Some benefit to the shareholder usually accompanies the issue of warrants, conversion rights or stock options. Their use typically reduces the interest rate paid on a bond issue, for example, or supplants a normal salary increment for employees. Nevertheless, these exchanges represent a potential decrease in the existing shareholders’ share of ownership. Accounting Principles Board Opinion No. 15 requires that issuers report both primary and fully diluted earnings per share when a significant potential dilution exists.
Primary earnings per share is based on a number of shares that includes both outstanding shares and common stock equivalents, where the latter include not only warrants and options, but also any convertible securities whose effective cash yield is less than two thirds of the prime rate at their date of issuance. Fully diluted earnings per share are calculated in a similar way, but include all convertible securities, regardless of yield.
Any after-tax interest expense on shares that would be eliminated by conversion is added to net income, which is then divided by the number of shares that would exist after the exercise of the rights or options. To allow for the capital inflow from payments of the exercise price on warrants and stock options, APB No. 15 calls for use of the so-called treasury stock method. If the average market price of common stock is greater than the exercise price of warrants or options, they are assumed to be exercised in calculating primary earnings per share, with the cash received used to repurchase shares at the average market price during the year. In applying the treasury stock method to fully diluted earnings per share, the higher of the average or year-end stock price is used.