Question

Retained Earnings Policy

Public enterprises are required to present earnings per share data on the income statement. Consider the effect of dilutive and antidilutive convertible securities. Discuss this information from the perspective of a shareholder, and discuss what shareholders would expect to discern from this information.

In your responses to your peers, discuss potential challenges that might arise from the presentation of this information and shareholders' interpretations. How should this information be communicated to shareholders?

Answer 1

STEP 1 - EFFECT OF DILUTIVE AND ANTIDILUTIVE CONVERTIBLE SECURITIES FROM THE PERSPECTIVE OF A SHAREHOLDER - Publically traded companies can offer either dilutive or anti dilutive securities. These have a potential impact on stock's earning per share. The main concern of shareholders after new securities are issued or after securities are converted is that their ownership interests are dimished.

DILUTIVE SECURITIES - These are not common stocks initially rather most dilutive securities provide a mechanism through which the owner of the security can obtain additional common stock. This mechanism can be either an option or conversion. If triggering the mechanism results in a decreased EPS for existing shareholder - by increasing the total amount of outstanding shares then the instrument is said to be a dilutive security. Diltution can be caused due to number of dilutive securities such as stock options, restricted and performance stock units, preferred stock, warrants and convertible debt. Ditultion may cause the share price to decline because dilution reduces the company's EPS. The extent of decline depends on the percentage of dilution.

ANTIDILUTIVE SECURITIES - Not all security mechanisms result in decreased EPS, and some even increase EPS. If securities are retired, converted or affected through certain corporate activities, and the transaction results in an increased EPS, then the action is considered to be anti-dilutive. Some security instruments have provisions or ownership rights that allow the owners to purchase additional shares when another security mechanism would otherwise dilute their ownership interests. These are often called antidilution provisions.

CHALLENGES - The number of debentures to be converted are based on accounting estimates. The estimates may change according to management's perspective and based on an external expert. Judging the reliability of the estimates is very tough. Actual number of shares converted may be very different from the original management's estimates. Such facts are disclosed as a part of statement of profit and loss which inturn forms part of annual report of the company. Anti-diltutive effect is not disclosed as a matter of prudence as it takes into account foreseeable profits.

Such information is communicated to shareholders through Annual report.