7.1 Share-Based Payment Awards | DART – Deloitte Accounting Research Tool

7.1.1 Basic EPS

During the requisite service period or nonemployee’s vesting period, share-based payment awards do not affect the calculation of basic EPS (other than the effect of the cost as a reduction of income available to common stockholders) unless the awards are participating securities. An entity must apply the two-class method when calculating basic and diluted EPS for such awards (see Section 7.1.3).

Once the good has been delivered, the service has been rendered, or the customer has purchased goods or services from the entity, vested awards that are considered outstanding common shares affect the denominator in the calculation of basic EPS. That is, such awards will be included in the weighted-average number of common shares from the date on which they become vested outstanding common shares. If the awards do not become outstanding common shares during the period and are not considered participating securities, they generally are not included in the calculation of basic EPS. However, contingently issuable shares should be included in the denominator of basic EPS when there are no circumstances in which those shares would not be issued (see Section 3.3.2.5 for more information).

Connecting the Dots

Employee awards of shares that vest when the grantee becomes eligible for retirement must be considered outstanding shares in the denominator of basic EPS as of the date on which the grantee is eligible to retire and retain the shares. This is because, once the employee is eligible to retire, there are no conditions that must be met for the common stock to be issued. Such shares are not considered contingently issuable shares since an agreement that requires an entity to issue common shares only after the mere passage of time is not considered a contingently issuable share arrangement. In other words, no remaining service period is associated with the issuance of the shares since the holder can retire at any time and receive the shares.

Share-based payment awards often contain clawback features. ASC 718-10-30-24, ASC 718-20-35-2, and ASC 718-10-55-8 address the impact of clawback features.

30-24 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall not be reflected in estimating the grant-date fair value of an equity instrument.

35-2 A contingent feature of an award that might cause a grantee to return to the entity either equity instruments earned or realized gains from the sale of equity instruments earned for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature (see paragraph 718-10-55-8), shall be accounted for if and when the contingent event occurs. Example 10 (see paragraph 718-20-55-84) provides an illustration of an employee award with a clawback feature.

55-8 Reload features and contingent features that require a grantee to transfer equity shares earned, or realized gains from the sale of equity instruments earned, to the issuing entity for consideration that is less than fair value on the date of transfer (including no consideration), such as a clawback feature, shall not be reflected in the grant-date fair value of an equity award. Those features are accounted for if and when a reload grant or contingent event occurs. A clawback feature can take various forms but often functions as a noncompete mechanism. For example, an employee that terminates the employment relationship and begins to work for a competitor is required to transfer to the issuing entity (former employer) equity shares granted and earned in a share-based payment transaction.

Clawback features, as contemplated in ASC 718, are protective provisions that require or permit the recovery of value transferred to award holders who violate certain conditions. Examples include the violation of a noncompete or nonsolicitation agreement, termination of employment for cause (e.g., because of fraud or noncompliance with company policies), and material restatements of financial statements. ASC 718 requires that the effect of a clawback feature be accounted for only when the contingent event that triggers the clawback occurs. In a manner consistent with this guidance, vested common shares issued in a share-based payment should be considered outstanding shares in the calculation of basic EPS from the date vesting is complete. It would not be appropriate to exclude such common shares from the denominator of the calculation of basic EPS on the basis of the guidance in ASC 260 on contingently issuable (returnable) shares. This conclusion is consistent with paragraph 92 of the Background Information and Basis for Conclusions of Statement 128, which indicates that vested shares for which the consideration has been received should be included in the calculation of basic EPS. It is also consistent with informal discussions with the FASB staff.

7.1.2 Diluted EPS

While share-based payment awards generally do not affect the calculation of basic EPS (other than the effect of the cost as a reduction of income available to common stockholders) during the requisite service period or nonemployee’s vesting period (unless the award is a participating security), an entity generally includes them in the denominator when calculating diluted EPS if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260 (see Section 4.1.2 for more information). Further, awards (e.g., stock options or warrants) that do not become outstanding common shares when the good is delivered or the service is rendered, and that are not considered participating securities, are not included in the calculation of basic EPS but may be included in the denominator of diluted EPS before they are settled (e.g., are exercised, are canceled, or expire).

An entity may change the terms or conditions of a share-based payment award. ASC 718-20-35-3 states, in part, that “[e]xcept as described in [ASC] 718-20-35-2A, a modification of the terms or conditions of an equity award shall be treated as an exchange of the original award for a new award.” ASC 718-30-35-5 contains similar guidance for liability-classified awards and states, in part, that “[a] modification of a liability award is accounted for as the exchange of the original award for a new award.” In accordance with this guidance, a modification of a share-based payment award that is not subject to the exception in ASC 718-20-35-2A is treated as a cancellation of the existing award and the issuance of a new award. In a manner consistent with the guidance in ASC 718, an entity should treat the original and modified awards as two separate awards in calculating diluted EPS. Thus, when the treasury stock method applies to a modified share-based payment award, an entity would perform the following two treasury stock method calculations:

Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period before the modification (weighted, as appropriate, for the period).
Calculations based on the terms of the award and the average market price of the entity’s common stock for the period during the financial reporting period after the modification (weighted, as appropriate, for the period).

The sum of these two calculations will equal the incremental common shares that are included in the calculation of diluted EPS for the period.

ASC 718-20-35-2A addresses situations in which an entity modifies a share-based payment award but is not required to apply modification accounting. Entities will need to consider the specific facts and circumstances associated with such types of modifications to determine whether they should be treated as a single award or two separate awards in the calculation of diluted EPS in the period that includes the change to the terms or conditions of the award.

7.1.2.1 Treasury Stock Method

Section 4.2 addresses the application of the treasury stock method of calculating diluted EPS. An entity generally includes the dilutive effect of share-based payment awards (e.g., restricted stock, stock options) in the denominator of the calculation of diluted EPS by applying the treasury stock method, under which it is assumed that any service condition will be met. When applying the treasury stock method to a stock option, the entity assumes that two hypothetical transactions have occurred. The first is the hypothetical exercise of the award (or, for a restricted stock award, the hypothetical vesting of the award); the second is the hypothetical repurchase of shares at the average market price during the period by using the assumed proceeds that will be generated from the hypothetical exercise of the award (or, for a restricted stock award, the hypothetical vesting of the award). The incremental shares that would be hypothetically issued are the number of shares assumed to be issued upon exercise of the award (or, for a restricted stock award, the vesting of the award) in excess of the number of shares assumed to be repurchased with the assumed proceeds. The incremental shares are included in the number of diluted potential common shares as a component of the denominator in the calculation of diluted EPS.

While the treasury stock method applies to both vested and unvested stock options, as discussed in Section 4.2.2.1, it is used for such awards only when the average market price of the entity’s common stock during the period exceeds the exercise price of the awards (i.e., the award is in the money) on an award-by-award basis. Thus, an entity needs to perform a separate treasury stock method calculation for each individual in-the-money award. An entity may perform the same calculation for awards that are granted to employees on the same day with the same terms and conditions (the awards would presumably have the same grant-date fair-value-based measure). Out-of-the-money awards are considered antidilutive and excluded from the denominator in the calculation of diluted EPS. The determination of whether an award is in-the-money or out-of-the-money is made on an individual award basis. See Section 4.2 for further discussion of the application of the treasury stock method.

7.1.2.1.1 Assumed Proceeds

ASC 260-10-45-29 and 45-29A discuss the proceeds that are assumed under the treasury stock method. When determining the amount of assumed proceeds that a share-based payment award will generate, an entity aggregates (1) the exercise price of the award, if any, and (2) the average amount of cost attributed to share-based payment awards not yet recognized.1 Because there is no exercise price for restricted stock awards, the entity includes in the assumed proceeds only the average amount of cost not yet recognized.

7.1.2.1.2 Period Outstanding

An entity must consider the amount of time a share-based payment award was outstanding during the reporting period. If an award was outstanding for the entire reporting period, the incremental shares determined under the treasury stock method are included in the calculation of diluted EPS for the entire reporting period. By contrast, if an award was issued, exercised (or, for a restricted stock award, becomes vested), or forfeited during the reporting period, the incremental shares are included only for the period in which the award was outstanding when the treasury stock method is applied. Once the award is exercised (or, for a restricted stock award, becomes vested), the shares issued are considered outstanding common shares and are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculations of basic and diluted EPS). See further discussion in Section 4.2.2.1.3.1.

7.1.2.1.3 Quarter-to-Date Versus Year-to-Date Calculations

When applying the treasury stock method to a quarterly period, an entity should use the average market price for the period to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS. That is, the entity computes the number of incremental shares for the quarterly period as though that period is a discrete period. By contrast, in accordance with ASC 260-10-55-3, in the denominator of the calculation of diluted EPS for the year-to-date period, an entity includes a weighted-average number of incremental shares for each of the quarterly periods. The average market price for the year-to-date period is not used as though the year-to-date period was a separate discrete period. Example 1 in ASC 260-10-55-38 through 55-50 (excerpted in Section 4.10) and Example 12 in ASC 260-10-55-85 through 55-87 (excerpted in Section 4.9.1.1) illustrate quarter-to-date and year-to-date EPS calculations. See Section 4.9.1 for further discussion of the calculation of year-to-date EPS under the treasury stock method.

7.1.2.1.4 Forfeitures

ASC 718 allows an entity to make an entity-wide accounting policy election to either (1) estimate the number of awards that are expected to vest or (2) account for forfeitures when they occur. The entity’s election will affect the amount of compensation cost included in income available to common stockholders (the numerator in the calculation of diluted EPS). However, regardless of the entity’s policy election, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive. Once an entity has determined the number of outstanding awards that will have a dilutive effect on the calculation of diluted EPS, the entity uses the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS.

For example, an entity that elects to estimate forfeitures may determine that only 90 percent of the share-based payment awards issued to grantees are expected to eventually vest even though none have actually been forfeited yet. Accordingly, only 90 percent of the awards’ fair-value-based measure is recognized as compensation cost over the requisite service period or nonemployee’s vesting period. However, when determining the number of incremental shares to include in the denominator of the calculation of diluted EPS, an entity must assume that all outstanding dilutive awards that contain only a service condition will vest or become exercisable. Therefore, when calculating diluted EPS, the entity must (1) determine the number of all outstanding awards that are dilutive and (2) apply the treasury stock method.

When the treasury stock method is applied, the assumed proceeds are also calculated on the basis of the actual number of all outstanding dilutive awards regardless of the entity’s forfeiture policy election or whether certain of those awards are not expected to eventually vest. The amount of average unrecognized cost is therefore based on the total number of outstanding dilutive awards at the beginning of the period and at the end of the period.

7.1.2.1.5 Treasury Stock Method Examples

The following examples illustrate the application of the treasury stock method to share-based payment awards in the calculation of diluted EPS:

ASC 260-10

Example 8: Application of the Treasury Stock Method to a Share-Based Payment Arrangement

55-68 This Example illustrates the guidance in paragraph 260-10-45-28A for the application of the treasury stock method when share options are forfeited.

55-69 Entity A adopted a share option plan on January 1, 20X7, and granted 900,000 at-the-money share options with an exercise price of $30. All share options vest at the end of three years (cliff vesting). Entity A’s accounting policy is to estimate the number of forfeitures expected to occur in accordance with paragraph 718-10-35-1D or 718-10-35-3. At the grant date, Entity A assumes an annual forfeiture rate of 3 percent and therefore expects to receive the service for 821,406 [900,000 × (.97 to the third power)] share options. On January 1, 20X7, the fair value of each share option granted is $14.69. Grantees forfeited 15,000 stock options ratably during 20X7.

55-69A The average stock price during 20X7 is $44. Net income for the period is $97,385,602. For the year ended December 31, 20X7, there are 25,000,000 weighted-average common shares outstanding. This guidance also applies if the service inception date precedes the grant date.

55-70 The following table illustrates computation of basic and diluted EPS for the year ended December 31, 20X7.

Example 7-1

Employee Stock Options — No Exercises or Forfeitures During the Period

Assume the following:

Entity A has net income of $5 million, as well as 1 million common shares outstanding, for the year ended December 31, 20X2.
As of December 31, 20X2, A also has 100,000 employee stock options outstanding. All the stock options were granted on January 1, 20X1, and vest solely on the basis of a two-year service condition. On December 31, 20X1, 50,000 stock options vested. The remaining 50,000 stock options vest on December 31, 20X2. All options are still outstanding on December 31, 20X2 (i.e., none have been exercised).
All the stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
Entity A recognizes compensation cost for these stock options on a straight-line basis over the service period from January 1, 20X1, to December 31, 20X2.
The average market price of A’s common stock for the year ended December 31, 20X2, was $15 per share.

Entity A calculates diluted EPS for the year ended December 31, 20X2, as follows:

The above calculation of diluted EPS is simplified since it is presented annually without consideration of diluted EPS amounts reported in A’s interim financial statements. ASC 260-10-55-3 states, in part, “For year-to-date diluted EPS, the number of incremental shares to be included in the denominator shall be determined by computing a year-to-date weighted average of the number of incremental shares included in each quarterly diluted EPS computation.” Therefore, in an actual calculation of year-to-date diluted EPS, an entity must include the weighted-average incremental shares on the basis of the amounts calculated for interim periods (i.e., quarterly financial reporting periods). For example, assume that when applying the treasury stock method, A determined that it must include 10,000 and 15,000 incremental shares in the denominator of the calculation of diluted EPS for its first and second quarter, respectively. When calculating the number of incremental shares to include in the denominator for the year-to-date six-month period, A would assign equal weight to the 10,000 and 15,000 incremental shares. Therefore, 12,500 incremental shares [(10,000 + 15,000) ÷ 2] are included in the denominator of the calculation of diluted EPS for the year-to-date six-month period. See Sections 4.9.1 and 4.9.6 for more information.

The example below illustrates the application of the treasury stock method to stock option awards when a portion of the awards was exercised during the period. Once the awards are exercised, the shares issued are considered outstanding common shares and are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

Example 7-2

Employee Stock Options — Exercises During the Period

Assume the same facts as in the example above, except that the 50,000 employee stock options that vested on December 31, 20X1, were exercised on June 30, 20X2.

Entity A calculates diluted EPS as follows:

As noted in Example 7-1, the above calculation of diluted EPS is a simplified annual computation that does not take into account interim calculations of diluted EPS as required by ASC 260-10-55-3. The above calculation is further simplified because of how exercises during the period are factored into the calculation. In the above example, the “weighting” effect on incremental common shares for stock options exercised during the period is factored into the calculation by weighting the number of stock options outstanding during the entire period (i.e., one treasury stock method calculation is performed to calculate the diluted impact of all stock options). A more precise way to factor in stock options exercised during the period is to perform two calculations under the treasury stock method — one for stock options that were outstanding for the entire period and one for stock options that were exercised during the period. Under this approach, the “weighting” effect on incremental common shares for stock options exercised during the period is captured by multiplying the incremental common shares by a factor (i.e., percentage) that is determined on the basis of the period during which the options were outstanding. See Example 4-2 for an illustration of this method.

While the more precise calculation may yield results that do not differ from those under the simplified approach, an entity should consider its specific facts and circumstances in determining when a simplified approach is appropriate. In some circumstances, a simplified approach could result in exclusion of the dilutive effect of awards that were not outstanding during the entire period because of a difference between the average stock price during the entire reporting period and the average stock price during the period in which the awards were outstanding.

The example below illustrates the application of the treasury stock method to stock option awards when there is a forfeiture during the period.

Example 7-3

Employee Stock Options — Forfeitures During the Period

Assume the following:

Entity A has net income of $1 million for the quarter ended March 31, 20X1, as well as 100,000 common shares outstanding for the entire period from January 1, 20X1, to March 31, 20X1.
On January 1, 20X1, A granted 10,000 employee stock options to 10 employees (1,000 stock options each).
All the stock options have an exercise price of $5 per option and a grant-date fair-value-based measure of $1 per option, and they cliff vest after two years of service.
The average market price of A’s common stock for the three-month period ended March 31, 20X1, was $6.50 per share.
Entity A has a policy of estimating forfeitures, and it estimates that 8,000 of the stock options will eventually vest. It therefore has accrued compensation cost on the basis of this forfeiture estimate.
On February 1, 20X1, an employee terminates and forfeits 1,000 stock options.

Entity A calculates the number of incremental shares to include in the denominator of the calculation of diluted EPS under the treasury stock method, as well as diluted EPS (for the three-month period ended March 31, 20X1), as follows:

Note that A must base the calculation of diluted EPS on the actual number of awards outstanding (i.e., actual forfeitures) in a given reporting period rather than on its estimate of the number of awards expected to forfeit. In addition, note that the above calculation is simplified because of how forfeitures during the period are factored into the calculation. In the above example, the “weighting” effect on incremental common shares for stock options forfeited during the period is factored into the calculation by weighting the number of stock options outstanding during the entire period (i.e., one treasury stock method calculation is performed to calculate the diluted impact of all stock options). A more precise way to factor in stock options forfeited during the period is to perform two calculations under the treasury stock method — one for stock options that were outstanding for the entire period and one for stock options that were forfeited during the period. Under this approach, the “weighting” effect on incremental common shares for stock options forfeited during the period is captured by multiplying the incremental common shares by a factor (i.e., percentage) that is determined on the basis of the period during which the options were outstanding. See Example 4-2 for an illustration of this method.

While the more precise calculation may yield results that do not differ significantly from those under the simplified approach, an entity should consider its specific facts and circumstances in determining when a simplified approach is appropriate. In some circumstances, a simplified approach could result in exclusion of the dilutive effect of awards that were not outstanding during the entire period because of a difference between the average stock price during the entire reporting period and the average stock price during the period in which the awards were outstanding.

7.1.2.2 Service Conditions

ASC 260-10

Treatment of Contingently Issuable Shares in Weighted-Average Shares Outstanding

45-13 Shares issuable for little or no cash consideration upon the satisfaction of certain conditions (contingently issuable shares) shall be considered outstanding common shares and included in the computation of basic EPS as of the date that all necessary conditions have been satisfied (in essence, when issuance of the shares is no longer contingent). Outstanding common shares that are contingently returnable (that is, subject to recall) shall be treated in the same manner as contingently issuable shares. Thus, contingently issuable shares include shares that meet any of the following criteria:

They will be issued in the future upon the satisfaction of specified conditions.
They have been placed in escrow and all or part must be returned if specified conditions are not met.
They have been issued but the holder must return all or part if specified conditions are not met.

Share-Based Payment Arrangements

45-32 Fixed grantee stock options (fixed awards) and nonvested stock (including restricted stock) shall be included in the computation of diluted EPS based on the provisions for options and warrants in paragraphs 260-10-45-22 through 45-27. Even though their issuance may be contingent upon vesting, they shall not be considered to be contingently issuable shares (see Section 815-15-55 and paragraph 260-10-45-48). However, because issuance of performance-based stock options (and performance-based nonvested stock) is contingent upon satisfying conditions in addition to the mere passage of time, those options and nonvested stock shall be considered to be contingently issuable shares in the computation of diluted EPS. A distinction shall be made only between time-related contingencies and contingencies requiring specific achievement.

Generally, an entity will use the treasury stock method to determine the number of common shares related to share-based payment awards with only a service condition (i.e., no performance or market condition) to include in the denominator of the calculation of diluted EPS provided that the awards are dilutive. (See Section 7.1.2.1.5 for examples illustrating the application of the treasury stock method to share-based payment awards.)

A restricted stock award is not included in the denominator of the calculation of basic EPS during the award’s requisite service period or before the nonemployee award has vested, even if the shares of stock have been legally issued. Such shares are considered contingently returnable shares, as described in ASC 260-10-45-13. For example, if the grantee does not deliver the good or render the service, the shares are returned to the entity. Once the vesting conditions have been satisfied, the shares are considered outstanding common shares and therefore are included in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

In addition, an unexercised stock option award is not included in the denominator of the calculation of basic EPS even if the award is vested. That is, even if an award’s vesting conditions have been satisfied, an unexercised stock option (containing an exercise price that is not nominal) is not an outstanding common share until it is exercised.

However, an award that contains a right to nonforfeitable dividends or dividend equivalents that participate in undistributed earnings with common stock is a participating security even before the award’s vesting conditions have been satisfied (i.e., during the vesting period). Therefore, the issuer is required to apply the two-class method discussed in Section 7.1.3 when calculating basic and diluted EPS. When calculating diluted EPS for unvested awards that are considered participating securities, an entity must determine which is more dilutive to apply, the treasury stock method or the two-class method. See Section 5.5.4 for more information.

In the calculation of diluted EPS, unvested awards and unexercised stock option awards that vest solely on the basis of a service condition are included in the denominator of the calculation of diluted EPS during their requisite service period (or before the nonemployee award has vested) or during the period the options are unexercised under the treasury stock method.

7.1.2.3 Performance and Market Conditions

ASC 260-10

Share-Based Payment Arrangements

45-31 Awards with a market condition, a performance condition, or any combination thereof (as defined in Topic 718) shall be included in diluted EPS pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-57.

45-32 Fixed grantee stock options (fixed awards) and nonvested stock (including restricted stock) shall be included in the computation of diluted EPS based on the provisions for options and warrants in paragraphs 260-10-45-22 through 45-27. Even though their issuance may be contingent upon vesting, they shall not be considered to be contingently issuable shares (see Section 815-15-55 and paragraph 260-10-45-48). However, because issuance of performance-based stock options (and performance-based nonvested stock) is contingent upon satisfying conditions in addition to the mere passage of time, those options and nonvested stock shall be considered to be contingently issuable shares in the computation of diluted EPS. A distinction shall be made only between time-related contingencies and contingencies requiring specific achievement.

Contingently Issuable Shares

45-48 Shares whose issuance is contingent upon the satisfaction of certain conditions shall be considered outstanding and included in the computation of diluted EPS as follows:

If all necessary conditions have been satisfied by the end of the period (the events have occurred), those shares shall be included as of the beginning of the period in which the conditions were satisfied (or as of the date of the contingent stock agreement, if later).
If all necessary conditions have not been satisfied by the end of the period, the number of contingently issuable shares included in diluted EPS shall be based on the number of shares, if any, that would be issuable if the end of the reporting period were the end of the contingency period (for example, the number of shares that would be issuable based on current period earnings or period-end market price) and if the result would be dilutive. Those contingently issuable shares shall be included in the denominator of diluted EPS as of the beginning of the period (or as of the date of the contingent stock agreement, if later).

45-49 For year-to-date computations, contingent shares shall be included on a weighted-average basis. That is, contingent shares shall be weighted for the interim periods in which they were included in the computation of diluted EPS.

45-50 Paragraphs 260-10-45-51 through 45-54 provide general guidelines that shall be applied in determining the EPS impact of different types of contingencies that may be included in contingent stock agreements.

45-55 Contingently issuable potential common shares (other than those covered by a contingent stock agreement, such as contingently issuable convertible securities) shall be included in diluted EPS as follows:

An entity shall determine whether the potential common shares may be assumed to be issuable based on the conditions specified for their issuance pursuant to the contingent share provisions in paragraphs 260-10-45-48 through 45-54.
If those potential common shares should be reflected in diluted EPS, an entity shall determine their impact on the computation of diluted EPS by following the provisions for options and warrants in paragraphs 260-10-45-22 through 45-37, the provisions for convertible securities in paragraphs 260-10-45-40 through 45-42, and the provisions for contracts that may be settled in stock or cash in paragraph 260-10-45-45, as appropriate.

For share-based payment awards with a performance or market condition, an entity must first apply the guidance on contingently issuable shares in ASC 260-10-45-48 through 45-55 to determine whether the awards should be included in the calculation of diluted EPS for the reporting period. That is, the entity needs to determine the number of awards, if any, that would be issuable at the end of the reporting period if the end of the reporting period were the end of the contingency period. Once the entity has determined that a stock or stock option award should be included in the calculation of diluted EPS for the reporting period, the entity must use the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS.

An entity may be recording compensation cost for an award that only contains a performance or market condition because the entity believes that it is probable that the award will vest (performance condition) or, for example, that the employee will remain employed for the derived service period (market condition). However, in such cases, the related incremental shares would be included in the denominator of the calculation of diluted EPS only if the performance or market condition (i.e., the contingency) has been met as of the end of that particular reporting period, under an assumption that the end of the reporting period is the end of the contingency period.

See Section 4.5 for further discussion of the contingently issuable share method. Section 4.9.4 includes discussion of application of the contingently issuable share method in the calculation of year-to-date diluted EPS.

7.1.2.3.1 Performance-Based Awards

ASC 260-10

Contingently Issuable Shares

45-51 If attainment or maintenance of a specified amount of earnings is the condition and if that amount has been attained, the additional shares shall be considered to be outstanding for the purpose of computing diluted EPS if the effect is dilutive. The diluted EPS computation shall include those shares that would be issued under the conditions of the contract based on the assumption that the current amount of earnings will remain unchanged until the end of the agreement, but only if the effect would be dilutive. Because the amount of earnings may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied. Example 3 (see paragraph 260-10-55-53) illustrates that provision.

45-54 If the contingency is based on a condition other than earnings or market price (for example, opening a certain number of retail stores), the contingent shares shall be included in the computation of diluted EPS based on the assumption that the current status of the condition will remain unchanged until the end of the contingency period. Example 3 (see paragraph 260-10-55-53) illustrates that provision.

Assume that a stock award legally vests only if an entity’s cumulative net income at the end of the third annual reporting period exceeds $10 million. At the end of each reporting period, the entity assesses whether cumulative net income has exceeded $10 million as if that reporting date were the end of the third annual reporting period. If the performance condition has been met at the end of a reporting period, the entity includes the award in the calculation of diluted EPS. To determine the number of incremental shares of stock to include in the denominator of the calculation of diluted EPS, the entity applies the treasury stock method if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260.

However, if the entity’s cumulative net income has not exceeded $10 million at the end of the reporting period, the entity does not include the award in the calculation of diluted EPS even if it is recording compensation cost because it believes that it is probable that the award will vest (i.e., it is probable that the performance target will be achieved). The entity excludes the award from the calculation of diluted EPS because the performance condition (i.e., the contingency) has not been met as of the end of that reporting period.

Example 7-4

Calculating Diluted EPS When Vesting of Stock Options Is Contingent on Future Earnings

Assume the following:

Entity A has net income of $12 million and $5 million for the year and quarter ended December 31, 20X1, respectively, as well as 5 million common shares outstanding for the quarter ended December 31, 20X1.
On January 1, 20X1, A granted 1 million employee stock options. The stock options vest on December 31, 20X2, if the recipients remain employed and A’s cumulative net income for the two-year period ended December 31, 20X2, equals or exceeds $10 million.
As of December 31, 20X1, all the stock options remain outstanding.
The stock options have an exercise price of $10 per option and a grant-date fair-value-based measure of $2 per option.
The average market price of A’s common stock for the quarter ended December 31, 20X1, was $15 per share.

If the end of the reporting period (December 31, 20X1) is considered the end of the contingency period, the performance target is deemed to be achieved. As a result, A includes the employee stock options in the calculation of diluted EPS for the quarter ended December 31, 20X1. To determine the number of incremental shares to include in the calculation’s denominator, A must then apply the treasury stock method if the effect is dilutive.

Entity A calculates diluted EPS under the treasury stock method for the quarterly period ended December 31, 20X1, as follows:

Alternatively, assume that A had generated net income of less than $10 million for the year ended December 31, 20X1. In that case, A excludes the employee stock options from the calculation of diluted EPS because the contingency is not deemed to have been met as of the end of the reporting period. Therefore, A is not required to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS under the treasury stock method. However, if A believes that it is probable that the performance target will be attained by the end of the performance period (December 31, 20X2), A recognizes compensation cost over the requisite service period for the number of awards expected to vest.

There may be other circumstances in which an entity issues performance-based awards for which performance is calculated on the basis of an average metric over several periods. When calculating whether contingently issuable shares for such awards should be included in the calculation of diluted EPS, an entity applies ASC 260-10-45-51 and ASC 260-10-45-54, which require the entity to assume that the current status of the condition (e.g., the current amount of earnings) will remain unchanged until the end of the contingency period. In addition, footnote (f) to Example 3 in ASC 260-10-55-56 states, in part, that “[p]rojecting future earnings levels and including the related contingent shares are not permitted.” Because the guidance precludes the projection of future earnings levels, earnings (or any other metric) in future periods would be presumed to be zero. See further discussion in Section 4.5.2.3. See also the example below.

Example 7-5

Calculating Diluted EPS for an Award That Vests on the Basis of Average Metrics

On January 1, 20X1, Entity A granted 1 million performance-based restricted stock units (RSUs) to a group of its key employees. The RSUs cliff vest on December 31, 20X3, if the recipients remain employed and A achieves two performance metrics during the three-year period from January 20X1 to December 20X3: (1) a three-year average revenue growth rate of at least 10 percent and (2) a three-year average operating margin of at least 6 percent.

The number of contingently issuable shares that are included in the calculation of diluted EPS is determined on the basis of the three-year averages of both the revenue growth rate and operating margins, which are calculated as follows: (1) the actual revenue growth rate and operating margin attained to date and (2) an assumption of zero revenue growth rate and zero operating margin for any remaining periods.

Entity A determines the number of shares to include in the calculation of diluted EPS by using the following assumptions:

December 31, 20X1

No shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 4 percent [(12% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
The three-year average operating margin of 2 percent [(6% for 20X1 + 0% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.

December 31, 20X2

No shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 7 percent [(12% for 20X1 + 9% for 20X2 + 0% for 20X3) ÷ 3 years] is below 10 percent.
The three-year average operating margin of 4 percent [(6% for 20X1 + 6% for 20X2 + 0% for 20X3) ÷ 3 years] is below 6 percent.

December 31, 20X3

The 1 million shares are included in the calculation of diluted EPS because:

The three-year average revenue growth rate of 11 percent [(12% for 20X1 + 9% for 20X2 + 12% for 20X3) ÷ 3 years] is above 10 percent.
The three-year average operating margin of 7 percent [(6% for 20X1 + 6% for 20X2 + 9% for 20X3) ÷ 3 years] is above 6 percent.

As noted in Example 7-1, in the above example, year-to-date amounts are used for simplicity.

7.1.2.3.2 Market-Based Awards

ASC 260-10

Contingently Issuable Shares

45-52 The number of shares contingently issuable may depend on the market price of the stock at a future date. In that case, computations of diluted EPS shall reflect the number of shares that would be issued based on the current market price at the end of the period being reported on if the effect is dilutive. If the condition is based on an average of market prices over some period of time, the average for that period shall be used. Because the market price may change in a future period, basic EPS shall not include such contingently issuable shares because all necessary conditions have not been satisfied.

45-53 In some cases, the number of shares contingently issuable may depend on both future earnings and future prices of the shares. In that case, the determination of the number of shares included in diluted EPS shall be based on both conditions, that is, earnings to date and current market price — as they exist at the end of each reporting period. If both conditions are not met at the end of the reporting period, no contingently issuable shares shall be included in diluted EPS.

Assume that a stock award legally vests only if the entity’s share price increases by more than 20 percent after the grant date. At the end of each reporting period, the entity would assess whether its share price has, in fact, increased by more than 20 percent after the grant date. If, at the end of a reporting period, the market condition has been met, the entity includes the award in the calculation of diluted EPS. To determine the number of incremental shares to include in the denominator of the calculation of diluted EPS, the entity applies the treasury stock method if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260.

However, if the entity’s share price has not increased by more than 20 percent at the end of the reporting period, the award is not included in the calculation of diluted EPS even if the entity is recording compensation cost because it believes that, for example, the employee will remain employed for the derived service period. The award is excluded because the market condition (i.e., the contingency) has not been met as of the end of that reporting period. Moreover, if an employee does remain employed for the derived service period, the employee is deemed to have earned (i.e., vested in) the award. In this circumstance, the entity will not reverse any previously recognized compensation cost even if the market condition is never satisfied. If the market condition is never satisfied, the shares issuable under the award will never become issued and outstanding. Therefore, the shares will never be included in the weighted-average number of common shares (i.e., the denominator in the calculation of basic and diluted EPS).

7.1.3 Participating Securities and the Two-Class Method

ASC 260-10-45-59A through 45-70 (excerpted in Chapter 5) discuss the two-class method of calculating EPS. The two-class method is an earnings allocation formula under which a participating security is treated as having rights to earnings that would have otherwise been available to common shareholders. Entities are required to use the two-class method to calculate basic and diluted EPS if their capital structure includes common stock and either (1) participating securities or (2) multiple classes of common stock.

7.1.3.1 Participating Securities

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.

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.

Provided that an instrument’s participation feature is nondiscretionary and objectively determinable, the instrument’s classification as a participating security depends on the participation mechanism and the nature of the instrument. Section 5.3 provides additional guidance on the definition of a participating security. Table 5-1 discusses whether instruments typically included in capital structures are considered participating securities.

As noted in the definition of a participating security, participation does not need to be in the form of a dividend. Any participation by a security in the distribution of a company’s earnings (under an assumption that there is a full distribution of earnings) would constitute participation, regardless of whether a cash payment is, or would be accounted for as, a dividend. Example 5-5 provides an illustration.

7.1.3.1.1 Dividend-Paying Share-Based Payment Awards Before Vesting

An award is a participating security if, during the vesting period, it contains a nonforfeitable right to dividends or dividend equivalents that participate in the distribution of earnings with common stock. That is, an award is considered a participating security if it accrues cash dividends (whether paid or unpaid) any time the common shareholders receive dividends — when those dividends do not need to be returned to an entity if the employee (or nonemployee grantee) forfeits the awards. The entity is required to apply the two-class method when computing basic and diluted EPS. By contrast, if the right to dividends or dividend equivalents is forfeitable with the underlying award, the award is not considered a participating security. Furthermore, the entity is not required to deduct forfeitable dividends payable on a nonvested share award from the numerator in calculating income available to common stockholders.

7.1.3.1.2 Dividend-Paying Share-Based Payment Awards After Vesting

After an award has vested, it is a participating security if it contains a right to receive dividends or dividend equivalents with common shareholders, because the right is nonforfeitable when the award vests. Therefore, an entity must apply the two-class method when calculating basic and diluted EPS unless the award becomes outstanding common shares once vesting is complete. For example, the two-class method does not apply to a restricted stock award after a grantee receives outstanding common shares because the good has been delivered or the service has been rendered. Once the award becomes outstanding common shares, the entity includes those shares in the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS).

7.1.3.2 Calculation Under the Two-Class Method

When an entity’s capital structure includes participating securities but only a single class of common stock, the entity uses the following three-step process to calculate basic and diluted EPS:

Step 1	Use the two-class method to calculate basic EPS.2
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 the 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.

While an entity is required to present, on the face of the income statement, basic and diluted EPS for its common stock, as discussed in Section 9.1.4, the entity is permitted, but not required, to present basic and diluted EPS for a participating security. Section 5.5.4 further discusses the application of the two-class method to the calculation of diluted EPS and includes examples illustrating its application to share-based payment awards.

7.1.4 Settlement in Shares or Cash

ASC 260-10

Share-Based Payment Arrangements

45-30 If share-based payment arrangements are payable in common stock or in cash at the election of either the entity or the grantee, the determination of whether such share-based awards are potential common shares shall be made based on the provisions in paragraph 260-10-45-45. If an entity has a tandem award (as defined in Topic 718) that allows the entity or the grantee to make an election involving two or more types of equity instruments, diluted EPS for the period shall be computed based on the terms used in the computation of compensation cost for that period.

Contracts That May Be Settled in Stock or Cash

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

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

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

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

As discussed in Section 4.7, an entity must consider the impact on the calculation of diluted EPS of a contract indexed to an entity’s common stock that (1) may be settled in cash or common shares or (2) has an accounting classification that differs from its assumed settlement for EPS purposes.

Share-based payment awards that cannot be settled in the entity’s shares (e.g., liability-classified, cash-settled stock appreciation rights) are not included in the calculation of basic or diluted EPS. That is, share- based payment awards that always must be settled in cash are not included in the denominator in the EPS calculation. However, the compensation cost recorded in net income (and therefore income available to common stockholders) will affect the numerator in the EPS calculation.

Conversely, a share-based payment award that can be settled in cash or shares is evaluated under ASC 260-10-45-45 through 45-47. Subject to one exception, regardless of whether the election to settle in cash or shares is at the option of the issuing entity or the holder, the entity must include the incremental number of shares that results from applying the treasury stock method in the denominator of the calculation of diluted EPS if the effect is dilutive on the basis of the antidilution sequencing requirements of ASC 260. If the award is classified as a liability, an entity may be required to adjust the numerator in accordance with ASC 260-10-45-46. This adjustment is made to remove the incremental effect of accounting for the award as a liability (i.e., so that the numerator reflects only the compensation cost that would have been recognized if the award had been classified as equity). In addition, in calculating the average unrecognized cost of the arrangement under the treasury stock method, the entity should use the amount of cost that would have been left unrecognized if the award had been classified as equity.

The one exception to the requirement to assume share settlement is related to a share-based payment award that is classified as a liability because of the requirements in ASC 718-10-25-15. For these awards, if past experience or a stated policy provides a reasonable basis for an entity to conclude that the arrangement will be settled in cash, no incremental shares need to be included in the denominator of the calculation of diluted EPS.3 In addition, no adjustment to the numerator is needed since the assumed settlement for diluted EPS is aligned with the accounting classification. See ASC 260-10-45-45A for additional discussion.

See Sections 4.7 and 4.9.5 for further discussion of contracts that may be settled in cash or stock.

7.1.5 Early Exercise of Stock Options

An early exercise refers to a grantee’s ability to change his or her tax position by exercising an option or similar instrument and receiving shares before the good has been delivered or the service has been rendered (i.e., before the award vests). If the employee terminates employment before rendering the requisite service (or a nonemployee forfeits the award before completion of the vesting period), the entity usually can repurchase the shares for either of the following:

The lesser of the fair value of the shares on the repurchase date or the exercise price of the award.
The exercise price of the award.

The purpose of the repurchase feature is effectively to require the grantee to satisfy the vesting conditions to receive any economic benefit from the award. Early exercise is therefore not considered to be a substantive exercise for accounting purposes. See Sections 3.4.3 and 5.4.2.3 of Deloitte’s Roadmap Share-Based Payment Awards for additional information.

7.1.5.1 Basic EPS

The shares issued to a grantee upon an award’s early exercise would not be considered outstanding for basic EPS purposes until the award’s vesting conditions have been satisfied. This conclusion is consistent with the intent of ASC 260-10-45-13, which is that shares that are subject to a contingent repurchase provision, as described above, are excluded from the calculation of basic EPS until the shares are no longer contingently returnable (i.e., the entity’s call option lapses).

However, if the shares subject to repurchase contain nonforfeitable rights to dividends or dividend equivalents, the shares are participating securities. That is, an award is considered a participating security if it accrues cash dividends (whether paid or unpaid) any time the common shareholders receive dividends that do not need to be returned to the entity if the grantee forfeits the award. If legally issued shares are considered participating securities, the entity must use the two-class method to calculate basic EPS. See Section 7.1.3 for a discussion of the application of the two-class method to share-based payment awards.

7.1.5.2 Diluted EPS

After a grantee early exercises an option, the entity continues to use the treasury stock method to calculate diluted EPS. When using this method to calculate the number of incremental shares to be included in diluted EPS, the entity normally is required to include the exercise price of the award in determining the assumed proceeds in accordance with ASC 260-10-45-29. (See Section 7.1.2.1 for a discussion of the application of the treasury stock method to share-based payment awards.) However, in this case, because the grantee has early exercised the award and has therefore already paid cash, (1) there is no cash that will be received from the grantee in the future and (2) the cash received could have already been used to repurchase shares during the requisite service period (or before the nonemployee award has vested). As a result, the cash received is not included in the calculation of assumed proceeds.

When calculating diluted EPS for an early-exercised award that is considered a participating security, an entity must determine whether the treasury stock method or the two-class method is more dilutive. See further discussion in Section 5.5.4.

7.1.6 Employee Stock Purchase Plans

7.1.6.1 General

An employee stock purchase plan (ESPP) is a share-based payment plan that is usually offered to a broad base of employees so that they can participate in ownership of the entity generally at a discounted price. Employees contribute to the plan through payroll deductions during the purchase period (e.g., six months). At the end of the purchase period, the employer’s stock is purchased at the purchase price, which is generally a discounted price. See Chapter 8 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of ESPPs.

The effect that an ESPP has on an entity’s EPS depends on the terms of the plan. Generally, the participating employees can choose not to purchase the shares and can have their withholdings during the purchase period refunded because either (1) the employees can elect to have previous withholdings refunded before the end of the purchase period or (2) the shares will not be purchased if the employee fails to provide the requisite service (i.e., if the employee terminates employment before the end of the purchase period). In practice, it is atypical for an employee’s withholdings during the purchase period not to be refundable because participants are generally not allowed to purchase shares at the end of the purchase period if they are no longer employed by the entity. However, the EPS accounting for ESPPs for which the participating employees are unable to receive a refund of withholdings made during the purchase period is addressed below.

7.1.6.2 Withholdings Are Not Refundable

If the terms of the ESPP do not allow employees to choose not to purchase the shares (i.e., the employee’s participation is irrevocable because the employee is not entitled to a refund of amounts previously withheld during the purchase period, regardless of whether he or she is terminated), the guidance on contingently issuable shares applies to the calculation of basic and diluted EPS. According to this guidance, the number of shares, if any, that would be issuable at the end of the reporting period, under the assumption that the end of the reporting period is the end of the purchase period (this number is based on the amounts withheld by the entity to date), is included in the weighted-average number of common shares outstanding for both basic and diluted EPS.

7.1.6.3 Withholdings Are Refundable

7.1.6.3.1 Basic EPS

If the terms of the ESPP allow employees to choose not to purchase the shares (i.e., employees are entitled to a refund of amounts previously withheld during the purchase period either at their election or upon termination of employment), the shares issuable under the ESPP are treated as employee stock options that are granted as of the beginning of the purchase period. Accordingly, the shares issuable under the ESPP are not included in the denominator of the calculation of basic EPS until they have been actually issued. The fact that the shares issuable under the ESPP are not included in basic EPS during the purchase period is based on the guidance in ASC 260-10-45-12C on contingently issuable shares.

7.1.6.3.2 Diluted EPS

As discussed in the previous section, when the terms of the ESPP allow employees to choose not to purchase the shares, the shares issuable under the ESPP are treated as employee stock options that are granted as of the beginning of the purchase period. Accordingly, the shares issuable under the ESPP are included in the denominator of diluted EPS under the treasury stock method, as discussed in ASC 260-10-45-22 through 45-29A. To apply the treasury stock method to an ESPP, an entity must also apply the guidance on contingently issuable shares, as discussed in ASC 260-10-45-48 and 45-49 and ASC 260-10-45-52.

Because the participants’ ability to purchase shares under an ESPP is based on a service condition, the grant date and service inception date are the start date of the purchase period provided that all the conditions for establishing a grant date have been met. The withholding of amounts from the employees’ pay during the purchase period merely represents the funding mechanism for the eventual payment of the exercise price. This withholding mechanism does not affect the grant date or service inception date of the ESPP.

The number of incremental common shares to be included in the calculation of diluted EPS is based on the number of shares that would be issuable if the reporting date were the end of the contingency period (i.e., the purchase period) in accordance with ASC 260-10-45-52, net of the hypothetical shares that could be repurchased in accordance with the treasury stock method. Therefore, the sponsor of an ESPP must consider each of the following to calculate the effect of the ESPP on diluted EPS:

Employee withholdings — The amount of employee withholdings represents the exercise price for the shares to be purchased by employees and is also used to calculate the number of shares assumed to be issued during the purchase period. For diluted EPS purposes, this amount should represent the total amount of employee withholdings expected to be made during the entire purchase period.4 Entities should consider the elections made by participating employees to estimate this amount.

Expected forfeitures may affect the amount of recognized compensation cost during the purchase period but should not be factored into the estimation of employee withholdings. As discussed in Section 7.1.2.1.4, regardless of an entity’s accounting policy election related to how it reflects forfeitures in the recognition of compensation cost, the denominator in the calculation of diluted EPS is based on the actual number of awards outstanding (i.e., the number of awards is reduced only for actual forfeitures) in a given reporting period provided that the effect is dilutive.

Changes to employee withholding elections during the purchase period are treated as modifications and are only reflected in EPS prospectively.
Purchase price formula — The purchase price of an ESPP is generally based on the lesser of the stock price at the beginning of the purchase period and that at the end of the purchase period; therefore, the sponsor will need to consider its stock price as of both the beginning of the purchase period and the end of the reporting period. The stock price as of the end of the reporting period is used as the proxy for the stock price as of the end of the purchase period in accordance with the guidance in ASC 260-10-45-52 on contingently issuable shares. The sponsor would use the lower of these two stock prices to calculate the purchase price when the ESPP allows employees to purchase shares on the basis of a formula that incorporates the lesser of the stock price at the beginning and that at the end of the purchase period.
Average unrecognized compensation cost — The average amount of unrecognized compensation cost attributable to future service, if any, is a component of the assumed proceeds under the treasury stock method.

The incremental number of common shares included in diluted EPS is calculated as follows (see also Example 7-6):

Number of shares assumed issued under the ESPP:

Employee withholdings (first bullet above) ÷ purchase price (second bullet above)

Less

Number of shares assumed repurchased:

Assumed proceeds (i.e., employee withholdings [first bullet above] plus average unrecognized compensation cost [third bullet above]) ÷ average market price of the issuer’s stock for the reporting period

Connecting the Dots

Unlike an entity’s accounting for diluted EPS for early-exercised stock options, an entity may include the money withheld (and expected to be withheld during the remaining purchase period) from employees’ pay as a component of the assumed proceeds in calculating diluted EPS for ESPPs. These withholdings are not considered a prepayment of the exercise price for diluted EPS purposes because the entity must refund such amounts to employees that do not ultimately purchase shares under the ESPP. (This requirement differs from the terms of early-exercised stock options.)

Example 7-6

Diluted EPS for ESPP

On July 1, 20X1, Entity A establishes a qualified ESPP that allows its employees to purchase shares of its common stock during a six-month purchase period that begins on July 1, 20X1, and ends on December 31, 20X1. The ESPP allows A’s employees to elect to withhold up to 10 percent of their salary to purchase A’s common stock at the end of the purchase period. Employees may make their election at any time during the purchase period, but once the election is made it cannot be changed during the purchase period. The shares will be purchased at a price per share that is equal to the lesser of (1) 90 percent of A’s stock price as of July 1, 20X1, or (2) 90 percent of A’s stock price as of December 31, 20X1. Participants are allowed to withdraw from the ESPP at any time before the end of the purchase period and are automatically withdrawn if they are terminated before the end of the purchase period. For any such withdrawals, A must refund the amounts withheld from the participant’s pay. Shares are issued under the ESPP on January 1, 20X2.

Assumptions related to A’s calculation of diluted EPS for the quarterly period ended September 30, 20X1, include the following:

Common stock prices per share:
- July 1, 20X1 — $50.
- September 30, 20X1 — $40.
- Average market price during the period beginning on July 1, 20X1, and ending on September 30, 20X1 — $45.
Employee payroll withholdings:
- Actual through September 30, 20X1 — $3.5 million.
- Expected from October 1, 20X1, through December 31, 20X1 — $3.7 million.
Average unrecognized compensation cost for the period — $1.3 million.

The effect on diluted EPS of the ESPP for the quarterly period ended September 30, 20X1, is calculated as follows:

The shares issuable under the ESPP would be included in basic EPS prospectively once they are issued (i.e., on January 1, 20X2). While not relevant to this example, if the purchase period ended during a quarterly financial reporting period, in addition to including the shares as outstanding on a weighted-average basis for the period, an entity would need to include incremental shares in diluted EPS on a weighted-average basis for the portion of the quarterly period for which the shares had not yet been issued. See Section 4.2.2.1.3.1 for further discussion.

Connecting the Dots

ASC 260-10-45-21A states:

Changes in an entity’s share price may affect the exercise price of a financial instrument or the number of shares that would be used to settle the financial instrument. For example, when the principal of a convertible debt instrument is required to be settled in cash but the conversion premium is required to (or may) be settled in shares, the number of shares to be included in the diluted EPS denominator is affected by the entity’s share price. In applying both the treasury stock method and the if-converted method of calculating diluted EPS, the average market price shall be used for purposes of calculating the denominator for diluted EPS when the number of shares that may be issued is variable, except for contingently issuable shares within the scope of the guidance in paragraphs 260-10-45-48 through 45-57. See paragraphs 260-10-55-4 through 55-5 for implementation guidance on determining an average market price.

In accordance with this guidance, the number of shares assumed to be issued under an ESPP would be calculated by using the average market price of the entity’s stock. However, before ASC 260-10-45-21A was added by ASU 2020-06, entities applied the guidance on contingently issuable shares in ASC 260-10-45-52 to calculate the number of shares assumed to be issued under an ESPP (as noted in the guidance and example above). This guidance is consistent with footnote 1 of FASB Technical Bulletin 97-1 (superseded), which indicated that an entity applies the guidance on contingently issuable shares to determine the accounting for diluted EPS.

On the basis of informal discussions with the FASB staff, we understand that the amendments made to ASC 260 by ASU 2020-06 (i.e., the addition of ASC 260-10-45-21A) were not intended to address when the guidance on contingently issuable shares applies to the calculation of diluted EPS. Indeed, ASC 260-10-45-21A specifically states that these amendments do not apply to contingently issuable shares. Therefore, the accounting for diluted EPS that entities applied in practice before adopting ASU 2020-06 is still acceptable. However, because it is often difficult to determine when to apply the guidance on contingently issuable shares in ASC 260, it would also be acceptable for an entity to apply the guidance in ASC 260-10-45-21A on variable denominators to calculate the number of shares assumed issued under an ESPP. Such accounting for diluted EPS would represent an accounting policy election that must be applied consistently.

If ASC 260-10-45-21A is applied to calculate the number of shares assumed to be issued in Example 7-6, the number of shares would equal 177,778 (i.e., total expected withholdings of $7,200,000 divided by $40.50 [$45 average market price for the period multiplied by 90 percent]). As a result, the ESPP would be antidilutive for the period since the number of shares assumed to be repurchased would be greater than the number of shares assumed to be issued. This example illustrates that an entity’s application of ASC 260-10-45-21A to calculate the number of shares assumed to be issued in an ESPP would result in less dilution (or no dilution) compared with application of the contingently issuable share method.

7.1.7 Redeemable Awards

SAB Topic 14.E requires public entities to consider the requirements of ASR 268 (FRR Section 211) and ASC 480-10-S99-3A for redeemable share-based payment awards. See Section 5.10 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of the recognition and measurement requirements for redeemable share-based payment awards. Also, in addition to the discussion below, see Section 3.2.4.2 for more information about redeemable common shares.

7.1.7.1 Share-Based Payment Awards Redeemable at Fair Value

Share-based payment awards on common shares that are redeemable at fair value are accounted for in the same manner as common shares that are redeemable at fair value. In ASC 480-10-S99-3A, the SEC staff clarified that increases or decreases in the carrying amount of common shares that are redeemable at fair value do not affect income available to common stockholders. That is, changes in the redemption amount do not affect income available to common stockholders (the numerator in the calculation of basic EPS) if the redemption value of redeemable shares is based on the fair value of the shares. When calculating diluted EPS, an entity must apply the treasury stock method to determine the number of incremental shares to include in the calculation’s denominator.

7.1.7.2 Share-Based Payment Awards Redeemable at an Amount Other Than Fair Value

Share-based payment awards on common shares that are redeemable at an amount other than fair value are accounted for in the same manner as common shares that are redeemable at an amount other than fair value (e.g., formula price). That is, increases or decreases in the carrying amount of redeemable share-based payment awards are reflected in EPS under the two-class method, as discussed in ASC 260-10-45-59A through 45-70. The increase or decrease in the carrying amount of redeemable share-based payment awards is treated similarly to the reduction in income from continuing operations (or net income) from current-period distributions. See Section 7.1.3 for a discussion of the application of the two-class method. In calculating diluted EPS, an entity must determine whether the treasury stock method or the two-class method is more dilutive.

7.1.7.3 Share-Based Payment Awards Redeemable at Intrinsic Value

The SEC’s guidance in ASC 480-10-S99-3A does not address the EPS treatment of share-based payment awards with a redemption amount that is based on an award’s intrinsic value. Entities may therefore make a policy decision to (1) analogize to the guidance in ASC 480-10-S99-3A on common shares that are redeemable at fair value or (2) treat the increases or decreases in the carrying amount of these awards as an additive or subtractive amount in arriving at income available to common stockholders.

Under the first alternative, the increase or decrease in the carrying amount of the redeemable share-based payment award (i.e., changes in the redemption amount) does not affect income available to common stockholders (the numerator in the calculation of basic EPS). Under the second alternative, however, such an increase or decrease is treated as a preferential distribution. That is, the entity accounts for the current-period change in the carrying amount of the redeemable share-based payment award as an additive or subtractive amount in arriving at income available to common stockholders (the numerator in the calculation of basic EPS). Regardless of the alternative selected, the entity must apply the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation of diluted EPS.

7.1.7.4 Contingently Redeemable Share-Based Payment Awards

Share-based payment awards on common shares that are contingently redeemable at fair value or at an amount other than the awards’ fair value (e.g., redeemable upon a change in control) do not affect income available to common stockholders (the numerator in the calculation of basic EPS) until it is probable that the contingency will occur. That is, awards that are contingently redeemable are not remeasured to their redemption amount until it is deemed probable that the contingency will occur. When calculating diluted EPS, an entity must apply the treasury stock method to determine the number of incremental shares to include in the denominator of the calculation.

7.1.8 Awards of a Consolidated Subsidiary

7.1.8.1 Share-Based Payment Awards Issued by a Consolidated Subsidiary and Settled in Subsidiary’s Common Shares

Share-based payment awards issued by a consolidated subsidiary that are settled by issuing the subsidiary’s common shares affect not only the subsidiary’s calculation of diluted EPS but also the calculation of the parent’s diluted EPS, as described in ASC 260-10-55-20 through 55-22 (excerpted in Section 8.8.1.1) and illustrated in Example 7 in ASC 260-10-55-64 through 55-67 (excerpted in Section 8.8.1.2).5

While such awards do not affect the weighted-average number of common shares outstanding (i.e., the denominator in the calculation of basic EPS for either the subsidiary or the parent), the compensation cost associated with these awards (during the requisite service period or nonemployee’s vesting period) will affect both the subsidiary’s and the parent’s net income or loss.

To calculate the parent’s diluted EPS, the subsidiary must first calculate its own diluted EPS (regardless of whether the subsidiary reports EPS). The amount of the subsidiary’s diluted EPS is then multiplied by the number of the subsidiary’s shares that the parent is assumed to own (after the hypothetical exercise of the awards is taken into consideration). The product of those two amounts is then included in the numerator (as a substitute for the parent’s proportionate share of the subsidiary’s earnings) of the calculation of the parent’s diluted EPS.

As noted in ASC 260-10-55-21, the guidance in ASC 260-10-55-20 also applies to investments in common stock of corporate joint ventures and investee companies that are accounted for under the equity method.

Example 7-7

Impact on EPS of Share-Based Payment Awards Issued by a Subsidiary

Assume that the following apply to Parent P:

Its net income is $100, excluding any net income or loss of Subsidiary A (i.e., as if A is unconsolidated).
Throughout the period, 100 shares of its common stock were outstanding. No other securities have been issued.
It owns 90 of A’s common shares (out of 100 outstanding).

Assume that the following apply to A:

Its net income is $100 (after intercompany eliminations, etc.).
Throughout the period, 100 shares of its common stock were outstanding.
At the beginning of the period, it granted 10 fully vested stock options to its employees to purchase 10 shares of its common stock at $1 per share.
The average market price of its common stock during the period is $2 per share.

The calculation of A’s diluted EPS is as follows:

7.1.8.2 Share-Based Payment Awards Issued by a Subsidiary but Settled in the Parent’s Common Shares

Share-based payment awards issued by a consolidated subsidiary that are settled by issuing the parent’s common shares will not affect the subsidiary’s denominator in the calculation of diluted EPS because the awards do not represent potential common shares of the subsidiary. However, during the awards’ requisite service period or nonemployee’s vesting period, the compensation cost associated with them will affect the subsidiary’s net income or loss. (See Sections 2.8 and 2.9 of Deloitte’s Roadmap Share-Based Payment Awards for a discussion of the accounting for share-based payment awards issued by a subsidiary but settled in the parent’s common shares.)

By contrast, for the parent, the share-based payment awards do represent potential common shares in the calculation of diluted EPS. Therefore, the awards are included in the parent’s denominator of the calculation of diluted EPS under the treasury stock method. Because the subsidiary is recording compensation cost in its financial statements for these awards during the requisite service period or nonemployee’s vesting period, the parent’s proportionate share of the compensation cost will have been included in the parent’s net income or loss.