Wording of question - If converted for Diluted EPS

CFA Level I FRA
#1

My question: When calculating Diluted EPS, why in the explanation is “preferred dividends” subtracted and not ADDED in the NUMERATOR? We apply the “IF-CONVERTED METHOD” for diluted EPS. Does Kaplan’s website have an incorrect answer to the question? HELP!

An analyst has gathered the following information about Barnstabur, Inc., for the year:

Reported net income of $30,000.
5,000 shares of common stock and 2,000 shares of 8%, $90 par preferred stock outstanding during the whole year.
Barnstabur, has $60,000 of 6.0% convertible bonds outstanding, with each of the 60 bonds convertible into 110 shares of Barnstabur common stock.
If Barnstabur’s effective tax rate is 40%, what will Barnstabur report for diluted earnings per share (EPS)?

Below is Kaplan online’s explanation:

Diluted EPS = adjusted earnings after conversion (EAC) / weighted average plus potential common shares outstanding.

Step 1: Calculate Adjusted EAC

adjusted EAC: net income - preferred dividends

  • after-tax interest on convertible debt
    = adjusted earnings available for common shares

preferred dividends = (0.08)(90)(2,000) = 14,400

convertible debt interest = (60,000)(0.06)(1 – 0.40) = 2,160

adjusted EAC = (30,000 – 14,400 + 2,160) = $17,760

Step 2: Calculate Weighted average plus potential common shares outstanding.

weighted average common shares = 5,000
shares from conversion of convertible bonds = (60 × 110) = 6,600
weighted ave. plus potential common shares outst. = 11,600

Step 3: Calculate Diluted EPS

Diluted EPS = 17,760 / 11,600 = $1.53.

(Study Session 7, Module 21.4, LOS 21.h)

#2

Preferred dividends belong to the preferred shareholders, not the common shareholders.

EPS uses only earnings that belong to the common shareholders.

The calculation looks correct.

#4

When calculating diluted EPS, we apply the “if-converted method”. Thus, shouldn’t we add on to net income the $ amount that we are now not distributing as a preferred dividend?

#5

Yes, if the preferred stock is convertible.

It appears that in this question only bonds are convertible.

#6

2,000 shares of 8%, $90 par preferred stock outstanding during the whole year.

These are the preferred stock that pay an 8% dividend yield. So are we to assume the preferred stock was never converted, since they subtracted the annual amount owed, instead of adding? I thought calculating diluted EPS assumes the “if-converted method”; hence, my question of why didn’t we add the amount to the numerator?

#7

Does it say that it’s convertible preferred?

#8

Excellent, now I understand. The question did not say convertible; thus we subtract the $14,400 since the company must still distribute it as a preferred dividend.

Thank you again, S2000.

#9

My pleasure.

#10

Yup, only when it says “convertible” then we make the necessary adjustments.