4.5 Contingently Issuable Shares
4.5.1 General
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.
Contingently Issuable Shares
45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:
- If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
- If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).
45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.
45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining
the EPS impact of different types of contingencies that may be included in contingent stock agreements.
Contingently issuable shares include common
shares that are issuable for little or no cash consideration when certain
conditions are met, as well as shares of common stock that have been issued and
are subject to return (sometimes referred to as “contingently returnable
shares”).18 Various contingencies may affect the ultimate issuance of common shares.
Typical contingencies underlying contingently issuable share arrangements
include, but are not limited to, one or more of the following:
Neither the mere passage of time nor a condition that is within the counterparty’s control represents
a condition that results in a contingently issuable share arrangement. For share-based payment
arrangements that vest solely on the basis of a service condition, an entity assumes that the requisite
service period will be met for diluted EPS purposes.
Section 3.3.2.5
addresses the impact on basic EPS of contingently issuable shares and indicates
that shares of common stock subject to contingencies are not included in the
denominator of basic EPS until the contingency is resolved. In other words,
shares of common stock are not included in the denominator of basic EPS until
they are no longer contingently issuable. The decision tree below summarizes the
guidance in ASC 260-10-45-48 on when contingently issuable shares are included
in the denominator of diluted EPS. In the decision tree, it is assumed that the
contingent stock agreement was outstanding for the entire reporting period. See
Section 4.5.7
for a comparison between the impact on basic EPS and that on diluted EPS in
contingently issuable share arrangements.
While the concept behind the inclusion of contingently issuable shares in the calculation of diluted EPS may seem straightforward (i.e., the number of common shares that would be issued, if any, should be included in the denominator in the calculation of diluted EPS for a reporting period on the basis of an assumption that the last day of the reporting period was the end of the contingency period), the determination of the number of contingently issuable shares to include in the calculation of diluted EPS can be complex in certain circumstances. In addition, an entity may have contingently issuable potential common shares to which it must apply the treasury stock method or if-converted method if issuance of such potential common shares is assumed on the basis of conditions at the end of the reporting period.
ASC 260-10-45-51 through 45-54 include additional guidance that must be applied to determine the dilutive EPS impact of the following different types of contingencies that may be included in contingent stock agreements:
- Attainment or maintenance of a specified amount of future earnings (see Section 4.5.2).
- Market price of common stock at a future date (see Section 4.5.3).
- Attainment or maintenance of a specified amount of future earnings and market price of common stock at a future date (see Section 4.5.4).
- Discrete events or conditions (see Section 4.5.5).
Contingently issuable share arrangements may also include the contingent issuance of potential common shares. ASC 260-10-45-55 through 45-57 address these types of arrangements. See also Section 4.5.6.
Regardless of the nature of the contingency underlying a contingently issuable share arrangement, if the effect is dilutive, ASC 260-10-45-48(b) requires that entities determine the number of shares that would be issuable (or otherwise included in the denominator) on the basis of an assumption that the last day of the reporting period was the end of the contingency period and that such common shares are included in the denominator of diluted EPS as of the beginning of the financial reporting period
(or as of the date of the contingent stock agreement, if later). Thus, if the arrangement that gives rise
to contingently issuable shares or contingently issuable potential common shares was outstanding
during the entire financial reporting period, the number of additional common shares included in the
denominator in the calculation of diluted EPS is considered to have been outstanding for the entire
financial reporting period. See Section 4.9.4 for additional discussion of the calculation of the number of
contingently issuable shares to include in a year-to-date calculation of diluted EPS.
4.5.1.1 Passage of Time and Events Within Control of Counterparty Are Not Contingencies
An agreement that requires an entity to issue common shares or potential common shares after
the mere passage of time is not considered a contingently issuable share arrangement because the
passage of time is not a contingency. Similarly, an agreement that requires a condition to be met before
common shares or potential common shares are issued is not considered a contingently issuable
share arrangement if the specified condition is within the counterparty’s control. Thus, the guidance on
contingently issuable shares is not applicable and the common shares must be included in diluted EPS,
if they are dilutive, in accordance with the applicable guidance in ASC 260. These types of arrangements
may represent share-based payment arrangements, which are discussed in Section 7.1.2.
An entity may have entered into an arrangement that requires the purchase of outstanding common
shares after the mere passage of time (e.g., on a specified future date). If the common shares are legally
issued and outstanding, they are not considered contingently returnable. Rather, the entity must pay a
purchase price to purchase the common shares and the purchase will occur upon the mere passage
of time. An entity should generally include common shares whose repurchase is contingent on the
passage of time in its calculation of diluted EPS because the shares are currently outstanding and an
assumption that common shares are purchased before the actual consummation of the purchase would
be antidilutive, which is prohibited, as discussed in ASC 260-10-45-17. See Section 4.8.4 for further
discussion of forward contracts to repurchase common shares.
4.5.1.2 No Antidilution
The prohibition on including common shares in the denominator of diluted EPS if the effect would be
antidilutive, as well as the control number and sequencing requirements discussed in Section 4.1.2,
applies to the inclusion of contingently issuable shares in the denominator in the calculation of diluted
EPS. Generally, contingently issuable shares will be antidilutive in the following circumstances:
- When there is a loss within a quarterly financial reporting period, the contingently issuable shares are not included in the calculation of diluted EPS for the quarterly financial reporting period because doing so would be antidilutive. However, the common shares are included in the year-to-date calculation of diluted EPS if there is income on a year-to-date basis and the effect is dilutive. See further discussion in Section 4.9.4.
- The contingently issuable share arrangement involves the issuance of potential common shares (e.g., options or warrants) as opposed to common shares and the effect of assumed exercise or conversion, when the antidilution sequencing requirements of ASC 260 are considered, is antidilutive.
4.5.1.3 Method of Settlement
As discussed in Section
4.7.2, if a contract can be settled in common stock or cash
at the option of the entity or the counterparty, it is always presumed that
it will be settled in common stock. Under ASC 260-10-45-45, any resulting
potential common shares are included in diluted EPS if they are
dilutive.
Contingently issuable share arrangements may be accounted for as liabilities (or
assets in some circumstances). For example, a contingent stock agreement
that represents contingent consideration in a business combination is often
classified as a liability and measured at fair value, with changes in fair
value recognized in earnings. When contingently issuable shares are
accounted for as a liability (or as an asset) at fair value, with changes in
fair value recognized in earnings, an entity must adjust the numerator to
reverse the mark-to-market adjustment recognized in earnings during the
financial reporting period, in addition to including the incremental common
shares in the denominator, if the aggregate effect on the numerator and
denominator is dilutive. See further discussion in Section 4.7.3 and
Example
4-16.
No adjustments would be made to the numerator or denominator for an arrangement
indexed to the issuing entity’s stock that must be settled in cash.
4.5.2 Contingency Based on Future Earnings or Another Performance Measure
4.5.2.1 General
ASC 260-10
Contingently Issuable Shares
45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
Common shares that are contingently issuable on the basis of the attainment or maintenance of future
earnings generally represent contracts with a contingency based on one of the following two types:
- Achieving a specified amount of earnings during a specified period (e.g., achieving a minimum amount of net income during a single year or a minimum amount of aggregate net income over a number of years).
- Achieving a specified level of earnings over a specified period (e.g., achieving an average level of quarterly net income over a single year or an average level of annual net income over a number of years).
While the guidance in ASC 260-10-45-51 is written in the context of the
attainment or maintenance of future earnings, this guidance would also apply
to contingently issuable shares based on the attainment or maintenance of
another performance measure (e.g., revenues, costs or expenses, EBITDA,
operating income).
4.5.2.2 Amount of Future Earnings or Other Performance Measures
Some common shares are contingently issuable on the basis of the attainment of a specified amount
of earnings or another performance measure during a specified period. ASC 260-10-45-51 states that
for these arrangements, “[t]he diluted EPS computation shall include those shares that would be issued
under the conditions of the contract based on the assumption that the current amount of earnings
will remain unchanged until the end of the agreement, but only if the effect would be dilutive” (emphasis
added). Therefore, the number of common shares, if any, to include in the calculation of diluted EPS is
based on the cumulative earnings achieved as of the end of the financial reporting period. Because the
amount of earnings may change in subsequent financial reporting periods, common shares that are
included in the calculation of diluted EPS in a quarterly financial reporting period may be subsequently
excluded from the calculation of diluted EPS in one or more future quarterly financial reporting periods
because of the occurrence of losses in subsequent periods. See Example 4-15 for an illustration of this
concept.
Some contingent stock agreements contain multiple targets related to future earnings or other
performance measures. In some of these arrangements, the counterparty can receive a stated number
of common shares if one of multiple targets is met; in other arrangements, the counterparty is entitled
to a stated number of common shares that varies depending on which targets are met. For example, the
entity may agree to issue additional common shares if more than one target is met. The same guidance
described above applies to these types of arrangements. See Examples 4-16 and 4-17 for more
information. Also see Section 4.5.4 for a discussion of common shares that are contingently issuable
depending on both future earnings and future stock prices.
4.5.2.3 Level of Future Earnings or Other Performance Measures
Common shares may be contingently issuable on the basis of the attainment of a specified level of earnings or another performance measure over a specified period (e.g., an average amount of net income over a three-year period). In such arrangements, an entity must consider several important concepts in ASC 260-10-45-48(b) and ASC 260-10-45-51, including the following:
- “[T]he number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive” (emphasis added).
- “The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive” (emphasis added).
On the basis of this guidance, when common shares are contingently issuable in the future on the basis of the attainment of a specified average level of earnings or another performance measure over a period, an entity must focus on the amount, not the level, achieved as of the end of each financial reporting period (this treatment is similar to that for contingently issuable shares based on an amount of future earnings or another performance measure). In other words, the level of future earnings or another performance measure cannot be projected in the determination of the number of contingently issuable shares, if any, to include in the calculation of diluted EPS. Footnote (f) in Example 3 in ASC 260-10-55-53 through 55-56 states, in part, that “[p]rojecting future earnings levels and including the related contingent shares are not permitted by this Subtopic.”
Therefore, when common shares are contingently issuable in the future on the
basis of the attainment of a specified average level of earnings or another
performance measure, the calculation of the number of shares to be included
in the denominator for diluted EPS, if any, should be based only on the
actual amount of earnings or another performance measure achieved through
the reporting date. In accordance with ASC 260, the entity should assume
that the current amount of earnings or another performance measure will be
unchanged and thus that there are no additional earnings or other
performance measures achieved in the future. An assumption that the current
amount of earnings will remain unchanged would result in an assumption of
zero earnings or other performance measures in the future periods included
in an average calculation. It would not be appropriate for an entity to
assume that the future earnings or another performance measure would be at a
level equal to the most recently reported amount, because such an assumption
would be a projection that the earnings level or other performance measure
will remain unchanged. Such a projection would be inconsistent with ASC 260
since it (1) refers to an assumption that the amount, not the level, will
remain unchanged and (2) specifically prohibits any projection of future
earnings or another performance measure. While the approach applied to
common shares that are contingently issuable on the basis of a level of
earnings or another performance measure over a specified future period is
the same approach applied when the contingency is based on an amount of
future earnings or another financial measure during a specified future
period, the impact on diluted EPS may be significantly different when the
contingency is based on a level of future earnings or another performance
measure. For illustrations, see Examples 4-18 and 7-5.
Note that this guidance does not apply to shares that are contingently issuable on the basis of stock prices. See Section 4.5.3 for more information.
4.5.2.4 Examples
Example 4-15
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Single
Earnings Target)
Company X, a calendar-year-end company, purchases Subsidiary Y on January 1, 20X7, for $100 million plus a
commitment to issue 100,000 shares of X’s common stock to the former owners of Y if Y has net income of
$10 million in fiscal year 20X7.
Subsidiary Y reports the following net income (net loss) during the year ended December 31, 20X7:
- Quarter ended March 31, 20X7 — $5 million.
- Quarter ended June 30, 20X7 — $7 million.
- Quarter ended September 30, 20X7 — ($4) million.
- Quarter ended December 31, 20X7 — $17 million.
In determining whether the 100,000 common shares are included in diluted EPS during each financial reporting
period, X must apply ASC 260-10-45-51 and assume that the current amount of earnings achieved to date
remains unchanged until the end of the contingency period. Accordingly, as of the end of each financial
reporting period, X assumes that the cumulative amount of net income does not change (i.e., X produces no
income or loss during the remaining contingency period).
In accordance with ASC 260-10-45-51, X would include the following common shares in the denominator in the
calculations of diluted EPS during each quarterly financial reporting period during the year:
The contingency would not be met if the contingency period ended on the last day of the first quarter (i.e.,
$5 million of net income is less than $10 million), so the contingently issuable shares should not be assumed to
be outstanding for the calculation of diluted EPS for the first quarter ended March 31, 20X7.
The contingency would be met if the contingency period ended on the last day of the second quarter (i.e., X has
reported year-to-date net income of $12 million). Therefore, the 100,000 common shares must be included in
the calculation of diluted EPS for the second quarter ended June 30, 20X7, in accordance with ASC 260-10-45-51,
which requires an assumption that the current amount of earnings will remain unchanged until the end of the
contingency period. The common shares should be considered outstanding for diluted EPS purposes from the
beginning of the quarter.
The contingency would not be met if the contingency period ended on the last day of the third quarter
because, after the net loss reported during the third quarter ended September 30, 20X7, X has cumulatively
generated only $8 million of net income. Therefore, the contingently issuable shares should not be assumed to
be outstanding in the calculation of diluted EPS for the third quarter ended September 30, 20X7.
The contingency would be met if the contingency period ended on the last day of the fourth quarter (i.e., X
has reported year-to-date net income of $25 million), so the 100,000 common shares must be included in the
calculation of diluted EPS for the fourth quarter ended December 31, 20X7. The common shares should be
considered outstanding for diluted EPS purposes from the beginning of the quarter.
See Example 4-34 for an illustration of the common shares included in diluted EPS for the year-to-date
calculations.
Example 4-16
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Multiple Earnings Targets)
Company L, a calendar-year-end company, purchases Subsidiary M on January 1, 20X1, for $100 million plus a commitment to issue 100,000 shares of L’s common stock to the former owners of M if M achieves any of the following income targets:
- $100 million of net income in any single calendar year over the three-year period ended December 31, 20X3 (Target 1).
- $175 million of net income over any successive two calendar-year periods over the three-year period ended December 31, 20X3 (Target 2).
- $300 million of net income over the three-year period ended December 31, 20X3 (Target 3).
In addition, if M achieves two of the three targets, an additional 50,000 common shares will be issued.
Company L classifies its obligation to issue the common shares as a liability that is measured at fair value, with changes in fair value recognized in earnings.
For simplicity, this example includes only annual periods. Subsidiary M reports the following net income during each of the three years in the period ended December 31, 20X3:
- Year ended December 31, 20X1 — $95 million.
- Year ended December 31, 20X2 — $80 million.
- Year ended December 31, 20X3 — $125 million.
In determining the common shares issuable under the contingent stock agreement that are included in diluted EPS during each financial reporting period, L must apply ASC 260-10-45-51 and assume that the current amount of earnings achieved to date remains unchanged until the end of the contingency period. Accordingly, as of the end of each financial reporting period, L assumes that the cumulative amount of net income does not change (i.e., no income or loss is produced during the remaining contingency period).
In accordance with ASC 260-10-45-51, L should include the following common shares in the denominator in the calculations of diluted EPS:
The contingency would not be met if the contingency period ended on December 31, 20X1, because none of the three targets are met; thus, the contingently issuable shares should not be assumed to be outstanding for diluted EPS.
The contingency would be met if the contingency period ended on December 31, 20X2 (i.e., M has reported cumulative net income of $175 million, which meets Target 2). Therefore, 100,000 common shares must be included in the calculation of diluted EPS for the year ended December 31, 20X2, in accordance with ASC 260-10-45-51, which requires an assumption that the current amount of earnings will remain unchanged until the end of the contingency period.
The contingency is met as of December 31, 20X3. In fact, both Target 1 and Target 3 are met. Therefore, 150,000 common shares must be included in the denominator in the calculation of diluted EPS for the year ended December 31, 20X3.
In addition to the inclusion of the common shares in the denominator, any mark-to-market adjustment on the obligation related to the issuance of the common shares should be reversed from the numerator. If the combination of that reversal and the outstanding shares included in the denominator is antidilutive, diluted EPS should not reflect the issuance of the common shares or the reversal of the mark-to-market amount reported during the period.
Example 4-17
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings
(Multiple Discrete Earnings Targets)
Company X, which reports on a calendar-year basis, purchases Subsidiary Y on January 1 for $100 million plus
20,000 shares of X’s common stock for each year within the next five years in which Y has net income of
$10 million or more. By June 30 of year 1, Y has net income of $15 million.
The 20,000 shares of X’s common stock would be issuable if the end of the contingency period were June
30 instead of December 31; therefore, the 20,000 common shares should be included in the denominator
of diluted EPS for the three months ending on June 30. The common shares should be included in the
denominator as of the interim period beginning on April 1, which is the beginning of the period in which the
conditions were satisfied. Therefore, the 20,000 shares will be included in the denominator of the calculation of
diluted EPS for the entire three-month interim period ending on June 30. The common shares will be included
in the denominator of diluted EPS for the six months ending on June 30 in accordance with the guidance in ASC
260-10-45-49.
Because there are five separate measurement periods for the contingency, each measurement period in which
a finite number of common shares may be issued should be treated as a separate contingency and evaluated
on the basis of whether X may be required to issue the common shares for each period on a stand-alone basis.
If the purchase agreement requires X to issue 100,000 shares of its common stock if Y achieves $50 million in
cumulative net income at the end of five years, no shares would be included in diluted EPS until the end of the
reporting period for which X has cumulative earnings in excess of $50 million.
For discussion of the impact of the arrangement on basic EPS, see Example
3-29.
Example 4-18
Calculating Diluted EPS When Issuance of Shares Is Contingent on Average Level of Future
Operating Margin
Entity A grants an employee a performance-based restricted stock award on January 1, 20X1, that vests on
December 31, 20X3. According to the terms of the award, the number of shares that will be earned and will
vest depends on A’s three-year average operating margin in accordance with the following schedule:
For the year ended December 31, 20X1, A achieved an operating margin of 40 percent.
In calculating the number of shares to be included in diluted EPS, A should
assume that the operating margin for the years
ending December 31, 20X2, and December 31, 20X3, is
zero. As a result, as of and for the year ended
December 31, 20X1, no contingently issuable shares
should be included in the calculation of diluted EPS
because the average three-year operating margin is
13.33 percent, or (40% + 0 + 0) ÷ 3.
Note that the conclusion would have differed if the contingency was based solely on A’s stock price.
See Section 4.9.4.1 for examples that include quarterly and year-to-date calculations.
4.5.3 Contingency Based on Future Market Price of Common Stock
4.5.3.1 General
ASC 260-10
Contingently Issuable Shares
45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.
Common shares may be contingently issuable in the future on the basis of the fair value of the entity’s common stock price. ASC 260-10-45-52 provides the following guidance on how to apply the contingently issuable share method to such arrangements in the calculation of diluted EPS:
- If the number of shares issuable is based on the entity’s common stock price at a specified future date, an entity should use the end-of-period stock price.
- If the number of shares issuable is based on an average of the entity’s common stock price over some future period, an entity should use the average over the same period, with the last day in the average ending on the last day of the reporting period.
The above guidance is consistent with ASC 260’s approach to assuming that the
end of the reporting period is the end of the contingency period.
Share-based payment awards with market conditions are subject to the guidance on contingently issuable shares based on the market price of an entity’s common stock at a future date. See further discussion in Section 7.1.2.3.2.
Connecting the Dots
ASC 260-10-45-21A requires entities to use an
average share price to calculate the impact on diluted EPS of
instruments for which the entity’s share price may affect (1) the
exercise price of the instrument or (2) the number of shares that
may be issued to settle the instrument provided that the arrangement
is not subject to the guidance on contingently issuable shares. It
may be unclear whether an entity should apply the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares or the
guidance in ASC 260-10-45-21A on variable denominators. 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 current guidance
in ASC 260 that addresses what constitutes a contingently issuable
share is often difficult to interpret in practice.
4.5.3.2 Examples
Example 4-19
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Future Stock Prices
Company A acquires Company B in a business combination. The purchase price
includes an obligation for A to pay an additional
amount to B if the fair value of A's stock exceeds
$30 on the two-year anniversary of the business
combination. This payment would be equal to the fair
value of 100,000 shares of A's stock on that date.
Company A can meet this obligation by paying the
cash value of 100,000 shares of stock or by issuing
100,000 shares of stock. Assume that this contingent
consideration arrangement is classified as a
liability and measured at fair value, with changes
in fair value recognized in earnings.
The contingently issuable shares related to this arrangement should be included
in diluted EPS if the market price of A’s common
stock at the end of each reporting period exceeds
$30 per share and the adjustment to the numerator to
reverse the period’s mark-to-market impact is
dilutive to EPS. If the market price is $30 per
share or less, the contingent shares should not be
included in diluted EPS and the mark-to-market
adjustment recognized in earnings from the contract
should not be reversed from the numerator in the
calculation of diluted EPS.
Example 4-20
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Future Stock Prices
Company E entered into an option to sell common shares to a counterparty that contains the following key
terms:
- Notional amount — The notional amount depends on the market price of E’s common stock on the exercise date:
- If E’s common stock price is between $25.00 and $29.99, the counterparty can exercise for 10,000 shares.
- If E’s common stock price is between $30.00 and $34.99, the counterparty can exercise for 20,000 shares.
- If E’s common stock price is between $35.00 and $39.99, the counterparty can exercise for 30,000 shares.
- If E’s common stock price is greater than $40.00, the counterparty can exercise for 40,000 shares.
- Exercise price — $25.00 per common share.
This arrangement does not represent a contingently issuable share. Rather, E
should apply the guidance in ASC 260-10-45-21A on
variable denominators to determine the number of
shares issuable under the treasury stock method.
Example 4-21
Calculating Diluted EPS When the Issuance of Shares Is Contingent on Total Shareholder Return
Company T grants an employee a restricted stock award on January 1, 20X1, that vests in three years on a cliff basis (i.e., a three-year service period). The number of shares that vest varies depending on T’s total shareholder return (TSR) over a three-year annualized period, calculated on the basis of the closing price of T’s common stock on December 31, 20X4, and the closing price of T’s common stock on the January 1, 20X1, grant date. It is assumed that dividends declared by T during this three-year period are reinvested. The award is designed to compensate the grantee for providing three years of service to the company; the level of compensation is indexed to T’s performance over that three-year period.
In calculating diluted EPS for the year ended December 31, 20X1, T is considering the following two alternatives related to determining the number of incremental common shares to include in the denominator (note that, for simplicity, the amount of unrecognized compensation cost is ignored in this example):
- Alternative 1 — Include an incremental number of common shares on the basis of the TSR for the year ended December 31, 20X1, under an assumption that the TSR over the three-year annualized period ended December 31, 20X4, will equal the TSR over the annual period ended December 31, 20X1.
- Alternative 2 — Include an incremental number of common shares, if any, on the basis of the TSR for the annual period ended December 31, 20X1, and zero TSR for the remaining two annual periods in the three-year annualized period ending December 31, 20X4. Under this alternative, it is assumed that T’s common stock price does not change from the closing price on December 31, 20X1, and that T does not declare any dividends during the remaining two annual periods. For simplicity purposes, under this approach, T uses the annual TSR for the year ended December 31, 20X1, divided by a factor of 3.
Alternative 2 is consistent with ASC 260. ASC 260-10-45-52 addresses
contingently issuable share arrangements that depend
on the future market price of common stock and
states, in part, that when the number of shares
contingently issuable depends on the market price of
stock at a future date, the “computations of diluted
EPS shall reflect the number of shares that would be
issued based on the current market price at the end
of the period being reported on if the effect is
dilutive.” Although the price of a common share
cannot be less than zero and, therefore, the
approach applied to contingency issuable shares
based on an earnings metric (which can be negative)
sometimes differs from the approach applied to
contingency issuable shares based on stock prices,
the price of T’s common stock as of December 31,
20X4, will most likely be more or less than the
closing price on December 31, 20X1. Alternative 1
would result in a projected growth in T’s common
stock price over the remaining two years in the
vesting period and is thus inconsistent with ASC
260-10-45-52.
Further, ASC 260-10-45-48(b) states, in part, that “[i]f all necessary
conditions have not been satisfied by the end of the
period, the number of contingently issuable shares
included in diluted EPS shall be based on the number
of shares, if any, that would be issuable if the end
of the reporting period were the end of the
contingency period.” While this guidance could be
interpreted as meaning that T should assume that the
award vests on the basis of TSR over a one-year
period (i.e., that the award fully vests at the end
of the first year), such an approach (i.e.,
Alternative 1) is inconsistent with the terms of the
award, which require that three years of service be
performed and that the grantee be compensated for
the return on stock price over a three-year period.
Such an approach would also be inconsistent with the
measurement of compensation cost under ASC 718,
which is based on a market condition reflecting a
three-year period. While Alternative 2 will result
in the inclusion of fewer incremental common shares
than Alternative 1, such an approach is appropriate
and consistent with the prohibition in ASC 260
related to projecting future share prices.
Alternative 2 is also consistent with the approach
in Example 4-18.
Note that if the award’s terms had differed, the conclusion reached could have differed as well. For example, if the award allowed the grantee to terminate service after one year and receive a number of common shares on the basis of TSR for the year ended December 31, 20X1, and that number of incremental common shares exceeded the number that would vest on the basis of the calculation in Alternative 2, the higher incremental number of common shares on the basis of the termination provision should be included in diluted EPS.
4.5.4 Contingency Based on Both Future Earnings or Other Performance Measures and the Future Price of Common Stock
ASC 260-10
Contingently Issuable Shares
45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and
future prices of the shares. In that case, the determination of the number of shares included in diluted EPS
shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end
of each reporting period. If both conditions are not met at the end of the reporting period, no contingently
issuable shares shall be included in diluted EPS.
Common shares may be contingently issuable in the future on the basis of both (1) the attainment of a
specified amount of earnings and (2) the fair value of the entity’s common stock price at a future date.
In these situations, an entity must consider the guidance applicable to each condition to determine the
number of common shares, if any, that would be issuable on the basis of the conditions on the reporting
date.
4.5.5 Discrete Events or Conditions
4.5.5.1 General
ASC 260-10
Contingently Issuable Shares
45-54 If the contingency is based on a condition other than earnings or market price (for example, opening
a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS
based on the assumption that the current status of the condition will remain unchanged until the end of the
contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.
When the condition underlying the contingent issuance of common shares is the
occurrence or nonoccurrence of a discrete event or condition other than
earnings or market prices, the entity should include the number of common
shares that would be issued, assuming that the current status of the
condition will not change. As with the guidance applicable to earnings and
market price conditions, the number of common shares included in diluted EPS
is based on an assumption that the end of the reporting period is the end of
the contingency period. See Example 4-22 for an illustration of
how the application of the guidance on contingently issuable shares differs
depending on whether the contingency is based on the occurrence or
nonoccurrence of a specified event or condition.
4.5.5.2 Examples
Example 4-22
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on an
IPO
Company C has issued the following instruments:
- $1 million of preferred stock. The preferred stock pays cash dividends at a stated rate and is mandatorily convertible into common stock if C completes an IPO of its common stock.
- An option that gives its holder the ability to acquire 10,000 shares of C’s common stock at a price per share of $10 and that becomes exercisable in three years if C has not completed an IPO.
If an IPO has not occurred as of the reporting date, the preferred stock should
not affect the denominator in C’s calculation of
basic or diluted EPS. The option would have no
impact on basic EPS since it is not a participating
security. However, if dilutive, the incremental
common shares resulting from the option should be
included in diluted EPS. The option represents a
contingently issuable potential common share. In
accordance with ASC 260-10-45-54, C must assume that
the current status of the condition (i.e., an IPO)
as of the reporting date will remain unchanged until
the end of the contingency period. Accordingly, the
potential common shares resulting from the option
are included in the calculation of diluted EPS, if
dilutive, because it must be assumed that an IPO
will not occur since one has not occurred as of the
reporting date.
If an IPO occurs, C should include
the common shares issued upon mandatory conversion
of the preferred stock in its calculation of basic
EPS on a weighted-average basis, taking into account
the period for which those shares were issued and
outstanding (i.e., C would further adjust diluted
EPS to reflect those common shares as outstanding
from the beginning of the period to the date of the
IPO). The incremental common shares potentially
issuable as a result of the option would not be
included in the calculation of basic or diluted EPS
for the reporting period that includes the IPO
(i.e., as of the end of the reporting period, the
option is no longer exercisable).
Example 4-23
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on a Favorable Lawsuit
Company X, the claimant in a patent infringement lawsuit, has agreed to issue its external legal counsel 10,000 common shares if it is successful in receiving at least $50 million in damages from the defendant. The receipt of $50 million or more in damages is considered a favorable outcome of the litigation. Company X should treat common shares whose issuance is contingent on the favorable outcome of a lawsuit similarly to how it treats common shares whose issuance is contingent on the attainment of an earnings contingency. That is, the calculation of diluted EPS should include common shares that would be issued in accordance with the conditions of the contingent stock agreement if the amount of current “earnings” remains unchanged until the end of the agreement (only if the effect would be dilutive). The current “earnings” from the lawsuit would be zero. Because the favorable outcome of a lawsuit represents a gain contingency, any “earnings” (i.e., gain) from the lawsuit should be recorded in accordance with ASC 450 and would not be included in diluted EPS until they are realized.
Example 4-24
Treatment in Diluted EPS of Shares Whose Issuance Is Contingent on Continued Employment
Company M has a mandatory deferred compensation plan under which covered employees are required to
defer the amount of compensation payable in one calendar year in excess of $1 million until completion of the
deferral period. The deferral period ends when the employee ceases to earn $1 million annually or reaches the
defined retirement age as an employee of M. If the employee is terminated or resigns, he or she is not eligible
to receive any distribution under the plan. The compensation deferred under the plan is only payable to the
participant in shares of M’s common stock over a five-year period once the participant is eligible to receive the
distribution.
A participant’s deferred compensation is held in an escrow account until the individual is eligible to receive
distributions. The escrow account does not bear interest; however, it receives the dividend equivalent on the
basis of the equivalent number of shares of common stock into which the cash value of the account would be
converted, depending on the closing price of M’s common stock on the NYSE for the trading day preceding the
original deferral. Distributions from the account are based on the equivalent number of shares of common
stock into which the cash value of the distribution would be converted, depending on the closing price of the
stock on the NYSE for the trading day preceding the distribution.
The common stock issuable under the plan is considered contingently issuable because the common stock
will not be issued if the employee is terminated or resigns from M’s employment before retirement. The
shares issuable under the plan should be included in the calculation of diluted EPS as of the reporting date
for participants that continue to be employed under the assumption that the end of the reporting period is
the end of the contingency period (i.e., the participant has not been terminated and has not resigned before
retirement and therefore would be entitled to amounts in his or her account). Since the number of contingently
issuable shares depends on the market price of M’s common stock, the number of common shares included in
the denominator of diluted EPS should be based on M’s common stock price at the end of the reporting period
in accordance with ASC 260-10-45-52.
For an illustration of the impact of the arrangement on basic EPS, see Example
3-30.
4.5.6 Contingently Issuable Potential Common Shares
ASC 260-10
Contingently Issuable Shares
45-55 Contingently issuable potential common shares (other than those covered by a contingent stock
agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:
- An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
- If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10- 45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.
45-56 Neither interest nor dividends shall be imputed for the additional contingently issuable convertible
securities because any imputed amount would be reversed by the if-converted adjustments for assumed
conversions.
45-57 However, exercise or conversion shall not be assumed for purposes of computing diluted EPS unless
exercise or conversion of similar outstanding potential common shares that are not contingently issuable is
assumed. See Example 3 (paragraph 260-10-55-53) for an illustration of this guidance.
An entity may be party to contingently issuable potential common shares (e.g., written call options to sell common stock) that become exercisable only if a contingent event occurs. For these types of arrangements, an entity should apply the guidance in ASC 260-10-45-48 through 45-54 to determine whether the potential common shares should be assumed to be issuable and, if so, the entity should use the appropriate method to determine the dilutive impact, if any, of the potential common shares. If the arrangement represents contingently convertible debt, see Section 4.4.3.
If an entity has issued potential common shares for which a contingency only
affects the terms of the instrument (e.g., a contingency only affects the
exercise price or the number of common shares), the contingency will only
potentially affect the terms that are used to apply the appropriate method for
calculating the dilutive impact, if any, of such an instrument. See further
discussion in Sections
4.2.2.1.1, 4.2.2.1.2.1, 4.3.2.1.1, 4.3.2.1.2.1, and 4.4.2.3.
See Section 7.1.2.3
for discussion of the accounting for diluted EPS for share-based payment awards
with performance or market conditions.
4.5.7 Summary of Treatment of Contingently Issuable Shares in Basic and Diluted EPS
The graphic below summarizes the treatment of contingently issuable shares in the denominator in the calculations of basic and diluted EPS.
Footnotes
18
Outstanding common shares that are contingently
returnable (i.e., subject to recall) are treated in the same manner as
contingently issuable shares in the calculation of diluted EPS. Thus,
whether the shares have been issued to the counterparty is not relevant.
See Section
7.1.1 for discussion of the impact of clawback features
on share-based payment awards.