Dilutive Securities and Anti-dilutive Securities

Dilutive securities and anti-dilutive securities can impact the calculation of earnings per share (EPS) in opposite ways. It is therefore very important to ascertain whether the inclusion of a financial instrument in the EPS calculation has dilutive or anti-dilutive properties.

Dilutive versus Anti-dilutive Securities and Implications for EPS Calculation

Dilutive securities are those financial instruments that are potentially convertible into common stock and could potentially dilute or decrease EPS due to the increase in the number of ordinary shares after conversion. In contrast, some potentially convertible securities are anti-dilutive. This means that their inclusion in the EPS calculation would result in an EPS which is higher than the company’s basic EPS. Under both IFRS and US GAAP, however, these anti-dilutive securities are excluded from the calculation of diluted EPS. As a rule, diluted EPS should always be less than or equal to basic EPS. Besides, it should reflect the maximum potential dilution from the conversion of potentially dilutive financial instruments.

Example of Basic and Diluted EPS

A company has a net income of $2,000,000, an average of 250,000 shares of common outstanding stock, and 10,000 shares of convertible preferred stock. Each preferred share pays a dividend of $13 per share and is convertible into one share of the company’s company stock. What is the company’s basic and diluted EPS? Solution Basic EPS calculation, using the equation: $$ \text{Basic EPS}=\cfrac {\text{Net income} – \text{Preferred dividend}}{\text{Weighted average number of shares outstanding}} $$ $$ \begin{align*} \text{Net income} – \text{Preferred dividend} & = $2,000,000 – (10,000 × $13) \\ & = $2,000,000 – $130,000 \\ & = $1,870,000 \end{align*} \\ $$ Therefore, $$ \text{Basic EPS} =\cfrac {$1,870,000}{250,000} = $7.48 $$ Diluted EPS calculation, using the equation: $$ \text{Diluted EPS} =\cfrac {(\text{Net income})}{ \begin{align*} & \text{Weighted average number of shares outstanding} \\ & +\text{New common shares that would have been issued at conversion} \\ \end{align*}} $$ If each convertible preferred stock is converted into one share then, under the if-converted method, the company has an additional 10,000 × 1 = 10,000 common outstanding stock and no preferred dividend would be paid. Therefore, $$ \text{Diluted EPS} =\cfrac {$2,000,000}{(250,000 + 10,000)} = $7.69. $$ Given that this value is greater than the basic EPS of $7.48, the convertible preferred shares are said to be anti-dilutive. As such, the effect of their conversion would be excluded from the diluted EPS calculation. As a result, Diluted EPS = Basic EPS = $7.48.

Question

Which of the following statements is accurate? A. Diluted EPS should always be greater than basic EPS. B. The inclusion of anti-dilutive securities would result in a diluted EPS which is less than the basic EPS. C. The inclusion of anti-dilutive securities would result in a diluted EPS which is greater than the basic EPS. Solution The correct answer is C. The inclusion of anti-dilutive securities results in a diluted EPS which is greater than the basic EPS. For this reason, IFRS and US GAAP exclude these securities from the diluted EPS calculation. A is incorrect because, by their very nature, anti-dilutive securities result in a diluted EPS which is greater than the basic EPS, when included. B is incorrect because as a rule, diluted EPS should always be less than or equal to basic EPS.