Financial instruments and reporting
The Dilution Engine
Basic EPS strips preferred dividends, diluted adds only dilutive shares by treasury-stock and if-converted, and segments clear 10 percent.
How the exam words it
- -The stem gives net income, preferred dividends, and weighted-average shares and asks for basic EPS.
- -It gives options with an exercise price and an average market price and asks for the incremental diluted shares.
- -It gives convertible bonds or preferred and asks for the numerator add-back and the denominator shares.
- -It gives segment revenue, profit, or assets and asks whether a segment is reportable.
The playbook
- 1Compute basic EPS as net income minus preferred dividends over weighted-average common shares, subtracting cumulative preferred whether or not declared.
- 2For options in the money, use the treasury stock method: incremental shares equal options minus (options times exercise price over the average market price).
- 3For convertibles, use if-converted: add back after-tax interest for bonds or the preferred dividend for preferred, and add the conversion shares.
- 4Include only dilutive securities, and flag a segment as reportable when its revenue, absolute profit or loss, or assets reach 10 percent of the segment total.
The trap
Forgetting to subtract undeclared cumulative preferred in basic EPS, or adding back pretax rather than after-tax interest under the if-converted method for bonds.
How the exam varies it
The same pattern, re-skinned along these axes:
Basic EPS versus diluted EPSTreasury stock method versus if-converted methodAn EPS computation versus a segment reportability test
Drill this pattern
8 questions of The Dilution Engine from across the AUD topics. Clear it by getting 5 right with a streak of 3.