4.8 Diluted EPS for Specific Types of Transactions or Events | DART

4.8.1 Prior-Period Adjustments

An entity may be required to restate its previously reported net income as a result of a correction of an error. An entity may also be required to retrospectively adjust previously reported net income for other reasons (e.g., a change in accounting principle that is applied retrospectively). As discussed in Section 8.1, in these situations, previously reported basic and diluted EPS must be adjusted as if the restated or retrospectively adjusted income or loss had been originally reported in the prior period(s).

4.8.2 Shareholder Distributions

4.8.2.1 Stock Dividends and Stock Splits

In a stock dividend, stock split, or reverse stock split, basic and diluted EPS must be retrospectively adjusted for all prior financial reporting periods. See further discussion in Section 8.2.1.

4.8.2.2 Rights Issue

A rights issue represents an offer to existing common stockholders to purchase additional shares of common stock for a specified amount for a given period. A rights issue may contain a bonus element that is akin to a stock dividend, in which case retrospective adjustment to basic and diluted EPS is required for all prior reporting periods. See further discussion in Section 8.2.2.

4.8.3 Certain Issuances of Common Stock

4.8.3.1 Common Stock Subscriptions

Stock subscriptions are a mechanism by which an entity can offer employees and other investors the ability to purchase shares of the entity’s common stock typically over a period of time and without a broker’s commission. The impact of a stock subscription agreement on basic and diluted EPS will depend on the extent to which the investor is entitled to participate in dividends before the subscription agreement is fully paid and the shares of common stock are outstanding. See Section 8.3.1 for discussion, including illustrative examples, of the impact on basic and diluted EPS of stock subscription agreements that must be settled in common stock.

4.8.3.2 Common Stock Issued for Note Receivable

The facts and circumstances associated with legally outstanding common stock that was issued in return for a note receivable will vary depending on the contractual terms of the arrangement. ASC 260 does not provide specific guidance on situations in which an entity has issued shares of common stock to an investor that are legally outstanding and not subject to any vesting conditions in return for a note receivable. The determination of whether the common shares issued in return for a note receivable should be considered outstanding and included in the denominator in the calculation of basic EPS, or should be treated as potential common shares and included only in diluted EPS under the treasury stock method, depends on whether the entity has the ability and intent to cancel the shares if the note receivable is not repaid. See further discussion in Section 8.3.2.

4.8.3.3 Distributions That Are Considered Issuances of Common Stock

Certain entities, particularly real estate investment trusts and other entities that are required to periodically distribute a certain portion of their taxable income, make distributions to common shareholders that give the individual shareholders the ability to elect to receive their entire distribution in cash or common shares of an equivalent value, with a potential limitation on the total amount of cash that shareholders may receive in the aggregate. As discussed in Section 8.3.3, the common stock portion of these types of distributions is accounted for as a share issuance rather than as a stock dividend. While the common stock portion of these dividends will not be reflected in the calculation of basic EPS until the shares are issued, diluted EPS will be affected before the common shares issued for the distribution become outstanding. The impact on diluted EPS must be accounted for in accordance with the guidance in ASC 260-10-45-45 and 45-46 on contracts that may be settled in cash or stock at the option of the counterparty. Under this guidance, the entity must presume that the holders of the entity’s common stock will elect to receive shares. The receipt of shares will always be more dilutive than the receipt of cash because the measurement of the liability for the dividend payable is the same regardless of the settlement method (i.e., the monetary value of the dividends is the same and, therefore, the entity is not required to remeasure the dividend liability). See further discussion in Section 8.3.3.

4.8.3.4 Nominal Issuances

A nominal issuance of common stock involves a transaction in which the total consideration payable by the party that receives the shares is nominal in relation to the fair value of the common shares issued. A nominal issuance may also be associated with an issuance of potential common stock, such as an option or warrant to purchase common stock. Under ASC 260, nominal issuances of common stock must be treated retrospectively in the same manner as a stock dividend or stock split. See further discussion in Section 8.3.4.

4.8.3.5 Own-Share Lending

An entity may loan its shares of common stock to an investment bank or investor in conjunction with an issuance of convertible debt. Such shares are “loaned” because the counterparty is unable to borrow shares in the market to hedge its exposure to the conversion option in the convertible debt or because the borrowing cost is prohibitive. As noted in ASC 470-20-45-2A, although loaned shares are legally outstanding, they are generally not considered outstanding common shares in the calculation of diluted EPS. See further discussion in Section 8.5.

4.8.3.6 Unit Structures

Unit structures represent a combination of (1) a debt instrument (the “note”) and (2) a contract to issue common shares (the “purchase contract”).23 In addition to evaluating whether one or more of the component instruments is a participating security, the issuer must determine whether the if-converted or treasury stock method must be applied to calculate the dilutive effect of the potential common shares issuable under the purchase contract. If the note and purchase contract are considered a single combined freestanding financial instrument, the unit structure is treated as a convertible debt instrument in accordance with ASC 470-20-25-3 and the if-converted method is applied to calculate diluted EPS. However, if the note and purchase contract are considered separate freestanding financial instruments, the issuer must perform an additional analysis to determine whether to apply the if-converted method or the treasury stock method in calculating diluted EPS. The discussion below addresses the matters to consider when the note and purchase contract are considered separate freestanding financial instruments.

ASC 260-10-55-9 specifies that when options or warrants (as well as forward sale contracts) require or permit the counterparty to elect to tender debt or other securities of the issuer (or its parent or subsidiary), the if-converted method applies unless tendering cash would be more advantageous to the counterparty. Therefore, when the unit structure permits the counterparty to tender the note as payment of the purchase price for the shares of common stock issuable under the purchase contract, the if-converted method is generally applied because it is not more advantageous to the counterparty to pay cash to acquire the common shares issuable under the purchase contract.

The terms of certain unit structures must be further considered because the counterparty does not have the unconditional right to tender the note to the entity in satisfaction of the amount owed to the issuer to acquire the common shares issuable under the purchase contract. For example, a unit structure may consist of the following instruments and terms:

An entity issues a note with a term of five years and a purchase contract that requires the counterparty to acquire the entity’s common stock at the end of three years (i.e., share settlement is required). The principal amount of the note is the same as the purchase price in the purchase contract.
Three months before the settlement of the purchase contract, the note is subject to remarketing (i.e., resale by the noteholders) for a price that is at least equal to the note’s principal amount. If the market rate of interest for the issuer has increased since the original issuance of the note, the third party that facilitates the remarketing is required to increase the fixed rate of interest on the note to the rate that will result in the resale of the notes at their stated principal amount.
If the remarketing is successful, the counterparty can elect to (1) retain the remarketed note with a remaining term of two years and three months or (2) sell the note in the remarketing for cash proceeds that equal or exceed the purchase price in the purchase contract. The counterparty cannot elect to tender the note to the issuer in satisfaction of the purchase price in the purchase contract.
If the remarketing is unsuccessful, the counterparty may elect to put the note to the entity in satisfaction of the purchase price on the purchase contract.

For these types of arrangements (i.e., those that do not provide the counterparty with the unconditional right to tender the note to satisfy the purchase price in the purchase contract), the if-converted method must be applied to calculate the dilutive effect of the potential common shares issuable under the purchase contract unless both of the following conditions are met:

The remarketing of the notes is designed to represent a transaction among creditors in accordance with ASC 470-50-40-7 — For this to be the case, the third party that facilitates the remarketing must be acting only as an agent of the noteholders. If the issuer has any discretion to change any substantive term of the notes, the third party that facilitates the remarketing would be deemed to be acting as an agent of the issuer. For example, if the issuer has the discretion to (1) change the stated interest rate on the notes from a fixed rate to a variable rate or (2) extend the maturity date of the notes, the third party that facilitates the remarketing would be deemed an agent of the issuer. In these situations, the if-converted method is applied to calculate the dilutive effect of the unit structure.
It is probable that the remarketing of the notes will be successful — If, at any point, it is not probable (or no longer probable) that the remarketing will be successful, the entity must apply the if-converted method because it is not advantageous for the counterparty to pay cash in lieu of tendering the note to satisfy the purchase price in the purchase contract.

If the two conditions above are met, the issuer would apply the treasury stock method to calculate the dilutive effect of the potential common shares issuable under the purchase contract.

An entity should carefully consider individual facts and circumstances, as well as the specific contractual terms, in evaluating the appropriate EPS treatment of unit structures. The evaluation of the appropriate EPS treatment for unit structures must be performed as of each financial reporting date.

4.8.4 Certain Repurchases of Common Stock

4.8.4.1 Forward to Repurchase Common Stock and Mandatorily Redeemable Common Stock

ASC 480-10

EPS

45-4 Entities that have issued mandatorily redeemable shares of common stock or entered into forward contracts that require physical settlement by repurchase of a fixed number of the issuer’s equity shares of common stock in exchange for cash shall exclude the common shares that are to be redeemed or repurchased in calculating basic and diluted earnings per share (EPS). Any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to shares that are to be redeemed or repurchased that have not been recognized as interest costs in accordance with paragraph 480-10-35-3 shall be deducted in computing income available to common shareholders (the numerator of the EPS calculation), consistently with the two-class method set forth in paragraphs 260-10-45-60 through 45-70.

4.8.4.1.1 Forward Purchase Contracts Within the Scope of ASC 480-10-45-4

Under ASC 260-10-45-35, an entity is generally required to apply the reverse treasury stock method to calculate the dilutive effect on forward purchase contracts related to the entity’s common stock. However, ASC 480-10-45-4 is an exception to this guidance that applies only to forward contracts that must be physically settled by repurchase of a fixed number of the entity’s common shares in exchange for cash. For these contracts, the shares of common stock to be repurchased are excluded from both basic and diluted EPS and the reverse treasury stock method is not applied in the calculation of diluted EPS. All other forward purchase contracts that are not subject to the exception in ASC 480-10-45-4 must be reflected in dilutive EPS under ASC 260-10-45-35 if they are dilutive. Thus, the reverse treasury stock method would apply to the following types of forward contracts that obligate the issuer to purchase common shares:

Forward contracts to purchase outstanding shares that give the counterparty (holder) the option to elect either gross physical or net settlement.
Forward contracts to purchase a variable number of outstanding shares that may be settled on either a gross physical or net basis.

4.8.4.1.2 Mandatorily Redeemable Common Stock Within the Scope of ASC 480-10-45-4

In accordance with ASC 480-10-45-4, the denominator in the calculations of basic and diluted EPS should not include any mandatorily redeemable common shares that must be physically settled by repurchase of a fixed number of the issuer’s equity shares in exchange for cash.

4.8.4.2 Accelerated Share Repurchase Programs

An accelerated share repurchase program involves a combination of transactions that includes (1) an immediate repurchase of common shares and (2) a forward contract to either issue common shares or receive additional common shares depending on the volume-weighted average daily purchase prices of the entity’s common stock purchased in the market by the counterparty. The entity can generally choose to settle the forward contract in cash or shares of common stock; however, in some cases, it must receive cash when it is in a gain position. For diluted EPS purposes, the entity must generally apply the treasury stock method to determine the dilutive effect of the forward contract. See Section 8.4.2 for further discussion of the application of the treasury stock method to the forward contract.

4.8.4.3 Redeemable Equity Securities

An entity may have outstanding equity securities (which include NCIs) that are classified in temporary equity in accordance with ASC 480-10-S99-3A. Redeemable equity securities are discussed in detail in Chapter 3 and Section 8.8.4. While remeasurement adjustments required under ASC 480-10-S99-3A may affect income available to common stockholders in the calculation of basic EPS, there is generally no incremental impact on the denominator of diluted EPS because the settlement of any redemption is in cash rather than the issuance of common shares. However, if the redeemable equity securities are convertible, the if-converted method must be applied in the calculation of diluted EPS.

4.8.4.4 Reclassification of Common Stock to a Liability

As discussed in Section 3.2.4.4, a conditionally redeemable common stock instrument may become mandatorily redeemable as a result of the resolution of a condition associated with redemption. In these circumstances, the common shares are removed from the denominator in the calculation of basic EPS as of the reclassification date. There is generally no incremental impact on diluted EPS from such reclassification because removing the common shares as of an earlier date would be antidilutive. If the common stock subject to reclassification is convertible or exchangeable, provided that the event giving rise to the reclassification from an equity instrument to a liability does not affect the conversion or exchange feature, the common stock would continue to be subject to the if-converted method of calculating diluted EPS if this method is more dilutive than the two-class method of calculating diluted EPS. In fact, the common stock may be subject to the if-converted method for periods both before and after reclassification.

4.8.4.5 Tracking Stock

Some entities have issued classes of stock characterized as “tracking” or “targeted” stock, which measure the performance of a specific business unit, activity, or asset of the entity. Shares of tracking stock are traded as separate securities although they typically do not have any specific claim on the related assets and may have limited or no voting rights. According to ASC 260-10-45-60B, an entity with tracking stock must calculate and present EPS for each class of common stock by using the two-class method.

The terms of tracking stock often allow the issuing entity, at its option, to exchange or redeem shares of tracking stock for shares of the issuer’s main common stock in such a way that the entity would have one less class of common stock outstanding. The terms of this feature generally require an entity to pay a premium to the class being redeemed as a result of the transaction. When the entity pays a premium over fair value to redeem a class of tracking stock, the premium should be treated as a reduction from net income in arriving at income available to common stockholders of the class whose shares are being used for the redemption. The rationale for this treatment is that the holders of the tracking stock being redeemed have received a benefit that constitutes an additional contractual return to them. That benefit is absorbed by the class of common stock for which the entity has issued shares in return for the extinguishment of the class of tracking stock.

For diluted EPS, the if-converted method should be applied when a class of tracking stock that can be exchanged or converted into the issuer’s main common stock — regardless of which party, if any, controls the conversion rights — is outstanding during a reporting period, including during a period in which the tracking stock is exchanged or converted. The if-converted method applies only to the calculation of diluted EPS for the class of stock into which the tracking stock is convertible and should be applied only if it is more dilutive than the two-class method of calculating diluted EPS for this class. While an entity may be required to apply the if-converted method to the class of stock into which the tracking stock is convertible, it would not be required to include, as an adjustment to the numerator, the premium payable on exchange or conversion in each reporting period. See further discussion in Section 4.4.2.2.4.

4.8.5 Business Combinations and Reorganizations

ASC 260-10-55-17 does not permit the retrospective adjustment of EPS for shares of common stock issued in a business combination. Rather, such shares issued as part of the purchase price affect the weighted-average common shares outstanding in the calculation of diluted EPS only from the issuance date. However, in reverse merger transactions and certain reorganizations that are considered akin to split-like situations, the number of shares of common stock included in the denominator of diluted EPS is retrospectively adjusted to the earliest period presented to reflect the recapitalization. See Section 8.6 for discussion of these types of situations as well as of the impact of spin-off transactions.

4.8.6 Master Limited Partnerships

MLPs generally have multiple classes of outstanding partnership interests and therefore must apply the two-class method to calculate basic and diluted EPS. If an MLP has outstanding partnership interests that may be converted into another class of partnership interest, diluted EPS should be calculated on the basis of the more dilutive of the two-class method or the if-converted method. If an MLP has issued forwards, options, warrants, or similar instruments to sell partnership interests, diluted EPS should be calculated on the basis of the two-class method or the treasury stock method as applicable. See Section 8.9 for further discussion of the EPS accounting considerations related to MLPs.

4.8.7 Common Stock Issued in R&D Arrangements

See Section 8.10 for discussion of the impact that the sponsor for a specific transaction involving a R&D entity has on net income and income available to common stockholders.

4.8.8 Other Compensatory Arrangements

Section 7.2 discusses when common stock held by an ESOP is considered outstanding and the accounting for diluted EPS by sponsors of ESOPs. Section 7.3 discusses the impact on the calculation of diluted EPS in other compensatory arrangements, including profits interests and common stock owned by a rabbi trust.