Earnings per share FASB project on convergence with the IFRS - Essay Example

Earnings per Share - FASB project on convergence with the IFRS Introduction: The Financial Accounting Standards Board (FASB) avers to serve "the investing public through transparent information resulting from high-quality financial reporting standards" (FASB, Home Page). The International Accounting Standards Board (IASB) and the FASB acknowledge that the convergence of International Financial Reporting Standards (IFRS) and the U.S. Generally Accepted Accounting Principles (GAAP) is the primary objective of both boards. The FASB has taken up several 'projects' to address issues where differences have been found in reporting standards and have successfully concluded many; some are under current scrutiny. One of the current issues is the reporting of 'Earnings per Share' or EPS as it is popularly known. Different tools are available for making financial analysis of stocks and range from the very simple and elegant to the very complex and difficult to understand. The financial performance of the company, and therefore, its future prospects and stock performance, is better understood through the calculation of some important ratios that assist us in a detailed appraisal. The EPS method looks at the financial performance of the company; focusing on the earnings recorded per ordinary share in a particular accounting period. This number provides a clear picture of the actual profitability of the company and is used to calculate the Price to Earnings (PE) ratio which represents the ratio of the market price of the share compared with EPS. Since the share price changes almost continually this latter ratio also keeps changing and needs to be calculated on real time basis at the time of making investment related decisions. This is the most important ratio used by the market generally to assess the relative rating of a share and the company's prospects and, of course, is the easiest to understand. It identifies the number of years' earnings needed to cover the current market price of the share. This paper presents the results of a detailed study of this project and its immediate and long term implications for the accounting fraternity as well as the users of accounting statements, viz. the management, shareholders and other stakeholders of the company as well as auditors, potential suitors (for takeover bids) and public. The Standards IAS are a set of financial reporting policies that typically require increased disclosure and restrict management's choices of measurement methods relative to the accounting standards of the local GAAP standards (Ashbaugh & Pincus, 2001). With regard to the Earnings per Share the FASB issued a statement (Statement No. 128: Earnings per Share) and the IASB its statement IAS-33. Both boards have been working together to resolve the differences in order to bring convergence in the two statements and plan to make their final recommendations open for public comment in the first quarter of 2008. This draft will be open comment for 120 days and will then be adopted, with modifications, if required through public opinion. This draft will represent the third such 'exposure draft' on the subject, the earlier ones required many changes based on public comment and had to be revised. The earlier drafts were based on the comments on the statement 128 in 2003 and the first exposure draft in 2005. The description of EPS i.e. The basic earnings divided by the average number of ordinary shares outstanding during the period (IAS33-R.10) leads us to the immediate issues involved: a) How are the basic earnings to be calculated, and b) what is the number of shares the earnings must be divided by to arrive at the EPS. We examine how these are considered under the IFRS and GAAP to arrive at the differences between the current practices under the two regulations. Basic Earnings The concept is to arrive at the profit of the company that is attributable to the ordinary shareholders of the company and therefore the basic earnings must be calculated as net profit (or loss) less preference dividends (IAS33-R.12). Preference dividends include all non-cumulative or cumulative preference share dividends declared during the accounting period, whether or not declared (IAS33-R.14). In the US GAAP the definition of basic earnings is the same with only a few differences difficult for the investing public to comprehend (Van der Meulen et al, 2006). In their study, the authors (ibid) report that that accounting earnings prepared in accordance with US GAAP do not significantly outperform IFRS earnings and that the IFRS earnings are as value relevant and timely as US GAAP earnings. Next to these similarities, they suggest that US GAAP earnings are typically better indicators of future firm performance. Based on the study, they conclude that market participants do not react significantly different to IFRS or US GAAP accounting information. US GAAP compliant accounting information also has some desirable earnings attributes, making the move towards US GAAP beneficial for market participants involved. The reason is that US stock exchanges allow foreign firms to report under their local standards, provided there is a reconciliation of earnings and shareholders' equity with US GAAP (called 20F reconciliation). Shares Calculation The calculation of the number of ordinary shares held in the company represent that part of the total equity that is subordinate to all other classes of equity instruments and whose rights are limited to the residual net assets if the company were to be liquidated (IAS33-R.5). However, the number of ordinary shares may vary during the accounting period for different reasons, for example, declaration of a bonus issue of shares to existing shareholders; splitting of shares; issue of fresh equity to the general public or to existing shareholders through a rights issue; buy back of shares; mergers requiring readjustment of the shareholding; conversion of a convertible instrument, or other instruments that may be settled in cash or shares etc. For determining the number of ordinary shares held in the company the weighted average over the entire accounting period is to be considered (IAS33-R.20) and the number of shares outstanding is adjusted as if the event had occurred at the beginning of the earliest period presented (IAS33R.27-28). The number of shares at the beginning of the earliest period presented is restated to take account of additional shares issued, adjusted for the effect of the share's ex rights value (IAS33R.A2). In the US GAAP the weighted average is allowed to be drawn over the quarterly financial periods. A share is to be taken into consideration only if the full consideration has been realized from the stockholder (IAS33-R.21) and if the shares are partly paid then they are to be accounted as a fraction of a fully paid up share the fraction determined by the extent they are entitled to participate in dividends relative to fully paid up shares (IAS33-R15A). Contingently returnable shares, subject to satisfaction of some condition, are not treated as outstanding. They are excluded from the calculation of basic EPS until no longer subject to recall (IAS33-R.24-25) i.e. the contingency is satisfied. Diluted Earnings per Share is the ratio between the diluted earnings and the diluted shareholding in the entity. The diluted number of shares represents the total of the basic common shares and the dilutive potential common shares; and the diluted earnings the sum of basic earnings plus the dilutive effect of assumed conversions such as convertible preference dividends, interest (after-tax) on convertible debt and effect of assumed conversion of potential common shares. Under the US GAAPanti-dilution (dilution that results in Diluted EPS being larger than the basic EPS) is not allowed if assumed conversion has an anti-dilutive effect on EPS and such conversion is not assumed. In case of reported losses from continuing operation potential common shares are not to be added and both the diluted and the basic EPS is to be reported to be the same. To calculate the dilutive potential common shares two methods may be used: The treasury stock methodfor calculating the dilutive effect of call options and warrants assumes that the exercise of options and warrants has occurred at the beginning of the period or at the time of issuance, whichever is later. The proceeds from exercise are assumed to be used purchase common stock the average market price during the period. Incremental shares are to be included in the denominator of diluted EPS. Stock-based compensationto employees, in terms offixed awards and non-vested stock to be issued must be considered outstanding as of grant date. Under the If-Converted Method the treatment of convertible securities requires that a) preferred dividends convertible to convertible preferred stock must be added to income available to common stockholders; b) Interest charges (after-tax) to convertible debt must be added to income available to common stockholders; and c) Convertible preferred stock or convertible debt must be assumed to be converted the beginning of period or at the time of issuance, whichever is later. In case of mergers the ordinary shares issued, accounted for using the purchase method (opening + purchase - issue) are considered outstanding from the date of the acquisition (IAS33-R.22). The weighted average number of shares for each period is the total of the weighted average number of shares of the combined entity for that period, adjusted into the equivalent shares of the newly combined entity (IAS33R.22). US GAAP regulations show no difference in calculation methods. Where the number of shares outstanding increases because of bonus issues, share splits and other similar events, basic and diluted EPS for all periods presented should be restated. The EPS calculations should give effect to these changes even if these events occur after the balance sheet date, but before the financial statements are issued (IAS33R.64). Similar provisions exist under the US GAAP. EPS calculations should also be adjusted, in both standards of reporting, for the effects of errors and changes in accounting policies accounted for retrospectively, and the effects of a business combination accounted for as a uniting of interests (IAS33R.64). Restatement of prior-period diluted EPS amounts is not allowed for a change in the previous assumptions used, for example assumed conversion of contingently issuable shares, or for the conversion of potential ordinary shares into ordinary shares outstanding (IAS33R.65). An entity is encouraged to disclose share transactions which occur after the balance sheet date - disclosure of such events is 'encouraged' where non-disclosure would affect the ability of the financial statement users to make decisions (IAS33-R.70 (d), 71). The US GAAP makes the disclosure of such events mandatory. Separate EPS presentation on the face of the income statement is required for each class of ordinary shares, even where the amounts are negative. Basic and diluted EPS should be presented with equal prominence (IAS33R.66). Under both standards an entity should disclose: 1. The amounts used as the numerator in calculating basic and diluted EPS, and a reconciliation of the amounts to the net profit or loss for the period; and 2. The weighted average number of shares used as the denominator in calculating basic and diluted earnings per share, and a reconciliation of these denominators to each other Both the FAS 128 and the IAS 33 require presentation of basic and diluted EPS on the face of the income statement. Both standards use similar methods for calculating EPS, and the few differences may be summarized as under: 1. In case of contracts that may be settled in shares or cash the US GAAP presumes that such contracts will be settled in shares but may be allowed to be shown as settled in cash if the company provides evidence to support this assumption. In the IFRS, however, all such contracts are assumed to be settled in shares. 2. For the calculation of the year to date diluted EPS for options and warrants using treasury stock method and for contingently issuable shares - the number of incremental shares, under the US GAAP, is computed using the year-to-date weighted average of the number of incremental shares included in each quarterly calculation. The IFRS does not allow the calculation of the weighted average and the entire year is considered as one single period. The FASB method provides more specific implementation guidance for some of the calculations required. In the absence of implementation guidance, enterprises following IAS 33 would not be prohibited from using alternative bases for determining the impact of contingently issued shares (IASC-US Comparison Project). 3. Potentially issuable shares against contingently convertible debt are included in diluted EPS under the US GAAP using the 'if-converted' method. Under the IFRS potentially issuable shares are considered and the shares taken into account for the calculation of the diluted EPS if the contingency is satisfied within the reporting period. 4. Another significant difference between US GAAP and IAS is the treatment of the development costs associated with research and development. Under US GAAP these items are required to be expensed as incurred, whereas under IAS 38 there is the option to capitalize these items under certain circumstances (IASC-US Comparison Project). 5. Essentially the main difference between the two standards is that FASB requires more disclosure than the IAS. The FASB requires the disclosure of per-share amounts for income from continuing operations on the face of the income statements and for extraordinary items, accounting changes and discontinued operations. The IASC requires only net profit per-share amounts on the face of the income statements and encourages other disclosures. In their efforts towards convergence of the two standards it has been tentatively decided to follow the IFRS methods to eliminate the differences noted above. The significant convergences achieved so far are: 1. Only those instruments whose conversion is mandatory and the holders of the instrument could participate in current period earnings with common shareholders should be reflected in the basic EPS calculation. 2. Options and warrants should be included in the computation of basic EPS if (a) the instrument is currently exercisable into common shares for little or no cost to the holder of the instrument, or (b) the instrument can presently participate in earnings with common shareholders. 3. Eliminate the weighted-average computations for calculating contingently issuable shares and require that contingently issuable shares be included in diluted EPS from the beginning of the period that the conditions for issuance are satisfied, or at the date of the contingent share agreement, if later. 4. For quarterly and year-to-date computations of diluted EPS, the dilutive effect of options and warrants (and their equivalents) should be reflected by applying the treasury stock method for the year-to-date period independently from any interim computation. 5. For Instruments that can be settled in cash or shares, the following changes have already been made: It should be presumed that the contract will be settled in shares if the effect is dilutive even if the instrument is cash settlement only but contains a provision for settlement in shares under special circumstances (other than bankruptcy of the issuer). That presumption may not be overcome, regardless of past practice or stated policy to the contrary. "Instruments (either freestanding or separately accounted for as a component of a compound instrument) that can be settled in cash or shares, are classified as a liability, and are marked-to-market each reporting period with gains and losses recognized in earnings should no longer be subject to (a) the treasury stock method (including fully and partially vested share-based payment awards), (b) the if-converted method, or (c) the two-class method. That is, the Board decided that the change in fair value recognized in earnings captures the dilutive effect of those instruments, eliminating the need to include such instruments in the determination of diluted earnings per share (EPS)." (FASB, Home Page) The treasury stock method should be modified for all instruments. The modified treasury stock method would (1) include the end-of-period value of the liability as an assumed proceed (if applicable) and (2) use the end-of-period market price in computing the number of incremental shares to be included in the determination of diluted EPS. As a result of the modifications to the treasury stock method, instruments classified as a liability (but that are not re-measured fair value) that will be settled by issuing an equal value of equity instruments for the carrying value of the liability will have no effect on the diluted EPS calculation. Impact of the proposed convergence Uniformity of reporting standards shall allow investors and potential investors to understand the important indictors - the EPS and the diluted EPS - with total clarity. It will also assist in understanding market reaction to the financial performance reports of a company. Differences cause financial and managerial accounting problems for multinational enterprises such as the need to keep several set of records (Schoenfeld, 1981). The diluted EPS is considered to be a better indicator of the future performance of a company as it reflects the dilutive effects of transactions that have implications for future performance. Uniformity in the reporting standards and how each of the factors affecting the diluted EPS has been treated is important to investment decision making, especially in companies that have off-shore operations and use the IFRS standards. Bibliography Ashbaugh, H and Pincus, M. (2001): Domestic Accounting Standards, International Accounting Standards, and the Predictability of Earnings, Journal of Accounting Research,39(3), pp. 417-434 Ernst and Young Assurance and Advisory Business Service (2007): U.S. GAAP v. IFRS: The basics downloaded on February 20, 2008 from: www.ey.com/Global/assets.nsf/US/Assurance_US_GAAP_v_IFRS/$file/us_gaap_v_ifrs.pdf - FASB - website - project on Earnings per Share: accessed on February 20, 2008 from: http://www.fasb.org/project/short-term_intl_convergence.shtml IFRS Work Books - For Accounting Professionals: IAS 33. Earnings per Share available online from: http://www.accountingreform.ru Similarities and differences: A comparison of IFRS and US GAAP, A PWC publication (October 2007) downloaded from: http://www.pwc.com/extweb/pwcpublications.nsf/docid/74d6c09e0a4ee610802569a1003354c8 Van-der- Meulen, on line resource accessed on February 20, 2008 from: http://www.business.uiuc.edu/accountancy/research/vkzcenter/conferences/france/papers/Van_der_Meulen_Gaeremynck_Willekins.pdf The IASC-U.S. Comparison Project (2000): A report on the Similarities and Differences between IASC standards and US CAAP. Chapter 2. Financial Executive, accessed on February 20, 2008 from: http://www.sciencedirect.com.ezproxy.umuc.edu/science_ob=ArticleURL&_udi=B7GWN-4FH4V43-2&_user=961261&_rdoc=1&_fmt=&_orig=search&_sort=d&view=c&_acct=C000049394&_version=1&_urlVersion=0&_userid=961261&md5=8b6602197b19895a5fba9cb1a681925f Schoenfeld, H.W. (1981): International Accounting: Development, Issues and Future Directions, Journal of International Business Studies, 12(2) p 83-100. Source Citation: "Earnings per share standard is finalized."Journal of Accountancy183. n5(May 1997):16(2).Academic OneFile.Gale.University of MD University College.18 Feb. 2008 . Research Tracker Topic/Key Concepts Sources Consulted Search Terms Used Results/Comments/Notes Comparison IFRS and U.S. GAAP EPS Google Scholar IFRS + US + GAAP + EPS Some sources are indicated. The [BOOK]The Influence of Specific Accounting Differences on the Choice Between IFRS Or US GAAP Yields a report of relevance. US GAAP and IFRS Google Scholar GAAP vs. IFRS + U.S. Located a downloadable article on the subject published by Ernst & Young FASB Google FASB Home page accessed to identify a project for the paper and details of the current status, including some in-text quotes used. Accounting Standard comparison UMUC JSTOR IAS 33 + Earnings per Share and Limiters "business" and "Finance" Found one article of relevance Ashbaug used partly. Similarities and Differences Google EPS + Similarities + difference Found the PWC downloadable booklet Accounting Standard comparison UMUC EBSCO 128 + Earnings per Share and Limiters "business" and "Finance" Found the article by Schoenfeld Earnings per Share Standards UMUC Academic One Earning per Share + Standards Found Article from Journal of Accountancy. Read More