4.4 If-Converted Method

4.4.1 Scope

ASC 260-10

Convertible Securities and the If-Converted Method

45-40 The dilutive effect of convertible securities shall be reflected in diluted EPS by application of the if-converted method. . . .

ASC 260-10-45-40 states that the if-converted method applies to convertible securities. ASC 260-10-20 defines a convertible security as “[a] security that is convertible into another security based on a conversion rate.” While convertible debt and preferred securities are the most common types of convertible securities subject to the if-converted method, this method is not limited to instruments that allow the counterparty to benefit from increases in the price of the entity’s common stock. Rather, in accordance with the definition of convertible security in ASC 260-10-20, the if-converted method applies to any security that is convertible into another security on the basis of a conversion rate. Thus, the if-converted method applies to any of the following securities:

Convertible debt securities.
Convertible preferred stock.
Mandatorily convertible securities.
Common stock that is convertible into another class of common stock.
Stock-settled debt.

The if-converted method also applies to written call options and forward sale contracts that, upon settlement, cause the counterparty to receive common shares of the entity when either of the following conditions is met:

The counterparty is required to tender a debt security or preferred security of the entity as payment of the exercise price or forward price.
The counterparty has the option to pay the exercise price or forward price in either (1) cash or (2) a debt security or preferred security of the entity, and payment of the debt security or preferred security is more advantageous to the counterparty than paying cash. See further discussion in Section 4.6.

There are some exceptions to the application of the if-converted method to the contract types discussed above. Specifically, an entity should not apply the if-converted method to calculate the dilutive impact in the following situations:

Settlement of conversion for the convertible security is required entirely in cash (i.e., no common shares are issued on settlement of the conversion feature). See Section 4.7 for discussion of contracts settled in cash.
The two-class method of calculating diluted EPS is more dilutive than the application of the if-converted method to convertible securities that are participating securities. See Section 5.5.4 for discussion of the two-class method of calculating diluted EPS.

Connecting the Dots

The treasury stock method never applies to the calculation of a convertible security’s impact on diluted EPS. Rather, ASC 260-10-45-40 requires that an entity use the if-converted method to calculate the dilutive effect of convertible securities. However, for an Instrument C convertible debt security, the if-converted method is applied in a manner that produces the same dilution as the treasury stock method.

In the discussion below, it is assumed that the convertible securities are subject to the if-converted method and do not represent participating securities. If convertible securities subject to the if-converted method meet the definition of a participating security, as discussed in Section 5.5.4, an entity must apply the more dilutive of the if-converted method or the two-class method of calculating diluted EPS. Chapter 6 includes more detailed discussion of the appropriate method applied to determine the dilutive effect of different types of convertible debt securities.

4.4.2 Application of the If-Converted Method

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.

Convertible Securities and the If-Converted Method

45-40

The dilutive effect of convertible securities shall be reflected in diluted EPS by application of the if-converted method. Under that method:

If an entity has convertible preferred stock outstanding, the preferred dividends applicable to convertible preferred stock shall be added back to the numerator. The amount of preferred dividends added back will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.
If an entity has convertible debt outstanding:

1. Interest charges applicable to the convertible debt shall be added back to the numerator. For convertible debt for which the principal is required to be paid in cash, the interest charges shall not be added back to the numerator.

2. To the extent nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt never been recognized, the numerator shall be appropriately adjusted. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.

3. The numerator shall be adjusted for the income tax effect of (b)(1) and (b)(2).
The convertible preferred stock or convertible debt shall be assumed to have been converted at the beginning of the period (or at time of issuance, if later), and the resulting common shares shall be included in the denominator. See paragraph 260-10-45-21A if the incremental shares are variable (such as when calculating a conversion premium).

45-41 In applying the if-converted method, conversion shall not be assumed for purposes of computing diluted EPS if the effect would be antidilutive. Convertible preferred stock is antidilutive whenever the amount of the dividend declared in or accumulated for the current period per common share obtainable on conversion exceeds basic EPS. Similarly, convertible debt is antidilutive whenever its interest (net of tax and nondiscretionary adjustments) per common share obtainable on conversion exceeds basic EPS.

45-42 Dilutive securities that are issued during a period and dilutive convertible securities for which conversion options lapse, for which preferred stock is redeemed, or for which related debt is extinguished during a period, shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise, dilutive convertible securities converted during a period shall be included in the denominator for the period prior to actual conversion. The common shares issued upon actual conversion shall be included in the denominator for the period after the date of conversion. Consequently, shares assumed issued shall be weighted for the period the convertible securities were outstanding, and common shares actually issued shall be weighted for the period the shares were outstanding.

4.4.2.1 No Antidilution

ASC 260-10-45-41 prohibits application of the if-converted method, and conversion is not assumed, if the effect of such application would be antidilutive. ASC 260-10-45-41 also provides guidance on how to evaluate whether an individual convertible debt or convertible preferred security would be antidilutive. In addition to determining whether a convertible security is individually antidilutive, an entity must consider the antidilution sequencing requirements (see Section 4.1.2.3).

The determination of whether a convertible security is dilutive to EPS should be made as of each reporting date. The current fair value of the entity’s common stock relative to the conversion price of the convertible security is not relevant to this determination (see Example 4-11). Unlike the treasury stock method, which applies only to in-the-money written freestanding call options on common stock, the if-converted method applies to convertible securities that are out-of-the-money if the effect is dilutive. As a result of this difference, the if-converted method is often more dilutive than the treasury stock method. See Chapter 6 for further discussion.

4.4.2.2 Numerator Adjustments

Under the if-converted method, an entity must make various adjustments to the numerator (i.e., income available to common stockholders). Those adjustments include the following, as applicable:

Convertible debt (including share-settled debt):
- Interest expense recognized during the period is added back to the numerator (see Section 4.4.2.2.1) unless the principal amount of the convertible debt instrument must be paid in cash (i.e., an Instrument C convertible debt instrument).15
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if interest on the convertible debt had not been recognized, the numerator should be adjusted (see Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.3).
- Certain gains or losses recognized on actual settlement of the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.4).
- An entity should adjust the numerator for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
Convertible preferred stock:
- Dividends that reduced the numerator during the reporting period are added back to the numerator (see Section 4.4.2.2.1.2).
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if dividends on the convertible preferred stock had not reduced income available to common stockholders, the numerator should be adjusted (see also Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible preferred stock instrument should be reversed from the numerator (see also Section 4.4.2.2.3).
- Certain deemed dividends recognized on actual settlement of the convertible preferred stock instrument that reduced net income to arrive at income available to common stockholders should be reversed from the numerator (see Section 4.4.2.2.4).
- The numerator should be adjusted for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
Common stock convertible or exchangeable into another class of common stock:
- Under the if-converted method, an entity does not typically need to adjust the numerator when common stock is convertible or exchangeable into another class of common stock. Rather, the calculation of diluted EPS for the class of common stock into which the other class is exchangeable or convertible will include the effect of conversion under the if-converted method. However, the two-class method may be more dilutive than the if-converted method. See further discussion in Section 5.5.4.

Connecting the Dots

An entity must take additional considerations into account when its capital structure includes multiple classes of common stock or participating securities. Even if an entity’s convertible debt or convertible preferred stock does not meet the definition of a participating security, given the effect of the if-converted method on the numerator, an entity will be required to reallocate undistributed earnings among multiple classes of common stock or participating securities under the two-class method.

If an entity’s convertible debt or convertible preferred stock meets the definition of a participating security, the if-converted method is applied only if its application is more dilutive than the two-class method of calculating diluted EPS. When the two-class method of calculating diluted EPS is more dilutive, an entity may need to reallocate undistributed earnings to the convertible debt or convertible preferred stock when applying this method. See Chapter 5 for further discussion of participating securities and the two-class method.

4.4.2.2.1 Interest and Dividends

4.4.2.2.1.1 Capitalized Interest16

ASC 835-20 specifies that the historical cost of acquiring an asset includes the costs necessarily incurred to bring it to the condition and location necessary for its intended use. If activities necessary to bring an asset to that condition and location must be performed, the interest costs incurred during that period as a result of expenditures for the asset are included in the historical cost of acquiring the asset. As noted in ASC 350-40, interest costs incurred while developing internal-use computer software may be capitalized in accordance with ASC 835-20. The capitalization of interest costs introduces additional complexities with respect to calculating the add-back to the numerator related to (1) interest expense that would not have been recognized had the convertible debt instrument not been outstanding during the reporting period and (2) capitalized interest that was subsequently recognized in earnings as part of the subsequent accounting for the qualifying assets.

4.4.2.2.1.1.1 Interest Costs Capitalized During the Reporting Period

Only interest costs that have been expensed during a financial reporting period may be added back to the numerator during that reporting period. The capitalization of interest costs should not result in any additional complexity under the if-converted method if an entity either (1) has recognized interest costs only on convertible debt instruments subject to the if-converted method (e.g., the entity has no other borrowings outstanding) or (2) has convertible debt instruments subject to the if-converted method that are associated with specific qualifying assets. The entity will simply add back to the numerator the interest expense recognized in earnings on its convertible debt (i.e., the portion not capitalized, which will be readily identifiable) and any related tax effects. However, if an entity has outstanding debt other than convertible debt and does not associate the convertible debt with specific qualifying assets, the capitalization rate used to calculate the amount of interest costs capitalized into the carrying amount of qualifying assets will reflect a composite rate comprising interest costs incurred on convertible debt and other borrowings not subject to the if-converted method. In this circumstance, the entity will need to consistently apply a systematic and rational method to determine the following amounts:

The amount of interest costs incurred on convertible debt instruments subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.
The amount of the interest costs incurred on other borrowings not subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.

Once these amounts are determined, in applying the if-converted method, the entity should add the following three amounts back to the numerator (assuming that the addition of these amounts to the numerator and the common shares included in the denominator is dilutive on the basis of the antidilution sequencing requirements):

The amount of interest costs incurred during the reporting period on convertible debt instruments subject to the if-converted method that was recognized as an expense.
The amount of interest costs incurred during the reporting period on other borrowings not subject to the if-converted method that was recognized as an expense but that would have been capitalized if interest costs had not been incurred on convertible debt instruments subject to the if-converted method (i.e., under the assumption that the convertible debt instruments were converted at the beginning of the period or upon issuance if the convertible debt instrument was issued during the period). (This adjustment reflects a nondiscretionary adjustment under the if-converted method.)
The tax effect of the amounts in the first two bullets.

Entities will generally need to use a “with and without” approach to determine the amounts in the first two bullets above. However, in certain circumstances, an entity may be able to conclude that the total interest costs capitalized would have been unchanged (or would not have been materially different) if the convertible debt instruments subject to the if-converted method had not been outstanding during the reporting period. In these situations, the entity could simply add to the numerator the interest costs incurred on the convertible debt during the reporting period, net of tax.

Connecting the Dots

On the basis of materiality, some entities apply an accounting convention and do not capitalize interest on qualifying assets. In these situations, the amount of interest costs incurred on convertible debt instruments subject to the if-converted method that is added back to the numerator should reflect the amount actually reflected as an expense during the reporting period. Such entities should not perform the calculations described above because it would be inappropriate to add back a hypothetical amount that is calculated as if interest costs on qualifying assets had been capitalized.

4.4.2.2.1.1.2 Capitalized Interest Costs Subsequently Reflected in Earnings

Capitalized interest costs increase the basis of qualifying assets, resulting in an increase in depreciation expense for assets placed into service, a decrease in the gain on sale (or increase in loss on sale) for assets sold, or a decrease in the recognized earnings (or increase in the recognized losses) for equity method investees. Neither ASC 260 nor ASC 835-20 addresses the treatment of the earnings impact of capitalized interest costs under the if-converted method. Therefore, entities should consistently apply one of the following two approaches as an accounting policy election and provide appropriate disclosures:

Add back to the numerator the amounts of capitalized interest costs reflected in earnings during the reporting period that arose from interest costs capitalized during the reporting period, net of tax.
Do not add back to the numerator any amounts of capitalized interest costs that are reflected in earnings during the reporting period.

Although more conceptually pure, the first approach could be extremely complex. Under this approach, the objective is to add back to the numerator an amount arising from interest costs capitalized during the reporting period that would not have reduced earnings if the convertible debt instrument had not been outstanding during the reporting period. As discussed in Section 4.4.2.2.1.1.1, the mere calculation of the interest cost adjustment to the numerator is complex; this approach adds further complexity to the if-converted method.

It is not appropriate for an entity to apply an accounting policy under which it adds back to the numerator amounts that affected earnings during the reporting period that arose from interest costs capitalized in prior periods. This type of accounting approach is inconsistent with the guidance in ASC 260 on nondiscretionary adjustments because the expense amount that would be added back to the numerator would have been incurred regardless of whether the convertible debt instrument was outstanding during the current reporting period. This approach could also result in counting the same amounts as an “add-back to the numerator” in multiple reporting periods. Lastly, this approach is not consistent with ASC 260’s objective that the calculation of EPS reflect performance based on what has occurred during a reporting period. Because this approach is not acceptable, the selection between the two approaches discussed above will generally not result in material differences because the amount of interest costs capitalized and subsequently expensed in the same quarterly reporting period is generally insignificant.

4.4.2.2.1.2 Dividends

As discussed in Section 3.2.2, dividends on preferred stock reduce income available to common stockholders, or the numerator, in the calculation of basic EPS. ASC 260-10-45-40(a) states, in part, that “[t]he amount of preferred dividends added back [to the numerator] will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.” Thus, each type of dividend discussed in Section 3.2.2 that reduced the numerator in the calculation of basic EPS should be added back to the numerator under the if-converted method. As a result, such dividends that reduced basic EPS have no impact on the calculation of diluted EPS. Rather, the dilution of EPS that results from convertible preferred stock is captured through an assumption that the common shares issuable on conversion were outstanding during the reporting period.

Connecting the Dots

As discussed in Section 3.2.2, the application of ASC 260-10-S99-2 and ASC 480-10-S99-3A may result in deemed contributions during a period. In these circumstances, the amount of the contributions should be subtracted from income available to common stockholders under the if-converted method. See Sections 4.4.2.2.4 and 4.4.2.4.1 for additional considerations related to situations in which preferred stock is settled during a reporting period.

4.4.2.2.2 Nondiscretionary Adjustments

ASC 260 states that expenses or charges (other than interest expense on convertible debt) should be added back to the numerator as a nondiscretionary adjustment only if such amounts were “determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.” To meet the definition of a nondiscretionary adjustment, an income statement item must possess both of the following characteristics:

It is calculated on the basis of net income or loss or a similar measure — Similar measures could include net interest income, interest expense, income available to common stockholders, or EPS. Thus, a nondiscretionary adjustment could potentially arise for convertible preferred stock since the measure is not limited to items that affect an entity’s net income.
It arises from a contractual right or obligation of the entity — Any amount that does not arise from a contractual right or obligation of the entity is subjective and cannot be considered nondiscretionary.

Since a nondiscretionary adjustment must possess both of the characteristics described above, the types of nondiscretionary adjustments made under the if-converted method will be significantly limited in scope. See also Example 4-14.

Connecting the Dots

ASC 260-10-45-40(b)(2) states that if there are nondiscretionary adjustments that would have been calculated differently if interest expense on the convertible debt had not been recognized, “[t]he numerator shall be appropriately adjusted.” Thus, nondiscretionary adjustments may increase or decrease the numerator. In some cases, a nondiscretionary adjustment may arise from a contract that is recognized at fair value through earnings. In these circumstances, it is appropriate to calculate the fair value adjustment that would have been recognized during the period if interest expense on the convertible debt instrument had not been recognized during the period.

ASC 260-10-45-40(b)(2) does not specifically discuss situations in which the if-converted method is applied to a convertible debt instrument for which the principal amount must be paid in cash (i.e., an Instrument C convertible debt security). However, an entity should not make any nondiscretionary adjustments in such circumstances because ASC 260-10-45-40(b)(1) prohibits an entity from adding back interest charges on such convertible debt instruments to the numerator. Accordingly, net income or loss for the period would not change and no nondiscretionary adjustments would therefore be needed.

4.4.2.2.3 Mark-to-Market Adjustments

Except for convertible debt instruments that contain a separately recognized equity component, an entity may elect the fair value option and account for convertible debt at fair value, with changes in fair value recognized in earnings.17 The fair value option is often elected to avoid separation of an embedded derivative in accordance with ASC 815-15. In other situations, an entity may separate an embedded conversion option, redemption option, or other embedded feature from the host debt instrument and account for the bifurcated derivative at fair value under ASC 815-15.

Accounting for a convertible debt instrument at fair value under the fair value option, or separating an embedded derivative, does not obviate the need to apply the if-converted method. However, when a convertible debt instrument is accounted for at fair value, or the embedded conversion option or other embedded feature is separated as a derivative, the mark-to-market adjustment recognized in earnings during the reporting period must be reversed and treated as an adjustment to the numerator under the if-converted method. This adjustment is similar to the add-back to the numerator of interest expense on convertible debt instruments and applies to all convertible debt instruments and is only made if the combined effect of the numerator and denominator adjustments is dilutive.

If an entity has the option of settling a conversion of a convertible debt instrument in cash or stock and (1) the embedded conversion option has not been separated as an embedded derivative and (2) the fair value option has not been applied to the instrument, the entity would not adjust the numerator to reflect a mark-to-market amount that would have been recognized during a reporting period if the embedded conversion option had been separated or the fair value had been applied. Rather, the if-converted method would be applied, if dilutive.

Connecting the Dots

ASC 825-10-45-5 requires entities to “present separately in other comprehensive income the portion of the total change in the fair value” of a financial liability that is recognized at fair value through earnings and that “results from a change in the instrument-specific credit risk.” Since the credit component does not enter into the determination of net income, it should be excluded from the adjustment made to the numerator in the calculation of diluted EPS. This credit component would only be included in the adjustment to the numerator if the entity presented comprehensive income per share.

4.4.2.2.4 Settlement Adjustments

The conversion of a convertible security into common shares in accordance with the original conversion privileges may affect income available to common stockholders. The table below discusses some of these types of situations.

Table 4-6

Conversion Type	Impact on Numerator of Conversion
Convertible debt with a modified embedded conversion option (i.e., the embedded conversion option was modified in a transaction not accounted for as an extinguishment at some point before conversion)	Any remaining unamortized discount arising from the recognition of the discount on the convertible debt instrument (i.e., from the amount recognized in equity resulting from the modification of the convertible debt instrument) is recognized as interest cost (see Table 6-1).
Convertible preferred stock with a modified embedded conversion option (i.e., the embedded conversion option was modified in a transaction not accounted for as an extinguishment at some point before conversion)	Any remaining unamortized discount arising from the recognition of the discount on the convertible preferred stock instrument (i.e., from the amount recognized in equity resulting from the modification of the convertible preferred stock instrument) is recognized as a dividend on preferred stock (see Table 3-7).
Convertible debt with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion)	Any remaining unamortized discount on the convertible debt instrument is recognized as interest cost in accordance with ASC 815-15-40-1.
Convertible preferred stock with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion)	Any remaining unamortized discount on the convertible preferred stock instrument is recognized as a dividend on preferred stock (see Table 3-7).

Questions often arise regarding how the gains and losses and deemed dividends discussed in the table above affect the numerator under the if-converted method. Two views may be considered in such situations:

View A — The numerator should be adjusted to include the effect on income available to common stockholders that would have been recognized if all convertible securities outstanding during the reporting period had been converted at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity would need to calculate one or both of the following:
- Convertible securities outstanding at the end of the reporting period — The impact on income available to common stockholders that would have been recognized if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later).
- Convertible securities converted during the reporting period — The incremental impact on income available to common stockholders if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later). In this adjustment, an entity would reflect an increase or decrease to the amount that was recognized in income available to common stockholders, assuming an earlier conversion. To calculate this amount, the entity would need to determine the incremental effect on interest expense or dividends recognized, which could be affected by the discount amortization that was recognized before conversion.
View B — The numerator should not reflect any impact on income available to common stockholders as a result of assumed conversion at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity should (1) not adjust the numerator for convertible securities outstanding at the end of the period for any interest expense or dividends that would have been recognized if conversion had occurred at the beginning of the reporting period (or the date of issuance, if later) and (2) reverse from the numerator any interest expense or dividends that was recognized for convertible securities that were converted during the reporting period.

View B is appropriate because it is consistent with ASC 260-10-S99-2 (see Section 4.4.2.4.1) and the objective of the if-converted method. The if-converted method is designed to replace the (1) effect on the numerator when convertible securities are outstanding at any point during a reporting period with (2) common shares issuable upon conversion. Any interest expense or deemed dividends that would be recognized, if conversion is assumed, at the beginning of the period (or the date of issuance, if later) is not related to an equity transaction; rather, it results from the settlement of the host debt or preferred stock instrument and therefore should not factor into the determination of dilution under the if-converted method. Under the if-converted method, it is assumed that the cost of carrying a convertible security during a reporting period is fully replaced with the common shares that holders would own as equity investors during the reporting period. That is, the holder can participate in the earnings of the entity as either a holder of a security senior to common stock or as a holder of common stock, but not both. The interest expense or deemed dividends associated with conversion of the types of convertible securities referred to in Table 4-6 is considered participation as an investor in a security other than common shares.

One could argue View A on the basis that the original guidance that was codified in ASC 260-10-45-40 was issued before the release of the guidance referred to in Table 4-6 that requires entities to recognize such amounts upon conversion. Supporters of View A could also suggest that this view is consistent with (1) the definition of the if-converted method in the ASC master glossary, which states that it is “[a] method of computing EPS data that assumes conversion of convertible securities at the beginning of the reporting period (or at time of issuance, if later),” and (2) ASC 260-10-45-16, which states, in part, that “[t]he numerator also is adjusted for any other changes in income or loss that would result from the assumed conversion of . . . potential common shares.” However, View A is not required because ASC 260 does not mandate this approach and the adjustments discussed in ASC 260-10-45-16 pertain to items other than the convertible security that would have had a different impact on the numerator if the convertible security had not been outstanding during the reporting period.

4.4.2.2.5 Income Tax Effects

The income tax effects of adjustments to the numerator, if any, that are made under the if-converted method should be based on the application of ASC 740 and should reflect the marginal tax effect, if any, of adjustments to the numerator. Depending on the nature of the adjustment, the income tax consequences could be complex. For example, adjustments to the numerator could affect an entity’s assessment of whether a valuation allowance should be established or adjusted for deferred tax assets. For convertible preferred stock instruments, income tax adjustments are often unnecessary because dividends on preferred stock are generally not deductible.

4.4.2.3 Denominator Adjustments

Under the if-converted method, the denominator includes the common shares issuable upon conversion of convertible securities. The number of common shares issuable upon conversion of convertible securities 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 conversion varies only on the basis of the passage of time, the 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 the convertible security is outstanding and should assume conversion upon terms that maximize value to the counterparty.

If the number of common shares issuable upon conversion is subject to adjustment on the basis of the occurrence or nonoccurrence of a specified event that is not within the counterparty’s control (other than changes in the fair value of the entity’s stock price), the entity should apply the guidance on contingently issuable shares to determine the number of common shares issuable upon conversion. As discussed in Section 4.5, the entity should assume that the current status of the condition on 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 convertible securities subject to the if-converted method will have no impact on the application of this method unless and until such adjustment events occur. Table 4-3 lists common adjustment events that will have no impact on the application of the if-converted method before the occurrence of the related event.

If the number of common shares issuable upon conversion is linked to a specified rate, price, index, or other variable, the convertible security is considered to contain a variable conversion price. If the number of common shares issuable upon conversion 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 number of common shares issued on conversion on the basis of the average market price of the entity’s stock during the reporting period. (See Example 4-13 for an illustration of this concept.) If, however, the number of common shares issuable upon conversion 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 number of common shares issuable upon conversion reflects the conversion price at the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Under that guidance, it is assumed that the contingency (in this case, the conversion price) is resolved as of the end of the reporting period. Thus, an entity calculates the conversion 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 conversion 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 number of common shares issuable upon conversion is based on the lowest conversion price (highest conversion rate) available to the counterparty 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 conversion prices applicable for the entire time during the reporting period in which the convertible security was outstanding and should use the conversion price that is least advantageous to the entity and produces the highest number of common shares for the investor. The entity should not project future conversion prices since they will vary on the basis of changes in the rate, price, index, or other variable.
View C: The number of common shares issuable upon conversion is based on the average conversion 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 conversion (since neither party ultimately controls the rate, price, index, or other variable that affects the conversion price). The approach selected is considered an accounting policy election that must be applied consistently and disclosed.

If the convertible security or any embedded feature in the convertible security is classified as a liability and recognized at fair value, with changes in fair value reported in earnings, which may be required because of the variable terms of the contract, an entity must also adjust the numerator in calculating diluted EPS, as discussed in Section 4.4.2.2.3.

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

4.4.2.4 Instruments Issued, Redeemed, Converted, or Otherwise Settled During a Financial Reporting Period

If a convertible security is issued, redeemed, converted, or otherwise settled during a financial reporting period, the dilutive effect of the if-converted method should be included in the calculation of diluted EPS for the portion of the period in which the convertible security was outstanding. The incremental common shares added to the denominator should be weighted for the time outstanding during the reporting period.

4.4.2.4.1 Redemption or Induced Conversion of Convertible Securities

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 . . . When a registrant effects a redemption or induced conversion of only a portion of the outstanding securities of a class of preferred stock, the SEC staff believes that, for the purpose of determining whether the “if-converted” method is dilutive for the period, the shares redeemed or converted should be considered separately from the other shares of the same class that are not redeemed or converted. The SEC staff does not believe that it is appropriate to aggregate securities with different effective dividend yields when determining whether the “if-converted” method is dilutive, which would be the result if a single, aggregate computation was made for the entire series of preferred stock.

For example, assume a registrant has 100 shares of convertible preferred stock outstanding at the beginning of the period. The convertible preferred stock was issued at fair value, which was equal to its par value of $10 per share, and has a stated dividend of 5 percent, and each share of preferred stock is convertible into 1 share of common stock. During the period, 20 preferred shares were redeemed by the registrant for $12 per share.

In this example, the SEC staff believes that the registrant should determine whether conversion is dilutive (1) for 80 of the preferred shares by applying the “if-converted” method from the beginning of the period to the end of the period using the stated dividend of 5 percent and (2) for 20 of the preferred shares by applying the “if-converted” method from the beginning of the period to the date of redemption using both the stated dividend of 5 percent and the $2 per share redemption premium.

Accordingly, assuming that the dividend for the period for the preferred stock was $0.125 per share, a determination of whether the 20 redeemed shares are dilutive should be made by comparing the $2.125 per-share effect of assuming those shares are not converted to the effect of assuming those 20 shares were converted into 20 shares of common stock, weighted for the period for which they were outstanding. The determination of the “if-converted” effect of the 80 shares not redeemed should be made separately, by comparing the EPS effect of the $0.125 per-share dividend to the effect of assuming conversion into 80 shares of common stock.

As discussed in the SEC staff’s guidance in ASC 260-10-S99-2, when less than all shares of a class of convertible preferred stock are redeemed or converted in accordance with an inducement offer, the unit of account in the calculation of diluted EPS must be separated into the shares redeemed or converted and the remaining shares. Such separation results in the most dilutive calculation, which is consistent with the objective of diluted EPS. Further, although this issue is not specifically discussed in the SEC staff guidance above, the same approach should be applied when a portion of a class of convertible debt instruments is redeemed or converted in accordance with an inducement offer.

Connecting the Dots

When convertible securities are converted during a reporting period in accordance with an inducement offer, under the if-converted method, it is assumed that the securities were converted at the beginning of the reporting period or on the date of issuance, if later, on the basis of the stated conversion terms. Because the numerator adjustment will reflect a reversal of the additional consideration provided under the inducement offer, the application of the if-converted method during a period in which an induced conversion has occurred will typically be antidilutive for the specific securities that were settled in accordance with the inducement offer.

4.4.3 Contingently Convertible Instruments

ASC 260-10

Contingently Convertible Instruments

45-43 While the terms of contingently convertible instruments vary, a typical instrument includes a market price trigger that exceeds a specified conversion price of the issuer’s underlying stock price on the date of issuance by a specified percentage (for example, 10 percent, 20 percent, or 30 percent). Some contingently convertible instruments have floating market price triggers for which conversion is dependent upon the market price of the issuer’s stock exceeding the conversion price by a specified percentage or percentages at specified times during the term of the debt. Other contingently convertible instruments require that the market price of the issuer’s stock exceed a specified level for a specified period (for example, 20 percent above the conversion price for a 30-day period). In addition, contingently convertible instruments may have additional features such as parity features, issuer call options, and investor put options.

45-44 Contingently convertible instruments shall be included in diluted EPS (if dilutive) regardless of whether the market price trigger has been met. There is no substantive economic difference between contingently convertible instruments and convertible instruments with a market price conversion premium. The treatment for diluted EPS shall not differ because of a contingent market price trigger. The guidance provided in this paragraph also shall be applied to instruments that have multiple contingencies if one of the contingencies is a market price trigger and the instrument is convertible or settleable in shares based on meeting a market condition — that is, the conversion is not dependent (or no longer dependent) on a substantive non-market-based contingency. For example, this guidance applies if an instrument is convertible upon meeting a market price trigger or a substantive non-market-based contingency (for example, a change in control). Alternatively, if the instrument is convertible upon achieving both a market price trigger and a substantive non-market-based contingency, this guidance would not apply until the non-market-based contingency has been met. See Example 11 (paragraph 260-10-55-78) for an illustration of this guidance.

ASC 260-10-45-43 and 45-44 address when the if-converted method should be applied to convertible securities that are contingently convertible into common shares on the basis of a market price trigger or a market price trigger combined with a non-market-based contingency. Examples of non-market-based contingencies include an IPO and a change of control. The guidance in ASC 260-10-45-43 and 45-44 applies to all types of convertible instruments subject to the if-converted method. In accordance with this guidance, as well as the guidance applicable to contingently issuable shares, the application of the if-converted method to contingently convertible securities is as follows:

If the instrument becomes convertible only if (1) a specified price of the entity’s common stock (i.e., a market price trigger) is achieved or (2) either a market-price trigger or some other non-market-based contingency is met, the if-converted method should be applied, if dilutive, regardless of whether the contingencies are met.
If the instrument becomes convertible only if (1) a substantive non-market-based contingency is met or (2) a market price trigger and some other substantive non-market-based contingency are met, the if-converted method should be applied only if the non-market-based contingency has been met. For this purpose, the evaluation of whether the non-market-based contingency has been met should be as of the end of the reporting period. If the non-market-based contingency is met as of the reporting date and application of the if-converted method is dilutive, the dilutive effect should be included in diluted EPS from the beginning of the reporting period or the date of issuance, if later. This approach is consistent with the diluted EPS approach applied to contingently issuable shares (see Section 4.5). See Section 4.9.3 for discussion of application of the if-converted method to the calculation of year-to-date diluted EPS.

If a non-market-based contingency only accelerates the timing of the counterparty’s ability to convert the instrument into common shares, the non-market-based contingency is ignored and the if-converted method applies in all periods in which the convertible security is outstanding if the method is dilutive on the basis of the antidilution sequencing requirements of ASC 260. This situation may exist when a convertible security is convertible at the holder’s option at or near maturity and contingently convertible sooner on the basis of a non-market-based contingency.

4.4.4 Examples

Example 4-11

Relevance of Current Fair Value of Common Stock

Company A has issued nonparticipating convertible debt that permits the counterparty to convert the debt into common stock at a conversion price of $10 per common share. Any conversion must be settled entirely in common stock. The fair value of A’s common stock as of the date the convertible debt is issued is $8 per share. At the end of the reporting period, the fair value of A’s common stock is $6 per share and, for the reporting period, the average market price of A’s common stock is $7. While, economically, a counterparty would not be expected to convert the debt into common stock at any point during the reporting period, A must apply the if-converted method in calculating diluted EPS if the effect is dilutive. In performing this assessment, an entity should first determine whether the interest expense (net of taxes and any discretionary adjustments) per common share obtainable on conversion is less than basic EPS. If so, the convertible debt instrument is individually dilutive and the entity must next consider the antidilution sequencing requirements (see Section 4.1.2.3). If the convertible debt is dilutive in the context of A’s capital structure under the antidilution sequencing guidance, the if-converted method must be applied in the calculation of diluted EPS even though a rational investor would not convert the debt instrument.

Example 4-12

Application of If-Converted Method to Outstanding Convertible Preferred Stock and Convertible Debt

Company B, a calendar-year entity, has the following convertible securities outstanding:

Convertible preferred stock — $1 million of cumulative convertible preferred stock. The convertible preferred stock was originally issued in denominations of $1,000 at the liquidation preference and pays dividends at a rate of 7 percent per annum. The counterparty to the convertible preferred stock can convert the preferred stock into B’s common stock at any time at a conversion price of $5 per $1,000 liquidation value of convertible preferred stock. Settlement in shares of B’s common stock is required for any conversion.
Convertible debt — $1 million principal amount of convertible debt bearing interest at 12 percent per annum. The convertible debt was originally issued in denominations of $1,000 at the principal amount. The counterparty to the convertible debt can convert the convertible debt at any time at a conversion price of $5 per $1,000 principal amount of convertible debt. Settlement in shares of B’s common stock is required for any conversion.

The convertible preferred stock is outstanding during the entire period. The convertible debt is issued on July 15. For the year ended December 31, B’s income available to common stockholders (after dividends accumulated on the convertible preferred stock) was $5 million and there were 10 million weighted-average common shares outstanding. Company B’s income tax rate is 25 percent. The average market price of B’s common stock for the year is $5 per share.

The following table illustrates the calculation of whether the convertible preferred stock is dilutive under the if-converted method:

The convertible preferred stock is dilutive to B’s EPS because the dividends on the preferred stock per common share obtainable on conversion are less than basic EPS.

The following table illustrates the calculation of whether the convertible debt is dilutive under the if-converted method:

The convertible debt is dilutive to B’s EPS because the interest expense (net of tax) per common share obtainable on conversion is less than basic EPS. In reaching this conclusion, with respect to the potential common shares added to the denominator, an entity would assume conversion as of the issuance date, which is later than the beginning of the year. Since the convertible debt has only been outstanding for 5.5 months, the incremental common shares added to the denominator are weighted for 5.5 months.

Company B’s calculation of diluted EPS for the year ended December 31, which is based on the antidilution sequencing guidance in ASC 260, is as follows:

The average market price of B’s common stock is not relevant to the calculation of dilution under the if-converted method.

Example 4-13

Convertible Debt That May Be Settled in Stock or Cash

On January 1, 20X2, Company S issues $10 million of 10 percent debt that pays interest that compounds quarterly. On the December 31, 20X5, maturity date, S is required to pay the principal amount in either cash or common stock. If S elects to pay the principal amount in shares, it must deliver a number of shares that has a monetary value equal to the principal amount as determined on the basis of the average closing quoted price of S’s common stock over the 30-day period that ends one business day before the settlement date.

Company S is calculating diluted EPS for the quarterly period ended March 31, 20X2. The average price of S’s common stock for the quarterly period ended March 31, 20X2, is $25 per share. The average price of S’s common stock for the 30-day period ended March 30, 20X2, is $20 per share. For the quarterly period ended March 31, 20X2, S has 10 million weighted-average common shares outstanding and reported net income of $50 million. Income taxes are ignored in this example.

The debt obligation meets the definition of a convertible security, and the if-converted method must be applied to determine the dilutive impact because share settlement is presumed. The calculation of basic and diluted EPS for the quarterly period ended March 31, 20X2, is as follows:

The number of shares issuable upon conversion of the debt is determined on the basis of S’s average share price during the entire reporting period. This calculation is as follows: ($10,000,000 ÷ $25 = 400,000).

Example 4-14

Bonus as a Nondiscretionary Adjustment

Company D pays an annual bonus to its employees. The amount of the bonus is determined at year-end after D has closed its books and determined net income for the year before the bonus payment. Historically, D has paid an aggregate bonus equal to 10 percent of the increase in net income over the prior year. Employees are aware of this historical practice and expect D to continue it.

The variability in the amount of bonus paid does not represent a nondiscretionary adjustment because the bonus does not arise from a contractual obligation of D and the amount paid is ultimately subjective. Therefore, the numerator should not be adjusted to reflect an increased bonus payable if interest on convertible debt did not reduce net income.

ASC 260-10

Example 11: Computation of Basic and Diluted EPS for Three Examples of Contingently Convertible Instruments

55-78 The following Cases illustrate the guidance in paragraphs 260-10-45-43 through 45-46 related to diluted EPS computations for three examples of contingently convertible instruments:

Contingently convertible debt with a market price trigger (Case A)
Contingently convertible debt with a market price trigger, issuer must settle the principal amount of the debt in cash, but may settle any conversion premium in either cash or stock (Case B)
Convertible debt for which the principal and conversion premium can be settled in any combination of shares or cash (Case C).

55-79 Cases A, B, and C share all of the following assumptions:

Principal amount of the convertible debt: $1,000
Conversion ratio: 20
Conversion price per share of common stock: $50 Conversion price = (Convertible bond’s principal amount) ÷ (Conversion ratio) = $1,000 ÷ 20 = $50.
Share price of common stock at issuance: $40
Market price trigger: average share price for the year must exceed $65 (130% of conversion price)
Interest rate: 4%
Effective tax rate: 35%
Shares of common stock outstanding: 2,000.

Case A: Contingently Convertible Debt With a Market Price Trigger

55-81 The holder of the debt may convert the debt into shares of common stock when the share price exceeds the market price trigger; otherwise, the holder is only entitled to the par value of the debt.

55-82 The contingently convertible debt is issued on January 1, 200X, income available to common shareholders for the year ended December 31, 200X, is $10,000, and the average share price for the year is $55. The issuer of the contingently convertible debt should apply the guidance in paragraphs 260-10-45-43 through 45-44 which requires the issuer to include the dilutive effect of the convertible debt in diluted EPS even though the market price trigger of $65 has not been met. In this Case, basic EPS is $5.00. (Basic EPS = [Income available to common shareholders (IACS)] ÷ [Shares outstanding (SO)] = $10,000 ÷ 2,000 shares = $5.00 per share) and applying the if-converted method to the debt instrument dilutes EPS to $4.96 (Diluted EPS computed using the if-converted method = [IACS + Interest (1-tax rate)] ÷ (SO + Potential common shares) = ($10,000 + $26) ÷ (2,000 + 20) shares = $4.96 per share.)

Case B: Contingently Convertible Debt With a Market Price Trigger, Issuer Must Settle Principal in Cash, but May Settle Conversion Premium in Either Cash or Stock

55-84 The issuer of the contingently convertible debt must settle the principal amount of the debt in cash upon conversion and it may settle any conversion premium in either cash or stock. The holder of the instrument is only entitled to the conversion premium if the share price exceeds the market price trigger. The contingently convertible instrument is issued on January 1, 200X, income available to common shareholders for the year ended December 31, 200X is $9,980, and the average share price for the year is $64.

55-84A The if-converted method should be used to determine the earnings-per-share implications of convertible debt with the characteristics described in this Case. There would be no adjustment to the numerator in the diluted earnings-per-share computation for the cash-settled portion of the instrument (the principal amount of the debt) because that portion will always be settled in cash (see paragraph 260-10-45-40). The conversion premium should be included in diluted earnings per share based on the provisions of paragraphs 260-10-45-45 through 45-46 and 260-10-55-32 through 55-36A. The convertible debt instrument in this Case is subject to other applicable guidance in Subtopic 260-10 as well, including the antidilution provisions of that Subtopic.

55-84B In this Example, basic EPS is $4.99, and diluted earnings per share is $4.98. Basic EPS = IACS ÷ SO = $9,980 ÷ 2,000 shares = $4.99 per share. Diluted EPS would be calculated using the if-converted method by determining the number of shares needed to settle the conversion premium and adding that amount to shares outstanding to calculate the diluted EPS denominator. The average market price is used to determine the dilution in accordance with paragraph 260-10-45-21A. The effect would be dilutive in this case because the average market price of the shares exceeds the conversion price. However, if the average market price of the shares was less than the conversion price, then the conversion premium would be zero and there would be no dilutive effect. Diluted EPS = IACS ÷ (SO + Potential common shares) = ($9,980) ÷ (2,000 + 4.38) shares = $4.98 per share. Potential common shares = (Conversion spread value) ÷ (Average share price) = $14 × 20 shares ÷ $64 = 4.38 shares.

Case C: Convertible Debt That the Principal and Conversion Premium Can Be Settled in Any Combination of Shares or Cash

55-84C The issuer of the convertible debt can settle the principal and the conversion premium in any combination of cash or shares (the issuer has the option). Consistent with the facts in Case B, the convertible instrument is issued on January 1, 200X, income available to common shareholders for the year ended December 31, 200X, is $9,980, and the average share price for the year is $64.

55-84D The if-converted method should be used to determine the earnings-per-share implications of convertible debt. The effect of settling the principal and conversion premium in shares is included for purposes of calculating diluted earnings per share in accordance with the guidance in paragraph 260-10-45-45.

55-84E In this case, basic EPS is $4.99 (the same calculation in paragraph 260-10-55-84B), and diluted earnings per share is $4.95. Diluted EPS is calculated using the if-converted method = [IACS + Interest (1-tax rate)] ÷ (SO + Potential common shares) = (9,980 + 26) ÷ (2,000 + 20). See paragraph 260-10-55-82 for interest expense amount.

Footnotes

Section 4.4.2.2.1.1 does not apply to convertible debt instruments for which the principal amount must be paid in cash.

This section does not apply to convertible debt instruments for which the principal amount must be paid in cash because interest charges on such instruments are not added back to the numerator when the if-converted method is applied.

ASC 825-10-15-5(f) prohibits the election of the fair value option for convertible preferred stock that is classified in stockholders’ equity (whether permanent or temporary equity).

Confidential and Proprietary — for Use Solely by Authorized Personnel

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