Treasury stock
Under the cost method (most common), treasury stock is recorded at the reacquisition cost and shown as a contra-equity account. Reissuing treasury shares above cost credits Additional Paid-in Capital (APIC) — Treasury; reissuing below cost first reduces APIC — Treasury (to the extent available), then Retained Earnings. Treasury stock transactions never create income statement gains or losses.
Basic EPS
Basic EPS = (Net income − Preferred dividends) ÷ Weighted-average common shares outstanding.
IMPORTANT: Subtract preferred dividends declared on cumulative preferred stock whether or not declared, and on noncumulative preferred stock only if actually declared.
Diluted EPS
Diluted EPS incorporates the effect of potentially dilutive securities (stock options, convertible bonds, convertible preferred), but only if they're actually dilutive (i.e., they would decrease EPS) — anti-dilutive securities are excluded.
- Options/warrants: use the treasury stock method — assume exercise, then assume proceeds are used to repurchase shares at the average market price; only the net incremental shares increase the denominator.
- Convertible bonds: use the if-converted method — add back after-tax interest expense to the numerator, add the as-if-converted shares to the denominator.
EXAMPLE: Net income $500,000, 100,000 weighted-average common shares, no preferred stock. Basic EPS = $5.00. If 10,000 options with a $20 strike price are outstanding and the average market price is $25: proceeds = 10,000 × $20 = $200,000; shares repurchased = $200,000 ÷ $25 = 8,000; incremental shares = 10,000 − 8,000 = 2,000. Diluted EPS = $500,000 ÷ 102,000 = $4.90 (dilutive, since $4.90 < $5.00, so it's included).
EXAM TIP: If applying the treasury stock method would increase EPS (i.e., the exercise price exceeds the average market price — options are "out of the money"), the options are anti-dilutive and excluded entirely.