Wording of question - If converted for Diluted EPS

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)

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.

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?

Yes, if the preferred stock is convertible.

It appears that in this question only bonds are convertible.

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?

Does it say that it’s convertible preferred?

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.

My pleasure.