Welcome back. In this lesson we'll continue our discussion about diluted earnings per share. Previously we talked about the if converted method which was used for convertible debt and convertible preferred stock. In this lesson, we'll talk about the treasury stock method. In earlier lessons, we talked about the accounting for stock options. So, exercise would have an impact on basic earnings per share by changing the number of shares outstanding, that we can account for readily in doing our basic earnings per share by using the weighted average of the number of shares. But that diluted earnings per share is going to be calculated again as if those contingent shares were converted for the entire period. And it's calculated using something called the treasury stock method. So why a different method? Well, a difference between conversion of debt or preferred stock in exercise of an option as the proceeds from the stock price. Remember conversion of debt doesn't usually require an additional investment from the debt holder, you have a certain amount of that that's convertible into a certain number of shares. The same is usually true of preferred stock. Exercise of an option however or a warrant requires payment from the holder equal to the strike price. You recall when we discussed stock options and issuance of the stock option, the strike price or the exercise price was usually equal to the fair value of the stock, but over time this could change, but when you exercise the option you have to make a payment. So the question then becomes how do we account for the proceeds? Remember that when we were doing basic earnings per share, the reason why we used a weighted average was the theory, was that those resources were available to the company at the time the stock was issued. So if I issued stock for cash, I would do a weighted average because that reflects a period which the resources were available to the firm. Well for basic EPS, again that weighing does address the availability issue, the problem is how do we address that availability issue for diluted EPS, in a manner that's representationally faithful and comparable for options. The answer was the treasury stock method. We're going to assume exercise of options and warrants at the beginning of the period, or at issuance again if later. And you're going to assume that those proceeds are then used to purchase common stock at the average market price during the period. So that will include the incremental number of shares in the denominator when calculating earnings per share. What do we mean by incremental number of shares? We're going to take the number of shares that were issued on exercise of that option, and will decrease it based upon the number of shares I could have repurchased with the proceeds at the average stock price during the period. Complicated yes. But this is a way of coming up with a comparable method for accounting for the proceeds from our options across firms. So let's take an example with warrants. Let's go back to Stone Cold Refrigeration. They issue warrants to buy half a million shares of common stock at sixty dollars a share for a period of five years. They issue them on April 1st. So that's the beginning of the quarter. Net income for the second quarter was four million five hundred thousand. The average market price of the stock was 70 dollars a share. What is the impact on basic and diluted earnings per share? Well, there's no impact on basic earnings per share because these are warrants. But on the loaded earnings per share, we will assume that the warrants are converted to stock at the beginning of the period or the issued date if later. The number of shares increases by 500,000. But the proceeds are sixty dollars, the exercise price times 500,000 equals 30 million. I'm going to use that $30 million to repurchase treasury shares, hence the name, treasury stock method. The next step we're going to use those proceeds.30 million divided by the average share price is 70 dollars per share, is 428571. So now the net increase in the denominator is going to be 500000 shares issued, minus 428 571 shares repurchased, equals a net increase of 71,428 shares. There's no numerator effect. All of the effect is in the denominator. We haven't changed the numerator at all, and we're changing the denominator by the net effect based upon the shares being converted and taking the proceeds, and repurchasing some of those shares at the average market price during the period. And the net impact then is to add 71,428 to the denominator, when we calculate diluted earnings per share. So the higher the stock price is relative to the proceeds, the more the dilution will be. If the stock price and the proceeds are the same, the average stock price and the exercise price are the same, there would be zero dilution. And this we'll see subsequently in the next lesson, if the share price is less than the exercise price there would be anti dilution and we won't even consider it. So, let's go look at an example of the disclosure for earnings per share basic and diluted earnings per share. So let's take a look at a real life example. This is Nvidia Corporation which has done very well, thank you very much, out of gaming technology and now the technology for Artificial Intelligence in driverless cars for example. This is their discussion on earnings per share and they quote of course net income per share. Net income and earnings are generally interchangeable terms. So they described their basic net income per share or basic earnings per share, and it's computed as we discussed using that weighted average number of shares outstanding during the period. They talk about diluted earnings per share is computed using the weighted average number of common and potentially diluted shares outstanding during the period, and again they're using the treasury stock method, and they're not going to include anything in the calculation that's anti dilutive. They also have convertible notes which are outstanding with a net settlement feature that requires us premium conversion to settle the principal and amount of debt for cash, and the conversion premium for cash or shares of our common stock. So these could be settled in either cash or common stock. The convertible notes, note hedges and warrants, they contain various conversion features further described in note 11. They described this as the only be included again. If they're dilutive, and they talk about the hedges which we haven't talked about in this course which gets into a little bit more complicated discussion where the note hedges will not be included in the calculation of diluted earnings per share, because the pre exercise effect would be anti-dilutive under the treasury stock. So here is their reconciliation, the numerators and denominators, and here they start with net income and here's your denominator for your basic weighted average shares. And then they look at the diluted securities for equity awards, the stock compensation, the senior notes, and they look at the warrants issued which were essentially stock options, and they come up with a diluted weighted average per share. And you can see there's a pretty healthy difference between the basic earnings per share of three dollars and eight cents, and the diluted earnings per share of two dollars and 50 percent. And there were eight awards that were excluded because their effect would be anti-dilutive. And you know now that that means that the exercise price would be more than the fair value of the stock. They do describe how it's calculated as net income divided by basic weighted average shares, and calculated its net income divided by the mode of weighted shares. So here's a discussion in the notes that provide some additional information. The one percent convertible senior notes are included in the calculation of diluted earnings per share. Why? Well there's a conversion price, an adjusted conversion price of 20 dollars and 6 cents per share, and then the warrants have a dilutive impact because they have a conversion price of 27 dollars per share, at a time when the average stock price was 59 dollars and 30 cents per share. So now we know from our course, that that dilution whenever you have a strike price, an exercise price, that's less than fair value that they're going to be dilutive. If this fair value of the stock was 15 dollars, these would both be anti dilutive. So this is an example of how you can have a dilutive convertible note when you have a strike price on this. By the way, why are they using the treasury stock method instead of the if converted method because there is a conversion price, that's on these shares. So even though they're convertible, there is a conversion price that's involved adjusted. The denominator for diluted net income per share does not include any effect from convertible note hedge transactions. We didn't talk about that but it does talk about here that the effect would be dilutive which means that probably the options that they're using for the hedges are in the money. So here they entered into an agreement with a counterparty bank to terminate 63 million of the 75 million warrants outstanding, and a consideration of that, they delivered a total of 48 million shares of common stock to the counterparty bank which was determined each day based upon the shares, and the 44 million of the 48 million that had been issued related to the terminated warrants and the remaining 4 million were issued in the beginning of the fiscal year 2018. So you know then that these are options, right? So they would have been included in the diluted earnings per share from the beginning of the period, but only the 44 million that's actually exercised would be included once it's exercised. So those would be in your basic earnings per share. But the whole 48 million would have been in diluted earnings per share. The additional 4 million, because they weren't issued until 2018, won't affect basic earnings per share until 2018. So you can see the rest of this by going online and Invidia as a public corporation. So these financial statements are available to anyone. You can just use a search engine and find it without any problem. But this just gives you an idea of how the what we're talking about here gets disclosed in the notes and now that you understand the secret of how this is calculated you can understand this note yourself. And that concludes our discussion on earnings per share for this module. Thank you very much.
