How do I compute basic and diluted EPS when stock options are outstanding?

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AcadiFi · Accepted Answer

Basic EPS equals income available to common shareholders divided by weighted-average common shares outstanding. Diluted EPS adjusts the denominator for potentially dilutive instruments, but only if they reduce EPS. For options and warrants, use the treasury stock method. Assume the options are exercised at the start of the period, the company receives cash proceeds, and it uses those proceeds to repurchase shares at the average market price.

Example: Atlas Drone Systems reports net income of $840,000 and no preferred dividends. Weighted-average common shares are 300,000, so basic EPS is $2.80. The company also has 60,000 employee options with a strike price of $15. Average market price during the year is $20. Assumed proceeds are 60,000 x $15 = $900,000. At $20 per share, those proceeds repurchase 45,000 shares. Incremental shares are 60,000 - 45,000 = 15,000. Diluted EPS is $840,000 divided by 315,000 shares, or about $2.67.

The exam trap is adding all option shares to the denominator. Only the incremental shares count under the treasury stock method. Also, if the strike price is above the average market price, the options are antidilutive and ignored. Always check that diluted EPS is lower than basic EPS before including the instrument. Practice more in our CPA FAR question bank.

How do I compute basic and diluted EPS when stock options are outstanding?

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