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Welcome back. In our final lesson for this module,

Â we're going to talk about anti-dilution.

Â Anti-dilution occurs when the impact of a conversion or

Â exercise would increase earnings per share rather than decrease it.

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

Â it's said to be antidilutive,

Â and it's not included in determining diluted EPS.

Â So, when could this happen?

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

Â increases earnings per share. So what to look for?

Â Well, convertible preferred stock generally is

Â antidilutive whenever the amount of the declared or accumulated

Â dividends per additional common share exceeds basic EPS.

Â Convertible debt is antidilutive whenever net interest per

Â additional common share exceeds EPS. You can see that.

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

Â for convertible preferred stock,

Â when I take the amount of the preferred dividends

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

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

Â then the average is going to rise.

Â And that would be antidilutive.

Â The same logic applies to convertible debt.

Â Now, options are antidilutive whenever the strike price,

Â or the exercise price,

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

Â So those are pretty easy to see.

Â What about net losses?

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

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

Â So it's bizarre world,

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

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

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

Â Stone Cold Refrigeration has a 1,000

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

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

Â Well, if I use the treasury stock method there,

Â I would realize $25,000 on purchase,

Â 25 times a 1,000,

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

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

Â So the denominator would decrease by 250 shares

Â net and therefore the options are antidilutive.

Â So, I issue 1,000 shares,

Â I repurchase 1250 shares,

Â then denominator would decrease by 250 shares net.

Â Well, if I decrease the denominator,

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

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

Â This is where it gets kind of complicated.

Â What if I have convertible debt,

Â and convertible preferred shares and I have options?

Â The order in which I calculate earnings per share

Â could determine when a particular issue is dilutive or antidilutive.

Â So to reflect the maximum potential dilution,

Â we're going to consider each issue in

Â sequence from the most dilutive to the least dilutive.

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

Â Why do we look at options first?

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

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

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

Â If it decreases the number of shares outstanding and

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

Â So you include those first, and then,

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

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

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

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

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

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

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

Â In that example, a security that would not be

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

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

Â You can see the options,

Â there's no increase in the numerator.

Â There is an increase in the denominator.

Â So they are dilutive,

Â but the incremental earnings per share from conversion is zero.

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

Â But when we use the If converted method for

Â the convertible preferred stock, in this example,

Â the amount available to common shareholders would increase by

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

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

Â So the earnings per incremental share would be four dollars.

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

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

Â incrementally I'd have an increase of four dollars.

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

Â that's my after tax interest impact,

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

Â So the incremental earnings per share is $1.50.

Â So, that's a potentially more dilutive.

Â So I'm going to start my sequential calculation,

Â of course, with the options,

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

Â the lowest incremental earnings per share,

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

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

Â Let's look at the preferred stock in isolation.

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

Â and if I add an incremental impact of four dollars per

Â share to an average EPS of five dollars per share,

Â that would decrease total EPS and make the conversion dilutive.

Â The preferred stock would therefore be included in the calculation of

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

Â But if I look at it sequentially,

Â the options in the dilutive convertible debt are calculated first.

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

Â and it's calculated in the example,

Â diluted EPS after conversion is $3.23.

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

Â conversion of the options and the convertible debt,

Â EPS is $3.23 cents.

Â Well, the preferred stock would now be antidilutive.

Â Even though it was dilutive on its own,

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

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

Â my intermediate subtotal of diluted earnings per share,

Â if I add four dollars incremental to $3.23 average,

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

Â Therefore, when I'm sequencing,

Â that convertible preferred stock will be ignored

Â when calculating dilutive earnings per share.

Â So, what does that mean?

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

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

Â always complicated and perhaps arbitrary.

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

Â to be replaced anytime soon nor is net income.

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

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

Â which is known as basic earnings per share and

Â its companion diluted earnings per share. Thank you.

Â