Chapter 10 — Equity Transactions and Disclosures

10.3 Dividends

10.3.1 General

There are many types of distributions that may be made to holders of equity instruments. Entities must first determine whether a distribution or other nonreciprocal transfer to an equity holder represents an equity transaction (i.e., a dividend) or an expense. Once it is established that a distribution should be accounted for as a dividend, the entity must determine the appropriate accounting for the transaction. The sections below discuss the following:

Determining whether a distribution is accounted for as a dividend (see Section 10.3.2).
Accounting for stock dividends and stock splits, including reverse stock splits (see Section 10.3.3).
Accounting for other dividends to equity holders (see Section 10.3.4).

10.3.2 Determining Whether Distributions to Equity Holders Represent Dividends

ASC 505-30

Requirement to Allocate Repurchase Amount

25-4 Payments by an entity to a shareholder or former shareholder attributed, for example, to a standstill agreement, or any agreement in which a shareholder or former shareholder agrees not to purchase additional shares, shall be expensed as incurred. Such payments do not give rise to assets of the entity.

Allocating Repurchase Price to Other Elements of the Repurchase Transaction

30-2 An allocation of repurchase price to other elements of the repurchase transaction may be required if an entity purchases treasury shares at a stated price significantly in excess of the current market price of the shares. An agreement to repurchase shares from a shareholder may also involve the receipt or payment of consideration in exchange for stated or unstated rights or privileges that shall be identified to properly allocate the repurchase price.

ASC 845-10

Nonreciprocal Transfers With Owners

30-10 Accounting for the distribution of nonmonetary assets to owners of an entity in a spinoff or other form of reorganization or liquidation or in a plan that is in substance the rescission of a prior business combination shall be based on the recorded amount (after reduction, if appropriate, for an indicated impairment of value) (see paragraph 360-10-40-4) of the nonmonetary assets distributed. Subtopic 505-60 provides additional guidance on the distribution of nonmonetary assets that constitute a business to owners of an entity in transactions commonly referred to as spinoffs. A pro rata distribution to owners of an entity of shares of a subsidiary or other investee entity that has been or is being consolidated or that has been or is being accounted for under the equity method is to be considered to be equivalent to a spinoff. Other nonreciprocal transfers of nonmonetary assets to owners shall be accounted for at fair value if the fair value of the nonmonetary asset distributed is objectively measurable and would be clearly realizable to the distributing entity in an outright sale at or near the time of the distribution.

Nonreciprocal transfers to equity holders can represent dividends or expenses. A distribution that is made (or offered) to all holders of a particular class of equity in proportion to each holder’s ownership interest represents a dividend. For example, a pro rata distribution of cash or other assets to all holders of a particular class of equity in accordance with an entity’s articles of incorporation or bylaws is accounted for as a dividend. However, all non-pro-rata distributions to equity holders must be recognized in earnings as incurred (i.e., an expense) in accordance with ASC 505-30.5

Connecting the Dots

A repurchase of preferred stock from a specific investor (or group of investors) at fair value is not considered a non-pro-rata distribution even when the offer was not made to all holders of the class of stock that was redeemed. The same is true for a repurchase of common stock from a specific investor (or group of investors) at fair value. On the contrary, a repurchase of equity shares at an amount that exceeds fair value is considered a non-pro-rata distribution to a shareholder.

When an entity repurchases preferred stock at fair value, it is required to recognize a dividend for any difference between the fair value of the consideration paid and the net carrying amount of the preferred stock that was redeemed even though such transaction would not represent a pro rata distribution if the offer was not made to all preferred stockholders of the same class. This accounting is prescribed by ASC 260-10-S99-1 (see Section 10.3.4.3.7). The same accounting does not apply to repurchases of common stock at fair value.

The table below illustrates the treatment of certain nonreciprocal transfers to equity holders. In the table, it is assumed that payments that do not represent dividends are not reciprocal transactions addressed by other applicable literature and therefore must be expensed as incurred.

Table 10-3

Payments That Represent Dividends	Payments That Represent an Expense
A cash dividend paid to all holders of a class of common stock or a class of preferred stock	A repurchase of common stock from an individual shareholder for an amount that exceeds the fair value of the shares acquired
A stock dividend paid to all holders of a class of common stock (see Section 10.3.3)	An issuance of common stock to a new investor for an amount that is less than the fair value of the shares sold
Stock splits and reverse stock splits (see Section 10.3.3)	A modification to some, but not all, of the shares of a class of preferred stock
A repurchase of preferred stock at fair value (see Section 10.3.4.3.7)	A payment to a shareholder in return for a promise that the holder will not purchase additional shares of stock
A modification made to all outstanding shares of a class of preferred stock (see Section 10.3.4.3.5)	A payment made to a shareholder in return for a promise to abandon acquisition plans or other planned transactions
A triggered down-round feature that adjusts the exercise price of all outstanding warrants on common stock (see Section 10.3.4.3.6)	A litigation settlement with a shareholder
A rights issue made to all holders of a class of common stock that contains a bonus element (see Section 10.3.4.3.9)	A settlement of an employment contract with a shareholder
A tender offer made to all holders of a class of equity to repurchase shares at an amount that exceeds fair value
A pro rata spinoff of a subsidiary to all holders of a class of common stock (see Section 10.3.4.3.10)

For additional discussion of the evaluation of whether a payment to an equity holder is recognized as a dividend or an expense, see Section 10.4.2 as well as Section 3.2.4.3 of Deloitte’s Roadmap Earnings per Share.

10.3.3 Stock Dividends and Stock Splits (Including Reverse Stock Splits)

ASC 505-20

General

05-1 This Subtopic addresses the accounting for stock dividends and stock splits. It includes guidance for the recipient as well as for the issuer.

05-2 Many recipients of stock dividends look upon them as distributions of corporate earnings, and usually in an amount equivalent to the fair value of the additional shares received. If the issuances of stock dividends are so small in comparison with the shares previously outstanding, such issuances generally do not have any apparent effect on the share market price and, consequently, the fair value of the shares previously held remains substantially unchanged.

05-4 If there is an increase in the fair value of a recipient’s holdings, such unrealized appreciation is not income. In the case of a stock dividend or stock split, there is no distribution, division, or severance of corporate assets. Moreover, there is nothing resulting therefrom that the shareholder can realize without parting with some of his or her proportionate interest in the corporation.

05-5 See paragraph 260-10-55-12 for earnings per share (EPS) guidance if the number of common shares outstanding increases as a result of a stock dividend or stock split.

Entities

15-1 The guidance in this Subtopic applies to all entities that are corporations.

Transactions

15-2 The guidance in this Subtopic applies to all stock dividends and stock splits, with specific exceptions noted in paragraphs 505-20-15-3 through 15-3A.

15-3 The guidance in this Subtopic does not apply to the accounting for a distribution or issuance to shareholders of any of the following:

Shares of another corporation held as an investment
Shares of a different class
Rights to subscribe for additional shares
Shares of the same class in cases in which each shareholder is given an election to receive cash or shares.

15-3A Item (d) in the preceding paragraph includes, but is not limited to, a distribution having both of the following characteristics:

The shareholder has the ability to elect to receive the shareholder’s entire distribution in cash or shares of equivalent value.
There is a potential limitation on the total amount of cash that all shareholders can elect to receive in the aggregate.

For guidance on recognition of an entity’s commitment to make a distribution described in the preceding paragraph, see paragraph 480-10-25-14. For guidance on computation of diluted EPS of an entity’s commitment to make such a distribution, see the guidance in paragraphs 260-10-45-45 through 45-47.

Criteria for Treatment as Stock Dividend or Stock Split

25-1 This Section provides guidance on determining whether stock dividends and stock splits are to be accounted for in accordance with their actual form or whether their substance requires different accounting.

Stock Dividend in Form

25-2 The number of additional shares issued as a stock dividend may be so great that it has, or may reasonably be expected to have, the effect of materially reducing the share market value. In such a situation, because the implications and possible shareholder belief discussed in paragraph 505-20-30-3 are not likely to exist, the substance of the transaction is clearly that of a stock split.

25-3 The point at which the relative size of the additional shares issued becomes large enough to materially influence the unit market price of the stock will vary with individual entities and under differing market conditions and, therefore, no single percentage can be established as a standard for determining when capitalization of retained earnings in excess of legal requirements is called for and when it is not. Except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend as described in paragraph 505-20-30-3.

Stock Split in Form

25-4 A stock split is confined to transactions involving the issuance of shares, without consideration to the corporation, for the purpose of effecting a reduction in the unit market price of shares of the class issued and, therefore, of obtaining wider distribution and improved marketability of the shares.

25-5 Few cases will arise in which the aforementioned purpose can be accomplished through an issuance of shares that is less than 20 or 25 percent of the previously outstanding shares.

25-6 The corporation’s representations to its shareholders as to the nature of the issuance is one of the principal considerations in determining whether it shall be recorded as a stock dividend or a stock split. Nevertheless, the issuance of new shares in ratios of less than 20 or 25 percent of the previously outstanding shares, or the frequent recurrence of issuances of shares, would destroy the presumption that transactions represented to be stock splits shall be recorded as stock splits.

General

30-1 This Section provides guidance for the issuer and recipient of either a stock dividend or a stock split.

Issuer’s Accounting for a Stock Dividend or Stock Split

30-2 Section 505-20-25 provides guidance on determining whether a stock dividend or a stock split shall be accounted for according to its form or whether it shall be accounted for differently. The following guidance addresses the accounting for the substantive nature of the transaction as either a stock dividend or a stock split.

Stock Dividend

30-3 In accounting for a stock dividend, the corporation shall transfer from retained earnings to the category of capital stock and additional paid-in capital an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings that the shareholder may believe to have been distributed to him or her will be left, except to the extent otherwise dictated by legal requirements, in retained earnings subject to possible further similar stock issuances or cash distributions.

30-4 The accounting required in the preceding paragraph will likely result in the capitalization of retained earnings in an amount in excess of that called for by the laws of the state of incorporation; such laws generally require the capitalization only of the par value of the shares issued, or, in the case of shares without par value, an amount usually within the discretion of the board of directors. However, these legal requirements are, in effect, minimum requirements and do not prevent the capitalization of a larger amount per share.

Alternative Treatment Permitted for Closely Held Entity

30-5 In cases of closely held entities, it is presumed that the intimate knowledge of the corporations' affairs possessed by their shareholders would preclude any implications and possible shareholder belief as are referred to in paragraph 505-20-30-3. In such cases, there is no need to capitalize retained earnings other than to meet legal requirements.

Stock Split

30-6 In the case of a stock split, there is no need to capitalize retained earnings, other than to the extent occasioned by legal requirements.

Nonauthoritative AICPA Guidance

Technical Q&As Section 4150, “Stock Dividends and Stock Splits”

.02 Stock Dividend Affecting Market Price of Stock

Inquiry — A company issued a 10 percent stock dividend. May the dividend be treated as a stock split if the dividend resulted in a drop in the market price of the stock?

Reply — Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 505-20-25-3 states, in part: “except for a few instances, the issuance of additional shares of less than 20 or 25 percent of the number of previously outstanding shares would call for treatment as a stock dividend as described in paragraph 505-20-30-3.” FASB ASC 505-20-30-3 requires a transfer from retained earnings to the category of permanent capitalization in an amount equal to the fair value of the additional shares issued.

In order to treat the 10 percent “stock dividend” as a “split-up effected in the form of a dividend,” the company would have to demonstrate that the additional shares issued is “large enough to materially influence the unit market price of the stock” as indicated in FASB ASC 505-20-25-3.

SEC Rules, Regulations, and Interpretations

FRR 214. Pro Rata Stock Distributions to Shareholders (ASR 124)

Several instances have come to the attention of the Commission in which registrants have made pro rata stock distributions which were misleading. These situations arise particularly when a registrant makes distributions at a time when its retained earnings or its current earnings are substantially less than the fair value of the shares distributed. Under present generally accepted accounting rules, if the ratio of distribution is less than 25 percent of shares of the same class outstanding, the fair value of the shares issued must be transferred from retained earnings to other capital accounts. Failure to make this transfer in connection with a distribution or making a distribution in the absence of retained or current earnings is evidence of a misleading practice. Distributions of over 25 percent (which do not normally call for transfers of fair value) may also lend themselves to such an interpretation if they appear to be part of a program of recurring distributions designed to mislead shareholders.

It has long been recognized that no income accrues to the shareholder as a result of such stock distributions or dividends, nor is there any change in either the corporate assets or the shareholders’ interests therein. However, it is also recognized that many recipients of such stock distributions, which are called or otherwise characterized as dividends, consider them to be distributions of corporate earnings equivalent to the fair value of the additional shares received. In recognition of these circumstances, the [AICPA] has specified in Accounting Research Bulletin No. 43, Chapter 7, paragraph 10, that “, . . . the corporation should in the public interest account for the transaction by transferring from earned surplus to the category of permanent capitalization (represented by the capital stock and capital surplus accounts) an amount equal to the fair value of the additional shares issued. Unless this is done, the amount of earnings which the shareholder may believe to have been distributed will be left, except to the extent otherwise dictated by legal requirements, in earned surplus subject to possible further similar stock issuances or cash distributions.” . . .

The Commission also considers that if such stock distributions are not accounted for in this manner, the shareholders may be misled. In a recent stop order proceeding, [footnote omitted] the Commission found that a registration statement was materially misleading because a series of four stock distributions made between 1966 and 1968 “, . . . were ‘part of a frequent recurrence of issuances of shares’ . . . [and] . . . under generally accepted accounting principles they should have been accounted for as stock dividends.”

10.3.3.1 Scope

ASC 505-20 addresses the accounting for stock dividends and stock splits, which represent a type of pro rata distribution to all holders of a class of common stock or preferred stock for no consideration. ASC 505-20 discusses what constitutes a stock dividend and a stock split. In a stock split, the number of outstanding shares increases and the fair value per share decreases. In a reverse stock split, which is a type of stock split, the opposite is true (i.e., the number of outstanding shares decreases and the fair value per share increases).

In accordance with ASC 505-20, the following do not represent stock dividends or stock splits:

Distributions of shares issued by a third party. Such transactions represent distributions of nonmonetary assets that are accounted for as dividends if provided on a pro rata basis to all holders of a class of stock (see Section 10.3.4.3.10).
Distributions of shares of a different class (see Section 10.3.4.4.4).
Rights issues (see Section 10.3.4.3.9).
Distributions that permit shareholders to elect to receive the entire amount in cash or shares of equivalent value, with a potential limit on the total aggregate amount of cash payable. Such distributions are accounted for as a share issuance.

Certain free distributions by Japanese companies are also not accounted for as stock dividends or stock splits (see Section 10.3.4.4.5).

10.3.3.2 Recognition and Measurement

An entity that distributes shares of its stock pro rata to all existing holders for no consideration must evaluate whether the issuance has the characteristics of a stock dividend or a stock split under ASC 505-20. Stock dividends and stock splits usually involve common shares, but the guidance in ASC 505-20 also applies to stock splits on preferred securities. For a discussion of dividends on preferred stock that are paid in kind, see Section 10.3.4.3.1.

A distribution of shares meets the conditions of a stock split if it is made primarily to reduce the stock price (or, in the case of a reverse stock split, to increase the stock price), whereas it qualifies as a stock dividend if it is made primarily to give the shareholders some ostensibly separate evidence of their claim to an interest in retained earnings. In practice, a stock split and a stock dividend are generally distinguished on the basis of the number of shares issued. A stock dividend involves a smaller distribution of shares than a stock split and has less of an impact on the stock price. Therefore, issuances of shares of less than 20 to 25 percent of the number of previously outstanding shares (or less than 25 percent for SEC registrants) are generally considered stock dividends, whereas issuances of shares of greater than 20 to 25 percent of the number of previously outstanding shares (or 25 percent or greater for SEC registrants) are generally considered stock splits. Note that these percentages apply even if the stock exchange on which the entity’s shares are listed uses different percentages to distinguish between a stock dividend and a stock split.

However, some share issuances that meet the conditions of a stock dividend are accounted for as a stock split, particularly those made by:

Closely held entities.
Other entities that have an accumulated deficit.

In addition, the SEC has indicated that distributions of greater than 25 percent, which would generally be considered a stock split, may be more appropriately accounted for as stock dividends if they are part of a program of recurring distributions and therefore stock split treatment might be misleading to shareholders.

Stock dividends and stock splits are recognized and measured as follows:

Stock dividends — The entity transfers an amount equal to the fair value of the shares distributed from retained earnings to the capital stock accounts (e.g., par or stated value and APIC) and recognizes a journal entry in the period in which the stock dividend is issued. However, the number of outstanding shares is adjusted retrospectively in the EPS calculation (see Section 8.2.1 of Deloitte’s Roadmap Earnings per Share).
Stock split — There is no capitalization of retained earnings. If the par or stated value of the stock is also adjusted for a stock split (or reverse stock split), no journal entry is recognized (although the disclosed number of shares outstanding would be adjusted retrospectively). If the par or stated value of the stock is not adjusted for a stock split (or reverse stock split), the entity records a credit (or debit) to the par or stated value of the stock for the increase (or decrease) in the number of outstanding shares and an offsetting debit (or credit) to APIC. Stock splits (and reverse stock splits) are presented retrospectively in the financial statements and in the number of outstanding shares used to calculate EPS (see Section 8.2.1 of Deloitte’s Roadmap Earnings per Share).

Any transaction costs incurred in connection with a stock dividend or stock split must be expensed as incurred. For discussion of disclosures related to stock dividends and stock splits, see Section 10.10.3.8.

10.3.3.3 Post-Balance-Sheet Stock Dividends and Stock Splits

SEC Staff Accounting Bulletins

SAB Topic 4.C, Change in Capital Structure [Reproduced in ASC 505-10-S99-4]

Facts: A capital structure change to a stock dividend, stock split or reverse split occurs after the date of the latest reported balance sheet but before the release of the financial statements or the effective date of the registration statement, whichever is later.

Question: What effect must be given to such a change?

Interpretive Response: Such changes in the capital structure must be given retroactive effect in the balance sheet. An appropriately cross-referenced note should disclose the retroactive treatment, explain the change made and state the date the change became effective.

If an SEC registrant issues a stock dividend or undertakes a stock split (including a reverse stock split) after the balance sheet date but before the financial statements are issued, the registrant must (1) retrospectively adjust the balance sheet as if the issuance or split occurred as of the balance sheet date and (2) disclose the retrospective treatment, explain the change, and state the date the change became effective. For further discussion, see Section 8.2.1.1 of Deloitte’s Roadmap Earnings per Share.

10.3.4 Other Dividends

10.3.4.1 General

When accounting for distributions to equity holders other than stock dividends or stock splits, entities must consider the following:

When to recognize dividends on the balance sheet (see Section 10.3.4.2).
How to measure dividends (see Section 10.3.4.3).
The capital accounts used to recognize dividends (see Section 10.3.4.4).
Whether dividends affect reported EPS (see Section 10.3.4.5).
Disclosures (see Section 10.10.3).

10.3.4.2 Recognition

An entity recognizes a liability for dividends on common stock when the dividends are declared, at which time an obligation to pay them has been created. The entity derecognizes such liability once the dividends are paid or otherwise extinguished. The same recognition guidance applies to dividends on preferred stock, whether those dividends are cumulative or not (see Section 10.3.4.2.1).

In some cases, the terms of an equity instrument unconditionally obligate an entity to pay dividends as they accrue, regardless of whether the entity declares the dividends. In these situations, the dividends must be recognized as liabilities when they become contractually payable (i.e., the issuer incurs an unconditional obligation without a formal declaration of the dividends). For example, recognition would be required when an instrument’s terms include:

Unconditional dividend obligations (see Section 10.3.4.2.2).
Contingently payable dividends (see Section 10.3.4.2.3).

In addition, an entity may be required under other applicable U.S. GAAP to recognize dividends as an increase to the carrying amount of an equity instrument (as opposed to recognizing a dividend liability) in the absence of any formal declaration of a dividend. For example, such recognition would be required for:

Dividends paid in kind on preferred securities whether or not declared (see Section 10.3.4.3.1).
Redeemable equity securities that are remeasured to their redemption amount in accordance with the SEC’s guidance on temporary equity (see Section 10.3.4.3.3).
Preferred securities that contain an increasing-rate dividend feature (see Section 10.3.4.3.4).
An equity instrument that is modified or exchanged (see Section 10.3.4.3.5).
A down-round feature in an equity instrument that is triggered (see Section 10.3.4.3.6).
Certain redemptions of equity instruments (see Section 10.3.4.3.7).
Certain conversions (see Section 10.3.4.3.8).
A rights issue (see Section 10.3.4.3.9).

For other measurement considerations related to (1) dividends on preferred stock that are paid in common shares and (2) nonmonetary distributions, see Sections 10.3.4.3.2 and 10.3.4.3.10, respectively.

10.3.4.2.1 Cumulative Dividends

Nonauthoritative AICPA Guidance

Technical Q&As Section 4210, “Dividends”

.04 Accrual of Preferred Dividends

Inquiry — A corporation has cumulative preferred stock. It has not paid any dividends on this stock in the last three years. Should the corporation accrue the preferred dividends in arrears?

Reply — Generally, preferred stock contains a cumulative provision whereby dividends omitted in previous years must be paid prior to the payment of dividends on other outstanding shares. Since dividends do not become a corporate liability until declared, no accrual is needed. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 505-10-50-5 requires entities to disclose within its financial statements (either on the face of the statement of financial position or in the notes thereto) the aggregate and per-share amounts of arrearages in cumulative preferred dividends. Furthermore, FASB ASC 260-10-45-11 states that dividends accumulated for the period on cumulative preferred stock (whether or not earned) should be deducted from income from continuing operations and also from net income when computing earnings per share. If there is a loss from continuing operations or a net loss, the amount of the loss should be increased by those preferred dividends. Preferred dividends that are cumulative only if earned should be deducted only to the extent that they are earned.

If preferred dividends are not cumulative, only the dividends declared should be deducted. In all cases, the effect that has been given to preferred dividends in arriving at income available to common stockholders in computing basic earnings per share should be disclosed for every period for which an income statement is presented.

The terms of some preferred securities preclude the issuer from paying any dividends or making other distributions on shares of common stock before the entity pays accumulated cumulative dividends on preferred shares. Preferred securities for which dividend payments must be received for all prior years before any dividends may be paid to common stockholders are referred to as “cumulative”; preferred securities without such rights are referred to as “noncumulative.” Thus, for cumulative preferred stock, the dividends accumulate on the basis of the dividend payment terms and all accumulated dividends must be paid before any dividends may be paid on common stock. For noncumulative preferred stock, only the dividends payable for the current period must be paid before dividends can be paid on common stock.

Whether preferred stock is cumulative or noncumulative, dividends are not recognized as liabilities until the entity incurs an unconditional obligation to pay them. This generally occurs when the entity declares dividends on such shares. However, if the declaration and payment of dividends on preferred stock are controlled by the holder(s) of the preferred stock instrument, accrual (i.e., recognition) of the dividends as a liability before declaration is acceptable as an accounting policy provided that it is applied consistently, although the application of such policy is not required. The following examples illustrate situations in which it is acceptable to recognize dividends on preferred stock as liabilities as they accrue (i.e., without declaring the dividends) because the holder of the instrument has the unilateral right to require payment of the dividends:

The holder of preferred stock controls the entity’s board of directors and therefore has the unilateral ability to declare and require payment of any undeclared cumulative dividends.
The terms of convertible preferred stock require the issuing entity to pay in cash all unpaid cumulative dividends (whether or not declared) upon conversion of the preferred stock into common stock, and the holder of the convertible preferred stock has the unconditional right to elect to convert the instrument into common stock at any time.

Although an entity does not recognize a liability for dividends on preferred stock until it has an unconditional obligation to pay them, the entity may be required to capitalize dividends into the carrying amount of preferred stock in accordance with other applicable literature (e.g., redeemable securities and preferred shares that pay dividends in kind whether or not declared).

10.3.4.2.2 Unconditional Dividend Obligations

As discussed above, an entity is generally not required to recognize a liability for dividends on equity instruments until such dividends are declared. However, if the terms of an equity instrument unconditionally obligate the entity to pay dividends in cash or other assets on certain dates regardless of whether the entity declares such dividends, the dividend payments should be recognized as liabilities as they accrue and become unconditionally payable. For example, the terms of a preferred security could include a requirement for the issuer to pay dividends in cash on a quarterly basis (i.e., mandatory dividends). In essence, such terms effectively result in the declaration of all future dividends; therefore, the entity would be required to recognize the dividend payment obligations as they become contractually payable.

10.3.4.2.3 Contingently Payable Dividends

Although it is uncommon, dividends on an equity instrument may become contractually payable without any declaration by the entity upon the occurrence or nonoccurrence of a specified event (i.e., a contingency). In these situations, as long as the dividend feature is not a freestanding or embedded derivative that must be accounted for separately under ASC 815, the entity would not accrue a liability for the dividend payments until the contingency is resolved. In other words, the contingently payable dividends would be recognized as a liability only once the event that triggers payment occurs or fails to occur. This is because the resolution of the payment of the dividend is akin to the declaration of the dividend by the issuer.

For example, a cumulative preferred stock instrument may contractually require an entity to pay all accumulated and unpaid dividends if the entity declares a dividend on its common shares. In this case, if the entity does not declare a dividend on its common shares, the entity would not recognize a liability for any cumulative unpaid dividends on its preferred stock instrument. If, however, the entity declares a dividend on its common shares, the entity must accrue a liability for the cumulative unpaid dividends on the preferred stock instrument even if it has not formally declared payment of such dividends.

10.3.4.3 Measurement of Certain Dividends and Other Distributions

While the measurement of dividends payable in cash or a fixed monetary amount is relatively straightforward, special consideration is warranted when other types of dividends are measured.

10.3.4.3.1 PIK Dividends

As discussed in Section 9.5.5.1, dividends on preferred stock may be paid in additional shares of preferred stock (i.e., paid in kind). If such dividends become contractually payable on specified dates, they must be accrued (as an increase to the carrying amount of the preferred security) even if the dividends are not declared by the issuer. Determining the appropriate measurement of PIK dividends is important because the recognized amount (1) is added to the carrying amount of the preferred security on the balance sheet and (2) reduces net income in arriving at income available to common stockholders.

When dividends on preferred stock are paid in kind, the issuer may either issue additional fungible securities (with the same terms) to the holders or increase the stated liquidation preference of the original preferred stock instrument to reflect the dividend payment.6 Besides potential differences due to the compounding terms of the instrument, both payment methods are economically similar.

PIK dividends on preferred stock should be measured at fair value as of the commitment date for the payment of such dividends. If PIK dividends are nondiscretionary (i.e., neither the issuer nor the holder may elect to pay them in cash or in kind because all dividends must be paid in kind), the commitment date for the original preferred stock instrument is also the commitment date for the PIK dividends. If, however, the issuer or the holder can elect to have dividends paid in cash or in kind, those dividends are discretionary. Therefore, the commitment date for them is the date on which they become nondiscretionary (i.e., the date on which the dividends become payable in kind). The table below summarizes the measurement of PIK dividends (and assumes that the PIK dividend feature is not bifurcated as an embedded derivative).

Table 10-4

PIK Feature	Description	Measurement Date for PIK Dividends
Discretionary	A PIK feature is discretionary if either of the following conditions exist: The issuer or the holder can elect a form of payment other than in kind (e.g., the issuer has the option to settle dividend payment obligations by either delivering cash or paying in kind) In cases in which the convertible instrument or a portion thereof is converted before dividends are accrued, the holder will not always receive the number of equity shares upon conversion as if all dividends have been paid in kind	The date the dividends are accrued
Nondiscretionary	A PIK feature is nondiscretionary if both of the following conditions exist: Neither the issuer nor the holder can elect payment of dividends in a form other than in kind Regardless of the conversion date (whether converted in whole or in part), the holder will always receive the number of equity shares upon conversion as if all dividends have been paid in kind	The measurement date for the original equity instrument

There are two acceptable views on how to interpret the condition that for PIK dividend payments to be nondiscretionary, the holder must always receive the number of equity shares upon conversion as if all dividends have been paid in kind if the original instrument (or part of it) is converted before accumulated dividends are declared or accrued. An entity should select one interpretation and apply it consistently as an accounting policy election:

View A — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that would have accrued during the entire life of the security (i.e., to the contractual maturity date).

Under this view, the issuer must know at the inception of the original convertible instrument, regardless of the ultimate conversion date, the exact number of equity shares that will be issued to the holder upon full conversion (i.e., conversion of the original instrument adjusted for PIK dividends or, if PIK dividends are paid through the issuance of additional convertible instruments, conversion of both the original convertible instrument and any additional convertible instruments. Potential contingent adjustments to the conversion rate for other reasons do not necessarily need to be considered). If the issuer cannot determine the number of equity shares that will be issued or if the number of equity shares will differ depending on when the instrument is converted, the PIK feature is discretionary under this view. In most cases, PIK dividend payments would be discretionary under View A since entities typically do not issue convertible instruments that allow the holder to effectively earn future dividends that would not have accrued on an early conversion.
View B — Regardless of when during the security’s term the holder converts the instrument into equity shares, the holder must always receive upon conversion all of the dividends that have accrued during the entire period in which the security has been outstanding (i.e., to the conversion date).

Under this view, the holder always receives upon conversion the number of equity shares as if all dividends that have been earned to date are paid in equity shares (i.e., no dividends are payable in cash). If the conversion date falls between periodic contractual dividend dates (i.e., accrual, declaration, or payment dates) and the holder forfeits any dividends that would have accrued from the last dividend date, this forfeiture does not prevent the dividends from being nondiscretionary since they are still not payable in cash.

The view selected will not affect the conclusion that PIK dividends are discretionary in cases in which a convertible equity instrument allows either the holder or issuer to choose to pay dividends in cash or in kind. In these circumstances, the PIK dividends would be considered discretionary regardless of whether the entity adopted View A or View B. When applying the above alternatives to a redeemable nonconvertible instrument, an entity should substitute the “redemption date” for the “conversion date.”

Connecting the Dots

Entities should also evaluate whether a PIK dividend must be separated as an embedded derivative under ASC 815-15. Generally, PIK dividends will be considered clearly and closely related to the host equity instrument and therefore do not have to be bifurcated. However, if the PIK dividends are indexed to an underlying that differs from the economic characteristics and risks of a preferred security, bifurcation of the dividend feature would generally be required under ASC 815-15.

For discussion of the EPS implications of PIK dividends, see Section 3.2.2.2.3 of Deloitte’s Roadmap Earnings per Share.

Connecting the Dots

In January 2025, the FASB added a project to the EITF’s agenda to address an issuer’s measurement of PIK dividends. Entities should be aware that if a final ASU is issued on this topic, it may change the approach discussed above for measuring such dividends.

10.3.4.3.2 Dividends on Preferred Stock Paid in Shares of Common Stock

In accordance with ASC 260-10-45-12, when an entity pays dividends on preferred stock in shares of common stock, the dividends must be measured in a manner consistent with the treatment of common stock issued for goods or services (i.e., the fair value of the common shares issued). For additional discussion, see Section 3.2.2.2.4 of Deloitte’s Roadmap Earnings per Share.

10.3.4.3.3 Redeemable Securities Classified in Temporary Equity

Some preferred stock instruments contain redemption features that require the entity to classify the instruments in temporary equity under the SEC staff’s guidance on redeemable securities in ASC 480-10-S99-3A. Other equity instruments (e.g., common stock or noncontrolling interests) may similarly require classification outside of permanent equity.

Under the guidance in ASC 480-10-S99-3A, SEC registrants must subsequently remeasure redeemable securities to their redemption amount if such securities are currently redeemable or it is probable that they will become redeemable. These remeasurement adjustments, which increase the carrying amount of the instrument, are treated as dividends. Further, ASC 480-10-S99-3A(14) states, in part, that “[t]he redemption amount at each balance sheet date should also include amounts representing dividends not currently declared or paid but which will be payable under the redemption features or for which ultimate payment is not solely within the control of the registrant (for example, dividends that will be payable out of future earnings).” Therefore, the redemption amount includes both the stated redemption price and any dividends that must be paid upon redemption. For more information about the remeasurement of equity securities under ASC 480-10-S99-3A, see Section 9.5.

10.3.4.3.4 Increasing-Rate Preferred Stock

SEC Staff Accounting Bulletins

SAB Topic 5.Q, Increasing Rate Preferred Stock [Reproduced in ASC 505-10-S99-7]

Facts: A registrant issues Class A and Class B nonredeemable preferred stock15 on 1/1/X1. Class A, by its terms, will pay no dividends during the years 20X1 through 20X3. Class B, by its terms, will pay dividends at annual rates of $2, $4 and $6 per share in the years 20X1, 20X2 and 20X3, respectively. Beginning in the year 20X4 and thereafter as long as they remain outstanding, each instrument will pay dividends at an annual rate of $8 per share. In all periods, the scheduled dividends are cumulative.

At the time of issuance, eight percent per annum was considered to be a market rate for dividend yield on Class A, given its characteristics other than scheduled cash dividend entitlements (voting rights, liquidation preference, etc.), as well as the registrant’s financial condition and future economic prospects. Thus, the registrant could have expected to receive proceeds of approximately $100 per share for Class A if the dividend rate of $8 per share (the “perpetual dividend”) had been in effect at date of issuance. In consideration of the dividend payment terms, however, Class A was issued for proceeds of $79 3/8 per share. The difference, $20 5/8, approximated the value of the absence of $8 per share dividends annually for three years, discounted at 8%.

The issuance price of Class B shares was determined by a similar approach, based on the terms and characteristics of the Class B shares.

Question 1: How should preferred stocks of this general type (referred to as “increasing rate preferred stocks”) be reported in the balance sheet?

Interpretive Response: As is normally the case with other types of securities, increasing rate preferred stock should be recorded initially at its fair value on date of issuance. Thereafter, the carrying amount should be increased periodically as discussed in the Interpretive Response to Question 2.

Question 2: Is it acceptable to recognize the dividend costs of increasing rate preferred stocks according to their stated dividend schedules?

Interpretive Response: No. The staff believes that when consideration received for preferred stocks reflects expectations of future dividend streams, as is normally the case with cumulative preferred stocks, any discount due to an absence of dividends (as with Class A) or gradually increasing dividends (as with Class B) for an initial period represents prepaid, unstated dividend cost.16 Recognizing the dividend cost of these instruments according to their stated dividend schedules would report Class A as being cost-free, and would report the cost of Class B at less than its effective cost, from the standpoint of common stock interests (i.e., for purposes of computing income applicable to common stock and earnings per common share) during the years 20X1 through 20X3.

Accordingly, the staff believes that discounts on increasing rate preferred stock should be amortized over the period(s) preceding commencement of the perpetual dividend, by charging imputed dividend cost against retained earnings and increasing the carrying amount of the preferred stock by a corresponding amount. The discount at time of issuance should be computed as the present value of the difference between (a) dividends that will be payable, if any, in the period(s) preceding commencement of the perpetual dividend; and (b) the perpetual dividend amount for a corresponding number of periods; discounted at a market rate for dividend yield on preferred stocks that are comparable (other than with respect to dividend payment schedules) from an investment standpoint. The amortization in each period should be the amount which, together with any stated dividend for the period (ignoring fluctuations in stated dividend amounts that might result from variable rates,17 results in a constant rate of effective cost vis-a-vis the carrying amount of the preferred stock (the market rate that was used to compute the discount).

Simplified (ignoring quarterly calculations) application of this accounting to the Class A preferred stock described in the “Facts” section of this bulletin would produce the following results on a per share basis:

During 20X4 and thereafter, the stated dividend of $8 measured against the carrying amount of $10018 would reflect dividend cost of 8%, the market rate at time of issuance.

The staff believes that existing authoritative literature, while not explicitly addressing increasing rate preferred stocks, implicitly calls for the accounting described in this bulletin.

The pervasive, fundamental principle of accrual accounting would, in the staff’s view, preclude registrants from recognizing the dividend cost on the basis of whatever cash payment schedule might be arranged. Furthermore, recognition of the effective cost of unstated rights and privileges is well-established in accounting, and is specifically called for by FASB ASC Subtopic 835-30, Interest — Imputation of Interest, and Topic 3.C of this codification for unstated interest costs of debt capital and unstated dividend costs of redeemable preferred stock capital, respectively. The staff believes that the requirement to recognize the effective periodic cost of capital applies also to nonredeemable preferred stocks because, for that purpose, the distinction between debt capital and preferred equity capital (whether redeemable19 or nonredeemable) is irrelevant from the standpoint of common stock interests.

Question 3: Would the accounting for discounts on increasing rate preferred stock be affected by variable stated dividend rates?

Interpretive Response: No. If stated dividends on an increasing rate preferred stock are variable, computations of initial discount and subsequent amortization should be based on the value of the applicable index at date of issuance and should not be affected by subsequent changes in the index.

For example, assume that a preferred stock issued 1/1/X1 is scheduled to pay dividends at annual rates, applied to the stock’s par value, equal to 20% of the actual (fluctuating) market yield on a particular Treasury security in 20X1 and 20X2, and 90% of the fluctuating market yield in 20X3 and thereafter. The discount would be computed as the present value of a two-year dividend stream equal to 70% (90% less 20%) of the 1/1/X1 Treasury security yield, annually, on the stock’s par value. The discount would be amortized in years 20X1 and 20X2 so that, together with 20% of the 1/1/X1 Treasury yield on the stock’s par value, a constant rate of cost vis-a-vis the stock's carrying amount would result. Changes in the Treasury security yield during 20X1 and 20X2 would, of course, cause the rate of total reported preferred dividend cost (amortization of discount plus cash dividends) in those years to be more or less than the rate indicated by discount amortization plus 20% of the 1/1/X1 Treasury security yield. However, the fluctuations would be due solely to the impact of changes in the index on the stated dividends for those periods.

______________________________

15 “Nonredeemable” preferred stock, as used in this SAB, refers to preferred stocks which are not redeemable or are redeemable only at the option of the issuer.

16 As described in the “Facts” section of this issue, a registrant would receive less in proceeds for a preferred stock, if the stock were to pay less than its perpetual dividend for some initial period(s), than if it were to pay the perpetual dividend from date of issuance. The staff views the discount on increasing rate preferred stock as equivalent to a prepayment of dividends by the issuer, as though the issuer had concurrently (a) issued the stock with the perpetual dividend being payable from date of issuance, and (b) returned to the investor a portion of the proceeds representing the present value of certain future dividend entitlements which the investor agreed to forgo.

17 See Question 3 regarding variable increasing rate preferred stocks.

18 It should be noted that the $100 per share amount used in this issue is for illustrative purposes, and is not intended to imply that application of this issue will necessarily result in the carrying amount of a nonredeemable preferred stock being accreted to its par value, stated value, voluntary redemption value or involuntary liquidation value.

19 Application of the interest method with respect to redeemable preferred stocks pursuant to Topic 3.C results in accounting consistent with the provisions of this bulletin irrespective of whether the redeemable preferred stocks have constant or increasing stated dividend rates. The interest method, as described in FASB ASC Subtopic 835-30, produces a constant effective periodic rate of cost that is comprised of amortization of discount as well as the stated cost in each period.

SAB Topic 5.Q addresses the accounting by an SEC registrant that issues nonredeemable preferred stock with dividend payment rates in earlier periods at an amount lower than the stated fixed dividend rate that applies after the initial dividend rate period ends. Economically, a registrant can expect such stock to be issued at a discount to the proceeds that the issuer would have received had the dividend rate in the initial period been equal to the higher dividend rate that applies after the end of the initial period. In accordance with SAB Topic 5.Q, the registrant must amortize the discount on the increasing-rate preferred stock (representing the lower dividend rate in the earlier periods) over the period(s) preceding commencement of the stated higher fixed dividend rate by charging dividend cost against retained earnings (i.e., a deemed dividend) and increasing the carrying amount of the preferred stock (within equity) by a corresponding amount. The amortization of the discount is determined in a manner consistent with the interest method (i.e., the entity must use the interest method to recognize dividends on increasing-rate preferred stock).

Although SAB Topic 5.Q specifically discusses preferred stock issued at a discount to its liquidation preference, with stated dividends that increase over time, the guidance also applies to (1) preferred stock issued at its liquidation preference that contains a stated dividend rate that increases over time and (2) both redeemable and nonredeemable preferred stock. Since SAB Topic 5.Q merely interprets the scope of the interest method, it should also be applied by entities that are not SEC registrants.

Connecting the Dots

An issuer cannot avoid applying the SEC’s guidance on increasing-rate preferred stock on the basis that the holder may convert a preferred stock instrument into the issuer’s common shares before the stated dividend rate increases. The issuer does not control the ability to require the instrument to be converted into common stock and therefore does not have the unilateral ability to avoid an increase in the dividend rate. The same conclusion applies to a convertible preferred stock instrument that is mandatorily convertible into the issuer’s common shares if the issuer’s stock price increases to a stated amount per share.

An entity must analyze the specific terms of preferred stock to determine whether an instrument is considered increasing-rate preferred stock and is therefore subject to SAB Topic 5.Q. For additional discussion of whether a preferred stock instrument is within the scope of this guidance as well as recognition, measurement, and EPS considerations, see Section 3.2.2.3 of Deloitte’s Roadmap Earnings per Share.

10.3.4.3.5 Modifications or Exchanges

An entity may amend the terms of an equity instrument or achieve the same economic result by exchanging equity instruments. In such situations, the entity must determine the appropriate accounting for the modification or exchange. The table below notes situations in which an entity must recognize a dividend for a modification or exchange of an equity instrument. It is assumed in the table that the instrument was classified in equity before and after the modification.

Table 10-5

Type of Instrument Modified or Exchanged	When Recognition of a Dividend Is Required
Common stock	An entity recognizes a dividend for a modification or exchange involving common stock if both of the following conditions are met: The modification or exchange results in the transfer of additional fair value to the holder(s). The entity is not required to account for the additional fair value transferred as an expense or in accordance with other applicable literature. An entity generally does not account for any reduction in the fair value of a common stock instrument as a result of the modification or exchange. For more information about the accounting for a modification or exchange of common stock, see Section 10.6.1. For information about the EPS implications of a modification or exchange of common stock, see Section 3.2.6.2 of Deloitte’s Roadmap Earnings per Share.
Preferred stock	An entity recognizes a dividend for a modification or exchange involving preferred stock in either of the following situations: The modification or exchange is accounted for as an extinguishment of the original preferred stock instrument — If the consideration transferred for the redemption (1) represents the fair value of the preferred stock on the redemption date and (2) exceeds the net carrying amount of the preferred stock, the entity recognizes a dividend for the excess of the consideration transferred over the net carrying amount of the preferred stock in accordance with ASC 260-10-S99-1. The modification or exchange is not accounted for as an extinguishment of the original preferred stock instrument — If the modification or exchange results in an increase in the fair value of the instrument and the entity is not required to account for the increase as an expense or in accordance with other applicable literature, the entity recognizes a dividend for such increase. An entity recognizes a “deemed contribution” only if the modification or exchange is accounted for as an extinguishment of the original preferred stock instrument and the consideration transferred for the redemption is less than the net carrying amount of the preferred stock instrument that is redeemed. See ASC 260-10-S99-1. For more information about the accounting for a modification or exchange of preferred stock, see Section 10.6.2. For information about the EPS implications of a modification or exchange of preferred stock, see Section 3.2.6.1 of Deloitte’s Roadmap Earnings per Share.
Freestanding equity-classified contract on an entity’s common stock	The accounting for a modification or exchange of a freestanding equity-classified contract on an entity’s common stock is the same as the accounting for a modification or exchange of common stock. For more information about modifications or exchanges of freestanding equity-classified contracts on an entity’s common stock, see Section 10.6.3.1 as well as Section 6.1.4.1 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity. For more information about the EPS implications of a modification or exchange of a freestanding equity-classified contract on an entity’s common stock, see Section 3.2.6.4 of Deloitte’s Roadmap Earnings per Share.
Freestanding equity-classified contract on an entity’s preferred stock	The accounting for a modification or exchange of a freestanding equity-classified contract on an entity’s preferred stock is the same as the accounting for a modification or exchange of a preferred stock instrument. For more information about modifications or exchanges of freestanding equity-classified contracts on an entity’s preferred stock, see Section 10.6.3.2. For more information about the EPS implications of a modification or exchange of a freestanding equity-classified contract on an entity’s preferred stock, see Section 3.2.6.4 of Deloitte’s Roadmap Earnings per Share.

10.3.4.3.6 Down-Round Features

ASC 260-10

General

05-1A An entity may issue a freestanding financial instrument (for example, a warrant) with a down round feature that is classified in equity. This Subtopic provides guidance on earnings per share and recognition and measurement of the effect of a down round feature when it is triggered.

Financial Instruments That Include a Down Round Feature

25-1 An entity that presents earnings per share (EPS) in accordance with this Topic shall recognize the value of the effect of a down round feature in an equity-classified freestanding financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) when the down round feature is triggered. That effect shall be treated as a dividend and as a reduction of income available to common stockholders in basic earnings per share, in accordance with the guidance in paragraph 260-10-45-12B. See paragraphs 260-10-55-95 through 55-97 for an illustration of this guidance.

Financial Instruments That Include a Down Round Feature

30-1 As of the date that a down round feature is triggered (that is, upon the occurrence of the triggering event that results in a reduction of the strike price) in an equity-classified freestanding financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance), an entity shall measure the value of the effect of the feature as the difference between the following amounts determined immediately after the down round feature is triggered:

The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the currently stated strike price of the issued instrument (that is, before the strike price reduction)
The fair value of the financial instrument (without the down round feature) with a strike price corresponding to the reduced strike price upon the down round feature being triggered.

30-2 The fair values of the financial instruments in paragraph 260-10-30-1 shall be measured in accordance with the guidance in Topic 820 on fair value measurement. See paragraph 260-10-45-12B for related earnings per share guidance and paragraphs 505-10-50-3 through 50-3A for related disclosure guidance.

Financial Instruments That Include a Down Round Feature

35-1 An entity shall recognize the value of the effect of a down round feature in an equity-classified freestanding financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) each time it is triggered but shall not otherwise subsequently remeasure the value of a down round feature that it has recognized and measured in accordance with paragraphs 260-10-25-1 and 260-10-30-1 through 30-2. An entity shall not subsequently amortize the amount in additional paid-in capital arising from recognizing the value of the effect of the down round feature.

Freestanding Equity-Classified Financial Instrument With a Down Round Feature

45-12B For a freestanding equity-classified financial instrument and an equity-classified convertible preferred stock (if the conversion feature has not been bifurcated in accordance with other guidance) with a down round feature, an entity shall deduct the value of the effect of a down round feature (as recognized in accordance with paragraph 260-10-25-1 and measured in accordance with paragraphs 260-10-30-1 through 30-2) in computing income available to common stockholders when that feature has been triggered (that is, upon the occurrence of the triggering event that results in a reduction of the strike price).

Special recognition and measurement requirements apply each time a down-round feature in a freestanding equity-classified instrument is triggered (i.e., an entity sells shares of its stock for an amount less than the currently stated strike price or issues an equity-linked financial instrument with a strike price below the currently stated strike price).7 These requirements also apply to equity-classified convertible preferred stock but not to convertible debt instruments. An entity that does not present EPS is not required to apply the guidance unless it voluntarily discloses EPS in its financial statements.

When the strike price of an equity-classified instrument is reduced in accordance with the terms of a down-round feature, an entity is required to determine the amount of value that was transferred to the holder through the strike price adjustment. To calculate this amount, the entity compares the fair values of two hypothetical instruments whose terms are consistent with the actual instrument except that the instruments do not contain a down-round feature. The strike price of the first hypothetical instrument equals the strike price of the actual instrument immediately before the strike price reduction. The strike price of the second hypothetical instrument equals the strike price immediately after the down-round feature is triggered. The value transferred is the difference between the fair values of the two hypothetical instruments. The entity determines those fair values on the basis of the conditions immediately after the down-round feature is triggered by using the fair value measurement guidance in ASC 820.

Further, the entity recognizes the value transferred as a reduction of retained earnings and as an increase in APIC (i.e., as a deemed dividend). The amount of the charge to retained earnings is reflected as a reduction to income available to common stockholders in the basic EPS calculation. For a discussion of disclosures related to down-round features, see Section 10.10.3.10.

10.3.4.3.7 Redemptions

ASC 260-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: The Effect on the Calculation of Earnings per Share for a Period That Includes the Redemption or Induced Conversion of Preferred Stock . . .

S99-2 . . .

The Effect on Income Available to Common Stockholders of a Redemption or Induced Conversion of Preferred Stock

If convertible preferred stock is converted into other securities issued by the registrant pursuant to an inducement offer, the SEC staff believes that the excess of (1) the fair value of all securities and other consideration transferred in the transaction by the registrant to the holders of the convertible preferred stock over (2) the fair value of securities issuable pursuant to the original conversion terms should be subtracted from net income to arrive at income available to common stockholders in the calculation of earnings per share. Registrants should consider the guidance provided in Subtopic 470-20 to determine whether the conversion of preferred stock is pursuant to an inducement offer.

If an SEC registrant redeems a preferred security, the difference between (1) the fair value of the consideration transferred and (2) the carrying amount of the preferred security (net of issuance costs) is subtracted from (or added to) net income to arrive at income available to common stockholders in the calculation of EPS (see Section 10.5.1). This accounting applies even if the consideration transferred to redeem a preferred stock instrument is common stock or another class of equity instrument (see Section 10.6.2.2) provided that the amount of consideration transferred to redeem the preferred security equals the fair value of the security on the redemption date.

When the following conditions are met, an entity would also be required to recognize a dividend upon the redemption of common stock or an equity-classified derivative indexed to common stock:

The fair value of the consideration transferred to redeem the instrument exceeds the fair value of the instrument that is redeemed.
The redemption offer is made to all holders of the class of instrument subject to redemption.8

10.3.4.3.8 Inducements and Other Conversions

ASC 260-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: The Effect on the Calculation of Earnings per Share for a Period That Includes the Redemption or Induced Conversion of Preferred Stock . . .

S99-2 . . .

The Effect on Income Available to Common Stockholders of a Redemption or Induced Conversion of Preferred Stock

While ASC 260-10 addresses an SEC registrant’s accounting for an induced conversion of preferred stock, it does not provide guidance on when an induced conversion of preferred stock has occurred. To determine whether a conversion of preferred stock represents an induced conversion, an entity applies the guidance in ASC 470-20 (see Section 12.3.4 of Deloitte’s Roadmap Issuer’s Accounting for Debt). In addition, in certain situations, an entity is required to recognize a deemed dividend upon conversion of a preferred stock instrument into common shares in accordance with the original conversion privileges (see Section 10.7.2).

There is no specific guidance in U.S. GAAP on an issuer’s accounting for inducements made in conjunction with the settlement of an equity-classified derivative indexed to an entity’s common stock (e.g., an option or warrant). However, the accounting for such transactions is consistent with that for induced conversions of preferred securities and modifications and exchanges of freestanding equity-classified contracts on an entity’s common stock. Therefore, the incremental value transferred to induce early settlement of these instruments should be recognized as a dividend or an expense (see Section 10.3.2).

10.3.4.3.9 Rights Issues

ASC 260-10

Rights Issues

55-13 A rights issue whose exercise price at issuance is less than the fair value of the stock contains a bonus element that is somewhat similar to a stock dividend. If a rights issue contains a bonus element and the rights issue is offered to all existing stockholders, basic and diluted EPS shall be adjusted retroactively for the bonus element for all periods presented. If the ability to exercise the rights issue is contingent on some event other than the passage of time, the provisions of this paragraph shall not be applicable until that contingency is resolved.

55-14 The number of common shares used in computing basic and diluted EPS for all periods prior to the rights issue shall be the number of common shares outstanding immediately prior to the issue multiplied by the following factor: (fair value per share immediately prior to the exercise of the rights)/(theoretical ex-rights fair value per share). Theoretical ex-rights fair value per share shall be computed by adding the aggregate fair value of the shares immediately prior to the exercise of the rights to the proceeds expected from the exercise of the rights and dividing by the number of shares outstanding after the exercise of the rights. Example 5 (see paragraph 260-10-55-60) illustrates that provision. If the rights themselves are to be publicly traded separately from the shares prior to the exercise date, fair value for the purposes of this computation shall be established at the close of the last day on which the shares are traded together with the rights.

A rights issue represents an offer to existing common stockholders to purchase additional common shares for a specified amount for a given period. The purchase price is generally less than the fair value of the entity’s common stock. An entity may have a rights issue for various reasons, such as raising additional capital or preventing a takeover. Further, a rights issue:

Is effectively a dividend to existing common stockholders that allows them to subscribe to purchase additional shares of common stock.
Offsets dilution to an entity’s existing shareholders and may be favorable to entities for income tax reasons and because stock exchanges may not require the entity’s common shareholders to approve certain rights issuances.
May be executed through an underwriting by a broker-dealer.

A rights issue that contains a bonus element must be accounted for in the same manner as a stock dividend (i.e., fair value of the bonus element). For more information about the EPS accounting for a rights issue, see Section 8.2.2 of Deloitte’s Roadmap Earnings per Share.

10.3.4.3.10 Distributions of Nonmonetary Assets

ASC 845-10

Basic Principle

30-1 In general, the accounting for nonmonetary transactions should be based on the fair values of the assets (or services) involved, which is the same basis as that used in monetary transactions. . . . A transfer of a nonmonetary asset to a stockholder or to another entity in a nonreciprocal transfer shall be recorded at the fair value of the asset transferred and a gain or loss shall be recognized on the disposition of the asset.

Nonreciprocal Transfers With Owners

If an entity distributes nonmonetary assets to its shareholders (e.g., real estate or equity investments), the amount of the distribution is measured on the basis of the fair value of the assets distributed unless an exception applies. The distribution is measured on the basis of the recorded amounts (subject to impairment) if it is a pro rata distribution of shares of a consolidated subsidiary or an equity method investment that qualifies as a business. Such measurement also applies to distributions of nonmonetary assets in the context of spinoff transactions, reorganizations, liquidations, or plans to rescind a previous business combination.

10.3.4.4 Capital Accounts Used to Recognize Dividends or Other Distributions

10.3.4.4.1 General

Except for returns of capital (see Section 10.3.4.4.3), dividends are recognized with a debit to retained earnings. However, if the entity’s retained earnings are insufficient to cover the full amount of a dividend, special considerations are required.

If an entity has an accumulated deficit or would create an accumulated deficit by recognizing a dividend, it should first look to the state law of the jurisdiction in which it is incorporated to determine the appropriate equity account from which to charge a dividend. The state law may specify the equity account from which distributions to stockholders can be made (e.g., surplus, net profits for the fiscal year [or preceding fiscal year] in which the dividend is paid, or capital surplus). The entity should also review the terms of its bylaws, charter, or articles of incorporation for potentially applicable guidance.

If (1) the relevant state law or the entity's bylaws, charter, or articles of incorporation do not specifically address the equity account from which distributions to stockholders can be made and (2) the dividend is not recognized as a result of a remeasurement of a redeemable security under the SEC’s guidance on temporary equity, the entity should elect, and consistently apply and appropriately disclose, an accounting policy related to the capital account used to recognize dividends when the entity’s retained earnings are not sufficient to cover the dividends.9 Some entities analogize to the SEC’s guidance on temporary equity, which indicates that dividends in excess of retained earnings should be charged to APIC. Other entities record such dividends as an increase to accumulated deficit.

As noted above, the entity’s accounting policy election does not apply to equity securities that are classified in temporary equity. Dividends and any redemption-value measurement adjustments related to equity securities within the scope of the SEC’s guidance on temporary equity should be recognized as a reduction of APIC until APIC is reduced to zero. Once APIC is reduced to zero, the dividends should be recognized as an increase in accumulated deficit. This approach is consistent with ASC 480-10-S99-3A(20) and (21), which state, in part, that the “resulting increases or decreases in the carrying amount of a redeemable instrument . . . 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.”

Example 10-8

Dividends Recognized as an Increase in Accumulated Deficit

Entity H has an accumulated deficit of $75 million because of a significant goodwill impairment loss recorded in a prior period. The state in which H is incorporated allows a corporation’s board of directors, subject to any restriction in the corporation’s charter, to declare dividends out of the corporation’s surplus (i.e., retained earnings) or, if there is no surplus, the net profits of the corporation for the fiscal year in which the dividend is declared (or the preceding fiscal year) unless the capital of the corporation would become impaired (as defined statutorily). Distributions from the capital surplus (i.e., APIC) are allowed by the state in which H is incorporated only if the corporation’s stockholders approve the distribution, subject to any other restriction in the corporation’s charter.

In fiscal 20X1, H generated net income of $10 million. On December 31, 20X1, H’s board of directors declared $5 million of dividends to holders of its nonredeemable common stock. On the basis of state law, these dividends are considered to have come from H’s net income during the fiscal year and do not result in impairment of H’s capital. Therefore, H determined that it was appropriate to reflect the dividends as an increase in accumulated deficit since the dividends are not considered liquidating dividends under state law.

Example 10-9

Dividends Recognized as a Reduction of APIC

Entity J has an accumulated deficit as a result of the disposition of a material business segment that generated a significant loss. The state in which J is incorporated allows a corporation’s board of directors, subject to any restriction in the corporation’s charter, to make any distribution it has authorized if, after the distribution, the corporation would not be insolvent (as defined statutorily). Entity J’s charter does not require stockholder approval for any distribution authorized by its board of directors.

In fiscal 20X1, J’s board of directors declared dividends to the holders of its nonredeemable common stock in an aggregate amount equal to the net proceeds received upon the disposition of the business segment. Entity J has a policy to account for dividends paid when there is an accumulated deficit position as a reduction of APIC (unless APIC is zero). Given that (1) neither state law nor J’s charter addresses the account from which distributions to stockholders may be declared and (2) J's policy is to record the dividend as a reduction of APIC (and assuming that APIC is not zero), J would recognize these dividends as a reduction of APIC.

10.3.4.4.2 Dividends on Preferred Stock Issued by a Consolidated Subsidiary

There is no specific guidance in U.S. GAAP on whether, in the consolidated financial statements, dividends on a subsidiary’s preferred stock should be treated as an attribution of the subsidiary’s income to the noncontrolling interest or as a direct adjustment to retained earnings. As a result, either approach is acceptable as an accounting policy. For more information, see Section 6.8 of Deloitte’s Roadmap Noncontrolling Interests.

10.3.4.4.3 Liquidating Dividends and Other Returns of Capital

Nonauthoritative AICPA Guidance

Technical Q&As Section 4210, “Dividends”

.01 Write-Off of Liquidating Dividends

Inquiry — Quite a few years ago, cash dividends were distributed to stockholders in excess of earnings. The company would now like to “clean up” the stockholders’ equity section of the balance sheet by removing the account “Prior Years’ Liquidation Dividends” which is shown as a reduction of the capital stock account. Can the liquidating dividends account be written off against “retained earnings” or “paid in capital in excess of par value”?

Reply — Essentially, this question is a legal one as to whether cash distribution to stockholders in excess of earnings in prior years may be charged to earnings in subsequent years. When liquidating dividends are declared, the charge is made to accounts such as “capital repayment,” “capital returned,” or “liquidating dividends” which appear on the balance sheet as offsets to paid-in capital. By this treatment, the amount of capital returned as well as the amount of capital originally paid in can be disclosed. Perhaps the wisest thing to do under the circumstances is to consult legal counsel to determine whether the write-off proposed is legal under the corporate statutes of the state. Perhaps it is legally permissible, under the laws of incorporation, to reduce the par or stated value of the corporation’s stock, thereby creating a reduction surplus which may then be used retroactively to absorb the original deficit, on the ground that the excess payments were dividends in partial liquidation.

If an entity makes a distribution that represents a return of capital, it may present such amount separately as a contra account within APIC by using an appropriate description (e.g., liquidating dividends or capital returned). In a subsequent period, the entity may desire to write off amounts recorded as a contra-equity account for liquidating dividends against APIC or retained earnings. Similarly, an entity that has applied an accounting policy of charging dividends against APIC in the absence of retained earnings (see Section 10.3.4.4.1) may wish to remove the charges to APIC against the retained earnings of subsequent periods. Before performing any such reclassification, the entity should consider whether the state law of the jurisdiction in which the entity is incorporated, or the terms of its bylaws, charter, or articles of incorporation, prescribe a particular treatment. If the relevant state law or the entity’s bylaws, charter, or articles of incorporation do not address the question, the entity should elect and consistently apply an appropriate accounting policy. Note, however, that an SEC registrant is not permitted to write off an accumulated deficit against its capital accounts unless the conditions for a quasi-reorganization are met (see Section 10.9).

10.3.4.4.4 Issuance of a New Class of Stock to Existing Equity Holders

ASC 505-20-15-3 states, in part, that the guidance in ASC 505-20 “does not apply to the accounting for a distribution or issuance to shareholders of . . . [s]hares of a different class.” Nevertheless, for these transactions, it is generally appropriate to analogize to the accounting guidance in ASC 505-20 for stock dividends. Generally, the distribution to holders of a different class of shares would not qualify as a stock split.

Example 10-10

Issuance of a New Class of Stock to Common Shareholders

Entity K is a wholly owned subsidiary of Entity L. Entity K has 100 shares of Class A $1 par value common stock issued and outstanding and has retained earnings of $2,000. Entity K modifies its capital structure by issuing 100 shares of a new class of stock (Class B common stock) that has dividend rights and liquidation preference and a stated par value of $0.50. The stock is issued for no proceeds. All the Class B common stock is issued to the parent. Simultaneously with the issuance, the par value of the original Class A common stock is reduced to $0.50.

For these types of transactions, entities may generally analogize to the accounting guidance for stock dividends, which generally requires the dividend to be accounted for as a transfer between earnings surplus (retained earnings) and a category of permanent capitalization (capital stock or APIC) on the basis of the fair value of the shares issued. However, with respect to closely held companies, ASC 505-20-30-5 states that “there is no need to capitalize retained earnings other than to meet legal requirements.” Therefore, since the parent company (L) owns 100 percent of the common stock of the subsidiary (K), when K issues a stock dividend, L is not required to capitalize earned surplus other than to meet legal requirements.

10.3.4.4.5 Free Distributions by Japanese Companies

SEC Staff Accounting Bulletins

SAB Topic 1.D.2, “Free Distributions” by Japanese Companies [Reproduced in ASC 505-20-S99-1]

Facts: It is the general practice in Japan for corporations to issue “free distributions” of common stock to existing shareholders in conjunction with offerings of common stock so that such offerings may be made at less than market. These free distributions usually are from 5 to 10 percent of outstanding stock and are accounted for in accordance with provisions of the Commercial Code of Japan by a transfer of the par value of the stock distributed from paid-in capital to the common stock account. Similar distributions are sometimes made at times other than when offering new stock and are also designated “free distributions.” U.S. accounting practice would require that the fair value of such shares, if issued by U.S. companies, be transferred from retained earnings to the appropriate capital accounts.

Question: Should the financial statements of Japanese corporations included in Commission filings which are stated to be prepared in accordance with U.S. GAAP be adjusted to account for stock distributions of less than 25 percent of outstanding stock by transferring the fair value of such stock from retained earnings to appropriate capital accounts?

Interpretive Response: If registrants and their independent accountants believe that the institutional and economic environment in Japan with respect to the registrant is sufficiently different that U.S. accounting principles for stock dividends should not apply to free distributions, the staff will not object to such distributions being accounted for at par value in accordance with Japanese practice. If such financial statements are identified as being prepared in accordance with U.S. GAAP, then there should be footnote disclosure of the method being used which indicates that U.S. companies issuing shares in comparable amounts would be required to account for them as stock dividends, and including in such disclosure the fair value of any such shares issued during the year and the cumulative amount (either in an aggregate figure or a listing of the amounts by year) of the fair value of shares issued over time.

The SEC staff does not object to the accounting for certain free distributions of common stock to existing shareholders at par value (instead of fair value) when such accounting treatment is in accordance with Japanese practice and the registrant and its independent accountants conclude that the institutional and economic environment in Japan is sufficiently different from that in the United States. If a Japanese company elects this accounting treatment, it must disclose the method used, the fact that the method differs from the accounting treatment required for U.S. companies for stock dividends, and, in accordance with SAB Topic 1.D.2, “the fair value of any such shares issued during the year and the cumulative amount (either in an aggregate figure or a listing of the amounts by year) of the fair value of shares issued over time.”

10.3.4.5 EPS Considerations

Entities that present EPS must evaluate the impact that dividends have on the numerator in the calculation of basic EPS. Further, entities must determine whether equity instruments represent participating securities or a separate class of stock that they are required to account for under the two-class method of calculating EPS.10 For more information about the impact that dividends have on the calculation of EPS, see Section 8.4 and Chapter 9 as well as Deloitte’s Roadmap Earnings per Share).

Footnotes

An entity that transfers value to a holder of an equity instrument should first evaluate whether the transfer is reciprocal or nonreciprocal. If the entity receives something of value in return for the transfer and the accounting for the consideration received is specified by other applicable literature, the transaction is reciprocal in nature; therefore, the entity recognizes the consideration received in accordance with other applicable literature on the same basis as if the entity received cash. If, however, either (1) the entity does not receive commensurate value in return for the transfer (i.e., the transaction is nonreciprocal) or (2) the value received is not something that can be recognized in accordance with other authoritative literature, the value transferred as part of the transaction with the equity holder must be expensed as incurred.

If the preferred stock is convertible into other equity shares, there is a proportionate increase in the number of such shares that will be issued upon exercise of the conversion feature.

See Section 4.3.7.2 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity for a discussion of the definition of a down-round feature.

If the offer was made only to certain holders of the class of instrument being redeemed, an entity is required to account for the excess of the fair value transferred over the fair value of the instrument separately in accordance with other applicable literature (see also Section 10.3.2).

The election of an accounting policy is appropriate because the accounting for dividends in excess of retained earnings is not specifically addressed in U.S. GAAP.

If an equity instrument is a participating security or a separate class of stock, undeclared dividends also affect the calculation of EPS even though such dividends are not recognized in the financial statements.

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.