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Welcome back. In our final lesson for this module,

we're going to talk about anti-dilution.

Anti-dilution occurs when the impact of a conversion or

exercise would increase earnings per share rather than decrease it.

And if it increases earnings per share or decreases a loss in earnings per share,

it's said to be antidilutive,

and it's not included in determining diluted EPS.

So, when could this happen?

Well, when the net impact of changing the numerator and the denominator

increases earnings per share. So what to look for?

Well, convertible preferred stock generally is

antidilutive whenever the amount of the declared or accumulated

dividends per additional common share exceeds basic EPS.

Convertible debt is antidilutive whenever net interest per

additional common share exceeds EPS. You can see that.

So, if my basic EPS is one dollar and my EPS per share of issued stock,

for convertible preferred stock,

when I take the amount of the preferred dividends

over the number of shares issued is more than a dollar,

if I add a average of one dollar and add in an amount that's more than a dollar,

then the average is going to rise.

And that would be antidilutive.

The same logic applies to convertible debt.

Now, options are antidilutive whenever the strike price,

or the exercise price,

exceeds the average market price for the year as we talked about in the last lesson.

So those are pretty easy to see.

What about net losses?

Well, when there's a net loss anti-dilution works differently.

You don't decrease the net loss per share when calculating diluted earnings per share.

So it's bizarre world,

you're going to see things happening almost in the opposite direction.

So it greatly complicates the computation of net loss per share.

So, let's take a look at a quick example.

Stone Cold Refrigeration has a 1,000

options with the stock price of twenty $25 per share.

The average market price for the year is $20 per share.

Well, if I use the treasury stock method there,

I would realize $25,000 on purchase,

25 times a 1,000,

which then could be used to purchase 1,250 shares,

which would be 25,000 divided by the market price of $20.

So the denominator would decrease by 250 shares

net and therefore the options are antidilutive.

So, I issue 1,000 shares,

I repurchase 1250 shares,

then denominator would decrease by 250 shares net.

Well, if I decrease the denominator,

then my earnings per share would go up and that's antidilutive.

Well, what if I have more than one kind of share out there?

This is where it gets kind of complicated.

What if I have convertible debt,

and convertible preferred shares and I have options?

The order in which I calculate earnings per share

could determine when a particular issue is dilutive or antidilutive.

So to reflect the maximum potential dilution,

we're going to consider each issue in

sequence from the most dilutive to the least dilutive.

When we do that, we're going to look at options first.

Why do we look at options first?

Well, because they don't have any numerator effect.

So they don't have a per share amount that we're going to add in.

If exercise of the options increases the number of shares outstanding, it's dilutive.

If it decreases the number of shares outstanding and

the treasury stock method as we've already seen in an example, it's antidilutive.

So you include those first, and then,

you will go to work at any convertible debt or preferred shares.

And then, you'll proceed to convertible securities and begin with the one that has

the largest dilutive potential per share and proceed in order to the least dilutive.

So you're going to start with the lowest earnings per

incremental share and proceed to the next lowest, and so on.

You can see how the principle of sequencing is applied if you

look in Example 4 at ASC 260-10-55-57.

In that example, a security that would not be

antidilutive on its own becomes dilutive when it's sequenced.

Why is that? Well, here's from the example.

You can see the options,

there's no increase in the numerator.

There is an increase in the denominator.

So they are dilutive,

but the incremental earnings per share from conversion is zero.

That's because we're using the treasury stock method for those.

But when we use the If converted method for

the convertible preferred stock, in this example,

the amount available to common shareholders would increase by

6,400,000 as we add back the preferred stock dividends,

and the number of shares issued would be 1,600,000.

So the earnings per incremental share would be four dollars.

Because I would increase the numerator by 6,400,000,

I would increase the denominator by 1,600,000 shares,

incrementally I'd have an increase of four dollars.

The five percent convertible debentures would increase the numerator by $3,000,000,

that's my after tax interest impact,

and we'll increase the denominator by 2,000,000 shares.

So the incremental earnings per share is $1.50.

So, that's a potentially more dilutive.

So I'm going to start my sequential calculation,

of course, with the options,

and then I'm going to proceed to the five percent convertible debentures which are $1.50,

the lowest incremental earnings per share,

and conclude with the convertible preferred stock at four dollars per incremental share.

So, what if we looked at these in isolation first?

Let's look at the preferred stock in isolation.

The incremental EPS of converting the preferred stock is four dollars per share,

and if I add an incremental impact of four dollars per

share to an average EPS of five dollars per share,

that would decrease total EPS and make the conversion dilutive.

The preferred stock would therefore be included in the calculation of

dilutive EPS if that was the only convertible item I had.

But if I look at it sequentially,

the options in the dilutive convertible debt are calculated first.

Because the convertible debt has the lowest incremental EPS, we'll start with that,

and it's calculated in the example,

diluted EPS after conversion is $3.23.

So we started out with a five dollar basic EPS but after

conversion of the options and the convertible debt,

EPS is $3.23 cents.

Well, the preferred stock would now be antidilutive.

Even though it was dilutive on its own,

if it had been the only item out there, in sequence,

adding an incremental EPS of four dollars per share to an average EPS of $3.23 per share,

my intermediate subtotal of diluted earnings per share,

if I add four dollars incremental to $3.23 average,

that's going to increase EPS and that would make the conversion antidilutive.

Therefore, when I'm sequencing,

that convertible preferred stock will be ignored

when calculating dilutive earnings per share.

So, what does that mean?

Well, as you can see, it's complicated.

As we can see, earnings per share is often disparaged,

always complicated and perhaps arbitrary.

But it's still the headline earning number and it's not likely

to be replaced anytime soon nor is net income.

So it's something we need to know and understand as accountants or financial analysts in

order to understand the reporting of net income and the summary metric in particular,

which is known as basic earnings per share and

its companion diluted earnings per share. Thank you.