The calculation of the weighted average number of shares outstanding itself is not that difficult (see IAS 33 Example 2 or below example). And it is even easier if no changes have taken place in the number/amount of shares issued during the year. The general principle under IAS 33 is that shares should be included in calculating the weighted average number of shares outstanding during a year from the date the consideration is receivable (which in general is the date of the issue of the shares). [IAS 33 21]
Where shares are issued as consideration for the purchase of an asset or the payment of a liability, the shares are included in the calculation of the weighted average number of shares outstanding during a year from the date the asset is recognised or the liability is settled. In other situations, the date of inclusion should be derived from the terms and conditions attached to the issue of the respective shares. However, the substance of contracts associated with the issue (or buy back) of shares should also be considered. IAS 33 includes some examples to ensure proper and timely inclusion of shares issued in the calculation of the weighted average number of shares outstanding during a year:
- ordinary shares issued in exchange for cash are included when cash is receivable;
- ordinary shares issued on the voluntary reinvestment of dividends on ordinary or preference shares are included when dividends are reinvested;
- ordinary shares issued as a result of the conversion of a debt instrument to ordinary shares are included from the date that interest ceases to accrue;
- ordinary shares issued in place of interest or principal on other financial instruments are included from the date that interest ceases to accrue;
- ordinary shares issued in exchange for the settlement of a liability of the entity are included from the settlement date;
- ordinary shares issued as consideration for the acquisition of an asset other than cash are included as of the date on which the acquisition is recognised; and
- ordinary shares issued for the rendering of services to the entity are included as the services are rendered. [IAS 33 21]
Then there are partly paid shares….. (IAS 33 A15 – A16): Partly paid shares (ordinary shares issued but not fully paid), are treated in the calculation of basic earnings per share as a fraction of an ordinary share (payments received at reporting date as proportion of the total subscription price) to the extent that they were entitled to participate in dividends during the period relative to a fully paid ordinary share. If the partly paid shares are not entitled to participate in dividends they are also not included in the basic EPS calculation, but off course included in the calculation of diluted EPS.
The number of weighted average shares outstanding is used in calculating metrics such as Earnings per Share (EPS) in order to provide a fair view of a company’s financial condition.
Simply using the number of shares outstanding at the end of the reporting period might give a distorted picture of the company. Imagine a situation where the company exercises a share buyback at the end of the year. If that figure is taken and used to calculate EPS, It would be much higher and it would eventually amount to polishing the financial figures.
Suppose that Company XYZ Corporation has 500,000 shares at the beginning of its financial reporting period, i.e., April 1, 2016. At the beginning of the second quarter, debenture holders of the company decided to convert their holdings into equity shares totaling 100,000 shares. At the beginning of the fourth quarter, the company buys back 50,000 shares with its cash surplus. Now, the shares outstanding at the end of the year stand at 500,000 + 100,000 – 50,000 = 550,000. Now, should this figure be used to calculate EPS? No.
The number of shares outstanding has to be weighted over the period outstanding as follows:
Number of shares outstanding
Weighted average number of shares outstanding
For example, the opening figure of 500,000 remained unchanged for 3 months of the 12 month reporting period until the start of the second quarter, after which it changed (as a result the weighted average number of shares outstanding in the first quarter of the 12 month financial reporting period was 500,000 * 3 / 12 = 125,000).
Shares outstanding include shares owned by retail and institutional investors and restricted shares held by company officials and employees. Changes in the composition of the holdings do not change the number of total shares outstanding. New share issues, the exercise of stock options, conversion, and cancellations through buybacks will change the figure.
To achieve a proper and fair view of the changes in the number of shares and for calculation of EPS, the method of weighted average shares outstanding is used.
Basic EPS vs. Diluted EPS
The EPS calculated using the weighted average number of shares outstanding (see above calculation table example) is actually the “Basic EPS.”
The formula is as follows:
Basic EPS = (Net Income – Preferred Dividend) / Weighted Average Shares Outstanding
Basic EPS uses outstanding shares, which are actually held by the public and company insiders. These shares are non-dilutive because they do not include any options or securities that can be converted.
On the other hand, while calculating the dilutive EPS, the denominator includes all possible conversions that can take place and increase the number of shares held by parties. Diluted EPS is always less than the basic EPS as the denominator in the latter is higher. Companies with options, convertible bonds, etc., disclose both basic as well as diluted EPS in their financial disclosures.
In case there is a large difference between basic and diluted EPS, investors should be aware of the possible increase in the number of shares outstanding in the future.
See also: The IFRS Foundation