12.4 Earnings per Share

ASC 718-10

Earnings per Share

45-1 Topic 260 requires that equity share options, nonvested shares, and similar equity instruments granted under share-based payment transactions be treated as potential common shares in computing diluted earnings per share (EPS). Diluted EPS shall be based on the actual number of options or shares granted and not yet forfeited regardless of the entity’s accounting policy for forfeitures in accordance with paragraphs 718-10-35-1D and 718-10-35-3, unless doing so would be antidilutive. If vesting in or the ability to exercise (or retain) an award is contingent on a performance or market condition, such as the level of future earnings, the shares or share options shall be treated as contingently issuable shares in accordance with paragraphs 260-10-45-48 through 45-57. If equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments are outstanding.

45-2 Paragraphs 260-10-45-29 through 45-34 and Example 8 (see paragraph 260-10-55-68) provide guidance on applying the treasury stock method for equity instruments granted in share-based payment transactions in determining diluted EPS.

In calculating EPS, an entity should consider how a share-based payment award may affect (1) income available to common shareholders (i.e., the numerator in the EPS calculation) and (2) the weighted-average number of common shares or dilutive potential common shares (i.e., the denominator in the EPS calculation). Because an entity recognizes the fair-value-based measure of an award as compensation cost (or as a reduction of revenue) in arriving at the entity’s income available to common shareholders, awards granted in return for goods or services or as a sales incentive to a customer will typically affect the EPS numerator.

12.4.1 Basic EPS

ASC 260-10

Computation of Basic EPS

45-10 Basic EPS shall be computed by dividing income available to common stockholders (the numerator) by the weighted-average number of common shares outstanding (the denominator) during the period. Shares issued during the period and shares reacquired during the period shall be weighted for the portion of the period that they were outstanding. See Example 1 (paragraph 260-10-55-38) for an illustration of this guidance.

During the requisite service period or nonemployee’s vesting period, share-based payment awards do not affect the calculation of basic EPS (other than the effect of compensation cost as a reduction of income available to common shareholders) unless such awards are participating securities. An entity must apply the two-class method when calculating basic and diluted EPS for such awards (see Section 12.4.3).

Once the good has been delivered, the service has been rendered, or the revenue related to the sales incentive has been recognized, vested awards that are considered outstanding common shares affect the denominator in the calculation of basic EPS. That is, such awards will be included in the weighted-average number of common shares from the date on which they become vested outstanding common shares. If the awards do not become outstanding common shares during the period and are not considered participating securities, they generally are not included in the calculation of basic EPS. However, contingently issuable shares should be included in the denominator of basic EPS when there are no circumstances in which those shares would not be issued.

Connecting the Dots

Employee awards of shares that vest when the grantee becomes eligible for retirement must be considered outstanding shares in the denominator of basic EPS as of the date on which the grantee is eligible to retire and retain the shares. This is because, once the employee is eligible to retire, there are no conditions that must be met for the common stock to be issued. Such shares are not considered contingently issuable shares since an agreement that requires an entity to issue common shares only after the mere passage of time is not considered a contingently issuable share arrangement. In other words, no remaining service period is associated with the issuance of the shares since the holder can retire at any time and receive the shares.

Share-based payment awards often contain clawback features. See Section 3.9 for a discussion of such features. Because clawback features are protective provisions, ASC 718 requires that the effect of a clawback feature be accounted for only when the contingent event that triggers the clawback occurs. In a manner consistent with this guidance, vested common shares issued in a share-based payment transaction should be considered outstanding shares in the calculation of basic EPS from the date vesting is complete. It would not be appropriate to exclude such common shares from the denominator of the calculation of basic EPS on the basis of the guidance in ASC 260 on contingently issuable (returnable) shares. This conclusion is consistent with paragraph 92 of the Background Information and Basis for Conclusions of FASB Statement 128, which indicates that vested shares for which the consideration has been received should be included in the calculation of basic EPS. It is also consistent with informal discussions with the FASB staff.

12.4.2 Diluted EPS

ASC 260-10

Computation of Diluted EPS

45-16 The computation of diluted EPS is similar to the computation of basic EPS except that the denominator is increased to include the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. In computing the dilutive effect of convertible securities, the numerator is adjusted in accordance with the guidance in paragraph 260-10-45-40. Adjustments also may be necessary for certain contracts that provide the issuer or holder with a choice between settlement methods. See Example 1 (paragraph 260-10-55-38) for an illustration of this guidance.

No Antidilution

45-17 The computation of diluted EPS shall not assume conversion, exercise, or contingent issuance of securities that would have an antidilutive effect on EPS. Shares issued on actual conversion, exercise, or satisfaction of certain conditions for which the underlying potential common shares were antidilutive shall be included in the computation as outstanding common shares from the date of conversion, exercise, or satisfaction of those conditions, respectively. In determining whether potential common shares are dilutive or antidilutive, each issue or series of issues of potential common shares shall be considered separately rather than in the aggregate.

45-18 Convertible securities may be dilutive on their own but antidilutive when included with other potential common shares in computing diluted EPS. To reflect maximum potential dilution, each issue or series of issues of potential common shares shall be considered in sequence from the most dilutive to the least dilutive. That is, dilutive potential common shares with the lowest earnings per incremental share shall be included in diluted EPS before those with a higher earnings per incremental share. Example 4 (see paragraph 260-10-55-57) illustrates that provision. Options and warrants generally will be included first because use of the treasury stock method does not affect the numerator of the computation. An entity that reports a discontinued operation in a period shall use income from continuing operations (adjusted for preferred dividends as described in paragraph 260-10-45-11) as the control number in determining whether those potential common shares are dilutive or antidilutive. That is, the same number of potential common shares used in computing the diluted per-share amount for income from continuing operations shall be used in computing all other reported diluted per-share amounts even if those amounts will be antidilutive to their respective basic per-share amounts. (See paragraph 260-10-45-3.) The control number excludes income from continuing operations attributable to the noncontrolling interest in a subsidiary in accordance with paragraph 260-10-45-11A. Example 14 (see paragraph 260-10-55-90) provides an illustration of this guidance.

45-19 Including potential common shares in the denominator of a diluted per-share computation for continuing operations always will result in an antidilutive per-share amount when an entity has a loss from continuing operations or a loss from continuing operations available to common stockholders (that is, after any preferred dividend deductions). Although including those potential common shares in the other diluted per-share computations may be dilutive to their comparable basic per-share amounts, no potential common shares shall be included in the computation of any diluted per-share amount when a loss from continuing operations exists, even if the entity reports net income.

45-20 The control number for determining whether including potential common shares in the diluted EPS computation would be antidilutive should be income from continuing operations (or a similar line item above net income if it appears on the income statement). As a result, if there is a loss from continuing operations, diluted EPS would be computed in the same manner as basic EPS is computed, even if an entity has net income after adjusting for a discontinued operation. Similarly, if an entity has income from continuing operations but its preferred dividend adjustment made in computing income available to common stockholders in accordance with paragraph 260-10-45-11 results in a loss from continuing operations available to common stockholders, diluted EPS would be computed in the same manner as basic EPS.

Conversion Rate or Exercise Price

45-21A Changes in an entity’s share price may affect the exercise price of a financial instrument or the number of shares that would be used to settle the financial instrument. For example, when the principal of a convertible debt instrument is required to be settled in cash but the conversion premium is required to (or may) be settled in shares, the number of shares to be included in the diluted EPS denominator is affected by the entity’s share price. In applying both the treasury stock method and the if-converted method of calculating diluted EPS, the average market price shall be used for purposes of calculating the denominator for diluted EPS when the number of shares that may be issued is variable, except for contingently issuable shares within the scope of the guidance in paragraphs 260-10-45-48 through 45-57. See paragraphs 260-10-55-4 through 55-5 for implementation guidance on determining an average market price.

While share-based payment awards do not affect the calculation of basic EPS (other than the effect of compensation cost as a reduction of income available to common shareholders) during the requisite service period or nonemployee’s vesting period (unless the award is a participating security), an entity generally includes them in the denominator when calculating diluted EPS if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260. Further, awards (e.g., stock options or warrants) that do not become outstanding common shares when the good is delivered or the service is rendered, and that are not considered participating securities, are not included in the calculation of basic EPS but may be included in the denominator of diluted EPS before they are settled (e.g., are exercised, are canceled, or expire).

An entity may change the terms or conditions of a share-based payment award. ASC 718-20-35-3 states, in part, that “[e]xcept as described in paragraph 718-20-35-2A, a modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award.” ASC 718-30-35-5 contains similar guidance for liability-classified awards and states, in part, that “[a] modification of a liability award is accounted for as the exchange of the original award for a new award.” In accordance with this guidance, a modification of a share-based payment award that is not subject to the exception in ASC 718-20-35-2A is treated as a cancellation of the existing award and the issuance of a new award. In a manner consistent with the guidance in ASC 718, an entity should treat the original and modified awards as two separate awards in calculating diluted EPS. Thus, when the treasury stock method applies to a modified share-based payment award, an entity would perform the following two treasury stock method calculations:

Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period before the modification (weighted, as appropriate, for the period).
Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period after the modification (weighted, as appropriate, for the period).

The sum of these two calculations will equal the incremental common shares that are included in the calculation of diluted EPS for the period.

ASC 718-20-35-2A addresses situations in which an entity modifies a share-based payment award but is not required to apply modification accounting. Entities will need to consider the specific facts and circumstances associated with such types of modifications to determine whether they should be treated as a single award or two separate awards in the calculation of diluted EPS in the period that includes the change to the terms or conditions of the award.

12.4.2.1 Treasury Stock Method

ASC 260-10

Options, Warrants, and Their Equivalents and the Treasury Stock Method

45-22 The dilutive effect of outstanding call options and warrants (and their equivalents) issued by the reporting entity shall be reflected in diluted EPS by application of the treasury stock method unless the provisions of paragraphs 260-10-45-35 through 45-36 and 260-10-55-8 through 55-11 require that another method be applied. Equivalents of options and warrants include nonvested stock granted under a share-based payment arrangement, stock purchase contracts, and partially paid stock subscriptions (see paragraph 260-10-55-23). Antidilutive contracts, such as purchased put options and purchased call options, shall be excluded from diluted EPS.

45-23 Under the treasury stock method:

Exercise of options and warrants shall be assumed at the beginning of the period (or at time of issuance, if later) and common shares shall be assumed to be issued.
The proceeds from exercise shall be assumed to be used to purchase common stock at the average market price during the period. (See paragraphs 260-10-45-29 and 260-10-55-4 through 55-5.)
The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased) shall be included in the denominator of the diluted EPS computation.

Example 15 (see paragraph 260-10-55-92) provides an illustration of this guidance. See paragraph 260-10-45-21A if the exercise price of a financial instrument or the number of shares that would be used to settle the financial instrument is variable.

45-24 Paragraph not used.

45-25 Options and warrants will have a dilutive effect under the treasury stock method only when the average market price of the common stock during the period exceeds the exercise price of the options or warrants (they are in the money). Previously reported EPS data shall not be retroactively adjusted as a result of changes in market prices of common stock.

45-26 Dilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise, dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise. The common shares issued upon exercise of options or warrants shall be included in the denominator for the period after the exercise date. Consequently, incremental shares assumed issued shall be weighted for the period the options or warrants were outstanding, and common shares actually issued shall be weighted for the period the shares were outstanding.

45-27 Paragraphs 260-10-55-3 through 55-11 provide additional guidance on the application of the treasury stock method.

Share-Based Payment Arrangements

45-28 The provisions in paragraphs 260-10-45-28A through 45-31 apply to share-based awards issued to grantees under a share-based payment arrangement in exchange for goods and services or as consideration payable to a customer.

45-28A Awards of share options and nonvested shares (as defined in Topic 718) to be issued to a grantee under a share-based payment arrangement are considered options for purposes of computing diluted EPS. Such share-based awards shall be considered to be outstanding as of the grant date for purposes of computing diluted EPS even though their exercise may be contingent upon vesting. Those share-based awards are included in the diluted EPS computation even if the grantee may not receive (or be able to sell) the stock until some future date. Accordingly, all shares to be issued shall be included in computing diluted EPS if the effect is dilutive. The dilutive effect of share-based payment arrangements shall be computed using the treasury stock method. If the equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments were outstanding. See Example 8 (paragraph 260-10-55-68).

45-28B In applying the treasury stock method, all dilutive potential common shares, regardless of whether they are exercisable, are treated as if they had been exercised. The treasury stock method assumes that the proceeds upon exercise are used to repurchase the entity’s stock, reducing the number of shares to be added to outstanding common stock in computing EPS.

An entity generally includes the dilutive effect of share-based payment awards (e.g., restricted stock, stock options) in the denominator of the calculation of diluted EPS by applying the treasury stock method, under which it is assumed that any service condition will be met. When applying the treasury stock method to a stock option, the entity assumes that two hypothetical transactions have occurred. The first is the hypothetical exercise of the award (or, for a restricted stock award, the hypothetical vesting of the award); the second is the hypothetical repurchase of shares at the average market price during the period by using the assumed proceeds that will be generated from the hypothetical exercise of the award (or, for a restricted stock award, the hypothetical vesting for the award). The incremental shares that would be hypothetically issued are the number of shares assumed to be issued upon exercise of the award (or, for a restricted stock award, the vesting of the award) in excess of the number of shares assumed to be repurchased with the assumed proceeds. The incremental shares are included in the number of diluted potential common shares as a component of the denominator in the calculation of diluted EPS.

While the treasury stock method applies to both vested and unvested stock options, it is used for such awards only when the average market price of the entity’s common stock during the period exceeds the exercise price of the awards (i.e., the award is in-the-money) on an award-by-award basis. Thus, an entity needs to perform a separate treasury stock method calculation for each individual in-the-money award. An entity would perform the same calculation for awards that are granted on the same day with the same terms and conditions (the awards would presumably have the same grant-date fair-value-based measure). Out-of-the-money awards are considered antidilutive and excluded from the denominator in the calculation of diluted EPS. The determination of whether an award is in-the-money or out-of-the-money is made on an individual-award basis.

12.4.2.1.1 Assumed Proceeds

ASC 260-10

45-29 In applying the treasury stock method described in paragraph 260-10-45-23, the assumed proceeds shall be the sum of both of the following:

The amount, if any, the grantee must pay upon exercise.
The amount of cost attributed to share-based payment awards (within the scope of Topic 718 on stock compensation) not yet recognized. This amount includes share-based payment awards that are not contingent upon satisfying certain conditions as described in paragraph 260-10-45-32 and contingently issuable shares that have been determined to be included in the computation of diluted EPS as described in paragraphs 260-10-45-48 through 45-57.
Subparagraph superseded by Accounting Standards Update No. 2016-09.

45-29A Under paragraphs 718-10-35-1D and 718-10-35-3, the effect of forfeitures is taken into account by recognizing compensation cost for those instruments for which the employee’s requisite service has been rendered or the nonemployee’s vesting conditions have been met and no compensation cost shall be recognized for instruments that grantees forfeit because a service or performance condition is not satisfied. See Example 8 (paragraph 260-10-55-68) for an illustration of this guidance.

When determining the amount of assumed proceeds that a share-based payment award will generate, an entity aggregates (1) the exercise price of the award, if any, and (2) the average amount of compensation cost attributed to share-based payment awards not yet recognized.1 Because there is no exercise price for restricted stock awards, the entity includes in the assumed proceeds only the average amount of unrecognized compensation cost attributed to future goods or services not yet recognized.

12.4.2.1.2 Period Outstanding

An entity must take into account the amount of time a share-based payment award was outstanding during the reporting period. If an award was outstanding for the entire reporting period, the incremental shares determined under the treasury stock method are included in the calculation of diluted EPS for the entire reporting period. By contrast, if an award was exercised (or, for a restricted stock award, becomes vested) or forfeited during the reporting period, the incremental shares are included only for the period in which the award was outstanding when the treasury stock method is applied. Once the award is exercised (or, for a restricted stock award, becomes vested), the shares issued are considered outstanding common shares and are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic and diluted EPS).

12.4.2.1.3 Quarter-to-Date Versus Year-to-Date Calculations

ASC 260-10

Applying the Treasury Stock Method: Year-to-Date Computations

55-3 The number of incremental shares included in quarterly diluted EPS shall be computed using the average market prices during the three months included in the reporting period. For year-to-date diluted EPS, the number of incremental shares to be included in the denominator shall be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation. Example 1 (see paragraph 260-10-55-38) provides an illustration of that provision.

55-3A Computation of year-to-date diluted EPS when an entity has a year-to-date loss from continuing operations including one or more quarters with income from continuing operations and when in-the-money options or warrants were not included in one or more quarterly diluted EPS computations because there was a loss from continuing operations in those quarters is as follows. In computing year-to-date diluted EPS, year-to-date income (or loss) from continuing operations shall be the basis for determining whether or not dilutive potential common shares not included in one or more quarterly computations of diluted EPS shall be included in the year-to-date computation.

55-3B Therefore:

When there is a year-to-date loss, potential common shares should never be included in the computation of diluted EPS, because to do so would be antidilutive.
When there is year-to-date income, if in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was antidilutive (there was a loss from continuing operations in those periods), then those options or warrants should be included in the diluted EPS denominator (on a weighted-average basis) in the year-to-date computation as long as the effect is not antidilutive. Similarly, contingent shares that were excluded from a quarterly computation solely because there was a loss from continuing operations should be included in the year-to-date computation unless the effect is antidilutive.

Example 12 (see paragraph 260-10-55-85) illustrates this guidance.

When applying the treasury stock method to a quarterly period, an entity should use the average market price for the period to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS. That is, the entity calculates the number of incremental shares for the quarterly period as though that period is a discrete period. By contrast, in the denominator of the calculation of diluted EPS for the year-to-date period, an entity includes a weighted-average number of incremental shares for each of the quarterly periods. The average market price for the year-to-date period is not used as though the year-to-date period was a separate discrete period. Example 1 in ASC 260-10-55-38 through 55-50 and Example 12 in ASC 260-10-55-85 through 55-87 illustrate quarter-to-date and year-to-date EPS calculations.

12.4.2.1.4 Forfeitures

ASC 718 allows an entity to make an entity-wide accounting policy election to either (1) estimate the number of awards that are expected to vest or (2) account for forfeitures when they occur. The entity’s election will affect the amount of compensation cost included in income available to common shareholders (the numerator in the calculation of diluted EPS). However, regardless of the entity’s policy election, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive. Once an entity has determined the number of outstanding awards that will have a dilutive effect on the calculation of diluted EPS, the entity then uses the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS.

For example, an entity that elects to estimate forfeitures may determine that only 90 percent of the share-based payment awards issued to grantees are expected to eventually vest even though none have actually been forfeited yet. Accordingly, only 90 percent of the awards’ fair-value-based measure is recognized as compensation cost over the requisite service period or nonemployee’s vesting period. However, when determining the number of incremental shares to include in the denominator of the calculation of diluted EPS, an entity must assume that all outstanding dilutive awards that contain only a service condition will vest or become exercisable. Therefore, when calculating diluted EPS, the entity must (1) determine the number of all outstanding awards that are dilutive and (2) apply the treasury stock method.

When the treasury stock method is applied, the assumed proceeds are also calculated on the basis of the actual number of all outstanding dilutive awards regardless of the entity’s forfeiture policy election or whether certain of those awards are not expected to eventually vest. The amount of average unrecognized cost is therefore based on the total number of outstanding dilutive awards at the beginning of the period and at the end of the period.

12.4.2.1.5 Treasury Stock Method Examples

The examples below illustrate the application of the treasury stock method to share-based payment awards in the calculation of diluted EPS.

ASC 260-10

Example 8: Application of the Treasury Stock Method to a Share-Based Payment Arrangement

55-68 This Example illustrates the guidance in paragraph 260-10-45-28A for the application of the treasury stock method when share options are forfeited.

55-69 Entity A adopted a share option plan on January 1, 20X7, and granted 900,000 at-the-money share options with an exercise price of $30. All share options vest at the end of three years (cliff vesting). Entity A’s accounting policy is to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-1D or 718-10-35-3. At the grant date, Entity A assumes an annual forfeiture rate of 3 percent and therefore expects to receive the service for 821,406 [900,000 × (.97 to the third power)] share options. On January 1, 20X7, the fair value of each share option granted is $14.69. Grantees forfeited 15,000 stock options ratably during 20X7.

55-69A The average stock price during 20X7 is $44. Net income for the period is $97,385,602. For the year ended December 31, 20X7, there are 25,000,000 weighted-average common shares outstanding. This guidance also applies if the service inception date precedes the grant date.

55-70 The following table illustrates computation of basic and diluted EPS for the year ended December 31, 20X7.

Example 12-1

Employee Stock Options — No Exercises or Forfeitures During the Period

Assume the following about Entity A:

Entity A has net income of $5 million, as well as 1 million common shares outstanding, for the entire year ended December 31, 20X2.
As of December 31, 20X2, A also has 100,000 employee stock options outstanding. All the stock options were granted on January 1, 20X1, and vest solely on the basis of a two-year service condition. On December 31, 20X1, 50,000 stock options vested. The remaining 50,000 stock options vest on December 31, 20X2. All options are still outstanding on December 31, 20X2 (i.e., none have been exercised).
All the stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
Entity A recognizes compensation cost for these stock options on a straight-line basis over the service period from January 1, 20X1, to December 31, 20X2.
The average market price of A’s common stock for the year ended December 31, 20X2, was $15 per share.

Entity A calculates diluted EPS for the year ended December 31, 20X2, as follows:

Note that in the above calculation of diluted EPS, year-to-date amounts are used for simplicity. ASC 260-10-55-3 states, in part, “For year-to-date diluted EPS, the number of incremental shares to be included in the denominator shall be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation.” For example, assume that when applying the treasury stock method, A determined that it must include 10,000 and 15,000 incremental shares in the denominator of the calculation of diluted EPS for its first and second quarter, respectively. When calculating the number of incremental shares to include in the denominator for the year-to-date six-month period, A would assign equal weight to the 10,000 and 15,000 incremental shares. Therefore, 12,500 incremental shares [(10,000 + 15,000) ÷ 2] are included in the denominator of the calculation of diluted EPS for the year-to-date six-month period.

The example below illustrates the application of the treasury stock method to stock option awards when a portion of the awards was exercised during the period. Once the awards are exercised, the shares issued are considered outstanding common shares and are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

Example 12-2

Employee Stock Options — Exercises During the Period

Assume the same facts as in Example 12-1, except that the 50,000 employee stock options that vested on December 31, 20X1, were exercised on June 30, 20X2.

Entity A calculates diluted EPS as follows:

As noted in Example 12-1, the above calculation of diluted EPS is a simplified annual calculation that does not take into account interim calculations of diluted EPS as required by ASC 260-10-55-3. The above calculation is further simplified because of how exercises during the period are factored into the calculation. In the above example, the “weighting” effect on incremental common shares for stock options exercised during the period is factored into the calculation by weighting the number of stock options outstanding during the entire period (i.e., one treasury stock method calculation is performed to calculate the diluted impact of all stock options). A more precise way to factor in stock options exercised during the period is to perform two calculations under the treasury stock method — one for stock options that were outstanding for the entire period and one for stock options that were exercised during the period. Under this approach, the “weighting” effect on incremental common shares for stock options exercised during the period is captured by multiplying the incremental common shares by a factor (i.e., percentage) that is determined on the basis of the period during which the options were outstanding.

While the more precise calculation may yield results that do not differ from those under the simplified approach, an entity should consider its specific facts and circumstances in determining when a simplified approach is appropriate. In some circumstances, a simplified approach could result in exclusion of the dilutive effect of awards that were not outstanding during the entire period because of a difference between the average stock price during the entire reporting period and the average stock price during the period in which the awards were outstanding.

The example below illustrates the application of the treasury stock method to stock option awards when there is a forfeiture during the period.

Example 12-3

Employee Stock Options — Forfeitures During the Period

Assume the following:

Entity A has net income of $1 million for the quarter ended March 31, 20X1, as well as 100,000 common shares outstanding for the entire period from January 1, 20X1, to March 31, 20X1.
On January 1, 20X1, A granted 10,000 employee stock options to 10 employees (1,000 stock options each).
All the stock options have an exercise price of $5 per option and a grant-date fair-value-based measure of $1 per option, and they cliff vest after two years of service.
The average market price of A’s common stock for the three-month period ended March 31, 20X1, was $6.50 per share.
Entity A has a policy of estimating forfeitures, and it estimates that 8,000 of the stock options will eventually vest. It therefore has accrued compensation cost on the basis of this forfeiture estimate.
On February 1, 20X1, an employee terminates and forfeits 1,000 stock options.

Entity A calculates the number of incremental shares to include in the denominator of the calculation of diluted EPS under the treasury stock method, as well as diluted EPS (for the three-month period ended March 31, 20X1), as follows:

Note that A must base the calculation of diluted EPS on the actual number of awards outstanding (i.e., actual forfeitures) in a given reporting period rather than on its estimate of the number of awards expected to forfeit. In addition, note that the above calculation is simplified because of how forfeitures during the period are factored into the calculation. In the above example, the “weighting” effect on incremental common shares for stock options forfeited during the period is factored into the calculation by weighting the number of stock options outstanding during the entire period (i.e., one treasury stock method calculation is performed to calculate the diluted impact of all stock options). A more precise way to factor in stock options forfeited during the period is to perform two calculations under the treasury stock method — one for stock options that were outstanding for the entire period and one for stock options that were forfeited during the period. Under this approach, the “weighting” effect on incremental common shares for stock options forfeited during the period is captured by multiplying the incremental common shares by a factor (i.e., percentage) that is determined on the basis of the period during which the options were outstanding.

While the more precise calculation may yield results that do not differ significantly from those under the simplified approach, an entity should consider its specific facts and circumstances in determining when a simplified approach is appropriate. In some circumstances, a simplified approach could result in exclusion of the dilutive effect of awards that were not outstanding during the entire period because of a difference between the average stock price during the entire reporting period and the average stock price during the period in which the awards were outstanding.

12.4.2.2 Service Conditions

ASC 260-10

Treatment of Contingently Issuable Shares in Weighted-Average Shares Outstanding

45-12C Contractual agreements (usually associated with purchase business combinations) sometimes provide for the issuance of additional common shares contingent upon certain conditions being met. Consistent with the objective that basic EPS should represent a measure of the performance of an entity over a specific reporting period, contingently issuable shares should be included in basic EPS only when there is no circumstance under which those shares would not be issued and basic EPS should not be restated for changed circumstances.

45-13 Shares issuable for little or no cash consideration upon the satisfaction of certain conditions (contingently issuable shares) shall be considered outstanding common shares and included in the computation of basic EPS as of the date that all necessary conditions have been satisfied (in essence, when issuance of the shares is no longer contingent). Outstanding common shares that are contingently returnable (that is, subject to recall) shall be treated in the same manner as contingently issuable shares. Thus, contingently issuable shares include shares that meet any of the following criteria:

They will be issued in the future upon the satisfaction of specified conditions.
They have been placed in escrow and all or part must be returned if specified conditions are not met.
They have been issued but the holder must return all or part if specified conditions are not met.

Share-Based Payment Arrangements

45-32 Fixed grantee stock options (fixed awards) and nonvested stock (including restricted stock) shall be included in the computation of diluted EPS based on the provisions for options and warrants in paragraphs 260-10-45-22 through 45-27. Even though their issuance may be contingent upon vesting, they shall not be considered to be contingently issuable shares (see Section 815-15-55 and paragraph 260-10-45-48). However, because issuance of performance-based stock options (and performance-based nonvested stock) is contingent upon satisfying conditions in addition to the mere passage of time, those options and nonvested stock shall be considered to be contingently issuable shares in the computation of diluted EPS. A distinction shall be made only between time-related contingencies and contingencies requiring specific achievement.

Generally, an entity will use the treasury stock method to determine the number of common shares related to share-based payment awards with only a service condition (i.e., no performance or market condition) to include in the denominator of the calculation of diluted EPS provided that the awards are dilutive. (See Section 12.4.2.1.5 for examples illustrating the application of the treasury stock method to share-based payment awards.)

A restricted stock award is not included in the denominator of the calculation of basic EPS during the award’s requisite service period or before the nonemployee award has vested, even if the shares of stock have been legally issued. Such shares are considered contingently returnable shares as described in ASC 260-10-45-13. For example, if the grantee does not deliver the good or render the service, the shares are returned to the entity. Once the vesting conditions have been satisfied, the shares are considered outstanding common shares and therefore are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

In addition, an unexercised stock option award is not included in the denominator of the calculation of basic EPS even if the award is vested. That is, even if an award’s vesting conditions have been satisfied, an unexercised stock option (containing an exercise price that is not nominal) is not an outstanding common share until it is exercised.

However, an award that contains a right to nonforfeitable dividends or dividend equivalents that participate in undistributed earnings with common stock is a participating security even before the award’s vesting conditions are satisfied (i.e., during the vesting period). Therefore, the issuer is required to apply the two-class method discussed in Section 12.4.3 when calculating basic and diluted EPS. When calculating diluted EPS for unvested awards that are considered participating securities, an entity must determine which is more dilutive to apply, the treasury stock method or the two-class method.

In the calculation of diluted EPS, unvested awards and unexercised stock option awards that vest solely on the basis of a service condition are included in the denominator of the calculation of diluted EPS during their requisite service period (or before the nonemployee award has vested) or during the period the options are unexercised under the treasury stock method. (See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.)

12.4.2.3 Performance and Market Conditions

ASC 260-10

45-31 Awards with a market condition, a performance condition, or any combination thereof (as defined in Topic 718) shall be included in diluted EPS pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-57.

Contingently Issuable Shares

45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:

If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).

45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.

45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining the EPS impact of different types of contingencies that may be included in contingent stock agreements.

45-55 Contingently issuable potential common shares (other than those covered by a contingent stock agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:

An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10-45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.

For share-based payment awards with a performance or market condition, an entity must first apply the guidance on contingently issuable shares in ASC 260-10-45-48 through 45-55 to determine whether the awards should be included in the calculation of diluted EPS for the reporting period. That is, the entity needs to determine the number of shares, if any, that would be issuable at the end of the reporting period if the end of the reporting period were the end of the contingency period. Once the entity has determined that the award should be included in the calculation of diluted EPS for the reporting period, the entity must use the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS.

An entity may be recording compensation cost for an award that only contains a performance or market condition because the entity believes that it is probable that the award will vest (performance condition) or, for example, that the employee will remain employed for the derived service period (market condition). However, in such cases, the incremental shares that would be included in the denominator of the calculation of diluted EPS would be excluded if the performance or market condition (i.e., the contingency) has not been achieved as of the end of that particular reporting period, under an assumption that the end of the reporting period is the end of the contingency period.

12.4.2.3.1 Performance-Based Awards

ASC 260-10

45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.

45-54 If the contingency is based on a condition other than earnings or market price (for example, opening a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS based on the assumption that the current status of the condition will remain unchanged until the end of the contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.

Assume that a stock award legally vests only if an entity’s cumulative net income at the end of the third annual reporting period exceeds $10 million. At the end of each reporting period, the entity assesses whether cumulative net income has exceeded $10 million as if that reporting date were the end of the third annual reporting period. If the performance condition has been met at the end of a reporting period, the entity includes the award in the calculation of diluted EPS. To determine the number of incremental shares of stock to include in the denominator of the calculation of diluted EPS, the entity applies the treasury stock method if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260.

However, if the entity’s cumulative net income has not exceeded $10 million at the end of the reporting period, the entity does not include the award in the calculation of diluted EPS even if it is recording compensation cost because it believes that it is probable that the award will vest (i.e., it is probable that the performance target will be achieved). The entity excludes the award from the calculation of diluted EPS because the performance condition (i.e., the contingency) has not been met as of the end of that reporting period.

Example 12-4

Calculating Diluted EPS When Vesting of Stock Options Is Contingent on Future Earnings

Assume the following:

Entity A has net income of $12 million and $5 million for the year and quarter ended December 31, 20X1, respectively, as well as 5 million common shares outstanding for the quarter ended December 31, 20X1.
On January 1, 20X1, A granted 1 million employee stock options. The stock options vest on December 31, 20X2, if the recipients remain employed and A’s cumulative net income for the two-year period ended December 31, 20X2, equals or exceeds $10 million.
As of December 31, 20X1, all the stock options remain outstanding.
The stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
The average market price of A’s common stock for the year ended December 31, 20X1, was $15 per share.

If the end of the reporting period (December 31, 20X1) is considered the end of the contingency period, the performance target is deemed to be achieved. As a result, A includes the employee stock options in the calculation of diluted EPS for the quarter ended December 31, 20X1. To determine the number of incremental shares to include in the calculation’s denominator, A must then apply the treasury stock method if the effect is dilutive.

Entity A calculates diluted EPS under the treasury stock method for the quarterly period ended December 31, 20X1, as follows:

Alternatively, assume that A had generated net income of less than $10 million for the year ended December 31, 20X1. In that case, A excludes the employee stock options from the calculation of diluted EPS because the contingency is not deemed to have been met as of the end of the reporting period. Therefore, A is not required to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS under the treasury stock method. However, if A believes that it is probable that the performance target will be attained by the end of the performance period (December 31, 20X2), A recognizes compensation cost over the requisite service period for the number of awards expected to vest.

There may be other circumstances in which an entity issues performance-based awards for which performance is calculated on the basis of an average metric over several periods. When calculating whether contingently issuable shares for such awards should be included in the calculation of diluted EPS, an entity applies ASC 260-10-45-51 and ASC 260-10-45-54, which require the entity to assume that the current status of the condition (e.g., the current amount of earnings) will remain unchanged until the end of the contingency period. In addition, footnote (f) to Example 3 in ASC 260-10-55-56 states, in part, that “[p]rojecting future earnings levels and including the related contingent shares are not permitted.” While footnote (f) to Example 3 is associated with the calculation of diluted EPS for an interim period, we believe that it is appropriate to apply the guidance to both interim and annual periods. Because the guidance precludes the projection of future earnings levels, earnings (or any other metric) in future periods would be presumed to be zero. See further discussion in Section 4.5.2.3 of Deloitte’s Roadmap Earnings per Share. See also the example below.

Example 12-5

Calculating Diluted EPS for an Award That Vests on the Basis of Average Metrics

On January 1, 20X1, Entity A granted 1 million performance-based RSUs to a group of its key employees. The RSUs cliff vest on December 31, 20X3, if the recipients remain employed and A achieves two performance metrics during the three-year period from January 20X1 to December 20X3: (1) a three-year average revenue growth rate of at least 10 percent and (2) a three-year average operating margin of at least 6 percent.

The number of contingently issuable shares that are included in the calculation of diluted EPS is determined on the basis of the three-year averages of both the revenue growth rate and operating margins, which are calculated as follows: (1) the actual revenue growth rate and operating margin attained to date and (2) an assumption of zero revenue growth rate and zero operating margin for any remaining periods.

Entity A determines the number of shares to include in the calculation of diluted EPS by using the following assumptions:

December 31, 20X1

No shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 4 percent [(12% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
The three-year average operating margin of 2 percent [(6% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.

December 31, 20X2

No shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 7 percent [(12% for 20X1 + 9% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
The three-year average operating margin of 4 percent [(6% for 20X1 + 6% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.

December 31, 20X3

The 1 million shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 11 percent [(12% for 20X1 + 9% for 20X2 + 12% for 20X3) ÷ 3 years] is above 10 percent.
The three-year average operating margin of 7 percent [(6% for 20X1 + 6% for 20X2 + 9% for 20X3) ÷ 3 years] is above 6 percent.

As noted in Example 12-1, in the above example, year-to-date amounts are used for simplicity.

12.4.2.3.2 Market-Based Awards

ASC 260-10

45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.

45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.

Assume that an award legally vests only if the entity’s share price increases by more than 20 percent after the grant date. At the end of each reporting period, the entity would assess whether its share price has, in fact, increased by more than 20 percent after the grant date. If, at the end of a reporting period, the market condition has been met, the entity includes the award in the calculation of diluted EPS. To determine the number of incremental shares to include in the denominator of the calculation of diluted EPS, the entity applies the treasury stock method if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260.

However, if the entity’s share price has not increased by more than 20 percent at the end of the reporting period, the award is not included in the calculation of diluted EPS even if the entity is recording compensation cost because it believes that, for example, the employee will remain employed for the derived service period. The award is excluded because the market condition (i.e., the contingency) has not been met as of the end of that reporting period. Moreover, if an employee does remain employed for the derived service period, the employee is deemed to have earned (i.e., vested in) the award. In this circumstance, the entity will not reverse any previously recognized compensation cost even if the market condition is never satisfied. If the market condition is never satisfied, the shares issuable under the award will never become issued and outstanding. Therefore, the shares will never be included in the weighted-average number of common shares (i.e., the denominator in the calculation of basic and diluted EPS).

12.4.3 Participating Securities and the Two-Class Method

ASC 260-10

Participating Securities and the Two-Class Method

45-59A The capital structures of some entities include: a. Securities that may participate in dividends with common stocks according to a predetermined formula (for example, two for one) with, at times, an upper limit on the extent of participation (for example, up to, but not beyond, a specified amount per share) b. A class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights.

45-60 The two-class method is an earnings allocation formula that treats a participating security as having rights to earnings that otherwise would have been available to common shareholders but does not require the presentation of basic and diluted EPS for securities other than common stock. The presentation of basic and diluted EPS for a participating security other than common stock is not precluded.

45-60A All securities that meet the definition of a participating security, irrespective of whether the securities are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of basic EPS using the two-class method.

45-60B Under the two-class method:

Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends). Dividends declared in the current period do not include dividends declared in respect of prior-year unpaid cumulative dividends. Preferred dividends that are cumulative only if earned are deducted only to the extent that they are earned.
The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature.
The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.
Basic and diluted EPS data shall be presented for each class of common stock.

For the diluted EPS computation, outstanding common shares shall include all potential common shares assumed issued. Example 6 (see paragraph 260-10-55-62) illustrates the two-class method.

45-61 Fully vested share-based compensation subject to the provisions of Topic 718, including fully vested options and fully vested stock, that contain a right to receive dividends declared on the common stock of the issuer, are subject to the guidance in paragraph 260-10-45-60A.

45-61A Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method under the requirements of paragraph 260-10-45-60A.

45-62 Dividends or dividend equivalents transferred to the holder of a convertible security in the form of a reduction to the conversion price or an increase in the conversion ratio of the security do not represent participation rights. This guidance applies similarly to other contracts (securities) to issue an entity’s common stock if these contracts (securities) provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer. The scope of the guidance in this paragraph excludes forward contracts to issue an entity’s own equity shares.

45-63 In a forward contract to issue an entity’s own equity shares, a provision that reduces the contract price per share when dividends are declared on the issuing entity’s common stock represents a participation right. Such a provision constitutes a participation right because it results in a noncontingent transfer of value to the holder of the forward contract for dividends declared during the forward contract period. That is, the forward contract holder has a right to participate in the undistributed earnings of the issuing entity because a dividend declaration by the issuing entity results in a transfer of value to the holder of the forward contract through a reduction in the forward purchase price per share. Because that value transfer is not contingent — as opposed to a similar reduction in the exercise price of an option or warrant — the forward contract is a participating security, regardless of whether, during the period the contract is outstanding, a dividend is declared.

45-64 Paragraph superseded by Accounting Standards Update No. 2020-06.

45-65 Undistributed earnings for a period shall be allocated to a participating security based on the contractual participation rights of the security to share in those current earnings as if all of the earnings for the period had been distributed. If the terms of the participating security do not specify objectively determinable, nondiscretionary participation rights, then undistributed earnings would not be allocated based on arbitrary assumptions. For example, if an entity could avoid distribution of earnings to a participating security, even if all of the earnings for the year were distributed, then no allocation of that period’s earnings to the participating security would be made. Paragraphs 260-10-55-24 through 55-31 provide additional guidance on participating securities and undistributed earnings.

45-66 Under the two-class method the remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. This allocation is required despite its pro forma nature and that it may not reflect the economic probabilities of actual distributions to the participating security holders.

45-67 An entity would allocate losses to a nonconvertible participating security in periods of net loss if, based on the contractual terms of the participating security, the security had not only the right to participate in the earnings of the issuer, but also a contractual obligation to share in the losses of the issuing entity on a basis that was objectively determinable. Determination of whether a participating security holder has an obligation to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on the contractual rights and obligations of the participating security. The holder of a participating security would have a contractual obligation to share in the losses of the issuing entity if either of the following conditions is present:

The holder is obligated to fund the losses of the issuing entity (that is, the holder is obligated to transfer assets to the issuer in excess of the holder’s initial investment in the participating security without any corresponding increase in the holder’s investment interest).
The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the issuing entity.

45-68 A convertible participating security should be included in the computation of basic EPS in periods of net loss if, based on its contractual terms, the convertible participating security has the contractual obligation to share in the losses of the issuing entity on a basis that is objectively determinable. The guidance in this paragraph also applies to the inclusion of convertible participating securities in basic EPS, irrespective of the differences that may exist between convertible and nonconvertible securities. That is, an entity should not automatically exclude a convertible participating security from the computation of basic EPS if an entity has a net loss from continuing operations. Determination of whether a participating security holder has an obligation to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on the contractual rights and obligations of the participating security.

45-68A Paragraph not used.

45-68B Paragraph 718-10-55-45 requires that nonrefundable dividends or dividend equivalents paid on awards for which the requisite service is not (or is not expected to be) rendered be recognized as additional compensation cost and that dividends or dividend equivalents paid on awards for which the requisite service is (or is expected to be) rendered be charged to retained earnings. As a result, an entity shall not include dividends or dividend equivalents that are accounted for as compensation cost in the earnings allocation in computing EPS. To do so would include the dividend as a reduction of earnings available to common shareholders from both compensation cost and distributed earnings. Undistributed earnings shall be allocated to all share-based payment awards outstanding during the period, including those for which the requisite service is not expected to be rendered (or is not rendered because of forfeiture during the period, if an entity elects to account for forfeitures when they occur in accordance with paragraph 718-10-35-3). An entity’s estimate of the number of awards for which the requisite service is not expected to be rendered (or no estimate, if the entity has elected to account for forfeitures when they occur in accordance with paragraph 718-10-35-3) for the purpose of determining EPS under this Topic shall be consistent with the estimate used for the purposes of recognizing compensation cost under Topic 718. Paragraph 718-10-35-3 requires that an entity apply a change in the estimate of the number of awards for which the requisite service is not expected to be rendered in the period that the change in estimate occurs. This change in estimate will affect net income in the current period; however, a current-period change in an entity’s expected forfeiture rate would not affect prior-period EPS calculations. See Example 9 for an illustration of this guidance.

45-69 Paragraph not used.

45-70 See Example 9 (paragraph 260-10-55-71) for an illustration of this guidance.

The two-class method is an earnings allocation formula under which a participating security is treated as having rights to earnings that would have otherwise been available to common shareholders. Entities are required to use the two-class method to calculate basic and diluted EPS if their capital structure includes common stock and either (1) participating securities or (2) multiple classes of common stock.

12.4.3.1 Participating Securities

ASC Master Glossary

Participating Security

A security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. The form of such participation does not have to be a dividend — that is, any form of participation in undistributed earnings would constitute participation by that security, regardless of whether the payment to the security holder was referred to as a dividend.

Provided that an instrument’s participation feature is nondiscretionary and objectively determinable, the instrument’s classification as a participating security depends on the participation mechanism and the nature of the participating instrument. The table below discusses whether instruments typically included in capital structures are considered participating securities.

Instrument	Form of “Participation”	Is the Instrument a Participating Security?
Debt instruments	Potential participation is paid in cash or the contractual maturity amount is increased according to a formula tied to dividends on common stock.	Yes
Preferred stock	Potential participation is paid in cash according to a formula tied to dividends on common stock.	Yes
Preferred stock	Holders of preferred stock are entitled to receive a current-period dividend before holders of common stock can be paid dividends.	No
Convertible debt and preferred stock	For convertible debt, potential participation is paid in cash or the contractual maturity amount is increased according to a formula tied to dividends on common stock. For convertible preferred stock, potential participation is paid in cash according to a formula tied to dividends on common stock. Preferred stockholders may also be entitled to a stated return in addition to the dividend participation.	Yes
Convertible debt and preferred stock	For convertible debt, potential participation is achieved through a reduction of the conversion price or an increase in the conversion ratio. For convertible preferred stock, potential conversion is achieved through a reduction of the conversion price (i.e., an increase in the conversion ratio).	No
Options or warrants to sell common stock	Potential participation is paid in cash according to a formula tied to dividends on common stock.	Yes
Options or warrants to sell common stock	Potential participation is achieved through a reduction of the exercise price or an increase in the number of shares upon exercise.	No
Forward contract to sell common stock	Potential participation is achieved through a reduction of the forward price or an increase in the number of shares under the forward contract.	It depends. A facts-and-circumstances analysis must be performed
Forward contract to sell common stock	A formula that adjusts the forward price and the number of shares under the forward contract, depending on the market price of the stock as of the date the forward contract is settled.	It depends. A facts-and-circumstances analysis must be performed

As noted in the ASC master glossary definition of a participating security, participation does not need to be in the form of a dividend. Any participation by a security in the distribution of a company’s earnings (under an assumption that there is a full distribution of earnings) would constitute participation, regardless of whether a cash payment is, or would be accounted for as, a dividend.

Example 12-6

Warrants on Common Stock With Yield Rights

Entity J issues warrants to sell common stock that entitle the counterparty to a yield right, payable in cash, equal to 25 percent of the dividends J pays on its common stock for each common share into which the warrants are exercisable. Although the yield right is not labeled as a dividend, it is a participation right because the holder of the warrants is entitled to share in dividends declared on J’s common stock without exercising the warrants. Therefore, the two-class method of calculating EPS must be applied to the warrants. Regardless of whether J declared any dividends during the period, it must allocate undistributed earnings to the warrants.

Note that in this example, the warrants are considered participating securities regardless of the extent of participation. That is, because of the holders’ entitlement to any participation in dividends (i.e., between 1 and 100 percent), the warrants meet the definition of a participating security. However, if dividends paid by an entity are held in abeyance and paid to a warrant holder only upon exercise, such warrants would not be considered participating securities.

12.4.3.1.1 Dividend-Paying Share-Based Payment Awards — Before Vesting

An award is a participating security if, during the vesting period, it contains a nonforfeitable right to dividends or dividend equivalents that participate in the distribution of earnings with common stock. That is, an award is considered a participating security if it accrues cash dividends (whether paid or unpaid) any time the common shareholders receive dividends — when those dividends do not need to be returned to an entity if the grantee forfeits the awards. The entity is required to apply the two-class method when calculating basic and diluted EPS. By contrast, if the right to dividends or dividend equivalents is forfeitable with the underlying award, the award is not considered a participating security.

12.4.3.1.2 Dividend-Paying Share-Based Payment Awards — After Vesting

ASC 260-10-45-61 states:

Fully vested share-based compensation subject to the provisions of Topic 718, including fully vested options and fully vested stock, that contain a right to receive dividends declared on the common stock of the issuer, are subject to the guidance in paragraph 260-10-45-60A.

After an award has vested, it is a participating security if it contains a right to receive dividends or dividend equivalents with common shareholders, because the right is nonforfeitable when the award vests. Therefore, an entity must apply the two-class method when calculating basic and diluted EPS unless the shares become outstanding common shares. For example, the two-class method does not apply to a restricted stock award after a grantee receives outstanding common shares because the good has been delivered or the service has been rendered. Once the award becomes outstanding common shares, the entity includes those shares in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

12.4.3.2 Calculation Under the Two-Class Method

When an entity’s capital structure includes participating securities but only a single class of common stock, the entity uses the following three-step process to calculate basic and diluted EPS:

Step 1	Use the two-class method to calculate basic EPS.2
Step 2	Use the total earnings allocated to the common stock in step 1 to determine diluted EPS. If the participating security is also a potential common share, separately perform steps 2a and 2b to determine the dilutive effect.
Step 2a	Assume that the participating security has been exercised, converted, or issued; that is, apply the treasury stock method, the if-converted method, or the contingently issuable share method.
Step 2b	Add back the undistributed earnings allocated to the participating security (or securities) in arriving at basic EPS, and assume that all other dilutive potential common shares have been exercised, converted, or issued in the order in which they are antidilutive. Next, reallocate the undistributed earnings, including any additional income that would result from the exercise, conversion, or issuance of potential common shares, to the (1) common shares and potential common shares and (2) participating security (or securities).
Step 3	Determine which step — 2a or 2b — results in the more dilutive effect.

While an entity is required to present on the face of the income statement basic and diluted EPS for its common stock, the entity is permitted, but not required, to present basic and diluted EPS for a participating security.

The examples below illustrate (1) the calculation of basic and diluted EPS under the two-class method and (2) the use of this three-step process to determine diluted EPS.

Example 12-7

Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible Preferred Stock

Assume that Entity A has 1 million weighted-average shares of common stock outstanding for the fiscal year ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.

On January 1, 20X1, A issues 100,000 convertible preferred securities. Each preferred share is convertible into two shares of A’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend of $5 per share before any dividend is paid to the common shareholders. After the common shareholders are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are participating securities for which A must use the two-class method to calculate basic and diluted EPS. In fiscal year 20X1, A declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2 dividend for common shareholders).

The calculations under the two-class method are as follows:

Step 1 — Use the two-class method to calculate basic EPS.

Allocation of undistributed earnings:

To participating convertible preferred shares:

{(0.4 × 100,000 preferred shares*) ÷ [(0.4 × 100,000 preferred shares*) + (0.6 × 1,000,000 common shares**)]} × $2,500,000 undistributed earnings*** = $156,250

$156,250 ÷ 100,000 preferred shares* = $1.56 per share

To common shares:

{(0.6 × 1,000,000 common shares**) ÷ [(0.4 × 100,000 preferred shares*) + (0.6 × 1,000,000 common shares**)]} × $2,500,000 undistributed earnings*** = $2,343,750

$2,343,750 ÷ 1,000,000 common shares** = $2.34 per share

* Weighted-average number of participating convertible preferred shares outstanding.

** Weighted-average number of common shares outstanding.

*** Total undistributed earnings for the period.

Basic EPS amounts:

Step 2 — Determine diluted EPS.

Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share method to determine diluted EPS.

Determine the antidilution sequencing:

Since there are no potential common shares other than the participating convertible preferred shares, A determines that antidilution sequencing is not required.

Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating convertible preferred shares is assumed:

Step 2b — Use the two-class method to determine diluted EPS.

Because A’s capital structure only includes common shares and participating convertible preferred shares (i.e., there are no other potential common shares), basic and diluted EPS would be the same under the two-class method ($4.34).

Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.

In this example, A would disclose an amount of diluted EPS per common share that would result from applying the if-converted method ($4.17) because that amount is more dilutive than the amount that would result from applying the two-class method ($4.34). In accordance with ASC 260-10-45-60, A would be permitted, but not required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the income statement.

Example 12-8

Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible Preferred Stock With Convertible Debt and Warrants

Assume that Entity B has 1 million weighted-average common shares stock outstanding for the fiscal year ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.

On January 1, 20X1, B issues 100,000 convertible preferred securities. Each preferred share is convertible into two shares of B’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend of $5 per share before any dividend is paid to the common shareholders. After the common shareholders are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are participating securities for which B must use the two-class method to calculate basic and diluted EPS. In fiscal year 20X1, B declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2 dividend for common shareholders).

In addition, assume the following:

On January 1, 20X1, B issues warrants to purchase 100,000 shares of its common stock at $50 per share for a period of five years. The average market price of B’s stock price for 20X1 was $60 per share. The warrants do not meet the definition of a participating security.
On January 1, 20X1, B issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of B’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.

The calculations under the two-class method are as follows:

Step 1 — Use the two-class method to calculate basic EPS.

Allocation of undistributed earnings:

To participating convertible preferred shares:

{(0.4 × 100,000 preferred shares*) ÷ [(0.4 × 100,000 preferred shares*) + (0.6 × 1,000,000 common shares**)]} × $2,500,000 undistributed earnings*** = $156,250

$156,250 ÷ 100,000 preferred shares* = $1.56 per share

To common shares:

{(0.6 × 1,000,000 common shares**) ÷ [(0.4 × 100,000 preferred shares*) + (0.6 × 1,000,000 common shares**)]} × $2,500,000 undistributed earnings*** = $2,343,750

$2,343,750 ÷ 1,000,000 common shares** = $2.34 per share

* Weighted-average number of participating convertible preferred shares outstanding.

** Weighted-average number of common shares outstanding.

*** Total undistributed earnings for the period.

Basic EPS amounts:

This calculation is the same as the calculation of basic EPS in Example 12-7, because basic EPS is not affected by the warrants and convertible debt since neither security is a participating security.

Step 2 — Determine diluted EPS.

Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share method to determine diluted EPS.

Determine the antidilution sequencing:

Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating convertible preferred shares is assumed:

Step 2b — Use the two-class method to determine diluted EPS.

Step 3 — Determine which Step — 2a or 2b — results in the more dilutive effect.

In this example, B would disclose an amount of diluted EPS per common share that would result from applying the if-converted methods ($3.81) because that amount is more dilutive than the amount that would result from applying the two-class method ($3.92). In accordance with ASC 260-10-45-60, B would be permitted, but not required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the income statement.

Example 12-9

Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards

Assume that Entity C has 1 million weighted-average shares of common stock outstanding for the fiscal year ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.

On January 1, 20X1, C issues 250,000 nonvested share-based payment awards to its employees. The nonvested shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year of service (i.e., cliff vesting). The average market price of A’s stock price for 20X1 was $60 per share.

Holders of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the common shareholders. Accordingly, the nonvested shares are participating securities for which C must use the two-class method in calculating basic and diluted EPS. In fiscal year 20X1, C declares and pays $2.5 million in dividends for both the common shares and the nonvested shares.

Step 1 — Use the two-class method to calculate basic EPS.

Allocation of undistributed earnings:

To shares of restricted stock:

[250,000 shares of restricted stock* ÷ (250,000 shares of restricted stock* + 1,000,000 common shares**)] × $2,500,000 undistributed earnings*** = $500,000

$500,000 ÷ 250,000 shares of restricted stock* = $2.00 per share

To common shares:

[1,000,000 common shares** ÷ (250,000 shares of restricted stock* + 1,000,000 common shares**] × $2,500,000 undistributed earnings*** = $2,000,000

$2,000,000 ÷ 1,000,000 common shares** = $2.00 per share

* Weighted-average number of participating restricted shares outstanding.

** Weighted-average number of common shares outstanding.

*** Total undistributed earnings for the period.

Basic EPS amounts:

Step 2 — Determine diluted EPS.

Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share method to determine diluted EPS.

Determine the antidilution sequencing:

Because there are no potential common shares other than the participating nonvested shares, antidilution sequencing is not required.

Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the participating nonvested shares is assumed:

Step 2b — Use the Two-Class Method to Determine Diluted EPS.

Because A’s capital structure only includes common shares and the participating shares of restricted stock (i.e., there are no other potential common shares), basic and diluted EPS would be the same under the two-class method ($4.00).

Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.

In this example, C would disclose an amount of diluted EPS per common share that would result from applying the two-class method ($4.00) because that amount is more dilutive than the amount that would result from applying the treasury stock method ($4.68). In accordance with ASC 260-10-45-60, C would be permitted, but not required, to present basic and diluted EPS for the participating shares of restricted stock on the face of the income statement.

Example 12-10

Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards With Convertible Debt and Warrants

Assume that Entity D has 1 million weighted-average shares of common stock outstanding for the fiscal year ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.

On January 1, 20X1, D issues 250,000 nonvested share-based payment awards to its employees. The nonvested shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year of service (i.e., cliff vesting). The average market price of D’s stock price for 20X1 is $60 per share. Holders of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the common shareholders. Accordingly, the nonvested shares are participating securities for which D must use the two-class method in calculating basic and diluted EPS. In fiscal year 20X1, D declares and pays $2.5 million in dividends for both the common shares and the nonvested shares.

In addition, assume the following:

On January 1, 20X1, D issues warrants to purchase 100,000 shares of its common stock at $40 per share for a period of five years. The warrants do not meet the definition of a participating security.
On January 1, 20X1, D issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of D’s common stock and bears an interest rate of 3 percent.

Step 1 — Use the two-class Method to compute basic EPS.

Allocation of undistributed earnings:

To shares of restricted stock:

[250,000 shares of restricted stock* ÷ (250,000 shares of restricted stock* + 1,000,000 common shares**)] × $2,500,000 undistributed earnings*** = $500,000

$500,000 ÷ 250,000 shares of restricted stock* = $2.00 per share

To common shares:

[1,000,000 common shares** ÷ (250,000 shares of restricted stock* + 1,000,000 common shares**)] × $2,500,000 undistributed earnings*** = $2,000,000

$2,000,000 ÷ 1,000,000 common shares** = $2.00 per share

* Weighted-average number of participating restricted shares outstanding.

** Weighted-average number of common shares outstanding.

*** Total undistributed earnings for the period.

Basic EPS amounts:

Note that this calculation is the same as the calculation of basic EPS in Example 12-9 because basic EPS is not affected by the warrants and convertible debt since neither security is a participating security.

Step 2 — Determine diluted EPS.

Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share method to determine diluted EPS

Determine the antidilution sequencing:

Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the participating nonvested shares is assumed:

Step 2b — Use the two-class method to determine diluted EPS.

Step 3 — Determine which Step — 2a or 2b — results in the more dilutive Effect

In this example, D would use the two-class method to disclose diluted EPS per common share ($3.58) because that amount is more dilutive than the amount that would result from applying the if-converted method ($4.18). In accordance with ASC 260-10-45-60, D would be permitted, but not required, to present basic and diluted EPS for the participating shares of restricted stock on the face of the income statement.

12.4.4 Settlement in Shares or Cash

ASC 260-10

Share-Based Payment Arrangements

45-30 If share-based payment arrangements are payable in common stock or in cash at the election of either the entity or the grantee, the determination of whether such share-based awards are potential common shares shall be made based on the provisions in paragraph 260-10-45-45. If an entity has a tandem award (as defined in Topic 718) that allows the entity or the grantee to make an election involving two or more types of equity instruments, diluted EPS for the period shall be computed based on the terms used in the computation of compensation cost for that period.

Contracts That May Be Settled in Stock or Cash

45-45 The effect of potential share settlement shall be included in the diluted EPS calculation (if the effect is more dilutive) for an otherwise cash-settleable instrument that contains a provision that requires or permits share settlement (regardless of whether the election is at the option of an entity or the holder, or the entity has a history or policy of cash settlement). An example of such a contract accounted for in accordance with this paragraph and paragraph 260-10-45-46 is a written call option that gives the holder a choice of settling in common stock or in cash. An election to share settle an instrument, for purposes of applying the guidance in this paragraph, does not include circumstances in which share settlement is contingent upon the occurrence of a specified event or circumstance (such as contingently issuable shares). In those circumstances (other than if the contingency is an entity’s own share price), the guidance on contingently issuable shares should first be applied, and, if the contingency would be considered met, then the guidance in this paragraph should be applied. Share-based payment arrangements that are payable in common stock or in cash at the election of either the entity or the grantee shall be accounted for pursuant to this paragraph and paragraph 260-10- 45-46, unless the share-based payment arrangement is classified as a liability because of the requirements in paragraph 718-10-25-15 (see paragraph 260-10-45-45A for guidance for those instruments). If the payment of cash is required only upon the final liquidation of an entity, then the entity shall include the effect of potential share settlement in the diluted EPS calculation until the liquidation occurs.

45-45A For a share-based payment arrangement that is classified as a liability because of the requirements in paragraph 718-10-25-15 and may be settled in common stock or in cash at the election of either the entity or the holder, determining whether that contract shall be reflected in the computation of diluted EPS shall be prepared on the basis of the facts available each period. It shall be presumed that the contract will be settled in common stock and the resulting potential common shares included in diluted EPS (in accordance with the relevant guidance of this Topic) if the effect is more dilutive. The presumption that the contract will be settled in common stock may be overcome if past experience or a stated policy provides a reasonable basis to conclude that the contract will be paid partially or wholly in cash.

45-46 A contract that is reported as an asset or liability for accounting purposes may require an adjustment to the numerator for any changes in income or loss that would result if the contract had been reported as an equity instrument for accounting purposes during the period. That adjustment is similar to the adjustments required for convertible debt in paragraph 260-10-45-40(b).

45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled in stock or cash.

Contracts That May Be Settled in Stock or Cash

55-32 Adjustments shall be made to the numerator for contracts that are asset or liability classified, in accordance with Section 815-40-25, but for which the potential common shares are included in the denominator in accordance with the guidance in paragraph 260-10-45-45. For purposes of computing diluted EPS, the adjustments to the numerator are only permitted for instruments for which the effect on net income (the numerator) is different depending on whether the instrument is accounted for as an equity instrument or as an asset or liability (for example, those that are within the scope of Subtopics 480-10 and 815-40).

Share-based payment awards that cannot be settled in the entity’s shares (e.g., liability-classified, cash-settled SARs) are not included in the denominator of basic or diluted EPS. That is, share-based payment awards that always must be settled in cash are not included in the denominator in the EPS calculation. However, the compensation cost recorded in net income (and therefore income available to common shareholders) will affect the numerator in the EPS calculation.

Conversely, a share-based payment award that can be settled in cash or shares is evaluated under ASC 260-10-45-45 through 45-47. Subject to one exception, regardless of whether the election to settle in cash or shares is at the option of the issuing entity or the holder, the entity must include the incremental number of shares that results from applying the treasury stock method in the denominator of the calculation of diluted EPS if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260. If the award is classified as a liability, an entity may be required to adjust the numerator in accordance with ASC 260-10-45-46. This adjustment is made to remove the incremental effect of accounting for the award as a liability (i.e., so that the numerator reflects only the compensation cost that would have been recognized if the award had been classified as equity). In addition, in calculating the average unrecognized cost of the arrangement under the treasury stock method, the entity should use the amount of cost that would have been left unrecognized if the award had been classified as equity.

The one exception to the requirement to assume share settlement is related to a share-based payment award that is classified as a liability because of the requirements in ASC 718-10-25-15. For these awards, if past experience or a stated policy provides a reasonable basis for an entity to conclude that the arrangement will be settled in cash, no incremental shares need to be included in the denominator of the calculation of diluted EPS.3 In addition, no adjustment to the numerator is needed since the assumed settlement for diluted EPS is aligned with the accounting classification. See ASC 260-10-45-45A for additional discussion.

Changing Lanes

ASU 2020-06 eliminated the ability to overcome the presumption of share settlement for contracts other than share-based payment arrangements. For share-based payment arrangements, the FASB decided to retain the existing guidance. Paragraph BC114 of ASU 2020-06 states:

The classification guidance in Topic 718 is different from the classification guidance in Subtopic 815-40. Specifically, the guidance in paragraph 718-10-25-15 states that “. . . if an entity that nominally has the choice of settling awards by issuing stock predominantly settles in cash or if the entity usually settles in cash whenever a grantee asks for cash settlement, the entity is settling a substantive liability rather than repurchasing an equity instrument.” Under current GAAP, a liability-classified stock-based compensation arrangement may not be included in diluted EPS because of the existing guidance on contracts that may be settled in cash or shares. The Board decided to retain the current guidance for calculating diluted EPS for stock-based compensation because those arrangements are not within the scope of this project.

12.4.5 Early Exercise of Stock Options

An early exercise refers to a grantee’s ability to change his or her tax position by exercising an option or similar instrument and receiving shares before the good has been delivered or the service has been rendered (i.e., before the award vests). If the employee terminates employment before rendering the requisite service (or a nonemployee forfeits the award before completion of the vesting period), the entity usually can repurchase the shares for either of the following:

The lesser of the fair value of the shares on the repurchase date or the exercise price of the award.
The exercise price of the award.

The purpose of the repurchase feature is effectively to require the grantee to satisfy the vesting conditions to receive any economic benefit from the award. Early exercise is therefore not considered to be a substantive exercise for accounting purposes. See Section 3.4.3 for additional information.

12.4.5.1 Basic EPS

The shares issued to a grantee upon an award’s early exercise would not be considered outstanding for basic EPS purposes until the award’s vesting conditions have been satisfied. This conclusion is consistent with the intent of ASC 260-10- 45-13, which is that shares that are subject to a contingent repurchase provision, as described above, are excluded from the calculation of basic EPS until the shares are no longer contingently returnable (i.e., the entity’s call option lapses).

However, if the shares subject to repurchase contain nonforfeitable rights to dividends or dividend equivalents, the shares are participating securities. That is, an award is considered a participating security if it accrues cash dividends (whether paid or unpaid) any time the common shareholders receive dividends that do not need to be returned to the entity if the grantee forfeits the award. If legally issued shares are considered participating securities, the entity must use the two-class method to calculate basic EPS. See Section 12.4.3 for a discussion of the two-class method.

12.4.5.2 Diluted EPS

After a grantee early exercises an option, the entity continues to use the treasury stock method to calculate diluted EPS. When using this method to calculate the number of incremental shares to be included in diluted EPS, the entity normally is required to include the exercise price of the award in the calculation of assumed proceeds in accordance with ASC 260-10-45-29. (See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.) However, in this case, because the grantee has early exercised the award and has therefore already paid cash, (1) there is no cash that will be received from the grantee in the future and (2) the cash received hypothetically could have already been used to repurchase shares during the requisite service period (or before the nonemployee award has vested). As a result, the cash received is not included in the calculation of assumed proceeds.

When calculating diluted EPS for an early exercised award that is considered a participating security, an entity must determine whether the treasury stock method or the two-class method is more dilutive.

12.4.6 Employee Stock Purchase Plans

12.4.6.1 General

An ESPP is a share-based payment plan that is usually offered to a broad base of employees so that they can participate in ownership of the entity, generally at a discounted price. Employees contribute to the plan through payroll deductions during the purchase period (e.g., six months). At the end of the purchase period, the employer’s stock is purchased at the purchase price, which is generally a discounted price. See Chapter 8 for a discussion of ESPPs.

The effect that an ESPP has on an entity’s EPS depends on the terms of the plan. Generally, the participating employees can choose not to purchase the shares and can have their withholdings during the purchase period refunded because either (1) the employees can elect to have previous withholdings refunded before the end of the purchase period or (2) the shares will not be purchased if the employee fails to provide the requisite service (i.e., if the employee terminates employment before the end of the purchase period). In practice, it is atypical for an employee’s withholdings during the purchase period not to be refundable because participants are generally not allowed to purchase shares at the end of the purchase period if they are no longer employed by the entity. However, the section below addresses the EPS accounting for ESPPs for which the participating employees are unable to receive a refund of withholdings made during the purchase period.

12.4.6.2 Withholdings Are Not Refundable

If the terms of the ESPP do not allow employees to choose not to purchase the shares (i.e., an employee’s participation is irrevocable because the employee is not entitled to a refund of amounts previously withheld during the purchase period, regardless of whether the employee is terminated), the guidance on contingently issuable shares applies to the calculation of basic and diluted EPS. According to this guidance, the number of shares, if any, that would be issuable at the end of the reporting period, under the assumption that the end of the reporting period is the end of the purchase period (this number is based on the amounts withheld by the entity to date), is included in the weighted-average number of common shares outstanding for basic and diluted EPS.

12.4.6.3 Withholdings Are Refundable

12.4.6.3.1 Basic EPS

If the terms of the ESPP allow employees to choose not to purchase the shares (i.e., employees are entitled to a refund of amounts previously withheld during the purchase period either at their election or upon termination of employment), the shares issuable under the ESPP are treated as employee stock options that are granted as of the beginning of the purchase period. Accordingly, the shares issuable under the ESPP are not included in the denominator of the calculation of basic EPS until they have been actually issued. The fact that the shares issuable under the ESPP are not included in basic EPS during the purchase period is based on the guidance in ASC 260-10-45-12C on contingently issuable shares.

12.4.6.3.2 Diluted EPS

As discussed in the previous section, when the terms of the ESPP allow employees to choose not to purchase the shares, the shares issuable under the ESPP are treated as employee stock options that are granted as of the beginning of the purchase period. Accordingly, the shares issuable under the ESPP are included in the denominator of diluted EPS under the treasury stock method, as discussed in ASC 260-10-45-22 through 45-29A. To apply the treasury stock method to an ESPP, an entity must also apply the guidance on contingently issuable shares, as discussed in ASC 260-10-45-48 and 45-49 and ASC 260-10-45-52.

Because the participants’ ability to purchase shares under an ESPP is based on a service condition, the grant date and service inception date are the start date of the purchase period provided that all conditions for establishing a grant date have been met. The withholding of amounts from the employees’ pay during the purchase period merely represents the funding mechanism for the eventual payment of the exercise price. This withholding mechanism does not affect the grant date or service inception date of the ESPP.

The number of incremental common shares to be included in the calculation of diluted EPS is based on the number of shares that would be issuable if the reporting date were the end of the contingency period (i.e., the purchase period) in accordance with ASC 260-10-45-52, net of the hypothetical shares that could be repurchased in accordance with the treasury stock method. Therefore, the sponsor of an ESPP must consider each of the following to calculate the effect of the ESPP on diluted EPS:

Employee withholdings — The amount of employee withholdings represents the exercise price for the shares to be purchased by employees and is also used to calculate the number of shares assumed to be issued during the purchase period. For diluted EPS purposes, this amount should represent the total amount of employee withholdings expected to be made during the entire purchase period.4 To estimate this amount, entities should consider the elections made by participating employees.

Expected forfeitures may affect the amount of recognized compensation cost during the purchase period but should not be factored into the estimation of employee withholdings. As discussed in Section 12.4.2.1.4, regardless of an entity’s accounting policy election related to how it reflects forfeitures in the recognition of compensation cost, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive.

Changes to employee withholding elections during the purchase period are treated as modifications and are only reflected in EPS prospectively.
Purchase price formula — The purchase price of an ESPP is generally based on the lesser of the stock price at the beginning of the purchase period and that at the end of the purchase period; therefore, the sponsor will need to consider its stock price as of both the beginning of the purchase period and the end of the reporting period. The stock price as of the end of the reporting period is used as the proxy for the stock price as of the end of the purchase period in accordance with the guidance in ASC 260-10-45-52 on contingently issuable shares. The sponsor would use the lower of these two stock prices to calculate the purchase price when the ESPP allows employees to purchase shares on the basis of a formula that incorporates the lesser of the stock price at the beginning and that at the end of the purchase period.
Average unrecognized compensation cost — The average amount of unrecognized compensation cost attributable to future service, if any, is a component of the assumed proceeds under the treasury stock method.

The incremental number of common shares included in diluted EPS is calculated as follows (see also Example 12-11):

Number of shares assumed issued under the ESPP:

Employee withholdings (item 1 above) ÷ purchase price (item 2 above)

less

Number of shares assumed repurchased:

Assumed proceeds (i.e., employee withholdings [item 1 above] plus average unrecognized compensation cost [item 3 above]) ÷ average market price of the issuer’s stock for the reporting period

Connecting the Dots

Unlike an entity’s accounting for diluted EPS for early exercised stock options, an entity may include the money withheld (and expected to be withheld during the remaining purchase period) from employees’ pay as a component of the assumed proceeds in calculating diluted EPS for ESPPs. These withholdings are not considered a prepayment of the exercise price for diluted EPS purposes because the entity must refund such amounts to employees that do not ultimately purchase shares under the ESPP. (This requirement differs from the terms of early exercised stock options.)

Example 12-11

Diluted EPS for ESPP

On July 1, 20X1, Entity A establishes a qualified ESPP that allows its employees to purchase shares of its common stock during a six-month purchase period that begins on July 1, 20X1, and ends on December 31, 20X1. The ESPP permits A’s employees to elect to withhold up to 10 percent of their salary to purchase A’s common stock at the end of the purchase period. Employees may make their election at any time during the purchase period, but once the election is made it cannot be changed during the purchase period. The shares will be purchased at a price per share that is equal to the lesser of (1) 90 percent of A’s stock price as of July 1, 20X1, or (2) 90 percent of A’s stock price as of December 31, 20X1. Participants are allowed to withdraw from the ESPP at any time before the end of the purchase period and are automatically withdrawn if they are terminated before the end of the purchase period. For any such withdrawals, A must refund the amounts withheld from the participant’s pay. Shares are issued under the ESPP on January 1, 20X2.

Assumptions related to A’s calculation of diluted EPS for the quarterly period ended September 30, 20X1, include the following:

Common stock prices per share:
- July 1, 20X1 — $50.
- September 30, 20X1 — $40.
- Average market price during the period beginning on July 1, 20X1, and ending on September 30, 20X1 — $45.
Employee payroll withholdings:
- Actual through September 30, 20X1 — $3.5 million.
- Expected from October 1, 20X1, through December 31, 20X1 — $3.7 million.
Average unrecognized compensation cost for the period — $1.3 million.

The effect on diluted EPS of the ESPP for the quarterly period ended September 30, 20X1, is calculated as follows:

The shares issuable under the ESPP would be included in basic EPS prospectively once they are issued (i.e., on January 1, 20X2). While not relevant to this example, if the purchase period ended during a quarterly financial reporting period, in addition to including the shares as outstanding on a weighted-average basis for the period, an entity would need to include incremental shares in diluted EPS on a weighted-average basis for the portion of the quarterly period for which the shares had not yet been issued. See Section 4.2.2.1.3.1 of Deloitte’s Roadmap Earnings per Share for further discussion.

Connecting the Dots

ASC 260-10-45-21A states:

Changes in an entity’s share price may affect the exercise price of a financial instrument or the number of shares that would be used to settle the financial instrument. For example, when the principal of a convertible debt instrument is required to be settled in cash but the conversion premium is required to (or may) be settled in shares, the number of shares to be included in the diluted EPS denominator is affected by the entity’s share price. In applying both the treasury stock method and the if-converted method of calculating diluted EPS, the average market price shall be used for purposes of calculating the denominator for diluted EPS when the number of shares that may be issued is variable, except for contingently issuable shares within the scope of the guidance in paragraphs 260-10-45-48 through 45-57. See paragraphs 260-10-55-4 through 55-5 for implementation guidance on determining an average market price.

In accordance with this guidance, the number of shares assumed to be issued under an ESPP would be calculated by using the average market price of the entity’s stock. However, before ASC 260-10-45-21A was added by ASU 2020-06, entities applied the guidance on contingently issuable shares in ASC 260-10-45-52 to calculate the number of shares assumed to be issued under an ESPP (as noted in the guidance and example above). This guidance is consistent with footnote 1 of FASB Technical Bulletin 97-1 (superseded), which indicated that an entity applies the guidance on contingently issuable shares to determine the accounting for diluted EPS.

On the basis of informal discussions with the FASB staff, we understand that the amendments made to ASC 260 by ASU 2020-06 (i.e., the addition of ASC 260-10-45-21A) were not intended to address when the guidance on contingently issuable shares applies to the calculation of diluted EPS. Indeed, ASC 260-10-45-21A specifically states that these amendments do not apply to contingently issuable shares. Therefore, we believe that the accounting for diluted EPS that entities applied in practice before adopting ASU 2020-06 is still acceptable. However, because it is often difficult to determine when to apply the guidance on contingently issuable shares in ASC 260, it would also be acceptable for an entity to apply the guidance in ASC 260-10-45-21A on variable denominators to calculate the number of shares assumed to be issued under an ESPP. Such accounting for diluted EPS would represent an accounting policy election that must be applied consistently.

If ASC 260-10-45-21A is applied to calculate the number of shares assumed to be issued in Example 12-11, the number of shares would equal 177,778 (i.e., total expected withholdings of $7,200,000 divided by $40.50 [$45 average market price for the period multiplied by 90 percent]). As a result, the ESPP would be antidilutive for the period since the number of shares assumed to be repurchased would be greater than the number of shares assumed to be issued. This example illustrates that an entity’s application of ASC 260-10-45-21A to calculate the number of shares assumed to be issued in an ESPP would result in less dilution (or no dilution) compared with application of the contingently issuable share method.

12.4.7 Redeemable Awards

ASC 260-10

Certain Redeemable Financial Instruments

45-70A Paragraph 480-10-45-4 provides guidance on calculating basic and diluted EPS if an entity has mandatorily redeemable shares of common stock or has entered into certain forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock.

ASC 480-10

EPS

45-4 Entities that have issued mandatorily redeemable shares of common stock or entered into forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock in exchange for cash shall exclude the common shares that are to be redeemed or repurchased in calculating basic and diluted earnings per share (EPS). Any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to shares that are to be redeemed or repurchased that have not been recognized as interest costs in accordance with paragraph 480-10-35-3 shall be deducted in computing income available to common shareholders (the numerator of the EPS calculation), consistently with the two-class method set forth in paragraphs 260-10-45-60 through 45-70.

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(21) Common stock instruments issued by a parent (or single reporting entity). Regardless of the accounting method selected in paragraph 15, the resulting increases or decreases in the carrying amount of redeemable common stock should be treated in the same manner as dividends on nonredeemable stock and should be effected by charges against retained earnings or, in the absence of retained earnings, by charges against paid-in capital. However, increases or decreases in the carrying amount of a redeemable common stock should not affect income available to common stockholders. Rather, the SEC staff believes that to the extent that a common shareholder has a contractual right to receive at share redemption (in other than a liquidation event that meets the exception in paragraph 3(f)) an amount that is other than the fair value of the issuer’s common shares, then that common shareholder has, in substance, received a distribution different from other common shareholders. Under Paragraph 260-10-45-59A, entities with capital structures that include a class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights, should apply the two-class method of calculating earnings per share. Therefore, when a class of common stock is redeemable at other than fair value, increases or decreases in the carrying amount of the redeemable instrument should be reflected in earnings per share using the two-class method.FN17 For common stock redeemable at fair valueFN18, the SEC staff would not expect the use of the two-class method, as a redemption at fair value does not amount to a distribution different from other common shareholders.FN19

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FN17 The two-class method of computing earnings per share is addressed in Section 260-10-45. The SEC staff believes that there are two acceptable approaches for allocating earnings under the two-class method when a common stock instrument is redeemable at other than fair value. The registrant may elect to: (a) treat the entire periodic adjustment to the instrument’s carrying amount (from the application of paragraphs 14–16) as being akin to a dividend or (b) treat only the portion of the periodic adjustment to the instrument’s carrying amount (from the application of paragraphs 14–16) that reflects a redemption in excess of fair value as being akin to a dividend. Under either approach, decreases in the instrument’s carrying amount should be reflected in the application of the two-class method only to the extent they represent recoveries of amounts previously reflected in the application of the two-class method.

FN18 Common stock that is redeemable based on a specified formula is considered to be redeemable at fair value if the formula is designed to equal or reasonably approximate fair value. The SEC staff believes that a formula based solely on a fixed multiple of earnings (or other similar measure) is not considered to be designed to equal or reasonably approximate fair value.

FN19 Similarly, the two-class method is not required when share-based payment awards granted to employees are redeemable at fair value (provided those awards are in the form of common shares or options on common shares). However, those share-based payment awards may still be subject to the two-class method pursuant to Section 260-10-45.

SAB Topic 14.E requires public entities to consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A for redeemable share-based payment awards. See Section 5.10 for a discussion of the recognition and measurement requirements for redeemable share-based payment awards.

12.4.7.1 Share-Based Payment Awards Redeemable at Fair Value

Share-based payment awards on common shares that are redeemable at fair value are accounted for in the same manner as common shares that are redeemable at fair value. In ASC 480-10-S99-3A, the SEC staff clarified that increases or decreases in the carrying amount of common shares that are redeemable at fair value do not affect income available to common shareholders. That is, changes in the redemption amount do not affect income available to common shareholders (the numerator in the calculation of basic EPS) if the redemption value of redeemable shares is based on the fair value of the shares. When calculating diluted EPS, an entity must apply the treasury stock method to determine the number of incremental shares to include in the calculation’s denominator. See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.

12.4.7.2 Share-Based Payment Awards Redeemable at an Amount Other Than Fair Value

Share-based payment awards on common shares that are redeemable at an amount other than fair value are accounted for in the same manner as common shares that are redeemable at an amount other than fair value (e.g., formula price). That is, increases or decreases in the carrying amount of redeemable share-based payment awards are reflected in EPS under the two-class method, as discussed in ASC 260-10-45-59A through 45-70. The increase or decrease in the carrying amount of redeemable share-based payment awards is treated similarly to the reduction in income from continuing operations (or net income) from current-period distributions. See Section 12.4.3 for a discussion of the application of the two-class method. In calculating diluted EPS, an entity must determine whether the treasury stock method or the two-class method is more dilutive. See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.

12.4.7.3 Share-Based Payment Awards Redeemable at Intrinsic Value

The SEC’s guidance in ASC 480-10-S99-3A does not address the EPS treatment of share-based payment awards with a redemption amount that is based on an award’s intrinsic value. Entities may therefore make a policy decision to (1) analogize to the guidance in ASC 480-10-S99-3A on common shares that are redeemable at fair value or (2) treat the increases or decreases in the carrying amount of these awards as an additive or subtractive amount in arriving at income available to common shareholders.

Under the first alternative, the increase or decrease in the carrying amount of the redeemable share-based payment award (i.e., changes in the redemption amount) does not affect income available to common shareholders (the numerator in the calculation of basic EPS). Under the second alternative, however, such increase or decrease is treated like a preferential distribution. That is, the entity accounts for the current-period change in the carrying amount of the redeemable share-based payment award as an additive or subtractive amount in arriving at income available to common shareholders (the numerator in the calculation of basic EPS). Regardless of the alternative selected, the entity must apply the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS. See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.

12.4.7.4 Contingently Redeemable Share-Based Payment Awards

Share-based payment awards on common shares that are contingently redeemable at fair value or at an amount other than the awards’ fair value (e.g., redeemable upon a change in control) do not affect income available to common shareholders (the numerator in the calculation of basic EPS) until it is probable that the contingency will occur. That is, awards that are contingently redeemable are not remeasured to their redemption amount until it is deemed probable that the contingency will occur. When calculating diluted EPS, an entity must apply the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation. See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.

12.4.8 Awards of a Consolidated Subsidiary

12.4.8.1 Share-Based Payment Awards Issued by a Consolidated Subsidiary and Settled in the Subsidiary’s Common Shares

ASC 260-10

Securities of Subsidiaries

55-20 The effect on consolidated EPS of options, warrants, and convertible securities issued by a subsidiary depends on whether the securities issued by the subsidiary enable their holders to obtain common stock of the subsidiary or common stock of the parent entity. The following general guidelines shall be used for computing consolidated diluted EPS by entities with subsidiaries that have issued common stock or potential common shares to parties other than the parent entity

Securities issued by a subsidiary that enable their holders to obtain the subsidiary’s common stock shall be included in computing the subsidiary’s EPS data. Those per-share earnings of the subsidiary shall then be included in the consolidated EPS computations based on the consolidated group’s holding of the subsidiary’s securities. Example 7 (see paragraph 260-10-55-64) illustrates that provision.
Securities of a subsidiary that are convertible into its parent entity’s common stock shall be considered among the potential common shares of the parent entity for the purpose of computing consolidated diluted EPS. Likewise, a subsidiary’s options or warrants to purchase common stock of the parent entity shall be considered among the potential common shares of the parent entity in computing consolidated diluted EPS. Example 7 (see paragraph 260-10-55-64) illustrates that provision.

55-21 The preceding provisions also apply to investments in common stock of corporate joint ventures and investee companies accounted for under the equity method.

55-22 The if-converted method shall be used in determining the EPS impact of securities issued by a parent entity that are convertible into common stock of a subsidiary or an investee entity accounted for under the equity method. That is, the securities shall be assumed to be converted and the numerator (income available to common stockholders) adjusted as necessary in accordance with the provisions in paragraph 260-10-45-40(a) through (b). In addition to those adjustments, the numerator shall be adjusted appropriately for any change in the income recorded by the parent (such as dividend income or equity method income) due to the increase in the number of common shares of the subsidiary or equity method investee outstanding as a result of the assumed conversion. The denominator of the diluted EPS computation would not be affected because the number of shares of parent entity common stock outstanding would not change upon assumed conversion.

Example 7: Securities of a Subsidiary — Computation of Basic and Diluted EPS

55-64 This Example illustrates the EPS computations for a subsidiary’s securities that enable their holders to obtain the subsidiary’s common stock based on the provisions in paragraph 260-10-55-20. The facts assumed are as follows:

55-65 Parent Entity:

Net income was $10,000 (excluding any earnings of or dividends paid by the subsidiary).
10,000 shares of common stock were outstanding; the parent entity had not issued any other securities.
The parent entity owned 900 common shares of a domestic subsidiary entity.
The parent entity owned 40 warrants issued by the subsidiary.
The parent entity owned 100 shares of convertible preferred stock issued by the subsidiary.

55-66 Subsidiary Entity:

Net income was $3,600.
1,000 shares of common stock were outstanding.
Warrants exercisable to purchase 200 shares of its common stock at $10 per share (assume $20 average market price for common stock) were outstanding.
200 shares of convertible preferred stock were outstanding. Each share is convertible into two shares of common stock.
The convertible preferred stock paid a dividend of $1.50 per share.
No interentity eliminations or adjustments were necessary except for dividends.
Income taxes have been ignored for simplicity.

55-67 The following table illustrates subsidiary’s EPS.

Share-based payment awards issued by a consolidated subsidiary that are settled by issuing the subsidiary’s common shares affect not only the subsidiary’s calculation of diluted EPS but also the calculation of the parent’s diluted EPS, as described in ASC 260-10-55-20 through 55-22 and illustrated in Example 7 in ASC 260-10-55-64 through 55-67.

While such awards do not affect the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS for either the subsidiary or the parent), the compensation cost associated with these awards (during the requisite service period or nonemployee’s vesting period) will generally affect both the subsidiary’s and the parent’s net income or loss.

To calculate the parent’s diluted EPS, the subsidiary must first calculate its own diluted EPS (regardless of whether the subsidiary reports EPS). The amount of the subsidiary’s diluted EPS is then multiplied by the number of the subsidiary’s shares that the parent is assumed to own (after the hypothetical exercise of the awards is taken into consideration). The product of those two amounts is then included in the numerator (as a substitute for the parent’s proportionate share of the subsidiary’s earnings) of the calculation of the parent’s diluted EPS.

As noted in ASC 260-10-55-21, the guidance in ASC 260-10-55-20 also applies to investments in common stock of corporate joint ventures and investee companies that are accounted for under the equity method.

Example 12-12

Impact on EPS of Share-Based Payment Awards Issued by a Subsidiary

Assume that the following apply to Parent P:

Its net income is $100, excluding any net income or loss of Subsidiary A (i.e., as if A is unconsolidated).
Throughout the period, 100 shares of its common stock were outstanding. No other securities have been issued.
It owns 90 of A’s common shares (out of 100 outstanding).

Assume that the following apply to A:

Its net income is $100 (after intercompany eliminations, etc.).
Throughout the period, 100 shares of its common stock were outstanding.
At the beginning of the period, it granted 10 fully vested stock options to its employees to purchase 10 shares of its common stock at $1 per share.
The average market price of its common stock during the period is $2 per share.

The calculation of A’s diluted EPS is as follows:

The calculation of P’s consolidated diluted EPS is as follows:

12.4.8.2 Share-Based Payment Awards Issued by a Subsidiary but Settled in the Parent’s Common Shares

Share-based payment awards issued by a consolidated subsidiary that are settled by issuing the parent’s common shares will not affect the subsidiary’s denominator in the calculation of diluted EPS because the awards do not represent potential common shares of the subsidiary. However, during the employee’s requisite service period or nonemployee’s vesting period, the compensation cost associated with these awards will affect the subsidiary’s net income or loss. (See Sections 2.8 and 2.9 for a discussion of the accounting for share-based payment awards issued by a subsidiary but settled in the parent’s common shares.)

By contrast, for the parent, the share-based payment awards do represent potential common shares in the calculation of diluted EPS. Therefore, the awards are included in the parent’s denominator of the calculation of diluted EPS under the treasury stock method. (See Section 12.4.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.) Because the subsidiary is recording compensation cost in its financial statements for these awards during the requisite service period or nonemployee’s vesting period, the parent’s proportionate share of the compensation cost will have been included in the parent’s net income or loss.

Footnotes

The inclusion of the average amount of unrecognized compensation cost attributed to future goods or services not yet recognized is unique to share-based payment awards. That is, this component is only included in the assumed proceeds for share-based payment awards.

Undistributed losses would generally not be allocated to share-based payment awards in accordance with ASC 260-10-45-67 because such awards typically would not have a “contractual obligation to share in the losses of the issuing entity on a basis that was objectively determinable.” See Example 6 in ASC 260-10-55-62 and 55-63 for an illustration of the use of the two-class method for calculating basic EPS.

An entity would need to have a sufficient past practice of cash settlement as well as evidence of its intent to cash-settle the arrangement.

The entire purchase period is considered in the calculation of diluted EPS because the shares to be purchased under the ESPP are treated as employee stock options. Therefore, all amounts to be withheld from employees’ pay to purchase shares under the ESPP (i.e., withholdings to date and expected future withholdings during the remaining purchase period) must be considered in the calculation of diluted EPS.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.