Chapter 3 — Basic EPS
Chapter 3 — Basic EPS
3.1 Background
ASC 260-10
Basic EPS
10-1 The objective of basic
earnings per share (EPS) is to measure the performance of an
entity over the reporting period.
Computation of Basic EPS
45-10 Basic EPS shall be
computed by dividing income available to common stockholders
(the numerator) by the weighted-average number of common
shares outstanding (the denominator) during the period.
Shares issued during the period and shares reacquired during
the period shall be weighted for the portion of the period
that they were outstanding. See Example 1 (paragraph
260-10-55-38) for an illustration of this guidance.
As noted in ASC 260-10-45-10, basic EPS is calculated “by dividing income
available to common stockholders (the numerator) by the
weighted-average number of common shares outstanding (the
denominator) during the [reporting] period.” For illustrations of
the calculation of basic EPS for entities with simple and more
complex capital structures, see the example below and Example
3-32, respectively. The remainder of this chapter
addresses matters that affect the numerator and denominator in the
calculation of basic EPS.
Example 3-1
Basic EPS for Entity With Simple Capital Structure
This example illustrates the first-quarter calculation of basic EPS for Company A, which has a simple capital structure. Assume the following facts:
- Income from continuing operations and net income for the first quarter was $10 million.
- At the beginning of the period, A had 500,000 shares of common stock outstanding.
- On March 1, A issued 100,000 shares of common stock in a secondary offering.
- Company A only has shares of common stock outstanding. There is no noncontrolling interest (NCI) in A.
Weighted-average shares outstanding are calculated as follows:
The discussion in this chapter is generally in the context of an entity that
presents only one basic EPS amount (i.e., the entity does not have
any discontinued operations). Unless otherwise noted, in this
chapter, “net income” encompasses net income or net loss and refers
to (1) consolidated net income for an entity that does not have an
NCI and (2) income attributable to the parent for an entity with an
NCI. “Income available to common stockholders,” which is defined in
ASC 260-10-20, refers to income available or loss attributable to
common stockholders for (1) an entity that does not have an NCI and
(2) the parent for an entity that has an NCI. Sections
8.6.3, 8.7.1, and 8.7.2
discuss the accounting and presentation of EPS for an entity that
presents a discontinued operation and include an example of the
presentation of EPS for an entity that reports an NCI in a
discontinued operation.
3.1.1 Treating Capital Stock as Common Stock or Preferred Stock
3.1.1.1 Corporate Entities
ASC 260-10-20 defines common stock as “stock that is subordinate to all other stock of the issuer.” ASC 260 does not provide any other interpretive guidance on identifying whether a class of capital stock should be treated as common or preferred stock. However, the distinction is important for both the determination of the classes of capital stock for which the presentation of EPS is required and the calculation of basic and diluted EPS for those classes of capital stock. With respect to the presentation of EPS, as noted in Section 5.4.1, an entity with multiple classes of common stock is required to present basic and diluted EPS for each of these classes. Regarding the calculation of EPS, as discussed in this chapter, there are significant differences between the accounting for common stock and the accounting for preferred stock. Such differences may include the following:
- Dividends on preferred stock affect the numerator in the calculation of EPS, whereas dividends on common stock generally have no impact on EPS unless the two-class method of calculating EPS is required.
- While the classification and measurement guidance in ASC 480-10-S99-3A applies to all equity-classified redeemable securities, the EPS impact of adjustments to the redemption amount of redeemable securities for preferred stock significantly differs from that for common stock.
- According to ASC 260-10-S99-2, the difference between the fair value of consideration paid and the net carrying amount of preferred stock is treated as a dividend when preferred stock is redeemed; ASC 260-10-S99-2 does not apply to common stock.
Securities issued by corporations will typically be considered common stock or
preferred stock on the basis of their existing legal
form. However, in the calculation of basic EPS,
securities should be evaluated on the basis of their
substance rather than just their current legal form.
A security that is a preferred instrument in legal
form, shares the same characteristics as common
stock, and has no substantive preference attributed
to it should be considered a class of common stock
in the calculation of EPS, regardless of its legal
form. Similarly, a security that is a common
instrument in legal form and shares the same
characteristics as preferred stock because of a
substantive preference in dividends and liquidation
(without any participation with common shareholders
in the distribution of assets on liquidation) should
be considered a class of preferred stock in the
calculation of EPS, regardless of its legal form.
The laws in certain jurisdictions do not allow
certain types of entities to issue preference
shares; however, those entities may issue common
securities in legal form that have all the
characteristics of preferred stock. The two examples
below illustrate these concepts.
Example 3-2
Preferred Stock With Characteristics of Common Stock
Company B issues, to Company C, Series A convertible preferred stock (the
“Series A stock”) whose terms are substantially
the same as those of common stock. The relevant
terms of the Series A stock are as follows:
-
No rights to preferential or cumulative dividends; holders of the Series A stock share ratably with common stockholders in the payment of any dividends.
-
Not publicly traded. (B’s common stock is publicly traded.)
-
Voting rights are consistent with the rights of the common stock.
-
Nominal preference in liquidation of $0.01 per share.
-
Each share is convertible into one share of common stock at any time upon the transfer of the Series A stock by C to a third party.
-
Antidilution provisions are limited to stock splits and dividends.
There is no substantive difference between the Series A stock and the common
stock. As a holder of the Series A stock, C can
sell these shares to a third party at any time, at
which point the Series A stock would convert into
common stock with all the characteristics of the
current outstanding common stock. The sale of the
Series A stock is completely outside B’s control,
and there are no restrictions on the sale of the
Series A stock. Further, the Series A stock has
the exact same rights to receive dividends as
common stock and has no substantive preference
(i.e., the liquidation preference of $0.01 per
share is not substantive). Therefore, the Series A
stock should be treated as a class of common
stock.
Example 3-3
Common Stock With Characteristics of Preferred Stock
Company X is a limited liability company (LLC) domiciled and organized under the
laws of The People’s Republic of China (PRC).
According to PRC law, an LLC cannot issue
preference shares. Therefore, X has issued two
classes of shares — ordinary shares and Series A
shares, which is a special class of ordinary
shares. The Series A shares contain preferential
rights that are akin to preferred stock but are
not legally preferred securities because
preference shares cannot be issued by an LLC under
PRC law. The Series A shares result in the
economic equivalent of a preferred security. For
such a security, there is a priority related to
dividend rights and distributions on liquidation
and no ability to participate with ordinary
shareholders in the distribution of assets on
liquidation.
Although the Series A shares, like the ordinary shares, legally reflect common stock, the Series A shares should be considered preferred stock and the ordinary shares should be considered common stock under ASC 260. This is consistent with the definition of common stock in ASC 260-10-20, which refers to “stock that is subordinate to all other stock of the issuer.”
Section 3.3.2.2 discusses the treatment of instruments that are mandatorily convertible into common stock but that do not reflect common stock in substance before their conversion.
3.1.1.2 Limited Partnerships and Similar Entities
In a typical limited partnership, the general partner or partners own an
insignificant amount of partnership interests and
there is a single class of limited partnership
interests that represents substantially all of the
equity of the limited partnership. In these
situations, the limited partnership interests will
be treated as common stock. In other situations, the
general partnership interest or interests represent
a majority of the equity of the limited partnership
or the limited partnership has issued multiple
classes of limited partnership interests. In these
circumstances, the determination of whether the
limited partnership interests should be considered
akin to common stock or preferred stock should be
based on the substance of the instruments. We
understand that the SEC staff believes that if an
issued and outstanding equity interest is not in the
legal form of common stock or preferred stock, which
may include limited partnerships and similar
entities as well as other forms of organization in
foreign jurisdictions, the entity should evaluate
the economic characteristics and risks of the equity
interest, within the context of the entity’s other
capital instruments, to determine whether the
interest is more akin to common stock or preferred
stock. The primary focus should be on whether the
interest has a priority in dividends and a
substantive preference in liquidation.
3.2 Income Available to Common Stockholders
3.2.1 General
ASC 260-10
Income Available to Common Stockholders and Preferred
Dividends
45-11 Income available to common stockholders shall
be computed by deducting both the dividends declared in the period on
preferred stock (whether or not paid) and the dividends accumulated for the
period on cumulative preferred stock (whether or not earned) from income from
continuing operations (if that amount appears in the income statement) and
also from net income. If there is a loss from continuing operations or a net
loss, the amount of the loss shall be increased by those preferred dividends.
An adjustment to net income or loss for preferred stock dividends is required
for all preferred stock dividends, regardless of the form of payment.
Preferred dividends that are cumulative only if earned shall be deducted only
to the extent that they are earned.
45-11A For purposes of computing EPS in consolidated
financial statements (both basic and diluted), if one or more
less-than-wholly-owned subsidiaries are included in the consolidated group,
income from continuing operations and net income shall exclude the income
attributable to the noncontrolling interest in subsidiaries. Example 7 (see
paragraph 260-10-55-64) provides an example of calculating EPS when there is a
noncontrolling interest in a subsidiary in the consolidated group.
45-12 Preferred stock dividends that an issuer has
paid or intends to pay in its own common shares shall be deducted from net
income (or added to the amount of a net loss) in computing income available to
common stockholders. In certain cases, the dividends may be payable in common
shares or cash at the issuer’s option. The adjustment to net income (or net
loss) for preferred stock dividends payable in common stock in computing
income available to common stockholders is consistent with the treatment of
common stock issued for goods or services.
ASC 260-10-45-11 through 45-12 contain general guidance on calculating
the numerator for basic EPS. Generally speaking, income available to common stockholders
is calculated as net income less dividends on preferred stock. However, there are a number
of matters for an entity to consider in performing this calculation. Below is a summary of
the relevant considerations related to the calculation of the numerator for basic EPS
along with references to the sections in this chapter where these matters are discussed.
Chapter 6 contains
additional guidance on calculating basic EPS for convertible debt instruments. See
Section 9.1.6 for
discussion of the requirement for an SEC registrant to report income or loss applicable to
common stock on the face of the income statement.
The table below discusses the impact that various items generally
have on the calculation of income available to common stockholders in the calculation of
basic EPS. Because the table focuses on income available to common stockholders, it does
not address the allocation of such income to multiple classes of common stock, in which
case an entity is required to apply the two-class method of calculating basic EPS. Each of
the items in the table below is discussed in detail in the sections that follow.
Table 3-1
Generally Affects
Income Available to Common Stockholders1 | Generally Does Not
Affect Income Available to Common Stockholders |
---|---|
|
|
3.2.2 Dividends on Preferred Stock
3.2.2.1 General
Dividends on preferred stock are deducted from income from continuing
operations (if that amount appears on the income statement), as well as from net income,
to arrive at income available to common stockholders, which is the numerator in the
calculation of basic EPS. Only dividends associated with the current financial reporting
period are deducted from income from continuing operations (if that amount appears on
the income statement), as well as from net income, to arrive at income available to
common stockholders for the period. For example, as discussed in ASC 260-10-45-60B(a),
if dividends on cumulative preferred stock are declared in the current period but are
related to prior-period unpaid cumulative dividends, those dividends are not associated
with the current financial reporting period. Only dividends that accumulated during the
current period affect income available to common stockholders.
As noted in Section 8.7,
if an entity reports a discontinued operation, it must calculate basic EPS for both
income from continuing operations and net income (thus, income available to common
stockholders should be calculated for both income from continuing operations and net
income). While an entity may have any combination of one or more of income from
continuing operations, loss from continuing operations, net income, or net loss, the
remaining discussion in this chapter generally refers simply to a requirement to deduct
dividends from “net income” to arrive at “income available to common stockholders.” This
reference is intended to encompass (1) the addition of dividends to net loss to arrive
at loss attributable to common stockholders when an entity reports a net loss, (2) the
deduction of dividends from income from continuing operations when an entity reports
income and has a discontinued operation, and (3) the addition of dividends to loss from
continuing operations when an entity reports a loss and has a discontinued operation.
As discussed in the remaining subsections of Section 3.2.2, dividends that
reduce net income in arriving at income available to common stockholders include all of
the following:
- Dividends accumulated on cumulative preferred stock that are paid in cash.
- Dividends declared on noncumulative preferred stock that are paid in cash.
- Dividends accumulated on cumulative preferred stock that are paid in additional shares of preferred stock or in common stock.
- Dividends declared on noncumulative preferred stock that are paid in additional shares of preferred stock or in common stock.
- Contingent dividends on cumulative and noncumulative preferred stock when the contingency that requires the payment of those dividends occurs.
- Liquidating dividends upon the occurrence of the liquidation event.
- The accretion of dividends on certain increasing-rate preferred stock instruments.
- “Deemed dividends” that result from the remeasurement of preferred stock to its redemption amount under ASC 480-10-S99-3A.
-
Dividends that result from a down-round feature that has been triggered.
- “Deemed dividends” that result from the application of ASC 260-10-S99-2 to a redemption or induced conversion of preferred stock.
- Dividends on participating preferred stock.
- “Deemed dividends” from the reclassification of preferred stock to a liability.
3.2.2.2 Cumulative Versus Noncumulative Preferred Stock
3.2.2.2.1 Dividends on Cumulative Preferred Stock
Although the ASC master glossary does not define “cumulative
preferred stock,” preferred stock that must receive dividend payments for all prior
years before any dividend payments are made to common shareholders are described as
cumulative; those without this right are 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.
ASC 260-10-45-11 requires an entity to deduct from net income the
amount of dividends accumulated during a period on cumulative preferred stock. This is
required regardless of whether (1) the form of payment is cash or stock or (2) the
dividends have been declared or paid. However, preferred dividends that are cumulative
only if earned are treated as contingent dividends (see Connecting the Dots below).
Section 3.2.2.3
addresses dividends on increasing-rate preferred stock. Section 3.2.2.4 addresses dividends on redeemable
preferred stock. Section
3.2.2.7 addresses the EPS accounting for cumulative preferred stock that
meets the definition of a participating security.
While cumulative dividends on preferred stock are deducted from the
numerator in the calculation of basic EPS, such dividends are not necessarily
recognized on the balance sheet. For example, if an entity has issued redeemable
preferred stock that is classified in temporary equity, but remeasurement of the
preferred stock to its redemption amount is not required under ASC 480-10-S99-3A,
cumulative undeclared dividends on the preferred stock will have been reflected in the
calculation of basic EPS; however, those dividends would not be reflected in the
measurement of the temporary-equity classified preferred stock under ASC
480-10-S99-3A. The fact that remeasurement of redeemable preferred stock is not
required under ASC 480-10-S99-3A does not negate the requirement in ASC 260 to deduct
cumulative dividends on the preferred stock in the calculation of basic EPS.
Connecting the Dots
The language in ASC 260-10-45-11 that refers to whether
dividends on cumulative preferred stock are “earned” can be confusing. The first
sentence in ASC 260-10-45-11 requires an entity to deduct dividends that
accumulate on cumulative preferred stock for the period “whether or not earned”;
however, the last sentence of that paragraph states that preferred dividends are
cumulative only “if earned” and therefore should be deducted “only to the extent
that they are earned.” The discussion in ASC 260-10-45-11 regarding whether
dividends on cumulative preferred stock are “earned” should be interpreted as
signifying that such dividends for the period should be deducted from net income
to arrive at income available to common stockholders unless the dividends are
contingent upon the occurrence of an event outside the control of the preferred
stockholders that did not occur (e.g., dividends that are indexed to the entity’s
earnings). For further discussion, see Section 3.2.2.2.5.
3.2.2.2.2 Dividends on Noncumulative Preferred Stock
Noncumulative dividends do not accrue to the preferred stockholder
if they are not declared for the period. However, the preferred stockholders are
entitled to receive payment of the current period’s dividend before any dividends can
be declared on common stock. As explained in the nonauthoritative guidance of AICPA
Technical Q&As Section 4210.04, if preferred stock dividends are noncumulative,
“only the dividends declared should be deducted [from net income].” Therefore,
dividends on a noncumulative preferred stock instrument that is not remeasured to its
redemption amount under ASC 480-10-S99-3A and that does not meet the definition of a
participating security should not affect the calculation of basic or diluted EPS for
periods in which such dividends have not been declared or otherwise paid. Section 3.2.2.4 addresses
dividends on redeemable preferred stock. Section 3.2.2.7 addresses the EPS accounting for
noncumulative preferred stock that meets the definition of a participating security.
3.2.2.2.3 Dividends Paid in Shares of Preferred Stock
Dividends on preferred stock may be paid in additional shares of
preferred stock; such dividends are referred to as dividends that are “paid in-kind”
(PIK). Determining the appropriate measurement of PIK dividends is important because
the measured amount of these dividends reduces net income in arriving at income
available to common stockholders.
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 dividends
in cash or 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 such dividends 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 guidance related to PIK dividends. See
Section 9.5.5.1 of Deloitte’s Roadmap
Distinguishing Liabilities From Equity
for additional considerations related to determining whether PIK dividends are
discretionary or nondiscretionary.
Table
3-2
Measurement of PIK Dividends That Reduces Numerator in EPS
Calculation | |
---|---|
Commitment date is the same as the commitment date for the original preferred
stock (i.e., nondiscretionary PIK dividends) | PIK dividends should be measured at the fair value of the original preferred
stock on its commitment date. Generally, this will be on the issuance date
of the original preferred stock. |
Commitment date is not the same as the commitment date for the original
preferred stock (i.e., discretionary PIK dividends) | For cumulative
preferred stock, PIK dividends should be measured at their fair value as
of the date they accumulate. If the accumulation date differs from the
declaration or payment date and the entity does not recognize the
dividends on the balance sheet as additional shares of preferred stock
until that later date, an adjustment to the dividend amount previously
recorded should be recognized as of the date the additional shares of
preferred stock are recognized on the balance sheet.2 This adjustment will affect income available to common stockholders
in the period in which it is recognized. For
noncumulative preferred stock, PIK dividends should be measured at their
fair value as of the date they are declared. |
3.2.2.2.4 Dividends Paid in Shares of Common Stock
ASC
260-10
Income Available to Common Stockholders and Preferred
Dividends
45-12 Preferred stock dividends that an issuer
has paid or intends to pay in its own common shares shall be deducted from
net income (or added to the amount of a net loss) in computing income
available to common stockholders. In certain cases, the dividends may be
payable in common shares or cash at the issuer’s option. The adjustment to
net income (or net loss) for preferred stock dividends payable in common
stock in computing income available to common stockholders is consistent
with the treatment of common stock issued for goods or
services.
In accordance with ASC 260-10-45-12, when an entity has paid or
intends to pay dividends on preferred stock in shares of common stock, the adjustment
to the numerator in the calculation of basic EPS should be “consistent with the
treatment of common stock issued for goods or services.” ASC 260-10-45-45 does not
apply to the calculation of basic EPS when an entity has the option of paying
dividends in cash or common stock because ASC 260-10-45-45 only applies to the
calculation of diluted EPS. In accordance with ASC 260-10-45-12, the accounting for
basic EPS depends on whether an entity “has paid or intends to pay” dividends on
preferred stock in common stock.
For dividends on cumulative preferred stock, the amount of dividends
that reduces net income in arriving at income available to common stockholders should
be measured at the fair value of the shares of common stock expected to be delivered
in satisfaction of those dividends. For dividends on noncumulative preferred stock,
the amount of dividends that reduces net income in arriving at income available to
common stockholders should be measured at the fair value of the shares of common stock
that the entity has agreed to pay as a dividend as of the dividend declaration date.
The two examples below illustrate the application of these requirements to cumulative
preferred stock.
Example
3-4
Monetary Value of Dividends Is the Same, Whether Paid
in Cash or Shares of Common Stock
On January 1, 20X1, Entity A issues $10 million of
cumulative preferred stock. The terms of the preferred stock stipulate
that dividends accumulate quarterly, regardless of whether they are
declared, at a per annum rate of 10 percent. Entity A has the option of
paying dividends in either cash or a number of shares of common stock
equal to the cash amount. If A elects payment in shares of common stock,
the number of such shares is determined as of the date the dividends are
paid.
Because the monetary amount of the dividends is the same regardless of the form
of consideration, A should recognize, as a reduction of the numerator in
the calculation of EPS, a dividend on preferred stock of $250,000 in each
quarterly financial reporting period ($10,000,000 × 10% × 1/4 = $250,000).
Example
3-5
Monetary Value of Dividends Is Not the Same, Whether
Paid in Cash or Shares of Common Stock
On January 1, 20X1, Entity B issues $10 million of
cumulative preferred stock. The terms of the preferred stock stipulate
that dividends accumulate quarterly, regardless of whether they are
declared, at a per annum rate of 10 percent. Entity B has the option of
paying dividends in either cash or common stock. If B elects to pay
dividends in common stock, it must deliver a number of shares of common
stock that is equal to the cash amount of the dividends as of the date the
preferred stock was issued. The fair value of B’s common stock as of the
date the preferred stock was issued was $10 per share. Thus, in any period
for which dividends are declared and paid in common stock, B must deliver
to the holder 25,000 shares of common stock. Assume that the option of
paying dividends is not an embedded derivative that must be accounted for
separately under ASC 815-15.
Further assume the
following:
- During the first two years in which the preferred stock was outstanding, B had the intent to and did pay the dividends in cash on a quarterly basis.
- Beginning on January 1, 20X3, B needs to conserve cash for other business reasons and has decided to declare and pay the dividends on the preferred stock in shares of common stock during the year ended December 31, 20X3. The dividends accumulate and are declared on March 15, June 15, September 15, and December 15 of each year. The dividends are then paid within 30 days after declaration.
- On March 15, 20X3, the price of B’s common shares was $11 per share.
- On April 15, 20X3, when the dividends were paid, the price of B’s common shares was $12 per share.
- Entity B has a calendar year-end.
In calculating basic EPS for the first quarter ended March 31, 20X3, B should
recognize a reduction from net income of $275,000 to arrive at income
available to common stockholders (25,000 shares × $11.00 per share). Since
the obligation to deliver 25,000 shares of common stock is considered to
have occurred on March 15, 20X3, B would not subsequently adjust the
dividend amount to reflect the incremental $1.00 per share increase in the
fair value of its common stock.
3.2.2.2.5 Contingent Dividends
While ASC 260-10-45-11 states that dividends should be deducted from
net income to arrive at income available to common stockholders, which is the
numerator in the calculation of basic EPS, it does not specifically address how to
account for dividend payments that are contingent on future events. The only guidance
in ASC 260-10-45-11 that is relevant to this matter is that “[p]referred dividends
that are cumulative only if earned shall be deducted only to the extent that they are
earned.”
In such circumstances, an entity must consider the facts and
circumstances associated with each contingently payable dividend. Generally, the
impact of contingently payable dividends on the calculation of basic EPS depends on
the nature of the contingency. See further discussion in the table below.
Table
3-3
Nature of
Contingency3 | Type of Preferred
Stock | Treatment
|
---|---|---|
Dividends are payable solely after the passage of time provided that the
contingent event does not occur | Cumulative
| Dividends should be
reflected — as they accumulate and without regard to the contingency — as
a reduction of net income in arriving at income available to common
stockholders. If the contingent event occurs and the amount of the
dividends changes as a result (i.e., an increase or decrease in, or an
elimination of, the dividend amount), an entity may recognize an
adjustment to the numerator in the calculation of basic EPS in the period
in which the contingent event occurred. Prior reported EPS amounts should
not be revised. |
Noncumulative | Dividends should be
reflected, when declared, as a reduction of net income in arriving at
income available to common stockholders. A contingency of this type that
could affect the amount of the dividends after they are declared should
not affect the amount of dividends that are reduced from net income to
arrive at income available to common stockholders before the occurrence of
the contingency. If the contingent event occurs and the amount of
dividends changes as a result (i.e., an increase or decrease in, or an
elimination of, the dividend amount), an entity may recognize an
adjustment to the numerator in the calculation of basic EPS in the period
in which the contingent event occurred. Prior reported EPS amounts should
not be revised. | |
Dividends become payable only if the contingent event does
occur | Cumulative
| Dividends that
become payable only upon the occurrence of a contingent event (i.e., that
will not be payable upon the mere passage of time provided that no changes
in circumstances or events occur) should not affect the numerator in the
calculation of EPS until and unless the contingency occurs. |
Noncumulative |
Dividends that become payable only upon the occurrence
of a contingent event (i.e., that will not be payable upon the mere
passage of time with no changes in circumstances or events) should not
affect the numerator in the calculation of EPS until the contingency
occurs and the dividend has been declared. |
The example below illustrates the accounting for contingent
dividends.
Example
3-6
Contingent Dividends on Cumulative Convertible Preferred Stock
Company X issued, to Company Y, convertible preferred stock that earns a 7
percent annual dividend on a cumulative basis. The terms of the preferred
stock state that if Y were to convert the preferred stock into common
stock, Y would not receive any preferred stock dividends, including any in
arrears. Conversion is based on the initial issuance price of $1,000 per
share of preferred stock divided by the 30-day average market price of X’s
common stock. If, however, X redeems the shares from Y, Y would receive
dividends, including any in arrears.
The dividends potentially will be paid in the future unless Y elects to convert
the preferred stock into common stock, in which case it would no longer
have the right to receive the preferred stock dividends, including any in
arrears. Therefore, in the calculation of basic EPS, cumulative dividends
on the preferred stock should be subtracted from net income in arriving at
income available to common stockholders until the conversion occurs. If
conversion occurs, thereby removing Y’s right to receive the dividends,
including those in arrears, the calculation of basic EPS may reflect the
reversal of previously accumulated dividends in the quarter in which
conversion occurs. Company X should not revise previously reported EPS
amounts.
3.2.2.2.6 Liquidating Dividends
A liquidating dividend represents a type of distribution made by an
entity to its equity owners during its partial or complete liquidation. Liquidating
dividends are not paid solely out of the entity’s profits. Preferred stock has a
liquidation preference, which represents a right of preference over common
shareholders (and potentially preferences with respect to other classes of preferred
securities) in the event that the issuing entity is liquidated. As with the treatment
of contingent dividends (see Section
3.2.2.2.5), the calculation of income available to common stockholders
should not be affected by a liquidating dividend until a liquidation event occurs.
Similarly, changes to the liquidation preference of preferred stock that have no other
impact on the preferred stock (i.e., the change is only relevant in the event of a
liquidation of the issuing entity and does not affect the dividends on the preferred
stock before such liquidation) should also have no impact on income available to
common stockholders unless such changes result in a “deemed dividend” that must be
accounted for as a result of a modification to the terms of the preferred stock (see
Section 3.2.6.1).4 The example below illustrates the accounting for a liquidating dividend on
cumulative preferred stock.
Example
3-7
Impact of Liquidating Dividends on Cumulative Convertible Preferred
Stock
Assume the following facts:
- Company X issues 100,000 shares of Series A nonvoting convertible preferred stock for $1,000 per share (i.e., total proceeds of $100 million).
- The preferred stock pays cumulative dividends at a rate of 12 percent per annum from the issuance date.
- The liquidation preference of the preferred stock is equal to $1,000 per share, plus dividends accumulated and unpaid at a rate of 12 percent per annum, plus additional dividends at a rate of 5 percent per annum of the issuance price.
- The additional 5 percent that is added to the liquidation preference does not represent a cumulative dividend because it only represents a right of preference in liquidation of X. Company X can pay dividends on common stock provided that it has declared and paid all the cumulative dividends at a rate of 12 percent per annum.
- Company X can call the preferred stock at the end of five years from the issuance date, and on each successive date that is five years thereafter, at a redemption price equal to the issuance price per share, plus unpaid cumulative dividends at the 12 percent rate per annum.
In the calculation of basic EPS, net income
should be reduced by the 12 percent cumulative dividends, regardless of
whether they have been declared or paid. The additional 5 percent per
annum amount that is added to the liquidation preference is not considered
a cumulative dividend even though it accumulates and is added to the total
liquidation preference. Rather, that amount is considered a liquidating
dividend that merely increases the liquidation preference of the preferred
stock. That amount should have no impact on EPS because it is not
reflected for accounting purposes unless there is a liquidation of X.
If the additional 5 percent was also payable upon
a deemed liquidation of X (i.e., a change of control or sale of all or
substantially all of X’s assets), the conclusion would not change because
this dividend amount would still be considered a contingent dividend. See
also Table
3-3.
3.2.2.3 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 stock19 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.20 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,21 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 $10022 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 redeemable23 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.
____________________
19 “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.
20 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.
21 See Question 3 regarding variable increasing
rate preferred stocks.
22 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.
23 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.
In accordance with SAB Topic 5.Q, the SEC staff believes that an
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 preferred stock issued at its liquidation preference that
contains a stated dividend rate that increases over time. Further, the guidance applies
to both redeemable and nonredeemable preferred stock.
The specific terms of preferred stock must be analyzed to determine
whether the instrument is considered increasing-rate preferred stock to which SAB Topic
5.Q must be applied. The table below discusses the application of SAB Topic 5.Q to
certain types of preferred stock instruments, including the interaction between SAB
Topic 5.Q and the SEC’s guidance on redeemable preferred stock in ASC 480-10-S99-3A. The
discussion in the table assumes that no issuance costs are capitalized into the initial
carrying amount of the preferred stock and that any discount on the preferred stock
arises solely from an issuance price that is less than the preferred stock’s stated
liquidation preference. In the table, it is also assumed that callable preferred stock
is called by the issuer before the dividend “step-up.” If the preferred stock is not
called, a reassessment of the accounting may be necessary.
Table 3-4
Type of Preferred
Stock | Example | Application of SAB
Topic 5.Q |
---|---|---|
1.
Noncumulative preferred stock | Entity A
issues noncumulative preferred stock with a $1,000 liquidation preference
and receives $900. The stated dividends on the preferred stock increase over
time. The preferred stock may be callable or puttable. | SAB Topic 5.Q does
not apply to preferred stock with noncumulative dividends even if the
preferred stock was issued at a discount to its liquidation preference or
has a stated rate of dividends that increase over time. Dividends on
noncumulative preferred stock should be recognized as a reduction of net
income to arrive at income available to common stockholders only when
declared. There is no requirement to amortize any discount between the
issuance price and liquidation preference of the preferred stock unless the
preferred stock is a redeemable security subject to the remeasurement
requirements of ASC 480-10-S99-3A. |
2.
Cumulative preferred stock with fixed-rate dividends that do not increase
over time | Entity B
issues cumulative, 8 percent preferred stock with a $1,000 liquidation
preference and receives $900. The preferred stock may be callable or
puttable. | SAB Topic 5.Q does
not apply to preferred stock with cumulative dividends at a stated rate that
do not increase over time even if the preferred stock was issued at a
discount to its liquidation preference. (For this purpose, dividends would
be considered to be at a stated rate that does not increase over time if the
potential to increase is due solely to an increase in a market variable
rate.) Dividends on the cumulative preferred stock should be recognized at
the stated rate as a reduction of net income to arrive at income available
to common stockholders as the dividends accumulate, regardless of whether
they are declared. There is no requirement to amortize any discount between
the issuance price and liquidation preference of the preferred stock unless
the preferred stock is a redeemable security subject to the remeasurement
requirements of ASC 480-10-S99-3A. |
3.
Cumulative preferred stock with fixed-rate dividends that increase over
time | SAB Topic 5.Q applies
to preferred stock with cumulative dividends that increase over time if the
instrument was issued at a discount to its liquidation preference or the
“step-up” in the stated dividends occurs before the date on which the issuer
may call the instrument.(a) | |
3a.
Perpetual preferred stock | Entity C
issues perpetual cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter. The preferred
stock may be issued at its liquidation preference or at a discount to its
liquidation preference.(a) | SAB Topic 5.Q applies to perpetual preferred stock that is issued at its
liquidation preference or at a discount to its liquidation preference if the
stated dividends on the preferred stock increase over time. Dividends on the
cumulative preferred stock should be recognized as a reduction of net income
to arrive at income available to common stockholders as they accumulate,
regardless of whether the dividends are declared, on the basis of the
interest method. If the preferred stock was issued at a discount to the
liquidation preference, that discount should be included with the
increasing-rate dividends in the recognition of dividends under the interest
method.(b) The accretion of any such discount affects the
carrying amount of the preferred stock on the balance sheet (i.e., the
accretion is not just for EPS purposes). |
3b.
Puttable preferred stock | Entity D issues puttable cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter. The preferred
stock may be issued at its liquidation preference or at a discount to its
liquidation preference.(a) The preferred stock may also be
callable by the issuer. | The application of
SAB Topic 5.Q depends on whether the preferred stock was issued at a
discount to the liquidation preference or whether the issuer can call the
preferred stock before the “step-up” in the stated dividend rate. The fact
that the holder may put the instrument does not obviate the need to apply
SAB Topic 5.Q, since the issuer does not control the holder’s decision to
put the instrument; however, the put feature could affect how SAB Topic 5.Q
is applied. Dividends on the cumulative preferred stock should be recognized
as a reduction of net income to arrive at income available to common
stockholders as they accumulate, regardless of whether they are declared, as
follows:
|
3c.
Callable preferred stock | Entity E
issues callable cumulative preferred stock with a $1,000 liquidation
preference. The dividends on the preferred stock initially accumulate at
5 percent per annum and periodically increase thereafter starting at the
beginning of year 5. The issuer can call the preferred stock for its
liquidation preference at the beginning of year 5. The preferred stock may
be issued at its liquidation preference or at a discount to its liquidation
preference.(a) The preferred stock is not puttable by the
holder.(f) | The application of
SAB Topic 5.Q depends on whether the preferred stock was issued at a
discount to the liquidation preference and when the issuer can call the
preferred stock. Dividends on the cumulative preferred stock should be
recognized as a reduction of net income to arrive at income available to
common stockholders as they accumulate, regardless of whether they are
declared, as follows:
|
4.
Cumulative preferred stock with fixed-rate dividends that increase over time
only if a contingent event occurs | Entity F
issues cumulative preferred stock with a $1,000 liquidation preference.
Dividends on the preferred stock accumulate at a rate of 6 percent per
annum. The preferred stock is puttable at the option of the holder upon the
occurrence of a specified contingency that is outside the control of the
investor.(g) If the holder elects to put the preferred stock
upon the occurrence of the specified contingency, F can either redeem the
preferred stock at an amount equal to 130 percent of the liquidation
preference or not redeem the instrument, in which case the dividend rate on
the preferred stock increases to 10 percent per annum. | SAB Topic 5.Q does
not address situations in which the dividend increase results from a
substantive contingency that is outside the control of the investor. In a
manner consistent with the accounting for contingent dividends (see
Section
3.2.2.2.5), if the “step-up” in the dividend rate will not be
operative upon the mere passage of time and the investor does not control
the conditions that would result in an increase in the dividend rate,
dividends should accumulate and reduce net income in arriving at income
available to common stockholders on the basis of the stated rate, provided
that the contingent event that results in an increase in dividends does not
occur. The additional contingent dividends should be deducted from net
income in arriving at income available to common stockholders only when the
contingent event that requires such payment occurs. |
Notes to Table:
(a) Preferred stock is generally considered to have been
issued at a discount to its liquidation preference at any time the issuance
price (i.e., proceeds received from the investor before direct issuance
costs paid to third parties) is less than the preference that the holder of
the preferred stock has in liquidation of the issuing entity. For example,
preferred stock that is issued to an investor for $1 million that is
redeemable for $1 million plus a premium (whether in accordance with a call
option or put option) is considered to have been issued at a discount to its
liquidation preference. As another example, preferred stock is considered to
have been issued at a discount to its liquidation preference when the
preferred stock is issued with other freestanding financial statements
(e.g., detachable warrants) and the allocation of the proceeds to the
preferred stock results in an initial carrying amount that is less than its
liquidation preference. However, the mere fact that preferred stock has been
issued at a discount to its liquidation preference does not mean that SAB
Topic 5.Q applies to the recognition of dividends.
(b) The issuer may need to estimate (or derive) a life to
calculate an effective yield under the interest method.
(c) ASC 480-10-S99-3A may require remeasurement of the
preferred stock to its redemption amount if the redemption amount exceeds
the net carrying amount of the preferred stock before application of ASC
480-10-S99-3A.
(d) If the issuer does not intend to call the preferred
stock on the first dividend “step-up” date (or when the preferred stock is
otherwise first callable) because it is not economically advantageous to
call the preferred stock in considering the discount to the liquidation
preference and the increased dividends, SAB Topic 5.Q may be applied
differently. The application of SAB Topic 5.Q to the discount and the
“step-feature” will depend on the particular facts and circumstances. For
example, an application of the interest method on the basis of the expected
life of the instrument, as discussed in the second approach under footnote
(e), may be appropriate.
(e) When an issuer expects to exercise a call option to
avoid paying any dividends at a higher or “stepped-up” rate (i.e., the call
option may be exercised before the date the dividends increase), it is
generally most appropriate for the issuer to use the interest method to
amortize the entire discount between the issuance price and liquidation
preference over a period that ends with the call date. However, prior
informal discussions with the SEC staff have revealed that other approaches
may also be acceptable, including the following:
(f) If the preferred stock were puttable, the issuer would
also need to consider ASC 480-10-S99-3A.
(g) The increased dividends may result from penalty
payments upon the issuer’s failure to take certain actions (e.g., failure to
deliver common shares upon conversion within a stated period) or declines in
the issuer’s creditworthiness. If the investor controls the occurrence of
the events that result in the requirement for the issuer to either redeem
the preferred stock at a premium or increase the dividends, the preferred
stock would not be considered to have contingent increasing-rate dividends.
Therefore, the issuer would need to accrete the preferred stock instrument
on the basis of the greater of the redemption price or the increased
dividend rate.
|
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.
Although ASC 480-10-S99-3A(15) gives an entity the option of
recognizing redemption-amount measurement adjustments related to redeemable preferred
stock by using one of two methods when preferred stock is not redeemable on the balance
sheet date but it is probable that it will become redeemable (i.e., an accretion method
or a method that assumes the preferred stock is redeemable on the balance sheet date),
the entity must apply the effective yield method when SAB Topic 5.Q applies. Under SAB
Topic 5.Q, it is not appropriate to immediately recognize the entire discount between
the issuance price and the liquidation preference related to increasing-rate preferred
stock. Rather, an entity applies the SEC’s guidance on increasing-rate preferred stock
independently from the guidance on redeemable equity securities. However, some preferred
stock instruments may be subject to both sets of requirements.
3.2.2.4 Redeemable Preferred Stock
SEC Staff Accounting Bulletins
SAB Topic 3.C, Redeemable Preferred
Stock [Reproduced in ASC 480-10-S99-2]
Facts: Rule 5-02.27 of Regulation
S-X states that redeemable preferred stocks are not to be included in
amounts reported as stockholders’ equity, and that their redemption amounts
are to be shown on the face of the balance sheet. However, the Commission’s
rules and regulations do not address the carrying amount at which redeemable
preferred stock should be reported, or how changes in its carrying amount
should be treated in calculations of earnings per share . . . .
Question 1: How should the
carrying amount of redeemable preferred stock be determined?
Interpretive Response: The initial
carrying amount of redeemable preferred stock should be its fair value at
date of issue. Where fair value at date of issue is less than the mandatory
redemption amount, the carrying amount shall be increased by periodic
accretions, using the interest method, so that the carrying amount will
equal the mandatory redemption amount at the mandatory redemption date. The
carrying amount shall be further periodically increased by amounts
representing dividends not currently declared or paid, but which will be
payable under the mandatory redemption features, or for which ultimate
payment is not solely within the control of the registrant (e.g., dividends
that will be payable out of future earnings). Each type of increase in
carrying amount shall be effected by charges against retained earnings or,
in the absence of retained earnings, by charges against paid-in capital.
The accounting described in the preceding paragraph would
apply irrespective of whether the redeemable preferred stock may be
voluntarily redeemed by the issuer prior to the mandatory redemption date,
or whether it may be converted into another class of securities by the
holder. Companies also should consider the guidance in FASB ASC paragraph
480-10-S99-3A (Distinguishing Liabilities from Equity Topic).
Question 2: How should periodic
increases in the carrying amount of redeemable preferred stock be treated in
calculations of earnings per share . . . ?
Interpretive Response: Each type
of increase in carrying amount described in the Interpretive Response to
Question 1 should be treated in the same manner as dividends on
nonredeemable preferred stock.
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable Securities
S99-3A(20)
Preferred stock instruments issued by a parent (or single reporting
entity). Regardless of the accounting method selected in paragraph 15
and the redemption terms (that is, fixed price or fair value), the resulting
increases or decreases in the carrying amount of a redeemable instrument
other than common stock should be treated in the same manner as dividends on
nonredeemable stock and should be effected by charges against retained
earnings or, in the absence of retained earnings, by charges against paid-in
capital. Increases or decreases in the carrying amount should reduce or
increase income available to common stockholders in the calculation of
earnings per share . . . . Additionally, Paragraph 260-10-S99-2, provides
guidance on the accounting at the date of a redemption or induced conversion
of a preferred stock instrument.
In accordance with ASR 268, as interpreted by SAB Topic 3.C and ASC
480-10-S99-3A, preferred stock that is redeemable at the option of the holder or upon
the occurrence of an event outside the issuer’s control, other than an ordinary
liquidation, must be classified in temporary equity by an SEC registrant. Furthermore,
if the preferred stock is currently redeemable or it is probable that it will become
redeemable, the preferred stock must be periodically remeasured to its redemption
amount. Regardless of whether the redemption price represents a fair value or non–fair
value amount upon redemption, adjustments to remeasure redeemable preferred stock to its
redemption amount represent “deemed dividends” that must be reduced from net income in
arriving at income available to common stockholders.
ASC 480-10-S99-3A(14) states, in part, that when preferred stock “is
currently redeemable (for example, at the option of the holder), it should be adjusted
to its maximum redemption amount at the balance sheet date.” If the preferred stock is
not currently redeemable, but it is probable that it will become redeemable (for
example, when the redemption depends solely on the passage of time), an entity can
select one of two methods to remeasure the preferred stock to its redemption amount. ASC
480-10-S99-3A(15) describes these two methods as follows:
-
Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
-
Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
The method applied under ASC 480-10-S99-3A(15) to remeasure preferred
stock to its redemption amount will affect the periodic amount of “deemed dividends”
that reduce net income in arriving at income available to common stockholders. ASC
480-10-S99-3A(16)(e) stipulates that decreases to the carrying amount that result from
the application of ASC 480-10-S99-3A may only be recognized to the extent that such
decreases reflect recoveries of previously recognized increases to the carrying amount
as a result of the application of ASC 480-10-S99-3A. For additional guidance on applying
the SEC’s guidance on redeemable securities, see Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From
Equity.
Connecting the Dots
The redemption amount of redeemable preferred stock may vary
(e.g., it may be the fair value of the preferred stock or it may be based on an
index). In these situations, ASC 480-10-S99-3A allows an entity to reverse prior
increases in the carrying amount of the preferred stock that resulted from the
application of the subsequent-measurement guidance in ASC 480-10-S99-3A. These
increases would reverse the “deemed dividends” recorded in prior periods and would
be treated as a “deemed contribution” by the preferred stockholder. Thus, the
adjustment to net income to arrive at income available to common stockholders in a
particular period could be positive (i.e., a “credit” resulting from the reduction
of the redemption amount of redeemable preferred stock). However, on a cumulative
basis, adjustments to remeasure redeemable preferred stock to its redemption amount
may not be negative (i.e., cumulatively, there cannot be a positive adjustment to
net income in arriving at income available to common stockholders). ASC
480-10-S99-3A(16)(e) states:
[R]egardless of the accounting
method applied [the immediate or accretion method], the amount presented in
temporary equity should be no less than the initial amount reported in temporary
equity for the instrument. That is, reductions in the carrying amount of a
redeemable equity instrument from the application of [the immediate method or
accretion method] are appropriate only to the extent that the registrant has
previously recorded increases in the carrying amount of the redeemable equity
instrument from the application of [the immediate method or accretion method].
See Section
3.2.2.6.2.2 for discussion of the accounting for a redemption of redeemable
preferred stock that has been remeasured under ASC 480-10-S99-3A.
3.2.2.5 Convertible Preferred Stock
3.2.2.5.1 Convertible Preferred Stock That Contains a Down-Round Feature
ASC 260-10
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).
Under ASC 260, when a down-round feature in convertible preferred
stock is triggered (i.e., when the conversion price is adjusted), an entity must
immediately recognize a dividend (which reduces the numerator in the calculation of
basic EPS) on the basis of the increase in the fair value of the instrument. This
accounting is the same as the treatment of a down-round feature in a freestanding
equity-linked financial instrument, such as a warrant (see Section 3.2.5.3). However, down-round features in
convertible debt instruments do not affect EPS (i.e., they are not recognized as
dividends when they are triggered).
3.2.2.5.2 Redeemable Convertible Preferred Stock
The guidance in ASC 480-10-S99-3A on the subsequent measurement of
redeemable equity securities applies to convertible preferred stock that (1) is
currently redeemable or (2) it is probable will become redeemable. See Section 3.2.2.4 for discussion of
the application of ASC 480-10-S99-3A to redeemable preferred stock. See Sections 3.2.5.2.4 and 3.2.5.2.5 for additional guidance
on redeemable convertible preferred stock that contains a separately classified equity
component.
3.2.2.5.3 Participating Convertible Preferred Stock
Section
3.2.2.7 discusses the EPS accounting for participating convertible
preferred stock.
3.2.2.5.4 Accounting for a Conversion of Convertible Preferred Stock
A settlement of convertible preferred stock through the issuance of
common shares in accordance with the stated conversion privileges in the convertible
preferred stock agreement is not subject to ASC 260-10-S99-2 and has no incremental
impact on income available to common stockholders in the calculation of basic EPS,
provided that (1) the settlement is considered a “conversion” and (2) no component of
the convertible preferred stock instrument is separately classified either as a
derivative liability or within stockholders’ equity. Section 3.2.2.6.2.1 discusses whether a settlement
of convertible preferred stock is treated as a “conversion” or a redemption. Section 3.2.2.5.4.1 discusses the
EPS accounting for a settlement of a preferred stock host contract and an embedded
conversion option liability when the settlement is considered a “conversion.”
Section 3.2.2.5.4.2
discusses the EPS accounting for a settlement of convertible preferred stock that
contains a separately recognized equity component when the settlement is considered a
“conversion.” Section
3.2.2.6.3 discusses the EPS accounting for a settlement of convertible
preferred stock that arises from an induced conversion.
3.2.2.5.4.1 Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
The Codification does not specifically address the accounting for
a settlement of a preferred stock host contract and a separated embedded conversion
option liability through the issuance of common stock under the original conversion
terms of the instrument. As a result, there may be alternative views on the
accounting upon a settlement. The acceptable alternative views, when the settlement
is considered a conversion according to the original conversion privileges, as
opposed to a redemption or an induced conversion, are as follows:5
-
Redemption accounting — Even though the settlement occurred in accordance with the contractual conversion terms, it is treated as a redemption since the embedded conversion option was separated as a liability. As a result, an adjustment is made to net income in arriving at income available to common stockholders in accordance with ASC 260-10-S99-2. That adjustment, which is recognized in retained earnings, will equal the difference between the settlement-date fair value of the common stock issued on conversion and the aggregate of the carrying amounts of the preferred stock host contract and the separated embedded conversion option liability, as adjusted immediately before redemption accounting is applied.When entities use this approach, there is diversity in practice related to the adjustment to the carrying amount of the separated liability for the embedded conversion option that is made immediately before redemption accounting is applied. Some entities will adjust the liability for the embedded conversion option to its fair value under ASC 820 immediately before applying redemption accounting. Other entities will adjust the liability for the embedded conversion option to the fair value of the common stock issued upon conversion, or its “intrinsic value,” immediately before applying redemption accounting. While the final adjustment to the embedded conversion option liability may result in a gain or loss that is recognized in earnings under either approach, entities that apply the latter approach will recognize a larger gain or a smaller loss in earnings as a result of the reversal of any remaining time value in the embedded conversion option liability. Even if the latter view is applied to the adjustment of the carrying amount of the embedded conversion option liability, an adjustment will still be required under ASC 260-10-S99-2 if there is any unamortized discount or premium on the convertible preferred stock host contract. The accounting becomes more complex if the convertible preferred stock instrument is a redeemable security subject to the subsequent-measurement guidance in ASC 480-10-S99-3A. In these circumstances, the carrying amount of the preferred stock host contract must also be remeasured in accordance with the recognition and measurement guidance in ASC 480-10-S99-3A immediately before redemption accounting is applied.
-
Conversion accounting — Since the settlement occurred in accordance with the contractual conversion terms, it is treated in the same manner as a conversion of convertible preferred stock that has no separately recognized amount for the embedded conversion option. Common stockholders’ equity is increased by the sum of the carrying amount of the preferred stock host and embedded conversion option liability. As with the accounting for a conversion when the embedded conversion option is not separated from the hybrid convertible preferred stock instrument, ASC 260-10-S99-2 does not apply to the settlement. However, if the convertible preferred stock instrument is classified in temporary equity and is being remeasured to its redemption amount, an adjustment in accordance with the entity’s accounting policy for remeasuring redeemable securities under ASC 480-10-S99-3A should be recognized immediately before conversion accounting is applied.
-
Partial redemption/partial conversion accounting — This view underscores aspects of both redemption accounting and conversion accounting. Any unamortized discount on the preferred stock host contract is immediately amortized into retained earnings and considered a “deemed dividend” that reduces net income in arriving at income available to common stockholders. This approach is consistent with the accounting for a conversion of convertible preferred stock that contains a separately recognized equity component. Common stockholders’ equity is then increased by the sum of the carrying amounts of the preferred stock host contract and separated embedded conversion option liability in a manner similar to the accounting for a conversion. Under this approach, if no unamortized discount remains on the host contract, no adjustment will be needed upon settlement for the redemption accounting aspect. Further, if the convertible preferred stock is a redeemable security that is being remeasured to its redemption amount under ASC 480-10-S99-3A, an entity should remeasure the carrying amount of the preferred stock host contract in accordance with the recognition and measurement guidance in ASC 480-10-S99-3A immediately before accounting for the settlement of the instrument.
Section
3.2.2.6.2.1.1 discusses the EPS accounting for a redemption of
convertible preferred stock that contains a separately recognized embedded
conversion option derivative liability.
3.2.2.5.4.2 Convertible Preferred Stock That Contains a Separately Classified Equity Component
Section
3.2.5.2.4 discusses the EPS accounting for a settlement of convertible
preferred stock that contains a separately classified equity component related to
the embedded conversion option when the settlement is considered a “conversion.” As
discussed in that section, upon conversion, any remaining unamortized discount on
the convertible preferred stock should be immediately recognized as a dividend,
which reduces net income in arriving at income available to common stockholders. The
adjusted carrying amount of the convertible preferred stock and the carrying amount
of the separately recognized equity component should then be recognized in
stockholders’ equity to reflect the conversion. This entry has no impact on income
available to common stockholders. The accounting upon conversion will also be
affected by the application of ASC 480-10-S99-3A if the convertible preferred stock
instrument is a redeemable equity security that is subject to the
subsequent-measurement guidance in ASC 480-10-S99-3A. See further discussion in
Sections 3.2.5.2.4 and 3.2.5.2.5.
3.2.2.6 Redemption or Induced Conversion of Preferred Stock
3.2.2.6.1 General
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 following is the text of SEC Staff
Announcement: The Effect on Calculation of Earnings per Share for a Period
That Includes the Redemption or Induced Conversion of Preferred Stock.
Scope
This SEC staff announcement applies to redemptions
and induced conversions of equity-classified preferred stock
instruments. For purposes of this announcement:
-
Modifications and exchanges of preferred stock instruments that are accounted for as extinguishments, resulting in a new basis of accounting for the modified or exchanged preferred stock instrument, are considered redemptions.
-
A preferred stock instrument classified within temporary equity pursuant to the guidance in ASR 268 and paragraph 480-10-S99-3A is considered equity-classified, and redemptions and induced conversions of such securities would be subject to this guidance.
-
If an equity-classified security is subsequently required to be reclassified as a liability based on the provisions of other GAAP (for example, because a preferred share becomes mandatorily redeemable pursuant to Subtopic 480-10), the reclassification is considered a redemption of equity by issuance of a debt instrument.
The accounting for conversions of preferred stock
instruments into other equity-classified securities pursuant to
conversion privileges provided in the terms of the instruments at
issuance is not affected by this announcement.
The Effect on Income
Available to Common Stockholders of a Redemption or Induced Conversion
of Preferred Stock
If a registrant redeems
its preferred stock, the SEC staff believes that the difference between
(1) the fair value of the consideration transferred to the holders of the
preferred stock and (2) the carrying amount of the preferred stock in the
registrant’s balance sheet (net of issuance costs) should be subtracted
from (or added to) net income to arrive at income available to common
stockholders in the calculation of earnings per share. The SEC staff
believes that the difference between the fair value of the consideration
transferred to the holders of the preferred stock and the carrying amount
of the preferred stock in the registrant’s balance sheet represents a
return to (from) the preferred stockholder that should be treated in a
manner similar to the treatment of dividends paid on preferred stock. This
calculation guidance applies to redemptions of convertible preferred stock
regardless of whether the embedded conversion feature is “in-the-money” or
“out-of-the-money” at the time of redemption. The fair value of the
consideration transferred is reduced by the commitment date intrinsic
value of the conversion option if the redemption includes the
reacquisition of a previously recognized beneficial conversion feature in
a convertible preferred stock instrument.
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.
The scope of ASC 260-10-S99-2 includes the following two types of
transactions:
- Redemptions of preferred stock, which include any of the following:
- A redemption or other settlement of a preferred stock instrument that is classified in equity (whether permanent equity or temporary equity) in return for cash, other securities issued by the entity, or other consideration, including a redemption or other settlement of a convertible preferred stock instrument that is classified in equity, regardless of whether the embedded conversion option is in-the-money or out-of-the-money on the settlement date.
- A redemption or other settlement of a derivative instrument indexed to a preferred stock instrument that is classified in equity in return for cash, other securities issued by the entity, or other consideration.
- A modification or exchange of a preferred stock instrument classified in equity (whether permanent equity or temporary equity) that is treated as an extinguishment.
- A modification or exchange of a freestanding or embedded equity-classified derivative indexed to a preferred stock instrument that is treated as an extinguishment.
- A reclassification of a preferred stock instrument, including a freestanding derivative indexed to such an instrument, from equity to a liability.
- Induced conversions of convertible preferred stock instruments classified in equity (whether permanent equity or temporary equity).
ASC 260-10-S99-2 does not address the accounting for any of the
following transactions:
- A conversion of a convertible preferred stock instrument in accordance with its stated conversion privileges.6
- A modification or exchange of a preferred stock instrument that is classified in equity (whether permanent equity or temporary equity) that is not treated as an extinguishment, including a modification or exchange of a freestanding or embedded derivative instrument indexed to a preferred stock instrument that is classified in equity that is not treated as an extinguishment.
- A redemption, modification, exchange, conversion, or other settlement of common stock.
- A redemption, modification, exchange, exercise, or other settlement of a freestanding financial instrument that is indexed to common stock and classified in equity.
- A redemption, modification, exchange, conversion, exercise, or other settlement of an embedded derivative indexed to common stock that has an associated amount classified in equity.7
- A redemption, modification, exchange, conversion, or other settlement of an embedded derivative indexed to common stock that is not separated from a hybrid financial instrument.
- A redemption, modification, exchange, conversion, or other settlement of any liability-classified instrument (e.g., convertible debt).
For transactions not within the scope of ASC 260-10-S99-2, an entity
should consider other relevant guidance to determine the effect, if any, on net income
or income available to common stockholders. Section 3.2 discusses transactions subject to ASC
260-10-S99-2 as well as certain transactions that are not subject to ASC 260-10-S99-2.
Although the requirement in ASC 260-10-S99-2 specifically concerns SEC registrants,
nonregistrants that present EPS should also apply it.
The table below summarizes the types of transactions involving
preferred stock that are considered redemptions to which ASC 260-10-S99-2 would be
applied.
Table
3-5
Instrument
| Transaction | Considered
Redemption Requiring Application of ASC 260-10-S99-2? |
---|---|---|
Preferred stock classified in permanent or temporary equity | Extinguishment for
cash, other assets, or shares not pursuant to a “conversion” in accordance
with the stated conversion privileges:
| Yes. |
Modification or
exchange that is accounted for as an extinguishment. | Yes. | |
Modification or exchange that is not accounted for as an
extinguishment. | No. ASC 260-10-S99-2 does not apply to a modification or
exchange of an equity-classified preferred stock instrument that is not
accounted for as an extinguishment. However, a similar concept is applied
when the modification or exchange provides incremental value to the
preferred stockholder. See Section
3.2.6.1 for considerations related to the impact on EPS for a
modification or exchange of preferred stock that is not accounted for as
an extinguishment. | |
Reclassification
from equity to a liability. | Yes. | |
Conversion into common stock according to the stated conversion
privileges that is considered a “conversion.” | No. However, if the conversion is considered an induced conversion,
the guidance in ASC 260-10-S99-2 on induced conversions applies (see
Section
3.2.2.6.3). See also Sections 3.2.5.2.4 and 3.2.5.2.5 if the
preferred stock contains a separately recognized equity
component. | |
Preferred stock classified as liability | Extinguishment for
cash, other assets, or shares not pursuant to “conversion” in accordance
with the stated conversion privileges:
| No. ASC 405-20 and ASC 470-50 provides accounting and
reporting guidance on extinguishments of liabilities. |
Modification or
exchange that is accounted for as an extinguishment. | No. ASC 470-50 provides accounting and reporting guidance on
modifications and exchanges of liabilities. | |
Modification or
exchange that is not accounted for as an extinguishment. | No. ASC 470-50 provides accounting and reporting guidance on
modifications and exchanges of liabilities. | |
Conversion into
common stock according to the stated conversion privileges that is
considered a “conversion.” | No. ASC 470-20 provides accounting and reporting guidance on the
conversion of convertible debt into common stock. That guidance also
addresses the accounting for induced conversions. |
3.2.2.6.2 Redemption of Preferred Stock
In a redemption of preferred stock that is classified in permanent
or temporary equity, any difference between the fair value of consideration
transferred to redeem the preferred stock and the net carrying amount of the preferred
stock on the issuer’s balance sheet will affect net income available to common
stockholders regardless of whether the redemption is at a premium or a discount to the
net carrying amount. The SEC staff believes that this difference represents a return
to (from) the preferred stockholder that should be treated in a manner similar to the
treatment of dividends paid on preferred stock (i.e., a “deemed dividend” or a “deemed
contribution”). If the fair value of the consideration transferred exceeds the net
carrying amount of the preferred stock, the excess consideration (the premium paid)
represents a return to the preferred stockholders and is deducted from net income to
arrive at income available to common stockholders (a “deemed dividend”). If the fair
value of the consideration transferred is less than the net carrying amount of the
preferred stock, the discount is added to net income in arriving at income available
to common stockholders (a “deemed contribution”).
The table below addresses certain matters related to the redemption of preferred
stock.
Issue
|
Application
|
---|---|
Scope
|
The SEC staff’s view on redemptions of preferred stock in ASC
260-10-S99-2, must be applied to all extinguishments of preferred stock by
SEC registrants. It should also be applied by nonregistrants that report
EPS under ASC 260.
ASC 260-10-S99-2 applies to the redemption of
convertible preferred stock regardless of whether the conversion feature
is “in-the-money” or “out-of-the-money” as of the redemption date (see
Section 3.2.2.6.2.1). ASC
260-10-S99-2 also applies to the reclassification of preferred stock as a
liability (see Sections 3.2.2.8 and
3.2.3.5.1) and the redemption of
preferred stock that is classified as an NCI (see Sections 3.2.3.2.1 and 3.2.3.3.1).
|
Consideration transferred to redeem preferred stock
|
Under ASC 260-10-S99-2, it is presumed that the fair value of the
consideration transferred to holders to redeem a preferred stock
instrument reflects the fair value of the preferred stock that is being
redeemed. If the fair value of the consideration transferred to preferred
stockholders does not reflect the fair value of the redeemed shares, the
transaction involves other elements that should be accounted for in
accordance with other GAAP.
Publicly traded companies that repurchase preferred
stock may be obligated to pay a 1 percent excise tax under Internal
Revenue Code (IRC) Section 4501, which was added by the Inflation
Reduction Act of 2022. This excise tax should be included in the
adjustment to retained earnings that is recognized for the redemption of
the preferred stock in accordance with ASC 260-10-S99-2. See Deloitte’s
April 27, 2023, Heads
Up for more information about the accounting for this
excise tax.
|
Net carrying amount of preferred stock redeemed
|
Direct issuance costs capitalized at issuance of preferred stock —
Under ASC 260-10-S99-2, the net carrying amount of preferred stock, which
is used to calculate the adjustment to the numerator upon a redemption of
preferred stock, must include issuance costs that were capitalized into
the initial carrying amount of preferred stock. Such costs reduce the net
carrying amount of the preferred stock, and the excess of the
consideration transferred over this adjusted net carrying amount reduces
net income in arriving at income available to common stockholders in the
calculation of basic EPS. Because most entities have capitalized issuance
costs associated with preferred stock, the numerator in the calculation of
basic EPS will generally be adjusted in the period of a redemption of
preferred stock unless the preferred stock has already been remeasured to
its redemption amount under ASC 480-10-S99-3A (see Section 3.2.2.6.2.2).
Undeclared cumulative dividends — To calculate
the adjustment to net income to arrive at income available to common
stockholders upon a redemption of preferred stock, an entity should add
any undeclared cumulative dividends previously considered in the
calculation of basic EPS to the net carrying amount of the preferred stock
being redeemed when such amounts are not already included in the net
carrying amount of the preferred stock. In other words, when the
redemption price includes the payment of accumulated but undeclared
cumulative dividends that have already been included in the calculation of
income available to common stockholders in a prior period but that are not
recognized as part of the net carrying amount of the preferred stock on
the issuer’s balance sheet, an adjustment must be made to the excess of
the fair value of consideration transferred over the net carrying amount
of the preferred stock so that the impact of such cumulative dividends is
not “double counted.”
Declared and unpaid dividends (whether cumulative or not) — If an
entity has recognized a liability for accrued and unpaid declared
dividends, the carrying amount of this liability should be included with
the net carrying amount of the preferred stock in calculating the “deemed
dividend” or “deemed contribution” that adjusts net income to arrive at
income available to common stockholders.
Redeemable preferred stock — For a redemption of redeemable
preferred stock that is being remeasured to its redemption amount under
ASC 480-10-S99-3A, the net carrying amount should be adjusted immediately
before the redemption in accordance with the entity’s accounting for
remeasurement adjustments under ASC 480-10-S99-3A (see Section 3.2.2.6.2.2).
Convertible preferred stock with a separated embedded conversion
liability — See Section
3.2.2.6.2.1.1.
Convertible preferred stock with a separated equity component —
See Section 3.2.2.6.2.1.2.
|
Modification of preferred stock that is treated as an extinguishment |
An entity may incur fees and costs in a modification or exchange of
preferred stock that is treated as an extinguishment. Such fees and costs
should be treated in the same manner as that described in ASC 470-50-40-17
and 40-18 for modifications and exchanges of debt instruments that are
accounted for as extinguishments. Therefore, fees and costs incurred with
third parties should be capitalized into the carrying amount of the “new”
preferred stock instrument and fees and costs incurred with investors
should be considered associated with the “original” preferred stock
instrument and included as part of the charge (or credit) to retained
earnings for the extinguishment of the original preferred stock
instrument.
See Section
3.2.6.1 for more information about modifications and
exchanges of preferred stock.
|
Below are some examples illustrating the application of ASC
260-10-S99-2 to redemptions of preferred stock.
Example
3-8
Reacquisition of Preferred Stock on Open Market
Company B has 100,000 shares of outstanding
preferred stock that is not mandatorily redeemable but may be called at
B’s option at a price of $1,100 per share. Each outstanding share has a
liquidation preference of $1,000. The outstanding preferred stock has an
aggregate liquidation preference of $100 million and an aggregate net
carrying amount of $98 million (or $980 per share). The difference between
the aggregate liquidation preference and net carrying amount results from
capitalized issuance costs.
The preferred stock is currently trading at $1,075 per share. Company B has
recently issued other securities for which it plans to use those proceeds
to redeem the outstanding preferred stock. Since it is economically
favorable to B to repurchase the preferred stock in the open market in
lieu of exercising its redemption option, B acquires 50,000 shares of the
outstanding preferred stock for an aggregate price of $54 million, or
(50,000 shares × 1,075) + $250,000 in transaction costs.
Company
B’s “reacquisition” should be treated as a redemption of preferred stock
under ASC 260-10-S99-2 since this guidance applies to all types of
redemptions of preferred stock. The adjustment to income available to
common stockholders required for the redemption of the 50,000 shares of
preferred stock is a $5 million charge. This is treated in the same manner
as the payment of a dividend on preferred stock. The $5 million reduction
from net income to arrive at income available to common stockholders is
calculated as follows:
The
$5 million should not be recognized as a loss in the income statement;
rather, it is reflected as a reapportionment of equity between common
stockholders and preferred stockholders. The $5 million will, however,
have the same impact as a loss on the numerator in the calculation of
basic EPS.
Example
3-9
Reclassification of Preferred Stock From Equity to Liability
Company D has outstanding preferred stock with the
following terms:
- The preferred stock is automatically converted into common stock at a conversion price of $25 per share in the event that D effects a qualified IPO within the next five years.
- If D does not effect a qualified IPO by the end of the fifth year from the issuance date, the preferred stock becomes mandatorily redeemable in five years.
Company D should not classify the preferred
stock as a liability under ASC 480 before the fifth year from the issuance
date if it concludes that the conversion upon a qualified IPO is a
substantive feature. Furthermore, while D is required to classify the
preferred stock within temporary equity under ASC 480-10-S99-3A, it should
not remeasure the preferred stock to its redemption amount as long as the
occurrence of a qualified IPO by the end of year five is more than remote.
However, if a qualified IPO does not happen by the
end of year five, the preferred stock becomes a mandatorily redeemable
financial instrument for which reclassification as a liability is required
under ASC 480. In this circumstance, in accordance with ASC 480-10-30-2, D
should reflect the reclassification by measuring the liability initially
at fair value and reducing equity by the same amount without recognizing a
gain or loss. This reclassification is treated in the same manner as any
other extinguishment of preferred stock under ASC 260-10-S99-2. Therefore,
the difference between the initial fair value amount recognized for the
preferred stock upon reclassification as a liability and the net carrying
amount of the preferred stock (which should be adjusted under other
applicable GAAP, including ASC 480-10-S99-3A if applicable, immediately
before such reclassification) reflects a charge (or credit) to net income
in arriving at income available to common stockholders. See Section 3.2.2.8 for
further discussion of the reclassification of preferred stock to a
liability.
Example
3-10
Redemption of Subsidiary’s Preferred Stock by Parent
Company P has a wholly owned subsidiary, S, that has
outstanding Series A preferred stock held by third parties. The relevant
features of the Series A preferred stock are as follows:
- Dividends on the preferred stock are cumulative.
- The preferred stock is not mandatorily redeemable and therefore is not classified as a liability under ASC 480-10-25-4.
- The preferred stock is not redeemable at the option of the holder or upon the occurrence of any event outside S’s control and therefore is not classified in temporary equity.
- The preferred stock is redeemable, in whole or in part, on various dates at S’s option, with P’s consent. The redemption price is equal to fixed prices depending on the redemption date, plus any accrued and unpaid cumulative dividends up to the date of redemption. The fixed prices include a premium to the original issuance price.
In accordance with ASC 810-10-45-16, the Series A preferred stock is classified
as an NCI and is reported in permanent equity, separately from parent
equity, in P’s consolidated balance sheet. Company P treats dividends on
the preferred stock as income attributable to the NCI in its consolidated
income statement.
Company P is contemplating having S exercise its redemption option, which will
result in the redemption of the Series A preferred stock at a premium over
the net carrying amount. Because P is not required to remeasure the
preferred stock to its redemption amount under ASC 480-10-S99-3A or other
GAAP, before a redemption, P is not required to recognize the premium
payable on a redemption in its consolidated financial statements. Rather,
any redemption will be treated as a capital stock transaction under ASC
810-10-40-1 and 40-2. Thus, before redemption, the only impact that S’s
Series A preferred stock has on P’s basic EPS pertains to the dividends
that accumulate, which are being recognized in P’s consolidated income
statement as income attributable to the NCI, as stated above.
If S’s Series A preferred stock is redeemed, net income should be reduced, in
P’s consolidated financial statements, by the amount of the premium paid
to redeem the preferred stock to arrive at income available to common
stockholders. The adjustment to net income to arrive at income available
to common stockholders should be calculated as the fair value of the
consideration paid to extinguish the Series A preferred stock (which
includes the premium but not dividends that were previously recognized as
income attributable to NCI) over the net carrying amount of the preferred
stock as reported in NCI.
Under ASC 810, distributions to equity holders, including NCI holders, acting in
their capacity as owners should be excluded from the determination of the
consolidated entity’s net income. However, ASC 810 does not specifically
address whether the parent should treat dividends on a subsidiary’s
preferred stock as an attribution of the subsidiary’s income to the NCI or
as a direct adjustment to retained earnings. On the basis of informal
discussions with the FASB staff, we believe that there are two acceptable
alternatives for presenting dividends on a subsidiary’s preferred stock in
the parent’s consolidated income statement:
-
Alternative 1 — The parent presents the subsidiary’s preferred dividends as a component of the attribution of net income to the NCI on the face of the consolidated statement of income. The preferred dividends result in a decrease in consolidated net income attributable to the parent.
-
Alternative 2 — The parent treats the subsidiary’s preferred dividends as a direct adjustment when calculating income available to the parent’s common stockholders. The preferred dividends do not affect the reported amount of consolidated net income attributable to the parent, which is consistent with the accounting for dividends on preferred stock issued by the parent.
The parent should consistently apply the alternative it selects and should
consider disclosing its accounting policy under ASC 235-10-50. In this
example, assume that P has elected Alternative 1.
Under either alternative, the subsidiary’s preferred dividends will have the
same impact on income available to the parent’s common stockholders, which
is the numerator used in the consolidated entity’s EPS calculation. The
above guidance also applies to a subsidiary’s preferred securities that
are classified in temporary equity under ASC 480-10-S99-3A. The
alternative selected should also be applied to remeasurement adjustments
under ASC 480-10-S99-3A. For more information about the two alternatives,
see Section
6.8 of Deloitte’s Roadmap Noncontrolling Interests.
In this example, the premium on redemption of S’s Series A preferred stock
represents a return on investment to the holders of the preferred stock
that is not available to common stockholders and affects P’s basic EPS in
the same manner as the dividends on S’s Series A preferred stock. However,
since P presents dividends on S’s Series A preferred stock as part of
income attributable to the NCI, which reduces P’s consolidated net income,
the dividends and the premium on redemption are presented differently. The
premium on redemption is not treated as an allocation of income
attributable to NCI. This guidance is consistent with that in ASC
260-10-S99-2.
3.2.2.6.2.1 Redemption of Convertible Preferred Stock
As discussed in ASC 260-10-S99-2, in a redemption of convertible
preferred stock, the difference between the fair value of the consideration
transferred and the net carrying amount of the convertible preferred stock must be
deducted from net income in arriving at income available to common stockholders,
regardless of whether the embedded conversion feature is “in-the-money” or
“out-of-the-money” at the time of redemption.
Connecting the Dots
A convertible preferred stock instrument may be redeemed on
the basis of a price negotiated between the issuer and the investor. The
negotiated price will be affected by whether the conversion option is
“in-the-money” or “out-of-the-money” on the date the redemption price is agreed
upon. Provided that the convertible preferred stock instrument does not contain
any separately recognized derivative liability or equity components, the
conversion of the instrument into common stock in accordance with the stated
conversion privileges would have no impact on the numerator in the calculation
of basic EPS. Furthermore, the issuer could use cash to repurchase the shares of
its common stock issued on conversion in open market transactions without having
any impact on income available to common stockholders. The combination of the
conversion and open market share repurchase may achieve the same or a similar
economic outcome as redeeming the convertible preferred stock instrument with
the holder for cash. However, even though the economics may be the same or
similar, it is not appropriate to account for a redemption as comprising a
conversion and then a subsequent repurchase of the common stock. Rather, the
redemption must result in a charge (or credit) in the calculation of income
available to common stockholders. The example below illustrates this
concept.
Example
3-11
Redemption of Convertible Preferred Stock That
Contains an “In-the-Money” Conversion Option
Assume the following:
- Company X has preferred stock outstanding with a carrying value of $40 million.
- Company Y, the holder of the preferred stock, has the right to convert the preferred stock into 1.7 million shares of X’s common stock. Further, Y has the option to require X to redeem the preferred stock during a five-year period at rates declining ratably from 110 percent of par value plus unpaid cumulative dividends in the first year to 100 percent of par value in the fifth year.
- The current market value of the common stock is significantly higher than the redemption price of the preferred stock. Therefore, X expects Y to convert its preferred stock into the 1.7 million shares of common stock. Company Y has indicated that it intends to sell the common stock on conversion.
- Because of the effect such a large block of stock would have on the market price of X’s common stock if it were sold, X has agreed to pay Y the market price of the common stock in return for the preferred stock.
- The embedded conversion option in the convertible preferred stock has not been separated from the hybrid financial instrument.
Although the economic effect of the
transaction is similar to what would be achieved on Y’s conversion of
its preferred stock followed by X’s reacquisition of such shares as
treasury stock, the transaction is viewed as the redemption of preferred
stock. ASC 260-10-S99-2 stipulates that, for EPS purposes, the
difference between the fair value of the cash consideration paid to Y
and the net carrying amount of the preferred stock should be accounted
for as a reduction of net income in arriving at income available to
common stockholders.
The Codification does not explicitly address whether a settlement
of convertible preferred stock in accordance with a stated settlement provision in a
preferred stock agreement constitutes a conversion or a redemption. While an entity
may need to use judgment and consider the particular facts and circumstances in
determining whether a settlement of convertible preferred stock reflects a
conversion or redemption, certain guidance in ASC 470-20 on evaluating the
settlement of a debt instrument is relevant to this determination by analogy.
Specifically, ASC 470-20-40-5 indicates that the issuance of equity securities such
as common stock in accordance with an instrument’s original conversion terms to
settle a debt instrument that becomes convertible upon the issuer’s exercise of a
call option should be treated as a conversion if the instrument contained a
substantive conversion feature as of its issuance date; otherwise, the issuance of
equity securities should be accounted for as an extinguishment (i.e., a redemption).
For convertible preferred stock, an entity evaluates whether settlement occurred in
accordance with the terms of a substantive conversion feature by considering the
monetary value of the consideration (i.e., the payoff profile) as opposed to the
form of consideration (i.e., shares of common stock or cash). For example, some
convertible preferred stock instruments contain embedded “conversion terms” that
are, in essence, redemption features that are settled by delivery of a variable
number of shares of common stock. It is important for an entity to distinguish
between embedded features that are conversion options and those that are redemption
options since ASC 260-10-S99-2 applies to redemptions of preferred stock even if the
consideration transferred to redeem the shares is common stock of the issuer. That
is, a “conversion term” that results in the delivery of a variable number of shares
of common stock with a fixed monetary amount should be treated as a redemption.
Examples 3-12 through 3-14 illustrate the
treatment of settlements of convertible preferred stock in accordance with the
contractual terms of embedded features.
Example
3-12
Settlement of Convertible Preferred Stock With a
Fixed-Price Conversion Feature and a Fixed-Percentage Conversion
Feature
Company J has $10 million of
preferred stock outstanding with the following conversion terms:
- At any point after five years from the issuance date, the holder can convert the preferred stock into shares of common stock at a conversion price of $25 per share (the “fixed-price conversion feature”).
- At any point after five years from the issuance date, the issuer can settle the preferred stock by issuing a number of shares of common stock that has a fair value equal to the liquidation preference of the convertible preferred stock, divided by 90 percent and rounded to the closest number of whole shares (the “fixed-percentage conversion feature”). If the issuer elects to exercise this redemption feature, the holder has the right to elect to exercise its conversion option.
Company J has concluded that the preferred stock does not need to be classified
as a liability under ASC 480 and has analyzed the conversion terms as
consisting of an embedded conversion option with respect to the
fixed-price conversion feature and an embedded call option with respect
to the fixed-percentage conversion feature. Further, J has concluded
that it is not required to separate either of these embedded features
under ASC 815-15.
Below is an analysis of J’s EPS accounting depending on which conversion feature
constitutes the terms of the settlement of the convertible preferred
stock.
Scenario 1 — Fair Value of
Common Stock Is $30 per Share
In
this scenario, each holder will receive the following number of shares
of common stock under each feature:
Fixed-price
conversion feature | 40
shares | ($1,000 ÷ $25 = 40
shares) |
Fixed-percentage
conversion feature | 37
shares | ($1,000 ÷ 0.9 =
$1,111 ÷ $30 = 37 shares) |
The holder will elect to exercise its fixed-price conversion feature since doing
so is economically favorable. This settlement reflects a “conversion” in
accordance with the original conversion privileges of the convertible
preferred stock. ASC 260-10-S99-2 does not
apply.
Scenario 2 — Fair Value of
Common Stock Is $26 per Share
In this
scenario, each holder will receive the following number of shares of
common stock under each feature:
Fixed-price
conversion feature | 40
shares | ($1,000 ÷ $25 = 40
shares) |
Fixed-percentage
conversion feature | 43
shares | ($1,000 ÷ 0.9 =
$1,111 ÷ $26 = 43 shares) |
The holder will not elect to exercise its fixed-price conversion feature because
that would be economically unfavorable; therefore, settlement will occur
on the basis of the fixed-percentage conversion feature (provided that
the issuer elects to exercise its redemption option). This settlement
reflects a “redemption” of the convertible preferred stock. ASC
260-10-S99-2 does apply. When ASC 260-10-S99-2
is applied, the fair value of the consideration transferred that is used
in calculating the adjustment to arrive at income available to common
stockholders is $1,111 per share of preferred stock extinguished (i.e.,
43 shares × $26 per share = $1,111). Even though a conversion would have
provided the holder with a return of $40 per share of preferred stock,
which is calculated as ($26 per share – $25 per share) × 40 shares =
$40, it would not be appropriate to consider the fair value of the
consideration transferred to redeem the preferred stock to be $1,111
less $40 per share.
The
conclusions in this example would be unchanged if it was the holder, as
opposed to the issuer, that had the right to exercise the
fixed-percentage conversion feature.
Example
3-13
Settlement of Redeemable Convertible Preferred Stock
in Cash on the Basis of (1) Exercise of Conversion Option or (2)
Exercise of Redemption Option
Assume the
following facts:
- Company H, a nonpublic entity, has issued $25 million of Series B redeemable convertible preferred stock (the “Series B stock”) at its liquidation amount.
- The Series B stock contains dividends, payable in cash, that are cumulative and accrue at an annual rate of 8 percent.
- The holders of the Series B stock can convert the shares at any time at a fixed conversion rate of 25 shares of H’s common stock per $1,000 liquidation amount of Series B stock. Conversion automatically occurs upon a qualified IPO of H. Company H has the right to elect to settle conversion either entirely in shares of common stock or entirely in cash of an equivalent value. Further, H has sufficient authorized and unissued common shares to settle conversions in shares.
- The holders of the Series B stock also have the right to redeem the shares at any time after five years from the issuance date at an amount equal to 102 percent of the liquidation amount per share redeemed, plus any accrued and unpaid cumulative dividends, regardless of whether the dividends are declared. Settlement may occur either entirely in cash or entirely in a variable number of shares of H’s common stock with the same monetary value as the cash settlement amount at the option of the holder.
- Company H has the right to redeem the Series B stock at any time after five years from the issuance date at an amount equal to 110 percent of the liquidation amount per share redeemed, plus any accrued and unpaid cumulative dividends, regardless of whether the dividends are declared. Settlement may occur either entirely in cash or entirely in a variable number of shares of H’s common stock with the same monetary value as the cash settlement amount at the option of H.
- The Series B stock does not participate in dividends on H’s common stock and did not contain a separated equity component.
- Company H has determined that the host contract for the Series B stock is an equity instrument. The embedded conversion feature has not been separated as an embedded derivative because it is considered clearly and closely related to the host contract under ASC 815-15. Neither of the redemption options have been separated from the Series B stock under ASC 815-15 because they must be physically settled and the Series B stock is not readily convertible to cash.
- The Series B stock meets the conditions for classification in temporary equity, and H has applied the guidance in ASC 480-10-S99-3A in its financial statements included in a Form S-1 registration statement filed for an IPO. Because H has deemed a qualified IPO as being reasonably possible before the holders can redeem the shares and controls the ability to settle the Series B stock in common stock upon any conversion, the Series B stock is not remeasured to its redemption amount.
- Because H’s financial statements are included in a registration statement filed with the SEC, H presents basic and diluted EPS.
Scenario 1 —
Settlement of Conversion Option
If
settlement of the Series B stock occurs through exercise of the
conversion option, ASC 260-10-S99-2 does not
apply, regardless of whether the form of settlement is cash or
shares of H’s common stock. Since H controls the form of settlement upon
conversion, H is also not required to recognize any adjustments to net
income under ASC 480-10-S99-3A.
While the Series B stock was not being remeasured to its redemption amount, if
the facts were different, the Series B stock may need to be remeasured
to its redemption amount under ASC 480-10-S99-3A. For example, assume
the same facts as described above except that the holders, rather than
H, had the right to elect to settle any conversion in cash in lieu of
shares of common stock. In this circumstance, H would be required to
remeasure the Series B stock to the maximum amount of cash payable
pursuant to the conversion feature or put feature in accordance with its
accounting policy applied under ASC 480-10-S99-3A. The remeasurement
adjustment would be treated as a “deemed dividend” under ASC
480-10-S99-3A that would have an impact on the numerator in the
calculation of basic EPS.
As another example,
assume the same facts as described above except that the Series B stock
was not mandatorily converted into common stock upon a qualified IPO. In
this circumstance, the Series B stock would have needed to be
periodically remeasured to its redemption amount under ASC 480-10-S99-3A
because the holders control the ability to “put” the Series B stock for
cash and not convert it into common stock. Therefore, H would be
required to make a remeasurement adjustment in accordance with its
accounting policy applied under ASC 480-10-S99-3A. That amount, which
would be calculated on the basis of the redemption price underlying the
holders’ put option, would be treated as a “deemed dividend” in the
calculation of basic EPS. Thus, while ASC 260-10-S99-2 would not apply,
the application of ASC 480-10-S99-3A would have still resulted in a
reduction of net income in arriving at income available to common
stockholders; however, the amount of the adjustment would not have been
the same as the adjustment that would have been made if ASC 260-10-
S99-2 had applied to the conversion.
The above
alternatives illustrate the need for an entity to closely consider the
terms and features of preferred stock so that it can appropriately apply
ASC 480-10-S99-3A and ASC 260-10-S99-2.
Scenario 2 — Settlement of Redemption Option
If the Series B stock is settled through exercise of either of the redemption
options, ASC 260-10-S99-2 does apply regardless
of whether the form of settlement is cash or shares of H’s common stock.
In calculating the difference between the redemption price and the net
carrying amount of the Series B stock, H should exclude the portion of
the redemption price that pertains to unpaid cumulative dividends that
have already been included as adjustments to net income in arriving at
income available to common stockholders in prior reporting periods.
Example
3-14
Preferred Equity Redemption Cumulative Stock
Preferred equity redemption cumulative stock
(PERCS) is a form of equity instrument that is automatically converted
into shares of common stock on the mandatory conversion date or upon the
occurrence of certain other specified events (e.g., a merger,
consolidation, or similar extraordinary transaction). The issuer has the
option of calling the PERCS at any time before the mandatory conversion
date for a specified call price payable in the issuer’s common stock.
The call price may decline ratably during the period leading up to the
mandatory conversion date.
PERCS is generally
issued at a price equal to the issuer’s common stock price and, upon
mandatory conversion, is exchanged one-for-one for common stock.
However, the investor’s upside potential is “capped” (generally at a
level 30–35 percent over the initial issuance price) because the issuer
can call the PERCS by delivering fewer common shares to the extent that
the cap has been exceeded. In other words, the investor will receive one
common share in exchange for each PERCS share provided that the issuer’s
common stock price is less than or equal to the capped price. If the
issuer’s common stock price exceeds the “capped” price, the issuer will
call the instrument and the investor will receive a variable number of
shares of common stock that has a monetary value equal to the “capped”
price. Thus, upon any call, the investor will always receive less value
than it would have received in a conversion.
Generally, the PERCS investor receives a dividend during the period in
which the PERCS is outstanding and the dividend is higher than the
dividend on the issuer’s common stock. Such a dividend compensates the
investor for its limited ability to participate in the appreciation of
the common stock as a result of the call option. In substance, the PERCS
investor owns the underlying common stock and the issuer holds a call
option on this stock.
For example, assume that
an entity issues 10 shares of PERCS at $30 per share for an aggregate
purchase price of $300 when the fair value of the issuer’s common stock
is also $30 per share. Further assume that the PERC has a capped price
of $40. Upon settlement, the investor would experience the following
outcomes if the fair value of the issuer’s common stock was $20 and $50,
respectively:
- If the fair value of the issuer’s common stock at maturity was $20 per share, the investor would receive 10 shares of common stock that has an aggregate monetary value of $200. Ignoring dividends paid during the term of the instrument, the investor realizes an economic loss of $100.
- If the fair value of the issuer’s common stock at maturity was $50 per share, the investor would receive only 8 shares of common stock because the issuer would call the instrument at $40 per share (i.e., $40 × 10 = $400 ÷ $50 per share = 8 shares). The eight shares received would have an aggregate fair value of $400. Ignoring dividends paid during the term of the instrument, the investor realizes an economic gain of $100.
The impact on the numerator in the calculation of basic EPS for the instrument
described above is as follows:
-
If the issuer settles the PERCS by delivering a number of shares of common stock equal to the number of shares of PERCS shares settled, the numerator is unaffected. This settlement is treated in the same manner as a conversion of preferred stock according to its stated terms, as discussed in Section 3.2.2.5.4. In this example, as long as the fair value of the issuer’s common stock is $40 per share or less, the settlement will be made by delivering one share of common stock for each PERCS share.
-
If the issuer settles the PERCS by delivering a variable number of shares of common stock that is less than the number of PERCS shares settled, the numerator is unaffected. That is, in an exchange of common stock for outstanding PERCS shares in which the number of shares of common stock exchanged is less than the number of shares of common stock issuable at the 1:1 conversion rate, the issuer is not required to recognize a charge to net income in arriving at income available to common shareholders. ASC 260-10-S99-2 would not be considered applicable in this circumstance because the issuer has, in substance, called underlying common stock at an amount less than fair value. Transactions in the issuer’s common stock between the date of issuance of the PERCS shares and the settlement date would not affect this conclusion provided that such transactions were not targeted to PERCS holders to affect the outcome of the settlement of the PERCS.
-
If the issuer settles the PERCS by paying cash, other assets, or securities other than its outstanding common stock, either directly with the holder or by repurchasing the PERCS on the open market, this would be considered a redemption of the PERCS and ASC 260-10-S99-2 must be applied. This conclusion is reached on the basis that the settlement of the PERCS occurred in a manner that was outside the contractual terms of the instrument.
The conclusion on the application of ASC
260-10-S99-2 to PERCS is based on the unique terms of the instrument and
should not be applied by analogy to other instruments with different
terms.
The next section discusses the EPS accounting for a redemption of
a preferred stock host contract and the separated embedded derivative conversion
option liability. Section
3.2.2.6.2.1.2 discusses the EPS accounting for a redemption of
convertible preferred stock that contains a separately recognized equity component.
Section 3.2.2.6.2.2
discusses the redemption of preferred stock, including convertible preferred stock,
that is classified in temporary equity and is being remeasured to its redemption
amount under ASC 480-10-S99-3A.
3.2.2.6.2.1.1 Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
When an entity has separated an embedded conversion option from
a convertible preferred stock instrument and accounted for the embedded conversion
option as a derivative liability under ASC 815-15, any redemption of the
convertible preferred stock instrument consists of a redemption of both the
preferred stock host contract and the embedded conversion option liability. The
redemption of the preferred stock host contract component is within the scope of
ASC 260-10-99-2. An entity should apply the following approach to allocate the
total consideration paid upon redemption between the preferred stock host contract
and the separated embedded conversion option liability:
- Step 1 — Remeasure the embedded conversion option liability to its fair value immediately preceding the redemption. Any change in fair value should be recognized in earnings in the financial reporting period that includes the redemption.
- Step 2 — If the convertible preferred stock instrument is a redeemable equity security that is subject to remeasurement under ASC 480-10-S99-3A, the entity should apply its accounting policy under ASC 480-10-S99-3A and adjust the carrying amount of the preferred stock host contract to its redemption amount as of the date of the redemption. Any adjustment is considered a “deemed dividend” for which net income is adjusted in arriving at income available to common stockholders in the financial reporting period that includes the redemption.
- Step 3 — Compare the fair value of the total consideration paid to redeem the convertible preferred stock instrument with the sum of the carrying amounts of the preferred stock host contract and embedded conversion option liability after those carrying amounts have been adjusted in steps 1 and 2.
- If the total consideration transferred to redeem the convertible preferred stock instrument equals the sum of the carrying amounts of the preferred stock host contract and embedded conversion option liability, there is no incremental amount to be recognized in either earnings or as a “deemed dividend” to account for the redemption.
- If the total consideration transferred to redeem the convertible preferred stock instrument does not equal the sum of the carrying amounts of the preferred stock host and embedded conversion option liability, an allocation of the total consideration transferred on redemption to these two components is required. The total consideration paid to redeem the convertible preferred stock instrument should first be allocated to the embedded conversion option liability in an amount that equals the carrying amount of that component producing no incremental gain or loss. The remaining amount of the total consideration paid to redeem the convertible preferred stock instrument should be allocated to the preferred stock host contract. Any difference between this allocated amount and the carrying amount of the preferred stock host contract is within the scope of ASC 260-10-S99-2. Therefore, this difference should be recognized as a charge (or credit) to net income in arriving at income available to common stockholders in the financial reporting period that includes the redemption.
The example below illustrates a redemption of convertible
preferred stock that contains a separated embedded conversion option liability.
Example
3-15
Redemption of Convertible Preferred Stock That
Contains a Bifurcated Conversion Option
Company Z has issued and has outstanding redeemable convertible
preferred stock. Further, Z remeasures the convertible preferred stock
to its redemption amount in each period under ASC 480-10-S99-3A as if
the balance sheet date is the redemption date. The embedded conversion
option in the convertible preferred stock has been separated as a
derivative liability under ASC 815-15 and is being measured at fair
value, with changes recognized in earnings. In determining the
adjustment needed under the subsequent-measurement guidance in ASC
480-10-S99-3A, Z compares the redemption price with the sum of the
carrying amounts of the host preferred stock and derivative liability
and recognizes an adjustment only if those aggregate amounts are less
than the current redemption amount.
Assume
that the convertible preferred stock is redeemed on March 1, 20X1, in
accordance with the terms of the redemption feature in the convertible
preferred stock. If Z accounts for the settlement in the following
order, there will be no additional amounts to recognize under ASC
260-10-S99-2:
- First, remeasure the derivative liability to fair value under ASC 820 as of March 1, 20X1, with the adjustment recognized in net income.
- Next, remeasure the preferred stock host contract to equal the excess of (1) the redemption amount over (2) the sum of the carrying amounts of the preferred stock host and derivative liability, as remeasured in step 1. This adjustment reflects a “deemed dividend” that affects basic EPS.
- Last, recognize the settlement of the convertible preferred stock. The fair value of the total consideration transferred to redeem the convertible preferred stock will equal the adjusted aggregate carrying amounts recognized for the convertible preferred stock, since it was redeemed according to the same contractual redemption feature used to adjust the carrying amount to the redemption amount.
While ASC 260-10-S99-2 does not result in
an incremental adjustment, the adjustment recognized in the second
step will be treated as a “deemed dividend” (or “deemed contribution”)
for which net income is adjusted in arriving at income available to
common stockholders.
3.2.2.6.2.1.2 Convertible Preferred Stock That Contains a Separately Classified Equity Component
A convertible preferred stock instrument will have a separately
classified equity component only in limited circumstances (e.g., as a result of
the recognition of a down-round feature). In these circumstances, the amount
separately recognized in equity will affect the accounting for the redemption of
the convertible preferred stock under ASC 260-10-S99-2 because the redemption
consists of both the previously recognized equity component and the net carrying
amount of the convertible preferred stock instrument. See Sections 3.2.5.2.4 and
3.2.5.2.5 for
additional discussion of the EPS accounting for a redemption of convertible
preferred stock containing a separately recognized equity component. That section
also discusses the impact of the accounting for a redemption on remeasurement
adjustments related to the convertible preferred stock instrument that are
recognized under ASC 480-10-S99-3A.
3.2.2.6.2.2 Redemption of Preferred Stock Subject to Remeasurement Under ASC 480-10-S99-3A
Preferred stock, including convertible preferred stock, may be
classified in temporary equity under ASC 480-10-S99-3A as a result of redemption
features that allow the holder to redeem the security or allow for redemption upon
the occurrence of events outside the issuer’s control, other than an ordinary
liquidation. Under ASC 480-10-S99-3A(14) and 3A(15), redeemable preferred stock must
be remeasured to its redemption amount either if it is currently redeemable or if it
is probable that it will become redeemable.
When an entity redeems preferred stock that is being remeasured to
its redemption amount under ASC 480-10-S99-3A, the entity should remeasure the
preferred stock to its redemption amount immediately before accounting for the
redemption. If the preferred stock is being remeasured to its current redemption
amount and the redemption occurs in accordance with the redemption provisions used
to remeasure the preferred stock, the application of ASC 260-10-S99-2 may not result
in any incremental adjustment to the numerator in the calculation of basic EPS.
Rather, the adjustments for the redemption terms of the preferred stock will affect
the numerator through the application of ASC 480-10-S99-3A (see Section 3.2.2.4). In other
cases, an adjustment may be required under ASC 260-10-S99-2 for the redemption of
preferred stock that is classified in temporary equity even if the preferred stock
is being remeasured to its redemption amount under ASC 480-10-S99-3A before the
redemption. The example below illustrates this point.
Example
3-16
Redemption of Redeemable Preferred Stock
Company Z issues $100 million of preferred stock to
various investors. The preferred stock has the following terms:
- Dividends are cumulative at a rate of 5 percent per annum.
- The preferred stock is redeemable at the holder’s option at any point after five years from the issuance date at a price of $105 per share, or an aggregate amount of $105 million, plus any accumulated dividends that have not been paid.
Company Z incurred direct costs of $5
million in issuing the preferred stock.
Because
the preferred stock is redeemable at the option of the holder, it is
classified in temporary equity on Z’s balance sheet. Company Z has
elected to apply the accounting policy in ASC 480-10-S99-3A(15)(b) and
is therefore required to recognize changes in the redemption value
immediately as they occur and adjust the carrying amount of the
instrument to equal the redemption value at the end of each reporting
period. Under this method, the end of the reporting period is viewed as
if it were also the redemption date. Thus, in the first financial
reporting period after issuance of the preferred stock, Z adjusts the
carrying amount of the preferred stock to $105 million. As a result, a
“deemed dividend” is recognized in the amount of $10 million, which
reduces the numerator in the calculation of basic EPS in the period of
issuance of the preferred stock.
Two years after
issuance, Z negotiates with the investors to repurchase the preferred
stock at an aggregate redemption price of $102 million. There are no
unpaid accumulated dividends as of the date of repurchase.
The application of ASC 480-10-S99-3A immediately before
the accounting for the redemption has no impact because, according to
the contractual terms of the preferred stock, it is still redeemable for
an aggregate amount equal to $105 million. Since the $102 million fair
value of the consideration transferred is less than the net carrying
amount, Z applies ASC 260-10-S99-2 and recognizes a $3 million credit to
net income in arriving at income available to common stockholders for
the financial reporting period that includes the redemption.
Connecting the Dots
In almost every redemption of preferred stock that is not
being remeasured to its current redemption amount under ASC 480-10-S99-3A, net
income will be adjusted to arrive at income available to common stockholders in
the calculation of basic EPS. Even if the redemption price equals the original
issuance price, the fair value of the consideration transferred will almost
always differ from the net carrying amount of the preferred stock as a result of
direct issuance costs capitalized into the carrying amount of the preferred
stock.
3.2.2.6.3 Induced Conversion of Preferred Stock
When convertible preferred stock is converted into common stock
under an inducement offer, the excess of (1) the fair value of all securities and
other consideration transferred to the holders of the convertible preferred stock over
(2) the fair value of securities issuable according to the original conversion terms
should be deducted from net income to arrive at income available to common
stockholders in the calculation of basic EPS. In effect, an inducement represents the
payment of additional value to convertible preferred security holders for their
agreement to convert the securities. This additional value is always reflected as a
charge to net income in arriving at income available to common stockholders. Unlike
the accounting for a redemption of preferred stock, the accounting for an inducement
of convertible preferred stock can never involve a credit to net income in arriving at
income available to common stockholders.
Induced conversions of convertible debt are discussed in Section 6.6.1. Induced
conversions of common stock that is convertible into another class of common stock are
addressed in Section
3.2.4.1.
Connecting the Dots
In an induced conversion of convertible preferred stock, the
portion of the consideration transferred under the original conversion terms is
always accounted for as a conversion; therefore, ASC 260-10-S99-2 is not
applicable in such circumstances. Rather, ASC 260-10-S99-2 applies only to the
additional value resulting from the inducement offer for the instruments converted
in accordance with this offer.
ASC 260-10-S99-2 does not define an inducement but refers to the
guidance in ASC 470-20, which discusses whether a conversion of convertible debt
represents a conversion under an inducement offer.
ASC 470-20
Recognition of Expense Upon Conversion
40-13 The guidance in
paragraph 470-20-40-16 applies to conversions of convertible debt to
equity securities pursuant to terms that reflect changes made by the
debtor to the conversion privileges provided in the terms of the debt at
issuance (including changes that involve the payment of consideration) for
the purpose of inducing conversion. That guidance applies only to
conversions that both:
-
Occur pursuant to changed conversion privileges that are exercisable only for a limited period of time (inducements offered without a restrictive time limit on their exercisability are not, by their structure, changes made to induce prompt conversion)
-
Include the issuance of all of the equity securities issuable pursuant to conversion privileges included in the terms of the debt at issuance for each debt instrument that is converted, regardless of the party that initiates the offer or whether the offer relates to all debt holders.
Induced Conversions
40-14 A conversion includes an exchange of a
convertible debt instrument for equity securities or a combination of
equity securities and other consideration, whether or not the exchange
involves legal exercise of the contractual conversion privileges included
in terms of the debt. The preceding paragraph also includes conversions
pursuant to amended or altered conversion privileges on such instruments,
even though they are literally provided in the terms of the debt at
issuance.
40-15 The changed terms may
involve any of the following:
-
A reduction of the original conversion price thereby resulting in the issuance of additional shares of stock
-
An issuance of warrants or other securities not provided for in the original conversion terms
-
A payment of cash or other consideration to those debt holders that convert during the specified time period.
The guidance in [ASC 470-20-40-16] does not apply to
conversions pursuant to other changes in conversion privileges or to
changes in terms of convertible debt instruments that are different from
those described in this paragraph.
An entity should apply the guidance in ASC 470-20 to determine
whether a conversion of convertible preferred stock has occurred in accordance with an
inducement offer. In some cases, the offer may actually represent a modification of
the convertible preferred stock instrument rather than an inducement offer (see
Section 3.2.6 for
discussion of modifications to preferred stock). An inducement offer does not need to
be recognized until the date on which it is accepted by the holder, which is normally
the date on which the holder converts the convertible preferred stock into common
stock or enters into a binding agreement to do so.
The example below illustrates the accounting for an inducement of
convertible preferred stock under ASC 260-10-S99-2.
Example
3-17
Inducement of Convertible Preferred Stock
Company X has issued 1,000 shares of convertible preferred stock to
Company Y at a liquidation preference and original issuance price of
$1,000 per share for total consideration of $1 million. The convertible
preferred stock is not within the scope of ASC 480 and therefore is not
accounted for as a liability by X. The stated conversion terms allow Y to
convert the convertible preferred stock into shares of X’s common stock at
a conversion price of $25. Thus, upon conversion of all the shares of
convertible preferred stock, X would issue Y a total of 40,000 shares of
common stock.
Company X offers Y an inducement to
convert all of the convertible preferred stock into X’s shares of common
stock. Under the offer, Y has 30 days to convert the convertible preferred
stock into X’s shares of common stock at a conversion price of $20 per
share of convertible preferred stock in such a way that Y would receive
50,000 shares of common stock upon conversion of all the shares of
convertible preferred stock. This conversion would (1) occur in accordance
with changed conversion privileges that are exercisable only for a limited
time (i.e., 30 days) and (2) involve the issuance of all the shares of
common stock issuable according to the conversion privileges included in
the terms of the convertible preferred stock at issuance for each share of
convertible preferred stock that Y chooses to convert.
If Y accepts the offer and converts the shares of
convertible preferred stock in return for 50,000 shares of X’s common
stock, the inducement must be accounted for under ASC 260-10-S99-2. If the
offer is accepted and X’s common stock price is $15 on the date of the
induced conversion, the charge that adjusts net income in arriving at X’s
income available to common stockholders is $150,000, calculated as
follows:
The conclusion above would be unchanged if the induced conversion occurred under
the same inducement offer from Y instead of X.
An inducement of convertible preferred stock will result in a charge
to net income in arriving at income available to common stockholders even if the
conversion, after consideration of the inducement offer, is “out-of-the-money.” For
this reason, it is important to distinguish an inducement from a redemption of
convertible preferred stock. If the transaction discussed in the example above
reflected a redemption instead of an induced conversion, there would have been a
$250,000 credit to net income, as opposed to a $150,000 charge to net income, in
arriving at income available to common stockholders.
3.2.2.6.3.1 Induced Conversion of Convertible Preferred Stock That Contains an Embedded Conversion Option Accounted for as a Derivative Liability
ASC 260-10-S99-2 does not address the accounting for an induced
conversion of convertible preferred stock that contains an embedded conversion
option that has been separated and accounted for as a derivative liability. However,
since changes in the fair value of the embedded conversion option are recognized in
net income, the effect of the inducement offer will be reflected in net income as
part of those fair value changes. This obviates the need to recognize any “deemed
dividend” under ASC 260-10-S99-2.
3.2.2.6.3.2 Induced Conversion of Convertible Preferred Stock That Contains a Separately Classified Equity Component
Sections
3.2.5.2.4 and 3.2.5.2.5 address the EPS accounting for an induced conversion of
convertible preferred stock that contains a separately recognized equity component
related to the embedded conversion option. As discussed in those sections, an entity
should first account for the inducement component of the conversion in accordance
with ASC 260-10-S99-2, recognizing a “deemed dividend” for the additional value
provided as a result of the inducement offer. That “deemed dividend” reduces net
income in arriving at income available to common stockholders. Once this accounting
is reflected, the entity accounts for the remaining consideration transferred to the
holder(s) (i.e., the portion represented by the original conversion terms) as a
“conversion” on the basis of the accounting for a conversion of convertible
preferred stock in accordance with its original stated conversion privileges. Also,
as noted in Sections 3.2.5.2.4 and 3.2.5.2.5, the accounting upon an induced conversion will be affected
by the application of ASC 480-10-S99-3A if the convertible preferred stock
instrument is a redeemable equity security that is subject to the
subsequent-measurement guidance in ASC 480-10-S99-3A.
3.2.2.7 Participating Preferred Stock
ASC 260-10-20 defines a participating security as “[a] security that
may participate in undistributed earnings with common stock, whether that participation
is conditioned upon the occurrence of a specified event or not. The form of such
participation does not have to be a dividend — that is, any form of participation in
undistributed earnings would constitute participation by that security, regardless of
whether the payment to the security holder was referred to as a dividend.” When
preferred stock meets the definition of a participating security, income available to
common stockholders will be reduced by both of the following:
- Dividends on cumulative preferred stock, whether or not declared, and dividends declared on noncumulative preferred stock.
- An allocation of the undistributed earnings for the period on the basis of the contractual participation rights of the preferred security. (Losses are generally not allocated to participating preferred stock because such instruments generally only participate in undistributed earnings.)
See Chapter
5 for additional discussion of participating securities and the two-class
method.
3.2.2.8 Reclassification of Preferred Stock to a Liability
ASC
480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial
instrument will be redeemed only upon the occurrence of a conditional event,
redemption of that instrument is conditional and, therefore, the instrument
does not meet the definition of mandatorily redeemable financial instrument
in this Subtopic. However, that financial instrument would be assessed at
each reporting period to determine whether circumstances have changed such
that the instrument now meets the definition of a mandatorily redeemable
instrument (that is, the event is no longer conditional). If the event has
occurred, the condition is resolved, or the event has become certain to
occur, the financial instrument is reclassified as a liability.
A conditionally redeemable preferred stock instrument may become
mandatorily redeemable as a result of the resolution of a condition associated with the
redemption. In this situation, the preferred stock must be reclassified from equity
(generally, from temporary equity) to a liability. ASC 480-10-30-2 specifies that “[i]f
a conditionally redeemable instrument becomes mandatorily redeemable, upon
reclassification the issuer shall measure that liability initially at fair value and
reduce equity by the amount of that initial measure, recognizing no gain or loss.” While
this type of reclassification has no impact on net income, as discussed in the scope
section of ASC 260-10-S99-2, the reclassification is treated as a redemption of
preferred stock. Thus, any difference between the initial fair value amount of the
liability recognized under ASC 480-10-30-2 and the net carrying amount of the preferred
stock instrument on the reclassification date increases or decreases net income in
arriving at income available to common stockholders. If the preferred stock instrument
is classified in temporary equity and is being remeasured to its redemption amount,
immediately before the reclassification date, which may be a date other than the end
date of a financial reporting period, the net carrying amount of the preferred stock
should be adjusted in a manner consistent with the entity’s accounting policy for
remeasuring redeemable securities under ASC 480-10-S99-3A. See Example 3-9 for an illustration of
this point.
See Section
3.2.6 for information about a reclassification of the preferred stock that
results from a modification of the instrument.
Connecting the Dots
A preferred stock instrument issued by an SEC registrant that
becomes mandatorily redeemable upon the death of the holder is classified as a
liability from the inception of the instrument because the death of the holder is an
event that is certain to occur and SEC registrants are not subject to the scope
exception in ASC 480-10-15-7A. However, a preferred stock instrument that becomes
mandatorily redeemable upon the disability of the holder does not need to be
classified as a liability because the disability of the holder is not an event that
is certain to occur. Such an instrument may also not be classified in temporary
equity if the issuer has the ability and intent to maintain a fully funded insurance
policy (see ASC 480-10-S99-3A(3)(g)). However, upon the disability of the holder,
the preferred stock instrument would need to be reclassified from equity to a
liability and the guidance in ASC 260-10-S99-2 would apply.
3.2.3 Noncontrolling Interests
3.2.3.1 General
The numerator in the calculation of the parent’s basic EPS should
reflect only income from continuing operations and net income attributable to the
parent. In all cases, income attributable to NCIs should be excluded from the numerator
in the parent’s calculation of EPS.
3.2.3.2 Nonredeemable NCIs
An entity may have nonredeemable NCIs that are reported in its
consolidated financial statements. The NCI may be in the form of common stock or
preferred stock issued by a consolidated subsidiary.
3.2.3.2.1 Nonredeemable NCIs in the Form of Preferred Stock
Basic EPS calculated by an entity with a nonredeemable NCI in the
form of preferred stock is affected by dividends accumulated or paid on the preferred
stock by the subsidiary, as well as “deemed dividends” (or “deemed contributions”)
resulting from a modification, redemption, or induced conversion of the preferred
stock by the subsidiary.8 The accounting impact of these events and transactions is generally reflected at
the subsidiary level, with the subsidiary applying the same accounting that a parent
entity would use in such circumstances. Dividends resulting from any of these events
or transactions will be treated as reductions to the subsidiary’s net income in
arriving at the subsidiary’s income available to common stockholders, which will be
included in the numerator of the parent’s calculation of basic EPS. With respect to
redemptions and induced conversions of NCIs in the form of preferred stock, the
guidance in ASC 260-10-S99-2 should be applied to determine the impact on the parent’s
income available to common stockholders in its calculation of basic EPS. In accordance
with ASC 260-10-55-64 through 55-67, these adjustments may reflect an allocation of
the “deemed dividend” (or “deemed contribution”) between the parent’s interest in the
subsidiary’s common stock and any third-party holders of common stock provided that
the third-party noncontrolling common interest holders absorbed or received a portion
of such adjustments.9 See Section 3.2.2.6
for further discussion of redemptions and induced conversions of preferred stock and
Section 3.2.6 for more
information about modifications and exchanges of preferred stock. In addition, see
Section 8.8.1 for
discussion of the application of ASC 260-10-55-64 through 55-67.
Connecting the Dots
When a nonredeemable NCI in the form of preferred stock is
extinguished and the subsidiary has other NCIs in the form of common stock, the
accounting in the consolidated financial statements of the parent may depend on
whether the redemption price was paid by the parent or the subsidiary. Generally
speaking, if the redemption was paid by the parent, the entire difference between
the net carrying amount of the preferred stock and the redemption amount will
increase or reduce net income attributable to the parent in the parent’s
calculation of income available to common stockholders. Otherwise, only the
parent’s allocable portion of the difference between the net carrying amount of
the preferred stock and the redemption amount will increase or reduce net income
attributable to the parent in the parent’s calculation of income available to
common stockholders.
As noted in Example 3-10, an entity may adopt one of two alternative accounting
policies to present dividends on an NCI in the form of preferred stock. The
alternatives affect only the presentation. The impact on income available to common
stockholders will be the same. Under either presentation, dividends accumulated on
cumulative preferred stock and dividends declared on noncumulative preferred stock
will be a reduction to income attributable to the parent in arriving at income
available to common stockholders. If the consolidated subsidiary that has issued the
preferred stock also has outstanding shares of common stock, basic EPS will need to be
calculated at the subsidiary level to determine the amount of the subsidiary’s income
available to common stockholders that is included in the numerator in the parent’s
calculation of basic EPS.
For additional discussion of issues related to dividends on
preferred stock that is issued by a subsidiary to (1) third parties or (2) the parent,
see Section 8.8.2. For
more information about NCIs in the form of preferred stock that represent
participating securities, see Section 3.2.3.4.
3.2.3.2.2 Nonredeemable NCIs in the Form of Common Stock
When an entity has nonredeemable NCIs in the form of common stock,
the entity will need to calculate EPS at the subsidiary level to determine the portion
of the subsidiary’s income available to common stockholders that is included in income
available to common stockholders in the parent’s calculation of basic EPS. See
Section 8.8 for further
discussion of the EPS accounting when a parent has an NCI. See Section 3.2.3.4 for discussion of
NCIs in the form of common stock that participate in earnings of the parent. See
Section 3.2.4.3 for discussion of the
redemption of common stock.
3.2.3.2.3 Multiple Classes of Nonredeemable NCIs in the Form of Common Stock
If a subsidiary has multiple classes of common stock, it is
necessary to calculate basic EPS at the subsidiary level by using the two-class method
to determine the amount of the subsidiary’s income available to common stockholders
that is included in income available to common stockholders in the parent’s
calculation of basic EPS. See Chapter 5 for further discussion of participating securities and the
two-class method. See Section
3.2.3.4 for discussion of NCIs in the form of common stock that
participate in earnings of the parent.
3.2.3.3 Redeemable NCIs
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable Securities
S99-3A(22)
Noncontrolling interests. Paragraph 810-10-45-23 indicates that
changes in a parent’s ownership interest while the parent retains control of
its subsidiary are accounted for as equity transactions, and do not impact
net income or comprehensive income in the consolidated financial statements.
Consistent with Paragraph 810-10-45-23, an adjustment to the carrying amount
of a noncontrolling interest from the application of paragraphs 14–16 does
not impact net income or comprehensive income in the consolidated financial
statements. Rather, such adjustments are treated akin to the repurchase of a
noncontrolling interest (although they may be recorded to retained earnings
instead of additional paid-in capital). The SEC staff believes the guidance
in paragraphs 20 and 21 should be applied to noncontrolling interests as
follows:
- Noncontrolling interest in the form of preferred stock instrument. The impact on income available to common stockholders of the parent arising from adjustments to the carrying amount of a redeemable noncontrolling interest other than common stock depends upon whether the redemption feature in the equity instrument was issued, or is guaranteed, by the parent. If the redemption feature was issued, or is guaranteed, by the parent, the entire adjustment under paragraph 20 reduces or increases income available to common stockholders of the parent. Otherwise, the adjustment is attributed to the parent and the noncontrolling interest in accordance with Paragraphs 260-10-55-64 through 55-67.
- Noncontrolling interest in the form of common stock instrument. Adjustments to the carrying amount of a noncontrolling interest issued in the form of a common stock instrument to reflect a fair value redemption feature do not impact earnings per share. Adjustments to the carrying amount of a noncontrolling interest issued in the form of a common stock instrument to reflect a non-fair value redemption feature do impact earnings per share; however, the manner in which those adjustments reduce or increase income available to common stockholders of the parent may differ.FN20 If the terms of the redemption feature are fully considered in the attribution of net income under Paragraph 810-10-45-21, application of the two-class method is unnecessary. If the terms of the redemption feature are not fully considered in the attribution of net income under Paragraph 810-10-45-20, application of the two-class method at the subsidiary level is necessary in order to determine net income available to common stockholders of the parent.
____________________
FN20 Subtopic 810-10 does not
provide detailed guidance on the attribution of net income to the parent and
the noncontrolling interest. The SEC staff understands that when a
noncontrolling interest is redeemable at other than fair value some
registrants consider the terms of the redemption feature in the calculation
of net income attributable to the parent (as reported on the face of the
income statement), while others only consider the impact of the redemption
feature in the calculation of income available to common stockholders of the
parent (which is the control number for earnings per share
purposes).
An entity may have redeemable NCIs that are reported in its
consolidated financial statements; these interests may be in the form of common stock or
preferred stock. The impact of such NCIs on the parent’s calculation of basic EPS
depends on whether the redeemable NCI is in the form of preferred stock or common stock
and, for common stock, whether the redemption amount is a fair value amount or an amount
other than fair value.
3.2.3.3.1 Redeemable NCIs in the Form of Preferred Stock
ASC 480-10-S99-3A addresses when redeemable preferred stock must be
remeasured to its redemption amount. The requirements in ASC 480-10-S99-3A for
classification and measurement of a redeemable NCI in the form of preferred stock are
consistent with the guidance applicable to redeemable preferred stock issued by a
parent entity (see Section
3.2.2.4). When remeasurement is required, the adjustment to the carrying
amount of the preferred stock is treated in the same manner as a dividend on preferred
stock. There are three primary situations involving redeemable NCIs in the form of
preferred stock:
-
The redemption feature is issued or guaranteed by the parent.
-
The redemption feature is issued by the subsidiary (and not guaranteed by the parent) and all of the subsidiary’s shares of common stock are owned by the parent.
-
The redemption feature is issued by the subsidiary (and not guaranteed by the parent) and the subsidiary also has NCIs in the form of common stock.
If the redemption feature is issued or guaranteed by the parent, the
entire amount of the measurement adjustment (i.e., “deemed dividend”) under ASC
480-10-S99-3A represents an adjustment to income attributable to the parent to arrive
at the parent’s income available to common stockholders. This dividend may generally
be calculated as part of the parent’s calculation of income available to common
stockholders after the inclusion of the parent’s portion of the subsidiary’s income
available to common stockholders in the numerator in the parent’s calculation of basic
EPS.
Connecting the Dots
Redemption features that may be considered issued or guaranteed
by the parent include, but are not limited to, (1) put options issued by a parent
to the holder of preferred shares issued by the parent’s subsidiary if the put
options are considered embedded in the NCI at the consolidated level and (2) put
features that are embedded in preferred shares issued by a subsidiary that are
subject to a guarantee by its parent.
If the redemption feature is issued by the subsidiary (and not
guaranteed by the parent) and there is no other NCI in the subsidiary, the
remeasurement adjustment under ASC 480-10-S99-3A, along with any other dividends on
the preferred stock, will be treated as a reduction of the subsidiary’s net income in
the parent’s calculation of income available to common stockholders. This situation
results in the same impact on the parent’s basic EPS as when the parent issues or
guarantees the redemption feature.
If the redemption feature is issued by the subsidiary (and not
guaranteed by the parent) and parties other than the parent own shares of common stock
in the subsidiary, the remeasurement adjustment under ASC 480-10-S99-3A, along with
other dividends on the subsidiary’s preferred stock, will be treated as a reduction of
the subsidiary’s net income to arrive at the subsidiary’s income available to common
stockholders, which is then used to calculate the parent’s income available to common
stockholders. The amount of dividends and “deemed dividends” that reduce the parent’s
income available to common stockholders will reflect an allocation between the parent
and other common stockholders of the subsidiary. This occurs when the parent includes
its portion of the subsidiary’s income available to common stockholders in the
numerator to calculate the parent’s basic EPS. See further discussion of this process
in Section 8.8.
Example
3-18
Redeemable NCI in the Form of Preferred Stock
Parent A consolidates Subsidiary B under
ASC 810. Parent A has 1 million shares of common stock outstanding and
reported net income of $10 million for the year ended December 31, 20X1
(excluding B’s income). Subsidiary B has 1 million shares of preferred
stock outstanding and 1 million shares of common stock outstanding. For
the year ended December 31, 20X1, B reported net income of $5 million. In
addition, B paid $100,000 of dividends on the preferred stock and
increased the carrying amount of the preferred stock by $200,000 as a
result of a measurement adjustment under ASC 480-10-S99-3A. Consider the
following three scenarios:
- Scenario 1 — A owns all of B’s common stock and guaranteed the redemption feature in B’s preferred stock.
- Scenario 2 — A owns all of B’s common stock and did not guarantee the redemption feature in B’s preferred stock.
- Scenario 3 — A owns 800,000 shares of B’s common stock and did not guarantee the redemption feature in B’s preferred stock.
Parent A would report the following amounts
as the numerator in its calculation of basic EPS:
Scenario 1
Scenario 2
Scenario 3
Connecting the Dots
Under ASC 480-10-S99-3A(16)(e), decreases in the carrying amount
of a subsidiary’s redeemable preferred stock may only be recorded to the extent
that they reflect recoveries of previous increases to the carrying amount as a
result of the application of ASC 480-10-S99-3A.
ASC 260-10-S99-2 applies to the consolidated financial statements of
a parent when there is a redemption or an induced conversion of redeemable preferred
stock issued by a consolidated subsidiary that is classified as an NCI. However,
before accounting for any redemption or induced conversion, an entity must apply the
subsequent-measurement guidance in ASC 480-10-S99-3A. That is, immediately before
accounting for any redemption or induced conversion of a subsidiary’s preferred stock,
the entity should first remeasure the NCI (the subsidiary’s preferred stock) in
accordance with its accounting policy for remeasuring redeemable securities under ASC
480-10-S99-3A if the NCI was subject to remeasurement under ASC 480-10-S99-3A. The
entity should then apply ASC 260-10-S99-2 to account for the redemption or induced
conversion. In applying this guidance, the entity should apply the same concepts as
discussed in ASC 480-10-S99-3A(22)(a) if there is also an NCI in the form of common
stock in the subsidiary. In certain cases, there will be no incremental “deemed
dividend” as a result of the application of ASC 260-10-S99-2 to a redemption of a
subsidiary’s preferred stock because the NCI has been remeasured to the redemption
amount under ASC 480-10-S99-3A. For additional discussion of the complexities
associated with the accounting for redeemable NCIs, see Section 8.8.4.
Redeemable preferred stock issued by a subsidiary may represent a
participating security. See Section
3.2.3.4 for more information.
3.2.3.3.2 Redeemable NCIs in the Form of Common Stock
ASC 480-10-S99-3A addresses when redeemable common stock must be
remeasured to its redemption amount. The requirements in ASC 480-10-S99-3A for
classifying and measuring a redeemable NCI in the form of common stock are consistent
with the guidance applicable to redeemable common stock issued by a parent entity (see
Section 3.2.4.2).
Measurement adjustments under ASC 480-10-S99-3A that are made to the carrying amount
of an NCI in the form of common stock that is redeemable at fair value do not affect
the parent’s EPS. However, when an NCI in the form of common stock is redeemable at
any amount other than fair value, there is an impact on the parent’s EPS. When the
redemption amount is other than fair value, the adjustments to the carrying amount of
the NCI that are recognized under ASC 480-10-S99-3A are accounted for in one of two
ways:
-
As part of the attribution of the subsidiary’s income between the parent and the NCIs.
-
As an adjustment to the amount of income available to common stockholders by applying the two-class method of EPS at the subsidiary level.
Although either of these two approaches is acceptable as an
accounting policy, they generally do not differ in their ultimate impact on the
numerator in the parent’s calculation of basic EPS.
In addition to the alternatives above, there are also two acceptable
alternatives for the treatment of adjustments to the carrying amount under ASC
480-10-S99-3A.
- Treat the entire adjustment in the same manner as a dividend.
- Treat only the portion of the adjustment that reflects a redemption at an amount in excess of fair value in the same manner as a dividend.
In this case, the approach selected will have an impact on the
parent’s calculation of basic EPS.
Under ASC 480-10-S99-3A(16)(e), an entity employing any of the
alternatives discussed above may only record decreases in the carrying amount to the
extent that they reflect recoveries of previous increases to the carrying amount as a
result of the application of ASC 480-10-S99-3A. Furthermore, when an NCI in the form
of common stock is redeemable and the subsidiary also has common stock issued to third
parties that is not redeemable, the parent entity must consider the guidance in ASC
480-10-S99-3A(22)(a). According to that guidance, if the redemption feature in the
redeemable NCI in the form of common stock is either issued or guaranteed by the
parent, the EPS impact of changes to the redemption amount (i.e., “deemed dividends”
under ASC 480-10-S99-3A) should be allocated entirely to the parent.
The example below illustrates the accounting for an NCI in the form
of common stock that is redeemable at a non–fair value amount.
Example
3-19
NCI in the Form of Common Stock Redeemable at Non–Fair Value
Amount
Assume the
following:
- Parent A owns 80 percent of the common stock of Subsidiary B and consolidates B under ASC 810. The remaining 20 percent of B’s common stock is held by a third-party NCI holder.
- The NCI is redeemable at the option of the holder for an amount that does not represent fair value.
- For the reporting period ended December 31, 20X1, before the NCI is remeasured to its redemption amount, the carrying amount of the NCI under ASC 810 is $100,000. This amount reflects an increase of $20,000 as a result of an allocation of 20 percent of B’s net income of $100,000 for the period.
- There is a $50,000 incremental adjustment as of the end of the reporting period to recognize the NCI at its current redemption amount.
- For the reporting period ended December 31, 20X1, A earned net income (excluding B’s net income) of $500,000.
- There were 1 million weighted-average shares of A’s common stock outstanding for the period ended December 31, 20X1.
Parent A applies the recognition and measurement guidance on redeemable equity
securities in ASC 480-10-S99-3A and has elected to treat the entire amount
of remeasurement adjustments related to the NCI as dividends. Below is A’s
consolidated income statement for the reporting period ended December 31,
20X1, depending on whether A elects to (1) treat the remeasurement
adjustments as part of the allocation of income to NCI (Alternative 1) or
(2) apply the two-class method to calculate income available to common
stockholders (Alternative 2).
Connecting the Dots
Although ASC 260-10-S99-2 does not apply to the redemption of an
NCI in the form of common stock, the classification, measurement, and EPS guidance
in ASC 480-10-S99-3A applies if the NCI is redeemable for cash or other assets. If
a redeemable NCI in the form of common stock is being remeasured to its redemption
amount under ASC 480-10-S99-3A, immediately before accounting for any redemption
of the instrument, the entity should perform a final remeasurement of the NCI in
accordance with its accounting policy for remeasuring redeemable securities under
ASC 480-10-S99-3A and should apply the EPS guidance in ASC 480-10-S99-3A to that
remeasurement. The entity should then apply ASC 810 to account for the repurchase
of the NCI.
If an NCI is converted to another security in accordance with an
inducement offer, in addition to applying ASC 480-10-S99-3A if the NCI was a
redeemable security, the entity should consider the accounting impact of the
induced conversion. See Section
3.2.4.1 for further discussion of induced conversions of common
stock.
For additional discussion of the complexities associated with
the accounting for redeemable NCIs, see Section 8.8.4.
3.2.3.4 Participating NCIs
ASC 260-10-20 defines a participating security as “[a] security that
may participate in undistributed earnings with common stock, whether that participation
is conditioned upon the occurrence of a specified event or not. The form of such
participation does not have to be a dividend — that is, any form of participation in
undistributed earnings would constitute participation by that security, regardless of
whether the payment to the security holder was referred to as a dividend.” NCIs that
meet the definition of a participating security generally will fall into one of the
following categories:
-
NCI in the form of common stock that participates in earnings of the parent.
-
NCI in the form of preferred stock that participates in earnings of the subsidiary.
-
NCI in the form of preferred stock that participates in earnings of the parent.
-
NCI in the form of potential common stock that participates in earnings of the subsidiary.
-
NCI in the form of potential common stock that participates in earnings of the parent.
When an NCI in the form of common stock or potential common stock
participates in earnings of the parent, the parent should take the participation into
account by applying the two-class method after including its portion of the subsidiary’s
income available to common stockholders in its calculation of income available to common
stockholders. The effect of the participation should be based on the contractual
participating rights of the NCI holder. For example, if the holder only participates in
earnings of the parent that exclude the net income of the subsidiary, that fact must be
considered in the determination of the amount of the parent’s undistributed earnings
that are allocated between the NCI and the parent’s common stockholders. If the NCI that
participates in earnings of the parent is also a redeemable NCI, the impact that the
redemption provisions have on the calculation of the parent’s basic EPS must be
considered. See Section
8.8.4 for additional discussion of the accounting for redeemable NCIs. See
Chapter 5 for further
details regarding the two-class method of calculating EPS.
An NCI in the form of preferred stock may participate in either the
subsidiary’s or the parent’s earnings. If preferred stock of a subsidiary participates
in the subsidiary’s earnings, an entity needs to calculate basic EPS at the subsidiary
level by using the two-class method to determine the amount of the subsidiary’s income
available to common stockholders that is included in the parent’s income available to
common stockholders. If preferred stock of a subsidiary participates in the parent’s
earnings, the parent should calculate the impact of such participation after including
its portion of the subsidiary’s income available to common stockholders in its
calculation of income available to common stockholders. The effect of the participation
should be based on the contractual participating rights of the NCI holder. For example,
if the holder only participates in earnings of the parent that exclude the net income of
the subsidiary, that fact must be considered in the determination of the amount of the
parent’s undistributed earnings that are allocated between the NCI and the parent’s
common stockholders. If the NCI is also a redeemable NCI, the impact that the redemption
provisions have on the calculation of the parent’s basic EPS must be considered. See
Section 8.8.4 for
additional discussion of the accounting for redeemable NCIs. See Chapter 5 for additional discussion
of the two-class method of calculating EPS.
Section
5.5.2.5.4 addresses NCIs in the form of potential common stock that
participate in earnings of the subsidiary. Section 7.1.3 discusses participating NCIs that are
share-based payment awards.
3.2.3.5 Reclassification of NCIs to a Liability
ASC
480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial instrument will be redeemed
only upon the occurrence of a conditional event, redemption of that
instrument is conditional and, therefore, the instrument does not meet the
definition of mandatorily redeemable financial instrument in this Subtopic.
However, that financial instrument would be assessed at each reporting
period to determine whether circumstances have changed such that the
instrument now meets the definition of a mandatorily redeemable instrument
(that is, the event is no longer conditional). If the event has occurred,
the condition is resolved, or the event has become certain to occur, the
financial instrument is reclassified as a liability.
A conditionally redeemable NCI may become mandatorily redeemable as a
result of the resolution of a condition associated with redemption. In this situation,
the NCI must be reclassified from equity (generally, from temporary equity) to a
liability. ASC 480-10-30-2 specifies that “[i]f a conditionally redeemable instrument
becomes mandatorily redeemable, upon reclassification the issuer shall measure that
liability initially at fair value and reduce equity by the amount of that initial
measure, recognizing no gain or loss.” While this type of reclassification has no impact
on net income (regardless of whether the form of the NCI is preferred stock or common
stock), immediately before the reclassification date (which may a date other than the
end date of a financial reporting period), the entity should adjust the carrying amount
of the NCI in accordance with its accounting policy for remeasuring redeemable
securities under ASC 480-10-S99-3A if the NCI is being remeasured to its redemption
amount under ASC 480-10-S99-3A.
Section
3.2.6 addresses reclassifications of the NCI that result from modifications
of the instrument.
3.2.3.5.1 NCIs in the Form of Preferred Stock
As discussed in the scope section of ASC 260-10-S99-2, a
reclassification of an NCI in the form of preferred stock from equity to a liability
is treated as a redemption of preferred stock. See Section 3.2.3.2.1 for discussion of the accounting
for a redemption of an NCI in the form of preferred stock.
3.2.3.5.2 NCIs in the Form of Common Stock
A reclassification of an NCI in the form of common stock from equity
to a liability has no impact on basic EPS because ASC 260-10-S99-2 does not apply to
these types of reclassifications.
3.2.4 Common Stock
3.2.4.1 Multiple Classes of Common Stock
An entity that has multiple classes of common stock is subject to the
two-class method of calculating basic EPS. An entity may be deemed to have multiple
classes of common stock solely because one class is redeemable (see Section 3.2.4.2). Both basic and
diluted EPS must be calculated and presented for each class of common stock. See further
discussion of the two-class method in Chapter 5.
If one class of common stock is exchanged or converted into another
class of common stock, the entity should consider whether the transaction represents
either a redemption or a conversion of common stock. Section 3.2.2.6.2.1 discusses considerations related
to distinguishing between a redemption and a conversion. Redemptions of common stock are
further addressed in Section
3.2.4.3.
A class of common stock that is convertible into another class of
common stock could be converted in accordance with an inducement offer. In an induced
conversion from one class of common stock to another, the additional value resulting
from the inducement offer should be accounted for in one of two ways. It should be
treated either as a dividend in the application of the two-class method of calculating
basic EPS or as an expense in a manner consistent with the accounting for reacquisitions
of common stock at a price that exceeds fair value. Section 3.2.4.3 provides guidance on redemptions of
common stock that can be considered in the determination of whether the additional value
resulting from an inducement should be treated as an expense or as a dividend. In making
this determination, an entity may also consider the SEC staff’s views on the treatment
of the additional value transferred in a modification or exchange of preferred stock
that is not accounted for as an extinguishment. See Section 3.2.6 for more information.
If one class of common stock is converted to another class of common
stock in accordance with the stated conversion privileges of the instrument and the
conversion is not considered either a redemption or an induced conversion, the numerator
of basic EPS is unaffected.
3.2.4.2 Redeemable Common Stock
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable Securities
S99-3A(21)
Common stock instruments issued by a parent (or single reporting
entity). Regardless of the accounting method selected in paragraph 15,
the resulting increases or decreases in the carrying amount of redeemable
common stock should be treated in the same manner as dividends on
nonredeemable stock and should be effected by charges against retained
earnings or, in the absence of retained earnings, by charges against paid-in
capital. However, increases or decreases in the carrying amount of a
redeemable common stock should not affect income available to common
stockholders. Rather, the SEC staff believes that to the extent that a
common shareholder has a contractual right to receive at share redemption
(in other than a liquidation event that meets the exception in paragraph
3(f)) an amount that is other than the fair value of the issuer’s common
shares, then that common shareholder has, in substance, received a
distribution different from other common shareholders. Under Paragraph
260-10-45-59A, entities with capital structures that include a class of
common stock with different dividend rates from those of another class of
common stock but without prior or senior rights, should apply the two-class
method of calculating earnings per share. Therefore, when a class of common
stock is redeemable at other than fair value, increases or decreases in the
carrying amount of the redeemable instrument should be reflected in earnings
per share using the two-class method.FN17 For common stock
redeemable at fair valueFN18, the SEC staff would not expect the
use of the two-class method, as a redemption at fair value does not amount
to a distribution different from other common
shareholders.FN19
____________________
FN17 The
two-class method of computing earnings per share is addressed in Section
260-10-45. The SEC staff believes that there are two acceptable approaches
for allocating earnings under the two-class method when a common stock
instrument is redeemable at other than fair value. The registrant may elect
to: (a) treat the entire periodic adjustment to the instrument’s carrying
amount (from the application of paragraphs 14–16) as being akin to a
dividend or (b) treat only the portion of the periodic adjustment to the
instrument’s carrying amount (from the application of paragraphs 14–16) that
reflects a redemption in excess of fair value as being akin to a dividend.
Under either approach, decreases in the instrument’s carrying amount should
be reflected in the application of the two-class method only to the extent
they represent recoveries of amounts previously reflected in the application
of the two-class method.
FN18 Common
stock that is redeemable based on a specified formula is considered to be
redeemable at fair value if the formula is designed to equal or reasonably
approximate fair value. The SEC staff believes that a formula based solely
on a fixed multiple of earnings (or other similar measure) is not considered
to be designed to equal or reasonably approximate fair value.
FN19 Similarly, the two-class method is not
required when share-based payment awards granted to employees are redeemable
at fair value (provided those awards are in the form of common shares or
options on common shares). However, those share-based payment awards may
still be subject to the two-class method pursuant to Section
260-10-45.
An SEC registrant that has outstanding redeemable shares of common
stock is subject to the guidance in ASC 480-10-S99-3A. According to that guidance, if
the common stock is redeemable at the option of the holder or upon the occurrence of any
event outside the issuer’s control, other than an ordinary liquidation, the common stock
must be classified in temporary equity. As discussed in ASC 480-10-S99-3A(14), if the
common stock “is currently redeemable (for example, at the option of the holder), it
should be adjusted to its maximum redemption amount at the balance sheet date.” If the
common stock is not currently redeemable, but it is probable that it will become
redeemable, it must be remeasured to its redemption amount by using one of the following
acceptable methods discussed in ASC 480-10-S99-3A(15):
- Accrete changes in the redemption value over the period from the date of issuance (or from the date that it becomes probable that the instrument will become redeemable, if later) to the earliest redemption date of the instrument using an appropriate methodology, usually the interest method. Changes in the redemption value are considered to be changes in accounting estimates.
- Recognize changes in the redemption value (for example, fair value) immediately as they occur and adjust the carrying amount of the instrument to equal the redemption value at the end of each reporting period. This method would view the end of the reporting period as if it were also the redemption date for the instrument.
ASC 480-10-S99-3A(21) indicates that the adjustments to the carrying
amount under the two acceptable methods are treated in the same manner as dividends. If
such adjustments pertain to a remeasurement of the carrying amount of common stock that
is redeemable at fair value, changes to the carrying amount of the common stock do not
affect basic EPS. However, if such adjustments are recognized for common stock
redeemable at any amount other than fair value, the entity must apply the two-class
method to calculate basic EPS. Increases to the carrying amount of common stock
redeemable at a non–fair value amount are treated as dividends (or distributions) in the
application of the two-class method. That is, income available to common stockholders
would be reduced by actual cash distributions as well as these “deemed dividends” to
arrive at undistributed earnings. Decreases to the carrying amount of common stock
redeemable at a non–fair value amount, which may only be recognized to the extent the
decreases reflect recoveries of previously recognized increases to the carrying amount
as a result of the application of ASC 480-10-S99-3A, should be treated as “deemed
contributions” when the two-class method is applied. That is, income available to common
stockholders should be reduced by actual cash distributions and increased by these
“deemed contributions” to arrive at undistributed earnings.
In addition, footnote 17 of ASC 480-10-S99-3A provides the following
two acceptable alternative approaches for determining the amount of “deemed dividends”
and “deemed contributions” that pertain to ASC 480-10-S99-3A measurement adjustments to
the carrying amount of common stock redeemable at an amount other than fair value:
- Treat the entire adjustment in the same manner as a dividend.
- Treat only the portion of the adjustment that reflects a redemption at an amount in excess of fair value in the same manner as a dividend.
The approach selected will affect the calculation of basic EPS. The
two examples below illustrate the application of this guidance. For additional details
regarding the application of the SEC’s guidance on redeemable securities, see Chapter 9 of Deloitte’s Roadmap
Distinguishing Liabilities From
Equity.
Example
3-20
Treatment of Common Stock Redeemable at Fair Value in the Calculation of
Basic EPS
Company B issues common stock that contains a redemption provision entitling the
holder of the common stock to put the shares at fair value to B five years
after the issuance of the shares or at any time thereafter (redeemable
common stock). The redeemable common stock represents approximately 20
percent of all outstanding common stock and participates in all the rewards
to which other common shareholders are entitled. It is not considered
permanent equity but is included in temporary equity on B’s balance sheet in
accordance with FRR Section 211 and SEC Regulation S-X, Rule 5-02.27, as
interpreted by ASC 480-10-S99-3A. In accordance with ASC
480-10-S99-3A(15)(b), B has chosen to remeasure the redeemable common stock
to its redemption amount at the end of each reporting period as if that date
was the redemption date.
In B’s calculation of basic EPS, the redeemable common stock should be included
as outstanding common stock (i.e., included in the denominator). The
redeemable common stock is currently outstanding and participates in all the
rewards to which other common shareholders are entitled. Furthermore, since
the redeemable common stock has redemption terms requiring a repurchase
price at fair value, there is no incremental impact on B’s calculation of
basic EPS.
Example
3-21
Impact of Redeemable Common Stock on Basic EPS
Scenario 1
Entity Y has issued common stock with an embedded
redemption (“put”) feature. The put allows the common stockholder to
exchange its common stock for cash equal to the fair value of the common
stock as of the date the put is exercised. The put may be exercised at any
time (i.e., the shares are currently redeemable).
Entity Y has evaluated the common stock and the related put and concluded
the following:
- The put is not a freestanding financial instrument; instead, it is embedded in the common stock. The put does not need to be bifurcated as an embedded derivative under ASC 815-15-25-1 because it qualifies for the scope exception in ASC 815-10-15-74(a) (see also ASC 815-10-15-76).
- The common stock subject to the put is not classified as a liability under ASC 480.
- The puttable common stock is subject to the guidance in ASC 480-10-S99-3A. Accordingly, the shares are classified in temporary equity in Y’s balance sheet. Because they are currently redeemable, the shares are measured at their redemption amount (fair value) as of each balance sheet date.
Entity Y should not adjust income available to
common stockholders for changes in the carrying amount of its puttable
common stock when calculating basic EPS. Because the puttable shares
represent common stock rather than preferred stock and are redeemable at
fair value, changes in their carrying amount do not affect income available
to common stockholders in a manner consistent with ASC 480-10-S99-3A(21). In
addition, Y should not apply the two-class method of calculating basic EPS
as a result of the puttable common stock. ASC 480-10-S99-3A(21) indicates
that since a redemption at fair value does not transfer any value to or from
the holder of the puttable common stock, the two-class method does not
apply.
Although the adjustments to the carrying amount of the puttable common stock
have no impact on Y’s calculations of basic EPS, Y is still subject to the
guidance in ASC 480-10-S99-3A(16)(e), which indicates that “reductions in
the carrying amount of a redeemable equity instrument from the application
of paragraphs 14 and 16 are appropriate only to the extent that the
registrant has previously recorded increases in the carrying amount of the
redeemable equity instrument from the application of paragraphs 14 and
15.”
Scenario 2
Assume the same facts as in Scenario 1 except that the put allows the holders to
redeem the common stock at an amount equal to 10 times the most recent 12
months of Y’s EBITDA. In this circumstance, the redemption price is not
considered fair value or an amount that is designed to approximate fair
value. Footnote 18 of ASC 480-10-S99-3A states, in part, that “[t]he SEC
staff believes that a formula based solely on a fixed multiple of earnings
(or other similar measure) is not considered to be designed to equal or
reasonably approximate fair value.” Thus, because the redemption terms are
not at fair value, Y must consider any increases or decreases in the
carrying amount of the puttable common stock recognized under ASC
480-10-S99-3A in basic EPS by using the two-class method. Those increases
and decreases (limited by the amount of previously recorded increases to the
carrying amount, as discussed in ASC 480-10-S99-3A(16)(e)) should be
considered dividends (or distributed earnings) under the two-class method.
For more information on applying the two-class method, see Chapter 5.
3.2.4.3 Redemption of Common Stock
ASC
505-30
Requirement to Allocate Repurchase Amount
25-3 The facts and circumstances associated with a
share repurchase may suggest that the total payment relates to other than
the shares repurchased. An entity offering to repurchase shares only from a
specific shareholder (or group of shareholders) suggests that the repurchase
may involve more than the purchase of treasury shares. Also, if an entity
repurchases shares at a price that is different from the price obtainable in
transactions in the open market or transactions in which the identity of the
selling shareholder is not important, some portion of the amount being paid
presumably represents a payment for stated or unstated rights or privileges
that shall be given separate accounting recognition. See paragraph
505-30-30-3 for the measurement requirements associated with the different
elements identified within such a transaction.
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.
30-3 For example, the selling shareholder may agree
to abandon certain acquisition plans, forego other planned transactions,
settle litigation, settle employment contracts, or restrict voluntarily the
ability to purchase shares of the entity or its affiliates within a stated
time period. If the purchase of treasury shares includes the receipt of
stated or unstated rights, privileges, or agreements in addition to the
capital stock, only the amount representing the fair value of the treasury
shares at the date the major terms of the agreement to purchase the shares
are reached shall be accounted for as the cost of the shares acquired. The
price paid in excess of the amount accounted for as the cost of treasury
shares shall be attributed to the other elements of the transaction and
accounted for according to their substance. If the fair value of those other
elements of the transaction is more clearly evident, for example, because an
entity’s shares are not publicly traded, that amount shall be assigned to
those elements and the difference recorded as the cost of treasury shares.
If no stated or unstated consideration in addition to the capital stock can
be identified, the entire purchase price shall be accounted for as the cost
of treasury shares.
30-4 Transactions do arise, however, in which a
reacquisition of an entity’s stock may take place at prices different from
routine transactions in the open market. For example, to obtain the desired
number of shares in a tender offer to all or most shareholders, the offer
may need to be at a price in excess of the current market price. In
addition, a block of shares representing a controlling interest will
generally trade at a price in excess of market, and a large block of shares
may trade at a price above or below the current market price depending on
whether the buyer or seller initiates the transaction. An entity’s
reacquisition of its shares in those circumstances is solely a treasury
stock transaction properly accounted for at the purchase price of the
treasury shares. Therefore, in the absence of the receipt of stated or
unstated consideration in addition to the capital stock, the entire purchase
price shall be accounted for as the cost of treasury shares.
Allocating the Cost of Treasury Shares to Components of Shareholder
Equity Upon Formal or Constructive Retirement
30-5 An entity that
repurchases its own outstanding common stock may be required under paragraph
505-30-30-3 to allocate a portion of the repurchase price to other elements
of the transaction.
30-6 Once the cost of the treasury shares is
determined under the requirements of this Section, and if a corporation’s
stock is acquired for purposes other than retirement (formal or
constructive), or if ultimate disposition has not yet been decided,
paragraph 505-30-45-1 permits the cost of acquired stock to either be shown
separately as a deduction from the total of capital stock, additional
paid-in capital, and retained earnings, or be accorded the following
accounting treatment appropriate for retired stock.
30-7 The difference between the cost of the
treasury shares and the stated value of a corporation’s common stock
repurchased and retired, or repurchased for constructive retirement, shall
be reflected in capital.
30-8 When a corporation’s stock is retired, or
repurchased for constructive retirement (with or without an intention to
retire the stock formally in accordance with applicable laws), an excess
of repurchase price over par or stated value may be allocated between
additional paid-in capital and retained earnings. Alternatively, the excess
may be charged entirely to retained earnings in recognition of the fact that
a corporation can always capitalize or allocate retained earnings for such
purposes. If a portion of the excess is allocated to additional paid-in
capital, it shall be limited to the sum of both of the following:
- All additional paid-in capital arising from previous retirements and net gains on sales of treasury stock of the same issue
- The pro rata portion of additional paid-in capital, voluntary transfers of retained earnings, capitalization of stock dividends, and so forth, on the same issue. For this purpose, any remaining additional paid-in capital applicable to issues fully retired (formal or constructive) is deemed to be applicable pro rata to shares of common stock.
30-9 When a corporation’s stock is retired, or
repurchased for constructive retirement (with or without an intention to
retire the stock formally in accordance with applicable laws), an excess
of par or stated value over the cost of treasury shares shall be
credited to additional paid-in capital.
30-10 Gains on sales of treasury stock not previously
accounted for as constructively retired shall be credited to additional
paid-in capital; losses may be charged to additional paid-in capital to the
extent that previous net gains from sales or retirements of the same class
of stock are included therein, otherwise to retained earnings.
ASC 505-30 addresses the accounting for repurchases of common stock.
While ASC 260-10-S99-2 does not apply to a reacquisition of common stock, ASC
480-10-S99-3A applies to redeemable common stock. Therefore, the carrying amount of
redeemable common stock on the redemption date should reflect the amount that must be
recognized under ASC 480-10-S99-3A. That is, an adjustment to the carrying amount should
be made in accordance with ASC 480-10-S99-3A immediately before an entity records the
reacquisition of the common stock. The accounting guidance in ASC 505-30 would typically
apply to redeemable common stock only if the reacquisition occurs outside the terms of
the embedded redemption feature in the common stock. In the remaining discussion below,
it is assumed that the reacquisition of common stock occurs in accordance with an
arrangement other than an embedded redemption option in redeemable common stock.
When the price paid to reacquire shares of common stock is fair value,
the repurchase is treated solely as a treasury stock transaction and there is no impact
on income available to common stockholders in the calculation of basic EPS. The
denominator, however, is affected by the decrease in the number of shares of common
stock outstanding. Generally, the reduction in outstanding shares of common stock will
affect the weighted-average number of common shares outstanding only from the repurchase
date.10
ASC 505-30 states that, in some circumstances, the price paid to
repurchase common shares includes other elements, whether stated or unstated, for which
separate accounting is required and provides guidance on allocating the repurchase price
to these other elements. In accordance with ASC 505-30, when an entity pays an amount in
excess of fair value to repurchase its common shares and the excess is attributable to
the receipt of stated or unstated rights, privileges, or agreements in addition to the
treasury stock transaction, those other elements must be accounted for separately from
the treasury stock transaction element. The accounting for the other elements is subject
to the requirements of other GAAP. However, in some circumstances, an entity may
conclude that other GAAP requirements do not address the accounting for the excess of
the repurchase price over fair value and that this excess therefore represents an
expense or a dividend to a common shareholder. In reaching such a conclusion, an entity
must use judgment and evaluate the specific facts and circumstances associated with the
repurchase transaction. If an entity concludes that a payment in excess of fair value is
more characteristic of a dividend than an earnings charge (i.e., because the excess
represents a pro rata distribution), that dividend should reduce net income in arriving
at income available to common stockholders. There could be circumstances in which such a
dividend gives rise to the need to apply the two-class method of calculating basic EPS.
Connecting the Dots
ASC 505-30 discusses two important concepts that an entity must
consider when paying an amount in excess of the current market price to repurchase
shares of common stock.
- Excess of repurchase price per share over the current market price is “insignificant” — ASC 505-30-30-2 indicates that an allocation of the repurchase price to other elements of the 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.” This means that if an entity has determined that there are no other stated or unstated rights or privileges associated with the share repurchase for which separate accounting is required under other GAAP, and the excess of the repurchase price per share over the current market price per share is not significant, no separate accounting for the excess is required (i.e., the excess is part of the price paid in the treasury stock transaction and does not represent a dividend or expense item). However, even if the repurchase price exceeds the current market price of the common shares by an insignificant amount, an entity must still analyze the repurchase transaction to determine whether there are other elements of the repurchase transaction that should be recognized separately under other GAAP. The treasury stock transaction should not include consideration paid to the selling shareholder that must be accounted for under other GAAP. For this purpose, “significant” is generally interpreted in practice as 10 percent or more.
-
Excess of repurchase price per share over the current market price is “significant” — ASC 505-30-30-4 acknowledges that the excess of the amount paid to repurchase common shares over the current market price may constitute part of the treasury stock transaction even if the repurchase price is significantly “in excess of the current market price“ of the shares. ASC 505-30 focuses on a comparison of the repurchase price per share with the current market price per share; however, this is only the starting point in the analysis. Even if the repurchase price per share exceeds the current market price per share, there are generally no other stated or unstated rights to separately account for if the consideration paid does not exceed the fair value of the shares repurchased. An entity should consider the fair value measurement principles in ASC 820, in particular ASC 820-10-30-2 through 30-3A, in determining whether the repurchase price (i.e., the transaction price) exceeds the fair value of the shares repurchased. A repurchase price per share in excess of the current market price per share may represent an arm’s-length transaction price to just repurchase shares if the consideration paid exceeds the number of shares repurchased times the quoted market price (P × Q) because the shares are thinly traded or the repurchase involves a number of shares that exceed the number the market can readily absorb on a single trading day without significantly affecting the price per share. However, since it is presumed that a significant excess of the amount paid over the current market price represents an element other than a treasury stock transaction, an entity will need sufficient evidence to demonstrate that the repurchase price does not exceed the fair value of the shares repurchased. An entity should consider, among other matters, (1) the relationship it has with the selling shareholder (i.e., whether there is a related-party relationship or another transaction between the entity and the shareholder), (2) the facts and circumstances related to the share repurchase itself, and (3) what it believes to be the fair value of the shares repurchased (i.e., a market price to repurchase the number of shares repurchased). To conclude that the repurchase price represents an arm’s-length transaction when it does not represent P × Q, an entity must be able to determine that the same repurchase price would have been paid to any holder of the shares.11 If an entity cannot conclude that the consideration paid does not exceed the fair value of the shares repurchased, the excess must be associated with something other than the treasury stock transaction. If no other element is identified for which accounting is required under other GAAP, the excess should be treated as a dividend paid to the selling shareholder or as an expense. An entity must use judgment in making this determination and consider the facts and circumstances associated with the excess payment and the relationship between the entity and selling shareholder. When in doubt regarding the treatment of this excess amount, it is generally appropriate for an entity to account for it as an expense.
Example
3-22
Treasury Stock Purchase in Excess of Quoted Market Price
Company T, an entity with publicly traded stock, enters
into a transaction to immediately buy shares of its own common stock at a
price of $8.75 per share, which is approximately 25 percent above the
current quoted market price of $7 per share. The shares to be purchased are
currently held by a single corporation and represent approximately 17
percent of T’s outstanding common shares. Company T states three reasons for
purchasing the shares at an above-market price:
- Although the price is above the quoted market price, it is still an attractive price.
- In one transaction, T can effectively decrease dilution.
- Bidding for that volume of shares in the market, with such small volumes of trade (average daily trade volume is less than 1 percent of T’s total outstanding common shares), will significantly increase the market price even above the contract price.
Provided that the transaction does not involve
the receipt or payment of consideration in exchange for any stated or
unstated rights, privileges, or agreements in addition to the shares of
common stock repurchased, the entire purchase price should be accounted for
as the cost of treasury shares. ASC 505-30-50-3 states the following
regarding how a company should account for treasury shares purchased at a
stated price significantly in excess of the current market price of the
shares:
A repurchase of shares at a price significantly
in excess of the current market price creates a presumption that the
repurchase price includes amounts attributable to items other than the
shares repurchased. A repurchase of shares at a price significantly in
excess of the current market price may require an entity to allocate
amounts to other elements of the transaction under the requirements of
paragraph 505-30-30-2.
If the price paid in
excess of the current market price of the shares represented payment for
consideration received in the transaction other than the shares, the excess
should be attributed to the costs of the other element and accounted for
according to the substance of that element.
The purchase of the shares at a price in excess of the current market price
creates a presumption that the excess price is attributable to items other
than the shares. For the entire purchase price to be accounted for as the
costs of the treasury shares, this presumption needs to be overcome by
sufficient evidence to the contrary. If the presumption cannot be overcome,
the excess price should be attributed to the other items and accounted for
according to the substance of those items. Evidence may include, but is not
limited to, a valuation from an investment banker supporting the price paid
by the company and an analysis of the trading volume indicating that the
company could not purchase this volume of shares in a reasonable amount of
time without significantly affecting the current market price. For example,
T may be able to obtain sufficient evidence to conclude that the price paid
is not influenced by the issuer-holder relationship and that the price would
be the same if T had acquired that number of shares from another holder (or
group of holders).
If there is sufficient evidence to overcome the presumption that the price paid
in excess of the current market price of the shares represents payment for
consideration received in the transaction other than the shares, T should
account for the purchase of the shares in accordance with ASC 505-30-30-4,
which indicates that transactions to repurchase shares of common stock in
excess of the current market price may occur even if the excess is not
attributable to something other than a treasury stock transaction (i.e., the
repurchase price was representative of the fair value of the shares of
common stock repurchased). In other words, if the presumption is overcome,
the entire purchase price should be accounted for as the cost of the
treasury shares. Such accounting would generally be appropriate only if an
entity concludes that the repurchase price represents a price paid in an
arm’s-length transaction for the number of shares repurchased (i.e., a fair
value price for the shares repurchased).
The guidance discussed above also applies to the redemption of an NCI
in the form of common stock (see also Section
7.1.2.2 of Deloitte’s Roadmap Noncontrolling
Interests). If a repurchase of common stock occurs between an entity
and an employee, or with a nonemployee that was a customer or provided goods and
services to the entity, the guidance in ASC 718 should be considered. (For additional
discussion, see Deloitte’s Roadmap Share-Based Payment Awards.) The accounting considerations in
Section 3.2.4.1 are
relevant if an entity extinguishes common stock that was not issued in a share-based
payment arrangement through an induced conversion of one class of common stock to
another.12
3.2.4.3.1 Forward to Repurchase Common Stock and Mandatorily Redeemable Common Stock
ASC 480-10
EPS
45-4 Entities that have issued mandatorily
redeemable shares of common stock or entered into forward contracts that
require physical settlement by repurchase of a fixed number of the
issuer’s equity shares of common stock in exchange for cash shall exclude
the common shares that are to be redeemed or repurchased in calculating
basic and diluted earnings per share (EPS). Any amounts, including
contractual (accumulated) dividends and participation rights in
undistributed earnings, attributable to shares that are to be redeemed or
repurchased that have not been recognized as interest costs in accordance
with paragraph 480-10-35-3 shall be deducted in computing income available
to common shareholders (the numerator of the EPS calculation),
consistently with the two-class method set forth in paragraphs
260-10-45-60 through 45-70.
ASC 480-10-45-4 requires an entity to make the following adjustments
to the calculation of basic EPS for (1) mandatorily redeemable financial instruments
and (2) forward contracts that must be physically settled by repurchase of a fixed
number of shares of common stock in exchange for cash:
-
Numerator (i.e., 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, an entity excludes from the denominator shares of common stock that will be repurchased (i.e., it treats those shares as retired). See further discussion in Section 3.3.3.2.
Paragraph B68 of FASB Statement 150 states:
The
Board decided that the number of outstanding shares associated with physically
settled forward purchase contracts measured at the present value of the contract
amount should be removed from the denominator in computing basic and diluted
earnings per share in the same way as required for mandatorily redeemable shares
classified as liabilities. The Board reasoned that, because the accounting for
physically settled forward contracts reduces equity, even though the shares are
still outstanding, they are effectively accounted for as if retired. Like
mandatorily redeemable shares accounted for as liabilities, shares subject to
physically settled forward contracts should not be treated as outstanding in
earnings per share calculations. The Board noted that amounts paid to holders are
interest costs reflected in earnings available to common shareholders, the numerator
in calculating earnings per share.
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 repurchase] 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.
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.
Example
3-23
Calculating EPS When Shares Are Repurchased in a Forward
Contract
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 repurchase of 100 shares
in exchange for a 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 the 100
shares that are to be repurchased from the denominator in accordance with
ASC 480-10-45-4. Company A’s earnings for the year are $20,000 (excluding
interest cost accrued on the forward contract under ASC 480-10-35-3). 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
requirement 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, or $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).
See Chapter
5 for additional guidance on applying the two-class method.
3.2.4.3.2 Accelerated Share Repurchase Programs
ASC
505-30
Accelerated Share Repurchase Programs
25-5 An accelerated share repurchase program is a
combination of transactions that permits an entity to repurchase a
targeted number of shares immediately with the final repurchase price of
those shares determined by an average market price over a fixed period of
time. An accelerated share repurchase program is intended to combine the
immediate share retirement benefits of a tender offer with the market
impact and pricing benefits of a disciplined daily open market stock
repurchase program.
25-6 An entity shall account for such an
accelerated share repurchase program as the following two separate
transactions:
- As shares of common stock acquired in a treasury stock transaction recorded on the acquisition date
- As a forward contract indexed to its own common stock. Subtopic 815-40 provides guidance on the accounting for contracts that are indexed to an entity’s own common stock.
Example 1 (see paragraph 505-30-55-1)
provides an illustration of an accelerated share repurchase program that
is addressed by this guidance.
As noted in ASC 505-30-25-5, an accelerated share repurchase program
consists of two separate elements for accounting purposes — a treasury stock
transaction and a forward indexed to the issuer’s own stock. The treasury stock
transaction has no impact on the numerator in the calculation of basic EPS but does
affect the denominator as the shares of common stock are removed from the shares
outstanding from the acquisition date. See Section 8.4 for further discussion of accelerated share repurchase
programs.
3.2.4.3.3 Redemption of Tracking Stock
Some entities have issued classes of stock characterized as
“tracking” or “targeted” stock, which measures the performance of a specific business
unit, activity, or asset of the entity. Shares of tracking stock are traded as
separate securities although they typically are not associated with any specific claim
on the related assets and may grant limited or no voting rights. According to ASC
260-10-45-60B, an entity with tracking stock, which represents a separate class of
stock, must calculate and present EPS for each class of common stock by using the
two-class method.
The terms of tracking stock often allow the issuing entity, at its
option, to exchange or redeem shares of tracking stock for shares of another tracking
stock or the issuer’s main common stock in such a way that the entity would have one
less class of common stock outstanding. The terms of this feature generally require an
entity to pay a premium to the class being redeemed as a result of the transaction.
When the entity pays a premium over fair value to redeem a class of tracking stock,
the premium should be treated as a reduction from net income in arriving at income
available to common stockholders of the class whose shares are being used for the
redemption. The rationale for this treatment is that the holders of the tracking stock
being redeemed have received a benefit that constitutes an additional contractual
return to them. That benefit is absorbed by the class of common stock for which the
entity has issued shares in return for the extinguishment of the class of tracking
stock. The example below illustrates the accounting for a redemption of tracking
stock.
Example
3-24
Treatment of Redemption of Class of Tracking Stock
Company X has two classes of common stock outstanding
that separately track the results of operations of two different
businesses, A and B. Company X decided to redeem all outstanding shares of
its B tracking stock in exchange for shares of its A tracking stock. The
terms of the B stock being redeemed, as disclosed in the Form S-3 filed in
connection with the offering of that security, gave X the right to redeem
the B stock, at its discretion, by issuing shares of its A stock with a
market value equal to a 15 percent premium over the market price of the B
stock at the time of redemption. Therefore, the fair value of A stock to
be exchanged for the B stock will exceed the fair value of the B stock by
15 percent on the date the redemption is announced. The income available
to A stockholders should be reduced by the amount of the 15 percent
premium in the calculation of income available for common stockholders of
A for EPS purposes for the period.
3.2.4.4 Reclassification of Common Stock to a Liability
ASC 480-10
Mandatorily Redeemable Financial Instruments
25-7 If a financial
instrument will be redeemed only upon the occurrence of a conditional event,
redemption of that instrument is conditional and, therefore, the instrument
does not meet the definition of mandatorily redeemable financial instrument
in this Subtopic. However, that financial instrument would be assessed at
each reporting period to determine whether circumstances have changed such
that the instrument now meets the definition of a mandatorily redeemable
instrument (that is, the event is no longer conditional). If the event has
occurred, the condition is resolved, or the event has become certain to
occur, the financial instrument is reclassified as a liability.
A conditionally redeemable common stock instrument may become
mandatorily redeemable as a result of the resolution of a condition associated with
redemption. In this situation, the common stock must be reclassified from equity
(generally, from temporary equity) to a liability. ASC 480-10-30-2 specifies that “[i]f
a conditionally redeemable instrument becomes mandatorily redeemable, upon
reclassification the issuer shall measure that liability initially at fair value and
reduce equity by the amount of that initial measure, recognizing no gain or loss.” This
type of reclassification has no impact on net income and is not within the scope of ASC
260-10-S99-2 because that guidance does not apply to common stock instruments. However,
redeemable common stock is subject to the classification, measurement, and EPS guidance
in ASC 480-10-S99-3A. Therefore, if the common stock is being remeasured to its
redemption amount under ASC 480-10-S99-3A, immediately before the reclassification date
(which may be a date other than the end date of a financial reporting period), the
redeemable common stock instrument should be adjusted to its redemption amount in
accordance with the entity’s accounting policy for remeasuring redeemable securities
under ASC 480-10-S99-3A. If the common stock was not being remeasured to its redemption
amount under ASC 480-10-S99-3A, which may be the case if the redemption was contingent
and its occurrence was not probable, the entity must consider whether the amount payable
under the mandatory redemption feature exceeds the fair value of the common stock. If
so, the entity should consider the guidance on repurchases of common stock at amounts in
excess of fair value (see Section
3.2.4.3).
See Section
3.2.6.2 for more information about situations in which the reclassification
results from a modification of the instrument.
3.2.4.5 Common Stock Issued in Certain R&D Arrangements
See Section
8.10 for discussion of the impact on net income and income available to
common stockholders in certain R&D arrangements.
3.2.4.6 Excise Tax Obligations Related to the Repurchase of Common Stock
Publicly traded companies that repurchase common stock may be
obligated to pay a 1 percent excise tax under IRC Section 4501, which was added by the
Inflation Reduction Act of 2022. This excise tax obligation related to the repurchase of
common stock classified in permanent equity may be accounted for as a cost of the
treasury stock transaction (i.e., recorded in equity). Special considerations apply if
an entity repurchases common stock that is classified in temporary equity or has share
issuance transactions that reduce the total excise tax amount due. See Deloitte’s April
27, 2023, Heads Up
for more information about the accounting for this excise tax.
3.2.5 Other Securities
3.2.5.1 Participating Securities
3.2.5.1.1 Share-Based Payments
ASC
260-10
Participating Securities and the Two-Class Method
45-61 Fully vested share-based compensation
subject to the provisions of Topic 718, including fully vested options and
fully vested stock, that contain a right to receive dividends declared on
the common stock of the issuer, are subject to the guidance in paragraph
260-10-45-60A.
45-61A Unvested share-based payment awards that
contain nonforfeitable rights to dividends or dividend equivalents
(whether paid or unpaid) are participating securities and shall be
included in the computation of EPS pursuant to the two-class method under
the requirements of paragraph 260-10-45-60A.
In accordance with ASC 260-10-45-61 and 45-61A, the following
share-based payment awards represent participating securities to which an entity is
required to apply the two-class method of calculating basic EPS:
- Vested awards — Awards that do not represent outstanding shares of common stock that contain a right to receive dividends declared on the entity’s common stock.
- Unvested awards — Awards that contain a nonforfeitable right to dividends or dividend equivalents.
See Chapter
5 for further details regarding the definition of a participating
security and application of the two-class method and Section 7.1.3 for specific discussion related to
share-based payment awards.
3.2.5.1.2 Other Participating Securities
An entity may have issued freestanding financial instruments, other
than preferred stock and NCIs, that meet the definition of a participating security.
The most common types of instruments that may meet the definition of a participating
security are:
-
Options or warrants to purchase common stock.
-
Forward contracts to purchase or sell common stock.
-
Convertible debt securities.
See Chapter
5 for further discussion of the definition of a participating security
and application of the two-class method.
3.2.5.2 Settlement of Equity-Linked Financial Instruments
An entity may have issued and have outstanding contracts indexed to
its equity (i.e., equity-linked instruments). The security underlying these contracts
may be common stock or preferred stock. The contracts may be classified as assets or
liabilities or in stockholders’ equity. When these contracts are accounted for as assets
or liabilities, any difference between the fair value of the consideration paid or
received upon settlement and the carrying amount is recognized as a gain or loss in
earnings. Thus, the numerator in the calculation of basic EPS is affected through the
gains or losses recognized in net income. The settlement of equity-linked contracts
classified in stockholders’ equity is discussed below.
3.2.5.2.1 Freestanding Equity-Classified Contracts Indexed to an Entity’s Common Stock
ASC 815-40 addresses the settlement of freestanding equity-classified contracts indexed to an issuer’s common stock. ASC 260-10-S99-2 does not apply to the settlement of such contracts. As discussed in footnote 18 of EITF Topic D-98, the application of ASC 260-10-S99-2 “is limited to preferred stock
instruments.”13
The guidance in ASC 815-40 addressing the settlement of contracts
indexed to an entity’s common stock does not specifically address either (1) a
repurchase of an outstanding instrument at an amount that exceeds the fair value of
the instrument on the repurchase date or (2) an inducement offer to exercise the
instrument.
When an entity repurchases an outstanding contract indexed to its
common stock, the repurchase price is generally equal to the fair value of the
contract. However, if an entity pays an amount in excess of fair value, the excess
should be accounted for in the same manner as a repurchase of common stock at an
amount in excess of the current market price, as discussed in Section 3.2.4.3. Thus, if the
consideration transferred upon settlement exceeds the fair value of the equity-linked
instrument on the settlement date, the excess consideration may need to be recognized
as a dividend or an expense. Any such amount recognized as a dividend will reduce
income available to common stockholders in a manner similar to the application of the
two-class method.
If an entity settles a contract indexed to its common stock under an
inducement offer, the additional value provided as a result of the inducement offer,
which is calculated as the fair value of all securities and other consideration
transferred in the transaction over the fair value of the capital stock issuable
according to the original terms of the contract, should be treated as a dividend or an
expense. Any such amount recognized as a dividend will reduce income available to
common stockholders in a manner similar to the application of the two-class method.
Section 3.2.4.3
provides additional discussion of the treatment of such an amount as a dividend or an
expense.
See Section
3.2.5.3 for discussion of the treatment of down-round features in
freestanding equity-linked contracts that are classified in stockholders’ equity.
3.2.5.2.2 Freestanding Equity-Classified Contracts Indexed to an Entity’s Preferred Stock
The settlement of an equity-classified freestanding contract that is
indexed to an entity’s preferred stock is accounted for in the same way as a
settlement of convertible preferred stock that does not contain a separately
recognized equity component (see Sections 3.2.2.5.4, 3.2.2.6.2.1, and 3.2.2.6.3). A summary of the accounting, which depends on the nature of
the settlement, is as follows:
-
Exercise — A settlement of an equity-classified freestanding contract indexed to an entity’s preferred stock that occurs on the basis of an exercise of the instrument according to its stated terms is not accounted for under ASC 260-10-S99-2 and has no impact on the numerator in the entity’s calculation of basic EPS.
-
Redemption — ASC 260-10-S99-2 applies to the redemption of an equity-classified freestanding contract indexed to an entity’s preferred stock regardless of the form of the consideration provided on redemption. Therefore, any difference between the total fair value of the consideration transferred to redeem the instrument and the net carrying amount of the instrument should be treated as an adjustment to net income in arriving at income available to common stockholders.
-
Inducement — In an inducement, the excess of (1) the fair value of all securities and other consideration transferred in the transaction to the holders of the equity-linked contract over (2) the fair value of securities issuable in accordance with the original exercise terms should be deducted from net income to arrive at income available to common stockholders in the calculation of basic EPS. Once this additional value is recognized, the entity applies the accounting applicable to an exercise of an equity-classified freestanding contract indexed to an entity’s preferred stock. Accordingly, in such situations, there is no additional impact on the numerator in the calculation of basic EPS.
3.2.5.2.3 Convertible Debt That Contains a Separately Classified Equity Component Indexed to an Entity’s Common Stock
ASC 480-10 — SEC
Materials — SEC Staff Guidance
SEC Staff
Announcement: Classification and Measurement of Redeemable
Securities
S99-3A(3)(e)
Convertible debt instruments that contain a separately classified
equity component. Other applicable GAAP may require a convertible
debt instrument to be separated into a liability component and an equity
component.FN8 In these situations, the equity-classified
component of the convertible debt instrument should be considered
redeemable if at the balance sheet date the issuer can be required to
settle the convertible debt instrument for cash or other assets (that is,
the instrument is currently redeemable or convertible for cash or other
assets). For these instruments, an assessment of whether the convertible
debt instrument will become redeemable or convertible for cash or other
assets at a future date should not be made. For example, a convertible
debt instrument that is not redeemable at the balance sheet date but could
become redeemable by the holder of the instrument in the future based on
the passage of time or upon the occurrence of a contingent event is not
considered currently redeemable at the balance sheet date.
S99-3A(12)(d) For convertible debt instruments
that contain a separately classified equity component, an amount should
initially be presented in temporary equity only if the instrument is
currently redeemable or convertible at the issuance date for cash or other
assets (see paragraph 3(e)). The portion of the equity-classified
component that is presented in temporary equity (if any) is measured as
the excess of (1) the amount of cash or other assets that would be
required to be paid to the holder upon a redemption or conversion at the
issuance date over (2) the carrying amount of the liability-classified
component of the convertible debt instrument at the issuance
date.
S99-3A(16)(d) For convertible debt instruments
that contain a separately classified equity component, an amount should be
presented in temporary equity only if the instrument is currently
redeemable or convertible at the balance sheet date for cash or other
assets (see paragraph 3(e)). The portion of the equity-classified
component that is presented in temporary equity (if any) is measured as
the excess of (1) the amount of cash or other assets that would be
required to be paid to the holder upon a redemption or conversion at the
balance sheet date over (2) the carrying amount of the
liability-classified component of the convertible debt instrument at the
balance sheet date.FN15
S99-3A(23)
Convertible debt instruments that contain a separately classified
equity component. For convertible debt instruments subject to ASR
268 (see paragraph 3(e)), there should be no incremental earnings per
share accounting from the application of this SEC staff announcement.
Subtopic 260-10 addresses the earnings per share accounting.
____________________
FN8 See Subtopics 470-20 and 470-50; and
Paragraph 815-15-35-4.
FN15 ASR 268 does
not impact the application of other applicable GAAP to the accounting for
the liability component or the accounting upon derecognition of the
liability and/or equity component.
A convertible debt instrument will contain a separately recognized
component in common stockholders’ equity if the convertible debt:
- Has been modified in a transaction that increased the fair value of the embedded conversion option but did not result in an extinguishment (see ASC 470-50-40-15).
- Contains an embedded conversion option that has been reclassified from a derivative liability to equity (see ASC 815-15-35-4).
- Was issued at a substantial premium (see ASC 470-20-25-13).
The Codification addresses the accounting for a settlement of a
convertible debt instrument that contains a separately recognized component in common stockholders’ equity. While the classification and measurement provisions of ASC 480-10-S99-3A apply to convertible debt that contains a separately recognized component classified in common stockholders’ equity, the EPS guidance in ASC 480-10-S99-3A does not apply in such circumstances. Furthermore, ASC 260-10-S99-2 also does not apply to any settlement of a convertible debt instrument that contains a separately recognized component in common stockholders’ equity. This observation is consistent with footnote 18 of EITF Topic D-98, which states:
Topic D-42 also does not apply to convertible debt instruments that contain an
embedded conversion option indexed to the issuer’s common stock because the
application of Topic D-42 is limited to preferred stock instruments.
While this footnote was not codified, it continues to reflect the
SEC staff’s view. Therefore, neither the EPS guidance in ASC 480-10-S99-3A nor the EPS
guidance in ASC 260-10-S99-2 applies to any settlement of a convertible debt
instrument that contains a separately recognized component in common stockholders’
equity. Rather, only the settlement guidance in other areas of the Codification should
be applied (see Sections
6.2.2 and 6.3.2 for additional discussion). This view is premised on the SEC
staff’s view that because ASC 260-10-S99-2 applies only to preferred stock
instruments, it does not apply to equity-classified components that are indexed to an
entity’s common stock.
Connecting the Dots
The view expressed above would also apply to a convertible instrument issued in
the legal form of preferred stock that is classified as a liability under ASC
480-10-25-4 (i.e., a convertible preferred stock instrument for which the
principal amount must be paid in cash and that gives the issuer the option of
paying any excess conversion value in cash or stock).
3.2.5.2.4 Convertible Preferred Stock That Contains a Separated Equity Component Indexed to an Entity’s Common Stock
An entity may have outstanding convertible preferred stock
(classified in temporary equity or permanent equity) containing a separated equity component recognized in common stockholders’ equity. As noted in the previous section, ASC 480-10-S99-3A(23) provides special EPS guidance on convertible debt that contains a separate equity component recognized in common stockholders’ equity. Footnote 17 of EITF Topic D-98 states the following regarding applying this special guidance by
analogy:
The guidance provided in this paragraph for convertible
debt instruments that contain an equity-classified component should not be applied
by analogy to other equity instruments that are subject to ASR 268 and this SEC
staff announcement.
We think that the SEC staff included the reference to “convertible debt instruments” in this footnote because it believed that EITF Topic D-42 (i.e., ASC
260-10-S99-2) does apply to certain types of settlements of a host preferred stock instrument when the convertible preferred stock contains a separate component recognized in common stockholders’ equity. However, we do not think that the staff believed that the settlement of the equity-classified component indexed to the entity’s common stock is within the scope of ASC 260-10-S99-2 because of its view, as originally expressed in footnote 18 of EITF Topic D-98, that only preferred stock instruments are within the scope of EITF Topic D-42. The table below describes the
accounting guidance that applies to convertible preferred stock containing a
separately recognized component classified in common stockholders’ equity. The
following assumptions apply to the matters discussed in this table:
-
The embedded conversion option is indexed to the issuer’s common stock.
-
The embedded conversion option is not accounted for as a derivative liability.
-
The convertible preferred stock instrument is not classified as a liability.
The table does not comprehensively discuss the application of ASC
480-10-S99-3A, which may affect the accounting.
Table
3-7
Nature of
Separately Recognized Equity Component | Accounting for
Settlement |
---|---|
Modified embedded conversion option | As discussed in
Section
3.2.6.1.1, an entity should generally account for a
modification or exchange that affects the embedded conversion option in a
convertible preferred stock instrument, and that does not result in an
extinguishment, by recognizing any incremental fair value provided to the
preferred stockholder(s) as a “deemed dividend” or an expense. However,
given the lack of specificity in the accounting literature, an entity may
determine that it is appropriate to recognize — as a separate component of
common stockholders’ equity by analogy to ASC 470-50-40-15 — an increase
in the fair value of the embedded conversion option arising from a
modification or exchange affecting the embedded conversion option in a
convertible preferred stock instrument. The
accounting for a settlement of a convertible preferred stock instrument
containing a separately recognized component in common stockholders’
equity that resulted from a modification or exchange that affected the
embedded conversion option in a convertible preferred stock instrument
depends on the nature of the settlement as follows:
ASC 480-10-S99-3A applies to redeemable convertible preferred stock containing a
separately recognized component in common stockholders’ equity that
resulted from a modification or exchange that affected the embedded
conversion option in a convertible preferred stock instrument. The
classification of that separate equity component within equity (i.e., as
temporary equity or permanent equity) when convertible preferred stock is
a redeemable equity security is subject to an accounting policy election
for which two views are acceptable:
Regardless of which view is applied, if the convertible preferred stock
is being remeasured to its redemption amount in accordance with the
subsequent-measurement guidance in ASC 480-10-S99-3A, the entity should
follow its remeasurement policy under ASC 480-10-S99-3A and recognize the
effects of such remeasurement, including the impact on EPS, immediately
before accounting for any settlement. This “final” measurement adjustment
may affect the carrying amount of the convertible preferred stock and thus
the settlement accounting applied to the three settlement types discussed
above. |
Reclassified embedded conversion option (note that if the
reclassification occurs as a result of a modification or exchange, the
guidance in Section
3.2.6 applies) | ASC 815-15-35-4,
which addresses the accounting for a reclassification of an embedded
conversion option in a debt instrument from a liability to equity,
states: If an embedded conversion option in a
convertible debt instrument no longer meets the bifurcation criteria in
this Subtopic, an issuer shall account for the previously bifurcated
conversion option by reclassifying the carrying amount of the liability
for the conversion option (that is, its fair value on the date of
reclassification) to shareholders’ equity. Any debt discount recognized
when the conversion option was bifurcated from the convertible debt
instrument shall continue to be amortized. This approach should be applied when an embedded conversion option
indexed to the entity’s common stock in a preferred stock instrument is
reclassified from a derivative liability to equity. Therefore, the fair
value of the embedded conversion option liability should be reclassified
to stockholders’ equity and reported as a separate component of common
stockholders’ equity. The fair value of the embedded conversion option
liability should be adjusted, with any change recognized in earnings,
immediately before the reclassification so that the reclassified amount
reflects the fair value of the embedded conversion option on the
reclassification date. The accounting for a
settlement of a convertible preferred stock instrument that contains a
separately recognized component in common stockholders’ equity that
resulted from a reclassification of the embedded conversion option from a
liability to equity depends on the nature of the settlement as follows:
ASC 480-10-S99-3A applies to redeemable convertible preferred stock containing a
separately recognized component in common stockholders’ equity that
resulted from a reclassification of the embedded conversion option from a
liability to equity. The classification of that separate equity component
within equity (i.e., as temporary equity or permanent equity) when
convertible preferred stock is a redeemable equity security is subject to
an accounting policy election consistent with the two views discussed
above under “modified embedded conversion option.” Regardless of which
view is applied, if the convertible preferred stock is being remeasured to
its redemption amount in accordance with the subsequent-measurement
guidance in ASC 480-10-S99-3A, the entity should follow its remeasurement
policy under ASC 480-10-S99-3A and recognize the effects of such
remeasurement, including the impact on EPS, immediately before accounting
for any settlement. This “final” measurement adjustment may affect the
carrying amount of the convertible preferred stock and thus the settlement
accounting applied to the three settlement types discussed above. |
Down-round feature has been triggered
|
As discussed in Section 3.2.2.5.1, an entity may
recognize a dividend and an increase in APIC (i.e., common stockholders’
equity) as a result of a down-round feature that has been triggered in a
convertible preferred stock instrument.
The Codification does not specifically address the
accounting for a settlement of a convertible preferred stock instrument
containing a separately recognized component in common stockholders’
equity that resulted from the recognition of a down-round feature that has
been triggered. However, the following accounting would be acceptable
under GAAP:
ASC 480-10-S99-3A applies to redeemable convertible
preferred stock containing a separately recognized component in common
stockholders’ equity that resulted from a down-round feature that had been
previously triggered. On the basis of discussions with the staff in the
SEC’s Office of the Chief Accountant (OCA), we understand that the SEC
staff will object if an entity classifies the credit entry as APIC within
temporary equity. Therefore, if the convertible preferred stock is subject
to remeasurement under ASC 480-10-S99-3A, any remeasurement adjustments
must be made without regard to the amount recognized in APIC (permanent
equity) when the down-round feature was triggered. The SEC staff indicated
that SEC registrants must apply this view even though such application may
result in “double-counting” the effect on EPS for a convertible preferred
share that is being remeasured to its redemption amount for which a
down-round feature has been triggered. In addition, we have confirmed with
the OCA staff that this view applies only to convertible preferred stock
arrangements that are subject to the down-round guidance in ASC 260 -10.
Therefore, we believe that it is still acceptable to apply either of the
two alternative views discussed above on the classification of the
separately recognized equity component in a redeemable convertible
preferred share that contains a modified embedded conversion option or an
equity component from reclassification of the conversion option.
If the convertible preferred stock is being remeasured to its redemption
amount in accordance with the subsequent-measurement guidance in ASC
480-10-S99-3A, the entity should follow its remeasurement policy under ASC
480-10-S99-3A and recognize the effects of such remeasurement, including
the impact on EPS, immediately before accounting for any settlement. This
“final” measurement adjustment may affect the carrying amount of the
convertible preferred stock and thus the settlement accounting applied to
the three settlement types discussed above.
|
3.2.5.2.5 Convertible Preferred Stock That Contains a Separated Equity Component Indexed to the Entity’s Preferred Stock
It is unusual to encounter a convertible preferred stock instrument
with an embedded conversion option that is indexed to a different class of preferred
stock and a separately recognized equity-classified component. However, this situation
could exist if an entity reclassified an embedded conversion option indexed to a class
of preferred stock from a liability to equity after this feature was bifurcated from a
host preferred stock instrument. If this situation does exist, the separately
classified equity component must be classified outside of common stockholders’ equity
since the embedded conversion option is indexed to the issuer’s preferred stock. The
accounting for a settlement of such an instrument depends on the nature of the
settlement as follows:
-
Conversion — In accounting for a conversion, an entity should use the conversion accounting approach specified in Table 3-7. That is, any remaining discount on the convertible preferred stock should be immediately amortized and treated as a “deemed dividend” that reduces net income in arriving at income available to common stockholders.
-
Redemption — In a redemption, ASC 260-10-S99-2 applies to both the convertible preferred stock instrument and the separated equity component. Thus, the difference between the fair value of the total consideration transferred to redeem the convertible preferred stock over the aggregate carrying amounts of the convertible preferred stock and separately recognized equity component should be treated as a “deemed dividend” (or “deemed contribution”) that results in an adjustment to net income in arriving at income available to common stockholders.
-
Induced conversion — An induced conversion should be accounted for in a manner consistent with the approach specified in Table 3-7. That is, an entity should employ a two-step approach under which it first applies ASC 260-10-S99-2 to capture the additional value provided by the inducement offer and then applies the accounting specified for a conversion in accordance with the stated conversion privileges.
In line with the discussion in Table 3-7, ASC 480-10-S99-3A applies to
convertible preferred stock that contains a separately recognized equity component
indexed to an entity’s preferred stock. This separate equity component would generally
be classified in temporary equity if the convertible preferred stock is a redeemable
equity security subject to ASC 480-10-S99-3A. If the convertible preferred stock is
being remeasured to its redemption amount in accordance with the
subsequent-measurement guidance in ASC 480-10-S99-3A, the entity should follow its
remeasurement policy under ASC 480-10-S99-3A and recognize the effects of such
remeasurement, including the impact on EPS, before applying settlement accounting.
3.2.5.3 Down-Round Features in Freestanding Financial Instruments
ASC
260-10
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).
Example 16: Equity-Classified
Freestanding Financial Instruments That Include a Down Round
Feature
55-95 Assume Entity A issues
warrants that permit the holder to buy 100 shares of its common stock for
$10 per share and that Entity A presents EPS in accordance with the guidance
in this Topic. The warrants have a 10-year term, are exercisable at any
time, and contain a down round feature. The warrants are classified as
equity by Entity A because they are indexed to the entity’s own stock and
meet the additional conditions necessary for equity classification in
accordance with the guidance in Subtopic 815-40 on derivatives and hedging —
contracts in entity’s own equity (see paragraphs 815-40-55-33 through 55-34A
for an illustration of the guidance in Subtopic 815-40 applied to a warrant
with a down round feature). Because the warrants are an equity-classified
freestanding financial instrument, they are within the scope of the
recognition and measurement guidance in this Topic. The terms of the down
round feature specify that if Entity A issues additional shares of its
common stock for an amount less than $10 per share or issues an
equity-classified financial instrument with a strike price below $10 per
share, the strike price of the warrants would be reduced to the most recent
issuance price or strike price, but the terms of the down round feature are
such that the strike price cannot be reduced below $8 per share. After
issuing the warrants, Entity A issues shares of its common stock at $7 per
share. Because of the subsequent round of financing occurring at a share
price below the strike price of the warrants, the down round feature in the
warrants is triggered and the strike price of the warrants is reduced to $8
per share.
55-96 In accordance with the
measurement guidance in paragraphs 260-10-30-1 through 30-2, Entity A
determines that the fair value of the warrants (without the down round
feature) with a strike price of $10 per share immediately after the down
round feature is triggered is $600 and that the fair value of the warrants
(without the down round feature) with a strike price of $8 per share
immediately after the down round feature is triggered is $750. The increase
in the value of $150 is the value of the effect of the triggering of the
down round feature.
55-97 The $150 increase is
the value of the effect of the down round feature to be recognized in equity
in accordance with paragraph 260-10-25-1, as follows:
Additionally, Entity A reduces income available to common
stockholders in its basic EPS calculation by $150 in accordance with the
guidance in paragraph 260-10-45-12B. Entity A applies the treasury stock
method in accordance with paragraphs 260-10-45-23 through 45-27 to calculate
diluted EPS. Accordingly, the $150 is added back to income available to
common stockholders when calculating diluted EPS. However, the treasury
stock method would not be applied if the effect were to be antidilutive.
For equity-classified freestanding financial instruments that contain
a down-round feature (including equity-classified convertible preferred stock, as
discussed in Section
3.2.2.5.1), an adjustment to income available to common stockholders is
required when the down-round feature is triggered. That adjustment is calculated in
accordance with ASC 260-10-30-1. No such adjustment is required when a down-round
feature in a convertible debt instrument is triggered.
For equity-linked freestanding financial instruments that are classified as a liability
(e.g., the instrument does not meet the indexation conditions in ASC 815-40 for reasons
other than the down-round feature), the EPS adjustment discussed in ASC 260-10-30-1, as
well as the related recognition in equity of the effect of the triggered down-round
feature, is not required. Rather, the mark-to-market adjustment that must be recognized
in earnings for such liability-classified instruments will reflect the impact of the
down-round feature.
3.2.6 Modifications and Exchanges of Equity Instruments
3.2.6.1 Modification or Exchange of Preferred Stock
Modifications or exchanges of preferred stock instruments must be
evaluated to determine whether the changes reflect an extinguishment of preferred stock
that must be accounted for under ASC 260-10-S99-2. The Codification does not
specifically address how to perform this evaluation. However, in his remarks
before the 2014 AICPA Conference on Current SEC and PCAOB Developments, Kirk Crews, then
a professional accounting fellow in the SEC’s Office of the Chief Accountant, noted that
registrants may use one of the following approaches in determining whether an amendment
to, or exchange of, an equity-classified preferred stock instrument constitutes a
modification or extinguishment:
- Qualitative approach — An entity would consider the significance of additions, removals, and changes to existing contractual terms. In addition, the entity would “evaluate the business purpose for the changes and how the changes may influence the economic decisions of the investor.” If the entity determines that the changes are significant, it would treat the amendments or exchange as an extinguishment; otherwise, it would treat the changes as a modification to the preferred stock.
- Fair value approach — An entity would compare the fair value of the preferred stock after the amendment or exchange with the fair value of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. If there is a 10 percent or greater change in the fair value of the preferred stock, the entity would consider the preferred stock to be substantially different and account for the amendment or exchange as an extinguishment. If, however, the change is less than 10 percent, a preferred stock modification has occurred.
- Cash flow approach — An entity would compare the contractual cash flows of the preferred stock after the amendment or exchange with the contractual cash flows of the preferred stock immediately before the amendment or exchange to determine whether the preferred stock is substantially different. As it would under the fair value approach, the entity would consider a change of 10 percent or greater to be substantially different and would account for the amendment or exchange as an extinguishment. A change of less than 10 percent would be considered a modification. See ASC 470-50-40 for guidance on how to perform the 10 percent cash flow test.
Mr. Crews indicated that the qualitative approach is the “most common
approach” observed by the SEC staff.
Connecting the Dots
The cash flow approach is not appropriate unless the preferred
stock contains a redemption feature. Without a redemption feature, there are no
contractual cash flows to evaluate in a preferred stock instrument.
In addition, Mr. Crews noted that some registrants may be using the
legal form approach to determine whether an amendment to, or exchange of, an
equity-classified preferred stock constitutes a modification or an extinguishment. Under
the legal form approach, an exchange that results in the issuance of new preferred stock
would be accounted for as an extinguishment of the exchanged preferred stock. Mr. Crews
cautioned registrants that the legal form is merely one factor in the evaluation of
whether an amendment or exchange should be accounted for as a modification or an
extinguishment and emphasized that the form of the change in and of itself should not be
determinative of the accounting outcome.
Connecting the Dots
The three approaches described above are generally not applied to
a modification or exchange of preferred stock that is akin to a troubled debt
restructuring, since such a modification or exchange is generally not treated as an
extinguishment.
Mr. Crews suggested that if a registrant determines that an amendment
to, or exchange of, equity-classified preferred stock is a modification, it would be
appropriate for the entity to analogize to the modification guidance in ASC 718-20 on
modifications to equity-classified share-based payment awards. If the fair value of the
instrument after the modification exceeds its fair value before the modification, the
entity should recognize the incremental fair value to reflect the modification. Mr.
Crews indicated that the SEC staff would not object to an entity’s recognition of the
additional fair value in retained earnings as a deemed dividend from the entity to the
preferred stockholders. (This means that in calculating EPS, an entity would deduct the
incremental fair value from net income in determining income available to common
stockholders.) Mr. Crews suggested that in certain unique circumstances, it may be
appropriate to recognize the additional fair value as an expense (e.g., if facts and
circumstances indicate that it reflects compensation for agreeing to restructure the
preferred stock). He noted that the appropriate method for recognizing the additional
fair value would depend on “the underlying purpose for and circumstances surrounding the
modification.”
Connecting the Dots
The incremental fair value in a modification or exchange of
preferred stock that is not considered an extinguishment is generally treated either
as a “deemed dividend” that reduces net income in arriving at income available to
common stockholders or as an expense that reduces income available to common
stockholders through a reduction of net income. Although uncommon, there may be
circumstances in which a modification or exchange of preferred stock reflects a
transaction that only affects preferred stockholders. If an entity can conclude that
a modification or exchange solely reflects a reallocation of shareholder value
between preferred shareholder groups, it may be appropriate not to reflect the
incremental value provided to one preferred shareholder group since the incremental
loss to the corresponding preferred shareholder group is also not recognized.
However, if there is any impact on common shareholders, an entity must apply
the guidance discussed by the SEC staff to reflect the impact of the incremental
fair value provided to preferred stockholders as a result of the modification or
exchange of preferred stock.
It is not appropriate to account for a transfer of wealth from a
preferred stock investor to common shareholders as an increase to net income in
arriving at income available to common stockholders. That is, only increases in fair
value of preferred stock instruments are recognized in a modification or exchange of
preferred stock (i.e., reductions in fair value are not recognized).
Mr. Crews did not discuss the accounting for fees and costs paid to
investors in a modification or exchange of preferred stock that is not treated as an
extinguishment. However, these fees and costs should be recognized as charges to
retained earnings or net income in a manner consistent with the recognition of the
incremental fair value resulting from the modification or exchange. Accordingly, such
fees and costs will also reduce income available to common stockholders.
Mr. Crews did not discuss modifications or exchanges that are
accounted for as an extinguishment. ASC 260-10-S99-2 provides guidance on the EPS impact
of extinguishments (redemptions) of equity-classified preferred stock. Under that
guidance, an SEC registrant compares (1) the fair value of the consideration transferred
to the holders of the preferred stock (i.e., the fair value of the preferred stock
immediately after the modification or exchange along with any other consideration
transferred) and (2) the net carrying amount of the preferred stock immediately before
the modification or exchange (net of issuance costs). The difference is treated as a
return to (or from) the holder of the preferred stock in a manner similar to dividends
paid on preferred stock (i.e., the difference is deducted from net income to arrive at
income available to common stockholders under ASC 260-10-45-11).
Connecting the Dots
Under ASC 260-10-S99-2, the fair value of the consideration transferred to redeem a
preferred stock instrument is presumed to reflect the fair value of the preferred
stock that is being redeemed. If the fair value of the consideration transferred to
preferred stockholders does not reflect the fair value of the redeemed shares, the
transaction involves other elements that should be accounted for in accordance with
other GAAP.
Below are some examples illustrating modifications and exchanges of
preferred stock. As noted above, when the modification or exchange is treated as an
extinguishment, ASC 260-10-S99-2 applies.
Example 3-25
Modification to Add Mandatory Redemption Feature
Company A adds a mandatory redemption feature to its redeemable preferred stock.
Because the modification results in a requirement to reclassify the modified
instrument from equity to a liability, A concludes that the preferred stock
has been extinguished since an extinguishment has occurred any time a
preferred stock instrument is (1) modified and becomes a
liability-classified instrument or (2) exchanged for an instrument that is
classified as a liability.
Example 3-26
Exchange of Preferred Stock for Common Stock
Company D exchanges its outstanding preferred stock for common stock. This
type of exchange would always be treated as an extinguishment.
ASC 260-10-S99-2 does not apply when a debt instrument is exchanged for a
preferred stock instrument. In accordance with ASC 470-50-40-3, this type of
transaction must be treated as an extinguishment of debt, with a gain or
loss recognized in earnings (unless the transaction reflects a troubled debt
restructuring subject to ASC 470-60).
3.2.6.1.1 Modification or Exchange of Convertible Preferred Stock
An entity may modify the terms of the embedded conversion option in
a convertible preferred stock instrument or achieve the same results by exchanging
convertible preferred stock instruments. An entity may also add or eliminate a
substantive conversion option in a preferred stock instrument through a modification
or exchange. These types of transactions must be assessed to determine whether they
should be treated as an extinguishment.
When a modification or exchange of preferred stock results in the
addition of a conversion option that (1) is substantive as of the date of the
modification or exchange or (2) results in the elimination of a conversion option that
was substantive as of the date of the modification or exchange, the changes to the
terms of the preferred stock are qualitatively significant. In these circumstances,
application of the qualitative approach discussed by the SEC staff (see Section 3.2.6.1) is appropriate
and the modification or exchange is treated as an extinguishment of the existing
preferred stock instrument. Application of the fair value approach to a modification
or exchange of preferred stock that results in the addition or elimination of a
substantive conversion option is generally inappropriate. Application of the cash flow
approach to a modification or exchange of preferred stock that results in the addition
or elimination of a substantive conversion option is never appropriate because this
approach will not reflect any of the value attributable to the impact of the
modification or exchange on the conversion feature.
When a modification or exchange of preferred stock affects the
embedded conversion option in convertible preferred stock (i.e., the preferred stock
contains a substantive conversion feature before and after the modification or
exchange), an entity will often choose to apply the fair value approach discussed by
the SEC staff (see Section
3.2.6.1). When the modification or exchange affects both the embedded
conversion option and the host preferred stock contract, the entity must apply the
fair value approach, as explained by Mr. Crews in his speech (see Section 3.2.6.1).
That is, under the fair value approach, the fair value of the entire preferred stock
instrument is compared on a before-and-after basis to determine whether there is a 10
percent or greater change in the fair value of the entire preferred stock instrument.
However, if the overall change in the fair value of the entire preferred stock
instrument is less than 10 percent or the modification or exchange is determined to
only affect the fair value of the embedded conversion feature, an entity could
consider either of the following approaches:
-
An approach consistent with the approach specified for convertible debt instruments in ASC 470-50-40-10. Under ASC 470-50-40-10, “A modification or an exchange [that] affects the terms of an embedded conversion option, from which the change in the fair value of the embedded conversion option (calculated as the difference between the fair value of the embedded conversion option immediately before and after the modification or exchange) is at least 10 percent of the carrying amount of the original debt instrument immediately before the modification or exchange” is accounted for as an extinguishment. Under this approach, the change in the fair value of the embedded conversion feature arising from the modification or exchange is compared with the carrying amount of the convertible preferred stock instrument.
-
An approach that focuses on whether the change to the fair value of the conversion option is 10 percent or more, which is similar to the approach described in the SEC staff speech. Under this approach, the fair value of the embedded conversion option immediately before the modification or exchange is compared with the fair value of the embedded conversion option immediately after the modification or exchange.
Because the SEC staff speech and Codification do not specifically
address how to evaluate the impact of a modification or exchange of convertible
preferred stock that affects the terms of the embedded conversion option, an entity
may consider using either or both of these two approaches. However, in a manner
consistent with the two-step approach outlined in ASC 470-50 for modifications or
exchanges of convertible debt instruments (i.e., a 10 percent cash flow test followed
by a fair value test that focuses only on the impact of the modification or exchange
on the embedded conversion feature), in any modification or exchange of convertible
preferred stock, the evaluation should first focus on the impact of the modification
or exchange on the overall hybrid convertible preferred stock instrument; if that
analysis does not result in extinguishment accounting, a supplemental analysis should
be performed that focuses only on how the modification or exchange affects the terms
of the embedded conversion option. The approaches applied in these analyses could be
the same (i.e., the fair value approach for both analyses) or different (i.e.,
qualitative approach for the overall hybrid convertible preferred stock instrument and
one or more fair value analyses for the effect on the embedded conversion option).
Ultimately, an entity must use judgment and consider all relevant facts and
circumstances in determining whether the modification or exchange reflects an
extinguishment of the convertible preferred stock instrument. In performing these
analyses, the entity should generally apply a consistent approach for similar types of
modifications or exchanges.
If, after evaluating a modification or exchange that involves the
embedded conversion option in convertible preferred stock, an entity concludes that an
extinguishment has not occurred, the entity must determine the appropriate accounting
for the modification or exchange. ASC 470-50-40-15, which addresses modifications or
exchanges that affect the conversion option embedded in a debt instrument, states:
If a convertible debt instrument is modified or exchanged in a
transaction that is not accounted for as an extinguishment, an increase in the fair
value of the embedded conversion option (calculated as the difference between the
fair value of the embedded conversion option immediately before and after the
modification or exchange) shall reduce the carrying amount of the debt instrument
(increasing a debt discount or reducing a debt premium) with a corresponding
increase in additional paid-in capital. However, a decrease in the fair value of an
embedded conversion option resulting from a modification or an exchange shall not be
recognized.
This guidance only specifically addresses the accounting for
modifications or exchanges that affect an embedded conversion option in a debt
instrument. There is no guidance on accounting for a modification or exchange
involving an embedded conversion option in a convertible preferred stock instrument
that is not accounted for as an extinguishment. The SEC staff speech does, however,
discuss modifications and exchanges of preferred stock that are not treated as
extinguishments. As noted in Section
3.2.6.1, any incremental fair value provided to the preferred
stockholders as a result of the modification or exchange is treated as either a
“deemed dividend” or an expense. Considering this guidance, along with the fact that
modifications or exchanges of convertible preferred stock that affect the terms of an
embedded conversion option generally have an impact on the fair value of the overall
hybrid contract that is different from the change in fair value of just the embedded
conversion option, it is most appropriate for the entity to calculate the incremental
fair value, if any, arising from the modification or exchange by comparing the fair
value of the entire convertible preferred stock instrument before and after the
modification or exchange. Any incremental fair value would be treated as a “deemed
dividend” (or potentially as an expense, as discussed in the SEC staff speech), and
the entity would generally not recognize a separate equity component in common
stockholders’ equity as it would if the modification or exchange involved a
convertible debt instrument. This approach is appropriate given its consistency with
the accounting for other types of modifications or exchanges of preferred stock that
are not accounted for as an extinguishment (see Section 3.2.6.1).
When a “deemed dividend” is recognized as a result of the
incremental fair value of a convertible preferred stock instrument that results from a
modification or exchange that involves the embedded conversion option, the amount of
the dividend is accounted for as a reduction of net income in arriving at income
available to common stockholders and increases the carrying amount of the convertible
preferred stock. If the convertible preferred stock is classified in temporary equity
and is being remeasured to its redemption amount under ASC 480-10-S99-3A, the
adjustment from the modification is generally considered part of the “initial amount”
referred to in ASC 480-10-S99-3A(16)(e). That is, any reductions in the carrying
amount of the redeemable equity instrument as a result of the application of the
remeasurement guidance in ASC 480-10-S99-3A would be appropriate only to the extent
that the entity has previously recorded increases in the carrying amount of the
redeemable equity instrument as a result of the application of the remeasurement
guidance in ASC 480-10-S99-3A.
Below are two examples illustrating the accounting for modifications
or exchanges of convertible preferred stock.
Example 3-27
Exchange of Convertible Preferred Stock for Nonconvertible Preferred
Stock
Company B exchanges its 5 percent
cumulative convertible preferred stock for 10 percent nonconvertible
preferred stock. The conversion option in the convertible preferred stock
instrument was a substantive conversion option on the date of the
exchange. The exchange is treated as an extinguishment because the changes
to the terms of the preferred stock include the elimination of a
substantive conversion option.
Example 3-28
Modification of Conversion Price of Convertible Preferred
Stock
Company C modifies its outstanding 6
percent convertible preferred stock by increasing the conversion price and
extending the period over which the investors can convert the preferred
stock into common stock. This extension of the period over which the
investors can convert the preferred stock into common stock has an impact
on the host preferred stock contract because the stated dividend rate does
not reflect a market rate as of the date of the modification.
To determine whether this modification reflects an
extinguishment of the convertible preferred stock, C applies the following
fair-value-based approach:
- Step 1 — Company C first evaluates whether the modification results in a significant change in the fair value of the entire convertible preferred stock instrument and concludes that the change in the fair value of this instrument (calculated on the basis of the fair value of the convertible preferred stock instrument immediately before and immediately after the modification) is less than 10 percent; C therefore proceeds to the next step.
- Step 2 — Company C evaluates whether the modification results in a significant change in the fair value of the embedded conversion option in the convertible preferred stock instrument and concludes that the change in the fair value of this option (calculated on the basis of the fair value of the embedded conversion option immediately before and immediately after the modification) exceeds 10 percent. As a result, C concludes that the modification should be accounted for as an extinguishment.
In reaching a conclusion about whether a modification such as the one discussed
in this example reflects an extinguishment, an entity must use judgment
and consider all relevant facts and circumstances. While C has applied
only a fair value approach, it is important for an entity to also take
qualitative considerations into account. That being said, similar facts
and circumstances should result in similar conclusions (i.e., it would not
be appropriate to “switch” approaches over time to reach different
conclusions regarding whether a modification to convertible preferred
stock represents an extinguishment).
3.2.6.2 Modification or Exchange of Common Stock
Modifications and exchanges of common stock are less common than
modifications and exchanges of preferred stock. Moreover, the treatment of a
modification or exchange of common stock differs from that for preferred stock. As
discussed in Section
3.2.4.3, there is no impact on income available to common stockholders upon
a redemption of common stock unless the fair value of the consideration transferred
exceeds the fair value of the common shares redeemed. Therefore, modifications or
exchanges involving common stock do not need to be evaluated for extinguishment
accounting. Rather, the focus is on whether the modification or exchange results in the
transfer of additional fair value to the holder(s).
When an entity modifies or exchanges common stock and the resulting
impact is an increase in fair value, that increase must be treated as either a “deemed
dividend” or an expense. The appropriate treatment is determined in a manner similar to
the consideration of the appropriate treatment of redemptions of common stock and
modifications and exchanges of preferred stock (see Sections 3.2.4.3 and 3.2.6.1, respectively). If a modification or
exchange is accounted for as a “deemed dividend” to the holder(s), the impact of this
dividend is reflected in the calculation of basic EPS in a manner similar to the
application of the two-class method of calculating EPS. Specifically, if the entity has
multiple classes of common stock and modifies an entire class, the incremental fair
value will be treated as a dividend (i.e., actual distribution) to the modified class,
which will reduce the amount of income available to common stockholders for the class of
common stock that was not modified. If the entity only has a single class of common
stock, it must consider whether the modification results in multiple classes of common
stock to which the two-class method should be applied to appropriately reflect the
impact of the “deemed dividend.”
3.2.6.3 Modification or Exchange of Share-Based Payment Awards
Under ASC 718, modifications to share-based payment awards that result
in an increase in fair value of the award must be accounted for as compensation cost,
either immediately or over the remaining vesting period, depending on the facts and
circumstances. There is no evaluation of whether the modification or exchange results in
an extinguishment of the original award. Furthermore, an entity does not need to make
any incremental adjustments to net income to arrive at income available to common
stockholders. Any effect of the modification is included in net income. For further
discussion of the accounting for modifications of share-based payment awards, see
Chapter 6 of Deloitte’s
Roadmap Share-Based Payment
Awards.
Connecting the Dots
A modification to any award originally issued in a share-based
payment arrangement is always accounted for under ASC 718, even if the modification
occurs after the holder is no longer an employee (or a nonemployee service provider)
and causes the instrument to subsequently become subject to the accounting guidance
on financial instruments. For more information, see Chapter 6 of Deloitte’s Roadmap Share-Based Payment
Awards.
3.2.6.4 Modification or Exchange of Other Potential Common Stock
The table below outlines the accounting that is generally applied to
modifications and exchanges involving other potential common stock instruments that do
not represent share-based payment arrangements.
Table 3-8
Instrument Type
| Evaluate for
Extinguishment Accounting? | Accounting for
Modification or Exchange |
---|---|---|
Convertible debt
| Yes | A modification or
exchange of convertible debt is accounted for in accordance with ASC 470-50.
Whether such a modification or exchange is accounted for as a modification
or as an extinguishment, an entity is not required to make any incremental
adjustment to net income to arrive at income available to common
stockholders. Any effect of the modification or exchange is included in net
income. See Chapter
6 for further discussion of the calculation of basic EPS for
convertible debt instruments. |
Freestanding financial instrument indexed to common stock (e.g., an option or
forward to purchase common stock) — classified as an asset or liability | No |
A freestanding financial instrument indexed to an entity’s
common stock that is classified as an asset or liability will be recognized
at fair value, with changes in fair value recognized in earnings. A
modification or exchange of such an instrument will be reflected through the
change in fair value of the instrument that is recognized in net income.
|
Freestanding financial instrument indexed to common stock (e.g., an option
or forward to purchase common stock) — classified in equity
|
No
|
The Codification addresses an issuer’s accounting for a
modification or exchange of a freestanding equity-classified written call
option that remains equity-classified after the modification or exchange.
ASC 260-10-45-15 states:
For a modification or an
exchange of a freestanding equity-classified written call option described
in paragraph 815-40-35-17(d), an entity shall deduct the effect of the
modification or exchange (as measured in accordance with paragraph
815-40-35-16) in computing income available to common stockholders when
the modification or exchange is executed by the issuer and the holder or
unilaterally by the issuer (see paragraph 815-40-15-7H). Under ASC 815-40 a modification or exchange of a
freestanding equity-classified written call option that remains
equity-classified after the modification or exchange would be accounted for
by recognizing “the excess, if any, of the fair value of the modified or
exchanged instrument over the fair value of that instrument immediately
before it is modified or exchanged. . . . on the basis of the substance of
the transaction, in the same manner as if cash had been paid as
consideration.” Accordingly, an entity accounts for any incremental fair
value provided to the counterparty in a modification or exchange of an
equity-classified written call option. This incremental fair value provided
to the counterparty would be accounted for as a dividend, expense, or
component of a debt modification, or such accounting would otherwise depend
on the facts and circumstances (see ASC 815-40-35-17).
The Codification does not specifically address the accounting for a
modification or exchange of an equity-classified freestanding financial
instrument indexed to an entity’s common stock that is not a written call
option. ASC 260-10-S99-2 does not apply to freestanding financial
instruments indexed to common stock. Rather, it is generally appropriate to
apply ASC 718-20-35-3 by analogy and account for any increase in fair value
as a “deemed dividend” that reduces net income in arriving at income
available to common stockholders (or that is treated as a distribution if
the contract is a participating security). However, in some cases, the
increase in fair value may need to be accounted for as an expense or in
another manner. For considerations related to whether such an amount should
be recognized as a “deemed dividend” or as an expense, see Sections 3.2.4.3 and 3.2.6.1, respectively.
For more information about modifications or exchanges of freestanding
equity-linked instruments, see Sections
6.1.4 and 6.2.4 of
Deloitte’s Roadmap Contracts on an Entity’s Own Equity.
|
Freestanding
financial instrument indexed to preferred stock (e.g., an option or forward
to purchase preferred stock or convertible preferred stock) — classified as
an asset or liability |
No | A freestanding
financial instrument indexed to an entity’s preferred stock that is
classified as an asset or liability will be recognized at fair value, with
changes in fair value recognized in earnings. A modification or exchange of
such an instrument will be reflected through the change in fair value of the
instrument that is recognized in net income. |
Freestanding
financial instrument indexed to preferred stock (e.g., an option or forward
to purchase preferred stock or convertible preferred stock) — classified in
equity | Yes | A modification or
exchange of a freestanding financial instrument indexed to an entity’s
preferred stock that is classified in stockholders’ equity is accounted for
in the same manner as a modification or exchange of preferred stock.
Therefore, a modification or exchange of such an instrument is first
evaluated to determine whether it represents an extinguishment. See
Section
3.2.6.1 for guidance on determining whether a modification or
exchange of preferred stock is accounted for as an extinguishment. If the modification or exchange is treated as an
extinguishment, the difference between the fair value of the “new”
instrument and the net carrying amount of the instrument that was modified
or exchanged is reflected as an adjustment to net income in arriving at
income available to common stockholders in accordance with ASC 260-10-S99-2.
If the modification or exchange is not accounted for
as an extinguishment, any incremental fair value resulting from the
modification or exchange is accounted for as either a “deemed dividend” or
an expense. See Section
3.2.6.1 for further discussion of the accounting for a
modification of preferred stock. |
Connecting the Dots
An equity-classified instrument originally issued in a share-based
payment arrangement becomes subject to the accounting literature applicable to
financial instruments when it was issued to (1) an employee in exchange for services
and its terms are modified when the holder is no longer an employee, (2) a
nonemployee in exchange for goods or services and its terms are modified after the
nonemployee vests in the award and is no longer providing goods or services, or (3)
a grantee that is no longer a customer and its terms are modified after the grantee
vests in the award and both of the following conditions are
not met: (a) there is no increase in fair value of the award (or the ratio of
intrinsic value to the exercise price of the award is preserved — that is, the
holder is made whole) or the antidilution provision is not added to the terms of the
award in contemplation of an equity restructuring and (b) all holders of the same
class of equity instruments (e.g., stock options) are treated in the same manner
(see ASC 718-10-35-10).
3.2.6.5 Reclassification of Other Potential Common Stock
The table below describes whether ASC 260-10-S99-2 applies when an
embedded conversion option indexed to the reporting entity’s stock is reclassified
between an equity instrument and a derivative liability for reasons other than a
modification or exchange involving the instrument.
Table 3-9
Instrument
Type | Underlying | Reclassification | Whether ASC
260-10-S99-2 Applies as of the Reclassification Date |
---|---|---|---|
Convertible debt | Indexed
to common stock | From: One liability instrument To: Debt host contract and conversion option
derivative liability | No. ASC 815-15 applies to the separation of the embedded conversion
option as a derivative liability. ASC 260-10-S99-2 does not apply to the
separation of the embedded conversion option. See Chapter 6 for further discussion of the
calculation of basic EPS for convertible debt instruments. |
From: Debt host contract and conversion option derivative liability
To: Debt host contract and
equity component | No. Footnote 18 of EITF Topic D-98 states that “Topic
D-42 [which was codified in ASC 260-10-S99-2] also does not apply to
convertible debt instruments that contain an embedded conversion option
indexed to the issuer’s common stock because the application of EITF Topic
D-42 is limited to preferred stock instruments.” Therefore, ASC 260-10-S99-2
does not apply to the reclassification of the embedded conversion option
from a separated derivative liability to an equity component. However, ASC
480-10- S99-3A(12)(d) and 3A(16)(d) would apply to the equity component
after the reclassification if it is currently redeemable for cash or other
assets. See Chapter
6 for further discussion of the calculation of basic EPS for
convertible debt instruments. | ||
From: Debt host component and equity component To: Debt host contract and conversion option
derivative liability | No. As indicated in ASC 480-10-S99-3A(23), “there should be no incremental earnings per share accounting from the application of this SEC staff announcement” to convertible debt that contains a separated equity component that is indexed to the issuer’s common stock. Furthermore, footnote 18 of EITF Topic D-98 states that “Topic D-42 [which was codified
in ASC 260-10-S99-2] also does not apply to convertible debt instruments that contain an embedded conversion option indexed to the issuer’s common stock because the application of Topic D-42 is limited to preferred stock
instruments.” Therefore, ASC 260-10-S99-2 does not apply to this
reclassification. While ASC 480-10-S99-3A(12)(d) and 3A(16)(d) would have
applied to the equity component in periods before the reclassification if it
was currently redeemable for cash or other assets, that guidance would no
longer apply after the reclassification since there is no longer any equity
component reported for the instrument. See Chapter 6 for further discussion of the
calculation of basic EPS for convertible debt instruments. | ||
Convertible preferred stock | Indexed
to common stock | From: Debt host component and equity component (i.e.,
the principal amount of the convertible preferred stock must be settled in
cash) To: Debt host contract and conversion option
derivative liability | No. Although preferred stock in legal form, since the
instrument is classified as a liability, the accounting is the same as the
accounting for the reclassification of the equity component of convertible
debt that contains a separated equity component to a derivative liability.
See Chapter 6
for further discussion of the calculation of basic EPS for convertible debt
instruments. |
From: One preferred equity instrument To: Preferred equity host contract and conversion
option derivative liability | No. ASC 260-10-S99-2 may seem to apply because, before the separation
of the embedded conversion option, the instrument represented preferred
stock classified in equity (either permanent or temporary equity) and the
separation of the embedded derivative is akin to the transaction discussed
in the scope section of ASC 260-10-S99-2 (i.e., when an equity-classified
security must be subsequently reclassified as a liability). However, because
the entry recognized under ASC 815-15 to separate the conversion option
liability is a debit to preferred stock and a credit to a derivative
liability at the fair value of the derivative, the application of ASC
260-10-S99-2 would have no impact on the date of separation. The separation
could, however, affect the subsequent accounting for the convertible
preferred stock instrument under ASC 260-10-S99-2 and ASC 480-10-S99-3A.
If the convertible preferred stock is classified in
temporary equity and is being remeasured to its redemption amount, the
entity should perform one last remeasurement under ASC 480-10-S99-3A
immediately before separating the conversion option liability. ASC
480-10-S99-3A would continue to apply to the preferred stock host contract
if it was redeemable for cash or other assets. See
Sections
3.2.2.5.4.1, 3.2.2.6.2.1.1, and 3.2.2.6.3.1 for discussion of the
accounting for the settlement of the instrument. | ||
From: Preferred equity host contract and equity component classified
in common stockholders’ equity To: Preferred equity host contract and conversion option derivative
liability | No. Since the equity component is indexed to common stock, the reclassification to a liability is not subject to ASC 260-10-S99-2 because that guidance applies only to preferred stock (as discussed in footnote 18 of EITF Topic D-98). After the reclassification,
ASC 480-10-S99-3A may continue to apply to the preferred stock host
contract. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Sections 3.2.2.5.4.1, 3.2.2.6.2.1.1, and
3.2.2.6.3.1
for discussion of the accounting for the settlement of the instrument.
Note that this type of reclassification would not be
common in practice. | ||
From: Preferred equity host contract and conversion option derivative
liability To: Preferred
equity host contract and equity component classified in common stockholders’
equity | No. By analogy to ASC 815-15-35-4, the embedded
conversion option should be reclassified from a derivative liability to
common stockholders’ equity. ASC 260-10-S99-2 does not apply to this
reclassification because that guidance does not apply to (1) a conversion
option that is indexed to common stock or (2) a reclassification of a
liability to an equity instrument, which is not considered a redemption of
preferred stock. However, ASC 480-10-S99-3A would apply after the
reclassification if the convertible preferred stock is redeemable for cash
or other assets. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Section 3.2.5.2.4 for discussion of the
accounting for the settlement of the instrument. | ||
Indexed
to preferred stock | From: One preferred equity instrument To: Preferred equity host contract and conversion
option derivative liability | No. ASC 260-10-S99-2 may seem to apply because, before the separation
of the embedded conversion option, the instrument represented preferred
stock classified in equity (either permanent or temporary equity) and the
separation of the embedded derivative is akin to the transaction discussed
in the scope section of ASC 260-10-S99-2 (i.e., when an equity-classified
preferred stock instrument must be subsequently reclassified as a
liability). However, because the entry recognized under ASC 815-15 to
separate the conversion option liability is a debit to preferred stock and a
credit to derivative liability at the fair value of the derivative, the
application of ASC 260-10-S99-2 would have no impact on the date of
separation. The separation could, however, affect the subsequent accounting
for the convertible preferred stock instrument under ASC 260-10-S99-2 and
ASC 480-10-S99-3A. If the convertible preferred
stock is classified in temporary equity and is being remeasured to its
redemption amount, the entity should perform one last remeasurement under
ASC 480-10-S99-3A before separating the conversion option liability. ASC
480-10-S99-3A would continue to apply to the preferred stock host contract
if it is redeemable for cash or other assets. See
Sections
3.2.2.5.4.1, 3.2.2.6.2.1.1, and 3.2.2.6.3.1 for discussion of the
accounting for the settlement of the instrument. | |
From: Preferred equity host contract and conversion option derivative
liability To: Preferred
equity host contract and equity component classified in preferred
stockholders’ equity | No. By analogy to ASC 815-15-35-4, the embedded
conversion option should be reclassified from a derivative liability to
preferred stockholders’ equity. ASC 260-10-S99-2 does not apply to this
reclassification because that guidance does not apply to a reclassification
of a liability to an equity instrument, which is not considered a redemption
of preferred stock. However, ASC 480-10-S99-3A would apply after the
reclassification if the convertible preferred stock is redeemable for cash
or other assets. ASC 480-10-S99-3A may have also been applicable before this
reclassification. See Section 3.2.5.2.5 for
discussion of the accounting for the settlement of the instrument. Note that this type of reclassification would not be common
in practice. | ||
Freestanding financial instrument
|
Indexed to common stock
| From: Asset or liability To: Equity | No. The reclassification of the instrument from an asset or liability
to an equity-classified instrument is not subject to ASC 260-10-S99-2
because that guidance does not apply to a reclassification of an asset or
liability to equity. ASC 815-40-35-10 addresses the reclassification of an
equity-linked instrument from an asset or liability to equity. See Section 3.2.5.2.1 for discussion of the accounting for the
settlement of the instrument. |
From: Equity To:
Asset or liability | No. Footnote 18 of EITF Topic D-98 states, in part, that “the application of Topic D-42 [which was codified in ASC 260-10-S99-2] is
limited to preferred stock instruments.” ASC 815-40-35-9 addresses the
reclassification of an equity-linked instrument from equity to an asset or
liability. See Section 3.2.5.2 for discussion of the
accounting for the settlement of the instrument. | ||
Indexed to preferred stock
| From: Asset or liability To: Equity | No. The reclassification of the instrument from an asset or liability
to an equity-classified instrument is not subject to ASC 260-10-S99-2
because that guidance does not apply to a reclassification of an asset or
liability to equity. See Section 3.2.5.2.2 for discussion of the
accounting for the settlement of the instrument. | |
From: Equity To:
Asset or liability | Yes. This type of reclassification is akin to the transaction
discussed in the scope section of ASC 260-10-S99-2 (i.e., when an
equity-classified preferred stock instrument must be subsequently
reclassified as a liability on the basis of the provisions of other GAAP).
See further discussion of this type of reclassification in Section 3.2.2.8. See
Section
3.2.5.2 for discussion of the accounting for the settlement of
the instrument. |
3.2.7 Summary of Scope of ASC 260-10-S99-2
The table below summarizes the scope of ASC 260-10-S99-2 with respect to
financial instruments that do not represent an NCI. For purposes of the discussion in this
table, unless otherwise stated, any embedded conversion option is indexed to and settled
in the entity’s common stock and is not accounted for separately from the host contract.
While ASC 260-10-S99-2 may not be applicable, for certain transaction types, other
relevant GAAP may still result in an impact on net income or income available to common
stockholders as a result of the settlement. Although the table below does not discuss the
application of ASC 480-10-S99-3A, the sections referred to in the table do discuss such
application.
For NCIs, the accounting at the subsidiary level may affect the parent’s
EPS. For discussion of NCIs, see Section
3.2.3.
Table 3-10
Transaction
Type | Subject to ASC
260-10-S99-2 | Not Subject to ASC
260-10-S99-2 |
---|---|---|
Conversion
(or exercise) |
|
|
Redemption
(including a modification or exchange accounted for as an extinguishment)
Note that any modification or exchange that is not
accounted for as an extinguishment is not within the scope of ASC
260-10-S99-2. However, for accounting purposes, an entity generally accounts
for such modifications or exchanges when they result in an increase in the
fair value of the instrument. The impact depends on the nature of the
instrument modified. See Section 3.2.6 for additional information. |
|
|
Inducement
offer |
|
|
Reclassification |
|
|
Footnotes
1
These items affect income available to common
stockholders either directly (i.e., adjustments to net income to arrive at
income available to common stockholders) or indirectly (i.e., adjustments
to net income).
2
This Roadmap does not address the date on which
cumulative dividends must be recognized by an entity as either a
liability or shares of stock. The balance sheet recognition of
dividends on cumulative preferred stock will depend on the relevant
terms of the preferred stock instrument, including whether dividends
must be declared before payment. For guidance on when dividend
obligations should be recognized as a liability on the balance sheet,
see 505-10-05 (Q&A 08) in
Deloitte’s FASB Accounting Standards Codification Manual on
DART.
3
A contingency is an event that is not solely within
the control of the issuer or holder of the preferred stock.
4
The preferred stock is not considered increasing-rate preferred
stock merely because the carrying amount is at a discount to the liquidation
preference. See further discussion in Section 3.2.2.3.
5
In all circumstances, an entity should adjust the fair value
of the derivative liability through net income immediately before accounting for
the settlement.
6
A convertible preferred stock instrument may contain a
component that has been separately recognized in common stockholders’
equity. Upon conversion, in conjunction with other relevant guidance, an
entity is required to recognize any remaining unamortized discount on the
convertible preferred stock as a reduction to net income in arriving at
income available to common stockholders. Thus, while ASC 260-10-S99-2 does
not apply to a conversion, other guidance requires accounting that results
in a “deemed dividend” in a manner similar to the accounting under ASC
260-10-S99-2. See Section
3.2.5.2.4 for further discussion of this guidance, which
applies to all entities and not just SEC registrants.
7
See Section 3.2.5.2.3 for discussion of convertible debt that
contains a separately classified equity component.
8
ASC 260-10-S99-2 applies to the consolidated financial
statements of a parent in the period that includes a modification, an
extinguishment, or an induced conversion of preferred stock issued by a
consolidated subsidiary that is classified as an NCI.
9
If only the parent absorbed the impact of a dividend or “deemed
dividend,” an allocation to NCIs in the form of common stock is not
appropriate.
10
See Section
3.2.4.3.1 for guidance on situations in which the repurchase occurs on
the basis of the settlement of a forward contract to repurchase common stock.
11
For example, assume that the holder of the shares is a private equity
firm and that the issuer repurchases the shares to prevent the holder from
obtaining additional board representation or other influence over the
entity. The entity should compare the repurchase price with the amount
that would be paid to a holder of those shares in a transaction that is
not executed to prevent additional board representation or other influence
over the entity. It would not be appropriate for the issuer to assume that
other private equity investors would also demand repurchase at the same
price to avoid obtaining additional board representation or other
influence over the entity.
12
Depending on the facts and circumstances, the inducement charge
may need to be recognized in earnings rather than being treated as a dividend.
13
Footnote 18 of EITF Topic D-98 is not codified. See Section 3.2.5.2.3 for further
discussion of the applicability of this guidance.
14
Allocating to the separately recognized equity
component an amount equal to the amount initially recognized for
that component differs from the accounting for a redemption of a
convertible preferred stock instrument that contains an embedded
conversion option that has been reclassified from a derivative
liability to a separate component of common stockholders’ equity
(discussed below). This difference is justified because only the
incremental fair value of the embedded conversion option, as
opposed to its entire fair value, is recognized as a result of
the modification or exchange that affects the embedded
conversion option in a convertible preferred stock instrument.
15
Since the SEC staff has not previously
expressed any view on the redemption of convertible preferred
stock that contains a separately recognized equity component as
a result of a reclassification of the embedded derivative from a
liability to equity, it is appropriate to allocate an amount to
the equity component on the basis of its fair value on the
redemption date in a manner similar to the accounting applied to
convertible debt, as discussed in ASC 815-15-40-4.
16
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.5.2.4, the issuer in a conversion should
immediately amortize any remaining unamortized discount on the
preferred stock host, which will be treated as a dividend for which
net income is adjusted to arrive at income available to common
stockholders.
17
See footnote 16 for the accounting for the
settlement of the host contract component.
18
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.2.5.4.1, in a conversion accounted for under this
method, the issuer should immediately amortize any remaining
unamortized discount on the preferred stock host, which will be
treated as a dividend for which net income is adjusted to arrive at
income available to common stockholders.
19
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.4.3, the recognition of a dividend or an expense
may be required for a repurchase of common stock for an amount that
exceeds the fair value of the common stock repurchased.
20
While ASC 260-10-S99-2 does not apply, as noted in
Chapter
6, an expense must be recognized for an induced
conversion of a convertible debt instrument.
21
See footnote 20.
22
See footnote 20.
23
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.2.6.3.1, an inducement will affect net income
through the mark-to-market adjustment on the derivative
liability.
24
While ASC 260-10-S99-2 does not apply, if an
entity settles an equity-classified contract indexed to its common
stock under an inducement offer, the additional value resulting from
the inducement should be treated as a dividend or an expense. If the
value is recognized as a dividend, the amount of the dividend should
result in an adjustment to net income to arrive at income available
to common stockholders.
25
See footnote 23.
26
See footnote 23.
27
While ASC 260-10-S99-2 does not apply, as noted in
Section
3.2.4.1, the additional value resulting from an induced
conversion of one class of common stock into another should be
accounted for as either a dividend through application of the
two-class method of calculating basic EPS or as an expense in a
manner consistent with the accounting for reacquisitions of common
stock at a price that exceeds fair value.
3.3 Weighted-Average Number of Shares Outstanding
3.3.1 General
ASC 260-10
Computing a Weighted-Average
55-2 The weighted-average number of shares is an arithmetical mean average of shares outstanding and assumed to be outstanding for EPS computations. The most precise average would be the sum of the shares determined on a daily basis divided by the number of days in the period. Less-precise averaging methods may be used, however, as long as they produce reasonable results. Methods that introduce artificial weighting, such as the Rule of 78 method, are not acceptable for computing a weighted-average number of shares for EPS computations.
The denominator in the calculation of basic EPS is based on the weighted-average
number of common shares outstanding during the period. The denominator for basic
EPS does not include potential common stock. As discussed in Section 3.1.1, the
determination of whether an equity security meets the ASC 260-10-20 definition
of common stock should be based on the substance of the instrument in addition
to its legal form. There may be circumstances in which (1) equity shares in the
legal form of preferred stock do not have a substantive liquidation preference
and share all of the characteristics of common stock or (2) an equity security
represents a common equity instrument in legal form but has a substantive
liquidation preference and other characteristics of preferred stock. If an
equity security represents preferred stock in legal form but has all the
characteristics of common stock in its current form, it should be considered an
outstanding share of common stock in the calculation of basic EPS. Similarly, if
an equity security represents common stock in legal form but has all the
characteristics of preferred stock in its current form, it should not be
considered an outstanding share of common stock in the calculation of basic EPS.
In the situations discussed in the preceding two sentences, an entity may be
required to use the two-class method of calculating basic EPS.
In addition to evaluating whether an equity security meets the definition of common stock, an entity must consider a number of other matters in determining the number of shares of common stock included in the denominator in the calculation of basic EPS. Those matters include the following:
3.3.2 Determining Whether Common Shares Are Outstanding
Questions may arise about whether certain types of equity securities should be considered outstanding shares of common stock in the calculation of the weighted-average number of common shares outstanding.
3.3.2.1 Redeemable Common Stock
Shares of redeemable common stock that are legally issued and outstanding should be considered outstanding in the calculation of the weighted-average number of common shares outstanding since such shares represent common stock in both legal form and substance. The only exceptions are if (1) the shares have been legally issued but are subject to vesting conditions under the accounting guidance for share-based payment awards or (2) the shares meet the definition of a mandatorily redeemable financial instrument in ASC 480 and are classified as a liability. See also Example 3-20.
3.3.2.2 Mandatorily Convertible Instruments
An entity may have issued instruments that are mandatorily convertible into common stock. These instruments could include preferred stock or debt that is mandatorily convertible into common stock at a future date or common stock that is mandatorily convertible into another class of common stock at a future date. Even though conversion into shares of common stock will occur upon the mere passage of time, the outstanding shares of common stock included in the denominator in the calculation of basic EPS should be determined on the basis of the current form of the instrument. Therefore, shares of common stock underlying a mandatorily convertible preferred stock or debt instrument should not be included in the denominator in the calculation of basic EPS; however, the two-class method of calculating basic EPS is required if the mandatorily convertible instrument meets the definition of a participating security. Similarly, shares of a second class of common stock underlying a mandatorily convertible common stock instrument should not be included in the outstanding shares of the second class of common stock. However, the mandatorily convertible common stock instrument is considered outstanding common stock. In this circumstance, the two-class method of calculating EPS is required. See Chapter 5 for discussion of participating securities and the two-class method of calculating EPS.
Connecting the Dots
The treatment of mandatorily convertible instruments in the calculation of basic EPS is consistent with the accounting guidance that the FASB proposed in its August 7, 2008, exposure draft as part of a convergence project with the IASB. While that proposed guidance was never issued in final form, we understand that the SEC staff has previously concluded that an entity should not consider common stock as outstanding shares in the denominator in the calculation of basic EPS when those shares will be issued in the future upon a mandatory conversion or an exchange of another outstanding instrument. We understand that this view is based on the fact that the shares of common stock are not legally outstanding before the conversion or exchange, and the guidance on contingently issuable shares does not apply because there are no contingencies or uncertainties related to the ultimate issuance of such shares of common stock.
3.3.2.3 Share-Based Payment Awards
3.3.2.3.1 Nonvested Share Awards
During the requisite service period or nonemployee’s
vesting period, share-based payment awards do not affect the denominator
in the calculation of basic EPS. Once the awards are vested, the shares
of common stock that have been legally issued are considered outstanding
shares and are included in the denominator in the calculation of basic
EPS. That is, while nonvested shares of common stock that vest solely on
the basis of a service condition are not included in the denominator in
the calculation of basic EPS during the requisite service period or
nonemployee’s vesting period even if the shares have been legally
issued, once the goods are delivered or the service period is complete,
the shares become outstanding common stock and are included in the
weighted-average number of common shares outstanding. This is the case
even if the awards contain clawback features (see Section 7.1.1).
Such awards will be included in the weighted-average number of common
shares from the date on which they become vested outstanding common
shares. Although nonvested shares are not considered outstanding with
respect to the denominator in the calculation of basic EPS, all
outstanding nonvested shares that contain nonforfeitable rights to
dividends or dividend equivalents, when dividends are declared on shares
of common stock, are considered participating securities. Because the
nonvested shares are considered participating securities, the issuing
entity is required to apply the two-class method to calculate EPS. See
Section
7.1.3.1 for further discussion of when share-based
payment awards represent a participating security.
3.3.2.3.2 Stock Options
Share-based payment awards in the form of stock options
are not included in the denominator in the calculation of basic EPS,
whether the awards are vested or unvested. The same is true of
liability-classified share-based payment awards. However, stock option
awards and liability-classified awards could also meet the definition of
a participating security to which an entity is required to apply the
two-class method of calculating basic EPS.
3.3.2.3.3 Retirement-Eligible Employees
Awards of shares to employees that vest when the grantee becomes eligible
for retirement must be considered outstanding shares in the denominator
of basic EPS as of the date the grantee is eligible to retire and retain
the shares. This is because, once the employee is eligible to retire,
there are no conditions that must be met for the common stock to be
issued. Such shares are not considered contingently issuable shares
since an agreement that requires an entity to issue common shares only
after the mere passage of time is not considered a contingently issuable
share arrangement. In other words, no remaining service period is
associated with the issuance of the shares since the holder can retire
at any time and receive the shares.
3.3.2.4 Other Compensatory Arrangements
Section 7.2 discusses when common stock held by an employee stock ownership plan (ESOP) should be outstanding in the calculation of basic EPS. Section 7.3 discusses the impact that other compensatory arrangements, including profits interests and common stock owned by a rabbi trust, have on the calculation of basic EPS.
3.3.2.5 Contingently Issuable Shares
ASC 260-10
Treatment of
Contingently Issuable Shares in Weighted-Average
Shares Outstanding
45-12C Contractual agreements
(usually associated with purchase business
combinations) sometimes provide for the issuance of
additional common shares contingent upon certain
conditions being met. Consistent with the objective
that basic EPS should represent a measure of the
performance of an entity over a specific reporting
period, contingently issuable shares should be
included in basic EPS only when there is no
circumstance under which those shares would not be
issued and basic EPS should not be restated for
changed circumstances.
45-13 Shares issuable for
little or no cash consideration upon the
satisfaction of certain conditions (contingently
issuable shares) shall be considered outstanding
common shares and included in the computation of
basic EPS as of the date that all necessary
conditions have been satisfied (in essence, when
issuance of the shares is no longer contingent).
Outstanding common shares that are contingently
returnable (that is, subject to recall) shall be
treated in the same manner as contingently issuable
shares. Thus, contingently issuable shares include
shares that meet any of the following criteria:
-
They will be issued in the future upon the satisfaction of specified conditions.
-
They have been placed in escrow and all or part must be returned if specified conditions are not met.
-
They have been issued but the holder must return all or part if specified conditions are not met.
Contingently issuable shares include:
-
Shares that will be issued in the future on the basis of the satisfaction of specified conditions (e.g., common shares issuable to a customer if certain levels of purchases are reached or common shares issuable to the seller of a business if the issuer’s common stock price does not increase by a specified date).
-
Shares that have been issued but that must be returned to the issuer if certain specified conditions occur or fail to occur.
The ASC 260 EPS guidance on contingently
issuable shares does not apply to the following:
-
Shares issuable solely upon the passage of time. (While contingent issuances of shares are usually based on the passage of time and another specified condition, shares issuable upon the mere passage of time are not contingently issuable because the passage of time is certain to occur.)
-
Share-based payment arrangements that are subject to ASC 718, including shares that vest on the basis of only a service condition and shares that have vested but that are subject to clawback provisions. (The relevant guidance on share-based payments applies to these arrangements.)
In accordance with ASC 260-10-45-12C and 45-13, when an entity is
contingently obligated to issue shares of common stock (i.e., the issuance
of common shares will occur only upon resolution of a substantive
contingency), those shares of common stock are not included in the
outstanding shares of common stock in the denominator in the calculation of
basic EPS. In other words, contractual arrangements that meet the definition
of contingently issuable shares are not outstanding shares of common stock
because ASC 260-10-45-12C specifies that “contingently issuable shares
should be included in basic EPS only when there is no circumstance under
which those shares would not be issued.” Thus, the outstanding common stock
of an entity includes such shares only when they are no longer contingently
issuable. Shares of common stock that are legally issued and outstanding but
contingently returnable are treated in the same manner as contingently
issuable shares. When the contingencies associated with contingently
issuable or contingently returnable shares are resolved, the shares of
common stock should be included in the calculation of weighted-average
common shares. Such shares are included in outstanding shares in the
calculation of basic EPS beginning on the date the last contingency was
resolved.
See Section 3.3.2.3.3 for discussion of
common stock held by retirement-eligible employees. See Section 7.1.1 for
discussion of the treatment of clawback features associated with vested
share-based payment awards.
The examples below illustrate application of the ASC 260
guidance on contingently issuable shares.
Example 3-29
Calculating
Basic EPS When Issuance of Shares Is Contingent on
Attainment of Future Earnings
Company X, which reports on a
calendar-year basis, purchased Subsidiary Y on
January 1 for $100 million plus 20,000 shares of X’s
common stock for each year within the next five
years in which Y has net income of $10 million or
more. By June 30 of year 1, Y has net income of $15
million.
While the 20,000 shares of X’s
common stock would be issuable if the end of the
contingency period were June 30 instead of December
31, the 20,000 common shares should be excluded from
basic EPS for the six months ended June 30, because
events could occur in the next six months that would
cause X not to issue the shares (i.e., Y could lose
$6 million in the next six months).
If Y’s net income for the year ended
December 31 was $12 million, the shares would be
included in the denominator for basic EPS for only
that portion of the year for which the contingency
was resolved (i.e., nothing could happen that would
cause X not to issue the shares). See Example
4-17 for an illustration of the
calculation of diluted EPS.
Because there are five separate
measurement periods for the contingency, each
measurement period in which a finite number of
common shares may be issued should be treated as a
separate contingency and evaluated on the basis of
whether X may be required to issue the common shares
for each period on a stand-alone basis for basic
EPS. If the purchase agreement required X to issue
100,000 shares of its common stock if Y achieved $50
million in cumulative net income at the end of five
years, no shares would be included in basic EPS
until the end of the contingency period and then
only if Y had cumulative earnings in excess of $50
million.
In the calculation of basic EPS,
shares that are contingently returnable should not
be considered outstanding for basic EPS until the
conditions under which return of the shares is
required have been satisfied. Thus, if the shares
discussed above had been legally issued and placed
into escrow, the accounting conclusion above would
not be affected.
Example 3-30
Calculating
Basic EPS When Issuance of Shares Is Contingent on
Continued Employment
Company M has a mandatory deferred
compensation plan under which covered employees are
required to defer the amount of compensation payable
in one calendar year in excess of $1 million until
completion of the deferral period. The deferral
period ends when the employee ceases to earn $1
million annually or reaches the defined retirement
age as an employee of M. If the employee is
terminated or resigns, he or she is not eligible to
receive any distribution under the plan. The
compensation deferred under the plan is only payable
to the participant in shares of M’s common stock
over a five-year period once the participant is
eligible to receive the distribution.
A participant’s deferred
compensation is held in an escrow account until the
individual is eligible to receive distributions. The
escrow account does not bear interest; however, it
receives the dividend equivalent on the basis of the
equivalent number of common stock into which the
cash value of the account would be converted,
depending on the closing price of the common stock
on the NYSE for the trading day preceding the
original deferral. Distributions from the account
are based on the equivalent number of common shares
that the cash value of the distribution would
convert into, depending on the closing price of the
stock on the NYSE for the trading day preceding the
distribution.
The common stock issuable under the
plan is considered contingently issuable shares
because the common stock will not be issued if the
employee is terminated or resigns from M’s
employment before retirement. The shares issuable
under the plan should be excluded from the
calculation of basic EPS because it is possible that
the employee will never receive the shares.
Further, the number of shares
contingently issuable may depend on the market price
of the stock at a future date. If the market price
may change in a future period, such contingently
issuable shares should not be included in basic EPS
because all necessary conditions have not been
satisfied. See Example 4-24 for
the effect of contingently issuable securities on
diluted EPS.
In addition, outstanding common
shares that are contingently returnable (i.e.,
subject to recall) should be treated in the same
manner as contingently issuable shares. If shares
are returnable or placed in escrow until they are
vested or some other contingent criteria are met,
the shares should be excluded from the denominator
in the computation of basic EPS even if they have
been issued.
3.3.2.5.1 Shares Issuable for Little or No Consideration
Shares issuable for little or no consideration that do
not contain any conditions that must be satisfied for the holder to
ultimately receive (or retain) the shares are not considered
contingently issuable. ASC 260-10-45-13 states, in part, that “shares
issuable for little or no cash consideration [that are not contingently
issuable shares] shall be considered outstanding common shares and
included in the computation of basic EPS.” In this section, it is
assumed that shares issuable for little or no consideration do not
contain any vesting conditions.
In determining the appropriate accounting for shares
issuable for little or no consideration, an entity must first assess
whether the issuance constitutes a nominal issuance of common stock. If
so, the shares of common stock are considered outstanding
retrospectively for all prior reporting periods presented. Section 8.3.4
discusses nominal issuances of common stock.
If the issuance is not considered nominal, the entity must determine
whether the consideration that must be paid for the holder to receive
the shares is “little or none.” Accordingly, the entity is required to
compare the consideration that must be paid by the holder with the fair
value of the shares of common stock to be received. This comparison is
only performed at the inception of the instrument on the basis of the
fair value of the common stock to be received on that date. Reassessment
is only necessary if the instrument is modified.
An entity must use judgment to determine the meaning of “little or none”
in this context. We believe that “little or none” generally means
“nonsubstantive.” If the consideration that must be paid for the holder
to receive the shares is determined to be “little or none,” the related
shares are considered outstanding with respect to the denominator in the
calculation of basic EPS.
Connecting the Dots
It is not appropriate to exclude from the denominator in the
calculation of basic EPS common shares that are issuable for
little or no consideration on the basis of any of the following:
- Beneficial ownership limitations that apply to the holder.
- The holder paid the entity a substantive amount to acquire the instrument.
- Conditions outside the share issuance agreement that could affect the holder’s ability or intent to ultimately acquire the underlying common shares.
Some entities issue options or warrants with an exercise price of $0.01
or less. Such instruments are often referred to as “penny warrants.”
Unless the issuer’s stock price is also nominal, the shares issuable
under equity-classified penny warrants must be included in the
denominator in the calculation of basic EPS. Diversity in practice may
exist with respect to whether the shares issuable under
liability-classified penny warrants that are measured at fair value
through earnings are reflected in the denominator in the calculation of
basic EPS. However, if such shares are not included in the denominator,
such instruments will typically be considered participating securities
because the holder would be economically compelled to exercise the
warrants if the entity declares a dividend. See Chapter 5 for more information about the
two-class method of calculating EPS.
The example below
illustrates the accounting for penny warrants.
Example 3-31
Penny
Warrants
Company G issues $100 million of
convertible debt with equity-classified detachable
warrants. The warrants enable the investors in the
convertible debt to acquire 10 million shares of
G’s common stock at an exercise price per share of
$0.01. On the date of issuance, the quoted market
price of G’s common stock is $25 per share. The
warrants are not considered to reflect a nominal
issuance of common stock.
The warrants are not
contingently issuable shares because no conditions
must be met before the underlying common stock is
issued. (This would be true even if the holder’s
ability to exercise the warrants is subject to a
beneficial ownership limitation, because the
holder would be able to sell shares to fully
exercise the warrants.) The exercise of the
warrants is virtually certain because the exercise
price is clearly nonsubstantive in relation to the
fair value of the common shares to be issued upon
exercise. Because G’s common stock will be issued
for little or no consideration, the shares
underlying the warrants should be considered
outstanding in the denominator in the calculation
of basic EPS from the issuance date of the
warrant. This conclusion would apply regardless of
whether the warrants are immediately exercisable
or will become exercisable on a future date on the
basis of the mere passage of time.
If the investors’ ability to
exercise the warrants depends on the satisfaction
of certain conditions, all of the necessary
conditions for issuance of the underlying common
shares would not be met as of the date the
warrants are issued and the shares underlying the
warrants should not be included in the denominator
in the calculation of basic EPS. In such
circumstances, the warrants represent contingently
issuable shares.
3.3.2.6 Common Stock Subscriptions
Stock subscriptions allow entities to offer employees and other investors the ability to purchase shares of the entity’s common stock typically over a period of time and without a broker’s commission. The impact of a stock subscription agreement on basic EPS depends on whether (1) the investor is entitled to participate in dividends before the subscription agreement is fully paid and (2) the shares of common stock are legally issued and outstanding. Generally, the shares of common stock underlying a fully unpaid stock subscription agreement have no impact on the denominator in the calculation of basic EPS; however, the two-class method may need to be applied if the arrangement represents a participating security. For partially paid stock subscription agreements, the common-share equivalent of the paid portion should generally be treated as outstanding shares of common stock if the investor is entitled to participate in dividends on that portion. See further discussion in Section 8.3.1.
3.3.2.7 Common Stock Issued for Note Receivable
The facts and circumstances associated with legally outstanding common stock that was issued in return for a note receivable will vary depending on the contractual terms of the arrangement. ASC 260 does not provide specific guidance on situations in which an entity has issued shares of common stock to
an investor that are legally outstanding and not subject to any vesting conditions in return for a note receivable. The determination of whether common shares issued in return for a note receivable should be considered outstanding and included in the denominator in the calculation of basic EPS, or should be treated as contingently issuable shares, depends on whether the entity has the ability and intent to cancel the shares if the note receivable is not repaid. See further discussion in Section 8.3.2.
3.3.2.8 An Entity’s Own Share Lending
An entity may loan its shares of common stock to an investment bank or third-party investor in conjunction with the issuance of convertible debt. Such shares are “loaned” because the investment bank or investor is unable to borrow shares in the market to hedge its exposure to the conversion option in the issuer’s convertible debt or because the borrowing cost is prohibitive. As noted in ASC 470-20-05-12B, although the “loaned” shares are legally issued and outstanding, those shares are generally not considered outstanding shares of common stock in the calculation of basic EPS. See further discussion in Section 8.5.
3.3.3 Repurchases of Common Stock
3.3.3.1 Shares of Common Stock That Have Been Repurchased
ASC 260-10-45-10 indicates that “[s]hares issued during the period and shares reacquired during the period shall be weighted for the portion of the period that they were outstanding.” Therefore, the weighted-average common shares outstanding should reflect the reduction of outstanding shares of common stock from the reacquisition date, whether the reacquired shares are canceled or held in treasury. Such repurchases include the shares of common stock acquired in the treasury stock component of an accelerated share repurchase program. See Section 8.4.1 for additional discussion of accelerated share repurchase programs.
3.3.3.2 Forwards to Repurchase Common Stock
ASC 480-10
EPS
45-4 Entities that have
issued mandatorily redeemable shares of common stock
or entered into forward contracts that require
physical settlement by repurchase of a fixed number
of the issuer’s equity shares of common stock in
exchange for cash shall exclude the common shares
that are to be redeemed or repurchased in
calculating basic and diluted earnings per share
(EPS). Any amounts, including contractual
(accumulated) dividends and participation rights in
undistributed earnings, attributable to shares that
are to be redeemed or repurchased that have not been
recognized as interest costs in accordance with
paragraph 480-10-35-3 shall be deducted in computing
income available to common shareholders (the
numerator of the EPS calculation), consistently with
the two-class method set forth in paragraphs
260-10-45-60 through 45-70.
The weighted-average shares of common stock outstanding should exclude shares of common stock that will be repurchased under a forward contract that requires an entity to repurchase a fixed number of its shares of common stock. Such shares of common stock should be removed from the shares of common stock outstanding beginning on the date the forward contract is entered into.
Questions often arise about 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. See Section 3.2.4.3.1 for further
discussion of the adjustments to the numerator for the shares of common
stock removed from the denominator.
3.3.4 Shareholder Distributions
In certain situations, the outstanding number of shares of common stock must be adjusted retrospectively for all prior periods presented. These situations include:
- Stock dividends and stock splits (including reverse stock splits) — see Section 8.2.1.
- Rights issues — see Section 8.2.2.
- Nominal issuances of common stock — see Section 8.3.4.
Other distributions to shareholders are considered the issuance of common stock and do not need to be treated retrospectively. Rather, in such cases, the shares of common stock are considered outstanding and included in the denominator of the calculation of basic EPS only from the issuance date. See further discussion in Section 8.3.3.
3.3.5 Business Combinations and Reorganizations
ASC 260 does not permit the retrospective adjustment of EPS for shares of common stock issued in a business combination. Rather, such shares issued as part of the purchase price affect the weighted-average common shares outstanding in the calculation of basic EPS only from the issuance date. However, in reverse merger transactions and certain reorganizations that are considered akin to split-like situations, the number of shares of common stock is retrospectively adjusted to the earliest period presented to reflect the recapitalization. See discussion of these types of situations, as well as the impact of spin-off transactions, in Section 8.6.
3.4 Example
As discussed above, basic EPS is calculated by first determining income
available to common stockholders, which takes into account dividends declared and
accumulated for preferred stock, among other adjustments to net income. Income
available to common stockholders (numerator) is then divided by the weighted-average
number of common shares outstanding (denominator). Dilutive securities are not
considered outstanding common stock for basic EPS. If there are contingently
issuable shares (shares issuable for little or no cash consideration upon the
satisfaction of certain conditions in accordance with a contingent stock agreement),
they are considered outstanding common stock in the calculation of basic EPS when
issuance is no longer contingent. The example below illustrates the first-quarter
calculation of basic EPS for an entity with a complex capital structure.
Example 3-32
Basic EPS for Entity With Complex Capital Structure
Assume the following facts:
- Company A has 20,000, $1,000 par value, 6 percent shares of convertible preferred stock outstanding for the entire period. The preferred stock does not participate in earnings with common shareholders.
- Income from continuing operations and net income for the first quarter ended March 31, 20X1, was $4 million.
- Company A had 4 million shares of common stock outstanding on January 1, 20X1.
- On March 1, 20X1, A issued 500,000 shares of common stock in a secondary offering, and on March 15, 20X1, options on 50,000 shares of common stock were exercised by employees.
- Employees hold options on 200,000 additional shares of common stock that vest and become exercisable over the next three to seven years. These options are not considered participating securities.
On the basis of the facts, the calculation of income available to common stockholders for the first quarter ended March 31, 20X1, is as follows:
The weighted-average shares of common stock outstanding during the first quarter ended March 31, 20X1, are calculated as follows:
Basic EPS for the first quarter ended March 31, 20X1, is calculated as follows:
The calculation of basic EPS is not affected by either the conversion option in the preferred stock or the unexercised employee stock options because neither security is considered a participating security. However, both would affect the denominator in the calculation of diluted EPS. For an example illustrating the calculation of basic EPS under the two-class method, see Chapter 5.