Chapter 7 — Share-Based Payment Awards and Other Compensation Arrangements

7.1 Share-Based Payment Awards

ASC 718-10

Earnings per Share

45-1 Topic 260 requires that equity share options, nonvested shares, and similar equity instruments granted under share-based payment transactions be treated as potential common shares in computing diluted earnings per share (EPS). Diluted EPS shall be based on the actual number of options or shares granted and not yet forfeited regardless of the entity’s accounting policy for forfeitures in accordance with paragraphs 718-10-35-1D and 718-10-35-3, unless doing so would be antidilutive. If vesting in or the ability to exercise (or retain) an award is contingent on a performance or market condition, such as the level of future earnings, the shares or share options shall be treated as contingently issuable shares in accordance with paragraphs 260-10-45-48 through 45-57. If equity share options or other equity instruments are outstanding for only part of a period, the shares issuable shall be weighted to reflect the portion of the period during which the equity instruments are outstanding.

45-2 Paragraphs 260-10-45-29 through 45-34 and Example 8 (see paragraph 260-10-55-68) provide guidance on applying the treasury stock method for equity instruments granted in share-based payment transactions in determining diluted EPS.

This section supplements the discussion in Chapters 3, 4, and 5 to address specific considerations related to the calculation of basic and diluted EPS for share-based payment awards.

In calculating EPS, an entity should consider how a share-based payment award may affect (1) income available to common stockholders (i.e., the numerator in the EPS calculation) and (2) the weighted-average number of common shares or dilutive potential common shares (i.e., the denominator in the EPS calculation). Because an entity recognizes the fair-value-based measure of an award as compensation cost (or as a reduction of revenue) in arriving at the entity’s income available to common stockholders, awards granted in return for goods or services or as consideration payable to a customer will typically affect the EPS numerator.

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.

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.

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.

Changing Lanes

ASU 2020-06 eliminated the ability to overcome the presumption of share settlement for contracts other than share-based payment arrangements. For share-based payment arrangements, the FASB decided to retain the existing guidance. Paragraph BC114 of ASU 2020-06 states:

The classification guidance in Topic 718 is different from the classification guidance in Subtopic 815-40. Specifically, the guidance in paragraph 718-10-25-15 states that “. . . if an entity that nominally has the choice of settling awards by issuing stock predominantly settles in cash or if the entity usually settles in cash whenever a grantee asks for cash settlement, the entity is settling a substantive liability rather than repurchasing an equity instrument.” Under current GAAP, a liability-classified stock-based compensation arrangement may not be included in diluted EPS because of the existing guidance on contracts that may be settled in cash or shares. The Board decided to retain the current guidance for calculating diluted EPS for stock-based compensation because those arrangements are not within the scope of this project.

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.

Footnotes

The inclusion of the average amount of unrecognized cost attributed to future goods or services not yet recognized is unique to share-based payment awards. That is, this component is only included in the assumed proceeds for share-based payment awards.

Undistributed losses would generally not be allocated to share-based payment awards in accordance with ASC 260-10-45-67 because they typically would not have a “contractual obligation to share in the losses of the issuing entity on a basis that was objectively determinable.” See Section 5.5.2.2 for more information.

An entity would need to have a sufficient past practice of cash settlement as well as evidence of its intent to cash-settle the arrangement.

The entire purchase period is considered in the calculation of diluted EPS because the shares to be purchased under the ESPP are treated as employee stock options. Therefore, all amounts to be withheld from employees’ pay to purchase shares under the ESPP (i.e., withholdings to date and expected future withholdings during the remaining purchase period) must be considered in the calculation of diluted EPS.

See Section 8.8 for further discussion of how to calculate EPS for a parent with a less-than-wholly-owned subsidiary.

7.2 Employee Stock Ownership Plans

7.2.1 General

7.2.1.1 Background

An ESOP is a qualified defined-contribution employee benefit plan designed to invest primarily in the stock of the sponsoring entity (referred to hereafter as the “sponsor”). ESOPs are “qualified” in the sense that the sponsor receives certain tax benefits because the plan meets the ESOP requirements of the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code of 1986 (IRC) as either a stock bonus plan or a combination of a stock bonus plan and a money purchase pension plan. Further, an ESOP:

Is organized through a trust fund and is generally funded through contributions made by the sponsor.
Must hold qualified common stock of the sponsor or noncallable preferred stock that is convertible into qualified common stock of the sponsor.6
May issue debt to fund the acquisition of shares of the sponsor. Loans owed by an ESOP may be entered into with the sponsor or with a third party. See Section 7.2.1.2 for further discussion of the difference between a leveraged ESOP and a nonleveraged ESOP.

The sponsor may make contributions to the ESOP through various means. It may issue its shares to the ESOP; make contributions of cash to the ESOP so that the ESOP can purchase the sponsor’s shares in the market; or make principal and interest payments on debt owed by the ESOP, resulting in the release of shares that serve as collateral on the ESOP’s debt. The shares held by an ESOP are either allocated or unallocated. Allocated shares represent shares held by an ESOP that have been assigned to the accounts of individual employee participants (referred to hereafter as “participants”). Allocated shares are generally subject to vesting requirements. Shares held by an ESOP that have not been assigned to individual participant accounts represent unallocated shares. As of the end of an ESOP’s fiscal year, generally only leveraged ESOPs have unallocated shares.

Participants do not pay taxes on allocated shares until they receive a taxable distribution from the ESOP. Upon termination of employment, participants may be able to “roll over” their vested shares into another qualified plan to defer taxation on the distribution. In some ESOPs, the vested shares of participants are repurchased by the sponsor or by the ESOP as of the date on which the participant’s employment is terminated. If the shares of common stock or convertible preferred stock held by an ESOP are not readily tradable, by law the sponsor must typically provide a put option that gives participants the right, but not the obligation, to sell vested shares at an amount generally designed to represent fair value (see further discussion in Section 7.2.4.2.1). Any unvested allocated shares of a participant that terminates employment are redesignated as unallocated shares and subsequently allocated to other participants.

Dividends paid on the sponsor’s stock may be distributed or allocated in various ways, including:

Dividends on allocated and unallocated shares held by an ESOP may be used to repay a loan owed by the ESOP. In these situations, the ESOP generally pays the dividend equivalent on allocated shares in additional shares of stock.
Dividends on allocated shares could be paid to participants in cash or through an allocation of additional shares with a value equal to the cash amount of the dividends.
Dividends on unallocated shares could be paid to participants in cash or through the allocation of additional shares of stock on the basis of a specified allocation formula (typically, the participant’s account balance).

ASC 718-40 addresses the accounting by sponsors of all ESOPs. Entities may sponsor other types of stock ownership plans that do not meet the definition of an ESOP because those plans do not meet the requirements for an ESOP in ERISA and the IRC. Those arrangements are subject to the accounting specified in other Codification subtopics.

Changing Lanes

The guidance in ASC 718-40 was codified from AICPA Statement of Position (SOP) No. 93-6, which superseded the previous guidance in SOP 76-3 (as interpreted by EITF Issue 89-8). Sponsors were required to apply SOP 93-6 to all shares acquired by an ESOP on or after January 1, 1993. While sponsors were encouraged to prospectively adopt SOP 93-6 for shares acquired by ESOPs before January 1, 1993, sponsors that did not elect to adopt SOP 93-6 for all shares owned by an ESOP would continue to apply the guidance in SOP 76-3 to the grandfathered ESOP shares (see ASC 105-10-70-2(c)). The guidance in SOP 76-3 was not codified, in part, because it was no longer expected to be widely applicable. Section 7.2.3.4 discusses the application of SOP 76-3 to leveraged ESOPs. The remaining guidance below is based on the requirements of ASC 718-40.

7.2.1.2 Leveraged Versus Nonleveraged ESOPs

For accounting purposes, it is important to distinguish between leveraged ESOPs and nonleveraged ESOPs. This is because the accounting and EPS requirements in ASC 718-40 differ significantly for the two different types of ESOPs. A leveraged ESOP is an ESOP that enters into a loan arrangement to acquire shares of the sponsor. A nonleveraged ESOP is an ESOP that does not enter into loans to acquire shares of the sponsor.

A leveraged ESOP may enter into a loan with a third party or with the sponsor. A loan entered into between an ESOP and a third-party lender is referred to as a direct loan. When an ESOP enters into a loan directly with a third party, the repayment of the loan is generally guaranteed by the sponsor. A loan entered into between an ESOP and the sponsor, with a related outside loan between the sponsor and a third-party lender, is referred to as an indirect loan. If an ESOP enters into a loan with the sponsor and the sponsor does not obtain a related loan with a third-party lender, the ESOP is considered internally leveraged and the loan between the ESOP and sponsor is an intercompany loan.

Loans with third parties must be reflected as debt on the sponsor’s balance sheet regardless of whether they are direct loans or indirect loans. Loans between a sponsor and an ESOP may not be reflected as assets or liabilities on the sponsor’s balance sheet. Thus, when an ESOP is only internally leveraged, the accounting relevant to leveraged ESOPs applies but no liability related to the ESOP’s debt is reflected on the sponsor’s balance sheet.

7.2.2 Nonleveraged ESOPs

7.2.2.1 General

In accordance with ASC 718-40-25-19, a sponsor of a nonleveraged ESOP reports compensation cost in each financial reporting period on the basis of the contributions that are required for the period under the terms of the plan, regardless of whether those contributions are made in cash or stock. When contributions are made in stock, the fair value of the stock contributed is used to measure compensation cost. Tax law requires sponsors to allocate the amounts contributed to individual participant accounts as of the end of the ESOP’s fiscal year. While the participants are generally subject to vesting requirements, any vesting requirements (and any forfeitures resulting from a failure to meet these requirements) have no impact on the prior compensation cost recognized by the sponsor. Any forfeited account balances are reallocated to other participants and could only indirectly reduce the subsequent-period compensation cost because of the reduction in the required contributions for that period.

Under ASC 718-40, if a nonleveraged ESOP does not hold shares related to the reversion of assets from another terminated employee benefit plan, the sponsor will not need to recognize any unearned ESOP compensation expense (contra-equity) account in a manner similar to how such accounts are recognized by sponsors of leveraged ESOPs. However, such a situation does not obviate the need for sponsors to estimate and accrue compensation expense during interim periods. Example 1 in ASC 718-40-55-34 through 55-38 illustrates the journal entries that must be recorded by a sponsor of a nonleveraged ESOP that holds common stock.

The impact of a nonleveraged ESOP on the sponsor’s calculation of basic and diluted EPS is relatively straightforward. ASC 718-40-45-1 and ASC 718-40-45-9 contain the EPS accounting requirements for nonleveraged ESOPs.

ASC 718-40

EPS

45-1 Dividends on preferred stock held by an employee stock ownership plan shall be deducted from net income net of any applicable income tax benefit when computing both basic and diluted earnings per share (EPS) if that preferred stock is considered outstanding (that is, if the employee stock ownership plan shares are allocated).

EPS

45-9 All shares held by a nonleveraged employee stock ownership plan shall be treated as outstanding in computing the employer’s earnings per share (EPS), except the suspense account shares of a pension reversion employee stock ownership plan, which are not treated as outstanding until they are committed to be released for allocation to participant accounts. If a nonleveraged employee stock ownership plan holds convertible preferred stock, the guidance in paragraphs 718-40-45-6 through 45-8 for leveraged employee stock ownership plans shall be considered.

As noted in the guidance above, the calculation of basic and diluted EPS by a sponsor of a nonleveraged ESOP is affected by dividends paid on any convertible preferred stock held by the ESOP, the outstanding shares of common stock held by the ESOP, and the application of the if-converted method when the ESOP holds convertible preferred stock. In addition, any redemptions of convertible preferred stock and the redemption provisions of common stock or convertible preferred stock held by the ESOP could also affect EPS.

Connecting the Dots

Unlike an entity that accounts for leveraged ESOPs, an entity that accounts for nonleveraged ESOPs would consider all shares of common stock or convertible preferred stock held by the ESOP to be outstanding shares in the calculation of EPS. The only exception applies to suspense account shares of a pension reversion ESOP, which are not treated as outstanding until they are committed to be released for allocation to participant accounts (referred to hereafter as “suspense pension reversion shares”).7 The EPS treatment of outstanding shares is considered the same, regardless of whether those shares are fully vested or remain subject to vesting requirements. The forfeiture of allocated shares would only affect future financial reporting periods to the extent that the sponsor’s required contributions are less because of the reallocation of forfeited shares.

7.2.2.2 Dividends

7.2.2.2.1 Dividends on Common Stock

Dividends paid on shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are not considered suspense pension reversion shares will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.

Connecting the Dots

Because all shares of common stock held by a nonleveraged ESOP are considered outstanding regardless of vesting requirements, the unvested portion of participants’ allocated shares are not considered participating securities.

7.2.2.2.2 Dividends on Convertible Preferred Stock

Section 3.2.2 discusses the general requirement to adjust net income (loss) for dividends on preferred stock to arrive at income available to common stockholders, which is the numerator in the calculation of EPS. ASC 718-40-45-1 explains that this general requirement applies to all shares of convertible preferred stock held by a nonleveraged ESOP, other than any suspense pension reversion shares. Dividends on outstanding shares of convertible preferred stock should include undistributed earnings of the sponsor if the outstanding shares of convertible preferred stock held by the nonleveraged ESOP meet the definition of a participating security. For example, if the shares of convertible preferred stock allocated to participants (whether vested or unvested) contain rights to participate in dividends with common shareholders, the allocated shares of convertible preferred stock held by a nonleveraged ESOP would meet the definition of a participating security. See Section 5.3 for further discussion of the definition of a participating security.

7.2.2.3 Outstanding Shares

7.2.2.3.1 Common Stock

All shares of common stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares are considered outstanding, and the sponsor must include such shares in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.

Connecting the Dots

Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of common stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.2.3.2 Convertible Preferred Stock

A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a nonleveraged ESOP as a result of the payment of dividends (see Section 7.2.2.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a nonleveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a nonleveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon events outside the control of the sponsor.

A sponsor’s diluted EPS will be further affected by the application of the if-converted method to the weighted-average number of shares of convertible preferred stock held by a nonleveraged ESOP. The if-converted method should be applied to all shares of convertible preferred stock held by a nonleveraged ESOP that are not considered suspense pension reversion shares. Section 4.4.1 discusses the general requirement to apply the if-converted method to convertible preferred stock in the calculation of diluted EPS. ASC 718-40-45-6 through 45-8 (excerpted in Section 7.2.3.1) further describe how the if-converted method is applied to convertible preferred stock held by a leveraged ESOP. ASC 718-40-45-9 explains that this guidance is also relevant to the accounting for a nonleveraged ESOP that holds convertible preferred stock. See Section 7.2.3.3.2 for further discussion.

Connecting the Dots

Given the recognition guidance in ASC 718-40 that applies to nonleveraged ESOPs, any vesting requirements associated with allocated shares of convertible preferred stock held by an ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.3 Leveraged ESOPs

7.2.3.1 General

The sponsor’s recognition and measurement of transactions involving leveraged ESOPs is more complicated than the accounting for nonleveraged ESOPs. The additional complications arise because a leveraged ESOP borrows money to acquire shares of common stock or convertible preferred stock of the sponsor and initially holds those shares in a suspense account. In contrast, a nonleveraged ESOP generally only holds common shares or convertible preferred shares that have been allocated to participants.

The shares held in the suspense account by a leveraged ESOP are referred to as suspense shares. Suspense shares are shares that have not been released, committed to be released, or allocated to participant accounts. Such shares generally collateralize the debt of a leveraged ESOP. The ESOP typically repays amounts on the borrowed funds as it receives contributions from the sponsor and dividends on the shares held. As the ESOP’s debt is repaid, suspense shares are allocated to participant accounts.

ASC 718-40-25-10 specifies that the sponsor must initially report the issuance of shares, sale of treasury shares, or acquisition of shares in the market by a leveraged ESOP as outstanding shares, with a “corresponding charge to unearned [ESOP] shares, a contra-equity account.” As shares are committed to be released, the contra-equity account for the unearned ESOP shares is credited with an offsetting debit to compensation cost, dividends payable, or other liabilities, depending on the specific purpose for the release of shares. Compensation cost is measured at the fair value of the shares as of the date the shares are committed to be released; any difference between the fair value and the original cost of the shares that is credited to the contra-equity account for the unearned ESOP shares is recognized as an adjustment to APIC. At any point in time, a leveraged ESOP will hold shares of common stock or convertible preferred stock that are considered suspense shares. Such shares are reflected in the sponsor’s balance sheet as unearned ESOP shares, a contra-equity account.

The above discussion serves as a high-level overview of the recognition and measurement guidance for leveraged ESOPs. For the specific recognition and measurement requirements applicable to leveraged ESOPs, sponsors should look to the accounting guidance in ASC 718-40.

ASC 718-40 contains the following guidance relevant to the EPS accounting for sponsors of leveraged ESOPs:

ASC 718-40

EPS

Issuance of Shares or the Sale of Shares to an Employee Stock Ownership Plan

45-2 Paragraph 718-40-25-10 states that an employer shall report the issuance of shares or the sale of treasury shares to an employee stock ownership plan when they occur and shall report a corresponding charge to unearned employee stock ownership plan shares, a contra-equity account. That account should be presented as a separate item in the balance sheet.

EPS

45-3 For purposes of computing basic and diluted earnings per share (EPS), employee stock ownership plan shares that have been committed to be released shall be considered outstanding. Employee stock ownership plan shares that have not been committed to be released shall not be considered outstanding.

45-4 Employers that use dividends on allocated employee stock ownership plan shares to pay debt service shall adjust earnings applicable to common shares in the if-converted computation for the difference (net of income taxes) between the amount of compensation cost reported and the amount of compensation cost that would have been reported if the allocated shares had been converted to common stock at the beginning of the period.

45-5 Prior period EPS shall not be restated for changes in the conversion rates.

Convertible Preferred Shares

45-6 The number of common shares that will be issued on conversion of the convertible shares held by an employee stock ownership plan that have been committed to be released shall be deemed outstanding in the if-converted EPS computations for diluted EPS if the effect is dilutive. Convertible preferred shares held by the employee stock ownership plan that have not been committed to be released shall not be considered outstanding and, accordingly, would be excluded from the if-converted computations for diluted EPS.

45-7 When participants withdraw account balances containing convertible preferred shares from an employee stock ownership plan, they may be entitled to receive common shares or cash with a value equal to either the fair value of the convertible preferred shares or a stated minimum value per share. Accordingly, if the value of the common stock issuable is less than the stated minimum value or the fair value of the preferred, participants may receive common shares or cash with a value greater than the value of the common shares issuable at the stated conversion rate. In determining EPS, the employer shall presume that such a shortfall will be made up with shares of common stock. However, that presumption may be overcome if past experience or a stated policy provides a reasonable basis to believe that the shortfall will be paid in cash. In applying the if-converted method, the number of common shares issuable on assumed conversion, which shall be included in the denominator of the EPS calculation, shall be the greater of the following:

The shares issuable at the stated conversion rate
The shares issuable if the participants were to withdraw the shares from their accounts.

45-8 Shares issuable on assumed withdrawal shall be computed based on the ratio of the average fair value of the convertible stock (or, if greater, its stated minimum value) to the average fair value of the common stock.

The calculation of basic and diluted EPS by a sponsor of a leveraged ESOP differs significantly from the EPS accounting by a sponsor of a nonleveraged ESOP because, unlike shares held by nonleveraged ESOPs, all shares held by leveraged ESOPs are not considered outstanding for EPS purposes. This difference exists because the unallocated shares serve as collateral on the loan obligation of a leveraged ESOP. According to ASC 718-40-45-3, shares held by a leveraged ESOP that have been either allocated or committed to be released (on the basis of the debt service payments) should be considered outstanding in the calculation of EPS. Shares that have not been committed to be released should not be included in the calculation of either basic or diluted EPS. As with the accounting for nonleveraged ESOPs, the vested status of a leveraged ESOP’s outstanding shares is not relevant to the sponsor’s calculation of basic and diluted EPS.

7.2.3.2 Dividends

7.2.3.2.1 Dividends on Common Stock

Dividends paid on shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) are charged to retained earnings. The payment of such dividends will generally have no impact on basic or diluted EPS unless they are paid in additional shares of common stock (i.e., unless they increase the outstanding shares of common stock held by the ESOP). If the sponsor has multiple classes of common stock or participating securities and is required to apply the two-class method, the shares of common stock held by the ESOP that are considered outstanding will be treated in the same manner as other outstanding shares of common stock of the same class issued by the sponsor to other investors. See Section 7.2.4.4 and Chapter 5 for further discussion of the two-class method.

Connecting the Dots

Generally, all dividends paid in cash on all shares of common stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of common stock to participants as a substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of common stock is the additional number of outstanding shares of common stock that are included in the denominator.

Because all shares of common stock held by a leveraged ESOP that are allocated (including committed-to-be-released shares) are considered outstanding regardless of vesting requirements, the unvested portion of shares of common stock allocated to participants is not considered participating securities. Although atypical, if dividends on unallocated shares of common stock are paid to participants or added to participant accounts, the sponsor must treat those dividends as additional compensation expense in accordance with ASC 718-40-25-16. In these circumstances, the sponsor should consider whether the two-class method should be applied to its undistributed earnings.

7.2.3.2.2 Dividends on Convertible Preferred Stock

Section 3.2.2 discusses the general requirement to adjust net income (loss) for dividends on preferred stock to arrive at income available to common stockholders, which is the numerator in the calculation of EPS. ASC 718-40-45-1 explains that this general requirement applies to all shares of convertible preferred stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1). Dividends on outstanding shares of convertible preferred stock should include undistributed earnings of the sponsor if the outstanding shares of convertible preferred stock held by the leveraged ESOP meet the definition of a participating security. See Section 5.3 for further discussion of the definition of a participating security.

Connecting the Dots

Generally, all dividends paid in cash on shares of convertible preferred stock held by a leveraged ESOP are used for debt service and the ESOP allocates additional shares of convertible preferred stock to participants as substitute payment of dividends on allocated shares. Provided that the monetary value of the additional allocated shares equals the cash amount of the dividends, the only additional impact on EPS that will result from the payment of dividends in additional shares of convertible preferred stock is the additional number of outstanding shares of convertible preferred stock that are used in the calculation of diluted EPS under the if-converted method (see Section 7.2.3.3.2).

If the shares of convertible preferred stock allocated to participants (whether vested or unvested) contain rights to participate in dividends with common shareholders, the allocated shares of convertible preferred stock held by a nonleveraged ESOP would meet the definition of a participating security. Although atypical, if dividends on unallocated shares of convertible preferred stock are paid to participants or added to participant accounts, the sponsor must treat such dividends as additional compensation expense in accordance with ASC 718-40-25-16. In these circumstances, the sponsor should also consider whether the two-class method should be applied to its undistributed earnings.

7.2.3.3 Outstanding Shares

7.2.3.3.1 Common Stock

Shares of common stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1) must be included in the denominator of both basic and diluted EPS on a weighted-average basis. The treatment of such shares is the same as that for outstanding shares of common stock owned by investors. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of common stock that are redeemable at the option of the participant or upon the occurrence of events outside the sponsor’s control.

Connecting the Dots

As with nonleveraged ESOPs, the vesting requirements associated with outstanding shares of common stock held by a leveraged ESOP have no bearing on the impact of those shares on basic and diluted EPS.

7.2.3.3.2 Convertible Preferred Stock

A sponsor’s basic EPS will be affected by shares of convertible preferred stock held by a leveraged ESOP as a result of dividend payments (see Section 7.2.3.2.2), redemptions, and remeasurement adjustments under ASC 480-10-S99-3A. Redemptions of preferred stock are addressed in Section 3.2.2.6. That guidance applies to redemptions of convertible preferred stock held by a leveraged ESOP even if the redeemed shares remain in the ESOP for reallocation to other participants. See Section 7.2.4 for additional considerations related to situations in which a leveraged ESOP holds shares of convertible preferred stock that are redeemable at the option of the participant or upon the occurrence of events outside the control of the sponsor.

A sponsor’s diluted EPS will be further affected by the application of the if-converted method to the weighted-average number of shares of convertible preferred stock held by a leveraged ESOP that are considered outstanding (as discussed in Section 7.2.3.1). Section 4.4.1 discusses the general requirement to apply the if-converted method to convertible preferred stock in the calculation of diluted EPS. ASC 718-40-45-6 through 45-8 further describe how the if-converted method is applied to convertible preferred stock held by a leveraged ESOP. That guidance explains that, for diluted EPS purposes, the following should be considered:

In the calculation of adjustments to the numerator related to the assumed conversion of convertible preferred stock into common stock, in addition to the adjustment for dividends on the convertible preferred stock that would not have been paid during the period if the convertible preferred stock had been converted into common stock, adjustments are also needed for the difference in tax benefits and compensation cost that would exist if the convertible preferred stock had been converted into common stock. See the examples in Sections 7.2.3.5.3 and 7.2.3.5.4.
Upon withdrawal of account balances, participants may be required, or may have the right, to either convert their shares of convertible preferred stock into shares of common stock or receive a cash amount equal to the conversion value. The amount of cash or the number of shares of common stock received upon conversion may equal the greater of (1) the if-converted value based on the stated conversion terms or (2) a stated minimum amount of the convertible preferred stock. The potential dilution calculated under the if-converted method must be the greater of those two amounts. In addition, the more dilutive of the two-class method or the if-converted method must be applied if the outstanding shares of convertible preferred stock meet the definition of a participating security. See further discussion in Section 5.5.4.

Connecting the Dots

In the calculation of diluted EPS, it is presumed that a contract that may be settled in cash or shares will be settled in shares. This presumption may not be overcome; therefore, a sponsor must apply the if-converted method to calculate the effect on diluted EPS of convertible preferred stock held by a leveraged ESOP. However, the numerator in the calculation may be affected in accordance with the guidance in ASC 260 on contracts that may be settled in cash or stock. (See further discussion in Section 4.7.)

7.2.3.4 Accounting Under SOP 76-3

AICPA SOP 76-3

.11 The Division believes that all shares held by an ESOP should be treated as outstanding shares in the determination of earnings per share. An ESOP is a legal entity holding shares issued by the employer, whether or not those shares have been allocated to employee accounts.

.12 Dividends paid on shares held by an ESOP should be charged to retained earnings. Such dividends should not be included at any time in compensation expense.

As discussed in Section 7.2.1.1, certain sponsors may still be applying the grandfathered guidance in SOP 76-3, as interpreted in EITF Issue 89-8, for shares acquired by leveraged ESOPs before January 1, 1993 (see ASC 105-10-70-2(c)). Under SOP 76-3, the accounting principles for nonleveraged ESOPs are the same as those for leveraged ESOPs. Sponsors that account for a leveraged ESOP in accordance with SOP 76-3 should charge all dividends to retained earnings and all shares held by a leveraged ESOP, regardless of whether they are allocated to participants, should be included in the denominator for both basic and diluted EPS. In EITF Issue 92-3, the Task Force reached a consensus that the tax benefits from dividends on unallocated stock held by a leveraged ESOP, which are recognized in retained earnings along with those dividends, should not be an adjustment to net income in the calculation of EPS. The Task Force noted that this consensus also applies to the application of the if-converted method to convertible preferred stock held by a leveraged ESOP.

The example below illustrates the accounting by a sponsor of a leveraged ESOP with shares of common stock accounted for under both SOP 76-3 and ASC 718-40.

Example 7-8

ESOP Shares Accounted for Under SOP 76-3 and ASC 718-40

Assume the following:

Entity A has sponsored an ESOP that holds shares of its common stock.
The ESOP has three direct loans.
The ESOP has unallocated shares that pertain to all three loans.
Shares of common stock purchased with the proceeds of the first loan were acquired before January 1, 1993, and are being accounted for under SOP 76-3 (as interpreted by EITF Issue 89-8).
Shares of common stock purchased with the proceeds of the second and third loans were acquired after December 31, 1992, and are being accounted for under ASC 718-40.

In the calculation of EPS, the unallocated shares of common stock pertaining to the first loan should be considered outstanding and included in the denominator in the calculations of both basic and diluted EPS. The unallocated shares of common stock pertaining to the second and third loans should not be considered outstanding in the denominator in the calculations of basic and diluted EPS until they have been committed to be released. All allocated shares of common stock held by the ESOP are included in the denominator in the calculations of both basic and diluted EPS. The accounting policies for each block of shares should be disclosed in the financial statements.

7.2.3.5 EPS Examples

ASC 718-40 includes four comprehensive examples illustrating the accounting for leveraged ESOPs. Those examples are shown below.

7.2.3.5.1 Common Stock Leveraged ESOP With a Direct Loan

ASC 718-40-55-4 through 55-8 contain an example illustrating an ESOP that owns common stock and is leveraged through a direct loan. The example addresses the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Case A: A Common-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan

55-4 This Case illustrates a common stock leveraged employee stock ownership plan with a direct loan. This Case has the following assumptions:

On January 1, Year 1, Entity A establishes a leveraged employee stock ownership plan.
The employee stock ownership plan borrows $1,000,000 from an outside lender at 10 percent for 5 years and uses the proceeds to buy 100,000 shares of newly issued common stock of the sponsor for $10 per share, which is the market price of those shares on the date of issuance.
Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
Dividends on all shares held by the employee stock ownership plan are used for debt service.
Cash contributions are made at the end of each year.
The year-end and average market values of a share of common stock follow.
The common stock pays normal dividends at the end of each quarter of 12.5 cents per share ($50,000 for the employee stock ownership plan’s shares each year). Accordingly, in this Case, the average fair value of shares is used to determine the number of shares used to satisfy the employers’ obligation to replace dividends on allocated shares used for debt service.
Principal and interest are payable in equal annual installments at the end of each year. Debt service is as follows.
The number of shares released each year is as follows.
The number of shares released for dividends is determined by dividing the amount of dividends on allocated shares by the average fair value of a share of common stock (for Year 2: $10,000 divided by $10.25 equals 976 shares). In this illustration, the remaining shares are released for compensation (for Year 2: 20,000 less 976 equals 19,024 shares).
Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participant accounts the following year. Shares released and allocated follow.
Income before employee stock ownership plan related charges is as follows.
All interest cost and compensation cost are charged to expense each year.
Excluding employee stock ownership plan shares, 1,000,000 shares are outstanding on average each year.
Entity A follows the guidance in Subtopic 740-10.
Entity A’s combined statutory tax rate is 40 percent each year.
Entity A’s only book-tax differences are those associated with its employee stock ownership plan.
No valuation allowance is necessary for deferred tax assets.

55-5 The following table sets forth Entity A’s employee stock ownership plan-related information. All amounts represent changes (credits in parentheses) in account balances.

55-6 Entity A would record journal entries from inception through Year 5 as follows.

55-7 Assuming Entity A terminates its employee stock ownership plan at the end of Year 2 (when the fair value of the suspense shares is $540,000 [60,000 shares multiplied by $9 per share], the unearned employee stock ownership plan share balance is $600,000, and the unpaid debt balance is $656,000), and assuming the suspense shares are sold to pay down the debt, Entity A would make the following journal entry.

55-8 The following tables set forth Entity A’s tax (assuming no termination) and earnings per share (EPS) computations.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as a result of (1) the reduction in net income associated with the interest and compensation expense recognized, net of the income tax benefit, and (2) the increase in outstanding shares of common stock for the shares of common stock released and allocated to participants in each financial reporting period. As shares of common stock are released from the collateral on the loan and allocated to participants, compensation expense is recognized in an amount equal to the fair value of the shares allocated and those shares become outstanding for the calculation of basic EPS. Dividends paid on the shares of common stock that have been allocated to participant accounts, which are paid in additional shares of common stock, are recognized in retained earnings and do not affect the numerator in the calculation of basic EPS. However, these additional shares of common stock do increase the outstanding shares of common stock in the denominator in the calculation of basic EPS. Dividends paid on unallocated shares of common stock are recorded as a reduction of debt and accrued interest and have no impact on basic EPS. In this example, there is no incremental impact on the sponsor’s calculation of diluted EPS on the basis of the terms of the leveraged ESOP.

7.2.3.5.2 Common Stock Leveraged ESOP With an Indirect Loan

ASC 718-40-55-10 through 55-19 contain an example illustrating an ESOP that owns common stock and is leveraged through an indirect loan. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example does not take into account the impact of the leveraged ESOP on the sponsor’s EPS calculations. However, the EPS considerations are discussed after the example.

ASC 718-40

Case B: A Common-Stock Leveraged Employee Stock Ownership Plan Used to Fund the Employer’s Match of a 401(k) Savings Plan With an Indirect Loan

55-10 This Case illustrates a common stock leveraged employee stock ownership plan used to fund the employer’s match of a 401(k) savings plan with an indirect loan. On January 1, Year 1, Entity B established an employee stock ownership plan to fund the employer’s match of its savings plan. All of the assumptions are the same as those outlined in Case A for Entity A, except as follows:

Entity B loaned its employee stock ownership plan $1,000,000 and concurrently obtained a related loan. The terms of both lending arrangements are the same as for Case A’s outside loan.
Entity B uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The average fair value of the shares for each year is used to determine the number of shares necessary to satisfy the matching obligation.
If the fair value of the shares released is less than Entity B’s matching obligation, Entity B contributes additional newly issued shares to the employee stock ownership plan to satisfy the remaining obligation.
Shares used to replace dividends on allocated shares used to service debt do not count toward the employer’s match.
The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.

Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $10.75 [see above table for average fair values] equals 18,605 shares).

55-11 The 20,000 shares released each year based on debt service payments follow.

55-12 Cumulative share amounts follow.

55-13 Note that dividends on top-up shares are paid in cash. Cumulative shares released include top-up shares.

55-14 The following table sets forth Entity B’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.

55-15 Entity B would record journal entries from inception through Year 2 as follows.

55-16 Note that the journal entry differs from Case A because Entity B receives an additional $10,000 deduction ($4,000 tax benefit) for the 976 top-up shares.

55-17 Assuming Entity B terminated its employee stock ownership plan at the end of Year 4 (when the fair value of the suspense shares is $240,000, the unearned employee stock ownership plan shares balance is $200,000, and the unpaid debt balance is $239,800), and assuming the employer buys back the suspense shares in an amount equal to the debt balance, there will be 17 suspense shares left, which must be allocated to participants. (In this Case the shares are used to partially satisfy the employer’s 401(k) matching obligation.) Entity B would make the following journal entry.

55-18 In this Case, Entity B’s taxes would be computed the same way as Case A. For Entity B the average number of employee stock ownership plan shares outstanding would be as follows.

55-19 This represents the cumulative numbers of shares released at the beginning of the year plus the end of the year (see the table in the preceding paragraph) divided by 2.

Although not specifically discussed in this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as a result of (1) the reduction in net income associated with the interest and compensation expense recognized, net of the income tax benefit, and (2) the increase in outstanding shares of common stock resulting from the release and allocation of common stock to participants in each financial reporting period. As shares of common stock are released from the collateral on the loan and allocated to participants, compensation expense is recognized in an amount equal to the fair value of the shares allocated and those shares become outstanding for the calculation of basic EPS. Compensation expense includes the fair value of the additional “top-up” shares allocated to participants. Dividends paid on the shares of common stock that have been allocated to participant accounts, which are paid in additional shares of common stock, are recognized in retained earnings and do not affect the numerator in the calculation of basic EPS. However, these additional shares of common stock do increase the outstanding shares of common stock in the denominator in the calculation of basic EPS. Dividends paid on unallocated shares of common stock are recorded as a reduction of debt and accrued interest and have no impact on basic EPS. In this example, there is no incremental impact on diluted EPS on the basis of the terms of the leveraged ESOP.

The total compensation expense recognized (before the effect of income taxes) that reduces the numerator in the calculation of basic EPS is as follows:

Dividends paid on allocated shares of common stock, regardless of whether they are paid in cash or with additional shares of common stock, do not affect the numerator in the calculation of EPS.

The following table shows the average shares of common stock that are released and allocated to participants in each financial reporting period and that become outstanding shares included in the denominator for basic EPS on a weighted-average basis:8

7.2.3.5.3 Convertible Preferred Stock Leveraged ESOP With a Direct Loan

The example in ASC 718-40-55-21 through 55-29 illustrates an ESOP that owns convertible preferred stock and is leveraged through a direct loan. The example includes the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Case C: A Convertible-Preferred-Stock Leveraged Employee Stock Ownership Plan With a Direct Loan

55-21 This Case illustrates a convertible preferred stock leveraged employee stock ownership plan with a direct loan. On January 1, Year 1, Entity D established an employee stock ownership plan with convertible preferred stock. The assumptions are as follows:

The borrowing, debt service, earnings, and tax assumptions are the same as those for Entity A outlined in Case A.
On January 1, Year 1, the employee stock ownership plan used the proceeds of the debt to buy 80,000 shares of newly issued convertible preferred stock of Entity D for $12.50 per share.
The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan shares). Accordingly, in this Case the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
All dividends on employee stock ownership plan shares are used for debt service.
The preferred stock is convertible into common stock at 1:1 ratio.
Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
The preferred stock is callable at $13.00 per share.
There is one vote per preferred share.
The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.

55-22 The shares released each year follow.

55-23 Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (16,000 multiplied by $1.25 in Year 2; 32,000 multiplied by $1.25 in Year 3; and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this illustration the remaining shares are released for compensation (16,000 less 1,600 in Year 2, 16,000 less 3,200 in Year 3, and so forth).

55-24 Additional share information follows.

55-25 The following chart sets forth Entity D’s employee stock ownership plan related information. All amounts represent changes (credits in parentheses) in account balances.

55-26 The journal entries to reflect the accounting for Entity D’s employee stock ownership plan from inception through Year 2 are as follows.

55-27 The tax and EPS calculations for Entity D follow.

55-28 If-converted computation.

55-29 Computations for (1), (2), and (3) follow.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as follows:

Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares. Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock are recorded as a reduction of debt and accrued interest and have no impact on the numerator.
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, basic EPS is unaffected because no shares of convertible preferred stock have been converted into shares of common stock.

The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:

Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.

7.2.3.5.4 Convertible Preferred Stock Leveraged ESOP With an Employer Loan

The example in ASC 718-40-55-30 through 55-33 illustrates an ESOP that owns convertible preferred stock and is leveraged through an internal loan with the sponsor. In this example, the ESOP is used to fund the sponsor’s match of its 401(k) savings plan. The example includes the impact on the sponsor’s basic and diluted EPS.

ASC 718-40

Example 2: A Convertible, Preferred-Stock, Leveraged Employee Stock Ownership Plan Used to Fund a 401(k) Savings Plan With an Employer Loan

55-30 This Example illustrates the guidance in paragraphs 718-40-25-7 through 25-17; 718-40-30-1 through 30-4; 718-40-35-1; 718-40-40-1 through 40-7; and 718-40-45-3 through 45-8 for a convertible preferred stock leveraged employee stock ownership plan used to fund a 401(k) savings plan with an employer loan. This Example has the following assumptions:

On January 1, Year 1, Entity E established a leveraged employee stock ownership plan with convertible preferred stock.
The employee stock ownership plan borrowed $1,000,000 from the employer at 10 percent for 5 years and used the proceeds to buy 80,000 shares of newly issued convertible preferred stock of Entity E for $12.50 per share.
Debt service is funded by cash contributions and dividends on employer stock held by the employee stock ownership plan.
Dividends on all of the original 80,000 shares held by the employee stock ownership plan are used for debt service.
Cash contributions are made at the end of each year.
The preferred stock pays dividends quarterly at an annual rate of $1.25 per share ($100,000 each year for the employee stock ownership plan’s shares). Accordingly, in this Example, the average fair value of the shares is used to determine the number of shares used to satisfy the employer’s obligation to replace dividends on allocated shares used for debt service.
The preferred stock is convertible at a 1:1 ratio into common stock.
Participants may not withdraw the convertible preferred stock from the employee stock ownership plan. When participants become eligible to withdraw shares from their account, they must either convert to common stock or redeem the preferred shares.
The preferred stock has a guaranteed minimum redemption value of $12.50 per share, to be paid in shares of common stock.
The preferred stock is callable at $13.00 per share.
There is one vote per preferred share.
The year-end and average fair values of a share of preferred stock (fair value is assumed to be greater than or equal to minimum value) follow.
Entity E uses shares released by the employee stock ownership plan to satisfy its matching obligation of 50 percent of voluntary employee contributions to the savings plan. The fair value of the shares at the end of each month is used to determine the number of shares necessary to satisfy the matching obligation. (Accordingly, in this Example, average fair values are used to determine the number of shares needed to satisfy the employer’s liabilities.)
If the fair value of the shares released is less than Entity E’s matching obligation, Entity E contributes additional newly issued shares (top-up shares) to the employee stock ownership plan to satisfy the remaining obligation. The top-up shares are issued at the end of the year. Dividends on the top-up shares are paid in cash.
Shares that replace dividends on allocated shares used to service debt do not count toward the employer’s match.
The employee contributions, required employer match, and the number of shares needed to fund the employee match follow.

Note that the number of shares needed to satisfy the employer’s matching obligation is determined by dividing the matching obligation by the average fair value of a share of common stock (for Year 1: $200,000 divided by $12.50 equals 16,000 shares).
Principal and interest are payable in annual installments at the end of each year. Debt service is as follows.
Shares are released from the suspense account for allocation to participants’ accounts based on a principal-plus-interest formula. The released shares are allocated to participants’ accounts at the beginning of the following year. Shares are assumed to be released ratably throughout the year.
The shares released each year follow.

Note that the number of shares released for dividends is determined by dividing the amount of dividends on allocated shares (12,481 multiplied by $1.25 in Year 2; 26,686 multiplied by $1.25 in Year 3, and so forth) by the average fair value of a share of preferred stock ($12.50 in Years 2 and 3). In this example, the remaining shares are released for compensation (14,205 less 1,248 in Year 2; 16,286 less 2,669 in Year 3, and so forth).
Additional share information follows.
The pre-employee stock ownership plan income, shares outstanding, and income tax assumptions are the same as for Example 1 (see paragraph 718-40-55-3).

55-31 The following chart sets forth Entity E’s employee stock ownership plan related information. All amounts represent changes (credits are in parentheses) in account balances.

55-32 The journal entries to reflect the accounting for Entity E’s employee stock ownership plan from inception through Year 2 are as follows.

55-33 The tax and earnings per share (EPS) computations for Entity E follow.

In this example, the leveraged ESOP affects the sponsor’s calculation of basic EPS as follows:

Numerator — Income available to common stockholders is reduced by the interest and compensation expense recognized and dividends paid on shares of convertible preferred stock allocated to participants, net of the related income tax benefits. As shares of convertible preferred stock are released from the collateral on the loan and allocated to participant accounts, the sponsor reports compensation expense equal to the current fair value of the shares (including the “top-up” shares). Dividends on allocated shares, which are paid in additional shares of convertible preferred stock, are recognized in retained earnings and reduce income available to common stockholders by an amount equal to the fair value of the additional shares of convertible preferred stock allocated to participant accounts. Dividends paid on unallocated shares of convertible preferred stock that are used to repay the debt between the sponsor and ESOP have no impact on the numerator.
Denominator — Because the ESOP holds convertible preferred stock that does not represent a participating security, there is no impact on basic EPS because no shares of convertible preferred stock have been converted into shares of common stock.

The following additional adjustments are necessary for the sponsor’s calculation of diluted EPS:

Numerator — Under the if-converted method, the following three adjustments are made to the numerator in the calculation of basic EPS: (1) an add-back equal to dividends paid during the year on allocated shares of convertible preferred stock, net of tax, under the assumption that those allocated shares were converted into common stock; (2) an add-back equal to the tax benefit that would have been received if the allocated shares of convertible preferred stock had been converted into shares of common stock and received dividends on the basis of the dividends paid on shares of common stock during the year; and (3) the additional compensation expense, net of tax, that would have been reported if the shares of convertible preferred stock had been converted into shares of common stock. All of these adjustments are calculated on the basis of the weighted-average outstanding shares during the period.
Denominator — Under the if-converted method, incremental shares of common stock are included under an assumption that the allocated shares of convertible preferred stock have been converted into shares of common stock. The if-converted method is applied to allocated shares of convertible preferred stock on a weighted-average basis. In all years except the final year, the application of the if-converted method is based on an assumption of redemption in shares of common stock on the basis of the minimum stated amount of the convertible preferred stock because this approach is more dilutive than conversion at the stated conversion terms.

7.2.4 Redeemable Shares Held by an ESOP

7.2.4.1 Scope of Temporary Equity Accounting

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(2) ASR 268 requires preferred securities that are redeemable for cash or other assets to be classified outside of permanent equity if they are redeemable (1) at a fixed or determinable price on a fixed or determinable date, (2) at the option of the holder, or (3) upon the occurrence of an event that is not solely within the control of the issuer. As noted in ASR 268, the Commission reasoned that “[t]here is a significant difference between a security with mandatory redemption requirements or whose redemption is outside the control of the issuer and conventional equity capital. The Commission believes that it is necessary to highlight the future cash obligations attached to this type of security so as to distinguish it from permanent capital.”

S99-3A(3) Although ASR 268 specifically describes and discusses preferred securities, the SEC staff believes that ASR 268 also provides analogous guidance for other redeemable equity instruments including, for example, common stock, derivative instruments, noncontrolling interestsFN2, securities held by an employee stock ownership planFN3, and share-based payment arrangements with employees.FN4 The SEC staff’s views regarding the applicability of ASR 268 in certain situations is described below.

____________________

FN2 The Master Glossary defines noncontrolling interest as “The portion of equity (net assets) in a subsidiary not attributable, directly or indirectly, to a parent. A noncontrolling interest is sometimes called a minority interest.” ASR 268 applies to redeemable noncontrolling interests (provided the redemption feature is not considered a freestanding option within the scope of Subtopic 480-10). Where relevant, specific classification and measurement guidance pertaining to redeemable noncontrolling interests has been included in this SEC staff announcement.

FN3 ASR 268 applies to equity securities held by an employee stock ownership plan (whether or not allocated) that, by their terms, can be put to the registrant (sponsor) for cash or other assets. Where relevant, specific classification and measurement guidance pertaining to employee stock ownership plans has been included in this SEC staff announcement.

FN4 As indicated in Section 718-10-S99, ASR 268 applies to redeemable equity-classified instruments granted in conjunction with share-based payment arrangements with employees. Where relevant, specific classification and measurement guidance pertaining to share-based payment arrangements with employees has been included in this SEC staff announcement.

ASC 480-10-S99-3A addresses the classification and measurement of redeemable equity securities. ASC 480-10-S99-3A(3) indicates that the classification and measurement guidance applies to shares of stock held by ESOPs, whether nonleveraged or leveraged. ASC 480-10-S99-3A must be applied by SEC registrants and in filings of financial statements by entities in the process of registering securities with the SEC. The application of ASC 480-10-S99-3A by other nonpublic entities is optional. See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of which entities are subject to the guidance in ASC 480-10-S99-3A.

7.2.4.2 Classification of ESOP Shares Within Temporary Equity

7.2.4.2.1 Classification of Shares

ASC 480-10-S99-3A(2) requires that equity securities be classified in temporary equity if they are redeemable at the option of the holder or upon the occurrence of an event not solely within the issuer’s control. Thus, shares of common stock or convertible preferred stock held by an ESOP, whether nonleveraged or leveraged, that are redeemable at the option of the participant or upon any event outside the sponsor’s control must be classified within temporary equity.

The shares of stock held by an ESOP may meet the requirements for classification in temporary equity because of various redemption features and terms. As discussed in EITF Issue 89-11, a sponsor of an ESOP is required to provide participants with a put option on their shares of stock when those shares are not readily tradable. EITF Issue 89-11 states, in part:9

Under federal income tax regulations, employer securities (such as convertible preferred stock) that are held by participants in an employee stock ownership plan (ESOP) and that are not readily tradeable on an established market must include a put option. The put option is a right to demand that the sponsor redeem shares of employer stock held by the participant for which there is no market for an established cash price. The employer may have the option to issue marketable securities for all or a portion of that option rather than to pay cash. The provisions of the ESOP may permit the ESOP to substitute for the sponsor as buyer of the employer stock; however, in no case can the sponsor require the ESOP to assume the obligation for the put option.

ASC 718-40-25-2 also discusses this put option requirement and other situations in which sponsors must repurchase shares of stock held by participants that withdraw their shares. ASC 718-40-25-2 states:

Regardless of whether an employee stock ownership plan is leveraged or nonleveraged, employers are required to give a put option to participants holding employee stock ownership plan shares that are not readily tradable, which on exercise requires the employer to repurchase the shares at fair value. Public entity sponsors sometimes offer cash redemption options to participants who are eligible to withdraw traded shares from their accounts, which on exercise requires the employer to repurchase the shares at fair value. Employers shall report the satisfaction of such option exercises as purchases of treasury stock.

In addition to the situations described above, shares of stock held by an ESOP may be redeemable as a result of various other features and terms, including, but not limited to, the following:

Shares of convertible preferred stock held by the ESOP may be redeemable upon the occurrence of a change of control or another deemed liquidation event involving the sponsor.
The sponsor may not have sufficient authorized and unissued shares of common stock to achieve the conversion of convertible preferred stock. For example, upon withdrawal, the holder may be entitled to receive a variable number of shares of common stock on the basis of a minimum stated value without any stated cap on the maximum number of shares of common stock that may need to be delivered. In the absence of a stated cap on the number of shares of common stock that must be delivered, the sponsor does not control the ability to deliver shares of common stock to satisfy such settlement requirements.

Connecting the Dots

The plan documents for an ESOP that holds common stock listed on a stock exchange may contain a stated put option that becomes operable only if the sponsor’s shares of common stock are no longer readily tradable (e.g., the shares are delisted from the stock exchange). In these situations, temporary equity classification of the shares of common stock held by the ESOP is required because it is not within an entity’s control to maintain the readily tradable status of its common stock. However, when the plan documents for an ESOP that holds common stock listed on a stock exchange do not contain a stated put option in the event that the sponsor’s shares of common stock are no longer readily tradable, additional consideration is necessary. In these situations, the sponsor does not control the ability to maintain the listing of its shares of common stock on a stock exchange. If the sponsor’s shares of common stock are delisted, they would no longer be considered readily tradable and put options would be issued to ESOP participants or their beneficiaries. However, an entity is not required to classify those shares of common stock in temporary equity if the sponsor has not yet legally conveyed a put option to the ESOP participants or their beneficiaries and if, upon receipt of a delisting notice or another event that would cause the sponsor’s shares to no longer be readily tradable, the sponsor has the unilateral ability to (1) terminate the ESOP, (2) accelerate the vesting of all shares of common stock held by the ESOP, and (3) distribute all the shares of common stock held by the ESOP participants or their beneficiaries before the sponsor’s shares become no longer readily tradable. That is, if the holder of the shares does not have a current redemption right and the sponsor controls the ability to avoid the holder’s redemption of the shares of common stock back to the sponsor under all circumstances (i.e., the sponsor controls the ability to effect a plan termination, which would avoid its requirement to provide a redemption option to the holders), temporary equity classification of the common stock held by the ESOP is not required. Note that entities must carefully evaluate the facts and circumstances to determine whether ESOP shares must be classified in temporary equity. As part of this evaluation, it may be necessary to legally interpret certain ERISA and IRC provisions related to the requirement to provide put options on shares that are not readily tradable.

In accordance with ASC 718-40-45-9, all shares held by a nonleveraged ESOP are treated as outstanding except the suspense account shares of a pension reversion ESOP, which are not treated as outstanding until they are committed to be released for allocation to participant accounts (see Section 7.2.2.1). Further, in accordance with ASC 718-40-45-3, shares held by a leveraged ESOP that have been either allocated or committed to be released (on the basis of the debt service payments) should be considered outstanding (see Section 7.2.3.1). However, when shares of stock held by an ESOP are redeemable (i.e., subject to a put option or other redemption upon the occurrence of events outside the sponsor’s control), the sponsor must classify all such shares in temporary equity. The SEC’s guidance does not distinguish between allocated and unallocated shares. See Section 7.2.4.2.2 for discussion of classification of the contra-equity account related to unearned ESOP shares. This guidance would also apply to nonleveraged ESOPs with suspense pension reversion shares.

Connecting the Dots

For both nonleveraged and leveraged ESOPs, the vested status of shares of stock held by the ESOP is not relevant to the classification of such shares within temporary equity.

See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of the classification guidance in ASC 480-10-S99-3A.

7.2.4.2.2 Classification of Unearned ESOP Shares of Leveraged ESOP

When the outstanding shares of stock of a leveraged ESOP must be classified in temporary equity, it is also appropriate to classify all or a portion of the related contra-equity account for unearned ESOP shares in temporary equity. Although not codified, EITF Issue 89-11 states, in part:

The Task Force reached a consensus that when ASR 268 (as presented in Section 211 of the “Codification of Financial Reporting Policies”) requires some or all of the value of the securities to be classified outside of permanent equity, a proportional amount of the debit in the equity section of the sponsor’s balance sheet (sometimes described as loan to ESOP or deferred compensation), if any, should be similarly classified.

7.2.4.3 Initial and Subsequent Measurement

Under ASC 480-10-S99-3A, redeemable equity securities that are classified in temporary equity must be initially measured at fair value. This requirement is generally consistent with the initial measurement guidance related to shares of stock held by an ESOP, whether nonleveraged or leveraged. In addition, ASC 480-10-S99-3A requires that redeemable equity securities classified in temporary equity be subsequently remeasured to their redemption amounts in each financial reporting period unless redemption is contingent on an event outside the sponsor’s and holder’s control and it is not probable that the instrument will become redeemable.

ASC 480-10-S99-3A contains one exception to this general classification guidance that is relevant to shares of stock held by an ESOP that are classified in temporary equity. Paragraphs 12(b) and 16(b) of ASC 480-10-S99-3A and ASC 480-10-S99-4 describe this one exception to the general measurement requirements.

ASC 480-10 — SEC Materials — SEC Staff Guidance

SEC Staff Announcement: Classification and Measurement of Redeemable Securities

S99-3A(12) Initial measurement. The SEC staff believes the initial carrying amount of a redeemable equity instrument that is subject to ASR 268 should be its issuance date fair value, except as follows: [Footnote omitted] . . .

b. For employee stock ownership plans where the cash redemption obligation relates only to a market value guarantee feature, the registrant may elect as an accounting policy to present in temporary equity either (i) the entire guaranteed market value amount of the equity securities or (ii) the maximum cash obligation based on the fair value of the underlying equity securities at the balance sheet date.

S99-3A(16) The following additional guidance is relevant to the application of the SEC staff’s views in paragraphs 14 and 15: . . .

SEC Observer Comment: Sponsor’s Balance Sheet Classification of Capital Stock With a Put Option Held by an Employee Stock Ownership Plan

S99-4 ASR 268 (see also paragraph 480-10-S99-3A) requires that to the extent that there are conditions (regardless of their probability of occurrence) whereby holders of equity securities may demand cash in exchange for their securities, the sponsor must reflect the maximum possible cash obligation related to those securities outside of permanent equity. Thus, securities held by an ESOP (whether or not allocated) must be reported outside of permanent equity if by their terms they can be put to the sponsor for cash. With respect to ESOP securities where the cash obligation relates only to market value guarantee features, the SEC staff would not object to registrants only classifying outside of permanent equity an amount that represents the maximum cash obligation of the sponsor based on market prices of the underlying security as of the reporting date; accordingly, reclassifications of equity amounts would be required based on the market values of the underlying security. Alternatively, the SEC staff would not object to classifying the entire guaranteed value amount outside of permanent equity due to the uncertainty of the ultimate cash obligation because of a possible market value decline in the underlying security.

This exception should not be applied by analogy. For example, it would not apply when an amount other than the market value guarantee may need to be redeemed by the sponsor for cash or other assets and that redemption could occur upon any event outside the sponsor’s control. If the exception does not apply, the entire carrying amount of the ESOP’s outstanding redeemable shares of stock must be classified in temporary equity.

See Chapter 9 of Deloitte’s Roadmap Distinguishing Liabilities From Equity for further discussion of the measurement guidance in ASC 480-10-S99-3A.

7.2.4.4 EPS Implications of Remeasurement Adjustments

ASC 480-10-S99-3A covers how the measurement adjustments to the redemption amounts of equity securities classified in temporary equity affect basic and diluted EPS. Generally, the EPS accounting implications are as follows:

Common stock — If the common stock is redeemable at fair value, the redemption amount adjustments have no impact on basic or diluted EPS. If the common stock is redeemable at an amount other than fair value, the two-class method of EPS must be applied and the redemption amount adjustments are treated as dividends in the application of the two-class method. Redemption provisions related to shares of common stock held by an ESOP will often reflect fair value redemptions and have no impact on the calculation of basic and diluted EPS.
Preferred stock — The redemption amount adjustments are treated as dividends in the calculation of EPS, regardless of whether the redemption is at a fair value or non–fair value amount. These deemed dividends reduce income available to common stockholders in the calculation of EPS.

Connecting the Dots

When an ESOP holds convertible preferred stock that is classified in temporary equity on the sponsor’s balance sheet, in the calculation under the if-converted method, the amount of any deemed dividends (along with any tax benefits) from remeasurement adjustments that reduce income available to common stockholders in the sponsor’s calculation of basic EPS will need to be added back to the numerator as part of the numerator adjustments discussed in Section 7.2.3.3.2.

See Sections 3.2.2.4 and 3.2.4.2 for further discussion of the EPS implications of remeasurement adjustments related to equity securities classified in temporary equity.

Footnotes

See definition of “employer securities” in IRC Section 409(l).

An employer that terminates a defined benefit pension plan may avoid part of the excise tax on an asset reversion by transferring the assets to an existing or newly created ESOP, which could be either leveraged or nonleveraged. The reverted assets may be used either to purchase shares of the employer stock or to retire existing ESOP debt. Because the number of shares the ESOP acquires in a pension plan reversion is usually more than the Internal Revenue Service permits to be allocated to participant accounts in a single year, some of the shares are held in a suspense account until they are committed to be released in future years for allocation to participant accounts. The guidance in ASC 718-40 on shares held by leveraged ESOPs applies to suspense account shares.

These calculations are based on the table in ASC 718-40-55-12.

Although not codified, the guidance in EITF Issue 89-11 is still relevant.

7.3 Other Compensation Arrangements

7.3.1 Profits Interests

Under ASC 718, awards granted as profits interests must be analyzed to determine whether they represent a substantive class of equity or whether they are more appropriately classified as a performance bonus or profit-sharing award. If a profits interest award is determined not to represent a substantive class of equity, it would not affect the calculation of EPS (other than with respect to the impact of any compensation expense on the numerator). If such an award does represent a substantive class of equity, in addition to the EPS considerations for share-based payment awards discussed in Section 7.1, entities must consider how the interest shares in the profits and losses of the issuer because a profits interest may meet the definition of a participating security to which the two-class method of EPS must be applied. See Section 5.3 for further discussion of the definition of a participating security.

7.3.2 Common Stock Issued to Fund Certain Retirement Benefit Payments

ASC 710-10

Deferred Compensation — Rabbi Trusts

05-8 The Deferred Compensation — Rabbi Trusts Subsections of this Subtopic address the accounting for deferred compensation arrangements where amounts earned by an employee are invested in the stock of the employer and placed in a rabbi trust. Certain of those plans allow the employee to immediately diversify into nonemployer securities or to diversify after a holding period (for example, six months); other plans do not allow for diversification.

05-9 The deferred compensation obligation of some plans may be settled in any of the following:

Cash, by having the trust sell the employer stock (or the diversified assets) in the open market
Shares of the employer’s stock
Diversified assets.

In other plans, the deferred compensation obligation may be settled only by delivery of the shares of the employer stock.

Deferred Compensation — Rabbi Trusts

45-3 For all of these types of plans, employer shares held by the rabbi trust shall be treated as treasury stock for earnings per share (EPS) purposes and excluded from the denominator in the basic and diluted EPS calculations. However, the obligation under the deferred compensation arrangement shall be reflected in the denominator of the EPS computation in accordance with the provisions of Section 260-10-45.

45-4 In accordance with paragraph 260-10-45-13, if an obligation is required to be settled by delivery of shares of employer stock (Plan A), those shares shall be included in the calculation of basic and diluted EPS. If the obligation may be settled by delivery of cash, shares of employer stock, or diversified assets (other than Plan A), those shares shall not be reflected in basic EPS but shall be included in the calculation of diluted EPS in accordance with paragraph 260-10-45-30 and paragraphs 260-10-45-45 through 45-46.

Some sponsors of defined benefit pension plans have issued common stock to trusts established to fund future retirement payments. The common stock of the sponsor is held until the rabbi trust is required to meet its retirement obligations, at which time the shares are sold to the public. Because the sponsor must consolidate the trust, the shares of common stock held by the trust should not be considered outstanding in the calculation of EPS. Although those transactions are not within the scope of ASC 718-40, the accounting is similar to the accounting for shares of a leveraged ESOP that have not been committed to be released, which are not considered outstanding shares. However, as discussed in ASC 710-10-45-3 and 45-4, the sponsor’s obligation under the deferred compensation arrangement should be reflected in the denominator in the EPS calculation in accordance with ASC 260-10. If an obligation must be settled by delivery of shares of employer stock (Plan A), those shares should be included in the calculations of both basic and diluted EPS. If the obligation may be settled by delivery of cash, shares of employer stock, or diversified assets (other than Plan A), those shares would not be reflected in basic EPS but would be included in the calculation of diluted EPS in accordance with the guidance in ASC 260 on contracts that may be settled in cash or stock. See further discussion in Section 4.7.