Basic and diluted earnings per share (EPS) explained for the CPA exam and intermediate accounting — this lecture shows how to calculate basic and diluted EPS with a focus on the impact of convertible securities like convertible bonds. Ideal for accounting practitioners and CPA, CMA, and EA candidates studying dilutive securities and financial reporting, this session walks through the if-converted method and three worked exercises covering bonds held all year, bonds issued mid-year, and partial conversions.

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Video Timeline & Key Concepts:
0:00 Introduction: learning objectives for basic and diluted EPS
0:15 Basic EPS: using actual shares outstanding and weighted average
0:44 Diluted EPS: the if-converted method and adding back interest net of tax
2:32 Exercise 1: convertible bonds outstanding all year and not converted
11:03 Exercise 2: bonds issued during the year (September 1) and the issuance date assumption
16:59 Exercise 3: partial conversion of 20 of 60 bonds on October 1
27:40 Summary of findings: comparing basic EPS to diluted EPS assumptions

Frequently Asked Questions:

What is the difference between basic EPS and diluted EPS?

Basic EPS is calculated using the actual weighted average shares outstanding during the period. Diluted EPS uses the if-converted method to include potential shares from convertible securities, showing a worst-case view of earnings per share if those securities had been converted.

What is the if-converted method?

The if-converted method assumes convertible securities were converted at the start of the period, or at the date of issuance if later. It adds the potential common shares to the denominator and adds back the related interest expense, net of tax, to the numerator when computing diluted EPS.

How do you handle convertible bonds issued during the year?

When bonds are issued mid-year, the if-converted assumption uses the issuance date rather than the start of the period. The potential shares are weighted for the portion of the year the bonds were outstanding, and the interest add-back is adjusted accordingly.

Why is diluted EPS always based on a worst-case scenario?

Diluted EPS is designed to warn investors of the maximum potential dilution. Regardless of how many securities were actually converted, it assumes the conversions that would most reduce EPS, so users can see the lowest earnings per share the company could report.

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