4.7 Contracts That May Be Settled in Stock or Cash

4.7.1 General

ASC 260-10

Contracts That May Be Settled in Stock or Cash

45-45 The effect of potential share settlement shall be included in the diluted EPS calculation (if the effect is more dilutive) for an otherwise cash-settleable instrument that contains a provision that requires or permits share settlement (regardless of whether the election is at the option of an entity or the holder, or the entity has a history or policy of cash settlement). An example of such a contract accounted for in accordance with this paragraph and paragraph 260-10-45-46 is a written call option that gives the holder a choice of settling in common stock or in cash. An election to share settle an instrument, for purposes of applying the guidance in this paragraph, does not include circumstances in which share settlement is contingent upon the occurrence of a specified event or circumstance (such as contingently issuable shares). In those circumstances (other than if the contingency is an entity’s own share price), the guidance on contingently issuable shares should first be applied, and, if the contingency would be considered met, then the guidance in this paragraph should be applied. Share-based payment arrangements that are payable in common stock or in cash at the election of either the entity or the grantee shall be accounted for pursuant to this paragraph and paragraph 260-10-45-46, unless the share-based payment arrangement is classified as a liability because of the requirements in paragraph 718-10-25-15 (see paragraph 260-10-45-45A for guidance for those instruments). If the payment of cash is required only upon the final liquidation of an entity, then the entity shall include the effect of potential share settlement in the diluted EPS calculation until the liquidation occurs.

45-45A For a share-based payment arrangement that is classified as a liability because of the requirements in paragraph 718-10-25-15 and may be settled in common stock or in cash at the election of either the entity or the holder, determining whether that contract shall be reflected in the computation of diluted EPS shall be prepared on the basis of the facts available each period. It shall be presumed that the contract will be settled in common stock and the resulting potential common shares included in diluted EPS (in accordance with the relevant guidance of this Topic) if the effect is more dilutive. The presumption that the contract will be settled in common stock may be overcome if past experience or a stated policy provides a reasonable basis to conclude that the contract will be paid partially or wholly in cash.

45-46 A contract that is reported as an asset or liability for accounting purposes may require an adjustment to the numerator for any changes in income or loss that would result if the contract had been reported as an equity instrument for accounting purposes during the period. That adjustment is similar to the adjustments required for convertible debt in paragraph 260-10-45-40(b).

45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled in stock or cash.

Contracts That May Be Settled in Stock or Cash

55-32 Adjustments shall be made to the numerator for contracts that are asset or liability classified, in accordance with Section 815-40-25, but for which the potential common shares are included in the denominator in accordance with the guidance in paragraph 260-10-45-45. For purposes of computing diluted EPS, the adjustments to the numerator are only permitted for instruments for which the effect on net income (the numerator) is different depending on whether the instrument is accounted for as an equity instrument or as an asset or liability (for example, those that are within the scope of Subtopics 480-10 and 815-40).

ASC 260-10-45-45 and 45-46 and ASC 260-10-55-32 contain the following two important concepts that must be considered for certain contracts regardless of the method used to calculate diluted EPS:

Contracts that provide for settlement in cash — When a contract may be settled in cash or common stock, an entity must assume share settlement when accounting for diluted EPS unless the arrangement is within the scope of the guidance in ASC 260-10-45-45A that addresses certain share-based payment awards.
Classification of contract for accounting purposes — An adjustment to the numerator is required for contracts that are classified as an asset or liability for accounting purposes but are treated as share-settled for diluted EPS. The adjustment to the numerator results in a consistent treatment of the classification of the contract and the accounting for diluted EPS. No adjustment would be made to the numerator for an equity-classified contract. That is, for a freestanding equity-classified contract, the entity would never adjust the numerator for the mark-to-market adjustment that would have been recognized if the contract had been classified as an asset or liability even if doing so would be dilutive. Rather, the effect of such a contract on diluted EPS is only reflected in the denominator by using the appropriate method (e.g., the treasury stock method).

Connecting the Dots

ASC 260 does not address whether an entity can assume cash settlement for contracts that the entity is permitted to settle in shares but for which such settlement would be uneconomical (e.g., the entity can pay $1 million in cash or $2 million in shares). In certain circumstances, it may be acceptable for an entity not to assume share settlement for diluted EPS purposes when doing so would reflect a settlement alternative that would never occur because it would be uneconomical. However, to conclude that share settlement is uneconomical, an entity would need to carefully consider the facts and circumstances and may have to use significant judgment. The entity may, for instance, need to support this conclusion by looking to the terms of the contract rather than to its intentions, expectations, or other entity-specific considerations. Entities are strongly encouraged to consult with their advisers in these circumstances.

4.7.2 Contracts That Provide for Settlement in Cash

4.7.2.1 General

ASC 260-10

Contracts That May Be Settled in Stock or Cash

45-47 Paragraphs 260-10-55-32 through 55-36A provide additional guidance on contracts that may be settled in stock or cash.

Contracts That May Be Settled in Stock or Cash

55-33 The references in paragraphs 260-10-45-30 and 260-10-45-45 for share-based payment arrangements that are payable in common stock or in cash at the election of either the entity or the grantee refer to using the guidance in paragraph 260-10-45-45A for purposes of determining whether shares issuable in accordance with such plans are included in the denominator for purposes of computing diluted EPS amounts. Accordingly, the numerator is not adjusted in those circumstances. Paragraph 260-10-55-36A illustrates these requirements.

Certain contracts indexed to an entity’s common stock must be settled in cash. Other contracts allow the entity or the counterparty to choose among one or more of net-cash settlement, net-share settlement, or physical settlement. While the guidance in ASC 260 only refers to settlement in cash or stock, the same considerations apply to a contract that allows for settlement in cash or potential common stock (e.g., a warrant on a convertible security that may be settled in cash or by delivery of the convertible security).

4.7.2.2 Contract Must Be Settled in Cash

A contract indexed to an entity’s common stock that must be net-cash-settled is classified as an asset or a liability for accounting purposes. Since the contract will not result in delivery of common shares, no incremental common shares should be added to the denominator in the calculation of diluted EPS. Any amounts reported in net earnings during a financial reporting period on the contract may not be reversed from the numerator in the calculation of diluted EPS.

4.7.2.3 Entity or Counterparty Controls Form of Settlement

When the entity controls the form of consideration upon settlement of a contract, the accounting for diluted EPS is determined on the basis of share settlement and the resulting potential common shares are included in diluted EPS if they are dilutive.19 The same is true if the counterparty controls the form of consideration upon settlement of a contract. That is, share settlement is always applied in the calculation of diluted EPS unless the guidance in ASC 260-10-45-45A applies. If the contract is classified as an asset or liability, the entity must both (1) adjust the numerator to reflect the accounting as an equity instrument and (2) apply the appropriate method of calculating diluted EPS to the contract (i.e., the treasury stock method, reverse treasury stock method, if-converted method, or contingently issuable share method) to determine whether the inclusion of such adjustments would be dilutive to EPS. See Example 4-31 for more information.

4.7.3 Classification of Contract for Accounting Purposes

4.7.3.1 General

ASC 260-10

Contracts That May Be Settled in Stock or Cash

55-36A

The following table illustrates the guidance in paragraphs 260-10-45-45 through 45-46 and 260-10-55-32 through 55-34 for the effects of contracts that may be settled in stock or cash on the computation of diluted EPS.

Under ASC 260, in the calculation of diluted EPS, the accounting classification of a contract must be consistent with its assumed settlement. Thus, when incremental common shares reflecting the effect of share settlement of a contract that is classified as an asset or liability are included in the denominator of diluted EPS, the numerator must reflect accounting for the contract as an equity instrument. These requirements are summarized in the table in ASC 260-10-55-36A. Note that when the numerator must be adjusted, the adjustment should be made net of tax. In addition, the application of numerator and denominator adjustments is subject to the antidilution requirements of ASC 260 (see Section 4.7.3.2).

Connecting the Dots

While footnote (a) in the table in ASC 260-10-55-36A only refers to settlement of a contract on a gross (or physical) basis, the share settlement requirements referred to in that table also apply to contracts that are net-share-settled.

ASC 260-10-55-36A applies to all equity-linked contracts and share-based payment awards.20 Under ASC 815-40, an equity-linked freestanding financial instrument (or embedded feature) can meet the conditions to be considered an equity instrument only if it is both (1) indexed to the reporting entity’s stock and (2) meets certain additional conditions for equity classification. The first requirement focuses on the indexation of the contract, and the second requirement focuses on the form of settlement of the contract.21 Although the requirements differ, under ASC 718, share-based payment awards must also meet certain conditions regarding indexation and form of settlement to be classified as equity instruments.22 Certain arrangements, whether within the scope of ASC 718 or ASC 815-40, may meet the form-of-settlement requirements to be classified as equity instruments but do not meet the indexation requirements and therefore must be classified as liabilities (or, in the case of instruments within the scope of ASC 815-40, as assets in some circumstances). When a contract is classified as an asset or liability for accounting purposes because it does not meet the relevant indexation requirements in ASC 718 or ASC 815-40, but the effect of share settlement of the contract is included in the denominator of diluted EPS, the calculation of diluted EPS must also include an adjustment to the numerator to reflect the accounting as if the contract was classified as an equity instrument even though such classification is prohibited by GAAP. See Section 4.7.3.2 for further discussion of antidilution considerations.

In applying ASC 260-10-55-36A to contracts for which a numerator adjustment may be necessary, an entity should consider two important matters:

Whether a numerator adjustment is necessary — The numerator can only be adjusted for a contract that is classified as an asset or liability (i.e., no adjustment would be made for a freestanding equity-classified contract). In addition, ASC 260-10-55-32 states, in part, that “the adjustments to the numerator are only permitted for instruments for which the effect on net income (the numerator) is different depending on whether the instrument is accounted for as an equity instrument or as an asset or liability.” For some contracts, the impact on net income during a reporting period would be the same regardless of the contract’s classification for accounting purposes. In these situations, the entity cannot adjust the numerator. For example, under ASC 718, an entity may recognize compensation cost for an award on the basis of the fair value of the award at the end of the reporting period, regardless of whether the award is classified as a liability or equity instrument, because the service inception date precedes the grant date. In this situation, it would be inappropriate to adjust the numerator.
The amount of the numerator adjustment — ASC 260-10-45-46 and ASC 260-10-55-32 indicate that the adjustment to the numerator should be limited to the difference in net income during the reporting period with respect to accounting for the contract as an asset or liability compared with accounting for the contract as an equity instrument. The accounting for some contracts affects net income regardless of how they are classified, but the amount reported in net income depends on a contract’s classification. For example, compensation cost is recognized on share-based payment awards regardless of whether they are classified as equity instruments or liability instruments, but the measurement differs depending on the classification. As another example, convertible debt securities affect reported net income regardless of whether the embedded conversion option is separated as a derivative liability or the fair value option is elected for the convertible debt security, but the amounts reported in net income differ depending on whether the embedded conversion option is separated or the fair value option is elected. In these types of situations, the numerator adjustment must be limited to the difference in reported net income of the assumed change in accounting classification. See Section 7.1.4 for further discussion of the application of this guidance to share-based payment awards.

Connecting the Dots

While ASC 260 only refers to reflecting a numerator adjustment for the difference in reported net income that results from the change in accounting classification, the numerator adjustment should also reflect the difference in income available to common stockholders for convertible preferred securities.

4.7.3.2 Antidilution and Control Number

As discussed in Section 4.1.2, an overriding principle underlying the calculation of diluted EPS is “no antidilution” based on the control number. The application of the control number to contracts subject to the guidance in ASC 260 on contracts that may be settled in cash or stock is discussed below.

4.7.3.2.1 Contracts That Must Be Settled in Cash

No adjustments should be made to the numerator or the denominator in the calculation of diluted EPS for equity-linked contracts or share-based payment arrangements classified as assets or liabilities that must be settled in cash. Therefore, the control number and antidilution concepts are not relevant in such cases.

4.7.3.2.2 Contracts That Provide the Entity or Counterparty With the Choice of Settlement Method

The application of the control number and antidilution concepts to a contract that permits the entity or the counterparty to choose the settlement method depends on the facts and circumstances. Table 4-7 discusses when adjustments are made to the numerator, and common shares are added to the denominator, in the calculation of diluted EPS for the scenarios discussed in ASC 260-10-55-36A. In this table, it is assumed that the contract is not a participating security for which the two-class method of calculating diluted EPS may be required.

Table 4-7

Settlement for Diluted EPS	Accounting Classification	Control Number Is a Loss	Control Number Is Earnings
Shares	Asset/liability	No adjustment is made to the numerator and no incremental common shares are added to the denominator.(a)	Treasury Stock/Reverse Treasury Stock Method If the contract is an option or warrant and is out-of-the-money, no adjustment is made to the numerator and no incremental common shares are added to the denominator.(b) In all other situations, the numerator is adjusted for any change in net income during the period that would result if the contract had been classified as an equity instrument and the incremental shares are added to the denominator if the aggregate effect of these adjustments is dilutive on the basis of the antidilution sequencing requirements of ASC 260. If-Converted Method(c) In addition to the numerator (if any) and denominator adjustments required under the if-converted method, as discussed in ASC 260-10-45-40, the numerator is adjusted for any change in net income during the period that would result if the embedded conversion option had not been separated as a derivative liability if the aggregate effect of these adjustments is dilutive on the basis of the antidilution sequencing requirements of ASC 260. Contingently Issuable Share Method For common shares that are considered issuable for diluted EPS on the basis of the guidance on contingently issuable shares discussed in Section 4.5, the numerator is adjusted for any change in net income during the period that would result if the contract had been classified as an equity instrument and the contingently issuable shares are added to the denominator if the aggregate effect of these adjustments is dilutive on the basis of the antidilution sequencing requirements of ASC 260. For potential common shares that are considered issuable for diluted EPS on the basis of the guidance on contingently issuable shares discussed in Section 4.5, the treasury stock method or reverse treasury stock method should be applied, as described above.
Shares	Equity	No adjustment is made to the numerator and no incremental common shares are added to the denominator.	Treasury Stock/Reverse Treasury Stock Method No adjustment is made to the numerator. Incremental common shares are included under the treasury stock method or reverse treasury stock method, if dilutive, on the basis of the antidilution sequencing requirements of ASC 260. If-Converted Method(c) The if-converted method is applied as described in ASC 260-10-45-40 if it is dilutive on the basis of the antidilution sequencing requirements of ASC 260. No additional adjustment is made to the numerator. Contingently Issuable Share Method No adjustment is made to the numerator. The incremental shares or potential common shares are included in the denominator on the basis of the contingently issuable share method if this method is dilutive in accordance with the antidilution sequencing requirements of ASC 260.
Cash	Asset/liability	No adjustment is made to the numerator and no incremental common shares are added to the denominator.	No adjustment is made to the numerator and no incremental common shares are added to the denominator.
Notes to Table: (a) An entity is not required to adjust the numerator for an increase in the reported net loss that results from an accounting classification of a contract that differs from its settlement for diluted EPS purposes. This numerator adjustment is not required even if its effect (after consideration of incremental shares that would be added to the denominator) would result in a diluted loss per share that exceeds the basic loss per share. This view is consistent with ASC 260-10-45-20, which states, in part, that “if there is a loss from continuing operations, diluted EPS would be computed in the same manner as basic EPS is computed, even if an entity has net income after adjusting for a discontinued operation.” (b) ASC 260-10-45-25 and ASC 260-10-45-35 require that the treasury stock method or reverse treasury stock method be applied only to options or warrants that are in-the-money. When an option or warrant is out-of-the-money (which is determined on the basis of the average market price during the reporting period as discussed in Sections 4.2.2.1 and 4.3.2.1), no adjustments must be made to the numerator or denominator in the calculation of diluted EPS regardless of the classification of the contract for accounting purposes or the settlement for diluted EPS purposes. (c) For convertible securities, the accounting classification refers to the accounting for the embedded conversion feature. It is assumed that the fair value option was not elected.

The examples in the next section illustrate the application of the guidance in the tables above.

4.7.4 Examples

Example 4-30

Liability-Classified Call Option on Common Stock — Diluted EPS Calculated on the Basis of Share Settlement

Company B enters into a freestanding written call option on its common stock that must be physically settled by delivery of the full stated number of common shares to the counterparty in exchange for payment of the exercise price. Company B does not currently have enough authorized and unissued shares to settle the contract in shares. As a result, under ASC 815-40, B must assume that the contract may need to be cash-settled and must account for the written call option as a liability at fair value, with changes in fair value recognized through earnings. The written call option is not a participating security.

Although the call option is classified as a liability, in accordance with ASC 260-10-45-45 and 45-46, B should assume that the contract will be settled in shares for diluted EPS purposes. Therefore, the dilutive effect of the call option should be reflected by using the treasury stock method in accordance with ASC 260-10-45-22 and 45-23, and the mark-to-market adjustment recognized during the reporting period should be reversed from the numerator in accordance with ASC 260-10-55-32 and ASC 260-10-55-36A. Such adjustments should only affect B’s calculation of diluted EPS if they are dilutive on the basis of the antidilution sequencing requirements of ASC 260.

Example 4-31

Liability-Classified Call Option on Common Stock — Diluted EPS Calculated on the Basis of Share Settlement

Assume the following regarding Company P during the first quarter ended March 31, 20X5:

P reports net income of $10 million.
P has 5 million weighted-average common shares outstanding during the quarter and reports basic EPS of $2.00 per share.
P has outstanding options that allow the counterparty to purchase 500,000 common shares at an exercise price of $40 per share. The options are not participating securities and are classified as a liability under ASC 815-40 because the counterparty can choose, upon exercise, to require settlement in cash or common shares.
P reports a $250,000 loss, net of tax, on the options in net income because the fair value of the options increases during the reporting period.
The average market price of P’s common stock during the period is $60 per share.

In calculating diluted EPS for the period, P must assume share settlement, if dilutive. In accordance with the table in ASC 260-10-55-36A, the numerator should be increased by $250,000 because, if the options had been classified as an equity instrument, the $250,000 net loss on the options would not have reduced reported net income. In addition, the denominator should be increased by 166,667 shares, which is calculated under the treasury stock method as 500,000 – (500,000 × $40 ÷ $60 = 333,333). Diluted EPS is calculated as follows:

Since share settlement is dilutive, P should report diluted EPS of $1.98.

Note that because an assumption of cash settlement results in no adjustments to the numerator or denominator, an entity only needs to consider whether share settlement is dilutive to EPS on the basis of the antidilution sequencing requirements in ASC 260. If share settlement is not dilutive, no adjustments would be made to the numerator or denominator. That is, the dilution is based on an approach consistent with cash settlement because share settlement is antidilutive.

Footnotes

This EPS accounting applies even if a contract is classified as a liability for accounting purposes because the issuing entity does not control the ability to issue the maximum number of shares that it could be required to deliver when the contract is share-settled.

See Section 7.1.4 for further discussion of share-based payment awards.

See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for further discussion of these requirements.

See Chapter 5 of Deloitte’s Roadmap Share-Based Payment Awards for further discussion of these requirements.

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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.