IAS 33 *Earnings per Share* requires listed companies to disclose not only basic earnings per share (EPS) but also diluted EPS. It seems that there is not widespread:

- understanding of the objective of the approach used in determining diluted EPS; and
- agreement that the objective and, hence, the approach provides the most useful information.

This post explores the objective of the approach, the reason why the IASB’s predecessor (IASC: International Accounting Standards Committee) selected it and implications for any possible changes to this aspect of IAS 33. This post covers:

- requirements of IAS 33
- 2 approaches compared
- why IAS 33 uses a time-series approach
- attempt to improve IAS 33 in 2008
- lesson from responses to the 2008 ED
- how to adjust for potential ordinary shares that are dilutive
- conclusion

## Requirements of IAS 33

IASC issued IAS 33 in 1997. IAS 33 requires companies with publicly traded shares to calculate and disclose:

**basic**EPS—reflecting the number of ordinary shares outstanding; and**diluted**EPS—reflecting both (a) the number of ordinary shares outstanding; and (b) the number of ordinary share shares that would result from all ‘dilutive’ potential ordinary shares.

IAS 33 explains that the objective:

- of
**basic**EPS is to provide a measure of the interest of each ordinary share in the company’s performance; - of
**diluted**EPS is consistent with that of basic EPS—to provide a measure of the interest of each ordinary share in the company’s performance—while giving effect to all dilutive potential ordinary shares**outstanding during the period**.

This post focuses on how to determine the **number** of potential ordinary shares in computing diluted EPS. It does not discuss how to determine **whether** potential ordinary shares are ‘dilutive’, or **how** to adjust for them when they are dilutive.

## 2 approaches compared

This section covers:

- time-series approach
- warning-signal approach
- comparing the 2 approaches

### Time-series approach

When companies compute diluted EPS, IAS 33 requires them to increase the denominator of EPS to reflect those ‘potential ordinary shares’ that are ‘dilutive’. To compute this increase, IAS 33 requires an approach that is sometimes called a time-series approach. That approach reflects dilutive potential ordinary shares:

- in full if they were outstanding throughout the current year; but
- on a time-proportion basis if they were outstanding for only part of the current year.

The argument for this approach is that the resulting measure of diluted EPS can be presented in a time series and be compared with diluted EPS of other periods.

### Warning-signal approach

IASC also considered a different approach for determining the denominator of diluted approach. That approach, sometimes called a warning-signal approach, reflects dilutive potential ordinary shares:

- in full if they were outstanding at the end of the current year; but
- not at all if they were no longer outstanding at that date.

The argument for a warning-signal approach is that the resulting measure of diluted EPS warns readers about possible future dilution: even if earnings remain unchanged in the future, basic EPS may reduce because future dilution could occur by issuing (or buying back) shares as a result of instruments that are already outstanding.

### Comparing the 2 approaches

The 2 approaches (time-series and warning-signal) give the same results if dilutive potential ordinary shares were outstanding throughout the current year and also at the end of the year.

But they give different results if the dilutive potential ordinary shares only came into existence during the year, or were no longer outstanding at the year end. The following example illustrates those differences.

For simplicity, the example covers:

- only one type of instrument that creates potential ordinary shares (a share warrant); and
- only how to determine
**how many**of those share warrants are reflected in the denominator of diluted EPS. It does not cover**how**those warrants affect the denominator. (For warrants, the calculation assumes that the proceeds of issuing the warrants are used to buy back shares. For some other instruments, different methods are used)

### Fact pattern for the example

Company A had 1,000 shares in issue throughout 20X3. Also, company A issued 365 share warrants on 30 December 20X3. Each warrant entitles the holder to elect to subscribe on 30 September 2X4 for 1 newly issued share by paying an issue price of £1.

Company B too had 1,000 shares in issue throughout 20X3. Also, company B had 365 share warrants outstanding on 1 January 20X3. Each warrant entitled the holder to elect to subscribe on 30 December 20X3 for 1 newly issued share by paying an issue price of £1.

The holders of Company B’s warrants elected not to subscribe for new shares, so the warrants lapsed on 30 December 20X3.

### Determining basic EPS

Companies A and B both had 1,000 shares in issue throughout 20X3. Therefore, they both use 1,000 shares as the denominator in determining basic EPS for 20X3.

### Determining diluted EPS as a time series

Companies A and B both had 365 warrants outstanding for only part of 20X3. For company A, they were outstanding for 1 day (30 December to 31 December). For company B, they were outstanding for 364 days (1 January to 30 December). So, the weighted average number of warrants outstanding during 20X3 was:

- for company A: 1 share (= 365 x [
^{1}/_{365}]) - for company B: 364 shares (= 365 x [
^{364}/_{365}])

### Determining diluted EPS as a warning signal

Company A had 365 warrants outstanding at the end of 20X3. Therefore, company A reflects 365 warrants in determining the denominator of diluted EPS for 20X3.

Company B no longer has any warrants outstanding at the end of 20X3. Therefore, company B reflects no warrants in the denominator of diluted EPS for 20X3.

### Number of potential ordinary shares

Table 1 summarises how many warrants companies A and B consider in determining the denominator of diluted EPS for 20X3. The table shows the number of warrants considered in both a time-series approach (middle column, as required by IAS 33) and a warning-signal approach (right-hand column).

Time series | Warning signal | |

Company A | 1 | 365 |

Company B | 364 | 0 |

As table 1 highlights, when potential ordinary shares are outstanding for only part of the year, the 2 approaches have opposite effects on the number of potential ordinary shares considered in determining the denominator of diluted EPS:

- Potential ordinary shares that both:
**(a) first become outstanding during the year; and (b) were still outstanding at the end of the year**. A warning-signal approach brings these potential shares into the denominator of diluted EPS. A time-series approach also brings them in, though it reduces their number because they weren’t outstanding for the whole year. - Potential ordinary shares that:
**(a) were outstanding for part of the year; but (b) were no longer outstanding at the end of the year**. A warning-signal approach does not bring these potential shares into the denominator of diluted EPS at all. A time-series approach brings them into the denominator, though it reduces their number because they weren’t outstanding for the whole year.

## Why IAS 33 uses a time-series approach

IASC did not publish a Basis for Conclusions with IAS 33. Indeed, IASC did not publish a Basis for Conclusions with any Standard until 1998 (IAS 19 *Employee Benefits*) and even after that did not issue a Basis for Conclusions with every Standard.

The IASB revised IAS 33 in 2003 and published at that time a Basis for Conclusions, covering that revision but not covering decisions reflected in the original version of IAS 33.

I discuss below:

- work in parallel with the US Financial Accounting Standards Board (FASB)
- the FASB’s reasoning
- IASC’s reasoning
- disclosing a warning signal as well?

### Work in parallel with the FASB

IASC developed IAS 33 at the same time as the FASB was developing new US GAAP requirements on EPS. IASC and the FASB carried out their projects at the same time and each paid attention to what the other was doing. But these were 2 separate (parallel) projects, not a single joint project.

### The FASB’s reasoning

The FASB concluded that a time-series approach was more appropriate than a warning-signal approach. This was because the resulting measure of diluted EPS can be presented in a time series and compared with diluted EPS of other periods. As explained in the FASB’s Basis for Conclusions on Statement of Financial Accounting Standards (SFAS) No. 128 *Earnings per Share* (in paragraph 80 of Appendix B *Background Information and Basis for Conclusions*) the FASB:

- viewed basic EPS as ‘a historic, “for the period” number’; and
- concluded that diluted EPS should be an extension of basic EPS.

### IASC’s reasoning

As noted in paragraph 81 of the FASB’s Basis for Conclusions, ‘the IASC initially concluded that the objective of diluted EPS should be to indicate the potential variability or risk attached to basic EPS as a consequence of the issue of potential common shares or to act as a warning signal of the potential dilution of basic EPS. Following that objective, diluted EPS would be computed using end-of-period shares and stock prices.’

Paragraph 81 goes on to say: ‘After much discussion, the IASC agreed to require that diluted EPS be computed following the FASB objective because (a) diluted EPS computed following a performance objective can be presented in a time series and compared with diluted EPS of other periods and (b) a “warning signal” objective can be adequately conveyed through supplementary note disclosure.’

From 1994, I attended most of the discussions on this project by the IASC’s Board. My recollection of those meetings is that most people speaking at those meetings had a mild preference for the warning-signal approach, but that preference was not strong enough for them to want to conclude differently from the FASB.

### Disclosing a warning signal as well?

Both the FASB and the IASC Exposure Drafts proposed disclosure requirements reflecting the IASC’s warning-signal objective, supplementing the time-series number for diluted EPS. Predictably, respondents did not favour this compromise proposal and IASC and the FASB did not include it in their final standards.

Thus, both IAS 33 and SFAS 128 require only the time-series number for diluted EPS. They do not require disclosure of other information that would provide a warning signal.

## Attempt to improve IAS 33 in 2008

In the mid 2000s, one of several joint ‘convergence’ projects by the IASB and FASB was a joint project to improve IAS 33 and SFAS 128. That project built on 2 earlier FASB exposure drafts, which had not yet led to final standards.

In that joint project, both the IASB and the FASB issued exposure drafts (EDs) in 2008. The aim was to eliminate most differences between IAS 33 and SFAS 128 affecting the denominator of EPS. The EDs also proposed other limited changes intended: to simplify and clarify some computations; and to make EPS provide investors with more useful information.

It was beyond the scope of that project to reconsider the approach to diluted EPS.

### After the 2008 ED

After reviewing the responses to its 2008 exposure draft *Simplifying Earnings per Share*, the IASB decided not to amend IAS 33 to reflect the exposure draft’s proposals, because:

- the responses showed that developing a final standard would take too much time and resource;
- it might be difficult to finalise a standard before finalising other projects, for example on financial instruments with characteristics of equity and financial statements presentation; and
- the IASB had at that time many other projects of higher priority.

## Lesson from responses to the 2008 ED

It was obvious at that time that many respondents to the 2008 exposure draft:

- did not realise that IAS 33 adopts a time-series approach to diluted EPS;
- intuitively preferred a warning-signal approach; and
- objected to some of the exposure draft’s proposals that, as a by-product, would have increased the magnitude of the difference between the outcomes of the time-series and warning-signal approaches.

Those responses led me to conclude that the IASB will have little chance of changing the calculation of diluted EPS significantly if it does not first:

- build much greater understanding of the purpose of the time-series approach; and
- seek consensus on whether IAS 33 should continue to use that approach, rather than a warning-signal approach.

## How to adjust for potential ordinary shares that are dilutive

This post discusses only how to determine the **number** of potential ordinary shares to be reflected in the denominator of diluted EPS.

It does not discuss:

- how to determine
**whether**potential ordinary shares are ‘dilutive’. **how**diluted EPS should reflect the issue proceeds of ordinary shares that would result from the**number**of dilutive potential ordinary shares reflected in the denominator of EPS. IAS 33 requires a calculation that assumes those proceeds are used to buy back ordinary shares. In a recent article in*The Footnotes Analyst*, Steve Cooper and Dennis Jullens advocate a different approach that reflects not only the ‘intrinsic value’ of the instruments underlying the potential ordinary shares, but also their ‘time value’. https://www.footnotesanalyst.com/the-diluted-eps-calculation-is-50-years-out-of-date/

Their article also advocates changes to how diluted EPS reflects: unrecognised stock-based compensation; and ‘anti-dilutive’ securities.

### An alternative view on the 2008 ED

Steve Cooper was an IASB Board Member when the IASB issued the 2008 ED. He was the only Board Member who voted against publication of the ED. His reasons for doing so are summarised in paragraphs AV1-AV5 of the Alternative View placed after the Basis for Conclusions published with the ED. He disagreed with the Board’s proposals:

- to make changes other than convergence in a convergence project, even though other work on financial instruments with the characteristics of equity was likely to lead to further changes to EPS; and
- for a new approach to diluted EPS for instruments measured at fair value through profit or loss.

## Conclusion

Responses to the 2008 exposure draft made it clear that many people did not realise that IAS 33 adopts a time-series approach to diluted EPS, and that many may prefer a warning-signal approach.

If the IASB wishes to revise IAS 33 at some point in the future, it should check whether that change could cause significant changes in the outcome of applying this aspect of IAS 33 (calculating diluted EPS). If changes in that outcome could be significant, the IASB may first need to build:

- much greater understanding of the purpose of the time-series approach; and
- consensus on whether to continue using that approach.