## Learning Outcomes

After reading this article, you will be able to explain the importance of diluted earnings per share (DEPS) as required by IAS 33. You will understand what constitutes potential ordinary shares, how to identify dilutive and anti-dilutive instruments, and how to calculate DEPS when convertible debt and share options are present. You will be able to distinguish between basic and diluted EPS and apply the required adjustments to both the numerator and the denominator.

## ACCA Financial Reporting (FR) Syllabus

For ACCA Financial Reporting (FR), you are required to understand the calculation and interpretation of diluted earnings per share (EPS) according to IAS 33. You should focus your revision on:

- The definition and relevance of potential ordinary shares
- Recognition and treatment of convertible debt, options, and warrants
- Calculation steps for diluted EPS, including adjustments to earnings and share numbers
- Identifying when instruments are dilutive or anti-dilutive
- Accurate presentation and disclosure of EPS in accordance with the standard

## Test Your Knowledge

_Attempt these questions before reading this article. If you find some difficult or cannot remember the answers, look more closely at that area during your revision._

1. Which types of financial instruments are commonly considered potential ordinary shares under IAS 33?
2. When calculating diluted EPS, which adjustments must be made to the profits attributable to ordinary shareholders?
3. True or false? All potential ordinary shares must be included in the diluted EPS calculation, regardless of whether they increase or decrease EPS.
4. Briefly explain the effect that convertible debt has on both the numerator and denominator of the diluted EPS calculation.
5. What is the general rule for including share options in diluted EPS, and how do you determine the number of additional shares to include?

## Introduction

IAS 33 sets out the principles for calculating both basic and diluted earnings per share (EPS). While basic EPS measures the profit attributable to each ordinary share actually in issue, diluted EPS (DEPS) reflects the potential dilution caused by instruments that could be converted into shares in the future, such as convertible debt or share options. For companies with potential ordinary shares in issue, DEPS is a key metric for investors, who are interested in how the EPS might decrease if all such instruments were converted.

> **Key Term: potential ordinary share**
> A financial instrument or other contract that may entitle its holder to ordinary shares in the future, such as convertible debt, options, or warrants.
> **Key Term: diluted earnings per share (DEPS)**
> EPS calculated as if all dilutive potential ordinary shares had been converted into ordinary shares at the beginning of the period or date of issue.
>
> **Test Tip:**
> When revising Diluted EPS and potential ordinary shares, connect each definition, method, or rule to the kind of question the assessment is likely to ask.

### The Concept of Dilution and Potential Ordinary Shares

Dilution can occur when a company has financial instruments in issue that could convert into ordinary shares in the future, reducing the earnings attributable to each existing share. These instruments are termed **potential ordinary shares** under IAS 33.

Examples of potential ordinary shares include:

- Convertible bonds or convertible preference shares (convertible debt)
- Options and warrants giving the right to purchase shares at a set price
- Contingently issuable shares, for example from business acquisitions

Potential ordinary shares are included in diluted EPS only if they are **dilutive**, meaning their conversion would decrease net EPS.

> **Key Term: dilutive**
> A potential ordinary share is dilutive if its assumed conversion into an ordinary share would decrease EPS from continuing operations.
> **Key Term: anti-dilutive**
> A potential ordinary share is anti-dilutive if its assumed conversion would increase EPS or reduce a loss per share from continuing operations.

### Calculating Diluted Earnings per Share (DEPS)

Diluted EPS is calculated to show the 'worst case' scenario for existing shareholders—what would happen if all potentially dilutive shares were issued. The calculation starts with the basic EPS figure and makes specific adjustments to both earnings (the numerator) and the weighted average number of shares (the denominator).

![Potential ordinary shares decision path under IAS 33, classifying convertibles, options, warrants, and contingently issuable shares for diluted EPS inclusion or anti-dilutive exclusion.](https://static.pastpaperhero.com/images/acca-fr-earnings-per-share-ias-33-diluted-eps-and-potential-ordinary-shares_00.png)

_Potential ordinary share instruments are tested by type to identify dilutive items included in diluted EPS and anti-dilutive items excluded._

**Step 1:** Start with the profit attributable to ordinary shareholders.

**Step 2:** Add back any interest (net of tax) or preference dividends that would be saved if dilutive convertible instruments were converted.

**Step 3:** Adjust the weighted average number of shares to include shares that would be issued if all dilutive potential ordinary shares were converted.

**Step 4:** Restate DEPS only if it is lower than basic EPS.

### Worked Example 1.1

A company reports a profit attributable to ordinary shareholders of \$2,000,000. It has 1,000,000 ordinary shares in issue throughout the year. The company has issued \$1,000,000 of 5% convertible loan notes. Each \$100 loan note is convertible into 40 ordinary shares. The tax rate is 30%. No conversions took place during the year.

Calculate the diluted earnings per share, assuming the loan notes are dilutive.

> **Answer:**
>
> - Basic EPS = \$2,000,000 / 1,000,000 = \$2.00 per share.
> - The annual interest on the loan notes is \$50,000 (5% of \$1,000,000). If converted, this interest would be saved, and the profit would need to be adjusted upward by \$35,000 (after tax: \$50,000 × 70%).
> - Number of shares on conversion: \$1,000,000 / \$100 = 10,000 loan notes. Each converts into 40 shares, so new shares = 10,000 × 40 = 400,000 shares.
> - Adjusted earnings: \$2,000,000 + \$35,000 = \$2,035,000
> - Adjusted shares: 1,000,000 + 400,000 = 1,400,000 shares
> - Diluted EPS = \$2,035,000 / 1,400,000 = \$1.45 per share

### Convertible Instruments in Diluted EPS

When a company has issued convertible bonds or convertible preference shares, the EPS calculation must consider the effect of conversion:

- The profit attributable to shareholders is increased by the after-tax interest or dividend that would be saved if the instruments are converted.
- The number of ordinary shares is increased by the shares issuable on conversion.

Only **dilutive** convertibles are included; if conversion would increase EPS rather than decrease it, conversion is ignored.

### Worked Example 1.2

During the year, a company reports a profit attributable to shareholders of \$1,200,000 with 800,000 ordinary shares in issue. It pays \$40,000 interest on 5% convertible loan notes (\$800,000 principal), each \$100 of loan note convertible into 25 shares. The tax rate is 25%. Calculate diluted EPS if the conversion is dilutive.

> **Answer:**
>
> - Basic EPS = \$1,200,000 / 800,000 = \$1.50 per share
> - Interest saved on conversion = \$40,000 × 75% = \$30,000 (net of tax). Adjusted profit = \$1,230,000
> - Number of loan notes: \$800,000 / \$100 = 8,000; new shares: 8,000 × 25 = 200,000; total shares = 1,000,000
> - Diluted EPS = \$1,230,000 / 1,000,000 = \$1.23 per share

### Options and Warrants

Options and warrants entitle holders to subscribe for shares, usually at a set exercise price. In the diluted EPS calculation, only options/warrants with an exercise price below the average market price during the period are potentially dilutive.

They do not affect the numerator, but the denominator is increased by the net number of shares that would be issued for 'no consideration.' The **treasury stock method** is applied:

- Calculate cash proceeds if all options are exercised.
- Calculate the number of shares those proceeds would 'buy' at average market price—these are not included in the denominator.
- The balance is treated as new shares issued for no consideration and added to the denominator.

### Worked Example 1.3

A company has 1,000,000 shares in issue and a profit of \$3,000,000. It also has 100,000 options outstanding with an exercise price of \$5. The average market price during the year is \$8.

> **Answer:**
>
> - Proceeds on exercise = 100,000 × \$5 = \$500,000
> - Number of shares that could be bought at market price: \$500,000 / \$8 = 62,500 shares
> - Net shares issued for no consideration: 100,000 – 62,500 = 37,500
> - Adjusted shares: 1,037,500
> - Diluted EPS: \$3,000,000 / 1,037,500 ≈ \$2.89 per share

### Dilutive vs Anti-dilutive Instruments

IAS 33 requires that only instruments that decrease EPS (dilutive) are included in diluted EPS. If conversion or exercise would result in a higher EPS (anti-dilutive), they must be excluded.

> **Exam Warning:**
> Some candidates mistakenly include all potential ordinary shares in the diluted EPS calculation. Only include instruments if their effect reduces EPS. If converted shares would have increased EPS or decreased a loss per share, **exclude them** from the diluted calculation.

### Disclosure and Presentation Requirements

IAS 33 requires companies to present both basic and diluted earnings per share:

- Both figures must be presented with equal prominence on the face of the statement of profit or loss.
- The figures must be shown for continuing and discontinued operations, if applicable.
- The main assumptions and how the figures were calculated must be disclosed.

## Summary

Diluted EPS gives shareholders and analysts a more cautious view of profitability, reflecting the full dilution effect if all potential ordinary shares were issued. Properly identifying potential ordinary shares, adjusting earnings and share numbers, and correctly excluding anti-dilutive instruments are essential.

## Key Point Checklist

_This article has covered the following key knowledge points:_

- Define potential ordinary shares and their significance under IAS 33
- Explain the concept and calculation of diluted EPS
- Identify which convertible instruments, options, and warrants are included in the diluted EPS calculation
- Distinguish between dilutive and anti-dilutive potential ordinary shares
- Apply the correct adjustments to both earnings and share numbers for diluted EPS
- Understand the disclosure requirements for diluted and basic EPS in published accounts

## Key Terms and Concepts

- potential ordinary share
- diluted earnings per share (DEPS)
- dilutive
- anti-dilutive


Earnings per share (IAS 33) - Diluted EPS and potential ordinary shares