The general treatment of convertible preferred stock in earnings per share (EPS) calculations is basically identical to that used for convertible bonds.
Common stock equivalency is determined by comparing the cash yield at issuance to 66 2/3 percent of the prime rate. If designated as an equivalent, it is treated that way as long as it is outstanding.
Impact on EPS
If it is necessary to assume conversion of preferred stock, an accountant must increase the denominator by the number of common shares that would have been issued.
The treatment for the numerator is different from the one used for bonds because the preferred dividends are not a factor in the calculation of net income.
If conversion is not assumed, the dividends on the preferred shares are deducted from net income to determine the earnings available to common stockholders.
On the other hand, if conversion is assumed, the dividends would not have been paid and, accordingly, are not deducted from net income.
Given that dividends are not deductible expenses for tax returns, there is no adjustment to the dividends for additional taxes.
For primary EPS, conversion is only assumed for convertible preferred stock that satisfies the following criteria:
The stock is considered to be equivalent to common shares
The stock is actually convertible within the next five years
For fully diluted EPS, conversion is assumed for all preferred shares that are convertible within the next 10 years. Preferred shares are anti-dilutive if the dividends saved per issuable common share exceed EPS without assuming conversion.
Suppose that the Sample Company has three issues of convertible preferred shares outstanding. Each has a par value of $10,000,000 and is convertible to 200,000 shares of common stock.
The following facts are known about each group:
The test for equivalency is shown below:
The impact on EPS denominators is presented as follows:
The reported net income will receive these adjustments:
The EPS calculations are presented below, including simple EPS. This is done to show the treatment of preferred dividends and the extent of dilution (the net income and outstanding shares are assumed).
Conversion or Issuance During the Period
If convertible preferred shares are converted during the reporting period, earnings per share (EPS) figures are calculated as if they were converted at the beginning of the period.
Therefore, the numerator is not adjusted for the preferred dividends that are actually paid during the part of the year in which they were outstanding.
The number of common shares issued at conversion is included in the weighted average of outstanding shares. For the period prior to conversion, the common shares that would have been outstanding are weighted by the appropriate fraction of the year.
For newly-issued convertible preferred stock, any adjustment to the numerator is limited to the number of dividends actually declared (or accumulated).
Under the assumption of conversion, the number of issuable common shares is weighted by the fraction of the year that the preferred stock was outstanding.