### CFA Practice Question

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### CFA Practice Question

Philpott Co. had 1,200,000 common shares outstanding on January 1 and December 31, 2011. In connection with the acquisition of a subsidiary company in June 2010, Philpott is required to issue 50,000 additional common shares on July 1, 2012, to the former owners of the subsidiary. Philpott paid \$300,000 in preferred shares dividends in 2011 and reported net income of \$5,100,000 for the year. Philpott's diluted earnings per share for 2011 should be ______.
A. \$4.25
B. \$4.00
C. \$3.84
Explanation: (\$5,100,000-\$300,000)/(1,200,000+50,000) = \$3.84

User Comment
shasha the 50k common share is to be issued in 2012, what the hell is it doing with eps for 2011? correct answer should be C, isn't it? and no diluted securities at all, why ask us to calculate diluted eps?
maflu I disagree. The upcoming 50,000 shares is the company's potential "liability" (just like a warrant): to calculate basic earnings per share you don't need to include it, but for diluted EPS you have to include it.
geet In the denominator for commmon shares, usually use the weighted avg number of common shares. How does that work in this case when the shares are in 2012 and its askin for 2011..?
mm04 The time line here is confusing...the acquisition was made at 06/2010, but the shares were issued in 07/2012 and the question is asking for EPS for 2011....anyone can help?
duhon The company benefits from the 2010 acquisition in 2011. Because the 50,000 shares represent its purchase of this benefit, it makes sense to include them in diluted EPS.
mbuechs2 Why shall we include a dilution in 2012 into earnings from 2011?
robbe1 Let's say the 2012 is a typo and should read 2011. I would expect to have average shares outstanding to be 225,000. The issue of 50,000 new shares takes place halfway during the year.
dasun the answer is correct. even through 50000 shares to be issued next year, it should be counted if this event is sure to be happened. ( refer to intermediate accounting textbook) I missed this problem too.
gene80 hmmm.. point noted.
patsy robbe1 for diluted we never time apportion across the year - always assume worst case.
our earning in the current year have benefited frm the acquisition in the prior year and so the upcoming share issue in relation to the purchase needs to be taken into account.
dimanyc i don't think it's correct. even if we have to account for 50,000 shrs that will be issued in the upcoming year, we need to calc the weighted avg of shrs, which would give us 1,225,000 in the denominator.
whoi no sir!

2012: 50k

2011: 1'200

but as long as it's already known that the issue is going to dilute earnings you might include the issue in the 2011 EPS calculation!
Adkins I agree this is a bit confusing. Here is one way to see it (not 100% sure if this is right but may help):
The acquisition went through in mid-2010 and would have added earnings to the 2011 income.
Part of the cost of acquisition is the requirement to deliver shares in mid-2012; and this cost of acquisition should be included in the EPS calculation for 2011 to match with the earnings from the acquisition.
ridone The answer does not make sense because we are assuming the shares will be converted hence included in the denominator, but we subtract the pref. div. in the numerator which to my understanding is inconsistent with the principle that pref. div. should be added to net income since if the shares are converted this will not be paid.
charliedba It makes sense. The reported net income of \$5,100,000 includes the \$300k paid to the pref shareholders so the 300k should be subtracted. The \$300 is not available to common shareholders.
mishis shares are issued to former owners of the subsidiary. This acts like a stock dividend. So, applies to previous common shares outstanding when calculating EPS.
Sibong26 @charliedba, to me it doesn't make sense why the pref div is included in the calc if the pref shares are added to the weighted average shares, shouldnt the pref div be excluded from the net income??
Katiepuff so the acquisition is 2010 basically contained a "warrant" for shares to be issued to later (2012). so when calculating diluted EPS for 2011 we assume this "warrant" will be converetd (as it is in 2012) and add the 50000 to outstanding stock. We also subtract the pref. dividends because they are aren't available for the common share holders and when calculating diluted EPS, we are basically figuring out the worst case scenario for the common shareholder.
mysuperCFA My understanding is that it can be likened to a stock split/dividend whereby the conversion applies to all outstanding stocks prior to the operation. The acquisition should have given rise to the additional shares from the date of acquisition.
NickGerli The more I think about it, the more it makes sense. Convertible bonds are converted to their common share equivalents even though there is no guarantee they will be converted. Or they might be converted in 10 years. Who knows. In this case, we know that 50,000 additional common shares will be coming next year, so we should add it. That's actually a less conservative assumption than assuming all convertible bonds are exercised.
Balinko Guys, it's intriguing to look at the comments-flow, but why there is no authoritative explanation for the authors that would save us the guess-work, which might even lead us to dead ends?
faraznq KIS(Keep it simple): Solve for Basic EPS first, Diluted EPS is always less than Basic. Booom!
Ignore 2012 share issuance, question is asking for 2011 Diluted EPS.
MonuPanda exactly i did the same. 5100K - 300K= 4800K .Then divide by common shares =1200K = 4\$ (BASIC EPS) so only option c is less than the basic eps hence select that.. and this will be always be dilutive since only extra shares are issued and there is no addition to NI for checking for anti delusion etc... Hope this clears the doubt.