Ethical Dilemma (Are there other options?)

After computing the current period’s basic and diluted EPS figures, you notice that while basic EPS continues its upward trend, diluted EPS has dropped slightly. In discussions with your manager regarding reasons for the decline, you identify numerous potentially dilutive securities that were considered in computing diluted EPS. Because the company has multiple dilutive securities, those securities were considered in turn, beginning with the convertible security that had the least favorable impact on EPS. As a result of considering the potentially dilutive securities in this order, convertible bonds that were potentially dilutive were not included in the computations because they became antidilutive after considering the effect of other convertible securities.

Your manager takes the position that if a security is dilutive when compared to basic EPS, then it should be included in the diluted EPS computations. He maintains that each dilutive security should be considered independently of the others. Including these convertible bonds in the diluted EPS computations would result in maintaining an upward trend for diluted EPS.

1. Is there merit to your manager’s position? That is, does the approach he is advocating make some sense?

2. Do the accounting standards allow for this flexibility in interpretation?

3. Prepare your defense for when your manager insists that diluted EPS be computed using his approach. What will you say to convince him that his approach is not acceptable?