4.2 Treasury Stock Method

4.2.1 Scope

ASC 260-10

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

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

The treasury stock method applies to the following types of potential common shares if they are dilutive7 (except in certain circumstances, discussed below):

Written call options (common stock) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of common stock at a fixed or otherwise determinable price, including those issued in share-based payment arrangements.8 These written call options are also called “warrants.”
Written call options (convertible securities) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of the entity’s convertible securities at a fixed or otherwise determinable price, including those issued in share-based payment arrangements. These written call options are also called “warrants on convertible securities.”
Forward sale contracts (common stock) — Contracts that require the entity to sell a specified quantity or amount of common stock to the counterparty at a fixed or otherwise determinable price.
Forward sale contracts (convertible securities) — Contracts that require the entity to sell a specified quantity or amount of convertible securities to the counterparty at a fixed or otherwise determinable price.
Nonvested shares (common stock) — Agreements between an entity and an employee or nonemployee in a share-based payment arrangement to issue common shares, provided that the counterparty meets a relevant vesting condition (i.e., a service, performance, or market condition).

An entity should not apply the treasury stock method to a contract listed above in the following situations:

The contract must be net settled in cash (i.e., no common shares or potential common shares are issued upon settlement).
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the treasury stock method.

The discussion in the next section focuses on the application of the treasury stock method to potential common shares within its scope that are not participating securities. If a potential common share is a participating security, an entity is required to use the more dilutive of the treasury stock method or the two-class method of calculating diluted EPS (see Section 5.5.4). Sections 4.2.2.3.4 and 4.6 discuss the application of the treasury stock method to instruments that contain multiple settlement alternatives. Section 7.1.2.1 provides additional guidance on applying the treasury stock method to potential common shares issued in a share-based payment arrangement.

4.2.2 Application of the Treasury Stock Method

4.2.2.1 Contracts to Sell Common Stock

ASC 260-10

Conversion Rate or Exercise Price

45-21 Diluted EPS shall be based on the most advantageous conversion rate or exercise price from the standpoint of the security holder. Previously reported diluted EPS data shall not be retroactively adjusted for subsequent conversions or subsequent changes in the market price of the common stock.

Variable Denominator

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

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

45-23

Under the treasury stock method:

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

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

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

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

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

Share-Based Payment Arrangements

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

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

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

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

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

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

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

The treasury stock method represents a method for determining the dilutive effect of options, warrants, nonvested shares, forward sale contracts, and similar instruments. Under this method, it is assumed that the proceeds that would be received upon settlement are used to repurchase common shares at the average market price during the period. ASC 260-10-45-23 through 45-32 describe how the treasury stock method is applied and include specific discussion of its application to share-based payment arrangements.

The treasury stock method is only applied to options and warrants that are in-the-money from the perspective of the counterparty. It is not applied to options and warrants that are out-of-the-money from the counterparty’s perspective, because (1) the holder would not elect to exercise an instrument that is not in-the-money and (2) application of the treasury stock method would generally be antidilutive. The determination of whether an option or warrant is in-the-money is made by comparing the average market price of the common stock during the period with the assumed proceeds received upon exercise of the instrument. For share-based payment awards, the proceeds include the exercise price and the average amount of cost not yet recognized. For all other instruments, the proceeds are limited to the exercise price. See Section 7.1.2.1 for additional discussion of the application of the treasury stock method to share-based payment awards.

An entity must determine whether options or warrants are in-the-money, and must apply the treasury stock method, on an instrument-by-instrument basis. If the average market price of common stock during the period exceeds the proceeds per common share issuable, an option or warrant is in-the-money. In determining whether an option or warrant is in-the-money, it is not appropriate for an entity to compare the end-of-period market price of the common stock with the proceeds. Further, in making this determination, as well as in applying the treasury stock method, an entity must consider the guidance in ASC 260-10-45-21, which states that diluted EPS is calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” This would include any exercise price available to the holder at some future date that results from the mere passage of time (see further discussion in Section 4.2.2.1.2.1). Sections 4.2.2.1.1 and 4.2.2.1.2 discuss considerations related to situations in which the number of shares or proceeds received upon exercise varies.

Connecting the Dots

An entity may classify options and warrants as liabilities and measure them at fair value, with changes in fair value recognized in earnings. When the treasury stock method is applied for diluted EPS purposes, the numerator must be adjusted because, under the treasury stock method, the instrument is assumed to be classified within equity (and the income statement effect of the contract would not have occurred had it been exchanged for common shares at the beginning of the period or on the date of issuance, if later). As discussed in Sections 4.2.2.3 and 4.7.3, the numerator adjustment reflects a reversal of the mark-to-market adjustment that was recognized on the option or warrant during the period, net of tax. The aggregate effect of this adjustment to the numerator and the incremental common shares included in the denominator could potentially yield a dilutive result during a reporting period even though the option or warrant was out-of-the-money from the counterparty’s perspective on the basis of a comparison of the (1) proceeds per common share issuable with (2) average market price of the entity’s common stock. Because the treasury stock method is not applied to options or warrants that are out-of-the-money, an entity should not include the dilutive result that would occur if the mark-to-market reversal was made to the numerator and the shares were added to the denominator.

In addition, the adjustment to the numerator and application of the treasury stock method to liability-classified options or warrants could potentially yield an antidilutive result during a financial reporting period even if the option or warrant was in-the-money from the counterparty’s perspective on the basis of a comparison of the (1) proceeds per common share issuable with (2) average market price of the entity’s common stock. Because an entity, in considering the antidilution sequencing requirements of ASC 260, does not apply the treasury stock method when options or warrants are antidilutive, the entity should not include the antidilutive result that would occur if the mark-to-market reversal was made to the numerator and the share adjustments were made to the denominator, even though the instrument was in-the-money from the counterparty’s perspective.

Nonvested shares of common stock are issued to employees and nonemployees in share-based payment arrangements. Because there is no exercise price for nonvested shares issued in a share-based payment arrangement, the treasury stock method is generally dilutive. However, the average cost not yet recognized for financial reporting purposes (which is considered proceeds) may possibly purchase more than the number of nonvested shares at the average market price during a financial reporting period.

Forward contracts to sell common stock must be settled regardless of whether they are in-the-money or out-of-the-money from the counterparty’s perspective; therefore, the treasury stock method always applies to forward sale contracts if they are dilutive. The determination of whether a forward sale contract is dilutive under the antidilution sequencing guidance in ASC 260 is made on an instrument-by-instrument basis. Forward sale contracts may be dilutive to EPS even if they are out-of-the-money from the counterparty’s perspective on the basis of the end-of-period market price of the entity’s common stock because, under the treasury stock method, it is assumed that there is a repurchase of common shares at the average market price during the period. Thus, when the entity considers the average market price of its common stock during the period, the contract is in-the-money and dilutive under the treasury stock method.

In applying the treasury stock method to a forward sale contract, an entity must consider the guidance in ASC 260-10-45-21, which states that diluted EPS is calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” This would include any forward price available to the holder at some future date that results from the mere passage of time. See further discussion in Section 4.2.2.1.2.1. Sections 4.2.2.1.1 and 4.2.2.1.2 discuss considerations related to situations in which the number of shares or proceeds received upon settlement varies.

Connecting the Dots

As discussed above, options and warrants are subject to the treasury stock method only if they are in-the-money on the basis of a comparison of the proceeds on exercise with the average market price during the period, whereas forward sale contracts are subject to the treasury stock method in all cases if the result is dilutive. This distinction based on the type of contract will not create any difference in the application of the treasury stock method to a contract that is classified as an equity instrument. This is because the treasury stock method will always be antidilutive when applied to options, warrants, and forward sale contracts that are out-of-the-money from the counterparty’s perspective on the basis of a comparison of the per-share proceeds upon exercise or settlement with the average market price of the entity’s common stock during the period. This distinction based on the type of contract may, however, create a difference between forward sale contracts and options and warrants in the calculation of diluted EPS when the contract is classified as an asset or liability because of the numerator adjustment that is required in this circumstance.

4.2.2.1.1 Adjustments to the Number of Shares Issuable on Settlement

The number of common shares issuable upon settlement of options, warrants, nonvested shares, forward sale contracts, and similar instruments may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.

If the number of common shares issuable upon settlement varies on the basis of only the passage of time, an entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty. See Example 4-1 for an illustration related to these concepts.

If the number of common shares issuable upon settlement is subject to adjustment on the basis of the occurrence or nonoccurrence of a specified event (other than changes in the fair value of the entity’s stock price) that is not within the counterparty’s control, an entity should apply the guidance on contingently issuable shares to determine the number of common shares issuable upon settlement. As discussed in Section 4.5, the entity should assume that the current status of the condition as of the reporting date will remain unchanged (i.e., the specified event will not occur). As a result, potential adjustment features that are commonly included in the terms of instruments to sell common stock will have no impact on the application of the treasury stock method until such adjustment events occur. The table below lists common adjustment events that will have no impact on the application of the treasury stock method before the occurrence of the related event.

Table 4-3

Common Adjustment Features That Do Not Affect Calculations of Diluted EPS Until the Adjustment Event Occurs
Stock splits, reverse stock splits, and stock dividends. Rights issues. Cash dividends. Pro rata distribution of other assets or properties to all common shareholders. Tender offers. Fundamental transactions (e.g., merger, change of control, reorganization, recapitalization, sale of all or substantially all of the entity’s assets). Down-round features. See Section 4.8.2 for discussion of the requirement to retrospectively adjust previously reported EPS amounts upon the occurrence of stock splits, reverse stock splits, stock dividends, and rights issues.

Common Adjustment Features That Do Not Affect Calculations of Diluted EPS Until the Adjustment Event Occurs

Stock splits, reverse stock splits, and stock dividends.
Rights issues.
Cash dividends.
Pro rata distribution of other assets or properties to all common shareholders.
Tender offers.
Fundamental transactions (e.g., merger, change of control, reorganization, recapitalization, sale of all or substantially all of the entity’s assets).
Down-round features.

See Section 4.8.2 for discussion of the requirement to retrospectively adjust previously reported EPS amounts upon the occurrence of stock splits, reverse stock splits, stock dividends, and rights issues.

If the number of common shares issuable upon settlement is linked to a specified rate, price, index, or other variable, an entity should determine the number of shares (see the table below) by applying either (1) the guidance in ASC 260-10-45-21A on variable denominators or (2) the guidance in ASC 260-10-45-48 through 45-57 on contingently issuable shares. Under the variable denominator approach, the entity would determine the number of common shares issuable upon settlement on the basis of the average of the specified rate, price, index, or other variable during the reporting period. As discussed in Section 4.5, under the contingently issuable share approach, the entity would reflect the number of common shares that would be issued upon settlement on the basis of the current rate, price, index, or other variable at the end of the reporting period (or on the basis of the average rate, price, index, or other variable, assuming settlement occurred on the last day of the reporting period if the contract stipulates an average rate, price, index, or other variable). As discussed in Section 4.2.2.1.3, under either approach, the stock price used to calculate the number of common shares assumed to be repurchased with the proceeds must reflect the average market price during the entire financial reporting period (or portion thereof during the reporting period the contract was outstanding). If the contract is classified as an asset or liability, the numerator must also be adjusted as part of the calculation under the treasury stock method, as discussed in Section 4.2.2.3.1.

Table 4-4

Determining the Number of Shares Issuable Upon Settlement When the Shares Vary on the Basis of a Specified Rate, Price, Index, or Other Variable
Type of Variable		Approach Used
Entity’s stock price		Average market price approach unless the arrangement represents a contingently issuable share9
Other rate, price, index, or variable		Average market price approach or contingently issuable share method

The average market price approach must be used if the number of shares varies on the basis of just the entity’s stock price. However, either the average market price approach or contingently issuable share method can be applied, as a policy choice, if the variability is due to something other than just the entity’s stock price, since ASC 260-10-45-21A only specifically addresses how an entity should account for diluted EPS when the variable is based only on the entity’s stock price.

See Example 4-3 for an illustration of how the treasury stock method is applied to a forward contract to sell a variable number of common shares depending on the market price of the entity’s common stock.

4.2.2.1.2 Proceeds

The determination of the proceeds used to apply the treasury stock method is generally straightforward. The proceeds represent the amount the counterparty must pay to receive the common shares underlying the contract (i.e., the exercise price or forward price) and, for share-based payments, include the average amount of compensation cost not yet recognized. However, as discussed below, an entity must take additional considerations into account in certain situations.

4.2.2.1.2.1 Adjustments to the Exercise Price or Forward Price

The exercise price or forward price of options, warrants, nonvested shares, forward sale contracts, and similar instruments may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.

If the exercise price or forward price varies on the basis of only the passage of time, an entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any exercise price or forward price that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty. See Examples 4-1 and 4-5 for illustrations related to these concepts.

If the exercise price or forward price is subject to adjustment on the basis of the occurrence or nonoccurrence of a specified event (other than changes in the fair value of the entity’s stock price) that is not within the counterparty’s control, an entity should apply the guidance on contingently issuable shares to determine the exercise price or forward price. As discussed in Section 4.5, the entity should assume that the current status of the condition as of the reporting date will remain unchanged (i.e., the specified event will not occur). As a result, potential adjustment features that are commonly included in the terms of instruments to sell common stock will have no impact on the application of the treasury stock method until such adjustments are made. Table 4-3 includes a list of common adjustment events that will have no impact on the application of the treasury stock method before the occurrence of the related event. See also Example 4-6.

If the exercise price or forward price varies solely on the basis of the entity’s stock price, the entity should apply ASC 260-10-45-21A, which requires that the entity determine the proceeds by using the average market price of the entity’s stock during the reporting period. If, however, the exercise price or forward price varies on the basis of a specified rate, price, index, or other variable (i.e., it is not based solely on the entity’s stock price), an entity may apply any of the following approaches since ASC 260 does not contain specific guidance on this matter:

View A: The proceeds reflect the exercise price or forward price as of the end of the reporting period — This view is consistent with the guidance in ASC 260 on contingently issuable shares. Although that guidance only specifically addresses how to determine the number of common shares, it may be applied by analogy to determine the exercise price or forward price. Under that guidance, it is assumed that the contingency (in this case, the amount of the exercise price or forward price) is resolved as of the end of the reporting period. Thus, an entity calculates the exercise price or forward price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement of the contract on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
View B: The proceeds reflect the lowest exercise price or forward price during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the exercise or forward prices applicable for the entire time during the reporting period in which the contract was outstanding and use the price that is least advantageous to the entity and produces the lowest proceeds. The entity should not project future exercise or forward prices since they will vary on the basis of changes in the rate, price, index, or other variable.
View C: The proceeds reflect the average exercise price or forward price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-23, which require the use of an average.

These three approaches are acceptable regardless of whether the entity or counterparty controls the timing of the settlement date (since neither party ultimately controls the rate, price, index, or other variable that affects the proceeds). The approach selected is considered an accounting policy election that must be applied consistently and disclosed.

Under any of the three approaches described above, the entity must assume that it repurchases common shares with the proceeds at the average market price during the reporting period (see Section 4.2.2.1.3). In addition, if the contract is classified as an asset or liability for accounting purposes, which may be required because of the variable terms,10 the calculation of diluted EPS under the treasury stock method should include an adjustment to the numerator, as discussed in Section 4.2.2.3.1. Example 4-4 illustrates the application of the alternative views to a forward sale contract.

It is not acceptable to determine the proceeds on the basis of the exercise price or forward price at the beginning of the reporting period because there is no basis in ASC 260 for the use of this approach.

Connecting the Dots

It may be unclear whether an entity should apply the guidance on contingently issuable shares in ASC 260-10-45-48 through 45-57 or the guidance on variable denominators in ASC 260-10-45-21A. In such cases, the entity must use judgment and there could be diversity in practice. On the basis of informal discussions with the FASB staff, we understand that the amendments that ASU 2020-06 made to ASC 260 were not intended to change an entity’s determination of whether the guidance on contingently issuable shares applies. In those discussions, the FASB staff acknowledged that the guidance in ASC 260 addressing what constitutes a contingently issuable share is often difficult to interpret in practice.

4.2.2.1.2.2 Prepaid Contracts

A prepaid forward sale contract is subject to the treasury stock method in the calculation of diluted EPS. Since the counterparty has already paid the forward price, there are no proceeds under the treasury stock method. Because there are no proceeds, the dilution under the treasury stock method is calculated as the number of common shares issuable under the contract. If the number of common shares varies, an entity should apply the guidance discussed in Section 4.2.2.1.1.

A counterparty to a stock option may prepay the exercise price before exercising the stock option. For example, a stock option issued to an employee in a share-based payment arrangement may be “early exercised” before the award has vested. In this circumstance, the entity generally is required or allowed to repurchase the stock option if it is ultimately not exercised (or, for share-based payment awards, if it does not vest). Because the counterparty has already paid cash to early exercise the option, there is no cash that will be received from the counterparty in the future. Further, the cash received could have been used to repurchase shares during the requisite service period. As a result, the cash received is not included in the computation of assumed proceeds. In the absence of average unrecognized cost for share-based payment awards, there will be no proceeds under the treasury stock method.

4.2.2.1.3 Average Market Price

ASC 260-10

Average Market Price

55-4 The average market price of common stock shall represent a meaningful average. Theoretically, every market transaction for an entity’s common stock could be included in determining the average market price. As a practical matter, however, a simple average of weekly or monthly prices usually will be adequate.

55-5 Generally, closing market prices are adequate for use in computing the average market price. When prices fluctuate widely, however, an average of the high and low prices for the period that the price represents usually would produce a more representative price. The method used to compute the average market price shall be used consistently unless it is no longer representative because of changed conditions. For example, an entity that uses closing market prices to compute the average market price for several years of relatively stable market prices might need to change to an average of high and low prices if prices start fluctuating greatly and the closing market prices no longer produce a representative average market price.

ASC 260-10-55-4 and 55-5 offer some flexibility related to an entity’s approach to calculating average market prices when the entity applies the treasury stock method. For entities whose common stock trades regularly, the most precise method is generally to average daily closing stock prices.11 However, as discussed in ASC 260-10-55-4, a simple average of weekly or even monthly common stock prices may be adequate in such circumstances. If an entity decides to calculate an average common stock price by using a basis other than an average of each day’s closing price, the entity should ensure that the averaging method does not misrepresent the average market price for the reporting period. The entity should apply the approach selected consistently over time unless changes in facts and circumstances result in the need to alter the approach used to calculate the average market price.

Connecting the Dots

The common stock of many entities trades outside regular trading hours (also referred to as “pre-market” or “after-hours” trading). In the United States, the regular trading hours for equity securities are from 9:30 a.m. to 4:00 p.m. (ET). Any trading before 9:30 a.m. (ET) is considered “pre-market” trading, and any trading after 4:00 p.m. (ET) is considered “after-hours” trading. ASC 260 refers to the use of closing stock prices, which represent the last published trade on the relevant exchange (i.e., in the United States, the last trade that occurs on or before 4:00 p.m. (ET)). Because the original pronouncement that was codified in ASC 260 was issued before the proliferation of pre-market and after-hours trading, ASC 260 does not mention market prices occurring outside regular trading hours. However, it is appropriate for entities not to include in the average market price any trade that was completed before or after regular trading hours. It may be appropriate for an entity to consider trades in its common stock that occur outside regular trading hours if trading in the entity’s common stock is limited, but the entity must take care before considering such market prices. In many cases, there is much less liquidity in pre-market and after-hours trading, which may significantly affect the price of trades. Furthermore, significant increases and decreases in the market price of an entity’s common stock often occur in pre-market or after-hours trading because of news released immediately before or after the markets close. Because the volume of trades outside regular trading hours is generally limited compared with trading volume during regular trading hours, trading participants often “over-react” more positively or negatively than they do when stock prices occur during regular trading hours. As a result, in the absence of a limited population of trades in an entity’s common stock during regular trading hours, an entity should not include market prices from trades that occur outside regular trading hours in calculating the average market price during a period.

Additional considerations may be necessary when an entity’s common stock is thinly traded. It may be more appropriate to use a method other than an average of a limited population of trading prices. ASC 260-10-55-5 discusses the use of an average of the high and low prices for the period that is due to high volatility in the company’s common stock. When an entity’s common stock trades very infrequently and in such a way that an average of closing common stock prices is not meaningful, it would be acceptable for an entity to use the average of the bid-and-ask price for the common stock to determine the average market price. This method should be applied until the entity’s common stock trades regularly and an average of closing prices becomes more appropriate.

Another situation in which additional consideration is required is the determination of average market prices in pre-IPO periods. As discussed in Section 8.6 and Appendix B, diluted EPS may need to be presented on the face of the income statement, in pro forma disclosures, or both when an entity’s financial statements are included in a registration statement filed with the SEC for an IPO of common stock. In these situations, observable prices of an entity’s common stock may be limited or altogether unavailable. As a result, the entity will need to consider valuations of its common stock. Such valuations, whether calculated internally or by a third party, must be prepared by using generally accepted valuation principles and must conform to the fair value measurement principles in ASC 820. An entity should consider any valuations prepared for the purpose of recognizing compensation cost for consistency with share-based payment arrangements.

While the number of periods related to deriving an average market price depends on the facts and circumstances, the calculation of the average market price should take into account common stock prices for the entire reporting period because ASC 260-10-55-4 requires that the average be meaningful. Therefore, when an entity consummates an IPO during a fiscal year, the average market price for the period should include (1) the stock price before the IPO, determined through the entity’s valuations of common stock (i.e., its IRC Section 409A valuations), and (2) the publicly traded stock prices for periods after the IPO. An entity cannot solely use its publicly traded stock price to calculate the average market price for the entire reporting period. In addition, an entity cannot assume that its publicly traded stock price upon IPO effectiveness represents the market price for the portion of the fiscal year that occurred before the IPO.

4.2.2.1.3.1 Contracts That Are Issued, Exercised, Forfeited, or Canceled, or That Expire, During a Financial Reporting Period

ASC 260-10-45-26 states, in part, that “[d]ilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding [and] dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise.” To meet the ASC 260 requirement under which diluted EPS must include incremental common shares weighted for the period in which an option, warrant, nonvested share, forward sale contract, or similar instrument was outstanding during a financial reporting period, the average market price used to apply the treasury stock method should reflect an average over the period in which the instrument was outstanding rather than an average over the entire financial reporting period. Thus, for contracts that are issued, exercised, forfeited, or canceled, or that expired, during a financial reporting period, an entity will need to calculate, on an instrument-by-instrument basis, the average market price for the portion of the period in which the instrument was outstanding. The average market price over the entire financial reporting period is used for all other instruments that were outstanding for the entire reporting period. See Example 4-2 for an illustration of an option exercised during a period.

For share-based payment awards, the average unrecognized cost, which is a component of proceeds, should also be based on an average during the period in which the award was outstanding. See also Section 7.1.2.1.

Connecting the Dots

As discussed in Section 4.2.2.1.3, ASC 260 offers some inherent flexibility, or practical approaches, related to the calculation of the average market price that is used to apply the treasury stock method. An entity may have a number of potential common shares that were not outstanding during the entire financial reporting period because of issuances, exercises, or cancellations. If the entity is able to determine that using the average market price for the entire financial reporting period to calculate the dilutive impact of such potential common shares reasonably approximates the dilutive effect that would exist if the average market price were separately calculated on an instrument-by-instrument basis by using the period in which each instrument was outstanding, it would be reasonable for the entity to use the average market price for the entire period even though this approach is less precise. The entity would still need to weight the incremental common shares that result from the treasury stock method for the period in which those potential common shares were outstanding during the financial reporting period. In determining whether it is appropriate to employ a more practical approach in which the average market price for the entire financial reporting period is applied because it closely approximates the result that would be achieved if the average market price was calculated on an instrument-by-instrument basis by using the period each instrument was outstanding, entities may want to consider factors such as the following:

The volatility in the market price of the entity’s common stock during the financial reporting period.
The number of potential common shares that were not outstanding for the entire financial reporting period (i.e., as a measure of the potential impact that such potential common shares could have on diluted EPS for the period).
The impact that potential common shares generally have on reported diluted EPS. The less sensitive the calculation of diluted EPS is to changes in assumptions, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.
The timing within the period in which potential common shares were issued, exercised, or canceled. The more even the distribution of issuances, exercises, or cancellations when amount and timing are considered, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.

Another way to apply the treasury stock method by using the average market price for the period is to weight the potential common shares and apply the average market price for the entire period. However, this approach may only be appropriate when the potential common shares are of the same type and have the same terms. See Examples 7-2 and 7-3.

4.2.2.2 Contracts to Sell Convertible Securities

ASC 260-10

Options and Warrants and Their Equivalents

55-6 Options or warrants to purchase convertible securities shall be assumed to be exercised to purchase the convertible security whenever the average prices of both the convertible security and the common stock obtainable upon conversion are above the exercise price of the options or warrants. However, exercise shall not be assumed unless conversion of similar outstanding convertible securities, if any, also is assumed. The treasury stock method shall be applied to determine the incremental number of convertible securities that are assumed to be issued and immediately converted into common stock. Interest or dividends shall not be imputed for the incremental convertible securities because any imputed amount would be reversed by the if-converted adjustments for assumed conversions.

55-7 Paragraphs 260-10-55-9 through 55-11 provide guidance on how certain options and warrants should be included in the computation of diluted EPS. Exercise of the potential common shares discussed in those paragraphs shall not be reflected in diluted EPS unless the effect is dilutive. Those potential common shares will have a dilutive effect if either of the following conditions is met:

The average market price of the related common stock for the period exceeds the exercise price.
The security to be tendered is selling at a price below that at which it may be tendered under the option or warrant agreement and the resulting discount is sufficient to establish an effective exercise price below the market price of the common stock obtainable upon exercise.

Although the treasury stock method does apply to options or warrants that allow the counterparty to purchase convertible securities, its application must be altered to reflect that the option or warrant is first settled by delivery of a convertible security, which may then be converted into common stock. For an option or warrant on convertible securities to be dilutive, the average market prices of both the convertible security and the common stock obtained upon conversion must exceed the exercise price of the option or warrant. See Example 4-7 for an illustration of the application of the treasury stock method to an option on convertible preferred stock. If an option or warrant contains multiple exercise or conversion alternatives, the guidance in ASC 260-10-55-9 through 55-11 must be considered. See Section 4.6 for more information.

An entity may enter into a forward contract to sell a convertible security (although this is not commonly seen in practice). For this type of contract, the entity and counterparty have agreed on the terms of the convertible security and purchase price but will not exchange the purchase price and security until a later settlement date. The dilutive effect, if any, resulting from a forward contract to sell a convertible security should be calculated by using the treasury stock method. As with the application of the treasury stock method to options or warrants to sell convertible securities, the calculation under the treasury stock method must take into account the common shares that would be issuable if the contract was settled for the convertible security and immediately converted into common stock. As a result, the treatment of a forward contract to sell a convertible security would be consistent with that for a forward contract to sell a common stock. The entity assumes that the forward price is used to purchase common shares, and the excess of the common shares issuable under the forward contract (based on the conversion rate when the forward sale contract is on a convertible security) over the common shares assumed repurchased at the average market price is included in the denominator in the calculation of diluted EPS. However, once the forward contract is settled and the convertible security is issued, diluted EPS is determined consistently with the treatment of other outstanding convertible securities. See Example 4-8 for an illustration of the application of the treasury stock method to a forward contract to sell convertible debt. See Chapter 6 for further discussion of the calculation of diluted EPS for outstanding convertible debt securities.

Connecting the Dots

Economically, the counterparty to a forward contract on a convertible security is “long” with respect to the convertible security. Nevertheless, the if-converted method is not applied to a forward contract to sell a convertible security. Under the if-converted method, interest and dividends must be added back to the numerator. As discussed in ASC 260-10-55-6, if interest and dividends were imputed on the convertible security underlying a forward contract to sell a convertible security, they would be immediately reversed by the assumed conversion of the convertible security into common shares. The only way the if-converted method could be applied to a forward contract to sell a convertible security would be to assume that the common shares underlying the convertible security were outstanding. However, unless the forward price was zero or nominal, this assumption would be inappropriate because it would fail to consider that an entity can use the proceeds received on payment of the forward price to purchase common shares. The concept underlying the calculation of diluted EPS is that the entity deploys any proceeds received from the issuance of potential common shares in a capital-efficient manner (i.e., to reduce dilution or increase diluted EPS). When the entity applies the treasury stock method, the dilution caused by issuing more common shares is offset by an assumed repurchase of common shares with the proceeds.

4.2.2.3 Method of Settlement

4.2.2.3.1 Contracts Classified as Assets or Liabilities

Options, warrants, nonvested shares, forward sale contracts, and similar instruments on the sale of common shares or potential common shares may be classified as assets or liabilities. When a contract is classified as an asset or a liability, the entity should first determine whether the treasury stock method should be applied to calculate the impact of the contract on diluted EPS. If the contract must be cash-settled in all circumstances (i.e., no common shares will be issued on settlement), the treasury stock method should not be applied and no adjustment should be made to the numerator or denominator in the entity’s calculation of diluted EPS.

If dilutive, the treasury stock method is applied when (1) a contract must be share-settled or (2) the entity or the counterparty is permitted to settle the contract in cash or common shares. Because it is assumed, under the treasury stock method, that a contract is classified as an equity instrument (and that the income statement effect of the contract would not have occurred if it had been exchanged for common shares at the beginning of the period or on the date of issuance, if later), an entity must, in addition to adding the incremental shares to the denominator, adjust the numerator when a contract is classified as an asset or liability. The numerator adjustment should reflect the change in net income that would have occurred during the reporting period if the contract had been classified in equity. Since contracts subject to the treasury stock method that are classified as assets or liabilities are typically measured at fair value, with changes in fair value recognized in earnings, and contracts classified as equity instruments are typically not remeasured, the adjustment to the numerator will typically reflect a reversal of the mark-to-market adjustment recognized on the contract during the reporting period, net of any associated income tax effects.12 However, the numerator adjustment should not be made, and the incremental shares should not be added to the denominator, if (1) the contract is an option or warrant and is out-of-the-money on the basis of a comparison of the exercise price with the average market price or (2) the aggregate effect of the two adjustments is antidilutive on the basis of the antidilution sequencing requirements in ASC 260. See Section 4.7 for further discussion of the accounting for diluted EPS for contracts subject to the treasury stock method that are classified as assets or liabilities.

4.2.2.3.2 Contracts Classified as Equity Instruments That Provide for Net-Share Settlement

Under the treasury stock method, it is assumed that contracts are settled physically or on a “gross” basis (i.e., the counterparty pays the exercise price or forward price and receives the gross number of common shares underlying the contract). Contracts subject to the treasury stock method often provide for net-share or “cashless” settlement. In a cashless settlement, the entity delivers to the counterparty a number of common shares with a current fair value (or a fair value determined on the basis of an average stock price) equal to the intrinsic value of the contract. The number of common shares delivered by the entity to the counterparty may be reduced by a number of shares with a fair value equal to the entity’s tax withholding requirements.

Economically, a net-share settlement of a contract to issue shares is equivalent to a physical settlement accompanied by a repurchase of shares with the proceeds paid by the counterparty. However, the treasury stock method requires an assumption that the entity repurchases common shares at the average market price during the financial reporting period; on the other hand, in a net-share settlement, the number of shares “repurchased” is based on the fair value of shares as of the settlement date or a weighted-average price over a specified period that differs from the average market price over the reporting period. Given the concept of an average market price that must be applied under ASC 260, contracts that allow for net-share settlement should be assumed to be exercised on a gross basis, with the dilution calculated under the treasury stock method.

Connecting the Dots

Settlement of options, warrants, and nonvested shares, net of the entity’s statutory withholding requirements, generally applies only to share-based payment arrangements; in certain circumstances, however, such features are included in an arrangement that is not a share-based payment award (e.g., options or warrants on partnership interests). In these withholding arrangements, whether the entity settles by issuing gross shares or by issuing shares net of statutory withholding requirements, the calculation of the dilutive effect under the treasury stock method is not affected. To include only the net shares issuable in the denominator of diluted EPS would be contrary to the antidilution guidance in ASC 260. In a withholding for statutory tax requirements, the entity is economically issuing the gross number of shares and then buying back shares from the counterparty. Since ASC 260 prescribes the treatment of the repurchase of common shares under the treasury stock method, any additional consideration of the net shares withheld to meet statutory withholding requirements would inappropriately result in taking into account the shares repurchased twice. Except for certain forward contracts to repurchase common shares (addressed in ASC 480-10- 45-4), the repurchase of common shares, even if it depends only on the passage of time, is not taken into account in in the calculation of diluted EPS before the shares are repurchased.

4.2.2.3.3 Contracts Classified as Equity Instruments That Provide for Net-Cash Settlement

Options, warrants, nonvested shares, forward sale contracts, and similar instruments on the sale of common shares or potential common shares that are classified as equity instruments may permit the entity to choose to settle the contract in cash or common stock. For these contracts, the treasury stock method must be applied because ASC 260 prevents an entity from overcoming the presumption of net share settlement.

If an equity-classified contract is antidilutive under the treasury stock method, the entity would not reflect an adjustment to the numerator under the assumption that the contract was classified as an asset or liability, even if it would be dilutive to do so. Numerator adjustments are only made to contracts classified as assets or liabilities that are considered share-settled for diluted EPS.

4.2.2.3.4 Contracts With Multiple Conversion or Settlement Alternatives

Certain contracts subject to the treasury stock method may offer the counterparty alternatives related to the consideration that it transfers to exercise, convert, or settle the contract in return for common shares issued by an entity. For example, a counterparty to a call option on common stock may be permitted to pay the exercise price in either cash or delivery of an entity’s debt instrument. ASC 260-10-55-8 through 55-11 address implications related to the calculation of diluted EPS for contracts with multiple conversion or settlement alternatives. ASC 260-10-55-8 states, in part, that “[w]hen several conversion alternatives exist, the computation shall give effect to the alternative that is most advantageous to the holder of the convertible security.” For contracts that offer the counterparty such alternatives with respect to the payment of the exercise or forward price, the guidance in ASC 260-10-55-8 through 55-11 must be applied to reflect the potential dilutive impact on diluted EPS. See further discussion in Section 4.6.

4.2.3 Examples

ASC 260-10

Example 15: Options, Warrants, and Their Equivalents

55-92 This Example illustrates the guidance in paragraphs 260-10-45-22 through 45-23.

55-93 Consider Entity A that has 10,000 warrants outstanding exercisable at $54 per share; the average market price of the common stock during the reporting period is $60. Exercise of the warrants and issuance of 10,000 shares of common stock would be assumed. The $540,000 that would be realized from exercise of the warrants ($54 × 10,000) would be an amount sufficient to acquire 9,000 shares ($540,000/$60). Thus, 1,000 incremental shares (10,000 – 9,000) would be added to the outstanding common shares in computing diluted EPS for the period.

55-94 The following is a shortcut formula for that computation (note that this formula may not be appropriate for share-based compensation awards [see paragraph 260-10-45-29]):

Incremental shares = [(market price – exercise price)/market price] × shares assumed issued under option; thus, [($60 – $54)/$60] × 10,000 = 1,000 incremental shares.

Example 4-1

Warrant to Sell Common Stock — Number of Common Shares and Exercise Price Vary Over Time

In conjunction with a debt issuance, on June 15, 20X2, Company D issued a warrant to Company H under which H has the right, but not the obligation, to purchase D’s common shares at any time from the issuance date until June 15, 20X7. The warrant contains the following key terms:

Notional amount — H can exercise the warrant for a number of common shares that varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — 50,000 common shares.
- If exercised between June 15, 20X3, and June 14, 20X4 — 52,500 common shares.
- If exercised between June 15, 20X4, and June 14, 20X5 — 55,000 common shares.
- If exercised between June 15, 20X5, and June 14, 20X6 — 57,500 common shares.
- If exercised between June 15, 20X6, and June 15, 20X7 — 60,000 common shares.
Exercise price — The exercise price for each common share purchased varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — $10.00 per common share.
- If exercised between June 15, 20X3, and June 14, 20X4 — $9.75 per common share.
- If exercised between June 15, 20X4, and June 14, 20X5 — $9.50 per common share.
- If exercised between June 15, 20X5, and June 14, 20X6 — $9.25 per common share.
- If exercised between June 15, 20X6, and June 15, 20X7 — $9.00 per common share.

From H’s perspective, it is most advantageous to wait and exercise the warrant between June 15, 20X6, and June 15, 20X7, because H pays a lower exercise price and is entitled to receive more common shares. Therefore, D should apply the treasury stock method, if dilutive, assuming a $9.00 exercise price per common share on 60,000 potential common shares.

Example 4-2

Option to Sell Common Stock — Option Is Exercised During the Period

Assume the following:

In 20X7, Company N issued options that allow the counterparty to purchase 10,000 shares of common stock at an exercise price of $27.50 per common share.
The counterparty may elect to exercise the options on a physical or net-share-settlement basis.
On March 2, 20X8, the counterparty exercised all the options in a net-share settlement.
Company N uses a weekly average to calculate the average market price for its quarterly financial reporting period ended March 30, 20X8, because it has concluded that a weekly average closely approximates a daily average. The weekly average is based on the closing stock price of N’s common stock on the last day of each week. The quoted closing prices of N’s common stock were as follows:
- January 5, 20X8: $32.23.
- January 12, 20X8: $31.77.
- January 19, 20X8: $32.93.
- January 26, 20X8: $33.12.
- February 2, 20X8: $33.88.
- February 9, 20X8: $32.71.
- February 16, 20X8: $34.03.
- February 23, 20X8: $34.48.
- March 2, 20X8: $36.00.
- March 9, 20X8: $35.55.
- March 16, 20X8: $35.01.
- March 23, 20X8: $34.16.
- March 30, 20X8: $33.08.

The following calculation shows the incremental common shares that would be added to the denominator in the calculation of diluted EPS, if the shares are dilutive, on the basis of an assumption that the options were exercised at the beginning of the period:

The incremental common shares added to diluted EPS of 1,193, along with the weighted-average common shares outstanding when the options are exercised, represent the total impact that the options had on diluted EPS.

If N determined that the average market price for the entire quarterly reporting period was a reasonable approximation of the average market price during the period the options were outstanding, the incremental common shares would have been calculated as follows:

Example 4-3

Forward Contract to Sell Common Shares — Number of Common Shares Varies on the Basis of the Stock Price

Some entities enter into forward contracts that require the counterparty to purchase a fixed dollar amount of the entity’s common shares on a future date. The number of common shares purchased varies on the basis of the entity’s common stock price. These contracts may be referred to as variable share forwards or range forwards. Although such contracts may be entered into on a stand-alone basis, they are commonly entered into as part of a unit offering that goes by many different names (e.g., Feline PRIDES, Upper DECS, MEDS, and PIES). The unit offerings also include a debt instrument with a principal amount equal to the forward price of the forward contract and a maturity date that coincides with the settlement date of the forward contract.

Assume that Company A enters into a variable-share forward contract with Investment Bank G that requires G to purchase A’s common stock for $50 in two years. The market price of A’s common stock on the date the forward contract is entered into is $50 per share. The forward contract contains the following key terms:

Issuance date — December 31, 20X0.
Settlement date — December 31, 20X2, or earlier at the option of A.
Unit price — $50.
Forward price cap — $60.
Forward price floor — $50.
Settlement price — The volume-weighted average closing price for the 20 trading days ending 3 trading days immediately preceding the settlement date (the “average settlement price”).

The number of common shares that G will receive upon settlement will depend on the average closing price of A’s common stock for a specified period immediately preceding the settlement date of the forward contract. Specifically:

If the average settlement price is greater than the forward price cap, G receives 0.833 shares.
If the average settlement price is less than the forward price cap but equal to or greater than the forward price floor, G receives a number of common shares equal to the average settlement price divided by $50 (i.e., $50 worth of common stock).
If the average settlement price is less than $50, G receives one share of common stock.

The forward contract described above is subject to the treasury stock method of calculating diluted EPS; however, in certain situations, the terms of the offering may require application of the if-converted method (see Section 4.8.3.6). For variable-share forward contracts, the treasury stock method is applied as follows:

Number of shares issued — Since the number of common shares issuable varies on the basis of the entity’s stock price, A applies the guidance on variable denominators in ASC 260-10-45-21A. In accordance with this guidance, diluted EPS must reflect the number of common shares that would be issued on the basis of A’s average stock price during the entire reporting period.
Number of shares repurchased — ASC 260 also requires that the average stock price be used to calculate the number of common shares assumed to be repurchased. This calculation would be based on the average market price of A’s common stock during the entire financial reporting period (or the period in which the contract was outstanding during the reporting period if the contract was entered into or settled during the reporting period).

Below are various calculations of the impact of the forward contract on diluted EPS for A’s quarterly financial reporting period ended March 31, 20X1. For each scenario, the average settlement price is calculated in accordance with the guidance in ASC 260-10-45-21A (i.e., on the basis of A’s average stock price during the reporting period — that is, the average of the daily closing quoted prices of A’s common stock for the entire quarterly financial reporting period). It is assumed that these contracts are not participating securities and that the two-class method therefore does not apply.

Scenario 1 — Average Market Price for Period Is $40

Scenario 2 — Average Market Price for Period Is $50

Scenario 3 — Average Market Price for Period Is $60

Scenario 4 — Average Market Price for Period Is $70

As illustrated in these calculations, (1) in all scenarios, the average settlement price equals the average stock price during the reporting period, and (2) this arrangement is dilutive only when the average market price for the entire financial reporting period exceeds the forward cap of $60.

Example 4-4

Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Specified Interest Rate and Expected Dividends

On April 1, 20X1, Company X enters into a forward contract with Investment Bank C that requires X to sell 21 million common shares to C no later than December 31, 20X1 (the maturity date). While all 21 million common shares must be sold and delivered to C no later than the maturity date, if sufficient notice is given, X may deliver all or a portion of the shares at any time between the trade date and the maturity date. Upon an early termination event, X is required to deliver any remaining common shares to C. Company X has classified the forward contract in equity, and it does not represent a participating security. For diluted EPS purposes, physical share settlement of the contract must be assumed.

Significant terms of the forward contract are as follows:

The initial forward price on the trade date is $22.00 per share.
On any day after the trade date, the forward price is equal to the forward price on the immediately preceding calendar day multiplied by the sum of 1 and the daily rate for this day, provided that the purchase price in effect on each forward price reduction date will equal the purchase price otherwise in effect on this date minus the forward price reduction amount for this date.
The daily rate is the USD federal funds rate minus 0.5 percent (the “spread”) divided by 365.
The forward price reduction dates are May 1, 20X1; August 1, 20X1; and November 1, 20X1.
The forward price reduction amount is $0.25 for each forward price reduction date.

Company X is calculating diluted EPS for its quarterly financial reporting period ended June 30, 20X1. The average market price of X’s common stock during the reporting period is $23.50 per share. The forward price as of June 30, 20X1, is $21.96. The lowest forward price during the reporting period is $21.83, which occurs on the May 1, 20X1, forward price reduction date. The average forward price during the reporting period is $21.90.

The forward price varies daily depending on the USD federal funds rate. Depending on the level of interest rates, the daily adjustments could increase or reduce the forward price. If the USD federal funds rate is less than 0.5 percent, the forward price will decline daily. If the USD federal funds rate exceeds 0.5 percent, the forward price will increase daily. The forward price will also decrease by a fixed amount on each forward price reduction date.

To calculate the dilutive effect of the forward contract under the treasury stock method, as discussed in Section 4.2.2.1.2.1, X may apply as an accounting policy any of the following three approaches to calculate the proceeds:

View A — The proceeds reflect the forward price as of the end of the reporting period.
View B — The proceeds reflect the lowest forward price during any day within the reporting period.
View C — The proceeds reflect the average forward price during the reporting period.

The alternative views under the treasury stock method for X’s financial reporting period ended June 30, 20X1, are as follows:

View A

View B

View C

In this example, if the USD federal funds rate stays constant from June 30, 20X1, to December 31, 20X1, because of the two remaining forward price reduction amounts, the forward price at maturity would be $21.46 per common share. However, an entity should not assume that the interest rate at the end of the reporting period stays constant until the maturity date and deduct the remaining forward price reduction amounts to arrive at a lower forward price at maturity. This approach would not reflect the forward price at maturity because interest rates may change.

It is acceptable for an entity to use any of the three approaches discussed above when applying the treasury stock method, regardless of whether the entity or counterparty controls the ability to settle the contract before its stated maturity. However, it is not appropriate to select one of the alternative views if the forward price is fixed only on the basis of scheduled reductions that are intended to approximate anticipated dividends. See the example below for an illustration of this concept.

Example 4-5

Forward Contract to Sell Common Shares — Fixed Forward Prices That Vary on the Basis of the Settlement Date

On September 7, 20X4, Company D enters into a forward contract with Investment Bank M that requires D to sell 10 million common shares to M no later than May 16, 20X5 (the maturity date). While all 10 million common shares must be sold and delivered to M no later than the maturity date, if sufficient notice is given, D may deliver all or a portion of the shares at any time between the trade date and the maturity date. Upon an early termination event, D is required to deliver any remaining common shares to M. Company D has classified the forward contract in equity, and it does not represent a participating security. For diluted EPS purposes, physical share settlement of the contract must be assumed.

The forward price per common share sold is fixed at varying prices that depend on the delivery date(s) of the shares. The fixed prices take into account both the time value of money and expected dividends on D’s common stock. The forward prices are as follows:

Company D is calculating diluted EPS for its quarterly financial reporting period ended December 31, 20X4. The average market price of X’s common stock during the reporting period is $64.50 per share.

Although only one fixed forward price may be operable on any given date, in accordance with ASC 260-10- 45-21, D should calculate diluted EPS in a manner that reflects the most disadvantageous outcome from D’s perspective. Therefore, on each financial reporting period date, D should look at the then-effective forward price and all future forward prices to determine which price is least advantageous to D. That settlement price should be used to calculate the proceeds from the forward under the treasury stock method. This approach is required regardless of whether the entity or counterparty controls the ability to settle the contract before its stated maturity.

For the quarterly period ended December 31, 20X4, the dilutive effect of the forward contract is calculated as follows:

The example below illustrates a forward sale contract with forward prices that decline on the basis of actual dividends.

Example 4-6

Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Actual Dividends

On January 2, 20X5, Company E enters into a forward contract with Investment Bank J that requires E to sell 25 million common shares to J no later than December 31, 20X5 (the maturity date). While all 25 million common shares must be sold and delivered to J no later than the maturity date, if sufficient notice is given, E may deliver all or a portion of the shares at any time between the trade date and the maturity date. Upon an early termination event, E is required to deliver any remaining common shares to J. Company E has classified the forward contract in equity, and it represents a participating security. For diluted EPS, physical share settlement of the contract must be assumed.

The forward price per common share sold is fixed at $65 per share, subject to adjustment only for standard antidilution events and cash dividends paid by E on its common shares. Company E typically pays a quarterly cash dividend of $1 per share on its common shares on March 15, June 15, September 15, and December 15.

Under the treasury stock method, the assumed proceeds should be based on the forward price at the end of the reporting period. While E may reasonably expect the forward price per share at maturity to decrease to $61 because of cash dividends it expects to declare, if only the passage of time is assumed, the forward price on each reporting date will not decline. Because E is under no obligation to pay any cash dividends on its common stock and E’s board of directors must declare a cash dividend before it is payable, under the treasury stock method, it should not be assumed that future dividends will be paid.

By contrast, when prespecified fixed adjustments are made to the forward price of a forward sale contract that are designed to represent anticipated dividends, upon the mere passage of time, the forward price will be adjusted; therefore, in accordance with ASC 260-10-45-21, the entity must assume that the proceeds will represent the lowest forward price during the remaining term of the contract. However, when the forward price is reduced only for actual dividends, because dividends do not need to be recognized under GAAP before they are declared, an entity is not required to anticipate the amount of future dividends that will be declared in determining proceeds under the treasury stock method. Rather, the forward contract is a participating security and distributed and undistributed earnings are taken into account in the calculation of basic EPS by using the two-class method. Diluted EPS is based on the more dilutive of the treasury stock method or the two-class method.

Example 4-7

Option to Sell Convertible Preferred Stock

Assume the following:

On January 1, 20X1, Company G issues 1,000 options that allow the counterparty to purchase a share of convertible preferred stock at $5,000 per share.
The convertible preferred stock is convertible into common stock at $25 per share at any time after two years (i.e., the holder can receive 200 shares of common stock for each share of convertible preferred stock).
The convertible preferred stock pays an annual dividend of $500 per share.
On the date the options are issued, G’s common stock is trading at $25 per share.
For the period ended December 31, 20X3, G’s common stock has an average market price of $40 per share.
For diluted EPS purposes, share settlement of the option must be assumed.

For the period ended December 31, 20X3, G must apply the treasury stock method to calculate diluted EPS because the options are in-the-money from the perspective of the counterparty. Under the treasury stock method, G must assume that the counterparties to the options would elect to exercise their options and purchase convertible preferred stock, which they would then convert into common stock. The calculation of the diluted impact of the options is as follows:

In this example, it is assumed that G classifies the option in equity. If the option were classified as a liability, G would also need to adjust the numerator if the aggregate effect of the numerator adjustment and incremental common shares is dilutive. See further discussion in Section 4.2.2.3.1 and Example 4-31.

Example 4-8

Forward to Sell Convertible Debt

On June 15, 20X1, Company Z enters into a forward contract to sell convertible debt securities to Investor A. The forward contract requires settlement on June 30, 20X2. Company Z enters into the contract as a capital-raising activity; however, since Z does not need the proceeds until the second half of 20X2 and A wants to lock in the purchase price, the parties enter into the contract before the convertible debt securities are actually issued.

According to the terms of the forward contract, A is required to pay $500 million to Z on June 30, 20X2, and Z is required to issue $500 million of convertible debt securities to A with the following terms:

Principal amount — $500 million (or $10,000 per debt security issued).
Number of securities — 50,000.
Maturity date — December 31, 20X9.
Interest rate — 4 percent per annum, payable quarterly in arrears.
Conversion terms — Convertible at any time after issuance at an initial conversion price of $25 per security, subject to adjustment for standard antidilution events, declining to $20 per security beginning on January 1, 20X9. Physical settlement is required for any conversion.

Company Z’s common stock price on the issuance date of the forward contract is $17.50 per share (i.e., the conversion option in the convertible debt instrument has no intrinsic value on the issuance date of the forward).

Company Z is calculating diluted EPS for the third quarter ended September 30, 20X1, and has concluded that it is not required to account for the forward contract as a liability, with changes in fair value recognized in earnings. The average market price of Z’s common stock for the quarter ended September 30, 20X1, is $22.50 per share.

The dilutive impact of the forward contract to sell convertible securities is calculated as follows:

See Section 4.10 for a comprehensive example illustrating the use of the treasury stock method in the calculation of diluted EPS. See Section 7.1.2.1.5 for examples of the application of the treasury stock method to share-based payment arrangements.

Footnotes

The treasury stock method does not apply to purchased options because they are always antidilutive (see Section 4.1.1.1).

The unpaid portion of a stock subscription agreement and common stock issued in return for a note receivable may be treated as written call options on common stock in the calculation of diluted EPS. See Sections 4.8.3.1 and 4.8.3.2 for more information.

It may be unclear whether an entity should apply the guidance on contingently issuable shares in ASC 260-10-45-48 through 45-57 or the guidance on variable denominators in ASC 260-10-45-21A. In these situations, entities must use judgment and there could be diversity in practice. On the basis of informal discussions with the FASB staff, we understand that the amendments to ASC 260 made by ASU 2020-06 were not intended to change how entities determine whether the guidance on contingently issuable shares applies. In those discussions, the FASB staff acknowledged that the guidance in ASC 260 that addresses what constitutes a contingently issuable share is often difficult to interpret in practice.

For more information about how the variability in terms of an equity-linked financial instrument affects its classification, see Chapter 4 of Deloitte’s Roadmap Contracts on an Entity’s Own Equity.

The average is generally a simple average. The use of a volume-weighted average is not necessarily more precise or more representative of the average market price of the entity’s common stock during a period.

If the contract represents a share-based payment award, the adjustment to the numerator should only reflect the incremental effect of the different accounting classification (i.e., the numerator is adjusted to reflect the compensation expense that would have been recognized during the reporting period if the award had been classified in equity). An adjustment to the proceeds is also required because the average compensation cost not yet recognized for financial reporting purposes must also be based on the amount that would have been left unrecognized if the award had been accounted for as an equity award. See further discussion in Section 7.1.4.

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