EARNINGS PER SHARE (EPS) - DILUTED

Where a company’s sources of finance includes either securities convertible into equity shares, or options and warrants which entitle holders to obtain equity shares, such financial instruments increase the likelihood that additional equity shares will be issued in the future. This possible increase in the number of shares is called potential dilution.

Case Study:

Suppose IStaR Ltd. has 30,000 equity shares outstanding in the market along with INR 100,000 of convertible debentures – that is, bonds that can be converted into equity shares. According to the terms of the debenture agreement, each INR 1,000 face value bond can be exchanged for 300 equity shares. If all the debentures were exchanged, bondholders would receive 30,000 new equity shares. The effect on current equity shareholders would be to dilute their claim to earnings from 100% - when they own all equity shares – to 50% - when they own only half of all outstanding shares.

Computed Basic EPS ignore this potential dilution of current shareholders’ ownership interest in the company. To recognize the increase in outstanding shares that would ensue from conversion or option exercise, IAS 19 / AS   (India) requires companies to compute Diluted EPS.

The diluted EPS is a conservative number of the earnings flow to each equity share. It’s conservative because it presumes the maximum possible new share creation – and thus minimum earnings flow to each equity share

The computation of Diluted EPS requires certain reasonable assumptions to be made. For example, once the bonds are converted into equity, the company need not make further bond interest payments.  Assumptions are also made for options or warrants exercise. When the holders of option or warrants exercise them, they receive equity shares; but at the same time, the company receives cash in an amount representing the exercised options or warrants. In the computation of the diluted EPS, this cash is assumed to be used to acquire the already outstanding equity shares in the market.

The Diluted EPS formula is:

To illustrate how the diluted EPS computation works, we will extend our IStaR example. Assume that on January 1, 2012 IStaR also had the following financial instruments outstanding:

• 1,000,000 of 5% convertible debenture bonds due in 15 years, which were sold at par (INR 1,000 per bond). Each INR 1,000 bond pays interest of 50 per year and is convertible into 10 equity shares
• Options to buy 20,000 shares of equity at INR 100 per share. These options were issued on February 9, 2011 and will expire on February 9, 2013

Let’s say the tax rate is 35% and IStaR shares sold for an average market price of INR 114 during 2012.

Each of these financial instruments is potentially dilutive and must be incorporated into the diluted EPS computation.

The convertible debentures are included in the dilutive EPS by assuming a conversion on the first day of the reporting period (here January 1, 2012). The after tax effect of interest payments on the debt is added back in the EPS numerator, and the additional shares that would be issued on conversion are added in the denominator. In the accounting terminology this is called as “if-converted” method.

As per this method, conversion of all the 1,000 bonds into 10,000 equity shares is presumed at the beginning of the year (January 1, 2012). No interest would have been paid on these debentures because all bonds are assumed to be converted as of January 1, 2012. This means that interest of 50,00 would not have been paid on presumptively converted bonds. With 35% tax rate, net income would increase by 32,500 (50,000 * [1-0.35]), and this amount is added to diluted EPS numerator.

The outstanding stock options will only affect the denominator of the diluted EPS computation. The adjustment reflects the difference between option exercise price (100 per equity share) and the average market price (114 per equity share) during the period. It is assumed that any proceeds received on exercise of the options (100 per share) are used to buy back already outstanding equity shares at the average market price for the period. This is called the treasury stock method.

Stock options are dilutive only when they are  in-the-money -  that is, when the average market price (114) exceeds the option price (100). Using the treasury stock method, we assume that 2,000,000 proceeds to the company from presumptive exercise price of the options ( 20,000 shares @ 100 per share) are used to repurchase previously issued equity shares at the 114 average market price. The cash from options is sufficient to acquire 17,544 shares (2,000,000 / 114 per share). Since 20,000 shares are presumed issued and 17,544 are presumed acquired, the difference 2,456 net new equity shares is added to dilutive EPS denominator.

Diluted EPS=( 1,257,331-70,000+32,500) / (173,333+10,000+2,456)

                                                                = INR 6.57 per share

Is EPS a meaningful number?

EPS data are published in the financial reports even though EPS suffers as a financial performance measure.

EPS ignores the amount of capital required to generate the reported earnings. This is easy to show with the following example that contrasts the 2013 financial performance of 2 companies:

	Company AB	Company PQ
Net income available to equity shareholders	1,000,000	1,000,000
Weighted average equity shares outstanding	100,000	100,000
Basic earnings per share (EPS)	INR 10	INR 10
Gross assets	20,000,000	30,000,000
Liabilities	10,000,000	10,000,000
Equity (Assets – Liabilities)	10,000,000	20,000,000
Return on equity (ROE)	10%	5%

Both Company AB and Company PQ report identical EPS of INR 10. But Company PQ needed twice as much equity capital and 50% more gross assets to attain the 1,000,000 net income. Even though both companies report the same level of net income and EPS, Company PQ has a return on equity of only 5%, while Company AB has 10%. It means that Company AB generates more earnings from the existing resources – that is, equity capital.

Because EPS ignore capital source, the problem arise when trying to interpret it. The narrow focus of EPS ratio clouds the comparison between two companies as well as year-on-year EPS changes for a single company. For example, even if year-on-year earnings level are the same, a company can improve its reported EPS by simply repurchasing some previously issued equity shares.

Earnings per share (EPS) is a popular and useful summary measure of a company’s profit performance. It tells you how much profit (or loss) each share of equity has earned after adjustments for potential dilution from options, warrants and convertibles are factored in.

But EPS has its limitations....

IFRS 9 amended again!

IFRS 9 - Financial Instruments much awaited amendment is finally out on November 19, 2013. The entities which need to deal with the financial instruments in line with IFRS, are probably aware of multiple standards covering this really titanic topic: IAS 39, IFRS 9, IFRS 7, IAS 32 and partially IFRS 13. 

The new standard - IFRS 9 - is still under development.

Let's see what are the 3 main changes brought in the amended IFRS 9:

• Mandatory effective date of IFRS 9 (1 January 2015) was removed. It means that you can apply old IAS 39 after 31-12-2014
• Financial Liabilities (Own Debt) at Fair Value has new requirements for the accounting and presentation of changes in the fair value when own debt is measured at fair value
• New hedge accounting rules!

New hedging rules were long-awaited, because the older rules in IAS 39 are really strict and hard to apply. 

Further post will explain Hedge Accounting in brief..Stay glued:)

CSR - Mandate for India Inc!

Niall Fitzerald, Former CEO, Unilever once said that “Corporate Social Responsibility is a hard-edged business decision. Not because it is a nice thing to do or because people are forcing us to do it because it is good for our business.

1. The Companies Act 2013 requires that every company (private/ public unlisted / listed) with Networth of ≥ INR 500 crore (5 billion) or Turnover of ≥ INR 1,000 crore (10 billion) or Net profit of ≥ INR 5 crore (50 million) during the financial year will constitute a CSR Board committee (CSRC).
   
2. The board will ensure that company spends, in every financial year, at least 2% of its average net profits during the immediately preceding 3 years, in pursuance of CSR policy. The CSR committee will consists of 3 or more directors with atleast 1 independent director. The Board’s report should disclose the composition of CSRC.
   
3. The board will approve the CSR policy and disclose its contents in the board report and place it on the company’s website.
   
4. If the company fails to spend the CSR amount, the Board will, in its report specify the reasons for not spending the amount.
   
5. The Ministry of Corporate Affairs (MCA) has issued “National Voluntary Guidelines on Social, Environmental & Economic Responsibilities of Business,” for voluntary adoption by companies. In addition, the SEBI has mandated that the top 100 listed entities, based on their market capitalization at the BSE and NSE, should include business responsibility reports as part of their Annual Reports.
   
6. Schedule VII of the Companies Act, 2013 sets out the activities, which may be included by companies in their CSR policies. They relate to:
1. eradicating extreme hunger and poverty
2. promotion of education
3. promoting gender equality and empowering women
4. reducing child mortality and improving maternal health
5. combating HIV, AIDs, malaria and other diseases
6. ensuring environmental sustainability
7. employment enhancing vocational skills
8. social business projects
9. contribution to certain funds such as the Prime Minister’s National Relief Fund and
10. other matters that may be prescribed.

The Impact of the above provisions on India Inc:

• There is no penal provision if a company fails to spend amount on CSR activities. The board will need to explain reasons for non-compliance in its report. The law always needs to be looked at from a “Fish-Eye Lens” perspective (to look everything in tandem rather than in silos). Section 134 (3) (o) requires that the Director’s Report laid before the Company general meeting shall include a statement giving details about the policy developed and implemented by the company on CSR initiatives taken during the year. Further, Section 134 (8) states that if a company contravenes the above provision, the company shall be punishable with a fine of ≥ INR 50,000 but may extend to INR 25,00,000 and every officer of the company who is in default shall be punishable with an imprisonment for a term which may extend to 3 years or a fine which shall be ≥ INR 50,000 but may extend to INR 5,00,000; or both.
  
• Due to determination of average profit as per section 198, actual expenditure on CSR activities for a company may be higher/ lower than 2% of its average profits for the last 3 years determined in accordance with the P&L.
  
• CSR requirements depends on net worth, turnover or net profit criterion, irrespective of whether the company is a public or private company. Every company covered by CSR needs to constitute a CSR committee with at least one independent director. This implies that even a private company will need to have an independent director if it is covered under CSR requirements.
  
• It is not absolutely clear whether a company will need to create provisions in the financial statements towards unspent if it fails to spend 2% of the amount of CSR activities in a particular year. The resolution of this issue may depend of legal/ other consequences, which may follow, if a company fails to spend the requisite amount in a particular year.
  
• As per the news report, when Sachin Pilot, the Corporate Affairs Minister, was asked whether the companies would get any tax benefits from CSR expenditure, he indicated that CSR expenditure is 2% of Profit Before Taxes (PBT) and therefore a kind of benefit is already available by way of deduction from taxable income. However, he mentioned that he will speak to Finance Minister and see what can be done.
  
• Clarification from Central Board of Direct Taxes (CBDT) is awaited to clear the ambiguity surrounding the deductibility of the CSR expense.

I’d like to sign off this post with a quote I read sometime back “When the wind blows there are those that build walls and then there are those that build windmills.”

Social good is a way of conducting business..

TREASURY SHARES

When a company buys back or reacquires its own shares, such portion of shares are called as Treasury Shares. These are the shares that the company keeps in its own treasury and therefore they will be deducted from equity. These shares don't pay dividends, have no voting rights, and should not be included in shares outstanding calculations for EPS. No gain or loss is recognized in the statement of profit and loss on the purchase, sale, issue or cancellation of an entity’s own equity instruments.

Case Study 1: Accounting of buy back of equity shares

IStaR Co buys back 100,000 of its own equity shares in the market for INR 10 per share. The accounting entry for recording the purchase of treasury shares as a deduction from equity is as follows:

Equity – Treasury Shares a/c………Dr                                        1000,000

To Cash/ Bank a/c                                                                                           1000,000

(Being treasury shares recognized as a deduction from equity)

Disclosures:

The amount of treasury shares held is disclosed separately either on the face of the balance sheet or in the notes to accounts. Further, a company provides disclosures in accordance with the requirements of Related Party Disclosures (RPD) in cases where the company reacquires its own equity instruments from related parties.

Indian companies have to comply with the requirements of the Share Buy Back rules as prescribed by SEBI (Securities and Exchange Board of India). In India, shares cannot be bought back for treasury operations.

Case Study 2: Treasury shares – Economic Hedge

IStaR is a big financial institution whose shares are listed and included in NIFTY 50 index of NSE (National Stock Exchange). IStaR issues a debenture whose principal amount varies with the movement in the NIFTY 50 share index (an ‘index tracker debt’). In order to hedge economically the equity derivative that is embedded in the debenture, IStaR purchases a portfolio of the shares contained in the NIFTY 50 index and classifies them as held-for-trading (HFT).

IStaR cannot classify its own purchased shares as held-for-trading (HFT) in order to hedge economically the index tracker debt. IAS 32 – Financial Instruments – Presentation requires that treasury shares should be shown in the balance sheet as a deduction from equity and not as assets, and that no gain or loss should be recognized in the profit or loss on such shares.

When an entity holds its own shares on behalf of others – when a financial institution holds its own shares on behalf of a client as a custodian – this represents an agency relationship and as a result the shares are not included in the balance sheet of the financial institution.

EARNINGS PER SHARE (EPS) - BASIC

EPS is simply profit amount divided by number of shares. Valuing a company as a whole is crucial during merger negotiations, buyouts or in similar arrangements – relatively rare events in the ongoing life of a company. For day-to-day valuations, many analysts prefer to focus on the value of single equity share. Here the earnings per share (EPS) computation helps to know how much of the company’s total earnings accrue to each share.

A simple capital structure exists when a company has no convertibles, no options or no warrants outstanding. The simple formula used to compute earnings per share (EPS) is:

To illustrate, IStaR Ltd. discloses the following information in the year 2012:

	January 1	December 31
Equity shares ( ` 1 face value)
160,000 shares issued and outstanding	160,000
200,000 shares issued and outstanding		200,000
Reserves	12,000,000	16,000,000
Retained earnings	1,100,000	1,800,000
7% Preference shares ( ` 100 face value)
10,000 shares issued and outstanding	1,000,000	1,000,000

The 40,000 additional equity shares were issued on September 1 and thus were outstanding for the last quarter of the year. The following factors explain the movement in retained earnings during the year 2012:

Retained earnings, January 1	1,100,000
Net income for the year	1,257,331
Preference dividend paid	(70,000)
Equity dividends	(487,331)
Retained earnings, December 31	1,800,000

The denominator of the basic EPS computation uses the weighted average number of equity shares outstanding. Since the additional shares were issued during the year, the weighted average number of outstanding shares is computed as follows:

  

Time	Shares outstanding (a)	Portion of the year (b)	Weighted average shares (c) = (a) * (b)
January 1 – August 31	160,000	2/3	106,667
September 1 – December 31	200,000	1/3	66,667
Weighted average outstanding shares			173,334

So now Basic EPS will be:

      = ` 6.85 per share

Companies Bill 2012 made easy ~ Better Corporate Governance, Stringent Disclosure Norms, CSR and more..

ANALYSIS OF THE NEW COMPANIES BILL 2012 

RELIANCE INDUSTRIES LTD

Posted by ~ Er Tejas Somaiya

Prelude

The Companies Bill 2011 was laid before the Parliament in December 2011 and was referred to Parliament Standing Committee on Finance. The Standing Committee submitted its report in June 2012 and based on Standing Committee's report, the Companies Bill 2011 was amended and was introduced as the new Companies Bill, 2012. The Bill was passed by the Lower House of Parliament on 18th December 2012. The Bill is pending the Upper House of Parliament-the Rajya Sabha and therefore, may undergo further changes.

The Bill is divided into 29 chapters and contains 470 clauses as against 658 sections in the existing Companies Act, 1956.

Corporate Governance: Concept of Independent Directors ("ID") has been introduced for the first time in Company Law. Some of the important points relating to IDs are mentioned below:

• Maximum number of directors has been increased from 12 to 15 directors. Further, no Central Government's permission in required to increase the maximum number of directors beyond 15. RIL's board presently comprises of 12 members with 7 Independent Directors. Thus, one of the clause (of the New Companies Bill) which mandates at least 1/3rd of total number of directors as IDs is already satisfied even if the number is increased to 15 members.
• Appointment of at least one woman director on the board has been made mandatory (for prescribed class or classes of companies). Presently, there is No Woman Director in RIL and hence, it is entitled a transition period of one (1) year for the compliance of this provision.
• Every company shall have at least one director resident in India for at least 182 days in previous calender year, is made mandatory for all companies. At present, all directors can be foreigners not residing in India.
• ID cannot be granted any stock options in companies and this appears to be in direct conflict with Clause 49 read with the applicable SEBI guidelines as per which, IDs may be granted stock options. Stock Options, granted to directors (Executive Directors), shall be included in the remuneration.
• A person cannot be director in more than 20 companies as against 15 companies in the existing Companies Act, 1956 and out of these 20 he cannot be an ID in more than 10 public companies.

Auditors and Accounts: The last audited accounts signatory for RIL includes - Chaturvedi & Shah, Deloitte Haskins & Sells and Rajendra & Co., Chartered Accountants

•  Every company must appoint an individual or a firm as an auditor at the first AGM, who shall hold office till the conclusion of its fifth AGM and thereafter till the conclusion of every fifth meeting. Further, the Bill mandates rotation of individual auditors in every five years and for audit firms every ten years.
• Auditors are prohibited from rendering specified services to the company/ its holding company/ subsidiary company which includes - internal audit, investment banking services, outsourced financial services, actuarial services, investment advisory services and other management services.
• Companies having subsidiaries are required to prepare consolidated financial statement of the company and all subsidiaries; the consolidated financial statements are also required to include financial statements of associate companies and joint ventures.

Corporate Social Responsibility (CSR)

• CSR has been made mandatory for companies with a Net Worth of INR 500 crores (INR 5 billion) or more, or a turnover of INR 1000 crores (INR 10 billion) or more, or a Net Profit of INR 5 crore (INR 50 million) or more during any financial year.
• Such companies must spend 2% of their Average Net Profits the company made during three immediately preceding financial years.
• Such company is required to constitute - Corporate Social Responsibility Committee of the board which shall include three (3) or more directors and one (1) independent director. This committee would formulate and recommend CSR activities to the Board.
  RIL on it's part is committed to 'safety of persons over all production targets'.

Mergers and Amalgamations:

• Merger of Indian company with foreign company is allowed under the New Companies Bill. The Companies Act, 1956 does not permit merger of Indian company into a foreign company.
• Mergers between two small companies or between holding company and it's wholly owned subsidiary has now been simplified without the requirement of the court process. Notice has to be issued to Registrar of Companies (ROC) and Official Liquidator (OL) first and objections/ suggestions have to be taken before the members in general meeting. Objections to such arrangement can be made by persons holding 10 percent of the shareholding or having outstanding debt of at least 5 percent of total outstanding debt as per latest audited financial results.

Serious Fraud Investigation Office (SFIO)

• Central Government shall establish an office called the SFIO to investigate frauds relating to a company; one such instance being SFIO investigating INR 850 crore (INR  8.5 billion) fraud in accounts of Reebok India.
• SFIO is empowered to arrest in respect of certain offences involving frauds. 

The Bill is passed by Loksabha and introduced in Rajyasabha, still waiting to be passed. Post passing by Rajyasabha consent of President of India will be necessary before the Bill becomes an Act.