Basic and diluted earnings per share (EPS)

2. Diluted earnings per share

An additional layer of complexity needs to be accounted for when a corporation has securities on the balance sheet that could potentially be converted to common shares. In those situations, basic EPS might be misleading because those extra shares might dilute earnings with “hidden” additions to the denominator. A diluted EPS calculation brings those hidden shares to light.

Convertible preferred stock, convertible bonds, stock options, and stock warrants are all considered potential common shares in a diluted EPS calculation. It’s essentially the same as the basic formula, but this time we add shares to the denominator as if all possible conversions were made during the period. This is a very conservative approach because it is highly unlikely for so many conversions to occur during one period.

Another note for diluted calculations is that the numerator needs to be altered to account for certain conversions. Recall from earlier that we use net income for the numerator. However, if we are converting bonds to common shares for the diluted calculation, we need to add the interest paid on those bonds back to net income because we are assuming that those bonds have been converted.

In general terms, add back to the numerator any cost associated with convertible balance sheet accounts that could have been avoided had the underlying security been converted to common stock.

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