Advanced Accounting · AS 20 Earnings Per Share

Diluted Earnings Per Share and Potential Equity Shares (AS 20)

Updated 4 October 2026 · Fact-checked

Diluted EPS under AS 20 shows earnings per share if all dilutive potential equity shares were converted or exercised. Add back after-tax interest and preference dividend to earnings, add the extra shares to the weighted average, then test each potential share for anti-dilution. Include only those that reduce EPS from continuing ordinary operations.

Understand Diluted Earnings Per Share and Potential Equity Shares

Basic EPS uses only the equity shares that exist today. But a company may have instruments that can become equity shares later: convertible debentures, convertible preference shares, share options and warrants. These are called potential equity shares. If they convert, existing shareholders own a smaller slice of profit. Diluted EPS shows that effect.

To compute it, you change both parts of the fraction. In the numerator, you take the profit attributable to equity shareholders and adjust it for the instruments you assume converted. If debentures convert, the interest stops, so you add back interest net of tax. If convertible preference shares convert, the preference dividend stops, so you add it back. In the denominator, you add the equity shares that would be issued on conversion.

Timing matters. Treat the instruments as converted at the start of the period, or from the date of issue if they were issued during the period. Shares that lapse or are cancelled during the period count only for the time they were outstanding.

Options and warrants work differently. Assume they are exercised and the exercise money is received. That money is treated as buying shares at fair value (the average fair value during the period). The remaining shares are treated as issued for no consideration. They add shares but no earnings. Options are dilutive only when the average fair value is higher than the exercise price.

Finally, apply the anti-dilution test. A potential equity share is dilutive only if converting it reduces net profit per share from continuing ordinary operations. If it would increase EPS (or reduce a loss per share), ignore it. When you have several instruments, rank them by earnings per incremental share, lowest first, and add them one by one. Stop when EPS stops falling.

Key rules to remember

Diluted EPS: Diluted EPS = (Profit attributable to equity shareholders + Adjustments) ÷ (Weighted average equity shares + Weighted average potential equity shares); Use only the potential equity shares that pass the anti-dilution test. Show the answer to two decimal places unless told otherwise.
Adjustment for convertible debentures: Add back: Interest × (1 − tax rate); Also add or deduct any other income or expense that changes on conversion, net of tax.
Adjustment for convertible preference shares: Add back: Preference dividend on the convertible shares; Use the dividend that was deducted to arrive at profit for equity shareholders.
Options and warrants: shares for no consideration: Shares for no consideration = Shares under option × (Fair value − Exercise price) ÷ Fair value; Same as shares under option − (shares under option × exercise price ÷ fair value). Use the average fair value for the period. Ignore the option if fair value is not above the exercise price.
Earnings per incremental share: Earnings per incremental share = Earnings added back ÷ Incremental shares; Rank from lowest to highest. A low figure means more dilutive and is tested first.
Anti-dilution rule: Dilutive only if EPS from continuing ordinary operations falls after including the instrument; The control figure is net profit from continuing ordinary operations, after preference dividend. Compare each step with the previous EPS.
Timing of conversion: Assume conversion at the start of the period, or the issue date if later; Weight the shares for the part of the period they were outstanding.

How to solve Diluted Earnings Per Share and Potential Equity Shares questions

Use this order for any diluted EPS question. It works for debentures, preference shares, options and a mix of them.

1Compute basic EPS first: profit attributable to equity shareholders (after preference dividend) divided by weighted average equity shares. Note the profit from continuing ordinary operations too, if given.
2List every potential equity share: convertible debentures, convertible preference shares, options and warrants.
3For each one, find the earnings adjustment (after-tax interest or preference dividend) and the incremental shares. For options, compute shares for no consideration using the average fair value. Weight for the period outstanding.
4Calculate earnings per incremental share for each instrument. Dilutive options add shares with no earnings effect, so they rank first at nil. Options whose exercise price is not below the average fair value are not dilutive and are ignored.
5Rank from lowest to highest. Add them one at a time to earnings and shares, recompute EPS each time.
6Keep an instrument only if EPS falls. Stop when the next one would raise EPS. Instruments that fail are anti-dilutive and ignored.
7State diluted EPS to two decimals, and show the working of adjusted earnings and adjusted shares.

Quickest way: Rank and add: the fast route for diluted EPS

When to use it: Use this when a question has two or more potential equity shares, or when you only need to know the final diluted EPS.

Write basic EPS at the top as your benchmark.
For each instrument write one line: earnings added back ÷ new shares = earnings per incremental share.
Use basic EPS as a first screen only. An instrument with earnings per incremental share above basic EPS will fail, so mark it out. This screen is preliminary. The final test is against the running EPS after you add the higher-ranked instruments (those with lower earnings per incremental share). The running EPS falls as you add them, so an instrument below basic EPS can still turn out to be anti-dilutive.
Add the survivors in rank order. Show a small table-style list: step, adjusted earnings, adjusted shares, EPS.
In MCQs, check the direction: diluted EPS can never be higher than basic EPS when you include only dilutive items. Any option showing a higher figure is wrong.
In written answers, show each adjustment on its own line with its tax effect. This earns step marks even if the final figure has an arithmetic slip.

Common mistakes in Diluted Earnings Per Share and Potential Equity Shares

Adding back interest without deducting tax.
Students remember that interest stops on conversion and forget that the tax saving on it stops too.
Fix: Always add back interest × (1 − tax rate), unless the question says the interest is already net of tax.
Including every potential equity share without the anti-dilution test.
The word diluted makes students assume every instrument must be included.
Fix: Compute earnings per incremental share and compare it with the running EPS. Drop any instrument that raises EPS.
Treating all option shares as new shares in the denominator.
Students forget that exercise money is assumed to buy shares at fair value.
Fix: Add only the shares for no consideration: shares under option × (fair value − exercise price) ÷ fair value.
Adding back preference dividend when starting from a profit figure that is before preference dividend.
Basic EPS uses profit after preference dividend. Students mix the two bases.
Fix: Start from profit available to equity shareholders. Add back the dividend only on the convertible preference shares you include.
Not weighting instruments issued during the year.
Students use the full number of conversion shares for the whole year.
Fix: Weight the incremental shares from the issue date to the year end. Instruments issued earlier count for the full period.
Testing anti-dilution against total net profit instead of profit from continuing ordinary operations.
The question gives several profit figures and the student picks the headline one.
Fix: When discontinued items are given, use profit from continuing ordinary operations as the control figure for deciding whether an instrument is dilutive.

Worked examples

Example 1

A company's net profit after tax is ₹6,00,000 and it has no preference shares. Weighted average equity shares are 1,00,000. It has 12% convertible debentures of ₹10,00,000 outstanding for the whole year, convertible into 20,000 equity shares. The tax rate is 30%. Compute basic and diluted EPS.

Show the solution

Basic EPS = ₹6,00,000 ÷ 1,00,000 = ₹6.00.
Interest on debentures = 12% × ₹10,00,000 = ₹1,20,000.
Interest net of tax = ₹1,20,000 × (1 − 0.30) = ₹84,000.
Earnings per incremental share = ₹84,000 ÷ 20,000 = ₹4.20. This is below ₹6.00, so the debentures are dilutive.
Adjusted earnings = ₹6,00,000 + ₹84,000 = ₹6,84,000.
Adjusted shares = 1,00,000 + 20,000 = 1,20,000.
Diluted EPS = ₹6,84,000 ÷ 1,20,000 = ₹5.70.

Answer: Basic EPS is ₹6.00 and diluted EPS is ₹5.70.

Example 2

Net profit after tax is ₹12,00,000. Preference dividend on 10% convertible preference shares (₹10,00,000 total) is ₹1,00,000. Weighted average equity shares are 2,00,000. Options over 40,000 equity shares at an exercise price of ₹50 are outstanding all year; average fair value is ₹80. The preference shares are convertible into 15,000 equity shares. All profit is from continuing ordinary operations. Compute basic and diluted EPS.

Show the solution

Profit for equity shareholders = ₹12,00,000 − ₹1,00,000 = ₹11,00,000.
Basic EPS = ₹11,00,000 ÷ 2,00,000 = ₹5.50.
Options: shares for no consideration = 40,000 × (80 − 50) ÷ 80 = 15,000. Earnings added = nil, so earnings per incremental share is nil. Nil is the lowest figure, so the options are ranked first.
Preference shares: earnings added back = ₹1,00,000; incremental shares = 15,000; earnings per incremental share = ₹6.67. This is higher than nil, so the preference shares are ranked second.
Add the options first: ₹11,00,000 ÷ (2,00,000 + 15,000) = ₹11,00,000 ÷ 2,15,000 = ₹5.12 (5.116 before rounding). EPS falls from ₹5.50, so the options are dilutive.
Add the preference shares next: (₹11,00,000 + ₹1,00,000) ÷ (2,15,000 + 15,000) = ₹12,00,000 ÷ 2,30,000 = ₹5.22. Adding the preference shares raises EPS from ₹5.12 to ₹5.22, so they are anti-dilutive and excluded. Their ₹6.67 is above the running EPS of ₹5.12.
Diluted EPS = ₹5.12.

Answer: Basic EPS is ₹5.50 and diluted EPS is ₹5.12. The convertible preference shares are anti-dilutive and are excluded.

Exam tips

Always show basic EPS first. The marker uses it to see whether you understand the anti-dilution benchmark.
Write the tax effect on interest as a separate line. Questions often give the tax rate only for this purpose.
For options, show the shares-for-no-consideration working in full. It carries its own step marks.
When a question gives several instruments, show a ranking by earnings per incremental share. This is the method AS 20 expects.
If the exercise price is not below average fair value, say so and exclude the options. A one-line reason earns the mark.

Practice questions from AS 20 Earnings Per Share

Diluted Earnings Per Share and Potential Equity Shares in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Diluted Earnings Per Share and Potential Equity Shares: frequently asked questions

What is the difference between basic EPS and diluted EPS?

Basic EPS uses only the equity shares actually in issue (weighted for the period). Diluted EPS also assumes conversion or exercise of dilutive potential equity shares, so it adjusts both earnings and the share count. It shows the effect on EPS of the dilutive potential equity shares, not a worst case, because anti-dilutive instruments are excluded.

What makes a potential equity share anti-dilutive?

It is anti-dilutive if including it would increase EPS (or reduce loss per share) from continuing ordinary operations. This happens when earnings added back per incremental share are higher than the current EPS. AS 20 says you ignore such instruments.

How are options and warrants treated in diluted EPS?

Assume they are exercised and that the money raised buys shares at average fair value. Only the extra shares, shares under option × (fair value − exercise price) ÷ fair value, are added to the denominator. No earnings adjustment is made. They are dilutive only if the average fair value is above the exercise price.

Do I add back preference dividend in diluted EPS?

Yes, but only for convertible preference shares that you include as dilutive. Basic EPS already deducts the dividend. If the shares convert, there is no dividend, so you add it back and increase the shares by the conversion number.