how do I calculate diluted earnings per share?

The Basic Earnings Per Share calculation is actually very straightforward:

take the net income or loss for the period and divide it by the time weighted average number of common shares outstanding during the period.

What becomes tricky is the Diluted Earnings Per Share which includes the dilutive effect of outstanding call options and warrants and their equivalents by application of the Treasury Stock method. Per the CICA Handbook, Section 3500.48, under the Treasury Stock method:

1. Exercise of options, warrants and their equivalents should be assumed at the beginning of the period (or at time of issuance, if later) and common shares should be assumed to be issued;
2. The proceeds from exercise should be assumed to be used to purchase common shares at the average market price during the period;
3. The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased) should be included in the denominator of the diluted earnings per share computation.

You should also keep in mind:

• Options and warrants only have a dilutive effect when they are ‘in the money’ (e.g. the average market price of the common shares exceeds the exercise price of the options or warrants) [CICA 3500.39];
• Non-vested stock, stock options or other stock-based payments subject to performance that are settled in stock are included whether vested or not [CICA 3500.40];
• When there is a year-to-date loss, potential common shares (e.g. options and warrants) are not included in the year to date diluted earnings per share because to do so would be anti-dilutive [CICA 3500.42].

You should refer to the CICA handbook in its entirety for the fine print but a simple step through the procedure would be:

1. Determine the weighted average number of common shares.
2. Determine the average price for the common shares (an average of the weekly or daily close prices for the period).
3. Determine which of the options or warrants during the period were in the money (e.g. the average price of the common shares exceeds the exercise price).
4. For those in the money, take the number of options/warrants granted and subtract the number of shares purchasable (where shares purchasable = number of options granted * exercise price / average share price). Add this number to the weighted average number of shares for the period and use this as the denominator for the Diluted Earnings per Share calculation.

If this seems quite laborious or confusing, try using the Business Ready template for Earnings Per Share Calculation to help guide you through.

For US GAAP, please refer to FAS Statement No. 128, Earnings per Share, for similar treatment.