The general treatment of convertible preferred stock in EPS calculations is basically identical to that given to convertible bonds. Common stock equivalency is determined by comparing the cash yield at issuance to 66 2/3 percent of the prime rate. If designated an equivalent, it is treated that way as long as it is outstanding.
Impact on EPS
If it is necessary to assume conversion of preferred stock, the accountant must increase the denominator by the number of common shares that would have been issued. The treatment for the numerator is different from the one used for bonds because the preferred dividends are not a factor in the calculation of net income. If conversion is not assumed, the divådends on the preferred shares are deducted from net income to get earnings available to common stockholders.
On the other hand, if conversion is assumed, the dividends would not have been paid and accordingly are not deducted from net income. Because dividends are not deductible expenses for tax returns, there is no adjustment to the dividends for additional taxes.
For primary EPS, conversion is assumed only for convertible preferred stock that is considered to be equivalent to common shares and is actually convertible within the next five years. For fully diluted EPS, conversion is assumed for all preferred shares that are convertible within the next 10 years. Preferred shares are antidilutive if the dividends saved per issuable common share exceed EPS without assuming conversion.
Suppose that the Sample Company has three issues of convertible preferred shares outstanding. Each has a par value of $10,000,000 and is convertible to 200,000 shares of common stock. These facts are known about each:
The test for equivalency is shown below:
The impact on the EPS denominators is presented in this table:
The reported net income will receive these adjustments:
The calculations of EPS are presented below, including simple EPS, in order to show the treatment of preferred dividends and the extent of dilution (the net income and outstanding shares are assumed):
Conversion or issuance during the period
If convertible preferred shares are converted during the reporting period, EPS figures are calculated as if they were converted at the beginning of the period. Therefore, the numerator is not adjusted for the preferred dividends actually paid during that part of the year in which they were outstanding. The number of common shares issued at conversion is included in the weighted average of outstanding shares. For the period prior to conversion, the common shares that would have been outstanding are weighted by the appropriate fraction of the year.
For newly issued convertible preferred stock, any adjustment to the numerator is limited to the amount of dividends actually declared (or accumulated). If conversion is assumed, the number of issuable common shares is weighted by the fraction of the year the preferred stock was outstanding.