Chapter 4 — Diluted EPS
Chapter 4 — Diluted EPS
4.1 Background
ASC 260-10
Diluted EPS
10-2 The objective of diluted EPS is consistent with that of basic EPS — to measure the performance of an entity over the reporting period — while giving effect to all dilutive potential common shares that were outstanding during the period.
Computation of Diluted EPS
45-16 The computation of diluted EPS is similar to the
computation of basic EPS except that the denominator is increased to include the
number of additional common shares that would have been outstanding if the
dilutive potential common shares had been issued. In computing the dilutive
effect of convertible securities, the numerator is adjusted in accordance with
the guidance in paragraph 260-10-45-40. Adjustments also may be necessary for
certain contracts that provide the issuer or holder with a choice between
settlement methods. See Example 1 (paragraph 260-10-55-38) for an illustration
of this guidance.
As noted above, diluted EPS is a per-share performance measure that includes (1)
outstanding common shares and (2) “additional common shares that would have been outstanding
if the dilutive potential common shares had been issued.” In calculating diluted EPS, an
entity assumes that all dilutive potential common shares within its capital structure were
outstanding during the reporting period and that net income (the numerator) was calculated
by using a consistent assumption. The complexity of calculating diluted EPS will vary
depending on the nature of an entity’s capital structure.
The graphic below illustrates the most common types of contractual arrangements that may involve potential common shares. See Table 4-1 for a summary of the methods applied to various types of contracts to determine the dilutive impact on EPS.
In calculating diluted EPS, an entity leverages the calculation of basic EPS.
Specifically, an entity calculates diluted EPS by making various adjustments to the
numerator and denominator in the calculation of basic EPS to reflect the impact of potential
common shares. To do so, the entity uses one of four methods — the treasury stock method,
the reverse treasury stock method, the if-converted method, or the contingently issuable
share method. The calculation of diluted EPS may also need to reflect adjustments to the
numerator for convertible instruments and contracts whose accounting classification differs
from their EPS treatment (e.g., contracts classified as assets or liabilities that are
considered share-settled for diluted EPS purposes). Entities with more complex capital
structures may also need to apply the two-class method in calculating diluted EPS. The
graphic below illustrates the types of adjustments to the numerator and denominator that an
entity may be required to make when calculating diluted EPS.
As discussed in Chapter
2, diluted EPS must be presented or disclosed any time basic EPS is presented
or disclosed. For entities that have multiple classes of common stock, diluted EPS must be
presented on the face of the income statement for each class of common stock. As discussed
in Section 8.7.1, if an entity
reports a discontinued operation, it must present diluted EPS from continuing operations and
net income on the face of the income statement and must present on the face of the income
statement, or disclose in the notes, diluted EPS for discontinued operations. For entities
with NCIs, diluted EPS is calculated on the basis of income attributable to the parent
(i.e., income attributable to NCIs is excluded from the calculation of diluted EPS). See
further discussion in Sections
8.7.2 and 8.8.
The discussion in this chapter is generally in the context of an entity
that presents only one amount of diluted EPS (i.e., the entity does not have any
discontinued operations). Unless otherwise noted, in this chapter, “net income” encompasses
both net income and net loss and refers to consolidated net income for an entity that does
not have an NCI and income attributable to the parent for an entity with an NCI. “Income
available to common stockholders,” which is defined in ASC 260-10-20, refers to income
available or loss attributable to common stockholders for an entity that does not have an
NCI and income available or loss attributable to common stockholders of the parent for an
entity that has an NCI. While an entity with a discontinued operation may have one or more
of income from continuing operations, loss from continuing operations, income from
discontinued operations, loss from discontinued operations, net income, or net loss,
references to “income” or “net income” in this chapter also encompass “loss” and “net loss,”
respectively.
The discussion in Sections 4.2 through 4.8 is based on an entity’s calculation of diluted EPS during a
discrete reporting period (i.e., a quarterly financial reporting period for an SEC registrant). Section 4.9
addresses special considerations related to calculating diluted EPS on a year-to-date basis.
This chapter does not discuss the application of the two-class method of calculating diluted EPS. For
discussion of that method, see Chapter 5.
4.1.1 Methods of Calculating Diluted EPS
The table below lists the different types of contracts to which an entity
generally applies the various methods of calculating diluted EPS.
Table 4-1
Type of Potential Common Share | Diluted EPS Method(s) Applicable | Section in This Chapter |
---|---|---|
Written call options (common stock) | Treasury stock | |
Written put options (common stock) | Reverse treasury stock | |
Nonvested shares (common stock) | Treasury stock | |
Forward sale contracts (common stock) | Treasury stock | |
Forward purchase contracts (common stock) | Reverse treasury stock | |
Convertible debt | If-converted | |
Convertible preferred stock | If-converted | |
Written call options (convertible securities) | Treasury stock | |
Forward sale contracts (convertible securities) | Treasury stock | |
Contingently issuable shares | Contingently issuable share |
4.1.1.1 Purchased Options
ASC 260-10
Purchased Options
45-37 Contracts such as purchased put options and
purchased call options (options held by the entity on its own stock) shall
not be included in the computation of diluted EPS because including them
would be antidilutive. That is, the put option would be exercised only when
the exercise price is higher than the market price and the call option would
be exercised only when the exercise price is lower than the market price; in
both instances, the effect would be antidilutive under both the treasury
stock method and the reverse treasury stock method, respectively.
Contracts that give an entity the right to either purchase or sell its common stock are never included in the calculation of diluted EPS because they would only be exercised by the entity when they are in-the-money and the resulting effect would be antidilutive under the treasury stock method or the reverse treasury stock method. Purchased options should not be included in the calculation of diluted EPS under the treasury stock method or reverse treasury stock method regardless of whether (1) the control number for calculating diluted EPS is income or a loss or (2) the purchased options are classified as an asset or within stockholders’ equity. If an entity has recognized a purchased option on its common stock as an asset at fair value, with changes in fair value recognized in earnings, the entity should not reverse the fair value adjustments recognized in earnings on the asset that have been included in the numerator in the calculation of diluted EPS.
Connecting the Dots
An entity may enter into a combination of purchased and written options on its
common stock in an attempt to economically hedge share dilution. Such strategies
commonly occur in conjunction with the issuance of convertible securities (e.g.,
capped call and other call spread transactions). ASC 260 does not allow an entity to
offset the dilutive effect of outstanding written options with purchased options
even if the options are with the same counterparty. Therefore, when an entity has
entered into both purchased and written options on its common stock, the accounting
for diluted EPS depends on the unit of account for such options. (For further
discussion of the identification of units of account, see Section 3.3.1 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.)
If an entity concludes that the purchased option and written option components are
separate freestanding financial instruments, the treasury stock or reverse treasury
stock method, as applicable, must be applied to the written option, with no
adjustments in the calculation of diluted EPS made for the purchased option. If,
however, an entity concludes that a combination of purchased and written options
constitutes a single unit of account, the entity should apply the treasury stock
method or reverse stock method, as applicable, to the combined contract provided
that it is dilutive to do so (i.e., the written option element is in-the-money from
the perspective of the counterparty). In this situation, the effect of the purchased
option component of the single combined freestanding financial instrument may
partially offset the dilutive impact of the written option component of the single
combined freestanding financial instrument. Regardless of the unit of account, the
entity should also consider whether purchased or written option contracts, or
combinations thereof, represent participating securities to which it must apply the
two-class method of calculating diluted EPS.
4.1.2 Antidilution and Control Number
4.1.2.1 General
ASC 260-10
No Antidilution
45-17 The computation of diluted EPS shall not
assume conversion, exercise, or contingent issuance of securities that would
have an antidilutive effect on EPS. Shares issued on actual conversion,
exercise, or satisfaction of certain conditions for which the underlying
potential common shares were antidilutive shall be included in the
computation as outstanding common shares from the date of conversion,
exercise, or satisfaction of those conditions, respectively. In determining
whether potential common shares are dilutive or antidilutive, each issue or
series of issues of potential common shares shall be considered separately
rather than in the aggregate.
45-18 Convertible securities may be dilutive on their own but antidilutive when included with other potential
common shares in computing diluted EPS. To reflect maximum potential dilution, each issue or series of
issues of potential common shares shall be considered in sequence from the most dilutive to the least dilutive.
That is, dilutive potential common shares with the lowest earnings per incremental share shall be included
in diluted EPS before those with a higher earnings per incremental share. Example 4 (see paragraph 260-10-55-57) illustrates that provision. Options and warrants generally will be included first because use of the
treasury stock method does not affect the numerator of the computation. An entity that reports a discontinued
operation in a period shall use income from continuing operations (adjusted for preferred dividends as
described in paragraph 260-10-45-11) as the control number in determining whether those potential common
shares are dilutive or antidilutive. That is, the same number of potential common shares used in computing the
diluted per-share amount for income from continuing operations shall be used in computing all other reported
diluted per-share amounts even if those amounts will be antidilutive to their respective basic per-share
amounts. (See paragraph 260-10-45-3.) The control number excludes income from continuing operations
attributable to the noncontrolling interest in a subsidiary in accordance with paragraph 260-10-45-11A.
Example 14 (see paragraph 260-10-55-90) provides an illustration of this guidance.
45-19 Including potential common shares in the denominator of a diluted per-share computation for continuing operations always will result in an antidilutive per-share amount when an entity has a loss from continuing operations or a loss from continuing operations available to common stockholders (that is, after any preferred dividend deductions). Although including those potential common shares in the other diluted per-share computations may be dilutive to their comparable basic per-share amounts, no potential common shares shall be included in the computation of any diluted per-share amount when a loss from continuing operations exists, even if the entity reports net income.
45-20 The control number for determining whether including potential common shares in the diluted EPS computation would be antidilutive should be income from continuing operations (or a similar line item above net income if it appears on the income statement). As a result, 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. Similarly, if an entity has income from continuing operations but its preferred dividend adjustment made in computing income available to common stockholders in accordance with paragraph 260-10-45-11 results in a loss from continuing operations available to common stockholders, diluted EPS would be computed in the same manner as basic EPS.
Only potential common shares that are dilutive (i.e., that reduce basic EPS) are included in the calculation of diluted EPS. ASC 260-10-45-17 through 45-20 illustrate two important concepts that an entity must consider in determining whether potential common shares are dilutive — the control number and antidilution sequencing. The application of these concepts in the calculation of diluted EPS for a discrete financial reporting period is discussed below. Section 4.9 discusses the application of these concepts to a year-to-date calculation of diluted EPS.
4.1.2.2 Control Number
The control number represents the single amount that an entity uses to determine
whether each potential common share issuance or series of issuances is dilutive. The
control number is applied, along with the antidilution sequencing requirements, to
calculate diluted EPS (see Section
4.1.2.3 for discussion of antidilution sequencing). The control number
simplifies the calculation of diluted EPS for an entity that presents a discontinued
operation because the entity includes the same potential common shares in the
calculation of diluted EPS for continuing operations, discontinued operations, and net
income. When an entity reports a discontinued operation, it uses income from continuing
operations as the control number and applies the antidilution sequencing requirements to
potential common shares to determine whether they are included in diluted EPS from
continuing operations. If so, the entity always includes those potential common shares
in the amounts of diluted EPS calculated for discontinued operations and net income,
even if such inclusion is antidilutive to those respective amounts of diluted EPS. The
table below summarizes the control number that is used to determine whether potential
common shares are included in the calculation of diluted EPS in accordance with the
antidilution sequencing requirements of ASC 260.
Table 4-2
Income Statement Contains
|
Control Number
|
Reporting If Control Number Is a Loss1
|
---|---|---|
No discontinued operations or NCIs
|
Income available to common stockholders2
|
The inclusion of potential common shares in diluted EPS
will always be antidilutive. Therefore, basic EPS and diluted EPS are the
same.
|
Discontinued operations only
|
Income available to common stockholders from continuing
operations3
|
The inclusion of potential common shares in diluted EPS
related to continuing operations will always be antidilutive. Therefore,
basic EPS and diluted EPS are the same for continuing operations,
discontinued operations, and net income even if an entity reports income
from continuing operations, income from discontinued operations, or net
income.
|
NCIs only
|
Income available to common stockholders of the parent4
|
The inclusion of potential common shares in diluted EPS
will always be antidilutive. Therefore, basic EPS and diluted EPS are the
same.
|
Discontinued operations and NCIs
|
Income available to common stockholders of the parent from
continuing operations5
|
The inclusion of potential common shares in diluted EPS
from continuing operations will always be antidilutive. Therefore, basic EPS
and diluted EPS are the same for continuing operations, discontinued
operations, and net income attributable to the parent even if the entity
reports income from continuing operations, income from discontinued
operations, or net income.
|
As discussed in the table above, when an entity reports a discontinued
operation, income from continuing operations is the control number used to determine
whether potential common shares are included in the calculation of diluted EPS in
accordance with the antidilution sequencing requirements of ASC 260. As a result, if an
entity reports a loss from continuing operations, all potential common shares will always be excluded from the calculations of diluted EPS from
continuing operations, discontinued operations, and net income regardless of whether
there is income or loss from discontinued operations and net income. Conversely, if an
entity reports income from continuing operations, all potential common shares that are
dilutive to income from continuing operations in accordance with the antidilution
sequencing requirements of ASC 260 will always be included in
the calculations of diluted EPS from continuing operations, discontinued operations, and
net income regardless of whether there is income or loss from discontinued operations
and net income. Thus, potential common shares that are dilutive to discontinued
operations will be excluded from diluted EPS from discontinued operations when those
potential common shares are antidilutive to continuing operations. Similarly, potential
common shares that are antidilutive to discontinued operations will be included in
diluted EPS from discontinued operations when those potential common shares are dilutive
to continuing operations. Because of this requirement, it is possible for diluted EPS to
be a smaller loss per share than the loss per share for basic EPS for discontinued
operations and net income when losses are reported for those items but income is
reported from continuing operations. Example 14 in ASC 260-10-55-90 and 55-91
illustrates how the control number concept can result in a diluted loss per share from
discontinued operations and net income that is less than the corresponding amounts of
basic loss per share.
ASC 260-10
Example 14: Antidilutive Securities
55-90 This Example illustrates the guidance in paragraph 260-10-45-18.
55-91 Assume that Entity A has income from continuing operations of $2,400, a loss from discontinued operations of $(3,600), a net loss of $(1,200), and 1,000 common shares and 200 potential common shares outstanding. Entity A’s basic per-share amounts would be $2.40 for continuing operations, $(3.60) for the discontinued operation, and $(1.20) for the net loss. Entity A would include the 200 potential common shares in the denominator of its diluted per-share computation for continuing operations because the resulting $2.00 per share is dilutive. (For illustrative purposes, assume no numerator impact of those 200 potential common shares.) Because income from continuing operations is the control number, Entity A also must include those 200 potential common shares in the denominator for the other per-share amounts, even though the resulting per-share amounts [$(3.00) per share for the loss from discontinued operation and $(1.00) per share for the net loss] are antidilutive to their comparable basic per-share amounts; that is, the loss per-share amounts are less.
4.1.2.3 Antidilution Sequencing
An entity is prohibited from applying antidilution (i.e., increasing basic EPS
for the control number) in calculating diluted EPS. Accordingly, an entity must
calculate diluted EPS in a manner that maximizes dilution (i.e., the amount of diluted
EPS calculated is the lowest possible amount based on all potential combinations of the
dilutive impact of potential common shares). To achieve this result, an entity must
“sequence” each issuance or series of issuance of potential common shares that are
individually dilutive in the order from most dilutive to least dilutive.6 Once these share issuances are sequenced, the entity includes the dilutive effect
of each potential common share in the calculation of diluted EPS until the inclusion of
the individually dilutive effect of a potential common share is antidilutive to the
overall calculation of diluted EPS. When this occurs, that potential common share, as
well as all other potential common shares that are less dilutive, is excluded from the
calculation of diluted EPS.
Antidilution sequencing is applied only to the control number. Thus, as stated above, when an entity has
a discontinued operation, the same potential common shares included in diluted EPS from continuing
operations are included in the calculations of diluted EPS for discontinued operations and net income.
Antidilution sequencing is required in the calculation of diluted EPS unless (1) the control number is a
loss (i.e., all potential common shares would be antidilutive) or (2) the entity has only one issuance of
potential common shares.
Connecting the Dots
When an entity has multiple issuances of the same potential common share, it generally must
consider each issuance separately in applying antidilution sequencing. Issuances of multiple
instruments may be aggregated and considered a single issuance for sequencing
purposes during a financial reporting period only if all the following conditions are met:
- The instruments are of the same type and have all the same terms (i.e., they are identical).
- The instruments were outstanding for the same days during the financial reporting period (i.e., they either were outstanding for the entire period or issued or expired on the same day during the financial reporting period).
Aggregation of multiple instruments into a single issuance for antidilution
sequencing purposes is only appropriate when each individual instrument has the same incremental
dilutive effect. Since the average market price that is used under the treasury stock method
is affected by the number of days a potential common share is outstanding during a financial
reporting period, it would not be appropriate to aggregate instruments with the same terms that
were not outstanding for the same number of days during a financial reporting period.
Example 4 in ASC 260-10-55-57 through 55-59 illustrates the concept of antidilution sequencing.
ASC 260-10
Example 4: Antidilution Sequencing
55-57 This Example illustrates the antidilution sequencing provisions described in paragraph 260-10-45-18 for Entity A for the year ended December 31, 20X0. This Example has the following assumptions:
- Entity A had income available to common stockholders of $10,000,000 for the year 20X0.
- 2,000,000 shares of common stock were outstanding for the entire year 20X0.
- The average market price of the common stock was $75.
- Entity A had the following potential common shares outstanding during the year:
- Options (not compensation-related) to buy 100,000 shares of common stock at $60 per share.
- 800,000 shares of convertible preferred stock entitled to a cumulative dividend of $8 per share. Each preferred share is convertible into two shares of common stock.
- 5 percent convertible debentures with a principal amount of $100,000,000 (issued at par). Each $1,000 debenture is convertible into 20 shares of common stock.
- The tax rate was 40 percent for 20X0.
55-58 The following table illustrates calculation of earnings per incremental share.
55-59 The following table illustrates calculation of diluted EPS.
Footnotes
1
The control number may be a loss when an entity
reports net income because it includes the impact of dividends on
preferred stock.
2
Income available to common stockholders generally
represents net income less preferred stock dividends. As discussed in
Chapter
3, many types of transactions represent “deemed” preferred
stock dividends that reduce net income in arriving at income available
to common stockholders.
3
Income available to common stockholders from
continuing operations generally represents income from continuing
operations less preferred stock dividends allocated to continuing
operations. As discussed in Chapter 3, many types of
transactions can result in adjustments to net income in arriving at
income available to common stockholders. When an entity presents a
discontinued operation, adjustments to net income to arrive at income
available to common stockholders must be allocated between continuing
and discontinued operations to arrive at income available to common
stockholders from continuing operations. Sections 8.6.3.2.1 and 8.7 further discuss
the accounting and presentation of EPS for an entity that presents a
discontinued operation.
4
Income available to common stockholders of the parent
generally represents net income attributable to the parent less
preferred stock dividends allocated to the parent. As discussed in
Chapter
3, many types of transactions can result in adjustments to
net income in arriving at income available to common stockholders. When
an entity presents an NCI, adjustments to income attributable to the
parent to arrive at income available to common stockholders of the
parent are determined by including the parent’s portion of income
available to common stockholders of the consolidated subsidiary in the
parent’s calculation of income available to common stockholders. See
Section
8.8 for further discussion of how EPS is calculated for an
entity with an NCI.
5
Income available to common stockholders of the parent
from continuing operations represents income attributable to the parent
from continuing operations less preferred stock dividends. As discussed
in Chapter
3, many types of transactions can result in adjustments to
net income in arriving at income available to common stockholders. When
an entity presents a discontinued operation and an NCI, the
considerations discussed in notes 3 and 4 of this table are relevant.
Example
8-19 illustrates the presentation of EPS for an entity that
reports an NCI in a discontinued operation.
6
Any potential common share that is individually antidilutive is
excluded from the antidilution sequencing process. For example, as discussed in
Section 4.2.2.1,
under the treasury stock method, options on common shares that are out-of-the-money
are individually antidilutive and would never be included in diluted EPS regardless
of the control number.
4.2 Treasury Stock Method
4.2.1 Scope
ASC 260-10
Options, Warrants, and Their Equivalents and the Treasury
Stock Method
45-22 The dilutive effect of
outstanding call options and warrants (and their
equivalents) issued by the reporting entity shall be
reflected in diluted EPS by application of the treasury
stock method unless the provisions of paragraphs
260-10-45-35 through 45-36 and 260-10-55-8 through 55-11
require that another method be applied. Equivalents of
options and warrants include nonvested stock granted under a
share-based payment arrangement, stock purchase contracts,
and partially paid stock subscriptions (see paragraph
260-10-55-23). Antidilutive contracts, such as purchased put
options and purchased call options, shall be excluded from
diluted EPS.
The treasury stock method applies to the following types of potential common
shares if they are dilutive7 (except in certain circumstances, discussed below):
-
Written call options (common stock) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of common stock at a fixed or otherwise determinable price, including those issued in share-based payment arrangements.8 These written call options are also called “warrants.”
-
Written call options (convertible securities) — Options and warrants written by an entity under which the counterparty has the right, but not the obligation, to purchase a specified quantity or amount of the entity’s convertible securities at a fixed or otherwise determinable price, including those issued in share-based payment arrangements. These written call options are also called “warrants on convertible securities.”
-
Forward sale contracts (common stock) — Contracts that require the entity to sell a specified quantity or amount of common stock to the counterparty at a fixed or otherwise determinable price.
-
Forward sale contracts (convertible securities) — Contracts that require the entity to sell a specified quantity or amount of convertible securities to the counterparty at a fixed or otherwise determinable price.
-
Nonvested shares (common stock) — Agreements between an entity and an employee or nonemployee in a share-based payment arrangement to issue common shares, provided that the counterparty meets a relevant vesting condition (i.e., a service, performance, or market condition).
An entity should not apply the treasury stock method to a contract listed above
in the following situations:
-
The contract must be net settled in cash (i.e., no common shares or potential common shares are issued upon settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the treasury stock method.
The discussion in the next section focuses on the application of the treasury
stock method to potential common shares within its scope that are not participating
securities. If a potential common share is a participating security, an entity is
required to use the more dilutive of the treasury stock method or the two-class
method of calculating diluted EPS (see Section 5.5.4). Sections 4.2.2.3.4 and 4.6 discuss the application
of the treasury stock method to instruments that contain multiple settlement
alternatives. Section
7.1.2.1 provides additional guidance on applying the treasury stock
method to potential common shares issued in a share-based payment arrangement.
4.2.2 Application of the Treasury Stock Method
4.2.2.1 Contracts to Sell Common Stock
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or
exercise price from the standpoint of the security
holder. Previously reported diluted EPS data shall not
be retroactively adjusted for subsequent conversions or
subsequent changes in the market price of the common
stock.
Variable
Denominator
45-21A Changes in an entity’s
share price may affect the exercise price of a financial
instrument or the number of shares that would be used to
settle the financial instrument. For example, when the
principal of a convertible debt instrument is required
to be settled in cash but the conversion premium is
required to (or may) be settled in shares, the number of
shares to be included in the diluted EPS denominator is
affected by the entity’s share price. In applying both
the treasury stock method and the if-converted method of
calculating diluted EPS, the average market price shall
be used for purposes of calculating the denominator for
diluted EPS when the number of shares that may be issued
is variable, except for contingently issuable shares
within the scope of the guidance in paragraphs
260-10-45-48 through 45-57. See paragraphs 260-10-55-4
through 55-5 for implementation guidance on determining
an average market price.
Options, Warrants, and Their Equivalents and the Treasury Stock Method
Under the treasury stock method:
- Exercise of options and warrants shall be assumed at the beginning of the period (or at time of issuance, if later) and common shares shall be assumed to be issued.
- The proceeds from exercise shall be assumed to be used to purchase common stock at the average market price during the period. (See paragraphs 260-10-45-29 and 260-10-55-4 through 55-5.)
- The incremental shares (the difference between the number of shares assumed issued and the number of shares assumed purchased) shall be included in the denominator of the diluted EPS computation.
Example 15 (see paragraph 260-10-55-92)
provides an illustration of this guidance. See paragraph
260-10-45-21A if the exercise price of a financial
instrument or the number of shares that would be used to
settle the financial instrument is variable.
45-25 Options and warrants will have a dilutive effect under the treasury stock method only when the average
market price of the common stock during the period exceeds the exercise price of the options or warrants
(they are in the money). Previously reported EPS data shall not be retroactively adjusted as a result of changes
in market prices of common stock.
45-26 Dilutive options or warrants that are issued during a period or that expire or are cancelled during a
period shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise,
dilutive options or warrants exercised during the period shall be included in the denominator for the period
prior to actual exercise. The common shares issued upon exercise of options or warrants shall be included in
the denominator for the period after the exercise date. Consequently, incremental shares assumed issued shall
be weighted for the period the options or warrants were outstanding, and common shares actually issued
shall be weighted for the period the shares were outstanding.
45-27 Paragraphs 260-10-55-3 through 55-11 provide additional guidance on the application of the treasury
stock method.
Share-Based Payment Arrangements
45-28 The provisions in
paragraphs 260-10-45-28A through 45-31 apply to
share-based awards issued to grantees under a
share-based payment arrangement in exchange for goods
and services or as consideration payable to a
customer.
45-28A Awards of share
options and nonvested shares (as defined in Topic 718)
to be issued to a grantee under a share-based payment
arrangement are considered options for purposes of
computing diluted EPS. Such share-based awards shall be
considered to be outstanding as of the grant date for
purposes of computing diluted EPS even though their
exercise may be contingent upon vesting. Those
share-based awards are included in the diluted EPS
computation even if the grantee may not receive (or be
able to sell) the stock until some future date.
Accordingly, all shares to be issued shall be included
in computing diluted EPS if the effect is dilutive. The
dilutive effect of share-based payment arrangements
shall be computed using the treasury stock method. If
the equity share options or other equity instruments are
outstanding for only part of a period, the shares
issuable shall be weighted to reflect the portion of the
period during which the equity instruments were
outstanding. See Example 8 (paragraph 260-10-55-68).
45-28B In applying the treasury stock method, all dilutive potential common shares, regardless of whether they are exercisable, are treated as if they had been exercised. The treasury stock method assumes that the proceeds upon exercise are used to repurchase the entity’s stock, reducing the number of shares to be added to outstanding common stock in computing EPS.
45-29 In applying the
treasury stock method described in paragraph
260-10-45-23, the assumed proceeds shall be the sum of
both of the following:
-
The amount, if any, the grantee must pay upon exercise.
-
The amount of cost attributed to share-based payment awards (within the scope of Topic 718 on stock compensation) not yet recognized. This amount includes share-based payment awards that are not contingent upon satisfying certain conditions as described in paragraph 260-10-45-32 and contingently issuable shares that have been determined to be included in the computation of diluted EPS as described in paragraphs 260-10-45-48 through 45-57
-
Subparagraph superseded by Accounting Standards Update No. 2016-09.
45-29A Under paragraphs
718-10-35-1D and 718-10-35-3, the effect of forfeitures
is taken into account by recognizing compensation cost
for those instruments for which the employee’s requisite
service has been rendered or the nonemployee’s vesting
conditions have been met and no compensation cost shall
be recognized for instruments that grantees forfeit
because a service or performance condition is not
satisfied. See Example 8 (paragraph 260-10-55-68) for an
illustration of this guidance.
45-32 Fixed grantee stock
options (fixed awards) and nonvested stock (including
restricted stock) shall be included in the computation
of diluted EPS based on the provisions for options and
warrants in paragraphs 260-10-45-22 through 45-27. Even
though their issuance may be contingent upon vesting,
they shall not be considered to be contingently issuable
shares (see Section 815-15-55 and paragraph
260-10-45-48). However, because issuance of
performance-based stock options (and performance-based
nonvested stock) is contingent upon satisfying
conditions in addition to the mere passage of time,
those options and nonvested stock shall be considered to
be contingently issuable shares in the computation of
diluted EPS. A distinction shall be made only between
time-related contingencies and contingencies requiring
specific achievement.
The treasury stock method represents a method for determining the dilutive
effect of options, warrants, nonvested shares, forward sale contracts, and
similar instruments. Under this method, it is assumed that the proceeds that
would be received upon settlement are used to repurchase common shares at the
average market price during the period. ASC 260-10-45-23 through 45-32 describe
how the treasury stock method is applied and include specific discussion of its
application to share-based payment arrangements.
The treasury stock method is only applied to options and warrants that are
in-the-money from the perspective of the counterparty. It is not applied to
options and warrants that are out-of-the-money from the counterparty’s
perspective, because (1) the holder would not elect to exercise an instrument
that is not in-the-money and (2) application of the treasury stock method would
generally be antidilutive. The determination of whether an option or warrant is
in-the-money is made by comparing the average market price of the common stock
during the period with the assumed proceeds received upon exercise of the
instrument. For share-based payment awards, the proceeds include the exercise
price and the average amount of cost not yet recognized. For all other
instruments, the proceeds are limited to the exercise price. See Section 7.1.2.1 for
additional discussion of the application of the treasury stock method to
share-based payment awards.
An entity must determine whether options or warrants are in-the-money, and must
apply the treasury stock method, on an instrument-by-instrument basis. If the
average market price of common stock during the period exceeds the proceeds per
common share issuable, an option or warrant is in-the-money. In determining
whether an option or warrant is in-the-money, it is not appropriate for an
entity to compare the end-of-period market price of the common stock with the
proceeds. Further, in making this determination, as well as in applying the
treasury stock method, an entity must consider the guidance in ASC 260-10-45-21,
which states that diluted EPS is calculated on the basis of “the most
advantageous conversion rate or exercise price from the standpoint of the
security holder.” This would include any exercise price available to the holder
at some future date that results from the mere passage of time (see further
discussion in Section
4.2.2.1.2.1). Sections
4.2.2.1.1 and 4.2.2.1.2
discuss considerations related to situations in which the number of shares or
proceeds received upon exercise varies.
Connecting the Dots
An entity may classify options and warrants as liabilities and measure them at
fair value, with changes in fair value recognized in earnings. When the
treasury stock method is applied for diluted EPS purposes, the numerator
must be adjusted because, under the treasury stock method, the
instrument is assumed to be classified within equity (and the income
statement effect of the contract would not have occurred had it been
exchanged for common shares at the beginning of the period or on the
date of issuance, if later). As discussed in Sections 4.2.2.3 and 4.7.3, the
numerator adjustment reflects a reversal of the mark-to-market
adjustment that was recognized on the option or warrant during the
period, net of tax. The aggregate effect of this adjustment to the
numerator and the incremental common shares included in the denominator
could potentially yield a dilutive result during a reporting period even
though the option or warrant was out-of-the-money from the
counterparty’s perspective on the basis of a comparison of the (1)
proceeds per common share issuable with (2) average market price of the
entity’s common stock. Because the treasury stock method is not applied
to options or warrants that are out-of-the-money, an entity should not
include the dilutive result that would occur if the mark-to-market
reversal was made to the numerator and the shares were added to the
denominator.
In addition, the adjustment to the numerator and application of the treasury stock method to liability-classified options or warrants could potentially yield an antidilutive result during a financial reporting period even if the option or warrant was in-the-money from the counterparty’s perspective on the basis of a comparison of the (1) proceeds per common share issuable with (2) average market price of the entity’s common stock. Because an entity, in considering the antidilution sequencing requirements of ASC 260, does not apply the treasury stock method when options or warrants are antidilutive, the entity should not include the antidilutive result that would occur if the mark-to-market reversal was made to the numerator and the share adjustments were made to the denominator, even though the instrument was in-the-money from the counterparty’s perspective.
Nonvested shares of common stock are issued to employees and nonemployees in
share-based payment arrangements. Because there is no exercise price for
nonvested shares issued in a share-based payment arrangement, the treasury stock
method is generally dilutive. However, the average cost not yet recognized for
financial reporting purposes (which is considered proceeds) may possibly
purchase more than the number of nonvested shares at the average market price
during a financial reporting period.
Forward contracts to sell common stock must be settled regardless of whether
they are in-the-money or out-of-the-money from the counterparty’s perspective;
therefore, the treasury stock method always applies to forward sale contracts if
they are dilutive. The determination of whether a forward sale contract is
dilutive under the antidilution sequencing guidance in ASC 260 is made on an
instrument-by-instrument basis. Forward sale contracts may be dilutive to EPS
even if they are out-of-the-money from the counterparty’s perspective on the
basis of the end-of-period market price of the entity’s common stock because,
under the treasury stock method, it is assumed that there is a repurchase of
common shares at the average market price during the period. Thus, when the
entity considers the average market price of its common stock during the period,
the contract is in-the-money and dilutive under the treasury stock method.
In applying the treasury stock method to a forward sale contract, an entity must
consider the guidance in ASC 260-10-45-21, which states that diluted EPS is
calculated on the basis of “the most advantageous conversion rate or exercise
price from the standpoint of the security holder.” This would include any
forward price available to the holder at some future date that results from the
mere passage of time. See further discussion in Section 4.2.2.1.2.1. Sections 4.2.2.1.1 and 4.2.2.1.2 discuss considerations related to
situations in which the number of shares or proceeds received upon settlement
varies.
Connecting the Dots
As discussed above, options and warrants are subject to the treasury stock
method only if they are in-the-money on the basis of a comparison of the
proceeds on exercise with the average market price during the period,
whereas forward sale contracts are subject to the treasury stock method
in all cases if the result is dilutive. This distinction based on the
type of contract will not create any difference in the application of
the treasury stock method to a contract that is classified as an equity
instrument. This is because the treasury stock method will always be
antidilutive when applied to options, warrants, and forward sale
contracts that are out-of-the-money from the counterparty’s perspective
on the basis of a comparison of the per-share proceeds upon exercise or
settlement with the average market price of the entity’s common stock
during the period. This distinction based on the type of contract may,
however, create a difference between forward sale contracts and options
and warrants in the calculation of diluted EPS when the contract is
classified as an asset or liability because of the numerator adjustment
that is required in this circumstance.
4.2.2.1.1 Adjustments to the Number of Shares Issuable on Settlement
The number of common shares issuable upon settlement of options, warrants, nonvested shares,
forward sale contracts, and similar instruments may vary because of (1) the passage of time; (2) the
occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares issuable upon settlement varies on the basis of only the passage of time, an entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty. See Example 4-1 for an illustration related to these concepts.
If the number of common shares issuable upon settlement is subject to adjustment
on the basis of the occurrence or nonoccurrence of a specified event (other
than changes in the fair value of the entity’s stock price) that is not
within the counterparty’s control, an entity should apply the guidance on
contingently issuable shares to determine the number of common shares
issuable upon settlement. As discussed in Section 4.5, the entity should assume
that the current status of the condition as of the reporting date will
remain unchanged (i.e., the specified event will not occur). As a result,
potential adjustment features that are commonly included in the terms of
instruments to sell common stock will have no impact on the application of
the treasury stock method until such adjustment events occur. The table
below lists common adjustment events that will have no impact on the
application of the treasury stock method before the occurrence of the
related event.
Table 4-3
Common Adjustment Features That Do Not Affect Calculations of Diluted EPS Until
the Adjustment Event Occurs |
---|
See Section 4.8.2 for discussion of the requirement to retrospectively adjust previously reported EPS amounts upon the occurrence of stock splits, reverse stock splits, stock dividends, and rights issues. |
If the number of common shares issuable upon settlement is linked to a specified
rate, price, index, or other variable, an entity should determine the number
of shares (see the table below) by applying either (1) the guidance in ASC
260-10-45-21A on variable denominators or (2) the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares. Under the
variable denominator approach, the entity would determine the number of
common shares issuable upon settlement on the basis of the average of the
specified rate, price, index, or other variable during the reporting period.
As discussed in Section
4.5, under the contingently issuable share approach, the
entity would reflect the number of common shares that would be issued upon
settlement on the basis of the current rate, price, index, or other variable
at the end of the reporting period (or on the basis of the average rate,
price, index, or other variable, assuming settlement occurred on the last
day of the reporting period if the contract stipulates an average rate,
price, index, or other variable). As discussed in Section 4.2.2.1.3, under either
approach, the stock price used to calculate the number of common shares
assumed to be repurchased with the proceeds must reflect the average market
price during the entire financial reporting period (or portion thereof
during the reporting period the contract was outstanding). If the contract
is classified as an asset or liability, the numerator must also be adjusted
as part of the calculation under the treasury stock method, as discussed in
Section
4.2.2.3.1.
Table
4-4
Determining the Number of Shares
Issuable Upon Settlement When the Shares Vary on the
Basis of a Specified Rate, Price, Index, or Other
Variable
| ||
---|---|---|
Type of Variable
|
Approach Used
| |
Entity’s stock price
|
Average market price approach unless
the arrangement represents a contingently issuable
share9
| |
Other rate, price, index, or variable
|
Average market price approach or contingently
issuable share method
|
The average market price approach must be used if the number
of shares varies on the basis of just the entity’s stock price. However,
either the average market price approach or contingently issuable share
method can be applied, as a policy choice, if the variability is due to
something other than just the entity’s stock price, since ASC 260-10-45-21A
only specifically addresses how an entity should account for diluted EPS
when the variable is based only on the entity’s stock price.
See Example 4-3
for an illustration of how the treasury stock method is applied to a forward
contract to sell a variable number of common shares depending on the market
price of the entity’s common stock.
4.2.2.1.2 Proceeds
The determination of the proceeds used to apply the treasury stock method is
generally straightforward. The proceeds represent the amount the
counterparty must pay to receive the common shares underlying the contract
(i.e., the exercise price or forward price) and, for share-based payments,
include the average amount of compensation cost not yet recognized. However,
as discussed below, an entity must take additional considerations into
account in certain situations.
4.2.2.1.2.1 Adjustments to the Exercise Price or Forward Price
The exercise price or forward price of options, warrants, nonvested shares, forward sale contracts, and
similar instruments may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of
a specified event; or (3) a specified rate, price, index, or other variable.
If the exercise price or forward price varies on the basis of only the passage of time, an entity should
apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the
most advantageous conversion rate or exercise price from the standpoint of the security holder.” The
entity must consider any exercise price or forward price that will be available to the counterparty at any
point during the term of the contract and assume settlement upon terms that maximize value to the
counterparty. See Examples 4-1 and 4-5 for illustrations related to these concepts.
If the exercise price or forward price is subject to adjustment on the basis of
the occurrence or nonoccurrence of a specified event (other than changes
in the fair value of the entity’s stock price) that is not within the
counterparty’s control, an entity should apply the guidance on
contingently issuable shares to determine the exercise price or forward
price. As discussed in Section 4.5, the entity should assume that the current
status of the condition as of the reporting date will remain unchanged
(i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of
instruments to sell common stock will have no impact on the application
of the treasury stock method until such adjustments are made. Table 4-3
includes a list of common adjustment events that will have no impact on
the application of the treasury stock method before the occurrence of
the related event. See also Example 4-6.
If the exercise price or forward price varies solely on the basis of the
entity’s stock price, the entity should apply ASC 260-10-45-21A, which
requires that the entity determine the proceeds by using the average
market price of the entity’s stock during the reporting period. If,
however, the exercise price or forward price varies on the basis of a
specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The proceeds reflect the exercise price or forward price as of the end of the reporting period — This view is consistent with the guidance in ASC 260 on contingently issuable shares. Although that guidance only specifically addresses how to determine the number of common shares, it may be applied by analogy to determine the exercise price or forward price. Under that guidance, it is assumed that the contingency (in this case, the amount of the exercise price or forward price) is resolved as of the end of the reporting period. Thus, an entity calculates the exercise price or forward price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement of the contract on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The proceeds reflect the lowest exercise price or forward price during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the exercise or forward prices applicable for the entire time during the reporting period in which the contract was outstanding and use the price that is least advantageous to the entity and produces the lowest proceeds. The entity should not project future exercise or forward prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The proceeds reflect the average exercise price or forward price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-23, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of the settlement date (since neither
party ultimately controls the rate, price, index, or other variable that
affects the proceeds). The approach selected is considered an accounting
policy election that must be applied consistently and disclosed.
Under any of the three approaches described above, the entity must assume that
it repurchases common shares with the proceeds at the average market
price during the reporting period (see Section 4.2.2.1.3). In addition,
if the contract is classified as an asset or liability for accounting
purposes, which may be required because of the variable terms,10 the calculation of diluted EPS under the treasury stock method
should include an adjustment to the numerator, as discussed in Section
4.2.2.3.1. Example 4-4 illustrates the application of the
alternative views to a forward sale contract.
It is not acceptable to determine the proceeds on the basis of the exercise
price or forward price at the beginning of the reporting period because
there is no basis in ASC 260 for the use of this approach.
Connecting the Dots
It may be unclear whether an entity should apply
the guidance on contingently issuable shares in ASC 260-10-45-48
through 45-57 or the guidance on variable denominators in ASC
260-10-45-21A. In such cases, the entity 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 that ASU 2020-06 made to ASC 260 were not intended to
change an entity’s determination of whether the guidance on
contingently issuable shares applies. In those discussions, the
FASB staff acknowledged that the guidance in ASC 260 addressing
what constitutes a contingently issuable share is often
difficult to interpret in practice.
4.2.2.1.2.2 Prepaid Contracts
A prepaid forward sale contract is subject to the treasury stock method in the
calculation of diluted EPS. Since the counterparty has already paid the
forward price, there are no proceeds under the treasury stock method.
Because there are no proceeds, the dilution under the treasury stock
method is calculated as the number of common shares issuable under the
contract. If the number of common shares varies, an entity should apply
the guidance discussed in Section 4.2.2.1.1.
A counterparty to a stock option may prepay the exercise price before exercising
the stock option. For example, a stock option issued to an employee in a
share-based payment arrangement may be “early exercised” before the
award has vested. In this circumstance, the entity generally is required
or allowed to repurchase the stock option if it is ultimately not
exercised (or, for share-based payment awards, if it does not vest).
Because the counterparty has already paid cash to early exercise the
option, there is no cash that will be received from the counterparty in
the future. Further, the cash received could have been used to
repurchase shares during the requisite service period. As a result, the
cash received is not included in the computation of assumed proceeds. In
the absence of average unrecognized cost for share-based payment awards,
there will be no proceeds under the treasury stock method.
4.2.2.1.3 Average Market Price
ASC 260-10
Average Market Price
55-4 The average market price
of common stock shall represent a meaningful
average. Theoretically, every market transaction for
an entity’s common stock could be included in
determining the average market price. As a practical
matter, however, a simple average of weekly or
monthly prices usually will be adequate.
55-5 Generally, closing market prices are adequate for use in computing the average market price. When
prices fluctuate widely, however, an average of the high and low prices for the period that the price represents
usually would produce a more representative price. The method used to compute the average market price
shall be used consistently unless it is no longer representative because of changed conditions. For example, an
entity that uses closing market prices to compute the average market price for several years of relatively stable
market prices might need to change to an average of high and low prices if prices start fluctuating greatly and
the closing market prices no longer produce a representative average market price.
ASC 260-10-55-4 and 55-5 offer some flexibility related to an entity’s approach
to calculating average market prices when the entity applies the treasury
stock method. For entities whose common stock trades regularly, the most
precise method is generally to average daily closing stock prices.11 However, as discussed in ASC 260-10-55-4, a simple average of weekly
or even monthly common stock prices may be adequate in such circumstances.
If an entity decides to calculate an average common stock price by using a
basis other than an average of each day’s closing price, the entity should
ensure that the averaging method does not misrepresent the average market
price for the reporting period. The entity should apply the approach
selected consistently over time unless changes in facts and circumstances
result in the need to alter the approach used to calculate the average
market price.
Connecting the Dots
The common stock of many entities trades outside regular trading hours (also
referred to as “pre-market” or “after-hours” trading). In the United
States, the regular trading hours for equity securities are from
9:30 a.m. to 4:00 p.m. (ET). Any trading before 9:30 a.m. (ET) is
considered “pre-market” trading, and any trading after 4:00 p.m.
(ET) is considered “after-hours” trading. ASC 260 refers to the use
of closing stock prices, which represent the last published trade on
the relevant exchange (i.e., in the United States, the last trade
that occurs on or before 4:00 p.m. (ET)). Because the original
pronouncement that was codified in ASC 260 was issued before the
proliferation of pre-market and after-hours trading, ASC 260 does
not mention market prices occurring outside regular trading hours.
However, it is appropriate for entities not to include in the
average market price any trade that was completed before or after
regular trading hours. It may be appropriate for an entity to
consider trades in its common stock that occur outside regular
trading hours if trading in the entity’s common stock is limited,
but the entity must take care before considering such market prices.
In many cases, there is much less liquidity in pre-market and
after-hours trading, which may significantly affect the price of
trades. Furthermore, significant increases and decreases in the
market price of an entity’s common stock often occur in pre-market
or after-hours trading because of news released immediately before
or after the markets close. Because the volume of trades outside
regular trading hours is generally limited compared with trading
volume during regular trading hours, trading participants often
“over-react” more positively or negatively than they do when stock
prices occur during regular trading hours. As a result, in the
absence of a limited population of trades in an entity’s common
stock during regular trading hours, an entity should not include
market prices from trades that occur outside regular trading hours
in calculating the average market price during a period.
Additional considerations may be necessary when an entity’s common stock is thinly traded. It may be more appropriate to use a method other than an average of a limited population of trading prices. ASC 260-10-55-5 discusses the use of an average of the high and low prices for the period that is due to high volatility in the company’s common stock. When an entity’s common stock trades very infrequently and in such a way that an average of closing common stock prices is not meaningful, it would be acceptable for an entity to use the average of the bid-and-ask price for the common stock to determine the average market price. This method should be applied until the entity’s common stock trades regularly and an average of closing prices becomes more appropriate.
Another situation in which additional consideration is required is the
determination of average market prices in pre-IPO periods. As discussed in
Section 8.6
and Appendix B,
diluted EPS may need to be presented on the face of the income statement, in
pro forma disclosures, or both when an entity’s financial statements are
included in a registration statement filed with the SEC for an IPO of common
stock. In these situations, observable prices of an entity’s common stock
may be limited or altogether unavailable. As a result, the entity will need
to consider valuations of its common stock. Such valuations, whether
calculated internally or by a third party, must be prepared by using
generally accepted valuation principles and must conform to the fair value
measurement principles in ASC 820. An entity should consider any valuations
prepared for the purpose of recognizing compensation cost for consistency
with share-based payment arrangements.
While the number of periods related to deriving an average
market price depends on the facts and circumstances, the calculation of the
average market price should take into account common stock prices for the
entire reporting period because ASC 260-10-55-4 requires that the average be
meaningful. Therefore, when an entity consummates an IPO during a fiscal
year, the average market price for the period should include (1) the stock
price before the IPO, determined through the entity’s valuations of common
stock (i.e., its IRC Section 409A valuations), and (2) the publicly traded
stock prices for periods after the IPO. An entity cannot solely use its
publicly traded stock price to calculate the average market price for the
entire reporting period. In addition, an entity cannot assume that its
publicly traded stock price upon IPO effectiveness represents the market
price for the portion of the fiscal year that occurred before the IPO.
4.2.2.1.3.1 Contracts That Are Issued, Exercised, Forfeited, or Canceled, or That Expire, During a Financial Reporting Period
ASC 260-10-45-26 states, in part, that “[d]ilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding [and] dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise.” To meet the ASC 260 requirement under which diluted EPS must include incremental common shares weighted for the period in which an option, warrant, nonvested share, forward sale contract, or similar instrument was outstanding during a financial reporting period, the average market price used to apply the treasury stock method should reflect an average over the period in which the instrument was outstanding rather than an average over the entire financial reporting period. Thus, for contracts that are issued, exercised, forfeited, or canceled, or that expired, during a financial reporting period, an entity will need to calculate, on an instrument-by-instrument basis, the average market price for the portion of the period in which the instrument was outstanding. The average market price over the entire financial reporting period is used for all other instruments that were outstanding for the entire reporting period. See Example 4-2 for an illustration of an option exercised during a period.
For share-based payment awards, the average unrecognized cost, which is a
component of proceeds, should also be based on an average during the
period in which the award was outstanding. See also Section
7.1.2.1.
Connecting the Dots
As discussed in Section 4.2.2.1.3, ASC 260 offers some inherent flexibility, or practical
approaches, related to the calculation of the average market price that is used to apply the
treasury stock method. An entity may have a number of potential common shares that were
not outstanding during the entire financial reporting period because of issuances, exercises, or
cancellations. If the entity is able to determine that using the average market price for the entire
financial reporting period to calculate the dilutive impact of such potential common shares
reasonably approximates the dilutive effect that would exist if the average market price were
separately calculated on an instrument-by-instrument basis by using the period in which each
instrument was outstanding, it would be reasonable for the entity to use the average market
price for the entire period even though this approach is less precise. The entity would still need
to weight the incremental common shares that result from the treasury stock method for the
period in which those potential common shares were outstanding during the financial reporting
period. In determining whether it is appropriate to employ a more practical approach in which
the average market price for the entire financial reporting period is applied because it closely
approximates the result that would be achieved if the average market price was calculated on an
instrument-by-instrument basis by using the period each instrument was outstanding, entities
may want to consider factors such as the following:
- The volatility in the market price of the entity’s common stock during the financial reporting period.
- The number of potential common shares that were not outstanding for the entire financial reporting period (i.e., as a measure of the potential impact that such potential common shares could have on diluted EPS for the period).
- The impact that potential common shares generally have on reported diluted EPS. The less sensitive the calculation of diluted EPS is to changes in assumptions, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.
- The timing within the period in which potential common shares were issued, exercised, or canceled. The more even the distribution of issuances, exercises, or cancellations when amount and timing are considered, the more likely it is that using the average market price during the entire financial reporting period for all potential common shares is appropriate.
Another way to apply the treasury stock method by using the average market price
for the period is to weight the potential common shares and
apply the average market price for the entire period. However,
this approach may only be appropriate when the potential common
shares are of the same type and have the same terms. See
Examples
7-2 and 7-3.
4.2.2.2 Contracts to Sell Convertible Securities
ASC 260-10
Options and Warrants and Their Equivalents
55-6
Options or warrants to purchase convertible securities
shall be assumed to be exercised to purchase the
convertible security whenever the average prices of both
the convertible security and the common stock obtainable
upon conversion are above the exercise price of the
options or warrants. However, exercise shall not be
assumed unless conversion of similar outstanding
convertible securities, if any, also is assumed. The
treasury stock method shall be applied to determine the
incremental number of convertible securities that are
assumed to be issued and immediately converted into
common stock. Interest or dividends shall not be imputed
for the incremental convertible securities because any
imputed amount would be reversed by the if-converted
adjustments for assumed conversions.
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.
Although the treasury stock method does apply to options or warrants that allow the counterparty to purchase convertible securities, its application must be altered to reflect that the option or warrant is first settled by delivery of a convertible security, which may then be converted into common stock. For an option or warrant on convertible securities to be dilutive, the average market prices of both the convertible security and the common stock obtained upon conversion must exceed the exercise price of the option or warrant. See Example 4-7 for an illustration of the application of the treasury stock method to an option on convertible preferred stock. If an option or warrant contains multiple exercise or conversion alternatives, the guidance in ASC 260-10-55-9 through 55-11 must be considered. See Section 4.6 for more information.
An entity may enter into a forward contract to sell a convertible security
(although this is not commonly seen in practice). For this type of contract, the
entity and counterparty have agreed on the terms of the convertible security and
purchase price but will not exchange the purchase price and security until a
later settlement date. The dilutive effect, if any, resulting from a forward
contract to sell a convertible security should be calculated by using the
treasury stock method. As with the application of the treasury stock method to
options or warrants to sell convertible securities, the calculation under the
treasury stock method must take into account the common shares that would be
issuable if the contract was settled for the convertible security and
immediately converted into common stock. As a result, the treatment of a forward
contract to sell a convertible security would be consistent with that for a
forward contract to sell a common stock. The entity assumes that the forward
price is used to purchase common shares, and the excess of the common shares
issuable under the forward contract (based on the conversion rate when the
forward sale contract is on a convertible security) over the common shares
assumed repurchased at the average market price is included in the denominator
in the calculation of diluted EPS. However, once the forward contract is settled
and the convertible security is issued, diluted EPS is determined consistently
with the treatment of other outstanding convertible securities. See Example 4-8 for an
illustration of the application of the treasury stock method to a forward
contract to sell convertible debt. See Chapter 6 for further discussion of the
calculation of diluted EPS for outstanding convertible debt securities.
Connecting the Dots
Economically, the counterparty to a forward contract on a convertible security is “long” with
respect to the convertible security. Nevertheless, the if-converted method is not applied to a
forward contract to sell a convertible security. Under the if-converted method, interest and
dividends must be added back to the numerator. As discussed in ASC 260-10-55-6, if interest
and dividends were imputed on the convertible security underlying a forward contract to sell
a convertible security, they would be immediately reversed by the assumed conversion of
the convertible security into common shares. The only way the if-converted method could be
applied to a forward contract to sell a convertible security would be to assume that the common
shares underlying the convertible security were outstanding. However, unless the forward price
was zero or nominal, this assumption would be inappropriate because it would fail to consider
that an entity can use the proceeds received on payment of the forward price to purchase
common shares. The concept underlying the calculation of diluted EPS is that the entity deploys
any proceeds received from the issuance of potential common shares in a capital-efficient
manner (i.e., to reduce dilution or increase diluted EPS). When the entity applies the treasury
stock method, the dilution caused by issuing more common shares is offset by an assumed
repurchase of common shares with the proceeds.
4.2.2.3 Method of Settlement
4.2.2.3.1 Contracts Classified as Assets or Liabilities
Options, warrants, nonvested shares, forward sale contracts, and similar
instruments on the sale of common shares or potential common shares may be
classified as assets or liabilities. When a contract is classified as an
asset or a liability, the entity should first determine whether the treasury
stock method should be applied to calculate the impact of the contract on
diluted EPS. If the contract must be cash-settled in all circumstances
(i.e., no common shares will be issued on settlement), the treasury stock
method should not be applied and no adjustment should be made to the
numerator or denominator in the entity’s calculation of diluted EPS.
If dilutive, the treasury stock method is applied when (1) a contract must be
share-settled or (2) the entity or the counterparty is permitted to settle
the contract in cash or common shares. Because it is assumed, under the
treasury stock method, that a contract is classified as an equity instrument
(and that the income statement effect of the contract would not have
occurred if it had been exchanged for common shares at the beginning of the
period or on the date of issuance, if later), an entity must, in addition to
adding the incremental shares to the denominator, adjust the numerator when
a contract is classified as an asset or liability. The numerator adjustment
should reflect the change in net income that would have occurred during the
reporting period if the contract had been classified in equity. Since
contracts subject to the treasury stock method that are classified as assets
or liabilities are typically measured at fair value, with changes in fair
value recognized in earnings, and contracts classified as equity instruments
are typically not remeasured, the adjustment to the numerator will typically
reflect a reversal of the mark-to-market adjustment recognized on the
contract during the reporting period, net of any associated income tax
effects.12 However, the numerator adjustment should not be made, and the
incremental shares should not be added to the denominator, if (1) the
contract is an option or warrant and is out-of-the-money on the basis of a
comparison of the exercise price with the average market price or (2) the
aggregate effect of the two adjustments is antidilutive on the basis of the
antidilution sequencing requirements in ASC 260. See Section 4.7 for
further discussion of the accounting for diluted EPS for contracts subject
to the treasury stock method that are classified as assets or
liabilities.
4.2.2.3.2 Contracts Classified as Equity Instruments That Provide for Net-Share Settlement
Under the treasury stock method, it is assumed that contracts are settled physically or on a “gross” basis (i.e., the counterparty pays the exercise price or forward price and receives the gross number of common shares underlying the contract). Contracts subject to the treasury stock method often provide for net-share or “cashless” settlement. In a cashless settlement, the entity delivers to the counterparty a number of common shares with a current fair value (or a fair value determined on the basis of an average stock price) equal to the intrinsic value of the contract. The number of common shares delivered by the entity to the counterparty may be reduced by a number of shares with a fair value equal to the entity’s tax withholding requirements.
Economically, a net-share settlement of a contract to issue shares is equivalent
to a physical settlement accompanied by a repurchase of shares with the
proceeds paid by the counterparty. However, the treasury stock method
requires an assumption that the entity repurchases common shares at the
average market price during the financial reporting period; on the other
hand, in a net-share settlement, the number of shares “repurchased” is based
on the fair value of shares as of the settlement date or a weighted-average
price over a specified period that differs from the average market price
over the reporting period. Given the concept of an average market price that
must be applied under ASC 260, contracts that allow for net-share settlement
should be assumed to be exercised on a gross basis, with the dilution
calculated under the treasury stock method.
Connecting the Dots
Settlement of options, warrants, and nonvested shares, net of the entity’s
statutory withholding requirements, generally applies only to
share-based payment arrangements; in certain circumstances, however,
such features are included in an arrangement that is not a
share-based payment award (e.g., options or warrants on partnership
interests). In these withholding arrangements, whether the entity
settles by issuing gross shares or by issuing shares net of
statutory withholding requirements, the calculation of the dilutive
effect under the treasury stock method is not affected. To include
only the net shares issuable in the denominator of diluted EPS would
be contrary to the antidilution guidance in ASC 260. In a
withholding for statutory tax requirements, the entity is
economically issuing the gross number of shares and then buying back
shares from the counterparty. Since ASC 260 prescribes the treatment
of the repurchase of common shares under the treasury stock method,
any additional consideration of the net shares withheld to meet
statutory withholding requirements would inappropriately result in
taking into account the shares repurchased twice. Except for certain
forward contracts to repurchase common shares (addressed in ASC
480-10- 45-4), the repurchase of common shares, even if it depends
only on the passage of time, is not taken into account in in the
calculation of diluted EPS before the shares are repurchased.
4.2.2.3.3 Contracts Classified as Equity Instruments That Provide for Net-Cash Settlement
Options, warrants, nonvested shares, forward sale contracts, and similar
instruments on the sale of common shares or potential common shares that are
classified as equity instruments may permit the entity to choose to settle
the contract in cash or common stock. For these contracts, the treasury
stock method must be applied because ASC 260 prevents an entity from
overcoming the presumption of net share settlement.
If an equity-classified contract is antidilutive under the treasury stock
method, the entity would not reflect an adjustment to the numerator under
the assumption that the contract was classified as an asset or liability,
even if it would be dilutive to do so. Numerator adjustments are only made
to contracts classified as assets or liabilities that are considered
share-settled for diluted EPS.
4.2.2.3.4 Contracts With Multiple Conversion or Settlement Alternatives
Certain contracts subject to the treasury stock method may offer the
counterparty alternatives related to the consideration that it transfers to
exercise, convert, or settle the contract in return for common shares issued
by an entity. For example, a counterparty to a call option on common stock
may be permitted to pay the exercise price in either cash or delivery of an
entity’s debt instrument. ASC 260-10-55-8 through 55-11 address implications
related to the calculation of diluted EPS for contracts with multiple
conversion or settlement alternatives. ASC 260-10-55-8 states, in part, that
“[w]hen several conversion alternatives exist, the computation shall give
effect to the alternative that is most advantageous to the holder of the
convertible security.” For contracts that offer the counterparty such
alternatives with respect to the payment of the exercise or forward price,
the guidance in ASC 260-10-55-8 through 55-11 must be applied to reflect the
potential dilutive impact on diluted EPS. See further discussion in
Section
4.6.
4.2.3 Examples
ASC 260-10
Example 15: Options, Warrants, and Their Equivalents
55-92 This Example illustrates the guidance in paragraphs 260-10-45-22 through 45-23.
55-93 Consider Entity A that has 10,000 warrants outstanding exercisable at $54 per share; the average market price of the common stock during the reporting period is $60. Exercise of the warrants and issuance of 10,000 shares of common stock would be assumed. The $540,000 that would be realized from exercise of the warrants ($54 × 10,000) would be an amount sufficient to acquire 9,000 shares ($540,000/$60). Thus, 1,000 incremental shares (10,000 – 9,000) would be added to the outstanding common shares in computing diluted EPS for the period.
55-94 The following is a
shortcut formula for that computation (note that this
formula may not be appropriate for share-based compensation
awards [see paragraph 260-10-45-29]):
Incremental shares = [(market price – exercise
price)/market price] × shares assumed issued under
option; thus, [($60 – $54)/$60] × 10,000 = 1,000
incremental shares.
Example 4-1
Warrant to Sell Common Stock — Number of Common Shares and Exercise Price Vary Over Time
In conjunction with a debt issuance, on June 15, 20X2, Company D issued a warrant to Company H under which H has the right, but not the obligation, to purchase D’s common shares at any time from the issuance date until June 15, 20X7. The warrant contains the following key terms:
- Notional amount — H can exercise the warrant for a number of common shares that varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — 50,000 common shares.
- If exercised between June 15, 20X3, and June 14, 20X4 — 52,500 common shares.
- If exercised between June 15, 20X4, and June 14, 20X5 — 55,000 common shares.
- If exercised between June 15, 20X5, and June 14, 20X6 — 57,500 common shares.
- If exercised between June 15, 20X6, and June 15, 20X7 — 60,000 common shares.
- Exercise price — The exercise price for each common share purchased varies depending on the date of exercise as follows:
- If exercised before June 15, 20X3 — $10.00 per common share.
- If exercised between June 15, 20X3, and June 14, 20X4 — $9.75 per common share.
- If exercised between June 15, 20X4, and June 14, 20X5 — $9.50 per common share.
- If exercised between June 15, 20X5, and June 14, 20X6 — $9.25 per common share.
- If exercised between June 15, 20X6, and June 15, 20X7 — $9.00 per common share.
From H’s perspective, it is most advantageous to wait and exercise the warrant between June 15, 20X6,
and June 15, 20X7, because H pays a lower exercise price and is entitled to receive more common shares.
Therefore, D should apply the treasury stock method, if dilutive, assuming a $9.00 exercise price per common
share on 60,000 potential common shares.
Example 4-2
Option to Sell Common Stock — Option Is Exercised During the Period
Assume the following:
- In 20X7, Company N issued options that allow the counterparty to purchase 10,000 shares of common stock at an exercise price of $27.50 per common share.
- The counterparty may elect to exercise the options on a physical or net-share-settlement basis.
- On March 2, 20X8, the counterparty exercised all the options in a net-share settlement.
- Company N uses a weekly average to calculate the average market price for its quarterly financial reporting period ended March 30, 20X8, because it has concluded that a weekly average closely approximates a daily average. The weekly average is based on the closing stock price of N’s common stock on the last day of each week. The quoted closing prices of N’s common stock were as follows:
-
January 5, 20X8: $32.23.
-
January 12, 20X8: $31.77.
-
January 19, 20X8: $32.93.
-
January 26, 20X8: $33.12.
-
February 2, 20X8: $33.88.
-
February 9, 20X8: $32.71.
-
February 16, 20X8: $34.03.
-
February 23, 20X8: $34.48.
-
March 2, 20X8: $36.00.
-
March 9, 20X8: $35.55.
-
March 16, 20X8: $35.01.
-
March 23, 20X8: $34.16.
-
March 30, 20X8: $33.08.
-
The following calculation shows the incremental common shares that would be
added to the denominator in the calculation of diluted EPS,
if the shares are dilutive, on the basis of an assumption
that the options were exercised at the beginning of the
period:
The incremental common shares added to diluted EPS of 1,193, along with the weighted-average common shares outstanding when the options are exercised, represent the total impact that the options had on diluted EPS.
If N determined that the average market price for the entire quarterly reporting period was a reasonable approximation of the average market price during the period the options were outstanding, the incremental common shares would have been calculated as follows:
Example 4-3
Forward Contract to Sell
Common Shares — Number of Common Shares Varies on the
Basis of the Stock Price
Some entities enter into forward contracts
that require the counterparty to purchase a fixed dollar
amount of the entity’s common shares on a future date. The
number of common shares purchased varies on the basis of the
entity’s common stock price. These contracts may be referred
to as variable share forwards or range forwards. Although
such contracts may be entered into on a stand-alone basis,
they are commonly entered into as part of a unit offering
that goes by many different names (e.g., Feline PRIDES,
Upper DECS, MEDS, and PIES). The unit offerings also include
a debt instrument with a principal amount equal to the
forward price of the forward contract and a maturity date
that coincides with the settlement date of the forward
contract.
Assume that Company A enters into a
variable-share forward contract with Investment Bank G that
requires G to purchase A’s common stock for $50 in two
years. The market price of A’s common stock on the date the
forward contract is entered into is $50 per share. The
forward contract contains the following key terms:
-
Issuance date — December 31, 20X0.
-
Settlement date — December 31, 20X2, or earlier at the option of A.
-
Unit price — $50.
-
Forward price cap — $60.
-
Forward price floor — $50.
-
Settlement price — The volume-weighted average closing price for the 20 trading days ending 3 trading days immediately preceding the settlement date (the “average settlement price”).
The number of common shares that G will
receive upon settlement will depend on the average closing
price of A’s common stock for a specified period immediately
preceding the settlement date of the forward contract.
Specifically:
-
If the average settlement price is greater than the forward price cap, G receives 0.833 shares.
-
If the average settlement price is less than the forward price cap but equal to or greater than the forward price floor, G receives a number of common shares equal to the average settlement price divided by $50 (i.e., $50 worth of common stock).
-
If the average settlement price is less than $50, G receives one share of common stock.
The forward contract described above is
subject to the treasury stock method of calculating diluted
EPS; however, in certain situations, the terms of the
offering may require application of the if-converted method
(see Section 4.8.3.6). For variable-share forward
contracts, the treasury stock method is applied as
follows:
-
Number of shares issued — Since the number of common shares issuable varies on the basis of the entity’s stock price, A applies the guidance on variable denominators in ASC 260-10-45-21A. In accordance with this guidance, diluted EPS must reflect the number of common shares that would be issued on the basis of A’s average stock price during the entire reporting period.
-
Number of shares repurchased — ASC 260 also requires that the average stock price be used to calculate the number of common shares assumed to be repurchased. This calculation would be based on the average market price of A’s common stock during the entire financial reporting period (or the period in which the contract was outstanding during the reporting period if the contract was entered into or settled during the reporting period).
Below are various calculations of the impact
of the forward contract on diluted EPS for A’s quarterly
financial reporting period ended March 31, 20X1. For each
scenario, the average settlement price is calculated in
accordance with the guidance in ASC 260-10-45-21A (i.e., on
the basis of A’s average stock price during the reporting
period — that is, the average of the daily closing quoted
prices of A’s common stock for the entire quarterly
financial reporting period). It is assumed that these
contracts are not participating securities and that the
two-class method therefore does not apply.
Scenario 1 — Average
Market Price for Period Is $40
Scenario 2 — Average
Market Price for Period Is $50
Scenario 3 — Average
Market Price for Period Is $60
Scenario 4 — Average
Market Price for Period Is $70
As illustrated in these calculations, (1) in
all scenarios, the average settlement price equals the
average stock price during the reporting period, and (2)
this arrangement is dilutive only when the average market
price for the entire financial reporting period exceeds the
forward cap of $60.
Example 4-4
Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Specified Interest
Rate and Expected Dividends
On April 1, 20X1, Company X enters into a forward contract with Investment Bank
C that requires X to sell 21 million common shares to C no
later than December 31, 20X1 (the maturity date). While all
21 million common shares must be sold and delivered to C no
later than the maturity date, if sufficient notice is given,
X may deliver all or a portion of the shares at any time
between the trade date and the maturity date. Upon an early
termination event, X is required to deliver any remaining
common shares to C. Company X has classified the forward
contract in equity, and it does not represent a
participating security. For diluted EPS purposes, physical
share settlement of the contract must be assumed.
Significant terms of the forward contract are as follows:
- The initial forward price on the trade date is $22.00 per share.
- On any day after the trade date, the forward price is equal to the forward price on the immediately preceding calendar day multiplied by the sum of 1 and the daily rate for this day, provided that the purchase price in effect on each forward price reduction date will equal the purchase price otherwise in effect on this date minus the forward price reduction amount for this date.
- The daily rate is the USD federal funds rate minus 0.5 percent (the “spread”) divided by 365.
- The forward price reduction dates are May 1, 20X1; August 1, 20X1; and November 1, 20X1.
- The forward price reduction amount is $0.25 for each forward price reduction date.
Company X is calculating diluted EPS for its quarterly financial reporting
period ended June 30, 20X1. The average market price of X’s
common stock during the reporting period is $23.50 per
share. The forward price as of June 30, 20X1, is $21.96. The
lowest forward price during the reporting period is $21.83,
which occurs on the May 1, 20X1, forward price reduction
date. The average forward price during the reporting period
is $21.90.
The forward price varies daily depending on the USD federal funds rate. Depending on the level of interest rates, the daily adjustments could increase or reduce the forward price. If the USD federal funds rate is less than 0.5 percent, the forward price will decline daily. If the USD federal funds rate exceeds 0.5 percent, the forward price will increase daily. The forward price will also decrease by a fixed amount on each forward price reduction date.
To calculate the dilutive effect of the forward contract under the treasury
stock method, as discussed in Section 4.2.2.1.2.1, X
may apply as an accounting policy any of the following three
approaches to calculate the proceeds:
-
View A — The proceeds reflect the forward price as of the end of the reporting period.
-
View B — The proceeds reflect the lowest forward price during any day within the reporting period.
-
View C — The proceeds reflect the average forward price during the reporting period.
The alternative views under the treasury stock method for X’s financial reporting period ended June 30, 20X1, are as follows:
View A
View B
View C
In this example, if the USD federal funds rate stays constant from June 30, 20X1, to December 31, 20X1, because of the two remaining forward price reduction amounts, the forward price at maturity would be $21.46 per common share. However, an entity should not assume that the interest rate at the end of the reporting period stays constant until the maturity date and deduct the remaining forward price reduction amounts to arrive at a lower forward price at maturity. This approach would not reflect the forward price at maturity because interest rates may change.
It is acceptable for an entity to use any of the three approaches discussed
above when applying the treasury stock method, regardless of
whether the entity or counterparty controls the ability to
settle the contract before its stated maturity. However, it
is not appropriate to select one of the alternative views if
the forward price is fixed only on the basis of scheduled
reductions that are intended to approximate anticipated
dividends. See the example below for an illustration of this
concept.
Example 4-5
Forward Contract to Sell Common Shares — Fixed Forward Prices That Vary on the Basis of the
Settlement Date
On September 7, 20X4, Company D enters into a forward contract with Investment
Bank M that requires D to sell 10 million common shares to M
no later than May 16, 20X5 (the maturity date). While all 10
million common shares must be sold and delivered to M no
later than the maturity date, if sufficient notice is given,
D may deliver all or a portion of the shares at any time
between the trade date and the maturity date. Upon an early
termination event, D is required to deliver any remaining
common shares to M. Company D has classified the forward
contract in equity, and it does not represent a
participating security. For diluted EPS purposes, physical
share settlement of the contract must be assumed.
The forward price per common share sold is fixed at varying prices that depend on the delivery date(s) of
the shares. The fixed prices take into account both the time value of money and expected dividends on D’s
common stock. The forward prices are as follows:
Company D is calculating diluted EPS for its quarterly financial reporting period ended December 31, 20X4. The
average market price of X’s common stock during the reporting period is $64.50 per share.
Although only one fixed forward price may be operable on any given date, in accordance with ASC 260-10-
45-21, D should calculate diluted EPS in a manner that reflects the most disadvantageous outcome from D’s
perspective. Therefore, on each financial reporting period date, D should look at the then-effective forward
price and all future forward prices to determine which price is least advantageous to D. That settlement price
should be used to calculate the proceeds from the forward under the treasury stock method. This approach is
required regardless of whether the entity or counterparty controls the ability to settle the contract before its
stated maturity.
For the quarterly period ended December 31, 20X4, the dilutive effect of the forward contract is calculated as
follows:
The example below illustrates a forward sale contract with forward prices that
decline on the basis of actual dividends.
Example 4-6
Forward Contract to Sell Common Shares — Forward Price Varies on the Basis of Actual Dividends
On January 2, 20X5, Company E enters into a forward contract with Investment
Bank J that requires E to sell 25 million common shares to J
no later than December 31, 20X5 (the maturity date). While
all 25 million common shares must be sold and delivered to J
no later than the maturity date, if sufficient notice is
given, E may deliver all or a portion of the shares at any
time between the trade date and the maturity date. Upon an
early termination event, E is required to deliver any
remaining common shares to J. Company E has classified the
forward contract in equity, and it represents a
participating security. For diluted EPS, physical share
settlement of the contract must be assumed.
The forward price per common share sold is fixed at $65 per share, subject to adjustment only for standard antidilution events and cash dividends paid by E on its common shares. Company E typically pays a quarterly cash dividend of $1 per share on its common shares on March 15, June 15, September 15, and December 15.
Under the treasury stock method, the assumed proceeds should be based on the forward price at the end of the reporting period. While E may reasonably expect the forward price per share at maturity to decrease to $61 because of cash dividends it expects to declare, if only the passage of time is assumed, the forward price on each reporting date will not decline. Because E is under no obligation to pay any cash dividends on its common stock and E’s board of directors must declare a cash dividend before it is payable, under the treasury stock method, it should not be assumed that future dividends will be paid.
By contrast, when prespecified fixed adjustments are made to the forward price of a forward sale contract that are designed to represent anticipated dividends, upon the mere passage of time, the forward price will be adjusted; therefore, in accordance with ASC 260-10-45-21, the entity must assume that the proceeds will represent the lowest forward price during the remaining term of the contract. However, when the forward price is reduced only for actual dividends, because dividends do not need to be recognized under GAAP before they are declared, an entity is not required to anticipate the amount of future dividends that will be declared in determining proceeds under the treasury stock method. Rather, the forward contract is a participating security and distributed and undistributed earnings are taken into account in the calculation of basic EPS by using the two-class method. Diluted EPS is based on the more dilutive of the treasury stock method or the two-class method.
Example 4-7
Option to Sell Convertible Preferred Stock
Assume the following:
- On January 1, 20X1, Company G issues 1,000 options that allow the counterparty to purchase a share of convertible preferred stock at $5,000 per share.
- The convertible preferred stock is convertible into common stock at $25 per share at any time after two years (i.e., the holder can receive 200 shares of common stock for each share of convertible preferred stock).
- The convertible preferred stock pays an annual dividend of $500 per share.
- On the date the options are issued, G’s common stock is trading at $25 per share.
- For the period ended December 31, 20X3, G’s common stock has an average market price of $40 per share.
- For diluted EPS purposes, share settlement of the option must be assumed.
For the period ended December 31, 20X3, G must apply the treasury stock method to calculate diluted EPS
because the options are in-the-money from the perspective of the counterparty. Under the treasury stock
method, G must assume that the counterparties to the options would elect to exercise their options and
purchase convertible preferred stock, which they would then convert into common stock. The calculation of the
diluted impact of the options is as follows:
In this example, it is assumed that G classifies the option in equity. If the
option were classified as a liability, G would also need to
adjust the numerator if the aggregate effect of the
numerator adjustment and incremental common shares is
dilutive. See further discussion in Section
4.2.2.3.1 and Example 4-31.
Example 4-8
Forward to Sell Convertible Debt
On June 15, 20X1, Company Z enters into a forward contract to sell convertible debt securities to Investor A.
The forward contract requires settlement on June 30, 20X2. Company Z enters into the contract as a capital-raising
activity; however, since Z does not need the proceeds until the second half of 20X2 and A wants to lock
in the purchase price, the parties enter into the contract before the convertible debt securities are actually
issued.
According to the terms of the forward contract, A is required to pay $500 million to Z on June 30, 20X2, and Z is
required to issue $500 million of convertible debt securities to A with the following terms:
- Principal amount — $500 million (or $10,000 per debt security issued).
- Number of securities — 50,000.
- Maturity date — December 31, 20X9.
- Interest rate — 4 percent per annum, payable quarterly in arrears.
- Conversion terms — Convertible at any time after issuance at an initial conversion price of $25 per security, subject to adjustment for standard antidilution events, declining to $20 per security beginning on January 1, 20X9. Physical settlement is required for any conversion.
Company Z’s common stock price on the issuance date of the forward contract is
$17.50 per share (i.e., the conversion option in the
convertible debt instrument has no intrinsic value on the
issuance date of the forward).
Company Z is calculating diluted EPS for the third quarter ended September 30, 20X1, and has concluded
that it is not required to account for the forward contract as a liability, with changes in fair value recognized in
earnings. The average market price of Z’s common stock for the quarter ended September 30, 20X1, is $22.50
per share.
The dilutive impact of the forward contract to sell convertible securities is calculated as follows:
See Section 4.10 for a comprehensive example illustrating the use of the treasury stock method in the calculation of diluted EPS. See Section 7.1.2.1.5 for examples of the application of the treasury stock method to share-based payment arrangements.
Footnotes
7
The treasury stock method does not apply to purchased
options because they are always antidilutive (see Section 4.1.1.1).
8
The unpaid portion of a stock subscription
agreement and common stock issued in return for a note
receivable may be treated as written call options on common
stock in the calculation of diluted EPS. See Sections
4.8.3.1 and 4.8.3.2 for more
information.
9
It may be unclear whether an entity should
apply the guidance on contingently issuable shares
in ASC 260-10-45-48 through 45-57 or the guidance
on variable denominators in ASC 260-10-45-21A. 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
guidance in ASC 260 that addresses what
constitutes a contingently issuable share is often
difficult to interpret in practice.
10
For more information about how the variability
in terms of an equity-linked financial instrument affects its
classification, see Chapter 4 of Deloitte’s
Roadmap Contracts on an Entity’s Own Equity.
11
The average is generally a simple average. The use
of a volume-weighted average is not necessarily more precise or more
representative of the average market price of the entity’s common
stock during a period.
12
If the contract represents a share-based payment
award, the adjustment to the numerator should only reflect the
incremental effect of the different accounting classification (i.e.,
the numerator is adjusted to reflect the compensation expense that
would have been recognized during the reporting period if the award
had been classified in equity). An adjustment to the proceeds is
also required because the average compensation cost not yet
recognized for financial reporting purposes must also be based on
the amount that would have been left unrecognized if the award had
been accounted for as an equity award. See further discussion in
Section
7.1.4.
4.3 Reverse Treasury Stock Method
4.3.1 Scope
ASC 260-10
Written Put Options and the Reverse Treasury Stock Method
45-35 Contracts that require
that the reporting entity repurchase its own stock, such as
written put options and forward purchase contracts other
than forward purchase contracts accounted for under
paragraphs 480-10-30-3 through 30-5 and 480-10-35-3, shall
be reflected in the computation of diluted EPS if the effect
is dilutive. If those contracts are in the money during the
reporting period (the exercise price is above the average
market price for that period), the potential dilutive effect
on EPS shall be computed using the reverse treasury stock
method. . . .
The reverse treasury stock method applies to contracts that require an entity to
repurchase its common stock. Such contracts include the following:13
-
Written put options (common stock) — Options written by an entity under which the counterparty has the right, but not the obligation, to sell a specified quantity or amount of common stock to the entity at a fixed or otherwise determinable price.
-
Forward purchase contracts (common stock) — Contracts that require the entity to purchase a specified quantity or amount of common stock from the counterparty at a future date at a fixed or otherwise determinable price.
An entity should not apply the reverse treasury stock method to a contract
listed above in the following situations:
-
The contract represents a forward contract to repurchase common stock that is within the scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 4.8.4.1.1).
-
The contract must be net settled in cash (i.e., no common shares are purchased upon settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.
The discussion in Section 4.3.2 focuses on the application of the reverse treasury stock method to
potential common shares within its scope that are not participating securities. If a potential common
share is a participating security, an entity is required to apply the more dilutive of the reverse treasury
stock method or the two-class method of calculating diluted EPS (see Section 5.5.4). Sections 4.3.2.2.3
and 4.6 discusses the application of the reverse treasury stock method to instruments that contain
multiple settlement alternatives.
4.3.2 Application of the Reverse Treasury Stock Method
4.3.2.1 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.
Variable
Denominator
45-21A
Changes in an entity’s share price may affect the
exercise price of a financial instrument or the number
of shares that would be used to settle the financial
instrument. For example, when the principal of a
convertible debt instrument is required to be settled in
cash but the conversion premium is required to (or may)
be settled in shares, the number of shares to be
included in the diluted EPS denominator is affected by
the entity’s share price. In applying both the treasury
stock method and the if-converted method of calculating
diluted EPS, the average market price shall be used for
purposes of calculating the denominator for diluted EPS
when the number of shares that may be issued is
variable, except for contingently issuable shares within
the scope of the guidance in paragraphs 260-10-45-48
through 45-57. See paragraphs 260-10-55-4 through 55-5
for implementation guidance on determining an average
market price.
Written Put Options and the Reverse Treasury Stock Method
45-35 Contracts that require
that the reporting entity repurchase its own stock, such
as written put options and forward purchase contracts
other than forward purchase contracts accounted for
under paragraphs 480-10-30-3 through 30-5 and
480-10-35-3, shall be reflected in the computation of
diluted EPS if the effect is dilutive. If those
contracts are in the money during the reporting period
(the exercise price is above the average market price
for that period), the potential dilutive effect on EPS
shall be computed using the reverse treasury stock
method. Under that method:
-
Issuance of sufficient common shares shall be assumed at the beginning of the period (at the average market price during the period) to raise enough proceeds to satisfy the contract.
-
The proceeds from issuance shall be assumed to be used to satisfy the contract (that is, to buy back shares).
-
The incremental shares (the difference between the number of shares assumed issued and the number of shares received from satisfying the contract) shall be included in the denominator of the diluted EPS computation.
45-36 For example, an entity
sells 100 put options with an exercise price of $25; the
average market price for the period is $20. In computing
diluted EPS at the end of the period, the entity assumes
it issues 125 shares at $20 per share to satisfy its put
obligation of $2,500. The difference between the 125
shares issued and the 100 shares received from
satisfying the put option (25 incremental shares) would
be added to the denominator of diluted EPS.
The reverse treasury stock method represents a method of determining the dilutive effect of a contract that obligates an entity to purchase its common shares. Under this method, it is assumed that the entity raises the proceeds necessary to satisfy its obligation under the share purchase contract by issuing its common shares to market participants at the average market price during the period. The excess of the common shares assumed issued over the common shares purchased under the contract represents the incremental common shares under the reverse treasury stock method. Contracts that are subject to the reverse treasury stock method must be classified as liabilities (or assets in some circumstances) in accordance with ASC 480 regardless of whether they provide for settlement in cash or shares. As a result, under the reverse treasury stock method, an entity is required to adjust the numerator in addition to including incremental common shares. See further discussion in Section 4.3.2.2.1.
Like the treasury stock method (as discussed in Section 4.2.2.1), the reverse treasury
stock method is only applied to written put options that are in-the-money from
the perspective of the counterparty. This determination is based on a comparison
of the exercise price with the average market price of the entity’s common
stock. The reverse treasury stock method should not be applied to an
out-of-the-money written put option that would be dilutive to EPS because of the
adjustment made to the numerator to reverse the mark-to-market amount recognized
on the contract during the reporting period. However, because forward purchase
contracts must be settled regardless of whether they are in-the-money or
out-of-the-money, the reverse treasury stock method should be applied to forward
contracts if such contracts are dilutive. An entity would determine whether a
forward purchase contract is dilutive to EPS on the basis of the aggregate
effect of the numerator adjustment and the incremental common shares to be
included in the denominator under the reverse treasury stock method.
Connecting the Dots
A written put option that is in-the-money from the perspective of the
counterparty may be antidilutive because of the adjustment to the
numerator to reverse the mark-to-market amount recognized on the
contract during the reporting period. ASC 260-10-45-17 precludes the
inclusion of this antidilutive effect in the calculation of diluted
EPS.
If a contract subject to the reverse treasury stock method is a participating security, the more dilutive of the reverse treasury stock method or the two-class method must be applied, as discussed in Section 5.5.4.
4.3.2.1.1 Adjustments to the Number of Shares Purchased Upon Settlement
The number of common shares to be purchased upon settlement of a written put option or forward purchase contract may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares purchased upon settlement varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty.
If the number of common shares purchased upon settlement is subject to
adjustment on the basis of the occurrence or nonoccurrence of a specified
event (other than changes in the fair value of the entity’s stock price)
that is not within the counterparty’s control, the entity should apply the
guidance on contingently issuable shares to determine the number of common
shares to be purchased on settlement. As discussed in Section 4.5, the
entity should assume that the current status of the condition as of the
reporting date will remain unchanged (i.e., the specified event will not
occur). As a result, potential adjustment features that are commonly
included in the terms of instruments subject to the reverse treasury stock
method will have no impact on the application of the reverse treasury stock
method until such adjustment events occur. Table 4-3 lists common adjustment
events that will have no impact on the application of the reverse treasury
stock method before the occurrence of the related event.
If the number of common shares to be purchased upon settlement is linked to a
specified rate, price, index, or other variable, the entity should determine
the number of shares (see Table 4-5) by applying either (1) the guidance in ASC
260-10-45-21A on variable denominators or (2) the guidance in ASC
260-10-45-48 through 45-57 on contingently issuable shares. Under the
variable denominator approach, the entity would determine the number of
common shares that would be purchased upon settlement on the basis of the
average of the specified rate, price, index, or other variable during the
reporting period. As discussed in Section 4.5, under the contingently
issuable share approach, the entity would reflect the number of common
shares that would be purchased upon settlement on the basis of the current
rate, price, index, or other variable at the end of the reporting period (or
on the basis of the average rate, price, index, or other variable, assuming
settlement occurred on the last day of the reporting period if the contract
stipulates an average rate, price, index, or other variable). As discussed
in Section
4.3.2.1.3, under either approach, the stock price used to
calculate the number of common shares assumed to be issued to pay the
purchase price of the written option or forward purchase contract must
reflect the average market price during the entire financial reporting
period (or portion thereof during the reporting period in which the contract
was outstanding). Since contracts subject to the reverse treasury stock
method are classified as assets or liabilities and typically recognized at
fair value, with changes in fair value reported in earnings, an entity must
also adjust the numerator in calculating diluted EPS under the reverse
treasury stock method, as discussed in Section 4.3.2.2.1.
Table
4-5
Determining the Number of Shares to
Be Purchased Upon Settlement When the Shares Vary on
the Basis of a Specified Rate, Price, Index, or
Other Variable
| |
---|---|
Type of Variable
|
Approach Used
|
Entity’s stock price
|
Average market price approach
|
Other rate, price, index, or
variable
|
Average market price approach or
contingently issuable share method
|
Although ASC 260-10-45-21A does not specifically refer to
the reverse treasury stock method, an entity must use the average market
price approach if the number of shares varies solely on the basis of the
entity’s stock price. Arrangements subject to the reverse treasury stock
method would not be expected to qualify for the contingently issuable share
approach under ASC 260 because any arrangement in which an entity receives
its own shares for little or no consideration would generally be
antidilutive in the calculation of diluted EPS. However, an entity can
choose to apply either the average market price approach or contingently
issuable share method as an accounting policy if the variability is due to
something other than just the entity’s stock price, since ASC 260-10-45-21A
only specifically addresses how an entity accounts for diluted EPS when the
variable is based on the entity’s stock price.
Connecting the Dots
As noted in the table above, the number of common shares assumed to be purchased
may be determined on the basis of conditions at the end of the
reporting period when the number of common shares assumed to be
issued to pay the purchase price is based on the average market
price over the entire financial reporting period. In such
circumstances, a written put option or forward purchase contract on
a number of common shares that varies on the basis of a rate, price,
index, or market variable other than stock price may be dilutive, or
in-the-money, for diluted EPS purposes even if the contract is
out-of-the-money from the perspective of the counterparty on the
basis of the market price of the entity’s common stock as of the end
of the reporting period.
4.3.2.1.2 Proceeds
The determination of the proceeds used to apply the reverse treasury stock method is generally
straightforward. The proceeds represent the amount the entity would need to raise to pay the purchase
price to acquire common shares under the contract (i.e., the exercise price or forward price). However,
as discussed below, an entity must take additional considerations into account in certain situations.
4.3.2.1.2.1 Adjustments to the Exercise Price or Forward Price
The exercise price or forward price of a written put option or forward purchase contract may vary
because of (1) the passage of time; (2) the occurrence or nonoccurrence of a specified event; or (3) a
specified rate, price, index, or other variable.
If the exercise price or forward price varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any exercise price or forward price that will be available to the counterparty at any point during the term of the contract and assume settlement upon terms that maximize value to the counterparty.
If the exercise price or forward price is subject to adjustment on the basis of
the occurrence or nonoccurrence of a specified event (other than changes
in the fair value of the entity’s stock price) that is not within the
counterparty’s control, the entity should apply the guidance on
contingently issuable shares to determine the exercise price or forward
price. As discussed in Section 4.5, the entity should assume that the current
status of the condition on the reporting date will remain unchanged
(i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of
instruments subject to the reverse treasury stock method will have no
impact on the application of the reverse treasury stock method until
such adjustments occur. Table 4-3 lists common adjustment
events that will have no impact on the application of the reverse
treasury stock method before the occurrence of the related event.
If the exercise price or forward price varies solely on the basis of the
entity’s stock price, the entity should apply ASC 260-10-45-21A, which
requires that the entity determine the purchase price by using the
average market price of the entity’s stock during the reporting period.
If, however, the exercise price or forward price varies on the basis of
a specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The purchase price reflects the exercise price or forward price as of the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Although that guidance only specifically addresses how to determine the number of common shares, it may be applied by analogy to determine the exercise price or forward price. Under that guidance, it is assumed that the contingency (in this case, the amount of the exercise price or forward price) is resolved as of the end of the reporting period. Thus, an entity calculates the exercise price or forward price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming settlement of the contract on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The purchase price reflects the highest exercise price or forward price during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the exercise or forward prices applicable for the entire time during the reporting period in which the contract was outstanding and should use the price that is least advantageous to the entity and produces the highest purchase price. The entity should not project future exercise or forward prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The purchase price reflects the average exercise price or forward price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-35, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of the settlement date (since neither
party ultimately controls the rate, price, index, or other variable that
affects the purchase price). The approach selected is considered an
accounting policy election that must be applied consistently and
disclosed.
Under the reverse treasury stock method, the purchase price payable by the
entity to settle a written put option or forward repurchase contract is
used to determine the number of common shares that the entity would be
assumed to issue to pay the purchase price. Under any of the three
approaches described above that are used to determine the purchase
price, the entity must assume that it issues common shares to pay the
purchase price at the average market price during the reporting period
(see Section
4.3.2.1.3). In addition, since contracts subject to the
reverse treasury stock method are classified as assets or liabilities
and typically recognized at fair value, with changes in fair value
reported in earnings, the calculation of diluted EPS should include an
adjustment to the numerator, as discussed in Section 4.3.2.2.1.
It is not acceptable to determine the proceeds on the basis of the exercise
price or forward price at the beginning of the reporting period because
there is no basis in ASC 260 for the use of this approach.
Connecting the Dots
When the exercise price or forward price of a written put option or forward purchase contract
subject to the reverse treasury stock method is automatically adjusted solely on the basis of
prespecified adjustments designed to represent the amount of dividends the entity is expected
to declare on typical dividend declaration dates, the highest exercise price or forward price that
may apply during the remaining term of the contract on the basis of only the passage of time
(which will generally be the exercise price or forward price as of the reporting date) must be
used in applying the reverse treasury stock method. This requirement results from the guidance
in ASC 260-10-45-21, which applies to adjustments to the exercise price or forward price that
are made on the basis of the mere passage of time. This requirement is applicable regardless
of whether the entity or counterparty controls the ability to settle the contract before its
stated maturity. Because the average market price used to determine the number of common
shares that would need to be issued to pay the purchase price will not yet reflect these future
dividends, this approach will often exacerbate the dilution under the reverse treasury stock
method. If the contract can only be exercised or settled before its stated maturity date upon
the occurrence of a contingent event that is not within the control of the counterparty, the
guidance on adjustments to the exercise price or forward price on the basis of the occurrence
or nonoccurrence of a specified event that is not within the counterparty’s control is applicable
(i.e., the guidance on contingently issuable shares in ASC 260-10-45-54).
If adjustments to the exercise price or forward price of a written put option or forward purchase
contract subject to the reverse treasury stock method occur only when and if the entity declares
a dividend on its common stock, the purchase price used to apply the reverse treasury stock
method should not reflect the impact of future dividends before their declaration. This is
because the entity is under no obligation to pay any cash dividends on its common stock and,
in the absence of the declaration of a cash dividend, the exercise price or forward price will not
change upon the mere passage of time.
4.3.2.1.2.2 Prepaid Contracts
A prepaid forward purchase contract is not subject to the reverse
treasury stock method because its application would always be
antidilutive. A prepaid written put option for which the prepayment is
not refundable (i.e., the issuing entity pays the exercise price net of
any option premium and is not entitled to a return of the prepaid amount
if the option is not exercised) is the economic equivalent of a prepaid
forward purchase contract in the calculation of diluted EPS. Therefore,
this contract is also not subject to the reverse treasury stock method
because it would be antidilutive.
In the case of a prepaid written put option for which the issuing entity
pays the exercise price net of any option premium up front and is
entitled to receive a return of the exercise price, the accounting for
diluted EPS will depend on the specific terms of the arrangement. If the
issuing entity has the option of receiving its prepayment back before
the expiration of the written put option, the prepayment should be
ignored and the reverse treasury stock method should be applied in the
same manner as it would if the written put option was not prepaid. If,
however, the prepayment is returned only if the contract expires
unexercised, there is no incremental dilutive effect of the contract,
because the issuing entity will either (1) receive its prepayment back
and no shares will be purchased because the contract expires unexercised
or (2) will not receive back the prepayment but will receive shares of
its own stock. In the first situation, no shares are repurchased and,
accordingly, there is no incremental dilutive impact. In the second
situation, it would be antidilutive to reflect the shares acquired.
4.3.2.1.3 Average Market Price
The same concepts discussed in Section 4.2.2.1.3 regarding the determination of the average market price under the treasury stock method apply under the reverse treasury stock method. Under the reverse treasury stock method, the average market price of the entity’s common stock is used to determine the number of common shares that are assumed to be issued to pay the exercise price or forward price of the contract.
4.3.2.1.3.1 Contracts That Are Issued, Exercised, Forfeited, or Canceled, or That Expire, During a Financial Reporting Period
ASC 260-10-45-26 states, in part, that “[d]ilutive options or warrants that are issued during a period or that expire or are cancelled during a period shall be included in the denominator of diluted EPS for the period that they were outstanding [and] dilutive options or warrants exercised during the period shall be included in the denominator for the period prior to actual exercise.” To meet the ASC 260 requirement under which diluted EPS must include incremental common shares weighted for the period in which a written put option or forward purchase contract was outstanding during a financial reporting period, the average market price used to apply the reverse treasury stock method should reflect an average over the period in which the instrument was outstanding rather than an average over the entire financial reporting period. Thus, for contracts that are issued, exercised, forfeited, or canceled, or that expired, during a financial reporting period, an entity will need to calculate, on an instrument-by-instrument basis, the average market price for the portion of the period in which the instrument was outstanding. The average market price for the entire financial reporting period should not be used to determine the number of common shares that would need to be issued to pay the exercise price or forward price of a contract subject to the reverse treasury stock method if the contract was not outstanding for the entire financial reporting period. The average market price over the entire financial reporting period is used only for instruments that were outstanding for the entire reporting period. See further discussion in Section 4.2.2.1.3.1.
4.3.2.2 Method of Settlement
4.3.2.2.1 General
With one exception, ASC 480 requires an entity to classify written put options
and forward purchase contracts as liabilities (or assets in some
circumstances) and to initially and subsequently measure such contracts at
fair value, with changes in fair value recognized in earnings.14 For written put options and forward purchase contracts, an entity
should first determine whether the reverse treasury stock method should be
applied to calculate diluted EPS. The reverse treasury stock method should
not be applied to contracts that meet any of the following conditions:
-
The contract is a forward purchase contract that is subject to ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3.
-
The contract must be cash-settled (i.e., no common shares are purchased on settlement).
-
The contract is a participating security and the two-class method of calculating diluted EPS is more dilutive than the reverse treasury stock method.
ASC 480-10-45-4 addresses the EPS accounting for a forward contract within the
scope of ASC 480-10-30-3 through 30-5 and ASC 480-10-35-3 (see Section 4.8.4.1.1).
If cash settlement of the contract is required, the reverse treasury stock
method is not applied and no adjustments are made to the numerator or
denominator in the calculation of diluted EPS. Any dilutive impact of the
contract is only reflected through the mark-to-market adjustment recognized
in earnings on the contract through the application of other GAAP.
The reverse treasury stock method is applied in all other circumstances if its
application is dilutive. Other circumstances include (1) the contract must
be share-settled or (2) the issuing entity or the counterparty is permitted
to elect settlement in cash or shares.
Although contracts subject to the reverse treasury stock method must be
classified as liabilities (or assets in some circumstances) for accounting
purposes, it is still assumed that the contract is classified as an equity
instrument under this method of calculating diluted EPS. Therefore, in
addition to the incremental shares that are added to the denominator under
the reverse treasury stock method, an adjustment to the numerator is also
required. The numerator adjustment should reflect the change in net income
that would have occurred during the reporting period if the contract had
been classified in equity. Since contracts subject to the reverse treasury
stock method are typically subsequently measured at fair value, with changes
in fair value recognized in earnings, and contracts classified as equity
instruments are typically not subsequently remeasured, the adjustment to the
numerator will reflect a reversal of the mark-to-market adjustment
recognized on the contract during the reporting period, net of any
associated income tax effects. However, the numerator adjustment should not
be made, and the incremental shares should not be added to the denominator,
if either (1) the contract is a written put option and is out-of-the-money
on the basis of a comparison of the exercise price with the average market
price or (2) the aggregate effect of the two adjustments is antidilutive on
the basis of the antidilution sequencing requirements in ASC 260. See
Section 4.7
for further discussion of the accounting for diluted EPS for contracts
subject to the reverse treasury stock method.
4.3.2.2.2 Contracts That Provide for Net-Share Settlement
Under the reverse treasury stock method, it is assumed that contracts are settled physically or on a “gross” basis (i.e., the entity pays the exercise price or forward price to the counterparty and receives the gross number of common shares underlying the contract). Contracts subject to the reverse treasury stock method often provide for net share or “cashless” settlement. Under a cashless settlement, the entity delivers to the counterparty a number of common shares with a current fair value (or a fair value determined on the basis of an average stock price) equal to the intrinsic value of the contract.
Economically, a net-share settlement of a contract to purchase shares is
equivalent to a physical settlement accompanied by an issuance of shares to
pay the exercise or forward price. However, an entity applying the reverse
treasury stock method must assume that common shares are issued at the
average market price during the financial reporting period; on the other
hand, in a net-share settlement, the number of shares “issued” is based on
the fair value of shares on the settlement date or a weighted-average price
over a specified period that differs from the average market price over the
reporting period. Given the concept of an average market price that must be
applied under ASC 260, contracts that allow for net-share settlement should
be assumed to be exercised on a gross basis, with the dilution calculated
under the reverse treasury stock method.
4.3.2.2.3 Contracts With Multiple Settlement Alternatives
Certain contracts subject to the reverse treasury stock method may offer the
counterparty alternatives related to the consideration that the entity
transfers to it in return for the common shares delivered to the entity. For
example, a counterparty to a put option may be permitted to require the
entity to pay the exercise price in cash or by delivering a debt instrument
of the entity. ASC 260-10-55-8 through 55-11 address the implications
related to the calculation of diluted EPS for contracts with multiple
settlement alternatives. ASC 260-10-55-8 states, in part, that “[w]hen
several conversion alternatives exist, the computation shall give effect to
the alternative that is most advantageous to the holder of the convertible
security.” For contracts that offer the counterparty such alternatives
related to the receipt of the exercise or forward price, the guidance in ASC
260-10-55-8 through 55-11 must be applied to reflect the potential dilutive
impact on diluted EPS. See further discussion in Section 4.6 and Example 4-29.
For certain written put options and forward purchase contracts, the entity may have the right to choose among multiple settlement alternatives, which affect the form of consideration transferred to the counterparty in return for the common shares the entity receives from the counterparty. Since ASC 260-10-55-8 through 55-11 only address settlement alternatives at the option of the counterparty, an entity is not required to apply that guidance when it may elect the settlement alternative. For contracts that give the entity an option regarding the form of consideration it transfers to the counterparty in return for common shares delivered by the counterparty, it is presumed that the entity will act in its best interests since it controls the election. An entity generally would also use this assumption in determining the fair value of the contract and, as discussed in Section 4.3.2.2.1, contracts subject to the reverse treasury stock method are typically measured at fair value.
4.3.3 Examples
Example 4-9
Application of Reverse Treasury Stock Method to Written Put Options — No Mark-to-Market
Adjustment in Period
On January 1, 20X1, Company A issues $100 million of debt securities with detachable put options on its
common stock. Purchasers of each $1,000 note receive 10 put options, giving them the right to require A to
purchase one share of its common stock for $25 per share, the market price of the common stock on the date
the put options are issued. The put options are exercisable at any time during a three-year period beginning
on the issuance date. The average price of A’s common stock during the reporting period ended December 31,
20X2, is $20 per share. For simplicity, assume that there is no mark-to-market adjustment on the written put
options during the reporting period ended December 31, 20X2.
The incremental shares of common stock that A includes in diluted EPS during the reporting period are
calculated as follows:
Example 4-10
Application of Reverse Treasury Stock Method to Written Put Options — Mark-to-Market
Adjustment in Period
Assume the same facts as in the example above, except that during the reporting
period ended December 31, 20X2, the fair value of the
liability for the put options increases from $5 million to
$6.5 million, resulting in a $1.5 million loss that Entity A
recognizes as a mark-to-market adjustment reducing net
income. Assume that A’s tax rate is 25 percent.
On the basis of these facts, in calculating the diluted impact of the put
options under the reverse treasury stock method, A would
need to make an adjustment to increase the numerator (i.e.,
income available to common stockholders) by $1,125,000
($1,500,000 × 75%). This adjustment is required because no
loss would have been recognized on the put options if they
had been classified in equity. Thus, the entity would
consider the $1,125,000 addition to the numerator and the
250,000 addition to the denominator in determining whether
the put options were dilutive during the period in
accordance with the antidilution sequencing requirements of
ASC 260.
Footnotes
13
The reverse treasury stock method does not apply to
purchased options because they are always antidilutive (see Section 4.1.1.1).
14
Forward purchase contracts that must be physically
settled by repurchase of a fixed number of the issuer’s common
shares are subject to the subsequent-measurement and EPS guidance in
ASC 480 (see Section 4.8.4.1.1).
4.4 If-Converted Method
4.4.1 Scope
ASC 260-10
Convertible Securities and the If-Converted Method
45-40 The dilutive effect of
convertible securities shall be reflected in diluted EPS
by application of the if-converted method. . . .
ASC 260-10-45-40 states that the if-converted method applies to convertible
securities. ASC 260-10-20 defines a convertible security as “[a] security that
is convertible into another security based on a conversion rate.” While
convertible debt and preferred securities are the most common types of
convertible securities subject to the if-converted method, this method is not
limited to instruments that allow the counterparty to benefit from increases in
the price of the entity’s common stock. Rather, in accordance with the
definition of convertible security in ASC 260-10-20, the if-converted method
applies to any security that is convertible into another security on the basis
of a conversion rate. Thus, the if-converted method applies to any of the
following securities:
-
Convertible debt securities.
-
Convertible preferred stock.
-
Mandatorily convertible securities.
-
Common stock that is convertible into another class of common stock.
-
Stock-settled debt.
The if-converted method also applies to written call options and forward sale contracts that, upon settlement, cause the counterparty to receive common shares of the entity when either of the following conditions is met:
- The counterparty is required to tender a debt security or preferred security of the entity as payment of the exercise price or forward price.
- The counterparty has the option to pay the exercise price or forward price in either (1) cash or (2) a debt security or preferred security of the entity, and payment of the debt security or preferred security is more advantageous to the counterparty than paying cash. See further discussion in Section 4.6.
There are some exceptions to the application of the if-converted method to the contract types discussed above. Specifically, an entity should not apply the if-converted method to calculate the dilutive impact in the following situations:
- Settlement of conversion for the convertible security is required entirely in cash (i.e., no common shares are issued on settlement of the conversion feature). See Section 4.7 for discussion of contracts settled in cash.
- The two-class method of calculating diluted EPS is more dilutive than the application of the if-converted method to convertible securities that are participating securities. See Section 5.5.4 for discussion of the two-class method of calculating diluted EPS.
Connecting the Dots
The treasury stock method never applies to the calculation of a
convertible security’s impact on diluted EPS. Rather, ASC 260-10-45-40
requires that an entity use the if-converted method to calculate the
dilutive effect of convertible securities. However, for an Instrument C
convertible debt security, the if-converted method is applied in a
manner that produces the same dilution as the treasury stock method.
In the discussion below, it is assumed that the convertible securities are
subject to the if-converted method and do not represent participating
securities. If convertible securities subject to the if-converted method meet
the definition of a participating security, as discussed in Section 5.5.4, an entity
must apply the more dilutive of the if-converted method or the two-class method
of calculating diluted EPS. Chapter 6 includes more detailed discussion of the appropriate
method applied to determine the dilutive effect of different types of
convertible debt securities.
4.4.2 Application of the If-Converted Method
ASC 260-10
Conversion Rate or Exercise Price
45-21 Diluted EPS shall be
based on the most advantageous conversion rate or exercise
price from the standpoint of the security holder. Previously
reported diluted EPS data shall not be retroactively
adjusted for subsequent conversions or subsequent changes in
the market price of the common stock.
Variable
Denominator
45-21A Changes in
an entity’s share price may affect the exercise price of a
financial instrument or the number of shares that would be
used to settle the financial instrument. For example, when
the principal of a convertible debt instrument is required
to be settled in cash but the conversion premium is required
to (or may) be settled in shares, the number of shares to be
included in the diluted EPS denominator is affected by the
entity’s share price. In applying both the treasury stock
method and the if-converted method of calculating diluted
EPS, the average market price shall be used for purposes of
calculating the denominator for diluted EPS when the number
of shares that may be issued is variable, except for
contingently issuable shares within the scope of the
guidance in paragraphs 260-10-45-48 through 45-57. See
paragraphs 260-10-55-4 through 55-5 for implementation
guidance on determining an average market price.
Convertible Securities and the If-Converted Method
The dilutive effect of convertible
securities shall be reflected in diluted EPS by application
of the if-converted method. Under that method:
- If an entity has convertible preferred stock outstanding, the preferred dividends applicable to convertible preferred stock shall be added back to the numerator. The amount of preferred dividends added back will be the amount of preferred dividends for convertible preferred stock deducted from income from continuing operations (and from net income) in computing income available to common stockholders pursuant to paragraph 260-10-45-11.
- If an entity has convertible debt outstanding:1. Interest charges applicable to the convertible debt shall be added back to the numerator. For convertible debt for which the principal is required to be paid in cash, the interest charges shall not be added back to the numerator.2. To the extent nondiscretionary adjustments based on income made during the period would have been computed differently had the interest on convertible debt never been recognized, the numerator shall be appropriately adjusted. Nondiscretionary adjustments include any expenses or charges that are determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.3. The numerator shall be adjusted for the income tax effect of (b)(1) and (b)(2).
- The convertible preferred stock or convertible debt shall be assumed to have been converted at the beginning of the period (or at time of issuance, if later), and the resulting common shares shall be included in the denominator. See paragraph 260-10-45-21A if the incremental shares are variable (such as when calculating a conversion premium).
45-41 In applying the if-converted method, conversion shall not be assumed for purposes of computing
diluted EPS if the effect would be antidilutive. Convertible preferred stock is antidilutive whenever the
amount of the dividend declared in or accumulated for the current period per common share obtainable on
conversion exceeds basic EPS. Similarly, convertible debt is antidilutive whenever its interest (net of tax and
nondiscretionary adjustments) per common share obtainable on conversion exceeds basic EPS.
45-42 Dilutive securities that are issued during a period and dilutive convertible securities for which conversion
options lapse, for which preferred stock is redeemed, or for which related debt is extinguished during a period,
shall be included in the denominator of diluted EPS for the period that they were outstanding. Likewise, dilutive
convertible securities converted during a period shall be included in the denominator for the period prior to
actual conversion. The common shares issued upon actual conversion shall be included in the denominator for
the period after the date of conversion. Consequently, shares assumed issued shall be weighted for the period
the convertible securities were outstanding, and common shares actually issued shall be weighted for the
period the shares were outstanding.
4.4.2.1 No Antidilution
ASC 260-10-45-41 prohibits application of the if-converted method, and conversion is not assumed, if the effect of such application would be antidilutive. ASC 260-10-45-41 also provides guidance on how to evaluate whether an individual convertible debt or convertible preferred security would be antidilutive. In addition to determining whether a convertible security is individually antidilutive, an entity must consider the antidilution sequencing requirements (see Section 4.1.2.3).
The determination of whether a convertible security is dilutive to EPS should be
made as of each reporting date. The current fair value of the entity’s
common stock relative to the conversion price of the convertible security is
not relevant to this determination (see Example 4-11). Unlike the treasury
stock method, which applies only to in-the-money written freestanding call
options on common stock, the if-converted method applies to convertible
securities that are out-of-the-money if the effect is dilutive. As a result
of this difference, the if-converted method is often more dilutive than the
treasury stock method. See Chapter 6 for further discussion.
4.4.2.2 Numerator Adjustments
Under the if-converted method, an entity must make various adjustments to the numerator (i.e., income available to common stockholders). Those adjustments include the following, as applicable:
- Convertible debt (including share-settled debt):
-
Interest expense recognized during the period is added back to the numerator (see Section 4.4.2.2.1) unless the principal amount of the convertible debt instrument must be paid in cash (i.e., an Instrument C convertible debt instrument).15
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if interest on the convertible debt had not been recognized, the numerator should be adjusted (see Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.3).
- Certain gains or losses recognized on actual settlement of the convertible debt instrument should be reversed from the numerator (see Section 4.4.2.2.4).
- An entity should adjust the numerator for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
-
- Convertible preferred stock:
- Dividends that reduced the numerator during the reporting period are added back to the numerator (see Section 4.4.2.2.1.2).
- To the extent that nondiscretionary adjustments were recognized during the financial reporting period and would have been calculated differently if dividends on the convertible preferred stock had not reduced income available to common stockholders, the numerator should be adjusted (see also Section 4.4.2.2.2).
- Any mark-to-market adjustment recognized on the convertible preferred stock instrument should be reversed from the numerator (see also Section 4.4.2.2.3).
- Certain deemed dividends recognized on actual settlement of the convertible preferred stock instrument that reduced net income to arrive at income available to common stockholders should be reversed from the numerator (see Section 4.4.2.2.4).
- The numerator should be adjusted for the relevant income tax effects of the above items (see Section 4.4.2.2.5).
- Common stock convertible or exchangeable into another class of common stock:
- Under the if-converted method, an entity does not typically need to adjust the numerator when common stock is convertible or exchangeable into another class of common stock. Rather, the calculation of diluted EPS for the class of common stock into which the other class is exchangeable or convertible will include the effect of conversion under the if-converted method. However, the two-class method may be more dilutive than the if-converted method. See further discussion in Section 5.5.4.
Connecting the Dots
An entity must take additional considerations into account when its capital structure includes
multiple classes of common stock or participating securities. Even if an entity’s convertible debt
or convertible preferred stock does not meet the definition of a participating security, given
the effect of the if-converted method on the numerator, an entity will be required to reallocate
undistributed earnings among multiple classes of common stock or participating securities
under the two-class method.
If an entity’s convertible debt or convertible preferred stock meets the definition of a
participating security, the if-converted method is applied only if its application is more dilutive
than the two-class method of calculating diluted EPS. When the two-class method of calculating
diluted EPS is more dilutive, an entity may need to reallocate undistributed earnings to the
convertible debt or convertible preferred stock when applying this method. See Chapter 5 for
further discussion of participating securities and the two-class method.
4.4.2.2.1 Interest and Dividends
4.4.2.2.1.1 Capitalized Interest16
ASC 835-20 specifies that the historical cost of acquiring an asset includes the costs necessarily incurred
to bring it to the condition and location necessary for its intended use. If activities necessary to bring an
asset to that condition and location must be performed, the interest costs incurred during that period
as a result of expenditures for the asset are included in the historical cost of acquiring the asset. As
noted in ASC 350-40, interest costs incurred while developing internal-use computer software may be
capitalized in accordance with ASC 835-20. The capitalization of interest costs introduces additional
complexities with respect to calculating the add-back to the numerator related to (1) interest expense
that would not have been recognized had the convertible debt instrument not been outstanding during
the reporting period and (2) capitalized interest that was subsequently recognized in earnings as part of
the subsequent accounting for the qualifying assets.
4.4.2.2.1.1.1 Interest Costs Capitalized During the Reporting Period
Only interest costs that have been expensed during a financial reporting period may be added back to
the numerator during that reporting period. The capitalization of interest costs should not result in any
additional complexity under the if-converted method if an entity either (1) has recognized interest costs
only on convertible debt instruments subject to the if-converted method (e.g., the entity has no other
borrowings outstanding) or (2) has convertible debt instruments subject to the if-converted method
that are associated with specific qualifying assets. The entity will simply add back to the numerator the
interest expense recognized in earnings on its convertible debt (i.e., the portion not capitalized, which
will be readily identifiable) and any related tax effects. However, if an entity has outstanding debt other
than convertible debt and does not associate the convertible debt with specific qualifying assets, the capitalization rate used to calculate the amount of interest costs capitalized into the carrying amount of qualifying assets will reflect a composite rate comprising interest costs incurred on convertible debt and other borrowings not subject to the if-converted method. In this circumstance, the entity will need to consistently apply a systematic and rational method to determine the following amounts:
- The amount of interest costs incurred on convertible debt instruments subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.
- The amount of the interest costs incurred on other borrowings not subject to the if-converted method that was capitalized during the reporting period versus the amount expensed during the reporting period.
Once these amounts are determined, in applying the if-converted method, the entity should add the following three amounts back to the numerator (assuming that the addition of these amounts to the numerator and the common shares included in the denominator is dilutive on the basis of the antidilution sequencing requirements):
- The amount of interest costs incurred during the reporting period on convertible debt instruments subject to the if-converted method that was recognized as an expense.
- The amount of interest costs incurred during the reporting period on other borrowings not subject to the if-converted method that was recognized as an expense but that would have been capitalized if interest costs had not been incurred on convertible debt instruments subject to the if-converted method (i.e., under the assumption that the convertible debt instruments were converted at the beginning of the period or upon issuance if the convertible debt instrument was issued during the period). (This adjustment reflects a nondiscretionary adjustment under the if-converted method.)
- The tax effect of the amounts in the first two bullets.
Entities will generally need to use a “with and without” approach to determine the amounts in the first two bullets above. However, in certain circumstances, an entity may be able to conclude that the total interest costs capitalized would have been unchanged (or would not have been materially different) if the convertible debt instruments subject to the if-converted method had not been outstanding during the reporting period. In these situations, the entity could simply add to the numerator the interest costs incurred on the convertible debt during the reporting period, net of tax.
Connecting the Dots
On the basis of materiality, some entities apply an accounting convention and do not capitalize interest on qualifying assets. In these situations, the amount of interest costs incurred on convertible debt instruments subject to the if-converted method that is added back to the numerator should reflect the amount actually reflected as an expense during the reporting period. Such entities should not perform the calculations described above because it would be inappropriate to add back a hypothetical amount that is calculated as if interest costs on qualifying assets had been capitalized.
4.4.2.2.1.1.2 Capitalized Interest Costs Subsequently Reflected in Earnings
Capitalized interest costs increase the basis of qualifying assets, resulting in
an increase in depreciation expense for assets placed into service,
a decrease in the gain on sale (or increase in loss on sale) for
assets sold, or a decrease in the recognized earnings (or increase
in the recognized losses) for equity method investees. Neither ASC
260 nor ASC 835-20 addresses the treatment of the earnings impact of
capitalized interest costs under the if-converted method. Therefore,
entities should consistently apply one of the following two
approaches as an accounting policy election and provide appropriate
disclosures:
-
Add back to the numerator the amounts of capitalized interest costs reflected in earnings during the reporting period that arose from interest costs capitalized during the reporting period, net of tax.
-
Do not add back to the numerator any amounts of capitalized interest costs that are reflected in earnings during the reporting period.
Although more conceptually pure, the first approach could be extremely complex. Under this approach,
the objective is to add back to the numerator an amount arising from interest costs capitalized during
the reporting period that would not have reduced earnings if the convertible debt instrument had
not been outstanding during the reporting period. As discussed in Section 4.4.2.2.1.1.1, the mere
calculation of the interest cost adjustment to the numerator is complex; this approach adds further
complexity to the if-converted method.
It is not appropriate for an entity to apply an accounting policy under which it
adds back to the numerator amounts that affected earnings during the
reporting period that arose from interest costs capitalized in prior
periods. This type of accounting approach is inconsistent with the
guidance in ASC 260 on nondiscretionary adjustments because the
expense amount that would be added back to the numerator would have
been incurred regardless of whether the convertible debt instrument
was outstanding during the current reporting period. This approach
could also result in counting the same amounts as an “add-back to
the numerator” in multiple reporting periods. Lastly, this approach
is not consistent with ASC 260’s objective that the calculation of
EPS reflect performance based on what has occurred during a
reporting period. Because this approach is not acceptable, the
selection between the two approaches discussed above will generally
not result in material differences because the amount of interest
costs capitalized and subsequently expensed in the same quarterly
reporting period is generally insignificant.
4.4.2.2.1.2 Dividends
As discussed in Section
3.2.2, dividends on preferred stock reduce income
available to common stockholders, or the numerator, in the
calculation of basic EPS. ASC 260-10-45-40(a) states, in part, that
“[t]he amount of preferred dividends added back [to the numerator]
will be the amount of preferred dividends for convertible preferred
stock deducted from income from continuing operations (and from net
income) in computing income available to common stockholders
pursuant to paragraph 260-10-45-11.” Thus, each type of dividend
discussed in Section 3.2.2
that reduced the numerator in the calculation of basic EPS should be
added back to the numerator under the if-converted method. As a
result, such dividends that reduced basic EPS have no impact on the
calculation of diluted EPS. Rather, the dilution of EPS that results
from convertible preferred stock is captured through an assumption
that the common shares issuable on conversion were outstanding
during the reporting period.
Connecting the Dots
As discussed in Section
3.2.2, the application of ASC 260-10-S99-2
and ASC 480-10-S99-3A may result in deemed contributions
during a period. In these circumstances, the amount of the
contributions should be subtracted from income available to
common stockholders under the if-converted method. See
Sections 4.4.2.2.4 and 4.4.2.4.1 for additional considerations
related to situations in which preferred stock is settled
during a reporting period.
4.4.2.2.2 Nondiscretionary Adjustments
ASC 260 states that expenses or charges (other than interest expense on convertible debt) should be added back to the numerator as a nondiscretionary adjustment only if such amounts were “determined based on the income (loss) for the period, such as profit-sharing and royalty agreements.” To meet the definition of a nondiscretionary adjustment, an income statement item must possess both of the following characteristics:
- It is calculated on the basis of net income or loss or a similar measure — Similar measures could include net interest income, interest expense, income available to common stockholders, or EPS. Thus, a nondiscretionary adjustment could potentially arise for convertible preferred stock since the measure is not limited to items that affect an entity’s net income.
- It arises from a contractual right or obligation of the entity — Any amount that does not arise from a contractual right or obligation of the entity is subjective and cannot be considered nondiscretionary.
Since a nondiscretionary adjustment must possess both of the characteristics
described above, the types of nondiscretionary adjustments made under
the if-converted method will be significantly limited in scope. See also
Example
4-14.
Connecting the Dots
ASC 260-10-45-40(b)(2) states that if there are nondiscretionary adjustments that would have been calculated differently if interest expense on the convertible debt had not been recognized, “[t]he numerator shall be appropriately adjusted.” Thus, nondiscretionary adjustments may increase or decrease the numerator. In some cases, a nondiscretionary adjustment may arise from a contract that is recognized at fair value through earnings. In these circumstances, it is appropriate to calculate the fair value adjustment that would have been recognized during the period if interest expense on the convertible debt instrument had not been recognized during the period.
ASC 260-10-45-40(b)(2) does not specifically discuss
situations in which the if-converted method is applied to a convertible
debt instrument for which the principal amount must be paid in cash
(i.e., an Instrument C convertible debt security). However, an entity
should not make any nondiscretionary adjustments in such circumstances
because ASC 260-10-45-40(b)(1) prohibits an entity from adding back
interest charges on such convertible debt instruments to the numerator.
Accordingly, net income or loss for the period would not change and no
nondiscretionary adjustments would therefore be needed.
4.4.2.2.3 Mark-to-Market Adjustments
Except for convertible debt instruments that contain a
separately recognized equity component, an entity may elect the fair value
option and account for convertible debt at fair value, with changes in fair
value recognized in earnings.17 The fair value option is often elected to avoid separation of an
embedded derivative in accordance with ASC 815-15. In other situations, an
entity may separate an embedded conversion option, redemption option, or
other embedded feature from the host debt instrument and account for the
bifurcated derivative at fair value under ASC 815-15.
Accounting for a convertible debt instrument at fair value
under the fair value option, or separating an embedded derivative, does not
obviate the need to apply the if-converted method. However, when a
convertible debt instrument is accounted for at fair value, or the embedded
conversion option or other embedded feature is separated as a derivative,
the mark-to-market adjustment recognized in earnings during the reporting
period must be reversed and treated as an adjustment to the numerator under
the if-converted method. This adjustment is similar to the add-back to the
numerator of interest expense on convertible debt instruments and applies to
all convertible debt instruments and is only made if the combined effect of
the numerator and denominator adjustments is dilutive.
If an entity has the option of settling a conversion of a
convertible debt instrument in cash or stock and (1) the embedded conversion
option has not been separated as an embedded derivative and (2) the fair
value option has not been applied to the instrument, the entity would not
adjust the numerator to reflect a mark-to-market amount that would have been
recognized during a reporting period if the embedded conversion option had
been separated or the fair value had been applied. Rather, the if-converted
method would be applied, if dilutive.
Connecting the Dots
ASC 825-10-45-5 requires entities to “present
separately in other comprehensive income the portion of the total
change in the fair value” of a financial liability that is
recognized at fair value through earnings and that “results from a
change in the instrument-specific credit risk.” Since the credit
component does not enter into the determination of net income, it
should be excluded from the adjustment made to the numerator in the
calculation of diluted EPS. This credit component would only be
included in the adjustment to the numerator if the entity presented
comprehensive income per share.
4.4.2.2.4 Settlement Adjustments
The conversion of a convertible security into common shares in accordance with
the original conversion privileges may affect income available to common
stockholders. The table below discusses some of these types of
situations.
Table 4-6
Conversion Type | Impact on Numerator of Conversion |
---|---|
Convertible debt with a modified embedded
conversion option (i.e., the embedded conversion
option was modified in a transaction not accounted for
as an extinguishment at some point before conversion) | Any remaining unamortized discount arising from the
recognition of the discount on the convertible debt
instrument (i.e., from the amount recognized in equity
resulting from the modification of the convertible debt
instrument) is recognized as interest cost (see Table
6-1). |
Convertible preferred stock with a modified embedded conversion option (i.e., the embedded conversion option was modified in a transaction not accounted for as an extinguishment at some point before conversion) | Any remaining unamortized discount arising from the recognition of the discount
on the convertible preferred stock instrument (i.e.,
from the amount recognized in equity resulting from
the modification of the convertible preferred stock
instrument) is recognized as a dividend on preferred
stock (see Table 3-7). |
Convertible debt with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion) | Any remaining unamortized discount on the convertible debt instrument is recognized as interest cost in accordance with ASC 815-15-40-1. |
Convertible preferred stock with a reclassified embedded conversion option (i.e., the conversion option was reclassified from a derivative liability to equity at some point before conversion) | Any remaining unamortized discount on the convertible preferred stock instrument
is recognized as a dividend on preferred stock (see
Table 3-7). |
Questions often arise regarding how the gains and losses and deemed dividends
discussed in the table above affect the numerator under the if-converted
method. Two views may be considered in such situations:
-
View A — The numerator should be adjusted to include the effect on income available to common stockholders that would have been recognized if all convertible securities outstanding during the reporting period had been converted at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity would need to calculate one or both of the following:
-
Convertible securities outstanding at the end of the reporting period — The impact on income available to common stockholders that would have been recognized if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later).
-
Convertible securities converted during the reporting period — The incremental impact on income available to common stockholders if the convertible securities had been converted at the beginning of the reporting period (or the date of issuance, if later). In this adjustment, an entity would reflect an increase or decrease to the amount that was recognized in income available to common stockholders, assuming an earlier conversion. To calculate this amount, the entity would need to determine the incremental effect on interest expense or dividends recognized, which could be affected by the discount amortization that was recognized before conversion.
-
-
View B — The numerator should not reflect any impact on income available to common stockholders as a result of assumed conversion at the beginning of the reporting period (or the date of issuance, if later). According to this view, provided that the effect is dilutive, an entity should (1) not adjust the numerator for convertible securities outstanding at the end of the period for any interest expense or dividends that would have been recognized if conversion had occurred at the beginning of the reporting period (or the date of issuance, if later) and (2) reverse from the numerator any interest expense or dividends that was recognized for convertible securities that were converted during the reporting period.
View B is appropriate because it is consistent with ASC 260-10-S99-2 (see
Section
4.4.2.4.1) and the objective of the if-converted method. The
if-converted method is designed to replace the (1) effect on the numerator
when convertible securities are outstanding at any point during a reporting
period with (2) common shares issuable upon conversion. Any interest expense
or deemed dividends that would be recognized, if conversion is assumed, at
the beginning of the period (or the date of issuance, if later) is not
related to an equity transaction; rather, it results from the settlement of
the host debt or preferred stock instrument and therefore should not factor
into the determination of dilution under the if-converted method. Under the
if-converted method, it is assumed that the cost of carrying a convertible
security during a reporting period is fully replaced with the common shares
that holders would own as equity investors during the reporting period. That
is, the holder can participate in the earnings of the entity as either a
holder of a security senior to common stock or as a holder of common stock,
but not both. The interest expense or deemed dividends associated with
conversion of the types of convertible securities referred to in Table 4-6 is
considered participation as an investor in a security other than common
shares.
One could argue View A on the basis that the original guidance that was codified
in ASC 260-10-45-40 was issued before the release of the guidance referred
to in Table 4-6
that requires entities to recognize such amounts upon conversion. Supporters
of View A could also suggest that this view is consistent with (1) the
definition of the if-converted method in the ASC master glossary, which
states that it is “[a] method of computing EPS data that assumes conversion
of convertible securities at the beginning of the reporting period (or at
time of issuance, if later),” and (2) ASC 260-10-45-16, which states, in
part, that “[t]he numerator also is adjusted for any other changes in income
or loss that would result from the assumed conversion of . . . potential
common shares.” However, View A is not required because ASC 260 does not
mandate this approach and the adjustments discussed in ASC 260-10-45-16
pertain to items other than the convertible security that would have had a
different impact on the numerator if the convertible security had not been
outstanding during the reporting period.
4.4.2.2.5 Income Tax Effects
The income tax effects of adjustments to the numerator, if any, that are made under the if-converted
method should be based on the application of ASC 740 and should reflect the marginal tax effect, if
any, of adjustments to the numerator. Depending on the nature of the adjustment, the income tax
consequences could be complex. For example, adjustments to the numerator could affect an entity’s
assessment of whether a valuation allowance should be established or adjusted for deferred tax assets.
For convertible preferred stock instruments, income tax adjustments are often unnecessary because
dividends on preferred stock are generally not deductible.
4.4.2.3 Denominator Adjustments
Under the if-converted method, the denominator includes the common shares issuable upon
conversion of convertible securities. The number of common shares issuable upon conversion of
convertible securities may vary because of (1) the passage of time; (2) the occurrence or nonoccurrence
of a specified event; or (3) a specified rate, price, index, or other variable.
If the number of common shares issuable upon conversion varies only on the basis of the passage of time, the entity should apply the guidance in ASC 260-10-45-21, which requires that diluted EPS be calculated by using “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” The entity must consider any settlement term that will be available to the counterparty at any point during the term the convertible security is outstanding and should assume conversion upon terms that maximize value to the counterparty.
If the number of common shares issuable upon conversion is subject to adjustment
on the basis of the occurrence or nonoccurrence of a specified event that is
not within the counterparty’s control (other than changes in the fair value
of the entity’s stock price), the entity should apply the guidance on
contingently issuable shares to determine the number of common shares
issuable upon conversion. As discussed in Section 4.5, the entity should assume
that the current status of the condition on the reporting date will remain
unchanged (i.e., the specified event will not occur). As a result, potential
adjustment features that are commonly included in the terms of convertible
securities subject to the if-converted method will have no impact on the
application of this method unless and until such adjustment events occur.
Table 4-3
lists common adjustment events that will have no impact on the application
of the if-converted method before the occurrence of the related event.
If the number of common shares issuable upon conversion is linked to a
specified rate, price, index, or other variable, the convertible security is
considered to contain a variable conversion price. If the number of common
shares issuable upon conversion varies solely on the basis of the entity’s
stock price, the entity should apply ASC 260-10-45-21A, which requires that
the entity determine the number of common shares issued on conversion on the
basis of the average market price of the entity’s stock during the reporting
period. (See Example 4-13 for an illustration of this concept.) If, however,
the number of common shares issuable upon conversion varies on the basis of
a specified rate, price, index, or other variable (i.e., it is not based
solely on the entity’s stock price), an entity may apply any of the
following approaches since ASC 260 does not contain specific guidance on
this matter:
-
View A: The number of common shares issuable upon conversion reflects the conversion price at the end of the reporting period — This view is consistent with the guidance on contingently issuable shares in ASC 260. Under that guidance, it is assumed that the contingency (in this case, the conversion price) is resolved as of the end of the reporting period. Thus, an entity calculates the conversion price on the basis of the current rate, price, index, or other variable as of the reporting date (or the average rate, price, index, or other variable, assuming conversion on the last day of the reporting period if the contract stipulates an averaging formula). See Section 4.5 for additional discussion of the contingently issuable share method.
-
View B: The number of common shares issuable upon conversion is based on the lowest conversion price (highest conversion rate) available to the counterparty during any day within the reporting period — This view is consistent with ASC 260-10-45-21, which requires that diluted EPS be calculated on the basis of “the most advantageous conversion rate or exercise price from the standpoint of the security holder.” As of each reporting date, the entity should evaluate all the conversion prices applicable for the entire time during the reporting period in which the convertible security was outstanding and should use the conversion price that is least advantageous to the entity and produces the highest number of common shares for the investor. The entity should not project future conversion prices since they will vary on the basis of changes in the rate, price, index, or other variable.
-
View C: The number of common shares issuable upon conversion is based on the average conversion price during the reporting period — This view is consistent with ASC 260-10-45-21A and ASC 260-10-45-23, which require the use of an average.
These three approaches are acceptable regardless of whether the entity or
counterparty controls the timing of conversion (since neither party
ultimately controls the rate, price, index, or other variable that affects
the conversion price). The approach selected is considered an accounting
policy election that must be applied consistently and disclosed.
If the convertible security or any embedded feature in the convertible security is classified as a liability
and recognized at fair value, with changes in fair value reported in earnings, which may be required
because of the variable terms of the contract, an entity must also adjust the numerator in calculating
diluted EPS, as discussed in Section 4.4.2.2.3.
It is not acceptable to determine the conversion price on the basis of the
conversion price at the beginning of the reporting period because there is
no basis in ASC 260 for the use of this approach.
4.4.2.4 Instruments Issued, Redeemed, Converted, or Otherwise Settled During a Financial Reporting Period
If a convertible security is issued, redeemed, converted, or otherwise settled
during a financial reporting period, the dilutive effect of the if-converted
method should be included in the calculation of diluted EPS for the portion of
the period in which the convertible security was outstanding. The incremental
common shares added to the denominator should be weighted for the time
outstanding during the reporting period.
4.4.2.4.1 Redemption or Induced Conversion of Convertible Securities
ASC 260-10 — SEC Materials — SEC Staff Guidance
SEC Staff Announcement: The Effect on the Calculation of Earnings per Share for
a Period That Includes the Redemption or Induced
Conversion of Preferred Stock
S99-2 . . . When a registrant effects a redemption or induced conversion of only a portion of the outstanding
securities of a class of preferred stock, the SEC staff believes that, for the purpose of determining whether
the “if-converted” method is dilutive for the period, the shares redeemed or converted should be considered
separately from the other shares of the same class that are not redeemed or converted. The SEC staff does not
believe that it is appropriate to aggregate securities with different effective dividend yields when determining
whether the “if-converted” method is dilutive, which would be the result if a single, aggregate computation was
made for the entire series of preferred stock.
For example, assume a registrant has 100 shares of convertible preferred stock outstanding at the beginning of
the period. The convertible preferred stock was issued at fair value, which was equal to its par value of $10 per
share, and has a stated dividend of 5 percent, and each share of preferred stock is convertible into 1 share of
common stock. During the period, 20 preferred shares were redeemed by the registrant for $12 per share.
In this example, the SEC staff believes that the registrant should determine whether conversion is dilutive
(1) for 80 of the preferred shares by applying the “if-converted” method from the beginning of the period to
the end of the period using the stated dividend of 5 percent and (2) for 20 of the preferred shares by applying
the “if-converted” method from the beginning of the period to the date of redemption using both the stated
dividend of 5 percent and the $2 per share redemption premium.
Accordingly, assuming that the dividend for the period for the preferred stock was $0.125 per share, a
determination of whether the 20 redeemed shares are dilutive should be made by comparing the $2.125
per-share effect of assuming those shares are not converted to the effect of assuming those 20 shares were
converted into 20 shares of common stock, weighted for the period for which they were outstanding. The
determination of the “if-converted” effect of the 80 shares not redeemed should be made separately, by
comparing the EPS effect of the $0.125 per-share dividend to the effect of assuming conversion into 80 shares
of common stock.
As discussed in the SEC staff’s guidance in ASC 260-10-S99-2, when less than all
shares of a class of convertible preferred stock are redeemed or
converted in accordance with an inducement offer, the unit of account in
the calculation of diluted EPS must be separated into the shares
redeemed or converted and the remaining shares. Such separation results
in the most dilutive calculation, which is consistent with the objective
of diluted EPS. Further, although this issue is not specifically
discussed in the SEC staff guidance above, the same approach should be
applied when a portion of a class of convertible debt instruments is
redeemed or converted in accordance with an inducement offer.
Connecting the Dots
When convertible securities are converted during a reporting period in
accordance with an inducement offer, under the if-converted
method, it is assumed that the securities were converted at the
beginning of the reporting period or on the date of issuance, if
later, on the basis of the stated conversion terms. Because the
numerator adjustment will reflect a reversal of the additional
consideration provided under the inducement offer, the
application of the if-converted method during a period in which
an induced conversion has occurred will typically be
antidilutive for the specific securities that were settled in
accordance with the inducement offer.
4.4.3 Contingently Convertible Instruments
ASC 260-10
Contingently Convertible Instruments
45-43 While the terms of
contingently convertible instruments vary, a typical
instrument includes a market price trigger that exceeds
a specified conversion price of the issuer’s underlying
stock price on the date of issuance by a specified
percentage (for example, 10 percent, 20 percent, or 30
percent). Some contingently convertible instruments have
floating market price triggers for which conversion is
dependent upon the market price of the issuer’s stock
exceeding the conversion price by a specified percentage
or percentages at specified times during the term of the
debt. Other contingently convertible instruments require
that the market price of the issuer’s stock exceed a
specified level for a specified period (for example, 20
percent above the conversion price for a 30-day period).
In addition, contingently convertible instruments may
have additional features such as parity features, issuer
call options, and investor put options.
45-44 Contingently
convertible instruments shall be included in diluted EPS
(if dilutive) regardless of whether the market price
trigger has been met. There is no substantive economic
difference between contingently convertible instruments
and convertible instruments with a market price
conversion premium. The treatment for diluted EPS shall
not differ because of a contingent market price trigger.
The guidance provided in this paragraph also shall be
applied to instruments that have multiple contingencies
if one of the contingencies is a market price trigger
and the instrument is convertible or settleable in
shares based on meeting a market condition — that is,
the conversion is not dependent (or no longer dependent)
on a substantive non-market-based contingency. For
example, this guidance applies if an instrument is
convertible upon meeting a market price trigger or a
substantive non-market-based contingency (for example, a
change in control). Alternatively, if the instrument is
convertible upon achieving both a market price trigger
and a substantive non-market-based contingency, this
guidance would not apply until the non-market-based
contingency has been met. See Example 11 (paragraph
260-10-55-78) for an illustration of this guidance.
ASC 260-10-45-43 and 45-44 address when the if-converted method should be applied to convertible
securities that are contingently convertible into common shares on the basis of a market price trigger or
a market price trigger combined with a non-market-based contingency. Examples of non-market-based
contingencies include an IPO and a change of control. The guidance in ASC 260-10-45-43 and 45-44
applies to all types of convertible instruments subject to the if-converted method. In accordance with
this guidance, as well as the guidance applicable to contingently issuable shares, the application of the
if-converted method to contingently convertible securities is as follows:
- If the instrument becomes convertible only if (1) a specified price of the entity’s common stock (i.e., a market price trigger) is achieved or (2) either a market-price trigger or some other non-market-based contingency is met, the if-converted method should be applied, if dilutive, regardless of whether the contingencies are met.
- If the instrument becomes convertible only if (1) a substantive non-market-based contingency is met or (2) a market price trigger and some other substantive non-market-based contingency are met, the if-converted method should be applied only if the non-market-based contingency has been met. For this purpose, the evaluation of whether the non-market-based contingency has been met should be as of the end of the reporting period. If the non-market-based contingency is met as of the reporting date and application of the if-converted method is dilutive, the dilutive effect should be included in diluted EPS from the beginning of the reporting period or the date of issuance, if later. This approach is consistent with the diluted EPS approach applied to contingently issuable shares (see Section 4.5). See Section 4.9.3 for discussion of application of the if-converted method to the calculation of year-to-date diluted EPS.
If a non-market-based contingency only accelerates the timing of the counterparty’s ability to convert
the instrument into common shares, the non-market-based contingency is ignored and the if-converted
method applies in all periods in which the convertible security is outstanding if the method is dilutive
on the basis of the antidilution sequencing requirements of ASC 260. This situation may exist when a
convertible security is convertible at the holder’s option at or near maturity and contingently convertible
sooner on the basis of a non-market-based contingency.
4.4.4 Examples
Example 4-11
Relevance of Current Fair Value of Common Stock
Company A has issued nonparticipating convertible debt that permits the counterparty to convert the debt
into common stock at a conversion price of $10 per common share. Any conversion must be settled entirely in
common stock. The fair value of A’s common stock as of the date the convertible debt is issued is $8 per share.
At the end of the reporting period, the fair value of A’s common stock is $6 per share and, for the reporting
period, the average market price of A’s common stock is $7. While, economically, a counterparty would not
be expected to convert the debt into common stock at any point during the reporting period, A must apply
the if-converted method in calculating diluted EPS if the effect is dilutive. In performing this assessment, an
entity should first determine whether the interest expense (net of taxes and any discretionary adjustments)
per common share obtainable on conversion is less than basic EPS. If so, the convertible debt instrument
is individually dilutive and the entity must next consider the antidilution sequencing requirements (see
Section 4.1.2.3). If the convertible debt is dilutive in the context of A’s capital structure under the antidilution
sequencing guidance, the if-converted method must be applied in the calculation of diluted EPS even though a
rational investor would not convert the debt instrument.
Example 4-12
Application of If-Converted Method to Outstanding Convertible Preferred Stock and Convertible Debt
Company B, a calendar-year entity, has the following convertible securities outstanding:
- Convertible preferred stock — $1 million of cumulative convertible preferred stock. The convertible preferred stock was originally issued in denominations of $1,000 at the liquidation preference and pays dividends at a rate of 7 percent per annum. The counterparty to the convertible preferred stock can convert the preferred stock into B’s common stock at any time at a conversion price of $5 per $1,000 liquidation value of convertible preferred stock. Settlement in shares of B’s common stock is required for any conversion.
- Convertible debt — $1 million principal amount of convertible debt bearing interest at 12 percent per annum. The convertible debt was originally issued in denominations of $1,000 at the principal amount. The counterparty to the convertible debt can convert the convertible debt at any time at a conversion price of $5 per $1,000 principal amount of convertible debt. Settlement in shares of B’s common stock is required for any conversion.
The convertible preferred stock is outstanding during the entire period. The
convertible debt is issued on July 15. For the year
ended December 31, B’s income available to common
stockholders (after dividends accumulated on the
convertible preferred stock) was $5 million and there
were 10 million weighted-average common shares
outstanding. Company B’s income tax rate is 25 percent.
The average market price of B’s common stock for the
year is $5 per share.
The following table illustrates the calculation of whether the convertible preferred stock is dilutive under the if-converted method:
The convertible preferred stock is dilutive to B’s EPS because the dividends on the preferred stock per common share obtainable on conversion are less than basic EPS.
The following table illustrates the calculation of whether the convertible debt is dilutive under the if-converted method:
The convertible debt is dilutive to B’s EPS because the interest expense (net of tax) per common share
obtainable on conversion is less than basic EPS. In reaching this conclusion, with respect to the potential
common shares added to the denominator, an entity would assume conversion as of the issuance date, which
is later than the beginning of the year. Since the convertible debt has only been outstanding for 5.5 months,
the incremental common shares added to the denominator are weighted for 5.5 months.
Company B’s calculation of diluted EPS for the year ended December 31, which is based on the antidilution
sequencing guidance in ASC 260, is as follows:
The average market price of B’s common stock is not relevant to the calculation of dilution under the
if-converted method.
Example 4-13
Convertible Debt That May Be Settled in Stock or
Cash
On January 1, 20X2, Company S issues $10 million of 10 percent debt that pays
interest that compounds quarterly. On the December 31,
20X5, maturity date, S is required to pay the principal
amount in either cash or common stock. If S elects to
pay the principal amount in shares, it must deliver a
number of shares that has a monetary value equal to the
principal amount as determined on the basis of the
average closing quoted price of S’s common stock over
the 30-day period that ends one business day before the
settlement date.
Company S is calculating diluted EPS for the quarterly period ended March 31,
20X2. The average price of S’s common stock for the
quarterly period ended March 31, 20X2, is $25 per share.
The average price of S’s common stock for the 30-day
period ended March 30, 20X2, is $20 per share. For the
quarterly period ended March 31, 20X2, S has 10 million
weighted-average common shares outstanding and reported
net income of $50 million. Income taxes are ignored in
this example.
The debt obligation meets the definition of a convertible security, and the if-converted method must be applied to determine the dilutive impact because share settlement is presumed. The calculation of basic and diluted EPS for the quarterly period ended March 31, 20X2, is as follows:
*
The number of shares issuable
upon conversion of the debt is determined on the
basis of S’s average share price during the entire
reporting period. This calculation is as follows:
($10,000,000 ÷ $25 = 400,000).
Example 4-14
Bonus as a Nondiscretionary Adjustment
Company D pays an annual bonus to its employees. The amount of the bonus is determined at year-end after
D has closed its books and determined net income for the year before the bonus payment. Historically, D has
paid an aggregate bonus equal to 10 percent of the increase in net income over the prior year. Employees are
aware of this historical practice and expect D to continue it.
The variability in the amount of bonus paid does not represent a nondiscretionary adjustment because the
bonus does not arise from a contractual obligation of D and the amount paid is ultimately subjective. Therefore,
the numerator should not be adjusted to reflect an increased bonus payable if interest on convertible debt did
not reduce net income.
ASC 260-10
Example 11:
Computation of Basic and Diluted EPS for Three
Examples of Contingently Convertible
Instruments
55-78 The following Cases
illustrate the guidance in paragraphs 260-10-45-43
through 45-46 related to diluted EPS computations for
three examples of contingently convertible
instruments:
- Contingently convertible debt with a market price trigger (Case A)
- Contingently convertible debt with a market price trigger, issuer must settle the principal amount of the debt in cash, but may settle any conversion premium in either cash or stock (Case B)
- Convertible debt for which the principal and conversion premium can be settled in any combination of shares or cash (Case C).
55-79
Cases A, B, and C share all of
the following assumptions:
- Principal amount of the convertible debt: $1,000
- Conversion ratio: 20
- Conversion price per share of common stock: $50 Conversion price = (Convertible bond’s principal amount) ÷ (Conversion ratio) = $1,000 ÷ 20 = $50.
- Share price of common stock at issuance: $40
- Market price trigger: average share price for the year must exceed $65 (130% of conversion price)
- Interest rate: 4%
- Effective tax rate: 35%
- Shares of common stock outstanding: 2,000.
Case A: Contingently Convertible Debt With a Market Price Trigger
55-81 The holder of the debt may convert the debt into shares of common stock when the share price exceeds
the market price trigger; otherwise, the holder is only entitled to the par value of the debt.
55-82 The contingently
convertible debt is issued on January 1, 200X, income
available to common shareholders for the year ended
December 31, 200X, is $10,000, and the average share
price for the year is $55. The issuer of the
contingently convertible debt should apply the guidance
in paragraphs 260-10-45-43 through 45-44 which requires
the issuer to include the dilutive effect of the
convertible debt in diluted EPS even though the market
price trigger of $65 has not been met. In this Case,
basic EPS is $5.00. (Basic EPS = [Income available to
common shareholders (IACS)] ÷ [Shares outstanding (SO)]
= $10,000 ÷ 2,000 shares = $5.00 per share) and applying
the if-converted method to the debt instrument dilutes
EPS to $4.96 (Diluted EPS computed using the
if-converted method = [IACS + Interest (1-tax rate)] ÷
(SO + Potential common shares) = ($10,000 + $26) ÷
(2,000 + 20) shares = $4.96 per share.)
Case B: Contingently Convertible Debt With a Market Price Trigger, Issuer Must Settle Principal in Cash, but May Settle Conversion Premium in Either Cash or Stock
55-84 The issuer of the contingently convertible debt must settle the principal amount of the debt in cash upon conversion and it may settle any conversion premium in either cash or stock. The holder of the instrument is only entitled to the conversion premium if the share price exceeds the market price trigger. The contingently convertible instrument is issued on January 1, 200X, income available to common shareholders for the year ended December 31, 200X is $9,980, and the average share price for the year is $64.
55-84A The if-converted
method should be used to determine the
earnings-per-share implications of convertible debt with
the characteristics described in this Case. There would
be no adjustment to the numerator in the diluted
earnings-per-share computation for the cash-settled
portion of the instrument (the principal amount of the
debt) because that portion will always be settled in
cash (see paragraph 260-10-45-40). The conversion
premium should be included in diluted earnings per share
based on the provisions of paragraphs 260-10-45-45
through 45-46 and 260-10-55-32 through 55-36A. The
convertible debt instrument in this Case is subject to
other applicable guidance in Subtopic 260-10 as well,
including the antidilution provisions of that
Subtopic.
55-84B In this Example, basic
EPS is $4.99, and diluted earnings per share is $4.98.
Basic EPS = IACS ÷ SO = $9,980 ÷ 2,000 shares = $4.99
per share. Diluted EPS would be calculated using the
if-converted method by determining the number of shares
needed to settle the conversion premium and adding that
amount to shares outstanding to calculate the diluted
EPS denominator. The average market price is used to
determine the dilution in accordance with paragraph
260-10-45-21A. The effect would be dilutive in this case
because the average market price of the shares exceeds
the conversion price. However, if the average market
price of the shares was less than the conversion price,
then the conversion premium would be zero and there
would be no dilutive effect. Diluted EPS = IACS ÷ (SO +
Potential common shares) = ($9,980) ÷ (2,000 + 4.38)
shares = $4.98 per share. Potential common shares =
(Conversion spread value) ÷ (Average share price) = $14
× 20 shares ÷ $64 = 4.38 shares.
Case C: Convertible Debt That the
Principal and Conversion Premium Can Be Settled in Any
Combination of Shares or Cash
55-84C The issuer of the
convertible debt can settle the principal and the
conversion premium in any combination of cash or shares
(the issuer has the option). Consistent with the facts
in Case B, the convertible instrument is issued on
January 1, 200X, income available to common shareholders
for the year ended December 31, 200X, is $9,980, and the
average share price for the year is $64.
55-84D The if-converted
method should be used to determine the
earnings-per-share implications of convertible debt. The
effect of settling the principal and conversion premium
in shares is included for purposes of calculating
diluted earnings per share in accordance with the
guidance in paragraph 260-10-45-45.
55-84E In this case, basic
EPS is $4.99 (the same calculation in paragraph
260-10-55-84B), and diluted earnings per share is $4.95.
Diluted EPS is calculated using the if-converted method
= [IACS + Interest (1-tax rate)] ÷ (SO + Potential
common shares) = (9,980 + 26) ÷ (2,000 + 20). See
paragraph 260-10-55-82 for interest expense amount.
Footnotes
15
Section
4.4.2.2.1.1 does not apply to
convertible debt instruments for which the
principal amount must be paid in cash.
16
This section does not apply to convertible debt
instruments for which the principal amount must be paid in cash
because interest charges on such instruments are not added back
to the numerator when the if-converted method is applied.
17
ASC 825-10-15-5(f) prohibits the election of the
fair value option for convertible preferred stock that is classified
in stockholders’ equity (whether permanent or temporary equity).
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.
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:
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
45-45 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
55-33 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
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). . . .
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).
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.
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.
|
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
19
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.
20
See Section
7.1.4 for further discussion of share-based payment awards.
21
See Deloitte’s Roadmap Contracts on an Entity’s Own Equity for
further discussion of these requirements.
22
See Chapter
5 of Deloitte’s Roadmap Share-Based Payment Awards for further
discussion of these requirements.
4.8 Diluted EPS for Specific Types of Transactions or Events
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 or a preferred security and (2) a variable-share forward contract to issue common shares or an option to issue common shares to the counterparty. An entity must evaluate the terms of these types of issuances to determine whether one or more of the component instruments is a participating security and whether the if-converted or treasury stock method must be applied to calculate diluted EPS.
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 either the debt instrument or preferred security as payment of the forward or exercise price, the if-converted method is applied unless it is more advantageous to the counterparty to pay cash to acquire common shares.
The terms of certain unit structures must be further considered because the counterparty does not have the unconditional right to tender the debt instrument or preferred security to the entity in satisfaction of the forward price or exercise price payable to acquire the common shares. 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 forward sale contract that requires the counterparty to purchase 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 forward price in the forward sale contract.
- Three months before the settlement of the forward contract, the note is subject to remarketing at an interest rate that results in net sales proceeds at least equal to the note’s principal amount.
- If the remarketing is successful, the counterparty can elect to (1) retain the note with a remaining term of two years and three months (generally with a remarketed interest rate) or (2) sell the note in the remarketing for cash proceeds that equal or exceed the forward price in the forward sale contract. The counterparty cannot elect to tender the note to the issuer in satisfaction of the forward price in the forward sale contract.
- If the remarketing is unsuccessful, the counterparty may elect to put the note to the entity in satisfaction of the forward price on the forward sale contract or pay the forward price in cash.
For these types of arrangements, the probability of a successful remarketing must be assessed. If it is
probable that the remarketing will be successful, the entity may apply the treasury stock method to the
forward sale contract. 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 forward price in the forward
sale contract. Prior reported EPS amounts should not be adjusted upon a change in probability of a
successful remarketing.
An entity should carefully consider individual facts and circumstances, and
specific contractual terms, of any financing
transaction in evaluating the appropriate
accounting and related EPS treatment. In the above
example, if the counterparty could elect to tender
the note to the issuer in satisfaction of the
forward price in the forward sale contract even if
the remarketing is successful, the entity would
need to consider the most advantageous settlement
from the perspective of the counterparty to
determine whether the if-converted method or
treasury stock method should be applied in the
calculation of diluted EPS. If neither cash nor
tendering the debt would be considered
advantageous, the if-converted method should be
applied in the calculation of diluted EPS.
The terms of certain unit structures involving
preferred stock significantly differ from those
involving debt instruments. Accordingly, it may
not be appropriate to apply the treasury stock
method to the equity purchase contract in a unit
structure that involves preferred stock. An entity
must evaluate the form and substance of these
transactions to appropriately calculate diluted
EPS.
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 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.
4.9 Year-to-Date Calculations of Diluted EPS
4.9.1 Treasury Stock Method
ASC 260-10
Applying the Treasury Stock
Method
Year-to-Date Computations
55-3 The number of incremental
shares included in quarterly diluted EPS shall be
computed using the average market prices during the
three months included in the reporting period. For
year-to-date diluted EPS, the number of incremental
shares to be included in the denominator shall be
determined by computing a year-to-date weighted average
of the number of incremental shares included in each
quarterly diluted EPS computation. Example 1 (see
paragraph 260-10-55-38) provides an illustration of that
provision.
55-3A Computation of
year-to-date diluted EPS when an entity has a
year-to-date loss from continuing operations including
one or more quarters with income from continuing
operations and when in-the-money options or warrants
were not included in one or more quarterly diluted EPS
computations because there was a loss from continuing
operations in those quarters is as follows. In computing
year-to-date diluted EPS, year-to-date income (or loss)
from continuing operations shall be the basis for
determining whether or not dilutive potential common
shares not included in one or more quarterly
computations of diluted EPS shall be included in the
year-to-date computation.
55-3B Therefore:
- When there is a year-to-date loss, potential common shares should never be included in the computation of diluted EPS, because to do so would be antidilutive.
- When there is year-to-date income, if in-the-money options or warrants were excluded from one or more quarterly diluted EPS computations because the effect was antidilutive (there was a loss from continuing operations in those periods), then those options or warrants should be included in the diluted EPS denominator (on a weighted-average basis) in the year-to-date computation as long as the effect is not antidilutive. Similarly, contingent shares that were excluded from a quarterly computation solely because there was a loss from continuing operations should be included in the year-to-date computation unless the effect is antidilutive.
Example 12 (see paragraph 260-10-55-85) illustrates this guidance.
As discussed in ASC 260-10-55-3 through 55-3B, the control number for
calculating year-to-date diluted EPS and applying the antidilution sequencing
requirements of ASC 260 is year-to-date net income.23 The number of incremental common shares included in the denominator under
the treasury stock method, when dilutive, must be based on a year-to-date
average of the number of incremental common shares calculated during each
quarterly financial reporting period. While incremental common shares may not
have been included in diluted EPS during a quarterly financial reporting period
because the control number for the period was a loss, to calculate year-to-date
diluted EPS in accordance with ASC 260-10-55-3 through 55-3B, an entity is
nevertheless required to calculate the number of incremental common shares under
the treasury stock method that would have been included in each quarterly
calculation of diluted EPS if the effect had been dilutive. In doing so, as
discussed in Section
4.2.2.1, the entity does not include out-of-the-money options and
warrants in quarterly diluted EPS. Thus, if options or warrants are
out-of-the-money in a quarterly financial reporting period, zero incremental
common shares will be included for that quarter in the year-to-date average.
However, for options or warrants that were in-the-money in a quarterly financial
reporting period but not included in diluted EPS because doing so would have
been antidilutive on the basis of the antidilution sequencing requirements of
ASC 260, such options or warrants may need to be included in year-to-date
diluted EPS since the antidilution sequencing requirements in a year-to-date
calculation of diluted EPS must be based on the year-to-date reported net
income.
Connecting the Dots
It may be intuitive to think that the incremental common shares included in year-to-date diluted
EPS should be calculated as if the year-to-date period was a discrete period. However, that
approach is not allowed for contracts subject to the treasury stock method. Using a year-to-date
approach to calculate the incremental common shares included in year-to-date diluted EPS may
be materially inconsistent with the requirements of ASC 260-10-55-3 through 55-3B. Consider
the following two examples:
- An entity calculating diluted EPS for an annual period that reports net income has 10 million options to sell common shares at $25 per share. The options are classified as equity instruments and must be share-settled. The average market prices of the entity’s common stock for the quarterly reporting periods in the annual period are $24.00, $24.50, $25.00, and $40.00 per share. The average market price of the entity’s common stock for the year is $28.38 per share. Under the approach required in ASC 260-10-55-3 through 55-3B, the incremental common shares added to the denominator would be 937,500, representing the average of the incremental shares for the fourth quarter and zero incremental shares for the first three quarters because the options are not in-the-money. However, when the year-to-date average market price is used, the incremental shares added to the denominator would be 1,190,980.
- An entity calculating diluted EPS for an annual period with reported net income has 10 million options to sell common shares at $25 per share. The options are classified as equity instruments and must be share-settled. The average market prices of the entity’s common stock for the quarterly reporting periods in the annual period are $26.00, $26.50, $27.00, and $20.00 per share. The average market price of the entity’s common stock for the year is $24.88 per share. Under the approach required in ASC 260-10-55-3 through 55-3B, the incremental common shares added to the denominator would be 422,849, representing the average of the incremental shares for each of the first three quarters and zero incremental shares for the fourth quarter because the options are not in-the-money. However, when the year-to-date average market price is used, the incremental shares added to the denominator would be zero because the options are not in-the-money.
If an instrument subject to the treasury stock method is a participating security, the more dilutive of the
treasury stock method or the two-class method of calculating diluted EPS must be applied, as discussed
in Section 5.5.4. See Section 4.9.5 for information about situations in which the settlement method
assumed for diluted EPS purposes differs from the accounting classification of a contract subject to the
treasury stock method.
4.9.1.1 Example
ASC 260-10
Example 12: Computing Year-to-Date Weighted-Average Shares Outstanding
55-85 The following Cases illustrate the guidance in paragraphs 260-10-55-3A through 55-3B for the quarterly
and annual computations of basic and diluted EPS for a company with options outstanding (equal to 20,000
incremental shares) that were in the money for the entire year (for simplicity purposes, this Example assumes
that the stock price never changed). Case A addresses year-to-date loss, and Case B addresses year-to-date
income. Note that in Case A, due to a loss for the period, zero incremental shares are included because the
effect would be antidilutive. Note that in Case B, zero shares included due to loss in the period.
Case A: Year-to-Date Loss
55-86 The following tables illustrate the computation of quarterly and year-to-date EPS.
Case B: Year-to-Date Income
55-87 The following tables illustrate the computation of quarterly and year-to-date EPS.
Note that if the options had been out of the money in any quarter, zero incremental shares would have been
included for that quarter in the year-to-date averaging.
4.9.2 Reverse Treasury Stock Method
The same year-to-date approach required for the treasury stock method would
apply under the reverse treasury stock method. However, because written put
options and forward purchase contracts are classified as liabilities (or assets
in some circumstances) and generally recognized at fair value, with changes in
fair value recognized in earnings (see Section 4.3.2.1), when the reverse
treasury stock method is applied for diluted EPS purposes, these instruments are
also subject to the year-to-date guidance on diluted EPS related to contracts
that have an assumed settlement method for diluted EPS that differs from the
classification for accounting purposes. See further discussion in Section 4.9.5.
4.9.3 If-Converted Method
As with the guidance applicable to the treasury stock method, the control number
for year-to-date diluted EPS is net income for the year-to-date period and the
antidilution sequencing requirements are applied on the basis of year-to-date
net income. The guidance on the weighting of incremental shares provided for
contracts subject to the treasury stock method is generally not relevant for
convertible securities subject to the if-converted method. See Example 4-32 and
Connecting the Dots below for more
information.
Connecting the Dots
If the control number for the year-to-date period is a loss, the if-converted method should
not be applied because its effect would be antidilutive. If the control number for the year-to-date
period is income, an entity should apply the if-converted method, assuming conversion
at the beginning of the period or the date of issuance of the convertible security, if later, if the
application of this method is dilutive to the year-to-date calculation of diluted EPS on the basis of
the antidilution sequencing requirements of ASC 260 as they apply on a year-to-date basis. This
is the case even if the if-converted method was not applied in one or more quarterly financial
reporting periods because there was a net loss during the period or the convertible security was
antidilutive for the period on the basis of the antidilution sequencing requirements in ASC 260.
Questions arise regarding how to calculate diluted EPS under the if-converted
method for convertible securities that are contingently convertible on the basis
of (1) only a substantive non-market-based contingency or (2) a market price
trigger and some other substantive non-market-based
contingency. As discussed in Section 4.4.3, for each quarterly financial reporting period,
the if-converted method should be applied only if the non-market-based
contingency has been met as of the end of the reporting period. If the
non-market-based contingency is met as of the reporting date and application of
the if-converted method is dilutive, the effect should be included in diluted
EPS from the beginning of the quarterly reporting period or the date of
issuance, if later. This is consistent with the approach to diluted EPS for
contingently issuable shares. While ASC 260 does not specifically address how to
calculate year-to-date EPS under the if-converted method when the
non-market-based contingency is met for only some of the quarterly periods
within a year-to-date period, the approach applied to contingently issuable
shares should be used to calculate diluted EPS on a year-to-date basis. Thus, if
the control number is income and the effect of conversion is dilutive on the
basis of the antidilution sequencing requirements of ASC 260, the common shares
included in the denominator would be weighted for the interim periods that were
included in the calculation of diluted EPS. The numerator adjustments under ASC
260-10-45-40 would be made only for the interim periods for which the common
shares issuable upon conversion were included. See Example 4-33 for more information.
If a convertible security subject to the if-converted method is a participating
security, the more dilutive of the if-converted method or the two-class method
of calculating diluted EPS must be applied, as discussed in Section 5.5.4. See
Section 4.9.5
for further discussion of situations in which the settlement method assumed for
diluted EPS purposes differs from the accounting classification of the
convertible security subject to the if-converted method.
Connecting the Dots
Under ASC 260-10-45-40, an entity must perform a
treasury-stock-type calculation for convertible debt instruments subject
to the if-converted method that require the issuer to pay the principal
amount in cash upon conversion (i.e., an Instrument C convertible debt
instrument). In particular, an entity would determine the effect on
diluted EPS by calculating the number of common shares that would be
issuable to settle the excess conversion value. The entity would perform
this calculation on the basis of its average stock price during the
period.
ASC 260-10-55-84 through 55-84B appear to indicate that
for calculations of year-to-date diluted EPS, an entity should use its
average share price for the year. However, this approach would be
inconsistent with the statement in the example that “[t]he conversion
premium should be included in diluted earnings per share based on the
provisions of paragraphs 260-10-45-45 through 45-46 and 260-10-55-32
through 55-36A.” These paragraphs require an entity to apply ASC
260-10-55-3, which states that in the calculation of year-to-date
diluted EPS, “the number of incremental shares to be included in the
denominator shall be determined by computing a year-to-date weighted
average of the number of incremental shares included in each quarterly
diluted EPS computation.” Therefore, although ASC 260-10-55-84 through
55-84B appear to indicate that the average share price for the year
should be used in the calculation of diluted EPS, an entity should
determine year-to-date diluted EPS for a convertible debt instrument
that requires the issuer to pay the principal amount in cash by
calculating a year-to-date average of the number of incremental shares
included in each calculation of quarterly diluted EPS. Such an approach
is consistent with the treasury stock method.
4.9.3.1 Examples
Example 4-32
Application of If-Converted Method to Quarterly and Annual Diluted EPS When There Are Periods of
Income and Loss
Company G reports the amounts below during its quarterly financial reporting periods for the year ended
December 31, 20X9; G does not report a discontinued operation during the year ended December 31, 20X9.
Assume that G has $5 million of 7.5 percent nonparticipating noncontingently convertible debt securities
outstanding for the entire year. The conversion price of the convertible securities is $25.00; therefore, the
debt securities are convertible into 200,000 common shares. The convertible securities must be settled in G’s
common shares and are accounted for at amortized cost. Company G has a tax rate of 25 percent.
Diluted EPS for each quarter in the year ended December 31, 20X9, would be calculated as follows:
Diluted EPS for the year ended December 31, 20X9, would be calculated as follows:
Note that because G reports a net loss during the third quarter, the annual diluted EPS amount of $1.83 does
not equal the sum of the quarterly diluted EPS amounts reported of $1.44 ($0.81 + $0.46 + $(1.00) + $1.17 =
$1.44). Further, if G had reported a net loss of $2,000,000 or $4.00 loss per basic share for the third quarter,
it would have reported a net loss of $500,000 for the year. Therefore, while the amounts of diluted EPS for the
first, second, and fourth quarters above would be unchanged, the diluted EPS for the year ended December 31,
20X9, would have been a $1.00 loss per share, which would have been the same amount reported as basic loss
per share.
Example 4-33
Application of If-Converted Method to Quarterly and Annual Diluted EPS for Contingently
Convertible Debt
Company H reported the amounts below during its quarterly financial reporting periods for the year ended
December 31, 20X4; H did not report a discontinued operation during the year ended December 31, 20X4.
Assume that H has $5 million of 7.5 percent nonparticipating contingently
convertible debt securities outstanding for the
entire year. The conversion price of the convertible
securities is $25.00; therefore, the debt securities
are convertible into 200,000 common shares. The
convertible securities must be settled in G’s common
shares and are accounted for at amortized cost. The
convertible securities are only convertible if the
following two conditions are met:
-
The market price of H’s common stock is $41.00 or more.
-
The occupancy rate of H’s commercial rental properties is 90 percent or more.
Company G has a tax rate of 25 percent.
Assume the following conditions at the end of each quarter in the year ended December 31, 20X4:
In accordance with ASC 260-10-45-44, an entity should include the convertible securities in diluted EPS,
assuming dilution, only in periods in which the non-market-based contingency is met. Therefore, the
if-converted method applies for the first, second, and fourth quarters of 20X4. The fact that the market price
trigger is not met in the second quarter does not preclude the application of the if-converted method for the
second quarter since market price triggers are disregarded in the determination of whether the if-converted
method applies to contingently convertible debt instruments.
Diluted EPS for each quarter in the year ended December 31, 20X4, would be calculated as follows:
Diluted EPS for the year ended December 31, 20X4, would be calculated as follows:
4.9.4 Contingently Issuable Share Method
ASC 260-10
Contingently Issuable Shares
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.
The approach to year-to-date diluted EPS that is applied to contingently
issuable shares or contingently issuable potential common shares is consistent
with that applied to potential common shares subject to the treasury stock
method. The incremental shares included in the denominator in the calculation of
diluted EPS, if they are dilutive to the calculation of year-to-date diluted EPS
on the basis of the antidilution sequencing requirements of ASC 260, are based
on a weighted average of the common shares included in each quarterly
calculation of diluted EPS. If the control number for the year-to-date period is
a loss, no incremental common shares are included in the denominator for the
year-to-date period even if incremental common shares were included in one or
more quarterly financial reporting periods because of net income for those
quarterly periods. Similarly, if the control number for the year-to-date period
is income, incremental common shares that were excluded from the denominator for
quarterly periods because of quarterly losses are included in the calculation of
year-to-date diluted EPS if the approach is dilutive on the basis of the
antidilution sequencing requirements in ASC 260. As noted in Section 4.9.1, the
antidilution sequencing requirements are applied to a calculation of
year-to-date diluted EPS on the basis of year-to-date net income.
If a contingently issuable share arrangement is a participating security, the more dilutive of the
contingently issuable share method or the two-class method of calculating diluted EPS must be applied,
as discussed in Section 5.5.4. If the settlement method assumed for diluted EPS purposes differs from
the accounting classification of a contract subject to the treasury stock method, see Section 4.9.5.
4.9.4.1 Examples
ASC 260-10-55-53 through 55-56 provide an example illustrating the calculation of quarterly and year-to-date
diluted EPS for an entity that has contingently issuable common shares based on net income and a
nonfinancial performance measure. The example highlights the following requirements of ASC 260:
- The number of common shares included in the denominator of quarterly diluted EPS is equal to the number of common shares that would be issued if the end of the reporting period was the end of the contingency period.
- Common shares may be included in one quarterly reporting period but not in subsequent quarterly reporting periods; as a result, there may be volatility in the amounts of quarterly diluted EPS.
- The calculation of year-to-date diluted EPS is based on the weighted-average common shares that have been assumed to be issuable in each quarterly financial reporting period.
ASC 260-10
Example 3: Contingently Issuable Shares
55-53 This Example
illustrates the contingent share provisions
described in paragraphs 260-10-45-13 and
260-10-45-48 through 45-57. This Example has the
following assumptions:
-
Entity A had 100,000 shares of common stock outstanding during the entire year ended December 31, 20X1. It had no options, warrants, or convertible securities outstanding during the period.
-
Terms of a contingent stock agreement related to a recent business combination provided the following to certain shareholders of Entity A:
-
1,000 additional common shares for each new retail site opened during 20X1
-
5 additional common shares for each $100 of consolidated, after-tax net income in excess of $500,000 for the year ended December 31, 20X1.
-
-
Entity A opened two new retail sites during the year:
-
One on May 1, 20X1
-
One on September 1, 20X1.
-
-
Entity A’s consolidated, year-to-date after-tax net income was:
-
$400,000 as of March 31, 20X1
-
$600,000 as of June 30, 20X1
-
$450,000 as of September 30, 20X1
-
$700,000 as of December 31, 20X1.
-
55-54 Note that in computing
diluted EPS for an interim period, contingent shares
are included as of the beginning of the period. For
year-to-date computations, paragraph 260-10-45-49
requires that contingent shares be included on a
weighted-average basis.
55-55 The following table illustrates the quarterly and annual calculation of basic and diluted EPS.
Example 4-34
Calculating Diluted EPS When Issuance of Shares Is Contingent on Amount of Future Earnings (Single
Earnings Target)
For the scenario discussed in Example 4-15, incremental common shares should be included in year-to-date
diluted EPS on a weighted-average basis. If it is assumed that X had 200,000 weighted-average common
shares outstanding and no other potential common shares and that the contingently issuable shares were not
classified as an asset or liability for accounting purposes, the calculation of X’s basic and diluted EPS for the
annual period would be as follows:
The weighted-average number of shares added for diluted EPS is calculated as follows:
4.9.5 Contracts That May Be Settled in Cash or Stock
ASC 260-10
Contracts That
May Be Settled in Stock or Cash
55-34 Year-to-date diluted
EPS calculations may require an adjustment to the
numerator in certain circumstances. For example, for
contracts that are share settled for EPS purposes, the
numerator adjustment is equal to the earnings effect of
the change in the fair value of the asset or liability
recorded pursuant to Section 815-40-35 during the
year-to-date period. In that example, the number of
incremental shares included in the denominator should be
determined in accordance with the guidance in paragraph
260-10-55-3.
As discussed in Section 4.7.3, a numerator adjustment is
required when a contract is classified (in whole or in part) as an asset or
liability for accounting purposes but the potential common shares are included
in the denominator of the calculation of diluted EPS. ASC 260-10-55-34 requires
that, in such situations, the numerator adjustment be calculated on the basis of
the income statement for the year-to-date period. However, the number of shares
included in the denominator must be calculated in accordance with ASC
260-10-55-3 (e.g., under the treasury stock, reverse treasury stock, and
contingently issuable share methods, the incremental common shares are included
on a year-to-date basis by using an average of the incremental common shares
calculated on a discrete quarterly basis). In other words, a year-to-date
approach is used to determine the numerator adjustment and an averaging approach
is used to determine the denominator adjustment, if these adjustments are
dilutive on the basis of the antidilution sequencing requirements of ASC 260.
See Section 4.9.3
for further discussion of the accounting for year-to-date diluted EPS under the
if-converted method.
Connecting the Dots
It is possible that an entity would reverse the entire mark-to-market
adjustment for the year-to-date period on a contract classified as an
asset or liability but only include incremental shares for one quarterly
period in a year-to-date calculation of diluted EPS (e.g., a
liability-classified option was in-the-money for only one quarterly
period). This result arises from the year-to-date approach used for the
numerator adjustment and the averaging approach used for the denominator
adjustment. However, an entity would never make the numerator adjustment
if no incremental shares were added to the denominator for the
year-to-date period. Similarly, neither the numerator nor the
denominator adjustment would be made if the combined result of those
adjustments was antidilutive for the year-to-date period.
4.9.6 Entities That Do Not Present Interim EPS
Some entities that are not subject to the periodic reporting requirements of the Exchange Act only
present EPS amounts in annual financial statements. In these situations, an entity is not required to
calculate EPS on a quarterly basis so that it can compute EPS amounts on an annual basis. Rather,
the annual period may be treated as a discrete period in the same manner in which a quarterly
financial reporting period is considered a discrete period for SEC registrants that file quarterly financial
statements on Form 10-Q. Treating an annual period as a discrete period could result in significantly
different diluted EPS amounts calculated under the treasury stock, reverse treasury stock, and
contingently issuable share methods.
SEC Considerations
The above guidance is not intended to apply to entities
that present diluted EPS in registration statements filed with the SEC.
Such entities must apply the guidance in ASC 260 on year-to-date diluted
EPS to any amounts of diluted EPS that are presented or disclosed.
Footnotes
23
For simplicity, in Section 4.9, we refer to “net
income” as the control number. However, as discussed in Section 4.1.2.2,
for an entity that has dividends on preferred stock, the control number
is income available to common stockholders. For an entity with a
discontinued operation, the control number is income available to common
stockholders from continuing operations. For an entity with an NCI, the
control number is income attributable to common stockholders of the
parent. See further discussion in Table 4-2.
4.10 Comprehensive Example
ASC 260-10-55-38 through 55-50 contain the following comprehensive example illustrating the
calculation of diluted EPS:
ASC 260-10
Example 1: Computation of Basic and Diluted EPS and Income Statement Presentation
55-38 This Example illustrates the quarterly and annual computations of basic and diluted EPS in the year 20X1
for Entity A, which has a complex capital structure. The control number used in this Example (and in Example 2)
is income from continuing operations. Paragraph 260-10-55-49 illustrates the presentation of basic and diluted
EPS on the face of the income statement. The facts assumed are as follows:
- Average market price of common stock. The average market prices of common stock for the calendar-year 20X1 were as follows.
- The average market price of common stock from July 1 to September 1, 20X1 was $71.
- Common stock. The number of shares of common stock outstanding at the beginning of 20X1 was 3,300,000. On March 1, 20X1, 100,000 shares of common stock were issued for cash.
- Convertible debentures. In the last quarter of 20X0, 4 percent convertible debentures with a principal amount of $10,000,000 due in 20 years were sold for cash at $1,000 (par). Interest is payable semiannually on November 1 and May 1. Each $1,000 debenture is convertible into 20 shares of common stock. No debentures were converted in 20X0. The entire issue was converted on April 1, 20X1, because the issue was called by Entity A.
- Convertible preferred stock. In the second quarter of 20X0, 600,000 shares of convertible preferred stock were issued for assets in a purchase transaction. The quarterly dividend on each share of that convertible preferred stock is $0.05, payable at the end of the quarter. Each share is convertible into one share of common stock. Holders of 500,000 shares of that convertible preferred stock converted their preferred stock into common stock on June 1, 20X1.
- Warrants. Warrants to buy 500,000 shares of common stock at $60 per share for a period of 5 years were issued on January 1, 20X1. All outstanding warrants were exercised on September 1, 20X1.
- Options. Options to buy 1,000,000 shares of common stock at $85 per share for a period of 10 years were issued on July 1, 20X1. No options were exercised during 20X1 because the exercise price of the options exceeded the market price of the common stock.
- Tax rate. The tax rate was 40 percent for 20X1.
55-39 The following table illustrates the income (loss) from continuing operations.
55-40 The following tables illustrate calculation of basic EPS for the first quarter.
55-41 The following table illustrates calculation of diluted EPS for the first quarter.
55-42 The following tables illustrate calculation of basic EPS for the second quarter.
55-43 The following table illustrates calculation of diluted EPS for the second quarter.
55-44 The following tables illustrate calculation of basic EPS for the third quarter.
55-45 The following tables illustrate calculation of diluted EPS for the third quarter.
Note that the incremental shares from assumed conversions are included in computing the diluted per-share
amounts for the discontinued operation and net loss even though they are antidilutive. This is because the
control number (income from continuing operations, adjusted for preferred dividends) was income, not a loss.
(See paragraphs 260-10-45-18 through 45-19.)
55-46 The following tables illustrate calculation of basic and diluted EPS for the fourth quarter.
Note that the incremental shares from assumed conversions are not included in computing the diluted
per-share amounts for net loss because the control number (net loss adjusted for preferred dividends) was a
loss, not income. (See paragraphs 260-10-45-18 through 45-19.)
55-47 The following tables illustrate calculation of basic EPS for the full year 20X1.
55-48 The following tables illustrate calculation of diluted EPS for the full year 20X1.
55-49 The following table illustrates how Entity A might present its EPS data on its income statement. Note that
the per-share amount for the discontinued operation is not required to be shown on the face of the income
statement.
55-50 The following table includes the quarterly and annual EPS data for Entity A. The purpose of this table
is to illustrate that the sum of the four quarters’ EPS data will not necessarily equal the annual EPS data. This
Subtopic does not require disclosure of this information.