decrease net income by preferred dividends. I don't know why i didn't see this before. I guess because this time, I am reading every single page of the Becker book:)

[Anonymous]

Ah okay, I see that now. I should probably start paying more attention to the examples haha.

So in the problem Mike originally posted, we are subtracting the preferred dividends to get diluted EPS because they are not convertible, right?

[mjbey1s]

@Mike030882, not problem. page 31 of the becker book also has a pass key that specifically states that on convertible P/S, to never decrease net income by the amount of the preferred dividends. I don't know why i never picked up on this before. Maybe because I am reading every single page of the Becker book this time:) Good luck!

[Mike J]

@Allison,

From the given information: “Convertible, noncumulative preferred stock issued at $50 par: $50,000”

So anything convertible is assumed converted. But for some reason it isn't fully converted.

It's quite possible I missed something. That's why I'm confused.

[mjbey1s]

Ok i see what your saying now too. Yes, if we can get Jeff to weigh in on this, I would like to understand why any amount of preferred should be subtracted from the numerator. Sorry, i missed the issue in the above questions.

[Author]

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