During its fiscal year, Richards' Distributing had net income of $100,000 (no extraordinary items) and 50,000 shares of common stock and 10,000 shares of preferred stock outstanding. Richards declared and paid dividends of $.50 per share to common and $6.00 per share to preferred. The preferred stock is convertible into common stock on a share-for-share basis. For the year, Richards Distributing should report diluted earnings (loss) per share of
A) $(0.80).
B) $1.00.
C) $1.67.
D) $2.67.

Question

Quizplus · Accepted Answer

Net income attributable to common shareholders = $100,000 - ($6.00 x 10,000) = $40,000

Number of common shares outstanding (basic) = 50,000

Number of common shares issued upon conversion of preferred shares = 10,000

Number of common shares outstanding (diluted) = 50,000 + 10,000 = 60,000

Earnings per share (basic) = $40,000 / 50,000 = $0.80

Earnings per share (diluted) = $40,000 / 60,000 = $0.67

Since the convertible preferred shares would be converted into common shares, they have a dilutive effect on earnings per share. Therefore, we need to use diluted earnings per share.

Diluted earnings per share = (Net income - Preferred dividends) / (Common shares outstanding + Conversion of preferred shares)

= ($100,000 - $60,000) / (50,000 + 10,000)

= $40,000 / 60,000

= $0.67

However, since the preferred shares are convertible at a 1:1 ratio, the weighted average number of shares outstanding would be increased by the conversion of the preferred shares in the denominator. Therefore, the diluted earnings per share will be lower than the basic earnings per share.

The answer is closest to choice C, $1.67, but that answer is incorrect as it is much higher than the basic earnings per share. The correct answer is $0.67, as shown above.

During Its Fiscal Year, Richards' Distributing Had Net Income of $100,000