8.4 Earnings per Share

ASC 480 does not comprehensively address how to determine EPS for instruments within its scope. Instead, an entity applies ASC 260 except as specified in ASC 480-10-45-4, which requires the entity to make certain adjustments to the EPS calculation performed under ASC 260 for (1) mandatorily redeemable financial instruments and (2) forward contracts that require physical settlement by repurchase of a fixed number of equity shares of common stock in exchange for cash (see Section 8.4.1). For other contracts within the scope of ASC 480, an entity applies ASC 260, including to other forward contracts and written put options on common stock (see Section 8.4.2) and share-settled debt (see Section 8.4.3). Special considerations are necessary for contracts that may be settled in stock or cash. For a detailed discussion of the computation of EPS, see Deloitte’s Roadmap Earnings per Share.

8.4.1 Mandatorily Redeemable Financial Instruments and Physically Settled Forward Contracts to Repurchase Common Stock

ASC 480-10

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 480-10-45-4 requires an entity to make the following adjustments to the EPS calculation for (1) mandatorily redeemable financial instruments and (2) forward contracts that require physical settlement by repurchase of a fixed number of equity shares of common stock in exchange for cash:

Numerator (i.e., the amount of income available to common stockholders) — The entity uses the two-class method to adjust the numerator for any amounts attributable to such shares that have not been accounted for as interest cost. Under the two-class method, the entity reduces the numerator for the amount of undistributed earnings that are allocable to the shares subject to repurchase.
Denominator (i.e., the number of shares outstanding) — In calculating basic and diluted EPS, the entity excludes from the denominator shares of common stock that will be repurchased (i.e., it treats those shares as retired).

Connecting the Dots

Questions often arise related to whether it is appropriate to reduce the denominator in the calculation of basic EPS when an entity has a forward contract to repurchase a variable number of shares that must be physically settled. Although the EPS guidance in ASC 480-10-45-4 refers to contracts in which a fixed number of shares must be physically settled, it is generally appropriate to reduce the denominator by the minimum number of shares of common stock that will be repurchased, but only if the contract specifies a contractual minimum. In these circumstances, the entity should apply a method akin to the two-class method for the number of shares removed from the denominator if those shares are entitled to dividends during the period of the forward contract and the holder is not obligated to return those dividends to the entity.

According to ASC 260-10-45-60 and ASC 260-10-45-60B, the two-class method is an earnings-allocation formula under which:

Net income is “reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends . . . that must be paid for the current period (for example, unpaid cumulative dividends).”
The “remaining earnings [are] 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 [are] divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.”

While the outstanding common shares are excluded from the denominator in the calculations of EPS, if the counterparty that owns the common shares has a contractual right to participate in dividends declared by the entity before the common shares are retired, the entity must treat the excluded common shares as participating securities under ASC 260. This is the case even if the issuing entity does not regularly declare or pay dividends. Under the two-class method, an entity adjusts the numerator for any dividends declared or paid and undistributed earnings, but only to the extent that these amounts have not been accounted for as interest cost.

Because ASC 480-10-45-3 requires entities to reflect in interest cost “[a]ny amounts paid or to be paid to holders of [forward purchase] contracts . . . in excess of the initial measurement amount,” the numerator is not adjusted for such amounts under the two-class method. For example, accrued cumulative dividends should be recognized as interest cost, even if they are not declared, as long as the holder is entitled to such dividends during the life of the contract or at settlement. Generally, therefore, no distributed earnings will be allocated to these participating securities because the dividends will have been recognized in earnings as interest cost; reflecting the distributed earnings under the two-class method would result in “double-counting” the impact on EPS. However, undistributed earnings must be allocated to these participating securities in accordance with ASC 260-10-45-60 through 45-70.

Other amounts attributable to the shares under the two-class method, however, might not have been recognized as interest cost. For example, the holder of a mandatorily redeemable financial instrument may have a participation right in 10 percent of dividends paid on common shares if or when they are declared. An amount may therefore be allocable to the shares subject to repurchase because all earnings for the period are assumed to have been distributed under the two-class method. However, this amount may not have been recognized as interest cost under ASC 480 if the holder is not entitled to it during the life of the contract or at settlement unless the issuer elects to declare a dividend on common stock. As discussed in Section 3.2.4.3.1 of Deloitte’s Roadmap Earnings per Share, the impact on EPS of treating the common shares as participating securities will often be the same as including the common shares in the denominator in the EPS calculations when an entity has undistributed earnings. If, however, a forward purchase contract on a fixed number of common shares contains fixed adjustments to the forward price that are based on anticipated dividends, the guidance in Section 5.3.3.5.2 of that Roadmap applies and the forward purchase contract is not a participating security.

Example 8-1

Basic EPS — Forward Contract to Repurchase Shares

Company A, a public business entity, has 1,000 outstanding common shares. On January 1, A enters into a forward contract that must be physically settled on December 31 by the repurchase of 100 shares in exchange for the fixed amount of $500. The forward contract does not provide for any subsequent adjustment of the repurchase price on the basis of the amount of actual dividends paid. Like other common shares, the 100 shares to be repurchased under the forward contract continue to be entitled to receive any dividends declared on common shares until the repurchase date. However, A declares no dividends during the year.

In calculating basic EPS for the year, A excludes from the denominator the 100 shares that are to be repurchased in accordance with ASC 480-10-45-4. Company A’s earnings for the year are $20,000. In the absence of the forward contract, basic EPS for the year would have been $20 ($20,000 ÷ 1,000).

ASC 480-10-45-4 also requires that A deduct from income available to common stockholders any amounts (including participation rights in undistributed earnings) attributable to shares that are to be repurchased. This is consistent with the two-class method described in ASC 260 (except to the extent that such amounts have already been recognized as interest cost under ASC 480-10-35-3). Because the forward contract in this situation does not return to A the actual dividends paid on the 100 shares to be repurchased, A deducts $2,000 from the EPS numerator to reflect the participation rights in undistributed earnings attributable to the 100 shares being repurchased ($20,000 × [100 ÷ 1,000]). Accordingly, the EPS numerator is $18,000 ($20,000 – $2,000). Because the EPS denominator is 900, basic EPS for the period is still $20 ($18,000 ÷ 900).

The SEC staff has indicated that if an equity-classified preferred stock is subsequently reclassified as a liability (e.g., a preferred share that was conditionally redeemable becomes mandatorily redeemable), the reclassification should be treated as a redemption of equity by issuance of a debt instrument in the calculation of EPS (see ASC 260-10-S99-2 and Section 3.2.2.8 of Deloitte’s Roadmap Earnings per Share). Further, ASC 480-10-30-2 requires an entity to initially measure the instrument at fair value upon reclassification, with an offset to equity and no gain or loss recognized. For EPS purposes, however, the numerator is adjusted for any change in the carrying amount. For example, if the new carrying amount under ASC 480 exceeds the carrying amount previously recorded in equity, that difference reduces the EPS numerator (i.e., the change is treated as a distribution to the holder of the instrument).

8.4.2 Other Forward Purchase Contracts and Written Put Options on Common Stock

ASC 260-10

Written Put Options and the Reverse Treasury Stock Method

45-35 Contracts that require that the reporting entity repurchase its own stock, such as written put options and forward purchase contracts other than forward purchase contracts accounted for under paragraphs 480-10-30-3 through 30-5 and 480-10-35-3, shall be reflected in the computation of diluted EPS if the effect is dilutive. If those contracts are in the money during the reporting period (the exercise price is above the average market price for that period), the potential dilutive effect on EPS shall be computed using the reverse treasury stock method. . . .

The reverse treasury stock method applies in the computation of diluted EPS to contracts that require an entity to repurchase its common stock. Such contracts include the following:

Written put options (common stock) — Options written by an entity under which the counterparty has the right, but not the obligation, to sell a specified quantity or amount of common stock to the entity at a fixed or otherwise determinable price.
Forward purchase contracts (common stock) — Contracts that require the entity to purchase a specified quantity or amount of common stock from the counterparty at a future date at a fixed or otherwise determinable price.

An entity should not apply the reverse treasury stock method to a contract listed above if the contract:

Represents a forward contract to repurchase common stock that is within the scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 8.4.1).
Must be net settled in cash (i.e., no common shares are purchased upon settlement).
Is a participating security, and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.

The reverse treasury stock method represents a method of determining the dilutive effect of a contract that obligates an entity to purchase its common shares. Under this method, it is assumed that the entity raises the proceeds necessary to satisfy its obligation under the share purchase contract by issuing its common shares to market participants at the average market price during the period. The excess of the common shares assumed issued over the common shares purchased under the contract represents the incremental common shares under the reverse treasury stock method.

Although contracts subject to the reverse treasury stock method must be classified as liabilities (or as assets in some circumstances) for accounting purposes, it is still assumed that they are classified as equity instruments under this method of calculating diluted EPS. Therefore, along with adding incremental shares to the denominator under the reverse treasury stock method, an entity must adjust the numerator to reflect the change in net income that would have occurred during the reporting period if the contract had been classified in equity. Since contracts subject to the reverse treasury stock method are typically subsequently measured at fair value, with changes in fair value recognized in earnings, and contracts classified as equity instruments are typically not subsequently remeasured, the adjustment to the numerator will reflect a reversal of the mark-to-market adjustment recognized on the contract during the reporting period, net of any associated income tax effects. However, the numerator adjustment should not be made, and the incremental shares should not be added to the denominator, if either (1) the contract is a written put option and is out-of-the-money on the basis of a comparison of the exercise price with the average market price (see below) or (2) the aggregate effect of the two adjustments is antidilutive on the basis of the antidilution sequencing requirements in ASC 260. See Section 4.7 of Deloitte’s Roadmap Earnings per Share for further discussion of the diluted EPS accounting for contracts subject to the reverse treasury stock method.

The reverse treasury stock method is only applied to written put options that are in-the-money from the perspective of the counterparty. This determination is based on a comparison of the exercise price with the average market price of the entity’s common stock. The reverse treasury stock method should not be applied to an out-of-the-money written put option that would be dilutive to EPS because of the adjustment made to the numerator to reverse the mark-to-market amount recognized on the contract during the reporting period. However, because forward purchase contracts must be settled regardless of whether they are in-the-money or out-of-the-money, the reverse treasury stock method should be applied to forward contracts if such contracts are dilutive. An entity would determine whether a forward purchase contract is dilutive to EPS on the basis of the aggregate effect of the numerator adjustment and the incremental common shares to be included in the denominator under the reverse treasury stock method.

See Section 4.3.2 of Deloitte’s Roadmap Earnings per Share for further discussion of the application of the reverse treasury stock method to potential common shares within its scope that are not participating securities. For example, see that Roadmap's guidance on special issues that arise when:

The number of common shares to be repurchased is variable (Section 4.3.2.1.1).
The exercise price or the forward price is variable (Section 4.3.2.1.2.1).
The contract is issued, exercised, forfeited, or canceled, or it expires, during a financial reporting period (Section 4.3.2.1.3.1).
The contract permits net share settlement (Section 4.3.2.2.2).
The contract has multiple settlement alternatives (Sections 4.3.2.2.3 and 4.6).

If a potential common share is a participating security, an entity is required to apply the more dilutive of the reverse treasury stock method or the two-class method of calculating diluted EPS (see Section 5.5.4 of Deloitte’s Roadmap Earnings per Share).

If a contract can be settled in common stock or cash at the option of the issuer, it is presumed that it will be settled in common stock. This presumption cannot be overcome (i.e., share settlement is always assumed in the calculation of diluted EPS).

The reverse treasury stock method is not applied if the contract must be cash settled (i.e., no common shares are purchased on settlement). Any dilutive impact of the contract is reflected through the mark-to-market adjustment recognized in earnings on the contract through the application of other GAAP, and no additional adjustments are needed in the calculation of diluted EPS. In all other circumstances, the reverse treasury stock method is used if its application is dilutive, which may include instances in which (1) the contract must be share settled, (2) the counterparty is permitted to require the entity to settle the contract in cash or by purchasing common shares, or (3) the entity is permitted to settle the contract in cash or by purchasing common shares.

8.4.3 Certain Variable-Share Obligations

8.4.3.1 General

For a holder of financial instruments issued in the form of shares that embody an unconditional obligation that the issuing entity must settle by issuing a variable number of common shares that are classified as liabilities under ASC 480-10-25-14 (see Chapter 6), there may not be any potential “upside” from increases in the issuing entity’s common stock. Nevertheless, such instruments meet the definition of a convertible security; therefore, the if-converted method of calculating diluted EPS must be applied to them. See Section 4.4 of Deloitte’s Roadmap Earnings per Share for detailed discussion of the application of the if-converted method.

In the discussion that follows, it is assumed that the if-converted method of calculating diluted EPS applies to a liability under ASC 480-10-25-14. For financial instruments not issued in the form of shares that are liabilities under ASC 480-10-25-14, the if-converted method may not apply to the calculation of diluted EPS.

8.4.3.2 Accounting for the Effect of Variability in the Number of Shares That Must Be Issued on Settlement

Because the settlement of liabilities under ASC 480-10-25-14 involves the issuance of a variable number of the issuer’s equity shares, special considerations apply when diluted EPS is calculated by using the if-converted method.

If the number of common shares issuable upon settlement of a liability under ASC 480-10-25-14 varies solely on the basis of the issuer’s share price (e.g., a preferred share that must be settled in a variable number of common shares equal to a fixed monetary amount), an entity must use the variable denominator guidance in ASC 260-10-45-21A to calculate the number of shares that would be issued. Under this guidance, the entity uses the average market price during the period to calculate the number of shares added to the denominator under the if-converted method. For example, if an entity issued a financial instrument in the form of a preferred share that embodies an unconditional obligation that must be settled by issuing a variable number of common shares equal to a fixed monetary amount (i.e., share-settled debt), the entity would use the average price of its common shares during the period to calculate the number of common shares that would be added to the denominator in the calculation of diluted EPS under the if-converted method.

However, on the basis of informal discussions with the FASB staff, we understand that the guidance in ASC 260-10-45-21A was not intended to address the diluted EPS accounting under the if-converted method when the conversion price or the number of shares issuable upon settlement varies on the basis of an underlying other than just share price. Rather, the guidance was only intended to address the diluted EPS accounting under the if-converted method when the variability in the settlement terms results solely from changes in the entity’s share price. Therefore, an entity does not have to apply the guidance in ASC 260-10-45-21A (although doing so would be acceptable) if the variability in the number of shares issuable upon settlement of a liability under ASC 480-10-25-14 results from changes in an underlying other than just the entity’s share price. (Section 4.4.2.3 of Deloitte’s Roadmap Earnings per Share discusses three methods that are acceptable in this situation.) Furthermore, ASC 260-10-45-21A should not be applied when diluted EPS must be calculated by using the contingently issuable share method. Rather, in a manner consistent with ASC 260-10-45-21A, when the contingently issuable share method applies, so does the relevant guidance in ASC 260 on diluted EPS calculations for contingently issuable share arrangements. In practice, entities must exercise judgment to determine whether the contingently issuable share method is required. During our informal discussions, the FASB staff acknowledged the difficulty of making this determination. Accordingly, entities are encouraged to consult with their independent accounting advisers.

If the instrument or any embedded feature in the instrument is classified as a liability and recognized at fair value, with changes in fair value reported in earnings (which may be required because of the variable terms of the contract), an entity must also adjust the numerator in calculating diluted EPS. See Section 4.4.2.2.3 of Deloitte’s Roadmap Earnings per Share for more information.

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.