Diluted EPS considers the effects on EPS of all the potential common shares that were outstanding during the year. If inclusion of these shares in the EPS calculation reduces the amount of EPS, then these potential common shares are dilutive and will be included in the calculation of diluted EPS. Otherwise, they are anti-dilutive and will be omitted from the calculation of diluted EPS. Including dilutive potential common shares in the EPS calculation may require adjustments to the numerator and the denominator of the basic EPS calculation. We will illustrate these adjustments for convertible preferred stock.
Recall from our earlier discussion that the dividends declared or accumulated during the period on preferred stock must be subtracted from net income in order to obtain the income applicable to the common shares. If the convertible preferred stock had been converted at the start of the period, however, the preferred dividends would not be subtracted from net income, and the denominator of the EPS calculation would include the additional shares that were issued on conversion. To illustrate, assume that Groucho company has a basic EPS of $5.00 per share, computed as shown in Figure 9.2
Inclusion of the potential common shares associated with the convertible preferred stock in the EPS calculation would result in a diluted EPS of $ 4.80, as follows:
In this case, Groucho would report on the face of the 2001 income statement a basic EPS of $5.00 and a diluted EPS of $4.80.