Chapter 5 — Two-Class Method
Chapter 5 — Two-Class Method
5.1 Background
This chapter discusses the calculation of EPS by using the two-class method,
which is an earnings allocation formula under which an entity (1) treats a
participating security as having rights to earnings that otherwise would have been
available to common shares and (2) establishes the entitlement to earnings (or
absorption of losses) of multiple classes of common stock. The two-class method
applies to both basic and diluted EPS. Potential common shares or common shares
exchangeable into other classes of common stock are subject to the two-class method
of calculating diluted EPS if the effect is more dilutive than the application of
another dilutive method of calculating diluted EPS (i.e., the treasury stock,
reverse treasury stock, if-converted, or contingently issuable share method).
See Chapter 9 for discussion of presentation and disclosure requirements related to situations in
which an entity has participating securities or multiple classes of common stock and uses the two-class
method to calculate EPS.
5.2 Scope
5.2.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-59A The capital structures of some entities include:
- Securities that may participate in dividends with common stocks according to a predetermined formula (for example, two for one) with, at times, an upper limit on the extent of participation (for example, up to, but not beyond, a specified amount per share)
- A class of common stock with different dividend rates from those of another class of common stock but without prior or senior rights.
45-60A All securities that meet the definition of a participating security, irrespective of whether the securities
are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of
basic EPS using the two-class method.
ASC 260-10-45-59A and ASC 260-10-45-60A specify that the two-class method of calculating EPS applies
to both participating securities and a “class of common stock with different dividend rates from those of
another class of common stock but without prior or senior rights.” Section 5.3 discusses the definition
of a participating security, and Section 5.4 addresses when an entity must apply the two-class method
because it has multiple classes of common stock.
5.2.2 Entities That Do Not Pay Dividends
Some entities do not regularly pay dividends on common stock. Other entities that do regularly pay
such dividends may not have declared any dividends during a financial reporting period. Even if an entity
does not intend to declare dividends on common stock or did not declare a current-period dividend
and therefore has no distributed earnings, the entity must still apply the two-class method of calculating
EPS if it has participating securities or multiple classes of common stock. Further, such an entity must
allocate current-period undistributed earnings between common shareholders and participating
security holders on the basis of the contractual rights of each security, as if all the earnings for the
period have been distributed.
The terms of covenants associated with debt or equity securities may require entities to obtain approval
from a third party before they can declare and pay dividends on common stock. Similarly, under
regulatory requirements, an entity may need to obtain approval from a regulator before it can declare
and pay dividends on common stock. Because ASC 260 requires an assumption that all earnings for the
period are distributed when an entity has participating securities or multiple classes of common stock,
the entity must apply the two-class method in such cases regardless of whether it has received approval
during the period to declare and pay dividends on common stock.
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 | |
Preferred stock | Potential participation is paid in cash
according to a formula tied to dividends on
common stock. | Yes | |
Holders of preferred stock are entitled to
receive a current-period dividend before
holders of common stock can be paid
dividends. | No | ||
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 | |
Potential participation is achieved through
a reduction of the conversion price or an
increase in the conversion ratio. | No | ||
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 | |
Potential participation is achieved through a reduction of the conversion price
(i.e., an increase in the conversion ratio). | No | ||
Options or warrants to
sell common stock | Potential participation is paid in cash
according to a formula tied to dividends on
common stock. | Yes | |
Potential participation is achieved through
a reduction of the exercise price or an
increase in the number of shares issued
upon exercise. | No | ||
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. | |
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. |
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.
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
1
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.
2
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.
3
Vested stock options would also be participating
securities if the holder is entitled to nonforfeitable dividends
during the period the option is outstanding.
5.4 Definition of Multiple Classes of Common Stock
5.4.1 General
ASC 260 only explicitly requires application of the two-class method when an
entity has multiple classes of common stock with different dividend rates and
the same level of subordination. Nevertheless, an entity should apply the
two-class method of calculating EPS when it has multiple classes of common
stock, regardless of whether (1) the dividend rates of each class are the same
or (2) one class has senior or prior rights. In comment letters, the staff in
the SEC’s Division of Corporation Finance has previously expressed its view that
ASC 260-10-45-60B(d) requires an entity with multiple classes of common stock to
present basic and diluted EPS for each class even if the classes have the same
dividend rates; thus, an entity should either (1) present basic and diluted EPS
for each class of common stock separately on the face of the income statement or
(2) present a single basic and diluted EPS on the face of the income statement
and clearly disclose that the EPS amounts pertain to each class of common stock.
An entity that chooses the latter option cannot simply assume that the amounts
of basic and diluted EPS for each class are the same. Rather, before reaching
such a conclusion, the entity must calculate basic and diluted EPS. It is
possible for EPS amounts to differ for multiple classes of common stock that
have the same dividend rates. For example, a participating security may only
participate in dividends ratably with one class of common stock, which could
have an impact on the calculation of basic EPS for that class of common stock.
(Section
5.5.3.2 discusses another situation in which a difference in
basic EPS may arise.) In addition, in the calculation of diluted EPS for
multiple classes of common stock, potential common shares are included on the
basis of the more dilutive of the two-class method or another relevant dilutive
method. As a result, there could be different amounts of diluted EPS for
multiple classes of common stock with the same dividend rates.
Section 3.1.1.1 discusses the determination of whether capital securities are treated as common
shares or preferred shares. While the treatment is generally based on the legal form of the security,
this is not always the case. If an entity has outstanding capital securities that are common stock in
legal form but have senior or prior rights over another class of common stock, the entity may treat the
outstanding securities as preferred securities in calculating EPS. In this circumstance, the outstanding
capital securities do not cause the entity to have multiple classes of common stock. However, the
two-class method of calculating EPS would still apply if the capital securities are participating securities.
The application of the two-class method of calculating EPS may differ depending on whether capital
securities are treated as a separate class of common stock or a participating security, because
participating securities generally do not participate in undistributed losses (see Section 5.5.2.2).
5.4.2 Redeemable Common Stock
When an entity has issued common stock that is redeemable at an amount other
than fair value and must be remeasured to its redemption amount under ASC
480-10-S99-3A, the security is treated in the same manner as a separate class of
stock in accordance with ASC 480-10-S99-3A(21). (See further discussion in
Section
5.5.3.1.) An NCI in the form of common stock that is redeemable at an
amount other than fair value and must be remeasured to its redemption amount
under ASC 480-10-S99-3A may also need to be treated as a separate class of stock
in the calculation of basic and diluted EPS at the subsidiary level.4 See further discussion in Section 5.5.2.5.4.
5.4.3 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 use the two-class method to
calculate and present EPS for each class of common stock. The two-class method
should be applied on the basis of the separate earnings attributed to each class
of stock, which represents the actual distributions, if any, to the respective
classes of stock and undistributed earnings available for payment of dividends
on these classes. An entity should show basic and diluted EPS for each class of
tracking stock on the face of the income statement. See Sections 3.2.4.3.3,
4.8.4.5, and
9.1.3 for
further discussion of EPS accounting matters applicable to tracking stock.
Footnotes
4
As noted in Section 8.8.1.1, the parent entity
must calculate basic and diluted EPS at the subsidiary level to
determine the amount of the subsidiary’s income that is included in the
numerator in the parent’s calculation of EPS.
5.5 Two-Class Method of Calculating EPS
5.5.1 General
ASC 260-10
Participating Securities and the Two-Class Method
45-60 The two-class method is
an earnings allocation formula that treats a
participating security as having rights to earnings that
otherwise would have been available to common
shareholders but does not require the presentation of
basic and diluted EPS for securities other than common
stock. The presentation of basic and diluted EPS for a
participating security other than common stock is not
precluded.
45-60A All securities that meet the definition of a participating security, irrespective of whether the securities
are convertible, nonconvertible, or potential common stock securities, shall be included in the computation of
basic EPS using the two-class method.
45-60B Under the two-class method:
- Income from continuing operations (or net income) shall be reduced by the amount of dividends declared in the current period for each class of stock and by the contractual amount of dividends (or interest on participating income bonds) that must be paid for the current period (for example, unpaid cumulative dividends). Dividends declared in the current period do not include dividends declared in respect of prior-year unpaid cumulative dividends. Preferred dividends that are cumulative only if earned are deducted only to the extent that they are earned.
- The remaining earnings shall be allocated to common stock and participating securities to the extent that each security may share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to each security shall be determined by adding together the amount allocated for dividends and the amount allocated for a participation feature.
- The total earnings allocated to each security shall be divided by the number of outstanding shares of the security to which the earnings are allocated to determine the EPS for the security.
- Basic and diluted EPS data shall be presented for each class of common stock.
For the diluted EPS computation, outstanding common shares shall include all potential common shares
assumed issued. Example 6 (see paragraph 260-10-55-62) illustrates the two-class method.
45-65 Undistributed earnings for a period shall be allocated to a participating security based on the contractual
participation rights of the security to share in those current earnings as if all of the earnings for the period
had been distributed. 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. For example, if an entity could avoid distribution of earnings to a participating security, even if all
of the earnings for the year were distributed, then no allocation of that period’s earnings to the participating
security would be made. Paragraphs 260-10-55-24 through 55-31 provide additional guidance on participating
securities and undistributed earnings.
45-66 Under the two-class method the remaining earnings shall be allocated to common stock and
participating securities to the extent that each security may share in earnings as if all of the earnings for the
period had been distributed. This allocation is required despite its pro forma nature and that it may not reflect
the economic probabilities of actual distributions to the participating security holders.
Participating Securities and Undistributed Earnings
55-25 If a participating security provides the holder with the ability to participate in all dividends declared with
the holders of common stock on a one-to-one per-share basis, then the undistributed earnings should be
allocated between the common stock and the participating security on a one-to-one per-share basis.
ASC 260 requires entities to apply the following two-step approach in allocating earnings under the
two-class method:
- Allocate distributed earnings to participating securities and common stock.
- Allocate undistributed earnings to participating securities and common stock.
The allocation of distributed earnings is based on the actual dividends or dividend equivalents, if
any, that were paid or payable during the period (and that pertain to the reporting period) to each
participating security and class of common stock. The amount of undistributed earnings that must be
allocated is equal to the numerator in the calculation of EPS less distributed earnings. Undistributed
earnings must be allocated to participating securities and classes of common stock on the basis of
their contractual entitlement to participate in distributions, under an assumption that all undistributed
earnings for the period were distributed. This hypothetical allocation is required regardless of whether
the entity intends to declare or pay dividends and even if there are contractual or legal restrictions on
the entity’s ability to pay dividends. The allocation of undistributed earnings to participating securities
and common shares should be based on the weighted-average participating securities and common
shares that were outstanding during a reporting period. It should not be based on the number of
participating securities or common shares outstanding as of the end of the reporting period. If an entity
can avoid a distribution of earnings to a participating security even if all earnings for the period were
distributed, the entity should not allocate undistributed earnings to that participating security.
The implementation guidance in ASC 260 on the two-class method of calculating EPS is written in the
context of basic EPS and does not explicitly address diluted EPS. However, the calculation of diluted
EPS under the two-class method is well established in practice and would be performed by using the
approach described in Section 5.5.4.
The remaining discussion in Section 5.5 provides guidance on using the two-class method to calculate
basic and diluted EPS. Section 5.5.5 provides examples illustrating the calculation of EPS under the
two-class method.
5.5.1.1 Quarterly and Year-to-Date Calculations
SEC Regulation S-X requires SEC registrants to present EPS in their quarterly reports on Form 10-Q.
Other entities that are required, or that elect, to present EPS may also issue financial statements on an
interim basis (e.g., quarterly or semiannually). When issuing interim-period financial statements, entities
include basic and diluted EPS for both the interim period and the year-to-date period.
For year-to-date calculations, an entity should allocate undistributed earnings to participating securities
and classes of common stock on a discrete, or independent, basis as if all undistributed earnings for
the entire year-to-date period were distributed. That is, the allocation is made without regard to how
the undistributed earnings were allocated for the interim financial reporting periods that are part
of the year-to-date financial reporting period. This approach is consistent with the guidance in ASC
260-10-55-3 through 55-3B, as discussed in Section 4.9, which requires that year-to-date diluted EPS be
calculated on the basis of the numerator for the year-to-date period.
The allocation of undistributed earnings in interim-period calculations of EPS (e.g., an EPS calculation for
a quarterly financial reporting period) is generally not controversial when the entitlement of common
shares and participating securities to share in earnings according to their contractual participation terms
is based on discrete interim periods. However, when the contractual participation terms related to
the rights to participate in distributions are based on distributions made over an entire annual period,
additional considerations are necessary regarding the calculations of EPS under the two-class method
for interim periods after the first interim period.
On the basis of informal discussions with the FASB staff during the deliberations of EITF Issue 07-4, there are two views in practice on the
allocation of undistributed earnings to interim periods, since the guidance
in ASC 260 on the two-class method is unclear on this matter. Specifically,
ASC 260-10-45-60B(b) states that undistributed earnings “shall be allocated
to common stock and participating securities to the extent that each
security may share in earnings as if all of the earnings
for the period had been distributed” (emphasis added). The two views
are related to the meaning of the phrase “all of the earnings for the
period” as follows (note that these two views are acceptable only when an
entity pays distributions by using a complex allocation formula on the basis
of an annual distribution):
-
View A: Discrete-period basis — Some interpret “all of the earnings for the period” as indicating that an allocation is required in an interim period on a discrete, or independent, basis as if all undistributed earnings for the interim period were allocated without regard to any allocations made in prior interim periods. In other words, each interim period would be treated in the same manner as an annual period is treated in a year-to-date calculation of EPS. Proponents of View A believe that this approach is required because it is consistent with the period-by-period approach that is generally prescribed by ASC 260. Under this approach, the undistributed earnings allocated to each participating security and class of common stock on a year-to-date basis will often not equal the sum of the interim-period undistributed earnings allocated to each participating security and class of common stock. This same phenomenon exists for calculations of diluted EPS when the two-class method does not apply.
-
View B: Cumulative-period basis — Others interpret “all of the earnings for the period” as not addressing how to allocate undistributed earnings to interim periods. Proponents of View B believe that each interim period is an integral part of a year-to-date period. They further believe that in interim periods after the first interim period, the prior interim-period allocations of undistributed earnings must be considered when distribution formulas are contractually based on earnings during an annual period so that the allocation of undistributed earnings is appropriately reflected in accordance with the “contractual participation rights” of each security under ASC 260-10-45-65. Under this approach, the undistributed earnings allocated to each participating security and class of common stock on a year-to-date basis will often equal the sum of the interim-period undistributed earnings allocated to each participating security and class of common stock; however, the two amounts may not be equal if the distribution formulas are complex or there are undistributed losses during a financial reporting period (i.e., as illustrated in Example 5-15, undistributed losses during a particular financial reporting period should not be allocated to securities that do not absorb losses).
Either of these two approaches is acceptable provided that it is applied
consistently as an accounting policy and disclosed, if material. Regardless
of the method chosen, the denominator in the calculation of diluted EPS will
continue to be subject to the guidance applicable to each method of
computing diluted EPS on an interim and year-to-date basis, as discussed in
Chapter 4.
Example 5-14
illustrates the application of these two alternative views.
5.5.1.1.1 Distribution Formulas That Include a Return of Originally Invested Capital
The allocation of cash distributions by some entities is contractually based on a distribution formula
(i.e., a “waterfall” formula) in which common shares or participating securities must first receive a return
of their initial invested capital before any distributions can be made on other securities. For example,
an entity may have three classes of participating preferred stock outstanding (i.e., Series A, Series B,
Series C) and common shares. The entity’s articles of incorporation, bylaws, or other organization
documents may specify that distributions must first be made to repay the remaining unreturned capital
contribution on Series A before any distributions can be made on Series B, Series C, and common stock.
Once the unreturned capital contributions have been distributed on Series A, distributions must be paid
to return the Series B unreturned capital contribution before distributions can be paid on Series C and common stock. Once Series C has received its unreturned capital contribution, distributions are paid on
Series A, Series B, Series C, and common stock according to a specified formula.
In these types of allocation formulas, regardless of the method applied in
Section
5.5.1.1 for interim-period calculations of EPS under the
two-class method, an entity should allocate undistributed earnings,
taking into consideration the unreturned capital contributions of each
security as of the beginning of the interim period. The two-class method
of calculating EPS is an allocation of earnings and therefore should be
applied on the basis of the return on capital rather than the
return of capital. For further discussion of the allocation of
undistributed earnings by an MLP, see Section 8.9.3.
5.5.2 Application of Two-Class Method to Participating Securities
5.5.2.1 Liability-Classified Participating Securities
An entity may have outstanding participating securities that are classified as liabilities for accounting
purposes. Liability-classified participating securities may be recognized in the statement of financial
position at fair value, with periodic changes in fair value recognized in earnings (or other comprehensive
income for the portion related to the change in the issuing entity’s own credit risk). Alternatively, such
securities may be recognized in the statement of financial position by using another measurement
attribute under other relevant GAAP, such as intrinsic value, current settlement value, or amortized
cost. The classification of securities as liabilities, and their subsequent-measurement attribute, has no
impact on whether they are participating securities to which an entity must apply the two-class method
of calculating EPS.
5.5.2.1.1 Distributed Earnings for Liability-Classified Participating Securities
Dividends declared on liability-classified participating securities that have
been recognized in the income statement as an expense (e.g., interest
expense, compensation expense, other income or expense) should not also
be treated as a reduction of income available to common stockholders to
arrive at undistributed earnings. The recognition of these dividends a
second time through the allocation of distributed earnings would result
in “double counting” the impact of these dividends. An entity should
count dividends declared once, but not twice, in calculating EPS under
the two-class method. See Example 5-19 for an illustration
of this concept.
5.5.2.1.2 Undistributed Earnings for Liability-Classified Participating Securities
The periodic change in the carrying amount of a liability-classified participating security (e.g., change
in fair value, change in intrinsic value, change in current settlement value, interest, dividends
on share-based payment awards not expected to vest) that is recognized in the income statement will
affect net income and therefore the amount of undistributed earnings (losses). Under the two-class
method of calculating EPS, an entity may not reverse such amounts from undistributed earnings or
losses. However, in calculating diluted EPS, an entity may be required to adjust the numerator to reverse
the income statement effect on certain potential common shares that are more dilutive under the
treasury stock, if-converted, or contingently issuable share method than under the two-class method of
calculating diluted EPS. Only in these circumstances is it appropriate to adjust undistributed earnings
for the earnings effect that resulted from classifying the instrument as a liability. See Section 5.5.4 for
further discussion of the two-class method of calculating diluted EPS.
5.5.2.2 Allocation of Undistributed Losses to Participating Securities
ASC 260-10
Participating Securities and the Two-Class Method
45-67 An entity would allocate losses to a nonconvertible participating security in periods of net loss if, based
on the contractual terms of the participating security, the security had not only the right to participate in the
earnings of the issuer, but also a contractual obligation to share in the losses of the issuing entity on a basis
that was objectively determinable. Determination of whether a participating security holder has an obligation to
share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based on
the contractual rights and obligations of the participating security. The holder of a participating security would
have a contractual obligation to share in the losses of the issuing entity if either of the following conditions is
present:
- The holder is obligated to fund the losses of the issuing entity (that is, the holder is obligated to transfer assets to the issuer in excess of the holder’s initial investment in the participating security without any corresponding increase in the holder’s investment interest).
- The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the issuing entity.
45-68 A convertible participating security should be included in the computation of basic EPS in periods of
net loss if, based on its contractual terms, the convertible participating security has the contractual obligation
to share in the losses of the issuing entity on a basis that is objectively determinable. The guidance in this
paragraph also applies to the inclusion of convertible participating securities in basic EPS, irrespective of the
differences that may exist between convertible and nonconvertible securities. That is, an entity should not
automatically exclude a convertible participating security from the computation of basic EPS if an entity has a
net loss from continuing operations. Determination of whether a participating security holder has an obligation
to share in the losses of the issuing entity in a given period shall be made on a period-by-period basis, based
on the contractual rights and obligations of the participating security.
An entity will have undistributed losses, as opposed to undistributed earnings, during a financial
reporting period in the following situations:
- The entity has a loss attributable to common stockholders.
- The entity has distributed more cash in the form of dividends or dividend equivalents than earnings for the period (i.e., cash distributions exceed income available to common stockholders).
Like undistributed earnings, undistributed losses must be allocated under the
two-class method of calculating EPS. When an entity has undistributed losses
and allocates a portion of those losses to a participating security, net
loss per common share will be reduced. Therefore, it is important to
determine whether participating securities share in undistributed losses
with common shareholders. If a participating security does not share in
losses, undistributed losses should be allocated only to the entity’s common stock.5 If an entity has multiple classes of common stock, undistributed
losses should be allocated to the classes of common stock in accordance with
their terms, which must take into account whether the classes of common
stock share equally in earnings or distributions on liquidation. See further
discussion in Section
5.5.3.3.
Connecting the Dots
It may seem intuitive to think that when undistributed losses are allocated solely to common
shares, there is no need to calculate diluted EPS under the two-class method. However, that
is not necessarily true. The control number for diluted EPS under the two-class method could
be income, notwithstanding cash distributions in excess of the control number for basic EPS, because (1) an entity must recalculate and reallocate undistributed earnings to apply the
two-class method when potential common shares are also participating securities and (2) the
entity may adjust the numerator in the calculation of diluted EPS if it has contracts that may be
settled in cash or common stock. See Section 5.5.4 for further discussion of the calculation of
diluted EPS under the two-class method.
Undistributed losses are allocated to a participating security only if the security contains a
nondiscretionary and objectively determinable contractual obligation to share in net losses.
Just because a security participates in earnings on a nondiscretionary and objectively determinable
basis does not mean it participates in losses. In fact, most participating securities do not share in losses.
A participating security only has a contractual obligation to participate in losses in the following two
circumstances:
- The counterparty is required to fund the losses of the entity (i.e., to “write a check” to the entity).
- The contractual principal or mandatory redemption amount of the participating security is reduced as a result of losses incurred by the entity.
Although the guidance in ASC 260-10-45-67 and 45-68 was written in the context of participating debt
or preferred stock instruments, it should be applied to all types of participating securities. An entity
must consider the contractual rights and obligations of the participating security in assessing whether
a security holder is obligated to share in the entity’s net losses on a period-by-period basis. It is unusual
for participating securities to have a contractual obligation to share in undistributed losses on an
objectively determinable and nondiscretionary basis. If the contractual terms of the participating security
do not specifically require the security holder to participate in losses or do not address the manner of
such loss participation, the entity should not allocate undistributed losses to the participating security.
Connecting the Dots
Because ASC 260-10-45-67 and 45-68 were only written to address participating debt or
preferred stock instruments, questions have arisen regarding whether a nonvested stock
award that is a participating security because the holder is entitled to nonforfeitable dividends
participates in losses. Undistributed losses (whether resulting from a net loss for a period or
distributed earnings that exceed income available to common stockholders) are generally not
allocated to share-based payment awards that meet the definition of a participating security
because the awards do not contain specific language that creates a contractual obligation
for the employee to absorb losses. The forfeiture provisions of the awards do not affect this
evaluation. However, once a nonvested share-based payment award vests and becomes an
outstanding share of common stock, it would participate in losses (see discussion of common
shares in Section 5.5.3.3). Therefore, when an entity has undistributed losses and nonvested
shares vest during a financial reporting period, the entity must allocate the undistributed losses
to the share-based payment arrangement for the portion of the period in which the award
was a vested common share. This allocation is generally performed on the basis of a weighted
average.
5.5.2.2.1 Allocation of Undistributed Losses to Participating Securities When an Entity Reports a Discontinued Operation
ASC 260 does not address how an entity should apply the two-class method when it reports a
discontinued operation. Entities will therefore need to consider how to allocate earnings (losses) under
the two-class method of calculating EPS, which must be done for continuing operations, discontinued
operations, and overall net income (loss) when an entity has participating securities or multiple classes
of common stock.
5.5.2.2.1.1 Distributed Earnings (Losses)
In a manner consistent with the typical application of the two-class method of
calculating EPS, any declared dividends reduce (increase) overall
net income (net loss) to arrive at undistributed earnings (losses).
Typically, distributed earnings will be considered as reducing
income (increasing losses) from continuing operations. However, if
the discontinued operation arises from a spin-off of a subsidiary
that has issued participating securities in the subsidiary, an
allocation of distributed earnings between continuing operations and
discontinued operations would be required.
5.5.2.2.1.2 Undistributed Earnings (Losses)
As discussed in Section 5.5.2.2, ASC 260 specifies that an entity should not allocate undistributed
losses to a participating security if, according to its contractual terms, the participating security does not
have a contractual obligation to absorb such losses on a basis that is nondiscretionary and objectively
determinable. In practice, it is uncommon for a participating security, including an unvested share-based
payment award, to participate in undistributed losses. If an entity reports income from continuing
operations but an overall net loss (because of losses from discontinued operations) or reports a loss
from continuing operations but overall net income (because of income from discontinued operations),
the entity must determine which measure is used to allocate income to participating securities when it
allocates income, but not losses, to participating securities.
If an entity has outstanding securities that participate in income, but not
losses, and those securities participate with common shareholders in
the entity’s overall net income, the entity should use overall net
income (loss) to allocate undistributed earnings (losses). That is,
these participating securities participate in all of the entity’s
undistributed earnings and none of its undistributed losses. The
table below illustrates the allocation of undistributed earnings
(losses) when an entity has participating securities that
participate in its overall net income but do not absorb
undistributed losses.
Table 5-3
Entity Reports6 | Continuing
Operations | Discontinued
Operations | Overall | Allocation to Participating Security |
---|---|---|---|---|
Scenario 1 | Income | Income | Income | The entity should allocate undistributed earnings
from continuing operations to the participating
security and should allocate undistributed earnings
from discontinued operations to the participating
security. The total amount of undistributed
earnings allocated to the participating security
from continuing and discontinued operations
should equal the overall undistributed earnings
allocated to the participating security. |
Scenario 2 | Income | Loss | Income | The entity should allocate undistributed earnings
from continuing operations to the participating
security and should allocate undistributed losses
from discontinued operations to the participating
security. The net amount of undistributed earnings
allocated to the participating security from
continuing and discontinued operations should
equal the overall undistributed earnings allocated
to the participating security. |
Scenario 3 | Income | Loss | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 4 | Loss | Loss | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 5 | Loss | Income | Loss | No allocations are made to the participating
security because the entity reported an overall
loss and the participating security does not absorb
losses. |
Scenario 6 | Loss | Income | Income | The entity should allocate undistributed losses
from continuing operations to the participating
security and should allocate undistributed earnings
from discontinued operations to the participating
security. The net amount of undistributed earnings
allocated to the participating security from
continuing and discontinued operations should
equal the overall undistributed earnings allocated
to the participating security. |
Connecting the Dots
As discussed in Section
4.1.2.2, the control number in the
determination of whether potential common shares are
dilutive is income from continuing operations. However, this
control number concept is not relevant to the allocation of
undistributed earnings (losses) to participating securities
in the scenarios above because the participating securities
participate in the overall performance of the entity. Thus,
solely with respect to allocating undistributed earnings
(losses) to participating securities under the two-class
method, the control number is overall net income (loss)
(i.e., total undistributed earnings [losses] for the
period).
In terms of calculating diluted EPS under the two-class method, which is
discussed in Section 5.5.4, the
treasury stock, reverse treasury stock, if-converted, or
contingently issuable share method would not be applied to
calculate diluted EPS in scenarios 4–6, because those
methods would be antidilutive since the control number in
the calculation of diluted EPS is income from continuing
operations, which is a loss in these scenarios. However, for
scenarios 1–3, since the control number is income, those
methods of calculating diluted EPS would be applied in
accordance with the antidilution sequencing requirements, as
discussed in Section 4.1.2.3.
If an entity has securities that participate with common shareholders in earnings, but not losses, and
those securities participate only in the earnings of a specific subsidiary or business operation of the
entity, the entity must consider the facts and circumstances related to the terms of the participating
securities to determine the proper allocation of undistributed earnings (losses) to continuing operations,
discontinued operations, and overall net income (loss) for the period. If securities participate only in
earnings of a specific subsidiary or business operation and that subsidiary or operation is contained
only within continuing operations or only within discontinued operations, the entity should base
its allocation of undistributed earnings only on the undistributed earnings (if any) from continuing
operations or discontinued operations, respectively. In all situations, the entity must ensure that the overall net amount allocated to a participating security (i.e., the aggregate of the allocations from
continuing and discontinued operations) reflects the net amount of undistributed earnings that would
be allocable to the participating security if all undistributed earnings in which the security is entitled to
participate had been distributed for the period.
5.5.2.3 Participating Securities Issued or Redeemed During an Interim Reporting Period
SEC Regulation S-X requires SEC registrants to present EPS in their quarterly reports on Form 10-Q.
Accordingly, if an entity has participating securities outstanding during a quarterly financial reporting
period, it is required to prepare EPS under the two-class method for those interim financial reporting
periods.
An entity may issue or redeem a participating security during a quarterly financial reporting period. A
counterparty may also convert a participating security into common stock during a quarterly financial
reporting period. There are two acceptable methods of incorporating the impact of the issuance,
redemption, or conversion of a participating security during a quarterly financial reporting period in
a quarterly calculation of EPS under the two-class method in accordance with ASC 260: the discrete
method and the weighted-average method. An entity’s choice of either method represents an
accounting policy that must be consistently applied and disclosed, if material.
5.5.2.3.1 Discrete Method
Under the discrete method, the entity prepares, during the single financial reporting period, two EPS
calculations for both basic and diluted EPS, one for the portion of the financial reporting period for
which the participating security was outstanding and the other for the portion of the financial reporting
period for which the participating security was not outstanding. The date of separation for the two
separate calculations is the date of the participating security’s issuance, redemption, or conversion. The
entity aggregates the two separate calculations to determine the reported amounts of basic and diluted
EPS for the entire quarterly financial reporting period.
The appropriateness of the discrete method depends on the entity’s performance of two financial
reporting closings during a single quarterly financial reporting period, with each closing reflecting the
same processes and internal controls normally applied to a quarter-end closing. Given the complexity
of this approach, which requires an entity to (1) allocate net income to the discrete portions of the
quarterly financial reporting period and (2) calculate accruals and estimates twice during a single
quarterly financial reporting period, entities will most likely choose to apply the weighted-average
method.
5.5.2.3.2 Weighted-Average Method
The weighted-average method is predicated on the general requirement in ASC 260 to determine
outstanding common shares and potential dilutive common shares on a weighted-average basis. The
two-class method is applied under this approach, as discussed below.
5.5.2.3.2.1 Numerator
Net income attributable to common stockholders is first reduced by dividends declared during the
quarterly reporting period, with the remaining amount representing undistributed earnings. The
amount of dividends, if any, paid on the participating securities issued, redeemed, or converted during
the period will represent the actual amount of dividends declared or paid on such securities during
the quarterly financial reporting period (i.e., the distributed earnings). Undistributed earnings will be allocated to common shares and the participating securities issued, redeemed, or converted during the
quarterly financial reporting period on the basis of the weighted-average number of common shares
and participating securities outstanding during the quarterly financial reporting period. An allocation
based on the weighted-average number of common shares and participating securities outstanding
during the quarterly financial reporting period (in lieu of an allocation based on the period-end number
of outstanding shares of common stock and participating securities) of undistributed earnings under
the two-class method is consistent with other guidance in ASC 260 (see ASC 260-10-45-26 and ASC
260-10-45-42, which address the treatment of options or convertible debt issued, canceled, exercised,
or converted during a reporting period). In addition, such allocation reflects the notion that income
is earned and distributed evenly throughout the financial reporting period and is not a one-time
distribution of earnings as of the end of the financial reporting period.
5.5.2.3.2.2 Denominator
In a manner similar to the treatment of the numerator, the number of outstanding common shares used
in an entity’s calculation of basic and diluted EPS should be based on the weighted-average number of
shares of common stock outstanding during the quarterly financial reporting period, as required by ASC
260-10-45-10.
ASC 260 does not require presentation or disclosure of basic or diluted EPS for a participating security
that is not a class of common stock. However, if an entity presents or discloses such EPS amounts, the
denominator in the EPS calculation should be the weighted-average number of securities outstanding
only for the period during the quarterly financial reporting period in which the class of participating
securities was outstanding. For example, if a class of participating securities was entirely redeemed or
settled on the 46th day of the quarterly financial reporting period, the weighted-average calculation of
the number of securities outstanding should be based on a 45-day period.
5.5.2.4 Participation Is Contingent on a Specified Event
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.
55-28 If a participating security provides the holder with the ability to participate in extraordinary dividends
and the classification of dividends as extraordinary is predetermined by a formula, for example, any dividend
per common share in excess of 5 percent of the current market price of the stock is defined as extraordinary,
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. If earnings for a given period exceed the
specified threshold above which the participating security would participate (that is, earnings for the period are
in excess of 5 percent of the current market price of the stock), undistributed earnings would be allocated to
the participating security according to its terms.
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.
55-30 If a participating security provides the holder with the ability to participate in all dividends up to a
specified threshold (for example, the security participates in dividends per common share up to 5 percent of
the current market price of the stock), 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. In this
example, undistributed earnings would be allocated to common stock and to the participating security up to
5 percent of the current market price of the common stock, as the amount of the threshold for participation
by the participating security is objectively determinable. The remaining undistributed earnings for the period
would be allocated to common stock.
55-31 See Example 9 (paragraph 260-10-55-71) for an illustration of this guidance.
As noted in ASC 260-10-55-27, the two-class method applies when a security participates in
earnings only upon the occurrence of a specified contingent event, provided that such participation
is objectively determinable and nondiscretionary. While various types of contingencies may affect
participation, examples include securities that participate (1) on the basis of the entity’s earnings or
other performance measures or the entity’s common stock price or (2) upon discrete events such as
the occurrence of an IPO or business combination. If participation is based on conditions that are not
objectively determinable or that are at the entity’s discretion if the contingency occurs, allocation of
undistributed earnings to the security under the two-class method is precluded. Participation may be
considered not objectively determinable if it depends on a condition that is subject to interpretation (i.e.,
it is subjective rather than objective).
Undistributed earnings should be allocated to a participating security that
participates contingently only if the condition on which participation is
based is satisfied as of the reporting date.7 Thus, for each financial reporting period, an entity must evaluate
whether the relevant condition has been met as of the reporting date under
an assumption that all undistributed earnings for the period are
distributed.8 If the relevant condition is met, the entity should allocate earnings
to the participating security on the basis of an assumption that all
earnings for the period were distributed (regardless of whether an actual
distribution was made for the period). This reporting-date approach is
consistent with the approach to diluted EPS approach for contingently
issuable shares, which is discussed in Section 4.5. Because the condition may
be met as of some reporting-period dates and not others, such securities may
participate in undistributed earnings in some quarterly financial reporting
periods but not in others. Example
5-18 illustrates this concept.
5.5.2.5 Application to Specific Types of Participating Securities
5.5.2.5.1 Participating Preferred Stock
An entity should apply the two-class method to preferred stock only if the preferred stock meets the
definition of a participating security. See Section 5.3.3.2 and Examples 5-2, 5-3, and 5-4 for discussion of
whether preferred stock meets the definition of a participating security.
As discussed in ASC 260-10-45-60, the two-class method is “an earnings allocation formula that treats a
participating security as having rights to earnings that otherwise would have been available to common
shareholders.” In accordance with ASC 260, an entity that has participating preferred stock should
allocate distributed and undistributed earnings in calculating basic EPS under the two-class method as
follows:
- Distributed earnings — Distributed earnings allocable to participating preferred stock include (1) the amount of dividends declared in the current period on the preferred stock; (2) the amount of any unpaid cumulative dividends on the preferred stock for the current period; and (3) the amount of any other current-period “deemed dividends” or “deemed contributions” on the preferred stock.9 In summary, distributed earnings equal the dividends on the preferred stock that reduce net income in arriving at income available to common stockholders during the financial reporting period. Distributed earnings on cumulative preferred stock would not include the payment of dividends that have accumulated in a prior financial reporting period, since those accumulated dividends would have been considered distributed earnings in that prior financial reporting period.Distributed earnings on common stock and other participating securities are based on the amount of dividends declared during the current period. If an entity is required to reduce income available to common stockholders to reflect a down-round feature, as discussed in Section 3.2.5.3, that amount would also be treated as distributed earnings.
- Undistributed earnings — To arrive at undistributed earnings, an entity adjusts both income (loss) from continuing operations and net income (loss) (or income [loss] from continuing operations attributable to common stockholders of the parent and net income [loss] attributable to common stockholders of the parent if the entity had an NCI) by the amount of distributed earnings to arrive at undistributed earnings or losses. Undistributed earnings or undistributed losses are allocated to common stock and participating securities, including participating preferred stock, to the extent that each security may share in such earnings or absorb such losses (as determined on the basis of the contractual participation rights of each participating security) under an assumption that all of the undistributed earnings or losses for the period were distributed.
The total earnings or losses allocated to each security (i.e., the sum of distributed earnings and
undistributed earnings or losses) are divided by the number of the security’s outstanding units to
calculate basic EPS for the security. Diluted EPS is calculated under the two-class method, as discussed
in Section 5.5.4. ASC 260-10-45-60 indicates that entities are permitted, but not required, to present
basic and diluted EPS for a participating preferred security. See further discussion in Section 9.1.4.
For illustrations of how the two-class method is applied by an entity whose
capital structure includes preferred stock that meets the definition of
a participating security, see Examples 5-16, 5-20, 5-21, and
5-22.
Table 5-4 summarizes various scenarios
related to preferred stock. The table also summarizes scenarios
illustrating whether and, if so, how an entity with a capital structure
that includes preferred stock should apply the two-class method of
calculating EPS, depending on whether (1) dividends on the preferred
stock are cumulative or noncumulative and (2) the preferred stock is a
participating security. In the scenarios, it is assumed that:
-
The entity’s capital structure includes only a single class of common stock and a single class of preferred stock that were not issued in a share-based payment arrangement.
-
The entity did not declare or pay any dividends on common stock during the period. (If the entity had declared dividends on common stock, those dividends would be included in the distributed earnings under the two-class method.)
-
The preferred stock does not represent a redeemable equity security for which periodic measurement adjustments are required under ASC 480-10-S99-3A. (If the entity’s preferred stock had been remeasured to its redemption amount under ASC 480-10-S99-3A, those measurement adjustments would be reflected as dividends or distributed earnings on the preferred stock.)
-
The preferred stock does not contain a contractual obligation to share in losses. (If the preferred stock had a contractual obligation to absorb losses, which would be unusual, any undistributed losses would be allocated to the preferred stock.)
Table 5-4
Dividends on
Preferred Stock | Preferred Stock Meets the Definition of
Participating Security | Preferred Stock Does Not Meet the
Definition of Participating Security |
---|---|---|
Cumulative (Regardless of Whether Declared or Paid) | ||
The entity
reports net
income for the
period that is
greater than
the cumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The remaining undistributed
earnings for the period should be allocated
to the common stock and preferred stock
on the basis of the contractual participation
rights of each security as if all earnings for
the period were distributed. | The two-class method does not apply.
The entity should compute income available
to common stockholders (the numerator in
the calculation of basic EPS) by deducting
from net income the dividends on the
preferred stock that accumulated during the
period. |
The entity
reports net
income for the
period that is
less than the
cumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The resulting undistributed
losses for the period should be allocated
entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by deducting from
net income the dividends on the preferred
stock that accumulated during the period. |
The entity
reports net loss
for the period. | The two-class method applies.
Distributed earnings for the period equal
the cumulative dividends on preferred stock
for the period. The resulting undistributed
losses for the period should be allocated
entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by adding to net
loss the dividends on the preferred stock
that accumulated during the period. |
Noncumulative (and Declared for the Period) | ||
The entity
reports net
income for the
period that is
greater than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared
on preferred stock for the period. The
remaining undistributed earnings for the
period should be allocated to the common
stock and preferred stock on the basis of
the contractual participation rights of each
security as if all earnings for the period were
distributed. | The two-class method does not apply.
The entity should compute income available
to common stockholders (the numerator in
the calculation of basic EPS) by deducting
from net income the dividends on the
preferred stock that were declared during
the period. |
The entity
reports net
income for the
period that is
less than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared on
preferred stock for the period. The resulting
undistributed losses for the period would be
allocated entirely to the common stock. No
undistributed losses should be allocated to
the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by deducting from
net income the dividends on the preferred
stock that were declared during the period. |
The entity
reports net loss
for the period. | The two-class method applies.
Distributed earnings for the period equal
the noncumulative dividends declared on
preferred stock for the period. The resulting
undistributed losses for the period should
be allocated entirely to the common stock.
No undistributed losses should be allocated
to the preferred stock because the preferred
stock does not contain a contractual
obligation to absorb losses. | The two-class method does not apply.
The entity should compute loss available to
common stockholders (the numerator in the
calculation of basic EPS) by adding to net
loss the dividends on the preferred stock
that were declared during the period. |
Noncumulative (and Not Declared or Paid for the Period) | ||
The entity
reports net
income for the
period that is
greater than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed earnings for the
period should first be allocated to the
preferred stock in an amount equal to the
noncumulative dividends on preferred stock
for the period. The remaining undistributed
earnings for the period should be allocated
to the common stock and preferred stock
on the basis of the contractual participation
rights of each security as if all earnings for
the period were distributed. | The two-class method does not apply.
There should be no adjustments to net
income. Net income for the period should
represent the numerator in the calculation
of basic EPS. |
The entity
reports net
income for the
period that is
less than the
noncumulative
dividends on
preferred stock. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed earnings for the
period (equal to net income for the period)
should be allocated entirely to the preferred
stock. No income or loss should be allocated
to the common stock. | The two-class method does not apply.
There should be no adjustments to net
income. Net income for the period should
represent the numerator in the calculation
of basic EPS. |
The entity
reports net loss
for the period. | The two-class method applies.
There are no distributed earnings for the
period. Undistributed losses (equal to net
loss for the period) should be allocated
entirely to the common stock. No income or
losses should be allocated to the preferred
stock because the preferred stock does not
contain a contractual obligation to absorb
losses. | The two-class method does not apply.
There should be no adjustments to net loss.
Net loss for the period should represent the
numerator in the calculation of basic EPS. |
See Section 5.5.2.5.3A for discussion of
application of the two-class method of calculating EPS to mandatorily
convertible preferred stock arrangements that contain a variable number
of common shares issuable upon settlement.
5.5.2.5.2 Participating Share-Based Payment Awards
ASC 260-10
Participating Securities and the Two-Class Method
45-68B Paragraph 718-10-55-45 requires that nonrefundable dividends or dividend equivalents paid on
awards for which the requisite service is not (or is not expected to be) rendered be recognized as additional
compensation cost and that dividends or dividend equivalents paid on awards for which the requisite service
is (or is expected to be) rendered be charged to retained earnings. As a result, an entity shall not include
dividends or dividend equivalents that are accounted for as compensation cost in the earnings allocation
in computing EPS. To do so would include the dividend as a reduction of earnings available to common
shareholders from both compensation cost and distributed earnings. Undistributed earnings shall be allocated
to all share-based payment awards outstanding during the period, including those for which the requisite
service is not expected to be rendered (or is not rendered because of forfeiture during the period, if an entity
elects to account for forfeitures when they occur in accordance with paragraph 718-10-35-3). An entity’s
estimate of the number of awards for which the requisite service is not expected to be rendered (or no
estimate, if the entity has elected to account for forfeitures when they occur in accordance with paragraph
718-10-35-3) for the purpose of determining EPS under this Topic shall be consistent with the estimate used
for the purposes of recognizing compensation cost under Topic 718. Paragraph 718-10-35-3 requires that an
entity apply a change in the estimate of the number of awards for which the requisite service is not expected
to be rendered in the period that the change in estimate occurs. This change in estimate will affect net income
in the current period; however, a current-period change in an entity’s expected forfeiture rate would not affect
prior-period EPS calculations. See Example 9 for an illustration of this guidance.
In addressing share-based payment awards granted to employees, ASC 718-10-35-3
states, in part, that “[t]he total amount of compensation cost
recognized at the end of the requisite service period for an award of
share-based compensation shall be based on the number of instruments for
which the requisite service has been rendered (that is, for which the
requisite service period has been completed).” Regarding the
determination of the amount of compensation cost to recognize in each
reporting period, ASC 718-10-35-3 allows entities to elect, as an
entity-wide accounting policy, to either (1) estimate forfeitures before
they occur (i.e., recognize compensation cost on the basis of the number
of share-based payment awards that are expected to vest) or (2)
recognize the effect on compensation cost of awards for which the
requisite service period is not rendered only when the award is
forfeited. The guidance in ASC 718-10-35-3 applies to all share-based
payment awards, regardless of their classification as an equity or
liability instrument.10
The accounting policy elected regarding the treatment of forfeitures will affect
how the entity treats dividends in applying the two-class method when it
has granted share-based payment awards that are participating securities
because they contain nonforfeitable rights to dividends before vesting.
The discussion below pertains to participating share-based payment
awards granted to employees that are classified as equity
instruments.11
-
Entity estimates forfeitures — Distributed earnings during a period will equal the current-period dividends on unvested participating share-based payment awards that are expected to vest (i.e., the amount of dividends on unvested participating share-based payment awards that have been charged to retained earnings during the period). Dividends on awards that are not expected to vest and that have been recognized as compensation expense are not considered distributed earnings under the two-class method since doing so would result in the “double counting” of such dividends. An entity should allocate undistributed earnings to all unvested participating share-based payment awards outstanding during the period on the basis of the weighted-average number of awards outstanding during the period. Undistributed losses are generally not allocated to share-based payment awards, as discussed in Section 5.5.2.2.
-
Change in estimated forfeitures — In accordance with ASC 718-10-35-3, in the period of a change in estimated forfeitures, an entity is required to adjust compensation cost to reflect the cumulative effect on current and prior periods of the change in the estimated number of instruments for which the requisite service period is expected to be or has been rendered. For equity-classified share-based payment awards, this adjustment will include two components: (1) a change in the amount of compensation cost recognized to date on the basis of the grant-date fair-value-based measure (i.e., an adjustment to compensation cost to cumulatively reflect the grant-date fair-value-based measure that should be recognized to date on the basis of the revised estimate of forfeitures) and (2) a change in the amount of compensation cost recognized to date for dividends declared on unvested awards (i.e., an adjustment to compensation cost [and retained earnings] to cumulatively reflect in compensation cost the dividends declared to date on awards that are not expected to vest, on the basis of the revised estimate of forfeitures). This adjustment should not affect previously reported EPS amounts. In the period in which the forfeiture adjustment is made, net income (the numerator) will be affected by the adjustment to compensation cost described above; however, there will be no effect on the application of the two-class method. The two-class method should reflect an allocation of current-period earnings, including the adjustment to compensation cost to reflect the change in estimated forfeitures. ASC 260 does not permit a cumulative adjustment to distributed earnings for a change in estimated forfeitures. Rather, in the period in which an adjustment is made to compensation expense for a change in estimated forfeitures, an entity should continue to allocate distributed earnings to unvested participating share-based payment awards on the basis of the amount of current-period dividends that are recognized in retained earnings for awards that have vested or that are expected to vest.12 The change in estimated forfeitures will also not affect the allocation of undistributed earnings in the period in which the change is made because the allocation of undistributed earnings to participating share-based payment awards does not depend on whether the outstanding awards are expected to vest. In summary, the adjustment that an entity must make to reflect the change in estimated forfeitures affects the entity’s net income during the period but not how the entity applies the two-class method of calculating EPS.
-
-
Entity accounts for forfeitures as they occur — Distributed earnings during a period will equal the current-period dividends on all unvested participating share-based payment awards (i.e., when an entity does not estimate forfeitures, it initially recognizes all dividends on unvested participating share-based payment awards within retained earnings). An entity should also allocate undistributed earnings to all unvested participating share-based payment awards outstanding during the period on the basis of the weighted-average number of awards during the period. Undistributed losses are generally not allocated to share-based payment awards, as discussed in Section 5.5.2.2.
-
Recognition of actual forfeitures — In accordance with ASC 718-10-35-3, an entity is required to recognize the effect of forfeitures as they occur. For equity-classified share-based payment awards, the adjustment recognized to reflect actual forfeitures will include two components: (1) a reduction in compensation cost equal to the amount of the grant-date fair-value-based measure recognized to date on the awards that are forfeited and (2) an increase in compensation cost equal to the amount of dividends declared to date on the awards that are forfeited (i.e., to cumulatively reflect the amount of dividends previously recognized in retained earnings that must be charged to expense because the awards did not vest). This adjustment should not affect previously reported EPS amounts. In the period in which the forfeitures occur and are recognized, net income (the numerator) will be affected by the adjustment to compensation cost described above; however, there will be no effect on application of the two-class method. The two-class method should reflect an allocation of current-period earnings, including the adjustment to compensation cost to reflect actual forfeitures. ASC 260 does not permit cumulative adjustments to distributed earnings to reflect actual forfeitures. Rather, in the period in which an adjustment is made to compensation expense to reflect actual forfeitures, an entity should continue to allocate distributed earnings to all unvested participating share-based payment awards in an amount equal to the current-period dividends declared on such awards. The recognition of forfeitures will also not affect the allocation of undistributed earnings in the period in which forfeitures occur because the allocation of undistributed earnings to participating share-based payment awards does not depend on whether the outstanding awards are expected to vest.
-
Connecting the Dots
The accounting policy an entity elects to account for forfeitures will affect the timing of the
recognition of compensation expense but will have no impact on the cumulative amount
of compensation expense recognized for a grant of equity-classified share-based payment
awards to employees once the requisite service period is completed. Regardless of the policy
an entity elects to account for forfeitures, the cumulative amount of compensation expense
recognized will be based on the awards that vest. While it may be intuitive to think that the
cumulative EPS impact under the two-class method would also be the same regardless of
the policy elected, this is not necessarily true because ASC 260 does not permit a cumulative
adjustment to distributed earnings in a reporting period to reflect the occurrence, or a change
in the estimate, of forfeitures that would have affected the amount of prior-period distributed
earnings. Cumulatively, basic EPS under the two-class method may be lower for an entity that
elects to account for forfeitures as they occur because dividends on awards that are forfeited
will ultimately be reflected in both distributed earnings and compensation cost (i.e., before
forfeiture, the dividends represent distributed earnings, and in the period in which the forfeiture
occurs, those same dividends must be reflected as compensation cost). The same phenomenon
may not occur when an entity estimates forfeitures because dividends on the awards not
expected to vest are initially treated as compensation cost (and therefore did not factor into
distributed earnings). The cumulative differences that could arise between the two approaches (i.e., recognizing forfeitures as they occur vs. estimating forfeitures) will ultimately depend on
the facts and circumstances, including the level of forfeitures and the significance of changes in
estimates when forfeitures are estimated for the purpose of recognizing compensation cost.
The policy election regarding the accounting for forfeitures should not, however, affect the
calculation of diluted EPS under the treasury stock method, which is based on the actual
number of nonforfeited awards regardless of an entity’s accounting policy election related to the
accounting for forfeitures. See ASC 718-10-45-1 for further discussion.
5.5.2.5.3 Mandatorily Redeemable Common Shares and Forward Contracts to Repurchase Common Shares
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.
Under ASC 480-10-45-4, when an entity has mandatorily redeemable common shares
or a forward purchase contract that must be physically settled by
repurchase of a fixed number of common shares in exchange for cash, the
common shares to be redeemed or repurchased are excluded from the
denominator in the calculation of basic and diluted EPS.13 While the outstanding common shares are excluded from the
denominator in the calculations of EPS, if the counterparty that owns
the common shares has a contractual right to participate in dividends
declared by the entity before the common shares are retired, the entity
must treat the excluded common shares as participating securities under
ASC 260. Under the two-class method, an entity adjusts the numerator for
any dividends declared or paid and undistributed earnings, but only to
the extent that these amounts have not been accounted for as interest
cost. Generally, no distributed earnings will be allocated to these
participating securities because the dividends will have been recognized
in earnings as interest cost; therefore, reflecting the distributed
earnings under the two-class method would result in “double-counting”
the impact on EPS. However, undistributed earnings must be allocated to
these participating securities in accordance with ASC 260-10-45-59A
through 45-70. As discussed in Section 3.2.4.3.1, the impact on
EPS of treating the common shares as participating securities will often
be the same as including the common shares in the denominator in the EPS
calculations when an entity has undistributed earnings. If, however, a
forward purchase contract on a fixed number of common shares contains
fixed adjustments to the forward price that are based on anticipated
dividends, the guidance in Section 5.3.3.5.2 applies and the
forward purchase contract is not a participating security.
ASC 480-10-45-4 only specifically applies to forward purchase contracts that involve the repurchase of
a fixed number of common shares in exchange for cash. The accounting for prepaid forward purchase
contracts that involve the repurchase of a fixed number of common shares and forward purchase
contracts on a variable number of common shares is discussed below.
5.5.2.5.3.1 Prepaid Forward Contracts to Repurchase Common Shares
An entity may enter into a forward contract to purchase a fixed number of common shares in exchange
for cash and prepay the forward price (i.e., a prepaid forward share purchase contract). A prepaid
forward share purchase contract does not meet the criteria to be accounted for as an asset or liability
under ASC 480-10-25-8 because it does not represent an obligation of the issuing entity to transfer
assets. More specifically, because the issuing entity prepays the forward price to the seller of the
common shares, it does not have an obligation to transfer assets in the future. This is the case even if
the entity is required to pay dividends to the counterparty when it declares dividends on its common
stock since an obligation to pay dividends does not exist before declaration.
While ASC 480-10-45-4 does not explicitly apply to prepaid forward share purchase contracts, it is
still generally appropriate to apply that guidance. That is, the common shares to be repurchased are
removed from the denominator in the calculations of basic and diluted EPS and the contract is treated
as a participating security if the counterparty that owns the common shares has a contractual right to
participate in dividends declared by the entity before the common shares are repurchased.
5.5.2.5.3.2 Forward Contracts to Repurchase a Variable Number of Common Shares
The EPS accounting for forward contracts to purchase a variable number of common shares in
exchange for cash depends on the facts and circumstances. If there is a minimum number of common
shares that will be repurchased and those shares have been removed from the denominator in the
calculation of basic and diluted EPS, the entity should apply the two-class method to the number of
common shares removed in a manner consistent with the guidance above if the counterparty has
a contractual right to participate in dividends declared by the entity before the common shares are
repurchased. When common shares are not removed from the denominator, since the common shares
are considered outstanding for EPS purposes, there is no need to treat them as participating securities
and the two-class method should not be applied. See further discussion in Section 3.2.4.3.1.
5.5.2.5.3A Forward Contracts to Sell a Variable Number of Common Shares
Section 5.3.3.5.3 addresses when a VSF contract represents a participating security. As noted in that discussion, if the following two conditions are met, a VSF contract constitutes a participating security and the two-class method of calculating EPS must be applied:
- 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 not at least reasonably possible that the contract ultimately will be settled within the final range.
When the two-class method of calculating EPS is required for a VSF contract
because it is not at least reasonably possible that the contract
ultimately will be settled within the final range, ASC 260 is not clear
on how earnings should be allocated to the participating security.
Therefore, either of the following two approaches would be acceptable as
an accounting policy election that is consistently applied:
-
Full impact approach — The full amount of distributed and undistributed earnings would be allocated to the VSF contract (i.e., the participating security). As a result, dividends may be allocated to the participating security that are in excess of the economic benefit that the holder receives from the actual and assumed distribution of earnings.
-
Incremental impact approach — The amount for which the VSF contract is considered to participate in earnings should equal the value of the additional common shares that results from distributed and undistributed earnings, under the assumption that all earnings for the period were distributed as dividends. In other words, the amount of participation by the VSF contract would be limited to the economic benefit, if any, to which holders of the VSF contract would be entitled if all earnings were distributed. This approach may involve a calculation of the difference between settlement amounts under the assumption that settlement occurs (1) outside the final range and (2) within the final range.
These same two approaches would also be acceptable if an entity has issued a
mandatorily convertible preferred stock instrument whose range
settlement provisions are similar to those of the VSF contracts
discussed in Section
5.3.3.5.3.
5.5.2.5.4 Participating NCIs and Equity Method Investments
An entity may report an NCI in a consolidated subsidiary (or own an equity
method investee) that has issued participating securities or that has
multiple classes of common stock. In these circumstances, basic and
diluted EPS must be calculated at the subsidiary (investee) level by
using the two-class method to determine the amount of the subsidiary’s
(investee’s) income available to common stockholders that is
attributable to the parent (investor). The parent’s (investor’s) portion
of the EPS amount of the subsidiary (investee) is included in the
numerator in the parent’s (investor’s) calculation of EPS. The parent’s
portion is determined by multiplying the number of shares of the
subsidiary’s (investee’s) common stock owned by the parent by the
subsidiary’s (investee’s) basic and diluted EPS amounts. The product of
these two amounts is included in the numerator in the parent’s
(investor’s) calculation of the consolidated group’s basic and diluted
EPS. In these circumstances, it is necessary to use the two-class method
to calculate the subsidiary’s (investee’s) basic and diluted EPS,
regardless of whether the subsidiary (investee) separately reports EPS.
See further discussion in Section 8.8.1.1.
Special considerations are necessary when an entity has an NCI in a consolidated
subsidiary in the form of common stock and that interest is redeemable
at an amount other than fair value, regardless of whether the redemption
obligation is an obligation of the subsidiary or its parent. In these
situations, the two-class method of EPS must be applied. See further
discussion in Sections
3.2.3.3 and 8.8.4.
An NCI in a consolidated subsidiary in the form of common stock or potential
common stock may participate in the earnings of the parent. An NCI in a
consolidated subsidiary in the form of preferred stock may also
participate in earnings of the parent. In these situations, the parent
should reflect the impact of such participation by applying the
two-class method after it has included its portion of the subsidiary’s
income available to common stockholders in its calculation of income
available to common stockholders. The effect of the participation should
be based on the contractual participating rights of the NCI holder. For
example, if the holder only participates in earnings of the parent that
exclude the net income of the subsidiary, that fact must be taken into
account in the determination of the amount of the parent’s undistributed
earnings that is allocated between the NCI and the parent’s common
stockholders. If the NCI that participates in the parent’s earnings is
also redeemable, the impact of the redemption provisions on the
calculation of the parent’s basic EPS must be considered. The impact of
such a redeemable NCI will depend on whether the NCI is in the form of
common stock or preferred stock. See Section 8.8.4 for additional
discussion of the accounting for redeemable NCIs.
5.5.2.5.5 Master Limited Partnerships
See Section 8.9.3.1
for discussion of the application of the two-class method to MLPs
containing incentive distribution rights that are treated as
participating securities.
5.5.3 Application of Two-Class Method to Multiple Classes of Common Stock
5.5.3.1 Redeemable Common Shares
An entity may have common shares that are redeemable securities. As discussed in Section 3.2.4.2, the
impact of the redemption feature on the calculation of EPS depends on the nature of the redemption
feature (i.e., fair value vs. non–fair value).
If an entity has common shares that are redeemable at fair value, in accordance with ASC 480-10-S99-3A(21), the two-class method of calculating EPS is not required solely because of the redemption
feature in the common stock. Similarly, the two-class method is not required when share-based
payment awards granted to employees are redeemable at fair value (provided that those awards are
in the form of common shares or options on common shares). However, an entity may be required to
apply the two-class method if it has determined that, for reasons other than the fair value redemption
feature, it has multiple classes of common stock or if it has determined that a share-based payment
award is a participating security. If the two-class method is applied for reasons other than the fair value
redemption feature, any change in the carrying amount to reflect the fair value redemption under the
subsequent-measurement guidance in ASC 480-10-S99-3A should not be treated as a dividend or
distributed earnings.
If an entity has common shares that are redeemable at any amount other than fair
value, in accordance with ASC 480-10-S99-3A(21), the entity must apply the
two-class method and any increase in the carrying amount of the redeemable
common stock under the subsequent-measurement guidance in ASC 480-10-S99-3A
should be treated as a dividend. Changes in the carrying amount of the
redeemable common stock should not affect income available to common
stockholders but should be treated as distributed earnings under the
two-class method. The SEC staff believes that to the extent that a common
shareholder has a contractual right to receive, at share redemption (in
other than a liquidation event that qualifies for the exception in ASC
480-10-S99-3A(3)(f)), an amount that is other than the fair value of the
common shares, that common shareholder has, in substance, received a
distribution different from that of other common shareholders. Under ASC
260-10-45-59A, entities with capital structures that include a class of
common stock with dividend rates that differ from those of another class of
common stock, but without prior or senior rights, should apply the two-class
method of calculating EPS. As discussed in Section 3.2.4.2, there are two methods
an entity may apply to determine the amount of any increase in the carrying
amount of common stock redeemable at an amount other than fair value that is
treated as a dividend or distributed earnings under the two-class
method.
In addition to the impact of distributed earnings, when the two-class method is applied, the entity must
allocate undistributed earnings (losses) to the redeemable common shares. See Section 3.2.4.2 for
further discussion of redeemable common securities.
5.5.3.2 Multiple Classes of Common Stock With the Same Rights to Distributions
As discussed in Section
5.4.1, in the calculation and presentation of EPS, an entity
may have multiple classes of common stock even if each class has the same
dividend rate. Since basic and diluted EPS must be presented for each class,
the entity should use the two-class method to calculate EPS. Since the
allocation of undistributed earnings is based on a hypothetical assumption
of the distribution of earnings on the basis of the weighted-average shares
of each class of common stock outstanding, in the calculation of basic EPS,
in the absence of participating securities that affect only one class, the
undistributed EPS of each class would generally be expected to be the same.
However, the distributed earnings allocated to each class must be based on
the actual dividends declared (or other distributions made) during the
financial reporting period. Thus, the distributed earnings component per
share will be the same for each class only when the actual and
weighted-average shares of each class are the same during the financial
period. When the actual and weighted-average shares of each class are not
the same, the basic EPS for each class of common stock would not be expected
to be the same, even though each of these classes of common stock has the
same contractual right to dividends (i.e., the same dividend rate per
share).
In addition, diluted EPS under the two-class method could also differ for each class depending on the
facts and circumstances, including the nature of securities and potential common shares in an entity’s
capital structure. See Section 5.5.4 for further discussion of the calculation of diluted EPS under the
two-class method.
5.5.3.3 Allocating Undistributed Losses When an Entity Has Multiple Classes of Common Stock
When an entity’s capital structure includes multiple classes of common stock to
which it must apply the two-class method, and the entity reports
undistributed losses, questions have arisen regarding whether each class of
common stock should participate in the allocation of the undistributed
losses. The guidance in ASC 260-10-45-67 and 45-68 on whether participating
securities absorb undistributed losses is not relevant to the allocation of
undistributed losses to a class of common stock but should be applied only
to participating securities (i.e., securities in a form other than an
outstanding common share). When an entity has multiple classes of common
stock, undistributed losses should be allocated to each class on the basis
of on their contractual terms, regardless of whether the classes have
specifically stated contractual obligations to absorb losses. However, the
allocation of undistributed losses may differ from the allocation of
undistributed earnings. For example, if an entity has two classes of common
stock that share equally in the entity’s residual net assets on liquidation
but have different participation rights to dividends, the entity should
allocate undistributed losses equally to each class. If, however, the rights
to share in the distribution of the residual net assets of the entity are
unequal between the classes, the entity should generally allocate
undistributed losses in accordance with the contractual distribution rights
upon liquidation.14 The entity should also carefully consider whether any liquidation
preference causes one of the classes to be more representative of a
preferred security for EPS purposes (see Section 3.1.1).
5.5.3.4 One Class of Common Stock Is Convertible Into Another Class
An entity may have two classes of common stock in which one class is convertible into the other class.
For this purpose, we refer to the class that is convertible into the other class as the “convertible class”
and the class of common stock into which the convertible class is convertible as the “main class.”
At the 2006 AICPA Conference on Current SEC and PCAOB Developments, Cathy Cole,
then associate chief accountant in the SEC’s Office of the Chief Accountant,
gave a speech addressing how an entity should apply ASC 260
when it has one class of common stock that is convertible into another
class. Ms. Cole stated that the SEC staff believes that an entity must use
the two-class method to present basic EPS for each class of common stock.
ASC 260 prohibits an entity from applying the if-converted method to the
convertible class or the main class in the calculation of basic EPS.
In these situations, an entity must also present diluted EPS for each class. Ms. Cole explained that an
entity should use the if-converted method when calculating diluted EPS of the main class, provided that
the conversion of the convertible class into the main class is dilutive (and that the if-converted method
is more dilutive than the two-class method of calculating diluted EPS). An entity should not apply the
if-converted method in calculating diluted EPS of the convertible class. Rather, diluted EPS for the
convertible class should be calculated by using the two-class method, as if all earnings were distributed
to each class of common stock on the basis of their contractual rights. For this purpose, an entity must
consider potential common shares of the convertible class by using the treasury stock method, the
if-converted method, or the contingently issuable share method, as applicable (see Section 5.5.4 for
further discussion of the application of the two-class method to the calculation of diluted EPS).
Ms. Cole referred to an example in which Class B common shares are convertible into Class A common
shares and stated, in part:
The first situation relates to diluted [EPS] when one class of common is
convertible into another class of common. [ASC 260] requires the use
of the two-class method of computing EPS in certain circumstances,
namely, when there is more than one class of common stock and the
classes have different dividend rates or when there are other
securities that have a right to participate in dividends with common
stock. . . .
As an example, a company may have two classes of common stock, say Class A and
Class B. Class A may be entitled to dividends at a rate that is 1.2
times that of Class B, but Class B may have twice the voting rights
of Class A. Class B may also be convertible at any time into Class A
on a 1 to 1 basis. . . .
[T]he staff believes that for diluted EPS, a company with two classes of common stock must actually present
both a basic and diluted earnings per share number for each class of common stock regardless of conversion
rights. One might ask, “If for diluted EPS, I have assumed the conversion of one class into the other, how can
I then present two diluted earnings per share numbers, one for each class? Doesn’t assuming the conversion
of one class into the other essentially eliminate the second class for diluted EPS purposes?” Well, for the
class being converted into (Class A in the example), we believe diluted EPS should be computed using the
if-converted method for the convertible class (Class B), if doing so would be dilutive. Diluted EPS for the
convertible class (Class B in the example) should be computed using the two-class method. Diluted EPS must
be presented for both classes.
You may ask, “What is the point of this second computation?” Why can’t the company just present diluted EPS
for Class A and be done with it? Well, there are several reasons for the presentation of diluted EPS for Class B.
The first reason is that while presenting diluted EPS for Class A assuming conversion of Class B may be more
dilutive for Class A, the assumed conversion might in fact be antidilutive for Class B. In our simple example, if
Class A is entitled to $1.20 of dividends for every $1.00 of dividends for Class B, then if Class B is allowed to share equally in earnings with Class A, then Class B would be entitled to a higher share of earnings on a diluted
basis assuming conversion, than it would be entitled to absent the conversion. Further, Class B shareholders
might be interested in knowing what diluted EPS would be for Class B shares, if the shares were not converted
into Class A. This might be especially true in circumstances where potential common shares would also affect
the computation.
The second reason for presenting EPS for Class B is that presenting diluted EPS only for Class A is inconsistent
with the guidance of [ASC 260-10-45-60B], which that says that basic and diluted EPS data should be presented
for each class of common stock. Thus, if there are two classes of common stock that means two sets of EPS
data. I just think of it as double the numbers . . . double the fun. Obviously though, the company should also
provide the appropriate footnote disclosures explaining its computation of basic and diluted EPS.
The SEC staff’s view is an appropriate interpretation of ASC 260 and should be
applied by all entities that present EPS under ASC 260.
In her remarks at the 2006 AICPA Conference, Ms. Cole also addressed the SEC
staff’s views on a particular scenario involving the application of the
two-class method by an entity that has two classes of common stock. She
stated:
There were two classes of common stock, let’s call
these A and B. Class A was entitled to one vote per share; Class B
was entitled to ten votes per share. The company’s articles of
incorporation stated that dividends could be paid on Class A without
an equal or any dividend being paid on Class B. However, dividends
could not be paid on Class B without an equal amount being paid on
Class A. Further, Class B was convertible into Class A on a 1-to-1
basis at any time. And, Class B common stock controlled
approximately 75% of the shareholder votes of the company. Classes A
and B shared equally in the net assets of the company on
liquidation. The company had historically paid dividends equally to
both classes. In applying the two-class method, the company had
allocated the undistributed earnings equally on a per share basis to
both classes.
In this case, there was no contractually
predetermined ratio of dividends between the classes of common
stock. [ASC 260], if applied literally in this situation, would have
resulted in no allocation of undistributed earnings to the Class B
common stock. Since the articles of incorporation provided that all
the earnings could be entirely distributed to Class A without any
distribution to Class B, no allocation would be made to Class B.
[ASC 260-10-45-65] states that “ . . . if an entity could avoid
distribution of earnings to a participating security, even if all of
the earnings for the year were distributed, then no allocation of
that period’s earnings to the participating security would be
made.”
However, company management believed it was
appropriate to allocate undistributed earnings between the two
classes on a 1-to-1 basis. Management believed that the allocation
of undistributed earnings must be done considering all of the rights
and privileges of the different shareholder groups. They thought
that it was unreasonable to think that the Class B common
stockholders that control the Board would systematically allow the
Board to pay dividends on Class A shares without paying them on
Class B as well. Also, since the Class B was convertible at any time
into Class A, the Class B stockholders could convert and capture any
differential dividend, after it was declared. But, although Class B
controlled the Board, the Board could not pay dividends on Class B
without paying an equal amount on Class A.
After additional consideration and consultation, we
came to believe that the particular facts in this case justified a
different answer from a strict application of [ASC 260]. The SEC
staff believes that the [guidance on the two-class method] was
generally written in the context of classes of participating
securities that do not control the company and that applying [such
guidance] by analogy in this case did not produce the most
transparent reporting. Thus, the staff did not object to the
company’s judgment on how to apply the two-class method in this
case. We did suggest that the company provide disclosures of the
factors it considered in determining that its methodology was
appropriate.
This view is also an appropriate interpretation of ASC 260 that should be
applied by all entities that present EPS under ASC 260.
5.5.3.5 Master Limited Partnerships
See Section 8.9.3.1
for discussion of the application of the two-class method to MLPs that
contain incentive distribution rights that are treated as part of the
general partner’s interest.
5.5.4 Calculation of Diluted EPS Under the Two-Class Method
ASC 260 does not specifically address how to apply the two-class method to the calculation of diluted EPS. In practice, however, entities have applied the approach outlined in proposed FASB FSP FAS 128-a. Under that approach, an entity applies the following three-step process to calculate diluted EPS under the two-class method:
- Step 1 — Use the two-class method to calculate basic EPS.
- Step 2 — Use the total earnings allocated to common stock in step 1 to determine diluted EPS. If a participating security is also a potential common share, separately perform steps 2a and 2b to determine the dilutive effect.
- Step 2a — Assume that the participating security has been exercised, converted, or issued; that is, apply the treasury stock method, the if-converted method, or the contingently issuable share method.
- Step 2b — Add back the undistributed earnings allocated to the participating security (or securities) in arriving at basic EPS, and assume that all other dilutive potential common shares have been exercised, converted, or issued in order of antidilution. Next, reallocate the undistributed earnings — including any additional income that would result from the exercise, conversion, or issuance of potential common shares — to the (1) common shares and potential common shares and (2) participating security (or securities).
- Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
The following should be noted regarding this three-step process:
- While step 2b requires a reallocation of undistributed earnings to common shares, potential common shares, and participating securities that are not assumed exercised, converted, or issued under step 2a, it is never appropriate to reverse or reallocate distributed earnings.
- As discussed in Section 4.7.3, for certain contracts that are assumed to be share-settled for diluted EPS purposes, an adjustment must be made to the numerator. The amount of this numerator adjustment would affect the amount of undistributed earnings to be reallocated under step 2b.
Further, an entity that has multiple classes of common stock must calculate diluted EPS for the second
class of common stock by using the two-class method, under an assumption that additional common
shares of the first class of common stock are outstanding as a result of the conversion of all potential
common shares outstanding. In such circumstances, the entity is required to reallocate undistributed
earnings to the second class of common stock. If there are potential common shares related to the
second class of common stock, diluted EPS reflects the more dilutive of the two-class method or the
applicable dilutive method (e.g., the treasury stock, if-converted, or contingently issuable share method)
for the second class of common stock.
While diluted EPS for the first class of common stock may reflect the conversion of the second class of
common stock into the first class of common stock, such conversion may not be assumed for diluted
EPS for the second class of common stock.
5.5.5 Examples
ASC 260 contains two examples illustrating the calculation of basic EPS under the two-class method
when there are participating securities outstanding. Those examples are reproduced below.
ASC 260-10
Example 6: Two-Class Method
55-62 This Example illustrates the two-class method of computing basic EPS (see paragraph 260-10-45-60B)
for an entity that has more than one class of nonconvertible securities. This method is described in paragraphs
260-10-45-59A through 45-70. Diluted EPS would be computed in a similar manner. This Example has the
following assumptions for the year 20X0:
- Net income was $65,000.
- 10,000 shares of $50 par value common stock were outstanding.
- 5,000 shares of $100 par value nonconvertible preferred stock were outstanding.
- The preferred stock was entitled to a noncumulative annual dividend of $5 per share before any dividend is paid on common stock.
- After common stock has been paid a dividend of $2 per share, the preferred stock then participates in any additional dividends on a 40:60 per-share ratio with common stock. (That is, after preferred and common stock have been paid dividends of $5 and $2 per share, respectively, preferred stock participates in any additional dividends at a rate of two-thirds of the additional amount paid to common stock on a per-share basis.)
- Preferred stockholders have been paid $27,000 ($5.40 per share).
- Common stockholders have been paid $26,000 ($2.60 per share).
55-63 Basic EPS for 20X0 would be computed as follows.
Example 9: Participating Securities and the Two-Class Method
55-71 Participating
securities should be included in the computation of
basic earnings per share using the two-class method. The
following Cases illustrate the guidance in paragraphs
260-10-45-59A through 45-70 for the application of the
two-class method of computing basic earnings per share
when:
-
An entity has participating convertible preferred stock (Case A).
-
An entity has participating convertible bonds (Case B).
-
An entity has participating warrants (Case C).
-
An entity has participating share-based payment awards (Case D).
55-72 The application of the two-class method in each of Cases A, B, and C presents an EPS calculation for
both the common stock and the participating security. This presentation is for illustrative purposes only. The
presentation of EPS is only required for each class of common stock (as clarified by this Example). However, the
presentation of basic and diluted EPS for a participating security other than common stock is not precluded.
Cases A, B, and C share both of the following assumptions:
- 10,000 shares of Class A common stock
- Reported net income of $65,000 for 20X1.
Case A: Participating Convertible Preferred Stock
55-73 Assume that Entity A had 5,000 shares of preferred stock outstanding during 20X1. Each share of
preferred stock is convertible into two shares of Class A common stock. The preferred stock is entitled to a
noncumulative annual dividend of $5 per share. After Class A has been paid a dividend of $2 per share, the
preferred stock then participates in any additional dividends on a 40:60 per share ratio with Class A. For 20X1,
the Class A shareholders have been paid $26,000 (or $2.60 per share), and the preferred shareholders have
been paid $27,000 (or $5.40 per share). Basic EPS under the two-class method for 20X1 would be computed as
follows.
Case B: Participating Convertible Debt Instrument
55-74 Assume that on January 1, 20X1, Entity A issues 1,000 30-year convertible bonds with an aggregate par
value of $1,000,000. Each bond is convertible into 8 shares of Class A common stock and carries a coupon
rate of 3 percent. After Class A has been paid a dividend of $2 per share, the bondholders then participate
in any additional dividends on a 40:60 per share ratio with Class A shareholders. The bondholders receive
common stock dividends based on the number of shares of common stock that the bonds are convertible
into. The bondholders do not have any voting rights prior to conversion into common stock. For 20X1, the Class
A shareholders have been paid $20,000 (or $2.00 per share). Basic EPS under the two-class method for 20X1
would be computed as follows.
Case C: Participating Warrants
55-75 Assume that Entity A had warrants to purchase 5,000 shares of common stock outstanding during 20X1.
Each warrant entitles the holder to purchase 1 share of common stock at $10 (fair value at date of grant) per
share. In addition, the warrant holders receive dividends on the underlying common stock to the extent they
are declared. For 20X1, common shareholders have been paid $26,000 (or $2.60 per share), and the warrant
holders have been paid $13,000 (or, also, $2.60 per share). Basic EPS under the two-class method for 20X1
would be computed as follows:
Case D: Participating Share-Based Payment Awards
55-76A Assume that Entity A had 25,000 shares of common stock and 5,000 unvested share-based payment
awards outstanding during 20X8 and reported net income of $100,000. The share-based payment awards
participate in any dividends on a 1:1 per-share ratio with common stock, and the dividends are nonforfeitable
by the holder of the share-based payment awards. Entity A’s accounting policy is to estimate the number of
forfeitures expected to occur in accordance with paragraph 718-10-35-3.
55-76B As of the beginning of 20X8, Entity A estimated that the requisite service will not be provided for 200 of
the 5,000 share-based payment awards outstanding. At the end of 20X8, Entity A adjusts its estimate to reflect
an increased expected forfeiture rate and now expects that the requisite service will not be provided for 300
awards. It recognizes the cumulative effect of this change in compensation cost in the current period.
55-76C Entity A paid a $1.50 per-share dividend at the end of 20X8. Net income includes an expense of $450
related to dividends paid to the awards for which the requisite service is not expected to be rendered in
accordance with paragraph 718-10-55-45. Basic EPS under the two-class method for 20X8 would be computed
as follows:
55-76D Note that in this illustrative example, application of the two-class method presents an EPS calculation
for both the common stock and the participating security, that is, the unvested share-based payment awards.
This presentation is for illustrative purposes only. The presentation of EPS is only required for each class of
common stock. However, the presentation of basic and diluted EPS for a participating security other than
common stock is not precluded. The disclosure in the notes to financial statements of actual distributions
to unvested share-based payment awards, rather than the amount presented as distributed earnings,
also is not precluded to reconcile earnings per common share and per unvested share-based payment
awards. For example, Entity A in the example above may disclose that actual distributions to unvested share-based
payment awards were $7,500 and that $450 of those distributions was included in net income as
compensation cost related to awards for which the requisite service is not expected to be rendered. Disclosure
on a per-share basis also is not precluded.
Below are additional examples illustrating the application of the two-class method.
Example 5-14
Allocation of Undistributed Earnings to Entity With “Waterfall” Formula
Entity C’s capital structure consists entirely of 1 million shares of Class A common stock and 1 million shares
of Class B common stock. Each Class A and Class B share is entitled to one vote on any matter submitted to a
vote of shareholders. Entity C’s certificate of incorporation specifies that C will make annual distributions on the
basis of the following waterfall allocation:
- First, Class A receives $0.25 per share.
- Next, Class B receives $0.25 per share.
- Last, earnings are distributed 40:60 to Class A and Class B on a per-share basis.
During the year ended December 31, 20X1, C reports the following amounts of net income:
Entity C makes distributions annually in March from the prior year’s earnings. The total amount distributed
must be approved by a majority vote of the Class A and Class B shareholders. According to C’s shareholder
agreement, the total distribution will equal the prior year’s distributable cash less any reserves approved
for future expenditures. Such distributions are not approved until after the audited financial statements for
the prior year are issued. This example is not intended to address whether C should calculate an amount of
distributed earnings during the current year or how C should treat any current-year distributions of prior-year
earnings. To determine these matters, an entity would need to use judgment and consider the relevant facts
and circumstances related to distributions. In this example, it is first assumed that there are no distributed
earnings for the year. The example then addresses how the EPS amounts would change if the current-year
earnings were considered distributed earnings during the fourth quarter.
No Distributed Earnings
For the annual period, C would allocate earnings under the two-class method of calculating basic and diluted
EPS as follows (note that the results would be the same if the earnings for the year were distributed earnings
for the fourth quarter):
For the annual period, basic and diluted EPS for each class of common stock would be calculated as follows:
The calculation of basic and diluted EPS for each interim period during the year
depends on which method in Section 5.5.1.1 is
applied (i.e., because the distributions are determined
on the basis of a waterfall that depends on the annual
period, the two views discussed in Section 5.5.1.1 are
acceptable). The allocation of undistributed earnings
according to the two views is as follows:
View A — Discrete-Period Basis
Under the discrete-period approach, it is assumed that earnings for each interim period are distributed in
accordance with the contractual distribution rights of each class of common stock as if the waterfall distribution
applied to the earnings for the interim period. As a result, Class B only receives a distribution in an interim
period in which undistributed earnings exceed $250,000.
View B — Cumulative-Period Basis
Under the cumulative-period approach, it is assumed that earnings on an interim basis are distributed in
accordance with the contractual distribution rights of each class of common stock in a manner consistent with
the application of the waterfall distribution to annual earnings. As a result, the allocation of earnings in quarters
after the first quarter is based on the cumulative amounts that would be allocated on the basis of the year-to-date
earnings. The distributions are as follows:
- First quarter — All of the first-quarter earnings are allocated to the Class A common stock because it is entitled to the first $250,000 of distributions.
- Second quarter — All of the second-quarter earnings are allocated to the Class B common stock because it is entitled to the next $250,000 of distributions. Since there was only $200,000 of earnings during the second quarter, the next $50,000 of earnings is carried over for allocation to Class B.
- Third quarter — Class B is entitled to the first $50,000 of the earnings for the third quarter. The remaining $250,000 is allocated on a 40:60 basis to Class A and Class B, resulting in the allocation of $100,000 and $150,000 of the remaining earnings to Class A and Class B, respectively.
- Fourth quarter — The $250,000 is allocated on a 40:60 basis to Class A and Class B, resulting in the allocation of $100,000 and $150,000 of the earnings to Class A and Class B, respectively.
According to the two views, basic and diluted EPS for the interim periods is as follows:
Under View B, the aggregate interim-period EPS amounts equal the annual amounts. This may not always be
the case. Under View A, the aggregate interim-period EPS amounts would not be expected to equal the annual
amounts.
Distributed Earnings
If the current-year earnings were distributed earnings in the fourth quarter (i.e., C declared a distribution, or it
was concluded that $1 million was equal to distributable cash for the year for which distribution was required),
the interim-period EPS for the first three quarters would not change according to each view. The fourth-quarter
EPS amounts would be as follows:
View A — Discrete-Period Basis
The EPS amounts for each class depend on how the Class A and Class B shares absorb undistributed losses.
Assume that the proceeds on liquidation are allocated pari passu (50:50) to each class. The EPS amounts would
be as follows:
Assume that the proceeds on liquidation are allocated in accordance with the 40:60 allocation of residual
earnings under the waterfall distribution. The EPS amounts would be as follows:
View B — Cumulative-Period Basis
The EPS amounts for each class would be unchanged from the fourth-quarter amounts under View B when
there were no distributed earnings because the earnings allocation is based on an annual distribution
approach. The distributed and undistributed earnings components for the fourth quarter would be as follows:
Example 5-15
Application of Two-Class Method — Interim and
Year-to-Date Basis
Entity R, a real estate investment trust, is required to
distribute at least 90 percent of its taxable income.
Entity R has the following classes of equity securities outstanding:
- One million shares of common stock.
- One million shares of participating cumulative preferred stock.
The preferred stock ranks senior to the
common stock with respect to the rights to receive
dividends and to participate in distributions upon
liquidation. Dividends on the preferred stock are paid
monthly. Holders of preferred stock are entitled to
receive, in preference and before any payment of
dividends on common stock, a monthly dividend of $1.50
per share ($18.00 per share, per annum). After payment
of this amount, holders of preferred stock are entitled
to participate in dividends paid on common stock on an
as-converted basis. The preferred stock does not absorb
any undistributed losses. The preferred stock is
convertible into 500,000 shares of common stock.
Assume the following for the six months ended June 30,
20X9:
- First quarter ended March 31, 20X9:
- Entity R’s net income was $20 million.
- Entity R declared $18 million
of dividends, consisting of the following:
- $4.5 million on the preferred stock at the stated monthly rate (1,000,000 × $1.50 × 3).
- $4.5 million on the preferred stock (based on participation in dividends declared on common stock).
- $9 million on common stock.
- Second quarter ended June 30, 20X9:
- Entity R’s net income was $3 million.
- Entity R declared $4.5 million of dividends, consisting only of the dividends on the preferred stock at the stated monthly rate (1,000,000 × $1.50 × 3).
On the basis of the above facts, R
would report the following amounts of basic EPS for the
quarterly and year-to-date periods:
Example 5-16
Application of Two-Class Method When Distributions Exceed
Earnings
Entity A has 1 million weighted-average common shares outstanding for the fiscal year ended December
31, 20X1, and current-period net income of $2 million. On January 1, 20X1, A issues 100,000 convertible
preferred securities. Each preferred share is convertible into two shares of A’s common stock. The preferred
shareholders are entitled to a noncumulative annual dividend of $5 per share before any dividend is paid
to the common shareholders. After the common shareholders are paid a dividend of $2 per share, the
preferred shareholders participate in any remaining undistributed earnings on a 40:60 per-share basis with
the common shareholders. Accordingly, the preferred securities are participating securities for which A must
use the two-class method to calculate basic and diluted EPS. However, the contractual terms of the preferred
securities do not address whether they would participate in the entity’s losses. In fiscal year 20X1, A declared
and paid $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2 dividend for common
shareholders).
Undistributed losses should be calculated under the two-class method as follows:
Undistributed losses should be allocated as follows:
- To participating convertible preferred shares — Because the contractual terms of the preferred securities do not address whether the preferred shareholders would participate in the entity’s losses, the undistributed losses should be allocated only to the common shareholders.
- To common shares — ($500,000) ÷ 1,000,000 weighted-average common shares outstanding = ($0.50) per share.
Amounts of basic EPS would be as follows:
Example 5-17
Application of Two-Class Method When Distributions Exceed Earnings for Share-Based Payment
Awards
Entity B has 1 million weighted-average common shares outstanding for the fiscal year ended December 31,
20X1, and current-period net income of $1 million. On January 1, 20X1, A issues 250,000 nonvested share-based
payment awards to its employees. Holders of nonvested shares have a nonforfeitable right to receive
cash dividends on a 1:1 per-share basis with the common shareholders. Accordingly, the nonvested shares
are participating securities for which A must use the two-class method to calculate basic and diluted EPS.
The contractual terms of the nonvested shares do not address whether they would participate in the entity’s
losses. In fiscal year 20X1, A declares and pays $2.5 million in dividends for both the common shares and the
nonvested shares (or a $2 dividend for both the common shareholders and holders of the nonvested share-based
payment awards).
Undistributed losses should be calculated under the two-class method as follows:
Undistributed losses should be allocated as follows:
- To nonvested shares — Because the contractual terms of the nonvested shares do not address whether the holders of nonvested share-based payment awards would participate in the entity’s losses, the undistributed losses should be allocated only to the common shareholders.
- To common shares — ($1,500,000) ÷ 1,000,000 weighted-average common shares outstanding = ($1.50) per share.
Example 5-18
Participation Contingent on Stock Price
Entity B, which has a calendar year-end, has outstanding convertible preferred stock that entitles the holders to
participate in dividends on common stock on a one-for-one share-equivalent basis with common shareholders
at any time dividends are declared, provided that the fair value of B’s common stock exceeds $25 per share for
any three consecutive days during the period within the current fiscal year since dividends were last declared.
If the market price contingency is met (i.e., the fair value of B’s common stock exceeds $25 per share for any
three consecutive days in the reporting period), the two-class method should be applied to the convertible
preferred stock for the financial reporting period on the basis of an assumption that all earnings for the period
have been distributed (regardless of whether any dividends actually have been declared). This treatment is
consistent with how earnings would be allocated between the common stock and convertible preferred stock if
all earnings for the period were actually distributed.
Assume that during the first quarter ended March 31, 20X1, the fair value of B’s common stock did not exceed
$25 for any three-consecutive-day period, but that for the second quarter ended June 30, 20X1, the fair value
of B’s common stock did exceed $25 for a three-consecutive-day period. Further assume that B did not declare
or pay any dividends on common stock during the year. For B’s calculation of EPS for the first quarter ended
March 31, 20X1, no undistributed earnings should be allocated to the convertible preferred stock because
the market price contingency has not been met. For B’s calculation of EPS for the second quarter ended June
30, 20X1, undistributed earnings should be allocated to the convertible preferred stock because the market
price contingency has been met. Since the allocation of undistributed earnings on a year-to-date basis is
determined on an independent, or discrete, basis, as discussed in Section 5.5.1.1, B should also allocate all
the undistributed earnings for the year-to-date period to the convertible preferred stock in calculating EPS
for the six-month period ended June 30, 20X1. This allocation of undistributed earnings is consistent with the
contractual participation terms of the convertible preferred stock.
Note that while market price contingencies are generally assessed at the end of the reporting period in the
calculation of EPS, in this example, the market price contingency must be assessed over the reporting period
on the basis of the contractual participation terms of the convertible preferred stock.
Example 5-19
Allocation of Earnings to Participating Debt
Entity D has the following outstanding securities in its capital structure:
- 1 million common shares.
- $10 million principal amount of senior notes (the “notes”).
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.
During the quarter ended December 31, 201X, D earns $15 million of pretax income before recognition of
interest expense on the notes. Entity D accrues $62,500 of interest on the notes in accordance with the stated
interest rate on the notes and declares dividends of $1,000,000, which, in accordance with the participation
rights of the notes, is payable in an amount of $400,000 on the notes and $600,000 on the common shares.
Assume that D’s tax rate is 25 percent.
On the basis of the above facts, D would report net income for the period of $10,903,125.(a) Entity D would
calculate distributed and undistributed earnings as follows:
In accordance with the contractual participation rights of the notes, $4,121,250(b) of the undistributed earnings
should be allocated to the notes and $6,181,875(c) to the common shares. Total earnings attributable to the
common shares are $6,781,875,(d) resulting in earnings per common share of $6.78.(e)
Note that in D’s application of the two-class method of calculating EPS, the $400,000 of distributed earnings to
the holders of the notes, based on the contractual right of the noteholders to participate in dividends declared
during the period, should not be reduced from the numerator (i.e., net income) because this amount has been
treated as interest cost and has reduced net income. Income available to common stockholders (net income in
this example) should be reduced only for undistributed earnings attributable to the noteholders because any
reflection of $400,000 as distributed earnings would result in “double-counting” the impact of this participation
in the calculation of EPS.
____________________
(a) $15,000,000 – $62,500 – $400,000 = $14,537,500 × 75% = $10,903,125. (Note
that the $400,000 in dividend equivalents paid on the
notes must be accounted for as interest expense since
the notes are classified as a liability.)
(b) $10,303,125 × 0.4 = $4,121,250.
(c) $10,303,125 × 0.6 = $6,181,875.
(d) $600,000 + $6,181,875 = $6,781,875.
(e) $6,781,875 ÷ 1,000,000 = $6.78.
Example 5-20
Allocation of Earnings to Participating Noncumulative Preferred Stock
Entity E has the following outstanding securities in its capital structure:
- One million common shares.
- 500,000 shares of Series A convertible preferred stock (the “preferred stock”).
The preferred stock is convertible into common stock on a 1:1 basis. Each holder of preferred stock is entitled
to receive noncumulative preferred dividends of $0.08 per share. After payment of the $0.08 noncumulative
dividend, any additional dividends are distributed between the common shareholders and preferred
stockholders (on an as-converted basis) on a 1:1 basis. Entity E has not declared any dividends, and does not
intend to pay or declare any dividends in the future, on any class of stock. For the year ended December 31,
20X1, E had net income of $5 million.
On the basis of the above facts, the preferred stock is a participating security. Accordingly, E is required to
calculate basic and diluted EPS under the two-class method. In applying the two-class method, E would first
determine the amount of noncumulative dividends that would be allocated to the preferred stock (i.e., $0.08
per share or $40,000). Any remaining earnings would be allocated to the common stock and preferred stock
(on an as-converted basis) on a 1:1 basis. On an as-converted basis, 500,000 shares of common stock would
be issued for the preferred stock. Compared with the 1 million outstanding common shares, the holders of the
preferred stock would be entitled to one-third of the undistributed earnings, or $1,653,333.(a) Total distributed
and undistributed earnings allocated to the preferred stock are $1,693,333,(b) as a result of which the common
shareholders would receive total earnings of $3,306,667(c) and basic EPS would be $3.31.(d)
____________________
(a) $5,000,000 – $40,000 = $4,960,000 × 1/3 = $1,653,333.
(b) $40,000 + $1,653,333 = $1,693,333.
(c) $5,000,000 – $40,000 = $4,960,000 × 2/3 = $3,306,667.
(d) $3,306,667 ÷ 1,000,000 = $3.31.
Example 5-21
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible
Preferred Stock
Assume that Entity A has 1 million weighted-average common shares outstanding for the fiscal year ended
December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, A issues 100,000 convertible preferred securities. Each preferred share is convertible into
two shares of A’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend
of $5 per share before any dividend is paid to the common shareholders. After the common shareholders
are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed
earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are
participating securities for which A must use the two-class method to calculate basic and diluted EPS. In fiscal
year 20X1, A declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2
dividend for common shareholders).
The calculations under the two-class method are as follows:
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Since there are no potential common shares other than the participating convertible preferred shares,
antidilution sequencing is not required.
Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Because A’s capital structure only includes common shares and participating convertible preferred shares (i.e.,
there are no other potential common shares), basic and diluted EPS under the two-class method would be the
same ($4.34).
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, A would disclose an amount of diluted EPS per common share that would result from applying
the if-converted method ($4.17) because that amount is more dilutive than the amount that would result from
applying the two-class method ($4.34). In accordance with ASC 260-10-45-60, A would be permitted, but not
required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the
income statement. For more information, see Section 9.1.4.
Example 5-22
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Convertible
Preferred Stock With Convertible Debt and Warrants
Assume that Entity B has 1 million weighted-average common shares stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, B issues 100,000 convertible preferred securities. Each preferred share is convertible into
two shares of B’s common stock. The preferred shareholders are entitled to a noncumulative annual dividend
of $5 per share before any dividend is paid to the common shareholders. After the common shareholders
are paid a dividend of $2 per share, the preferred shareholders participate in any remaining undistributed
earnings on a 40:60 per-share basis with the common shareholders. Accordingly, the preferred securities are
participating securities for which B must use the two-class method to calculate basic and diluted EPS. In fiscal
year 20X1, B declares and pays $2.5 million in dividends (or a $5 dividend for preferred shareholders and a $2
dividend for common shareholders).
In addition, assume the following:
- On January 1, 20X1, B issues warrants to purchase 100,000 shares of its common stock at $50 per share for a period of five years. The average market price of B’s stock price for 20X1 is $60 per share. The warrants do not meet the definition of a participating security.
- On January 1, 20X1, B issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of B’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.
The calculations under the two-class method are as follows:
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
This calculation is the same as the calculation of basic EPS in Example
5-21, because basic EPS is not affected
by the warrants and convertible debt since neither
security is a participating security.
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Calculation of diluted EPS for the common shares in which the use of the if-converted method for the participating
convertible preferred shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, B would disclose an amount of diluted EPS per common share that would result from applying
the if-converted method ($3.81) because that amount is more dilutive than the amount that would result from
applying the two-class method ($3.92). In accordance with ASC 260-10-45-60, B would be permitted, but not
required, to present basic and diluted EPS for the participating convertible preferred shares on the face of the
income statement. See further discussion in Section 9.1.4.
Example 5-23
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards
Assume that Entity C has 1 million weighted-average shares of common stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, C issues 250,000 nonvested share-based payment awards to its employees. The nonvested
shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year
of service (i.e., cliff vesting). The average market price of C’s stock price for 20X1 is $60 per share. Holders
of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the
common shareholders. Accordingly, the nonvested shares are participating securities for which C must use the
two-class method in calculating basic and diluted EPS. In fiscal year 20X1, C declares and pays $2.5 million in
dividends for both the common shares and the nonvested shares.
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Because there are no potential common shares other than the participating nonvested shares, antidilution
sequencing is not required.
Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the
participating nonvested shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Because C’s capital structure only includes common shares and the participating nonvested shares (i.e., there
are no other potential common shares), basic and diluted EPS under the two-class method would be the same
($4.00).
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, C would disclose an amount of diluted EPS per common share that would result from applying
the two-class method ($4.00) because that amount is more dilutive than the amount that would result from
applying the treasury stock method ($4.68). In accordance with ASC 260-10-45-60, C would be permitted, but
not required, to present basic and diluted EPS for the participating nonvested shares on the face of the income
statement. See further discussion in Section 9.1.4.
Example 5-24
Use of the Two-Class Method to Calculate Basic and Diluted EPS — Participating Nonvested Share-Based Payment Awards With Convertible Debt and Warrants
Assume that Entity D has 1 million weighted-average shares of common stock outstanding for the fiscal year
ended December 31, 20X1; a current-period net income of $5 million; and an effective tax rate of 40 percent.
On January 1, 20X1, D issues 250,000 nonvested share-based payment awards to its employees. The nonvested
shares have a grant-date fair-value-based measure of $50 per share and vest at the end of the fourth year
of service (i.e., cliff vesting). The average market price of D’s stock price for 20X1 is $60 per share. Holders
of nonvested shares have a nonforfeitable right to receive cash dividends on a 1:1 per-share basis with the
common shareholders. Accordingly, the nonvested shares are participating securities for which D must use the
two-class method in calculating basic and diluted EPS. In fiscal year 20X1, D declares and pays $2.5 million in
dividends for both the common shares and the nonvested shares.
In addition, assume the following:
- On January 1, 20X1, D issues warrants to purchase 100,000 shares of its common stock at $40 per share for a period of five years. The warrants do not meet the definition of a participating security.
- On January 1, 20X1, D issues 10,000 units of convertible bonds with an aggregate par value of $1 million. Each bond is convertible into 10 shares of D’s common stock and bears an interest rate of 3 percent. The convertible bonds do not meet the definition of a participating security.
Step 1 — Use the two-class method to calculate basic EPS.
Amounts of basic EPS:
Note that this calculation is the same as the calculation of basic EPS in
Example 5-23, because basic EPS is not
affected by the warrants and convertible debt since
neither security is a participating security.
Step 2 — Calculate diluted EPS.
Step 2a — Use the treasury stock method, the if-converted method, or the contingently issuable share
method to determine diluted EPS.
Determine the antidilution sequencing:
Calculation of diluted EPS for the common shares in which the use of the treasury stock method for the participating
nonvested shares is assumed:
Step 2b — Use the two-class method to determine diluted EPS.
Step 3 — Determine which step — 2a or 2b — results in the more dilutive effect.
In this example, D would use the two-class method to disclose diluted EPS per common share ($3.58) because
that amount is more dilutive than the amount that would result from applying the if-converted method ($4.18).
In accordance with ASC 260-10-45-60, D would be permitted, but not required, to present basic and diluted
EPS for the participating nonvested shares on the face of the income statement. See further discussion in
Section 9.1.4.
Footnotes
5
The allocation of undistributed losses is consistent
with the guidance in the MLP subsections of ASC 260 that addresses
the application of the two-class method to MLPs when distributions
exceed earnings. See further discussion in Section
8.9.3.
6
In this table, it is assumed
that the income or loss amounts are after the
allocation of any distributed earnings.
7
It would be highly unusual for securities that
participate only upon the occurrence of contingent events to
participate in losses.
8
If a security participates only in objectively
determinable and nondiscretionary dividends that meet the definition
of an extraordinary dividend, the amount of undistributed earnings
that would be assumed to be distributed will affect whether the
distribution of those earnings would qualify as an extraordinary
dividend.
9
Section 3.2.2
contains detailed discussion of what constitutes
dividends on preferred stock in the calculation of
income available to common stockholders. As
discussed in that section, dividends on preferred
stock include the accretion of dividends on
increasing-rate preferred stock, measurement
adjustments to reflect redeemable preferred stock at
its redemption amount under ASC 480-10-S99-3A, the
recognition of a down-round feature, and other
“deemed dividends” or “deemed contributions.”
Dividends on preferred stock that are treated as an
adjustment to net income to arrive at income
available to common stockholders represent
distributed earnings under the two-class method of
calculating EPS.
10
The entity-wide policy election related to the
treatment of forfeitures for employee awards can be made
separately from that for nonemployee awards.
11
All nonforfeitable dividends on share-based
payment awards that are classified as liabilities are recognized
in compensation expense.
12
The portion expected to vest
will be based on the revised estimated forfeitures
applicable to the current-period dividends. Thus,
distributed earnings for the period will equal the
amount of current-period dividends on unvested
participating share-based payment awards that are
recognized in retained earnings.
13
As discussed in Section 3.2.4.3.1, the
accounting for the common shares as being effectively retired is
an exception to the general requirement that outstanding common
shares must be included in the denominator for both basic and
diluted EPS.
14
If one class of common stock is redeemable at the
option of the holder, the entity should consider the terms of the
redemption and the application of the guidance in ASC 480-10-S99-3A
in the determination of how to allocate undistributed losses.