6.1 Earnings per Share and the Statement of Cash Flows

Earnings per Share and the Statement of Cash Flows

EPS and the statement of cash flows are both listed under presentation of financial statements in the FAR syllabus (topics 2.3.5 and 2.3.7). This section computes basic EPS with weighted average shares and retrospective share adjustments, diluted EPS with the treasury share and if-converted methods and anti-dilution ranking, and operating, investing, and financing cash flows under the direct and indirect methods.

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1. PAS 33 Earnings Per Share (EPS)

PAS 33 applies mandatorily to entities whose ordinary shares or potential ordinary shares are publicly traded on the Philippine Stock Exchange (PSE), or entities in the process of issuing ordinary shares in public securities markets.

Basic Earnings Per Share

Basic EPS measures the earnings power of an enterprise attributable to each ordinary share outstanding during the period.

$\text{Basic EPS} = \frac{\text{Net Profit (Loss) Attributable to Ordinary Equity Holders}}{\text{Weighted Average Number of Ordinary Shares (WANOS)}}$

Numerator Adjustments (Preference Dividends)

The net profit or loss attributable to ordinary equity holders is derived by deducting preference dividends from net profit after tax:

1. Cumulative Preference Shares: Deduct one full year's contractual dividend, whether declared or not. Dividends in arrears from prior periods paid in the current period are ignored because they were deducted in prior years.
2. Non-Cumulative Preference Shares: Deduct preference dividends only if declared during the current accounting period.

Denominator Mechanics: WANOS & Retrospective Adjustments

Ordinary shares issued or repurchased during the period are time-weighted based on the proportion of time they were outstanding:

• Cash Issuance / Debt Conversion: Weighted from the date cash is receivable or debt extinguished.
• Treasury Share Reacquisitions: Weighted reduction from the date of reacquisition.
• Retrospective Adjustments (Bonus Elements):
  • Share Dividends (Stock Dividends) and Stock Splits: Change the number of shares outstanding without any corresponding change in resources. They must be treated as if they had occurred at the beginning of the earliest period presented (retrospective application).
  • If a stock dividend or stock split occurs after the reporting period but before the financial statements are authorized for issue, the per-share computations for all periods presented must be based on the new number of shares.
  • Rights Issues: Contain a bonus element because shares are offered at an exercise price below current fair value. An adjustment factor is applied to shares outstanding prior to the rights issue: $\text{Rights Adjustment Factor} = \frac{\text{Fair Value per Share Immediately Prior to Exercise}}{\text{Theoretical Ex-Rights Price (TERP)}}$

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2. Diluted Earnings Per Share

Diluted EPS reflects the dilution that would occur if all potential ordinary shares that are dilutive were converted into ordinary shares.

Potential Ordinary Shares

Instruments that may entitle their holders to ordinary shares: convertible bonds payable, convertible preference shares, share options, and share warrants.

Methods of Computation

                                Potential Ordinary Shares
                                            │
                    ┌───────────────────────┴───────────────────────┐
                    ▼                                               ▼
           Share Options & Warrants                         Convertible Securities
            (Treasury Share Method)                          (If-Converted Method)
                    │                                               │
      • Assumed exercised at start of year            • Assumed converted at start of year
      • Proceeds buy treasury shares at               • Numerator: Add back after-tax
        average market price                            interest or preference dividend
      • Incremental shares =                          • Denominator: Add ordinary shares
        Options x (1 - Strike / Market Price)           issued upon conversion

1. The Treasury Share Method (Options and Warrants)

Applied to options and warrants:

1. Options are assumed to be exercised at the beginning of the period (or grant date, if later).
2. The proceeds hypothetically received from the exercise are assumed to be used to repurchase ordinary shares on the open market at the average market price during the reporting period.
3. The net incremental shares are added to the WANOS denominator:

$\text{Incremental Ordinary Shares} = \text{Total Options} \times \left(1 - \frac{\text{Exercise Price}}{\text{Average Market Price}}\right)$

Dilution Rule: Options and warrants are dilutive only when the exercise price is less than the average market price of ordinary shares ("in-the-money"). If the exercise price exceeds the average market price, they are anti-dilutive and omitted.

2. The If-Converted Method (Convertible Bonds & Preference Shares)

Applied to convertible securities:

1. Securities are assumed to have been converted into ordinary shares at the beginning of the period (or issuance date, if later).
2. Convertible Bonds Payable:
   • Numerator Adjustment: Add back interest expense recognized during the period, net of tax effect: $\text{Interest Expense} \times (1 - \text{Tax Rate})$.
   • Denominator Adjustment: Add the number of ordinary shares issuable upon conversion.
3. Convertible Preference Shares:
   • Numerator Adjustment: Add back the preference dividend (cancel the initial deduction made in Basic EPS).
   • Denominator Adjustment: Add the number of ordinary shares issuable upon conversion.

Test for Dilution vs. Anti-Dilution

• Potential ordinary shares are dilutive if their conversion would decrease basic EPS from continuing operations (or increase loss per share from continuing operations).
• Potential ordinary shares are anti-dilutive if their conversion increases basic EPS from continuing operations. Anti-dilutive instruments are strictly excluded from Diluted EPS.
• Ranking Rule for Multiple Instruments: When an entity has multiple potential ordinary shares, they must be ranked from most dilutive to least dilutive based on their incremental EPS (incremental earnings / incremental shares). They are included sequentially in the Diluted EPS calculation; as soon as an instrument causes EPS to increase, that instrument and all subsequent instruments are excluded as anti-dilutive.

Comprehensive Worked Example: Basic & Diluted EPS

Sierra Madre Corporation reports the following for the year ended December 31, 2026:

• Net income: PHP 5,400,000 (all from continuing operations).
• Tax rate: 25%.
• Ordinary shares outstanding throughout 2026: 600,000 shares.
• 8% Cumulative Preference Shares, PHP 100 par, 20,000 shares issued (PHP 2,000,000 par), convertible into 80,000 ordinary shares. Contractual dividend = PHP 160,000.
• 10% Convertible Bonds Payable, face amount PHP 2,000,000 issued at par, convertible into 100,000 ordinary shares. Interest expense recognized in 2026 = PHP 200,000.
• Share Options: 50,000 options to purchase ordinary shares at an exercise price of PHP 30 per share. The average market price of ordinary shares during 2026 was PHP 50 per share.

Step 1: Compute Basic EPS $\text{Numerator} = \text{Net Income (PHP 5,400,000)} - \text{Cumulative Preference Dividend (PHP 160,000)} = \text{PHP }5{,}240{,}000$ $\text{WANOS} = 600{,}000 \text{ shares}$ $\text{Basic EPS} = \frac{\text{PHP }5{,}240{,}000}{600{,}000} = \text{PHP }8.7333$

Step 2: Compute Incremental EPS for Potential Ordinary Shares

1. Share Options (Treasury Share Method):

   • Exercise proceeds = $50,000 \times \text{PHP }30 = \text{PHP }1{,}500{,}000$
   • Shares repurchased = $\text{PHP }1{,}500{,}000 / \text{PHP }50 = 30,000 \text{ shares}$
   • Incremental shares = $50,000 - 30,000 = 20,000 \text{ shares}$
   • Numerator impact = PHP 0
   • $\text{Incremental EPS} = \frac{\text{PHP }0}{20{,}000} = \text{PHP }0.00$ (Rank 1 - Most Dilutive)

2. 10% Convertible Bonds (If-Converted Method):

   • Numerator savings = $\text{Interest Expense (PHP 200,000)} \times (1 - 0.25) = \text{PHP }150{,}000$
   • Incremental shares = $100,000 \text{ shares}$
   • $\text{Incremental EPS} = \frac{\text{PHP }150{,}000}{100{,}000} = \text{PHP }1.50$ (Rank 2)

3. 8% Convertible Preference Shares (If-Converted Method):

   • Numerator savings = $\text{Dividend Saved} = \text{PHP }160{,}000$
   • Incremental shares = $80,000 \text{ shares}$
   • $\text{Incremental EPS} = \frac{\text{PHP }160{,}000}{80{,}000} = \text{PHP }2.00$ (Rank 3)

Step 3: Sequential Dilution Testing

All three instruments are dilutive. Final Diluted EPS = PHP 6.94.

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3. PAS 7 Statement of Cash Flows

PAS 7 requires an entity to prepare a statement of cash flows analyzing cash and cash equivalent movements across three operational categories:

Definitions & Scope

• Cash: Cash on hand and demand deposits.
• Cash Equivalents: Short-term, highly liquid investments that are readily convertible to known amounts of cash and subject to an insignificant risk of changes in value. Under standard criteria, an investment normally qualifies as a cash equivalent only when it has a short maturity of three months or less from its date of acquisition (e.g., 90-day BSP treasury bills, money market placements).

The Three Activities

                                    PAS 7 Activities
                                           │
         ┌─────────────────────────────────┼─────────────────────────────────┐
         ▼                                 ▼                                 ▼
Operating Activities              Investing Activities              Financing Activities
• Principal revenue-producing     • Acquisition & disposal of       • Changes in equity capital
  activities                        long-term assets (PPE,            and borrowings
• Direct Method (Gross receipts/    intangibles)                    • Issuance/redemption of shares
  payments)                       • Purchase/sale of debt/equity    • Proceeds/repayments of loans
• Indirect Method (Adjusts net      investments                       and bonds
  profit for non-cash/working     • Cash advances & loans to        • Principal lease liability
  capital items)                    third parties                     payments

Operating Cash Flows: Direct vs. Indirect Method

1. Direct Method (Encouraged by PAS 7): Discloses major classes of gross cash receipts and gross cash payments:

   • Cash receipts from customers
   • Cash paid to suppliers for merchandise
   • Cash paid to employees for wages and salaries
   • Cash paid for operating overhead and income taxes

2. Indirect Method: Reconciles net profit or loss to net cash flow from operating activities:

   • Start with Profit or Loss before tax.
   • Add back non-cash expenses: Depreciation, amortization, impairment losses, bad debt expense.
   • Deduct non-cash income: Reversal of provisions, unrealized foreign exchange gains.
   • Eliminate investing/financing gains or losses: Deduct gain on sale of PPE/investments; add back loss on sale of PPE/investments; add back finance costs.
   • Adjust for working capital changes:
     • Deduct increases in current operating assets (Accounts Receivable, Inventory, Prepayments).
     • Add decreases in current operating assets.
     • Add increases in current operating liabilities (Accounts Payable, Accrued Expenses).
     • Deduct decreases in current operating liabilities.

Classification Choices for Interest & Dividends under PAS 7

Non-Cash Investing and Financing Transactions

Investing and financing transactions that do not require the use of cash or cash equivalents (e.g., acquiring PPE by assuming a lease liability, converting bonds payable to ordinary shares, acquiring a business via share issue) are excluded from the statement of cash flows itself. They must be disclosed comprehensively in the notes to financial statements.