NEW YORK -- A new accounting rule being used by companies reporting fourth-quarter earnings this week simplifies the way they express earnings per share -- but may also create some confusion during the transition period from the old system.
The change decreed by the Financial Accounting Standards Board, which took effect Dec. 15, requires companies to state earnings per share just two ways: basic and diluted. It drops a third category, primary earnings per share.
Earnings per share is calculated by dividing profits by outstanding stocks. It is a widely used by the investment community to gauge a company's financial performance and whether its stock is a good buy.
"Basic" earnings per share take into account only common stock, while "primary" earnings are spread out among common stock as well as other securities linked to the company, including some stock options and convertible debt. "Diluted" earnings are even wider, taking into account preferred stock and other items.
The new rule makes it mandatory for companies to post both basic and fully diluted earnings per share, eliminating the opportunity for them to mask from investors the effect of stock options on per-share profits.
Under the old system, many companies did not report simple or basic earnings per share. That made it difficult for investors to gauge how a company's per-share profits were diluted by large stock option packages for employees, especially executives.
While the rule benefits investors who in the past couldn't see the effects of stock options on a company's per-share earnings, the new rule also could cause some confusion at first since primary earnings -- the one category that is no longer used -- had been the most widely quoted measure of a company's per-share profits.
Many analysts and financial media, including The Associated Press, now plan to replace primary earnings per share with diluted earnings per share, which could be much lower. That would give the appearance that a company isn't performing as well as before.
Also, the diluted number will replace the primary earnings per share figure in key formulas investors use to determine whether to buy or sell a company's stock -- such as price/earnings ratio, which is the stock price divided by earnings per share.