Diluted earnings per share is the amount of earnings for the period available to each share of common stock outstanding during the reporting period and to each share that would have been outstanding assuming the issuance of common shares for all dilutive potential common shares outstanding during that period (FASB Statement No. 128, Appendix E). Potential common stock is a security or other contract that may entitle its holder to obtain common stock during the reporting period or after the end of it, so options, warrants, convertible debt, convertible preferred stock and contingent stock agreements all sit inside the term, and dilution is the reduction in earnings per share that assuming their conversion, exercise or issuance produces (FASB Statement No. 128, Appendix E).
How the Number Is Built
The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued (FASB Statement No. 128, paragraph 11).
Written as an equation, that is income available to common stockholders plus the effect of assumed conversions, over the weighted-average number of common shares plus the dilutive potential common shares (FASB Statement No. 128, Appendix C).
diluted EPS = (income available to common stockholders + effect of assumed conversions)
/ (weighted-average common shares + dilutive potential common shares)The numerator starts from income available to common stockholders, which is income or loss from continuing operations, or net income or net loss, adjusted for preferred stock dividends (FASB Statement No. 128, Appendix E). How that deduction behaves on a cumulative class, where the period’s accumulation reduces the figure whether or not a dividend is declared, is set out in preferred stock.
The denominator starts from the weighted-average number of common shares outstanding, the count produced by relating the portion of time within a reporting period that common shares have been outstanding to the total time in that period (FASB Statement No. 128, Appendix E). Two mechanics carry the common cases, and they are not interchangeable.
The Treasury Stock Method
The dilutive effect of outstanding call options and warrants, and their equivalents, issued by the reporting entity is reflected in diluted EPS by application of the treasury stock method unless other provisions of the standard require that another method be applied (FASB Statement No. 128, paragraph 17). Under that method, exercise is assumed at the beginning of the period, or at the time of issuance if later, the proceeds from exercise are assumed to be used to purchase common stock at the average market price during the period, and the incremental shares, meaning the difference between the number of shares assumed issued and the number of shares assumed purchased, are included in the denominator (FASB Statement No. 128, paragraph 17).
Equivalents of options and warrants include nonvested stock granted under a share-based payment arrangement, stock purchase contracts and partially paid stock subscriptions, and antidilutive contracts such as purchased put options and purchased call options are excluded from diluted EPS altogether (FASB Accounting Standards Update 2020-06).
Options and warrants have a dilutive effect under this method only when the average market price of the common stock during the period exceeds the exercise price of the options or warrants, which is what being in the money means here (FASB Statement No. 128, paragraph 18). At or below that price the assumed proceeds buy back at least as many shares as the assumed exercise issues, so nothing is added. The method takes its name from the assumed repurchase rather than from stock a corporation actually holds uncancelled, and that separate equity item is in treasury shares.
The If-Converted Method
The dilutive effect of convertible securities is reflected in diluted EPS by application of the if-converted method, under which the convertible preferred stock or convertible debt is assumed to have been converted at the beginning of the period, or at the time of issuance if later, and the resulting common shares are included in the denominator (FASB Statement No. 128, paragraph 26).
Because the conversion is assumed, the payments the entity would then no longer make are returned to the numerator. Preferred dividends applicable to convertible preferred stock are added back, interest charges applicable to convertible debt are added back, and the numerator is adjusted for the income tax effect of those add-backs (FASB Statement No. 128, paragraph 26).
One carve-out changes that add-back. For convertible debt for which the principal is required to be paid in cash, the interest charges are not added back to the numerator (FASB Accounting Standards Update 2020-06).
The codified home is ASC Topic 260, which carries the treasury stock method at paragraph 260-10-45-23 and the if-converted method at paragraph 260-10-45-40 (FASB Accounting Standards Update 2020-06). How an address like that reads is in ASC accounting.
The Reverse Treasury Stock Method
A third mechanic sits outside both. Contracts that require the reporting entity to repurchase its own stock, such as written put options and forward purchase contracts, are reflected in the computation of diluted EPS if the effect is dilutive, and where those contracts are in the money during the reporting period, meaning the exercise price is above the average market price for that period, the dilutive effect is computed using the reverse treasury stock method (FASB Statement No. 128, paragraph 24).
Under that method the assumed cash runs the other way. Issuance of enough common shares is assumed at the beginning of the period, at the average market price during the period, to raise the proceeds the contract needs, those proceeds are assumed to be used to satisfy the contract by buying shares back, and the incremental shares, meaning the difference between the number of shares assumed issued and the number of shares received from satisfying the contract, are included in the denominator (FASB Statement No. 128, paragraph 24).
The Antidilution Rule
Potential common shares enter the computation only where they lower the per-share result. The computation of diluted EPS does not assume conversion, exercise or contingent issuance of securities that would have an antidilutive effect on earnings per share, and in making that determination each issue or series of issues of potential common shares is considered separately rather than in the aggregate (FASB Statement No. 128, paragraph 13). Antidilution is an increase in earnings per share amounts or a decrease in loss per share amounts (FASB Statement No. 128, Appendix E).
Order matters once several issues are outstanding, because a convertible security can be dilutive on its own and antidilutive when included with other potential common shares. To reflect maximum potential dilution, each issue or series of issues is considered in sequence from the most dilutive to the least dilutive, so those with the lowest earnings per incremental share are included before those with a higher one (FASB Statement No. 128, paragraph 14).
A loss shuts the door. No potential common shares are included in the computation of any diluted per-share amount when a loss from continuing operations exists, even if the entity reports net income (FASB Statement No. 128, paragraph 16). An entity that reports a discontinued operation in a period uses income from continuing operations, adjusted for preferred dividends, as the control number for deciding whether potential common shares are dilutive or antidilutive, so the same number of potential common shares used for that line is used in computing every other reported diluted per-share amount (FASB Accounting Standards Update 2015-01, ASC 260-10-45-18).
A Worked Example
Say a corporation’s records for the year carry the figures below, with no preferred stock outstanding.
Net income 2,400,000
Weighted-average common shares outstanding 1,000,000
Options outstanding 100,000
Exercise price 15
Average market price during the period 25
Convertible debt, face amount 1,000,000
Stated interest at 6% 60,000
Common shares issuable on conversion 50,000
Tax rate assumed 21%
Basic EPS 2,400,000 / 1,000,000 = 2.40
Treasury stock method
assumed proceeds 100,000 x 15 = 1,500,000
shares repurchased 1,500,000 / 25 = 60,000
incremental shares 100,000 - 60,000 = 40,000
If-converted method
interest add-back 60,000 x (1 - 0.21) = 47,400
shares added = 50,000
Antidilution check, most dilutive first
options 0 / 40,000 = 0.00
convertible debt 47,400 / 50,000 = 0.95
Diluted numerator 2,400,000 + 47,400 = 2,447,400
Diluted denominator 1,000,000 + 40,000 + 50,000 = 1,090,000
Diluted EPS 2,447,400 / 1,090,000 = 2.25Both issues sit below the basic figure on their earnings per incremental share, so both are dilutive and both go into the count. Had the exercise price stood above the average market price for the period, the assumed repurchase would have absorbed the whole assumed issuance and the options would have added nothing.
Who Has to Present Diluted Earnings Per Share
The requirement follows the securities rather than the size of the entity. Presentation of earnings per share is required of all entities that have issued common stock or potential common stock if those securities trade in a public market, either on a stock exchange, domestic or foreign, or in the over-the-counter market, including securities quoted only locally or regionally, and of an entity that has made a filing or is in the process of filing with a regulatory agency in preparation for the sale of those securities in a public market (FASB Statement No. 128, paragraph 6).
Two carve-outs sit in the same paragraph. Presentation is not required for investment companies or in statements of wholly owned subsidiaries, and an entity that is not required to present earnings per share but chooses to present it anyway does so under the same provisions (FASB Statement No. 128, paragraph 6).
Where the two figures land on the page turns on the capital structure. Entities with only common stock outstanding present basic per-share amounts for income from continuing operations and for net income on the face of the income statement, and all other entities present basic and diluted per-share amounts for those same two lines on the face of the income statement with equal prominence (FASB Statement No. 128, paragraph 36).
The disclosure is where a preparer’s schedule work actually lands. For each period for which an income statement is presented, an entity discloses a reconciliation of the numerators and the denominators of the basic and diluted per-share computations for income from continuing operations, and that reconciliation includes the individual income and share amount effects of all securities that affect earnings per share. The same paragraph calls for the securities that could potentially dilute basic EPS in the future but were left out of the diluted computation because including them would have been antidilutive (FASB Statement No. 128, paragraph 40).
What Diluted Earnings Per Share Is Not
Basic Earnings Per Share
Basic EPS is the amount of earnings for the period available to each share of common stock outstanding during the reporting period (FASB Statement No. 128, Appendix E), computed by dividing income available to common stockholders by the weighted-average number of common shares outstanding during the period (FASB Statement No. 128, paragraph 8). One line separates the two figures: basic counts the shares that exist, and diluted counts those plus the shares the dilutive contracts would produce. That is also why diluted EPS does not land above basic EPS on the same income, since a potential common share that would raise the figure is antidilutive and the rule keeps it out.
A Dilutive Deal
The word carries a second sense in transaction work, and it is not this computation. A deal is described as dilutive where the acquirer’s earnings per share would come out lower after it and accretive where they would come out higher, which is a forecast about what a transaction would do to a per-share result. The disciplined pro forma presentation an SEC filing takes for that comparison sits in accretion. Diluted EPS is a reported figure for a period that has already closed.
A stock split is a third thing again, because it raises every holder’s share count in the same proportion and does not dilute the ownership interests of existing shareholders at all, which stock split works through.
Common Questions
The standard does not answer that. The objective of diluted EPS is consistent with that of basic EPS, to measure the performance of an entity over the reporting period while giving effect to all dilutive potential common shares that were outstanding during the period (FASB Statement No. 128, paragraph 11), and the objective the standard carried forward from the earlier opinion was that earnings per share would be computed on a consistent basis and presented in the most meaningful manner (FASB Statement No. 128, paragraph 2). Neither sets a threshold.
The gap between the basic and the diluted figure is the effect of the dilutive potential common shares that were outstanding during the period (FASB Statement No. 128, paragraph 11), and the required reconciliation names each of those securities and its individual effect.
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