One of the many oddities of computing diluted earnings per share
Among much else, IAS 33 addresses the issue of contracts that may be settled either in common shares or in cash at the issuer’s option, and says the enterprise should presume for this purpose the contract will be settled in common shares, and include the resulting potential common shares in diluted earnings per share if their effect is dilutive. Old Canadian GAAP used to say something similar, but then it went on: “The presumption that such a contract will be settled in common shares may be overcome if past experience or a stated policy provides a reasonable basis to believe that the contract will be paid partially or wholly in cash. In such circumstances, if this contract is presented as an equity instrument or has both an equity component and a liability component, the numerator should be adjusted for any changes in income or loss that would have resulted if the contract had been classified wholly as a financial liability.”
The basis for conclusions to IAS 33 recounts that the original IASB exposure draft originally proposed following the same approach as Canadian GAAP, and indeed that the majority of respondents to the exposure draft agreed with this proposal. But it goes on: “Although the proposed treatment would have converged with that required by several liaison standard-setters, for example, in US SFAS 128 Earnings per Share, the Board concluded that the notion of a rebuttable presumption is inconsistent with the stated objective of diluted earnings per share.” (If you wonder what this objective actually consists of, the standard rather unilluminatingly sums it up merely as being “to provide a measure of the interest of each ordinary share in the performance of an entity – while giving effect to all dilutive potential ordinary shares outstanding during the period.”)
A more recent exposure draft to simplify IAS 33, issued in 2008, came at these kinds of instruments in a different way altogether, rationalizing that the equity portion of such contracts (as an embedded derivative) would likely be measured at fair value through profit and loss, or if not, that the liability for the present value of the redemption amount would meet its definition of a participating instrument. For contracts measured at fair value through profit or loss, the exposure draft proposed that “the change in the fair value of the instrument affects the interests of the ordinary shares in the entity’s performance during the period. Because the numerator reflects the effect of those instruments on ordinary equity holders, it is not necessary to increase the denominator for the number of additional shares that would arise from the exercise or conversion of those instruments.” For participating instruments, the exposure draft proposed calculating diluted earnings per share either by assuming their conversion into shares, or else by assuming that the instruments remain unconverted and allocating profit or loss according to their economic entitlements, whichever approach generates the more dilutive result. But anyway, this project is currently “paused,” with no apparent prospect of the pause button being lifted any time soon.
What’s the best approach to this issue? You might be forgiven for thinking the above-cited objective of diluted earnings per share means to wave as large a cautionary flag as possible regarding all the existing threats to maintaining reported earnings per share. But the basis for conclusions to the 2008 exposure draft points out: “In developing the original version of IAS 33, the (old IASC) rejected the idea that diluted EPS should indicate the potential variability or risk attached to basic EPS as a consequence of the issue of potential ordinary shares and so act as a warning signal of the potential dilution of EPS…In other words, diluted EPS serves as input that users of financial statements can use in considering an entity’s capacity to generate cash flows from its existing resource base. Diluted EPS is not itself a prediction.” The trouble, surely, is that it certainly looks like some kind of prediction to many users. But it’s not – it’s a model, and one that enthusiasts can tinker with for days on end.
If the object is really to help users “consider” the capacity to generate future cash flows, I wonder about the utility of a number generated by such a mechanical and programmatic process. I mean, in the issue at hand, wouldn’t the consideration of future cash flows be best served by applying the best estimate (subject to suitably rigorous limits) of what’s actually going to happen in the future, as per the old Canadian GAAP approach? And regarding the approach set out in the stalled exposure draft, it may make sense to measure the embedded derivative within a convertible instrument at fair value through profit or loss, but even so, does that treatment really do anything to enhance a user’s ability to consider the capacity to generate future cash flows? IFRS sets out no shortage of rules in this area, but you might struggle to identify much in the way of principles…
The opinions expressed are solely those of the author.