[niggy]

I am very confused when I am doing an excise of calculating EPS. The question said:

The company had following capital structure during Yr 1 and Yr 2:

Preferred stock, $10 Par, 4% cumulative, 25,000 shares issued and outstanding $250,000

Common stock $5 par, 200,000 shares issued and outstanding.

The company reported net income of $500,000 for the year ended Dec 31, Yr 2. The company paid no dividend in Yr 1, and paid $16,000 in preferred dividends in Yr 2. So, for Yr 2, what is the basic EPS?

my calculation is $500,000 – 4% * 250,000 * 2 (for Yr 1 and Yr 2) = $480,000 available to common stock holders

Then basic EPS = $480,000 / 200,000 = 2.40

But the answer to this question is 2.45. So it didn’t count the $10,000 preferred dividend that accumulated but didn’t paid out for Yr 1. Can anyone tell me why??

AUD - 76 (May 2012)
BEC - 81 (July 2012)
REG - 61 (Aug 2012), rematch 83 (October 2012)
FAR - 85 (May 2013)

Based on Becker 2012 self-study.
Currently licensed PA CPA since July 2013.

[J]

The formula for Basic EPS is (Net Income – CY Preferred Dividends) / WACS Outstanding

With respect to cumulative preferred dividends in arrears, they are counted in the year that they go into arrears (if that makes sense), even if they have not been declared and hence are not a liability of the entity (the idea is that they are assigned to that year when they eventually are declared).

Hence, in this problem, $10,000 are preferred dividends in arrears from Year 1. When Year 2 dividends are paid to preferred shareholders ($16,000), only $10,000 would be counted as CY Preferred Dividends when calculating EPS; $10,000 would have been subtracted out from N.I. in Year 1, even if not paid/declared. This is true even though the entity is really only covering $6,000 of the $10,000 Year 2 preferred dividends. So, just plug the numbers into the formula:

(500,000 – 10,000) / 200,000 = $2.45 Basic EPS

[niggy]

I think i got your points. So you are trying to say, if I calculate Yr 1 basic EPS first, the $10,000 preferred dividend that didn't paid would count into Yr 1 formula. And if I already count it in Yr 1, I would not count it again in Yr 2, that's why only use current year preferred dividend number (don't care if it is paid or even declared).

Thank you for helping out! I really have issue understanding this EPS thing, but your explanation make sense!!

Thank you a lot!

AUD - 76 (May 2012)
BEC - 81 (July 2012)
REG - 61 (Aug 2012), rematch 83 (October 2012)
FAR - 85 (May 2013)

Based on Becker 2012 self-study.
Currently licensed PA CPA since July 2013.

[niggy]

I think i got your points. So you are trying to say, if I calculate Yr 1 basic EPS first, the $10,000 preferred dividend that didn't paid would count into Yr 1 formula. And if I already count it in Yr 1, I would not count it again in Yr 2, that's why only use current year preferred dividend number (don't care if it is paid or even declared).

Thank you for helping out! I really have issue understanding this EPS thing, but your explanation make sense!!

Thank you a lot!

AUD - 76 (May 2012)
BEC - 81 (July 2012)
REG - 61 (Aug 2012), rematch 83 (October 2012)
FAR - 85 (May 2013)

Based on Becker 2012 self-study.
Currently licensed PA CPA since July 2013.

[J]

Yes, exactly. Suppose you had the same information in terms of WACS outstanding for Year 1, and the entity's net income for Year 1 was $300,000. Even though you are not paying out preferred dividends in Year 1 and have not even declared them, you would still subtract out the amount that will go into arrears when calculating Basic EPS:

(300,000 – 10,000) / 200,000 = $1.45 EPS for Year 1.

The idea is kind of something along the lines of what is applicable or allocated to common shareholders in terms of earnings; the preferred dividends are subtracted out because even if not paid in that year, when dividends are eventually declared (and this is how a corporation's earnings are distributed out to shareholders), a preferred stockholder has preference on getting them, so whatever is left afterwards is available for the common shareholders.

By the way, one other important point: If preferred stock is noncumulative and dividends are not declared in a year, you don't include it in the calculation. The logic is the same; if it is not cumulative and not declared/paid in a certain year, no cumulative right exists and nothing would be in arrears and hence carried to the next year.

[Author]

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