8.6 Business Combinations and Reorganizations
ASC
260-10
Business Combinations and
Reorganizations
55-17 When
common shares are issued to acquire a business in a business
combination, the computations of EPS shall recognize the
existence of the new shares only from the acquisition date.
In reorganizations, EPS computations shall be based on
analysis of the particular transaction and the provisions of
this Subtopic.
8.6.1 Business Combinations
ASC 260-10-55-17 does not permit the retrospective adjustment of
EPS for shares of common stock issued in a business combination. Shares of
common stock issued as part of the purchase price should affect the
weighted-average shares of common stock outstanding in the calculation of EPS
only from the issuance date. The same approach applies to an asset purchase that
is not accounted for as a business combination because the acquired assets do
not meet the definition of a business. In both business combinations and asset
acquisitions, the acquiring entity must also consider the impact on EPS of any
contingent consideration issuable under the guidance in ASC 260 on contingently
issuable shares (see Sections
3.3.2.5 and 4.5).
8.6.1.1 Reverse Acquisitions
Because the number of shares of common stock outstanding
after a reverse acquisition often significantly differs from the number of
shares of common stock outstanding before the reverse acquisition, the
weighted-average shares of common stock outstanding for the purpose of
comparatively presenting EPS should be retrospectively adjusted to the
earliest period presented to reflect the effect of the recapitalization that
occurs in a reverse acquisition. In effect, the reverse acquisition is
similar to a stock split for the accounting acquirer, and retrospectively
adjusting the weighted-average shares of common stock outstanding is
consistent with the accounting required by ASC 260 for stock dividends,
stock splits, and reverse stock splits. See Section 8.2.1 for further discussion
of the impact of stock dividends, stock splits, and reverse stock splits.
Case A in Example 1 in ASC 805-40-55-8 through 55-17 illustrates the
calculation of EPS in a reverse acquisition.
8.6.2 Reorganizations
ASC 260-10-55-17 states that for reorganizations, EPS
calculations should be based on analysis of the particular transaction and the
provisions of ASC 260. For this purpose, reorganizations include changes in the
ownership form of an entity as well as other changes in capital structure.
The FRM provides guidance on the EPS accounting for changes in
capital structure at or before closing of an IPO. (ASC 260, however, does not
contain such guidance.) While this guidance specifically applies to changes in
capital structure that occur in conjunction with an IPO, it would also be
relevant to other changes in capital structure.
FRM Topic 3
3430 Other Changes
in Capitalization at or Prior to Closing of an
IPO
3430.1
Generally, the historical balance sheet and
statement of operations (including EPS) should not be
revised to reflect modifications of the terms of
outstanding securities that become effective after the
latest balance sheet date, although pro forma data may
be necessary. Depending on the facts and circumstances,
the staff may not object if the registrant and its
independent accountants elect to present retroactively a
conversion of securities as if it had occurred at the
date of the latest balance sheet included in the filing
(with no adjustment of earlier statements). However, if
the original instrument accrues interest or accretes
toward redemption value after the balance sheet date
until the conversion actually occurs, or if the terms of
the conversion do not confirm the carrying value, only
pro forma presentation would be deemed appropriate.
In a manner consistent with the guidance in Section 3430 of the
FRM,4 retrospective adjustment of previously reported EPS amounts is generally
appropriate only when retrospective treatment is required under ASC 260 or other
U.S. GAAP. Such retrospective adjustments to EPS are required in the following
circumstances:
-
Prior-period adjustments (see Section 8.1).
-
Distributions and other transactions accounted for as stock dividends, stock splits, and reverse stock splits (see Section 8.2.1).
-
Rights issues (see Section 8.2.2).
-
Changes in reporting entity, which include certain common-control transactions that are treated akin to poolings-of-interest (see Section 8.6.3).
However, certain types of changes in capital structure may be
viewed as akin to a stock dividend, stock split, reverse stock split, or rights
issue for which retrospective application is appropriate for EPS purposes. We
refer to these types of changes in capital structure as split-like
changes.
The split-like situations for which retrospective
treatment may be appropriate for EPS purposes include certain carve-out
situations, certain reverse mergers (see Section 8.6.1.1), and certain other
changes in the form of ownership of an entity. Only the simplest types of
changes in the form of ownership of an entity (which may also be referred to as
reclassifications) would be considered split-like situations
for which previously reported EPS amounts may be retrospectively adjusted. These
types of simple changes in form of ownership, which are further discussed below,
do not represent the types of changes in capital structure discussed in Section
3430 of the FRM for which the SEC staff does not believe retrospective treatment
is allowed. When retrospective presentation of EPS is appropriate for changes in
the form of ownership, the historical balance sheets should generally not be
retrospectively revised. Furthermore, the retrospective adjustments to EPS may
not be made before the completion of the change in form of ownership.
As noted in Section 3430 of the FRM, the SEC staff will
generally object to retrospective treatment for conversions of equity securities
that occur in conjunction with an IPO (e.g., conversion of preferred stock into
common stock regardless of whether the conversion occurs in accordance with the
stated terms of the preferred stock). Such conversions or exchanges are
accounted for only prospectively after they have occurred. Entities are
encouraged to consult with both their independent accountants and the staff of
the SEC on a prefiling basis if they wish to account for these types of changes
in capital structure retrospectively. In the absence of prior agreement by the
SEC staff, it is not appropriate for an entity to account for any change in
capital structure that is not a split-like situation retrospectively for
EPS purposes.
In some situations, the changes in capital structure that occur
in conjunction with an IPO include both simple reclassifications and other more
complex changes. Simple and more complex changes may even occur with respect to
the same equity security. In these situations, it may be appropriate, once the
changes have occurred, to present the simple changes retrospectively for EPS
purposes and present the other changes only prospectively. Below are some
examples illustrating changes in capital structure and the related impact on
reported amounts of EPS.
Example 8-8
LLC to Corporation Conversion —
Simple Change in Ownership Form
Assume that Entity A:
- Is an LLC with one class of outstanding membership units (i.e., common units).
- Has 1 million common units outstanding.
- Has no other equity instruments or potential common stock outstanding.
- Has filed a Form S-1 registration statement for an IPO of common stock.
- Will be converted from an LLC to a corporation in conjunction with the IPO.
- Plans to sell 10 million shares of common stock to the public as part of the IPO and will convert its existing common units to shares of common stock on a 40:1 basis. Thus, after the IPO, A will have 50 million shares of common stock outstanding.
Since the conversion from common units to common stock will not happen until the
consummation of the IPO, A should present, in the
financial statements included in the Form S-1
registration statement filed with the SEC, basic and
diluted earnings per unit (EPU) calculated on the basis
of the outstanding common units. In addition, A should
present unaudited pro forma basic and diluted EPS in the
Form S-1 registration statement reflecting the
conversion of common units to common stock. (In
accordance with Article 11, this pro forma information
is provided outside the financial statements.) Since the
common stock issued in the IPO will not be used to
extinguish any existing securities of A, the pro forma
EPS calculations should be performed on the basis of the
40:1 conversion rate only. The additional 10 million
shares of common stock to be issued in the IPO would not
be included in the pro forma basic and diluted EPS
amounts (although the necessary disclosures in a
capitalization table or other sections of the Form S-1
registration statement should be considered). See
Section B.2.1.4 for further discussion
of the requirement to provide pro forma EPS when there
are changes in capital structure at or near the closing
of an IPO.
With respect to A’s financial statements filed under the Exchange Act after the
IPO (i.e., Forms 10-K and 10-Q), it is appropriate to
consider the conversion from common units to common
stock as a split-like situation for which
retrospective application to prior financial reporting
periods for EPS purposes is appropriate. In these
particular circumstances, such retrospective application
will result in the same number of shares of common stock
outstanding for basic and diluted EPS for all historical
periods before the IPO. Entity A would not, however,
retrospectively revise the historical balance sheets
(i.e., for periods before the conversion, the historical
balance sheets would continue to reflect outstanding
common units). Entity A should provide, in the notes to
the financial statements, appropriate disclosures
describing the conversion from common units to common
stock. Entity A would only report EPS in the historical
financial statement periods in accordance with the
retrospective presentation on the basis of the
conversion from common units to common stock. Entity A
would not be required to disclose EPU for periods before
the conversion in its historical financial statements
filed under the Exchange Act after the IPO, and no pro
forma EPS would be included in those Exchange Act
filings. See Section B.2.1.4
for further discussion of the requirement to provide pro
forma EPS when there are changes in capital structure at
or near the closing of an IPO.
Note
that there may be diversity in practice related to the
presentation of EPS amounts for historical periods in
financial statements issued after the IPO. The
presentation approaches applied in practice will depend
on the particular facts and circumstances. An entity is
encouraged to consult with its independent accountants
and to discuss its presentation approach with the SEC
staff on a prefiling basis.
Example 8-9
LLC to Corporation Conversion —
Complex Change in Ownership Form
Assume that Entity B:
- Is an LLC with the following outstanding membership units:
- Class A common units.
- Class B common units.
- Preferred units.
- Has 1 million Class A common units outstanding.
- Has 100,000 Class B common units outstanding. The Class B common units represent unvested management incentive units issued to employees for whom vesting is based on a service condition. The Class B common units participate in distributions with the Class A common units on a nonforfeitable basis. Upon vesting, the Class B common units are converted into Class A common units on a 1:1 basis.
- Has 250,000 preferred units outstanding. The preferred units are redeemable but are not convertible in accordance with their stated terms. The preferred units participate in distributions on the Class A common units.
- Has no other equity instruments or potential common stock outstanding.
- Has filed a Form S-1 registration statement for an IPO of common stock.
- Will be converted from an LLC to a corporation in conjunction with the IPO.
- Plans to sell 60 million shares of common stock to the public as part of the IPO and to effectuate the following changes in its existing capital structure:
- Class A common units will be exchanged for capital units issued by the LLC on a 1:1 basis, and the capital units will then be immediately exchanged for common stock on a 40:1 basis.
- Class B common units will be exchanged for capital units issued by the LLC on a 1:1 basis, and the capital units will then be immediately exchanged for common stock on a 40:1 basis. Entity B has modified the Class B common units to result in acceleration of vesting upon completion of the IPO.
- Preferred units will be exchanged for capital units issued by the LLC on a 10:1 basis, and the capital units will then be immediately exchanged for common stock on a 40:1 basis.
- Thus, after the IPO, B will have 204 million shares of common stock outstanding.
Since the conversion of Class A common units, Class B common units, and
preferred units to capital units and then common stock
will not happen until the consummation of the IPO, B
should present basic and diluted EPU under the two-class
method in the financial statements included in the Form
S-1 registration statement filed with the SEC. Further,
B should present unaudited pro forma basic and diluted
EPS in the Form S-1 registration statement to reflect
the conversions and exchanges of Class A common units,
Class B common units, and preferred units into common
stock. (In accordance with Article 11, this pro forma
information is provided outside the financial
statements.) Since the 60 million shares of common stock
issued in the IPO will not be used to extinguish any of
B’s existing securities, the pro forma EPS calculations
should be performed on the basis of the respective rates
of conversions and exchanges into common stock. The
additional 60 million shares of common stock would not
be included in pro forma basic and diluted EPS amounts
(although the necessary disclosures in a capitalization
table or other sections of the Form S-1 registration
statement should be considered). See Section
B.2.1.4 for further discussion of the
requirement to provide pro forma EPS when there are
changes in capital structure at or near the closing of
an IPO.
With respect to B’s financial statements filed under the Exchange Act after the
IPO (i.e., Forms 10-K and 10-Q), it is appropriate to
consider the conversion of Class A common units to
common stock as akin to a split-like situation
for which retrospective application to prior financial
reporting periods for EPS purposes is appropriate. In
these particular circumstances, such application will
result in the same number of common shares outstanding
for basic and diluted EPS for all historical periods
before the IPO. Entity B should continue to treat the
Class B common units as participating securities in
calculating basic EPS for historical periods and should
apply the more dilutive of the two-class method or the
treasury stock method to calculate diluted EPS. For this
purpose, in applying the treasury stock method, it would
be acceptable for B to consider the Class B common units
as potential shares of common stock (in lieu of
potential Class A common units); however, the two-class
method is expected to be more dilutive. Entity B should
not consider the conversion of preferred units into
common stock in calculating historical EPS for periods
before the IPO. Rather, it should continue to apply the
two-class method for both basic and diluted EPS (note
that, according to their stated terms, the preferred
units were not convertible into Class A common units).
Note that the intermediate step involving conversion of
Class A common units, Class B common units, and
preferred units into capital units before conversion
into shares of common stock is irrelevant because at no
point are capital units outstanding (i.e., they are
immediately converted into shares of common stock upon
consummation of the IPO). Entity B would not
retrospectively revise the historical balance sheets
(i.e., for periods before the conversion, the historical
balance sheets would continue to reflect outstanding
Class A common units, Class B common units, and
preferred units). Entity B should provide, in the notes
to the financial statements, appropriate disclosures
describing the conversion and exchange transactions.
Entity B would only report EPS in the historical
financial statement periods. Entity B would not be
required to disclose EPU for periods before the
conversion in its historical financial statements filed
under the Exchange Act after the IPO.
For EPS calculations related to
financial reporting periods ending after the IPO, with
one exception, B would no longer need to apply the
two-class method since it only has a single class of
common stock outstanding. Entity B may need to apply the
two-class method in the first financial reporting period
ending after the IPO if that period began before the IPO
was effective. See Section 5.5.2.3
for discussion of the EPS accounting related to
situations in which a participating security is
extinguished during a financial reporting period.
This example does not address the
accounting consequences associated with the acceleration
of vesting of the Class B common units or the
extinguishment of the preferred units (i.e., the
conversion was not in accordance with the original
stated terms). Entity B must apply the appropriate
accounting under ASC 718 for the acceleration of vesting
of the Class B common units and the appropriate
accounting under ASC 260 for the extinguishment of the
preferred units (see Section 3.2.2.6).
Note that there may be diversity
in practice related to the presentation of EPS amounts
for historical periods in financial statements issued
after the IPO. The presentation approaches applied in
practice will depend on the particular facts and
circumstances. An entity is encouraged to consult with
its independent accountants and to discuss its
presentation approach with the SEC staff on a prefiling
basis.
Example 8-10
Conversion of Preferred Stock Into
Common Stock in Accordance With Its Stated Terms in
Conjunction With an IPO
Assume that Entity C:
- Has a capital structure consisting of 1 million shares of common stock and 50 million shares of 10 percent Series A preferred stock with an aggregate liquidation preference of $50 million (the “preferred stock”).
- Is in the process of filing for an IPO of common stock that will be considered a qualified IPO.
- Plans to offer 150 million shares of common stock to the public as part of the IPO.
- Has no other equity instruments outstanding other than nonparticipating options on common stock.
Further assume that the
dividends on the preferred stock are cumulative at a
stated rate of 10 percent per annum and participate in
dividends with the common stock once the cumulative
dividends have been paid. In the event of a qualified
IPO, the preferred stock is automatically converted into
shares of common stock at a rate of two shares of common
stock for each share of preferred stock.
In the historical financial statements included in the Form S-1 registration
statement filed with the SEC, C should present basic and
diluted EPS on the basis of the existing capital
structure and would not assume that the preferred stock
has been converted into shares of common stock for its
calculation of basic EPS. That is, C should calculate
basic EPS by using the two-class method and should
calculate diluted EPS by using the more dilutive of the
two-class method or the if-converted method for the
preferred stock. Further, C should use the treasury
stock method to calculate the diluted impact of the
options. Company C should present unaudited pro forma
basic and diluted EPS in the Form S-1 registration
statement to reflect the conversion of the preferred
stock into common stock. (In accordance with Article 11,
this pro forma information is provided outside the
financial statements.) The additional 150 million shares
of common stock issued to the public in the IPO should
not be included in pro forma basic and diluted EPS
amounts (although C should consider which disclosures it
may need to provide in a capitalization table or other
sections of the Form S-1 registration statement). See
Section B.2.1.4 for further discussion
of the requirement to provide pro forma EPS when there
are changes in capital structure at or near the closing
of an IPO.
With respect to C’s financial statements filed under the Exchange Act after the
IPO (i.e., Forms 10-K and 10-Q), the conversion of
preferred stock into common stock may not be treated
retrospectively on the balance sheet or in the
calculation of EPS. Rather, once the IPO is complete,
EPS for periods thereafter would reflect the capital
structure after the IPO (i.e., only common stock and
options). Since the options are not participating
securities, C would not be required to continue to apply
the two-class method after the IPO. However, C should
consider the impact of the conversion of the preferred
stock, which is a participating security, in the period
in which the conversion occurs. See Section
5.5.2.3 for discussion of the EPS
accounting related to situations in which a
participating security is converted during a financial
reporting period. Company C should also provide
appropriate disclosures describing the conversion in the
notes to the financial statements. However, C would not
disclose pro forma EPS in its filings on Form 10-K or
Form 10-Q that are provided after the IPO (see Section
B.2.1.4).
In the absence of a prior
agreement with the SEC staff, C should not account for
the conversion of the preferred stock retrospectively
for EPS purposes.
Example 8-11
Redemption of Preferred Stock in
Conjunction With an IPO
Assume the same facts as in Example 8-10,
with the following differences:
-
The preferred stock does not contain a conversion feature.
-
In conjunction with the IPO, Company C has agreed to redeem the preferred stock for cash.
In the historical financial statements included in the Form S-1 registration
statement filed with the SEC, C should present basic and
diluted EPS on the basis of the existing capital
structure and would not assume that the preferred stock
has been redeemed for cash. That is, C should calculate
basic and diluted EPS by using the two-class method
because the preferred stock is a participating security.
Company C should also use the treasury stock method to
calculate the dilutive impact of the options. Company C
should present unaudited pro forma basic and diluted EPS
in the Form S-1 registration statement to reflect the
settlement of the preferred stock. (In accordance with
Article 11, this pro forma information is provided
outside the financial statements.) In this pro forma EPS
calculation, C should (1) add back the cumulative
dividends and any undistributed earnings allocated to
the preferred stock under the two-class method in its
historical calculation of basic EPS and should reflect
as outstanding for both basic and diluted EPS the
estimated number of common shares (from the total 100
million common shares issued in the IPO) that would be
needed to raise sufficient proceeds to redeem the
preferred stock. Any additional common shares issued to
the public as part of the IPO (i.e., beyond the number
of shares estimated to redeem the preferred stock)
should not be included in the pro forma basic and
amounts of diluted EPS (although C should consider which
disclosures it may need to provide in a capitalization
table or other sections of the Form S-1 registration
statement). The pro forma EPS calculations should also
take into account any gain or loss that would have
increased or reduced income available to common
stockholders in the historical periods from the
redemption of the preferred stock. See Section
B.2.1.5 for further discussion of the
requirement to provide pro forma EPS when an entity uses
the proceeds from an offering of common stock to
extinguish preferred stock.
With respect to C’s financial statements filed under the Exchange Act after the
IPO (i.e., Forms 10-K and 10-Q), the redemption of the
preferred stock may not be treated retrospectively on
the balance sheet or in the calculation of EPS. Rather,
once the IPO is complete, EPS for periods thereafter
should reflect the capital structure after the IPO
(i.e., only common stock and options). Since the options
are not participating securities, C would no longer be
required to apply the two-class method after the IPO.
However, C should consider the impact of the
extinguishment of the preferred stock on basic and
diluted EPS in the period of extinguishment (i.e., the
adjustment to income available to common stockholders
under ASC 260-10-S99-2 that an entity is required to
make in accounting for the extinguishment). See also
Section 5.5.2.3 for discussion of the
EPS accounting related to situations in which a
participating security is extinguished during a
financial reporting period. Furthermore, C should
provide, in the notes to the financial statements,
appropriate disclosures describing the redemption.
Company C would not disclose pro forma EPS in its
filings on Form 10-K or Form 10-Q that occur after the
IPO (see Section B.2.1.4).
Note
that since the preferred stock in this example does not
contain a contractual conversion feature, the pro forma
EPS accounting is the same, regardless of whether C (1)
issued common shares to holders of the preferred stock
in exchange for their shares or (2) used a portion of
the proceeds from the issuance of 100 million common
shares to redeem the preferred stock for cash. Also, in
both situations, C must consider the impact on income
available to common stockholders in the period in which
the redemption occurs in accordance with ASC
260-10-S99-2. See Section 3.2.2.6
for further discussion of the impact of a redemption of
preferred stock.
In the absence
of a prior agreement with the SEC staff, C should not
account for the extinguishment of the preferred stock
retrospectively for EPS purposes.
Example 8-12
Exchange of One Class of Common
Stock for Another Class of Common Stock in
Conjunction With an Elimination of a Dual-Class
Common Stock Structure
Assume the following:
- The common stock structure of Company D is dual-class — Class A common stock and Class B common stock.
- Class A common stock and Class B common stock share in dividends 60:40.
- For each matter submitted for a vote of common shareholders, holders of Class A common stock have 1.5 votes per share and holders of Class B common stock have 1 vote per share.
- There are 50 million shares of Class A common stock outstanding and 50 million shares of Class B common stock outstanding.
- The board of directors of D votes to eliminate the dual-class common stock structure; therefore, each share of Class B common stock will be exchanged for 0.67 shares of Class A common stock, and no cash will be involved in the exchange. As a result, 33.5 million shares of Class A common stock will be issued to retire all outstanding shares of Class B common stock.
- To complete this exchange, D is required to file a proxy statement regarding the proposed exchange. (This example is not intended to address the filings that an entity is required to provide to the SEC to eliminate a class of common stock. Such filings will depend on the entity’s facts and circumstances and consultation with its legal advisers.)
- Company D receives the necessary approvals from its common shareholders.
In the historical financial statements included in the filing(s) that it must
provide to the SEC to effectuate this exchange, D should
present basic and diluted EPS under the two-class method
on the basis of the existing capital structure and would
not assume that the Class B common stock will be
exchanged for Class A common stock. Company D should
also present unaudited pro forma basic and diluted EPS
in the filing(s) that must be provided to the SEC
regarding the exchange. (In accordance with Article 11,
this pro forma information is provided outside the
financial statements.) This pro forma basic and diluted
EPS will be based on an assumption that D has only Class
A common stock outstanding. This pro forma EPS
information is provided as a result of the change in
capital structure (see Section
B.2.1.4).
With respect to D’s financial statements filed under the Exchange Act (i.e.,
Forms 10-K and 10-Q) after the exchange of Class A
common stock for Class B common stock, it is appropriate
for D not to reflect the exchange retrospectively on the
balance sheet or in the calculation of EPS. Rather, once
the exchange is complete, EPS for periods thereafter
would reflect the capital structure after the exchange
(i.e., only Class A common stock). For historical
periods before the exchange, D would continue to present
both classes of common stock on the balance sheet and
EPS under the two-class method for each class of common
stock. Company D would not disclose pro forma basic and
diluted EPS in its filings on Form 10-K or Form 10-Q
that are provided after the exchange (see Section
B.2.1.4).
Note that in a review of selected filings by entities that have eliminated a
dual-class common stock structure, diversity in practice
was identified regarding the balance sheet and EPS
treatment in historical financial statements. Some
registrants retrospectively presented historical periods
after completion of the exchange to eliminate the
dual-class common stock structure. However, such
registrants appear to have been influenced, at least in
part, by the fact that the two classes of common stock
had the same rights to dividends and only contained
different voting rights. When the EPS amounts under the
two-class method of EPS are different for the historical
periods, it is appropriate that the historical financial
statements issued after the elimination of the
dual-class common stock structure should continue to
show each class separately on the balance sheet as well
as separate basic and diluted EPS amounts for each class
on the face of the income statements. However, diversity
in practice may exist with respect to this matter.
Regardless of the presentation approach used for the
face of the financial statements, the disclosures in the
notes to the financial statements should fully and
transparently describe the prior common stock structure
and the changes resulting from the exchange until the
latest income statement that corresponds to the latest
period when there were two classes of common stock
outstanding is no longer presented in filings with the
SEC.
Given the diversity in
practice, and how practices will inevitably depend on
the particular facts and circumstances, an entity is
encouraged to consult with its independent accountants.
An entity may also wish to discuss its presentation in
historical financial statements with the SEC staff on a
prefiling basis.
Example 8-13
Mutual-to-Stock Conversion
Entity E, which currently is in the form of a mutual ownership, is being
converted into a common stock ownership structure. For
financial reporting periods after the conversion from
mutual ownership to stock ownership, amounts of basic
and diluted EPS should be presented on the basis of
earnings and outstanding shares of common stock and
potential common stock after the conversion. Entity E is
not required to present amounts of basic and diluted EPS
for prior reporting periods. See Appendix
B for discussion of the inclusion of
unaudited pro forma basic and diluted EPS in any filing
with the SEC before the conversion.
Reporting EPS on the basis of earnings after the conversion may result in EPS
amounts that will not be comparable to EPS amounts
determined in future years and, further such EPS amounts
may not fully reflect the expected relationship between
earnings for the year and the amount of outstanding
stock as of the balance sheet date. Therefore, the
income statement caption should be sufficiently
descriptive to inform the reader about the unique nature
of EPS in the year of conversion, and the method of
presentation should be disclosed in the notes.
See Appendix
B for additional discussion of when pro forma EPS amounts are
required in filings with the SEC.
8.6.2.1 Common Misapplications of ASC 260 in IPOs
An entity will inevitably face a number of challenges when
determining the appropriate calculation and presentation of EPS in financial
statements included in a filing for an IPO under the Securities Act and in
the entity’s first filings on Form 10-Q and Form 10-K under the Exchange
Act. The SEC staff has issued EPS guidance related to a number of
circumstances that an entity may encounter. See further discussion in
Appendix B.
Some of the more common misapplications of ASC 260’s presentation and
disclosure requirements in filings preceding and immediately after an IPO
are as follows:
- In IPO filings:
- Inappropriately presenting only pro forma EPS in financial statements included in IPO filings when presentation of only historical EPS on the face of the income statement is required. Article 11 stipulates that pro forma EPS should not be included in the financial statements unless such inclusion is specifically required by U.S. GAAP. ASC 260-10-45-7 requires presentation of historical EPS on the face of the income statement. See further discussion in Section 8.6.3.
- Including preferred stock that is mandatorily convertible as of the IPO date in the outstanding shares of common stock in the calculation of basic EPS in financial statements included in IPO filings. Converted preferred stock should be included in the outstanding shares of common stock in the calculation of basic EPS only from the point of conversion. In periods before the conversion, the two-class method of EPS may apply in the calculation of basic EPS.
- In filings under the Exchange Act on Form 10-K or Form 10-Q after consummation of the IPO:
- Omitting historical EPS on the face of the income statement. ASC 260-10-45-7 requires presentation of historical EPS on the face of the income statement.
- Including preferred stock that was converted into common stock as of the IPO date in the outstanding shares of common stock used in the calculation of basic EPS for financial reporting periods before the IPO. Retrospective application is not appropriate in these circumstances.
- Presenting pro forma EPS on the face of the income statement when such presentation is not specifically required by U.S. GAAP (e.g., including the effects of the conversion of preferred stock that was converted as of the IPO date in pro forma EPS presented on the face of the income statement).
Another common misapplication is the treatment of nominal
issuances. See Section
8.3.4 for more information.
8.6.3 Spin-Offs and Other Dispositions
8.6.3.1 Background
Entities often wish to separate certain businesses or
operations from the larger public entity. Generally, this may be
accomplished by two primary means. The larger entity could effectuate an IPO
of the common stock of the separate business while retaining or losing
control of the subsidiary, or it could distribute such stock to the larger
entity’s shareholders (a “spin-off”). In a spin-off, a parent entity
distributes shares of a subsidiary to the parent company’s shareholders so
that the subsidiary becomes a separate, independent company. When the
business operations that are being spun off are held by the parent in
various subsidiaries or divisions, the parent will transfer the net assets
being spun off to a newly formed subsidiary established to effect the
spin-off. The common stock of the subsidiary that is spun off is usually
distributed on a pro rata basis, and the spin-off is most often structured
to be a tax-free distribution to shareholders. State law and the rules of
the stock exchanges govern whether a company must seek shareholder approval
for a spin-off.
The meaning of the term “spin-off,” as used in this section,
is intended to be relatively broad (e.g., it is not limited to any
particular type of transaction). While the discussion primarily focuses on
spin-off transactions, similar EPS accounting considerations apply to IPOs
of a subsidiary’s common stock. Thus, the accounting guidance below is
generally equally applicable to IPOs of entities that were previously part
of a larger entity even if those share offerings are not spin-offs from a
legal perspective. The process and specific steps related to accomplishing
an IPO will, however, differ from those for spin-offs. These differences
include the nature and content of the filings that an entity needs to
provide to the SEC to complete the transaction.
The next section discusses the accounting considerations for
the parent entity that spins off a portion of its business operations.
Section
8.6.3.3 discusses the accounting considerations related to
the portion of the parent that is being spun off.
8.6.3.2 Parent Entity
8.6.3.2.1 Presentation of Discontinued Operations
When a parent completes the spin-off of a portion of its
business that qualifies as a discontinued operation, the provisions of
ASC 205-20 pertaining to presentation and disclosure of discontinued
operations apply to the parent’s financial statements and the provisions
of ASC 260-10-45-3 apply to the presentation of EPS (see Sections 9.1.5
and 9.2.2.1
for more information). In such circumstances, the parent will be
required to retrospectively present the disposed-of business as a
discontinued operation in the historical financial reporting periods
presented in financial statements issued after the completion of the
spin-off. The parent cannot present the operations of the disposed-of
business as a discontinued operation until the shares of the subsidiary
are distributed. If the parent files a registration statement that
incorporates by reference financial statements that do not reflect the
discontinued-operations treatment, it may need to take into account
additional considerations related to presentation and disclosure of the
disposed-of business in historical financial statements. For more
information, see Chapter 8 of Deloitte’s Roadmap Impairments and Disposals
of Long-Lived Assets and Discontinued Operations.
When a parent consummates a disposition of a portion of
its business that does not qualify as a discontinued operation, the
impact of the disposition on reported amounts of EPS should be limited
to relevant disclosures in the notes to the financial statements.
Regardless of whether the spin-off constitutes a discontinued operation,
the parent may be required to present pro forma financial information,
including pro forma EPS. See Appendix B for further discussion
of pro forma financial information.
8.6.3.2.2 Weighted-Average Stock Price in Prior Periods
The fair value and quoted market price of the parent’s
common stock will decline on the distribution date (i.e., the date a
spin-off is consummated and the parent’s stock trades on an ex-dividend
basis). However, it is not appropriate for the parent to adjust the
weighted-average stock prices used in the calculation of diluted EPS for
financial reporting periods before the spin-off because ASC 260 does not
allow the parent to adjust the weighted-average stock prices in prior
reporting periods to take into account the impact the spin-off had on
the parent’s common stock price.
As discussed above, when a spin-off qualifies for
presentation as a discontinued operation, the parent will be required to
retrospectively recast prior financial reporting periods to treat the
subsidiary as a discontinued operation. In such circumstances, the
parent will be required to present basic and diluted EPS for continuing
operations and net income. The parent will also need to calculate basic
and diluted EPS related to discontinued operations, although it may
disclose such amounts in lieu of presenting them on the face of the
income statement. This change in presentation of EPS will affect the
control number used to determine whether potential common stock is
dilutive. As discussed in Section 8.7.1.1, when an entity
reports a discontinued operation, the control number is income from
continuing operations. Although a change in the control number used for
determining whether potential common stock is dilutive may affect which
potential common shares are included in diluted EPS, the calculation of
the incremental number of shares for each potential common share
arrangement is unchanged because, as discussed above, the parent is
prohibited from adjusting the weighted-average stock prices previously
used in the calculation of diluted EPS.
8.6.3.2.3 Additional Common Stock Issued
To take into account the dilution caused by a spin-off,
the parent may issue additional shares of common stock to its employees
or adjust the terms of options on common stock it issues. The example
below addresses the impact on EPS of an additional issuance of common
stock. Example
8-15 illustrates the impact on EPS of an adjustment to
the terms of outstanding stock options.
Example 8-14
Additional
Issuance of Common Stock in a Spin-Off
Parent A spins off Subsidiary B on January 1,
20X1. In conjunction with the spin-off, A issues
additional shares of nonparticipating restricted
common stock to employees in an attempt to take
into account the dilution on A’s common stock
price caused by the spin-off. The additional
shares issued are calculated as follows:
The holders of the restricted
common stock did not receive any shares of common
stock in the subsidiary entity spun off.
Before the spin-off, the holders
of the restricted common stock had 100,000 shares
with a fair value of $1 million. Immediately after
the spin-off, the holders of the restricted common
stock had 133,333 shares with a fair value of $1
million. While the holders were neutralized, the
original terms of the restricted stock agreement
did not give the holders the ability either to
receive shares of common stock of the subsidiary
that was spun off or to receive additional shares
of the parent’s common stock as a result of the
dilution in the parent’s share price. Therefore,
under ASC 718, the issuance of these additional
shares gives rise to compensation. Such shares
should not be included in the parent’s EPS
calculations retrospectively; rather, they should
be included only prospectively from issuance. The
vested shares should be included in the
denominator of basic EPS, and the unvested shares
should be included in diluted EPS by using the
treasury stock method.
Note that the accounting under ASC 718 will differ if the original terms of the
restricted stock agreement provided for the
issuance of additional common shares of the parent
to offset the dilution caused by a spin-off.
However, regardless of the accounting under ASC
718, the additional shares of common stock should
not be included in EPS retrospectively because the
parent’s common stock price may not be adjusted
retrospectively.
Example 8-15
Adjustment to
Terms of Stock Options in a Spin-Off
Parent X spins off Subsidiary Y
on June 1, 20X1. Before the spin-off, X had stock
options outstanding that were previously issued to
an investor in a financing transaction. The terms
of the stock options and the quoted market price
of X’s common stock are as follows:
Immediately after the spin-off,
the quoted market prices of X’s and Y’s common
stock are as follows:
In accordance with the original terms of the stock options, the notional amount
and exercise price are adjusted to $1.5 million
and $66.67, respectively. This adjustment is
required in accordance with the terms of the stock
options in lieu of the options becoming
exercisable into shares of common stock of both X
and Y. By design, the adjustment caused the
options to have the same intrinsic value before
and after the spin-off. (In practice, the terms of
stock options may require that the adjustments be
calculated on the basis of theoretical fair
values, thus maintaining the same theoretical fair
value. As long as those adjustments are standard
antidilution provisions and are made in a
commercially reasonable manner, the accounting
would not differ.)
For EPS amounts presented before the June 1, 20X1, spin-off date, X should not
adjust previously reported amounts of diluted EPS
for the adjustments made to the stock options as a
result of the spin-off. This is consistent with
not adjusting, in prior periods, the
weighted-average stock prices used to calculate
diluted EPS. Furthermore, if the stock options
represented participating securities, there would
be no need to change amounts of distributed or
undistributed earnings allocated to the stock
options when the two-class method is applied to
the calculation of basic or diluted EPS.
Note that the lack of adjusting
previously reported EPS amounts would not change
if either (1) the terms of the stock options
caused them to become exercisable into common
shares of both the parent and the subsidiary being
spun off (on the basis of the number of shares of
the subsidiary’s common stock received by each
holder of the parent’s common stock in the
spin-off) or (2) the terms of the stock options
were adjusted but the original terms of the stock
option agreement did not contain this adjustment.
However, in the latter circumstance, X (the
parent) would be required to consider the impact
on current-period EPS for the modification made to
the stock options.
8.6.3.2.4 Transactions Giving Rise to NCIs
If a parent distributes less than all of its ownership
interests in a subsidiary and retains control after the completion of
the spin-off, NCIs in the subsidiary will be recognized in the parent’s
consolidated financial statements. See Section 8.8 for discussion of EPS
considerations related to NCIs.
8.6.3.3 Spun-Off Entity
8.6.3.3.1 Background of Registration of Spin-Off With SEC
In the United States, a parent will effectuate a
spin-off of a portion of its business by generally filing either a Form
10 under the Exchange Act or a Form S-1 or Form S-4 under the Securities
Act. The discussion below is only intended to provide a high-level
overview of the registration of a spin-off with the SEC. The ultimate
determination of which form (or forms) must be filed with the SEC to
complete a spin-off is a legal determination that an entity is required
to make in consultation with its legal advisers.
SEC Staff Legal Bulletin No. 4, issued on September 16,
1997, expresses the views of the SEC’s Division of Corporation Finance
on whether Section 5 of the Securities Act applies to spin-offs; the
bulletin also addresses related matters, including how securities
received in spin-offs may be resold under the Securities Act.5 Paragraph 4(A) of the staff legal bulletin states:
[T]he subsidiary [that is being spun off] does not
have to register a spin-off under the Securities Act when:
-
the parent shareholders do not provide consideration for the spun-off shares;
-
the spin-off is pro-rata to the parent shareholders;
-
the parent provides adequate information about the spin-off and the subsidiary to its shareholders and to the trading markets;
-
the parent has a valid business purpose for the spin-off; and
-
if the parent spins-off “restricted securities,” it has held those securities for at least two years.
The nature of the information about the spin-off and the
subsidiary that must be provided to the parent’s shareholders and to
trading markets depends on whether the subsidiary is a reporting company
(i.e., subject to the Exchange Act) or a nonreporting company. Paragraph
4(B)(3)(a) of the staff legal bulletin further states:
If the subsidiary is a non-reporting company, the
parent provides adequate information if, by the date it spins-off
the securities:
-
it gives its shareholders an information statement that describes the spin-off and the subsidiary and that substantially complies with Regulation 14A or Regulation 14C under the Exchange Act; and
-
the subsidiary registers the spun-off securities under the Exchange Act.
Registration of the securities of the subsidiary under
the Exchange Act is most often accomplished through the filing of a Form
10, which is a general form for registration of securities under Section
12(b) or 12(g) of the Exchange Act. Form 10 contains an information
statement whose purpose is to provide adequate information regarding the
spin-off to the parent’s shareholders and to the trading markets.
However, it is not appropriate to file a Form 10 registration statement
if the spin-off must be registered under the Securities Act. When
registration under the Securities Act is required, a registration
statement must be filed with the SEC under the Securities Act, typically
either a Form S-1 or Form S-4, to complete the spin-off. As discussed
above, the ultimate determination of which form (or forms) must be filed
with the SEC to complete a spin-off is a legal determination that an
entity is required to make in consultation with its legal advisers.
8.6.3.3.2 Financial Statements of Entity Being Spun Off
In periods before the completion of a spin-off, the
financial statements of the business operations being spun off that are
included in the filings with the SEC that are necessary to complete the
spin-off are either consolidated financial statements or combined
financial statements. The nature of the financial statements will depend
on how the business operations being spun off were legally “housed”
within the larger parent:
- Consolidated financial statements — The business operations being spun off were operated entirely within a separate consolidated subsidiary of the parent. That subsidiary itself may also be a parent entity with a number of consolidated subsidiaries.
- Combined financial statements — The business operations being spun off were not operated entirely within a separate consolidated subsidiary of the parent. Various scenarios may be applicable in such circumstances, including one or more of the following:
- The business operations being spun off represent a combination of a number of the parent’s subsidiaries.
- The business operations being spun off represent a combination of specific divisions or discrete operations within one or more of the parent’s subsidiaries.
In some situations, the parent may combine the business
operations being spun off into a separate consolidated subsidiary that
is created in contemplation of the spin-off. As a result, the spun-off
entity’s financial statements for periods before the spin-off may be
combined for certain periods and consolidated for others.
Connecting the Dots
The combined financial statements of the
business operations being spun off are often referred to as
“carve-out financial statements,” which is a generic term used
to describe separate financial statements that are derived from
the financial statements of a larger entity. The nature of those
financial statements may vary. Carve-out financial statements
could reflect combined financial statements of various
subsidiaries of a common parent.
The ASC master glossary does not define the term
“carve-out financial statements,” and the Codification does not
provide any specific guidance on preparing such statements,
including guidance related to EPS. Thus, the preparation of
carve-out financial statements is generally based on established
practices; however, some diversity in practice may exist. For
more information about the financial statements of carve-out
entities, see Deloitte’s Roadmap Carve-Out Financial
Statements.
The examples below
illustrate the preparation of combined or consolidated financial
statements for a business operation being spun off by a parent.
Example 8-16
Combined
Financial Statements
Entity A operates over 500 retail apparel stores
in the United States, each of which is housed in a
separate legal entity that A owns directly. Entity
A decides to spin off its specialty apparel retail
operations consisting of 100 specialty apparel
stores. While each of the 100 specialty retail
stores resides in a separate legal entity owned by
A, the financial statements of the specialty
retail business will consist of combined financial
statements because they represent the combination
of 100 different legal entities rather than a
single subsidiary that owns the 100 specialty
retail stores.
Example 8-17
Consolidated
and Combined Financial Statements
Entity S, which provides global
shipping services, decides to spin off certain of
its marine operations, including the marine and
support transportation services provided to
offshore oil and gas exploration, development, and
production facilities worldwide. The marine
operations have been historically owned through
various subsidiaries of S. In anticipation of the
spin-off, on January 1, 20X6, S creates a new
subsidiary and transfers the various businesses
comprising the marine operations into the new
subsidiary.
The financial
statements of the marine operations being spun
off, presented as of and for the years ended
December 31, 20X7, will consist of the
following:
- Consolidated balance sheets as of December 31, 20X7, and 20X6.
- Consolidated and combined statements of income and comprehensive income for the three years in the period ended December 31, 20X7, consisting of consolidated statements for the two years in the period ended December 31, 20X7, and combined statements for the year ended December 31, 20X5.
- Consolidated and combined statements of cash flows and changes in equity for the three years in the period ended December 31, 20X7, consisting of consolidated statements for the two years in the period ended December 31, 20X7, and combined statements for the year ended December 31, 20X5.
8.6.3.3.3 EPS of Entity Being Spun Off Included in a Registration Statement
EPS of an entity being spun off may be presented in a
Form 10 or other filing with the SEC in either the audited financial
statements or supplemental unaudited pro forma information that is
presented outside the audited financial statements. The table below
describes the general presentation of EPS for the spun-off entity, which
depends on whether it is (1) a carve-out of various operations,
businesses, or subsidiaries of the parent (a “carve-out entity”) or (2)
one of the parent’s separate subsidiaries (referred to hereafter as an
“existing subsidiary”).
Table 8-3
Nature of Spun-Off
Entity | Type of Financial Statements of
Spun-Off Entity | EPS in Audited Financial
Statements? | Unaudited Pro Forma EPS Presented
Outside Audited Financial Statements? |
|---|---|---|---|
Carve-out entity | Combined | Generally, no | Generally, yes |
Existing subsidiary | Consolidated | Generally, yes | It depends |
Carve-out entities typically do not include historical
basic or diluted EPS in the audited financial statements that are
included in the SEC filing because they constitute a number of different
businesses or operations that represent a new reporting entity once the
spin-off is consummated. Furthermore, carve-out entities typically do
not have a separate and independent common equity capital structure
until the spin-off is consummated. For this reason, only unaudited pro
forma EPS is presented for carve-out entities (and such information is
presented outside the financial statements). The objective of the pro
forma EPS is to present earnings per basic and diluted common share on
the basis of the common share capital structure of the spun-off entity
that will occur in conjunction with the spin-off. This presentation is
generally based on the distribution ratio and other relevant terms of
the spin-off. See Appendix B for further discussion of the preparation of
pro forma EPS.
The audited consolidated financial statements of
existing subsidiaries must generally include basic and diluted EPS,
which are calculated on the basis of the actual common shares and
potential common shares of the existing subsidiary that were
historically outstanding. In addition, unaudited pro forma EPS would
also typically be presented outside the financial statements when
changes in the capital structure of the existing subsidiary are expected
to occur in conjunction with the spin-off (e.g., stock splits, reverse
stock splits, or conversions or redemptions of outstanding convertible
securities).
Connecting the Dots
Between January 1, 2016, and July 1, 2021, 93
spin-offs were identified by using publicly available
information for which filings were made with the SEC under U.S.
GAAP before completion of the spin-off. The types of filings
made with the SEC to effectuate the spin-offs included Form 10
information statements, Forms 8-K with information statements,
Forms S-1, and Forms S-4. The following observations were noted
in a review of these filings:6
-
Nature of entity being spun off — For all financial statement periods presented before the spin-off, (1) 71 entities represented carve-out entities, (2) 19 entities represented existing subsidiaries, and (3) three entities represented carve-out entities that became an existing subsidiary during a financial statement reporting period presented before the spin-off.
-
Nature of financial statements — All of the carve-out entities presented combined financial statements, and all of the existing subsidiaries presented consolidated financial statements. The entities that were both a carve-out and an existing subsidiary presented combined and consolidated financial statements.
-
EPS presented in audited historical financial statements — Of the 93 spin-offs, only 21 entities presented EPS in the audited historical financial statements. One of these entities was a carve-out entity. EPS was presented in the audited historical financial statements for all but two of the 22 entities that presented consolidated financial statements. Those two entities did present unaudited pro forma basic and diluted EPS outside of the audited financial statements.
-
Pro forma EPS — Unaudited pro forma EPS related to the spin-off was presented by 81 of the 93 entities. For 80 of the 81 entities that presented unaudited pro forma EPS, such information was presented outside the financial statements. One entity presented unaudited pro forma EPS as a footnote to the audited financial statements. Ten of the twelve entities that did not present pro forma EPS had presented historical EPS amounts in the audited consolidated financial statements in the filing with the SEC. (Five of these ten entities were public entities before the spin-off.) For the other two entities that did not present pro forma EPS, historical EPS amounts were also not included in the audited financial statements in the filing with the SEC. These two entities were carve-out entities. It is unclear why these two entities did not present pro forma EPS information in the filing with the SEC. Of the 20 entities that presented consolidated financial statements with audited historical EPS, 10 also presented unaudited pro forma EPS and 10 did not present pro forma EPS. The table below provides additional information related to the 81 entities that did present unaudited pro forma EPS.
Table 8-4
|
Basic and Diluted Share Amounts
|
Number of Entities
|
|---|---|
|
Entities That Reported Net Losses in All
Income Statement Periods for Which Pro Forma EPS
Was Presented(a)
| |
|
Basic and diluted share amounts were the same
for all income statement periods for which pro
forma EPS was presented(b)
|
13
|
|
Basic and diluted share amounts were the same
for each income statement period for which pro
forma EPS was presented, but basic and diluted
share amounts differed among income statement
periods(c)
|
4
|
|
Total
|
17
|
|
Entities That Reported Net Income in One or
More Income Statement Periods for Which Pro Forma
EPS Was Presented
| |
|
Basic and diluted share amounts were the same
for all income statement periods for which pro
forma EPS was presented(b)
|
13
|
|
Basic and diluted share amounts were the same
for each income statement period for which pro
forma EPS was presented, but basic and diluted
share amounts differed among income statement
periods(c)
|
8
|
|
Basic share amounts were the same for all
income statement periods for which pro forma EPS
was presented and diluted shares were the same for
all income statement periods for which pro forma
EPS was presented; however, the number of diluted
shares exceeded the number of basic
shares(d)
|
7
|
|
Basic share amounts were the same for all
income statement periods for which pro forma EPS
was presented; diluted shares were different for
each income statement period for which pro forma
EPS was presented and, in all cases, exceeded the
number of basic shares(e)
|
2
|
|
Basic and diluted share amounts were different
for each income statement period for which pro
forma EPS was presented(f)
|
26
|
|
Total
|
56
|
|
Other
| |
|
Basic and diluted shares were based on those of
the acquirer of the spun-off entity, adjusted to
reflect shares and potential common stock issued
in the acquisition
|
4
|
|
No change to basic and diluted shares
previously reported as a public company; pro forma
adjustments pertained to other items
|
1
|
|
Basic and diluted shares were adjusted to
reflect a conversion of Class B shares held by
parent to Class A shares for an entity that was
publicly traded before the spin-off
|
1
|
|
Basic and diluted shares were adjusted to
reflect a stock split for the spun-off entity that
was publicly traded before the spin-off
|
1
|
|
An adjustment was made so that diluted shares
equaled basic shares as a result of other pro
forma adjustments made by an entity that was
publicly traded before the spin-off
|
1
|
|
Total
|
8
|
|
Notes to
Table:
| |
|
(a) Since the numerator in the
calculation of basic EPS was a loss, any potential
common shares would have been antidilutive.
(b) For the 26 entities that
presented the same number of basic and diluted
shares for all income statement periods for which
pro forma EPS was presented, pro forma basic and
diluted shares were calculated on the basis of
parent shares outstanding and the distribution
ratio. However, there was diversity in how those
assumptions were applied in the calculations. The
approaches used by these entities were as
follows:
| |
|
(c) For the 12 entities that
presented the same number of basic and diluted
shares for each income statement period for which
pro forma EPS was presented, but for which basic
and diluted share amounts differed among income
statement periods, pro forma basic and diluted
shares were calculated on the basis of parent
shares outstanding and the distribution ratio.
However, there was diversity in how those
assumptions were applied in the calculations:
| |
|
(d) For the seven entities
that presented the same number of basic shares for
all income statement periods for which pro forma
EPS was presented and the same number of diluted
shares for all income statement periods for which
pro forma EPS was presented, but for which those
basic and diluted share amounts differed, pro
forma basic and diluted shares were calculated on
the basis of the parent’s shares outstanding and
the distribution ratio. However, there was
diversity in how those assumptions were applied in
the calculations:
| |
|
(e) For the two entities that
presented the same number of basic shares for all
income statement periods for which pro forma EPS
was presented and a different number of diluted
shares for each income statement period for which
pro forma EPS was presented (with the diluted
shares exceeding the basic shares in all periods),
pro forma basic and diluted shares were calculated
on the basis of the parent’s shares outstanding
and the distribution ratio. However, there was
diversity in how those assumptions were applied in
the calculations:
| |
|
(f) For the 26 entities that
presented a different number of basic and diluted
shares for each income statement period for which
pro forma EPS was presented (with the diluted
shares exceeding the basic shares in each such
period), pro forma basic and diluted shares were
calculated on the basis of the parent’s shares
outstanding and the distribution ratio. However,
there was diversity in how those assumptions were
applied in the calculations. The approaches used
by these entities were as follows:
| |
8.6.3.3.4 Historical Financial Reporting Periods in Exchange Act Filings
Once the spin-off is completed, the spun-off entity
becomes subject to periodic reporting under the Exchange Act (i.e., on
Form 10-K and Form 10-Q). The financial statements included in Exchange
Act filings for at least one year (and generally for the oldest two
years) will represent historical financial statements of the spun-off
entity before the spin-off was completed. Depending on the facts and
circumstances, questions may arise regarding the calculation of
historical EPS amounts for the periods before the spun-off entity was a
separate entity (i.e., in the historical financial statements presented
that pertain to periods before the completion of the spin-off). This
section discusses considerations related to the calculation of EPS
amounts in historical financial reporting periods when the spun-off
entity was not a separate publicly traded entity. The historical
financial reporting periods discussed are the historical financial
statements for periods before the spin-off that are included in Exchange
Act filings after the spun-off entity becomes a separate publicly traded
entity.
ASC 260 does not provide any specific guidance on how a
spun-off entity should calculate basic or diluted EPS in historical
financial reporting periods before the entity issued publicly traded
common stock in an IPO or a spin-off. However, this issue was discussed
in 1999 by the then Big Six accounting firms as well as at a meeting of
the SEC Regulations Committee later that year. The following two types
of transactions were discussed:
-
A parent company forms a new subsidiary to which it transfers the assets and liabilities of a business it previously operated as an unincorporated division. The parent company then takes the newly formed subsidiary public or spins it off. Note that, in this scenario, the historical financial statements of the spun-off entity would generally represent combined financial statements. This scenario would include any situation in which the entity taken public previously consisted of business operations, divisions, or subsidiaries that were “carved out” from the larger entity. Thus, this scenario is consistent with the carve-out scenario discussed in Section 8.6.3.3.3.
-
A parent company takes a previously existing subsidiary public or spins it off. The previously existing subsidiary could be wholly owned or less than wholly owned. Note that, in this scenario, the historical financial statements of the subsidiary would generally represent consolidated financial statements. This scenario is consistent with the existing-subsidiary scenario discussed in Section 8.6.3.3.3.
While the SEC staff has not provided any guidance on
these transactions, on the basis of the prior discussions referred to
above as well as our understanding of the approaches most commonly
applied in practice, an entity should generally apply the approaches
discussed in the table below when calculating the spun-off entity’s
basic and diluted EPS for the historical financial statement periods
before the spin-off. However, because there is no authoritative guidance
on this topic, diversity in practice may exist and the EPS approach
selected by a spun-off entity will depend on the relevant facts and
circumstances. An entity should discuss this matter with its independent
accountants and consider seeking the views of the SEC staff on a
prefiling basis.
Table 8-5
Entity Type | Basic EPS | Diluted EPS |
|---|---|---|
Carve-out | Use the number of shares of common stock outstanding as of the date the new
subsidiary went public (i.e., the spin-off date)
as the denominator for all prior historical
periods.7 In a spin-off, this amount would equal the
distribution ratio multiplied by the number of the
parent’s common shares as of the spin-off date.
Any additional shares sold in an IPO (i.e., “new
money”) should be included in the denominator only
from the date of sale. Note that the above approach applies only to the
presentation of historical EPS amounts. The equity
accounts in the historical balance sheets are not
retrospectively revised. | Use the number of shares of common stock outstanding as of the date the new
subsidiary went public (i.e., the spin-off date)
as the denominator for all prior historical
periods.8 In a spin-off, this amount would equal the
distribution ratio multiplied by the number of the
parent’s common shares as of the spin-off date.
Any additional shares sold in an IPO (i.e., “new
money”) should be included in the denominator only
from the date of sale. Note that this approach typically results in the
use of the same number of weighted-average common
shares for diluted EPS as is used for basic EPS
for all prior reporting periods. However, if the
entity assumes (rather than issues) convertible
securities or other forms of potential common
stock as part of the separation, those securities
assumed would also be treated as having been
outstanding during all prior financial reporting
periods and may result in diluted EPS that is less
than basic EPS. |
Existing subsidiary | Use the number of shares of common stock actually outstanding in each prior
financial reporting period as the denominator,
adjusted for any stock splits, reverse stock
splits, stock dividends, or other equity
transactions that must be retrospectively
presented under ASC 260.9
| Use the number of shares of common stock and potential common stock (i.e., stock
options, convertible securities) actually
outstanding in each prior financial reporting
period as the denominator, adjusted for any stock
splits, reverse stock splits, stock dividends, or
other equity transactions that must be
retrospectively presented under ASC 260.10
|
For carve-outs, the approach described in the table
above will often result in inclusion of the dilutive effects of
potential common stock by the spun-off entity only from the date on
which those instruments are issued or granted. It is very common for the
spun-off entity to grant share-based payment awards to employees on or
shortly after the spin-off to “replace” awards previously granted by the
parent. The dilutive impact that the “replaced” awards previously had on
the parent’s diluted EPS will generally not be reflected by the spun-off
entity in its historical financial statements, because the calculation
of diluted EPS takes into account the dilutive effects of the spun-off
entity’s potential common shares only from the date they are granted and
ignores any potential common shares held by employees of the spun-off
entity that were outstanding in prior periods and granted by the parent.
The basis for the approach applied by carve-outs is as
follows:
- Since no shares of common stock have actually been outstanding in periods before the spun-off entity became a separate public entity, the number of shares of common stock issued as of the date the entity went public as a separate entity is the most objective measure of the outstanding common shares for historical calculations of EPS. Furthermore, treating such common shares as if they had been outstanding for all prior financial reporting periods is consistent, by analogy, with the treatment of stock splits and reverse stock splits under ASC 260.
- Any options, warrants, or other potential common shares that were not previously outstanding should not be included in the historical number of shares outstanding for diluted EPS purposes. Rather, options, warrants, or other potential common shares issued after the date the spun-off entity became a separate public entity should only be reflected from the date of issuance in accordance with ASC 260 (i.e., such issuances do not reflect items that are presented retrospectively under ASC 260).
- Conversions of preferred stock or other securities into common stock, as well as other changes in capital structure occurring after the date the spun-off entity became a separate public entity, are not included in the weighted-average shares of common stock for the historical periods in accordance with ASC 260. Rather, only stock splits, reverse stock splits, and other similar transactions that must be treated retrospectively under ASC 260 are treated on a retrospective basis. (Note that such treatment is inherent given that the actual number of shares of common stock on the date the spun-off entity went public is generally used in the calculations of historical EPS amounts.)
The approach applied to carve-outs will result in
reported EPS amounts that are not comparable to EPS amounts presented
after the date on which the spun-off entity becomes publicly traded. A
lack of comparability may also result from other changes in the spun-off
entity’s capital structure that occur after the spin-off is
completed.
For existing subsidiaries, the approach described in the
table above fosters consistency with the calculation of historical EPS
by existing subsidiaries spun off from their parent that previously
presented EPS under ASC 260 because they were publicly traded entities
before the spin-off. However, this approach applies regardless of
whether the existing subsidiary originally presented EPS in its
historical financial statements before it became a separate public
entity. In applying this approach, the existing subsidiary may be
required to estimate the fair value of its common stock in prior
financial reporting periods so that it can apply the treasury stock
method or reverse treasury stock method of calculating diluted EPS. The
EPS amounts for prior financial reporting periods generally will be the
same amounts that were reported in the filing with the SEC to consummate
the spin-off. Thus, the fair value estimates of the existing
subsidiary’s common stock were most likely previously estimated.
The extent to which historical amounts of the existing
subsidiary’s basic and diluted EPS differ will depend, in part, on the
extent to which its capital structure was largely independent of the
capital structure of the larger consolidated group. For example, if the
share-based payment awards of the existing subsidiary’s employees were
previously granted by the parent, the dilution potentially caused by
those instruments may not be reflected in the historical diluted EPS of
the existing subsidiary.11 However, if the existing subsidiary’s capital structure was
largely independent of the parent (e.g., the existing subsidiary
previously granted share-based payment awards to its employees that were
indexed to the existing subsidiary’s common stock), the dilutive impact
of employee share-based payment awards may be included in the historical
diluted EPS of the existing subsidiary.12 Thus, the comparability of historical EPS amounts to EPS amounts
reported for financial reporting periods after the spin-off will depend
on the extent to which the existing subsidiary operated a capital
structure separate from its parent before the spin-off.
Connecting the Dots
The two approaches described above obviate the
need for spun-off entities to apply significant judgments and
assumptions regarding the number of common shares, participating
securities, and potential common shares that may have existed if
they had operated as a separate entity during the historical
financial reporting periods. The judgments and assumptions that
a spun-off entity would need to apply to the historical
financial reporting periods before it was a separate publicly
traded entity, so that the spun-off entity could calculate basic
and diluted EPS as if it operated independently and separately
from its parent, would cause the EPS amounts to be more pro
forma in nature.
The two approaches described above also
appropriately take into account changes in the spun-off entity’s
capital structure that occur before or contemporaneously with
the initial issuance of the spun-off entity’s common stock.
Generally, when a parent owns 100 percent of a subsidiary, the
number of outstanding shares of the subsidiary’s common stock,
if any, is largely irrelevant (e.g., whether a subsidiary has
one share or one billion shares of common stock issued to its
parent). Since an entity that applies either approach would
effectively treat changes in capital structure involving the
outstanding number of common shares of the spun-off entity’s
common stock in the same manner as a stock split or reverse
stock split, when those changes occur before or
contemporaneously with the initial offering of the spun-off
entity’s common stock, EPS amounts presented in the historical
periods are not affected by the share ownership structure that
existed when the parent owned 100 percent of the spun-off
entity.
While these two approaches eliminate the need
for entities to use significant judgments and estimates that
would be necessary under an approach whose objective is to
reflect historical EPS amounts as if the spun-off entity was
previously separate and independent from its parent, these
approaches may result in a significant lack of comparability
with EPS amounts reported after the spin-off. Therefore,
spun-off entities should consider the disclosures they may need
to provide to inform financial statement users about this lack
of comparability. In certain circumstances, pro forma EPS may be
required for changes in capital structure (see Appendix
B).
Connecting the Dots
Between January 1, 2016, and July 1, 2021, 93
spin-offs were identified by using publicly available
information for which the spun-off entity made filings to the
SEC under U.S. GAAP. In a review of these filings, the following
observations were noted regarding EPS amounts presented for
annual historical financial reporting periods in the spun-off
entity’s first filing after the spin-off on Form 10-K:
-
For the 71 spun-off entities that presented combined financial statements before the spin-off (i.e., carve-out entities):
- Fifty-six entities included the same number of common shares in basic and diluted EPS in each historical period before the spin-off; this number of common shares was calculated on the basis of the distribution ratio as of the spin-off date.13
- Five entities presented the
same number of common shares in the denominator of
basic EPS for each historical period before the
spin-off; this number of common shares was
calculated on the basis of the distribution ratio
as of the spin-off date. These five entities
presented a number of common shares in the
denominator of diluted EPS that exceeded the
number of common shares included in the
denominator of basic EPS.
- Three of these entities presented the same number of common shares in the denominator of diluted EPS for each historical period before the spin-off (unless the entity reported a net loss in a period); this number of diluted shares was calculated on the basis of the dilutive effect of potential common shares as of the date of the spin-off.
- Two of these entities presented the same number of common shares in the denominator of diluted EPS for each historical period before the spin-off (unless the entity reported a net loss in a period); these entities did not disclose the method used to calculate the number of incremental common shares for diluted EPS.
- Six entities were merged with another entity immediately after the spin-off; therefore, amounts of basic and diluted EPS for historical periods were based on the shares of the acquirer.
- Three entities did not present EPS amounts for the historical periods before the spin-off. One of these entities did present pro forma EPS information that assumed the spin-off had occurred as of an earlier period.
- One entity presented a different number of common shares in the denominator of basic EPS for each historical period before the spin-off and a different number of common shares in the denominator of diluted EPS for each historical period before the spin-off (unless the entity reported a net loss in a period); the number of common shares for basic and diluted EPS differed in all historical periods before the spin-off (unless the entity reported a net loss in a period). The notes to that entity’s financial statements disclosed that the entity determined the number of common shares for basic and diluted EPS by multiplying the distribution ratio by the number of weighted-average basic and diluted shares previously reported by its parent.
- Each of the 19 spun-off entities that
presented consolidated financial statements before the
spin-off (i.e., existing subsidiaries), as well as the
three entities that presented both combined and
consolidated financial statements before the spin-off,
had specific facts and circumstances that affected the
number of common shares used in the calculations of
basic and diluted EPS in the historical financial
statements with respect to reporting periods before the
spin-off.
- Ten entities had previously presented basic and diluted shares in each historical period before the spin-off on the basis of the amounts they had previously reported as stand-alone entities (e.g., publicly traded entities); in some situations, the basic and diluted share amounts were retrospectively adjusted to take into account a stock split or reverse stock split that occurred in conjunction with the spin-off.
- Six entities included the same number of common shares in basic and diluted EPS in each historical period before the spin-off; this number of common shares was calculated on the basis of the number of common shares outstanding as of the spin-off date (retrospectively adjusted to take into account a stock split or reverse stock split that occurred in conjunction with the spin-off, as applicable).
- Three entities that had previously presented basic and diluted EPS in the audited financial statements that were included in the SEC filing related to the spin-off presented the same number of basic and diluted shares in the historical periods before the spin-off that were previously reported (retrospectively adjusted to take into account a stock split or reverse stock split that occurred in conjunction with the spin-off, as applicable). Two of these entities reported only net losses in all historical periods (one of these two entities disclosed potentially dilutive securities that were excluded because they were antidilutive). One entity reported net income in a historical period before the spin-off; in this case, the number of diluted shares exceeded the number of basic shares.
- One entity was merged with another entity immediately after the spin-off; therefore, amounts of basic and diluted EPS for historical periods were based on the shares of the acquirer.
- One entity included the same number of common shares in basic EPS in each historical period before the spin-off; this number of common shares was calculated on the basis of the number of common shares outstanding as of the spin-off date. This entity also included the same number of common shares in diluted EPS in each historical period before the spin-off; this number of common shares equaled the basic shares plus incremental potential common shares that were calculated as of the date of the spin-off.
- One entity did not present EPS amounts for the historical periods before the spin-off. This entity, which was public before the spin-off, also did not present pro forma EPS information.
Of the 93 spun-off entities, only three entities
presented pro forma EPS in the Exchange Act filing after the
spin-off. Each of these three entities was a carve-out entity
before being spun off. In all three situations, the pro forma
information was labeled unaudited and included the impact of a
merger-related transaction that occurred in conjunction with the
spin-off.
We have noted situations in practice in which carve-out
entities did not present any EPS amounts in the historical financial
statements ending before the spin-off date that are subsequently
included in Exchange Act filings with the SEC (although such situations
are not identified in the observations above). The basis for this view
is that the spun-off entity constitutes a combination of businesses,
operations, or subsidiary entities of the parent that represents a new
reporting entity as of the spin-off date. As a result, any presentation
of historical EPS amounts presumably would be considered a pro forma
measurement that is determined not to be appropriate and meaningful to
financial statement users because it does not faithfully represent the
capital structure of the spun-off entity if it had operated
independently in those prior financial reporting periods. In these
observed circumstances, the spun-off entity also did not disclose
historical EPS on a pro forma basis because such information had already
been disclosed in a registration statement filed with the SEC before
completion of the spin-off. Given this diversity in practice, an
approach different from the approach described in Table 8-5 may be
considered acceptable for carve-out entities, depending on an entity’s
specific facts and circumstances. An entity is encouraged to discuss
this matter with its independent accountants and may wish to discuss its
presentation with the SEC staff on a prefiling basis.
8.6.3.3.5 First Quarterly Financial Reporting Period as a Public Entity
The calculation of basic and diluted EPS for the first
quarterly financial reporting period that ends after the spin-off should
be based on the shares of common stock and potential common stock
outstanding during that financial reporting period. If a spin-off occurs
within a financial reporting period, the first quarterly financial
statements of the spun-off entity ending after the spin-off will contain
“pre-spin” and “post-spin” days. For spun-off entities that were
previously carve-outs, there are two acceptable approaches an entity can
apply to calculate the weighted-average common shares and potential
common shares used to calculate diluted EPS for the first quarterly
financial reporting period ending after the spin-off. The spun-off
entity could use the number of shares of common stock outstanding as of
the date the entity went public (i.e., the spin-off date) as the number
of shares outstanding during the pre-spin days. This is the approach
described for carve-outs in Table 8-5. Alternatively, an
entity could, to enhance comparability, assume that the following number
of weighted-average common shares and potential common shares calculated
for the post-spin days was outstanding during the entire quarterly
financial reporting period:
-
The common shares that were issued as of the spin-off date (based on the distribution ratio)
-
The potential common shares issued as of the spin-off date to replace instruments previously issued by the parent.
If this approach is applied, the entity should consider
the possible impact on potential common shares that were forfeited
during the post-spin days in the financial reporting period. See the
example below.
Example 8-18
EPS in First
Quarterly Period After Entity Becomes Public
Entity
Assume the
following:
- Entity C is created to own the assets and liabilities of a carved-out portion of certain businesses of its parent.
- Entity C is spun off from its parent on February 1, 20X1. On that date, C has 100 million shares of common stock outstanding that begin trading on the NYSE.
- Entity C’s first financial reporting period ending after the spin-off consists of a period beginning on January 1, 20X1, and ending on March 31, 20X1.
- On the date of the spin-off, C issues the following instruments to replace instruments previously issued by its parent to C’s employees:
- 500,000 shares of restricted common stock that contain nonforfeitable rights to dividends and meet the definition of a participating security. These awards were previously issued by C’s parent to C’s employees in prior periods and vest over a defined service period on a cliff basis. None of these awards vest during the three months ended March 31, 20X1; however, 50,000 of these awards are forfeited on March 1, 20X1.
- Options to purchase 5 million shares of common stock that do not meet the definition of a participating security. These awards were previously issued by C’s parent to C’s employees and vest over a defined service period on a cliff basis. None of these awards were exercised during the three months ended March 31, 20X1.
- On March 1, 20X1, C issues 50 million additional shares of common stock and a $100 million principal amount of convertible debt securities to third-party investors. On March 15, 20X1, Entity C grants its employees options to acquire 2.5 million shares of common stock. The vesting of these awards is based solely on a service period that begins on March 15, 20X1. The options are not considered participating securities.
In its calculation of
basic and diluted EPS for the three months ended
March 31, 20X1, C applies the following
approach:
- The 100 million shares of common stock that are issued to investors of C’s parent as of the date of the spin-off are considered outstanding for the entire quarterly financial reporting period.
- Regarding the replacement awards:
- The 450,000 restricted stock awards that are issued on the spin-off date and outstanding for the remaining period are considered outstanding for the entire period in the allocation of undistributed earnings under the two-class method of calculating basic EPS for the quarterly period ending March 31, 20X1. With respect to diluted EPS, in the determination of the more dilutive of the two-class method or the treasury stock method for these awards, the weighted-average potential common shares calculated for the period beginning February 1, 20X1, and ending March 31, 20X1, are assumed to be the weighted-average potential common shares outstanding for the entire financial reporting period.
- The 50,000 restricted stock awards that are issued on the spin-off date and forfeited on March 1, 20X1, are considered outstanding from January 1, 20X1, to February 28, 20X1, in the allocation of undistributed earnings under the two-class method of calculating basic EPS for the quarterly period ending March 31, 20X1. With respect to diluted EPS, in the determination of the more dilutive of the two-class method or the treasury stock method for these awards, the weighted-average potential common shares calculated for the period beginning February 1, 20X1, and ending February 28, 20X1, are assumed to be the weighted-average potential common shares outstanding for the period beginning January 1, 20X1, and ending February 28, 20X1.
- The weighted-average dilutive effect of the 5 million stock options issued as replacement awards on the spin-off date, as calculated for the period beginning February 1, 20X1, and ending March 31, 20X1, is assumed to be the weighted-average potential common shares for the entire financial reporting period.
- The additional 50 million shares of common stock and the $100 million principal amount of convertible debt securities issued to investors on March 1, 20X1, are considered outstanding common shares and potential common shares in the denominators of basic and diluted EPS only from the issuance date to the end of the reporting period.
- The 2.5 million options granted as share-based payment awards to employees on March 15, 20X1, are considered outstanding potential common shares in the denominator of diluted EPS only from the date of issuance.
Connecting the Dots
It would be inappropriate for a spun-off entity
not to present the amounts of basic and diluted EPS for the
first quarterly period ending after a spin-off. Even if an
entity concludes that it is appropriate to present such amounts
only for financial reporting periods
ending after a spin-off is consummated (see Section
8.6.3.3.4), it would not be appropriate for the
entity to present basic and diluted EPS in the first financial
reporting period ending after the spin-off only for the days
within that period on which the entity was publicly traded.
8.6.4 Transfers of Net Assets Between Entities Under Common Control
ASC
805-50
Transactions Between Entities Under
Common Control
45-3 The nature of and effects
on earnings per share (EPS) of nonrecurring intra-entity
transactions involving long-term assets and liabilities
need not be eliminated. However, paragraph 805-50-50-2
requires disclosure.
ASC 805-50 provides guidance on the financial statement
presentation of the receiving entity in a transfer of assets and liabilities
among entities under common control. According to that guidance, the receiving
entity must retrospectively adjust financial statements presented for previous
periods during which the entities were under common control to reflect the
transfer. If the receiving entity presents EPS, given the retrospective
adjustments, the entity will also be required to adjust previously reported EPS
amounts. See Appendix
B of Deloitte’s Roadmap Business Combinations for further
discussion of transfers of assets and liabilities between entities under common
control. See also Section
9.2.2.6 for related disclosure requirements.
Footnotes
4
SEC Final Rule 33-10786 should not
change the SEC staff’s views on the guidance that addresses
retrospective treatment of modifications of securities that occur after
the balance sheet date.
5
The staff legal bulletin represents the views of
the staff of the SEC’s Division of Corporation Finance and is
not a rule, regulation, or statement of the SEC.
6
All but three of these filings occurred
before the amendments made by SEC Final Rule 33-10786 to
the pro forma financial information requirements of
Article 11. Therefore, the analyses presented below
related to such filings could be affected by the
different pro forma financial information requirements
before the amendments made by SEC Final Rule 33-10786.
7
The subsidiary entity
established by the parent to effectuate the
spin-off may be initially capitalized with a
nominal number of shares of common stock. At or
before the time the spin-off occurs, the number of
common shares is increased significantly (e.g., in
conjunction with the distribution ratio in a
spin-off). In these situations, the number of
common shares issued as of the date the spin-off
occurs represents the relevant number of common
shares to include in the denominator for all
historical financial reporting periods. The
increase from the number of nominal shares at
initial formation to the number of shares issued
as of the spin-off date represents a stock split
that is treated retrospectively, as described in
Section 8.2.1.
8
See footnote 7.
9
It is not uncommon for
existing subsidiaries to have been historically
capitalized with a nominal number of common
shares. At the time the existing subsidiary’s
common stock is distributed in a spin-off, the
number of common shares is increased significantly
through a stock split. In accordance with ASC 260,
an entity should retrospectively adjust the
outstanding common shares used to compute the
weighted-average shares outstanding for the
effects of the stock split. Additional common
shares that are sold (i.e., “new money”) should be
included in EPS only from the issuance date.
Therefore, adjustments to the EPS amounts
previously included in the registration statement
filed to effectuate the offering of the existing
subsidiary’s common shares would most likely only
be necessary to account for the effect of stock
splits or reverse stock splits that occurred in
conjunction with the offering (i.e., were
effective as of the date of the offering). For the
appropriate treatment of other changes in capital
structure that occur in conjunction with the
spin-off, which may include changes in the form of
ownership or redemptions or conversions of
securities other than common stock, see Section
8.6.2.
10
See footnote 9.
11
The compensation cost, however, will be included
in the financial statements of the existing subsidiary.
12
This situation is more likely if the existing
subsidiary had common stock owned by third parties other than
the parent.
13
Ten of the 56 entities
reported only losses in the historical periods
before the spin-off. Three of the 10 entities that
reported only losses in the historical periods
disclosed a number of potential common shares that
were excluded from the calculation of diluted EPS
in the historical periods before the spin-off
because the inclusion of those shares would have
been antidilutive.