5.3 Definition of a Participating Security

5.3.1 General

ASC 260-10 — Glossary

Participating Security

A security that may participate in undistributed earnings with common stock, whether that participation is conditioned upon the occurrence of a specified event or not. The form of such participation does not have to be a dividend — that is, any form of participation in undistributed earnings would constitute participation by that security, regardless of whether the payment to the security holder was referred to as a dividend.

The definition of a participating security is broad and encompasses securities that participate in undistributed earnings in any form provided that the security participates in its current form. Participation does not necessarily need to be in the form of a dividend. Any participation in the undistributed earnings of an entity would constitute participation by a security, regardless of whether a cash payment is, or would be accounted for as, a dividend (see Example 5-1). A security need not participate on a 1:1 basis with common stock to be a participating security. A security that participates only after common shareholders have received a specified amount of dividends or that participates up to a cap, or on the basis of a specified threshold, would constitute a participating security.

The definition includes securities that participate in dividends on common stock only upon the occurrence of a specified event. However, if the participation rights are not objectively determinable or are objectively determinable but the event that results in participation has not occurred, no undistributed earnings would be allocated to the security. Similarly, undistributed earnings are not allocated to a security unless it participates on a nondiscretionary basis. See Section 5.3.2 for further discussion of how the two-class method is applied when a security participates only upon the occurrence of specified events or on a discretionary basis.

The determination of whether a security is a participating security to which an entity must apply the two-class method of calculating EPS depends neither on the contract’s classification for accounting purposes as an asset, liability, or equity instrument nor on the subsequent measurement of the contract at amortized cost, fair value, or another measurement attribute. However, as discussed in Sections 5.5.2.1 and 5.5.4, the contract’s classification and resulting subsequent-measurement attribute may affect how the two-class method is applied to calculate EPS.

The table below discusses whether instruments typically included in capital structures are considered participating securities. In this table, it is assumed that the instrument’s participation feature is nondiscretionary and objectively determinable. The remaining discussion in Section 5.3 focuses on additional considerations relevant to the instruments discussed in this table as well as other participation-type features and instruments.

Table 5-1

Instrument	Form of “Participation”	Is the Instrument a Participating Security?	Additional Discussion
Debt instruments	Potential participation is paid in cash or the contractual maturity amount is increased according to a formula tied to dividends on common stock.	Yes	Section 5.3.3.1
Preferred stock	Potential participation is paid in cash according to a formula tied to dividends on common stock.	Yes	Section 5.3.3.2
Preferred stock	Holders of preferred stock are entitled to receive a current-period dividend before holders of common stock can be paid dividends.	No	Section 5.3.3.2
Convertible debt	Potential participation is paid in cash or the contractual maturity amount is increased according to a formula tied to dividends on common stock.	Yes	Section 5.3.3.1
Convertible debt	Potential participation is achieved through a reduction of the conversion price or an increase in the conversion ratio.	No	Section 5.3.3.3
Convertible preferred stock	Potential participation is paid in cash according to a formula tied to dividends on common stock. Preferred stockholders may also be entitled to a stated return in addition to the dividend participation.	Yes	Section 5.3.3.3
Convertible preferred stock	Potential participation is achieved through a reduction of the conversion price (i.e., an increase in the conversion ratio).	No	Section 5.3.3.3
Options or warrants to sell common stock	Potential participation is paid in cash according to a formula tied to dividends on common stock.	Yes	Section 5.3.3.4
Options or warrants to sell common stock	Potential participation is achieved through a reduction of the exercise price or an increase in the number of shares issued upon exercise.	No	Section 5.3.3.4
Forward contract to sell common stock	Potential participation is achieved through a reduction of the forward price or an increase in the number of shares under the forward contract.	It depends. A facts-and-circumstances analysis must be performed.	Section 5.3.3.5
Forward contract to sell common stock	A formula is used to adjust the forward price and the number of shares under the forward contract, depending on the market price of the stock on the date the forward contract is settled.	It depends. A facts-and-circumstances analysis must be performed.	Section 5.3.3.5.3

See Section 8.9 for discussion of when incentive distribution rights issued by an MLP represent a participating security.

5.3.2 Participation Upon Contingent Events or Terms That Are Discretionary or Not Objectively Determinable

ASC 260-10

Participating Securities and Undistributed Earnings

55-26 If a participating security provides the holder with the ability to participate with the holders of common stock in dividends declared contingent upon the occurrence of a specified event, the occurrence of which is subject to management discretion or is not objectively determinable (for example, liquidation of the entity or management determination of an extraordinary dividend), then the terms of the participating security do not specify objectively determinable, nondiscretionary participation rights; therefore, undistributed earnings would not be allocated to the participating security.

55-27 If a participating security provides the holder with the ability to participate with the holders of common stock in earnings for a period in which a specified event occurs, regardless of whether a dividend is paid during the period (for example, achievement of a target market price of a security or achievement of a certain earnings level), then undistributed earnings would be allocated to common stock and the participating security based on the assumption that all of the earnings for the period are distributed. Undistributed earnings would be allocated to the participating security if the contingent condition would have been satisfied at the reporting date, irrespective of whether an actual distribution was made for the period.

55-29 If a participating security provides the holder with the ability to participate in extraordinary dividends and the classification of dividends as extraordinary is within the sole discretion of the board of directors, then undistributed earnings would be allocated only to common stock. Since the classification of dividends as extraordinary is within the sole discretion of the board of directors, undistributed earnings would not be allocated to the participating security as the participation in the undistributed earnings would not be objectively determinable.

ASC 260-10-55-26 and ASC 260-10-55-29 indicate that undistributed earnings should be allocated to a security only if the terms of the security specify objectively determinable, nondiscretionary participation rights. While the guidance refers to a security that participates in earnings on a basis that either is not objectively determinable or is discretionary as a “participating security,” there would be no impact on the calculation of diluted EPS for such securities. However, the disclosure requirements in ASC 260-10-55-24 must be considered in such circumstances.

ASC 260-10-55-27 further clarifies that, although the right of a security to participate only upon the occurrence of a specified event that is objectively determinable and nondiscretionary represents a participation right, undistributed earnings would be allocated to the participating security during a financial reporting period only if the contingent condition was satisfied as of the reporting date. This guidance is consistent with that applied to calculate diluted EPS under the contingently issuable share method, as discussed in Section 4.5.

Examples 5-8, 5-9, and 5-11 illustrate securities that participate only in extraordinary dividends.

5.3.2.1 Equity Restructurings

The ASC master glossary defines an equity restructuring as a “nonreciprocal transaction between an entity and its shareholders that causes the per-share fair value of the shares underlying an option or similar award to change, such as a stock dividend, stock split, spinoff, rights offering, or recapitalization through a large, nonrecurring cash dividend.” Potential common shares in the form of options, warrants, or convertible securities often contain contractual antidilution provisions related to cash payments or adjustments to the terms of an instrument in the event of an equity restructuring. Such features do not cause the instrument to represent a participating security. Rather, an equity restructuring should generally affect only the outstanding shares (i.e., the denominator) in an entity’s calculation of EPS. This guidance is consistent with the guidance in ASC 260-10-55-12 on stock dividends and stock splits, which requires an adjustment to the denominator but no adjustments to the numerator. Section 8.2.1 further discusses the impact on EPS of a stock split, reverse stock split, or stock dividend.

5.3.3 Application to Specific Instruments

5.3.3.1 Debt Instruments

A debt instrument, whether convertible or nonconvertible, may include a stated interest rate and allow holders to participate in dividends on common stock according to a specified formula. Provided that the participation is objectively determinable and nondiscretionary, the debt instrument represents a participating security. In applying the two-class method, an entity generally does not allocate any distributed earnings to the debt instrument because the distributed earnings have been recognized as interest costs. However, the two-class method should be used to allocate undistributed earnings to the participating debt instrument. See further discussion in Section 5.5.2.

5.3.3.2 Preferred Stock

The impact on EPS of dividends on preferred stock depends on whether the preferred stock instrument is a participating security. If preferred stock meets the definition of a participating security, an entity must apply the two-class method to calculate EPS, which reduces EPS attributable to common shareholders because of the allocation of undistributed earnings to the preferred stock. For preferred stock that does not meet the definition of a participating security, only dividends declared in the period (whether or not paid) and dividends accumulated for the period on cumulative preferred stock (whether or not earned) reduce net income in the calculation of income available to common stockholders.1 As explained in the (nonauthoritative) guidance in AICPA Technical Q&As Section 4210.04, if preferred stock dividends are noncumulative, “only the dividends declared should be deducted [from net income].” Therefore, dividends on noncumulative preferred stock that does not meet the definition of a participating security should not affect the calculation of EPS in financial reporting periods for which dividends have not been declared or otherwise paid.

Questions have arisen regarding whether preferred stock should be considered a participating security merely because preferred dividends must be paid before dividends can be paid on common stock. In particular, all accumulated dividends on cumulative preferred stock, as well as the current-period dividends on noncumulative preferred stock, must be paid before dividends can be paid on common stock. Some may believe that when an entity is evaluating whether preferred stock is a participating security, it should assume that all earnings for the period are distributed; therefore, all preferred stock instruments are participating securities because they will receive an allocable share of such distributions on the basis of the preferred stock’s stated dividend rate. However, the mere preference in dividends does not cause all preferred stock instruments to represent participating securities. Rather, for preferred stock to meet the definition of a participating security, it must have a contractual right to participate with common shareholders in the amount of undistributed earnings. In other words, an entity should determine whether preferred stock is a participating security on the basis of the contractual rights to share or participate in dividends on common stock and not on the basis of the right of preference in distributions (i.e., the right to receive dividends before dividends can be paid on common stock). To apply the two-class method of calculating EPS, an entity must assume that all earnings for the period are distributed; however, this assumption is only necessary if the entity concludes that a preferred stock instrument is a participating security because the instrument shares in distributions when dividends are paid on common stock. See Examples 5-2, 5-3, and 5-4 for illustrations of this concept.

See Section 5.5.2.5.1 for additional discussion of the application of the two-class method to preferred stock instruments that meet the definition of a participating security.

5.3.3.3 Convertible Securities

5.3.3.3.1 General

ASC 260-10

Participating Securities and the Two-Class Method

45-62 Dividends or dividend equivalents transferred to the holder of a convertible security in the form of a reduction to the conversion price or an increase in the conversion ratio of the security do not represent participation rights. This guidance applies similarly to other contracts (securities) to issue an entity’s common stock if these contracts (securities) provide for an adjustment to the exercise price that is tied to the declaration of dividends by the issuer. The scope of the guidance in this paragraph excludes forward contracts to issue an entity’s own equity shares.

A reduction in the conversion price, or an increase in the conversion rate, of a nonmandatorily convertible security on the basis of dividends declared on an entity’s common stock does not represent participation in earnings and therefore does not cause a convertible security to meet the definition of a participating security. Such convertible securities are unlike other participating securities that ensure their holders’ participation if undistributed earnings were distributed. The holder of a convertible security cannot benefit from a reduced conversion price (or increased conversion rate) if the instrument is not converted. Thus, the participation right is contingent on the conversion of the convertible security. Adjustments to the conversion price or conversion rate of a convertible security that result from antidilution features (e.g., upon a stock split, a stock dividend, or an equity restructuring) or down-round features would also generally not qualify as participation in earnings. However, the guidance on down-round features in convertible preferred stock (see ASC 260-10-25-1, ASC 260-10-30-1, ASC 260-10-35-1, and ASC 260-10-45-12B) applies if the down-round feature is triggered (see Section 3.2.2.5.1. The guidance on down-round features does not apply to convertible debt instruments.

5.3.3.3.2 Mandatorily Convertible Securities

An entity may have issued instruments that are mandatorily convertible into common stock. These instruments could include preferred stock or debt that is mandatorily convertible into common stock at a future date or common stock that is mandatorily convertible into another class of common stock at a future date. Although conversion into shares of common stock will occur upon the mere passage of time, the outstanding shares of common stock included in the denominator in the calculation of basic EPS should be determined on the basis of the current form of the instrument. Therefore, shares of common stock underlying a mandatorily convertible preferred stock or debt instrument should not be included in the denominator in the calculation of basic EPS; however, the two-class method of calculating basic EPS is required if the mandatorily convertible instrument meets the definition of a participating security. Similarly, shares of a second class of common stock underlying a mandatorily convertible common stock instrument should not be included in the outstanding shares of the second class of common stock. However, the mandatorily convertible common stock instrument is considered a class of outstanding common stock. In such circumstances, an entity is required to apply the two-class method of calculating EPS.

A mandatorily convertible security would meet the definition of a participating security if the holder is entitled to participate in (benefit from) dividends declared on an entity’s common stock through a (1) receipt of cash dividends or (2) reduction of the conversion price or increase in the conversion rate. The guidance in ASC 260-10-45-62 does not apply to mandatorily convertible securities; rather, for such securities, an entity should apply the guidance applicable to forward contracts to sell common stock.

Connecting the Dots

Some securities that are mandatorily convertible on a fixed or determinable date also contain call or put options that allow the issuer or holder to settle the security at an amount other than the if-converted value (e.g., an option that allows the issuer to call the security for its principal or par amount). In these circumstances, the entity must evaluate whether it is at least reasonably possible that such an option would be exercised. If exercise is reasonably possible, the security is accounted for as a nonmandatorily convertible security (see Section 5.3.3.3.1). However, if the option is determined to be nonsubstantive, the instrument would be accounted for as a mandatorily convertible security. An entity must exercise professional judgment in making this determination. Careful attention should be given to (1) contingently exercisable call or put options and (2) the pricing of the conversion feature compared with the call or put option.

5.3.3.3.3 Increase in Liquidation Preference of Convertible Preferred Stock

A convertible preferred security that participates in dividends on common stock on an as-converted basis through an increase in its liquidation preference meets the definition of a participating security unless such an increase results in a contingent transfer of value to the holder. For example, if the increase in the liquidation preference would affect the instrument upon its conversion, redemption, or settlement in a liquidation of the issuer, the value transferred is noncontingent because the holder would, in all circumstances, benefit from the increase in the liquidation preference (i.e., there is no possible settlement in which the holder would not benefit). If, however, the increase in the liquidation preference would not affect the monetary value of the security in a settlement scenario whose occurrence is at least reasonably possible, the instrument would not represent a participating security because the transfer of value is contingent (e.g., if the increase in the liquidation preference affects the conversion price only, the instrument would not be a participating security because it could be redeemed instead of being converted). This guidance is consistent with that on adjustments to the conversion price of a nonmandatorily convertible security (i.e., because the holder’s ability to benefit from this adjustment is contingent, the instrument is not a participating security).

In addition to considering whether the convertible preferred stock is a participating security, an entity should assess whether any increase in the liquidation preference that results from dividends declared on common stock could affect the measurement of the preferred stock (e.g., redeemable preferred stock subject to remeasurement under ASC 480-10-S99-3A) and may be treated as a dividend on preferred stock. See Sections 3.2.2.2.6 and 3.2.2.4 for further discussion.

5.3.3.4 Options and Warrants to Sell Common Stock

ASC 260-10-45-62 applies to options and warrants to sell common stock under which the counterparty has a right, but not an obligation, to purchase an entity’s common stock. In accordance with ASC 260-10-45-62, dividends or dividend equivalents transferred to a holder of an option or warrant in the form of a reduction to the exercise price or an increase in the number of common shares issuable upon exercise do not represent participation rights. Thus, regardless of whether the exercise price is reduced (or the number of common shares received on exercise is increased) on the basis of actual or anticipated dividends, the option or warrant does not represent a participating security. An option or warrant would be a participating security if the holder is entitled to participate in dividends on an entity’s common stock through the receipt of a cash payment, provided that the realization of such dividend rights does not depend on whether the option or warrant is exercised. See Examples 5-5 and 5-6 for illustrations of this concept.

See Section 3.2.5.3 for discussion of the impact on EPS of situations in which the exercise price of an option or warrant to sell common stock is adjusted as a result of a down-round provision.

5.3.3.5 Forward Sale Contracts

5.3.3.5.1 General

ASC 260-10

Participating Securities and the Two-Class Method

45-63 In a forward contract to issue an entity’s own equity shares, a provision that reduces the contract price per share when dividends are declared on the issuing entity’s common stock represents a participation right. Such a provision constitutes a participation right because it results in a noncontingent transfer of value to the holder of the forward contract for dividends declared during the forward contract period. That is, the forward contract holder has a right to participate in the undistributed earnings of the issuing entity because a dividend declaration by the issuing entity results in a transfer of value to the holder of the forward contract through a reduction in the forward purchase price per share. Because that value transfer is not contingent — as opposed to a similar reduction in the exercise price of an option or warrant — the forward contract is a participating security, regardless of whether, during the period the contract is outstanding, a dividend is declared.

An entity may enter into a forward sale contract to issue its common shares on a stand-alone basis as a means of raising equity capital that is needed in the future, as part of an accelerated share repurchase agreement, or in conjunction with a unit offering. The forward price in the forward contract may be subject to adjustment upon the occurrence of various conditions or events, including, but not limited to, stock dividends, stock splits or reverse stock splits, cash dividends, mergers or other fundamental changes, increased hedging costs, other dilutive or concentrating events, the entity’s common stock price, interest rates, or the mere passage of time. The determination of whether an adjustment to the forward price of a forward sale contract constitutes a participation right that causes the contract to meet the definition of a participating security depends on the nature of the adjustment. Such an adjustment also affects the entity’s evaluation of whether the forward sale contract meets the conditions in ASC 815-40 to be indexed to the entity’s stock and classified in stockholders’ equity, as discussed in Deloitte’s Roadmap Contracts on an Entity’s Own Equity. However, as discussed in Section 5.3.1, the classification of a forward sale contract as an asset, liability, or equity instrument does not affect whether the contract is a participating security.

A forward sale contract is a participating security if it contains a provision that automatically reduces the forward price when the entity declares (1) any dividends on its common stock or (2) dividends on its common stock that exceed a stated level. In these circumstances, the reduction to the forward price is objectively determinable and nondiscretionary on the basis of the entity’s declaration of dividends on its common stock and varies depending on whether dividends are declared or on the amount of declared dividends. This conclusion is premised on the notion that a reduction to the forward price in a forward sale contract represents a noncontingent transfer of value to the holder because the contract must be settled on a future date or dates. Unlike exercise or conversion price adjustments in an option or convertible security, the transfer of value from a forward price reduction is not contingent on the actions of the holder; therefore, the entity must treat the contract as a participating security.

However, some forward sale contracts contain mechanisms or formulas that may result in a reduction to the forward price that does not constitute participation under ASC 260-10-45-59A through 45-70. ASC 260-10-45-65 states, in part, “If the terms of the participating security do not specify objectively determinable, nondiscretionary participation rights, then undistributed earnings would not be allocated based on arbitrary assumptions.” Thus, forward sale contracts that contain terms permitting dividend participation under certain conditions do not represent participating securities when the participation terms are (1) not objectively determinable or (2) discretionary. Even if an adjustment to the terms of a forward sale contract is objectively determinable and nondiscretionary, an entity must evaluate additional considerations in determining whether the mechanism or formula that results in a reduction to the forward price constitutes participation in dividends under ASC 260.

5.3.3.5.2 Fixed Reductions to Forward Price Based on Anticipated Dividends

Some forward sale contracts that may be settled at the option of the entity or counterparty before the stated final maturity date contain fixed reductions to the forward price that occur over the contract’s term and are designed to mirror the anticipated dividends that the entity is expected to declare on its common stock. When adjustments to the forward price are fixed at the inception of the contract and do not depend on actual dividends paid or earnings of the entity, the forward contract is not a participating security as defined in ASC 260.

ASC 260-10-45-63 states, in part, that “a provision that reduces the contract price per share when dividends are declared on the issuing entity’s common stock represents a participation right” (emphasis added). A contract term that reduces the forward price by a fixed amount on anticipated dividend dates is not a participation feature because the reduction in the forward price is fixed at the inception of the contract and does not depend on (or vary with) actual dividends paid to common shareholders. The following “fixed” settlement terms would also not cause a forward sale contract to represent a participating security — provided that no payments or adjustments are made — if, on an expected dividend date, the entity does not declare dividends or declares dividends on its common stock that are more or less than expected amounts:

A single forward price is established at inception (with no subsequent adjustments) to reflect the expected dividends that will be distributed during the period of the forward sale contract.
At inception of the contract, the entity is required to make a fixed cash payment to the counterparty; this payment is equal to the present value of dividends that are expected to be remitted over the term of the forward sale contract (“prepaid dividends”).
The forward sale contract requires the entity to make a fixed cash payment upon settlement rather than at inception (as illustrated in the previous bullet). This fixed payment is determined at inception on the basis of the dividends that are expected to be remitted over the term of the forward sale contract and does not vary according to actual dividends paid.
The entity is required to make periodic fixed cash payments to the counterparty throughout the term of the forward sale contract on dates that correspond to the expected dividend distribution dates. The payments are fixed at inception and do not vary according to actual dividends paid.

Forward price adjustments or payments that are not fixed at the inception of a forward sale contract and are subject to adjustment on the basis of the amount of dividends declared by the entity on its common stock represent participating securities in accordance with ASC 260-10-45-63.

In some situations, the counterparty is permitted to terminate the forward sale contract early and share-settle it at its current fair value on the date the entity declares a dividend greater than a specified amount. This feature is intended to protect the counterparty from the negative impact that unexpected dividends can have on the fair value of the forward sale contract. Such a feature is not a participation feature under ASC 260 because the settlement amount (i.e., the fair value of the forward sale contract as of the date of the dividend declaration) does not vary with the amount of dividends declared by the entity. Therefore, when a forward sale contract with fixed forward price reductions on expected dividend dates allows the counterparty to settle the contract early if the entity declares, on a periodic dividend declaration date, a dividend that is greater than the fixed reduction on that date under the contract’s terms, the contract does not represent a participating security.

5.3.3.5.3 Forward Contract to Issue a Variable Number of Common Shares

The evaluation of whether a forward contract to issue a variable number of common shares is a participating security can be more complex than the evaluation of fixed-price forward sale contracts. A more complex, yet fairly common, forward sale contract is a variable share forward (VSF) sale contract, which is often issued in conjunction with a unit offering that also includes a debt or preferred security but may also be issued on a stand-alone basis. For discussion of the implications of VSF contracts and unit structures with respect to diluted EPS, see Section 4.2.2.1.1 (and Example 4-3) and Section 4.8.3.6.

Connecting the Dots

In accounting for a unit structure that includes a VSF contract, an entity must consider whether the debt or preferred security (the “security”) and the VSF contract represent a single unit or two units of account. The determination of the unit of account can affect the classification of the unit structure as a liability or equity instrument, which in turn will affect the subsequent measurement and EPS accounting. The components in a unit structure are typically considered separate units of accounting because the counterparty has the right to transfer the security and VSF contract independently and there is substance to the separation of the contracts. In these situations, the entity must determine the classification of the security and the VSF contract for accounting purposes, which will affect the allocation of proceeds to the separate instruments. The classification of the VSF contract as a liability or equity instrument will also have an impact on the accounting for diluted EPS, which, as discussed in Section 4.8.3.6, should be determined by using the treasury stock or if-converted method depending on the facts and circumstances. If the contract is classified as a liability instrument, the entity may need to adjust the numerator in accordance with the guidance in ASC 260 on contracts that may be settled in cash or stock (see Section 4.7.3). If the VSF contract is a participating security, the entity must (1) apply the two-class method to the VSF contract in calculating basic EPS and (2) determine the more dilutive of the (a) treasury stock method or if-converted method as applicable or (b) two-class method of calculating diluted EPS.

In a VSF contract, the number of common shares issued on settlement depends on the price of the entity’s common stock. The terms of a typical VSF contract might require settlement in the manner illustrated in the table below. In this table, it is assumed that the counterparty pays $100 in cash as of the settlement date and that the fair value of the entity’s common stock as of the trade date is also $100 per share.

Table 5-2

Entity’s Common Stock Price as of Reference Date of Contract Settlement	Number of Common Shares Counterparty Receives	Observations
Below $100	One share of stock	The counterparty is exposed to declines in the price of the issuer’s stock below $100.
Above $100 but below $120 (the original range)	A number of shares equal in value to $100	The counterparty neither benefits nor loses as the price of the common stock changes within the price range.
$120 or more	0.8333 shares	The counterparty participates in a portion of the appreciation of the issuer’s stock above $120. The counterparty does not receive full participation since it receives less than one share of the entity’s common stock.

Typically, a VSF contract has an intermediate term (e.g., three to five years). Many VSF contracts also contain antidilution provisions that are designed to compensate the counterparty for increases in dividends that occur during the term of the contract. However, the counterparty will receive no benefit for increases in dividends if the VSF contract is settled within a calculable range (the final range, which, as discussed below, is not necessarily the same as the original range).

The original range and final range are often identical if no dividend increases occur during the term of the VSF contract. However, under the terms of many VSF contracts, the final range is reduced as dividends increase. For example, according to the terms of the VSF contract described in the table above, the original range of the common stock price is $100 to $120. If the entity increases its normal quarterly dividends by $4 during the term of the VSF contract, the contract would not entitle the counterparty to a dividend benefit if the common stock price used for settlement of the contract is between $100 and $116, the final range. The calculation of the final range depends on the antidilution formula described in the contract for each VSF. In the context of this section, the dividend benefit represents the incremental value received by the counterparty compared with the benefit that the counterparty would have received if no adjustment had been made for increases in dividends.

The determination of whether a VSF contract includes a participation right and, thus, whether the entity is required to use the two-class method to calculate EPS, will depend on the relevant terms of the VSF contract. Some VSF contracts contain a participation mechanism or formula that does not constitute participation under ASC 260-10-45-59A through 45-70. Other VSF contracts potentially participate in dividends depending on the entity’s common stock price that is used to calculate the settlement of the VSF contract.

See Section 5.5.2.5.3A for discussion of application of the two-class method of calculating EPS to a VSF contract that represents a participating security because it is not at least reasonably possible that the contract ultimately will be settled within the final range.

5.3.3.5.3.1 VSF Contracts Whose Participation Formula Does Not Constitute Participation

Some VSF contracts contain terms that permit a type of dividend participation that does not cause such contracts to represent participating securities. As discussed in ASC 260-10-45-65, a key factor related to determining whether a VSF contract is a participating security is whether the terms of the security specify “objectively determinable, nondiscretionary participation rights.” Participation in only extraordinary dividends through an adjustment to the common stock prices used in the determination of the range for settlement purposes cannot represent a participation feature unless an extraordinary dividend is objectively defined. Example 5-11 illustrates a VSF contract that participates only in extraordinary dividends.

In other situations, the compression of the original range as a result of dividends declared by the entity on its common stock will not benefit the counterparty upon settlement. That is, regardless of the compression of the original range, the counterparty does not benefit from dividends declared by the entity. See the next section for more information about how to make this determination at inception of a VSF contract.

5.3.3.5.3.2 Evaluating the Participation Formula in VSF Contracts

If a VSF contract contains a participation formula that results in compression of the original range when the entity declares dividends on its common stock, the entity must identify a range of share prices used to determine the settlement of the contract within which the counterparty will not benefit from dividends on the entity’s common stock during the term of the contract. If, at inception of the contract, it is at least reasonably possible that the share price used to determine settlement will be within this identified range and other conditions are met, the VSF contract will not be considered a participating security.2 In performing this analysis, an entity often must qualitatively evaluate outcomes. However, a quantitative evaluation and involvement of a specialist may be appropriate in other instances.

If both of the following conditions are met, a VSF contract is not considered a participating security:

The VSF contract does not entitle the counterparty to participate in dividends if it is settled within the final range.
At the inception of the VSF contract, it is at least reasonably possible that the contract ultimately will be settled within the final range.

The first condition is factual and depends on the specific terms of the contract. Typically, the final range of a VSF contract is reduced as dividends are paid or are increased during the term of the contract. However, this may not be the case for certain VSF contracts. If the VSF contract entitles the counterparty to dividends, payable in cash, when the entity declares dividends on its common stock, the contract would be a participating security. If, on the other hand, the terms of the VSF contract do not entitle the counterparty to any possible benefits when the entity declares dividends on its common stock (i.e., the counterparty does not receive dividends in cash or through any adjustment to the terms of the contract), the VSF contract would not be a participating security.

In applying the second condition, an entity must exercise professional judgment and perform a scenario analysis of future expected dividends during the term of the contract. In the context of this evaluation, ASC 450-20-20 defines reasonably possible as “[t]he chance of the future event or events occurring is more than remote but less than likely.” While not a bright line, “reasonably possible” generally connotes a likelihood of 10 percent or more.

In evaluating whether settlement of the contract within the final range is reasonably possible, an entity should consider factors such as the following:

The terms of the VSF contract, including its maturity date and the formula for adjustments to the original range.
The volatility of the underlying common stock.
The relationship between (1) the price of the common stock on the date the VSF contract is entered into and (2) the low and high end of the original range.
Historical and expected dividend levels.

With respect to the factor in the third bullet above, there is no bright line regarding the appropriate extent of the difference between the low end of the range and the high end of the original and expected final range. In some situations, an entity may only need to perform a qualitative evaluation to determine that the VSF contract is not a participating security. (See Example 5-12 for an illustration of this notion.) In other circumstances, an entity may need to perform a quantitative financial analysis to determine whether it is at least reasonably possible that the VSF contract will be settled within the final range (i.e., the original range after adjustment for expected dividends). An entity should consider consulting with a specialist when performing such an analysis, especially if the entity’s common stock is highly volatile or a meaningful change in dividends is expected during the term of the VSF contract.

An entity can perform the following steps to determine whether a VSF contract is a participating security:

Assess whether the counterparty to the VSF contract can participate in dividends (i.e., can benefit from dividends declared by the entity on its common stock) under any circumstance. If so, go to step 2. If not, the VSF contract is not a participating security and no further analysis is needed.
Determine whether the participation feature (e.g., objectively determinable or nondiscretionary rights) is within the scope of ASC 260-10-45-59A through 45-70. If so, go to step 3. If not, the VSF contract is not a participating security and no further analysis is needed.
Evaluate whether there is a range of share prices that governs the settlement of the VSF contract and does not permit the counterparty to participate in dividends. If so, go to step 4. If there is no such range, the VSF contract is a participating security and no further analysis is needed.
Analyze whether the original range is narrow enough that it is not at least reasonably possible that the entity’s common stock price would be settled within the original range. If so, the VSF contract is a participating security and no further analysis is needed. If not, go to step 5.
Determine final ranges by considering a number of reasonably possible final share prices and reasonably possible dividend levels or changes in dividend levels. Evaluate whether it is at least reasonably possible that the VSF contract will be settled within a final range. A qualitative analysis is acceptable if the original range is large, the prospects for significant increases in dividends are remote, and the stock is not highly volatile. If an evaluation of the final ranges indicates that it is not at least reasonably possible that the counterparty to the VSF contract will not receive a dividend benefit (i.e., only in remote circumstances will the counterparty not receive a dividend benefit), the VSF contract is a participating security and the two-class method should be applied.

An entity only needs to evaluate whether a VSF contract is a participating security at the inception of the contract, unless the contract is subsequently modified, in which case a reassessment is required.

5.3.3.6 Mandatorily Redeemable Common Shares and Forward Contracts to Repurchase Common Shares

ASC 480-10-45-4 addresses the EPS accounting for mandatorily redeemable common shares and forward repurchase contracts that must be physically settled by repurchase of a fixed number of common shares in exchange for cash. For these instruments, the common shares subject to redemption or repurchase are excluded from the denominator in the calculation of EPS. However, if the holder of the common shares subject to redemption or repurchase is entitled to dividends before the redemption or repurchase, the entity must apply the two-class method in calculating EPS. See further discussion in Section 5.5.2.5.3.

5.3.3.7 Share-Based Payment Awards

ASC 260-10

Participating Securities and the Two-Class Method

45-61 Fully vested share-based compensation subject to the provisions of Topic 718, including fully vested options and fully vested stock, that contain a right to receive dividends declared on the common stock of the issuer, are subject to the guidance in paragraph 260-10-45-60A.

45-61A Unvested share-based payment awards that contain nonforfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are participating securities and shall be included in the computation of EPS pursuant to the two-class method under the requirements of paragraph 260-10-45-60A.

Nonvested shares of common stock and nonvested stock options represent participating securities if the holder has a nonforfeitable right to participate in dividends or dividend equivalents during the requisite service period (or nonemployee’s vesting period).3 The share-based payment awards would represent participating securities only if the holder receives cash when the entity (1) declares dividends on its common stock and (2) retains such cash even if it forfeits the award or does not exercise the stock option. If, however, the holder of a stock option is only entitled to a reduction of the exercise price or an increase in the number of common shares issuable upon exercise, the stock option would not be a participating security for the same reason options and warrants that are only entitled to a dividend benefit in the form of a reduction of the exercise price or increase in number of common shares issuable upon exercise are not participating securities (see Section 5.3.3.4). See Section 7.1.3.1 for further discussion of the application of the definition of participating security to share-based payment awards.

5.3.3.8 Noncontrolling Interests

NCIs that may meet the definition of a participating security generally will fall into one of the following categories:

NCI in the form of common stock that participates in earnings of the parent.
NCI in the form of preferred stock that participates in earnings of the subsidiary.
NCI in the form of preferred stock that participates in earnings of the parent.
NCI in the form of potential common stock that participates in earnings of the subsidiary.
NCI in the form of potential common stock that participates in earnings of the parent.

If the participating NCI is a share-based payment award, see Section 7.1.3.

5.3.3.9 Own-Share Lending

ASC 470-20

Own-Share Lending Arrangements Issued in Contemplation of Convertible Debt Issuance

45-2A Loaned shares are excluded from basic and diluted earnings per share unless default of the share-lending arrangement occurs, at which time the loaned shares would be included in the basic and diluted earnings-per-share calculation. If dividends on the loaned shares are not reimbursed to the entity, any amounts, including contractual (accumulated) dividends and participation rights in undistributed earnings, attributable to the loaned shares shall be deducted in computing income available to common shareholders, in a manner consistent with the two-class method in paragraph 260-10-45-60B.

An entity may loan its shares of common stock to an investment bank or third-party investor in conjunction with the issuance of convertible debt. Such shares are “loaned” because the investment bank or investor is unable to borrow shares in the market to hedge its exposure to the conversion option in the issuer’s convertible debt or because the borrowing cost is prohibitive. Although the “loaned” shares are legally issued and outstanding, they are generally not considered outstanding shares of common stock in the calculation of EPS. However, if the borrower of the shares receives dividends while holding the shares and is not obligated to reimburse them to the entity, the loaned shares represent participating securities and the two-class method of calculating EPS must be applied. See Section 8.5 for further discussion of own-share lending arrangements.

5.3.4 Examples

Example 5-1

Debt Instrument With Interest Payment Terms That Vary on the Basis of Dividends Declared on Common Stock

Entity D issues $10 million of senior notes (the “notes”) that mature 10 years from the issuance date. The notes pay interest quarterly, in arrears, at a rate of 2.5 percent per annum. The holders of the notes are also entitled to participate in dividends declared on D’s common stock on a 40:60 basis. The participation feature allows the holders to receive, in cash, an amount equal to 66.67 percent of all dividends declared and paid to D’s common stockholders. The notes meet the definition of a participating security because the holders participate in undistributed earnings with holders of D’s common stock. See Example 5-19 for an illustration of how the two-class method is applied to the notes.

Example 5-2

Evaluation of Cumulative Preferred Stock

Entity A’s capital structure consists of one class of common stock and one class of cumulative perpetual preferred stock. The preferred stock has priority over the common stock in liquidation and has a stated dividend rate of 5 percent. In addition, there are no terms that would result in the preferred stock’s participation in dividends with common stock. For the current period, A declares a 5 percent dividend on its preferred stock.

Because the preferred stock does not participate in dividends with common stock (i.e., the preferred stockholders are only entitled to cumulative dividends on the preferred stock at the stated dividend rate of 5 percent), it does not meet the definition of a participating security. As a result, A should not use the two-class method to calculate basic and diluted EPS. However, in accordance with ASC 260-10-45-11, A’s calculation of income available to common stockholders (i.e., the numerator in the calculation of basic EPS) should reflect the dividends on its preferred stock, regardless of whether they are declared.

Note that because the dividends on preferred stock have been declared for the period, the conclusion above would be unchanged if the dividends on the preferred stock were noncumulative.

Example 5-3

Evaluation of Cumulative Convertible Preferred Stock

Entity Z’s capital structure consists of one class of common stock and one class of cumulative perpetual convertible preferred stock. The preferred stock has priority over the common stock in liquidation and is convertible at any time into Z’s common stock on a 1:1 basis. The preferred stock has a stated cumulative dividend rate of 8 percent and participates in dividends declared on common stock on an “as if converted” basis (i.e., holders of the preferred stock are entitled to receive the same dividend that common stockholders receive). Entity Z did not declare any dividends on common stock or preferred stock during the period.

Because the preferred stock’s “as if converted” dividend feature would result in its participation in dividends with common stock, the preferred stock meets the definition of a participating security. As a result, Z would be required to use the two-class method to calculate basic and diluted EPS even though it did not declare and pay dividends for the period and regardless of whether it ever intends to declare and pay a dividend. Entity Z should allocate the current-period undistributed earnings between common stockholders and preferred stockholders on the basis of the contractual rights of each security as if all of the earnings for the period had been distributed.

In this example, Z should first reduce income from continuing operations (and net income) by the amount of the stated dividend rate that must be paid for the period (i.e., the unpaid 8 percent cumulative dividend). If Z has a loss from continuing operations (or a net loss), the loss would be increased by the amount of the stated dividend that accumulates for the period. Entity Z should then allocate the remaining undistributed earnings (losses) between the common stock and the preferred stock on the basis of what would happen if all of the current-period earnings (losses) were distributed. Entity Z should use the resulting earnings allocated to its common stock to determine basic and diluted EPS for its common stock.

Note that because of the “as if converted” dividend participation feature, the EPS on common stock in this example would be the same if the stated dividend feature of the preferred stock was noncumulative and either (1) the noncumulative dividends on the preferred stock for the period were declared or (2) the noncumulative dividends on the preferred stock for the period were not declared but net income for the period was greater than or equal to the amount of the stated preferred dividends. When applying the two-class method in such circumstances, Z would first allocate earnings to the noncumulative preferred stock in the amount of the stated dividend, regardless of whether the stated dividends were paid, since those dividends must be paid to the preferred stockholders before any remaining current-period earnings may be distributed between the common stockholders and the preferred stockholders. The remaining undistributed earnings (losses) would then be allocated in the same manner as they would according to the original facts in the example.

However, the EPS on common stock would be different if the noncumulative dividends on the preferred stock were not declared during the period and either (1) the stated dividend on the noncumulative preferred stock was greater than net income or (2) the entity reported a net loss for the period. In such circumstances, the amount of dividends (if any) allocated to the noncumulative preferred stock would be limited to net income reported for the period. That is, if the entity reported net income for the period in an amount equal to or less than the stated dividend on the noncumulative preferred stock, all of the net income for the period would be allocated to the noncumulative preferred stock. If the entity reported a net loss for the period, there would be no allocation of earnings to the noncumulative preferred stock (provided that the holders of the preferred stock do not have a contractual obligation to share in losses) and the entire net loss for the period would be allocated to the common stock.

See Section 5.5.2.5.1 for further discussion of the application of the two-class method to participating preferred stock.

Example 5-4

Evaluation of Noncumulative Preferred Stock

Entity M’s capital structure consists of one class of common stock and one class of noncumulative perpetual preferred stock. The preferred stock has priority over the common stock in liquidation. In addition, the terms of the preferred stock stipulate that preferred stockholders must be paid the stated dividend rate of 7 percent before common stockholders can receive a dividend. The preferred stockholders do not otherwise have rights to dividends paid to common stockholders.

Although the preferred stockholders must be paid the stated dividend before the common stockholders receive a dividend, the preferred stock is not considered a participating security because it does not participate in dividends with common stock. As a result, M should not use the two-class method to calculate basic and diluted EPS. However, M should deduct from net income any dividends declared during the period (regardless of whether they were paid during the period) to calculate income available to common stockholders (i.e., the numerator in the calculation of basic EPS). If there is a net loss, the amount of the loss would be increased by the amount of those dividends.

Note that if the noncumulative dividends on preferred stock for the period had not been declared, net income would represent the numerator in the calculation of basic EPS (i.e., the entity would not need to adjust net income to determine income available to common stockholders).

Example 5-5

Warrants on Common Stock With Yield Rights

Entity J issues warrants to sell common stock that entitle the counterparty to a yield right, payable in cash, equal to 25 percent of the dividends J pays on its common stock for each common share into which the warrants are exercisable. Although the yield right is not labeled as a dividend, it is a participation right because the holder of the warrants is entitled to share in dividends declared on J’s common stock without exercising the warrants. Therefore, the two-class method of calculating EPS must be applied to the warrants. Regardless of whether J declared any dividends during the period, it must allocate undistributed earnings to the warrants.

Note that, in the above example, the warrants are considered participating securities regardless of the extent of participation. That is, because of the holders’ entitlement to any participation in dividends (i.e., between 1 percent and 100 percent), the warrants meet the definition of a participating security. However, if dividends paid by an entity are held in abeyance and paid to a warrant holder only upon exercise, such warrants would not be considered a participating security.

Example 5-6

Warrants on Common Stock for Which the Exercise Price Is Adjusted on the Basis of Dividends

Entity K issues warrants to sell common stock that entitle the counterparty to purchase 100,000 common shares at an exercise price of $10 per share. Various adjustments may be made to the exercise price and the number of common shares received upon exercise, including standard antidilution adjustments and adjustments based on cash dividends. With respect to adjustments for cash dividends, the warrant agreement states that if any cash is distributed to all or substantially all holders of common stock — other than a quarterly cash dividend that does not exceed $0.20 per share, as adjusted for any stock split, reverse stock split, stock dividend, or similar dilutive event — the exercise price will be reduced on the basis of a formula in the warrant agreement. The formula specifies that the adjustment to the exercise price will be calculated on the basis of the exercise price before the adjustment multiplied by the quotient of (1) the market price of K’s common stock on the last trading day preceding the first date on which the common stock trades without the right to receive such distribution minus the amount of cash dividend in excess of $0.20 and (2) the market price on this date as specified in (1).

Although the holder of the warrant is entitled to a benefit when K declares any quarterly dividend in excess of $0.20 per share, the warrant is not a participating security in accordance with ASC 260-10-45-62. The warrant in this example has a substantive exercise price. See Section 3.3.2.5 and Example 3-31 for discussion of warrants with nonsubstantive exercise prices.

Example 5-7

Option on Membership Interests With Rights to Distributions to Meet Tax Obligations

Entity O, an LLC, issues options that entitle the counterparty to purchase 10,000 membership interests at a price of $1,000 per unit. Because O is an LLC that is taxed as a partnership, the options contain a provision stipulating that if O makes cash distributions during an annual period, those distributions will include a payment to holders of the options that is equal to any taxable income from the partnership that results from the options multiplied by the maximum federal tax rate.

The options meet the definition of a participating security because, if O distributes its earnings, it is required to make cash distributions to the holders of the options on the basis of the formula specified in the option agreement. In applying the two-class method, O should allocate undistributed earnings to the options on the basis of the amount of cash that would be distributed to the option holders, provided that all earnings for the period were distributed. In doing so, O will reflect an allocation of undistributed earnings to the option holders on other than a 1:1 basis with common shareholders.

Note that if the option agreement had stated that O’s board of managers had the right, but not the obligation, to make a cash distribution to the option holders in the event of an adverse tax consequence during an annual period, this right would represent a participation feature that is not objectively determinable and nondiscretionary; therefore, no undistributed earnings would be allocated to the options under the two-class method of calculating EPS.

Example 5-8

Forward Sale Contract With Reduction to Forward Price on the Basis of Extraordinary Dividends — Contract Does Not Specify Objectively Determinable, Nondiscretionary Participation Rights

Entity A enters into a forward sale contract on its common stock that entitles the counterparty to a dividend benefit (paid in the form of a reduction in the forward price) related only to extraordinary dividends. The forward contract defines an extraordinary dividend as one that must be characterized as such by a vote of the board of directors. Dividends can be paid at any level without being characterized as extraordinary. The forward contract is not a participating security, and A is not required to use the two-class method because the contract does not specify objectively determinable, nondiscretionary participation rights since the determination of whether a dividend qualifies as an extraordinary dividend is subjective.

Conversely, if the terms of the forward sale contract did specify objectively determinable and nondiscretionary participation rights pertaining to extraordinary dividends, the contract would be a participating security under ASC 260-10-45-59A through 45-70. The example below illustrates this notion.

Example 5-9

Forward Sale Contract With Reduction to Forward Price on the Basis of Extraordinary Dividends — Contract Specifies Objectively Determinable, Nondiscretionary Participation Rights

Entity B enters into a forward sale contract on its common stock that entitles the counterparty to dividend benefits (paid in the form of a reduction in the forward strike price) related only to extraordinary dividends. Extraordinary dividends are defined as those in excess of 200 percent of the prevailing dividend rate as of the date on which B enters into the forward contract. The participation right is objectively determinable and nondiscretionary; therefore, the forward sale contract meets the definition of a participating security. As a result, undistributed earnings would be allocated to the forward contract in periods in which, if all earnings had been hypothetically distributed, an extraordinary dividend would have resulted.

Example 5-10

Forward Sale Contract With Adjustments to Forward Price on the Basis of Anticipated Dividends Fixed at Inception

Entity Z enters into an accelerated share repurchase (ASR) agreement with Bank B. Under the guidance in ASC 505-30-25-5 and 25-6, the ASR agreement comprises two separate transactions: (1) the acquisition of treasury stock and (2) a forward contract indexed to Z’s stock. The forward sale contract is classified in equity under ASC 815-40.

To facilitate the treasury stock purchased by Z, B borrows Z’s common shares from third parties. Ultimately, B must return Z’s common shares to those third-party lenders. To obtain the shares, B purchases Z’s common shares from the open market during the term of the ASR agreement. The prices of those open-market purchases are used to determine the settlement amount of the forward sale contract between Z and B.

The settlement terms of the forward sale contract are as follows:

On each day on which B executes a purchase of Z’s common shares in the open market, a daily difference amount will be determined. The daily difference amount equals the number of shares repurchased, multiplied by the difference between (1) the volume-weighted-average price of Z’s common stock on the date of purchase and (2) the forward price specified in the forward sale contract.
The forward price for each purchase is initially set at the closing price of Z’s common stock at the inception of the ASR agreement. Each day, the forward price is reset to equal the prior day’s forward price, increased by a fixed interest rate. In addition, the forward price is reduced by $0.10 on each of Z’s anticipated quarterly ex-dividend dates. The $0.10 reduction in the forward price is intended to mimic expected future dividend payments to compensate B for the resulting negative impact on Z’s common stock price on those dates. However, the amount of this reduction is fixed and is not contingent on actual future dividend payments by Z.

The final settlement amount (which may be settled in Z’s common shares or cash at Z’s option) is equal to the sum of all daily difference amounts.

Because the forward price reduction on each anticipated quarterly dividend date is fixed at the inception of the contract and does not vary according to actual dividends paid or earnings, the forward contract is not a participating security.

Example 5-11

VSF Contract — Participation Only in Extraordinary Dividends

Entity A enters into a VSF contract that entitles the counterparty to a dividend benefit related only to extraordinary dividends. The contract defines an extraordinary dividend as a dividend that is characterized as such by a vote of the board of directors. Dividends can be paid at any level without being characterized as extraordinary. The VSF contract is not a participating security because it does not specify objectively determinable, nondiscretionary participation rights since the determination of whether a dividend qualifies as an extraordinary dividend is subjective.

In contrast, Entity B enters into a VSF contract that entitles the counterparty to dividend benefits through a reduction to the forward price related only to extraordinary dividends. In B’s case, extraordinary dividends are defined as dividends in excess of 200 percent of the prevailing dividend rate as of the date on which B enters into the contract. This VSF contract may be a participating security. In making this determination, B would be required to evaluate the impact an extraordinary dividend would have on the original range. If the VSF contract is considered a participating security, undistributed earnings should be allocated to the contract only if the distribution of all undistributed earnings would constitute an extraordinary dividend.

Example 5-12

VSF Contract — Qualitative Evaluation to Determine Whether the Contract Is a Participating Security

Entity X enters into a VSF contract that permits the counterparty to participate in increases in dividends on X’s common stock if the contract is settled outside the final range. The term of the VSF contract is three years, the low end of the original range equals the fair value of one share of X’s common stock at the inception of the contract, the high end of the range equals 125 percent of the low end of the range, and X does not pay a dividend or expect to pay one in the foreseeable future. Entity X’s common stock is not highly volatile. On the basis of these facts, it is acceptable to conclude that it is at least reasonably possible that the VSF contract ultimately will be settled within the range (i.e., the original range and final range are identical because a dividend increase is not expected).

Note that, as discussed in Section 5.3.3.5.3.2, an entity must consider whether, at inception, it is at least reasonably possible that a VSF contract will ultimately be settled within the final range. A final range whose upper end is less than 110 percent of the lower end might contradict a conclusion that is reasonably possible that the final stock price will be settled within the final range. A final range whose upper end is less than 120 percent of the lower end must be carefully considered.

Example 5-13

VSF Contract — Quantitative Evaluation to Determine Whether the Contract Is a Participating Security

Entity Y enters into a VSF contract with the following terms:

The counterparty must pay $100 to acquire Y’s common shares as of the settlement date, which is in one year.
The number of common shares issued by Y depends on the fair value of Y’s common stock five days before the settlement date (the reference date) as follows:
- If the fair value of Y’s common shares on the reference date is below $100, Y issues one common share.
- If the fair value of Y’s common shares on the reference date is above $100 but below $120 (the original range, subject to adjustment), Y issues a number of common shares that have a fair value of $100.
- If the fair value of Y’s common shares on the reference date is $120 or more, Y issues 0.8333 common shares.
The original range is $100 to $120, but this range is reduced if Y increases its normal dividends during the term of the VSF contract. For example, if Y increases its normal dividends by $4 during the term of the contract, the original range is reduced from $100–$120 to $100–$116. The settlement amount is determined on the basis of the final range, which is the original range plus any compression for dividend increases. The final range is adjusted for any standard antidilution events pertaining to Y’s common stock just as it is for dividends.

When Y enters into the VSF contract, it expects to increase dividends during the contract term, and it is possible that such an increase could cumulatively reach $1.00 during the term of the contract. Entity Y has determined that it should perform a quantitative analysis of the likelihood that the final range will be wide enough that it is at least reasonably possible that the final common share price on the reference date will be within the final range.

Entity Y devises two scenarios to gauge the sensitivity of the final range to different increases in dividends: one scenario depicts the effect of a $1.00 cumulative dividend increase; the other scenario depicts the effect of a $4.00 cumulative dividend increase. Using the formula contained in the terms of the VSF contract, Y calculates the final ranges for each scenario, as shown below.

Table 1 Illustration of Final Range With a $1 Increase in Dividends

Table 2 Illustration of Final Range With a $4 Increase in Dividends

On the basis of the following factors, Y concludes that it is reasonably possible that the VSF contract will be settled within the final range:

The final range is reduced by $1.00 for each $1.00 of increased dividends.
It is unlikely that dividends would increase by more than $1.00 given Y’s expected performance, marketplace expectations, and the behavior of its competitors.
The common stock is not highly volatile, and the term of the VSF contract is sufficiently short to support a conclusion that it is reasonably possible that the stock price will be within the indicated final range on the reference date.

Therefore, Y concludes that the VSF contract is not a participating security.

Footnotes

See Section 3.2.2 for additional discussion of the nature and types of dividends on preferred stock as well as the treatment of preferred stock dividends in the calculation of income available to common stockholders.

An entity must also analyze the likelihood that the contract will be settled inside or outside a range of share prices to determine whether the instrument is a liability under ASC 480-10-25-14. For more information, see Section 6.2.4.4 of Deloitte’s Roadmap Distinguishing Liabilities From Equity.

Vested stock options would also be participating securities if the holder is entitled to nonforfeitable dividends during the period the option is outstanding.

Confidential and Proprietary — for Use Solely by Authorized Personnel

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