4.6 Contracts With Multiple Settlement Alternatives

4.6.1 General

ASC 260-10

Options and Warrants and Their Equivalents

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

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

55-8 When several conversion alternatives exist, the computation shall give effect to the alternative that is most advantageous to the holder of the convertible security. Similar treatment shall be given to preferred stock that has similar provisions or to other securities that have conversion options that permit the investor to pay cash for a more favorable conversion rate.

55-9 Options or warrants may permit or require the tendering of debt or other securities of the issuer (or its parent or its subsidiary) in payment of all or a portion of the exercise price. In computing diluted EPS, those options or warrants shall be assumed to be exercised and the debt or other securities shall be assumed to be tendered. If tendering cash would be more advantageous to the option holder or warrant holder and the contract permits tendering cash, the treasury stock method shall be applied. Interest (net of tax) on any debt assumed to be tendered shall be added back as an adjustment to the numerator. The numerator also shall be adjusted for any nondiscretionary adjustments based on income (net of tax). The treasury stock method shall be applied for proceeds assumed to be received in cash.

55-10 The underlying terms of certain options or warrants may require that the proceeds received from the exercise of those securities be applied to retire debt or other securities of the issuer (or its parent or its subsidiary). In computing diluted EPS, those options or warrants shall be assumed to be exercised and the proceeds applied to purchase the debt at its average market price rather than to purchase common stock under the treasury stock method. The treasury stock method shall be applied, however, for excess proceeds received from the assumed exercise. Interest, net of tax, on any debt assumed to be purchased shall be added back as an adjustment to the numerator. The numerator also shall be adjusted for any nondiscretionary adjustments based on income (net of tax).

55-11 Convertible securities that permit or require the payment of cash by the holder of the security at conversion are considered the equivalent of warrants. In computing diluted EPS, the proceeds assumed to be received shall be assumed to be applied to purchase common stock under the treasury stock method and the convertible security shall be assumed to be converted under the if-converted method. See Example 11 (paragraph 260-10-55-78) for guidance on the effects of contingently convertible instruments on diluted EPS.

Certain contracts offer the counterparty conversion or settlement alternatives related to how the contract will be settled. ASC 260-10-55-7 through 55-11 address how to calculate the dilutive impact of certain contracts that offer the counterparty conversion or settlement alternatives, as well as certain contracts that require the entity to use the proceeds to retire debt or other securities. This guidance requires an entity to assume the conversion or settlement alternative that is most advantageous to the counterparty in calculating diluted EPS. In doing so, the entity may apply the treasury stock method, the if-converted method, or a combination of both.

ASC 260-10-55-10 indicates that if “[t]he underlying terms of certain options or warrants . . . require that the proceeds received from [exercise] be applied to retire debt or other securities of the issuer,” an entity must assume, in computing diluted EPS, that the proceeds from the assumed exercise of those options or warrants are “applied to purchase the debt [or other securities of the issuer] at its average market price rather than to purchase common stock under the treasury stock method.” Note that this guidance applies only when the underlying terms of the options or warrants dictate how the issuer must use the proceeds. It does not apply if the terms or provisions of other arrangements involving the issuer (e.g., debt covenants) require the issuer to use the proceeds from the exercise of such options or warrants to repay outstanding indebtedness. Rather, in those circumstances, the treasury stock method should be applied without alteration. That is, the entity should assume that the proceeds are used to repurchase its common shares at the average market price during the period and should not adjust the numerator to reverse interest expense on the issuer’s debt.

ASC 260-10-55-11 indicates that if a holder of a convertible security is required to both tender the security and pay cash to convert the security into common stock, when conversion is dilutive, the proceeds to be received upon exercise should be assumed to be used to purchase common stock under the treasury stock method and the convertible security should be assumed to be converted under the if-converted method. A holder of a convertible security may be permitted, but not required, to both tender the security and pay cash to convert the security into common stock. That is, the holder is entitled to either (1) tender the convertible security in return for a fixed or determinable number of common shares or (2) tender the convertible security and pay cash in return for a stated number of common shares that exceeds the number of common shares receivable under the first alternative. In these circumstances, diluted EPS should be calculated on the basis of the alternative that is most advantageous to the holder of the security in accordance with ASC 260-10-55-8.

4.6.2 Examples

Example 4-25

Option That Permits Tendering of an Entity’s Preferred Stock as Payment of Exercise Price

Company A issues 1,000 options that, if exercised, permit the counterparty to elect to tender either a share of the $2,750 face value of A’s outstanding preferred stock or $2,500 in exchange for 100 common shares. The preferred stock pays dividends at 10 percent annually. On the date the option is issued, the common stock of A is trading at $25 per share. The following year, A has $20 million in income from continuing operations and weighted-average shares outstanding of 8 million, and the common stock has an average market price of $40 per share. Assume that the preferred stock has a market price of $2,600 as of the date A is calculating diluted EPS.

In applying the treasury stock method, because the options are in-the-money, A should assume that the counterparty will elect to exercise its option and pay $2,500 in cash rather than tendering preferred stock that has a market price of $2,600. Because the exercise of the option would dilute EPS, the treasury stock method, as described in ASC 260-10-55-9, should be applied to calculate the incremental dilutive shares as follows:

Example 4-26

Option That Requires Tendering of the Issuer’s Preferred Stock as Payment of Exercise Price

Company B issues 1,000 options that, if exercised, require the counterparty to tender a share of the $2,750 face value of B’s outstanding preferred stock in exchange for 500 shares of common stock. On the date the option is issued, B’s common stock is trading at $5 per share. The preferred stock pays dividends at 10 percent annually. The following year, B has $15 million in income from continuing operations, weighted-average shares outstanding of 4 million, and an average market price of common stock of $15 per share. Assume that the preferred stock has a market price of $2,750 as of the date B is calculating diluted EPS.

In calculating diluted EPS, B must apply the if-converted method because the options are in-the-money and require the counterparty to tender preferred stock as payment of the exercise price. The following table shows B’s calculations of basic and diluted EPS for the period:

Example 4-27

Option That Requires Application of Proceeds From Exercise to Retire an Entity’s Preferred Stock

Company C issues 400,000 options to purchase common stock at $40 per share, which, if exercised, require C to retire with the proceeds 1,000 shares of preferred stock with a face value of $2,750. The preferred stock pays dividends at 10 percent annually. Company C has income from continuing operations of $15 million, weighted-average shares outstanding of 4 million, and an average market price of common stock of $50 per share. The average fair value of the preferred stock is $2,800.

Because the options are in-the-money, the treasury stock method described in ASC 260-10-55-10 must be applied to C’s calculation of diluted EPS. The following table illustrates C’s calculation of diluted EPS for the period:

Example 4-28

Convertible Securities That Permit Payment of Cash at Conversion

Company D issues 10,000 convertible bonds with a face value of $1,000 that allow the counterparty to pay $200 in cash and surrender the bond for 40 shares of common stock. The convertible bonds pay interest at 10 percent annually. Company D has income from continuing operations of $15 million, weighted-average shares outstanding of 4 million, and an average market price of common stock of $50 per share.

Exercise of the convertible bonds is dilutive; therefore, under the combination of the if-converted and treasury stock method, as described in ASC 260-10-55-11, D should assume that the counterparties would elect conversion. The impact on diluted EPS is calculated as follows (income taxes are ignored):

Example 4-29

Application of Reverse Treasury Stock Method to Written Put Option With Multiple Settlement Alternatives

Company E enters into a written put option that allows the counterparty to sell 10,000 common shares to E at $20 per share. The written put option must be physically settled. Upon exercise, the counterparty is permitted to require E to deliver either $200,000 in cash or a $200,000 principal amount of 7.5 percent debt issued by E. Company E is required to classify the put option as a liability and measure it at fair value, with changes in fair value recognized in earnings. Thus, in calculating diluted EPS, E must also consider the numerator adjustment that is required (see Section 4.7.3).

In the determination of whether the put option is dilutive to E’s EPS and to calculate diluted EPS under the reverse treasury stock method, an additional consideration is necessary because the counterparty has an option to elect to require E to deliver a debt instrument in lieu of cash, which results in a variable exercise price. If the fair value of the debt instrument exceeds $200,000, the counterparty would elect to require E to deliver the debt instrument rather than cash. As a result, for each financial reporting period for which E calculates diluted EPS, it must consider whether it is more advantageous for the counterparty to receive the debt instrument or cash. This assessment is based on a comparison of $200,000 with the fair value of the debt instrument as of the end of the reporting period, which is consistent with View A in Section 4.3.2.1.2.1.

If the fair value of the debt instrument is less than $200,000, the counterparty would elect to receive cash on exercise of the put option and the reverse treasury stock method should be applied under the assumption that E is required to deliver $200,000 in return for 10,000 common shares. If the fair value of the debt instrument exceeds $200,000, the counterparty would elect to receive the debt instrument on exercise of the put option. Accordingly, E will be required to calculate an effective exercise price of the put option to determine whether the put option is in-the-money from the counterparty’s perspective and, if so, the dilutive impact. Below are four different scenarios related to the average market price of E’s common stock and the fair value of the debt instrument. These scenarios illustrate the application of ASC 260-10-55-7 through 55-10.

Scenario 1 — Average Market Price of E’s Common Stock Is $22; Fair Value of Debt Instrument Is $175,000

Because the fair value of the debt instrument is less than the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive cash on exercise of the put option. When only the cash exercise price per share and the average market price of E’s common stock during the period are considered, the put option is out-of-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method does not apply to E’s calculation of diluted EPS.

Scenario 2 — Average Market Price of E’s Common Stock Is $22; Fair Value of Debt Instrument Is $225,000

Because the fair value of the debt instrument exceeds the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive the debt instrument on exercise of the put option; therefore, an effective exercise price must be calculated. The effective exercise price is $22.50 per share ($225,000 ÷ 10,000 shares = $22.50). When the effective exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the put option are dilutive under the antidilution sequencing requirements of ASC 260.

Scenario 3 — Average Market Price of E’s Common Stock Is $18; Fair Value of Debt Instrument Is $175,000

Because the fair value of the debt instrument is less than the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive cash on exercise of the put option. When only the cash exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS, if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the written put option are dilutive under the antidilution sequencing requirements of ASC 260.

Scenario 4 — Average Market Price of E’s Common Stock Is $18; Fair Value of Debt Instrument Is $225,000

Because the fair value of the debt instrument exceeds the cash amount the counterparty may receive upon exercise, it is assumed that the counterparty would elect to receive the debt instrument on exercise of the put option; therefore, an effective exercise price must be calculated. The effective exercise price is $22.50 per share ($225,000 ÷ 10,000 shares = $22.50). When the effective exercise price per share and the average market price of E’s common stock during the period are considered, the put option is in-the-money from the counterparty’s perspective; therefore, the reverse treasury stock method applies to E’s calculation of diluted EPS, if the incremental shares and any numerator adjustment associated with mark-to-market adjustments recognized during the period on the put option are dilutive under the antidilution sequencing requirements of ASC 260.

The calculations under the reverse treasury stock method (any numerator adjustments are ignored) are as follows:

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