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Principles of Accounting, Volume 1: Financial Accounting

14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance

Principles of Accounting, Volume 1: Financial Accounting14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
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  1. Preface
  2. 1 Role of Accounting in Society
    1. Why It Matters
    2. 1.1 Explain the Importance of Accounting and Distinguish between Financial and Managerial Accounting
    3. 1.2 Identify Users of Accounting Information and How They Apply Information
    4. 1.3 Describe Typical Accounting Activities and the Role Accountants Play in Identifying, Recording, and Reporting Financial Activities
    5. 1.4 Explain Why Accounting Is Important to Business Stakeholders
    6. 1.5 Describe the Varied Career Paths Open to Individuals with an Accounting Education
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
  3. 2 Introduction to Financial Statements
    1. Why It Matters
    2. 2.1 Describe the Income Statement, Statement of Owner’s Equity, Balance Sheet, and Statement of Cash Flows, and How They Interrelate
    3. 2.2 Define, Explain, and Provide Examples of Current and Noncurrent Assets, Current and Noncurrent Liabilities, Equity, Revenues, and Expenses
    4. 2.3 Prepare an Income Statement, Statement of Owner’s Equity, and Balance Sheet
    5. Key Terms
    6. Summary
    7. Multiple Choice
    8. Questions
    9. Exercise Set A
    10. Exercise Set B
    11. Problem Set A
    12. Problem Set B
    13. Thought Provokers
  4. 3 Analyzing and Recording Transactions
    1. Why It Matters
    2. 3.1 Describe Principles, Assumptions, and Concepts of Accounting and Their Relationship to Financial Statements
    3. 3.2 Define and Describe the Expanded Accounting Equation and Its Relationship to Analyzing Transactions
    4. 3.3 Define and Describe the Initial Steps in the Accounting Cycle
    5. 3.4 Analyze Business Transactions Using the Accounting Equation and Show the Impact of Business Transactions on Financial Statements
    6. 3.5 Use Journal Entries to Record Transactions and Post to T-Accounts
    7. 3.6 Prepare a Trial Balance
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  5. 4 The Adjustment Process
    1. Why It Matters
    2. 4.1 Explain the Concepts and Guidelines Affecting Adjusting Entries
    3. 4.2 Discuss the Adjustment Process and Illustrate Common Types of Adjusting Entries
    4. 4.3 Record and Post the Common Types of Adjusting Entries
    5. 4.4 Use the Ledger Balances to Prepare an Adjusted Trial Balance
    6. 4.5 Prepare Financial Statements Using the Adjusted Trial Balance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  6. 5 Completing the Accounting Cycle
    1. Why It Matters
    2. 5.1 Describe and Prepare Closing Entries for a Business
    3. 5.2 Prepare a Post-Closing Trial Balance
    4. 5.3 Apply the Results from the Adjusted Trial Balance to Compute Current Ratio and Working Capital Balance, and Explain How These Measures Represent Liquidity
    5. 5.4 Appendix: Complete a Comprehensive Accounting Cycle for a Business
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  7. 6 Merchandising Transactions
    1. Why It Matters
    2. 6.1 Compare and Contrast Merchandising versus Service Activities and Transactions
    3. 6.2 Compare and Contrast Perpetual versus Periodic Inventory Systems
    4. 6.3 Analyze and Record Transactions for Merchandise Purchases Using the Perpetual Inventory System
    5. 6.4 Analyze and Record Transactions for the Sale of Merchandise Using the Perpetual Inventory System
    6. 6.5 Discuss and Record Transactions Applying the Two Commonly Used Freight-In Methods
    7. 6.6 Describe and Prepare Multi-Step and Simple Income Statements for Merchandising Companies
    8. 6.7 Appendix: Analyze and Record Transactions for Merchandise Purchases and Sales Using the Periodic Inventory System
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  8. 7 Accounting Information Systems
    1. Why It Matters
    2. 7.1 Define and Describe the Components of an Accounting Information System
    3. 7.2 Describe and Explain the Purpose of Special Journals and Their Importance to Stakeholders
    4. 7.3 Analyze and Journalize Transactions Using Special Journals
    5. 7.4 Prepare a Subsidiary Ledger
    6. 7.5 Describe Career Paths Open to Individuals with a Joint Education in Accounting and Information Systems
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  9. 8 Fraud, Internal Controls, and Cash
    1. Why It Matters
    2. 8.1 Analyze Fraud in the Accounting Workplace
    3. 8.2 Define and Explain Internal Controls and Their Purpose within an Organization
    4. 8.3 Describe Internal Controls within an Organization
    5. 8.4 Define the Purpose and Use of a Petty Cash Fund, and Prepare Petty Cash Journal Entries
    6. 8.5 Discuss Management Responsibilities for Maintaining Internal Controls within an Organization
    7. 8.6 Define the Purpose of a Bank Reconciliation, and Prepare a Bank Reconciliation and Its Associated Journal Entries
    8. 8.7 Describe Fraud in Financial Statements and Sarbanes-Oxley Act Requirements
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  10. 9 Accounting for Receivables
    1. Why It Matters
    2. 9.1 Explain the Revenue Recognition Principle and How It Relates to Current and Future Sales and Purchase Transactions
    3. 9.2 Account for Uncollectible Accounts Using the Balance Sheet and Income Statement Approaches
    4. 9.3 Determine the Efficiency of Receivables Management Using Financial Ratios
    5. 9.4 Discuss the Role of Accounting for Receivables in Earnings Management
    6. 9.5 Apply Revenue Recognition Principles to Long-Term Projects
    7. 9.6 Explain How Notes Receivable and Accounts Receivable Differ
    8. 9.7 Appendix: Comprehensive Example of Bad Debt Estimation
    9. Key Terms
    10. Summary
    11. Multiple Choice
    12. Questions
    13. Exercise Set A
    14. Exercise Set B
    15. Problem Set A
    16. Problem Set B
    17. Thought Provokers
  11. 10 Inventory
    1. Why It Matters
    2. 10.1 Describe and Demonstrate the Basic Inventory Valuation Methods and Their Cost Flow Assumptions
    3. 10.2 Calculate the Cost of Goods Sold and Ending Inventory Using the Periodic Method
    4. 10.3 Calculate the Cost of Goods Sold and Ending Inventory Using the Perpetual Method
    5. 10.4 Explain and Demonstrate the Impact of Inventory Valuation Errors on the Income Statement and Balance Sheet
    6. 10.5 Examine the Efficiency of Inventory Management Using Financial Ratios
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  12. 11 Long-Term Assets
    1. Why It Matters
    2. 11.1 Distinguish between Tangible and Intangible Assets
    3. 11.2 Analyze and Classify Capitalized Costs versus Expenses
    4. 11.3 Explain and Apply Depreciation Methods to Allocate Capitalized Costs
    5. 11.4 Describe Accounting for Intangible Assets and Record Related Transactions
    6. 11.5 Describe Some Special Issues in Accounting for Long-Term Assets
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  13. 12 Current Liabilities
    1. Why It Matters
    2. 12.1 Identify and Describe Current Liabilities
    3. 12.2 Analyze, Journalize, and Report Current Liabilities
    4. 12.3 Define and Apply Accounting Treatment for Contingent Liabilities
    5. 12.4 Prepare Journal Entries to Record Short-Term Notes Payable
    6. 12.5 Record Transactions Incurred in Preparing Payroll
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  14. 13 Long-Term Liabilities
    1. Why It Matters
    2. 13.1 Explain the Pricing of Long-Term Liabilities
    3. 13.2 Compute Amortization of Long-Term Liabilities Using the Effective-Interest Method
    4. 13.3 Prepare Journal Entries to Reflect the Life Cycle of Bonds
    5. 13.4 Appendix: Special Topics Related to Long-Term Liabilities
    6. Key Terms
    7. Summary
    8. Multiple Choice
    9. Questions
    10. Exercise Set A
    11. Exercise Set B
    12. Problem Set A
    13. Problem Set B
    14. Thought Provokers
  15. 14 Corporation Accounting
    1. Why It Matters
    2. 14.1 Explain the Process of Securing Equity Financing through the Issuance of Stock
    3. 14.2 Analyze and Record Transactions for the Issuance and Repurchase of Stock
    4. 14.3 Record Transactions and the Effects on Financial Statements for Cash Dividends, Property Dividends, Stock Dividends, and Stock Splits
    5. 14.4 Compare and Contrast Owners’ Equity versus Retained Earnings
    6. 14.5 Discuss the Applicability of Earnings per Share as a Method to Measure Performance
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  16. 15 Partnership Accounting
    1. Why It Matters
    2. 15.1 Describe the Advantages and Disadvantages of Organizing as a Partnership
    3. 15.2 Describe How a Partnership Is Created, Including the Associated Journal Entries
    4. 15.3 Compute and Allocate Partners’ Share of Income and Loss
    5. 15.4 Prepare Journal Entries to Record the Admission and Withdrawal of a Partner
    6. 15.5 Discuss and Record Entries for the Dissolution of a Partnership
    7. Key Terms
    8. Summary
    9. Multiple Choice
    10. Questions
    11. Exercise Set A
    12. Exercise Set B
    13. Problem Set A
    14. Problem Set B
    15. Thought Provokers
  17. 16 Statement of Cash Flows
    1. Why It Matters
    2. 16.1 Explain the Purpose of the Statement of Cash Flows
    3. 16.2 Differentiate between Operating, Investing, and Financing Activities
    4. 16.3 Prepare the Statement of Cash Flows Using the Indirect Method
    5. 16.4 Prepare the Completed Statement of Cash Flows Using the Indirect Method
    6. 16.5 Use Information from the Statement of Cash Flows to Prepare Ratios to Assess Liquidity and Solvency
    7. 16.6 Appendix: Prepare a Completed Statement of Cash Flows Using the Direct Method
    8. Key Terms
    9. Summary
    10. Multiple Choice
    11. Questions
    12. Exercise Set A
    13. Exercise Set B
    14. Problem Set A
    15. Problem Set B
    16. Thought Provokers
  18. Financial Statement Analysis
  19. Time Value of Money
  20. Suggested Resources
  21. Answer Key
    1. Chapter 1
    2. Chapter 2
    3. Chapter 3
    4. Chapter 4
    5. Chapter 5
    6. Chapter 6
    7. Chapter 7
    8. Chapter 8
    9. Chapter 9
    10. Chapter 10
    11. Chapter 11
    12. Chapter 12
    13. Chapter 13
    14. Chapter 14
    15. Chapter 15
    16. Chapter 16
  22. Index

Earnings per share (EPS) measures the portion of a corporation’s profit allocated to each outstanding share of common stock. Many financial analysts believe that EPS is the single most important tool in assessing a stock’s market price. A high or increasing earnings per share can drive up a stock price. Conversely, falling earnings per share can lower a stock’s market price. EPS is also a component in calculating the price-to-earnings ratio (the market price of the stock divided by its earnings per share), which many investors find to be a key indicator of the value of a company’s stock.

Concepts In Practice

Microsoft Earnings Announcements Exceeds Wall Street Targets

While a company’s board of directors makes the final approval of the reports, a key goal of each company is to look favorable to investors while providing financial statements that accurately reflect the financial condition of the company. Each quarter, public companies report EPS through a public announcement as one of the key measures of their profitability. These announcements are highly anticipated by investors and analysts. The suspense is heightened because analysts provide earnings estimates to the public prior to each announcement release. According to Matt Weinberger of Business Insider, the announcement by Microsoft of its first quarter 2018 EPS reported at $0.95 per share, higher than analysts’ estimates of $0.85 per share, caused the value of its stock to rise by more than 3% within hours of the announcement.17 While revenue was the other key metric in Microsoft’s earnings announcement, EPS carried more weight in the surge of the company’s market price.

Calculating Earnings per Share

Earnings per share is the profit a company earns for each of its outstanding common shares. Both the balance sheet and income statement are needed to calculate EPS. The balance sheet provides details on the preferred dividend rate, the total par value of the preferred stock, and the number of common shares outstanding. The income statement indicates the net income for the period. The formula to calculate basic earnings per share is:

Earnings per Share equals (Net income minus Preferred dividends) divided by Weighted Average Common Shares Outstanding.

By removing the preferred dividends from net income, the numerator represents the profit available to common shareholders. Because preferred dividends represent the amount of net income to be distributed to preferred shareholders, this portion of the income is obviously not available for common shareholders. While there are a number of variations of measuring a company’s profit used in the financial world, such as NOPAT (net operating profit after taxes) and EBITDA (earnings before interest, taxes, depreciation, and amortization), GAAP requires companies to calculate EPS based on a corporation’s net income, as this amount appears directly on a company’s income statement, which for public companies must be audited.

In the denominator, only common shares are used to determine earnings per share because EPS is a measure of earnings for each common share of stock. The denominator can fluctuate throughout the year as a company issues and buys back shares of its own stock. The weighted average number of shares is used on the denominator because of this fluctuation. To illustrate, assume that a corporation began the year with 600 shares of common stock outstanding and then on April 1 issued 1,000 more shares. During the period January 1 to March 31, the company had the original 600 shares outstanding. Once the new shares were issued, the company had the original 600 plus the new 1,000 shares, for a total of 1,600 shares for each of the next nine months—from April 1 to December 31. To determine the weighted average shares, apply these fractional weights to both of the stock amounts, as shown in Figure 14.15.

Number of Shares times the Portion of Year equals Weighted Shares (respectively): 600 times 3/12 equals 150. 1,600 times 9/12 equals 1,200. Weighted average shares 1,350.
Figure 14.15 Weighted Shares. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

If the shares were not weighted, the calculation would not consider the time period during which the shares were outstanding.

To illustrate how EPS is calculated, assume Sanaron Company earns $50,000 in net income during 2020. During the year, the company also declared a $10,000 dividend on preferred stock and a $14,000 dividend on common stock. The company had 5,000 common shares outstanding the entire year along with 2,000 preferred shares. Sanaron has generated $8 of earnings ($50,000 less the $10,000 of preferred dividends) for each of the 5,000 common shares of stock it has outstanding.

Earnings per share=$50,000$10,0005,000=$8.00Earnings per share=$50,000$10,0005,000=$8.00

Think It Through

Ethical Calculations of Earnings per Share

When a company issued new shares of stock and buys other back as treasury stock, EPS can be manipulated because both of these transactions affect the number of shares of stock outstanding. What are ethical considerations involved in calculating EPS?

Measuring Performance with EPS

EPS is a key profitability measure that both current and potential common stockholders monitor. Its importance is accentuated by the fact that GAAP requires public companies to report EPS on the face of a company’s income statement. This is only ratio that requires such prominent reporting. If fact, public companies are required to report two different earnings per share amounts on their income statements—basic and diluted. We’ve illustrated the calculation of basic EPS. Diluted EPS, which is not demonstrated here, involves the consideration of all securities such as stocks and bonds that could potentially dilute, or reduce, the basic EPS.

Common stock shares are normally purchased by investors to generate income through dividends or to sell at a profit in the future. Investors realize that inadequate EPS can result in poor or inconsistent dividend payments and fluctuating stock prices. As such, companies seek to produce EPS amounts that rise each period. However, an increase in EPS may not always reflect favorable performance, as there are multiple reasons that EPS may increase. One way EPS can increase is because of increased net income. On the other hand, it can also increase when a company buys back its own shares of stock. For example, assume that Ranadune Enterprises generated net income of $15,000 in 2020. In addition, 20,000 shares of common stock and no preferred stock were outstanding throughout 2020. On January 1, 2020, the company buys back 2,500 shares of its common stock and holds them as treasury shares. Net income for 2020 stayed static at $15,000. Just before the repurchasing of the stock, the company’s EPS is $0.75 per share:

Earnings per share=$15,00020,000shares=$0.75pershareEarnings per share=$15,00020,000shares=$0.75pershare

The purchase of treasury stock in 2020 reduces the common shares outstanding to 17,500 because treasury shares are considered issued but not outstanding (20,000 − 2,500). EPS for 2020 is now $0.86 per share even though earnings remains the same.

Earnings per share=$15,00017,500shares=$0.86per shareEarnings per share=$15,00017,500shares=$0.86per share

This increase in EPS occurred because the net income is now spread over fewer shares of stock. Similarly, EPS can decline even when a company’s net income increases if the number of shares increases at a higher degree than net income. Unfortunately, managers understand how the number of shares outstanding can affect EPS and are often in position to manipulate EPS by creating transactions that target a desired EPS number.

Ethical Considerations

Stock Buybacks Drive Up Earnings per Share: Ethical?

Public companies can increase their earnings per share by buying their own stock in the open market. The increase in earnings per share results because the number of shares is reduced by the purchase even though the earnings remain the same. With fewer shares and the same amount of earnings, the earnings per share increases without any change in overall profitability or operational efficiency. A Market Watch article attributing Goldman Sachs states, “S&P 500 companies will spend about $780 billion on share buybacks in 2017, marking a 30% rise from 2016.”18 An article in Forbes provides some perspective by pointing out that buying back shares was legalized in 1982, but for the majority of the twentieth century, corporate buybacks of shares was considered illegal because “they were thought to be a form of stock market manipulation. . . . Buying back company stock can inflate a company’s share price and boost its earnings per share—metrics that often guide lucrative executive bonuses.”19 Is a corporation buying back its shares an ethical way in which to raise or maintain the price of a company’s shares?

Earnings per share is interpreted differently by different analysts. Some financial experts favor companies with higher EPS values. The reasoning is that a higher EPS is a reflection of strong earnings and therefore a good investment prospect. A more meaningful analysis occurs when EPS is tracked over a number of years, such as when presented in the comparative income statements for Cracker Barrel Old Country Store, Inc.’s respective year ends in 2017, 2016, and 2015 shown in Figure 14.16.20 Cracker Barrel’s basic EPS is labeled as “net income per share: basic.”

Cracker Barrel Old Country Store, Inc. Consolidated Statements of Income (In thousands except share data) Fiscal years ended July 28, 2017, July 29, 2016, and July 31, 2015 (respectively): Total Revenue $2,926,289, 2,912,351, 2,842,284. Less Cost of goods sold (exclusive of depreciation and rent) 891,293, 928,176, 924,171. Less Labor and other related expenses 1,017,124, 1,066,188, 992,382. Less Other store operating expenses 563,300, 554,534, 523,307. Equals Store operating income 454,572, 423,453, 402,424. Less General and administrative expenses 141,414, 142,982, 147,544. Equals Operating income 313,158, 280,471, 254,880. Less Interest expense 14,271, 14,052, 16,679. Equals Income before income taxes, 298,887, 266,419, 238. Less Provision for income taxes 96,988, 77,120, 74,298. Equals Net income 201,899, 189,299, 163,903. Net income per share: basic $8.40, 7.91, 6.85. Net income per share: diluted $8.37, 7.86, 6.82. Basic weighted average shares outstanding 24,031,810, 23,945,041, 23,918,368. Diluted weighted average shares outstanding 24,118,288, 24,074,273, 24,048,924.
Figure 14.16 Consolidated Statements of Income for Cracker Barrel. (attribution: Copyright Rice University, OpenStax, under CC BY-NC-SA 4.0 license)

Most analysts believe that a consistent improvement in EPS year after year is the indication of continuous improvement in the earning power of a company. This is what is seen in Cracker Barrel’s EPS amounts over each of the three years reported, moving from $6.85 to $7.91 to $8.40. However, it is important to remember that EPS is calculated on historical data, which is not always predictive of the future. In addition, when EPS is used to compare different companies, significant differences may exist. If companies are in the same industry, that comparison may be more valuable than if they are in different industries. Basically, EPS should be a tool used in decision-making, utilized alongside other analytic tools.

Your Turn

Would You Have Invested?

What if, in 1997, you invested $5,000 in Amazon? Today, your investment would be worth nearly $1 million. Potential investors viewing Amazon’s income statement in 1997 would have seen an EPS of a negative $0.11. In other words, Amazon lost $0.11 for each share of common stock outstanding. Would you have invested?

Solution

Answers will vary. A strong response would include the idea that a negative or small EPS reflects upon the past historical operations of a company. EPS does not predict the future. Investors in 1997 looked beyond Amazon’s profitability and saw its business model having strong future potential.

Think It Through

Using Earnings per Share in Decision-Making

As a valued employee, you have been awarded 10 shares of the company’s stock. Congratulations! How could you use earnings per share to help you decide whether to hold on to the stock or keep it for the future?

Footnotes

  • 17 Matt Weinberger. “Microsoft’s Cloud Business Is Driving a Revenue Surge That’s Well above Wall Street Targets.” Business Insider. April 26, 2018. https://www.businessinsider.com/microsoft-q3-fy18-earnings-revenue-eps-analysis-2018-4
  • 18 C. Linnane and T. Kilgore. “Share Buybacks Will Rise 30% to $780 Billion Next Year, says Goldman Sachs.” Market Watch. November 22, 2016 https://www.marketwatch.com/story/share-buybacks-will-return-with-a-vengeance-next-year-2016-11-21.
  • 19 Arne Alsin. “The Ugly Truth Behind Stock Buybacks.” Forbes. Feb. 28, 2017. https://www.forbes.com/sites/aalsin/2017/02/28/shareholders-should-be-required-to-vote-on-stock-buybacks/#69b300816b1e
  • 20 Cracker Barrel. Cracker Barrel Old Country Store 2017 Annual Report. September 22, 2017. http://investor.crackerbarrel.com/static-files/c05f90b8-1214-4f50-8508-d9a70301f51f
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